R. Charles Moyer is Professor of Finance and Chairman of the Area of Finance in the College of Business Administration. Texas Tech University. Raymond E. Spudeck is an Assistant Professor in the Department of Finance, College of Commerce and lndlustry at the University of Wyoming. David B. Cox is an Instructor in the Area of Finance in the College of Business Administration at Texas Tech University

Cox, David B.

Moyer, R. Charles

Spudeck, Raymond E.

English

Georgia Southern University: Digital Commons@Georgia Southern

Southern Business Review Volume 13 Issue 1 Article 5 April 1987 Requested, Recommended and Allowed Returns to Equity: Serendipity or Substance R. Charles Moyer Texas Tech University Raymond E. Spudeck University of Wyoming David B. Cox Texas Tech University Follow this and additional works at: https://digitalcommons.georgiasouthern.edu/sbr  Part of the Business Commons, and the Education Commons Recommended Citation Moyer, R. Charles; Spudeck, Raymond E.; and Cox, David B. (1987) "Requested, Recommended and Allowed Returns to Equity: Serendipity or Substance," Southern Business Review: Vol. 13: Iss. 1, Article 5. Available at: https://digitalcommons.georgiasouthern.edu/sbr/vol13/iss1/5 This article is brought to you for free and open access by the Journals at Digital Commons@Georgia Southern. It has been accepted for inclusion in Southern Business Review by an authorized administrator of Digital Commons@Georgia Southern. For more information, please contact digitalcommons@georgiasouthern.edu. l REQUESTED, RECOMMENDED AND ALLOWED RETURNS TO EQUITY: SERENDIPITY OR SUBSTANCE R. Charles Moyer. Raymond £. Spudeck and David B. Cox Introduction In a series of landmark decisions. the United States Supreme Court has established the judicial standards which guide the determination of the fair rate of return on common equity capital which is appropriate for a regulated utility to earn as it discharges its public obligation to serve its customers. Notably. in the Federal Power Commission v. Hope Natural Gas Company (320 U.S. 591,603 (1944) ) and the Bluefield Water Works and Improvement Company v. Public Service Commission of West Virginia (262 U.S. 679. 692-3 (1923) ), the court defined a fair rate of return in term~ of (I) as~uring confidence in the financial integrity of the enterprise. so as to maintain its credit, (2) achieving a level of return comparable to the levels earned by investors in other enterprises of corresponding risk and uncertainty. and (3) attracting capital on rea~onable terms. In reality. the fair rate of return concept has been viewed by many regulatory bodies as representing a zone of reasonableness - "bounded at one level by investor interest against confiscation and the need for averting any threat to the security for the capital embarked upon the enterpri~e. At the other level it is hounded by consumer interest against excessive and unrea~onable charges for service" (Pennsylvania Public Utility Commission \". Bell Telephone Company of Pennsylvania (43 PUR 3d 241. 246 (Pa. 1962) ). Thus, within this judicial framework of a fair rate of return. we find that regulators have frequently sought to achieve a balance between the intere~t~ of the stockholder~ of the utility and the intere~t~ of consumer~ ~erved by that utility. The objective of this paper is to examine the relative influence of the various parties represented in a typical rate proceeding (the company. tht: commission staff, and intcrvenors) in the final determination of an allowed rate of return in a particular ca~. We intend to provide some in~ight into how this halancc is achieved. The Process In a typical rate proceeding. testimony i~ offered by the company. the regulatory staff. and one or more intervenors, regarding a fair rate of return on common equity for the applicant utility. Commonly. the company file, it~ testimony on rate of return well in advance of the actual hearing (a lag of 6 to 9 months between the company's filing and the actual hearing is common. both at the ,tate level and before the FERC). Staff and intervenors normally file their testimony about ~ne month or less prior to the actual hearing. Because of the lag between the time the firm files its testimony and the time the case is actually heard. one might expect. a priori , that the company's testimony might have !es~ impact on the final rate decision than that provided by the other parties in the hearing. The company ~ometimes updates its initial cost of equity capital testimony just prior to the hearing of the case, often in the context of rebuttal testimony it prepares. 28 __. , :•: --~• ._ .- ! f •• - ' , I • , . • • •• • , t: ,( :• • •; l ,• • • • • ' 1 •'•If•'! I?• l 1• f.' "< • • 1 I' I ; I' J:: • I: f J ~:,!,I•,, , , •••,!Ji' .. --With this information at hand, the regulatory commission establishes an allowed rate of return on common equity which is announced as part of its final order in the case. The allowed rate of return on common equity together with the embedded cost of debt and preferred stock, weighted in accordance with the proportions of each in the firm ·s approved capital structure, forms the overall rate of return which tbe firm is authorized to earn on its rate base assets. The focus of this article is on the degree of influence each of the three major parties to a rate proceeding has in the determination of the final authorized rate of return on common equity. The Model Our model consider5 1he au1horized return on common equity (ROE) 10 be a function of (I) the utility's requested ROE, (2) the commission staffs recom-mended ROE. (3) the intervenor's recommended ROE (or the average of intervenors' recommended ROE'5 in cases where more than one intervenor supplies ROE testimony), and (4) the perceived "quality' ' of 1he regulatory environment as reponed by Value Line. The model is written as: ROE= a+ /31 CO +/32 ST +/33 IN +/34 REG!+ /35 REG2 [I) where ROE co ST REGI REG2 = commission·s final authorized return on common equi1y; = utilily company's requested return on common equity: = commission staff', recommended return on common equity: = a control variable equal to I if the regulatory environment is considered average. and zero otherwise; = a control variable equal to I if the regulatory environment is considered above-average. and zero otherwise; The excluded set for the regulatory quality variahle is the helow-averagc regulatory environment. To estimate equation (I) using ordinary least squares regression techniques. data on fifty-five electric utility rate proceedings occurring from 1977 through I 983 were collected from Public Utility Reports. All cases with complete information were included in the sample. The quality of regulation measures were obtained from Value Line The model v.as then e,umated using ordinary least squares regression. In addition to the variables shov.n in equation [I]. we also controlled for nudear risk by including a zero-one "dummy" variable (variable equals I for nuclear involvement, zero otherwise) in order to account for a firm's nuclear generation or construction activity. Although 1t did not turn out to be Matistically significant. the nuclear generation and construction variable is reponed along with the other results in Table I. The R 2 (coefficient of determination) of the model is .8341. indicating that over 83 percent of the vanauon in the final authorized return on common equity is explained by the recommended and requested returns which arc filed by the various parties to a case and by the quality of the regulatory environment. A doser examination of Table I reveals several interesting insights. First. notice that the coefficient of th; intervenor's recommended ROE is not statiMically different from zero, indicati ng that. on average. intervenor's recommendations 29 7 WUWl:ONiii TABLE 1 Regres ion Result, or Equation I 11 (Dependent Variable = ROE (Return on Equity Authorized in the Comnm~ion, · Final Rate Order)) Independent Variable Intercept (conMant term} CO (company ROE reque~tJ ST (staff ROE recommendauon) IN (intervenor ROE recommendauonJ REG I (Average Regulator) Environment) REG2 (Above-average Reg Environment) NUC (Nuclear reliant utility} • Coefficient s1gmficant at IO'lc level **Coefficient significant at I % level Coefficient 1.635 0 342 0428 0.082 0.090 0 509 0.174 R~ = 0 8341 F = 46.244 t-Statistic 1.827* 4071 .. 3.894** 0.659 0.496 I 822* 0.957 did not carry a ~ignificant weight m the,e rate proceedings. Compare the magnitude of the ,tatisucally sigmficant coefficient, of the uuht)' company·, and the ,1affs ROfa. 0 342 and 0.428 respec11vely . The,e coetfic1enb ,uggest that although, on average. the ,taff, recommended ROE receive, greater weight by the comm1,,1on m 11s final order. the utilit) s requc\led ROI-' " abo an nnportant consideration. The greater weight placed on the ,taff', recnmmcndauon ma) reflect. in part. the fact that the Maff will have filed it, te,umony in clo\Cr proximity to the actual rate proceed mg. and therefore II ma) more accurate!) reflect capital market cond11mn, at the lime of the hearing. The model abo ,uggcsts that. on average. neither the ,taff nor the utility firm·, recommcnJauon, dominate the dec1smn proce,~ Regarding the quality of regulation, the model indicate, that commissions considered below average do not ,yMematicall) grant lower ROE, than those comml\s1ons con\ldered 10 be average (the cocffic1cnt of REG I 1, not ,tausucall) different from zero). Tho,e commission, considered ahovc average. however. appear to ~ystemaucally grant higher return~ on equity than tho~c con\ldered belo\l, 30 average. The magnitude of the difference is approximately 51 basis points. Finally, notice that no preferential treatment is given to nuclear-reliant utilities above that contained in the requested and recommended ROEs presented in the hearing (the coefficient of the NUC variable is not statistically different from zero). Forecasting with the Model In addition to explaining the relative importance of the ROE recommendations made by the various parties to a rate proceeding, this model also has potential value as a forecasting tool to predict authorized returns on equity. The ability to forecast returns on equity prior to a final rate order would be of value to manage-ment in its internal budgeting process, and it might also be of value to investors. A prediction of the final ROE can be found by substituting the known values into the model as reported in Table I. For example, assume that a utility ha~ filed for rate relief and in the process has asked for a 17 percent return on com-mon equity. The commission staff analysis recommends 15 percent, and an in· tervenor has suggested 14 percent. The utility has no nuclear facilities. and the regulatory commission is considered to be of average quality. Using this infor-mation and substituting in the estimated model. a prediction of the authorized return on common equity ROE can be made as follows: ROE(e~tl= 1.635 + .342(17) + .428(15) + .082(14) + . 09(1) + . 509(0) + . 174(0) 15.11% Note that for prediction purposes. all variables in the model are used , regardless of whether or not they were statistically significant when the model was estimated. In general this procedure will result in more accurate forecasts. Given the same information. the forccasted ROE in the case where a commission is considered to be of above-average quality is: ROE(est)= 1.635 + .342(17) + + .082(14) + .09(0) + .509( I) + . I 74(0) 15.53% The difference between the two forecasts represents the expected impact of the change in the regulatory environment from average to above-average . Conclusions and Limitations We have examined the determinant~ of the final allowed rate of return on common equity using a sample of 55 case~ which were decided between 1977 and 1983. In general. we concluded that the commission staff recommendations carry the greatest weight in the final determination, followed by the company's recommendations. Thus it appears that commissions do attempt to achieve a ··balance" between the interests of ratepayers and those of stockholders. Intervenor's recommendations regarding ROE were not statistically significant in explaining 1he final authorized ROE. Finally. we found that above-average regulatory commissions authorize returns approximately SI basis points higher than those authorized by below-average commissions. 31 - SZPTW -•tlllffftNICM--ZI Although the model has potential use as a tool to forecast the final authorized ROE to a utility. it would be desirable to test this forecasting accuracy using an independent sample of rate cases from a different time period. and to compare the accuracy of this model to other "naive" forecasting models. Finally, it is useful to remember that return on common equity is only one clement in me final rate case decision. Our analysis has been done under the simplifying assumption !hat there were no systematic offsets to high or low allowed returns, such as disallowances from rate base, expense disallowances. the use of hypothetical capital structures, and the like. Each of these factors. and many more like them. can greatly influence the company's ability to actually earn the authorized return on common equity. R. Charles Moyer is Professor of Finance and Chairman of the Area of Finance in the College of Business Administration. Texa~ Tech University. Raymond E. Spudeck is an Assistant Professor in the Department of Finance, College of Commerce and ln<lustry at the University of Wyoming. David B. Cox is an Instructor in the Area of Finance in the College of Business Administration at Texas Tech University. 32 ----

Requested, Recommended and Allowed Returns to Equity: Serendipity or Substance

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Requested, Recommended and Allowed Returns to Equity: Serendipity or Substance

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