Commission Abandons Risk Premium Model, Relies Exclusively on Discounted Cash Flow and Capital-Asset Pricing Models
On October 17, 2024, the Federal Energy Regulatory Commission (Commission) issued an order revising the methodology for establishing the return on equity (ROE) for transmission owners (TOs) operating within the footprint of the Midcontinent Independent System Operator, Inc. (MISO). This same methodology likely will be applied to other TOs with an RTO-wide ROE who are subject to a complaint filed pursuant to Section 206 of the Federal Power Act.
Specifically, the Commission clarified that the methodology to evaluate ROEs in response to a Section 206 complaint should rely only on two financial models: the Discounted Cash Flow (DCF) model and the Capital-Asset Pricing model (CAPM). In prior orders vacated by the U.S. Court of Appeals for the D.C. Circuit (D.C. Circuit), the Commission had also incorporated a Risk Premium model into its ROE methodology. The Commission’s decision to revise its methodology has the effect of reducing the MISO TOs’ base ROE from 10.02% to 9.98%.
BACKGROUND
The Commission’s order emanates from two complaints filed in 2013 and 2015 pursuant to Section 206 of the Federal Power Act alleging, among other things, that the then-existing 12.38% ROE for the MISO TOs was unjust and unreasonable. In a series of prior orders issued in the complaint proceedings, the Commission sought to establish a methodology to determine whether the 12.38% ROE was unjust and unreasonable and, if so, what the new just and reasonable base ROE should be. In 2019, the Commission issued Opinion No. 569 which employed the DCF model and the CAPM to analyze existing base ROEs under Section 206 of the FPA. The Commission specifically declined to incorporate the Expected Earnings and Risk Premium models into its methodology. In 2020, however, in an order on rehearing (Opinion 569-A), the Commission reversed course and again revised its methodology to incorporate the Risk Premium model alongside the DCF model and CAPM. Later that same year, the Commission issued Opinion No. 569-B which largely affirmed Opinion No. 569-A, including the use of the Risk Premium model. In 2022, the D.C. Circuit vacated and remanded the Opinion 569 orders on the basis that the Commission had failed to offer a reasoned explanation justifying the use of the Risk Premium model in its ROE methodology when previous orders had identified several deficiencies and disadvantages with that model. MISO Transmission Owners v. FERC, 45 F.4th 248 (D.C. Cir. 2022).
ORDER
In today’s order, which was issued in response to the D.C. Circuit’s ruling, the Commission abandoned the use of the Risk Premium model in the methodology for determining the justness and reasonableness of existing base ROEs and the methodology for establishing new just and reasonable base ROEs. The Commission found that the record evidence did not support a finding that investors use the Risk Premium model, or that concerns regarding the model’s methodological flaws had been adequately resolved. The Commission noted, however, that it was not foreclosing the use of the Risk Premium model in future proceedings if the concerns regarding the model are adequately addressed with record evidence.
Because of its decision to abandon the Risk Premium model, the Commission established a new base ROE for the MISO TOs using the CAPM and DCF model. The DCF model established a zone of reasonableness of 6.97% to 12.07%, and the CAPM established a zone of reasonableness of 7.80% to 13.09%. Averaging the top and bottom of the DCF model and CAPM zones of reasonableness produced a composite zone of reasonableness of 7.39% to 12.58% and a midpoint of 9.98%. Based on this midpoint, the Commission determined that the MISO TOs’ 12.38% ROE (which is 153 basis points above the range of the presumptively just and reasonable ROE) was unjust and unreasonable.
Consistent with Commission policy, which sets an RTO-wide ROE at the midpoint of the zone of reasonableness when the transmission owners receiving the RTO-wide ROE are determined to be of average risk, the Commission established the just and reasonable replacement ROE for the MISO TOs at 9.98%. The order requires the MISO TOs to provide refunds based on the 9.98% base ROE, with interest, for the first complaint proceeding’s 15-month refund period from November 12, 2013, through February 11, 2015, and for the period from September 28, 2016 (the date of the initial order on the complaints) to the date of today’s order. As it did in Opinion No. 569-A, the Commission used the replacement base ROE as the currently effective ROE for the second complaint that was filed in 2015, and determined that 9.98% had not been shown to be unjust and unreasonable. Therefore, the Commission did not order refunds for the second complaint period.
IMPLICATIONS
Today’s order refines the methodology the Commission will employ to determine: (i) whether an existing ROE remains just and reasonable; and (2) if not, how the new replacement ROE should be established. Now that the Commission’s ROE methodology has been clarified, we anticipate that transmission owners will evaluate existing ROEs based on current data and the Commission’s revised methodology to determine whether new Section 205 filings are warranted. Similarly, we anticipate that customers will perform their own evaluations to determine whether complaints challenging existing ROEs could be successful. Of course, today’s order may be subject to rehearing requests and judicial review that could lead to future revisions to the ROE methodology. We will continue to report on future refinements to the Commission’s policy as they develop.
A copy of the Commission order can be found here.
