A Survey of Recent PUC Rulings
With most restructuring efforts at a standstill in the energy industry, state public utility commissions (PUCs) have tended to shift their attention back to the art and science of ratemaking. For electric and gas utilities, that has meant a renewed emphasis on the mechanics of setting a maximum allowed rate of return on common equity (ROE). In particular, in rate orders handed down during the past 12 months, state PUCs have focused both on declining interest rates and increased financial risks-and how those two factors should affect investor expectations .
The California PUC offers a prime example of the new challenges faced by PUCs across the country in setting ROE. The state PUC sets ROEs for all of its energy utilities in a single, annual generic proceeding, but, in the recent past, the obligatory work of restructuring and deregulation had thrown the annual process off track.
In general, the California PUC begins with a financial model, such as the discounted cash-flow (DCF) model, then tempers those results with a look at interest rates and financial risk. Interest rate trends offer a benchmark to determine whether ROE should move up or down from the last authorized rate. Risk factors help the PUC decide where to place ROE within the range of reasonableness indicated by the financial model.
Lately it appears that California is getting back on track with its ROE reviews. But past disruptions in the procedural schedule have put the state's investor-owned electric utilities on different timetables, introducing staggered start and end dates from company to company for studies used to estimate capital costs, risk, and financial indicators.
For example, in California's latest reported generic ROE decision for investor-owned energy utilities, issued in November 2002, the PUC increased ROE for San Diego Gas & Electric (SDG&E) in its prior ROE application for calendar year 2003, but not so for Pacific Gas & Electric, Southern California Edison, or Sierra Pacific Power. The reason stemmed from timing differences, as forecasts of interest rate trends pointed steeply downward during the study period applicable to SDG&E .
Nevertheless, policy and mechanics remain important, even in California, regarding two key factors: interest rates and risk.
Interest Rate Trends. In its 2002 ruling, the California PUC stuck with precedent on the effect of interest rates, saying it would continue to rely on "AA"-rated utility bonds rather than 30-year U.S. Treasury bonds as a measure of investor requirements and interest rate trends. The PUC earlier had concluded that prices for 30-year Treasury bonds were susceptible to "tremendous turmoil in the foreign market," as when foreign investors fled to the safety of government-issued securities during the last major stock market sell-off
Financial Risk. On the question of risk, the California PUC also agreed with prior policy that diversifiable risks (those specific to the company) ought not be allowed to inflate the ROE allowance and push rates higher for consumers, since utility companies should be able to mitigate firm-specific risk, such as by assembling a balanced portfolio of investments or supply resources. By contrast, ROE and ratepayers should not get blanket protection from non-diversifiable risk, or market risk, which represents the variability of investment outcomes driven by the economy as a whole.
Nevertheless, the PUC did not ignore diversifiable risks entirely in its 2002 opinion. Rather, it seemed willing to accept the idea that today's utilities face higher risks than before-warranting higher compensation, all else being equal-even if that higher risk level is to some degree a product of an increase in diversifiable risk.
Thus, in its 2002 generic order, the PUC acknowledged that the utilities it regulated had claimed increases in diversifiable and non-diversifiable business and regulatory risks, but it saw little to gain in the current political climate by attempting to analyze and account separately for each category.
In short, the commission said investors and the general public now see the electric utility industry as "highly unstable"-buffeted by broad regulatory and business forces. The utilities themselves have identified a host of new risks: financing of large under-collections, municipalization, performance-based ratemaking mechanisms, cogeneration, direct access, distributed generation, substations, photovoltaic systems, diesel fuel, propane, power procurement, and legislation pending in Sacramento regarding generation, procurement, and purchase of high-cost renewable energy.
Given this climate, the PUC dispatched with any need to exclude diversifiable risk from consideration. Instead, it found a net increase in overall utility risks. That increase warranted an ROE award for calendar 2003 at the middle to upper end of the range otherwise found just and reasonable for each utility.
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