Market-based and accounting standards for public utility rate regulation

Market-Basedand Accounting Standards for Public Utility Rate Regulation Wilbur G. Lewellen John J. McConnell, Purdue University

The possible usefulness of finance theory in developing appropriate approaches to the regulation of public utility service prices has received considerable attention. Of particular interest has been the matter of cost of capital as a guide to fair rate of return determination. From an underlying concept of the proper goal of regulation-to duplicate for public utility investors the risks and rewards they would be subjected to if their capital were committed to unregulated enterprises-the present paper develops a basis for selecting the correct regulatory approach. That approach is seen to be supportive of traditional accounting-based regulatory commission procedures, and to argue against cost of capital as a return standard.

The problem of establishing an appropriate regulatory framework for the determination of fair earnings levels for public utility firms is a recurring one in the literature of economics and finance. The fundamental dilemma is straightforward : insofar as the production of the relevant services is concerned, economies of operating scale in almost every instance argue for the concentration of production within a single large enterprise in a given geographical market. Unless the price the enterprise charges for those services is controlled, however, it will be able to exploit its natural monopoly position to the detriment both of its particular customers and society’s border interests in an efficient pattern of real resource allocation. Hence, the objective of regulation is somehow to achieve a competitive corporate earnings outcome in an inherently noncompetitive production context. The fact that the services being provided are typically basic and essential ones accentuates the significance of the problem.

Address correspondence to: Wilbur G. Lewellen, Krannart Graduate School of Industrial Administration, Purdue University, Lafayette, Indiana 47907. JOURhrAL OFBUSINESS RESEARCH I (1979), 117-138 117 0 Elsevier North Holland, Inc., 1979 0148-2963/79/02117-22SO1.75

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In practice, the focus of regulatory deliberations is on the rate of return a utility should be permitted to earn on its invested capital. The ostensible guiding principle is that enunciated by the U.S. Supreme Court in its decisions in the landmark Hope Natural Gas and Bluefield Water Works cases, wherein it was asserted, inter alia, that a proper rate of return is one that will enable the utility to compensate its shareholders at a level commensurate with the investment risks they bear. This principle is, of course, consistent with contemporary views of the securities-price-determination process in the capital markets, and it forms the cornerstone of all prevailing normative treatments of asset valuation and financial structure phenomena. The intent of the present paper is neither to dispute the principle nor to question those normative models; instead, the intent is to reexamine the matter of which risks utility shareholders should bear, and recommend a regulatory procedure for rate of return determination that will produce both the correct risk exposure and the correct compensation therefor. We shall, in the process, disagree with many recent such recommendations. The Regulatory Goal

The central tenet around which the analysis is organized is very simple: stockholders of public utility firms should be confronted with security-market risk burdens and return opportunities precisely matching those they would confront as equity investors in unregulated enterprises-and only if this condition is met will resources be allocated to utilities in a manner consonant with the over-all resource allocative efficiency objectives of the community. From that proposition, a quite definite approach to regulation emerges. The point seems to us virtually indisputable. In a well-developed, broadly based, highly liquid capital market like that of the United States, wherein information is quickly and widely disseminated and securities transaction costs are modest, capital will be rechanneled among various investment opportunities until the return prospects in each are just sufficient to reward investors for the respective associated risks. This characterization, together with its attendant implication of a specific (linear) equilibrium risk-return relationship among securities pursuant to investor portfolio-building activities, has extensive theoretical and empirical support in received doctrine [3, 8, 13, 171. If, then, resources are competitively so allocated when left to their own devices, any interference by a regulatory authority-either by way of insulation or exacer-

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bation-with the risk attributes of particular securities, such as those of public utility enterprises, will inevitably lead to a distortion in the flow of capital and to a suboptimal pattern of resource utilization. Only if the inherent demand, production cost, and market capitalization rate contingencies of the underlying activity involved are fully borne by utility investors will the proper amount of investment in that activity be forthcoming. The foundation of our suggestions for a regulatory strategy, therefore, is one of replicating for utility stockholders the normal competitive market risk exposure circumstances of the unregulated sector. The analysis is motivated by the trend in the developing literature of regulation, and in the testimony of regulatory proceedings, to urge a modem market-value-based cost of capital approach to the establishment of a fair rate of return for the utility enterprise [ 1, 4, 161. The venerable comparable earnings posture organized around capital structure book values, accounting profits, and imbedded book costs-which most regulatory agencies have traditionally employed-has come in for increasing criticism. While the notion that cost of capital is an appropriate standard of return has considerable superficial plausibility, and while the intellectual temptation to modernize the tone of regulatory deliberations is great, it can be shown that the consequence of such a position is perverse in terms of the risk exposure test just described. Analytical Framework These matters will be treated, both for reasons of expositional convenience and as a means of casting the fundamental issues in as bold a relief as possible, in the usual context of an efficient competitive capital market free of material transactions costs. The familiar discounted-expected-cash-flow representation of the security valuation process will be assayed. Firms are assumed to have capital structures comprised only of two instruments-common stock and consol bonds-and bankruptcy costs will be ignored. Although this is a rather stylized scenario, it has ample precedent in the literature as a point of departure and it serves well the immediate need to develop the conceptual argument. Opportunities for extention and enrichment of the analysis will be commented upon subsequently. In such a milieu, wherein a flat-rate tax on corporate income is imposed and interest payments are tax deductible, it has repeatedly been shown that the Modigliani-Miller [ 14, 151 prescription for

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the valuation of a levered enterprise will hold [ 6, 12, 181. Thus, if T is the corporate tax rate, i is the coupon rate on the firm’s bonds, D is the par value of those bonds, and r is the prevailing market yield requirement on debt instruments, investors’ portfolio arbitrage and personal leverage opportunities will force the total market value of a levered corporation, V,, to depart from that of an otherwiseidentical unlevered firm, Vu, precisely by the relationship iDT

v, = v, + -

r

’

Further, if the firm’s annual preinterest-and-tax operating cash flows (implicitly, net of depreciation reinvestment) are assumed to arise from a stable probability distribution having a mean of y, if OJis the after-corporate-tax capitalization rate that would be applied by investors to such a contingent set of prospects were they generated by an unlevered firm (which prospects would simply be the latter’s divident payments), and if V, and V, are used to denote the market value of the firm’s common stock and bonds, respectively, we have from ( 1) that V, + v, =

r(l

-T)+iDT CY

r

(2)

or, since V, = iD/r for consols, v, =

y(l -T) a

(3)

Accordingly, the three potential sources of fluctuation in the market value of the firm’s equity-that is to say, the elements of shareholder market risk exposure-are readily apparent. The market price of common shares will, ceteris paribus: (1) rise when 7 increases; (2) fall when cyincreases; and (3) rise when r increases. This, of course, is the standard story for the unregulated enterprise. The question here then becomes one of specify%g a regulatory scheme that will subject utility stockholders-as Y, (II,and r vary over time-to exactly the same price fluctuations they would face from the investments in similar unregulated companies. Unless they are so positioned, we have previously argued, the terms of their participation in the market will differ, the competitive-sector outcome will not be replicated, investment decisions will be dis-

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torted, and resources will end up being misallocated as between regulated and unregulated companies. Capital Cost Regulation

Given the valuation expressions indicated, the costs of debt and equity capital are easily specified, also in standard fashion. These are defined as the minimum rates of return investment projects must promise, when financed in either of the two ways, in order to be just acceptable to the firm-where the criterion of acceptability is the condition that the market price of the firm’s existing common shares not decline as a result of the decision. For equityfinanced new investments, therefore, the requirement is that total equity market value rise by at least the amount of additional funds raised, a requirement that translates from Equation (3) into the marginality test

dh _

1

=

d[yU a

dI

r)l/dl

-(I

-n7

d(iD/r)

(4)

where dI is the cost of the incremental project involved and d [ F( 1 - 7’)] /dI its expected after-tax rate of return, for our present case of level perpetual cash flow streams. Since, with a fully equity-financed investment, no added borrowing is undertaken, the term d(iD/r)/dIis zero, and the test resolves to

for the cost of (read: prospective return required to justify raising) equity capital. This is the Modigliani-Miller result, and asserts that equity-financed projects must provide earnings rates at least equal to the market capitalization rate applicable to unlevered enterprises in the relevant risk class-i.e., tirms whose operating cash flow prospects are characterized by similar stochastic properties. If the project were debt-financed instead, no new equity claims on the firm would be created, and-assuming effective me-first protection for prior bondholders [ 91 -the acceptability criterion, my (3), would become

Ws =

z

o=

d[y(l cl!

T)l/dI

(6)

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but, in order for fresh bonds to be issued, the yield to investors thereon will have to match the then-prevailing market interest rate (i = r) ‘and a total of dI of such financing is needed, in the absence of equity support. Hence, the term d(D/r)/dI is equal simply to dI/dI, or unity, and we have

d[yU -

T)l

=R

dI

D

=or(l -T)

as the after-tax cost of debt. Again, this is the Modigliani-Miller prescription, with its familiar message that the required return on investments financed entirely with borrowed funds depends only on a firm’s operating-risk circumstances as captured in Q (as long as the investments are in the existing line of business involved) and the corporate tax rate--not on the actual interest rate on the bonds themselves. The latter, of course, disappears as a factor because of the underlying portfolio substitution opportunities of personal for corporate leverage, which establishes Equation (3) as the equilibrium valuation relationship. A regulatory procedure that sets allowable utility rates of return equal to capital costs, therefore, would employ the identified (but, necessarily, inferred) Rs and RD as the basis of those determinations-whereas the traditional approach to regulation has been to look to imbedded debt interest costs and visible book returns on equity of comparable-risk enterprises in establishing permissible earnings levels. The differing dynamic equity-market-price risk implications of the two approaches will be examined here primarily in the context of an illustrative situation, for ease and clarity of presentation. For current purposes, such an illustration will suffice to reveal the central issues of concern, and the generalizability of the analysis will be readily apparent as the discussion proceeds. We shall have further observations about extensions and more formalized modes of treament later on. The Utility Firm: Initial Conditions

Consider the case of a public utility enterprise that has just been awarded the franchise to provide service to a particular geographical territory, ‘and that is thereupon about to organize itself as a firm to undertake that activity. Let us suppose that initial expenditures of $1000 are required to obtain the necessary productive (real) assets, that demand for the relevant services is expected to

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be stable over time, that reinvestment of the assets’ depreciation charges each year will exactly maintain the productive capacity to service this demand, and that the firm announces its intention to finance itself half with debt and half with equity. In an efficient capital market, the necessary total funds will be forthcoming from investors only if the regulatory agency having jurisdiction over the utility establishes an initial price schedule for its services sufficient to provide returns, given the business risks involved, commensurate with those available elsewhere in the market. Let us assume, in that connection, that the demand for the utility’s output is expected to be stable in the specific sense that annual net cash operating revenues are stochastic, but are characterized by a distributuion having a constant mean, and that this distribution has attributes like those of the operating cash flows of unregulated companies from which a 12% unlevered earnings (and dividend) yield is presently deemed necessary. Finally, assume the prevailing pretax interest rate to be 4% and the corporate tax rate to be 50%. On that basis, the expected annual operating earnings requirement of the utility is the P* which, by (2), satisfies the condition

v, + VD =500+500=

Y*( 1 - .5) + (.04)(500)(.5) .12 .04

from whence F* = $180. Only, then, if this prospective earnings level is allowed by the regulatory agency can $500 of equity and $500 of debt be raised by the utility to begin operations. We need not, in fact, inquire as to how the agency arrives at the figure; a trial-and-error process of suggesting proposed service prices would do perfectly well. What we do know, however, is that the utility firm’s proferred debt and equity securities cannot be sold at a combined price of $1000 unless the indicated $180 of preinterestand-tax mean annual cash flow is anticipated by investors. Once the regulators so provide, the flotation can be accomplished, the needed real assets can be purchased, and the enterprise can initiate its service activities. This is our base case. Thereafter, on the other hand, the particular ongoing procedure adopted for monitoring the enterprise for regulatory purposes does become important and is the object of our concern.

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Fair Returns and Capital Attraction As a prelude to those deliberations, it is worth emphasizing both that the concept of fair return has content only as an ex-ante notion and-as importantly-that there is a distinction between fair and proper returns, in terms of resource allocation implications. The latter point is the essence of our perspective on the regulatory process. In an efficient capital market environment, securities prices will accurately reflect all available information about the enterprises on which they represent claims, and those prices will by definition be driven in equilibrium to the levels which provide competitively fair ex-ante yield prospects. As long, therefore, as a regulatory agency announces its policy for setting the price of a utility’s services and adheres to that policy over time, the returns to the firms’s security holders will be entirely fair, in the normal market sense. In our base-case previous example, a volume of capital appropriate to whatever y* is established by the regulators will always be forthcoming on the front end, although only a F* of $180 per annum will command exactly the needed initial $1000 specified. Ex post, of course, the actual returns to investors may be quite different during any given time interval because of the unavoidable operating-circumstance (actual demand and production cost) contingencies associated with the enterprise’s activities. All those returns nonetheless will be fair-absent any change in the original regulatory posture established-whether they meet expectations or not. That’s the chance investors take. A sterner requirement of regulation, however, is that the returns promised and provided be not only fair but that they be properwhere the propriety test is one which insists that real capital resources end up being attracted to utilities in no greater nor no less a volume than would occur if the utility business were productioncompetitive and unregulated. This result, in turn, will ensue only if regulatory agencies adopt a procedure that gives rise to a risk/return situation for utility investors which fully duplicates that which would be confronted on securities holdings in equivalent operating-risk unregulated companies. It is that requirement, as we shall see, which militates against cost-of-capital regulatory postures, which argues that not just any risk/return target will be acceptable even though any one will provide strictly fair returns, and which can lead to some fairly definite recommendations about a desirable style of regulation.

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Standards for Utility Rate Regulation

Regulation in a Stable Environment In the format of our illustrative case, if external market conditions and the utility’s operating attributes do not change over time, of course, virtually any consistently applied regulatory scheme will suffice as proper. Thus, if the regulatory authority examined the firm’s position periodically, it would find that its operating earnings had averaged $180 per annum, would find its securities continuing to sell at their original (book and market) values, and would see both interest and equity-capitalization rates for the firm and other firms being steady. A cost-of-capital approach to regulation, therefore, would define Rs = a = .12and RD = CY( 1 - 7’) = .06; it would impute a weighted after-tax average cost of (.5)(.12) + (.5)(.06) = .09, based on either book or market weights; it would translate that figure into an 18% pretax desired earnings rate on the firm’s $1000 of total asset investment; and it would conclude (correctly) that the existing expected operating earnings level of $180 per annum was appropriate. Alternatively, the traditional approach would look to visible accounting returns on book equity and imbedded costs. It would scrutinize unregulated companies in comparable earnings-risk and capital structure circumstances. It would find, upon doing so, that such equivalent unregulated companies were generating. (P - zD)(l - T) = [ 180 - (.04)(500)](1

- 5) = $80

of after-interest-and-tax profits per $500 of book equity, for a 16% rate of return; it would regard 4% as the cost of the utility firm’s debt; it would thereby establish (.5)(.16) + (.5)(.04) = .lO as the book-weighted desired competitive earnings rate on the utility’s $1000 asset base, for an indicated figure of $100 per annum; it would add back the $80 of taxes that would be due on the equity component of earnings, as a cost; and it would thereupon also arrive at $180 as the target pretax operating earnings goal-suggesting no need for a service-price change. This traditional procedure perhaps merits some additional comment. While it may, at first glance, appear inconsistent for regulatory agencies-as is their custom-to specify a target weightedaverage earnings rate by combining a posttax equity figure with a pretax debt one, the anomaly is only apparent rather than real. The saving grace is the attendant treatment of corporate taxes as an expense of doing business, in the manner shown. Hence, if S

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126

is used to denote the book value of common shares, the standard regulatory approach is to prescribe

(S+D)

(y* -iD)(l

-T) (m)

s

=(P* -iD)(l

S + s&J]

- T)+iD

(9)

as the relevant (after-tax but preinterest) criterion for aggregate earnings levels on invested assets of S + D; this is our figure of $100. In transforming that criterion into its pretax counterpart, however, an amount T(y* - iD) is added to reflect the implied equity earnings tax bill, resulting in (y*--iD)(l

-T)+iD+T(F*-iD)=F*-QI+jD=

8*

(10)

as the ultimate operating earnings recommendation (our $180). If instead the initial weighted-average comparable earnings rate were computed in after-tax terms, in the form (F*-iD)(l S

-T)

(&

S

+ i(1 ;T)D(&)

and this rate put on a pretax basis by (1 - 7’), and then applied to S + D would be y* as the desired absolute two computational schemes therefore

(11)

dividing through by the factor of assets, the outcome again operating earnings level. The are identical.

Interest Rate Fluctuations

It will not be the case, though, that the traditional and cost of capital approaches to continuing regulation will yield similar eamings-rate recommendations when market conditions depart from those which prevailed at the time the utility’s securities were originally issued. One source of such discrepancies is changes in interest rates. Should it occur, for example, that required market yields on debt securities rise to 5% in our illustrative situation, the utility’s (consol) bonds will decline in price from $500 to $400 in the secondary market, pursuant to their 4% coupon rate. By (3) then, the price of the firm’s common shares will increase to

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Standards for Utility Rate Regulation

v = 180(1 - -5) (1 - .5)(.04X500) = $550 S .12 .OS assuming-just for the moment-no other changes either in operations or in the external environment [ 11 I. Absent such other changes, of course, the firm’s costs of debt and equity capital, which depend only on CYalso do not change; Rs and RD remain at 12% and 6%, respectively. The traditional regulatory procedure would, as we have seen, examine unregulated companies in like circumstances concurrently, in contemplating the need for possible earnings-rate revision for the utility. Because, as is true of the utility, no change in internal corporate operations or existing debt coupons has taken place, returns on book equity and imbedded debt costs will also not have changed nor, of course, will the book amounts S and D. The regulatory computations portrayed in (9) and (IO), therefore, will still yield $180 as the indicated appropriate operating profit level, and the conclusion will be that the utility need not have its service prices altered. The impact thus will be to leave the interest-rategenerated equity price increase to $550 untouched-and thereby to leave the utility’s shareholders in exactly the same position they would be in had they invested instead in an identical unregulated company. By our standards, this is the correct result, for competitive resource allocation purposes. A market-value-based cost of capital regulatory scheme, on the other hand, would have a perverse influence. With equity market value now at $550 and debt at $400, the implied weighted average after-tax cost of capital would become RA

= (. 12)(550/950) + (.06)(400/950)

= -0947

or 18.94% before taxes. The conclusion thereupon would be that the utility should be permitted to earn at a higher rate (up from the original 18%) on its asset investments. Application of this new rate to the $1000 of total assets would suggest P* = $189.40 as the target annual figure, and result in an equity market value of V _ (189.40)(-s) S.12 after implementation

-

(.5)(.04)(500) .05

= $589 2.

(or, really, the announcement)

of the rate

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Wilbur G. Lewellen and John J. McConnell

revision. In effect, the utility’s shareholders will be rewarded additionally by such a regulatory approach. We see no logic in that sort of outcome, as we see no merit in any procedure that does not replicate the normal securities-market risk/return consequences that would be associated with a corresponding equity ownership position in the unregulated sector-whatever the size or direction of the discrepancy. A decline in required debt yields would have just the opposite impact both on V, initially and on the regulators’ subsequent response thereto. A drop to 3% in r will lower V, to $416.67, but the traditional regulatory approach would-again because all firms’ internal accounting earnings circumstances remain intact-recommend no rate revision. Accordingly, utility investors’ capital losses would match those experienced simultaneously by unregulated firms’ shareowners. A market-weighted cost of capital computation, however, would argue for a further operating earningsrate reduction and thereby result in an extra regulatory penalty. The source of the problem, of course, is obvious: interest rate fluctuations alter the relative market values V, and V, , and even though firms’ true capital costs Rs and RD are not changed, the weighted average of the two is-inevitably-in a way that will cause regulatory action based thereon to accentuate utility equity price variations. A book-weighted cost of capital scheme of regulation would be insulated from the particular indicated aberations. Because Rs and RD are unaffected by changes in r, weighting them by S and D would continue to lead to 9% after taxes and 18% before taxes as the proper utility rate of return target, and to $180 per annum as the recommended earnings level for the firm. While this is not the posture suggested by most advocates of a cost of capital approach, it is certainly a viable one-and it is, by the criterion of attempting to reproduce the unregulated-company share price contingencies, a superior choice. Unfortunately, it is only helpful insofar as interest rate changes alone are concerned; other environmental phenomena are not so readily accommodated. Changes in Equity Capitalization

Rates

Among these is the second factor identified

in Equation (3) as an influence on equity values: the market capitalization rate applicable to the business risk class in which a firm falls. Suppose, for whatever reason, market sentiments change in such a way that 10% rather

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Standards for Utility Rate Regulation

than 12% comes to be regarded by investors as an adequate postcorporate-tax unlevered yield from enterprises whose annual operating cash flows, Y, have the stochastic properties at issue. Upon that change, and assuming interest rates have not also been affected, the aggregate market price of the utility’s common shares will rise to

v = 180(.5) S

-x--

(.5)(.04)(500) .04

= $650

and given now an a equal to .lO, we have-and the expert analyst would discover-that capital costs of Rs = .10and RD = .05apply to the firm’s new situation, as specified in equations (4) through (7). Because, however, equity and debt book values are invariant for both the utility and its unregulated peers, and because the internal operations of both will continue as before, a traditional regulatory agency will be unmoved by the capitalization rate change; indeed, in the normal course of affairs, the agency will not even detect the change. Consequently, annual (prospective) operating earnings of $180 will still seem appropriate, and the same equity price increase will be realized-and preserved-for utility shareholders and unregulated-firm investors alike. Were cost of capital instead to be employed as the regulatory standard, a rate revision would be prompted. Using market weights, the perceived new correct after-tax rate of return would become RA = (.10)(650/l

150) +(.05)(500/l

150) = .0782

or, with book weights RA = (.10)(500/1000)

+ (.05)(500/1000)

= .075

and both measures would suggest an apparent need to lower the utility’s annual operating earnings level. The implied pretax figures of $156.40 and $150 on a $1000 asset rate base would, respectively, produce postregulation aggregate equity values of $532 and $500, down from the $650 first occasioned by the capitalization rate change. More generally, it can be shown-whether equity capitalization rates decrease or increase-that the market-weighted version of this approach will always partially restore V, to its prerate-change value ($500 in the situation at hand), while the bookrated version will always fully restore that value. The latter, there-

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fore, is essentially a scheme for eliminating for utility shareholders the impact of all such rate fluctuations on the prices of their securities. Because unregulated-sector equity investors are not so protected, we object to that scheme as a regulatory procedure. In effect, whenever an unregulated company issues debt or equity securities on terms mandated by the market conditions prevailing at the time of issue, it and the securityholders involved are inevitably speculating on possible future interest and capitalization rate changes. Such contingencies are unavoidable in a dynamic and uncertain environment, and the contention here simply is that the same speculative aspects should attend investments in utility securities, if resource allocation parity as between regulated and unregulated companies is to b.e achieved. Changes in Operating Profit

Finally, the utility’s operating earnings may, due to a change in the surrounding demand or production-cost circumstances of the firm (occasioned perhaps by technological advances), systematically depart from the figure that was intended and anticipated in the initial rate-setting decision. It might turn out, for example, that at some point the mean level of operating cash flow, H, being realized annually by the utility increases to $210 from the original $180 target. If that level is expected by investors to persist, and nothing else has changed, the total market value of the firm’s common shares will rise to v = 210(.5) S

--xi--

(.5)(.04)(500) .04

= $625

whereupon a market-value-based capital cost regulatory monitoring procedure would emerge with a recommendation that a revision in the firm’s after-tax earnings rate on total assets to RA =(.12)(625/l

125) +(.06)(500/l

125) = .0933

would be in order, given that its risk classification (a = .12) has not changed. Accordingly, a pretax y* of $186.67 would become the new target, and V, would be diminished to $527.80 by the rate revision. If book value debt and equity weights were employed, of course, the resulting RA would remain at 9%, the original $180 operating earnings level would be reconfirmed as the target, and a

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reduction in p thereto would restore V, to $500. Once again, therefore, a book-weighted cost of capital approach is seen to be implicitly a share-price-stabilizing regulatory scheme. The question then becomes: what would transpire under the traditional regulatory procedure thus far applauded? The answer is very simple, and it highlights what the authors perceive to be the fundamental issue involved. If similar unregulated companies have not also experienced operating earnings increases, their returns on book equity will remain (and be expected to remain) at 16% (SSO/SSOO), th eir equity market values will still be $500, and a rate reduction for the utility to restore it to that position would be called for-and inevitably would be executed by the regulatory agency. If, however, book equity earnings for such comparable firms had simultaneously risen to the same extent as those of the utility-and thereby equity values to $625 for them as well-the traditional regulatory assessment of their (book) situations would lead to a recommendation that the utility be allowed to keep its higher earnings level, and that assessment would in fact be correct. Succinctly put, if the competitive sector risk/return outcome is to be replicated in its entirety for utility investors-as the authors have argued as a resource allocation principle-utility earnings should be allowed to increase when unregulated-firm earnings do, and should be controlled by service-rate revision when unregulatedfirms earnings do not. A book-return-oriented, comparable accounting earnings approach to regulation will produce that result and allow other environmental changes to have their normal impact on utility equity prices. In the situation considered here cost of capital schemes will instead either tend to reduce or exacerbate earnings and equity-price movements for utilities, destroying what we regard as the important parity with unregulated companies’ shareholder market positions. The origin of the difference, obviously, is the focus of traditional approach directly and exclusively on internal corporate operating phenomena. Since firm profitability, as therein identified in accounting terms, is the real key to whether utilities are exploiting their monopoly situations vis-a-vis competitive enterprises, this is the appropriate regulatory focus. External market prices are merely a reaction to that fundamental earning power, in the light of prevailing alternative securities yield opportunities and capitalization rates. There is no reason to attempt to regulate those reactions for utilities-which, effectively, is what cost of capital regulatory procedures do-any more than they are regulated for other enterprises.

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Wilbur G. Lewellen and John J. McConnell

To the extent this occurs, underlying asset involvement decisions cannot help but be affected. Combined Effects While the impact on share values of changes in interest rates and unlevered-equity yield requirements have been treated separately, the more likely environmental circumstance certainly is one in which the two would be varying simultaneously-being joint reflections of the broad securities risk-return profile which prevails at any given moment in the marketplace. Conveniently, however, the combined consequences of changes in the two together are simply additive-pursuant to the general relationship between the overall effect on a variable that is in turn a linear function of other variables, and the separate contributibns of individual changes in those other variables. Thus, from the specific fashion in which Vs depends on r and Q as expressed in Equation (3), it will be the case that (12)

wherein, if you will, we have argued that neither aV,/acu nor aV, /ar are the proper purview of regulation, although they do impact cost of capital calculations. Changes only in reported utility operating earnings are a legitimate concern, and even then only when they are out of line with levels in the unregulated sector of the economy. Other Regulatory Schemes The consideration here of what we have described as the traditional and cost of capital approaches to regulation, of course, by no means exhausts the full range of such procedures. There is a traditional as well as a Modigliana-Miller view of capital cost measurement itself; there are interpretations of cost of capital which assert that the appropriate index is that composite capitalization rate that renders the present value of a firm’s total cash flows to securityholders equal to the current market price of its securities; and there have been suggestions that the goal of regulation should be to maintain the utility firm’s equity market value at book value. Little more than a cursory analysis is required to show that all

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such schemes also fail the test of replicating the unregulated-firm share price contingencies for utility stockholders. The last of these approaches, obviously, is easily dismissed. It is a procedure for virtually eliminating utility equity price fluctuations and is clearly in conflict with the character of unregulatedsector equity ownership positions. Similarly, the composite capitalization rate definition of average capital cost suffers from the inevitable problem of being affected by external-and, to us, irrelevant-variations in r and (Y, thereby leading to regulatory responses when none are merited. To return to the case where required market yields on debt instruments rise from 4% to 5% for example, the aggregate market value of our illustrative utility firm’s outstanding securities will decline from $1000 to $950with, as we saw, V, increasing to $550 and the company’s 4% coupon consol bonds falling in price to $400 on the secondary market. Since total prospective annual cash flows to security holders consist of the (Y - io>( 1 - 7’) available to equity owners and the iD due bondholders, the implicit market-price-matching capitalization rate would become R

=

(180 - 2W.5) + 20 _ 100_ 550 + 450

.1053

950

up from the . IO-i.e., 1OO/lOOO-which prevailed prior to the change in r. Consequently, a revision in the utility’s allowable earnings rate on assets would be indicated, and such a revision would alter V, in a way that would destroy its symmetry with interest-rate-induced changes in equity prices in the unregulated situation. The so-called traditional measures of cost of capital produce equally unsatisfying regulatory results. While there are almost as many variants thereof as there are versions of payback period as an investment criterion, most utilize some form of earnings/price ratio as the standard of equity cost and either a current or an historical interest rate as the ostensible cost of debt financing. Depending on the latter choice, on how taxes are handled, and on whether market or book capital structure proportions are employed in arriving at a weighted average capital cost, a wide range of alternative outcomes will ensue and each will have its own (undesirable) sensitivity to swings in r and cy.

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Extensions We have, of course, cast our discussion in the very congenial analytical context of level perpetual cash flow streams, consol bonds, and an efficient capital market. While this is not an unusual scenario in the literature, it is obviously only a starting point for a fullblown treatment of the relevant issues. Financial structure elements other than the simple pure debt and equity inputs previously considered-including preferred shares and the various taxdeferral items which are becoming increasingly important for utilities-need to be given explicit recognition, as do fmite-maturity borrowings. Relaxing the convenient assumption that depreciation reinvestment is just sufficient to maintain productive capacity, and allowing for something less than full dividend payout of earnings-and thereby growth-are also obvious next steps toward a more comprehensive analysis. The possible complications associated with a likely secular inflation in the utility’s productive-factor input prices, with a consideration of matters of debt capacity, and with the phenomenon of a succession of new debt and equity security issues by the firm over time, demand similar careful attention. This last point bears particularly on the question of the marginality test for new-investment acceptability that will be imposed by utility management, and the extent to which tracking the changes in accounting results for unregulated companies as they make incremental investments will induce-or allow-appropriate corresponding utility-firm real-asset acquisition decisions. Inevitably, it should. While, clearly, any new funds raised-whether by a utility or some other enterprise-must be invested so as to offer the suppliers returns equal to the then-prevailing market yield opportunities (costs of capital) in order not to harm existing stockholders, changes in those yield requirements over time will subsequently show up in changes in the ratio of operating earnings to invested book capital, as new projects are undertaken. Accordingly, if such a ratio is monitored in the unregulated section as we have urgedand allowed to be duplicated by the utility-the latter firm will in fact be able and willing to test new projects sequentially at the thenextant cost of capital return rates on the margin, while still preserving the correct market-price risk-exposure circumstances of prior security holders as portrayed above. In short, fair ex-ante returns, and correct ex post ones can coexist.

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Implementation and Measurement The contrivance of dealing with a public utility for which environmental effects on equity values can be traced from the point of its inception as an enterprise-and drawing parallels with an unregulated company of exactly the same age and in exactly the same operating-risk and capital structure circumstances-imparts a degree of precision to the analysis here which will not be easy to match in the less clean milieu wherein regulatory deliberations actually take place. Such a focus has the singular virtue of eliminating all factors that bear on firm value except those of immediate interest, and it does reveal the undesirable features of cost of capital approaches to regulation as interferences with the goal of replicating the unregulated risk profile for utility stockholders. If those approaches fail of logic even in a convenient environment of the sort depicted, they must also fail in a more complicated one. The attendant commendation of the standard accounting-oriented comparable-earnings regulatory procedure in that environment, it should be noted, has important implications for the direction of regulatory research and for efforts to improve the quality of regulatory testimony. One obvious such implication is the irrelevance of other utility firms’ earnings levels as input data to the determination of allowable rates of return. Because they are regulated, and the peculiarities of past decisions by the regulatory agencies in the various applicable jurisdictions will be reflected in their present operating results, those results are quite useless as guides to correct earnings rates. Only the unregulated sector is a legitimate object of inquiry in this regard. A second implication, however, is as pertinent. We have argued that the price of a utility’s shares should be permitted to fluctuate as it will in the market in the normal unregulated way, so long as internal operating earnings levels are competitively reasonable. In defining reasonable, of course, it is still necessary to consider unregulated companies in similar business-risk situations. And that is the key to the appropriate focus of testimony and evidence in rate proceedings: the determination of comparability should consider internal operating earnings variability. The proper measure of risk is selecting a peer-group set of unregulated companies to use a standard, therefore, is not the systematic security-risk parameter of the capital asset pricing model, but instead a counterpart operating earnings beta [ 51, where the benchmark market index

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might perhaps logically be constructed from the time series of aggregate unregulated-sector corporate profits. In this fashion, the utility’s external share price risk attributes will simply follow automatically as they would for an unregulated enterprise whose underlying earnings links to the broader economy are similar. Indeed, there is a kind of circularity even in contemplating an external security-price risk measure as a vehicle for locating comparable companies, since that parameter in our view should be a result of enlightened regulatory rate of return decisions, not a determinant of them. Some considerable amount of buttoning up remains for purposes of effective implementation of the framework described. One must, for instance, be concerned about regulatory lag-i.e., the appropriate frequency and timing of the monitoring deliberations of the regulatory agency. Clearly, if the intervals between reviews are substantial, opportunities for utility earnings to depart significantly from desired (competitive) levels will exist. To note that any approach to regulation must confront that difficulty and therefore that our proposal is not uniquely disadvantaged in this regard, is, of course, not to solve the problem. There is also the matter of possible differences in the relative quality of unregulated-firm and utility-company stated book earnings in making the appraisals suggested, due to differences in accounting procedures. The virtual absence of product inventories for utilities, in contrast with the typical industrial enterprise, may be particularly bothersome in this regard in times of inflation. A corresponding worry applies to capital-asset book values, in terms both of accounting depreciation conventions and actual economic deterioration in productive capacity; one must wonder whether each dollar’s worth of visible balance sheet fixed assets really means the same thing for a utility as it does for the general run of unregulated corporations, most of whom do manufacture goods rather than provide services. Additionally, even if these measurement issues can be handled, there is the problem that, in attempting to set service prices for the utility, the regulatory authority may thereby impact simultaneously the operating-risk attributes of the firm [2, 71. Thus, depending on the stochastic properties of the demand curve involved, a change in price may affect not only the level but the variability of operating income and cause the utility to move into a new business risk category-for which the target rate of return chosen initially by the regulators may no longer be quite appro-

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for Utility Rate Regulation

priate. Hence, the process may have to contain some iterative aspects in practice. While none of these are trivial matters, they should be manageable-and an understanding of the proper conceptual underpinnings of regulation should improve the prospects for their resolution. Summary From the proposition that competitive investment parity for the stockholders of public utility firms requires an exposure to equity price risks commensurate with those in the unregulated sector-in order for resource allocation decisions not to be distorted as between the two sections-a critique of cost of capital as a basis for establishing allowable utility operating rates of return was developed. Such a procedure was found to interfere with the sensitivity of utility share values to changes in external market conditions, and thereby to be inferior to the traditional regulatory rate of return deliberations which focus on internal accounting returns. Although the latter scheme is by no means free of its own set of difficilties in implementation, the issues are primarily ones of measurement rather than of principle, and these can be attacked systematically in their own terms. To us, that appears a more fruitful line of inquiry for future research in the area of regulation than does a continuing preoccupation with captial cost estimates. Our modest objectives here will have been met if some incentive for contemplating such a redirection has been provided. References 1.

Davis, B., and F. Sparrow, Valuation Models in Regulation, BellJ. Econ. Management Sci. 3 (Autumn, 1972): 544-67.

2.

Elton, E. and M. Gruber, Valuation and the Cost of Capital for Regulated Industries, J. Finance 26 (June, 1971): 661-70.

3.

Fama, E., Efficient Capital Markets: A Review of Theory and Empirical Evidence, J. Finance 25 (May, 1970): 383417.

4.

Gordon, M., Testimony, Federal Communications 16258,1966.

5.

Gordon, M. and P. Halpem, Cost of Capital for a Division of a Firm, J. Finance 14 (September, 1974): 1153-63.

6.

Haley, C. and L. Schall, ?%e Theory York, 1973.

Commission, FCC Docket

of Finnncial Decisions, McGraw-Hill, New

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Jaffe, J. and G. Mandelker, The Value of the Firm Under Regulation, J. Ffnunce 31 (May, 1976): 701-713. Jensen, M. (ed.), Studies in the Theory of Financial Markets, Praeger, New York, 1972. Kim, H., McConnell, J. and Greenwood, P., Capital Structure Rearrangements and Me-First Rules in an Efficient Capital Market, J. Finance 31 (June, 1978): 789810. 10.

Lewellen, W., A Conceptual Re-Appraisal of Cost of Capital, Fin. Management 3 (Winter, 1974): 63-70.

11.

Lewellen, W., Some Extensions (January, 1975): 13-24.

of Capital Structure

Theory, J. Bus. Res. 3

12.

Lewellen, W., The Cost of Capital,Kendall-Hunt,

13.

Lintner. K; The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets, Rev. Eco. Stat. 46 (February, 1965): 13-37.

14.

Mod&liar& F. and M. Miller, The Cost of Capital, Corporation Finance, and the Theory of Investment, Am. Eco. Rev. 48 (June, 1958): 261-97.

15.

Modigliani, F. and M. Miller, Corporate Income Taxes and the Cost of Capital, Am. Eco. Rev. 53 (June, 1963): 433-43.

16.

Myers, S., The Application of Finance Theory to Public Utility Rate Cases, Bell J. Eco. Management Sci. 3 (Spring, 1972): 58-97.

17.

Sharpe, W., Portfolio Theory and Capital Markets, McGraw-Hill, New York, 1970.

18.

Stiglitz, J., A Re-Examination of the Modigliani-Miller Rev. 59 (December, 1969): 784-93.

1976.

Theorem,

Am. Eco.