Discussion
of Issues
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-15-0259-PAA-WS continue to be used until the leverage
formula is readdressed in 2017. 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. (Archer, Yeazel)
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. 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.
Methodology
The leverage formula relies on two ROE models. Staff
adjusts 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 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 natural gas utilities. The market return for
the 2016 leverage formula was calculated using a quarterly DCF model with stock
prices as of May 12, 2015.
Staff averages the indicated returns of the above models
and adjusted the result as follows:
•
A bond yield differential of 45 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.
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.
Updated Leverage Formula
In the
instant docket, staff updated the leverage formula using the most recent 2016
financial data and the Commission approved methodology. The derivation of the
leverage formula using the current methodology with updated financial
information is presented in Attachment 1 of this recommendation.
Using the updated
financial data in the leverage formula decreases both the lower end of the
current allowed ROE range by 111 basis points and the upper end of the range by
53 basis points. Overall, the spread between the range of returns on equity
based on the updated leverage formula is 300 basis points (7.63 percent to
10.63 percent). 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 300 basis point spread reflected in the updated leverage formula
is significantly greater than the 20-year average spread of 187 basis points.
The inflated
ROE spread 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 largely still in effect. In its press
release dated April 27, 2016, the Federal Reserve stated:[9]
Consistent with its statutory mandate, the
Committee seeks to foster maximum employment and price stability. The Committee
currently expects that, with gradual adjustments in the stance of monetary
policy, economic activity will expand at a moderate pace and labor market
indicators will continue to strengthen. Inflation is expected to remain low in the
near term, in part because of earlier declines in energy prices, but to rise to
2 percent over the medium term as the transitory effects of declines in energy
and import prices dissipate and the labor market strengthens further. The
Committee continues to closely monitor inflation indicators and global economic
and financial developments.
Against this backdrop, the Committee
decided to maintain the target range for the federal funds rate at 1/4 to 1/2
percent. The stance of monetary policy remains accommodative, thereby
supporting further improvement in labor market conditions and a return to 2
percent inflation.
In determining the timing and size of
future adjustments to the target range for the federal funds rate, the
Committee will assess realized and expected economic conditions relative to 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. In
light of the current shortfall of inflation from 2 percent, the Committee will
carefully monitor actual and expected progress toward its inflation goal. The
Committee expects that economic conditions will evolve in a manner that will
warrant only gradual increases in the federal funds rate; the federal funds
rate is likely to remain, for some time, below levels that are expected to
prevail in the longer run. However, the actual path of the federal funds rate
will depend on the economic outlook as informed by incoming data.
The most
recent assumed Baa3 bond rate of 5.63 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 2015. As shown on the
following page, Chart 1-1 illustrates the change in the slope of the 2016
leverage formula compared to the current leverage formula.
Chart 1-1
Comparison
of Annual Leverage Formulas
Source: FPSC Staff Analysis
Chart 1-2
illustrates the change in the slope of the leverage formula for the six years
2011 through 2016.
Chart 1-2
Comparison
of Annual Leverage Formulas since 2011
Source:
FPSC Staff Analysis
In 2015, by
Order No. PSC-15-0259-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 2015 are expected to continue in 2016.[10]
Although
staff recommends the current 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 current
in-place leverage formula and approve the updated leverage formula. In
developing the leverage formula, staff used the same methodologies used in the
2011 docket. The updated model produced the following leverage formula:
Return on Common Equity = 5.63% + (2.001 ÷ Equity Ratio)
Where the
Equity Ratio = Common Equity ÷ (Common Equity + Preferred Equity + Long-Term
and Short-Term Debt)
Range: 7.63% @ 100% equity to 10.63% @ 40% equity
In
conjunction with the updated leverage formula, if the Commission decides to
approve the updated leverage formula, the returns on common equity should be
capped at 10.63 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.
Conclusion
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. Staff
believes retaining the use of the current in-place leverage formula until the
leverage formula is addressed again in 2017 is a reasonable alternative to
updating the formula using current 2016 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.
Based on the
aforementioned, staff recommends that the current leverage formula approved by the
Commission in Order No. PSC-15-0259-PAA-WS continue to be used until the leverage
formula is readdressed in 2017.
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. (Leathers)
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.
