5. 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, a number of factors may affect the appropriate debt costs and return on equity such as the regulatory environment and the specific operations of the individual company. We have extensively considered the 2008-2010 financial crises in A.05-05-002 et al. in D.09-05-019, and again in A.09-05-001 et al. in D.10-10-036.

We attempt to set the debt costs and return on equity 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 as a starting point to arrive at a fair return on equity.

5.1. Legal Standard

The legal standard for setting the fair rate of return has been established by the United States Supreme Court in the Bluefield and Hope cases.⁷ The Bluefield decision states that a public utility is entitled to earn a return upon the value of its property employed for the convenience of the public, and sets forth parameters to assess a reasonable return. Such return should be equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings attended by corresponding risks and uncertainties. That return should also be reasonably sufficient to ensure confidence in the financial soundness of the utility, and adequate, under efficient management, to maintain and support its credit and to enable it to raise the money necessary for the proper discharge of its public duties.

Hope held that the value of a utility's property could be calculated based on the amount of prudent investment minus depreciation, which we call rate base. Hope reinforces the Bluefield decision and emphasizes that the returns should be sufficient to cover operating expenses and capital costs of the business. The capital cost of business includes debt service and stock dividends. The return should also be commensurate with returns available on alternative investments of comparable risks. However, in applying these parameters, we must not lose sight of our duty to utility ratepayers to protect them from unreasonable risks including risks of imprudent management.

⁷ Bluefield Water Works & Improvement Company v. Public Service Commission of the State of Virginia, 262 U.S. 679 (1923) and Federal Power Commission v. Hope Natural Gas Company, 320 U.S. 591 (1944).