We have often debated the appropriate discount rate to use in our long-term capacity expansion and capital budgeting decisions. In the past I have argued for a "risk premium" over the cost of debt, but I could never justify a number. If we could somehow determine the value that our members would place on their cash, we could determine a better discount rate.
How should we value the member’s equity held by AECI? One approach would price the equity as if it were being held by a publicly traded, investor-owned utility.
When we retain earnings at AECI we are essentially investing our member’s money in the cooperative for them. Our returns that our customers expect from their investments depends on the riskiness of the investment. If they choose to invest their money in a savings account, they would expect very low returns, but they would be taking very low risk. An investment in a startup company may provide high returns but presents much greater risk.
We could estimate a value for the members’ equity by comparing it with an alternate investment of similar risk. Imagine if, instead of investing their cash in AECI, our members could have invested in a neighboring investor-owned utility, an investment which should present risk simlar to an investment in AECI.
The value (cost) of equity in a publicly-traded company is determined using this formula:
Cost of Equity = Risk Free Rate + Relative Riskiness of IOUs * Average Stock Market Risk Premium
The Risk Free Rate (T-Bill rate) is currently near zero, but over the past 80 years it has averaged 3.8%. In just the last 20 years (ending 2008) it averaged 4.25%.
The relative riskiness of a stock relative to the market can be computed using regression and is known as the stock’s “beta”. The beta of our neighboring utilities is 0.72 for Ameren, 0.79 for Great Plains Energy, and 0.77 for Empire District Electric (showing that Empire and Great Plains are considered a higher risk investment than Ameren). The overall average beta for utilities over a 30-year period has been about 0.75.
The average large company stock market return over the last 80 years has been 11.7%, which represents a 7.9% Average Stock Market Risk Premium (the difference between 11.7 and 3.8).
Using these figures, the long-run cost of equity for a large Midwestern utility should be:
Cost of Equity = 3.8 + (0.75 * 7.9) = 9.725% (say about 10% in round numbers).
What do you think of this approach? Does it make any sense? Should this be our new discount rate? This higher number would bias us toward shorter-term projects, but maybe that is a better approach. I would love to hear your comments.
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I agree this question merits discussion. Here are a few of my initial thoughts:
ReplyDeleteMy belief is that using AECI’s predicted cost of money is appropriate for evaluating investment decisions in resource planning analysis.
What I see as one of the most significant differences between an investor owned utility and an electric cooperative is the need for return on investment. The lack of required ROI gives cooperatives the economic advantage of valuing variable operations dollars on the same basis as fixed costs associated with long term debt. If we were to apply an additional premium to capital dollars, the result would be a financial preference for lower fixed cost generation sources with higher variable cost. This would result in a net cost of power that is higher than optimal.
As far as adding a risk premium, I would agree that large capital projects come with significant budget uncertainty. This results in a bus bar cost that is uncertain until completion of the project; that is, unless construction risk is largely placed on an EPC provider, in which case it would add to the overall project cost. Contrast this with the uncertainty of the bus bar cost associated with a low capital project that has a higher dependence on variable fuel costs.
I would suggest that both high capital and low capital generation resources have risks that make the resulting power cost uncertain to some degree. This uncertainty or risk is a significant factor that must be considered in the ultimate resource decision. The current approach to assessing various risks is through the use of sensitivities including cost overruns with capital intensive projects as well as several fuel and other scenarios. This approach allows testing of a resource decision against a wide range of variations to provide an indication of a plan’s vulnerability to specific risks.