California Cost of Capital Proposed Decision: A Year’s Reprieve Before ROEs Drop for EIX and PCG

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______________________________________________________________________________

Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

______________________________________________________________________________

May 12, 2017

California Cost of Capital Proposed Decision:

A Year’s Reprieve Before ROEs Drop for EIX and PCG

We are removing Edison International (EIX) and PG&E Corp. (PCG) from our recommended list due to the uncertainty as to their future allowed returns on equity (ROE). The Proposed Decision issued on May 10 by two Administrative Law Judges (ALJs) at the California Public Utilities Commission (CPUC), if adopted by the Commission, would require the state’s four investor owned utilities to file applications in a full cost of capital proceeding in March 2018, with rates based on the new cost of capital calculation to take effect on January 1, 2019. The decision would also require the utilities to answer a series of challenging questions as to the appropriate level of their allowed ROEs, reflecting what appears to be wider institutional support at the CPUC for a reduction in the allowed returns of the state’s utilities. If the CPUC’s objective is to bring the allowed ROEs of California’s utilities down to national average levels, we estimate the earnings impact on EIX and PCG could range from 1.2% to 6.3% of 2019 consensus EPS, depending on how the national average is calculated. We thus see EIX and PCG as unlikely to outperform over the next 12 months.

Portfolio Manager’s Summary

  • On May 10, the two ALJs assigned to the CPUC’s Cost of Capital proceeding issued a proposed decision modifying the settlement filed in February by the state’s investor owned utilities, the Office of Ratepayer Advocates and TURN, and raising the specter of lower ROEs for California utilities starting 2019. The settlement would have:
    • Slightly reduced the allowed ROEs for EIX subsidiary Southern California Edison (SCE) and PCG subsidiary Pacific Gas & Electric (PG&E), setting these at 10.30% and 10.25%, respectively, for the two year period 2018-2019;
    • Deferred California’s next full cost of capital proceeding for the state’s utilities from April 2017 to April 2019, with the utilities’ resulting ROEs to go into effect on January 1, 2020.
  • The new proposed decision accepts the slightly lower allowed ROEs stipulated in the settlement, but only for 2018, requiring a full review of the utilities’ cost of capital commencing in March 2018 with the new ROEs to take effect January 1, 2019.
  • Importantly, the decision would require the utilities to answer as series of challenging questions as to the appropriate level of their allowed ROEs, reflecting what appears to be wider institutional support at the CPUC for a cut in the allowed returns of the state’s utilities.
  • To estimate the extent of this cut and its impact on SCE and PG&E, we note that the ROEs allowed these two utilities in 2018 under the Proposed Decision are 20-95 basis points above the national average, depending on how the average ROE is calculated. More specifically:
    • The average ROE set by state regulators in 2016 rate cases for transmission and distribution utilities was 9.35%, or 95 bps less than SCE’s 2018 allowed ROE of 10.30% and 90 bps below PG&E’s 2018 allowed ROE of 10.25%.
  • The average ROE allowed by state regulators in 2016 rate cases for all electric utilities was 9.62%, or 68 bps below SCE’s 2018 allowed ROE and 63 bps below PG&E’s.
  • The average allowed ROE currently prevailing for all electric utilities, regardless of when their last rate case was determined, is 10.07%, while the average allowed ROE currently prevailing for T&D utilities is only one basis point lower at 10.06% — 23 to 24 bps below SCE’s 2018 allowed ROE and 18 to 19 bps below PG&E’s.
  • We think the CPUC will seek to avoid the 90-95 bps cut in allowed ROEs required to bring the ROEs of California’s utilities into line with the national average for T&D utilities. Rather than risk the confidence of investors with such a dramatic reduction, we believe the CPUC is more likely to adopt a gradual approach, bringing California’s allowed ROEs into line with the average ROE set in recent rate cases for all electric utilities (a cut of 63-68 basis points if we take 2016 rate cases as our benchmark) or into line with the average prevailing allowed ROE for all electric utilities (a reduction of 23-24 bps based on current data).
  • A reduction in the 2019 allowed ROEs of SCE and PG&E to the levels implied by these three different benchmarks would erode the earnings potential of the two utilities’ parent companies, EIX and PCG, by 1.5% to 6.2% of 2019 consensus EPS in the case of EIX and by 1.2% to 6.3% of 2019 consensus in the case of PCG. Specifically, were the 2018 cost of capital proceeding to set the 2019 allowed ROE of these two utilities at a level equal to:
  • The average ROE set by state regulators in 2016 rate cases for transmission and distribution utilities (9.35%), the allowed earnings of EIX and PCG would be cut by 6.2% and 6.3%, respectively;
  • The average ROE allowed by state regulators in 2016 rate cases for all electric utilities (9.62%), the allowed earnings of EIX and PCG would be cut by 4.5% for both utilities;
  • The average allowed ROE currently prevailing for all electric utilities, regardless of when their last rate case was determined (10.07%), the allowed earnings of EIX and PCG would be cut by 1.5% and 1.2%, respectively.
  • Based on our expectation that the CPUC will seek to avoid a dramatic reduction in the allowed ROEs of California’s utilities, we believe the most likely earnings impact of the 2018 cost of capital proceeding will be to reduce the earnings potential of EIX and PCG by ~1.5% to 4.5%.
  • Given this risk, we see EIX and PCG as unlikely to outperform over the next twelve months.
  • We prefer AEP and XEL, both of which are well positioned in the group.

Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology


Source: SSR analysis

Details

On February 7, 2017, California’s four investor owned utilities,[1] the state’s Office of Ratepayer Advocates (ORA), and private ratepayer advocacy group The Utility Reform Network (TURN) jointly filed a petition with the California Public Utilities Commission (CPUC) requesting:

  • Reductions ranging from 5 to 15 basis points in the utilities’ authorized ROEs, effective January 1, 2018;
  • A re-calculation of each utility’s authorized cost of debt and preferred stock, again effective January 1, 2018; and
  • The deferral of the utilities’ next cost of capital proceeding from April 22, 2017 to April 22, 2019, with the utilities’ new allowed ROEs to go into effect on January 1, 2020.

On May 10, 2017, Administrative Law Judges McKinney and Hecht issued a proposed decision in response to the utilities’ petition, which we summarize below. The proposed decision will take effect only if the Commission votes to approve it. The earliest date that the proposed decision may be considered by the Commission is June 15, 2017.

In their proposed decision, ALJs McKinney and Hecht would:

  • Accept the proposed reduction in the utilities’ ROEs, from 10.45% to 10.30% for SCE, from 10.40% to 10.25% for PG&E, from 10.30% to 10.20% for SDG&E and from 10.10% to 10.05% for SoCalGas;
  • Accept the proposed reset of the utilities’ cost of long term debt and preferred stock in 2018;
  • Shorten the proposed deferral of the utilities’ next cost of capital proceeding from April 22, 2017 to April 22, 2018, with the new allowed ROEs to go into effect on January 1, 2019.

Finally, and importantly, the ALJs’ proposed decision would require each of the utilities, in their 2018 cost of capital applications, to address a series of questions apparently intended to challenge the assumptions on which the utilities’ current cost of capital is based. These questions include:

  • How does the utility’s business risk compare to other utilities nationally and in the state? Separate comparisons are to be presented against vertically integrated and T&D utilities. The utilities are also asked whether their business risk has changed since the utilities’ cost of capital was last determined by the Commission in its 2012 cost of capital proceeding.
  • How does the utility’s level of financial risk compare to other utilities nationally and in the state?
  • How does the utility’s level of regulatory risk compare to other utilities nationally and in the state?
  • How does the utility’s capital structure compare to other utilities nationally and in the state?
  • How does the utility’s authorized ROE compare to other utilities nationally and in the state?
  • What regulatory, tax, policy, legal, technological or accounting changes have occurred since the 2013 cost of capital application that impact the level of risk faced by the utility?

The chain of events leading up to the Proposed Decision issued by ALJs McKinney and Hecht suggest to us that there may be broader institutional support at the CPUC for a reevaluation of utilities’ allowed returns. In particular, we note that:

    • On April 17th, the Administrative Law Judge originally assigned to the case was removed.
    • On the following day, the Policy and Planning Division of the CPUC issued a white paper on the determination of utilities’ cost of capital, highlighting the fact that the allowed ROEs for California utilities are above the national average.
    • Within a week, the proposed decision issued of the original ALJ, which would have approved in substance the joint petition of the four investor owned utilities, the ORA and TURN, was withdrawn.
    • Within three weeks, a new proposed decision, shortening the deferral of the utilities’ next cost of capital proceeding by 12 months and requiring the utilities to address the questions listed above, was issued by the two new ALJs assigned to the case.

If our interpretation of the institutional context is correct, the questions posed by the Proposed Decision of ALJs McKinney and Hecht would seem to highlight facts that could be used to advance the case for a reduction in the allowed ROEs of California’s investor owned utilities. For example:

  • The first question posed in the Proposed Decision, how does each utility’s business risk compare to other utilities nationally and in the state, highlights the fact that California’s utilities as for the most part transmission and distribution utilities, with only PG&E continuing to own higher risk power generation assets, including its Diablo Canyon nuclear power plant.
  • Similarly, the follow-on question, how has each utilities’ business risk changed since the utilities’ cost of capital was last determined by the Commission in its 2012 cost of capital proceeding, highlights the fact that while Southern California Edison previously operated a major power generation asset, the San Onofre Nuclear Generating Station, this plant has since been retired.
  • The question how does each utility’s level of financial risk compare to other utilities nationally and in the state highlights the relatively robust credit ratings of California’s investor owned utilities, all of which have at least two single-A ratings.[2]
  • The question how does each utility’s level of regulatory risk compare to other utilities nationally and in the state highlights the regulatory structures in place in California that materially mitigate financial risk, including the forward looking rate setting procedure used in the state’s triennial general rate cases, which minimizes regulatory lag in return of and on invested capital; the decoupling of the allowed revenues set in these proceedings from utilities’ volume sales; the use of tracking accounts to ensure prompt recovery of fuel, purchased power and other recoverable costs; and the indexation of utilities’ allowed ROEs, cost of long term debt and cost of preferred stock to the yield of the Moody’s utility bond index, ensuring adequate recovery of the cost of debt and preferred stock and the preservation of interest and preferred dividend coverage ratios.[3]
  • Similarly, the question how does the utility’s capital structure compare to other utilities nationally and in the state highlights the relatively robust capital structures allowed California’s investor owned utilities.[4]
  • Finally, the question how does each utility’s authorized ROE compare to other utilities nationally and in the state highlights the fact that the ROEs allowed the state’s three major electric utilities now range from 10.2% to 10.3%, whereas the average ROE allowed by state regulators in electric utility rate cases nationally in 2016 was only 9.77%. The average allowed transmission and distribution utilities in 2016 rate cases was even lower, at 9.35%. Similarly, the allowed ROE of Southern California Gas, at 10.3%, is also well above the national average of 9.5% set in gas utility rate cases last year.

Only the final question set by the Proposed Decision would seem to cut in the utilities’ favor: what regulatory, tax, policy, legal, technological or accounting changes have occurred since the 2013 cost of capital application that impact the level of risk faced by the utility? In response to this question, we believe the utilities can cite a series of regulatory and technological development that have increased the risk of their business, including:

  • The combination of net energy metering and the falling cost of solar panels, which have combined to erode utilities’ volume sales to homes with solar rooftops arrays and drive up the cost of electricity for the utilities’ other customers;
  • California’s decision in 2011 to increase its renewable energy target for investor owned utilities to 33% by 2020, up from 20% previously, increasing the cost of electricity to utilities’ customers and eroding grid stability by increasing reliance on intermittent renewable resources;
  • California’s 2015 decision to end its rate freeze for the state’s lowest volume electricity consumers, thus materially increasing the number of utility customers affected by these cost increases;
  • The passage of legislation in 2016 (Assembly Bill 32) requiring a 40% reduction in greenhouse gas emissions from 1990 levels by 2030, limiting the ability of utilities to rely upon conventional fossil fuel power plant to offset the volatility of renewable energy supplies;
  • The compliance deadlines set by California’s State Water Resources Control Board for the elimination of once-through cooling systems at the state’s steam turbine generating stations, contributing to the accelerated retirement of many conventional power plants, including PG&E’s decision to retire the state’s largest power station, the 2,250 MW Diablo Canyon nuclear power station.

On balance, we believe that the questions posed by the Proposed Decision of ALJ’s McKinney and Hecht reflect institutional support at the CPUC for a reduction in utilities’ allowed returns in the next cost of capital proceeding, which pursuant to the PD would occur in 2018 with effect on January 1, 2019. To estimate the extent of this reduction and its impact on Southern California Edison and Pacific Gas & Electric, we note that the ROEs allowed these two utilities in 2018 under the joint petition and accepted in the Proposed Decision are 20-95 basis points above the national average, depending on how the average ROE is calculated. More specifically:

  • The average ROE set by state regulators in 2016 rate cases for transmission and distribution utilities was 9.35%, or 95 bps less than SCE’s 2018 allowed ROE of 10.30% and 90 bps below PG&E’s 2018 allowed ROE of 10.25%.
  • The average ROE allowed by state regulators in 2016 rate cases for all electric utilities was 9.62%, or 68 bps below SCE’s 2018 allowed ROE and 63 bps below PG&E’s.
  • The average allowed ROE currently prevailing for all electric utilities, regardless of when their last rate case was determined, is 10.07%, while the average allowed ROE currently prevailing for T&D utilities is only one basis point lower at 10.06% — 23 to 24 bps below SCE’s 2018 allowed ROE and 18 to 19 bps below PG&E’s.

We think the CPUC will seek to avoid the 90-95 bps cut in allowed ROEs required to bring the ROEs of California’s utilities into line with the national average for T&D utilities. Rather than risk the confidence of investors with such a dramatic reduction, we believe the CPUC is more likely to adopt a gradual approach, bringing California’s allowed ROEs into line with the average ROE set in recent rate cases for all electric utilities (a cut of 63-68 basis points if we take 2016 rate cases as our benchmark) or into line with the average prevailing allowed ROE for all electric utilities (a reduction of 23-24 bps based on current data).

A reduction in the 2019 allowed ROEs of SCE and PG&E to the levels implied by these three different benchmarks would erode the earnings potential of the two utilities’ parent companies, Edison International (EIX) and PG&E Corp. (PCG) by 1.5% to 6.2% of 2019 consensus EPS in the case of EIX and by 1.2% to 6.3% of 2019 consensus in the case of PCG. Specifically, were the 2018 cost of capital proceeding to set the 2019 allowed ROE of these two utilities at a level equal to:

  • the average ROE set by state regulators in 2016 rate cases for transmission and distribution utilities (9.35%), the allowed earnings of EIX and PCG would be cut by 6.2% and 6.3%, respectively;
  • the average ROE allowed by state regulators in 2016 rate cases for all electric utilities (9.62%), the allowed earnings of EIX and PCG would be cut by 4.5% for both utilities;
  • the average allowed ROE currently prevailing for all electric utilities, regardless of when their last rate case was determined (10.07%), the allowed earnings of EIX and PCG would be cut by 1.5% and 1.2%, respectively.

Based on our expectation that the CPUC will seek to avoid a dramatic reduction in the allowed ROEs of California’s utilities, we believe the most likely earnings impact of the 2018 cost of capital proceeding will be to reduce the earnings potential of EIX and PCG by ~1.5% to 4.5%.

Less adverse outcomes also remain a possibility. First, utility bond yields may rise over the remainder of the year, so that during the 2018 cost of capital proceeding the average ROEs set in electric utility rate cases over the prior 12 months could be higher than they are today. Second, the CPUC could continue its prior practice of setting allowed ROEs for the state’s utilities at a premium to the national average, enhancing their capacity to attract capital for the state’s energy infrastructure needs. The allowed ROEs set for SCE and PG&E in the CPUC’s 2012 cost of capital proceeding were 60-65 bps above the average ROE allowed by state regulators nationally in 2012 rate cases for T&D utilities. If we were to add the same premium to the average ROEs allowed in 2016 rate cases nationally for T&D utilities, the reduction in the allowed ROEs of SCE and PG&E would be limited to about 30 bps for both utilities, implying a cut in allowed earnings of 2.1% of consensus 2019 EPS for EIX and 2.3% for PCG.

Finally, we do not believe the capital structure of SCE is at risk. We do see a risk that PG&E’s allowed equity ratio could be cut, but believe this risk to be relatively low. The average allowed equity ratio in 2016 rate cases nationally was 48% for T&D utilities and 48.5% for all utilities, in line with SCE’s allowed equity of 48% but below PG&E’s allowed equity ratio of 52%. The average prevailing allowed equity ratio in 2016, regardless of when the rate cases setting these ratios were determined, was 49.4% for T&D utilities and 50.3% for all utilities, above SCE’s 48% but again below PG&E’s 52%. Generally allowed equity ratios do not change as frequently as allowed ROEs, so we believe the CPUC would be more likely to look at prevailing allowed equity ratios, rather than the average set in 2016 rate cases. We therefore see very little risk to SCE, and expect that the CPUC will allow PG&E to maintain its current equity ratio of 52%, instead choosing to reflect the higher equity ratio in a slightly lower allowed ROE compared to SCE.

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

  1. PG&E Corp.’s Pacific Gas & Electric, Sempra Energy’s San Diego Gas & Electric, Edison International’s Southern California Edison and Southern California Gas Company.
  2. San Diego Gas & Electric: A1/A/A; Southern California Edison: A2/BBB+/A-; Pacific Gas & Electric: A3/BBB+/A-; Southern California Gas: A1/A/A.
  3. In the intervening years, the utilities’ cost of capital was subject to modification to pursuant to indexation mechanism (the or CCM).

    Pursuant to California’s Cost of Capital Mechanism, utilities’ allowed ROEs, as well as their cost of debt and preferred stock, were to be adjusted up or down to reflect movements in the yield of Moody’s utility bond index. Specifically, following a 12-month period in which the average yield of the Moody’s index was more than 100 b.p. above or below its level at the time of the triennial cost of capital proceeding (the benchmark level), the utilities’ allowed ROEs, cost of debt and cost of preferred would be adjusted by one half of the amount by which the index had moved relative to the benchmark.

  4. The average equity ratio allowed set by state regulators in electric utility rate cases in 2016 49% and in gas utility rate cases 50%. By comparison, San Diego Gas & Electric is allowed an equity ratio of 50.5%, Southern California Gas 52%, and Pacific Gas & Electric 52%. While the equity ratio of Southern California Edison is below the national average at 48%, we note that the utility is allowed to maintain preferred stock equal to 9% of its total capital.
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