Return on Equity
In this decision, the AUC approved a return on equity (“ROE”) of 8.5 per cent and a deemed equity ratio of 37 per cent (39 per cent for Apex Utilities Inc.) (collectively “Parameters”) for 2023 on a final basis. The Parameters apply to the following utilities:
AltaLink Management Ltd.(”AML”);
Apex Utilities Inc. (“AUI”);
ATCO Electric Ltd. (“AE”);
ATCO Gas & Pipelines Ltd. (“AGP”);
ENMAX Power Corporation (“ENMAX”);
EPCOR Distribution & Transmission Inc. (“EDT”);
FortisAlberta Inc. (“Fortis”);
City of Lethbridge;
The City of Red Deer; and
The Parameters do not apply to EPCOR Energy Alberta GP Inc. or ENMAX Energy Corporation because they are regulated under the Electric Utilities Act (“EUA”) and the Regulated Rate Option Regulation. Similarly, the Parameters do not apply to Direct Energy Regulated Services as default service provider under the Gas Utilities Act (“GUA”) and the Default Gas Supply Regulation.
Background and Procedural Summary
Under the Public Utilities Act (“PUA”), the GUA, and the EUA, the AUC is required to set a fair return for utilities to set just and reasonable rates for customers. The Parameters are the components of a fair return determined in a generic cost of capital (“GCOC”) proceeding. While each of these statutes provides matters for the AUC to consider, there is no given method for determining a fair return.
The AUC held that determining just and reasonable rates requires the AUC to balance the interests of both the utility and its customers. Rates must provide the utility a reasonable opportunity to earn a fair return on invested capital while also ensuring that customers are not paying more than is required to maintain safe, reliable, and economic service. The AUC noted that, in applying its judgment, the AUC often assesses conflicting evidence on risk, including the differing interests and perspectives of debt and equity investors.
The AUC considered three factors when setting a fair return: comparable investments, capital attraction, and financial integrity. The AUC held these factors to be well-established and was satisfied that the fair return standard is met when the return satisfies these three factors while also understanding that a fair return is one component of the AUC’s determination of just and reasonable rates. The AUC noted that another component of just and reasonable rates is a reasonable opportunity to recover costs and expenses, including capital costs, operating costs, taxes, and depreciation. In January 2022, the AUC initiated the 2023 GCOC proceeding. It issued a letter notifying interested parties that it would be bifurcating this proceeding The first stage, decided in this decision, established the parameters for 2023. The second stage will focus on 2024 and future years.
2023 Parameters and Completion of Current GCOC Proceeding
The AUC noted its recognition of the continuing uncertainty and volatility of financial markets due to the COVID-19 pandemic. In response, the AUC indicated that it was prepared to extend the cost of capital parameters previously approved for 2022 for one year.
Key Economic and Market Submissions
The AUC noted that it generally considers a number of key economic indicators and financial market conditions in determining a just and reasonable ROE and deemed equity ratios. Indicators include the interest rate environment, credit spreads, market volatility, and some other indicators that serve as inputs to and guide the outcome of the capital asset pricing model (“CAPM”). The AUC found that market volatility and inflationary pressures, especially regarding food and energy prices, have been amplified by the geopolitical risks, uncertainty, and global economic ramifications triggered by Russia’s recent invasion of Ukraine. The AUC held that the evidence before it showed upward pressure associated with inflation and interest rates. Other indicators such as credit spreads and the market equity risk premium (“MERP”) remained largely stable. However, market volatility remains elevated, making it difficult to forecast relevant economic conditions for 2023.
(a) Inflation, Interest Rate Increase and Credit Spreads
The utilities argued that the expected future path of the policy interest rate should place upward pressure on authorized ROEs and other rates of return in the capital markets. The AUC found that the utilities’ preparedness to accept the current ROE of 8.5 per cent, combined with the ongoing and pervasive uncertainty regarding the timing and extent of future changes in inflation and interest rates, support a continuation of the current GCOC parameters into 2023.
(b) Market Equity Risk Premium
The AUC quoted the following description of MERP with approval: Like the cost of capital itself, the market equity risk premium is a forward-looking concept. It is by definition the premium above the risk-free interest rate that investors can expect to earn by investing in a value-weighted portfolio of all risky investments in the market. The premium is not directly observable and must be inferred or forecasted based on known market information.
Estimates of a forward-looking MERP are used as an input in the CAPM and the empirical capital asset pricing model (ECAPM). The greater the estimate of the forward-looking MERP, the higher the ROE generated by the CAPM and the ECAPM, all else being equal. Different approaches can be used to estimate the forward-looking MERP.
The AUC accepted the Consumers’ Coalition of Alberta (“CCA”)’s data and argument showing that the average annual MERP had remained largely stable since 2018. The AUC determined that the data supports a continuation of the current GCOC parameters.
(c) Market Volatility
The AUC considered market volatility and the lack of certainty and clarity in available market data relevant for determining the Parameters. The current elevated volatility and uncertain outlook were determined to likely affect economic and market fundamentals in 2023. The AUC found that the elevated market volatility supports a continuation of the GCOC Parameters.
(d) Business Risk and Earning Above Awarded ROE
Parties submitted conflicting assessments of changes to business risk since the 2018 GCOC decision. The ATCO Utilities/Apex/Fortis submitted that there have been significant transformations occurring in the utility industry since 2018, including an emphasis on decarbonization; a focus on environmental, social, and governance standards; the need for grid modernization; and changes in the way in which customers are receiving utility service. These utilities stated that they are directly affected by these transformations, and these changes engender risk and uncertainty for utilities at a level seldom witnessed in the past. Customer groups submitted that there has been little if any change in business risk. Some customer groups pointed to the utilities achieving actual ROEs in excess of the Commission-approved ROEs.
The AUC was of the view that historical earnings above or below the approved ROEs do not help to determine what the ROE for a future test period should be. The AUC was not persuaded that there was a quantifiable change in business risk that would require a change in the deemed equity ratios for 2023.
Comparable Returns on Equity
All utilities supported keeping the ROE at 8.5 per cent, and some argued that current economic indicators would lead to a higher ROE for 2023 if the AUC were to carry out a full GCOC proceeding. The AUC held that the objective of the GCOC is to consider the market expectation for the utilities raising the capital necessary to provide safe and reliable utility service in Alberta. The AUC noted that in setting the GCOC for the utilities in Alberta, other jurisdictions can be a useful indicator or benchmark for evaluating contemporaneous rates of return and whether return expectations are generally increasing or decreasing. The AUC observed that ROEs from other jurisdictions referenced by interveners or calculated using formulaic methodologies do not materially depart from the AUC’s last approved 8.5 per cent figure. The AUC, therefore, concluded that information from other jurisdictions does not bring the AUC’s approved ROE into question.
The AUC concluded that there is insufficient support to depart from the currently approved ROE and the deemed equity ratios. The AUC determined that maintaining the existing ROE of 8.5 per cent will, when combined with the existing deemed equity ratios, provide the utilities with a fair return for 2023. The AUC also saw no quantifiable business risk that would require a change in the deemed equity ratios for 2023. The AUC, therefore, found that the deemed equity ratios for 2023 should remain unchanged from 2022.