Table of Contents
Issue Description Page
Case
Background. 3
1 Model
or method for return on common equity (Livingston) 4
1A Equity
Ratio (Livingston) 6
1B Change
to the cost of debt (Springer) 7
1C Before-Tax
vs. After-Tax Cost of Capital (Springer) 9
1D Bond
Yield Differential Adjustment (Springer) 12
1E Private
Placement Premium Adjustment (Springer) 14
1F Small-Utility
Risk Premium Adjustment (Springer) 16
2 Updated
financial data (Livingston) 18
3 Range
of returns on common equity (Maurey) 20
4 Close
Docket (Hartman) 23
Attachment
A.. 24
Case
Background
Section 367.081(4)(f), Florida Statutes (F.S.), authorizes
this Commission to establish, not less than once each year, a leverage formula
to calculate a reasonable range of returns on equity (ROE) for water and
wastewater (WAW) utilities. In Docket No. 070006-WS, the Commission established the current leverage formula by Order No. PSC-07-0472-PAA-WS.
On May 8, 2008, staff filed a recommendation asking the
Commission to approve the recommended 2008 leverage formula. At the May 20
Agenda Conference, after hearing from staff and from counsel of the Office of
Public Counsel (OPC) and Utilities, Inc. (UI), the Commission decided that it
would be appropriate and administratively efficient to set the establishment of
the 2008 leverage formula for WAW utilities directly for hearing.
A prehearing conference was held October 13, 2008, and
Prehearing Order No. PSC-08-0702-PHO-WS was issued on October 21, 2008. The
formal hearing was held on October 23, 2008. OPC and UI sponsored witnesses
and participated at the hearing.
This recommendation addresses the issues and evidence
presented at the October 23, 2008 hearing.
The Commission has jurisdiction pursuant to Section 367.081,
Florida Statutes.
Discussion
of Issues
Issue 1:
What is the most appropriate model or method to
estimate a fair and reasonable return on a water and wastewater (WAW) utility’s
common equity capital?
Recommendation:
The most appropriate models to estimate a fair and
reasonable return on common equity capital for a WAW utility for inclusion in
the leverage formula are the Discounted Cash Flow (DCF) model and the Capital
Asset Pricing Model (CAPM). (Livingston)
Position
of the Parties
OPC:
A two-stage DCF model and a CAPM model based on the
actual long-term relationship between inflation and the earned risk premium is
an appropriate method to estimate a fair and reasonable return on a water and
wastewater (WAW) utility’s common equity capital.
Utilities Inc.:
The Discounted Cash Flow (DCF) model and the Capital
Asset Pricing Model (CAPM) as applied by the PSC Staff in current leverage
formula are the most appropriate models or methods to estimate a fair and
reasonable return on a water and wastewater (WAW) utility’s common equity
capital.
Staff Analysis:
Witness James A. Rothschild,
testifying on behalf of the OPC, employed two cost of capital models in his
analysis. He applied the DCF model to the natural gas index set forth by the
Commission in Order No. PSC-01-2514-FOF-WS (2001 Order).
(TR 92-93, EXH 5) A hearing was last held by the Commission on its WAW ROE
leverage formula methodology in 2001. Each year since the 2001 Order, staff
has updated the WAW ROE leverage formula for current financial information.
(EXH 2) Witness Rothschild applied a modified version of the CAPM to ten
groups of companies selected from the Ibbotson Associates 2008 Yearbook. (TR
78, 81) The results of these analyses and the application of his professional
judgment led the witness to suggest revisions to the DCF and CAPM methods used
by staff in its recommendation filed May 8, 2008. (TR 41, EXH 2)
Although witness
Rothschild has some differences of opinion regarding certain inputs to the DCF
and CAPM methods used by staff, those differences do not extend to the use of
the DCF and CAPM as appropriate financial models, nor do the differences extend
to the use of the comparative group of gas companies for his analyses. (OPC BR
4, TR 37-39, 155) Witness Rothschild agrees with the use of a DCF model
applied to the natural gas index as set forth in the 2001 Order. (TR 38)
Witness Pauline M.
Ahern, appearing on behalf of UI, testifies that the results of the leverage
formula included in staff’s May 8, 2008 recommendation are reasonable for
establishing a return on equity for WAW utilities in Florida. (UI BR 2, TR 24,
EXH 2) Witness Ahern determined the appropriateness of the allowed return on
common equity incorporated in staff’s May 2008 recommendation by applying four
cost of capital models. She applied the DCF model, CAPM, Risk Premium Model,
and the Comparable Earnings Model to the market data of a proxy group of AUS
Utility Reports water companies as well as the companies in the natural gas
proxy group. (TR 168, EXH 2, EXH 42)
Witness Ahern does not
agree with the modifications to the application of the DCF model recommended by
witness Rothschild. (TR 193-195) She believes his recommended changes to the
inputs to the DCF and CAPM would inappropriately understate the required return
on equity for WAW utilities in Florida. (TR 194-200)
Both witnesses agree that the DCF model is an appropriate
model for estimating a fair and reasonable return on a WAW utility’s common
equity capital. (TR 24, 89) Both witnesses also agree that the CAPM is an
appropriate model for estimating a fair and reasonable return on a WAW
utility’s common equity capital. (TR 24, 78) Witness Ahern testifies the
models used in the Commission’s current leverage formula methodology are fair
and reasonable. (TR 24) While witness Rothschild agrees that the DCF model
and CAPM should be used to estimate return, he suggests certain modifications
be made to the Commission’s application of the CAPM. (TR 37-39)
Witness Rothschild opposes the use of analyst forecasts of
growth rates in the DCF model used to calculate the risk premium input for the
CAPM. (TR 39) Witness Ahern disagrees, claiming that witness Rothschild
provides no basis for this assertion. (TR 183) Witness Ahern calculated risk
premium cost rates using both versions of the DCF model. (TR 183) This
analysis concluded that the difference in the average common equity cost rate
as well as the median equity cost rate for the two models was .05%. (TR 183,
EXH 26) In addition, the results of both models were lower than witness
Rothschild’s DCF model results as shown on Exhibit 5, page 1. (TR 183, EXH 2,
EXH 5)
Based on an analysis
of this issue and review of the witnesses’ testimonies, staff recommends that
the DCF and CAPM models continue to be the most appropriate methods to estimate
the return on common equity capital for WAW utilities in Florida. (TR 61-63,
75) Therefore, based on the record in this proceeding, staff recommends that
the most appropriate models to estimate a fair and reasonable return for a WAW
utility for inclusion in the leverage formula are the DCF model and the CAPM.
Issue 1A:
Should the leverage formula methodology take into
account an individual utility’s equity ratio in the determination of return on
equity?
Recommendation:
Yes. (Livingston)
Position
of the Parties
OPC:
Yes.
Utilities Inc.:
Yes. The leverage formula methodology should take
into account an individual utility’s common equity ratio in the determination
of the rate of return on common equity, providing that the individual utility’s
common equity ratio is reasonable and appropriate for ratemaking purposes.
Staff Analysis:
OPC and UI both agree that the leverage formula
should take into account an individual utility’s equity ratio in the
determination of return on equity (ROE). (OPC BR 11, UI BR 9-10)
Historically, the Commission’s WAW ROE leverage formula has specifically
adjusted the cost of equity consistent with a utility’s capital structure. (TR
120) Staff agrees with the position of the parties on this issue and
recommends the leverage formula methodology continue to take into account an
individual utility’s equity ratio in the determination of return on equity.
Issue 1B:
Should the leverage formula methodology take into
account the change to the cost of debt in response to changes in the level of
common equity in a utility’s capital structure?
Recommendation:
No. (Springer)
Position
of the Parties
OPC:
Yes. This is not only consistent with the same
Modigliani & Miller principle that is the basis for the leverage formula,
but the relationship between capital structure and cost of debt is confirmed by
the actual data associated with the comparative group of companies.
Utilities Inc.:
No, it is not necessary to change the cost of debt
in response to changes in the level of common equity in a utility’s capital
structure.
Staff Analysis:
OPC witness Rothschild testifies
that the leverage formula methodology should take into account the change to
the cost of debt in response to changes in the level of common equity in a
utility’s capital structure. (TR 49-50) He believes that, when computing the
overall cost of capital for a particular company, both the cost of equity
derived from the leverage formula that is consistent with the subject company’s
capital structure and the actual embedded cost of debt of the subject company
must be used. (OPC BR 12) Witness Rothschild argues that the work done by
Modigliani and Miller is generally regarded as the breakthrough work on the
relationship between capital structure and cost of capital, and that this work
forms the basis for the leverage formula used by the Commission.
(TR 50, 219-220) Witness Rothschild argues that Modigliani and Miller showed
that, if it were not for income taxes and bankruptcy risk, the capital
structure selected by a company would have no impact on the overall cost of
capital. (TR 50) Witness Rothschild believes that the cost of debt must vary
in response to changes in the level of common equity in a utility’s capital
structure since the overall cost of capital remains constant over different
capital structures and the cost of equity varies depending on the equity
ratio. (TR 221) He asserts that the relationship between bond ratings and
capital structure for the natural gas index shows that the cost of debt does
vary in relation to the equity ratio. (EXH 8)
Rather than merely
assign the same cost of capital to all WAW utilities, witness Rothschild notes
the concept behind the leverage formula begins by recognizing that each utility
uses a different capital structure. (TR 220) He believes that, because
utilities use different capital structures, even if the overall cost of capital
were the same from company to company, the cost of equity would change due to
variations in the capital structures used. (TR 220-221) In other words, the
witness believes two WAW companies that have the same business risk will have
different financial risk if they use different capital structures. (TR 221)
He states that the Modigliani and Miller principle tells us that as the
percentage of common equity goes up, financial risk goes down, which causes
both the cost of debt and the cost of equity to go down. (TR 221) Witness
Rothschild argues that the expectation of the lower cost of debt must be
modeled into the determination of the leverage formula for it to produce a
correct answer. (TR 225-226)
UI witness Ahern testifies
that holding the debt cost rate constant for purposes of deriving the WAW ROE
leverage formula is reasonable for two reasons. (TR 175) First, she states
that the revenue requirement formula ensures that the regulated utility will
receive sufficient earnings to compensate for the expenses it incurs to service
both its debt and equity obligations. (TR 174) Witness Ahern adds that, in
the ratemaking process, the embedded cost of debt is utilized in the
calculation of the overall rate of return. (TR 211-212) In addition, she
states that the cost of debt is a function of many factors. (TR 175) The bond
rating process itself indicates that bond ratings are not simply and
exclusively a function of debt ratios, especially historical or point in time
debt ratios. (TR 176)
Witness Ahern
testifies that the current leverage formula assumes that if Florida WAW
utilities had bonds which were rated, they would be rated Baa3 by Moody’s,
which is equivalent to a BBB- by Standard & Poor’s (S&P). (UI BR 10,
TR 177) She notes the bond rating process is comprehensive, both qualitative
and quantitative, and does not focus exclusively on the debt ratio. (TR 177)
Witness Ahern explains that the business risk/financial risk matrix indicates
that utilities with a BBB- rating and a weak business risk profile would likely
have a modest financial risk profile, and those with a strong business risk
profile would likely have an aggressive financial risk profile. (TR 177) The
range of financial risk indicative ratios published by S&P are shown on
page 12 of Exhibit 23. (TR 177, EXH 23) The total debt to total capital
indicative ratios for utilities with a modest financial risk profile range from
25 percent to 40 percent, while those with an aggressive financial risk profile
range from 45 percent to 60 percent. (TR 177) Witness Ahern asserts that
utilities with BBB- bond ratings by S&P (and Baa3 by Moody’s) could have
debt ratios ranging from 25 percent to 60 percent and still maintain the BBB-
(Baa3) bond rating. (TR 177) Based on this review, witness Ahern concluded it
was not necessary to allow the cost rate of debt to vary in the derivation of
the Commission’s WAW ROE leverage formula. (TR 177)
Staff agrees with
witness Ahern that it is not necessary to allow the cost rate for debt to vary
in the derivation of the leverage formula. (TR 175) Both witnesses agree the
primary purpose of the Commission’s WAW ROE leverage formula is to provide an
easily applied mechanism to avoid the expense and burden of hiring expert cost
of capital witnesses for each WAW proceeding. (TR 142, TR 204-205) In
addition to the reasons offered by witness Ahern for why such an adjustment is
not necessary, from a practical standpoint, staff believes it would be
administratively burdensome to recalibrate the WAW ROE leverage formula each
time it is used. For these reasons, staff does not believe it is necessary to
vary the cost rate of debt in the derivation of the Commission’s WAW ROE
leverage formula.
Issue 1C:
Should the determination of the leverage formula be
based on a before-tax or after-tax cost of capital?
Recommendation:
The determination of the leverage formula should be
based on an after-tax cost of capital. (Springer)
Position
of the Parties
OPC:
The determination of the leverage formula should be
based on a before-tax cost of capital. This will provide the cost of equity as
experienced by equity investors.
Utilities Inc.:
The determination of the leverage formula should be
based upon an after-income tax overall cost of capital. To do otherwise
assumes that the revenue cost of capital is identical over an equity ratio
range of 40% to 100% which is not at all the case.
Staff Analysis:
OPC witness Rothschild testifies that the
determination of the leverage formula should be based on a before-tax cost of
capital. In his opinion, this will provide the cost of equity as experienced
by equity investors. (TR 52) Witness Rothschild states that it is important
that the Commission use the before-tax cost of capital so customers are not
harmed by excessive use of equity in the capital structure of WAW utilities in Florida. (TR 51-52) He states that, if the goal of the Commission is to compute the cost
of equity as experienced by equity investors, the overall cost of capital that
should be held constant is the one determined prior to consideration of income
taxes. (TR 51) He asserts that, since a utility is only entitled to recover
prudently incurred costs, absent a showing of why a particular company cannot
finance its rate base with a reasonable amount of debt, a company is only
entitled to charge ratepayers for a leverage formula-determined cost of capital
that considers the real world impact of taxes. (TR 52) Witness Rothschild
believes that, if there is a utility with a special situation that could
explain why it is appropriate for it to use an excessively high level of common
equity in its capital structure, it could ask the Commission to give it a
return in excess of the amount determined by the leverage formula. (TR 52)
Without such a showing, it would be inappropriate to charge ratepayers the
higher cost of an inherently inefficient capital structure. (TR 53)
Witness Rothschild contends
that, if the Commission does not use the before-tax cost of capital, the
leverage formula would fail to include the effect of income taxes. (OPC BR 14,
TR 151-152) He believes the version of the formula that fails to include the
effect of income taxes would not make the capital structure selected
indifferent to ratepayers. (TR 55) According to his reading of Modigliani and
Miller’s paper, there is an optimal capital structure when income taxes are
taken into account. (TR 151) If a company uses too much or too little equity,
inefficiency is produced. (TR 151)
Witness Rothschild
believes that regulation should be a substitute for competition. (OPC BR 15,
TR 153) He asserts that if a company uses an inefficient capital structure and
its competition is using an efficient capital structure, the one using the
inefficient capital structure will earn a lower return. (TR 153) It is
witness Rothschild’s opinion that using a before-tax cost of capital in the
leverage formula provides this result, and that the use of an after-tax cost of
capital will not. (TR 51-52)
UI
witness Ahern testifies that the determination of the leverage formula should
be based on an after income tax overall cost of capital. (TR 177-178) She
states that to do otherwise assumes the revenue cost of capital is identical
over an equity ratio range of 40 percent to 100 percent, which is not the
case. (TR 177-178) Witness Ahern agrees with witness Rothschild’s summation
of Modigliani and Miller’s principle, stating that “Modigliani and Miller
showed that if it were not for income taxes and bankruptcy risk, the capital
structure selected by a company would have no impact on the overall cost of
capital.” (UI BR 12-13) However, by holding the before income tax overall
cost of capital constant, witness Ahern testifies that witness Rothschild’s
recommendation results in the exact opposite, and that differing amounts of
debt and equity in the capital structure have absolutely no impact on the
revenue cost of capital. (UI BR 11, TR 178) This led witness Ahern to
recommend the Commission reject witness Rothschild’s proposal that the before
income tax overall cost of capital be held constant in the leverage formula.
(UI BR 13, TR 179)
Staff believes
witness Rothschild has an incomplete understanding of Modigliani and Miller’s
work in this area. (TR 179-180) While it is true the 1958 paper by Modigliani
and Miller that first put forth the principle upon which the Commission
leverage formula is based was done so without consideration of taxes,
Modigliani and Miller published a number of follow-up papers discussing this
principle. (EXH 9) Their continued work in this area showed that when
corporate and personal taxes are considered, the results lead to the same
conclusions Modigliani and Miller reached in their earlier paper. (EXH 9)
Since the results are the same with or without consideration of taxes, it is
not necessary to explicitly consider taxes when determining the relationship
between financial leverage and the cost of equity.
In addition to the
infirmities witness Ahern identified in the application of witness Rothschild’s
recommended leverage formula, she also correctly notes that his recommendation
on this issue would result in a constant revenue cost of capital over the 40 to
100 percent equity ratio range. (TR 180-181) Staff believes that not only is
this outcome inappropriate for the reasons outlined in witness Ahern’s
testimony and discussed above, this exact same argument was considered and
rejected by the Commission in Order No. 19718 when raised by witness Rothschild
in the 1988 hearing on the Commission’s WAW ROE leverage formula.
(TR 177-180)
Finally, while
witness Rothschild does raise a valid concern regarding the impact a high
equity ratio has on a company’s cost capital, his argument is off point in the
instant case. (TR 51-52) There are examples of utilities in other industries
regulated by this Commission that have the same ROE but have different equity
ratios.
The companies with the higher equity ratios have higher costs of capital by
operation of math and these higher costs are recovered from their respective
customers. However, the WAW ROE leverage formula specifically adjusts the cost
of equity based on the financial leverage of the subject company. (TR 120)
Therefore, the issue witness Rothschild raised about recovering the cost
resulting from an inefficient capital structure from a utility’s customers is
unwarranted with respect to WAW utilities in Florida.
For the foregoing
reasons, staff recommends the determination of the leverage formula continue to
be based on an after-tax cost of capital.
Issue 1D:
Is it appropriate to make a Bond Yield Differential adjustment?
If so, how should this adjustment be made?
Recommendation:
Yes. Staff recommends the Commission continue to
make a bond yield differential adjustment as reflected in Attachment A to this
recommendation. (Springer)
Position
of the Parties
OPC:
No. The cost of debt increases when a company uses
a higher proportion of debt. This higher interest expense is exactly the same
factor that causes an increase in the risk experienced by the equity holders,
which is what the leverage already formula measures. The adjustment is
therefore a double-count.
Utilities Inc.:
Yes. The bond yield differential reflected in the
debt cost rate in the leverage formula compensates bondholders for the
riskiness of a Baa3 rated public utility bond relative to that inherent in an A
rated public utility bond. It does not compensate the common equity
shareholders for the added relative risk.
Staff Analysis:
OPC witness Rothschild testifies that when a utility
issues a bond, the bond yield or interest expense the utility must pay on the
bond is related to the risk bond investors perceive to be associated with the
bond. (OPC BR 15, TR 57) He also states that, while numerous factors
contribute to the determination of a bond rating, important factors such as the
coverage ratio and internal cash generation are influenced by the capital
structure, i.e. the degree of financial leverage used by a utility. (TR 57)
Witness Rothschild believes that interest expense increases when a company
increases the percentage of total debt financing in its capital structure. (TR
58) In addition, he argues that because of higher interest expense and fewer
dollars of equity, both the income available to equity and the associated
income taxes decrease. (TR 58) This leads witness Rothschild to believe that
higher interest expense, lower income available to common shareholders, and
lower income taxes all result in a lower coverage ratio. (TR 58) It is
witness Rothschild’s opinion that this increase in risk experienced by equity
holders is the same risk measured by the leverage formula. (TR 58) Therefore,
he concludes that adding a factor for the anticipated higher cost of debt is a
double-count. (TR 58)
Witness Rothschild
claims Exhibit 11, page 2 of 2, shows that when there is a lower amount of
equity in the capital structure of the natural gas index, the bond rating of
the company is lower. (OPC BR 16, EXH 11) This leads him to believe that no
additional bond yield differential should be made because increased risk from a
higher proportion of debt in the capital structure is already reflected in the
bond rating of the company. (EXH 11)
UI witness Ahern testifies
that it is appropriate to include a bond yield differential adjustment in the
cost of common equity calculation in the leverage formula because the bond
yield differential reflected in the debt cost rate only compensates bond
holders for the increased riskiness inherent in Baa3 public utility bonds
relative to the riskiness inherent in A rated public utility bonds. (UI BR
13-14, TR 184) She believes it is neither necessary nor appropriate to change
the debt cost rate as common equity ratios change. (TR 184) Therefore,
witness Ahern believes that there is no mechanism in the leverage formula to
compensate common equity holders for their increased risk exposure for
investing in the common equity of utilities with Baa3 rated bonds. (UI BR 14,
TR 184)
Staff agrees with
witness Ahern that it is appropriate to make a bond yield differential
adjustment in the derivation of the Commission’s WAW ROE leverage formula. (TR
184) The average bond rating for the natural gas index is A. (TR 145, EXH
11) The assumed bond rating for the average WAW utility in Florida is Baa3.
(TR 177) By failing to appropriately recognize this incremental difference in
risk between the companies in the natural gas index and the average WAW utility
in Florida, witness Rothschild’s recommended leverage formula produces results
that understate the required return for these utilities. (TR 184, TR 145-146)
For these reasons, staff recommends the Commission continue to make a bond
yield differential adjustment as reflected in Attachment A to this
recommendation.
Issue 1E:
Is it appropriate to make a Private Placement
Premium adjustment? If so, how should this adjustment be made?
Recommendation:
Yes. Staff recommends the
Commission continue to make a Private Placement Premium adjustment of 50 basis
points as reflected in Attachment A to this recommendation. (Springer)
Position
of the Parties
OPC:
It is not appropriate to make a private placement
premium adjustment. Borrowers self-select their debt issuance choice to
minimize financing costs, so there is no premium paid for private placement.
Utilities Inc.:
Yes. It is appropriate to make a Private Placement
Premium adjustment because investors in such debt demand compensation for the
lack of liquidity relative to large, readily saleable public traded debt. The
adjustment should be made in a manner identical to that in the current leverage
formula.
Staff Analysis:
OPC witness Rothschild testifies that there are a
sufficient number of investors, such as retirement funds and life insurance
companies, that plan to hold an investment to maturity and have no reason to
expect a private placement premium. (OPC BR 16, TR 59) Witness Rothschild
states that he attempted to find studies that evaluated the cost difference
between private placement and public placement debt. (TR 59) The only study
he said he was able to find was a working paper entitled “Financial Contracting
and the Choice between Private Placement and Publicly Offered Bonds,” dated
November, 2004, by Simon H. Kwan of the Economic Research Department of the
Federal Reserve Bank of San Francisco and Willard T. Carleton of the Department
of Finance at the University of Arizona. (TR 59) The authors concluded:
Finally, we find
evidence that borrowers self-select their debt issuance choice to minimize
financing costs. However, switchers that issue debt in both markets do not
realize significant cost savings by issuing bonds in the private market. (TR
59)
Witness Rothschild believes this
shows that the private placement alternative is selected when the borrower
perceives an opportunity to experience a lower cost of debt rather than as a
mechanism for higher cost. (TR 59-60)
UI witness Ahern testifies
that it is appropriate to include a private placement premium in the cost of
common equity calculation in the leverage formula because investors demand
compensation for the lack of liquidity experienced with this type of debt
relative to large, readily saleable publicly traded debt. (UI BR 14-15, TR
186) She states that privately placed debt is typically held to maturity and
does not, by definition, have a public market in which it is traded. (TR 186)
This leads witness Ahern to believe that holders of privately placed debt
require a higher return than holders of publicly held debt, and that this
higher return premium must be reflected in the common equity cost rate. (UI BR
15, TR 186)
Staff agrees with
witness Rothschild that companies that have access to both publicly and
privately placed debt may not realize significant cost savings between the two
forms of financing. (TR 59) However, witness Rothschild failed to demonstrate
that the average Florida WAW utility is capable of accessing both public and
private financing. (TR 109) Witness Rothschild, when asked whether he could
identify any WAW utility under the Commission’s jurisdiction that has issued
equity through private placement, stated that he had not studied the issue.
(TR 109) He also admitted that he did not specifically study the small WAW
utilities in Florida to which the leverage formula is legislatively mandated to
apply. (TR 109) In addition, staff believes that the average WAW utility in Florida does not have access to public financing. (TR 145-146) The fact that an average
WAW utility in Florida cannot access public financing justifies the inclusion
of a private placement premium adjustment to compensate for the lack of
liquidity and the higher cost of financing of privately placed debt. (TR 186)
For these reasons, staff recommends the Commission continue to make a Private
Placement Premium adjustment of 50 basis points as reflected in Attachment A to
this recommendation.
Issue 1F:
Is it appropriate to make a Small-Utility Risk
Premium adjustment? If so, how should this adjustment be made?
Recommendation:
Yes. Staff recommends it is appropriate for the
Commission to continue to include a small utility risk premium of 50 basis
points in the cost of common equity calculation in the leverage formula as
reflected in Attachment A to this recommendation. (Springer)
Position
of the Parties
OPC:
No. First, not all companies to which the leverage
formula could be applied are small. Second, financial theory explains why
there shouldn’t be a small company premium, and empirical review of financial
data shows that financial theory is correct: there is no small company
premium.
Utilities Inc.:
Yes. Size is a factor which affects business risk
and must be reflected in the common equity cost rate. Since the WAW utilities
operating in Florida are all significantly smaller than the companies
comprising the Natural Gas Index used to calculate the leverage formula, they
are relatively more risky.
Staff Analysis:
OPC witness Rothschild testifies that investors only
demand compensation for the risk a company has in relation to the overall
market. (OPC BR 17, TR 60) He believes the information reported in Exhibit 6
proves that small companies have provided higher returns since 1926, but these
returns can be explained by higher betas of the companies. (TR 60, EXH 6) The
exhibit displays 10 groups of companies grouped according to size. (EXH 6)
Witness Rothschild states the data indicates that if a small company has a
lower beta it would also have a lower expected return, and this proves there is
no reason for a small company to require a higher return due to its size. (TR
60)
Witness Rothschild
testifies that risks typically faced by small firms would not be replicated for
a regulated public utility. (OPC BR 18, TR 248) He believes an unregulated,
small firm is more likely to have one or only a few key products that could be
subject to obsolescence or vulnerable to attack from a larger, more powerful
competitor. (TR 248) However, witness Rothschild also argues that regulated
WAW utilities should not fear competition because they have the protection of
territorial monopolies, and they have products with no chance of becoming
obsolete. (TR 248) For these reasons, he believes there is no small company
premium. (TR 60)
UI witness Ahern testifies
that it is appropriate to include the small-utility risk premium in the cost of
common equity calculation because size is a factor which affects business risk
and must be reflected in the common equity cost rate in the leverage formula.
(UI BR 16, TR 186) She states that smaller companies are less capable of
coping with significant events which affect sales, revenues, and earnings. (TR
186-187) Witness Ahern argues that the loss of revenues from a few large
customers, for example, would have a greater effect on a small company than on
a much larger company with a larger customer base. (TR 187) She states that
the average WAW utility under the Commission’s jurisdiction is a small,
regulated utility. (EXH 46) Witness Ahern believes the allowed overall costs
of capital and fair rates of return applied to these companies must reflect the
impact of their small size on the common equity cost rate. (TR 187) She
testifies that size is an important factor which affects common equity cost
rates and the Florida WAW utilities, including Utilities, Inc., on a
consolidated basis. (TR 187) Witness Ahern states that these are
significantly smaller companies than the average company in the natural gas
index whose market data are utilized in the derivation of the WAW ROE leverage
formula. (TR 187)
Witness Ahern
testifies that a comparison of Florida WAW utilities to the natural gas index
used in the leverage formula indicates a small size premium of 428 basis points
or 4.28 percent. (UI BR 17, TR 188-189) This premium is based upon data
contained in Chapter 7 of SBBI entitled, “Firm Size and Return.” (TR
189) Based on this analysis, witness Ahern believes the 50 basis point small
utility risk premium currently included in the Commission’s WAW ROE leverage
formula is an extremely conservative estimate of the adjustment needed to
reflect the business risk differential between Utilities, Inc., the average
Florida WAW utility, and the natural gas index. (TR 189-190)
With respect to
large, publicly traded companies with investment grade credit ratings relative
to small, publicly traded companies with investment grade credit ratings, staff
agrees with witness Rothschild that it is not necessary to recognize a premium
for the difference in size. (TR 60) However, with respect to large, publicly
traded companies with investment grade credit ratings, relative to extremely
small companies without access to the public debt or equity markets, staff
agrees with witness Ahern that a small utility risk premium adjustment like the
one included in the current Commission WAW ROE leverage formula is appropriate
and necessary. (TR 186-187) Staff agrees with witness Ahern that the average
WAW utility in Florida is significantly smaller than the average company in the
natural gas index whose market data are utilized in the derivation of the WAW
ROE leverage formula. As such, the loss of revenues from a few large customers
would have a greater effect on a small company than on a much larger company
with a larger customer base. (TR 187) For these reasons, staff recommends it
is appropriate for the Commission to continue to include a small utility risk
premium of 50 basis points in the cost of common equity calculation in the
leverage formula as reflected in Attachment A to this recommendation.
Issue 2:
Should the following leverage formula methodology be
applied using updated financial data:
Return on Common Equity = 7.36% + 2.123/Equity Ratio
Where the Equity Ratio = Common Equity / (Common Equity +
Preferred Equity + Long-Term and Short-Term Debt)
Range 9.48% @ 100% equity to 12.67% @ 40% equity
Recommendation:
No, the recommended WAW ROE leverage formula should
be approved without using updated financial information. The leverage formula
identified above results in a reasonable range of common equity returns for the
average WAW utility in Florida and should be approved. (Livingston)
Position
of the Parties
OPC:
No. Instead, the leverage formula methodology
proposed by Mr. Rothschild should be applied using updated financial data.
Utilities Inc.:
Yes, the current leverage formula results in a
reasonable range of common equity cost rate for the average WAW utility in Florida.
Staff Analysis:
OPC witness Rothschild
testifies that the existing leverage formula fails to consider that the cost of
debt changes along with the cost of equity as capital structure changes. (TR
49-50) In addition, he believes the existing leverage formula does not
recognize the real-world impact of income taxes as a critical part of capital
structure selection. (OPC BR 19, TR 251-252) Finally, witness Rothschild
believes the results of the DCF and CAPM analyses overstate the return on
equity for WAW utilities in Florida. (OPC BR 10)
Witness Rothschild
states that for the leverage formula to be appropriate, it is critical for the
Commission to change the form of the leverage formula. (TR 91) Witness
Rothschild recommends the following leverage formula be applied:
k = (OCC – D
(1-ER))/ER
where
k = cost of equity
D = cost of debt,
determined as a function of the percentage of equity in the capital structure
OCC = overall cost of
capital
ER = equity ratio
(TR 40)
Witness Rothschild notes that if a
utility has characteristics that make it particularly different from the
average Florida WAW utility, it may make the argument that the leverage formula
should not apply to it. (TR 98)
UI witness Ahern
testifies that the results of the current leverage formula are reasonable for
establishing a return on common equity for WAW utilities in Florida. (TR 167)
She concludes that, while witness Rothschild’s argument that the cost of debt
varies with leverage is theoretically valid, it is not necessary to make this
change to the Commission’s leverage formula methodology. (TR 175) Witness
Ahern believes the Commission’s assumption that the debt cost rate is constant
over a common equity range of 40% to 100% is reasonable. (TR 175)
Witness Ahern
testifies that witness Rothschild’s recommendation to base the derivation of
the WAW ROE leverage formula on the before-tax cost of capital would result in
a constant revenue cost of capital and therefore is inappropriate. (TR
179-180) This same argument has been previously considered and rejected by the
Commission in Order No. 19718.
Witness Ahern
testifies that witness Rothschild’s DCF and CAPM analyses are flawed and result
in returns that are inadequate for determining the required ROE for WAW
utilities in Florida. (TR 168, 204) She states that because of the numerous
deficiencies in these analyses, his recommended changes to the Commission’s WAW
ROE leverage formula should be rejected. (UI BR 1-2)
The witnesses agree the concept of a leverage formula is a
creative, innovative approach to streamline rate proceedings for Florida WAW
utilities. (OPC BR 19, TR 168, 251) Witness Ahern notes that approximately
two-thirds of the WAW utilities in Florida reported annual revenues equal to or
less than $200,000 in 2007. (UI BR 20, EXH 46) She argues that it would be
cost prohibitive for each of these utilities to hire cost of capital experts
for a rate case. (UI BR 20) Witness Ahern believes these utilities represent
the average WAW utility in Florida to which the leverage formula is intended to
apply. (UI BR 21)
Witness Ahern testifies that the results of the leverage
formula proposed by staff in its May 8, 2008 recommendation is reasonable. (TR
167, EXH 2) The results indicated by witness Rothschild’s recommended leverage
formula are much lower than the returns authorized for other regulated entities
in Florida. (TR 54, 148-149) Therefore, staff believes it would be
inappropriate to accept witness Rothschild’s proposed leverage formula.
Based on this analysis,
as well as staff’s analysis in previous issues, staff recommends the following
leverage formula methodology be applied:
Return on
Common Equity = 7.36% + 2.123/Equity Ratio
Where the Equity Ratio = Common Equity / (Common Equity +
Preferred Equity + Long-Term and Short-Term Debt)
Range: 9.48% @ 100% equity to 12.67% @ 40% equity
Issue 3:
What is the appropriate range of returns on common
equity for water and wastewater (WAW) utilities pursuant to Section 367.081
(4)(f), Florida Statutes?
Recommendation:
Staff recommends the following leverage formula:
Return on Common Equity = 7.36% + 2.123/Equity Ratio
Where the Equity Ratio = Common
Equity / (Common Equity + Preferred Stock + Long-term and Short-term Debt)
Range: 9.48% @ 100% equity to 12.67% @ 40% equity
In addition, staff recommends the
Commission cap returns on common equity at 12.67% for all WAW utilities with
equity ratios less than 40 percent to discourage imprudent financial risk. (Maurey)
Position
of the Parties
OPC:
The range should be calculated using the formula
recommended by Mr. Rothschild. The appropriate return on equity to allow to a
water or wastewater company with a common equity ratio of 40.0% is 10.53%; at
an inefficient equity ratio of 100%, it is 6.52%
Utilities, Inc.:
The appropriate range of the rate of return on
common equity is the range proposed by the PSC Staff as outlined in Exhibit 2.
Staff Analysis:
Two witnesses presented testimony in this proceeding
regarding the appropriate range of returns on common equity for WAW utilities
pursuant to Section 367.081(4)(f), Florida Statutes. OPC witness Rothschild
recommends a number of changes to the current Commission methodology for
determining the range of returns on equity for WAW utilities. (TR 33-44) He
determined ROE estimates based on the DCF model and the CAPM of 9.42%-9.43% and
9.37%, respectively. (TR 75, 86) Witness Rothschild’s recommended leverage
formula results in a range of returns on equity of 6.52% at 100 percent equity
and 10.53% at 40 percent equity. (TR 54)
UI witness Ahern testifies that the results of staff’s
recommended leverage formula are reasonable for establishing the ROE for WAW
utilities in Florida. (TR 204; EXH 2) Although she did not recommend an ROE
for purposes of this proceeding, witness Ahern did perform an analysis that
indicated ROE estimates of 11.47% based on the DCF model and 12.20% based on
the CAPM. (TR 208, EXH 42) Based on her analysis, witness Ahern concludes
that the results of the staff recommended WAW ROW leverage formula are
reasonable if not conservatively low. (TR 204-205)
The statutory principles for determining the appropriate
rate of return for a regulated utility are set forth by the U.S. Supreme Court
in its Hope and Bluefield decisions.
These decisions define the fair and reasonable standards for determining rate
of return for regulated enterprises. Namely, these decisions hold that the
authorized return for a public utility should be commensurate with returns on
investments in other companies of comparable risk, sufficient to maintain the
financial integrity of the company, and sufficient to maintain its ability to
attract capital under reasonable terms. (TR 149-150, 192, 205)
Each of witness Rothschild’s recommended adjustments to
the Commission’s methodology for determining the WAW ROE leverage formula has
been discussed in detail in the previous issues. Rather than repeat those
arguments and the rebuttal testimony to each adjustment offered by witness
Ahern, staff will briefly summarize the primary defect in witness Rothschild’s
testimony and the basis for staff’s recommendation in the instant issue.
While witness Rothschild correctly begins his analysis by
applying generally accepted financial models to an index of regulated natural
gas companies as a proxy for WAW utilities, his end result is compromised by
his failure to recognize the significant difference in risk between the average
company in the proxy group and the average WAW utility in Florida. (TR 92,
142, 148-154, 186-192, 244) It was repeatedly demonstrated that witness
Rothschild lacks a thorough understanding of the WAW utilities under the
Commission’s jurisdiction that are the subject of this proceeding. (TR 94-100,
109, 144-146) The proxy group contains large companies that are all publicly
traded, all have investment grade bond ratings, and all have annual revenue at
or above $1 billion. (EXH 11, EXH 47, pp. 19-20) In contrast, the group of
WAW utilities under the Commission’s jurisdiction is comprised of numerous
small companies. (TR 94, 188) Of the 267 certificated WAW utilities under the
Commission’s jurisdiction, 176 or 66 percent have annual revenues less than
$200 thousand. (EXH 46) Of this same group, 247 or 88 percent have annual
revenues less than $1 million. (EXH 46) Witness Rothschild could not identify
any WAW utility in Florida that has an investment grade bond rating. (TR
144-145) With the exception of Aqua America, witness Rothschild could not identify
any WAW utility in Florida that has publicly traded equity. (TR 144-145) By
basing his recommended leverage formula on the indicated ROE for a group of
large, publicly traded natural gas companies without making any adjustment for
the difference in risk between the proxy group and the average WAW utility in
Florida, witness Rothschild’s recommended range of returns significantly
understates the required return on equity for the WAW companies under the
Commission’s jurisdiction. (TR 54, 148-149, 183-188)
The inadequacy of the indicated returns from witness
Rothschild’s recommended leverage formula is readily apparent when recent
Commission decisions are considered. In Order No. PSC-08-0436-PAA -GU, the Commission approved an authorized ROE of 11.0% for St. Joe Natural
Gas Company.
If St. Joe’s 60 percent equity ratio were plugged into witness Rothschild’s
recommended leverage formula, the indicated return would have been 8.46%. (TR
54) In contrast, staff’s recommended leverage formula indicates an ROE of
10.9% for a utility with an equity ratio of 60 percent. (EXH 2) The staff
analyses in Issues 1(B) – 1(F) discuss in detail the deficiencies in witness
Rothschild’s approach to developing his recommended leverage formula that cause
his recommended returns to be inadequate.
As noted earlier, both the Hope and Bluefield decisions require regulatory commissions to authorize returns that are
fair, just, and reasonable. (TR 192, 205) Witness Rothschild was unable to
cite to any exceptions in either of these U.S. Supreme Court decisions that
support his recommendation that this Commission approve a leverage formula that
would result in authorized returns for WAW utilities that are systematically
significantly less than authorized returns for other regulated companies
operating in the same jurisdiction. (TR 149-150)
Based on its analysis of the cost of capital testimony
presented in this case and its recommendations in the previous issues, staff
recommends the Commission adopt the leverage formula specified above and
presented in greater detail in Attachment A to this recommendation. Staff also
recommends the Commission cap returns on common equity at 12.67% for all WAW
utilities with equity ratios less than 40 percent. Staff believes this will
discourage imprudent financial risk. This cap is consistent with the
methodology approved in numerous previous Commission orders regarding the WAW
ROE leverage formula.
Issue 4:
Should this docket be closed?
Recommendation:
No. This docket is a perpetual docket and should
not be closed until next year’s docket is opened. (Hartman)
Position
of the Parties
OPC:
No.
Utilities Inc.:
No.
Staff Analysis:
This docket is a perpetual docket and should not be
closed until next year’s docket is opened.
|
State of Florida
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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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May 8, 2008
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|
TO:
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Office of Commission Clerk (Cole)
|
|
FROM:
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Division of Economic Regulation (Springer, Maurey,
Bulecza-Banks)
Office of the General Counsel (Hartman)
|
|
RE:
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Docket No. 080006-WS – Water and wastewater industry annual reestablishment of authorized range of return on common equity for water
and wastewater utilities pursuant to Section 367.081(4)(f), F.S.
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|
AGENDA:
|
05/20/08 – Regular Agenda – Proposed Agency Action - Interested Persons May Participate
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COMMISSIONERS ASSIGNED:
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All Commissioners
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PREHEARING OFFICER:
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Argenziano
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CRITICAL DATES:
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12/30/08 – Pursuant to Section 367.081(4)(f), Florida Statutes
|
|
SPECIAL INSTRUCTIONS:
|
None
|
|
FILE NAME AND LOCATION:
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S:\PSC\ECR\WP\080006.RCM.DOC
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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 (ROE) for water and
wastewater (WAW) utilities. In Docket No. 070006-WS, the Commission established the current leverage formula by Order No. PSC-07-0472-PAA-WS, issued June 1, 2007.
This staff recommendation utilizes the current leverage
formula methodology established in Order No. PSC-01-2514-FOF-WS, issued December 24, 2001, in Docket No. 010006-WS. Since then, the Commission has used this methodology in establishing the leverage formula.
This methodology uses returns on equity from financial
models based upon an index of natural gas utilities. In establishing the
methodology, the Commission found that relatively few WAW utilities have
actively traded stocks. Furthermore, the available WAW utilities were heavily
influenced by regulation in one state – California – and by merger activity.
Therefore, the Commission has used natural gas utilities as the proxy companies
for the leverage formula since 2001. There are many natural gas utilities that
have actively traded stocks and forecasted financial data. Staff used natural
gas utilities that derive at least 55% of their revenue from regulated rates.
These utilities have market power and are influenced significantly by economic
regulation. As explained in the body of this recommendation, the model results
based on natural gas utilities are adjusted to reflect the risks faced by
Florida WAW utilities.
The Commission has jurisdiction pursuant to Section
367.081, Florida Statutes.
Discussion of Issues
Issue 1:
What is the appropriate range of returns on
common equity for water and wastewater (WAW) utilities pursuant to Section
367.081(4)(f), Florida Statutes?
Recommendation:
Staff recommends that the current leverage
formula methodology be applied using updated financial data. Staff recommends
the following leverage formula:
Return
on Common Equity = 7.36% + 2.123/Equity Ratio
Where the Equity Ratio = Common
Equity / (Common Equity + Preferred Equity + Long-Term and Short-Term Debt)
Range: 9.48% @ 100% equity to 12.67% @ 40% equity
(Springer)
Staff Analysis:
Section 367.081(4)(f), Florida Statutes,
authorizes the Commission to establish a leverage formula to calculate a
reasonable range of returns on equity for WAW utilities. The Commission must
establish this leverage formula not less than once a year.
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 debt 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 ROE models. Staff
adjusted the results of these models to reflect differences in risk and debt
cost between the index of companies used in the models and 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). This DCF model is an annual
model and uses prospective growth rates. The index consists of 10 companies that derive at least 55% 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 for the index of NG utilities. The market return for the 2008 leverage
formula was calculated using a quarterly DCF model.
Staff averaged the indicated returns of the above models
and adjusted the result as follows:
·
A bond yield differential of 39 basis points is added to reflect
the difference in yields between an A/A2 rated bond, which is the median 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 because
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
derivation of the recommended leverage formula using the current methodology
with updated financial data is presented in Attachment 1.
Staff recommends that the Commission cap returns on
common equity at 12.67% for all water and wastewater utilities with equity
ratios less than 40%. Staff believes that this will discourage imprudent
financial risk. This cap is consistent with the methodology in Order No. PSC-01-2514-FOF-WS.
Issue 2:
Should the Commission close this docket?
Recommendation:
No. Upon
expiration of the protest period, if a timely
protest is not received from a substantially affected person, the decision
should become final and effective upon the issuance of a Consummating Order.
However, this docket should remain open to allow staff to monitor changes in
capital market conditions and to readdress the reasonableness of the leverage
formula as conditions warrant. (Hartman, Springer)
Staff Analysis:
Upon expiration of the protest period, if a
timely protest is not received from a substantially affected person, the
decision should become final and effective upon the issuance of a Consummating
Order. However, this docket should remain open to allow staff to monitor
changes in capital market conditions and to readdress the reasonableness of the
leverage formula as conditions warrant.
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SUMMARY OF RESULTS
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Leverage Formula
Update
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|
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Updated Results
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Currently in Effect
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(A) DCF ROE for Natural Gas Index
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9.68%
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8.89%
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(B) CAPM ROE for Natural Gas Index
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11.40%
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10.98%
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AVERAGE
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10.54%
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9.93%
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Bond Yield Differential
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0.39%
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0.42%
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Private Placement Premium
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0.50%
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0.50%
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Small-Utility Risk Premium
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0.50%
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0.50%
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Adjustment to Reflect Required Equity
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|
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Return at a 40% Equity Ratio
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0.73%
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0.66%
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Cost of Equity for Average Florida WAW
|
|
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Utility at a 40% Equity Ratio
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12.67%
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12.01%
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2007 Leverage Formula
(Currently in Effect)
|
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Return on Common Equity =
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7.10% + 1.961/ER
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Range of Returns on Equity =
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9.07% - 12.01%
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2008 Leverage Formula
(Recommended)
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Return on Common Equity =
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7.36% + 2.123/ER
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Range of Returns on Equity =
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9.48% - 12.67%
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|
|
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Marginal Cost of
Investor Capital
Average Water and
Wastewater Utility
Weighted
Marginal
Marginal
Capital
Component Ratio Cost
Rate Cost Rate
Common Equity
46.37% 11.94% 5.53%
Total Debt
53.63% 7.36% * 3.95%
100.00%
9.48%
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 7.36% + 2.123/.40 = 12.67%
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% 12.67% 5.07%
Total Debt
60.00% 7.36% * 4.42%
100.00% 9.48%
Where: ER = Equity Ratio = Common
Equity/(Common Equity + Preferred Equity + Long-Term Debt + Short-Term Debt)
* Assumed Baa3 rate for March 2008
plus a 50 basis point private placement premium and a 50 basis point small
utility risk premium.
Sources: Moody's
Credit Perspectives and Value Line Selection and Opinion