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-2019-0267-PAA-WS continue to be used until
readdressed in 2021. Accordingly, staff recommends the following leverage
formula:
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 percent
at 100 percent equity to 10.55 percent at 40 percent 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-2019-0267-PAA-WS. (Richards,
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. For administrative efficiency, the
leverage formula is used to determine the appropriate return for an average
Florida WAW utility. 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,
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 the leverage formula, the
Commission will determine the appropriate ROE based on the evidentiary record
in that proceeding.
COVID-19 Impact
In light of the recessionary impact on the economy caused
by the ongoing COVID-19 pandemic, the Federal Open Market Committee (Committee)
voted twice in March 2020 to reduce the target range for the federal funds
rate. On March 3, 2020, the Committee decided to lower the federal funds target
range from 1.50 - 1.75 percent to 1.00 - 1.25 percent. On
March 15, 2020, the Committee decided to lower the federal funds target range
from 1.00 - 1.25 percent to 0.00 - 0.25 percent, and reasoned, “The effects of
the coronavirus will weigh on economic activity in the near term and pose risks
to the economic outlook.” On
April 29, 2020, the Committee decided to maintain the target range for the
federal funds rate of 0.00 - 0.25 percent. The Committee expects to maintain
this target range until it is confident that the economy has weathered recent
events and is on track to achieve its maximum employment and price stability
goals.
Further, due to the recent decrease in risk-free interest
rates and the uncertainty in the bond market, the volatility of the spread
between the Utility 25/30-year BBB Bond Yield and the U.S. 30-year Treasury
Bond Yield has been much greater than usual as demonstrated in Figure 1-1. This
extreme volatility causes weekly fluctuations in the spread. Staff believes it
is not reasonable to set a range of returns on equity for setting rates going
forward using data that is influenced by the current catastrophic economic event.
Due to this unusual and unique economic situation, staff recommends the current
2019 leverage formula remain in place.
Figure 1-1
Spread between the 25/30-Year BBB Bond
Yield
and the 30-Year U.S. Treasury Bond
Yield
Source: Value Line Selection and Opinion
Updated Leverage Formula
Although staff recommends the 2019 leverage formula remain
in place, staff has provided the updated leverage formula using the most recent
financial information should the Commission decide not to continue to use the
2019 leverage formula and approve the updated leverage formula. The updated
model produced the following leverage formula:
Return on Common
Equity = 5.46% + (1.81 ÷ Equity Ratio)
Where the Equity Ratio
= Common Equity ÷ (Common Equity + Preferred Equity + Long-Term and Short-Term
Debt)
Range: 7.27 percent
at 100 percent equity to 9.99 percent at 40 percent equity
In conjunction with the updated leverage formula, the
returns on common equity should be capped at 9.99 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-2018-0327-PAA-WS.
Methodology
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 WAW companies that have
actively traded stock and forecasted financial data. To establish the proxy
group, staff selected five natural gas companies and seven 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 5.46 percent.
The projected assumed Baa3 bond rate of 5.46 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 2019 leverage formula is 6.05 percent.
The lower Baa3 bond rate of 5.46 percent is the primary driver of the overall
decrease in the results of the 2020 leverage formula compared to the 2019
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:
1)
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.
2)
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 April 1, 2020, 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, 2020.
Consistent with Order No. PSC-2018-0327-PAA-WS, staff
averaged the results of the DCF and CAPM models and adjusted the result of 7.62
percent as follows:
1)
A bond yield differential of 55 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.
2)
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.
3)
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 9.17 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 82 basis
points to reflect an estimated required return of 9.99 percent at an equity
ratio of 40 percent. Table 1-1 shows the components that comprise the upper
range of the leverage formula as compared between the 2019 leverage formula and
the 2020 leverage formula.
Table 1-1
Adjusted ROE Comparison
|
Component
|
2019
|
2020
|
|
DCF Model
|
7.39%
|
7.09%
|
|
CAPM
|
8.97%
|
8.15%
|
|
Average
|
8.18%
|
7.62%
|
|
Bond Yield Differential
|
0.60%
|
0.55%
|
|
Private Placement Premium
|
0.50%
|
0.50%
|
|
Small Utility Risk Premium
|
0.50%
|
0.50%
|
|
Adjusted ROE Average
|
9.78%
|
9.17%
|
|
Adj. To Reflect Required Equity
Return at a 40% Equity Ratio
|
0.77%
|
0.82%
|
|
Upper Range of ROE
|
10.55%
|
9.99%
|
Source: Staff
worksheets
Using the most recent financial data in the leverage
formula decreases the lower end of the current allowed ROE range by 58 basis
points and decreases the upper end of the range by 56 basis points. Overall,
the spread between the range of returns on equity based on the updated leverage
formula is 272 basis points (7.27 percent to 9.99 percent). In comparison, the
range of returns on equity for the existing leverage formula from 2019 is 270
basis points (7.85 percent to 10.55 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 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.
Conclusion
In staff’s opinion, the current leverage formula range of
returns on equity of 7.85 percent to 10.55 percent initially approved in 2019
is still reasonable for WAW utilities. Due to the economic volatility caused by
the unique situation of the COVID-19 pandemic, staff believes retaining the use
of the current 2019 leverage formula until the leverage formula is addressed
again in 2021 is a reasonable alternative to updating the formula using current
2020 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. Based
on the aforementioned, staff recommends that the current leverage formula
approved by the Commission in Order No. PSC-2019-0267-PAA-WS continue to be
used until the leverage formula is readdressed in 2021.
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. (Lherisson)
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.
