Cross-sectional analysis of utility returns: regulatory and investor implications

Cross-Sectional Analysis of Utility Returns: Regulatory and Investor Implications

is assistant professor offinance at Pembroke State University. The authors are grateful for suggestions provided by participants in the Wake Forest Finance and Economics Research Workshops; Professor Frederick Harris; Douglas E. Schaller, BellSouth Communications; Henry E. Kilpatrick, Jr. and Marv Rosenberg, both of the Federal Energy Regulatory Commission; and Felicia Marston. They acknowledge support provided by the Babcock Research Fellows Program at Wake Forest University. R. Charles Moyer is Integon professor offinance at Babcock Graduate School of Management, Wake Forest University. E. Tylor Claggett, Jr.,

March 1997

What is the spread between expected and required returns on common equity for electric and combination electric and gas distribution utilities, using the market-to-book value ratio? We find that the M/B ratio is negatively associated with such factors as the level of long-term interest rates, and positively associated with the earned return on common equity and operation in afavorable regulatory climate. E. Tylor Claggett, ]r. and R. Charles Moyer

I

n 1976, Foster wrote that regulation

has been unable to respond promptly or adequately in recent years to changing economic conditions .... Regulation of public utility earnings has not been efficient because commissions, as well as utilities, are identified as responsible for rapid price increases. Regulatory agencies are understandably sensitive to the loss of public esteem which follows from even cost-justified rate increases. Perhaps only a broader public understanding and acceptance of relevant economic criteria will alleviate this problem. 1

The problems that Foster alluded to in 1976 related primarily to the inability of regulation to provide utilities with a fair opportunity to earn returns consistent with investor return requirements. This regulatory failure persisted through the mid-1980s. In the interim, m u c h w o r k has been d o n e to deepen our understanding of problems inherent in the regulatory process. For example, Atkinson and Nowell have considered the role played by regulatory lag as a substitute policy tool. 2 Shome and Smith have explored the relationship b e t w e e n

53

interest rates and equity costs in the utility industry 3 and Claggett and Moyer have modeled the cyclical behavior of equity return shortfalls. 4 he relationship between expected and required returns for utilities over time has important implications for potential utility investors. In addition, with the passage of the Energy Policy Act of 1992 and related FERC orders implementing open access to transmission lines, it is increasingly important for investors to understand the potential sources of bias in the regulatory process that may cause utilities to earn subpar or superior returns. The possible downside to earnings is of particular concern as utilities face the prospect of stranded costs arising from the competitive pressures of wholesale and retail wheeling. By enhancing our understanding of the regulatory process and its shortcomings, we may gain insight into how to improve that process in the future. This article provides an analysis of the cross-sectional variation in the spread between the returns expected by investors and required investor returns for electric and combination electric and natural gas distribution utilities during a period of time when utility returns, on average, were at least adequate, relative to investor return requirements (1987-92). The insights developed from our analysis should be of value to utility investors in the new era or increased competition. Following Gordon 5 and Carleton/6 w e use the ratio of the market value of common equity to the

T

54

book value of common equity (M/B) to measure the deviation between expected and required returns. We find that M/B ratios are negatively associated with the level of long-term interest rates, positively associated with the allowed return on equity, positively associated with common equity ratios, negatively associated with the proportion of revenues derived from electric utility opera-

It is increasingly important for investors to understand potential sources of bias in the regulatory process that may cause subpar or superior returns.

tions and negatively associated with the percentage of allowance for funds used during construction (AFUDC) relative to the book value of common e q u i ~ This last finding suggests that other regulatory assets, such as premiums incurred in the repurchase of debt and discounts offered to retain certain customer classes, are likely to be valued at less than their nominal amount, particularly as the pace of competition quickens. This conclusion is supported in a recent study by Boatsman, Khurana and Loudder. 7 Firms operating in "favorable" regulatory jurisdictions are val-

ued more highly by investors than firms operating in normal or unfavorable jurisdictions. We find evidence of significant lags in the regulatory process between capital market requirements and firm performance. Even in unfavorable regulatory jurisdictions, most utility firms have been able to sustain M/B ratios significantly in excess of 1.0 between 1987 and 1992. following section briefly views the regulatory process and some problems associated with its implementation. Next, we pose hypotheses about the determinants of expected utility returns relative to required returns. The data and empirical results of our analysis follow. The final section offers conclusions and implications for investors and regulators.

I. The Regulatory Process Historically, the rate determination process for regulated electric utilities has been primarily a cost reimbursement system. Two venerable cases, Bluefield Water Works and Improvement Company v. Public Service Commission of the State of West Virginia s and Federal Power Commission et al. v. Hope Natural Gas Co.,9 have established important principles underlying the equity return component of the costbased rate setting process. These rulings require that a utility should be authorized returns sufficient to maintain its credit, attract capital, assure confidence in the financial integrity of the firm, and provide for returns commensurate with the risks assumed. The dynamic nature of return requirements as business conditions The Electricity Journal

and capital market conditions change was also recognized. he judicial standards offer little direction regarding the choice of a methodology for establishing appropriate equity returns. Nor do these standards offer much guidance for judging the adequacy of a realized return on common equi~. Theoretically, a utility can file a rate case whenever its realized return on common equity falls short of its estimated cost of equity capital. But considerations of cost in the preparation of a rate case and the risks associated with the regulatory process generally cause a utility firm to be reluctant to file new cases unless the projected equity return shortfall is significant, as occurs during periods of rapid inflation or w h e n new plants are brought into service. Regulatory commissions can also initiate a rate review if prevailing rate levels produce higher realized returns than those required by investors. The relationship between required and expected returns for regulated utilities is important because, as Averch and Johnson demonstrated, firms subject to perverse rate of return regulation are motivated to use productive inputs in proportions that are inconsistent with cost minimization. 1° The A-J hypothesis has been tested in a number of subsequent studies, n Others have examined the impact of specific regulatory policies, such as fuel adjustment clauses, on the performance and risk of utilities, a2 Still others have found that utility

T

March 1997

commissions use regulatory lag as a substitute policy tool that can offset the impact of the A-J effect.13 The early A-J effect research was conducted during a period of low inflation and low interest rates, stable fuel costs for most electric utilities, and economies of size associated with the construction of new power plants. These conditions essentially ended in

Theoretically, a utility can file a rate case whenever its realized return on common equity falls short of its estimated cost of equity capital.

the late 1960s, as construction costs increased and accelerated with the oil crisis of the early 1970s. From that time until the late 1980s, the operating environment for most electric utilities was characterized by volatile (and often high) interest rates, inflation rates, and fuel costs; diseconomies associated with the construction of new base-load generating plants; and increased regulatory uncertainty associated with an aggressive application of the used and useful and prudent investment standards in the determination of allowable rate base assets. Today the prospect of increased

competition in the electric utility industry has added an additional element of uncertainty for investors with respect to the recovery of stranded costs. f differences between required and expected returns on equity persist over long time periods, investor returns in utility stocks are likely to experience long cyclical swings that may either enhance or impair the ability of these utilities to attract capital on reasonable terms. On the other hand, if these differences tend to be largely explainable by business cycle factors and are quickly corrected, the resource misallocation impacts should be less severe. We have examined the variation in aggregate required and earned (as a proxy for expected) returns on common equity for utilities over the period from 1976 to 1990. We have found that "return on equity shortfalls for electric utilities can be explained in large part by business cycle factors. ''14 However, these shortfalls appear to persist for long periods of time, raising the prospect of resource misallocations and capital-raising difficulties by individual utility firms.

I

II. H y p o t h e s e s Assuming a constant growth common equity valuation model, the relationship between the M / B ratio and expected and required returns on equity has been shown to be: 15

[11

E1 (l-b) M

B-

B

ke-br

55

where M is the market value of common equity per share, B is the book value per share, E1 is the expected earnings in period 1, b is the expected constant percentage of earnings retained, r is the expected r e ~ r n on common equity, and ke is the required return on common equi~. By simplifying equation [1], and assuming that ke = r, the market value of equity to the book value of equity ratio, M/B, becomes: 16

[2]

M B

long-term debt, preferred stock and common equity capital). Firms that persistently earn less than their required return on common equity are expected to include more debt in their capital structure to reduce the financial impact on common stockholders of this shortfall. Rao and Moyer have shown that utilities in unfavorable regulatory environments substitute debt for equity in their capital structures to compensate

-1

An examination of equation [1] reveals that whenever ke < r, then M / B > 1. Similarl~ if ke > r, then M/B < 1.17 Factors that influence the M / B ratio for a utility imply the following hypothesized partial relationships: 1. A positive association between M/B and earned returns on common equity. Earned returns are assumed to be a proxy for expected returns on common equity. Given a level of required returns-which does not vary greatly across utility companies at any point in time (electric utility betas show little cross-sectional variation)---higher earned returns should lead to larger M / B ratios. The M / B ratio is defined as the market price per share of common stock divided by the book value per share (times 100). 2. A positive association between a firm's common equity ratio (ER) and its M/B ratio. The ER is defined as the common equity capital divided by permanent capital (longterm debt, current maturities of

56

---=~-.......~ - - .

- ~-~i~'--~.~-

for the negative impacts of unfavorable regulation on equity investors. TMIn addition, unfavorable regulatory jurisdictions may mandate more leveraged capital structures in an (often mistaken) attempt to lower capital costs. Hence, the common equity ratio may be viewed as a proxy for the long-term impact of the regulatory climate facing a firm.19 3. A negative association between M/B and the ratio of the percentage "'allowancefor funds used during construction" (AFUDC) to the average book value of common equity. AFUDC is a bookkeeping entry that "recognizes" income for fi-

nancial reporting purposes on utility construction work in progress (CWIP). AFUDC is capitalized into CWIE so that once a utility actually brings the plant into service, it earns a return both on the physical cost of the plant and on the accumulated AFUDC. Thus there is a timing difference between the recognition of earnings from plant under construction and the realization of an actual cash return. Because of the risk that some of the AFUDC may not be permitted in rate-base once the plant is completed, investors discount this component of earnings, resulting in lower "effective" earned returns on common equity and hence an expected lower M/B ratio. For example, Bowen found that investors discount the value of a dollar of AFUDC earnings to a level between 41 and 74 percent of a dollar of actual cash earnings, depending on the year examined. 2° The treatment of regulatory assets such as the AFUDC component of CWIP is an increasingly important concern as the forces of competition come to bear in the electric utility indus-

~.21

4. A positive association between the quality of the regulatory climate facing a utility and the M/B ratio. The quality of the regulatory environment is represented by two d u m m y (1,0) variables: U (for firms operating in unfavorable environments as defined by Value Line), and F (for firms in favorable environments). 22For example, if a firm operates in an unfavorable regulatory environment, the value of the U variable is set equal to 1, The ElectricityJournal

otherwise it is 0. Firms that are neither in the U or F classes operate in average regulatory environments. More (less) favorable climates are anticipated to result in higher (lower) M / B ratios. This direct measure of regulatory climate indicates the impact of the current regulatory climate on M/B ratios, whereas the common equity ratio indicates the impact of regulatory climate over a period of time sufficiently long for the utility to adjust its capital structure in response. 5. A negative association between the level of interest (TB) rates and M/B. Interest rates are measured by the average yield on U.S. Treasury bonds. High interest rates typically are associated with higher rates of inflation and greater regulatory lag, leading to shortfalls between allowed and earned returns on equity. In addition, at high interest rate levels, there is a greater risk that the allowed re~_rn on equity will not equal the required return. We have shown this relationship for aggregates of electric utility fifThS. 23

6. A negative association between the percentage of revenues (PER) derivedfrom electric operations and M/B. Pure electric utilities are expected to sell at a discount relative to combination (gas and electric) companies. The pace of deregulation was clearly established for the natural gas industry over most of the period of our analysis. In addition, gas utilities generally do not face significant risk of plant disallowances, due to the less capital intensive nature of March 1997

that industry and the shorter lead times in bringing plant into service. 7. The general economic and financial market environment, including environmental concerns, conservation concerns, the general level of business activity, etc., are expected to influence utility M/B ratios. These factors change over time and affect the entire industry. We proxy the impact of these industry-wide factors by using a series of time-

i I .7 T -r f i -:-1I

study. With this type of model, firm-specific differences that are not accounted for by the other independent variables are captured in the appropriate constant terms and d u m m y variables. Since our interest is only in the variables 1 through 6 as described above, the results reported below do not include individual time and firm variable coefficients. We modified the basic LSDV model to accommodate unspecified, systematic effects that change as a function of time. Final134 we correct for the presence of first order, autocorrelated disturbances with the Durbin Two-Step Method, as described in Kmenta. as These relationships suggest the following model for testing: [3]

L'G

01 Bit - o. + ~ I31-5(Di) + k87 73 ~_, ~6-77( FM,) + ~78( ROEit) + i=2

dependent d u m m y (1,0) variables. For example, the d u m m y variable, Dt, takes a value of I if the observation occurs in year t and zero otherwise. The reference (omitted) year is 1992. Similarl~ the d u m m y variable, FMi, takes a value of I for firm I and zero otherwise. Firm number I is the reference (omitted) firm. hese relationships are best addressed by what is commonly referred to as the least squares d u m m y variable (LSDV) model. 24This model is most appropriate w h e n using panel (pooled by cross-section and timeseries) data, as in the present

T

1379(ER/t) + [380(AFUDCit) + 1381(U/t) + 1382(F/t) + #83( TBt) + ~84( PERit)

where the individual variables are as defined above, the subscript t refers to the year and the subscript i refers to the individual firm.

III. D a t a Data for investor-owned, pure electric and combination electric and gas utilities cover the period from 1987 through 1992, a period of generally declining required equity returns for utilities. The primary sources of the data are the

57

Turner Utility Reports and Value Line. Observations are pooled across time to produce the aggregate sample. The sample consists of the 73 pure electric and combination electric and gas utilities for which complete data were available each year from 1987 through 1992. 26Table I provides a listing of the sample firms. alues for the common equity market-to-book ratios (M/B), rates of earned return on common equip, common equity ratios, and the percentage of revenues derived from electric utility operations are obtained from Turner. AFUDC values and regulatory environment rankings come from Value Line. Yields on 30-year U.S. Treasury bonds come from the Federal Reserve Bulletin, Table A24.

V

IV. Discussion of Results Utility M / B ratios have varied dramatically over the past 20 years, generally remaining well below 1.0 from the mid-1970s through the mid-1980s. By early 1992, the average M/B ratio for the Salomon Brothers 97 electric u t i l i t i e s 27 w a s 1.58, with a range from 0.76 to 2.73. The spread of allowed minus earned returns on common equity has exhibited similar variation. The average spread in 1976 was 110 basis points. The average spread increased to a high of 280 basis points in 1980, and remained positive until 1987. It decreased to a negative 30 basis points in 1988. The substantial variation in observed utility M / B ratios and the spread between allowed and ex-

58

pected returns, both over time and cross-sectionall~ suggest significant differences across regulatory bodies in the application of rate of return regulation. We have found that equity return shortfalls, in aggregate, were greater during periods of high inflation, as Shortfalls decreased during business cycle expansions and increased during contractions. We conclude that the utility regulatory process has been ineffective in establishing achievable equity return targets for electric utility firms in periods of high inflation and lower business activit)a a9

Table 2 provides the results from the estimation of equation [3]. Overall, the model explains about 76 percent (adjusted Ra) of the observed variation in M/B over the period from 1987 to 1992. It is clear that the higher the earned return on common equity, the greater is the M/B ratio. This result is predicted from equation [1] and indicates the important role played by current earned returns in the formation of market expectations. s hypothesized, there is a strong negative relationship between long-term interest rates, as measured by the yield on

A

Table 1" Sample of Investor-Owned Utilities Used in the Analysis 1. Allegheny Power Systems, Inc. 2. American Electric Power Company 3. Atlantic Energy, Inc. 4. Baltimore Gas & Electric Company 5. Carolina Power & Light Company 6. Central Hudson Gas & Electric Corp. 7. Central Louisiana Electric Company 8. Central Maine Power Company 9. Central and Southwest Corporation 10. Central Vermont Public Service Co. 11. CILCORP, Inc. 12. Cincinnati Gas & Electric Company 13. CIPSCO, Inc. 14. Commonwealth Energy System 15. Consolidated Edison Co. of New York 16. Delmarva Power & Light Company 17. Dominion Resources, Inc. 18. DPL, Inc. 19. DQE, Inc. 20. Duke Power Company 21. Empire District Electric Company 22. Florida Progress Corporation 23. General Public Utilities Corporation 24. Green Mountain Power Corporation 25. Hawaiian Electric Industries, Inc. 26. Houston Industries, Inc. 27. Idaho Power Company 28. IES Industries, Inc. 29. Interstate Power Company 30. Iowa-Illinois Gas & Electric Company 31. IPALCO Enterprises, Inc. 32. Kansas City Power & Light Company 33. KU Energy Corporation 34. LG&E Energy Corp. 35. MDU ResourcesGroup, Inc. 36. Minnesota Power & Light Company

37. Montana Power Company 38. Nevada Power Company 39. New York State Electric & Gas Corp. 40. Niagara Mohawk Power Company 41. NIPSCO Industries 42. Northeast Utilities 43. Northern States Power Company 44. Ohio Edison Company 45. Oklahoma Gas & Electric Company 46. Orange & Rockland Utilities, Inc. 47. Otter Tail Power Company 48. PacifiCorp 49. Pennsylvania Power & Light Company 50. Philadelphia Electric Company 51. Portland General Corporation 52. Potomac Electric Power Company 53. Public Service Company of Colorado 54. Public Service Enterprise Group, Inc. 55. Puget Sound Power & Light Co. 56. Rochester Gas & Electric Corporation 57. St. Joseph Light & Power Company 58. San Diego Gas & Electric Company 59. SCANA Corporation 60. SCE Corp. 61. Sierra Pacific Resources 62. The Southern Company 63. Southern Indiana Gas & Electric Co. 64. Southwestern Electric Service Co. 65. TECO Energy, Inc. 66. TNP Enterprises, Inc. 67. Union Electric Company 68. Washington Water Power Company 69. Western Resources, Inc. 70. Wisconsin Energy Corporation 71. Wisconsin Public Service Corporation 72. WPL Holdings, Inc.

The ElectricityJournal

Table 2: Determinants of Market to Book (rvl/B) Ratios for Electric and Combination Electric and Gas Utilities* 1987-1992

Variable

Coefficient

t-Statistic

Significance

ROE~t TBi ERjt

1.55 -28.45 0.25

6.63 -18.26 1.13

<0.0001 <0.0001 0.261

,a,FU DCit -1.97 -3.82 0.0002 PERit -0.42 -1.89 0.06 Uit -0.94 -0.33 0.74 Fit 7.03 1.48 0.14 Constant 309.82 13.84 <0.0001 Adjusted r2 = 0.761; F-statistic= 17.69; n = 437**; Significance level = <0.0001 * Coefficients for the individual companydummyvariables(FMi) and yearlydummyvariables (D0 are not presented, but are availablefrom ttie authors on request. ~*With the Durbin Two-Step Method one observation is sacrificed, resulting in a total numberof observations of 437 ratherthan 438 (the productof 73 firms t rues 6 years).

30-year U.S. Treasury bonds, and M/B ratios. This result is consistent with our aggregate analysis, which indicates that equity return shortfalls increase with increases in inflation rates. 3° We also find a significant negative relationship between AFUDC, as a percentage of book value of common equity, and M/B ratios. Firms that have high proportions of AFUDC relative to their equity base are valued significantly less than firms with low AFUDC risk exposure. The discounting of AFUDC earnings most likely reflects the risk of nonrecovery of these capitalized noncash earnings w h e n a construction project is completed and an attempt is made to place it (along with accumulated AFUDC) into rate base. Many of the large disallowances of rate-base assets have been associated with the AFUDC component of these assets" costs. The finding with respect to the AFUDC variable suggests a similar market discounting of other regulatory assets, as discussed March 1997

above. We anticipate that the increased impact of the forces of competition will further reduce the market valuation of the AFUDC component of CWIP and other regulatory assets. he percentage of total revenues derived from electric utility service has a negative and significant (6 percent level) impact on M/B. This result is consistent with the higher risk (due to regulatory uncertainty and the threat of new competition) facing electric utility firms relative to natural gas distribution companies during this time period. The signs of the d u m m y variables representing regulatory climate are as hypothesized, but are not significant at conventional levels. Similarly, the sign on the equity ratio variable is positive, as hypothesized, but not significant. The weak significance of these variables may be attributable to the fact that they both were hypothesized to act as proxy variables for regulatory risk--the regulatory climate variable serv-

T

ing as proxy for current levels of regulatory risk and the common equity ratio serving as a longterm indicator of regulatory risk. Because of the significant positive correlation between regulatory climate and the common equity ratio (+0.25 between the equity ratio and favorable regulatory climates and -0.11 between the equity ratio and unfavorable regulatory climates----both significant at the .01 level), our results suggest that M/B ratios are negatively (positively) influenced by an unfavorable (favorable) regulatory climate. 31

V. Conclusions and Implications Overall the results of the analysis are consistent with our prior expectations of the relationship between required and expected returns on common equip, and thus confirm our prior research resuits and the work of others in a somewhat different regulatory and economic environment. The M/B ratio is positively related to earned returns on equity, negatively related to the level of interest rates, negatively related to AFUDC as a percentage of the book value of common equip, and negatively related to the percentage of a utility firm's revenues derived from the provision of electric utility services. We also find evidence supporting a positive relationship between regulatory climate and M/B. The period of analysis, 1987-92, is a time of variable, but generally declining, required rates of return for utility equity investors. The lag in the de59

cline of earned returns relative to required returns has resulted in an overall increase in M / B ratios during the examination period. ur findings in this paper, together with those reported earlier,32indicate that the regulatory process has been slow to respond to declining required rates of return, i.e., the rate of return d e m a n d e d by investors as compensation for the risk assumed in a company's stock--as evidenced by M / B ratios that have been persistently greater than 1.0 since the late 1980s. Although not tested directly in this paper, we reference evidence of the opposite effect over the period from the mid-1970s until the latter part of the 1980s. Because the regulatory process has not been capable of responding in a timely manner to significant changes in capital market conditions that alter investor-required rates of return, there is a real prospect that utility managers may choose suboptimal real asset mixes and suboptimal capital structures. Our results have implications for investors. First, it is clear that investors continue to view AFUDC earnings as being riskier (and hence, worth less) than cash earnings. This valuation impact is likely to be enhanced with increased competition. Furthermore, investors should be cautious of other regulatory assets that may be lost to the forces of competition. Second, the positive relationship between the equity proportion in the capital structure observed 33and confirmed here, albeit weakly; indicates that inves-

O

60

tors should be sensitive to the long-term impacts of regulatory decisions on financial risk---not just the immediate earnings effects. Overly equity-rich capital structures lead to unnecessarily high capital costs, while equity-starved capital structures may weaken utility companies at a point in time when the effects of new competition suggest the need for more conservative financing practices.

II,,

li ~

J,,

;;',~.",,6",..'~,.'1~i

-~ ',~ ,::~1 .-~-3" -~ "-~. '~,1%~-1 z-//

The strong negative relationship between M/B and the level of long-term interest rates highlights the inherent problem of regulation to respond quickly to changing capital market conditions. Cost of capital indexing arrangements can help to minimize this problem and should be valued by investors. Finally; the significant, negative relationship between the percentage of electric utility revenues and M/B ratios highlights the importance of investors carefully evaluating the weighted risk associated with combination gas and electric utility firms.

he passage of the 1992 Energy Policy Act represents the first step toward an imminent change in the structure and competitiveness of the electric utility industr3a. 34The incentives provided for a new class of producers to enter the power generation market, the approval of wholesale wheeling of power between producers, and the prospect of retail wheeling will all place pricing pressure on electric utility firms as they compete in this new market environment. Those firms whose performance has suffered from unfavorable regulation will be especially hard-pressed to compete in this new environment. Firms that hope to remain competitive will be under great pressure in the near future to reduce operating costs, strengthen their balance sheets, and lower their capital costs. The prospect of a newly competitive environment makes it all the more important for investors to be aware of the impacts of the regulatory process on firm performance and return requirements. •

T

Endnotes:

1. J.R. Foster, Fair Return Criteria and Estimation, BAYLORL. REV.,28, Fall 1976, at 883-936. 2. S.E. Atkinson and C. Nowell, Explaining Regulatory Commission Behavior in the Electric Utility Industry, so. ECON.J., Jan 1994, at 634-43. 3. D. K. Shome and S. D. Smith, An Econometric Analysis of Equity Costs and Risk Premiums in the Electric Utility Industry: 1971-1985, FIN.REV.,Nov. 1988,

at 439-52. 4. E.T. Claggett and R. C. Moyer, An Examination of Factors Influencing Ag-

The Electricity Journal

gregate Electric Utility Return Shortfalls,

justment Clauses on Electric Utilities, J.

ELEC. J., Dec. 1993/Jan. 1994 at 60-65.

BUS., A p r i l 1990, at 165-86.

5. M.J. G O R D O N , THE INVESTMENT F I N A N C -

13. S.E. A t k i n s o n a n d C. Nowell, Explaining Regulatory Commission Behavior in the Electric Utility Industry, so.

ING A N D VALUATION OF THE C O R P O R A TION

(Richard D. Irwin, 1963).

6. W.T. Carleton, Rate of Return, Rate

Base and Regulatory Lag under Conditions of Changing Capital Costs, LAND t~CON., M a y 1974, at 145-51.

14. Claggett a n d Moyer, supra note 4. 15. Gordon, supra note 5; see also M.J. G O R D O N , THE COST OF CAPITAL TO A PUB-

7. J.R. Boatsman, I. K. Khurana, a n d M. L. Loudder, Market Valuation of

Regulatory Assets in Public Utility Firms, ACCTG.REV., July 1996, at 357. t

8. Bluefield Water Works a n d Imp r o v e m e n t C. v. Public Service C o m m i s s i o n of West Virginia, 262 U.S. 679 (1923). 9. Federal P o w e r C o m m i s s i o n et al. v. H o p e N a t u r a l Gas Co., 320 U.S. 591 (1944). 10. H. Averch a n d L. Johnson, Behav-

ior of the Firm Under Regulatory Constraint, AM. ECON. REV., Dec. 1962, at t 052-69. 11. R o b e r t M. S p a n n , Rate of Return Regulation and Efficiency in Production: An Empirical Test of the AverchJohnson Thesis, 5 BELL J. E C O N . & MGT. ScI. 38-52 (1974); L. C o u r v i l l e , Regulation and Efficiency in the Electric Utility Industry, 5 BELL J. E C O N . & MGT. SCI. 53-74 (1974); H.C. Petersen, An Empirical Test of Regulatory Effects, BELLJ. ICON., S p r i n g 1975, at 111-26; T. C o w ing, The Effectiveness of Rate-of-Return

Regulation: An Empirical Test Using Profit Functions, in PRODUCTION ECONOMICS: A D U A L A P P R O A C H TO THEORY AND APPLICATIONS215-46 (M. Fuss a n d D. M c F a d d e n , eds., N o r t h Holl a n d P u b l i s h i n g Co. 1978); F.M. Goll o p a n d S. J. K a r l s o n , The Electric

Power Industry: An Econometric Model of Intertemporal Behavior, LAND ECON., Aug. 1980, at 299-314; R.A. N e l s o n ,

Regulation, Capital Vintage, and Technical Change in the Electric Utility Industry, REV. ECON. & STATS. Feb. 1984, at 59-69. 12. M.J. Brennan a n d E. S. Schwartz,

Regulation and Corporate Investment Policy, j. FIN., M a y 1982, at 289-300; J. Golec, The Financial Effects of Fuel Ad-

March 1997

ECON. J., Jan. 1994, at 634-43.

UTILITY(Mich State Univ. Public Utility Studies, 1974). LIC

16. Recognizing that E1/B in equation [1] is equal to the return on equity, r, a n d setting the required rate of return, ke, equal to the expected return e a r n e d return, r, yields: M

r(1-b)

B

r-br

This equation can be simplified to yield equation [2]. 17. O u r analysis uses M / B ratios b a s e d on b o o k values from public financial reports, rather than regulatory b o o k values for each firm, because of the difficulty in obtaining or d e r i v i n g consistent r e g u l a t o r y b o o k values for the universe of firms used in our study. Regulatory b o o k values m a y differ from b o o k values d e r i v e d from public financial reports because of accounting differences (e.g. depreciation, rate-base inclusion, and so on) in the two reporting environments. The p r i m a r y impact of these differences is a scaling effect that should not bias the results of our analysis. 18. R. Rao and R. C. Moyer, Regulatory

Climate and Electric Utility Capital Structure Decisions, FIN. REV., Feb. 1994, at 97-124. 19. The regulatory climate variable discussed below incorporates the impact of the current regulatory climate on the m a r k e t ' s relative valuation of a firm, whereas the equity ratio is a p r o x y for the longer term impact of r e g u l a t o r y climate. 20. R.M. Bowen, Valuation of Earnings

Components in the Electric Utility Industry, ACCTG.REV., Jan. 1981, at 1-22. 21. Boatsman, supra note 7.

22. Value Line I n v e s t m e n t S u r v e y evaluates the quality of r e g u l a t o r y commissions b a s e d on factors such as allowed rates of r e t u r n granted, treatm e n t of CWIP, length of r e g u l a t o r y lags, a n d w h e t h e r or not interim rate increases are granted. 23. Claggett a n d Moyer, supra note 4. 2 4 . WILLIAM H. GREENE, E C O N O M E T R I C

ANALYSIS466-470 (2nd ed., Macmillan Co., 1993). 25. Disturbance term serial correlation is c o m m o n w h e n using p a n e l data for p a r a m e t e r estimations. W h e n the LSDV coefficients of Equation 3 were estimated w i t h o u t the autocorrelation correction, the Durbin-Watson (D-W) statistic was 1.61, indicating an unacceptable level of positive first-order autocorrelation in the d i s t u r b a n c e term. After a p p l y i n g the D - W TwoStep correction, the D-W statistic increased to 1.84--representing a significant i m p r o v e m e n t . See KMENTA, ELEMENTS OF ECONOMETRICS 318 (2nd ed., Macmillan Co., 1986). 26. The s a m p l e was restricted to those firms with c o m p l e t e d a t a for all years so that the LSDV p r o c e d u r e for panel data could be applied. 27. S a l o m o n Brothers, "Electric Utilities," M o n t h l y Updates. 28. Claggett a n d Moyer, supra note 4. 29. Id. at 64. 30. Claggett a n d Moyer, supra note 4. 31. Also, there is a significant, positive correlation (+0.31) b e t w e e n the earned return on c o m m o n equity a n d the equity ratio. This result is consistent with firms in favorable r e g u l a t o r y environments earning higher equity returns. 32. Claggett a n d Moyer, supra note 4. 33. Rao a n d Moyer, supra note 18. 34. A discussion of the i m p a c t of the 1992 Energy Policy Act on the risk of electric utilities can be f o u n d in R.C. Moyer, The Impending Restructuring of

the Electric Utility Industry: Causes and Consequences, BUS.ECON., Oct. 1993, at 40-44.

61