By Robert Keyton Energy industry analyst - PowerPoint Presentation

ByRobert KeytonEnergy industry analystFederal Energy Regulatory commission4/5/19 The FERC’s Return on Common Equity Methodology Disclaimer: The views expressed in this presentation do not necessarily represent the views of the Commission.

Timeline of Recent FERC ROE-Related Events2 Opinion No. 531 Opinion No. 551 Emera Maine Decision Coakley Briefing Order MISO Briefing Order NOI on ROE Opinion No. 531-A Opinion No. 531-B

Background on NETOs ROE3 Transmission owners within the Independent System Operator New England (ISO-NE) are commonly referred to as NETOs. The NETOs recover transmission-related costs through formula rates. According to the Commission, the NETOs represent a diverse group of utilities, so when setting the base ROE for this group of utilities it was developed using the midpoint of a constant growth DCF analysis. The NETOs’ base ROE was set at 11.14 percent in a 2006 Commission order. However, a Section 206 ROE complaint was filed in 2011 stating that the NETOs’ base ROE of 11.14 percent was unreasonable.

Opinion No. 5314 Issued on June 19, 2014, reducing the NETOs’ base ROE from 11.14 to 10.57 percent The base ROE of 10.57 percent was based on the upper midpoint of a two-step DCF analysis. The upper midpoint was chosen because the Commission determined that the midpoint result of 9.39 percent would not satisfy Hope and Bluefield and it felt an ROE reduction of that magnitude could undermine the NETOs ability to attract capital in electric transmission. Op. No. 531 at PP 142 and 150. The Commission was also concerned that capital market conditions were anomalous. Therefore, it found it necessary and reasonable to consider additional record evidence, including evidence of alternative benchmark methodologies and state commission-approved ROEs. Op. No. 531 at P 145. Using evidence of alternative benchmark methodologies in the record, the Commission stated that it found the risk premium analysis, CAPM, and expected earnings analysis informative. However, the Commission stated that it used them to inform the placement of the base ROE as opposed to using them to establish the placement of the base ROE.

Opinion No. 531: Two-Step DCF5 Formula K=(1 + .5(g))(D/P) + g g=(2/3)(ST) + (1/3)(LT) Short-term growth (ST): uses 3-5 year short-term IBES growth rates retrieved from Yahoo Finance Long-term growth (LT): uses the average of long-term GDP projections taken from three sources Dividend Yield (D/P): based on the average of monthly actual historical dividend yields for the most recent six month data period.

Opinion No. 531-A6 Issued on October 16, 2014, confirming that the long-term growth portion of the two-step DCF will be 4.39 percent. The 4.39 percent represents the average long-term GDP growth from the following three sources: Energy Information Administration, Social Security Administration, and IHS Global Insight.

Opinion No. 531-B7 Issued on March 3, 2015, addressing requests for rehearing filed by the NETOs, a group of complainants and intervenors (Petitioners), and one other intervenor. The Commission rejected the NETOs claim that every ROE within the zone of reasonableness of the two-step DCF is reasonable (range was from 7.03% to 11.74%), therefore, making their previously authorized ROE of 11.14 percent reasonable. The Commission rejected the Petitioners claim that the Commission may only deviate from the central tendency of the DCF results by performing a “relative risk analysis” between the NETOs and the proxy group companies. The Commission stated that unique capital market conditions required it to perform a review of additional record evidence. This evidence included alternative benchmark methodologies and state commission-authorized ROEs, which corroborated that an upward adjustment to the base ROE was warranted.

Opinion No. 531-B: State Commission-Authorized ROEs8 The Commission stated that it did not rely on state commission-authorized ROEs for determining where to place the NETOs’ base ROE. However, according to the Commission, because transmission is riskier than distribution, state commission-authorized ROEs were used as evidence to show that a 9.39 percent midpoint two-step DCF result did not satisfy the requirements of Hope and Bluefield. The state commission-authorized ROEs in the record were from Regulatory Research Associates reports covering a two-year period.

Opinion No. 531-B: Risk Premium Analysis9 For the risk premium method, the Commission stated that it “is ‘based on the simple idea that since investors in stocks take greater risk than investors in bonds, the former expects to earn a return on a stock investment that reflects a “premium” over and above the return they expect to earn on a bond investment.’” Op. No. 531-B at P 90. The risk premium analysis in the record relied on the premium between FERC-authorized ROEs and Moody’s Baa Public Utility Bond Yields back to April 2006.

Opinion No. 531-B: CAPM10 For the Capital Asset Pricing Model (CAPM) the Commission stated “that ‘CAPM is utilized by investors as a measure of the cost of equity relative to its risk.”’ Op. No. 531-B at P 102. The CAPM method in the record had the following components: R j = Rf + βj (Rp ) + Rps Where: Rj = required ROE for stock j; Rf = risk-free rate (six-month actual hist. avg. for 30-year Treasury); βj = beta, or systematic risk, for stock j (retrieved from Value Line); Rp = Rm – Rf = risk premium; Rm = expected return on the market portfolio (market capitalization-weighted constant growth DCF for the S&P 500 companies); and Rps = risk premium adjustment under the assumption that small market capitalization companies earn higher returns than large market capitalization companies using data provided by Morningstar (in later time periods provided by Duff & Phelps).

Opinion No. 531-B: Expected Earnings Analysis11 Commission stated the following about the expected earnings method: “We consider the NETOs’ expected earnings analysis to be sound, as it is forward-looking, based on a reliable source of earnings data, and approximately converts the proxy groups’ earnings to reflect average returns.” Op. No. 531-B at P 126. Based on the most distant book return estimate (net income/[common equity ratio*total capitalization amount]) provided by Value Line for individual companies it tracks.

MISO TOs12 Transmission owners within the Midcontinent Independent System Operator, Inc. (MISO) are commonly referred to as the MISO TOs. The MISO TOs recover transmission-related costs through formula rates.According to the Commission, the MISO TOs represent a diverse group of utilities, so when setting the base ROE for this group of utilities it was developed using the midpoint of a constant growth DCF analysis. The MISO TOs’ base ROE was set at 12.38 percent in a 2002 Commission order However, a Section 206 ROE complaint was filed in 2013 stating that the MISO TOs’ base ROE of 12.38 percent was unreasonable.

Opinion No. 55113 Issued on Sept. 28, 2016, reducing the MISO TOs base ROE from 12.38 to 10.32 percentThe base ROE of 10.32 percent was based on the upper midpoint of a two-step DCF analysis. The upper midpoint was chosen because the Commission determined that the midpoint result of 9.29 percent would not “accurately [reflect] equity returns necessary to meet Hope and Bluefield” and it felt an ROE reduction of that magnitude could undermine the MISO TOs ability to attract capital in electric transmission. Op. No. 551 at PP 119 and 128. The Commission was also concerned that capital market conditions were anomalous. Therefore, it found it necessary and reasonable to consider additional record evidence, including evidence of alternative benchmark methodologies and state commission-approved ROEs. Op. No. 551 at P 137. Using evidence of alternative benchmark methodologies in the record, the Commission stated that it found the risk premium analysis, CAPM, and expected earnings analysis informative. However, the Commission stated that it used them to inform the placement of the base ROE as opposed to using them to establish the placement of the base ROE.

Emera Maine Decision14 On April 14, 2017, the D.C. Circuit Court issued the Emera Maine decision vacating and remanding Opinion No. 531. First Prong: While the Court agreed with the Commission that under a section 206 proceeding not every ROE within the zone of reasonableness was reasonable, it agreed with the NETOs’ that the Commission did not adequately show that the NETOs’ base ROE of 11.14 percent was unreasonable. Second Prong: the Court agreed with the customers that the Commission failed to show why a 10.57 percent base ROE for the NETOs was reasonable, especially given that the Commission found alternative ROE methods informative but did not use them for calculating the base ROE for the NETOs.

Coakley Briefing Order15 On October 16, 2018, the Commission issued an order proposing a method for addressing four section 206 ROE complaint cases. Complaint I previously resulted in Opinion No.531. The remaining complaints each had an initial decision issued by a Judge. To determine whether the ROE in each complaint is reasonable, it proposed to use the quartile centered around the midpoint (avg. risk company) for the DCF, CAPM, and Expected Earnings approaches. If current ROE falls within the avg. quartile for the three ROE methods then it is presumed reasonable and the complaint is dismissed. To determine the midpoint for each ROE method, it proposed a new high-end outlier test to use in conjunction with its existing low-end outlier and natural break tests. Results higher than 150 percent of the median result (inclusive of all observations) are removed from the analysis, subject to a natural break test, as they are atypical. For Complaint I, it proposed an avg. quartile ranging from 9.60 to 10.99 percent. Given that the current base ROE of 11.14 percent was outside that range, it was found to be unreasonable. For Complaint I, to determine the NETOs’ new base ROE, it proposed to avg. the midpoint results for the DCF, CAPM, and Expected earnings along with the point-estimate of the risk premium analysis.For Complaint I, its proposal resulted in a base ROE of 10.41 percent. However, it “[directed] participants to file briefs regarding our proposed approaches to the FPA section 206 inquiry and how they should apply in the First Complaint and the three subsequent complaints.” Coakley Briefing Order at P 55.

MISO Briefing Order16 Issued on November 15, 2018 The Commission proposed a method for addressing two section 206 ROE complaint cases. Complaint I previously resulted in Opinion No.551. The remaining complaint had an initial decision issued by a Judge. In general, used the same approach from the Coakley Briefing Order.For Complaint I, it proposed an avg. quartile ranging from 9.55 to 10.95 percent. Given that the current base ROE of 12.38 percent was outside that range, it was found to be unreasonable. For Complaint I, its proposal resulted in a base ROE of 10.28 percent. However, as with the Coakley Briefing Order it “[directed] participants to file briefs regarding our proposed approaches to the FPA section 206 inquiry and how they should apply to the Second Complaint.” MISO Briefing Order at P 56.

NOI on ROE17 The Commission issued a Notice of Inquiry (NOI) on March 21, 2019, seeking comments on whether any changes should be made to its proposed ROE policy as discussed in the Coakley and MISO Briefing Orders for electric utilities. The NOI is separated into eight broad categories: A. Role and Objectives of the Commission’s Base ROE Policy B. ROEs for different Commission-regulated industries C. Performance of the DCF Model D. Proxy Groups E. Financial Model Choice F. Mismatch between Market-based ROE determinations and Book- Value Rate Base G. First Prong of ROE Determination H. Model Mechanics and Implementation