On June 19, 2015, at its Open Meeting, the Federal Energy Regulatory Commission (FERC or Commission) adopted a new methodology for determining the rate of return on equity (ROE) for FERC-jurisdictional electric utilities, and applied this new methodology in a pending complaint case involving the New England transmission owners. The Commission also set for hearing and settlement judge procedures in five complaints involving challenges to electric utility ROEs that have been pending for several years, expressing hope that the New England decision would provide guidance. Finally, the Commission acted on a partial remand from the United States Court of Appeals for the D.C. Circuit (D.C. Circuit) of the Southern California Edison Company’s (SoCal Edison) base ROE case.

During the Open Meeting, Acting Chairman Cheryl LaFleur stated that

At various times, each of my peers has publicly emphasized the importance of addressing the backlog of ROE cases at the Commission. When I became Acting Chairman, I stated that acting on the backlogged ROE orders was a high priority for me. I established specific goals for addressing the ROE cases, including that any resolution would be fair to customers and investors, principled and sustainable, and represent a consensus of my colleagues. While we did not achieve unanimous agreement on all points, I believe that we have met these goals.

Her comments were echoed by Commissioners Moeller, Norris, and Clark. The group acknowledged that it had allowed the backlog of ROE cases to languish too long without action, but that it had not undertaken the decision to change the Commission’s approach to ROE lightly. Norris noted his partial dissent to the decision on the basis that the Commission was tilting the balance too far in favor of the electric utilities, which would result in harm to the consumers.

New England Decision

The Commission’s decision in Martha Coakley v. Bangor Hydro-Electric Co., Opinion No. 531, 147 FERC ¶ 61,234 (2014) affirms in part and reverses in part the initial decision by the presiding Administrative Law Judge Peter Cianci (Presiding Judge) concerning the New England Transmission Owners’ (NETOs) base return on equity as provided for in ISO New England Inc.’s (ISO-NE) open access transmission tariff (Tariff). The order changes the Commission’s approach to determining the base return on equity for public utilities from a one-step discounted cash flow (DCF) analysis to a two-step DCF analysis with a narrower zone of reasonableness, and, applying this approach to the facts of the proceeding, sets the ROE half way between the midpoint of the zone of reasonableness and top of that zone.    The order institutes a paper hearing to allow the participants an opportunity to submit evidence on whether the gross domestic product (GDP) is a reasonable basis for determining the long-term dividend growth rate which is used in the second step of the DCF analysis.  The order also changes the Commission’s practice on post-hearing ROE adjustments.


The New England proceeding was initiated in response to a September 30, 2011, complaint alleging that the NETOs’ 11.14% base ROE was unjust and unreasonable because capital market conditions had changed significantly since that base ROE was established in 2006. The Commission issued an order establishing hearing and settlement judge procedures on May 3, 2012 with a refund effective date of October 1, 2011.

Unable to reach a settlement, the parties went to hearing in May 2012 which lasted several days. The Presiding Judge issued an Initial Decision on August 6, 2013 in which he implemented the one-step DCF methodology that the Commission used for public utilities.  He determined it was appropriate to adopt two different ROEs in the proceeding—one for the 15-month refund period from October 1, 2011 (i.e., the refund effective date) to December 31, 2012, and one for the prospective period commencing when the Commission issues its order setting the going-forward base ROE. He found the just and reasonable base ROE for the refund period to be 10.6%  based on data from a six-month study period in 2012 and the just and reasonable base ROE for the prospective period to be 9.7% based on data from a six-month study period ending March 2013.  The Presiding Judge found that reducing utility ROEs below 10% for a prolonged period could be harmful to the industry, but he expressly declined to rule on the NETOs’ hotly contested contention that post-2007 financial market conditions cause the DCF method to understate common equity costs and require modification of FERC’s standard DCF approach.    The Complainants, Eastern Massachusetts Consumer Owned Systems, NETOs, and FERC Trial Staff each filed briefs on and opposing exceptions to the Initial Decision.

The Commission Moves from a One-Step DCF Methodology to a Two-Step DCF Methodology for Public Utilities, Considers GDP as a Measure for Long-Term Growth, and Narrows the Zone of Reasonableness

In this order, the Commission moves from the one-step DCF methodology it has historically used in public utility cases, which considers only short-term growth projections, to the two-step DCF methodology used in natural gas and oil pipeline cases, which considers both short- and long-term growth projections in estimating a company’s cost of equity. This change in methodology continues the basic DCF formula used to calculate ROE, a simplified expression of which is k = D / P plus  + G where “k” is the discount rate (or investors’ required rate of return), “D” is the current dividend, “P” is the price of the common stock, and “G” is the expected growth rate in dividends. However, the change affects the calculation of “G” for public utilities.

Under the two-step DCF methodology, security analysts’ five-year forecasts for each company in the proxy group, as published by the Institutional Brokers Estimate System (IBES), are used for determining growth for the short term and long-term growth is based on forecasts of long-term growth of the economy as a whole, as reflected in the gross domestic product (GDP). The Commission considers earnings forecasts made by investment analysts to be the best available estimates of short-term dividend growth expectations because they are likely relied on by investors when making their investment decisions. The Commission adopts the GDP as the long-term growth projector because in its view “it is reasonable to expect that public utilities, which transmit electricity to supply energy to the national economy, will sustain growth consistent with the growth of the economy as whole” and “public utilities’ internal growth rates now approximate GDP.” Order at P 40. The short-term forecast receives a two-thirds weighting and the long-term forecast receives a one-third weighting in calculating the growth rate in the DCF model.

The Commission believes the relative stability of long-term growth rates vis-à-vis short term growth rates will help narrow the zone of reasonableness which has the ancillary effect of reducing the significance of selecting a particular point within the zone as just and reasonable for a given utility or group of utilities. The Commission also narrows the zone by discontinuing its prior practice of calculating high and low common equity cost estimates for each proxy group company, and for short-term dividend growth using both the IBES estimates and a so-called sustainable growth calculation largely based on retained earnings.  Consistent with its two step approach, the Commission now derives a single common equity cost for each proxy group company by using the proxy company’s average dividend yield for the study period and using only the IBES estimates in calculating the short-term component of the expected dividend growth rate. Order at PP 37, 39, 77.

Finally, the Commission notes that “while the DCF model remains the Commission’s preferred approach to determining allowed rate of return, the Commission may consider the extent to which economic anomalies may have affected the reliability of DCF analyses in determining where to set a public utility’s ROE within the range of reasonable returns established by the two-step constant growth DCF methodology.” Order at P 41. The Commission explains that “[w]hile the Commission has previously found the midpoint of the zone of reasonableness to be the appropriate measure of central tendency for determining the base ROE for a diverse group of utilities (as opposed to the median, used for a single utility), the midpoint does not represent a just and reasonable outcome if the midpoint does not appropriately represent the utilities’ risks.” Order at P 144.

The Commission Applies the Revised Methodology in the New England Proceeding and Sets the NETO ROE Halfway Between the Midpoint and the Top End of the Zone of Reasonableness

After setting forth its new approach to the electric industry DCF analysis, the Commission applies that approach to the facts of the New England proceeding, finding that the just and reasonable ROE for the NETOs was 10.57%. In arriving at this ROE, the Commission explains that it used the NETOs’ starting proxy group; the financial data necessary to conduct a DCF analysis of that proxy group using the two-step DCF methodology, which was available on the record; and the necessary GDP growth predictions. It concluded that the two-step DCF analysis produces a zone of reasonableness of from 7.03% to 11.74%. Based on the record in the New England proceeding, including the “unusual capital market conditions present,” the Commission concludes “that a mechanical application of the DCF methodology with the use of the midpoint here would result in an ROE that does not satisfy the requirements of Hope and Bluefield.” Order at P 142. Based on this information, record evidence, and unusual capital market conditions, the Commission decided to place the NETOs’ base ROE halfway between the midpoint of the zone of reasonableness and the top of that zone rather than at the midpoint of the zone of reasonableness. One of the concerns identified was that the Commission was “faced with circumstances under which the midpoint of the zone of reasonableness established in this proceeding has fallen below state commission-approved ROEs, even though transmission entails unique risks that state-regulated electric distribution does not.” Order at P 148.The Commission is careful to emphasize that its decision to set the ROE at the midpoint of the upper half of the zone of reasonableness is fact-dependent and case-specific. The Commission sets only one ROE for the full period, rejecting the Presiding Judge’s decision to establish two ROEs (one for the locked-in period and one for the prospective period). In addressing this issue, the Commission finds that the fact that the NETOs were not required to pay refunds between the end of the 15-month refund period and the conclusion of the proceeding was immaterial and “purely a matter of refund liability in the context of a 206 proceeding.” Order at P 66.

Finally, the Commission explains that the 10.57% ROE is subject to adjustment through a paper hearing during which the participants to the proceeding will be allowed the opportunity to present evidence concerning the appropriate long-term growth projection to be used for public utilities under the two-step DCF methodology. This paper hearing will not extend to any other issues litigated by the parties at hearing and will not involve any further updating of the financial data.

The Commission Ends Its Practice of Post-Hearing Updates

In addition to announcing its new two-step DCF methodology and applying it to the facts of the case, the Commission also announces a change to its past practice on post-hearing ROE adjustments. Specifically, the Commission ends its practice of updating the ROE based on changes in U.S. Treasury bond yields during the proceeding, in light of its shift to the two-step DCF methodology and mounting evidence that U.S. Treasury bond yields are not necessarily a reliable one-for-one indicator of changes in investor-required returns. In making this change, the Commission explained that “the capital market conditions since the 2008 market collapse and the record in this proceeding have shown that there is not a direct correlation between changes in U.S. Treasury bond yields and changes in ROE.” Order at P 158. In fact, “[t]he record in this proceeding also casts doubt on the magnitude, not just the direction, of the relationship between U.S. Treasury bond yields and utility ROE.” Order at P 159. Therefore, the Commission concludes that “rather than updating ROEs by taking official notice of post-hearing changes in U. S. Treasury bond yields, a more reasonable approach is to allow the participants in a rate case to present the most recent financial data available at the time of the hearing, including post-test period financial data then available.” Order at P 160.

The Commission Continues to Cap Incentive Returns at the Upper End of the Zone of Reasonableness

The Commission finds that its two-step DCF methodology would in general produce narrower zones of reasonableness. This finding is based on the Commission’s determination long-term growth rates are more stable than short-term growth rates and the elimination of the high- and low-end ROE estimate for each proxy company. The Commission determines that FPA Section 219 requires that any rate incentive must be consistent with FPA Section 205 which dictates that an incentive return must be within the zone of reasonableness. Accordingly, the Commission concludes that whenever a utility’s base ROE is changed pursuant to either Section 205 or 206 any incentive returns previously granted the utility cannot be allowed to exceed the top of the zone of reasonableness established by the two-step methodology. Order at P 165.

Orders on Complaints

At the same time it issued the Order on Initial Decision in the New England proceeding, the Commission took action on five pending complaint cases involving ROE and struck a sixth complaint from the Open Meeting Agenda. Those complaints include: another complaint against the NETOs (filed on December 27, 2012, likely in part to preserve the NETOs’ customers’ right to refunds), two complaints against Florida Power Corporation, and two complaints against Southwestern Public Service Company. The sixth complaint involved Public Service Company of Colorado’s production formula rate ROE and was likely struck in response to a pleading filed by the parties to that proceeding two days prior to the Open Meeting.

In each case, the Commission set the complaint for hearing and settlement judge procedures, holding the hearing in abeyance pending settlement procedures. The Commission encouraged the parties to make every effort to settle their dispute and to use the guidance provided through Opinion No. 531.

SCE Order on Remand

On April 15, 2010, the Commission issued an order approving a base ROE of 9.54% for three of SoCal Edison’s transmission projects after updating the results of the DCF analysis based on the yields on 10-year constant maturity U.S. Treasury bonds during the DCF analysis period and the locked-in period in that proceeding. SoCal Edison requested rehearing of the Commission’s decision to take official notice of and update the ROE based on the yields on 10-year constant maturity U.S. Treasury bonds, proffering expert witness testimony to challenge the use of these bonds as a proxy for the change in SoCal Edison’s cost of equity. The Commission declined to consider SoCal Edison’s expert testimony on the subject and did not revise its decision to update the DCF analysis results, so SoCal Edison filed an appeal with the D.C. Circuit Court of Appeals. The D.C. Circuit remanded the case because, under the Administrative Procedure Act, the Commission must allow a party the opportunity to challenge any facts of which the Commission takes official notice outside the record. Order at P 6.

On remand and in conjunction with the new policy outlined in Opinion No. 531, the Commission accepted SoCal Edison’s contention that its capital costs did not change significantly during the locked-in period as compared to the DCF analysis period used to determine its 10.55% base ROE. As a result, the Commission reverses its prior determination and finds that it is no longer appropriate to base a post-hearing adjustment to SoCal Edison’s ROE on the change in U.S. Treasury bond yields for the locked-in period from March 1, 2008 through December 31, 2008. Instead, the Commission approves a base ROE for SoCal Edison for the locked-in period of 10.55%.


The short-term effect of the Commission’s decision in the New England proceeding is likely to be higher calculated ROEs; however, the long-term outcome is not clear. Both the NETOs and the customers in the New England proceeding will likely request rehearing of the Commission’s decision and file court appeals, which may affect the final outcome. Further, while the Commission has set the ROE in this case at the midpoint of the top half of the zone of reasonableness, it has indicated that it will continue to address ROE on a case-by-case basis and that its determination in the New England proceeding was a result of the “unusual” capital market conditions and necessary to “appropriately represent the utilities’ risks” and encourage necessary transmission investment.

Because the revised DCF methodology takes into account more stable long-term growth and calculates only one estimated common equity cost for each proxy company, it should result in “narrower” zones of reasonableness (i.e., lower high points and higher low points). However, it does not follow that the results of the two-step methodology will be necessarily higher or lower than under the one-step DCF methodology—that will depend upon how the two methods react to the same set of financial data. Conceivably, one method in comparison to the other could produce higher ROEs when applied to one set of data and lower ROEs with another set of data. For example, in the New England proceeding and using the financial data for the six months ended March 2013, the Presiding Judge’s application of the old single-step DCF methodology would have produced a 9.7% ROE whereas the Commission’s application of the two-step methodology produced a 9.37% ROE before placement of the ROE between the midpoint and top end of the zone of reasonableness.

Until the market recovers and as long as utilities can demonstrate the existence of anomalous financial market conditions, argue the need to ensure sufficiently high ROEs to raise capital to finance needed transmission expansion, show that state commission ROEs are higher than those generated by the DCF analysis, and/or provide the results of non-DCF ROE methodologies that indicate higher common equity costs than the DCF method, utilities may be able to justify setting the ROE at the half-way point between the  top of the zone of reasonableness and the zone of reasonableness’s median  in the case of single utilities of average risk and midpoint  in the case of multiple utilities.