The Federal Energy Regulatory Commission (FERC) on Nov. 21 approved an order that alters the Commission’s methodology for analyzing the base return on equity, or ROE, component of a jurisdictional public utility’s rates.
In remarks on the order, FERC Chairman Neil Chatterjee said that the new method was technically sound, legally durable, and would provide much needed certainty.
The order applies the revised base ROE methodology to two complaint proceedings involving the base ROEs of Midcontinent Independent System Operator (MISO) transmission owners: the first proceeding is rehearing of Opinion No. 551, in which the Commission applied the base ROE methodology established for New England transmission owners in Opinion No. 531, and the second proceeding is a review of an initial decision by an administrative law judge (Docket Nos. EL14-12-003, EL15-45-000).
In Emera Maine v. FERC, the U.S. Court of Appeals for the D.C. Circuit remanded the Commission’s decision in Opinion No. 531, finding that the Commission had neither properly demonstrated that the existing base ROE in that proceeding was unjust and unreasonable under the first prong of Federal Power Act (FPA) section 206 nor properly justified its selection of a new base ROE under the second prong of section 206.
FERC subsequently issued briefing orders for both these MISO proceedings and separate New England proceedings at issue in Opinion No. 531.
In the briefing order in the MISO proceedings, the Commission proposed changes to its ROE methodology to address the issues that the D.C. Circuit remanded to the Commission in Emera Maine v. FERC and directed the parties to submit briefs addressing those proposed changes.
FERC’s order, which was approved at its Nov. 21 open meeting, addresses those proposed changes in light of the briefs and other evidence in these proceedings.
FERC’s order adopts the changes that were proposed in the briefing order, with certain revisions. Principally, this draft order adopts the use of the discounted cash flow model and capital-asset pricing model (CAPM) to determine utilities’ cost of equity.
However, the order rejected the briefing order’s proposal to also use the expected earnings and the risk premium models in the Commission’s revised ROE methodology.
The order concludes that using the discounted cash flow and CAPM models will make the Commission’s ROE determinations more accurately reflect how investors make their investment decisions, while also avoiding deficiencies in other models.
Zone of reasonableness
The discounted cash flow and CAPM models will be used to establish a composite zone of reasonableness. The zone of reasonableness produced by each model will be given equal weight and averaged to determine the composite zone of reasonableness.
FERC will use that composite zone of reasonableness to evaluate whether an existing base ROE remains just and reasonable under the first prong of FPA section 206 and to establish a new just and reasonable base ROE, under the second prong of FPA section 206, when the existing base ROE has been shown to be unjust and unreasonable.
The order adopts the proposal in the briefing order to use ranges of presumptively just and reasonable ROEs in the Commission’s analysis of existing ROEs under the first prong of FPA section 206.
Specifically, within the composite zone of reasonableness, the revised methodology will establish quartile ranges of presumptively just and reasonable ROEs, FERC said.
If an existing ROE falls within the applicable quartile range based on the risk of the utility or utilities, it is presumed just and reasonable. If it falls outside of the applicable quartile range, it is presumed unjust and unreasonable.
The range of presumptively just and reasonable ROEs for each utility or group of utilities would be based on its risk profile. For example, the range for an average risk group of utilities, like the MISO transmission owners, is the quarter of the zone of reasonableness centered on the midpoint of the zone.
In addition, the order adopts certain other changes to the Commission’s ROE methodology, such as the high-end outlier test that was proposed in the briefing order to screen out comparison group results that should not be relied upon.
The order also adopts a revised low-end outlier test that eliminates from the discounted cash flow and CAPM proxy groups any ROE results that are less than the yields of generic corporate “Baa” bonds plus 20 percent of the CAPM risk premium.
FERC grants one complaint, dismisses a second
In applying the revised base ROE methodology, including the CAPM, to these proceedings, the order granted the complaint in the first proceeding, finding that the MISO transmission owners’ 12.38 percent base ROE is unjust and unreasonable and that a just and reasonable replacement base ROE for the MISO transmission owners is 9.88 percent. The order requires appropriate refunds based on that determination.
It also applies the revised base ROE methodology to the complaint in the second proceeding, which results in dismissing that complaint.
The order finds that, in order to grant relief in the second proceeding, the Commission would need to find the 9.88 percent ROE established in the first proceeding to be unjust and unreasonable. FERC, however, found that the 9.88 percent ROE falls within the range of presumptively just and reasonable ROEs established in the second proceeding, and that the evidence in that proceeding does not rebut this presumption.
Therefore, FERC dismissed the complaint in the second proceeding, declined to order a prospective change to the 9.88 percent ROE and did not require refunds in that proceeding. Commissioner Richard Glick partially dissented on this aspect of FERC’s order.