Alternative ways to calculate utilities’ costs of service allow policy makers to achieve social goals in a way that’s fair and economically efficient.
Why similar U.S and Canadian risk profiles yield varied rate-making results.
Cost of capital is often a contentious issue in utility ratemaking. This is due, in part, to the inexact nature of the tools available to financial analysts and the considerable room for divergent opinions on key inputs to cost-of-capital estimation. Perhaps for this very reason, and to achieve regulatory efficiency, Canadian regulators widely adopted a formulaic approach to setting return on equity (ROE). However, an unusual degree of rancor has evolved north of the border as allowed ROEs in Canada, once at parity, have fallen near 200-basis points below their U.S. peers.
Witnessing the increasing gap between U.S. and Canadian allowed ROEs, a growing chorus of financial and market analysts have criticized the formulaic method widely adopted by Canadian regulators. The National Energy Board (NEB) recently took the decisive step of abandoning the formulaic approach it popularized back in 1994. Moreover, provincial regulators in Alberta, Quebec, Ontario and British Columbia recently reviewed the formula’s continued use. Some consumer advocates argue, however, that Canada’s ROE formula is, in fact, working properly, and the gap in authorized returns can be justified by relative risks between U.S. and Canadian utilities.
Exploring the evolution of cost-of-capital determination in Canada, and contrasting it with the U.S. experience, reveals some interesting differences and similarities between the business, financial and regulatory risk profiles of Canadian and U.S. utilities—as well as implications for allowed ROEs. These insights help clarify whether a formula reliably can track equity costs over time and serve as a supplement or replacement for the standard litigated approach to cost-of-capital determinations.
Regulators in both countries consider three primary factors when establishing a just and reasonable allowed return. These include: 1) capital attraction; 2) financial integrity; and 3) comparable returns. That is, the authorized return must allow the regulated utility to attract capital on reasonable terms under a variety of different market conditions, to maintain its financial integrity and borrowing capacity, and to offer investors the opportunity to earn a return comparable to other businesses with commensurate risks. U.S. regulators are guided by several important court decisions including Federal Power Commission v. Hope Natural Gas (1944) and Bluefield Water Works and Improvement Company v. PSC of W. Va. (1923). The seminal ROE decision for Canadian regulators is Northwestern Utilities v. City of Edmonton (1929), although the Hope and Bluefield decisions also are cited extensively in Canada.Until the early 1990s, U.S. and Canadian regulators followed similar paths in establishing the cost of common equity for regulated public utilities. U.S. regulators relied primarily on discounted cash flow (DCF) models and various risk premium approaches, including the capital asset pricing model (CAPM), while Canadian regulators tended to rely on equity risk premium (ERP) models and comparable earnings tests, while placing less weight on DCF results due to concerns over