The Federal Energy Regulatory Commission (FERC) issued Order 569‑A on May 21, significantly revising the methodology used to analyze the base return on equity (ROE) of a public utility’s rates under the Federal Power Act. Because the order remains subject to further legal challenge and FERC had last revised its guidance on acceptable methodologies six months earlier in Order 569, uncertainty in acceptable methodologies may continue for some time.
In Order 569, FERC applied a revised methodology for analyzing the base ROE using the discounted cash flow (DCF) model and capital-asset pricing model (CAPM). FERC rejected use of the expected earnings or risk premium models. Order 569 gave each model equal weight in establishing the composite “zone of reasonableness.” Order 569 also established four quartiles of presumptively just and reasonable ROEs within the overall composite zone of reasonableness.
Significant Changes to Order 569 on Rehearing
During a Commission meeting on May 21, 2020, the Commission addressed the extensive challenges to Order 569 on rehearing, highlighting six significant changes.
First, the order accepted the use of a risk premium model in addition to the DCF model and the CAPM. Although the Commission did not accept use of the expected earnings model for use in the instant proceeding, it did not foreclose using that model in future proceedings if parties can show that the Commission’s concerns are addressed. The concerns with the expected earning model include that the estimated returns are based on book value and not stock price, the latter of which an investor must pay. The Commission also found that because market value substantially exceeds book value, the expected earnings model does not measure accurately an investor’s return expectations.
Second, the order retains the two-step DCF model (which considers both short-term and long-term public utility growth projections), but increases the weighting of the short-term growth rate to 80% from 66.6%, and decreases the weighting of the long-term growth rate to 20% from 33.3%. The Commission continued to find appropriate the use of the Institutional Brokers' Estimate System (IBES) for short-term growth rates for the DCF model.
Third, the order clarifies that the Commission will consider only Value Line Investment Survey growth rates for use with the CAPM. The Commission is “purposefully taking different approaches for the sources of short-term growth rate data in the DCF and CAPM” because the CAPM “is a better candidate for a new growth rate data source.”
Fourth, Order 569-A increases, but does not eliminate, the high-end outlier test. Order 569 adopted the high-end outlier test to exclude from the proxy group any company whose estimated cost of equity exceeds 150% of the median cost of equity of that group, subject to a natural break analysis. Order 569-A revised this to use a 200% threshold, while also maintaining the natural break test as a check on the outlier test to ensure that only outliers are removed from the proxy group. The Commission denied rehearing on challenges to the low-end outlier test.
Fifth, the Order adjusted the zone of reasonableness to reflect the single-point result of the risk premium model to ensure the model is reflected under the analysis of both prongs of Section 206.
Finally, the Order shifts from a quartile approach to one that sets three equal ranges of presumptively just ROEs that cover the entire zone of reasonableness. In Order 569, the lower half of the first quartile and the upper half of the fourth quartile were outside the zone of presumptively just and reasonable ROEs. The remaining zone was divided into three equal segments corresponding to the relative risk of the investment. The zone of presumptive reasonability was centered at the midpoint for investments of average risk, the upper midpoint for above average risk, and the lower midpoint for below average risk. Persuaded by arguments that the Commission’s ranges of presumptively just and reasonable base ROEs should encompass the entire composite zone of reasonableness, the ranges of presumptively just and reasonable base ROEs will be calculated by dividing the overall composite zone of reasonableness into three equal portions and no longer excluding half of the first and fourth quartiles.
If you have any questions on the issues discussed in this post, please contact the authors.