Discussion
of Issues
Issue 1:
Should the leverage formula methodology be modified?
Recommendation:
Yes. Several refinements should be made to the
leverage formula methodology to reflect newly available information and to
reflect best practices. The leverage formula methodology should be modified to
include a combined proxy group of natural gas and WAW utilities with updated
financial data based on market-capitalization based weighted averages. Also,
the cost of debt used in determining the leverage formula should be based on
the projected cost of debt. (Richards)
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. However, use of the leverage formula by utilities is
discretionary and a utility can file cost of equity testimony in lieu of using
the leverage formula. 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 in a rate case or limited proceeding file testimony in lieu
of the use of the leverage formula, the Commission will determine the
appropriate ROE based on the evidentiary record in that proceeding.
Since 2001, staff has used the leverage formula
methodology established in Order No. PSC-2001-2514-FOF-WS and reaffirmed in Order
No. PSC-2008-0846-FOF-WS. This methodology used ROEs derived from financial
models applied to an index of natural gas utilities. The Commission determined
in 2001 and 2008 that there were an insufficient number of publicly traded WAW
utilities that met the requisite criteria to assemble an appropriate proxy
group, and therefore, natural gas utilities were used instead. However, due to
mergers and acquisitions of natural gas utilities over the past two years, the
number of acceptable natural gas utilities has been reduced from eight to six. Concurrently,
the number of publicly-traded water companies followed by Value Line has risen
from four to nine. Based on comments made at the workshop and its own analysis,
staff has modified the selection of proxy companies and determined that a
combination of qualified WAW and natural gas utilities is reasonable and
appropriate for a proxy group to use in calculating the leverage formula. Staff
selected natural gas utilities and WAW utilities that derive at least 50 percent
of their revenue from regulated rates. These utilities have market power and
are influenced significantly by economic regulation. As explained later in this
recommendation, the returns calculated using the proxy group are adjusted to
reflect the risks faced by Florida WAW utilities.
Methodology
Staff’s
recommendation for the leverage formula reflects certain modifications from the
previously approved methodology. As mentioned earlier, staff expanded the proxy
group to include WAW utilities as well as natural gas utilities. The updated
index consists of six natural gas companies and seven WAW companies that derive
at least 50 percent of their total revenue from regulated operations. These
companies have a median Standard and Poor’s bond rating of “A”.
In addition, staff used a
weighted average, where appropriate, as opposed to using a simple average as
was done in the previous leverage formula calculations. The weighted average
was calculated using the market capitalization of the proxy companies. Staff
used the market- capitalization based weighted average because of the size
disparity among the companies comprising the new proxy group. There is a much
greater size difference between companies in both assets and revenues when
using both WAW and natural gas companies as opposed to using only natural gas
companies. As pointed out in UIF’s comments, “a market value weighted average
is consistent with the manner in which returns for the Standard & Poor’s
500 composite Index (S&P) are estimated.”
Staff used a market capitalization weighted average of: (1) Discounted Cash
Flow (DCF) model results, (2) the Beta values in the Capital Asset Pricing Model
(CAPM), and (3) the equity ratio of the proxy group.
In addition to the modifications to the leverage formula
methodology cited above, staff used a projected yield on Baa3 rated public
utility bonds to estimate the bond yield of an average Florida WAW utility in
the calculation of the weighted average cost of capital of the proxy group.
Staff believes using a projected yield is appropriate because required returns
are forward looking and based on projections. The previously approved
methodology used the most current monthly average bond yield for a Baa2 rated
utility and added the 120-month average spread between a Baa3 rated utility
bond yield and the Baa2 rated bond yield as published by Value Line Investment
Survey (Value Line). Staff updated its methodology to use the projected Baa2
rated utility bond yield for the upcoming four quarters as published by the
most recent Blue Chip Financial Forecasts (Blue Chip). Staff then added the
120-month average spread to the projected Baa2 rated utility bond yield to
estimate a projected Baa3 rated utility bond yield. Aside from the
modifications cited above, all other aspects of the previously approved
leverage formula methodology remain unchanged.
The leverage formula relies on ROE models described below.
Staff adjusted the results of these models to reflect differences in risk and
debt cost between the proxy group and the average Florida WAW utility. The ROE
models include a four percent adjustment for flotation costs. The ROE models
are as follows:
•
A multistage Discounted Cash Flow (DCF) model applied
to an index of natural gas and WAW utilities that have publicly traded stock
and are followed by the Value Line. This DCF model is an annually compounded
model and uses prospective dividend growth rates.
•
A Capital Asset Pricing Model (CAPM) that relies on a
market return for companies followed by Value Line, the average projected yield
on the U.S. Treasury’s 30-year bonds published by Blue Chip Financial
Forecasts, and the weighted average beta for the index of natural gas and WAW
utilities. The market return for the 2018 leverage formula was calculated using
a quarterly DCF model with stock prices as of April 16, 2018.
Staff averaged the results of the DCF and CAPM models and
adjusted the result as follows:
•
A bond yield differential of 64 basis points was added
to reflect the difference in yields between an A/A2 rated bond, which is the
median bond rating for the combined 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 and smaller companies are considered by investors to be
more risky than larger companies.
After the above adjustments, the resulting cost of equity
estimate is included in the weighted average capital structure of the proxy
group of utilities to derive the leverage formula.
Workshop
Comments
On November 8, 2017, staff held a workshop to solicit
input from interested persons regarding potential changes to the current
leverage formula methodology. As part of the workshop, interested persons were
requested to file comments by October 30, 2017. The only stakeholders that
filed comments in the docket were the Office of Public Counsel (OPC) and Utilities,
Inc. of Florida (UIF). OPC also filed post-workshop comments on January 31,
2018. OPC’s suggestions all resulted in lowering the ROE while UIF’s
suggestions mostly resulted in increasing the ROE.
OPC Comments
•
OPC submitted that the Commission adopt a rule setting
forth the leverage formula. OPC contended that continued application of the
leverage formula constitutes an un-adopted rule.
•
OPC questioned the applicability of a Bond Yield
Differential if an all WAW utility proxy group is used. OPC specifically
questioned whether the assumed bond rating of Baa3 for the average WAW utility
in Florida is still a valid assumption.
•
OPC stated that the leverage formula should
differentiate between Class A WAW utilities and Class B and C WAW utilities.
OPC opined that Class A WAW utilities would not need a small-utility risk
premium.
•
OPC further commented that the small-utility risk
premium adjustment is duplicative of the bond yield risk premium and ignores
the fact that several Florida WAW utilities could be comparable to water
utilities included in the new index and therefore the small-utility risk
premium should be removed from the formula.
•
OPC also submitted that the private placement premium
of 50 basis points should be removed from the leverage formula for Class A WAW
utilities. OPC does not believe that investors require a premium for the lack
of liquidity of privately placed debt for large Florida WAW utilities that are
owned by substantially larger corporations. OPC further questioned why the
private placement premium of 50 basis points is fixed and if it is reasonable.
•
Finally, OPC submitted that flotation costs should not
be included in the DCF and CAPM models since none of Florida’s WAW utilities
are publicly traded and do not incur costs related to issuing new shares of
stock.
Staff Response to OPC’s
Comments
Regarding OPC’s request for the Commission to adopt a
leverage formula rule, Section 367.081(4)(f), F.S., states:
The Commission may regularly, not less often than
once each year, establish by order a leverage formula or formulae that
reasonably reflect the range of returns on common equity for an average water
or wastewater utility and which, for purposes of this section, shall be used to
calculate the last authorized rate of return on equity for any utility which
otherwise would have no established rate of return on equity. In any other
proceeding in which an authorized rate of return on equity is to be
established, a utility, in lieu of presenting evidence on its rate of return on
common equity, may move the commission to adopt the range of rates of return on
common equity that has been established under this paragraph. (Emphasis added)
Staff believes the statute, on its face, makes it clear
that the Commission may establish a leverage formula by order. The Commission
reviews the leverage formula yearly. Thus, if it was codified in a rule, the
Commission would have to initiate rulemaking every year to review the leverage
formula. Based on the statutory language allowing the leverage formula to be
established by Commission order, it appears that the legislature did not intend
the Commission to be in a constant rule making posture for this matter. Establishing
a rule for the leverage formula may limit the Commission’s discretion in an
area where maximum discretion is advised. Maximum discretion is advised because
determination of the required return on equity is subjective and a matter of
opinion arrived at by informed judgement. Consequently, staff does not
recommend establishment of a rule for the leverage formula.
Regarding the bond yield differential, staff believes it
is a necessary adjustment that recognizes the spread between the median bond
rating of the utility proxy group (usually an A rating) to the assumed average
Florida WAW utility’s bond rating which is the lowest investment grade bond
rating (Baa3). If the Florida WAW utilities under the Commission’s jurisdiction
were to be rated, staff believes that, on average, they would be well below
investment grade.
Regarding OPC’s contention that the leverage formula
should differentiate between large Class A WAW utilities and smaller Class B
and C WAW utilities, staff disagrees. The leverage formula is derived to
appropriately compensate the average WAW utility in Florida. The largest WAW utility
in Florida is substantially smaller and more risky from a financial perspective
than the utilities in the proxy group. UIF is by far the largest WAW utility in
Florida and has total common equity of $47 million. The average market
capitalization of the utilities in staff’s recommended proxy group is $5.45
billion and the smallest company has a market capitalization of $400 million.
Small-company risk premiums are a widely accepted adjustment that has been used
by financial analysts for decades to account for the differences in the
expected returns between small-cap and large-cap companies. If any adjustment
should be made to account for the difference between the Class A and Class B and
C WAW utilities, an upward adjustment should be made for Class B and C WAW
utilities.
Reasons why smaller WAW utilities are more risky than
other utilities include: (1) WAW utilities are more capital intensive than electric
or natural gas utilities; (2) WAW utilities experience lower relative
depreciation rates than other utilities, thereby providing less cash flow; (3)
WAW utilities experience consistently negative free cash flow, thereby
increasing their financing requirements; (4) WAW utilities’ credit metrics are
inferior to those of electric and natural gas utilities; (5) Florida WAW
utilities are substantially smaller than electric and natural gas utilities by
virtually any measure including total revenues, total assets, and market
capitalization; (6) WAW utilities’
earnings are much more volatile (uncertain) than electric and natural gas
utilities’ earnings; and (7) WAW utilities experience many more business
failures than electric and natural gas utilities.
Regarding OPC’s claim that the risk premium adjustment is
duplicative, staff disagrees. The small-utility risk premium adjustment and the
bond yield risk premium adjustment are not the same and compensate an investor
for different risks. The small-utility risk premium is an adjustment for the
smaller sized companies based on market capitalization and the bond yield risk
premium is an adjustment based on the assumed credit rating of the average
Florida WAW utility (Baa3) as compared to the median credit rating of the proxy
group (A).
Regarding OPC’s comment about the private placement
premium, the Commission has previously included this adjustment to reflect the
difference in yields on publicly traded debt and privately placed debt, which
is illiquid. Staff admits that a private placement premium may change over time
based on financial market conditions. However, information regarding actual
private placement premiums is not readily available to derive an actual amount.
Nevertheless, staff believes recognition of the private placement risk should
be included in the leverage formula. The private placement premium of 50 basis
points was approved by the Commission in Order No. PSC-2008-0846-FOF-WS. In
its order, the Commission stated:
In addition, we find that the average WAW utility in
Florida does not have access to public financing. 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. For these reasons,
we find that that it is appropriate to continue to make a private placement
premium adjustment of 50 basis points as reflected in Attachment A to this
Order.
Staff believes the average WAW utility in Florida
continues to not have access to public financing and will have to pay a higher
interest rate for privately placed debt and a private placement premium is
still appropriate.
Regarding flotation costs, staff disagrees with OPC and
believes that accounting for flotation costs in the application of the models
is appropriate and in accordance with financial theory and application of the
financial models. Although none of Florida’s WAW utilities are publically
traded, application of the DCF and CAPM models to a proxy group is used to
approximate the required return on equity and appropriate estimation of the
required ROE includes an adjustment for flotation costs.
UIF
Comments
UIF retained ScottMaden, Inc., management consultants, to
file comments of its behalf. Ms. Pauline M. Ahern, CRRA, who testified on
behalf of UIF in the 2008 leverage formula docket, submitted comments. In
summary, Ms. Ahern provided 47 pages of technically detailed suggestions to
change the DCF and CAPM methodologies used to derive the ROE of the proxy
group. Those suggestions are summarized below.
• The Commission
should consider including a WAW utility index along with or replacing the natural gas utility index in the leverage
formula.
• The
Commission should consider changing the DCF model to utilize the single-stage DCF model and use expected growth rate
projections of EPS (earnings per share) as published
in Value Line in place of using projected dividends.
• The
Commission should eliminate foreign companies in the CAPM Market Equity Risk Premium (MERP) because the WAW utilities are
based in the U.S.
• The CAPM
MERP should be based on a market-value weighted average instead of a simple average.
• The
Commission should add two additional MERP estimates to the CAPM and average the results. The first one using a linear
Ordinary Least Squares regression, and the second using an Empirical CAPM.
• The
private placement premium should remain at 50 basis points.
• The small-utility risk premium should
be increased from 50 basis points to 100 basis points.
• Flotation
costs of 20 basis points, or 4%, should be included.
• The
Commission should use a projected yield on Baa3/BBB- rated public utilities in
the derivation to adjust the cost of
equity at a 40% equity ratio.
Staff Response to UIF’s
Comments
Several of UIF’s suggestions are already included in the
current leverage formula methodology as a result of the outcome of the 2008
hearing and subsequent order. In this docket, staff included WAW utilities
along with the natural gas utilities in its proxy group as suggested by UIF to
increase the sample group of companies available. The private placement premium
and small-utility risk premium are also included in the current methodology.
Staff does not believe that the small-utility risk premium should be increased
without further study to determine if that would be appropriate. Staff agrees
that flotation costs should be recognized in the application of the ROE models
and they have been since 2001.
UIF suggested that an estimated projected yield on Baa3
rated public utility bonds be used to calculate the assumed bond yield for the
average Florida WAW utility. The required return on equity is a forward-looking
concept and is based on projections. Also, the costs included in the test year
should reflect the costs expected during the period rates are going to be in
effect. Consequently, staff believes it is reasonable to use a projected Baa3
rated utility bond yield and that it is consistent with staff’s practice of
relying on the projected risk-free rate used in the CAPM.
Regarding UIF’s suggestion to use a single-stage DCF model
using expected earnings growth in the model, staff disagrees. All DCF models
are derived from the equation that represents all expected cash flows into
perpetuity. The multi-stage model allows staff to avail itself of the explicit
expected dividends provided by Value Line. Using a less robust form of the DCF
model provides no benefit. Staff also disagrees with the use of expected
earnings growth in lieu of expected dividend growth. DCF theory is unambiguous
when explaining that the expected cash flows associated with a share of stock
are dividends. This is important because the time value of money underscores
DCF theory and all earnings are not paid out to investors when they are earned.
Expected earnings are crucial to determining expected dividends, but expected
dividends are the expected cash flows that determine the value of a stock.
Regarding UIF’s recommendation that foreign stocks be
removed from the determination of the expected market return in the CAPM model,
staff disagrees. Under CAPM theory, the expected market return is the return on
all asset classes worldwide. Most analysts use the expected return on the US
stock market as a proxy for the return on all asset classes out of convenience.
Consequently, there is no reason to exclude foreign companies trading on the US
market.
Regarding UIF’s recommendations to consider adding more
versions of the CAPM to the leverage formula analysis, staff believes the
additional methodologies require a much greater level of subjectivity than the
traditional CAPM but will continue to consider their inclusion in the leverage
formula analysis.
Conclusion
For the reasons discussed above, staff recommends several
refinements to the leverage formula methodology to reflect newly available
information and to reflect best practices. The leverage formula methodology
should be modified to include a combined proxy group of natural gas and WAW
utilities with updated financial data based on market-capitalization based weighted
averages. Also, the cost of debt used in determining the leverage formula
should be based on the projected cost of debt.
Issue 2:
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:
The leverage formula methodology described in Issue
1 should be applied using a proxy group comprised of natural gas and WAW
utilities and updated financial data. Accordingly, the following leverage
formula should be used until the leverage formula is addressed again in 2019:
ROE = 6.24% + (1.94
÷ Equity Ratio)
Where the Equity Ratio = Common Equity ÷ (Common Equity +
Preferred Equity + Long-Term and Short-Term Debt)
Range: 8.18% at
100% equity to 11.08% at 40% equity
Additionally, the Commission should cap returns on common
equity at 11.08 percent for all WAW utilities with equity ratios less than 40
percent. This is in an effort to discourage imprudent financial risk. This cap
is consistent with the methodology in Order No. PSC-2008-0846-FOF-WS.
(Richards)
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. However, use of the leverage formula by utilities is
discretionary and a utility can file cost of equity testimony in lieu of using
the leverage formula. 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 in a rate case or limited proceeding file testimony in lieu
of using of the leverage formula, the Commission will determine the appropriate
ROE based on the evidentiary record in that proceeding.
Updated
Leverage Formula
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 an average 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.
In the instant docket, staff updated the current leverage
formula using the most recent 2018 financial data and the methodology described
in Issue 1 which uses a proxy group including both natural gas and WAW
utilities and market-capitalization based weighted average results. The
derivation of the leverage formula is presented in Attachment 1.
Using the updated financial data in the revised leverage
formula decreases the lower end of the current allowed ROE range by 56 basis
points and decreases the upper end of the range by 8 basis points. Overall, the
spread between the range of returns on equity based on the updated leverage
formula is 290 basis points (8.18 percent to 11.08 percent). In comparison, the
range of returns on equity for the existing leverage formula from 2011 is 242
basis points (8.74 percent to 11.16 percent).
The projected assumed Baa3 bond rate of 6.24 percent used
in the updated leverage formula calculation includes a 50 basis point
adjustment for small-company risk and a 50 basis point adjustment for a private
placement premium and remains low relative to historic levels. In comparison,
the assumed Baa3 bond rate used in the existing leverage formula is 7.13
percent. The lower Baa3 bond rate of 6.24 percent is the cause of the decrease
at the lower end of the range and the increased spread.
Based on the aforementioned, staff believes the revised
leverage formula methodology applied to a proxy group of natural gas and WAW
utilities with updated financial data based on market-capitalization weighted
averages produces a reasonable range of ROEs for WAW utilities and reflects current
financial markets. As such, staff recommends the following leverage formula be
used until a new leverage formula is determined in 2019:
ROE = 6.24% + (1.94
÷ Equity Ratio)
Where the Equity Ratio = Common Equity ÷ (Common Equity +
Preferred Equity + Long-Term and Short-Term Debt).
The appropriate range of returns on equity is 8.18% at
100% equity to 11.08% at 40% equity.
Additionally, staff recommends that the Commission cap
returns on common equity at 11.08 percent for all WAW utilities with equity ratios
less than 40 percent. Staff recommends this in an effort to discourage
imprudent financial risk. This cap is consistent with the methodology in Order
No. PSC-2008-0846-FOF-WS.
Issue 3:
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. (Harper)
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.
