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 original version of the current leverage
formula methodology was established in Order No. PSC-2001-2514-FOF-WS.[1] On October 23, 2008, the Commission held a
formal hearing in Docket No. 20080006-WS to allow interested parties to provide
testimony regarding the validity of the leverage formula.[2] Based on the record in that proceeding,
the Commission approved the 2008 leverage formula in Order No. PSC-2008-0846-FOF-WS.[3] In that order, the Commission reaffirmed
the methodology that was previously approved in Order No. PSC-2001-2514-FOF-WS.
From 2012 through 2017, the Commission
found that the range of returns on equity derived from the annual leverage
formulas were not optimal for determining the appropriate authorized ROE for
WAW utilities due to Federal Reserve monetary policies that resulted in
historically low interest rates. Consequently, the Commission decided it was
reasonable to continue using the range of returns on equity of 8.74 percent to
11.16 percent from the 2011 leverage formula approved by Order No.
PSC-2011-0287-PAA-WS until 2018.
On November 8, 2017, Commission staff held
a workshop to solicit input from interested persons regarding potential changes
to the current leverage formula methodology. 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. On June 26, 2018, the Commission approved the current leverage formula by
Order No. PSC-2018-0327-PAA-WS. The
June 2018 Order approving the current leverage formula provided necessary and
timely updates to the leverage formula methodology.
Section 367.081(4)(f), F.S., authorizes the
Commission to establish a range of returns for setting the authorized ROE for
WAW utilities. However, use of the leverage formula by the utilities is
discretionary and a utility can file cost of equity testimony in lieu of using
the leverage formula. The Commission may set an ROE for WAW utilities based on
record evidence in any proceeding. If a utility files cost of equity testimony,
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 utilities pursuant to Section 367.081(4)(f),
Florida Statutes?
Recommendation:
The leverage formula methodology approved in Order
No. PSC-2018-0327-PAA-WS using a proxy group comprised of natural gas and WAW
utilities and updated financial data should be used. Accordingly, the following
leverage formula should be used until the leverage formula is addressed again
in 2020:
ROE = 6.05 + (1.80 ÷ Equity Ratio)
Where the Equity Ratio = Common Equity ÷ (Common Equity +
Preferred Equity + Long-Term and Short-Term Debt)
Range: 7.85% at 100% equity to 10.55% at 40% equity
The Commission should cap returns on common equity at 10.55
percent for all WAW utilities with equity ratios less than 40 percent. Imposing
a cap serves to discourage imprudent financial risk. This cap is consistent
with the methodology in Order No. PSC-2018-0327-PAA-WS. (Hightower)
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 a 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.
Methodology
In the instant docket, staff updated the current leverage
formula using the most recent financial data applied to the methodology approved
in Order No. PSC-2001-2514-FOF-WS, reaffirmed in Order No. PSC-2008-0846-FOF-WS
and modified in Order No. PSC-2018-0327-PAA-WS. The methodology uses ROEs
derived from widely accepted financial models applied to an index of natural
gas and water and wastewater companies that have actively traded stock and
forecasted financial data. To establish the proxy group, staff selected 4
natural gas companies and 7 WAW companies that derive at least 50 percent of
their total revenue from regulated operations and have a Standard and Poor’s
credit rating. These selected companies have market power and are influenced
significantly by economic regulation and have a median Standard and Poor’s bond
rating of “A”.
Consistent with the approved methodology, staff used a
market capitalization weighted average for: (1) the 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.
Assumed Cost Of Debt
Staff used a projected yield on Baa2 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. A
projected yield is used because required returns are forward looking and based
on projections.
Consistent with the methodology approved in Order No.
PSC-2018-0327-PAA-WS, staff used the projected Baa2 rated utility bond yield for
the upcoming four quarters as published in the most recent Blue Chip Financial
Forecast (Blue Chip). Staff then added the 120-month historical average spread
between the Baa and A Corporate Utility Bond to the projected Baa2 rated
utility bond yield to estimate a projected Baa3 rated utility bond yield of
6.05 percent.
The projected assumed Baa3 bond rate of 6.05 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 2018 leverage formula is 6.24 percent.
The lower Baa3 bond rate of 6.05 percent is the primary driver of the overall decrease
in the results of the 2019 leverage formula compared to the 2018 leverage
formula.
Estimated Cost Of Equity
The current leverage formula relies on two 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 Value Line. This DCF model is an annually compounded model and
uses prospective dividend growth rates as published by Value Line.
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 as of May 1, 2019, 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 CAPM was calculated using a
quarterly DCF model with stock prices as of April 15, 2019.
Consistent with Order No. PSC-2018-0327-PAA-WS, staff
averaged the results of the DCF and CAPM models and adjusted the result of 8.18
percent as follows:
A bond yield differential of 60 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 assumed credit
quality of a typical Florida WAW utility.
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 of 9.78 percent is included in the weighted average capital structure
of the proxy group to derive the leverage formula. The derivation resulted in
an adjustment of 77 basis points to reflect an estimated required return of
10.55 percent at an equity ratio of 40 percent. Table 1 shows the components
that comprise the upper range of the leverage formula.
Table 1
Adjusted
ROE
|
DCF Model
|
7.39%
|
|
CAPM
|
8.97%
|
|
Average
|
8.18%
|
|
Bond Yield Differential
|
0.60%
|
|
Private Placement Premium
|
0.50%
|
|
Small Utility Risk Premium
|
0.50%
|
|
Adjusted ROE Average
|
9.78%
|
|
Adj. To Reflect Required Equity Return at a 40% Equity
Ratio
|
0.77%
|
|
Upper Range of ROE
|
10.55%
|
Source: Staff worksheets
Leverage
Formula
The updated leverage formula is: ROE = 6.05 % + (1.80 ÷
Equity Ratio)
The resulting range of returns is 7.85 percent at 100
percent equity to 10.55 percent at 40 percent equity.
Using the most recent financial data in the leverage
formula decreases the lower end of the current allowed ROE range by 26 basis
points and decreases the upper end of the range by 37 basis points. Overall,
the spread between the range of returns on equity based on the updated leverage
formula is 270 basis points (7.85 percent to 10.55 percent). In comparison, the
range of returns on equity for the existing leverage formula from 2018 is 281
basis points (8.11 percent to 10.92 percent).
In developing the updated leverage formula, staff
acknowledges 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.
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 2020:
ROE = 6.05% + (1.80 ÷ 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 7.85% at
100% equity to 10.55% at 40% equity.
Additionally, staff recommends that the Commission cap
returns on common equity at 10.55 percent for all WAW utilities with equity
ratios less than 40 percent. Staff recommends a cap to discourage imprudent
financial risk. This cap is consistent with the methodology in Order No. PSC-2018-0327-PAA-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. (Trierweiler)
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.
