DATE:	June 2, 2011
TO:	Office of Commission Clerk (Cole)
FROM:	Division of Economic Regulation (Salnova, Cicchetti, Maurey, Springer) Office of the General Counsel (Klancke)
RE:	Docket No. 110006-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.
AGENDA:	06/14/11 – Regular Agenda – Interested Persons May Participate
COMMISSIONERS ASSIGNED:			All Commissioners
PREHEARING OFFICER:			Brisé
CRITICAL DATES:			None
SPECIAL INSTRUCTIONS:			None
FILE NAME AND LOCATION:			S:\PSC\ECR\WP\110006.RCM.DOC

 

 Case Background

Section 367.081(4)(f), Florida Statutes (F.S.), 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.  The leverage formula methodology currently in use was established in Order No. PSC-01-2514-FOF-WS.[1]  On October 23, 2008, the Commission held a formal hearing in Docket No. 080006-WS to allow interested parties to provide testimony regarding the validity of the leverage formula.  Based on the record in that proceeding, the Commission approved the 2008 leverage formula in Order No. PSC-08-0846-FOF-WS.[2]  In that order, the Commission reaffirmed the methodology that was previously approved in Order No. PSC-01-2514-FOF-WS.  In 2010, the Commission established the leverage formula currently in effect by Order No. PSC-10-0401-PAA-WS.[3]

This staff recommendation utilizes the current leverage formula methodology established in Order No. PSC-08-0846-FOF-WS.  This methodology uses returns on equity (ROE) derived from financial models applied to an index of natural gas utilities.  Based on the results of staff’s annual review, there is an insufficient number of WAW utilities that meet the requisite criteria to assemble an appropriate proxy group.  Therefore, since 2001, the Commission has used natural gas utilities as the proxy companies for the leverage formula.  There are many natural gas utilities that have actively traded stocks and forecasted financial data.  Staff used natural gas utilities that derive at least 49 percent 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.

Although subsection 367.081(4)(f), F.S., authorizes the Commission to establish a range of returns for setting the authorized ROE for WAW utilities, the Commission retains the discretion to set an ROE for WAW utilities based on record evidence in any proceeding.  If one or more parties file testimony in opposition to the use of the leverage formula, the Commission will determine the appropriate ROE based on the evidentiary record in that proceeding. 

The Commission has jurisdiction pursuant to Section 367.081, F.S.

 

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 =  7.13% + 1.610/Equity Ratio

    

Where the Equity Ratio = Common Equity / (Common Equity + Preferred Equity + Long-Term and Short-Term Debt)

 

            Range:  8.74% @ 100% equity to 11.16% @ 40% equity

(Salnova, Cicchetti, Springer) 

Staff Analysis: 

 Section 367.081(4)(f), F.S., 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 but a linear function of the debt to equity ratio over the relevant range;

3)                  The marginal weighted average cost of investor capital is constant over the equity ratio range of 40 percent to 100 percent; 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 percent to 100 percent.

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 (NG) utilities  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 9 companies that derive at least 49 percent 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 2011 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 57 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 derivation of the recommended leverage formula using the current methodology with updated financial data is presented in Attachment 1. 

 

For administrative efficiency, the leverage formula is used to determine the appropriate return for an average Florida WAW utility.  Traditionally, the Commission has applied the same leverage formula to all WAW utilities.  As is the case with other regulated companies under the Commission’s jurisdiction, the Commission has discretion in the determination of the appropriate ROE based on the evidentiary record in any proceeding.  If one or more parties file testimony in opposition to the use of the leverage formula, the Commission will determine the appropriate ROE based on the evidentiary record in that proceeding. 

 

Based on the foregoing. staff recommends that the Commission cap returns on common equity at 11.16 percent for all WAW utilities with equity ratios less than 40 percent.  Staff believes that this will discourage imprudent financial risk.  This cap is consistent with the methodology in Order No. PSC-08-0846-FOF-WS.

 

Issue 2: 

 Should this docket be closed?

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.  (Klancke, Salnova)

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.

Attachment 1

Page 1 of 6

 

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                        49.30%                       10.40%                       5.13% 

Total Debt                                50.70%                       7.13% *                      3.61%

                                                            100.00%                                                         8.74%

 

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 7.13% + 1.610/.40 = 11.16%

 

 

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%                       11.16%                        4.46%

Total Debt                                 60.00%                       7.13% *                       4.28%

                                                            100.00%                                                          8.74%

 

Where: ER = Equity Ratio = Common Equity/(Common Equity + Preferred Equity + Long-Term Debt + Short-Term Debt)

 

* Assumed Baa3 rate for March 2011 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

Attachment 1

                                                                                                                                           Page 3 of 6

ANNUAL DISCOUNTED CASH FLOW MODEL

 

NOTE: The cash flows for this multi-stage DCF Model are derived using the average forecasted dividends and the near term and long term growth rates.  The discount  rate, 8.25%, equates the cash flows with the average stock price less flotation cost.

$39.89  = April  2011 average stock price with a 4% flotation cost.

8.25% = Cost of equity required to match the current stock price with the expected cash flows.

 Sources:

1.  Stock Prices - S&P Stock Guide, May 2011  Edition.

2.  DPS, EPS, ROE -  Value Line Issue:  March 11, 2011.

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, May 1,                                               2011)

Beta     =          Measure of industry-specific risk (Average for water utilities followed by Value Line)

MR      =          Market return (Value Line Investment Survey For Windows, May 2011)

9.40%  =          4.94% + 0.67(11.28% - 4.94%) + 0.20%

Note:  Staff calculated the market return using a quarterly DCF model for a large number of dividend paying stocks followed by Value Line.  For May 2011, the result was 11.28%.  Staff also added 20 basis points to the CAPM result to allow for a four-percent flotation cost.

 

 

Attachment 1

Page 5 of 6

 

 

 

Attachment 1 Page 6 of 6

 

 

INDEX STATISTICS AND FACTS

 

 

Value Line Investment Survey for Windows, May 2011   

S.E.C. Forms 10Q and 10K for Companies

AUS Utility Report, May 2011