VII. Return on Common Equity

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.²⁴ 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 assure 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.

The Hope decision reinforces the Bluefield decision and emphasizes that such 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.

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 as a starting point to arrive at a fair ROE.

The models commonly used in ROE proceedings are the Capital Asset Pricing Model (CAPM), Discounted Cash Flow (DCF) Analysis, and Market Risk Premium (MRP). Detailed descriptions of each financial model are contained in the record and are not repeated here. It is the application of these subjective inputs that result in a wide range of ROEs being recommended by the parties. The results of these financial models are used to establish a range from which the parties apply risk factors and individual judgment to determine a fair ROE.

A. SCE's Return on Equity

There are two distinct positions on a fair test year 2005 ROE for SCE. SCE and ORA jointly recommended that SCE maintain its currently authorized 11.60% ROE and Aglet-TURN recommended that SCE's authorized ROE be lowered to 10.20%.

1. SCE and ORA's Position

SCE and ORA joint ROE recommendation was based on a Memorandum of Understanding (MOU) they entered into prior to SCE filing its ROE application. That MOU, signed by SCE on April 26, 2004 and by ORA on April 28, 2004, was based on "the current evidence on interest rates ..."²⁵

SCE and ORA identified three specific factors that led to the MOU. First interest rates began to increase in March 2004. By May 5, 2004, the Aa utility bond rate and Treasury long-term average rate had increased by 70 basis points and 72 basis points, respectively, from their lowest levels in March of 2004. SCE and ORA attributed that increase in interest rates to the March 2004 news of a 308,000 increase in non-farm payroll employment, a 5.1% consumer price increase for the first three months of 2004 compared to a 1.9% increase for all of 2003, and news that retail sales rose more rapidly than expected.²⁶

Second, their comparison of May 5, 2004 Moody's Aa Utility Bond rate of 6.52% and Treasury long-term average rate of 5.41% with a respective 6.98% and 4.90% average rate at the time SCE's last ROE decision was issued led them to believe that interest rates were returning to interest rate levels that prevailed at the end of 2002, and that the differences were not material enough to indicate a change in SCE's test year 2005 ROE.²⁷ Further, SCE and ORA comparison of Global Insight Aa utility bond interest rate September 2002 forecast of 7.16% for test year 2003 with its May 2004 test year 2005 interest rate forecast of 6.59% did not warrant a change in SCE's authorized ROE.²⁸

Third, they expected interest rates to rise in the future due to the economic news identified above, Global Insight's April 22, 2004 message that higher rates are just a matter of time, and Chairman Greenspan's April 21, 2004 comment that, among other matters, indicators of business investment point to increases in spending for many types of capital equipment.

While ORA relied strictly on the changing interest rate environment, SCE believing that changes in interest rates are only one factor to consider in setting a fair ROE prepared the traditional financial models to support its recommendation.²⁹ Preliminary financial models were prepared by SCE in February and March 2004, while the financial models incorporated into its testimony were prepared subsequently. Its CAPM model, that incorporated Global Insight May 2004 forecasted treasury rates, was prepared a few days prior to the filing of its May 10, 2004 application. Its DCF and MRP financial models were prepared in late April or early May.³⁰

SCE used a proxy group of 14 electric companies in its financial models as risk proxies for SCE. SCE placed no reliance on its DCF result on the basis that many of the comparable companies in proxy group do not comply with DCF formula assumptions, such as having a stable dividend payout ratio, stable price/earnings ratio, and stable market-to-book ratio that is close to one. An SCE example of noncompliance with the formula assumptions was that four of the 14 companies in its proxy group had cut their dividends within the past two years, thereby negating the stable dividend payout assumptions.

SCE derived a broad 7.89% to 13.72% ROE range from its financial models. This broad range was derived from the lowest and highest result of the financial model undertaken by SCE. The range by individual financial model results undertaken by SCE and by Aglet-TURN, are set forth in Appendix B. The exclusion of its DCF model results compacted that broad range to a 10.33% to 13.72% range.

2. Aglet-TURN's Position

Aglet-TURN applied the CAPM, DCF, and MRP financial models to establish a base for its ROE recommendation. It used a proxy group of 82 electric, combination and natural gas distribution utilities as its proxy group in its financial models as risk proxies for SCE. Its application of those models resulted in a 9.50% to 12.67% ROE range for SCE's test year 2005. From those results Aglet-TURN derived an average CAPM of 11.97%, DCF of 9.66%, and MRP of 11.22%. Aglet-TURN then weighted those average results giving equal weight to its DCF and MRP averages, and placing two-thirds weight to the results of simple MRP and one-third weight to its CAPM.³¹ Less weight was given to its CAPM on the basis that some of the measured betas³² used in the CAPM formula were unstable and subject to severe fluctuations. That weighting resulted in a 10.60% ROE recommendation for SCE prior to any adjustment for risk.

Aglet-TURN then assessed financial, business and regulatory risk it found facing SCE to determine what impact those risks should have on the overall ROE. From that assessment, Aglet-TURN concluded that adjustments were appropriate to recognize changes in regulatory and interest rate risks.

From its regulatory risk analysis, Aglet-TURN found that SCE had experienced an improved regulatory climate. In support of this finding Aglet-TURN cited recent favorable comments from the three major rating agencies, Moody's, Standard and Poor's (S&P), and Fitch. Those observations included a Moody's June 5, 2004 recognition of a continuing improvement in the California regulatory environment, including the Commission's approval of the Mountainview generation project, and recent Commission actions relating to other energy matters.³³ Approximately two months later, Moody's upgraded SCE's credit rating to A3 from Baa2 in recognition of a more constructive regulatory environment in California.³⁴ S&P recognized in July of 2003 the Commission's willingness to protect creditworthiness.³⁵ Fitch noted an improved regulatory environment at the Commission at the time it restored SCE's credit ratings to investment grade in September 2002.³⁶

Based on judgment, Aglet-TURN concluded that this improved regulatory climate has reduced the risk of California utilities and their cost of equity by approximately 100 basis points. That adjustment, applied to its 10.60% weighted financial models, resulted in an adjusted ROE of 9.60%.

Aglet-TURN's assessment of interest rate changes resulted in an assessment that there was a 60 basis points increased interest rate risks. That interest rate risk added to Aglet-TURN's adjusted 9.60% ROE for SCE resulted in a recommended 10.20% ROE for SCE's test year 2005.

3. Discussion

We must set the ROE at the lowest level that meets the test of reasonableness.³⁷ At the same time, our adopted ROE should be sufficient to provide a margin of safety for payment of interest and preferred dividends, to pay a reasonable common dividend, and to allow for some money to be kept in the business as retained earnings.

Although the parties agree that the models are objective, the results are dependent on subjective inputs.³⁸ The parties used different proxy groups, risk-free rates, beta, market risk premiums, growth rates, calculations of market returns, and time periods within their respective financial models. Parties even took different positions on the appropriateness of the individual financial models. For example, SCE rejected its DCF result, while PG&E declined to use the CAPM and Aglet-TURN placed less weight on its CAPM result than on its DCF and MRP results. Each party addressed the strengths of their respective financial modeling results while other parties addressed their defects and some even went so far as to recalculate the other party's financial modeling based on selective changes.³⁹ Even if those selective changes were considered, the individual party's overall ROE range based on the financial models would not materially change. For example, Aglet-TURN's financial models as recalculated by SCE would result in an overall 11.16% average compared to the 10.95% simple average of Aglet-TURN's financial models. Even if that modified result were adopted it would still fall within the midpoint of Aglet-TURN's overall 9.50% to 12.67% range, as shown in Appendix B.

From these broad ROE ranges the parties advance arguments in support for their respective analyses and in criticism of the input assumptions used by other parties. These arguments will not be addressed extensively in this opinion, since they do not materially alter model results.

The following tabulation summarized the average point of the individual financial models used by SCE and Aglet-TURN. The tabulation also includes the simple weighted average of those financial model results and individual ROE recommendation for SCE by SCE, Aglet-TURN and ORA

	CAPM	DCF	MRP	OVERALL AVERAGE	RECOMMENDED ROE
SCE	12.04%	9.16%	11.10%	10.85%40	11.60%
Aglet-TURN	11.97%	9.66%	11.22%	10.95%41	10.20%
ORA	-	-	-	-	11.60%

The financial models are used only to establish a range from which individual judgment can be applied to determine a fair ROE. Each model complements the other to arrive at a balanced ROE range. The CAPM focuses on the kinds of risks for which investors demand compensation, the DCF on a cash flow stream, and the MRP risk positioning.

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. We affirmed this view in D.89-10-031, which established ROEs for GTE California, Inc. and Pacific Bell, noting that we continue to view the financial models with considerable skepticism.

We find no reason to exclude or adopt the financial modeling results of any one party. Therefore, we will establish a ROE range based on the model results and informed judgment. After considering the evidence on the market conditions, trends, creditworthiness, interest rate forecasts, quantitative financial models based on subjective inputs, risk factors, and interest coverage presented by the parties and applying our informed judgment, we conclude that a subjective ROE range deemed fair and reasonable for SCE's test year 2005 is 10.40% to 11.40%.⁴²

We compared that range to the overall financial model results of SCE and Aglet-TURN and found it to be within the mid range of SCE's 7.89% to 13.72% and Aglet-TURN's 9.50% to 12.67% broad ROE range. We also observed that SCE's 7.89% to 13.72% broad range was lower than its 13.15% to 13.81% test year 2003 results while its common equity ratio of 48.00% remained constant, indicating a lower required ROE for its test year 2005 than approved for its test year 2003.⁴³

Having established a fair and reasonable ROE range based on the financial models we next consider the additional risks identified by the parties to determine what modification, if any, is warranted in setting a specific ROE. Those factors are regulatory and interest rate risks.

Aglet-TURN identified specific instances of improved California regulatory environment, some of which are identified in the above discussion of its recommendation. There is no dispute that the regulatory climate in California has improved from the utilities' prior ROE proceeding. However, the financial models are based on a proxy of comparable companies selected by the individual parties to assess a range or average ROE prior to assessing risks not reflected in those models.

There is no evidence, let alone a comparison between the California improved regulatory environment to the regulatory environment of the proxy companies, that justifies a substantial (100 basis points) downward adjustment from the financial models.⁴⁴ However, there is evidence that California's regulatory environment is rated average. For example, the Regulatory Research Associates raised its rating of California regulation to average in recognition of the progress California has made in stabilizing the electric industry and restoring the major utilities to financial health.⁴⁵ Therefore, we find no basis to reduce the utilities ROE for an improved California regulatory climate.

As to interest rate risks, 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."⁴⁶ That consistent practice has also resulted in the practice of only adjusting rate of return by one half to two thirds of the change in the benchmark interest rate.⁴⁷

Consistent with our practice to moderate changes in ROE relative to changes in interest rates we compare the most recent trend of interest rate forecasts from the date that testimony was prepared in the April/May time period to the September 2004 submittal date. There was a 10 basis points increase in interest rate forecast from the May 2004 forecast of 6.59% to the September 2004 forecast of 6.69%. In contrast, the test year 2003 ROE proceeding experienced a 46 basis points decrease in interest rate forecast from the May 2002 Aa utility bond interest rate forecast of 7.62% to the September 2002 interest rate forecast of 7.16%. The current interest rate trend is moving in a moderate upward direction indicating increased interest rate risks.

Based on the recent interest rate changes, the utilities are facing increased interest rate risks warranting the approval of an ROE at the upper end of the ROE range found to be fair and reasonable in this proceeding. We apply informed judgment in setting SCE's test year 2005 ROE at 11.40%, the top of the ROE range found fair and reasonable for SCE. A comparison of that authorized ROE to SCE's 11.60% requested and Aglet-TURN's 10.20% recommended ROE for SCE set forth in Appendix A demonstrates that the adopted ROE would not change SCE's position within the S&P benchmarks. Irrespective of which ROE is used, SCE's interest coverage, the most important ratio to SCG would remain in the A range of S&P's benchmarks and its debt to capital and cash flow to debt ratios would remain within the BBB range of S&P's benchmarks.

B. PG&E's Return on Equity

There are three distinct positions on PG&E's test year 2005 ROE. PG&E recommended an 11.60% ROE, Aglet-TURN 10.20%, and ORA 10.22%. There is no dispute on approving an 11.20% ROE for PG&E's true up 2004 year. That is because PG&E's Modified Settlement Agreement (MSA) approved in its bankruptcy proceeding requires a minimum of 11.22% ROE for PG&E until one of the rating agencies raises PG&E's company credit rating into an A category, which equates to at least a A-minus rating by S&P or a A3 rating by Moody's.

1. PG&E's Position

PG&E applied the CAPM and MRP financial models to establish a basis for its test year 2005 ROE recommendation. It used a proxy group of 29 electric and 13 local natural gas distribution companies in its financial models as risk proxies. PG&E used only the DCF and MRP models. It did not use the CAPM financial model on the basis that significant adjustments to the model would be necessary to compensate for unusual conditions in the U.S. Treasury securities market, interest rate sensitivity of utility stocks, understated cost of equity for companies with betas of less than 1.0, and the CAPM failure to account for risks not accounted for by covariation with the market index.⁴⁸

PG&E derived a broad 9.20% to 11.40% ROE range from its financial models. This broad range was derived from the lowest and highest results of the financial models undertaken by PG&E. The range of individual financial model results undertaken by PG&E, along with the results of Aglet-TURN and ORA's financial model results are set forth in Appendix C. The average point of PG&E's DCF was 9.60% and MRP 11.10%. PG&E then derived a 10.60%⁴⁹ simple average of its financial models prior to making an adjustment for financial risk. PG&E then adjusted the result of its financial models upward by 100 basis points to mitigate financial risk related to the difference between its equity level to the average equity level of its proxy companies.⁵⁰ That 100 basis points upward adjustment added to its 10.60% average result of its financial models equates to a test year 2005 ROE of 11.60%.

PG&E identified other risks in support of its position that its modeling result, even after adjustment for financial leverage, still understates its actual cost of equity. First, a hybrid generation industry, composed of unregulated generators and regulated utility generation, may lead to greater instability before a stable market design can be designed and implemented. Second, PG&E's high bundled electric prices provide a stimulus for the creation and growth of municipally owned and operated distribution systems within PG&E's territory, thereby increasing the potential for increasing competition for electric distribution service. Third, a firm just exiting bankruptcy will leave investors with some perception of an elevated level of risk due to the recent financial distress. PG&E equated those additional risks, not measurable by PG&E, to a level of risks that is somewhat greater than the average utility.⁵¹

2. Aglet-TURN's Position

Aglet-TURN applied its same model results and adjustments for regulatory and interest rate risks to PG&E that were addressed in the above SCE discussion. Although Aglet-TURN recommended a 10.20% ROE for PG&E, consistent with the other parties, it concluded that PG&E should be authorized the 11.22% minimum ROE required by the MSA approved in PG&E's bankruptcy proceeding. It also recommended that as soon as PG&E attains a rating agency upgrade to the A level that PG&E's authorized ROE should be lowered to Aglet-TURN's 10.20% recommended ROE from the 11.22% minimum ROE require by the MSA.

3. ORA's Position

ORA, not relying strictly on the changing interest rate environment as it did for SCE, applied the CAPM, DCF, and MRP financial models to determine its recommended ROE for PG&E. It used a proxy group of 29 electric and 12 local natural gas distribution companies in its financial models as risk proxies for PG&E. From those models, ORA derived a broad 8.99% to 11.15% ROE range. The average point of its CAPM was 10.89%, DCF 9.43%, and MRP 10.34%. Based on a simple average of the average point of its financial models, ORA recommended a 10.22% ROE for PG&E's test year 2005. ORA made no adjustment for risks outside of the financial models.

ORA then considered the MSA executed by the Commission and PG&E, which was incorporated into PG&E's confirmed Plan of Reorganization. Based on its model results and the MSA guidelines, ORA recommended a ROE of 11.22% for PG&E's true up year 2004 and test year 2005.

4. Discussion

The process for setting a fair and reasonable ROE and use of financial models to assist us in establishing that ROE is set forth in our discussion of SCE's ROE and will not be repeated herein. Consistent with that discussion we use the same method for establishing a fair and reasonable ROE for PG&E.

The following tabulation summarized the average point of the individual financial models used by PG&E, Aglet-TURN and ORA, including the simple weighted average of the financial model results and recommended test year 2005 ROE for PG&E by those parties.

	CAPM	DCF	MRP	OVERALL AVERAGE	RECOMMENDED ROE
PG&E	9.60%	-	11.10%	10.35%52	11.60%
Aglet-TURN	9.66%	11.97%	11.22%	10.95%53	10.20%
ORA	9.43%	10.89%	10.34%	10.22%	11.22%

Consistent with our SCE financial model discussion, we find no reason to exclude or adopt the financial modeling results of any one party. Therefore, we will establish a ROE range based on the model results and informed judgment.

After considering the evidence on the market conditions, trends, creditworthiness, interest rate forecasts, quantitative financial models based on subjective inputs, risk factors, and interest coverage presented by the parties and applying our informed judgment, we conclude that a subjective range of ROE deemed fair and reasonable for PG&E's test year 2005 is 10.01% to 11.01% prior to consideration of PG&E's financial leverage proposal.⁵⁴ A comparison of that range to the overall financial model results of PG&E, Aglet-TURN, and ORA finds it to be in the upper range of PG&E's 9.20% to 11.40% broad range, Aglet-TURN's 9.50% to 12.67%, and ORA's 8.99% to 11.15%.

PG&E's proposal to mitigate financial leverage by a 100 basis points upward adjustment to its authorized ROE was based on an after-tax weighted average cost of capital (ATWACC) difference between its test year 2005 capital structure and the average capital structures of its electric and gas proxy groups.

PG&E introduced the concept of using ATWACC in its test year 1999 ROE proceeding (A.98-05-021). At that time, PG&E sought a 100 basis points upward adjustment to its authorized ROE on the basis that cost of capital is independent of a company's actual debt/equity capital structure as long as its structure is within the broad range where cost of capital remains constant.⁵⁵ With no evidence on how ATWACC would perform under a range of economic conditions and no comparative information to gauge how it compared to the broader market, we did not find that ATWACC was more accurate or useful than other methods with which we use. We continued to rely on the CAPM, DCF, and MRP as a basis for determining a fair and reasonable ROE.

In this proceeding, PG&E provided evidence on how its ATWACC would compare to its electric and gas proxy groups. PG&E demonstrated that its test year 2005 common equity ratio of 52% is 4% lower than the 56% average of its electric proxy group and 11% lower than the 63% average of its gas proxy group. Based on PG&E's assumption that it was comparable in risks to its electric and gas proxy groups, PG&E applied a 7.82% ATWACC, simple average of its electric companies proxy group ATWACC average of 7.666% and gas proxy group average of 8.079%, to PG&E's Test Year 2005 capital structure. The result of that calculation was 11.65%. The difference between PG&E's financial models simple average result of 10.60% and its ATWAAC result of 11.65% was 105 basis points, of which PG&E rounded to 100 basis points to arrive at a 11.60% ROE for its test year 2005. Based on the 10.51% simple average of all the parties' financial model results, a 100 basis points upward adjustment would equate to a test year 2005 ROE of 11.51%.

If the ATWAAC method proposed by PG&E were adopted, the use of informed judgment in determining a fair and reasonable ROE would appear to be restricted to the selection of only comparable electric and gas proxies, preclude the establishment of a range of reasonableness, and eliminate the need for the CAPM, DCF, and MRP financial models. We are also concerned with PG&E's use of a simple average of electric and gas proxy groups having substantially different common equity ratios (56.09% for electric and 62.94% for gas) while PG&E has a ratemaking common equity ratio of 52.00%s and its electric operations represent 75% of its total operations.⁵⁶ Absent more evidence on the merits of using an ATWAAC method, we are not prepared to relinquish our informed judgment in establishing either a range of reasonableness or a specific ROE. We do invite PG&E to provide additional evidence on the use of ATWCC in its next ROE proceeding.

With the factoring in of increased interest rate risks and rejection of PG&E's financial leverage proposal, PG&E's test year 2005 ROE should be set at 11.01%, the top of its 10.01% to 11.01% ROE range found reasonable. However, that ROE is lower than the 11.22% ROE approved in PG&E's bankruptcy proceeding as part of the MSA. Therefore, consistent with the terms of the MSA, PG&E's true up year 2004 and test year 2005 ROE should remain at 11.22%. That adopted ROE would not change PG&E's position within the S&P benchmarks, as shown in Appendix A. While PG&E's debt to capital ratio would decline from S&P's A range to BBB range with the inclusion of debt equivalence, PG&E's interest coverage, the most important ratio to PG&E would remain within S&P's A range benchmark and cash flow to debt remain within S&P's BBB range.