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-16-0254-PAA-WS continue to be used until the leverage
formula is readdressed in 2018 and a workshop be scheduled for the fall of 2017
to review and update, if necessary, the methodology used to determine the
leverage formula. 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, 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. 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 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 updated index consists of five 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 2017 leverage formula was calculated using a quarterly DCF model with stock
prices as of April 14, 2017.
Consistent
with Order No. PSC-01-2514-FOF-WS, staff
averaged the indicated returns of the above models and adjusted the result as
follows:
•
A bond yield differential of 62 basis points is added
to reflect the difference in yields between an A/A2 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.
Updated
Leverage Formula
In the
instant docket, staff updated the leverage formula using the most recent 2017
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 the lower end of the
current allowed ROE range by 104 basis points and decreases the upper end of
the range by 40 basis points. Overall, the spread between the range of returns
on equity based on the updated leverage formula is 306 basis points (7.70
percent to 10.76 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 306 basis point spread reflected in the updated leverage
formula is significantly greater than the 20-year average spread of 206 basis
points.
The inflated
ROE spread relative to the 2011 leverage formula is caused by the low bond
rates resulting from the Federal Reserve’s various monetary policies and quantitative
easing programs. In its press release dated May 3, 2017, the Federal Reserve
stated:
Consistent with its statutory mandate, the
Committee seeks to foster maximum employment and price stability. The Committee
views the slowing in growth during the first quarter as likely to be transitory
and continues to expect that, with gradual adjustments in the stance of
monetary policy, economic activity will expand at a moderate pace, labor market
conditions will strengthen somewhat further, and inflation will stabilize
around 2 percent over the medium term. Near-term risks to the economic outlook
appear roughly balanced. The Committee continues to closely monitor inflation
indicators and global economic and financial developments.
In view of realized and expected labor
market conditions and inflation, the Committee decided to maintain the target
range for the federal funds rate at 3/4 to 1 percent. The stance of monetary
policy remains accommodative, thereby supporting some further strengthening in
labor market conditions and a sustained return to 2 percent inflation.
[…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 5.66 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 2016. As shown on the
following page, Chart 1-1 illustrates the change in the slope of the 2017
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 seven years 2011 through 2017.
Chart 1-2
Comparison
of Annual Leverage Formulas since 2011
Source:
FPSC Staff Analysis
In 2016, by Order
No. PSC-16-0254-PAA-WS, issued June 29, 2016, 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 2017 are expected to continue in 2018.[12]
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 = 5.66% + (2.040
÷ Equity Ratio)
Where the
Equity Ratio = Common Equity ÷ (Common Equity + Preferred Equity + Long-Term
and Short-Term Debt)
Range: 7.70% @ 100% equity to 10.76% @ 40% equity
In
conjunction with the updated leverage formula, the returns on common equity
should be capped at 10.76 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.
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 2018 is a reasonable alternative to updating the
formula using current 2017 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. However, along with changes in market
conditions, mergers and acquisitions have affected the number of natural gas
companies included in the proxy group. In 2008, the leverage formula consisted
of 10 natural gas companies, in comparison, only five companies currently meet
the established criteria to be included in the proxy group. Staff recommends a
workshop be scheduled for the fall of 2017 to evaluate and update the companies
comprising the comparable group and to investigate whether or not to revise the
current leverage formula.
Based on the aforementioned, staff recommends that the current leverage
formula approved by the Commission in Order No. PSC-16-0254-PAA-WS continue to be
used until the leverage formula is readdressed in 2018 and that a workshop be
scheduled for the fall of 2017 to review and update, if necessary, the
methodology used to determine the leverage formula.
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. This docket should be closed upon issuance
of an order establishing a new docket number in 2018. (DuVal)
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. This docket should be closed upon issuance of an order
establishing a new docket number in 2018.
