Document Rar71y1BdO4G6pRKM5yX8Dgqk

22510 Federal Register / Vol. 51, No. 119 / Friday. June .20, 1986 / Rules and Regulations Do k,=----- |(l+kj " + (l+k.) + (l+g) (l+k.) u+ (l+8)| + g 4Po Where: ksmarket required rate of return (annual effective rate) And. as indicated above, the Commission also introduced the concept of the `'ratemaking rate of return," which is derived by a formula which adjusts the rale produced, by the 442 Effective Rate Model. This staff report reviews the Commission s analysis of Order No. 422 on (he ratemaking rate of return issue and makes some modifications to that analysis. In the process, wc hope that the issues related to the ratemaking rate of return concept and its application become clearer. B. Definitions Many terms are being used in this proceeding that arc similar in appearance and close in meaning. It Is easy to understand how a reader may get confused. TJhe purpose of this section is to put the various terms in perspective and thereby to make the reading easier. Unless otherwise specified, these concepts are used in reference to common equity capital only. First, three adjectives often applied lo the phrase "rate of return on common equity" are required, 'expected and earned. The first two are often used.interchangeably. Sometimes the latter two are used together. This can raise ambiguities in a reader's mind. In market equilibrium, investors' required and expected rates of return are equal, by definition: supply equals demand. The supply. side of the market reflects what investors require while the demand Bide reflects what investors expect. The basis for estimating investors' required rates of return with a discounted cash flow model depends on the assumption of market equilibrium. The DCF model estimates investors' expected rateB of return. In contrast, the earned rate of return is the rate of return actually earned by a company on the book value of its common equity investment. It is an accounting rate of return rather than a market rate of rotum like the investors' expected and required rates of return. A second useful distinction Is between nominal and effective rates of return.. Generally, these are different ways of expressing the same thing. There are strict mathematical relationships between these rates. The difference between effective and nominal rales is that the former includes the compounding effects of intrayear earnings in the total return for the year. When compounding occurs only once per year, the effective and nominal rates are the same. However, when the compounding is more frequent, the effective rate is higher than the nominal rate. For preferred stock and debt, the dividends and interest constitute the total returns paid by the company to the investor. As a result, for these types of securities, the difference between the nominal and effective return i9 only the return obtained by the investor through his own reinvestment of dividends or interest during each year. In contrast, utility common stock investors receive their return through a combination of dividends and reinvestment of retained earnings. Since some of a utility's earnings are normally retained, the difference between effective and nominal rates for common stock would include two components: (1) The return that the investor obtains from his own intrayear reinvestment of the dividends he receives on a quarterly basis and (2) the return that the utility obtains through its intrayear reinvestment of the portion of its earning9 that it retains on the investors' behalf. The 442 Effective Rate Model produces an estimate of the investors' effective required rate of return on common equity since it incorporates these two return components. The 420 Model produces a rate which cannot be characterized as either a nominal or an effective rate as they are defined above. Rather, the 420 Model produces an estimate of investors' effective required rate less that portion of the intrayear return that the investor obtains through his own reinvestment of dividends. In other words, it is the rate that the company has to pBy out to the investor (what can properly be referred to as the cost to the company, excluding flotation costs) in order for the investor to have the opportunity to earn his effective required rate. We shall refer to the rate produced by the 420 Model as the "420 nominal rate." Another set of terms used in reference to rale of return on common equity include allowed, benchmark and rotemaking. The "allowed" rate of return Is the rate that the regulatory commission uses in determining the utility's revenue requirements. For purposes of this report, the final'two terms are defined in terms specific to this proceeding. The following definitions are provided from Order No. 442: "Benchmark rate of return" means the rate of return on common equity that is determined each quarter based on the findings made in the annuel proceeding regarding the quarterly indexing procedure and the average cost of common equity end the average ralemaking rate of return on common equity for the jurisdictional operations of public utilities. "Ralemaking rate of return" means the rate of return on common equity that, when applied to rate base in determining revenue requirements Tor ratemaking purposes, will give Investors the opportunity to obtain the effeclive required rate of return on common equity and give firms the opportunity to recover flotation costs. Also, it should be pointed out that the quarterly indexing procedure established by Order No. 442 defines the benchmark rale of return in terms of the ratemaking rate. Finally, reference.should be made to the "cost of capital" to the company or. more specifically, the "cost of common equity." Generally, this has been defined as the sum of the investors' required rate of return and on allowance for the flotation costs involved in new slock issuances. Since the required rate of return can bo defined in terms of effective, nominal and "420 nominal" rates, as discussed above, so too can the cost. Order No. 442 established the definition of the cost of common equity in terms of the investors' effective required rate. On rehearing this co9t is being defined in terms of the "420 nominal." C. Order No. 442 As suggested above, In the second annual generic rate of return proceeding, the Commission made two important changes from the first annual proceeding. First, tt adopted a different DCF model---the so-called 442 Effective Rate Model. Second, it introduced the concept of the ratemaking rate of return. The objective of the ratemaking rate of return was to determine the rate of return which, if allowed. wiU give the utility the opportunity to earn enough revenues to provide its investors with the return they require. In the first change, the 442 Effective Rate Model estimates the Investors' effective required rate of retumrather than some nominal required rate.8 Order No. 442 explains that the primary difference between the effective and nominal rates Is that the former is always larger because it includes the returns investors expect from reinvestment of intrayear earnings-- reinvestment of dividends by the investor and reinvestment of retained earnings by the firm. 51 FR 343 at footnote 13. The order proceeds to note that the effective rate is not the appropriate basis for allowed, or benchmark, rates of return. According to that order, the appropriate basis for the benchmark-rates of return is the ratemaking rate of return. This is the second, and most important, change in Order No. 442. To arrive at the ratemaking rate of return, the investors' effective required rate of return determined by the new model was adjusted lo achieve three objectives:, 1. Eliminate from the investors' effective required rate of return that portion which relates to their reinvestment of quarterly dividends. 9 According to Order No. 442. the 420 Model was "intended to estimate the investors* nominal quarterly required rale of return on common equity." Si FR 343 at 346. As explained above, the 420 Model is better viewed as providing an estimate of a different type of "nominal" rate than the nominal quarterly rnte. Ae a basis for allowed rates of return, the nominal quarterly rate appears to incorporate aspects of the rolcniaking rate concept. GLEASON-000775