A Highly Personal Comment on on the Use of the CAPM in Public Utility Rate Cases Author(s): Willard T.

Carleton Reviewed work(s): Source: Financial Management, Vol. 7, No. 3 (Autumn, 1978), pp. 57-59 Published by: Wiley on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665012 . Accessed: 08/02/2013 07:28
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Highly
the Use

Personal
of the

Comment

on

On Public

CAPM Cases

in

Utility

Rate

Willard T. Carleton

Willard T. Carleton is William R. Kenan, Jr., Professor of Business Administration at the University of North Carolina at Chapel Hill.

* Professors BrighamandCrum(hereafter BC) have a valuableservicein their article[3]. They performed have broughtto the attentionof academicians a controversythat since the Breen/Lerner[1] and Myers hadbeenarguedoverprimarily in the [10]interchange trenches- utility rate hearings.The focus of BC's criticism is quite narrow, calling attention to the effects of risk non-stationarity on measuredbetas, hence on estimated costs of equity. BC appear to acceptas valid the underlying theory,a subjectof increasingdisputein itself. The purposeof my note is not to find fault with the BC analysisand examples; ink will be spilledin Finansurelymuchfault-finding cial Managementwithoutmy help.1RatherI should like to add to the menu of CAPM problems,in the
'Indeed, BC's prose has the evangelical tones of the reformed sinner. Professor Brigham and I were adversaries in the Comsat rate case [2, 8, 9], where non-stationarity of beta was a major point of contention. It is gratifying to observe a heightened sensitivity to CAPM implementation issues in the BC article.

same generalspirit as BC.2 The firstitem on this menuis the effectof monetary The rateof return in the typical phenomena. expressed utility case is an annual rate, presumably applicable for an indefinitely prospectively long future.The Gordon valuationformula,k = D/P + g, reflects,among other things, similar assumptions:k, the cost of equity, normallyis estimatedusing annualdata; it is then by construction an internal rate of return assumedconstantfor all futuretime. Such a construction obviouslyis invalid if the term structureof interestrateshas a significant slope, for then we should find a k1for year 1, a k2for year2, andso forth- instead of forcing an average k by (usually)implicit
2For a description of statistical specification and estimation problems that afflict regulatory uses of the CAPM beyond both the scope of the BC paper and the limited purposes of this note, see [4]. Also, misapplication of Bayesian methods can now be added to the list of horror stories on regulatory uses of the CAPM. For a highly adversarial discussion of one of these, see [7]. 57

1978 FinancialManagement Association

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58

1978 FINANCIALMANAGEMENT/AUTUMN

assumption. Now let us examine the manner in which a "riskless" nominal rate of return, RF, has to be employed in order to implement the CAPM in a rate of return application. If / is derived using as RM(the surrogate for rate of return on the market portfolio) annual data, then RF should be the rate on an appropriate one-year security in the formula
E(RC) = RF + 3C [E(RM)RF],

Case

Observation Observation Date 1 Date 2 .127

1
2

.136 .157

.162 .157 .157

where E(Rc

= one-year estimated cost of equity capital for company C (i.e., E(Rc) = k); RF one-year "riskless" rate of return; company C's estimated beta; R cE(R estimated spread of average, E(RM)- RF annual rate of return on the market over RF assumed stationary.

The use of any other RF, of either shorter or longer maturity than the data interval that generated $cand E(RM), in the presence of a yield curve slope, is formally incorrect. How much damage can result can be appreciated once we contemplate that 1) monthly or quarterly data intervals are usually employed in beta estimation, to secure degrees of freedom, and 2) the correct use of a short term Treasury bill yield as RF would then lead, ceteris paribus, to frequent wide swings in E(Rc).3 For a hypothetical example, assume that c = 1.0 and E(RM) - RF = .005 (corresponding to an annualized rate spread of .0617). Also assume that on Treasury securities we observe, at two different dates, the following:
Observation Observation Case

Date 1

Date2

1. Monthly yield on one-month bill Annualized yield 2. Monthly equivalent

.005 .0617 .0057 .07 .0072 .09

.0076 .095 .095 .09 .0072 .09

bill yieldon one-year Yieldon one-year bill 3. Monthlyequivalent bond yieldon ten-year
Annualized yield

The results, in terms of estimated E(Rc), in annualized units are:

3The correct use is in the compound interest formula, E(Rc) = is the one-month CAPM[1 +ERc)Mo]12 - 1, where E?RC)Mo derived cost of equity capital for company C. Casual inspection of CAPM-based testimony [7] gives me the impression that disingenuous errors are frequently made in the adversarial setting of utility rate hearings.

The only correct assertion on date 1, given the assumptions, is that company C's cost of equity capital is at an annual rate of 12.7%for the next month and on date 2 it is 16.2%. Any other conclusions would be attributableto the spirit of advocacy that infuses expert witness testimony in public utility rate cases. This includes the intuitively reasonable proposition that the "long-term (annual) cost of equity is 15.7%at both dates" - a proposition that is both misleading and incorrect in terms of statistics, the arithmetic of compound interest, and the formalisms of the CAPM. The range and shift of interest rates depicted are well within the range we have observed in recent years. It is also true that ambiguities in the regulatory use of the expression, "rate of return," make it uncertainjust what maturity yield and shifts are important to regulation. Nonetheless and the point of this note - the CAPM is sufficiently formalized so that the data interval and hypothesized investor holding period are co-specified. If this leads to rate of return estimates that are revised substantially with every shift in Treasury bill yields, by implication requiring continuous rate hearings, there is not much we can do about the matter without scuttling the CAPM framework. I suspect that this problem with CAPM use will be appreciated by any thoughtful student of finance. It is in fact the CAPM-specific illustration of what is encountered when any formal framework is employed to determine the "cost of equity capital." My second item on the problem menu shares this characteristic, but its appreciation requires a subtler understanding of what rate of return regulation tends to produce economically and what it is intended to do legally. By now it is commonplace [5] that rate of return-ratebase regulation tends to drive a company's stock price, ceteris paribus, up or down toward book value. It would seem necessary that any stock price-based cost of capital model used to estimate utility rates of return be modified explicitly to incorporate the effects of investor knowledge of this result. The Gordon model has been so modified [6] but, to the best of my knowledge, the CAPM has not been. In the same spirit, the famous Hope case decision requires that rate of return allowances protect the credit standing and financial integrity of the enter-

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ON THEUSE OF THECAPM CARLETON/COMMENT

59

prise. On occasion, for example, it may be necessary for a utility commission to permit a company because of bond indenture provisions - to earn an overall rate of return that bears no obvious relationship to the conventional weighted cost of capital, in which equity cost is estimated by any one of our market-based technologies. If one wishes to adopt CAPM terminology, the Hope criteria require regulation to take into account the downside part of nonsystematic risk. The question before the house in this note is: Can the known-to-investors circumstances of regulation be incorporated within both the equilibrium proposition and market model of the CAPM? At the risk of being provocative, I would assert the answer is no, and the reason is straightforward. If one contemplated the market/book value of equity tendencies and financial integrity implications of utility regulation in the abstract, one would likely conclude that utility investors face trivial risks, so the choice of the CAPM or some other frame of reference to estimate cost of equity is so much small change. On the other hand, the impact of changing technology/cost considerations, income distribution influences over utility pricing, environmental questions, and above all volatile inflation and interest rate experiences have produced gaps between what we generally think regulation does and what it actually does. In particular, the period between the emergence of a spread between investor-required and company-realized rate of return and its disappearance - regulatory lag - can be both long and uncertain. To many students of utility regulation, regulation itself has been the main source of investor risk in recent years. And no situation of actual lag is a stationary one; it implies non-constant expected rates of return to the firm and to investors over future periods. Yet the CAPM would appear to require, for implementation, that there be no external force (regulation) systematically shifting the firm's profit opportunities through time in a fashion intimately tied

to the investor valuation process. Brigham and Crum finish on a conservative advisory note: "Yet, at present, the CAPM should be used in utility rate cases, if at all, only with a great deal of caution." Without necessarily subscribing to all of the BC analysis, I wonder whether they didn't stop short of the more appropriate recommendation.

References
1. WilliamJ. Breenand EugeneM. Lerner,"On the Use of f in Regulatory Proceedings,"Bell Journal of Science (Autumn 1972), Economicsand Management pp. 612-21. 2. Eugene F. Brigham, Testimony, Federal Communications Commission,Docket Number 16070(October 1971). and Roy L. Crum,"On the Use of 3. EugeneF. Brigham the CAPM in Public Utility Rate Cases," Financial (Summer1977),pp. 7-15. Management "A Note on the Use of the CAPM 4. WillardT. Carleton, for Utility Rate of Return Determination,"forthcoming in Applicationsin Finance(TIMS Studies in Finance),eds. EdwinJ. Elton and MartinJ. Gruber. 5. WillardT. Carleton,"Rate of Return,Rate Base and of Changing Capital Regulatory Lag UnderConditions Costs," Land Economics(May 1974),pp. 145-51. 6. WillardT. Carleton,Testimonyon CarolinaPower& Fair Rate of Return,North Carolina LightCompany's Utilities CommissionDocket Number E-2, Sub. 297 (April 1977). Public 7. WillardT. Carleton,Testimonyfor Community Service Company,New Mexico Public ServiceCommission,Case Number 1378(December1977). 8. WillardT. Carleton,Testimonyfor the FederalCommunications Commission, Docket Number 16070 (February1972). 9. WillardT. Carleton,Testimonyfor the FederalCommunications Commission, Docket Number 16070 (September1973). 10. Stewart C. Myers, "On the Use of 3 in Regulatory A Comment,"Bell Journalof Economics Proceedings: and Management Science(Autumn1972),pp. 622-27.

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