This article, from law firm Troutman Sanders, provides a little insight as to how utilities decide on a return on investment.
At FERC’s monthly meeting in June, the Commission tentatively set the base return on equity (“ROE”) in ISO New England Inc.’s (“ISO-NE”) Open Access Transmission Tariff (“OATT”) at 10.57%. During the process, FERC announced a new method to calculate ROEs for jurisdictional electric utilities. Specifically, FERC’s new method will incorporate short and long-term measures of growth in dividends, thus incorporating the two-step discounted cash flow (“DCF”) method FERC already uses in setting rates for natural gas and oil pipelines. As applied to the ISO-NE ROE proceeding, FERC tentatively used the gross domestic product (“GDP”) as its long-term growth rate estimate, subject to a paper hearing established by FERC. The Commission also determined that, based on the record established in the ISO-NE ROE proceeding, the appropriate base ROE for ISO-NE’s OATT should be set halfway between the midpoint of the zone of reasonableness (9.39%) and the top of the zone of reasonableness (11.74%).
By way of background, New England transmission owners (“TOs”) recover their transmission revenue requirements through formula rates contained in ISO-NE’s OATT. Under the ISO-NE OATT, the formula rates are calculated according to a single base ROE. In 2006, the base ROE for the New England TOs was set at 11.14%, consisting of a base of 10.4% with an upward adjustment of 74 basis points accounting for changes in capital market conditions—specifically, the yield of 10-year U.S. Treasury bonds.
On September 30, 2011, a group of state utility regulators in the New England area (“Complainants”) filed a complaint at FERC arguing that, due to changes in capital market conditions since the base ROE was established in 2006, the 11.14% base ROE had become unjust and unreasonable and should be lowered. Complainants further asserted in their complaint that their DCF analysis demonstrated that the zone of reasonableness used to calculate the base ROE should be 7.0% to 11.4%, with a midpoint of 9.2%. Based on this analysis, Complainants argued that the base ROE should not exceed 9.2%. FERC set the matter for hearing.
On August 6, 2013, Administrative Law Judge Michael J. Cianci issued an Initial Decision, finding that the base ROE of 11.14% was unjust and unreasonable, and concluded that two defined time periods would be appropriate when determining a new base ROE. The Initial Decision recommended a higher ROE for an initial 15-month refund period – beginning one day after the complaint was filed and ending on December 31, 2012 – because Judge Cianci found that the cost of equity evidence for that time period required higher base ROE percentages. Judge Cianci then concluded that the base ROE for the refund period should be set at 10.6% and the base ROE for the following prospective period should be 9.7%. Although Judge Cianci generally accepted the New England TOs expert’s zone of reasonableness, Judge Cianci used the midpoint of the zones, reasoning that it conformed with traditional DCF analysis adopted by FERC, instead of halfway between the midpoint and the high end of the zone of reasonableness, which the New England TOs recommended.
In its order, FERC decided to adopt a two-step method when calculating the base ROE for jurisdictional public utilities, thus incorporating long-term growth rates into its analysis. Acting Chairman Cheryl LaFleur stated that adopting the new method “appropriately narrows the zone of reasonableness in the DCF analysis.” Also, FERC decided to eliminate its past practice of using U.S. Treasury bond yields to make adjustments to the base ROE after the record in a hearing proceeding has been closed. While doing so, FERC reasoned that there is not necessarily a direct correlation between U.S. Treasury bond yields and a public utility’s ROE. Instead, FERC will allow parties to present the most recent financial data available at the time of the hearing – including post-test period financial data –to incorporate that data into the ROE analysis. Finally, FERC confirmed that a utility’s total ROE will still be capped at the upper end of the revised zone of reasonableness.
With regard to the ISO-NE ROE proceeding, FERC reversed Judge Cianci’s decision to use the midpoint of the zone of reasonableness, and instead elected to use the halfway point between the midpoint of the zone of reasonableness and the top of that zone. FERC based its decision on several reasons established in the record presented in the proceeding, including (1) unusual capital market conditions, (2) the fact that FERC’s midpoint of the zone of reasonableness was lower than alternative methods used to calculate ROEs, and (3) the ROEs recently adopted by state public commission’s have generally been higher than FERC’s midpoint of the zone of reasonableness. Acting Chairman LaFleur stated that the base ROE set for the New England TOs “should set a level sufficient to attract investment in interstate electric transmission” and hopefully “provides appropriate guidance for the resolution of related ROE complaint proceedings” currently pending at FERC.
Because the new two-step method adopted by FERC incorporates both short and long-term measures of growth in dividends, FERC tentatively decided to use GDP as a measure of long-term growth in the ISO-NE ROE proceeding. While such a practice is already used in the natural gas and oil pipeline industry, FERC established a paper hearing so that participants can present evidence regarding the appropriate long-term growth rate that should be used when calculating the base ROE for ISO-NE’s OATT. Subject to the long-term growth rate that is ultimately used, FERC tentatively found that the just and reasonable base ROE for ISO-NE’s OATT is 10.57%.
Commissioner John Norris issued a separate opinion, dissenting in part from FERC’s order. During the meeting Commissioner Norris stated that while he generally thought that the base ROE for the New England TOs needed to increase, FERC’s order resulted in an ROE that was too high.
Going forward, it appears that FERC may be more sympathetic to arguments raised by utilities advocating that FERC should adopt an ROE above the midpoint of the zone of reasonableness in order to attract sufficient capital investment and thus, build new infrastructure. However, it remains to be seen whether FERC’s decision to do so with regard to the New England TOs’ ROE will apply to other jurisdictional utilities’ ROE as well. Regardless, FERC will employ its newly adopted two-step DCF method to calculate such ROEs.
Troutman Sanders LLP
Energy & Energy-Related Practices
Federal Regulation of Electricity and Gas