THE USE OF CUSTOMER DISCOUNT RATE
IN REVENUE REQUIREMENT COMPARISONS
Proceedings of the
25th
Annual Iowa State Regulatory Conference, 1986
By
Michael J. Majoros, Jr.
Consultant
Snavely, King & Associates, Inc.
Good Morning. It is a pleasure and
an honor to appear before you today and engage in this debate. I would like to thank Dr. Cowles and Dr.
White for the invitation. I am a
consultant specializing in public utility rate matters. I have presented testimony in a number of
proceedings, generally on behalf of public utility customers and regulatory
commission staffs.
Typically my testimony has presented
alternative recommendations to a utility’s revenue requirement filing. I have found that most issues in a public
utility rate case revolve around conceptual “gray areas” amenable to
debate. In fact, Dr. White and I have
met in the past on the battlefield to discuss certain issues, and today, Dr.
Howe and I debate another of the gray areas.
ISSUES
The issue I intend to explore today
is the validity of the use of customer discount rates to evaluate revenue
requirement comparison models. I will
also consider the relationship between utility and customer discount
rates. Finally, I will discuss some of
the measurement problems in determining the level of the customers discount
rate.
I conclude that the customers’
discount rate is a relevant statistic in evaluating ratemaking models and that
that rate will always be higher than the rate of the utility studied.
DISCOUNT RATE
A discount rate is a compound
interest factor used to determine the net present value of a stream of future
cash flows. It embodies the user’s time
preference, inflation, and risk expectations.
When a firm evaluated new
investments, it must assume that they are as risky as current investments;
hence, the appropriate discount rate is the firm’s current cost of
capital. Public utilities may use their
last allowed overall rate of return, that is, the embedded cost of capital, or
their perception of incremental capital costs taking into consideration
anticipated trends in debt and equity cost rates.
There are broadly two classes of
public utility customers – individuals and firms. The discount rate of a firm is hypothetically
derived in the same manner as a utility’s cost of capital, that is, through an
analysis of the composite effect of business and financial risk. Large heavily
capitalized utility customers will likely have composite risk characteristics
not much different from utilities.
Smaller firms, however, particularly those with limited capitalization
will in all probability have a cost of capital, and hence discount rates,
higher than the utility that serves them.
The individual’s discount rate is quite another matter.
In his text Financial Markets and
Institutions (McMillan Publishing Co., Inc. 1983) Robert D. Auerbach
states:
The interest
rate individuals use to discount future expected income streams to obtain
present values is not observed in the market place. It is the subjective real interest rate
in each individual’s mind that is fundamental to his or her valuation of
securities.” (p.147).
The problem with individual
consumers’ discount rates is that it is a spectrum, not a single number. Consider the extremes. At the low end of the income spectrum are
consumers living at or below the poverty level.
For such individuals the discount rate is practically infinity because
the deferral of a dollar on income means that the consumer must forego basic
necessities of life; food, clothing, shelter.
As income increase, the opportunity
cost of the incremental dollar falls.
For low to moderate income consumers, who are likely to be net debtors, it
is the finance charge rate on consumer credit -- 18 to 24 percent. At the high income end of the spectrum, the
discount rate becomes the marginal return from individual investments – stocks,
bonds, real estate, tax shelters. One
this is certain, the individual discount rate is not the discount rate of the
utility. For the vast majority of individuals
it will be substantially higher.
Hence, while it is possible to
determine the current embedded cost of capital of utilities and large corporate
customers through observation of published data, it is much more difficult –
arguably impossible – to determine a composite individual and small firm
discount rate. Nevertheless, individuals
are highly sensitive to the impact of changes in their future cash flows, as
evidenced by today’s current wave of mortgage refinancings. The individual’s discount rate, although
subjective, is a very real factor in his or her economic behavior.
REVENUE REQUIREMENT COMPARISON MODELS
Revenue requirement comparison
models are typically presented as evidence in utility rate proceedings to
persuade regulators to adopt one or another of ratemaking alternatives having
different streams of future costs and benefits.
A revenue requirement model presents
an implied choice between the several alternatives that are often highly
sensitive to the discount rate.
I have two examples of ratemaking
models with me today. Both compare
revenue requirement streams that differ as to their future timing. The one characteristic common to both of the
models is that each presumes a constant rate of return throughout the period,
and that rate of return is the utility’s cost of capital. The equity component of the rate of return
considers inflation, risks and the utility’s investors expectations.
Model 1 was prepared by me for
presentation in a Public Utilities Fortnightly Article. It had its genesis in testimony I presented
regarding the subject matter in a proceeding a number of years prior to the PUF
article.
This model deals with the once
controversial subject of tax normalization versus flow through. It is a five-year revenue requirement
comparison of the two methods. It
assumes a constant 46 percent tax rate, an 11.75 percent pretax and 9.887
percent post-tax cost of capital. The model
reveals that if the hypothetical utility’s post-tax cost of capital is used to
discount the two cash flow streams they are equal, that is, the net present
values of both streams are the same --$115,244.
The second example is a model
prepared by Dr. White which considers the economic implications of a
depreciation reserve deficiency. As we
all know, service life estimates are rarely fixed and many time are changed
throughout the life of utility plant.
When this occurs the issues of remaining life depreciation and reserve
imbalances generally arise. Dr. White’s
model compares a straight-line whole life revenue requirement stream assuming
that original life estimates were correct, with an alternative stream in which
the original service life estimates were changed and the remaining life
technique was used to correct the resulting reserve imbalance. Dr. White used the utility’s after-tax cost
of capital as a discount factor to demonstrate the equality of the two revenue
requirement streams.
Dr. White and I both determined that
it was proper to discount the cash flow streams, and we both demonstrated that
the utility’s discount factor is defined as its after-tax rate of return. Furthermore, in both examples we have imputed
that discount rate to the utility’s customers.
Thus, using that assumption, all other things being equal, it was
presumed that the parties to whom the alternatives were presented would use the
utility’s discount factor to make the implied choice because any other discount
would skew the results and eliminate the equality.
It is reasonable to assume that the
customers would use the utility’s cost of capital to evaluate cash flow streams
under those circumstances? I think the
answer is no. The customer would
use their own discount rates to evaluate the alternatives.
IMPACT OF THE CUSTOMERS DISCOUNT RATE
The impact of using the customers
discount rate is the reason for our debate.
In the example 1, normalization vs. flow through model, any rate higher
than the utility’s after tax cost of capital would support the conclusion, all
other thing being equal, that flow through was the superior method. In fact, all things were not equal in that
debate and normalization was adopted.
However, it is important to understand that a recognition of the
customers discount rate if indeed higher than the utility’s would largely
explain why there was so much—about 20 years worth of customer opposition to
normalization.
MEASUREMENT
If it could be shown that the
customer’s discount rate was always equal to a utility’s embedded after tax
cost of capital then we would not be having this debate because the customers
rate would always implicitly recognized in revenue requirement model. On the other hand, if the customer rate is
not equal to the utility’s cost rate, we are faced with a measurement
problem. As I stated previously, there
are broadly two classes of utility customers: firms and individuals. Large firm’s discount rates can be observed
in the market place. Small firm and
individual discount rates, however, are not observed in the market place. They are fundamentally subjective personal
valuation standards.
I am not here today to advocate any
particular measurement technique, nor am I here to estimate a composite
customer discount rate. However, I will
state that the individuals discount rate is different from and higher that the
utility’s cost of capital.
Obviously, there is a wide range of
customer discount rate measurement possibilities. In the past, I have seen estimates tied to
consumer credit card costs. I have also
seem estimates of composite (individuals and firms) customer discount rates in
which a rate is estimated for both classes of customers and then weighted to
determine both classes of customers and then weighted to determine the
composite. I have also seen reference to
the social rate of discount which is based on the opportunity cost of public
spending. All of these measurement
approaches to determine the customer’s discount rate have one consistent
characteristic. The yield result that
bear no relationship to the utility’s cost of capital.
CONCLUSION
The issue today is whether the
customer’s discount rate should be considered in a revenue requirement
comparison. I submit that the customers
discount rate should be considered when a model is presented which implies that
choice can be made. In that
circumstance, it is the discount rate of the parties to whom the choice is
presented that is the relevant statistic.
I thank you for listening and once
again would like to thank Dr. White and Dr. Cowles for inviting me here today.
COMPARISON OF NORMALIZATION AND
FLOW-THROUGH
REVENUE REQUIREMENTS REFLECTING RATE BASE
REDUCTION OF ACCUMULATED DEFERRED TAXES
| |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Total |
| Normalization Cost of Service |
$38,309 |
$34,226 |
$29,048 |
$23,995 |
$21,977 |
$147,515 |
|
Net
Present Charges |
34,862 |
28,344 |
21,892 |
16,429 |
13,716 |
115,243* |
|
Flow-through Cost of Service |
34,050 |
19,314 |
16,504 |
44,361 |
40,699 |
154.928 |
|
Net
Present Charges |
30,986 |
15,995 |
12,438 |
30,424 |
25,401 |
115,244* |
| |
|
|
|
|
|
|
|
Cost of Capital – Post-tax = .09887 |
| |
|
|
|
|
|
|
| |
|
|
|
|
|
|
| |
Per Cent |
Cost |
Pretax
Weighted
Cost |
Tax
Effect |
Posttax
Weighted
Cost |
|
|
|
| Debt |
45 |
.09 |
.0405 |
(.01863) |
.02187 |
|
|
|
| Equity |
55 |
.14 |
.0770 |
-0- |
.07700 |
|
|
|
| Total |
100 |
|
.1175 |
(.01863) |
.09887 |
|
|
|
| |
|
|
|
|
|
|
|
|
|
* Difference in totals due to rounding. |
Return to paragraph ▲
COMPARISON
OF REVENUE REQUIREMENTS
| |
Correct Service Life Estimate |
Revised Service Life Estimate |
| |
(No Reserve Deficiency) |
(Reserve Deficiency) |
| |
|
|
|
|
|
|
| |
Cash Flow |
Revenue |
Cash Flow |
Revenue |
| Year |
Debt |
Equity |
Requirements |
Debt |
Equity |
Requirements |
| 1 |
$101.40 |
$87.60 |
$408.00 |
$78.90 |
$72.60 |
$333.00 |
| 2 |
67.14 |
63.78 |
460.57 |
39.27 |
45.95 |
366.47 |
| 3 |
60.47 |
59.38 |
566.48 |
84.53 |
77.18 |
643.83 |
| 4 |
56.94 |
57.30 |
781.55 |
78.88 |
73.10 |
852.78 |
| 5 |
663.89 |
462.35 |
1,425.61 |
683.70 |
476.16 |
1,490.73 |
Present
Value |
$600.00 |
$400.00 |
$2,563.83 |
$600.00 |
$400.00 |
$2,563.83 |
| |
|
|
|
|
|
|
| |
|
|
|
|
|
|
| |
Per Cent |
Cost |
Pretax
Weighted
Cost |
Tax
Effect 1/ |
Pretax
Weighted
Cost |
|
| Debt |
60 |
.12 |
.72 |
(.036) |
.36 |
|
| Equity |
40 |
.17 |
.68 |
-0- |
.68 |
|
| Total |
100 |
|
1.40 |
|
.104 |
|
| |
|
|
|
|
|
|
|
1/
50 percent tax rate |
|
|
|
|
Return to paragraph ▲
|
