6. Today's Capital Markets
In general, companies' long-term capital cost rates for debt and equity are equal to required returns on risk-free securities plus a risk premium associated with each company. For a public utility, other factors may affect the appropriate return on equity such as the regulatory environment and the specific operations of the individual company.
6.1. 2008-2010 Financial Markets Environment
The financial markets in the United States are suffering a significant and prolonged dislocation in large part due to the home mortgage lending market and other credit market problems, which directly led to the failures or mergers of many long-standing financial institutions. The economy has since entered a stage of recession and slow recovery. In response, there has been the federal government's intervention including the "Emergency Economic Stabilization Act of 2008,'' H.R. 1424 (Public Law 110 343), with a stated purpose, amongst others, "to immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States."4 This followed closely on the heels of the earlier "Housing and Economic Recovery Act of 2008," H.R. 3221 (Public Law 110 289).5 And, in early 2009, the new administration enacted the American Recovery and Reinvestment Act of 2009 (Public Law 111-5).6 This act was intended to make "supplemental appropriations for job preservation and creation, infrastructure investment, energy efficiency and science, assistance to the unemployed, and State and local fiscal stabilization, for the fiscal year ending September 30, 2009, and for other purposes." Although we are more than a year into the recovery process, we still face a confused and uncertain financial environment as we consider a base year 2010 cost of capital for these six companies.
6.2. Government Action in the Financial Markets
DRA asserts that the massive government spending and Federal Reserve actions have successfully affected the credit markets and that the worst of the credit crisis is over. Additionally, the short-term credit market has loosened up considerably. LIBOR7 rates peaked in the fall of 2008 and have declined. Likewise, the long-term credit market appears to be loosening up, as credit spreads have declined. In addition, the stock market has rebounded significantly from its lows in March of 2009.
Applicants on the other hand assert that there is significant risk to them. Park for example argues there will be a slow recovery and that equity costs reflect this (Park Opening Brief at 4) and we note that to date it has been a slow but steady recovery.
As we have moved into 2010, we continue to see an economy which is only slowly recovering; unemployment remains high and the stock market overall has seen slow improvements while still having many "down days." We believe that we must continue to provide a stable foundation, a consistent return on equity, which allows the utilities to provide safe and reliable service to ratepayers and attract and retain investors.
6.3. Current Capital Conditions and the Volatility
between Stocks and Bonds
To assess the effect of recent capital market volatility on the equity risk premium and the equity cost rate, DRA argues we must look at the volatility of stocks relative to bonds in the recent timeframe.
DRA offered in its testimony that a McKinsey & Co. (McKinsey) study entitled "Why the Crisis Hasn't Shaken the Cost of Capital" demonstrates that the financial crisis has not significantly changed the firm's long-term estimate of the equity risk premium, which DRA believes remains in the 3.5 to 4 percent range. According to DRA, McKinsey developed an equity risk premium based on the price level of the Standard & Poor's 500, Gross Domestic Product growth, and corporate profits. DRA argues the McKinsey study shows that "[t]aking all these factors into account, we think there has been no significant change in the long-term cost of equity capital."8 (Exhibit DRA-1 at 12.)
Valencia argues, relying on testimony offered jointly for Park/Apple and San Gabriel, that although a recovery has begun, because "[interest rate] spreads continue to be much higher than in the past"-indicating that "we are not out of the woods with respect to financial markets" (citing to Ex. SG-5 at 48) and that "a brighter employment picture and stabilizing home prices are still missing from the recovery puzzle." (Valencia Opening Brief at 4-5.)
We agree with Applicants that the "employment picture" is still very worrisome, and we take note that the current California unemployment rates reported in the press are in the 10% range, which is quite high. We otherwise note that in May 2009 (when these applications were filed), the Dow Jones Industrial Average started and ended the month at approximately 8,500 points and by October 2009 (after submission and during our deliberative process) it started at 9,500 and ended at 9,700 points. This current value is still far below the Dow Jones Industrial Average values in May 2008, which started at 13,000 points and ended at 12,500 points.9 Thus a certain degree of recovery has occurred considering the March 6, 2009 low value of 6,600 points for the Dow Jones Industrial Average. So while we may not be "out of the woods," we think we see a workable pathway. (The Dow Jones Industrial Average was at 9,774 points on June 30, 2010.)
6.4. Water and Gas Distribution Stocks
Compared to Stocks in General
DRA compared the water utility and gas distribution stocks' performance relative to the Standard & Poor's 500 over the past year. (Exhibit DRA-1, Page 6 of Attachment JRW-3.) DRA claims that it compared the average stock price performance of its water utility and gas distribution proxy group versus the Standard & Poor's 500's price performance over the past year.
DRA asserts that over the year, the Standard & Poor's 500 has declined 25.6%, while the water utility stocks have declined only 0.1% and gas distribution companies' stocks have declined only 7.0%. Thus, DRA asserts the stocks of both water utilities and gas distribution companies have vastly outperformed the market and have held up extremely well in the current market. Further, according to DRA, the Standard & Poor's 500 was over 3.5 times more risky than the Water Proxy Group stocks and was over 2.5 times more risky than the Gas Proxy Group stocks as measured by the coefficient of variation. Thus, water utility and gas distribution company stocks have been low risk investments in this down market.
Finally, DRA notes:
. . . It is important to be mindful of how the industry has performed in the wake of the financial crisis that began in September of 2008. Water utility stocks have performed substantially better than the Standard and Poor's 500 since that time. (Citation omitted.) Thus, the Applicants cannot make the case that their stock performance justifies an upward adjustment of their [cost of capital]. (DRA Reply Brief at 13.)
We are mindful that we must take the long view and not over-react to short-term fluctuations, even ones which span portions of several years.
6.5. Conclusion
We find that the debt markets and interest rates are still at near all-time low rates, provided willing lenders are found. By our authorizing a continued and stable return on equity, thus assuring the opportunity for a prudently managed utility to be profitable, the utilities should be able to borrow to meet their reasonable needs for capital. We agree with DRA that the utility sector has been more stable than the market as a whole, and thus we do not see any significant increase in risk to California Class A water utilities due to the broader market problems.
4 http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=110_cong_bills&docid=f:h1424enr.txt.pdf. See Section 2(1); and also:
SEC. 101. PURCHASES OF TROUBLED ASSETS. (a) Offices; Authority (1) AUTHORITY - The Secretary is authorized to establish the Troubled Asset Relief Program (or `TARP') to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary, and in accordance with this Act and the policies and procedures developed and published by the Secretary.
5 http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=110_cong_public_laws&docid=f:publ289.110.pdf.
6 http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h1enr.txt.pdf.
7 The London Interbank Offered Rate (LIBOR) is a daily reference rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market (or interbank market).
8 Richard Dobbs, Bin Jang, and Timothy Koeller, "Why the Crisis Hasn't Shaken the Cost of Capital," McKinsey Quarterly (December 2008) at 6.
9 Dow Jones Industrial Average values were derived from charts available on line at finance/yahoo.com and numerous other sources.
