Meeting the Challenges for Sustainable Water Utilities In Connecticut s Regulatory Structure. Rate of Return Rich Sobolewski Connecticut OCC

Transcription

1 Meeting the Challenges for Sustainable Water Utilities In Connecticut s Regulatory Structure Rate of Return Rich Sobolewski Connecticut OCC

2 The Rate Process in Connecticut Rate of Return Rate Base Regulation Net Operating Income = Rate of Return Rate Base Earlier today we went over Rate Base Now we will talk about how we set Rate of Return

3 The Rate Process in Connecticut Rate of Return Overall Rate of Return (weighted cost of capital) Is estimated in a rate case Composite of: The Cost of borrowed funds (cost of debt capital) The Cost of ownership funds (cost of equity capital)

4 The Rate Process in Connecticut Rate of Return Historical capitalization or capital structure data is found on Balance Sheet Capital Structure SFRs D Schedules These are pro forma or forecasted Rate Year Levels Match the timing of rate base Total capitalization ($) and rate base ($) should be about the same Schedule D-1 is a summary schedule, which is supported by specific schedules for each class of capital

5 The Rate Process in Connecticut Rate of Return Sample D Schedules For Constitution State Water Company Test Year is Calendar Year 2008 Rate Year is Calendar Year 2010

6 Constitution State Water Company Proposed Pro Forma Rate of Return (Schedule D-1.0) Class of Capital Referen ce Amount ($) Short-term Debt D-2.0 1,000,000 Long-term Debt D-3.0 9,000,000 Preferred Stock D-4.0 1,000,000 Common Equity D-5.0 9,000,000 Total % of Tot al Cost (%) Weight ed Cost (%) 5.00 % 5.00% 0.25% % 6.50% 2.93% 5.00 % 8.00% 0.40% % % 5.40%

7 Constitution State Water Company Proposed Pro Forma Rate of Return Schedules Schedule D-2.0 Pro Forma Embedded Cost of Short Term Debt Issue List Amount Interest Rate Annual Interest Bank A $500, % $30,000 Bank B $500, % $20,000 Total $1,000, % $50,000

8 Constitution State Water Company Proposed Pro Forma Rate of Return Schedules Schedule D-3.0 Pro Forma Embedded Cost of Long-Term Debt Issue List Amount Interest Rate Annual Interest Bank X $3,000, % $210,000 Bank Y $3,000, % $195,000 Bank Z $3,000, % $180,000 Total $9,000, % $585,000

9 Constitution State Water Company Proposed Pro Forma Rate of Return Schedules Schedule D-4.0 Pro Forma Embedded Cost of Preferred Stock Type/List Amount Dividend Rate Annual Dividend Issue A $500, % $35,000 Issue B $500, % $45,000 Total $1,000, % $80,000

10 Constitution State Water Company Proposed Pro Forma Rate of Return Schedules Schedule D-5.0 Projected Pro Forma Common Stock Equity Description Amount End of Test Year Balance $8,800,000 +Net Income 1/1/09 3/31/ ,000 -Dividends Paid 4/1/09-200,000 +Estimated Net Income 4/1 9/30/ ,000 -Dividends Paid 10/1/09-200,000 + Est. Net Income 10/1 12/31/ ,000 Projected Balance at 12/31/09 $9,000,000

11 The Rate Process in Connecticut Rate of Return Commission reviews capital structure for: Accuracy Reasonableness in comparison to proxy group or industry average Cost effectiveness Debt is lower cost; Equity has income tax gross-up; Balance with Rate Base ($)

12 The Rate Process in Connecticut Rate of Return If there is an issue, with any of these Commission can employ a hypothetical capital structure for ratemaking purposes. In the last few years, especially in water utility rate cases hypothetical or target capital structures have been used in a majority of cases by the DPUC.

13 The Rate Process in Connecticut Rate of Return Return on Equity Investors need to get a return for the use of their money and for relative risk. Cost of capital represents an opportunity cost Higher risk investments require higher expected returns to attract investors Regulated utilities are viewed as some of the least risky industries

14 The Rate Process in Connecticut Rate of Return Water utilities are generally viewed as not very risky compared to other companies because: Heavily regulated No Competition Indispensible product Renewable resource Water companies are not risk free Health and environmental regulations (water quality standards, stream flow) High fixed costs Security/contamination issues

15 Hope and Bluefield Court cases Established Factors for Determining a Fair Rate of Return Comparable earnings for comparable risk Maintain financial integrity Capital attraction Established end result doctrine (How rate base and return are arrived at is not important as long as end result is reasonable)

16 Factors in estimating Cost of Equity Company specific 1. Availability of market data 2. Non-publicly traded companies 3. Is parent/holding company comparable? Selected Proxy Group 1. Assure comparable risk 2. Regulated/non-regulated subsidiaries 3. Risk measures (Bond ratings, Stock Rankings, Value Line info) 4. Risk Factors (Size, growth rates, customer mix)

17 Cost of Equity Estimation Methods Discounted Cash Flow (DCF) Most widespread regulatory acceptance Most Company specific model Formula uses readily available data Forward looking Recognizes time value of money Problems: Growth rates are subjective Analyst growth rates short-term, cost of equity is long-term

18 Cost of Equity Estimation Methods Discounted Cash Flow (DCF) Simplified DCF Model K= D 1 /P 0 + G Where K = cost of equity capital D 1 = Expected annual dividend P 0 = Current stock price G = Constant growth rate

19 Cost of Equity Estimation Methods Discounted Cash Flow (DCF) Methods to Measure G (Growth) Historical Dividends per share Earnings per share Book Value per share Forecasted Dividends per share Earnings per share

20 Cost of Equity Estimation Methods Risk Premium (RP) RP - Start off with a risk free interest rate as the base. Usually some form of US Treasury Bond/Note. Add an equity risk premium for the added risk of making an equity investment Most Utilized Risk Premium Method by Utility Regulators is the Capital Asset Pricing Model (CAPM)

21 Cost of Equity Estimation Methods - CAPM CAPM Formula K= Rf + B (Rp) K = Cost of Equity (%) Rf = risk free rate B = Beta Rp= Expected market risk premium Estimated by using (Rm-Rf), where Rm = expected return on market

22 Discounted Cash Flow (DCF) K= Rf + B (Rp) Rf = risk free rate (Measured by a long-term Treasury) 30-year Treasury = 4.32% for 3 rd Qtr 2009 B = Beta (Measure of relative risk vs. the stock market) Stock market as a whole: Beta = 1.0 Utility industries as a whole are lower risk than the entire stock market so betas are below 1.0. Value Line s - Water industry beta = 0.86

23 Discounted Cash Flow (DCF) K= Rf + B (Rp) Rp= Expected market risk premium Estimated by using (Rm-Rf), Rm = expected return on market Estimating Rp is the most controversial part of CAPM Premium is subjective Can be done using Historic Risk Premiums (Morningstar/Ibbotson) or Forecasts/Surveys (Wall Street Rating Agencies, CFOs, Economists)

24 Cost of Equity Estimation Methods - CAPM Strengths and weaknesses of CAPM + Easily understood + Premiums readily available - Using Historic data assumes history will be similar to past - Not Company specific (Uses proxy group or industry average)

25 Other Cost of Capital Methods Used by Connecticut DPUC Ibbotson Build-up Method Risk Premium Method that includes Premiums For Size and Industry Update of Company s Last Rate Case Survey of Recent Decisions (Allowed ROEs)

26 Which Cost of Equity of Method is the Best? No method is precise all are estimates Each method has strengths and weaknesses No one method is regarded as superior Use multiple methods to provide a range and as a check against one another

27 Rate of Return Summary Commission Balancing Act Allowed Rate of Return or Cost of Equity may have consequences if unfair or unreasonable? If too high: Company is likely to recover costs that exceed cost of capital Ratepayers will pay a higher revenue requirements If too low: Company may not recover costs its cost of capital which could impact financial integrity, ability to attract new capital Could lead to Credit Rating Downgrade