The SC decided only on the asset base of utilities, not on the rate used to determine the “return” of the utility. This rate is called the Weighted Average Cost of Capital (WACC) in common parlance.
As I argued in that column, ERC’s use of the Capital Asset Pricing Model (CAPM) in calculating the cost of equity of utilities will result in an arbitrary number. We must ask this: How do we know if the resulting cost of equity represents the “least cost” or , as the SC puts it, “fair and reasonable”?
The literature points to the Market-to-Book Ratio (MBR). In his 1988 book “The Economics of Regulation: Principles and Institutions,” renowned economist Alfred Kahn discussed the MBR in the context of regulated industries, particularly utilities. The simplified textbook formula for MBR is the ratio between the price of the stock market shares over the firm’s booked equity.
Kahn argued that a persistently high market-to-book ratio in regulated industries could indicate that utilities earned returns above their actual cost of capital. This disparity suggests that regulators might be allowing excessive profits — effectively granting utilities an economic rent at the expense of consumers.
Kahn pointed out that if the assets were to be based on their actual cost (as argued in the Philippine Supreme Court case) — then, for consistency, regulators should also use actual returns calculated on the book value of capital. If such actual costs are used, to prevent excessive profits, the return on equity (ROE) should equal the cost of the equity.
Kenneth R. Meyer made similar arguments in his “Market to Book Ratio,” published in the Electricity Journal in March 1997, where he pointed out the economic basis of the MBR.
He argued that “utilities with MBRs greater than one means consumers are overpaying the shareholders; on the other hand, shareholders are penalized when the MBR is less than one is diminished when MBRs are less than one.”
Meyer suggested that the best way for utility regulators to manage the “regulatory compact” between investors and consumers is to adopt a mechanism that allows the utility’s common stock price to vary around unity. He suggested a range of 0.7 to 1.3.
In the Philippine rate structure context, this implies that a utility’s cost of equity will also have to be subjected to regular “true-up” calculations in the same manner other costs are subjected to the same regular calculations.
The concept of “least cost” as it applies to the cost of equity has yet to be addressed within the ERC’s regulatory framework. In light of the Supreme Court’s recent ruling, it it may be time to do so.
A power industry expert with over 40 years in experience as chief executive officer in firms ranging from banking, power, and advisory services.
