On June 19, 2014, FERC announced a new methodology to calculate the return on equity (“ROE”) for jurisdictional electric utilities and used that methodology to tentatively set the base ROE at 10.57 percent for the New England Transmission Owners (“NETOs”) operating in the ISO New England Inc. (“ISO-NE”). FERC’s new methodology will incorporate both short-term and long-term measures of growth projections in estimating a company’s cost of equity, thus incorporating the two-step discounted cash flow (“DCF”) methodology FERC uses in setting ROEs for natural gas and oil pipelines.
In 2006, the base ROE for the NETOs was set at 11.14 percent. On September 30, 2011, a group of state utility regulators in the New England area filed a complaint at FERC arguing that, due to changes in capital market conditions since the base ROE was established in 2006, the 11.14 percent base ROE had become unjust and unreasonable. On August 6, 2013, Administrative Law Judge (“ALJ”) Michael J. Cianci issued an Initial Decision, finding that the base ROE of 11.14 percent was unjust and unreasonable, and concluding that two defined time periods would be appropriate when determining a new base ROE. Judge Cianci found that the base ROE for the initial 15 month refund period – beginning one day after the complaint was filed and ending on December 31, 2013 – should be set at 10.6 and the base ROE for the following prospective period should be 9.7 percent. Although Judge Cianci generally accepted the NETOs’ zone of reasonableness, the ALJ used the midpoint of the zones instead of halfway between the midpoint and the high end of the zone of reasonableness, which the NETOs recommended.
In its order, FERC adopted a two-step methodology when calculating the base ROE for jurisdictional public utilities, adding long-term growth rates into its analysis. FERC tentatively applied Gross Domestic Product as a measure of growth in the ISO-NE ROE proceeding while also establishing a paper hearing so participants can present evidence regarding the appropriate long-term growth rate measure. Additionally, FERC eliminated its practice of using U.S. Treasury bond yields to make adjustments to the base ROE after the record in a hearing proceeding has been closed, and instead decided to allow parties to present the most recent financial data available at the time of the hearing. Finally, FERC confirmed that a utility’s total ROE will still be capped at the upper end of the revised zone of reasonableness.
With respect to the ISO-NE ROE proceeding, FERC reversed Judge Cianci’s decision to use the midpoint of the zone of reasonableness (between 7.03 percent and 11.74 percent) and instead elected to use the halfway point between the midpoint of the zone of reasonableness and the top of that zone (between 9.39 percent and 11.74 percent), thus tentatively setting the base ROE for the NETOs at 10.57 percent. FERC based its decision on several reasons, including (1) unusual capital market conditions, (2) the fact that FERC’s midpoint of the zone of reasonableness was lower than the midpoint of alternative methods used to calculate ROEs, (3) the ROEs recently adopted by state public commissions have generally been higher than FERC’s midpoint of the zone of reasonableness, and (4) the unique financial and business risks faced by investors in companies that focus on electric transmission infrastructure.
Acting Chairman LaFleur stated that the base ROE set for the NETOs “should set a level sufficient to attract investment in interstate electric transmission” and hopefully provides guidance for related ROE complaint proceedings currently pending at FERC. Meanwhile, Commissioner John Norris issued a separate opinion, dissenting in part from FERC’s order. In his partial dissent, Commissioner Norris stated that while he generally thought that the base ROE for the NETOs needed an upward adjustment from the central tendency, FERC’s decision to set the ROE at the midpoint of the upper half of the zone of reasonableness is unjustified and sets troubling precedent, subjecting “consumers to unjust and unreasonable rates in [the ISO-NE ROE] proceeding and potentially in future ROE proceedings.”
A copy of the order is available here.