Document rkvRnrLZ95zY4Om1N3RR170G

saSiaaa-B 22512 Federal Register / Vol. 51, No. 119 / Friday, June 20, 1986 / Rules and Regulations F. Conclusions This report has reviewed the "rulemaking rate of return" concept as it was conceived and developed in Order No. 442. Our review indicates that, while the concept has ratemaking rate concept, we believe it is appropriate for the Commission to rely on the 420 nominal rate for purposes.of determining benchmark rates of return in this proceeding. This is the rate that has traditionally been used as the basistor allowed rates of return. As shown tn the preceding analysis, it is the rote that investors expect and require from the utility, and, as such, U is the rate that the utility has to pay out to investors. potential merit, the discussion and analysis on this issue in Order No. 442 may have been Attachment 1 misleading, and there are some questions on both the concept and its application that deserve further comment and consideration. First, the discussion of the ratemaking rate Derivation of the 420 Model From the 442 Effective Rate Model The DCF model adopted in Order No. 442 estimates the shareholder's required effective annual rate of return.1 concept in Order No. 442 appears to have been unclear. The concept of the ratemaking rate and the adjustment to the cost of capital implied by that concept was linked Do k, 4Po lU+k.VTi-bU+U*+U+gHi+V#V*i+li+8)l+8 predominately with establishing consistency between the definitions of rale case and rate of return in setting utility revenue requirements. However, the adjustment was actually doing more. It was also converting an effective rate of return to a nominal rate by reducing the effective rate for the Where: k=markel required rale of return (annua! effective rate) Concurrent (indicated) annual dividend rnto Po = current market price of stock g = dividcnd growth rate (annual rate). intrayear reinvestment of dividends by This effective rate includes the return which investors have the opportunity, to obtain on their investors and for the intrayear reinvestment' own by reinvesting the quarterly dividends in the same or another investment yielding the of retained earnings by the utility. same effective rate.1 Second, it appears that the analysis of The term: Order No. 442 supporting the ratemaking rale adjustment was at least misleading. The adjustment to the cost of common equity was said to be based on the number of compounding periods used in the measure of rate base. Instead, staffs more recent -- [(1+M TS+(1 +-ke) 4+(1 -f g) (1 + k,) M+(l +g)J 4Pb onalysis suggests that it should be a function of the frequency of compounding and the rate of return on the intrayear reinvestment of represents the return earned from the dividends received during the year and the income retained earnings by the utility. earned by reinvesting the dividends during the course of the year. It also appears that the ratemaking rate The term: concept may be better characterized as relating to a difference between the rate of return that ratepayers "pay in" and the rote of return that utilities "pay out" due to the intrayear reinvestment phenomenon. (In this Do [(l + k*'1,-lj + |l-fM ft-l)-t-(l+g) [(1+k.)-' 4Po '-ill regard, the Appendix to this report shows how the 420 Model estimates the return that investors expect/require the utility to "pay out" to them.) Finally, there are a number of questions represents the return earned on dividend reinvestment income alone. When the dividend reinvestment income is subtracted from the 442 Effective Rate Mode), the result is the 420 Model: related to the ratemaking rate concept and its application that deserve further comment and consideration. Is the concept valid? I9 there kTM ~k.--^ mi+k,) "-i|-t-i(i+k.iB-ti+(i+gH(t+y--in really a difference between the so-called "pay In" and "pay out" rates? Is this 4P0 difference due to the intrayear reinvestment of retained earnings or is it due to the way rate base is defined or estimated? If the concept is valid, how should it be Do Do = -- {l + l + (l + g! + (l+g)| + g = "(4 + Zg] + g 4P 4P dealt with from a policy perspective? Should it be ignored and the benefits be allowed to accrue to Investors? Should an adjustment be Dividing through by 4, made to the cost of common equity for purposes of setting allowed rates of return? Or,.should the adjustment be made through some other element of the cost of service? Po k* --(l4-.5g)+g . Po If the ratemaking rate concept is valid and the Commission chooses to make some adjustment to the cost of service to reflect its effects, what is the empirical magnitude of such adjustment? What are the parameters where k43o=Market required rale of return less the return from reinvestment of dividends. AU other definitions are the same. that determine the size of the adjustment? (FR Doc. 85-13728 Filed 5-10-66; 8:45 am] Are they merely the frequency of compounding and the reinvestment rate of BILLING COOC 6717-OHK return? If the adjustment is made through the rate of return, is there some formula, simitar to that adopted.in Order No. 442, that could 1 The derivation of this model from the general be used? furm of the discounted cash flow model may be In sum. given the still unresolved issues, found in Appendix A of Order No. 442. particularly the question of the validity of the * Order No. 442, P. 24. 1 GLEASON-000777