Forecasts Send ROEs Wide of the Mark
In a recent "Offpeak" ("Forecasting is Just That," Jan. 1, 1996, p. 54), David Foti and Clay Denton report data showing the percentage of error found in various seven-year forecasts of natural gas prices (1988-94) produced by the American Gas Association (A.G.A.), Energy Information Administration (EIA), DRI/McGraw-Hill (DRI), Gas Research Institute, and WEFA Group. These errors ranged from approximately 50 to 95 percent.
What does that say about utility ratemaking, where regulators sometimes rely on a 20-year horizon?
Until recently, the Federal Energy Regulatory Commission (FERC) has calculated just and reasonable rate of return on equity (ROE) using the traditional Discounted Cash Flow (DCF) model, which posits that investors require an ROE equal to the sum of the expected yield for the next period, plus the anticipated (by investors) long-term growth rate (g) in cash flow (dividends). The simplified constant-growth version of this model is: r = D1/Po + g, where Po is an estimate of the current price of the stock, D1 denotes the next-period expected dividend, and g indicates the expected annual growth rate in dividends. The FERC estimates the next-period expected dividend by adjusting the indicated dividend for one half-year of expected growth. The adjustment factor = 1 + g/2.
For many years, the FERC determined the requisite growth term g using financial forecasts (Value Line, Zack's, IBES, and others) of the rate of earnings growth for natural gas pipelines or electric utilities. It then converted these earnings-growth forecasts to
estimated growth rates for dividends through the model relationship g = b x r, where b represents the forecasted rate of earnings on book value and r marks the retention ratio. However, in a line of recent cases, the FERC has virtually abandoned its traditional use of the DCF model. (See, Ozark Gas Trans. Sys., 68 FERC ¶ 61,032 ; NW Pipeline Corp., 71 FERC ¶ 61,253 ; Panhandle Eastern Pipe Line Corp., 71 FERC ¶ 61,228 ; Williston Basin Interstate Pipeline Co., 72 FERC ¶ 61,074 .)
In calculating the g term, the FERC now skips over the step that converts earnings estimates to dividend estimates. Instead, the FERC relies directly on earnings-growth rate estimates, as though they were equivalent to the dividend-growth rates required by the DCF model. Further, with respect to these earnings-growth rate estimates, the FERC has decreed that "a projection limited to five years, with no evidence of what is anticipated beyond that point, is not consistent with the DCF model and cannot be relied on in a DCF analysis" (Ozark at ¶ 61,105).
In Ozark, FERC staff employed 20-year forecasts of natural gas consumption prepared by DRI/ McGraw-Hill as a proxy for the long-term earnings-growth rate for interstate natural gas pipelines. The FERC rejected an initial determination by a skeptical administrative law judge (ALJ): "The DRI data have no demonstrated accuracy, are related only in a tangential sense to the gas pipeline industry, and are not relied on by investment advisory services." Instead, the FERC accepted the position of the staff witness that "reliance on DRI data in projecting long-term growth is reasonable," and that the DRI data provided "the best proxy [the witness] found for pipeline earnings growth to meet the requirements of the DCF methodology assuming a stream of income in the future" (Ozark at ¶ 61,106-7).
Moreover, in Williston Basin the FERC found that, as compared to traditional financial forecasts, "DRI is a better measure of long-term growth expectations and will be used for that purpose" (Williston Basin at ¶ 61,376). In that case the FERC took "official notice of the DRI data for gas consumption and retail price . . . to calculate a long-term dividend growth rate." Subsequently, FERC staff and other parties testifying on rate of return generally have included forecasts in their DCF g term calculations that attempt to estimate real, retail natural gas consumption out to the year 2015. They create these forecasts by assembling separate forecasts of natural gas prices and consumption and general inflation produced by DRI, EIA, A.G.A., and others.
If the seven-year forecasts highlighted by Foti and Denton evince errors as large as 50 to 95 percent, how can the 20-year forecasts currently used by the FERC's ROE analyses report errors less than 200 percent or more?
Given the slim theoretical relationship between these long-term forecasts and the data required by the g term of the DCF model, and given the high probability that today's long-term forecasts of gas consumption out to 2015 will prove wildly inaccurate, the FERC may well wish to reconsider its current rationale.
Stephen M. Merchant
A.J. Rowe & Associates, Inc.
Who Pays the Price
In their case study of Jersey Central Power & Light Co. ("Saying No to Municipalization: JCP&L Case Sets Grassroots Standard," Feb. 1, p. 29), authors James Lanard and Glenn Steiger forgot an important factor in the utility's successful campaign against the Aberdeen, NJ, municipalization effort and Anchor Glass Container, the industrial customer.
Jersey Central's mission was more than just "Get the job done." This slogan also implied conveying, at any price, any untruth or half-truth, as necessary. The tactic proved especially effective since Anchor Glass remained unwilling to match the level of rhetoric employed by the utility.
Examples of Jersey Central's outrageous behavior can be found in misrepresentations about stranded costs, "unsightly" replacement facilities, and revenue lost for the township from gross receipts and franchise taxes.
As the FORTNIGHTLY reported ("Muni Fight Shuts Anchor's Door," Mar. 1, p. 10), Anchor Glass will close its Aberdeen plant. The jobs, property taxes, and contributions to Jersey Central's fixed costs will soon evaporate.
Who will absorb the long-term impact of that revenue loss: Jersey Central or its remaining customers? Will the utility pay reparations to Aberdeen for having annihilated a large industrial presence? The answers are obvious. Perhaps Jersey Central will launch a "We Feel Your Pain" campaign in the township.
KTM Energy Consulting Services
[Editor's Note: KTM consulted with Anchor Glass on the Aberdeen case.]
Reliability: Remember the Titanic!
Mr. George Loehr of the Northeast Power Coordinating Council recently warned that electric restructuring must accommodate the laws of physics: "Whatever economists may wish, the government may legislate, or FERC may mandate, Kirchhoff's Laws are not going to change." ("Transmission Reliability in the Brave New World," Feb. 1, 1995, p. 12). Mr. Loehr addresses the real-time impacts of the immutable laws (and facts) of physics on system operation. His admonition comes as a breath of fresh air to those among us who are beginning to suffocate in a sea of economic theory and market hocus-pocus.
Kirchhoff's Laws are simple. They tell us that the behavior of electric circuits is instantaneously predictable under any given set of conditions. Such behavior depends entirely upon the load (the customer), the available path or paths (transmission and distribution), and the source (generation) of the electric circuit (system). No economic theory can make that prediction, and no market condition will alter that behavior.
An understanding of Kirchhoff's Laws is essential to reliable electric system operation, and reliability is the key to system performance. Reliability demands cooperation and coordination among electric system dispatch operators in controlling generation, transmission, and distribution facilities. Satisfactory performance in these complex systems is often achieved without the consuming public being aware of the interdependence of individual systems.
Mr. Loehr reminds us that the reliability of the electric system, which so many of us take for granted, has been achieved largely through industry cooperation under the guidance of the North American Reliability Council (NERC) and its regional councils. Any electric restructuring based on market economic theories alone, without taking into account these voluntary and cooperative efforts, will likely undermine the exceptional reliability of America's electric systems. Any economic decision to unbundle or disaggregate electric system functions is certain to introduce added risk.
By and large, the debate over restructuring the electric industry has ignored these very simple, but critical, principles in favor of purely economic solutions. State and federal regulators (and legislators) involved in restructuring should introduce themselves to some of the more elementary physical and operation principles before it becomes too late. To do otherwise may saddle utilities and their customers with the cost of new generation and transmission facilities (em required simply to guarantee existing levels of reliability and service.
As an engineer, I believe we can find solutions that will accommodate both operations and economic theory. However, my experience tells me that such solutions usually come at a price. The cost of accommodating economic theory may well exceed any benefits achieved. In the end, who will be better off?
We are far into the restructuring voyage, running full steam ahead. Mr. Loehr's words of caution may well sound the warning to slow down before we enter the proverbial ice field and, like the Titanic, cross paths with the Kirchhoff iceberg.
Galen D. Denio
Nevada Public Service Commission
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