VI. Long-Term Debt and Preferred Stock Costs
Long-term debt and preferred stock costs are based on actual, or embedded, costs. Future interest rates must be anticipated to reflect projected changes in a utility's cost caused by the issuance and retirement of long-term debt and preferred stock during the year. This is because the ROE is established on a forecast basis each year.
In D.90-11-057, we recognized that actual interest rates do vary and that our task is to determine "reasonable" debt cost rather than actual cost based on an arbitrary selection of a past figure.14 In that regard, we concluded that the latest available interest rate forecast should be used to determine embedded debt cost in ROE proceedings. Consistent with this conclusion, the assigned Commissioners' Scoping Memo and Ruling allowed the utilities to update their long-term debt and preferred stock costs to reflect September 2004 Global Insight forecasted interest rates. That update was submitted on September 27, 2004 as Late-Filed Exhibit 34 by SCE and Late-Filed Exhibit 35 by PG&E.
A. SCE
SCE projected its test year 2005 long-term debt cost to be 6.97% based on a simple average of its year end 2004 and year end 2005 long-term debt forecasts. That forecast provided for the issuance of $100 million in new long-term debt in 2004 and no new long-term debt in 2005. Based on its late-filed exhibit that updated the impact of the most recent forecast of interest rates, SCE lowered its forecast of long-term debt cost to 6.96% from 6.97%. This rate is 123 basis points lower than the 8.19% long-term debt cost authorized in SCE's test year 2003 ROE proceeding.
SCE used that same method to calculate a preferred stock cost of 7.01%. Its forecast of preferred stock cost provided for the issuance of $200 million of traditional preferred stock in 2004 and an additional $450 million in test year 2005, as detailed in its Exhibit 3 at pages 22 to 24.
Subsequent to the filing of its application, Moody's upgraded SCE's preferred stock to investment grade. In response to that upgrade, SCE obtained quotes from three investment banks on the coupon rate at which SCE could expect to favorably issue new preferred equity in the current market. Those quotes were 81 basis points, 33 basis points, and 44 basis points, respectively, above the Aa utility bond rate.15 Based on a 53 basis points simple average of the investment banks quotes, SCE lowered its preferred stock cost to 6.83% from 7.01%. Based on the most recent forecast of interest rates, SCE further lowered its preferred stock cost to 6.73% from 6.83%.
B. PG&E
PG&E projected a true up year 2004 long-term debt cost of 5.82%. That cost was based on a weighted average of its actual 2004 debt cost prior to April 12, 2004 and its forecast of long-term debt changes that would occur as a result of new issuances, retirements, change in interest rates of its floating rate debt, and changes in the amortization of loss on reacquired debt during the year. For 2004, PG&E expects to refinance $799 million of bank debt with the proceeds from the issuance of replacement tax exempt Pollution Control (PC) Bonds. Those replacement PC Bonds would be issued in two series, one that is expected to be a three-year fixed-rate bond, and the other a 30-year floating-rate bond.
PG&E projected a test year 2005 long-term debt cost of 5.94%, based in part on its forecast of debt changes that would occur during the year and in part on PG&E's expected implementation of a Dedicated Rate Component (DRC) financing, as provided for in D.03-12-035.
The DRC financing provides a framework for PG&E to refinance a portion of its exit financing if legislation satisfactory to the Commission, TURN, and PG&E is enacted and signed into law that would allow for the securitization of the Modified Settlement Agreement (MSA) Regulatory Asset. Ratepayers would receive the full benefit of this financing through a lower revenue requirement of the MSA Regulatory Asset. After such legislation is enacted, and pursuant to a subsequent financing order from the Commission authorizing the securitization of its DRC, PG&E expects to receive proceeds up to $3 billion.16 Those DRC proceeds would be used to pay off existing debt and to buy back common stock so that PG&E can achieve and maintain a target capital structure containing 52% common equity.
PG&E included approximately $44 million in interest rate hedging cost as a component of its test year 2005 long-term debt pursuant to D.03-09-020.17 That interest rate cost resulted from PG&E's October 20 and November 3, 2003 execution of $4.2 billion in interest rate hedges used to implement its approved bankruptcy plan to exit from Chapter 11. PG&E seeks to recover its hedging cost over the life of the debt that was hedged.
PG&E projected its preferred stock costs of 6.76% for 2004 and 6.42% for 2005, similar to the method it estimated its embedded long-term cost of debt. The embedded cost of preferred stock reflects the same costs of preferred as authorized in PG&E's 2003 cost of capital proceeding, absent Quarterly Income Preferred Securities (QUIPS).18 That is because QUIPS, comprised half of PG&E's pre-bankruptcy preferred stock, were deemed in default as a result of its bankruptcy and redeemed on April 12, 2004. For the period after April 12, 2004, PG&E projected changes in its preferred stock. The changes included a decrease due to the removal of the amortization of refunding premiums associated with a 1994 preferred stock redemption and a decrease due to the mandatory redemption of a portion of two issues of higher cost preferred stock.
PG&E also updated its long-term debt costs to reflect the most recent forecast of interest rates. That update resulted in its long-term debt cost being increased to 5.90%19 from 5.82% in its true up year 2004 and to 6.10%20 from 5.94% in test year 2005. There was no change in PG&E's preferred stock cost.
C. Discussion
There was no dispute on SCE's test year 2005 cost of long-term debt, or on PG&E's true up year 2004 and test year 2005 costs of long-term debt and preferred stock.
ORA took exception to SCE's test year 2005 cost of preferred stock. ORA forecasted a 6.04% preferred stock cost for SCE based on the historical spread of mandatory redemption preferred stock21 issued by SCE in the early 1990's, Moody's recent upgrading of SCE's preferred stock to investment grade, and on the assumption that SCE would continue to issue mandatory redemption preferred stock. However, ORA's forecast of SCE's preferred stock was based on the issuance of a type of preferred stock that SCE will not be issuing. SCE will issue traditional preferred stock, not mandatory preferred stock.22 Hence, we must reject ORA's forecast of preferred stock cost.
SCE's forecast of preferred stock cost based on quotes from investment banks for the issuance of perpetual preferred stock in the current market is more appropriate. However, SCE provided no explanation on why the quote of 81 basis points above Moody's Aa utility rate spread was more than double the other two quotes. Absent the identification of specific benefits in using the highest Moody's Aa utility rate spread quote, we would expect SCE to exercise prudent management judgment by rejecting that quote. A simple average of the two remaining quotes would result in a more realistic cost estimate. Even with a trend of rising interest rate projections and the continued existence of prior embedded preferred stock, an adjustment based on the simple average of two investment banks would have reduced SCE's overall revenue requirement at this time.23
As required by D.03-09-020, a Commission Financing Team reviewed PG&E's hedging analysis and supported the terms of the hedges and PG&E's strategy for executing the hedges. Although PG&E incurred $44 million in hedging cost, ratepayers benefited by almost $51 million in annual interest expense due to a drop in interest rates, for a present value of $455 million. PG&E has substantiated that its cost incurred during hedging was reasonable and should be authorized to recover its hedging cost as part of its long-term debt.
SCE and PG&E's long-term debt and preferred stock forecasted costs are consistent with the most recent forecast of interest rates. PG&E's 5.90% long-term debt and 6.76% preferred stock costs for true up year 2004 and the following long-term debt and preferred stock costs for the utilities' test year 2005 are consistent with the law, in the public interest and should be adopted.
SCE |
PG&E | |
Long-Term Debt |
6.96% |
6.10% |
Preferred Stock |
6.73% |
6.42% |
Having determined the appropriate costs of long-term debt and preferred stock we address the appropriate ROE.
| Weighted Factor | Debt Cost | Weighted Debt Cost | |
| Actual Jan.-April 12th | 27.87% | 7.51% | 2.09% |
| Projected Post April 12th | 72.13% | 5.28% | 3.81% |
| Weighted Cost | 5.90% |
