Regulators are in the unenviable position of determining an allowance for ROE that’s fair to consumers and investors in a volatile economy. The cases that stand out this year are those in which regulators explored the limits of their discretion.
A review of the rate cases decided over the past year indicates that the economy remains at the forefront in the news, and on the minds of regulators in rate-case proceedings. The issue has taken a new twist, however, as regulators are now placed in the unenviable position of determining an allowance for return on equity (ROE) that’s fair to consumers and investors in a volatile economy. When Fortnightly presented this feature last year, we reported that regulators were seeking to determine the effect the dip in the stock market, falling interest rates and tightening credit might have on financial modeling, as well as subjective views of the return necessary to attract investors. This time, the cases that stand out are those in which regulators are exploring the limits of their discretion under the regulatory compact to balance the interests of consumers and shareholders in the face of a severe economic downturn.
The task of setting the return or profit component of regulated rates for utility service is one that begins with a review of mathematically derived estimates of the return expected by investors in the future. Regulators also are called on to use their informed judgement to produce a result that’s fair to consumers and investors alike. The final answer often is expressed as a range of “reasonable” results that would at either end provide a fair return to investors and reasonable rates for consumers. This gives regulators some wiggle room when determining a final ROE figure or when seeking other ways to hold down rates for consumers—or to keep rates high enough to make sure a utility has access to capital.
A recent case decided in Michigan shows how the financial crisis might redound to the benefit of shareholders in a rate-case setting. In that case, the state public service commission (PSC) ruled that Detroit Edison’s ROE should remain at 11 percent, even though its staff recommended a rate of 10.5 percent and other parties presented evidence supporting lower figures. The utility had asked for an allowance of 11.25 percent, a rate only slightly above the approved rate set in 2006. The PSC concluded that maintaining the status quo on the company’s ROE in light of Michigan’s economic circumstances and the U.S. credit crisis was the most prudent course of action. The commission said the worldwide crisis and ensuing breakdown in confidence among financial institutions led to rising long-term borrowing rates. It also noted that the credit-system freeze causes concern for the utility’s continued ability to provide financing for infrastructure investment needs, and then to continue to provide safe, reliable and abundant power at reasonable rates. The PSC concluded that “a cautious approach in changing the company’s ROE is necessary to ensure investor confidence and company access to capital markets” [Re The Detroit Edison Co., Case No. U-15244, 270 PUR4th 134 (Mich.P.S.C.2008 )].
Regulators in Connecticut looked at the crisis another way. While setting rates for United Illuminating (UI), the Connecticut Department of Public Utility Control (DPUC) lowered the company’s ROE from a level of 9.7 percent set in 1996 to 8.75 percent in a rate case heard this year. It rejected a claim by the electric utility that financial models relied on in the past should be adjusted to account for a change in investor behavior as a result of the crisis, including a shift away from looking at dividend payments as a measure of long-term growth and instead focusing more on earnings per share as a guide to investment decisions. The company claimed that dividend growth has remained stagnant due to heightened financial concerns in the utility industry. Expressing a keener interest in the macroeconomic issues at play, the DPUC concluded that although the overall outlook for the economy as a whole is weak, investors likely will continue looking to the utility sector as a safe haven amidst a volatile market environment. The DPUC said that even though the company was embarking on a high volume of capital spending and infrastructure improvements, that would be offset by UI’s strong financial position, limited risk profile, visible forward-earnings stream, high dividend yield, strong balance sheet and strong cash position. Despite higher spreads and yields, utilities still outperform most sectors of the bond market. As such, the cost of equity for the electric industry is among the lowest of all industries in the United States. All these indicators suggested a substantial decline in the overall equity cost rate, in the view of the DPUC [Re The United Illuminating Co., Docket No. 08-07-04, Feb. 4, 2009 (Conn.D.P.U.C.)].
Focusing directly on the plight of consumers during the current economic crisis, the DPUC in a second case reduced rates for a natural gas local distribution company (LDC) by $16.2 million, reflecting an allowed ROE of 9.31 percent. The department rejected claims by the utility that a rate increase was required due to current economic conditions that had resulted in nearly 15,000 residential service terminations due to non-payment of bills. Rather than hike rates to cover past-due bills, the current economic conditions required the LDC to share in the economic difficulties of Connecticut citizens by aggressively managing its operational expenses and capital investments, the department said. Driving home this point, the DPUC disallowed for rate-making purposes, costs incurred for non-qualified pension plans, finding that ratepayers shouldn’t have to fund excessive pension benefits in difficult economic times [Re Connecticut Natural Gas Corp.,274 PUR4th 345 (Conn.D.P.U.C. 2009)].
In perhaps the most dramatic example of ratemaking meets an economy in crisis, the New York Public Service Commission (PSC) has in recent cases addressed consumer issues by imposing what it calls an “austerity savings” adjustment for energy utilities operating in the state. In those cases, the PSC actually increased the ROE in accordance with the results of financial models, but at the same time took away revenues by adjusting cost-of-service estimates to reflect the savings expected under mandated austerity savings programs. The PSC was careful to explain, however, that if the cost savings weren’t found, the utility could petition for a deferral of the costs and possible recovery in a future rate period.
For example, the PSC recently has approved a rate increase of $721 million for Consolidated Edison of New York. In that case, the PSC established an ROE of 10 percent for the utility, an increase from its earlier authorized ROE of 9.1 percent. The PSC reviewed several measures designed to reduce the level of the increase in the context of the current economic downturn. It determined that Con Edison should impose additional cost-cutting measures and directed the company to identify and implement an “austerity budget” that would reduce its revenue requirement by $60 million for the coming year.
The issue of the proper ROE remained separate from the austerity savings ruling, however. Through the trial briefing stage, the company supported an 11-percent equity return allowance but reflected only 10 percent in its May 2008 tariff filing. The PSC noted that it’s unusual for a utility to support one equity return in testimony and to reflect a lower one in the revenue request set forth in its tariff filing, but accepted the filing and went on to examine the results of financial models presented in the case. The PSC did note that the revenue requirement difference between 10 percent and 11 percent was approximately $115 million a year. The company described its 10-percent request as part of its proposal to “ameliorate bill impacts on customers.” The PSC went on to find that assigning a two-thirds weight to results under its own discounted cash flow analysis, and one-third weight to an average of the capital asset pricing model to the results presented by the parties to the case, showed that independent of the company’s offer to settle for a 10-percent return based on its original request, the same increase in the company’s ROE proved to be the one that the evidence had shown to be adequate to compensate investors and attract capital in the near future.
Nevertheless, turning back to the issue of the macroeconomic concerns in the marketplace, the PSC stated that expenditures that are reasonable during average or good economic times aren’t necessarily reasonable when economic conditions are extremely poor. When consumers are experiencing an extraordinarily harsh economic climate, a certain measure of frugality is properly expected from utilities and a reprioritizing of expenditures may be needed, the PSC said, citing such measures as freezing executive pay, restricting hiring, cutting travel costs and other so-called “discretionary” expenses. With this said, it ordered a downward adjustment to the company’s revenue requirement amounting to $60 million, half of which will be subject to further review and potential deferral based on a review of the company’s ability and best efforts to implement the required measures effectively. It pointed out that this amounts to approximately 3.6 percent of non-fuel operation and maintenance costs and emphasized that the company’s management will be responsible for determining how best to achieve the $60 million revenue requirement reduction while maintaining reliability, service quality, and safety [Re Consolidated Edison Co. of New York, Inc., Cases 08-E-0539, 08-M-0618, Apr. 24, 2009 (N.Y.P.S.C.); See also Central Hudson Gas & Electric Corp., 274 PUR4th 257 (N.Y.P.S.C. 2009) where the PSC also discussed macroeconomic conditions that may be used as a basis for requiring the so-called austerity adjustments to a company’s revenue requirements].