By Rich Heidorn Jr.
In a victory for transmission owners, FERC on Tuesday signaled a major change in how it sets TOs’ return on equity rates, saying it will no longer rely solely on the discounted cash flow (DCF) model it has used since the 1980s.
Instead, the commission said it will give equal weight to results from the DCF and three other techniques: the capital asset pricing model (CAPM), expected earnings model and risk premium model.
The commission’s new policy came in its long-awaited response to the D.C. Circuit Court of Appeals’ April 2017 ruling vacating Opinion 531, FERC’s 2014 order on the New England Transmission Owners’ (NETOs) ROE rates. (See Court Rejects FERC ROE Order for New England.)
Tuesday’s order proposes a methodology for addressing the issues remanded to the commission in Emera Maine v. FERC and pending in three other proceedings involving NETOs’ ROEs, setting a paper hearing on how the methodology should apply.
“In relying on a broader range of record evidence to estimate NETOs’ cost of equity, we ensure that our chosen ROE is based on substantial evidence and bring our methodology into closer alignment with how investors inform their investment decisions,” the commission wrote (EL11-66-001, et al.).
Higher Hurdle for ROE Complaints
FERC said it would use the methodology to determine initially whether an existing ROE remains just and reasonable. It said it will use three of the models — the DCF, CAPM and expected earnings — to establish a composite zone of reasonableness, which will be “an evidentiary tool to identify a range of presumptively just and reasonable ROEs.” (The risk premium model results in a single number and cannot produce a range of reasonable rates, the commission said.)
“Under this approach, we intend to dismiss an ROE complaint if the targeted utility’s existing ROE falls within the range of presumptively just and reasonable ROEs for a utility of its risk profile — unless that presumption is sufficiently rebutted,” the commission said.
This new threshold, and FERC’s indication that it will act more quickly on complaints, appears to address complaints by TOs and the Edison Electric Institute over “pancaked” ROE complaints being filed while prior cases remained pending. (See EEI White Paper Calls for End to ‘Pancaked’ Rate Cases.)
When the existing ROE has been shown to be unjust and unreasonable, the commission said, it will use all four models to produce four individual cost of equity estimates; the just and reasonable ROE will be the average of the results.
“For each of the DCF, CAPM and expected earnings models, we propose to use the central tendency of the respective zones of reasonableness as the cost of equity estimate for average risk utilities. We would then average those three midpoint/median figures with the sole numerical figure produced by the risk premium model to determine the ROE of average risk utilities. We would use the midpoint/medians of the resulting lower and upper halves of the zone of reasonableness to determine ROEs for below or above average risk utilities, respectively. Because our current policy is to cap a utility’s total ROE, i.e., its base ROE plus incentive ROE adders, at the top of the zone of reasonableness, we propose to use the composite zone of reasonableness produced by the DCF, CAPM and expected earnings to establish the cap on a utility’s total ROE.”
Based on evidence from the first NETO complaint, the new approach resulted in a range of presumptively just and reasonable ROEs of 9.6 to 10.99%. Based on this analysis, the commission said the just and reasonable base ROE would be 10.41% and the cap on NETOs’ total ROE, including incentives, would be 13.08%.
“However, these findings are merely preliminary,” it added, saying the paper hearing would incorporate feedback on its proposed framework.
The commission’s 2014 ruling — prompted by a 2011 complaint by New England state officials and others alleging that the NETOs’ 11.14% base ROE was excessive — reduced the base ROE to 10.57%. (See FERC Splits over ROE.) But the D.C. Circuit said FERC failed to meet its burden of proof in declaring the existing 11.14% rate unjust and unreasonable.
Although FERC acknowledged that using multiple models increases the “administrative burden” in ROE cases, the commission said it decided to broaden its approach after concluding that the DCF methodology no longer captures how investors make decisions.
“We believe that, since we adopted the DCF methodology as our sole method for determining utility ROEs in the 1980s, investors have increasingly used a diverse set of data sources and models to inform their investment decisions. Investors appear to base their decisions on numerous data points and models, including the DCF, CAPM, risk premium and expected earnings methodologies.”
The commission said the DCF methodology produced lower ROEs than the three other models for the four test periods at issue in the NETO proceeding. It noted that the models’ results sometimes “move in opposite directions.”
The commission’s order includes an appendix explaining the four approaches. The two-step DCF methodology incorporates both short-term and long-term growth projections. CAPM is used by investors to measure the cost of equity relative to risk.
The risk premium methodology considers interest rates as a direct input to compare returns on stock investments to that on less risky bonds.
The expected earnings analysis is based on the book value of individual stocks and can be either backward-looking using historical earnings, or forward-looking using analysts’ earnings forecasts.
Analyst: Higher Rates Likely
ClearView Energy Partners analyst Christine Tezak said the commission’s new approach will likely result in higher top values to the zone of reasonableness than seen since Opinion 531’s adoption. “This potential re-expansion of the zone of reasonableness would make it more likely that transmission owners will realize higher base ROEs than the DCF model alone indicated without a subsequent subjective upward adjustment. A broader range of reasonableness returns also looks likely to restore the full value of incentive adders awarded to transmission owners in prior proceedings.”
Information on how FERC may apply the new methodology to other TOs may come at Thursday’s open commission meeting, the agenda for which includes the NETO docket.
“We will be looking for an indication at the open meeting as to whether the industry should begin integrating these new principles into pending, recently filed and upcoming rate cases and pending complaints now, or wait” for the conclusion of the paper hearing, Tezak wrote.
The commission set a 60-day deadline for filing initial briefs (Dec. 17), with reply briefs due 30 days after that (Jan. 17, 2019).
The New England TOs are Emera Maine (formerly Bangor Hydro Electric); Avangrid’s Central Maine Power; National Grid; New Hampshire Transmission; The United Illuminating Co.; Unitil Energy Systems; Fitchburg Gas and Electric Light; Vermont Transco; and Eversource Energy (formerly Northeast Utilities, Connecticut Light and Power, NSTAR Electric, Western Massachusetts Electric Co. and Public Service Company of New Hampshire).
Commissioner Richard Glick, who formerly worked at Avangrid, did not take part in the ruling.
Commissioner Neil Chatterjee on Wednesday acknowledged concerns that uncertainty over how FERC would respond to the D.C. Circuit’s remand had chilled transmission investments. “So, our action should help ensure [there is] more clarity going forward,” he said during remarks at the Department of Energy’s Electricity Advisory Committee meeting.
At the commission’s open meeting Thursday, Chatterjee said “the commission will need to make important decisions about how the policy we’ve proposed in Emera Maine applies” in other ROE dockets.
Commissioner Cheryl LaFleur, who was chair when the commission issued Order 531, said that ruling was a compromise that set a tighter zone of reasonableness, with the ROE higher within the zone. “Here we’re allowing a much wider band and the ROE is in the middle of the band.”