Issue 1:
What is the appropriate range of returns on common equity for water and wastewater utilities pursuant to Section 367.081(4)(f), Florida Statutes?
Recommendation:
Staff recommends that the current leverage formula approved by the Commission in Order No. PSC-14-0272-PAA-WS continue to be used until the leverage formula is readdressed in 2016. Accordingly, 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
Additionally, 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 this will discourage imprudent financial risk. This cap is consistent with the methodology in Order No. PSC-08-0846-FOF-WS. (D. Buys)
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 common equity for WAW utilities. The Commission must establish this leverage formula not less than once a year.
In 2014, by Order No. PSC-14-0272-PAA-WS, the Commission approved staff’s recommendation to continue to use the leverage formula initially approved in 2011. The Commission kept the 2011 leverage formula in place because Federal Reserve monetary policies lowered interest rates to historically low levels, thereby increasing the slope of the leverage formula graph relative to previous years. The Federal Reserve’s monetary policies and resulting capital market conditions that existed in 2012 through 2014 are expected to continue in 2015.[9]
In the instant docket, staff updated the leverage formula using the most recent 2015 financial data and the Commission approved methodology. Using the updated financial data in the leverage formula decreases the lower end of the current allowed ROE range by 95 basis points while increasing the upper end of the range by 35 basis points relative to the current leverage formula. The spread between the range of returns on equity based on the updated leverage formula is 372 basis points (7.79 percent to 11.51 percent). This is the second largest spread for the allowed ROE for WAW utilities in the approximately 33 years the leverage formula has been in use in Florida. In comparison, the spread in the range of returns on equity for the existing leverage formula is 242 basis points (8.74 percent to 11.16 percent).
The increase in the spread in the range of the ROE from the updated leverage formula relative to the 2011 leverage formula is caused by the very low bond rates resulting from the Federal Reserve’s various monetary policies and quantitative easing programs, which are still in effect. In its press release dated April 29, 2015, the Federal Reserve stated:
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.[10]
In the same press release, the Federal Reserve further stated:
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
The most recent assumed Baa3 bond rate of 5.31 percent used in the updated leverage formula calculation, which includes a 50 basis point adjustment for small company risk and a 50 basis point adjustment for a private placement premium, remains low relative to historic levels. In comparison, the assumed Baa3 bond rate used in the existing leverage formula is 7.13 percent.
Because interest rates are at historically low levels, thereby increasing the slope of the leverage formula relative to prior years, staff believes the range of returns on equity produced from the updated leverage formula is not optimal for determining the appropriate authorized ROE for Florida WAW utilities at this time. An increase in the slope of the leverage formula means a given change in the equity ratio will result in a greater change to the cost of equity. The results of this year’s leverage formula produced a slope consistent with the slopes produced by financial data for 2012 through 2014. As shown on the following page, Chart 1-1 illustrates the change in the slope of the leverage formula using updated data compared to the current leverage formula.
Chart 1-1
Chart 1-2 illustrates the change in the slope of the leverage formula for the five years 2011 through 2015.
Chart 1-2
In staff’s opinion, the existing leverage formula range of 8.74 percent to 11.16 percent initially approved in 2011 is still reasonable for WAW utilities. Therefore, staff recommends that the current leverage formula approved in Docket No. 110006-WS continue to be used for determining the return on equity for WAW utilities in 2015. Staff believes retaining the use of the current leverage formula until the leverage formula is addressed again in 2016 is a reasonable alternative to updating the formula using current 2015 financial information.
Staff continues to believe the leverage formula is a sound, workable methodology that reduces the costs and administrative burdens in WAW rate cases by eliminating the need for cost of equity testimony. Many of the WAW utilities under the Commission’s jurisdiction are small operations that find it beneficial to avoid the costs associated with presenting cost of equity testimony.
Although staff recommends the current 2011 leverage formula remain in place, staff has provided the updated leverage formula using the most recent financial information should the Commission decide to not continue to use the 2011 leverage formula and approve the updated leverage formula. The updated model produced the following leverage formula:
Return on Common Equity = 5.31% + (2.480 ÷ Equity Ratio)
Where the Equity Ratio = Common Equity ÷ (Common Equity + Preferred Equity + Long-Term + Short-Term Debt)
Range: 7.79% @ 100% equity to 11.51% @ 40% equity
In conjunction with the updated leverage formula, the returns on common equity should be capped at 11.51 percent for all WAW utilities with equity ratios less than 40 percent to discourage imprudent financial risk. This cap is consistent with the methodology in Order No. PSC-08-0846-FOF-WS.
In developing the updated leverage formula, staff used the same methodologies used in the 2011 docket. 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 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 eight natural gas companies that derive at least 50 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 natural gas utilities. The market return for the 2015 leverage formula was calculated using a quarterly DCF model with stock prices as of May 15, 2015.
Staff averaged the indicated returns of the above models and adjusted the result as follows:
• A bond yield differential of 44 basis points is added to reflect the difference in yields between an A-/A3 rated bond, which is the median bond rating for the natural gas 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 natural gas utilities. The derivation of the leverage formula using the current methodology with updated financial information 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 aforementioned, staff believes that the current range of returns on common equity of 8.74 percent to 11.16 percent is still reasonable for WAW utilities. As such, staff recommends the current leverage formula authorized by the Commission in Order No. PSC-14-0272-PAA-WS remain unchanged until the leverage formula is readdressed in 2016.
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. (Janjic, Mapp)
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.