Setting the return on equity (ROE) that utility stockholders may earn from providing certain services, primarily electric transmission and pipeline services, is a fundamental aspect of FERC’s cost-of-service regulatory regime.[1] FERC has used the same basic method to determine ROE since the 1980s but recently made some reforms that applied to a few electric transmission cases. Now FERC has issued a Notice of Inquiry (NOI) seeking public comments regarding those reforms and whether reforms should also be applied to interstate gas and oil pipelines.

The ROE along the with debt interest rate is applied to a utility’s invested capital in setting the revenue to be collected by rates and is a principal driver of profitability. By the same token, an appropriate ROE policy that balances both investor and consumer interests is critical to achieving FERC’s overarching mission of ensuring just and reasonable rates. Accordingly, changes in the way FERC sets the ROE should be of great importance to energy consumers and to any company or investor with an interest in an electric utility, gas pipeline, or oil pipeline that is subject to FERC’s cost-of-service regulation.

Background

Since the 1980s, the Commission has used what is known as the Discounted Cash Flow (DCF) financial model to determine ROEs for regulated entities. The DCF model develops a range of returns earned on investments in companies with corresponding risks, i.e., a proxy group. FERC then sets the utility’s allowed equity return within that range. According to the NOI, the DCF model is based on the premise that a stock’s price is equal to the present value of the stream of expected dividends discounted at a market rate commensurate with its risk. The investor’s required ROE is thus estimated to be the stock’s current dividend yield plus the projected future growth rate of dividends.

In a 2018 order addressing a court remand of ROE determinations regarding electric transmission rates, FERC observed that investors do not rely on any one financial model and proposed to determine ROE by giving equal weight to four financial models instead of primarily relying on the DCF model. The estimates from those models would be averaged to produce a single ROE. In addition to DCF, the financial models are:

Capital Asset Pricing Model (CAPM), which is based on the theory that the market-required rate of return for a security is equal to the risk-free rate plus a risk premium associated with the specific security.

Expected Earnings, which determines the expected earnings on the book value of a stock by calculating the returns on book equity expected from a group of companies with risks comparable to those of the utility. Those returns are the opportunity cost of investing in the utility instead of the other companies.

Risk Premium, according to the NOI, is based on the idea that investors expect to earn a return on stock that reflects a premium above the expected return on a bond investment, because the stock investment involves greater risk. The NOI observes that investors’ required risk premiums expand with low interest rates and shrink at higher interest rates, and that this link between interest rates and risk premiums provides a helpful indicator of how the interest rate environment affects investors’ required rates of return.

Inquiry

FERC wants to give all stakeholders the opportunity to comment on the its ROE policy and seeks comments on a variety of general topics. Those topics, and the many questions posed in the NOI, address both fundamental issues as well as nuts-and-bolts concerns regarding data and the application of the various models. The topics include:

  • The role and objectives of FERC’s ROE policy. How does the new ROE method impact the predictability of an ROE determination? Should the same ROE be applied to all utilities in the same RTO or ISO? Should the ROE reflect the cost of capital at the time of an investment or should it be adjusted to reflect changed conditions?
  • Whether FERC should apply a single ROE policy across the electric, interstate natural gas pipeline and oil pipeline industries.
  • Performance of the DCF model. Is it robust over time and under differing investment conditions?
  • Financial model choice. What are the strengths and weaknesses of the financial models (other than DCF) and should FERC weigh some models over others based on their respective characteristics?
  • Guidelines for proxy groups and the placement of the ROE within the range (or zone of reasonableness).
  • How should FERC should determine whether an existing ROE is unjust and unreasonable?
  • The mechanics and implementation of the financial models discussed in the NOI, including data issues.

FERC has many options regarding its next steps on this initiative. The NOI’s purpose is to identify issues and get very broad feedback on them and perhaps initial ideas on how to address them. After it receives comments, FERC’s options include asking for further comments on more narrowly drawn questions, issuing a policy statement providing guidance on how FERC will address certain issues, or proposing rules for determining ROEs that would be codified in regulations. Alternatively, FERC could decide that its existing ROE policies are just and reasonable and take no further action.

Initial comments on the NOI are due 90 days after its publication in the Federal Register and Reply Comments are due 120 days after such publication