On June 6, 2013, the Edison Electric Institute (EEI) issued a white paper urging the Federal Energy Regulatory Commission (FERC) to reevaluate the method it uses to establish returns on equity (ROEs) for transmission investments. In the white paper, EEI asserts that investment in transmission infrastructure provides considerable benefits to transmission customers, and notes that transmission investment by its members has nearly doubled between 2001 and 2011.
According to EEI, the need for continued transmission investment is undisputed, and many of the projects that will provide the most significant benefits to customers are the large regional and inter-regional backbone projects. As EEI explains, “these projects also carry the most upfront development time, longer construction schedules, and overall risk.” However, without a sufficient ROE, electric utilities are likely to choose short-term, more local projects, instead of riskier, more strategic options. EEI also asserts that in order for the reforms in Order No. 1000 to be effective in promoting the construction of projects identified in regional and inter-regional planning processes, utilities need to be assured of adequate returns on those investments.
EEI stresses that the risks and challenges associated with developing transmission have not diminished in recent years. According to EEI, these risks and challenges separate transmission investment from investments in any other utility infrastructure where the projects tend to be smaller in size, shorter in duration, and located in a single area. Regulatory certainty is required to obtain and maintain financing, because transmission projects tend to be long-term in nature.
EEI also asserts that utilities compete globally and with other industries for capital. The ROE approved by FERC for an electric utility is intended to give investors a return “comparable to returns on similar investments of comparable risk. In order for utilities to attract capital to develop needed transmission, the ROE approved by FERC must be adequate and stable to attract investors and meet regulatory standards affirmed by the courts.” In order for investors to be willing to commit capital to utilities, they must expect to earn a predictable return that is commensurate with the returns for comparable-risk investments. Accordingly, EEI explains that FERC decisions significantly reducing ROEs would further shrink the pool of funds available for transmission investment. EEI states, “if returns on electric transmission infrastructure are not sufficient and stable, investors will avoid such investments and will instead seek better and more stable returns elsewhere.”
According to EEI, the Discounted Cash Flow (DCF) financial model currently used by FERC to establish ROEs results in transmission ROEs that are below currently authorized state ROEs by 200 or more basis points. EEI encourages FERC to take the opportunity to consider adjustments to its DCF methodology to avoid sending unintended investment signals. EEI’s white paper sets forth a number of specific suggestions:
Requests to lower existing ROEs should be required to demonstrate that the existing ROEs fall outside the range of reasonableness.
FERC should exercise flexibility, within or as an adjunct to, its existing DCF methodology to account for the current, extraordinary financial environment and ensure that ROEs are sufficient to support needed investment.
FERC should consider the results of alternative approaches, such as the risk premium method and the capital asset pricing model, and should consider the results of the current DCF analysis performed on a proxy group of companies from other capital-intensive industries or low-risk firms from the competitive sector.
FERC should increase the threshold for the exclusion of low estimates in a proxy group to eliminate returns that are not at least 200-300 basis points above the prevailing long-term utility bond yield; and/or incorporate projected bond yields and then apply the currently applicable 100-basis-point threshold.
FERC should adjust its policy of removing both the low and high DCF values if only one value is an outlier. The FERC should recognize that low and high DCF values for a utility are independent estimates, and the fact that one is considered to be an outlier does not compromise the remaining estimate for that utility.
FERC should establish a shorter period of time for excluding companies with a recent dividend cut.
EEI concludes by urging FERC to reaffirm its commitment to transmission investment by making necessary adjustments in its approach to setting a just and reasonable ROE for transmission investment. EEI’s white paper is available here.
EEI’s white paper is certain to be controversial, since customer groups have been arguing for lower ROEs for many months. With approximately 20 cases pending before FERC seeking amendments to electric utilities’ ROEs, FERC is likely to decide what direction to take in the near future. We expect to see action from FERC on these issues in the coming months, perhaps as soon as FERC’s open meeting in July.