The decision discussed how asset valuation affects consumer rates. Using the simplified formula R = 0 + (V-D) r, the SC explained that this formula should balance the interests of utilities and consumers.
The SC decision on the ODRC addresses the V-D component of the formula. The SC didn't address this decision's "r" component. However, I believe the recent SC decision may impact the "r."
In practice, the "r" component is the return on capital, translated into the Weighted Average Cost of Capital formula, or the WACC. In simple terms, it measures the cost of debt and the cost of equity, generally assuming a 70-30 debt-to-equity ratio.
Not appropriate for Philippine setting
Regulators typically calculate the debt component based on prevailing borrowing costs in the market. However, calculating the cost of equity is more problematic. The ERC uses the Capital Asset Pricing Model (CAPM) to calculate the cost of equity. I have consistently maintained that the CAPM is not an appropriate methodology for the Philippines.
Although many regulators worldwide use the CAPM, this does not automatically make it appropriate for the Philippines — especially considering the recent SC decision. The number we obtain from the CAPM formula as the utilities' cost of equity must reflect what the SC requires as an actual test of the rates obtained from the formula. The rates must be just and reasonable and represent the "least cost."
CAPM debunked
I have argued that the number derived from the CAPM calculated by the ERC is arbitrary. It is arbitrary because the numbers used to calculate the CAPM use sources that are extraneous to the Philippine economy. The ERC uses numbers from Bloomberg indices and a number from a New York institution (Damorandam). None of these numbers reflect the actual cost of equity in the Philippines.
Economists have debunked the CAPM as a useless theory for deriving the cost of equity associated with a stock's " beta." In a famous 1992 study, two economists, French and Fama, declared that "Beta as the sole variable in explaining returns on stocks is dead." Further, Fama claimed, "CAPM is useless for precisely what it was developed to do."
If the number coming out from the CAPM calculation is arbitrary, it raises a critical question: How will we know that utilities are allowed a fair rate of return?
'Least cost' test
Given the SC's requirement of proof that the ERC calculated the number derived based on a "least cost manner," how will we know whether the cost of equity calculated by the ERC using the CAPM was done according to the principles laid down by the SC? How can we prove that this was the least cost?
I will discuss how to address this problem in my subsequent columns.
A power industry expert with over 40 years in experience as chief executive officer in firms ranging from banking, power, and advisory services.
