United States: FERC Acts To Ensure That Utility Cost-Based Rates Include An Adequate Return On Equity

In June, the Federal Energy Regulatory Commission ("FERC" or "Commission") issued Opinion No. 531, which details three significant changes to the way FERC determines the rate of return on equity ("ROE") in public utility rate cases.1 First, FERC modified its longstanding discounted cash flow ("DCF") model for calculating ROE.2 Second, FERC ended its practice of applying a post-hearing adjustment to ROE based on changes in United States Treasury bond yields.3 Third, FERC decided that the ROE of the group of public utilities in question should not be set at the "point of central tendency" established by the range of reasonable ROEs, but instead should be set at the point halfway between the range's point of central tendency and the range's highest point.4 Each of these changes is explained below. 

In conjunction with Opinion No. 531, FERC set for hearing a backlog of cases involving disputes over public utility rates.5 In each case, the Commission stated that "we expect the evidence and any DCF analyses presented by the participants in this proceeding to be guided by our decision in Opinion No. 531."6 As compared to FERC's preexisting approach to ROE, Opinion No. 531 appears likely to increase the ROE component in public utility cost-based rates, thereby increasing a public utility's overall return. However, the long-term reach of FERC's new ROE analysis remains unclear.

How Regulators Use the DCF Model and Establish a Range of Reasonable ROEs

Under cost-of-service ratemaking, certain costs are considered operating expenses and are recovered dollar-for-dollar in the utility's annual revenue requirements, while other costs are capitalized, "thus entering the cost of service in the form of annual allowances for depreciation and return on the undepreciated portion of the investment."7 In order to attract necessary capital, the utility must offer "a risk-adjusted expected rate of return sufficient to attract investors."8 This "return" on the utility's investments represents the cost expended by the utility to raise capital.9 

For more than 30 years, the dominant method used by FERC to estimate investors' required rate of return has been the DCF model. The premise of the DCF methodology is that "an investment in common stock is worth the present value of the infinite stream of dividends discounted at a market rate commensurate with the investment's risk."10 This "constant growth" DCF model can be expressed as a formula:

k = D/P (1+0.5g) + g.

In this formula, D is the current dividend, P is the price of the company's common stock, and g is the expected growth rate in the company's dividends. The formula solves for k, which represents the rate of return investors require to invest in a company's common stock.11 

In a rate case, FERC applies the DCF formula to each member of a group of comparable utilities, known as a proxy group. This generates a range of ROEs. Screening criteria, which can result in the exclusion of particular companies from the analysis, are applied to establish a range of reasonable ROEs. The ROE of the public utility that is the subject of FERC's review is selected from within this range. FERC's past practice has been to set the subject public utility's ROE at the point of central tendency of the proxy group's range of ROEs. 

Applying the Two-Step DCF Methodology to Public Utilities 

Since the mid-1990s, FERC has used a "one-step" DCF methodology in public utility rate cases (i.e., in the electric industry) while using a "two-step" DCF methodology in natural gas pipeline and oil pipeline rate cases. Under the one-step DCF methodology, FERC calculates two dividend yields for each proxy group company: one based on the proxy group company's highest stock price from a six-month study period, and one based on the proxy group company's lowest stock price from the same study period. Next, FERC develops two estimates of short-term dividend growth rates. A low cost of equity for each proxy group company is developed using the lowest dividend yield plus the lowest dividend growth rate projection. A high cost of equity for each proxy group company is developed using the highest dividend yield plus the highest dividend growth rate projection.12

In Opinion No. 531, FERC decided that henceforth it will apply the two-step DCF methodology in public utility rate cases. The result is a single average dividend yield calculated for each company in the proxy group. The dividend growth rate estimate for each proxy group company will take into account both projected short-term growth rates (constituting two-thirds of the total growth rate estimate) and projected long-term growth (one-third of the total).13 The short-term growth rate estimate will be based on the five-year forecast for each proxy group company, as published in the Institutional Brokers Estimate System ("IBES"). The long-term growth rate estimate will be based on forecasts of the long-term growth of the economy as a whole, stated in terms of gross domestic product.14 In the case before it, FERC reopened the record and established a "paper hearing" to give the participants in that case "an opportunity to present evidence concerning the appropriate long-term growth projection to be used for public utilities under the two-step DCF methodology."15 

Eliminating the Post-Hearing ROE Adjustment Based on U.S. Treasury Bond Yields

FERC's cost-of-service ratemaking for public utilities relies predominantly on "test-period" evidence, which is evidence about the subject utility's costs limited to a specific time period that ends before the rate case goes to hearing. Use of test-period evidence gives the parties a known universe of facts to dispute. One exception is FERC's use of post-test-period data regarding ROE. FERC's practice has been to adjust the subject utility's ROE based on U.S. Treasury bond yields. FERC determines the change in U.S. Treasury bond yields as of the date of its order as compared to such yields as of the end of the hearing in the case.16 FERC then adjusts the final ROE by the amount of the change in U.S. Treasury bond yields. For example, a 1 percent drop in bond yields between the end of a hearing and FERC's order would result in a 1 percent downward adjustment to the utility's ROE.17

In Opinion No. 531, FERC decided that U.S. Treasury bond yields no longer "provide a reliable and consistent metric for tracking changes in ROE after the close of the record in a case."18 Instead, FERC will allow participants in a rate case "to present the most recent financial data available at the time of the hearing, including post-test period financial data then available."19 FERC already uses this approach in natural gas pipeline and oil pipeline rate cases.20

Selecting an ROE From Within the Range of Reasonable ROEs 

Once a range of reasonable ROEs is developed by applying the DCF model to each member of a proxy group, FERC must select one ROE from within that range. Traditionally, FERC has set the subject public utility's ROE at the "point of central tendency" within the range of ROEs. For a diverse group of public utilities, the point of central tendency is the midpoint within the range, which, as FERC uses the term, is the arithmetic mean of the single lowest and the single highest ROE. In contrast, for an individual public utility, the point of central tendency is the median.21 The median is the middle number in a series, such that half of the numbers are higher and half are lower than the median. 

In Opinion No. 531, the issue in dispute was the appropriate ROE for the New England Transmission Owners, a group of utilities that had transferred operational control of their transmission facilities to ISO-New England. FERC decided that it would not set the ROE at the midpoint of the range of ROEs. Instead, FERC selected the point halfway between the midpoint and the highest point in the zone of reasonableness (the 75th percentile), which FERC described as the "central tendency for the top half of the zone of reasonableness."22 In Opinion No. 531, the resulting midpoint was 9.39 percent, but the point at the 75th percentile of the range was 10.57 percent. 

In rejecting the midpoint ROE, FERC explained its concern that the "capital market conditions in the record are anomalous, thereby making it more difficult to determine the return necessary to attract capital."23 The New England Transmission Owners had argued that five other "benchmark methodologies" showed that the DCF-based midpoint in that case was too low to attract capital: (i) a risk premium analysis, which examines the premium that investors require to invest in equities; (ii) a capital asset pricing model ("CAPM"), which is a model that examines investor expectations about the future by taking into consideration the tendency of a stock's price to follow changes in the market as a whole; (iii) an analysis of natural gas pipeline ROEs; (iv) a DCF analysis applied to non-utilities; and (v) an expected earnings analysis, which involves a comparison of the earnings investors can expect to receive from investing in public utilities, as compared to investing in other opportunities of comparable risk.24 

FERC found that the risk premium analysis, the CAPM, and the expected earnings analysis were "informative" and supported the conclusion that the midpoint ROE was too low to attract capital. FERC did not consider the DCF analysis of non-utilities or the natural gas pipeline ROE analysis to be probative because they did not analyze the returns of public utilities.25 

At several points, FERC's analysis focused on the unique characteristics of companies in the business of building and owning electric transmission assets. For example, FERC found persuasive the fact that state regulatory commissions have approved public utility ROEs above the DCF midpoint ROE. According to FERC, transmission investment "entails unique risks that state-regulated electric distribution does not."26 Investors in electric transmission infrastructure face risks such as "long delays in transmission siting, greater project complexity, environmental impact proceedings, requiring regulatory approval from multiple jurisdictions overseeing permits and rights of way, liquidity risk from financing projects that are large relative to the size of a balance sheet, and shorter investment history."27 FERC emphasized that it has an obligation to set an ROE in this case "at a level sufficient to attract investment in interstate electric transmission," explaining that such investment "helps promote efficient and competitive electricity markets, reduce costly congestion, enhance reliability, and allow access to new energy resources, including renewables."28 

Opinion No. 531 may allow a utility to justify an ROE greater than the median without making a company-specific showing of relative risk. In prior decisions, FERC has required a showing that the risk affecting the subject company be higher than the risk faced by the other members of the proxy group. As recently as 2013, FERC explained that any analysis attempting to "demonstrate that a deviation from the median ROE is justified" must present a comparison between "the risk level of the subject company and the risk level of each of the proxy group companies. This is the crux of the analysis, and if it is lacking, the analysis is incomplete."29 In light of the general evidence relied on in Opinion No. 531, a company-specific showing of relative risk may no longer be the "crux" of the analysis. 

Finally, FERC explained that its decision to set the New England Transmission Owners' base ROE above the range's point of central tendency involved considerations that are distinct from its analysis of "incentive adders" pursuant to Section 219 of the Federal Power Act.30 FERC's task when evaluating a base ROE is to set the ROE at a level that "enables the utility to attract investment." In contrast, FPA Section 219 authorized FERC to establish incentive above that base ROE. FERC cautioned that it will not permit its new analysis of base ROE and its analysis of FPA Section 219 incentives to be combined in a way that results in an ROE that exceeds the top of the zone of reasonableness established by its new two-step DCF methodology.31 

Likely Effect on Public Utility Rates 

FERC's departure in Opinion No. 531 from three aspects of its existing policy on ROE will result in a higher ROE for the New England Transmission Owners. In the Initial Decision under review in Opinion No. 531, the Administrative Law Judge found that the prospective ROE for the New England Transmission Owners should be set at 9.7 percent.32 In contrast, FERC's analysis in Opinion No. 531 resulted in a tentative finding that the appropriate ROE was 10.57 percent.33  

Opinion No. 531's higher ROE did not result from FERC's switch to the two-step DCF model. The two-step DCF model alone resulted in a midpoint ROE of 9.39 percent34—lower than the prospective 9.7 percent ROE approved in the Initial Decision. Rather, the higher ROE resulted from FERC's decision to select the midpoint of the "upper half" of the zone of reasonableness rather than selecting the midpoint of the full zone. Moreover, FERC's focus on the midpoint as the point of central tendency (because the ROE of a group of utilities was at issue) raises questions about how FERC's analysis from Opinion No. 531 will be applied in the context of setting a single public utility's ROE, where the Commission uses the median of the range of reasonable ROEs as opposed to the midpoint.35 Notwithstanding the differences in the ROE analysis for a single utility and grous of utilities, the Commission's order in Seminole Electric Cooperative, Inc. v. Florida Power Corp. instructs the parties to apply Opinion No. 531 in establishing a single utility's ROE.36

FERC also emphasized that the new two-step DCF model produces "a narrower zone of reasonableness, consistent with the fact [that] different firms in a regulated industry would not ordinarily be expected to have widely varying levels of profitability."37 This narrower zone of reasonableness may result in a point of central tendency within the "upper half" of the zone of reasonableness that is close enough to the overall point of central tendency to support the selection of that higher ROE. 

In sum, although two aspects of Opinion No. 531 will apply in all future public utility rate cases, the largest identifiable change in the ROE in that order was based on a case-specific analysis—performed in the context of "anomalous" capital market conditions—of the level of return needed to encourage investments in transmission where that ROE will apply to a group of public utilities rather than to a single public utility. Had FERC's ROE policies remained unchanged, the result would have been lower ROEs. Therefore, Opinion No. 531 is likely to increase public utility returns in cost-based rates, but the scope and magnitude of this effect as applied to other public utilities remains unclear.


1 Martha Coakley v. Bangor Hydro-Electric Co., Opinion No. 531, 147 FERC ¶ 61,234 at P 7 (2014) ("Opinion No. 531"). A public utility is an entity subject to the Federal Power Act because it owns facilities used for the transmission of electric energy in interstate commerce or for the sale of such energy at wholesale in interstate commerce. 16 U.S.C. § 824 (2012).

2 Opinion No. 531 at PP 32–41.

3 Id. at PP 157–160.

4 Id. at P 151.

5 ENE (Environment Northeast) v. Bangor Hydro-Electric Co., 147 FERC ¶ 61,235 (2014); Seminole Electric Cooperative, Inc. v. Florida Power Corp., 147 FERC ¶ 61,236 (2014); Seminole Electric Corp. v. Duke Energy Florida, Inc., 147 FERC ¶ 61,237 (2014); Golden Spread Electric Cooperative, Inc. v. Southwestern Public Service Co., 147 FERC ¶ 61,238 (2014); Golden Spread Electric Cooperative, Inc. v. Southwestern Public Service Co., 147 FERC ¶ 61,239 (2014).

6 Seminole Electric Corp. v. Duke Energy Florida, Inc., 147 FERC ¶ 61,237 at P 21.

7 Alfred E. Kahn, The Economics of Regulation: Principles and Institutions 27 (2nd ed. 1988).

8 Canadian Ass'n of Petroleum Producers v. FERC, 254 F.3d 289, 293 (D.C. Cir. 2001).

9 See id.

10 Opinion No. 531 at P 14 (citing, as an example, Canadian Ass'n of Petroleum Producers, 254 F.3d at 293).

11 Id. at P 15.

12 Id. at PP 25–26.

13 Id. at P 39.

14 Id. at P 39.

15 Id. at P 43.

16 Id. at P 157.

17 Id. at P 159.

18 Id. at P 160.

19 Id. at P 160.

20 Id. at P 160.

21 Id. at P 26.

22 Id. at P 151.

23 Id. at P 145.

24 Id. at P 146.

25 Id. at P 146.

26 Id. at P 148.

27 Id. at P 149.

28 Id. at P 150.

29 El Paso Natural Gas Co., 145 FERC ¶ 61,040 at P 698 (2013); see also id. at P 686 (reversing the Administrative Law Judge's finding that the pipeline's relative risk justifies an ROE "well above" the median of the proxy group companies, and setting the pipeline's ROE at the median). See, e.g., Southern California Edison Co., 92 FERC ¶ 61,070 at 61,266 (finding that the appropriate ROE for the subject public utility should be above the point of central tendency for the comparison group because the utility "is more risky than the comparison group"), reh'g denied, 108 FERC ¶ 61,085 (2004).

30 Opinion No. 531 at P 153.

31 Id. at P 165.

32 Id. at P 5.

33 Id. at P 142.

34 Id. at P 147.

35 See S. Cal. Edison Co. v. FERC, 717 F.3d 177, 186 (D.C. Cir. 2013).

36 Seminole Electric Cooperative, Inc. v. Florida Power Corp., 147 FERC ¶ 61,236 at P 16.

37 Opinion No. 531 at PP 38, 161.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Kevin J. McIntyre
Matthew R. McGuire
In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.