A. Lawrence Kolbe

Compensation for the risk of stranded costs

Abstract Electric utilities now face the risk that existing assets, costs or contract commitments may be ‘stranded’ by increased competition, leaving shareholders rather than customers to bear the costs. An important policy question is whether shareholders have already been compensated for this risk under traditional cost of service regulatory principles. The economic principles of asymmetric risk imply that even if investors are fully cognizant of the risks of stranded costs, capital market prices fully reflected such risks and regulators always set the allowed rate of return equal to the true cost of capital, it is mathematically impossible for investors to have been previously compensated for these risks.

Rate of Return Practices in Use

This chapter discusses the regulatory approaches to estimating the rate of return around the globe and focuses on how regulators determine the cost of equity and debt, as well as approaches to setting capital structure and (where applicable) addressing the impact of income taxes. We emphasize that regulation spans a wide range of approaches to arrive at the allowed rate of return. Using examples from North America, Europe, and Australia, Chapter 9 describes commonly used approaches to setting the allowed rate of return for regulated entities. Specifically, the chapter addresses whether a traditional cost of service, a performance-based system, or some other framework is applied. The basic introduction and survey of approaches provided in this chapter is designed to enable the reader to put situation-specific cost of capital estimation approaches in broader context.

Legal Foundations and Regulatory Frameworks for a Fair Return

This chapter begins the discussion of cost of equity estimation. Various economic theories postulate how the cost of equity is determined in capital markets. Tests of those theories have not yet resolved the matter. As a result, there are a number of methods that in practice are used to estimate the cost of capital. This chapter sets the stage by framing the problem and by addressing some implementation issues common to all models, for example, sample selection.

Asymmetric Risk: Theory and Examples

This chapter addresses the presence of asymmetric risk affecting the value or usefulness of utility assets adversely, how this risk is reflected in capital markets and the measured cost of capital, and possible adjustments needed in regulatory allowances to compensate for it. In situations where the distribution of returns facing a regulated company includes a material asymmetry, setting the allowed rate of return at the observed market cost of capital may not be sufficient for the risk the utility investors bear. This chapter describes why this is the case, using the example of how junk bonds are priced to reflect default risk versus how stocks are priced to reflect black swan events. It examines the California energy crisis and the natural gas price deregulation process of the mid-1980s. Even when it is agreed that there is an asymmetric risk of material adverse events, it can be difficult for traditional regulatory procedures to address the problem. Solutions may involve trying to avoid the problem rather than compensate it in advance, but the preferred approach will depend heavily on the circumstances. The chapter discusses potential future asymmetric risks facing the utility sectors, including impacts of fracking on the gas pipeline industry or the risks of stranded capital investments in electric utility infrastructure if flat or falling demand persists or even accelerates.

Financial Asset Pricing Principles

The “cost of capital” is a necessary benchmark in picking the fair allowed rate of return. The cost of capital is the expected rate of return in capital markets on alternative investments of equivalent risk. The cost of debt capital is relatively straightforward to assess, but determining the cost of equity capital is much harder.

Discounted Cash Flow Models

The capital asset pricing model and similar risk premium models focus on understanding the risk–return trade-off in capital markets. The discounted cash flow (DCF) model attempts instead to estimate the cost of capital by analyzing the securitys expected future cash flows relative to its current price. The DCF model assumes that the current price equals the sum of those expected future cash flows discounted at a constant discount rate, and it solves for the discount rate that equates that sum with the price. We address implementation issues, including difficulty in determining the securitys expected future cash flows, as well as issues inherent in the fundamental theoretical assumptions underlying the DCF. In particular, we caution against an absolute reliance on the assumption that the price of a stock is given by the present value formula. Valuing options requires techniques other than the DCF formula, such as the well-known Black–Scholes model.

The Capital Asset Pricing Model and Variations

The capital asset pricing model (CAPM) estimates the cost of capital as the sum of a risk-free rate and a premium for the risk of the particular security. In the theoretical version of the CAPM, the best proxy for the risk-free rate is the short-term government interest rate. The risk premium is the product of the premium required on an average-risk investment (called the “market risk premium” or MRP) and the relative risk of the security in question (called beta). The MRP cannot be directly observed nor can a securitys true beta. Even the measure of the risk-free rate is subject to debate.

Multifactor and Other Cost of Capital Estimation Models

The capital asset pricing model (CAPM) and discounted cash flow (DCF) models are the methods currently most widely used in rate regulation. Sometimes regulators consider cost of capital estimates based on the sum of an interest rate and a risk premium that is not derived from a formal model such as the CAPM. The risk premium might be based on realized returns for a subset of stocks, on the historical difference between DCF estimates of the cost of capital and interest rates, or on comparison of historical allowed returns to bond yields. The arbitrage pricing theory (APT) is a general model that provides for multiple risk factors of concern to investors. This chapter covers the risk premium model, the APT as well as the Fama–French model, which is the most widely used version of the APT. The chapter also covers the “buildup” approach and the comparable earnings method. The “comparable earnings” method, which utilizes realized accounting rates of return, was once the widely used method in the United States, but in recent decades it has fallen into disfavor.

Approaches to Rate Base Measurement

Regulators determine the amount of money that needs to be recovered by utilities by multiplying the rate of return by the “rate base” or “regulated asset base.” This chapter focuses on the economic pros and cons of alternative rate base approaches. The traditional “Original Cost” (OC) rate base widely used in Canada and the United States can have serious problems such as “rate shock” when times of high investment increase rates increase prices early in the assets life. Alternative rate base approaches, such as “Trended Original Cost”, which trends the OC rate base for inflation, or “replacement cost new net of depreciation,” which considers the current cost of construction adjusted for the age and condition of existing assets, may be useful alternatives that avoid substantially reducing the rate base simply because time is passing. It may also be useful to consider making the return on and of rate base level in either nominal or real terms. This chapter discusses these various approaches and their pros and cons, as well as their current use in regulatory settings.

Motivation: Why a Book Now on the Required Rate of Return?

In recent decades, many countries have switched from public to private ownership of large companies in the energy and transportation fields. Private ownership may come with a need for public oversight of the prices the company can charge. The private ownership–public oversight model has long been used in Canada and the United States (US), and well-established legal and administrative procedures in those countries are potential models for newly privatized companies elsewhere. Those models, which focused heavily on the fair rate of return companies required on the capital they invested, were explicitly rejected by the United Kingdom (UK), the pioneer in the privatization movement. Instead, the UK focused on regulating price trends in the belief that explicit analysis of the required return on capital would prove unnecessary. However, this belief proved incorrect. This book examines rate of return principles and associated practices in many countries to serve as an introduction for novices, a reference for the experienced, and a source of insight from the institutions used elsewhere in the world.