10. Cost of Capital
ORA and Southwest disagree over two cost-of-capital issues. First, ORA recommends a lower return on common equity (ROE) based on different factors used in ORA's modeling methodology. Second, ORA recommends that the test year cost of capital structure be based on Southwest's actual capital structure, rather than the hypothetical capital structure recommended by Southwest. As a result of these differences, Southwest recommends a rate of return of 9.57%, while ORA recommends a rate of return of 8.83%.
10.1. Return on Equity (ROE) and Capital
Structure
Southwest's recommended ROE is 11.60%, while ORA recommends 10.61%. Southwest and ORA both rely on the Discounted Cash Flow (DCF) model and Capital Asset Pricing Model (CAPM) to develop estimates for ROE. However, Southwest relies on two variants of the DCF model, the Constant Growth model and the Three-Stage DCF model, while ORA relies only on the Three-Stage model.
Southwest argues that ORA's proposed ROE ignores the Bluefield and Hope legal standards65 by not providing Southwest a reasonable opportunity to earn a fair rate of return. Southwest contends the "proxy group" of alternative investments used by ORA is not comparable to Southwest's financial condition. First, Southwest points out ORA's proxy group consists of utilities with an average bond rating of "A", while Southwest's bond rating is significantly lower. Second, the average capital structures of the proxy group have an equity component of 52%, while ORA's recommended equity component for Southwest is 36%. As a result, Southwest argues its investment risk is greater than the expected risk for ORA's proxy group, and the ROE should be increased to recognize this additional risk.
ORA maintains that its recommended ROE, based on the Three-Stage DCF model, is both reasonable and meets the Bluefield and Hope legal standards. ORA asserts that Southwest's current capital structure is a result of management imprudence in capital structure policy, and that over the past decade Southwest has consistently maintained a capital structure at odds with that approved by the Commission. It notes, for example, that the difference between the authorized debt ratio and actual debt ration has ranged from 10-14% in the last yen years. This higher debt ratio (64.1%) is, ORA says, significantly higher than the average capital structure of the proxy group (45.7%) used to estimate the cost of equity. ORA concludes that it is the growth in Southwest's Arizona and Nevada jurisdictions that drives the additional debt in the capital structure.
ORA asserts Southwest's recommendation for a higher ROE is a result of using different estimates of the risk-free rate of interest and the market-risk premium in the CAPM, and an additional difference results from Southwest's upward adjustment of its model to reflect greater financial and business risks. Further, ORA argues its use of only the Three-stage DCF model more appropriately reflects the current economy.
10.2. Discussion
The rate of return or cost of capital is derived from the capital structure and the formula that weights each cost component (debt, preferred stock, and common equity), and its associated cost factor. Therefore, in determining an appropriate cost of capital, the ROE and capital structure are related and must be addressed together.
In our recent decision, D.02-11-027,66 on cost of capital for PG&E, Edison, SDG&E and Sierra Pacific Power Company (Sierra), we addressed the standards employed to develop a reasonable return on equity, and optimum capital structure. D.02-11-027 also addresses the legal standards established by the Bluefield and Hope cases67 to set ROE. As we stated, "We attempt to set the ROE at a level of return commensurate with market returns on investments having corresponding risks, and adequate to enable a utility to attract investors to finance the replacement and expansion of a utility's facilities to fulfill its public utility service obligation. To accomplish this objective we have consistently evaluated analytical financial models and risk factors prior to exercising informed judgment to arrive at a fair ROE."68 We employ this same process in setting Southwest's ROE, and determining the appropriate capital structure in the instant proceeding.
We will adopt a capital structure based on Southwest's actual capital debt and equity ratios. We share ORA's concern that Southwest has consistently maintained capitalization levels well below what we have authorized in the past. We will not perpetuate the practice of ratepayer funding for equity that does not exist. Although we continue to encourage Southwest to increase the CE portion of its capital structure, we believe that it capital structure to date clearly has not led to that result. If Southwest can demonstrate changes to its capital structure in its next GRC, we will consider further modifications in that forum.
Our adopted ROE considers the analyses of both ORA and Southwest, and the analyses of other factors discussed in D.02-11-027. As we stated in D.02-11-027, "We must set the ROE at the lowest level that meets the test of reasonableness,"69 and, "In the final analysis, it is the application of informed judgment, not the precision of financial models, which is the key to selecting a specific ROE estimate."70 As ORA points out, the ROE should reflect the elimination of risk associated with Southwest's loss of revenues, protected via the balancing account provision recommended by ORA and Southwest. In addition, we have reduced other risks that affect Southwest's opportunity to earn its adopted ROE. These reductions in risks include the RRSMA we adopted in D.03-05-032, an attrition year mechanism that protects against increased costs due to inflation, and a phase-in of the increase in the adopted revenue requirement over four years, instead of the five years requested by Southwest. In consideration of other risks, we recognize that Southwest is a multi-jurisdictional utility, similar to Sierra, and that its major operations are in Arizona and Nevada, and not California. Thus, the impact of growth, and financing that growth in other states prevails in the total company capital structure. In consideration of these factors, we conclude that a ROE of 10.9%, combined with the following capital structure meets our standards for establishing a fair and reasonable ROE, and cost of capital.
Adopted Cost of Capital | |||
Capital Ratio |
Cost Factor |
Weighted Cost | |
Long-Term Debt |
60.94% |
7.75% |
4.72% |
Preferred Stock |
3.54% |
9.51% |
0.34% |
Common Stock |
35.52% |
10.90% |
3.87% |
Total 100.00% |
8.93% | ||
