Establishing Alternative Proxy Groups - PowerPoint Presentation

Establishing Alternative Proxy Groups Prepared for the Society of Utility and Regulatory Financial Analysts April 4, 2019

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Regulatory Guidance The use of alternative proxy groups for determining an ROE for utility companies is consistent with the “Corresponding Risk” standard set forth in the Bluefield and Hope Supreme Court Cases:Bluefield (1923) – “A public utility is entitled to such rates as will permit it to return on the value of the property which it employs for the convenience to the public equal to that generally being made…on investments in other business undertakings which are attended by corresponding risks and uncertainties, but it has no constitutional right to such profits as are realized or anticipated in highly profitable enterprises or speculative ventures.”Hope (1944) – “By that standard the return to the equity owner should commensurate with returns on investments in other enterprises having corresponding risks.”3Establishment of Alternative Proxy Groups

Definitions of Total Risk There are two definitions of total risk: Business Risk + Financial Risk = Total RiskOR Systematic Risk + Non-Systematic Risk = Total RiskThese definitions are mutually-exclusive, as no input is a perfect substitute for another input ( e.g. a measure of business risk is not a perfect substitute for non-systematic risk).The question is whether an analyst can find a group of non-utilities similar in total risk to a utility or a group of utilities.4Establishment of Alternative Proxy Groups

Academic Guidance Jack Clark Francis (Investments: Analysis and Management 5th ed) 5 Establishing Alternative Proxy Groups

Application to Public Utilities Simultaneously using ranges of systematic risk (as measured by unadjusted beta) AND non-systematic risk (as measured by the residual standard error) of a public utility proxy group, non-price regulated companies can be selected.First discussed for utilities in Financial Quarterly Review in Summer, 1994. 6Establishing Alternative Proxy Groups

Application - Selection Criteria A non-price regulated proxy group can be selected using the following criteria simultaneously (Hanley & Ahern, 1994): The unadj. βs of the non-utility cos. must lie within a range of the avg. unadj. β of the public utility or public utility proxy group, e.g. 2 standard deviations of β The res. std. errors of the non-utility cos. must lie within a range of the avg. res. std. errors of the public utility or public utility proxy group, e.g. 2 standard deviations of res. std. errors; andThe selected non-utility cos. must be domestic, i.e., US cos.7Establishment of Alternative Proxy Groups

Applications After the selection of the non-price regulated proxy group, an indicated ROE for that group can be estimated by: Applying cost of common equity models, such as the DCF, RPM, and CAPM to the non-utility proxy group; or An expected earnings analysis (determining the expected return on book equity) for the non-utility group.Because the non-utility proxy group is already similar in total risk to the utility proxy group, risk adjustments to the indicated ROE are unnecessary 8Establishment of Alternative Proxy Groups