A material capital structure mismatch, which occurs frequently, can lead to material misestimates of the appropriate allowed return on equity, perhaps on the order of 2 percentage points. That is...
Why similar U.S and Canadian risk profiles yield varied rate-making results.
clauses (to pass through the cost of purchased fuel), weather normalization clauses (to account for variations in revenue due to abnormal weather), and revenue decoupling mechanisms (to compensate for declining average use per customer). In fact, regulators in the United States are somewhat more likely to approve weather normalization clauses and revenue decoupling mechanisms. Further, U.S. regulators more commonly approve cost-tracking mechanisms for capital improvements and allow construction work in progress in rate base than do their Canadian peers.
Can a formula work?
The question remains whether regulators can effectively utilize a formula to establish the authorized ROE for regulated public utilities. Despite the inherent appeal of a formulaic approach, there are many obstacles that must be overcome. For example, if the formula is based on a single variable, such as the level of government interest rates, it might not fully reflect the different factors that equity investors consider when determining their required rate of return for a regulated public utility. Further, a formulaic approach can be severely tested when economic or financial market conditions deviate from long-term trends. Volatility in financial markets can cause every asset class to diverge from normal relationships with bonds. A fair return must ensure that the public utility has the opportunity to attract capital and maintain its financial integrity under a variety of different market conditions. The regulator has an obligation to set ROE so that the utility can raise the capital it needs to continue to provide safe and reliable service to customers. For these reasons, Canadian regulators are beginning either to modify the formula or abandon it entirely. Ontario decided to modify its existing formula in an effort to better reflect the risks associated with owning equity in a regulated utility via the replacement of government bond yields with utility bond yields, and reducing the sensitivity from 0.75 to 0.50. The NEB abandoned the formulaic approach in lieu of one that considers the utility’s overall cost of capital, including the capital structure, the cost of long-term debt, and the cost of common equity (ATWACC). British Columbia eliminated its current formula and directed that alternative approaches be examined. Alberta has suspended the use of its formula until financial markets settle and will re-evaluate the matter in 2011.
A formula recently was implemented in California. The California Public Utilities Commission (CPUC) uses the traditional DCF and CAPM approaches to establish the initial baseline ROE every three years, and that rate is then adjusted based on annual changes in corporate bond yields. By relying on a corporate bond yield rather than a government bond yield, the CPUC has chosen a method that reflects some of the risk factors associated with common equity. Both types of financial securities are subject to concerns about credit risk and default risk, while the government bond yield fails to reflect those important considerations. Regulators will be watching the success of the California formula and the revised Canadian adjustment mechanisms to see if formulae can be implemented while still satisfying principles of a fair return.
Many Canadian regulators are concluding that the task