XII. Return on Common Equity

At issue is the appropriate ROE for Sierra's electric distribution operations for 2001. The following tabulation summarizes the ROR position of each party.

Party	Recommended Return
Sierra	12.00%
Aglet	10.60
API	10.50
ORA	10.60

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 methods and risk factors prior to arriving at a fair ROE.

A. Financial Modeling

Historically, quantitative financial models are used as a starting point to estimate a fair ROE. The models commonly used in the cost of capital proceedings are the Capital Asset Pricing Model (CAPM), Discounted Cash Flow Analysis (DCF), and Market Risk Premium (MRP). Detailed descriptions of each financial model are contained in the record and are not repeated here.

Sierra, API, and ORA, each of which used different assumptions and numbers to run their financial models, presented CAPM, DCF, and MRP financial models in this proceeding. The financial models are used only to establish a range from which the parties apply their individual judgment to determine a fair ROE. Although the parties agree that the models are objective, the results are dependent on the subjective inputs. From these subjective inputs the parties advance arguments in support of their respective analyses and in criticism of the input assumption used by other parties. These arguments will not be addressed extensively in this opinion, since they do not alter the model results.

Aglet opted not to use the traditional financial models. Instead, Aglet used Pacific Gas and Electric Company's (PG&E) 1999 authorized ROE as a base and adjusted that base with upward and downward adjustments. The upward adjustments consisted of a 55 basis point adjustment to reflect an increase in interest rates, and a 10 basis point adjustment to reflect increased risk that faces Sierra's investors because of the company's smaller size, lower credit ratings, and individual variations in capital structure. The downward adjustments consisted of a 45 basis point adjustment to reflect the return to PG&E's credit quality single-A stable rating, and a 20 basis point reduction to reflect decreased risk from other risk factors. Aglet thus proposes an ROE of 10.60%.

The following tabulation summarizes the 9.30% - 12.90% broad ranges of results derived from the various quantitative financial models used by Sierra, API, and ORA:

Party	CAPM	DCF	MRP
Sierra	11.30-11.60%	11.80-12.90%	9.90-11.70%
API	10.22	10.51	10.73
ORA	9.30	11.12	11.22

B. Risk Factors

Sierra fine-tuned the results of its financial models to reflect informed judgment with respect to financial, business, and regulatory risk expected to occur in 2001 to arrive at its recommended ROE.

Financial risk is tied to the utility's capital structure. The proportion of its debt to permanent capital determines the level of financial risk that a utility faces. In general, the lower the proportion of a utility's total capitalization consisting of common equity, the higher the financial risk. Therefore, as a utility's debt ratio increases, a higher ROE may be needed to compensate for that increased risk.

Business risk is defined to be the degree of variability in operating results. That is, a company that has the most variability in operating results has the most business risk. An increase in business risk can be caused by a variety of events which include, but are not limited to, deregulation; poor management; a failed marketing campaign; fire in a factory; and, greater fixed costs in relationship to sales volume.

Regulatory risk pertains to new risks that may result from future regulatory action that this and other regulatory agencies might take. It also includes the potential disallowance of operating expenses and rate base additions.

1. Performance Based Rate Making

Included in Sierra's requested 12% ROE is 30 basis points applicable to its projected impact of the PBR mechanism being requested by a separate application, Application 00-07- 001 filed in July, 2000. Aspects of Sierra's proposed PBR include a revenue sharing mechanism exposing the shareholder to variations in earned rate of return, a revenue index mechanism requiring an annual productivity increase of 1.6% to stay in step with inflation, and a service performance mechanism penalizing shareholders for declines in service quality.

Sierra contends that a PBR mechanism carries its own set of risks, relative to traditional rate of return rate base regulation. Sierra identified three examples of major risk under a PBR mechanism. First, investors and ratepayers would not be protected from the risks that the company's financial integrity is compromised by possible inadequacies in the PBR parameters, such as the inflation index and the productivity threshold. Second, financial performance would become more volatile and unpredictable compared to orthodox rate of return regulation where investment recovery was relatively assured and stable, predictable returns were provided. Finally, each index component of the PBR formula would carry its own risk. In the case of the inflation component, one risk factor involves the relative input factor composition in the aggregate inflation index compared to Sierra's own input factor composition, resulting in a lack of conformity which introduces "index risks" so that year-to-year company profits become statically more volatile.

Aglet, API, and ORA oppose Sierra's proposed adjustment to the financial models for risk associated with PBR because the history of authorized returns on equity and investor expectations already include investor consideration and expectation of PBR risks.

Sierra, in identifying its examples of major risk under a PBR mechanism, acknowledged that a PBR mechanism substitutes one set of complex risk issues for another. No party in this proceeding attempted to identify or separate utilities included in their respective financial model study groups which utilize PBR mechanisms or attempted to quantify differences in risks and benefits between utilities with and without PBR mechanisms.

By D.94-11-076 we concluded that little or no weight should be given to diversifiable risks and that general economic factors such as interest rates and financial market trends carry more weight than risks associated with individual utilities or utility industries.⁸ By that same decision we found that PBRs revise the incentives inherent in cost of service regulation in order to better align shareholder and ratepayer interests which provide well-crafted incentives for shareholders and ratepayers and do not require any risk premium.⁹

All parties agreed in theory that diversifiable risks are not compensated in ROEs granted to a regulated industry. Further, ORA has identified, and Sierra has confirmed, that a PBR mechanism is a mechanism that can be diversified away by investors. No party has presented evidence to justify a reversal of our long-standing policy of excluding diversifiable risks from consideration of a fair ROE. Sierra's proposal to increase its ROE by 30 basis point for risks associated with a PBR mechanism upon adoption of such a mechanism currently under consideration for Sierra in A.00-07-001 is without support and should be denied.

2. Flotation Cost

Sierra includes a 30 basis point upward adjustment in its proposed ROE to reflect the impact of flotation cost. Flotation costs represent the direct and indirect costs of issuing new stock. Direct costs commonly include underwriter costs for marketing, consulting, printing and distributing a prospectus, legal costs, and discounts that must be provided to place the new stock.

The merits of a flotation cost adjustment were considered and rejected in a prior cost of capital proceeding involving the major California gas and electric companies and Sierra. At that time we concluded that any merit to a flotation adjustment would apply only to existing stock at the time of actual new issuance's and not to sales in the secondary market. We also concluded that such an adjustment is inappropriate as long as utility stocks are trading significantly above their book value. We further concluded that any reconsideration of a flotation adjustment in a future proceeding would require a showing of theoretical and practical utility and market specific data, and a showing that a flotation cost adjustment does not shift the burden of the transaction costs from investors to ratepayers. At such a time, we would consider referring the flotation adjustment to a workshop.¹⁰

Sierra does not anticipate issuing any new stock in the 2001 test year. Sierra has also confirmed that nothing with respect to flotation cost has changed since the last Commission decision denied the use of flotation costs, and has not submitted the necessary showing set forth in D.92-11-047 and summarized in the prior paragraph. Sierra has not met its burden of proof to justify the inclusion of its proposed 30 basis point flotation cost adjustment to its authorized ROE.

C. Conclusion

We will not approve Sierra's requested 11.70% ROE for its California electric distribution operations under traditional regulation or requested 12.00% ROE upon adoption of its proposed PBR mechanism. This ROE would provide Sierra's shareholders with an excessive return on equity. By excluding the upward flotation cost adjustment from Sierra's CAPM, DCF, and MRP financial models based on electric utility and gas distribution industries and excluding the upward flotation cost and PRB risk premium adjustments from its requested ROE, Sierra's subjective financial models support a 11.40% ROE without any further adjustments.

This ROE is 80 basis points higher than the 10.60% ROE being recommended by Aglet and ORA. We observe that ORA's subjective inputs to financial models similar to those used by Sierra did not include any premium for additional risk associated with PBR or flotation costs. Sierra's adjusted 11.40% ROE is also 90 basis points higher than the 10.50% ROE being recommended by API based on API's subjective inputs to similar financial model and inclusion of a partial premium for flotation costs.

As addressed in our financial modeling discussion, parties derived different results because of their use of subjective inputs. For example, each party used different proxy groups, risk-free rates, betas, market risk premiums, growth rates, calculations of historical market returns, and time periods within their respective models. Although each party addressed the strengths of their respective financial modeling results, other parties addressed their defects. Other than excluding from Sierra's financial modeling results its MRP analyses and upward risk premium for PBR and flotation costs, we have no reason to exclude or adopt the financial modeling results of any one party. Hence, we will establish a range from which the parties applied their individual judgement to determine a fair ROE for Sierra.

Sierra's recommended 12.00% ROE should be adjusted downward to exclude its 30 basis points PBR risk premium and 30 basis points flotation costs risk premium. This reduces Sierra's 12.00% ROE to 11.40% ROE (12.00% less: .30% PBR risk premium and the .30% flotation cost risk premium). The results of Sierra's MPR analysis should also be excluded for Sierra's failure to identify proprietary MPR data in its testimony and exhibits and failure to provide parties access to verify the reasonableness of the data results to prepare cross-examination questions or rebuttal testimony as required by Section 1822. However, this MPR exclusion has no material impact on Sierra's overall recommendation.

The maximum ROE based on Sierra's financial models adjusted for exclusion of PBR and flotation costs premium risks should be 11.40%. The midpoint ROE recommendation of API, Aglet, and ORA is 10.60%. Hence, a subjective range of ROE for Sierra is between 11.40% and 10.60%.

Parties, including Sierra, ORA and Aglet, state that the Commission has consistently authorized Sierra a ROE that was 10 basis points higher than the ROE granted the major energy utilities. This 10 basis points premium allegedly exist to compensate Sierra's investors for the smaller size, lower credit rating, and individual variation in capital structure in comparison to the major energy utilities. Aglet attempted to substantiate this 10 basis points assumption in a tabulation that showed authorized ROEs for the test years 1991, 1993, and 1994 in its brief. However, in 1993, Sierra was authorized an 11.95% ROE in comparison to PG&E's 11.90% ROE, a five basis points differential. More recently, in 1996 both Sierra and PG&E were authorized the same 11.60% ROE.11 This 10 basis points ROE premium above the major energy utilities authorized ROE has not been justified and should not be adopted for Sierra in this proceeding.

In the final analysis, it is the application of judgment, not the precision of financial models, which is the key to selecting a specific ROE estimate within the range predicted by analysis. We affirmed this view in D.89-10-031,¹² which established rates of return for GTE California, Inc. and Pacific Bell, noting that we continue to view these financial models with considerable skepticism.

We consistently consider the current estimate and anomalous behavior of interest rates when making a final decision on authorizing a fair ROE. In PG&E's 1997 cost of capital proceeding we stated "Our consistent practice has been to moderate changes in ROE relative to changes in interest rates in order to increase the stability of ROE over time."¹³

The parties are at odds on whether Treasury bonds or AA utility bonds should be used as a benchmark in establishing a fair ROE. In past Commission decisions, the Commission referenced 30-year Treasury bonds and AA utility bond interest rates as benchmarks for evaluating cost of common equity for electric utilities. In the 1999 cost of capital order,¹⁴ the Commission discussed evidence on the historic spread between authorized ROE and 30-year Treasury bond rates from test years 1990 to 1998, before deciding that AA utility bonds provide a better benchmark for setting the ROE. In the recent ROE application of San Diego Gas & Electric Company (SD&E) and other major energy utilities,¹⁵ we continued to rely on AA utility bonds during a period of time that the DRI forecast for 30-year Treasury bonds dropped during a tremendous turmoil in the foreign markets. At this time investors were fleeing to the safety of U.S. Government backed securities, resulting in Treasury rates falling to unusual low rates in comparison to AA utility bonds.

In this proceeding proponents of the use of Treasury bonds, including ORA, assert that Treasury bonds are a better benchmark than AA utility bonds because of major shifts in the behavior of Treasury bonds within the last few years. While there has been a dramatic variation in the recent forecast of treasuries and AA utility bonds, both instruments continue to reflect changes in interest rate forecasts. In those situations where AA utility bonds demonstrate an erratic change in forecast, less reliance should be placed on that forecast and more reliance should be placed on other interest rate forecasts whether it be treasuries or some other interest rate measurement. We conclude that no party provided a valid reason to replace AA utility bond forecasts with treasury forecasts as a benchmark for considering a fair ROE for Sierra. Hence, we will not depart from our practice of adjusting Sierra's model results based on changes in AA utility bond rates without good reason.

Consistent with our practice to moderate changes in ROE relative to changes in interest rates we compare the most recent trend of DRI interest rate forecasts between the date that testimony was prepared in April to the date this matter was submitted in October, 2000. The October 2000 DRI AA utility bond forecast for 2001 of 7.48% is 28 basis points lower than its April 2000 AA utility bond forecast of 7.76% for 2001. At the same time, the October 2000 DRI 30-year treasury bond forecast of 5.80% is 21 basis points lower than its April 2000 30-year treasury bond forecast of 6.01% for 2001. Similarly, the October 2000 DRI 10-year treasury forecast for 2001 is 5.71% or 51 basis points lower than its April 2000 10-year treasury forecast of 6.22% for 2001.

Irrespective of whether the AA utility bonds or a Treasury forecast is used to moderate changes in ROE relative to changes in interest rates, the interest rate trend is downward. There is a nine basis point difference in a change in interest rates between AA utility bond rates and 30-year treasuries and a 23 basis points difference in a change in interest rates between AA utility bond and 10-year treasuries.

After considering the evidence on the market conditions, trends, interest rate forecasts, quantitative financial models, risk factors, and interest coverage presented by the parties and applying our informed judgment, we conclude that 10.80% is just and reasonable ROE for Sierra. This ROE found reasonable for Sierra is based on the 11.00% midpoint of Sierra's adjusted 11.40% ROE and interested parties' average 10.60% ROE, adjusted downward by 20 basis points to reflect the current downward trend in interest rates for the 2001 test year. The 20 basis points downward adjustment is consistent with the Commission's practice of adjusting ROE's by one half to two-thirds of the change in the benchmark interest rate.¹⁶