Regulated Inequity : How Regulators’ Acceptance of Flawed Financial Analysis Inflates the Profit of Public Utility Companies in the United States

A critical aspect of public utility regulation is the determination of the allowed return on equity (“ROE”) incorporated in rates which is intended to match the utility’s cost of equity required to finance its assets. This is one of the more contentious parts of ratemaking as the cost of equity cannot be directly observed and is therefore estimated using financial models. The methodology The Federal Energy Regulatory Commission (“FERC”) uses to determine the ROE is subject to interpretation and has evolved over time. The most recent iteration which established FERC’s techniques for determining the just and reasonable ROE came from Opinion 569-A, issued in May 2020, which found the just and reasonable ROE for the Transmission Owners of the Midcontinent Independent System Operator (“MISO TOs”) to be 10.02%. The outcome resulted from the application of three financial models used to determine the cost of equity: the Risk Premium methodology, the Discounted Cash Flow (“DCF”) model, and the Capital Asset Pricing Model (“CAPM”).The purpose of this paper is to demonstrate that the methodology employed by FERC in Opinion 569 to award the MISO TOs’ ROE was biased upwards with the effect of favoring the financial interests of utility shareholders at the expense of ratepayers. The Risk Premium methodology is transparently circular as its result is tautologically dependent on past Commission rulings and can be summarily dismissed. The DCF analysis, although less self-fulfilling than the Risk Premium model, remains significantly biased in that its inputs are inextricably linked to regulatory outcomes. The CAPM is the only approach which can claim to reasonably avoid the circularity issue, although FERC misspecified the model which resulted in it affirming, and even exceeding, the estimates from the self-fulfilling methodologies. Unfortunately, mostly nothing about Opinion 569 could be considered aberrant in the context of utility ratemaking in the United States, whether be it for electric, gas, or water utilities. It is in fact an apt case-study which encompasses the prevailing methodologies used, in one form or another, by utility commissions throughout the nation to determine the ROE. As such, examination of the fallacies behind Opinion 569 reveals in general how regulators’ acceptance of flawed financial analysis inflates the profit of public utilities