In a long-awaited decision, the Federal Energy Regulatory Commission (FERC) issued Opinion No. 569 adopting a new methodology to determine whether the rate of return on common equity (ROE) used to calculate cost-based rates of a regulated public utility is unreasonable, and, if so, to establish a reasonable ROE for that utility. Based on application of its new methodology, the FERC determined that the ROE of 12.38% that had been used by most transmission owners (TOs) within the Midcontinent Independent System Operator (MISO) since 2002 was unjust and unreasonable, and that the replacement ROE for the MISO TOs is 9.88%.
In order to maintain its credit worthiness and enable it to attract capital as needed, a public utility is generally entitled to earn a ROE that is commensurate with returns being earned by other enterprises of comparable risk and sufficient to assure confidence in its financial integrity. However, the means of determining a ROE that meets this standard have been controversial. Opinion No. 569 is intended to establish a standard methodology for evaluating ROEs of public utilities that will pass appellate review. The FERC explained that the ROE methodology it adopted in Opinion No. 569 “will provide additional certainty and predictability to parties,” and would therefore assist both customers and regulated utilities to evaluate their litigation risks associated with potential challenges to existing ROEs.
Many public utilities calculate transmission service charges based on a specified ROE incorporated into cost-of-service formula rates established many years ago. Current interest rates are significantly below prevailing interest rates that existed at that time. For that reason, various consumer groups have filed complaints alleging that ROEs of transmission owners are no longer just and reasonable, and asking the FERC to order reductions in the ROEs. The U.S. Court of Appeals also has criticized the FERC’s methodology. In response, the FERC ordered a paper hearing in November 2018 to examine its method for determining a just and reasonable ROE for the MISO TOs.
FERC Adopts Revised ROE Methodology
The FERC historically has used a discounted cash flow (DCF) model to evaluate the reasonableness of ROEs. The DCF model assumes that an investment in common stock is worth the present value of the infinite stream of dividends discounted at a market rate commensurate with the investment’s risk. Under the two-step DCF model utilized by the FERC, the expected growth rate in dividends is calculated by using both short-term and long-term growth projections.
The FERC determined in Opinion No. 569 that, in addition to continuing to rely on the DCF model, it would also use a capital asset pricing model (CAPM) in its ROE analysis. The CAPM approach begins with determining a risk free rate (i.e., the average historical yield of a 30-year U.S. Treasury bond over a specified period) plus a market risk premium associated with the specific security. The FERC adopted a forward-looking approach to its CAPM analysis in which a one-step DCF model (based only on short-term growth projections) is applied to information from commercially-available sources for a market index comprised of dividend paying members of the S&P 500. The FERC explained in Opinion No. 569 that “the CAPM and DCF models most accurately reflect how investors make their investment decisions, therefore providing a more accurate cost of equity estimate and helping to minimize model risk to the greatest extent possible.”
Both the DCF model and the CAPM model depend on use of a proxy group of companies. The proxy group is to be determined on the basis of five screens: (1) a national group of companies considered to be electric utilities by Value Line; (2) companies with credit ratings no more than one notch above or below the utility whose ROE is at issue; (3) companies that pay dividends and have neither made nor announced a dividend cut during a six-month study period; (4) companies with no merger activity during that six-month study period; and (5) elimination of high-end and low-end outliers.
In its analysis, the FERC will divide the composite range of reasonableness into four quartiles. For average risk utilities, the presumptively just and reasonable range of ROEs is a quartile whose mid-point is at the mid-point of the composite range of reasonableness for all utilities and whose boundaries are equidistant above and below that mid-point. Similarly, the presumptively just and reasonable range of ROEs for above- and below-average utilities is based on consideration of ROEs of utilities with comparable risks.
The FERC’s analysis of the composite presumptively just and reasonable range of ROEs begins with separate determinations of the zone of reasonableness based on the DCF model and the CAPM model. The ROE at the top of the DCF zone of reasonableness will then be averaged with the ROE at the top of the CAPM zone of reasonableness, and the ROE at the bottom of the DCF zone of reasonableness will be averaged with the ROE at the bottom of the CAPM zone of reasonableness to determine a single composite zone of reasonableness.
Where the reasonableness of an existing ROE is challenged, the FERC will presume that the existing ROE is just and reasonable if it falls within the zone of reasonableness based on its application of the DCF and CAPM models. However, the presumption may be rebutted by evidence such as non-utility stock prices, investor expectations for non-utility stocks, various types of bond yields and their relation to stock prices, investor and other expert testimony, and testimony regarding the effects of rates on customers.
FERC Applies Revised ROE Methodology
Prior to issuance of Opinion No. 569, the FERC had pending before it two complaints involving the ROEs being collected by the MISO TOs. In the event of a complaint against existing rates under Section 206 of the Federal Power Act, the FERC may order that such rates be subject to refund for up to 15 months while the complaint is pending. In the First Complaint, the refund effective period was November 12, 2013-February 11, 2015. In Opinion No. 569, the FERC directed the MISO TOs to make the ROE determined in the First Complaint effective as of September 28, 2016. It also ordered the MISO TOs to provide refunds, with interest, for the First Complaint proceeding’s refund effective period.
In the Second Complaint, the refund effective period was from February 12, 2015-May 11, 2016. Section 206(a) of the Federal Power Act provides that if the FERC finds that existing rates are unjust and unreasonable, it is to determine the just and reasonable rate to be observed thereafter. The FERC determined in Opinion No. 569 that the ROE of 9.88% that became effective in September 2016 continues to be presumptively reasonable. Because the FERC lacks the statutory authority to order a change in that ROE effective prospectively from issuance of Opinion No. 569, it concluded that it could not order refunds of charges collected during the refund effective period in the Second Complaint.
Commissioner Richard Glick dissented from the decision not to order refunds of charges collected during the refund effective period of the Second Complaint. In his view, the FERC has ample statutory authority to order payment of such refunds, and “interpreting Section 206(b) to permit refunds in this instance is both more consistent with the FPA’s primary purpose of protecting consumers and more equitable given that the only reason we are faced with this question is that the Commission did not act on the First Complaint in the 15-month period before the Second Complaint was filed.”
It is practically inevitable that Order No. 569 will be the subject of requests for rehearing and, thereafter, to appellate review. The FERC is more likely to conclude that it has achieved its objective if the opinion withstands appellate scrutiny than if it results in any particular ROEs in its implementation over time. However, based on the language of Section 206 of the Federal Power Act, it would not be surprising for the Court of Appeals to conclude that the updated ROE should have been made effective for the refund effective period associated with the Second Complaint as well as for the refund effective period of the First Complaint.