A spate of newly announced deals, including Allegheny Energy’s proposed $9.27 billion acquisition of FirstEnergy, plus PPL’s takeover of E.ON US for $6.73 billion, has left the utility industry...
Why similar U.S and Canadian risk profiles yield varied rate-making results.
investors generally are concerned with three categories of risk: 1) financial risk; 2) business risk; and 3) regulatory risk. Consumer advocates argue that the Canadian regulatory environment offers additional protection for regulated utilities that aren’t available for most U.S. utilities. Specifically, they contend that Canadian-regulated utilities have lower risk profiles due to the use of deferral accounts and variance accounts, which reduce revenue uncertainty, and the prevalence of forecasted test years, which reduce regulatory lag.
However, upon examination of the regulatory landscapes in Canada and the United States, it becomes apparent that there are more similarities than differences. The NEB came to this conclusion when it found “[T]he Board’s view [is] that risk differences between Canada and the U.S. can be understood and accounted for, [and] the Board is of the view that U.S. comparisons are very informative for determining a fair return…” 5 The Ontario Energy Board concurred when it declared that “North American gas and electric utilities provide a relevant and objective source of data for comparison.” 6
There now have been issued five important provincial and federal decisions pertaining to the continued use of the formula and related cost of capital issues over the past year. Each of these decisions reflects the unique perspectives of the boards and the evidence evaluated, but there are some common threads:
• The current formula was suspended or eliminated in four of the five jurisdictions. Only Quebec kept the existing formula after resetting ROE;
• All boards, except Quebec, found data on U.S. utilities to provide beneficial information in reaching decisions;
• All boards recognized, to some degree, problems associated with exclusive reliance on the CAPM or ERP methods. They all relied upon multiple methods in reaching their decisions, and there was universal agreement with the Hope standard that it’s the results, and not the method that determines fairness;
• These provincial decisions allowed ROEs in the 9- to 10-percent range for rate periods 2009 through 2011, a considerable improvement over formula-produced ROEs approaching 8 percent for 2009; and
• Equity levels weren’t similarly impacted, with only modest changes from prior levels.
While these decisions, taken as a whole, reflect an encouraging trend toward a North American perspective on cost of capital, they also reveal the need for additional analysis and evidence to assist regulators with evaluation of relative risk across jurisdictions and between companies. This approach makes sense as financial markets have become more integrated and global in nature. Canadian utilities are competing for capital with companies from around the world. A lower authorized return places Canadian utilities at a relative disadvantage in terms of raising capital because equity investors typically perceive the risks associated with this group to be similar, if not comparable, to that of U.S. utilities.
Research has revealed that Canadian and U.S. regulated utilities have similar risk profiles, especially in terms of the most important factors that affect the stability of earnings and cash flows. Cost-recovery mechanisms are commonplace in both countries to mitigate various operating risks. For example, regulators tend to approve cost-recovery mechanisms such as fuel-recovery