FERC Acts To Ensure That Utility Cost-Based Rates Include An Adequate Return On Equity

In June, the Federal Energy Regulatory Commission ("FERC" or "Commission") issued Opinion No. 531, which details three significant changes to the way FERC determines the rate of return on equity ("ROE") in public utility rate cases.1 First, FERC modified its longstanding discounted cash flow ("DCF") model for calculating ROE.2 Second, FERC ended its practice of applying a post-hearing adjustment to ROE based on changes in United States Treasury bond yields.3 Third, FERC decided that the ROE of the group of public utilities in question should not be set at the "point of central tendency" established by the range of reasonable ROEs, but instead should be set at the point halfway between the range's point of central tendency and the range's highest point.4 Each of these changes is explained below. In conjunction with Opinion No. 531, FERC set for hearing a backlog of cases involving disputes over public utility rates.5 In each case, the Commission stated that "we expect the evidence and any DCF analyses presented by the participants in this proceeding to be guided by our decision in Opinion No. 531."6 As compared to FERC's preexisting approach to ROE, Opinion No. 531 appears likely to increase the ROE component in public utility cost-based rates, thereby increasing a public utility's overall return. However, the long-term reach of FERC's new ROE analysis remains unclear.

How Regulators Use the DCF Model and Establish a Range of Reasonable ROEs

Under cost-of-service ratemaking, certain costs are considered operating expenses and are recovered dollar-for-dollar in the utility's annual revenue requirements, while other costs are capitalized, "thus entering the cost of service in the form of annual allowances for depreciation and return on the undepreciated portion of the investment."7 In order to attract necessary capital, the utility must offer "a risk-adjusted expected rate of return sufficient to attract investors."8 This "return" on the utility's investments represents the cost expended by the utility to raise capital.9 For more than 30 years, the dominant method used by FERC to estimate investors' required rate of return has been the DCF model. The premise of the DCF methodology is 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."10 This "constant growth" DCF model can be expressed as a formula:

k = D/P (1+0.5g) + g. In this formula, D is the current dividend, P is the price of the company's common stock, and g is the expected growth rate in the company's dividends. The formula solves for k, which represents the rate of return investors require to invest in a company's common stock.11 In a rate case, FERC applies the DCF formula to each member of a group of comparable utilities, known as a proxy group. This generates a range of ROEs. Screening criteria, which can result in the exclusion of particular companies from the analysis, are applied to establish a range of reasonable ROEs. The ROE of the public utility that is the subject of FERC's review is selected from within this range. FERC's past practice has been to set the subject public utility's ROE at the point of central tendency of the proxy group's range of ROEs.

Applying the Two-Step DCF Methodology to Public Utilities

Since the mid-1990s, FERC has used a "one-step" DCF methodology in public utility rate cases (i.e., in the electric industry) while using a "two-step" DCF methodology in natural gas pipeline and oil pipeline rate cases. Under the one-step DCF methodology, FERC calculates two dividend yields for each proxy group company: one based on the proxy group company's highest stock price from a six-month study period, and one based on...