Utility companies are actively engaged in a range of activities with the goals of reducing the effects of weak demand, a higher uncertainty in energy costs, increased capital costs, and stagnant...
Why similar U.S and Canadian risk profiles yield varied rate-making results.
historic lows. Because the generic ROE formula used this government interest rate as its platform, the formula produced abnormally low results during a period in which investors were increasingly risk averse.
Formulaic Approach Problems
A formulaic approach to establish the allowed ROE for a public utility suffers from two primary challenges: 1) developing a formula that captures the complexity of investor-required equity returns amid varied economic and financial market conditions; and 2) updating the formula to reflect current economic and financial market conditions. Canadian utility regulators developed an ROE formula that relied exclusively on changes in the yield on the government of Canada’s long bond. For example, under the generic formula adopted in most Canadian provinces, when government bond yields declined by 100 basis points (1 percent) over the course of one year, the authorized ROE would decrease by 75 basis points (0.75 percent). As government interest rates steadily declined after the adoption of the ROE formula, the authorized ROE for regulated utilities followed a similar downward path. However, cost of equity capital doesn’t always decline when government bond yields are falling.
A case in point occurred during the recent financial crisis and economic recession, when credit spreads widened significantly and equity market volatility rose to unprecedented levels. The spread between government bond yields and corporate bond yields of comparable maturity expanded as central banks reduced their target interest rates in order to stimulate economic growth, while corporate bonds were perceived as more risky because investors were concerned with possible credit downgrades and higher default risks. Similarly, volatility in the equity markets, as measured by indicators such as the Chicago Board Options Exchange Volatility Index and the Montreal Stock Exchange’s Implied Volatility Index, rose to unprecedented levels, as equity investors feared financial markets would collapse after the U.S. bankruptcy filing of Lehman Brothers.
Despite the significantly higher risk in both the credit and equity markets, the Canadian ROE formula continued to produce lower returns on equity because government interest rates were declining in response to changes in monetary policy from the Federal Reserve Board and the Bank of Canada. The government bond yield simply failed to accurately reflect the risks associated with owning the common equity of regulated utilities. At a time when required equity returns were unmistakably increasing to reflect the heightened level of risk in financial markets, the formula was producing counter-intuitive results. This occurred because the ERP embedded within the ROE formula remains relatively static, 4 while, in reality, the ERP is constantly changing as investors’ perceptions change regarding the risk-reward relationship for common stocks. This situation demonstrates the difficulty of relying on any single variable—in this case government bond yields—to establish an appropriate ROE that satisfies the fair return standard.
Relative Risk Profiles
One way to assess the reasonableness of allowed ROEs for Canadian-regulated utilities vis-à-vis their U.S. counterparts is to examine the relative risk profiles of the two groups. Some consumer advocates have contended that the difference in authorized returns between Canadian and U.S. utilities can be justified by the differences in relative risk. For regulated utilities,