For an official paper copy, contact the Florida Public ServiceCommission at contact@psc.state.fl.us or call (850) 413-6770. There may be a charge for the copy.
State of Florida
Public Service
Commission
Capital Circle Office Center 2540 Shumard
Oak Boulevard
Tallahassee, Florida 32399-0850
-M-E-M-O-R-A-N-D-U-M-
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DATE: |
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TO: |
Director, Division of the Commission Clerk & Administrative Services (Bayó) |
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FROM: |
Division of Economic Regulation (Lester, Winters) Office of the General Counsel (Vining) |
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RE: |
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AGENDA: |
06/01/04 – Regular Agenda – Proposed Agency Action - Interested Persons May Participate |
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December 31, 2004 – Pursuant to Section 367.081(4)(f), Florida Statutes |
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SPECIAL INSTRUCTIONS: |
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FILE NAME AND LOCATION: |
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Case Background
Section 367.081(4)(f), Florida Statutes, authorizes the Commission to establish, not less than once each year, a leverage formula to calculate a reasonable range of returns on equity for water and wastewater utilities. In Docket No. 030006-WS, the Commission established the current leverage formula by Order No. PSC-03-0707-PAA-WS, issued on June 13, 2003.
This staff recommendation utilizes the current leverage formula methodology set forth in Order No. PSC-01-2514-FOF-WS, which uses returns on equity from financial models based upon an index of natural gas utilities.
Discussion of Issues
Return on Common Equity = 7.57% + 1.533/Equity Ratio
Where the Equity Ratio = Common Equity / (Common Equity + Preferred Equity + Long-Term and Short-Term Debt)
Range: 9.10% @ 100% equity to 11.40% @ 40% equity
(LESTER, WINTERS)
Staff notes that the leverage formula depends on four basic assumptions:
1) Business risk is similar for all WAW utilities;
2) The cost of equity is an exponential function of the equity ratio;
3) The marginal weighted average cost of investor capital is constant over the equity ratio range of 40% to 100%; and,
4) The cost rate at an assumed Moody’s Baa3 bond rating, plus a 50 basis point private placement premium and a 50 basis point small utility risk premium, represents the average marginal cost of debt to a Florida WAW utility over an equity ratio range of 40% to 100%.
For these reasons, the leverage formula is assumed to be appropriate for the average Florida WAW utility.
The leverage formula relies on two return on equity (ROE) models and several adjustments for differences in risk and debt cost in order to conform the results of the models to the average Florida WAW utility. Both models include a four percent adjustment for flotation costs. The models are as follows:
· A Discounted Cash Flow (DCF) model applied to an index of natural gas utilities (NG) that have publicly traded stock and are followed by the Value Line Investment Survey (Value Line). The DCF model is an annual model and uses prospective growth rates. The index consists of 12 companies that derive at least 60% of their total revenue from gas distribution service. These companies have a median Standard and Poor’s bond rating of A.
· A Capital Asset Pricing Model (CAPM) using a market return for companies followed by Value Line, the average yield on the Treasury’s long-term bonds projected by the Blue Chip Financial Forecasts, and the average beta of the index of NG utilities. The market return for the 2004 leverage formula was calculated using an annual model. Staff added 20 basis points to the annual model result to estimate a quarterly result.
The indicated returns of the above models are averaged and the resulting estimate is adjusted in the following manner:
· A bond yield differential of 43 basis points to reflect the difference in yields between an A/A2 rated bond, which is the average bond rating for the NG utility index, and a BBB-/Baa3 rated bond. Florida WAW utilities are assumed to be comparable to companies with the lowest investment grade bond rating, which is Baa3. This adjustment compensates for the difference between the credit quality of “A” rated debt and the credit quality of the minimum investment grade rating.
· A private placement premium of 50 basis points is added to reflect the difference in yields on publicly traded debt and privately placed debt, which is illiquid. Investors require a premium for the lack of liquidity of privately placed debt.
· A small utility risk premium of 50 basis points is added to reflect that the average Florida WAW utility is too small to qualify for privately placed debt.
After the above adjustments, the resulting cost of equity estimate is included in the average capital structure for the NG utilities. The cost of equity is determined at a 40% equity ratio and the leverage formula is derived. The leverage formula derived using the current methodology with updated financial data is presented in Attachment 1.
Attachment 1
Page 1 of 6
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SUMMARY OF RESULTS |
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Leverage Formula Update |
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Updated Results |
Currently in Effect |
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(A) CAPM ROE for Natural Gas Index |
10.02% |
9.53% |
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(B) DCF ROE for Natural Gas Index |
9.36% |
10.74% |
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AVERAGE |
9.69% |
10.13% |
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Bond Yield Differential |
.43% |
.44% |
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Private Placement Premium |
.50% |
.50% |
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Small-Utility Risk Premium |
.50%
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.50%
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Adjustment to Reflect Required Equity |
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Return at a 40% Equity Ratio |
.28%
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.38%
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Cost of Equity for Average Florida WAW |
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Utility at a 40% Equity Ratio |
11.40% |
11.96% |
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2003 Leverage Formula (Currently in Effect) |
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Return on Common Equity = |
8.16% + 1.518/ER |
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Range of Returns on Equity = |
9.68% - 11.96% |
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2004 Leverage Formula (Recommended) |
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Return on Common Equity = |
7.57% + 1.533/ER |
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Range of Returns on Equity = |
9.10% - 11.40% |
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Attachment 1
Page 2 of 6
Marginal Cost of Investor Capital
Average Water and Wastewater Utility
Weighted
Marginal Marginal
Capital Component Ratio Cost Rate Cost Rate
Common Equity 43.16% 11.12% 4.80%
Total Debt 56.84% 7.57% * 4.30%
100.00% 9.10%
A 40% equity ratio is the floor for calculating the required return on common equity. The return on equity at a 40% equity ratio is 7.57% + 1.533/.40 = 11.4%
Marginal Cost of Investor Capital
Average Water & Wastewater Utility at 40% Equity Ratio
Weighted
Marginal Marginal
Capital Component Ratio Cost Rate Cost Rate
Common Equity 40.00% 11.40% 4.56%
Total Debt 60.00% 7.57% * 4.54%
100.00% 9.10%
Where: ER = Equity Ratio = Common Equity/(Common Equity + Preferred Equity + Long-Term Debt + Short-Term Debt)
* Assumed Baa3 rate for April 2004 plus a 50 basis point private placement premium and a 50 basis point small utility risk premium.
Source: Moody's Credit Perspectives
Attachment 1
Page 3 of 6
ANNUAL DISCOUNTED CASH FLOW MODEL
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INDEX |
NATURAL GAS INDEX |
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APRIL |
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VALUE LINE ISSUE: Ed. 3 - MARCH 19, 2004 |
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COMPANY |
DIV 0 |
DIV 1 |
DIV2 |
DIV3 |
DIV4 |
EPS4 |
ROE4 |
GR1-4 |
GR4+ |
HIGH PRICE |
LOW PRICE |
AVG. PRICE |
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AGL RESOURCES |
1.12 |
1.12 |
1.12 |
1.12 |
1.12 |
2.35 |
12.00 |
1.0000 |
1.0628 |
29.41 |
27.53 |
28.470 |
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CASCADE NATURAL GAS |
.96 |
0.96 |
0.97 |
0.97 |
0.98 |
1.95 |
15.00 |
1.0069 |
1.0746 |
22.52 |
20.53 |
21.525 |
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ENERGEN CORP. |
.75 |
0.77 |
0.79 |
0.81 |
0.83 |
3.85 |
18.00 |
1.0253 |
1.1412 |
42.61 |
40.41 |
41.510 |
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KEYSPAN CORP. |
1.78 |
1.78 |
1.82 |
1.86 |
1.90 |
3.40 |
12.00 |
1.0220 |
1.0529 |
38.99 |
35.41 |
37.200 |
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LACLEDE GROUP |
1.36 |
1.36 |
1.37 |
1.37 |
1.38 |
2.10 |
11.00 |
1.0049 |
1.0377 |
31.35 |
27.54 |
29.445 |
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NICOR, INC. |
1.86 |
1.86 |
1.91 |
1.95 |
2.00 |
2.70 |
14.50 |
1.0245 |
1.0376 |
35.65 |
33.26 |
34.455 |
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NORTHWEST NATURAL GAS |
1.30 |
1.33 |
1.37 |
1.41 |
1.45 |
2.40 |
10.50 |
1.0292 |
1.0416 |
31.65 |
29.15 |
30.400 |
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PEOPLES ENERGY |
2.16 |
2.20 |
2.21 |
2.23 |
2.24 |
3.20 |
10.50 |
1.0060 |
1.0315 |
45.19 |
41.15 |
43.170 |
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PIEDMONT NATURAL GAS |
1.72 |
1.78 |
1.82 |
1.86 |
1.90 |
3.05 |
11.50 |
1.0220 |
1.0434 |
43.03 |
39.80 |
41.415 |
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SOUTH JERSEY INDUSTRIES |
1.62 |
1.67 |
1.70 |
1.74 |
1.77 |
3.40 |
10.50 |
1.0196 |
1.0503 |
42.10 |
40.24 |
41.170 |
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SOUTHWEST GAS |
.82 |
0.82 |
0.85 |
0.87 |
0.90 |
2.15 |
9.50 |
1.0315 |
1.0552 |
24.06 |
22.75 |
23.405 |
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WGL HOLDINGS |
1.30 |
1.30 |
1.31 |
1.33 |
1.34 |
2.15 |
9.50 |
1.0102 |
1.0358 |
30.39 |
27.75 |
29.070 |
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AVERAGE |
1.3958 |
1.4125 |
1.4359 |
1.4598 |
1.4842 |
2.73 |
12.0417 |
1.0168 |
1.0554 |
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33.436 |
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1.5664 |
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COST OF EQUITY |
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S&P STOCK GUIDE: MAY 2004 with April Stock Prices
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Stock Price w/four Percent Flotation Costs |
32.0988 |
Annual |
9.36% |
ROE |
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Cash Flows |
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1.28014 |
1.185877 |
1.102313 |
1.024729 |
.961839 |
26.5439 |
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Present Value of Cash Flows |
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32.0988 |
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$32.10 = April 2004 average stock price with a 4% flotation cost.
9.36% = Cost of equity required to match the current stock price with the expected cash flows.
Sources:
1. Stock Prices - S&P Stock Guide, May 2004 Edition.
2. DPS, EPS, ROE - Value Line Edition 3, March 19, 2004.
Attachment 1
Page 4 of 6
Capital Asset Pricing Model Cost of Equity for
Water and Wastewater Industry
CAPM analysis formula
K = RF + Beta(MR - RF)
K = Investor's required rate of return
RF = Risk-free rate (Blue Chip forecast for Long-term Treasury bond)
Beta = Measure of industry-specific risk (Average for water utilities followed by Value Line)
MR = Market return (Value Line Investment Survey
For Windows, May 2004)
10.02% = 5.48% + .73(11.46% - 5.48%)+ .20%
Note: We calculated the market return using an annual DCF model for a large number of dividend paying stocks followed by Value Line. For April 2004 stock prices, the result was 11.26%. We have added 20 basis points to allow for the quarterly compounding of dividends. The resulting market return is 11.46%. We have also added 20 basis points to the CAPM result to allow for a four-percent flotation cost.
Attachment 1
Page 5 of 6
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BOND YIELD DIFFERENTIALS Public Utility Long Term Bond Yield Averages
Long-Term Corporate Bond Yield Averages for Avg. Public Utility
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120 Month Average Spread |
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0.1074 |
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0.1074 |
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0.1074 |
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0.1074 |
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MONTH/YEAR |
A2 |
SPREAD |
A3 |
SPREAD |
Baa1 |
SPREAD |
Baa2 |
SPREAD |
Baa3 |
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Apr-2004 |
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6.35 |
0.04 |
6.39 |
0.04 |
6.42 |
0.04 |
6.46 |
0.04 |
6.50 |
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Source: Moody’s Credit Perspectives |
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Attachment 1
Page 6 of 6
INDEX STATISTICS AND FACTS
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Natural Gas Distribution Proxy Group |
S & P Bond Rating |
% of Gas Revenue |
V/L Market Capital (millions) |
Equity Ratio |
Value Line Beta |
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AGL Resources |
A- |
95% |
1,838.3 |
41% |
0.75 |
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Cascade Natural Gas |
BBB+ |
100% |
249.2 |
41% |
0.70 |
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Energen Corp. |
A- |
62% |
1,526.9 |
55% |
0.70 |
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KeySpan Corp. |
A+ |
60% |
6,119.0 |
37% |
0.75 |
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Laclede Group |
A |
74% |
594.2 |
35% |
0.70 |
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NICOR Inc. |
AA |
88% |
1,610.3 |
41% |
1.00 |
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Northwest Nat. Gas |
A |
98% |
840.4 |
46% |
0.65 |
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Peoples Energy |
A- |
70% |
1,661.7 |
44% |
0.75 |
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Piedmont Natural Gas |
A |
77% |
1,426.8 |
53% |
0.70 |
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South Jersey Industries |
A |
70% |
532.7 |
41% |
0.55 |
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Southwest Gas |
BBB- |
84% |
792.6 |
33% |
0.75 |
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WGL Holdings Inc. |
AA- |
63% |
1,419.3 |
49% |
0.70 |
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Average: |
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43.16% |
0.73 |
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Source: |
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Value Line Investment Survey for Windows, April 2004 |
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S.E.C. Forms 10Q and 10K for Companies |
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C.A. Turner Utilities Report, May 2004 |
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