21st Century ROEs: What Is Reasonable?

How to benchmark return on equity (ROE) and depreciation expense in utility rate cases.
Fortnightly Magazine - October 15 2003

How to benchmark return on equity (ROE) and depreciation expense in utility rate cases.


Let's face it. Despite industry restructuring and the advent of alternatives to traditional cost-of-service regulation, the determination of allowed returns on utility investments still remains among the contentious tasks faced by many utility regulators. Opposing estimates of investors' required rates of return easily can translate into disagreements worth tens of millions of dollars in a utility's annual revenue requirement. Because disputes of similar magnitude can arise in determining appropriate depreciation rates, these two investment-related cost-of-service items-the return on investment and the recovery of investment-often represent the largest, most disputed policy issues in regulated utilities' rate cases.

The complexity of the subject areas-cost of capital and depreciation studies-also tends to present significant challenges for regulatory decision makers. However, allowed depreciation rates and rates of return have important implications for a utility's ability to finance needed infrastructure investments and ensure adequate and reliable service to their customers. A utility's ability to recover these two investment-related cost-of-service items is critical to its credit rating, which, in turn, is an indicator of the utility's cost and ability to access capital markets and fund needed infrastructure investments.

Unregulated industry participants have sharply curtailed their capital spending, and even regulated utilities have been struggling with severe financial pressures and an unprecedented industrywide credit crunch. As the NARUC president and EEI chairman pointed out in a joint statement:

The electric power industry is now facing a financial crisis perhaps more acute than any in its modern history. ...All but a few electric power providers have found access to capital increasingly costly and enormously difficult to acquire. … Left uncorrected, these problems likely will further impede the financing and construction of critically needed infrastructure, particularly high-voltage transmission and local distribution systems.

Significantly, this is a crisis affecting not just companies and their shareholders-customers themselves and the U.S. economy are at risk if the industry cannot build out or even maintain its generation and delivery infrastructure."1

These financial woes are not solely the result of companies' financial difficulties in the unregulated segments of the industry. As Standard & Poor's (S&P) stresses, "insufficient regulated authorized returns" are one of the most significant factors contributing to the current "downward pressure" in credit quality and the credit rating agency's "decidedly negative" view of the future rating trends of the electric industry.2 S&P further notes that "the allowed returns…are typically less than what Standard and Poor's targets [and it] is disconcerting to find that utility credit quality … is not near the top of the agenda for state regulators."3

Only last year, for example, S&P downgraded a vertically integrated traditional electric utility from "A-" to "BBB" specifically because of regulatory actions marked by "low allowed ROEs" and "low plant depreciation allowances."4

Benchmarking recommended rates of return and depreciation rates against the returns and depreciation rates allowed in the rest of the country can help regulators in their efforts to assess the reasonableness of such recommendations. Analyzing recommended returns and depreciation rates relative to what has been allowed in utility rate cases across the United States can help ensure that a utility's rates are, in fact, allowing for the adequate recovery of, and return on, utility investments. Of course, such benchmarking of allowed returns and depreciation rates cannot be a substitute for proper cost of capital and depreciation studies. They also must recognize the credit rating agencies' dissatisfaction with currently authorized returns, and consider industry trends, changes in financial market conditions, and unique circumstances of individual utilities.

Benchmarking Allowed Rates of Return

The following example from a recent rate case is indicative of what regulatory commissions frequently face when deciding on an allowed rate of return. The particular utility filed for a rate increase requesting a return on equity (ROE) in the range of 11.5 percent to 12 percent. The commission staff argued that the appropriate ROE was between 8.5 percent and 9.5 percent, while public counsel provided testimony supporting a range of 10 percent to 10.25 percent. The commission analyzed the three expert recommendations and set the allowed ROE at 10 percent, finding that the low end of public counsel's cost of equity recommendation was most reasonable.

As it turns out, public counsel's recommendation also approximated the mid-point of all recommendations presented to the commission in this case: 10.25 percent is the midpoint between the low end of staff's recommendation (8.5 percent) and the high end of the utility's recommendation (12.0 percent); and the allowed ROE of 10 percent is the midpoint between the low end of staff's and the utility's recommendations (8.5 percent and 11.5 percent, respectively).

But how reasonable were these experts' recommendations? And was the public counsel's midpoint reasonable in that it represented adequate compensation for investors' capital? This, of course, is the $64,000 question-and it is extremely difficult to answer with great precision.

On an after-the-fact basis, the answer almost certainly is that the allowed ROE of 10 percent was not adequate. The utility was later downgraded by S&P based on a rationale that specifically pointed to the rate order's low allowed ROE and low depreciation allowances. In fact, the return allowed in this rate order marked the single lowest allowed ROE of all 18 electric utility rate orders issued by state commissions in that year. And even worse, the 10 percent ROE immediately became important "precedent" against which disputes over the allowed return would be evaluated in the commission's subsequent rate cases.

How could the reasonableness of the experts' recommendations have been evaluated when their recommendations initially were presented to the commission? We find that the comprehensive review of returns allowed in recent regulatory orders of other commissions can be used as a valuable benchmark to assess the likely adequacy of experts' rate of return recommendations.

For example, Figure 1 shows the range of ROEs that state regulatory commissions have allowed in each year from 1995 through the third quarter of 2002. (The chart is based on a two-year moving average to ensure a sufficient number of rate cases and avoid excess variability of the shown rate of return ranges. It also excludes the 10 percent rate of return order discussed above.) Figure 1 shows that the average of allowed ROEs has been between 11.1 percent and 11.3 percent in recent years. In 2001, at the time of the discussed rate case, the range of recently allowed ROEs spanned from a minimum of 10.3 percent to a maximum of 12.9 percent. However, given the rating agencies' concerns about the inadequacy of currently allowed rates of returns, the lower end of this range is unlikely to be consistent with adequate compensation of investors' capital. When 25 percent of the lowest allowed ROEs are excluded, the resulting lower bound of allowed ROEs (i.e., the first quartile) has been between 10.75 percent and 11 percent in recent years.

The red markers and underlined labels in Figure 1 indicate the ROE recommendations for staff, public counsel, and the company in the discussed rate case example. Compared to these recommendations, the range of recently allowed ROEs clearly illustrates that: (1) the utility's recommendations of 11.5 percent to 12 percent was within the range of state commissions' recently allowed ROEs; (2) the public counsel's recommendations of 10 percent to 10.25 percent was just below the lowest ROE authorized by any other state commission in the last few years; and (3) the staff's recommendation of 8.5 percent to 9.5 percent fell substantially short of any recently-allowed ROEs in the entire country.

The gray markers in Figure 1 also plot the staff's midpoint ROE recommendations in 11 other recent rate cases before the same commission. The data show that staff's recommendations in 1997 were substantially consistent with the low end of state commissions' allowed ROEs. They also show that, since then, staff's recommendations became increasingly disconnected from any returns allowed by utility regulatory commissions. In one of the more recent rate cases shown on this chart, the difference between staff's midpoint recommendation of 9.4 percent and the average of ROEs allowed by U.S. state commissions reduced the utility's annual revenue requirement by more than $60 million.

The benchmarking of ROE recommendations against allowed returns by other commissions not only makes staff's recommendations highly suspect, it also makes the public counsel's 10 percent to 10.25 percent questionable as an appropriate "midpoint" recommendation. In fact, if staff's recommendation had been rejected, the midpoint between the public counsel's and the utility's recommendations would have been 11 percent-a return on equity that, while still below the average of recently allowed ROEs, would have been more consistent with the mainstream of returns allowed by other commissions in the country.

Of course, such benchmarking cannot be a substitute for the proper estimation of the regulated company's cost of capital. Solely relying on the allowed return of other regulatory commissions to set the allowed return is unlikely to result in a proper estimate of a company's cost of capital and can lead to serious circularity problems.5 It must also be taken into consideration that benchmarking relies on past allowed returns for many different companies, while allowed returns apply to a specific utility's rates over the next several years. As a result, setting an appropriate allowed rate of return must account for industry trends, changes in financial market conditions, and unique circumstances of the individual regulated entity. For example, with respect to industry trends, it may be important to recognize factors such as changing risks due to increased competition or a rapidly (and often unpredictably) changing regulatory environment. It may also be important to reflect changes in financial market conditions, such as the industry's access to new capital and trends in interest rates.

Important company-specific factors may include the firm's specific risk profile relative to industry averages or infrastructure investment requirements that may put downward pressure on various financial ratios, such as free cash flow and interest coverage. To facilitate transmission infrastructure investments, for example, recently allowed ROEs have been in (and even above) the 12 to 13 percent range. In considering any company-specific factors, however, it is also important to avoid regulatory adjustments that appropriate benefits the company achieved through superior performance. For example, the Federal Energy Regulatory Commission will not generally lower a pipeline's ROE if its lower risk is the result of the pipeline's own efficiency. Reducing the allowed return simply because a company was able to reduce its business risk through superior performance relative to others in the industry would eliminate the very incentives that give rise to such performance gains.6

Benchmarking Depreciation Rates

Similar to the benchmarking of allowed rates of return, comprehensive benchmarking of depreciation rates can help commissions evaluate the likely reasonableness of experts' proposed depreciation rates. The example of another recent rate case can illustrate the benefits of such comparisons. In this case, the difference between the staff's and the company's recommended depreciation rates accounted for more than $100 million in annual revenue requirements. While the company proposed to increase average depreciation rates from approximately 3 percent to 3.4 percent per year, the staff's depreciation witness recommendation decreased average depreciation rates from approximately 3 percent to 2.2 percent. (An average depreciation rate of 2.2 percent is equivalent to an average depreciation life of 45 years, while a depreciation rate of 3.4 percent is equivalent to 29 years.)

Figure 2 shows how depreciation rates associated with the utility's preexisting depreciation rates and the experts' recommendations compared to average depreciation that regulators allowed in recent years for other utilities in the country. The figure shows that: (1) the utility's currently effective actual depreciation rates of 3 percent are approximately equal to the 25th percentile of average depreciation rates (i.e., the first quartile) of other utilities in the country; (2) the company's proposed depreciation rates of 3.4 percent are consistent with the median of other utilities' average depreciation rates; and (3) the staff's proposed 2.2 percent depreciation rate is below the fifth percentile (i.e., well below the mainstream) of average depreciation rates that regulatory commissions have allowed for other U.S. utilities.

Of course, a comparison of utilitywide averages for depreciation rates can be misleading because different asset types-such as production, transmission, and distribution assets-tend to have different depreciation lives. As a result, for example, the range of average depreciation rates for utilities with a disproportionate share of distribution facilities may not match the range of average depreciation rates of utilities with a disproportionate share of production assets.

It is consequently important to compare proposed depreciation rates for similar types of assets. Figure 3 illustrates this point through the benchmarking of actual and proposed depreciation rates for the previously discussed utility's distribution assets. In fact, the discrepancy of proposed depreciation rates for distribution assets accounted for much of the dispute between the staff's and the company's depreciation witnesses. The figure shows that the company's pre-existing actual depreciation rate for distribution assets was close to the 75th percentile of depreciation rates for other U.S. utilities distribution assets. However, while the company witnesses recommended depreciation rate was close to the median depreciation rate of other utilities in the country (and, in fact, somewhat below the median), the staff's proposed depreciation rate for the company's distribution assets was well below the range of the depreciation rates that state regulatory commissions have allowed for other U.S. utilities' distribution systems.

Clearly, staff's depreciation methodology resulted in average depreciation rates that were below the depreciation rates this commission previously had allowed, and well below the mainstream of depreciation rates allowed by other state regulatory commissions for similar assets.

The adoption of the staff's depreciation methodology by the commission in a prior rate case triggered the discussed downgrade of the utility's credit rating from "A-" to "BBB" by S&P due to "low allowed ROEs" and "low plant depreciation allowances." In a subsequent case, the benchmarking of proposed depreciation rates as illustrated in Figures 2 and 3 highlighted the unreasonableness of staff's recommendation and resulted in a favorable settlement based on depreciation rates that were consistent with those of other utilities in the country.

However, as is the case with determining appropriate rates of return, the benchmarking of depreciation rates cannot be a substitute for detailed depreciation studies that appropriately take account of company-specific and industrywide trends and circumstances. These factors, such as trends in technical and economic obsolescence, are important considerations in the determination of appropriate forward-looking depreciation rates that maintain the utility's financial strength and access to capital. Credit rating agency concerns over low depreciation allowances also suggest that the low end of the observed depreciation rates may not represent adequate investment recovery.

In conclusion, while not a substitute for the proper determination of a company's cost of capital or depreciation rates, a comparison of experts' estimates relative to what has been allowed by commissions in the rest of the country can help regulators in their efforts to arrive at reasonable allowed returns and depreciation rates. However, this comparison of allowed returns and depreciation rates must recognize current concerns over low authorized returns, and it should not ignore industry trends, changes in financial market conditions, and unique circumstances of the individual utility.

Such benchmarking can help ensure that a utility's rates, including rates of return and depreciation rates, are set at levels sufficient to compensate investors fairly, allow for timely investment recovery, maintain a utility's financial position, and attract new capital. Doing otherwise will jeopardize needed infrastructure investments and lead to lower reliability and higher costs to consumers in the long term. This is of particular importance in the context of significant infrastructure investment requirements, unprecedented industrywide financial pressures on the unregulated segments of the energy industry, and credit rating agencies' concerns that regulatory support for traditional utilities continues to disappoint.

  1. Joint statement of David A. Svanda, president-elect of the National Associate of Regulatory Utility Commissioners, and Erroll B. Davis Jr., chairman of the Edison Electric Institute, Chicago, Nov. 13, 2002.
  2. William R. Ferara, "State Utility Regulation Coming Back in Vogue?" Standard & Poor's, New York, Oct. 7, 2002.
  3. William R. Ferara, "Regulatory Support for U.S. Electric Utility Credit Continues to Disappoint," Standard & Poor's, New York, May 27, 2002.
  4. Standard & Poor's, "Ratings on Empire District Electric Co. Lowered to 'BBB'; Outlook Stable," RatingsDirect, July 2, 2002.
  5. Such circularity problems are created when methodologies used to set allowed returns or depreciation rates depend in part on variables that are a function of the allowed returns or depreciation rates.
  6. For a discussion of why company-specific factors can be an important consideration in any benchmarking exercise, see Pfeifenberger and Jenkins, "Big City Bias: The Problem With Simple Rate Comparisons," , December 2002, pp. 38-42. For a discussion of why it is important to provide and maintain strong performance incentives, see Weisman and Pfeifenberger, "Efficiency as a Discovery Process: Why Enhanced Incentives Outperform Regulatory Mandates," The Electricity Journal, January/February 2003, pp. 55-62.

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