presentation - State of Iowa

Report
Mark R. Schuling
Office of Consumer Advocate
Iowa Utilities Board
Hearing Room
9:00 – 11:00 a.m.
November 27, 2012
“If rates produce earnings that are below a fair
and reasonable level, they are unjust or
confiscatory to the owners of the utility
property and if rates produce earnings that are
above a fair and reasonable level, the rates are
oppressive to the utility's ratepayers. It is
essential to achieve an equitable balance
between investor and consumer interests.
“Davenport Water Co. v. Iowa State Commerce Comm'n,
190 N.W.2d 583, 604-05 (Iowa 1971).
2
For a utility whose stock is publicly traded, the task is
straightforward. You review the capital structure of the
utility company and determine the weighted average cost
of capital.
Long-term Debt
Preferred Stock
Common Equity
Amount
$4,000,000
$1,000,000
$5,000,000
TOTAL $10,000,000
Ratio
40.00%
10.00%
50.00%
Rate
6.0%
8.0%
10.0%
Cost
2.4%
0.8%
5.0%
100.00%
Weighted Average Cost of Capital 8.2%
3
Double leverage is often necessary when a holding company
exists because the holding company’s common equity
investment in the subsidiary is leveraged twice, once with the
holding company debt and a second time with subsidiary debt.
For example, if the holding company only has common equity in
its capital structure it must earn a 10% return from the
investment in the subsidiary in order to provide the appropriate
return on its common equity to its shareholders.
HOLDING COMPANY COMPANY
Common Equity
TOTAL
Amount
Ratio
Rate
Cost
$10,000,000
100.00%
10.0%
10.0%
$10,000,000
100.00%
Cost of Capital 10%
4
Because debt is usually less expensive than equity, a well-run
company uses leverage in an attempt to arrive at a combination
of debt and equity in its capital structure that results in the
lowest overall cost of capital. For example, when the holding
company invests in a subsidiary it uses equity and debt for its
capital investment. Since a portion of the capital invested by the
holding company requires less than a 10% return, a fair and
reasonable return should be less than the highest cost of
capital. An example of the true capital costs are shown below:
HOLDING COMPANY COMPANY
Amount
$4,000,000
Long-term Debt
$1,000,000
Preferred Stock
$5,000,000
Common Equity
TOTAL $10,000,000
Ratio
40.00%
10.00%
50.00%
Rate
6.0%
8.0%
10.0%
Cost
2.4%
0.8%
5.0%
100.00%
Weighted Average Cost of Capital 8.2%
5
“The Commission, on the other hand, maintains the
requirements of equal protection necessitate a double
leverage adjustment when a holding company is involved in
order to insure that utilities not so held are treated equally
with respect to a rate of return determination.
The Commission's position is well founded and is dispositive
of the Company's contention. The existence of a holding
company relationship, as here, produces a situation where
the subsidiary's capital structure is not truly reflective of the
actual debt-equity ratio therein. A double leverage
adjustment is an attempt to more accurately present the
capital structure of the subsidiary utility and, consequently,
an attempt to insure a fair rate of return determination.
“United Telephone Co. of Iowa v. Iowa State Commerce Comm’n,
257 N.W.2d 466, 479-80, 482 (Iowa 1977).
6
“[L]everage is the term used to describe “the advantage gained by
junior interests through the rental of capital at a rate lower than
the rate of return which they receive in the use of that borrowed
capital.” (citations omitted) By leveraging their investment with
debt, stockholders may effectively “own” a corporation which is
worth more than their original investment. (citations omitted)
“Thus, we see that by use of leverage [it becomes possible for]
the equity owners . . . to earn an over all rate of return in excess of
the cost of capital. The added earnings above the costs inure to
the benefit of stockholders as they then receive a higher rate of
return than if the institution had been financed entirely by equity.”
(citations omitted) Regulatory bodies prevent such an excess
earnings by analyzing a utility’s capital structure and allocating a
different weighted cost to each of the individual elements of the
capital structure, including debt so that the utility owners are
allowed to earn on the debt only what it costs them to secure the
leverage. (citations omitted) This is proper since a properly
regulated utility should be allowed to recover only its true costs.”
General Tel. Co. of the Southwest v. New Mexico Corp. Comm’n,
652 P.2d 1200,1205 (NM 1982).
7
This was recognized by the Tennessee Public Service
Commission:
[T]o ignore the effect of double leverage “could result in the parent’s
shareholders earning more on their investment in the company than
the market cost of equity.” The utility’s ambition to realize this
windfall for its stockholders explains in part the heated atmosphere
of the double leverage debate. As one economist noted, “We should
not be too surprised at the vigor of their (the utilities’) opposition
since they have a definite pecuniary interest in preserving the
comparative advantage this form of corporate arrangement has over
ordinary corporate arrangements. Presuming that regulatory
authorities ignore the effect of double leverage in determining the
rate of return to be allowed the subsidiaries of utility holding
companies, the holding companies can, have, and will no doubt
continue to earn millions of dollars of income in excess of their cost of
capital. Their opposition to regulatory recognition of the effect of
double leverage should therefore be taken for what it is worth.”
General Tel. Co. of the Southeast, Docket No. U-83-7247, 60 PUR4th 469, 472
(Tenn. PSC, Feb. 21, 1984) (emphasis in original, citing Basil Copeland,
“Double Leverage One More Time” 100 Public Utilities Fortnightly 19, Aug. 18,
1977).
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