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. 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. Based on the record in that proceeding,
the Commission approved the 2008 leverage formula in Order No. PSC-2008-0846-FOF-WS. 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), F.S.?
Recommendation:
The appropriate range of returns on common equity is
8.66 percent at 100 percent equity to 11.24 percent at 40 percent equity. This
range was determined using 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. Accordingly, the following leverage formula
should be used until the leverage formula is addressed again in 2025:
ROE = 6.94 + (1.719 ÷ Equity Ratio)
Where the Equity Ratio = Common Equity ÷ (Common Equity +
Preferred Equity + Long-Term and Short-Term Debt)
Range: 8.66% at 100% equity to 11.24% at 40% equity
The Commission should cap returns on common equity at
11.24 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 approved in Order No. PSC-2018-0327-PAA-WS. (McGowan)
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 on equity 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 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 WAW companies that have actively traded stock and
forecasted financial data. To establish the proxy group, staff selected five
natural gas companies and six WAW companies that derive at least 50 percent of
their total revenue from regulated operations and have a Standard and Poor’s
(S&P) credit rating. These selected companies have market power and are
influenced significantly by economic regulation and have an average S&P
bond rating of ‘A’.
Consistent with the approved methodology, staff used a
market capitalization weighted average for: (1) the Discounted Cash Flow model
results, (2) the Beta values in the Capital Asset Pricing Model, and (3) the
equity ratio of the proxy group.
Assumed Cost of Debt
Staff used a projected yield on Corporate Baa 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 average of the projected Corporate Baa
rated bond yield of 5.825 percent for the upcoming four quarters as published
in the April 1, 2024 Blue Chip Financial Forecast (Blue Chip). Staff then added
the 120-month historical average spread of 0.117 between the Baa and A
Corporate Utility Bond yields to the projected Corporate Baa rated bond yield
of 5.825 percent to estimate a projected Baa3 rated utility bond yield of 5.94
percent.
Staff added a 50 basis point adjustment for small-company
risk and a 50 basis point adjustment for a private placement premium to the
projected Baa3 rated utility bond yield of 5.94 percent to reflect the risk for
a typical Florida WAW utility, which resulted in a projected assumed debt cost
rate of 6.94 percent.
5.825% + 0.117% +
0.50% + 0.50% = 6.94%
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. Both of the ROE models include an adjustment of approximately
four percent 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 April 1, 2024, published by Blue
Chip, 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 8, 2024. Consistent with the Commission’s
approved methodology since 2001, the CAPM result was adjusted upward by 20
basis points to reflect flotation cost of approximately four percent.
Consistent with Order No. PSC-2018-0327-PAA-WS, staff
averaged the results of the DCF and CAPM models and adjusted the result of 9.04
percent as follows:
A bond yield differential of 47 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 lower
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 10.51 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 73 basis points to reflect an estimated required return of
11.24 percent at an equity ratio of 40 percent. Table 1-1 shows the components
that comprise the upper range of the leverage formula.
Table 1-1
Adjusted Return on Equity
|
DCF Model
|
7.91%
|
|
CAPM
|
10.17%
|
|
Average
|
9.04%
|
|
Bond Yield Differential
|
0.47%
|
|
Private Placement Premium
|
0.50%
|
|
Small-Utility Risk Premium
|
0.50%
|
|
Adjusted ROE Average
|
10.51%
|
|
Adj. To Reflect Required
Equity Return at a 40% Equity Ratio
|
0.73%
|
|
Upper Range of ROE
|
11.24%
|
Source: Staff Worksheets
Leverage Formula
The updated leverage formula is: ROE = 6.94% + (1.719 ÷
Equity Ratio)
The resulting range of returns is 8.66 percent at 100
percent equity to 11.24 percent at 40 percent equity.
Using the most recent financial data in the leverage
formula increases the lower end of the current allowed ROE range by 20 basis
points and increases the upper end of the range by 57 basis points. Overall,
the spread between the range of returns on equity based on the updated leverage
formula is 258 basis points (8.66 percent to 11.24 percent). In comparison, the
range of returns on equity for the current leverage formula from 2023 is 221
basis points (8.46 percent to 10.67 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 2025:
ROE = 6.94% + (1.719 ÷ 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 8.66% at
100% equity to 11.24% at 40% equity.
Additionally, staff recommends that the Commission cap
returns on common equity at 11.24 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. (Dose)
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.
