Calculating fairness. [Estimating fair return on equity for public utilities]
- National Economic Research Associates, Cambridge, MA (United States)
Despite the recent restructuring, unbundling, competition, and incentive regulation that has complicated the utility business, estimating the fair rate of return on equity (ROE) remains an important part of public utility base rate cases. For the past two decades, the two most popular methods that regulatory commissions have used for estimating the cost of equity capital for regulated utilities have been the dividend discount method (known as the Discounted Cash Flow model of DCF) and the Capital Asset Pricing Model (or CAPM). Both models use common stock price behavior to draw inferences about the cost of equity. The DCF combines a stock's dividend yield and its predicted dividend growth rate. The CAPM relates changes in a stock's price to changes in the overall market for security prices. These methods have come into question, however, as utilities have increasingly diversified into unregulated activities. When a utility's regulated activities account for 95 to 99 percent of its revenues, there is little practical need to question that its company-specific cost-of-equity capital is overwhelmingly dominated by its regulated activities. But as this percentage continues to decrease, a company's specific cost of equity, as calculated by the DCF or CAPM, is influenced to a larger degree by its unregulated subsidiaries. Two general remedies are available to resolve the problem of setting the fair ROE when the company has substantial holdings in unregulated subsidiaries. One is to abandon (either partially or fully) the practice of using company-specific market information and use a proxy group of comparable utilities instead. The other is to continue using company-specific data, but to adjust the resulting estimates to account for the utility's diversification activity.
- OSTI ID:
- 5371341
- Journal Information:
- Fortnightly; (United States), Vol. 131:21
- Country of Publication:
- United States
- Language:
- English
Similar Records
State regulators go with the [open quotes]flow[close quotes]
Fair return to equity: why and how