The CAPM theorizes that investors will want a return that yields, at least, the government bond rate, adjusted for the risk it takes in the venture.
The problem with the CAPM is that this has been debunked as a flawed theory. Eugene Fama and Kenneth French in their 1992 seminal work said the CAPM does not work. Yet, the ERC continues to use it. Worse, even the CAPM has strict conditions for it to work – and the Philippine market would not meet those requirements.
Where does this flawed interpretation come in when we talk about power rates? It happens when ERC determines the Weighted Average Cost of Capital (WACC). The tariff is determined by the WACC and the cost of Equity of the WACC is determined by the CAPM.
The question, then, becomes how the ERC determines the appropriate Cost of Equity and, thus, the WACC for distinct types of Power Sales Agreements (PSAs). There are PSAs fixed for the contract term and linked to the price of coal or diesel and the forex. In short, what is cheaper: a P4.96/kwh floating contract, or a P5.00/kwh fixed price contract?
Floating power sales agreements (PSAs) are unfair to the consumers because they pass on the risks of foreign exchange and fuel prices to them, while the generators enjoy a fixed return on equity based on the Capital Asset Pricing Model (CAPM). The traditional analysis of comparing the levelized cost of electricity of different technologies is wrong because it does not account for the uncertainty and volatility of the floating PSAs. In a floating PSA it is the consumer who takes the forex and fuel risk.
My solution is to have generators offer fixed-price contracts. Some generators have offered this type of contract in the past. Fixed-price PSAs are more advantageous to the consumers because they eliminate the volatility risk and provide a known fixed price for budgeting purposes. If the CAPM were to be used from the perspective of the consumer, the result will be lower power rates for consumers.
To be a little technical, I can show mathematically, a fixed-price PSA will always have a lower discount rate than a floating PSA from the consumer's perspective, using the capital asset pricing model (CAPM). A fixed-price PSA has no correlation with the market, so its beta is zero, while a floating PSA has a negative correlation with the market, so its beta is negative. The fixed PSA will always be cheaper than the floating PSA, all other things equal. That is simple math. (Well, it does involve some calculus, to be honest.)
Introducing fixed-price PSAs into the utility's energy mix will lead to lower power rates and more economic value for the consumers. We should scrap using the CAPM and introduce a methodology that will be fair to both investors and consumers. Financial and market literature is full of recommendations along this line.
A power industry expert with over 40 years in experience as chief executive officer in firms ranging from banking, power, and advisory services.
