On October 16, 2018, FERC proposed a new method to determine whether a utility’s return on equity (“ROE”) remains just and reasonable under section 206 of the Federal Power Act (“FPA”). Specifically, FERC discussed three additional methods, along with the well-known and traditionally used Discounted Cash Flow (“DCF”) analysis, and proposed to average the results to come to an equitable ROE. This new method will apply to successive complaints filed against the New England Transmission Owners (“NETOs”), regarding the justness and reasonableness of their existing ROE. Briefs related to this proposal are due on December 17, 2018.

In 2011, a group of transmission customers and state officials filed a complaint at FERC under FPA section 206 asserting that the NETOs’ ROE of 11.14% was unjust and unreasonable. After an Administrative Law Judge issued an initial decision on this matter, FERC issued Opinion No. 531 in 2014. In Opinion No. 531, FERC first decided to replace its usual “one-step” DCF policy with a two-step DCF analysis to determine whether an ROE is unjust and unreasonable. Second, FERC also determined that if a complainant could show that an ROE was above the point estimate produced by the DCF analysis, then that ROE would be unjust and unreasonable. Third, FERC declined to set the new ROE at the midpoint of the zone of reasonableness produced by the DCF because of “anomalous financial market conditions,” which made FERC “less confident[t] that the midpoint of reasonableness…accurately reflects set[ting] a return at a rate commensurate with other enterprises of comparable risk.” Lastly, FERC concluded that total ROE, which is composed of a utility’s base ROE plus any transmission incentive adders, should be limited to the top end of the zone of reasonableness. Therefore, using this approach, FERC set the base ROE for NETOs at 10.57%.

NETOs and some of their customers appealed this decision to the U.S. Court of Appeals for the District of Columbia Circuit (“D.C. Circuit”) and filed three other successive complaints at FERC. NETOs argued that (1) because its existing ROE of 11.14% fell between the zone of reasonableness envisioned by FERC (7.03%-11.74%), the existing ROE could not be unjust and unreasonable, and that (2) FERC did not adequately explain how an ROE of 11.14% was unjust and unreasonable. NETOs’ transmission customers argued that FERC did not sufficiently support its assertion that anomalous capital markets and alternative benchmark methodologies justified a base ROE above the midpoint of reasonableness. The D.C. Circuit quickly dismissed NETOs’ first argument because “the zone of reasonableness represents a broad range of potentially just and reasonable ROEs [and] not an exact dollar figure” and “as long as the rate selected by the Commission is within the zone of reasonableness, FERC is not required to adopt as just and reasonable any particular rate level.” However, the D.C. Circuit agreed with NETOs and its customers that FERC did not sufficiently support its finding that an ROE of 10.57% was just and reasonable. The D.C. Circuit stated that “FERC’s finding that 10.57% was a just and reasonable ROE, standing alone, did not amount to a finding that every other rate of return was not.” The D.C. Circuit reasoned that “FERC must make an explicit finding that [an] existing rate [is] unjust and unreasonable before proceeding to set a new rate.” Therefore, the D.C. Circuit vacated and remanded Opinion No. 531 and its progeny.

In the instant order, FERC (1) developed a new method to determine whether an existing ROE falls within an equitable zone of reasonableness and (2) established a framework for determining a new just and reasonable ROE if it does not fall within the zone of reasonableness. To satisfy the first category and because the D.C. Circuit stated FERC did not have to rely solely on the DCF methodology, FERC proposed to rely on three models that produce zones of reasonableness: the DCF, the capital-asset pricing model analysis (“CAPM”), and the expected earnings analysis (“Expected Earnings”) models. In fulfilling the second category, FERC proposed to rely solely on the risk premium (“Risk Premium”) analysis.

FERC explained that the CAPM “provides a market-based approach determined by…a measure of the risk based upon the volatility of a company’s stock price over time in comparison to the overall market, and the risk premium between the risk-free rate and the market’s return.” The Expected Earnings analysis “provides an accounting-based approach that uses investment analyst estimates of return on book value.” The Risk Premium approach, unlike the DCF, the CAPM, and Expected Earnings, does not produce a range of lawful ROEs; instead, it produces a single numerical point and is “based on the premium investors require above the return they expect to earn on a bond investment to reflect the greater risk of a stock investment.” While FERC said that none of the preferred approaches can conclusively determine or estimate the expected return for a utility, FERC will “average the results of the three methods that produce zones of reasonableness” and that average will “produce a composite zone of reasonableness that most accurately captures the cost of equity that informs the ROE.”

FERC directed NETOs, its transmission customers, state officials, and others who intervened in the proceeding to submit briefs to inform FERC of how to apply its four approaches to the successive complaints filed against NETOs at FERC. Briefs are due December 17, 2018.

A copy of FERC’s October 16 order is available here.