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State of Florida |
Public Service Commission Capital Circle Office Center ● 2540 Shumard
Oak Boulevard -M-E-M-O-R-A-N-D-U-M- |
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DATE: |
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TO: |
Office of Commission Clerk (Teitzman) |
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FROM: |
Division of Accounting and Finance (McGowan, D. Buys, Higgins) Office of the General Counsel (Bloom) |
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RE: |
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AGENDA: |
06/03/25 – Regular Agenda – Proposed Agency Action – Interested Persons May Participate |
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COMMISSIONERS ASSIGNED: |
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PREHEARING OFFICER: |
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SPECIAL INSTRUCTIONS: |
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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 return on equity (ROE) for water and wastewater (WAW) utilities. The original version of the current leverage formula methodology was established by 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 by Order No. PSC-2008-0846-FOF-WS.[3] In that order, the Commission reaffirmed the methodology that was previously approved by Order No. PSC-2001-2514-FOF-WS.[4]
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 Sunshine Water Services Company (formerly Utilities, Inc. of Florida). 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.[5] The June 2018 Order approving the current leverage formula provided necessary and timely updates to the leverage formula methodology.
The Commission has jurisdiction pursuant to Section 367.081, F.S.
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 8.51 percent at 100 percent equity to 10.51 percent at 40 percent equity. This range was determined using the leverage formula methodology approved by Order No. PSC-2018-0327-PAA-WS applied to a proxy group comprised of natural gas and WAW utilities using the most recent financial data. Accordingly, the following leverage formula should be used until this matter is addressed again in 2026:
ROE = 7.17% + (1.337 ÷ Equity Ratio)
Where the Equity Ratio = Common Equity ÷ (Common Equity + Preferred Equity + Long-Term Debt + Short-Term Debt)
Range: 8.51% at 100% equity to 10.51% at 40% equity
The Commission should cap returns on common equity at 10.51 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 by 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 ROE for an average Florida WAW utility. However, use of the leverage formula by the utilities is discretionary and a utility may file cost of equity testimony in lieu of using the leverage formula. 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 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 by Order No. PSC-2001-2514-FOF-WS, reaffirmed by Order No. PSC-2008-0846-FOF-WS, and modified by 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 & 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 (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 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 by Order No. PSC-2018-0327-PAA-WS, staff used the average of the projected Corporate Baa rated bond yield of 6.050 percent for the upcoming four quarters as published in the May 1, 2025 Blue Chip Financial Forecast (Blue Chip). Staff then added the 120-month historical average spread of 0.121 percent between the Baa and A Corporate Utility Bond yields to the projected Corporate Baa rated bond yield of 6.050 percent to estimate a projected Baa3 rated utility bond yield of 6.17 percent.[6]
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 6.17 percent to reflect the risk for a typical Florida WAW utility, which resulted in a projected assumed debt cost rate of 7.17 percent.
6.050% + 0.121% + 0.50% + 0.50% = 7.17%
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 multi-stage 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 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, 2025, 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 May 9, 2025. Consistent with the Commission’s approved methodology since 2001, the CAPM result was adjusted upward by 20 basis points to reflect flotation costs.
Consistent with Order No. PSC-2018-0327-PAA-WS, staff averaged the results of the DCF and CAPM models and adjusted the result of 8.60 percent as follows:
A bond yield differential of 36 basis points was added to reflect the difference in yields between an A-/A3 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 9.96 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 56 basis points to reflect an estimated required return of 10.51 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
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DCF Model |
7.25% |
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CAPM |
9.94% |
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Average |
8.60% |
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Bond Yield Differential |
0.36% |
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Private Placement Premium |
0.50% |
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Small-Utility Risk Premium |
0.50% |
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Adjusted ROE Average |
9.96% |
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Adjustment to Reflect Required Equity Return at a 40% Equity Ratio |
0.56% |
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Upper Range of ROE |
10.51% |
Source: Staff Worksheets
Leverage Formula
The updated leverage formula is: ROE = 7.17% + (1.337 ÷ Equity Ratio)
The resulting range of returns is 8.51 percent at 100 percent equity to 10.51 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 15 basis points and decreases the upper end of the range by 73 basis points. Overall, the spread between the range of ROE based on the updated leverage formula is 200 basis points (8.51 percent to 10.51 percent). In comparison, the range of ROE for the 2024 leverage formula is 258 basis points (8.66 percent to 11.24 percent). The change in the range from 2024 is due to a decrease of 44 basis points in the average result of the ROE models (9.04 percent to 8.60 percent), a decrease of 11 basis points in the bond differential (47 basis points to 36 basis points), and a decrease of 17 basis points in the adjustment to reflect the required return at a 40 percent equity ratio (73 basis points to 56 basis points).
The updated 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 conditions. As such, staff recommends the following leverage formula be used until a new leverage formula is determined in 2026:
ROE = 7.17% + (1.337 ÷ Equity Ratio)
Where the Equity Ratio = Common Equity ÷ (Common Equity + Preferred Equity + Long-Term Debt + Short-Term Debt).
The appropriate range of ROE is 8.51% at 100% equity to 10.51% at 40% equity.
Additionally, staff recommends that the Commission cap returns on common equity at 10.51 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 approved by 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. (Bloom)
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.
SUMMARY OF RESULTS
2025 Water and
Wastewater Leverage Formula
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Currently |
Updated |
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In Effect |
Results |
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(1) DCF ROE for Proxy Group |
7.91% |
7.25% |
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(2) CAPM ROE for Proxy Group |
10.17% |
9.94% |
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AVERAGE |
9.04% |
8.60% |
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Bond Yield Differential |
0.47% |
0.36% |
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Private Placement Premium |
0.50% |
0.50% |
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Small-Utility Risk Premium |
0.50% |
0.50% |
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Adjustment to Reflect Required Equity Return at a 40% Equity Ratio |
0.73% |
0.56% |
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Cost of Equity for Average Florida WAW Utility at 40% Equity Ratio |
11.24% |
10.51% |
2024 Leverage Formula (Currently in Effect)
Return on Common Equity = 6.94% + (1.719 ÷ Equity Ratio)
Range of Returns on Equity = 8.66% to 11.24%
2025 Leverage Formula (Updated Results)
Return on Common Equity = 7.17% + (1.337 ÷ Equity Ratio)
Range of Returns on Equity = 8.51% to 10.51%
Marginal Cost of
Investor Capital
Average Water and Wastewater
Utility
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Weighted |
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Marginal |
Marginal |
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Capital Component |
Ratio |
Cost Rate |
Cost Rate |
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Common Equity |
47.97% |
9.96% |
4.78% |
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Total Debt |
52.03% |
7.17%* |
3.73% |
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100.00% |
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8.51% |
A 40% equity ratio is the floor for calculating the required return on common equity.
The return on equity at a 40% equity ratio: 7.17% + (1.337 ÷ 0.40) = 10.51%
Marginal Cost of
Investor Capital
Average Water and
Wastewater Utility at 40% Equity Ratio
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Weighted |
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Marginal |
Marginal |
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Capital Component |
Ratio |
Cost Rate |
Cost Rate |
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Common Equity |
40.00% |
10.51% |
4.21% |
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Total Debt |
60.00% |
7.17%* |
4.30% |
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100.00% |
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8.51% |
Where the Equity Ratio = Common Equity ÷ (Common Equity + Preferred Equity + Long-Term Debt + Short-Term Debt)
*Assumed Baa3 rate for April 2025 plus a 50 basis point private placement premium and a 50 basis point small-utility risk premium.
Sources:
Blue Chip Financial Forecasts
Value Line Selection & Opinion
Company 10-K Filings
Discounted Cash Flow
Model Results
April 1, 2025 –
April 30, 2025
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DCF |
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STOCK PRICE |
DCF |
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Weighted |
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COMPANY |
High |
Low |
Avg. |
Results |
Weight |
Results |
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Atmos Energy Corporation |
161.49 |
141.59 |
151.54 |
6.97% |
23.47% |
1.63% |
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NiSource Inc. |
40.73 |
35.64 |
38.19 |
7.69% |
18.48% |
1.42% |
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Northwest Natural Holding |
44.38 |
38.94 |
41.66 |
7.83% |
1.66% |
0.13% |
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ONE Gas, Inc. |
79.24 |
69.75 |
74.50 |
6.95% |
4.15% |
0.29% |
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Spire Inc. |
79.81 |
71.28 |
75.55 |
7.26% |
4.36% |
0.32% |
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American States Water |
81.52 |
73.80 |
77.66 |
8.01% |
3.01% |
0.24% |
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American Water Works |
155.50 |
137.41 |
146.46 |
6.77% |
28.25% |
1.91% |
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California Water Service |
51.63 |
46.60 |
49.12 |
8.29% |
2.80% |
0.23% |
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Essential Utilities, Inc. |
41.65 |
36.72 |
39.19 |
7.82% |
10.90% |
0.85% |
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Middlesex Water |
67.09 |
59.37 |
63.23 |
8.92% |
1.14% |
0.10% |
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H2O America (f/k/a SJW Group)* |
57.17 |
49.42 |
53.30 |
6.94% |
1.77% |
0.12% |
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Average Weighted DCF Result: |
7.25% |
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The ROE of 7.25% represents the expected cost of equity required to match the average stock price, less three percent for flotation costs, with the present value of expected cash flows.
*SJW Group changed its name to H2O America on May 6, 2025.
Sources:
Stock prices obtained from Yahoo Finance for the 30-day period April 1, 2025 through April 30, 2025.
Natural Gas company dividends, earnings, and ROE obtained from Value Line Ratings & Reports issued February 21, 2025.
Water and Wastewater company dividends, earnings, and ROE obtained from Value Line Ratings & Reports issued April 4, 2025.
Capital Asset Pricing
Model Cost of Equity for
Water and
Wastewater Industry
CAPM analysis formula
K = RF + Beta (MR - RF) + 0.20%
K = Investor’s required rate of return
RF = Risk-free rate
(May 2025 Blue Chip forecast for 30-year U.S. Treasury Bond Yield)
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3Q 2025 |
4Q 2025 |
1Q 2026 |
2Q 2026 |
3Q 2026 |
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4.50% |
4.50% |
4.40% |
4.40% |
4.40% |
Average = 4.44%
Beta = Measure of industry-specific risk (market cap weighted average for the proxy
group of natural gas and WAW utilities)
MR = Market Return (Value Line Investment Analyzer Web Browser)
9.94% = 4.44% + 0.884 (10.43% ˗ 4.44%) + 0.20%
Note:
Staff calculated the market return using a quarterly DCF model for a large number of dividend paying stocks followed by Value Line. As of May 9, 2025, the result was 10.43%. The market return is adjusted to reflect a flotation cost of three percent for the companies included in the DCF market return calculation. Staff added 20 basis points to the CAPM result to reflect flotation costs for the proxy group.
Bond Yield for
Water and Wastewater Industry
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Credit Rating |
(A) |
Spread |
(A-) |
Spread |
(BBB+) |
Spread |
(BBB) |
Spread |
(BBB-) |
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NA |
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0.121 |
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0.121 |
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0.121 |
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120-Month Avg. Spread: |
0.121% |
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Total Equity Bond |
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Yield Differential: |
0.121% × 3 = 0.363% |
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2Q 2025 |
3Q 2025 |
4Q 2025 |
1Q 2026 |
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Forecast Corporate Baa Bond Yield |
6.10% |
6.10% |
6.00% |
6.00% |
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Average Forecasted Corporate |
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Baa Bond Rate: |
6.050% |
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Assumed Bond Yield for Baa3 Utilities:
0.121% + 6.050% = 6.171%
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Currently |
Updated |
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In Effect |
Results |
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Private Placement Premium |
0.50% |
0.50% |
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Small-Utility Risk Premium |
0.50% |
0.50% |
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Assumed Bond Yield for Baa3 Utilities |
5.94% |
6.17% |
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Assumed Bond Yield for Florida WAW Utilities |
6.94% |
7.17% |
Sources:
Value Line Selection & Opinion and Blue Chip Financial Forecasts (120-Month Avg. Spread)
Blue Chip Financial Forecast issued May 1, 2025 (Forecast Corporate Baa Bond Yield)
2025 Leverage
Formula Proxy Group
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S&P |
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V/L Market |
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Equity |
Value |
Value Line |
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Bond |
Regulated |
Capital |
Equity |
Ratio |
Line |
Beta |
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Company |
Rating |
Revenue |
(in millions) |
Ratio |
(Weighted) |
Beta |
(Weighted) |
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Atmos Energy Corporation |
A- |
94.00% |
$22,600 |
60.70% |
14.25% |
0.90 |
0.2112 |
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NiSource Inc. |
BBB+ |
96.84% |
17,800 |
43.32% |
8.01% |
0.95 |
0.1756 |
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Northwest Natural Holding |
A- |
89.84% |
1,600 |
42.42% |
0.70% |
0.90 |
0.0150 |
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ONE Gas, Inc. |
A- |
98.19% |
4,000 |
48.26% |
2.00% |
0.85 |
0.0353 |
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Spire Inc. |
BBB+ |
94.02% |
4,200 |
40.79% |
1.78% |
0.90 |
0.0393 |
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American States Water |
A |
70.10% |
2,900 |
49.74% |
1.50% |
0.75 |
0.0226 |
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American Water Works |
A |
91.05% |
27,200 |
42.40% |
11.98% |
0.85 |
0.2401 |
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California Water Service |
A+ |
98.01% |
2,700 |
54.24% |
1.52% |
0.85 |
0.0238 |
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Essential Utilities, Inc. |
A- |
87.67% |
10,500 |
44.61% |
4.86% |
0.90 |
0.0981 |
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Middlesex Water |
A |
92.94% |
1,100 |
53.62% |
0.61% |
0.80 |
0.0091 |
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H2O America (f/k/a SJW Group) |
A- |
97.88% |
1,700 |
42.76% |
0.75% |
0.80 |
0.0141 |
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Average |
A- |
91.87% |
$8,755 |
47.53% |
47.97% |
0.859 |
0.884 |
Sources:
Company 10-K Filings
Standard & Poor’s (S&P)
Value Line Ratings & Reports
[1]Order No. PSC-2001-2514-FOF-WS, issued December 24, 2001, in Docket No. 20010006-WS, In re: Water and wastewater industry annual reestablishment of authorized range of return on common equity of water and wastewater utilities pursuant to Section 367.081(4)(f), F.S.
[2]At the May 20, 2008, Commission Conference, upon request of the Office of Public Counsel, the Commission voted to set the establishment of the appropriate leverage formula directly for hearing.
[3]Order No. PSC-2008-0846-FOF-WS, issued December 31, 2008, in Docket No. 20080006-WS, In re: Water and wastewater industry annual reestablishment of authorized range of return on common equity for water and wastewater utilities pursuant to Section 367.081(4)(f), F.S.
[4]Order No. PSC-2001-2514-FOF-WS, issued December 24, 2001, in Docket No. 20010006-WS, In re: Water and wastewater industry annual reestablishment of authorized range of return on common equity for water and wastewater utilities pursuant to Section 367.081(4)(f), F.S.
[5]Order No. PSC-2018-0327-PAA-WS, issued June 26, 2018, in Docket No. 20180006-WS, In re: Water and wastewater industry annual reestablishment of authorized range of return on common equity for water and wastewater utilities pursuant to Section 367.081(4)(f), F.S.
[6]Staff relied on the A and Baa/BBB rated Corporate Utility Bond yields published by Value Line’s Selection & Opinion from April 2015 through March 2024 (108 months). On November 29, 2024, Value Line discontinued providing the Corporate Utility Bond yields in its Selection & Opinion publication. For April 2024 through March 2025 (12 months), staff relied on the Corporate Aaa and Baa bond yields published by Blue Chip Financial Forecasts in its calculations for the 120-month historical average spread.