Ratemaking Special Report

Return on Equity:

Fixing an appropriate rate of return on equity (ROE) for electric utility investors marks a fundamental component of the typical cost-of-service rate case conducted across the nation by state public utility commissions (PUCs). The following survey demonstrates the results of such cases, as observed over the past year.

As usual, the debate over ROE centers on current trends in interest rates, plus changes in the overall pattern of industry risk-as affected by on-again, off-again efforts at utility industry restructuring. Consider a recent decision from Connecticut as a good example of the broad range of issues that arise. In a case setting rates for Connecticut Light & Power Co. (CL&P), the state PUC said it was unable to justify the company's then-current ROE allowance of 10.3 percent-last set in Connecticut in a 1998 rate order-since a number of changed circumstances had intervened. It lowered ROE to 9.85 percent-below the 10-plus level often awarded by other states for other utilities during the same period. It cited factors such as:

Lower interest rates. (20-year T-Bond yields down from 5.5 to about 5.3 percent.)

Improved financial strength. (Bond ratings up from Ba2 to A2 [Moody's], and from BBB- to A- [S&P]. Equity ratio up from 33.4 to 51.1 percent.)

Lower business risk. (Divestiture of all generating plants.)

Lower tax rates. (New federal rate caps of 15 percent on both capital gains and corporate dividends).

In other words, more equity in capital structure implies less investor risk and undercuts need for a higher ROE. And lower interest rates put downward pressure on what utility stockholders might expect to receive from competing investments.

But another important factor, beyond the simple financial indexes, is the question of intangible industry risk. State regulators worry about events such as last summer's Northeast blackout. They fear that the new market institutions imposed by regional grid operators may fall short of ensuring the degree of reliability of service that customers (and investors) have come to expect.

Consider a second recent decision, from Indiana, setting rates for PSI Energy.

In that case, the company argued that the utility industry faces many uncertainties that augment risk: Stricter environmental regulations, changes in ownership, a strained transmission grid, and continuing controversy over wholesale market design and operation. Yet the commission accepted arguments by opposing parties that the numerous cost trackers used by PSI had distinguished PSI from other utilities and mitigated any excessive regulatory risks.

"The inescapable fact," said the commission, "is that trackers reduce risk to a utility and PSI has many more trackers than its peers."

Other changes brought by restructuring may also trim risk.

In the CL&P case cited above, the state PUC stressed that the selloff of power plants (making CL&P a wires-only utility) had enhanced the company's business profile, with management able to turn it focus to the lower-risk transmission and distribution systems. Moreover, as the PUC noted, utilities now collect a higher proportion of distribution costs through fixed charges than in the past.

And lower utility ROEs mirror the general downturn in stock prices seen in the early years of the new century. According to the Connecticut commission, CL&P had reinforced that notion by its own testimony regarding the cost of its pension plan. The decision notes that the company had testified that long-term expectations of returns for its pension plan (with assets devoted 70 percent in equities) should be lowered from 9.25 percent (as in 2002) to 8.75 percent, for the rate case test year.

How the Survey Was Conducted

This year's survey covers determinations of the cost of equity capital as made by state PUCs during the period from Oct. 1, 2003, through Sept. 15, 2004. The survey method remains similar to past years. Requests for information on the results of recent rate proceedings were sent to both regulators and utility financial officials. Direct examination of the commission rate orders, where available, provides additional information.

The traditional cost-of-service rate case remains the most obvious source of information on how utility regulators view the issue of shareholder earnings requirements. Nevertheless, other proceedings may contain findings relative to ROE, and those rulings are reported here as well, including cases that deal with performance-based rate plans, periodic earnings reviews, and special proceedings to determine revenue requirements for restructured electric "delivery-only" utility operations.

Explanatory notes accompany most entries, and citations (volume and page number) are provided for orders published in .

Endnotes

* Approved settlement agreement.

1. Settlement presented as basis for bankruptcy reorganization plan provides a $7.2 billion ratepayer contribution to utility's unrecovered costs of utility service. Approved agreement also creates a $2.21 billion regulatory asset to be amortized over 9-year period.
2. Reflects reduction to business risk attributable to implementation of balancing account rate mechanism, attrition year rate plan, and accelerated pipeline replacement program.
3. Application for approval of four-year rate plan for distribution and transmission services.
4. Utility requested increases of $140.1, $168.8, $195.6 and $226.3 million for rate plan years 2004 through 2007.
5. Department approved rate increases of $1.9, $25.1, $11.9 and $7 million for rate plan years 2004 through 2007.
6. ROE reflects reduced operating risk following industry restructuring and the divestiture of generation.
7. Utility's prior rate case decided 11/23/93.
8. PSC imputed short-term debt rate of 3.9% even though actual short-term loan rate was 7% to account for financial losses attributable to non-utility operations.
9. Approved ROE, which is greater than the 11.25% rate approved by the PSC in two other recent gas rate proceedings, is warranted by the small size and risk profile of the LDC.
10. Authorized ROE reflects finding by commission that utility faces financial risk due to numerous rate adjustment trackers that allow for periodic cost-based adjustments between rate cases.
11. Utility seeks temporary increase as shown and permanent increase of an additional $149.2 million. Board grants temporary increase as shown.
12. ROE from prior rate decision adopted for purpose of calculating temporary revenue requirement. ROE of 12.23% applied to investment in new generating plant pursuant to prior certificate ruling. Iowa UB issues binding rate findings as part of new plant certification process.
13. Utility authorized to reverse a write-down to equity resulting from adoption of Statement of Financial Accounting Standards No. 130 (Reporting Comprehensive Income) which required company to disclose a contingent minimum pension liability.
14. Utility required to file cost of service update pursuant to prior ruling approving a merger to determine if rate reduction is required.
15. PSC finds no rate decrease necessary. Rates capped through 2006 pursuant to prior approved merger agreement.
16. Initial rate increase serves as basis for newly approved performance-based rate plan.
17. Rate increase shown offset by $3.09 million elimination of universal service fund interim rate, $21.68 million gas cost adjustment, $0.73 million transitional energy facility adjustment, $6.78 million temperature adjustment clause rate adjustment, and $6.64 million gas supply service rate roll-in.
18. Three-year rate settlement approved 10/25/01. Commission approved rate plan modification 6/14/04 extending rate for 2 years to 6/06. ROE remains at 10.3% as decided in prior ruling. Prior ruling includes revenue sharing as follows: 100% to shareholders from 10.3% to 11.3% - 50/50 sharing of earnings from 11.3% to 14% - Above 14% 100% to ratepayers.
19. Commission updates revenue sharing plan. New sharing points as follows: 100% to shareholders at 10.3% to 10.5% earnings level - 70% shareholders/ 30% ratepayers at 10.5% to 11.3% earnings - 65% shareholders/ 35% ratepayers at 11.3% to 14% earnings and 100% to ratepayers at 14% and above earnings.
20. Proposed rates filed May 16, 2003. Utility also filed electric rate unbundling plan pursuant to prior order.
21. Multi-year rate plan calls for rate freeze through 2008. PSC approves initial rate increases as shown through implementation of electric retail access surcharge and natural gas merchant function charge.
22. Electric plan requires equal sharing with ratepayers of earnings above 12.25% threshold, while gas plan requires equal sharing above 12%.
23. Rate case was settled - ROE was NOT settled. Staff refused to go higher than 10%. Company refused to go lower than 10.75. In the end, case was settled on dollar amount.
24. Order approving agreement restricting ability of utility to seek future rate increase and reducing allowed ROE.
25. Utility filed cost of service study pursuant to prior ruling.
26. Proceeding follows finding by Department that sale of interest in nuclear facility by utility reduced revenue requirement.
27. Department reduces 10.5% ROE included in settlement agreement finding lower rate better matched existing market conditions.
28. Order approving application for authority to construct new generating facilities.
29. Commission finds it reasonable to set the following financial terms for facility lease: 12.7% return on equity and capital structure of 55% equity and 45% debt.
30. Final requirement unstated.
31. Commission rejected 0.25% "Wyoming-specific" risk premium proposed by the utility to account for past disallowance of deferred power costs.

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