Discussion
of Issues
Issue 1:
What is the appropriate range of returns on common
equity for water and wastewater utilities pursuant to Section 367.081(4)(f),
Florida Statutes?
Recommendation:
The appropriate range of returns on common equity is
8.58 percent at 100 percent equity to 10.25 percent at 40 percent equity. This
range was determined using the leverage formula methodology approved by Order
No. PSC-2018-0327-PAA-WS applied to a proxy group comprised of natural gas and
water and wastewater utilities using the most recent financial data.
Accordingly, the following leverage formula should be used until this matter is
addressed again in 2027:
Return on Common Equity = 7.46% + (1.115 ÷ Equity Ratio)
Where:
Equity Ratio = Common Equity ÷ (Common Equity + Preferred Equity + Long-Term
Debt + Short-Term Debt)
Range of
Returns: 8.58% at 100% equity to 10.25% at 40% equity
The equity ratio should be calculated using the averaging
methods pursuant to Rule 25-30.433(5), Florida Administrative Code (F.A.C). Additionally,
the Commission should cap returns on common equity at 10.25 percent for all WAW
utilities with equity ratios less than 40 percent, which serves to discourage
imprudent financial risk. (McGowan)
Staff Analysis:
Section 367.081(4)(f), F.S., authorizes the
Commission to establish, not less than once each year, a leverage formula to
calculate a reasonable range of returns on common equity for WAW utilities. For
administrative efficiency, the leverage formula is used to determine the
appropriate ROE for an average Florida WAW utility. However, use of the
leverage formula by the utilities is discretionary. A utility may file its own cost
of equity analysis and testimony in lieu of using the leverage formula. If one
or more parties in a rate case or limited proceeding file testimony in lieu of
using the leverage formula, the Commission will determine the ROE based on the
evidentiary record in that proceeding.
Methodology
In the instant docket, staff updated the current leverage
formula using the most recent financial data applied to the methodology
approved by Order No. PSC-2001-2514-FOF-WS, reaffirmed by Order No.
PSC-2008-0846-FOF-WS, and modified by the 2018 Order. The methodology uses ROEs
derived from widely accepted financial models applied to a proxy group of
natural gas and WAW companies that have actively traded stock and forecasted
financial data. To establish the proxy group, staff selected six natural gas companies
and six WAW companies that: (1) are followed by Value Line, (2) pay a dividend,
(3) derive at least 50 percent of their total revenue from regulated operations,
and (4) have an investment grade Standard & Poor’s (S&P) credit rating.
The selected proxy group companies have market power, are influenced
significantly by economic regulation, and have an average S&P bond rating
of “A-.”
Consistent with the approved methodology, staff used a
market-capitalization-weighted average for: (1) the Discounted Cash Flow (DCF)
model results, (2) the Beta values in the Capital Asset Pricing Model (CAPM),
and (3) the equity ratio of the proxy group.
Assumed Cost of Debt
Staff used a projected yield on corporate Baa bonds to
estimate the bond yield of an average Florida WAW utility in the calculation of
the weighted average cost of capital of the proxy group. A projected yield is
used because required returns are forward-looking and based on projections.
Consistent with the methodology approved by the 2018 Order,
staff used the average of the projected corporate Baa-rated bond yield of 6.350
percent for the upcoming four quarters as published in the May 1, 2026, Blue Chip Financial Forecasts (Blue
Chip). Staff then added the 120-month historical average spread of 0.115
percent between the Baa and A Corporate Utility Bond yields to the projected corporate
Baa-rated bond yield of 6.350 percent to estimate a projected Baa3-rated utility
bond yield of 6.46 percent.
Staff added a 50-basis-point adjustment for small-company
risk and a 50-basis-point adjustment for a private placement premium to the
projected Baa3-rated utility bond yield of 6.46 percent to reflect the risk for
a typical Florida WAW utility. Consistent with the methodology approved by the
2018 Order, these adjustments resulted in a projected assumed debt cost rate of
7.46 percent.
6.350% + 0.115% +
0.50% + 0.50% = 7.46%
Estimated Cost of Equity
The current leverage formula relies on two ROE models
described below. Staff adjusted the results of these models to reflect
differences in risk and debt cost between the proxy group and the average
Florida WAW utility. Both ROE models include an adjustment of approximately
four percent for flotation costs. The ROE models are as follows:
1)
A multi-stage DCF model applied to an index of natural
gas and WAW utilities that have publicly traded stock and are followed by Value
Line. This DCF model is annually compounded and uses prospective dividend
growth rates published by Value Line.
2)
A CAPM that relies on a market return for companies
followed by Value Line, the average projected yield on 30-Year U.S. Treasury
bonds as of May 1, 2026, as published by Blue Chip, and the weighted average
beta for the index of natural gas and WAW utilities. The market return for the
CAPM was calculated using a quarterly DCF model with stock prices as of May 4,
2026. Consistent with the Commission’s approved methodology since 2001, the
CAPM result was adjusted upward by 20 basis points to reflect flotation costs.
Consistent with the 2018 Order, staff averaged the results
of the DCF and CAPM models and adjusted the result of 8.45 percent as follows:
1)
A bond yield differential of 34 basis points was added
to reflect the difference in yields between an A-/A3 rated bond, which is the
median bond rating for the combined utility index, and a BBB-/Baa3 rated bond.
Florida WAW utilities are assumed to be comparable to companies with the lowest
investment grade bond rating, Baa3. This adjustment compensates for the
difference between the credit quality of “A-” rated debt and the assumed lower
credit quality of a typical Florida WAW utility.
2)
A private placement premium of 50 basis points is added
to reflect the difference in yields on publicly traded debt and privately
placed debt, which is illiquid. Investors require a premium for the lack of
liquidity associated with privately placed debt.
3)
A small-utility risk premium of 50 basis points is
added because the average Florida WAW utility is too small to qualify for
privately placed debt, and investors consider smaller companies to be riskier
than larger companies.
After the above adjustments, the resulting cost of equity
estimate of 9.79 percent is included in the weighted average capital structure
of the proxy group to derive the leverage formula. The derivation resulted in
an adjustment of 46 basis points to reflect an estimated required return of
10.25 percent at an equity ratio of 40 percent. Table 1-1 shows the components
that comprise the upper range of the leverage formula.
Table 1-1
Adjusted Return on Equity
|
DCF Model
|
7.43%
|
|
CAPM
|
9.47%
|
|
Average
|
8.45%
|
|
Bond Yield Differential
|
0.34%
|
|
Private Placement Premium
|
0.50%
|
|
Small-Utility Risk Premium
|
0.50%
|
|
Adjusted ROE Average
|
9.79%
|
|
Adjustment to Reflect Required
Equity Return at 40% Equity Ratio
|
0.46%
|
|
Upper Range of ROE
|
10.25%
|
Source: Staff
Worksheets.
Leverage Formula
Using the most recent financial data in the leverage
formula increases the lower end of the current allowed ROE range by 7 basis
points and decreases the upper end of the range by 26 basis points. Overall,
the spread between the ROE range based on the updated leverage formula is 167
basis points (8.58 percent to 10.25 percent). In comparison, the ROE range for
the 2025 leverage formula is 200 basis points (8.51 percent to 10.51 percent).
The change in the range from 2025 is due to a decrease of 15 basis points in
the average result of the ROE models (8.60 percent to 8.45 percent), a decrease
of 2 basis points in the bond differential (36 basis points to 34 basis
points), and a decrease of 10 basis points in the adjustment reflecting the
required return at a 40 percent equity ratio (56 basis points to 46 basis
points).
The leverage formula depends on four basic assumptions:
1)
Business risk is similar for all WAW utilities;
2)
The cost of equity is an exponential function of the
equity ratio but a linear function of the debt to equity ratio over the
relevant range;
3)
The marginal weighted average cost of investor capital
is constant over the equity ratio range of 40 percent to 100 percent; and
4)
The debt cost rate at an assumed Moody’s Baa3 bond
rating, plus a 50-basis-point private placement premium and a 50-basis-point
small-utility risk premium, represents the average marginal cost of debt to an
average Florida WAW utility over an equity ratio range of 40 percent to 100 percent.
For these reasons, the leverage formula is assumed to be
appropriate for the average Florida WAW utility.
Based on the aforementioned, staff believes the leverage
formula methodology approved by the 2018 Order applied to a proxy group of
natural gas and WAW utilities with updated financial data based on
market-capitalization-weighted averages, produces a reasonable range of ROEs
for WAW utilities and reflects current financial conditions. As such, staff
recommends that the following leverage formula be used until a new leverage
formula is determined in 2027:
Return on Common Equity = 7.46% + (1.115 ÷ Equity Ratio)
Where: Equity
Ratio = Common Equity ÷ (Common Equity + Preferred Equity + Long-Term Debt +
Short-Term Debt)
Range of
Returns: 8.58% at 100% equity to 10.25% at 40% equity
The equity ratio should be calculated using the averaging
methods pursuant to Rule 25-30.433(5), F.A.C. Additionally, the Commission should
cap returns on common equity at 10.25 percent for all WAW utilities with equity
ratios less than 40 percent, which serves to discourage imprudent financial
risk and is consistent with the methodology approved by the 2018 Order.
Issue 2:
Should this docket be closed?
Recommendation:
No. Upon expiration of the protest period, if a
timely protest is not received from a substantially affected person, the
decision should become final and effective upon the issuance of a Consummating
Order. However, this docket should remain open to allow staff to monitor
changes in capital market conditions and to readdress the reasonableness of the
leverage formula as conditions warrant. (Bloom)
Staff Analysis:
Upon expiration of the protest period, if a timely
protest is not received from a substantially affected person, the decision
should become final and effective upon the issuance of a Consummating Order.
However, this docket should remain open to allow staff to monitor changes in
capital market conditions and to readdress the reasonableness of the leverage
formula as conditions warrant.
