Excess Returns for LDCs: Principles, Evidence, and Remedies

Steven G. Kihm

inancial analysis reveals that rate-of- F return regulation has allowed natural gas distribution utilities to systematically earn re- turns in excess of their costs of capital. These excess returns represent an inefficiency of regu- lation, or what economists refer to as regulatory failure. If we are interested in achieving true economic efficiency, then actions should be taken to eliminate these excess returns.

Theory: Market Value Should Equal Book Value

Determining a fair rate of return for public utilities requires an understanding of legal and financial principles. There is a rich history of legal precedents in this area dating back to the turn of the century.’ Suffice it to say that the courts have called for a balancing of ratepayer and investor interests when determining the fair rate of return for a utility.

This paper focuses on the financial concepts of rate-of-return regulation. Financial principles indicate that the utility’s cost of capital is the efficient rate of return. That is, setting the rate of return equal to the cost of capital fully compen- sates investors without being excessive. The pub- lic utility finance literature embraces the concept of the cost of capital as the efficient return: “The regulator should set the allowed rate of return equal to the cost of capital so that the utility can achieve the optimal rate of investment at the minimum price to the ratepayers.”2

Steven G. Kihm, CFA, is a senior financialand pricing analyst in the Natural Gas Division of the Public Service Commission of Wisconsin. The views ex- pressed here are those of the author and not neces- sarily those of the Public Service Commission of Wisconsin.

Thus while many returns will provide incen- tive for investment into utility firms, there is no need to allow returns greater than the cost of capital to attract investors. As in any efficiency analysis, consumers should never be required to pay more than the minimum amount necessary to sustain the industry providing service to them.

Financial principles provide a very straight- forward way of determining whether a firm tends to earn returns equal to its cost of capital. If a firm is expected to just earn its cost of capital, the firm’s stock price will equal its book value.3 Put another way, when a firm just earns its cost of capital, the ratio of the firm’s market value to its book value should equal 1 (Exhibit 1).

. . . courts have called for a balancing of ratepayer and

investor interests when determining the fair rate . - .

The goal of parity between market value and book value is simply another way of saying that the allowed return should equal the utility’s cost of capital.* This fact is not particularly well- understood. If we truly believe in the principle that gas utility rates of return should equal the utilities’ costs of capital, then we should see gas distribution utility market-to-book ratios near 1, on average. We do not.

Evidence Market-to-book ratios for natural gas distri-

bution stocks today are clearly above 1. The 95- percent confidence interval around the mean market-to-book ratio for the Value Line gas distribution utilities is 1.43 to 1.64, and the

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median market-to-book ratio for these utilities is 1.56.5 These statistics leave little doubt about the current situation: Excess return expectations are clearly being impounded in gas distribution utility stock prices.

The analysis of utility market-to-book ratios over time produces results consis- tent with those presented above. Market- to-book ratios were analyzed for Moody’s gas distribution stock index over the pe- riod from 1957 through 1993. The 95- percent confidence interval around the mean market-to-book ratio for gas distri- bution utilities over this period is 1.28 to 1.62, and the median market-to-book ratio is 1.36.6 Again we have confirmation of excess returns, this time reaching back to the 1950s (Exhibit 2).

By allowing utilities to earn excess returns, regulation has certainly met the investors’ requirements, but in so doing it has violated the courts’ mandates as to the need to protect consumer interests. And not only is allowing gas distribution utilities to systematically earn excess returns unfair to consumers, as men- tioned earlier it represents a pure effi-

I Exhibit 1. Market-to-Book Ratios and Rates of Return

Lessthan1

Equal to 1

Regulators will allow the utility to eam, on average, rates of return that are LESS than itscostofcapital.

Regulators will allow the utilii to earn, on average, rates of return that are EQUAL to itscostofcapital.

More than 1 Regulators will allow the utility to earn, on average, rates of return that are GREATER than its cost of capital.

I Exhibit 2. Market-to-Book Ratios for Natural Gas Distribution Utilities

ciency loss to society.’ That is, when utilities systematically earn excess returns, we all pay more than we should for natural gas service. If we believe that economic efficiency is a proper objective to be pursued, then the inefficient excess returns should be purged from gas distribution utility income statements.

Some utility financial experts have argued that utilities should not be held to an efficiency standard requiring parity between market and book values when firms in nonregulated indus- tries are not held to the same standard. While it is true that market-to-book ratios for stocks in general are currently well above 1 and have been so for some time, that does not mean that utility stocks should also be allowed to exhibit such high market-to-book ratios. The high mar- ket-to-book ratios for firms in general merely manifest the imperfect nature of competition in most U.S. markets. Rather than exhibiting the desired performance expected under effective competition where earned returns are driven down to the cost of capital, imperfect competi- tion in actual markets allows some firms to earn excess returns indefinitely.8 For example, large,

Current (August 1995) 1.43 to 1.64 YES Long-Term (1 957-1 993) 1.28 to 1.62 YES

low-risk firms such as Coca-Cola and Merck regularly earn book returns well in excess of 30 percent. Because their earned returns are so much greater than their costs of capital, firms such as these sport market values many times greater than their book values.

Nonetheless, if the kind of economic effi- ciency expected under effective competition is to be a goal of regulation, then we should not set a mediocre standard based on the results of imperfect competition. The inability of market forces to drive many firms’ earned returns down to their costs of capital is simply evidence of market Failure. It does not justify allowing utility investors to earn excess returns. Investors in any industry are Fairly and ful!y compensated when the firm earns its cost of capital. Any amount above the cost of capital represents a pure efficiency loss to society and a windfall gain to investors at consumers’ expense. The market- to-book ratios of gas distribution stocks provide clear evidence of excess returns in that industry. The fact that excess returns are earned in other industries is irrelevant from an economic effi- ciency standpoint.

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Remedies Just as a poorly running car engine can be

tuned up to improve its efficiency, rate-of-return regulation can be tuned up to reduce the likelihood of excess rates of returns. To do so requires a return to financial principles in deter- mining appropriate allowed rates of return.

There are four important principles that should be kept in mind when setting rates of return: (1) allowed returns should reflect only risks that cannot be diversified away by inves- tors; (2) allowed returns should reflect only the relevant risks to investors, not risks to utility managers; (3) allowed returns should reflect dynamic changes in the risk-return relationship between stocks and bonds; and (4) allowed returns should be based on unbiased informa- tion. Strict adherence to these principles when setting rates of return will reduce the tendency for gas utilities to earn excess returns over time.

Diversifiable Versus Nondiversifiable Risk

The first two areas that need to be addressed focus on relevant risks. In many rate cases, utilities present arguments that they are more risky than a typical gas utility because of risks specific to their companies. Because of their higher company-specific risk, they argue, their investors demand higher returns. However, this basic argument is not consistent with financial principles.

- - - the only risks that investors are concerned

with are risks that cannot be diversified away.

Not all risks require investor compensation. Modern portfolio theory tells us that the only risks that investors are concerned with are risks that cannot be diversified away. Risks that are company-specific are generally diversifiable. In its primer on corporate finance, the Harvard Business Review notes, “[Ilnvestors can elimi- nate company-specific risk by simply properly diversifying portfolios.”9

This is a powerful conclusion. To show that one utility is more risky to investors than other utilities, one would not focus on specific risk factors affecting the company. As discussed

below, only the relative sensitivity of the firm to nondiversifiable macroeconomic risk factors is relevant in determining the utility’s cost of capital.

Until recently, many finance theorists be- lieved that all nondiversifiable risks could be captured in one risk measure (i.e., the beta coefficient of the capital asset pricing model (CAPM)). But after comparing decades of ex- pected and actual stock returns, many financial theorists now suggest that beta does not fully capture risks relevant to investors. Other factors appear to be important as well.

The consensus of financial researchers to- day is that a few parameters are needed to measure the nondiversifiable risk of any firm. These risks include sensitivity to unexpected changes in (1) interest rates, (2) inflation rates, and (3) U.S. industrial production.” Because these macro-type risks affect all firms to one degree or another, holding a large number of stocks does not reduce the exposure to these risks. On the other hand, firm-specific risks are unrelated from firm to firm and can therefore be canceled out by simply holding a large number of securities.

As an aside, it is important to note that the attack on the CAPM is not an attack on the foundations of modern portfolio theory. The problems with the CAPM have not led financial researchers to abandon the concept of diversifi- able and nondiversifiable risk. Analysis of actual investment results reveals that there is still no evidence that well-informed investors demand compensation for diversifiable risks.”

Managerial Versus Investor Risk A concept that is closely related to the

investors’ diversifiable and nondiversifiable risks is the important distinction between the risk profiles of utility managers versus those of utility investors. Unlike utility investors, who care only about nondiversifiable risk, utility manag- ers feel the impact of both diversifiable and nondiversifiable risk factors. The reason: Utility managers cannot diversify away any risks of their firm.

This is simply a reflection of the degree of the managers’ “investment” in the firm. Not only do many managers have a relatively high pro- portion of their wealth tied to their firm in the form of items such as stock options or employee stock ownership plans, but also all managers’

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income is directly tied to the firm. It is this income link that cannot be addressed via diver- sification. An example may help to illustrate this situation. Say that a pipeline is built near an industrial park served by a local gas distribution company. All of the industrial customers located there are now considering bypassing the utility. Is this a risk to investors? No. This is the type of firm-specific random event that is easily diver- sified away by other random events affecting other companies in the investor’s portfolio. Although not necessary to achieve diversifica- tion, the well-diversified investor might even own shares of the very pipeline company in- volved in the bypass. Because gains to one business at the expense of another are either directly or indirectly diversified away by hold- ing a large number of stocks, the risk of pipeline bypass is a nonevent to the truly well-diversified investor.

The same cannot be said as to the utility manager’s perception of this situation. The utility manager faces a real risk if the pipeline “steals” all the industrial customers. First of all, the size of the utility (in terms of revenues) could shrink dramatically. In many industries, and especially in the utility industry, managerial pay is more a function of company size than of financial performance.’* A utility’s size therefore reduces the potential for income gains through higher salaries. In the worst case, the utility manager could lose his or her entire income stream if his or her job were eliminated. Corpo- rate downsizing and reengineering in the face of shrinking sales volumes is a distinct possibility.

Are regulators responsible for compensat- ing utility managers for risks that are diversifiable to investors? Yes and no. Yes, regulators are responsible for seeing that utility managers’ salaries are sufficient to attract capable people willing to face the risks of running a utility. And no, the compensation for managerial risk should not be included in the allowed return. This makes sense. If managers face more risks than investors, why compensate investors via the rate of return for the managers’ increased risk? The managers are already compensated for risk-taking in their employment package. If they are not, that is a matter between the managers and the board of directors. It does directly involve the investors.

Compensation via the rate of return for risks diversifiable by investors, but not by managers,

is therefore doubly inefficient. First, investors do not require such compensation in order to be willing to invest in the utility. Second, the reward for the risk-taking goes to the wrong party (i.e., the investors, not the managers). Keeping this fact in mind will help to avoid compensating investors for risks that are not relevant to them.

Dynamic Reducfion in Risk Premiums The third area that deserves attention is

proper estimation of risk premiums. Marginal cost components of allowed returns, such as the cost of common equity, are often pegged to current bond yields. This makes financial sense because bond yields act as a floor below which equity returns would generally not be expected to fall. However, the important fact to notice when using this approach is that bonds have clearly increased in risk relative to stocks in recent decades.

- . . utility manager faces a real risk if the

pipeline “steals” all the industrial customers.

The reason for this relative risk shift is simple. In earlier times, inflation and interest rates were low and stable. In this environment, the principal value of a bond held up reasonably well and bonds were a relatively safe investment compared to stocks. But all that changed with the high-inflation, high-interest-rate environ- ment of the 1970s and early 1980s. Real bond principal was devoured over this period and the true risk of bonds became quite apparent to investors. Investors now demand sizable infla- tion premiums in pricing bonds in order to protect their principal. Thus while bond yields were near the inflation rate in the 1950s and 1 9 6 0 ~ ~ today corporate bond yields are about 500 basis points over the inflation rate. Stocks were affected to some extent by the financial environment of the 1970s and early 1980s, but the impact on stocks was much less than that observed in the bond market and, therefore, the risk premium between stocks and bonds has narrowed significantly. Financial research indi- cates that the risk premium of expected stock returns over bond yields has fallen from be-

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tween 6 and 8 percent prior to 1970 to as low as 2 to 3 percent today.13

With the current yield on long-term treasur- ies at about 7 percent, these results suggest that the average-risk stock today would sport a required return of only 9 to 10 percent. One could argue that the required return on gas distribution utility stocks, which tend to be less sensitive to nondiversifiable macroeconomic Summary shifts than are industrial firms, is even lower. Failure to reflect some amount of decline in the risk premium in setting allowed returns over- states the cost of capital and contributes to the

this tendency for analysts to overestimate firms’ growth potential into consideration when valu- ing securities. The same advice holds in setting allowed returns. If stock analyst forecasts are used as an input for the DCF model, the forecasts should be adjusted downward to cor- rect for the analyst bias.

Analysis of current and long-term market- to-book ratios reveals that rates of return for gas distribution utilities tend to exceed the utilities’ costs of capital. Strict adherence to financial

excess return problem.

Bias in Stock Analysts’ Forecasts The final area that requires scrutiny involves

the use of stock analysts’ forecasts in determin- ing the fair rate of return. Many commissions rely heavily on analysts’ forecasts in estimating the expected dividend growth of a utility. The expected growth rate is a critical input to the discounted cash flow (DCF) model and it bears directly on the estimated required return.

principles when setting allowed rates of return would produce results more in keeping with legal and financial principles.

Notes 1. Phillips, “The Regulation of Public Utilities,” Public

Utilities Reports (1984).

2. Roger A. Morin, “Regulatory Finance: Utilities’ Cost of Capital,” Public Utilities Reports (1994) (emphasis added).

3. Financial Analysts Journal (July-August 19941.

4. Kolbe, Read, and Hall, The Cost of Capital: Estimating the Rate ofReturn forpublic Utilities (MIT Press, 1984).

. . . dividend growth is also

leads to overstated

5 . Value Line Investment Survey, Value Screen (August overstated, which in turn 1995).

6. Moody’s Investors Service, Public UtilityManual(l994).

7. Schmalansee, The Control of Natural Monopolies (D.C. Heath and Company, 1979).

required rates of return.

8. Scherer and Ross, Industrial Market Structure and EconomicPerformance(Houehton Mifflin Co.. 3rd ed.. Interestingly enough, however, most stock

. Y

analysts do not forecast dividends per share 1990). directly.’* Rather, they forecast earnings per share. Because earnings per share and divi- dends per share tend to move in concert over time, many rate-of-return analysts substitute the analysts’ forecasted earnings growth for the forecasted dividend growth. Therein lies the problem. There is substantial evidence that stock analysts’ forecasts of earnings growth consistently overestimate actual earnings growth. This erroneous procedure means that dividend growth is also overstated, which in turn leads to overstated required rates of return.

A 1994 study in the mainstream finance literature reports that stock analysts’ forecasts overestimated true earnings in the 1982 to 1992 period by as much as 57 percent.I5 This and other finance literature caution investors to take

9. David W. Mullins, Jr., “Does the Capital Asset Pricing Model Work?” Corporate Finance and the Capital Markets 93 (Harvard Business Review, 1991) (empha- sis added).

10. Haugen, Modern Investment Theory (Prentice-Hall, 1986).

11. Stewart C. Myers, “Risk and Return in R&D Intensive Industries,” Randall S. Billingsley, editor, Corporate Financial Decision Making and Equity Analysis, (As- sociation for Investment Management and Research, 1995).

12. Public Utilities Fortnightly 19 (February 15, 19921.

13..loumalofApplied CorporateFinance 69 (Spring 1995).

14. Murphy, Stock Market Probabili[y 89 (Probus Publish-

15. Financial AnaIysts Journal 66 (September-October

ing, 1994).

1994).

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