Mark R. Schuling Office of Consumer Advocate

1. Double Leverage Mark R. SchulingOffice of Consumer Advocate Iowa Utilities Board Hearing Room 9:00 – 11:00 a.m. November 27, 2012

2. “If rates produce earnings that are below a fair and reasonable level, they are unjust or confiscatory to the owners of the utility property and if rates produce earnings that are above a fair and reasonable level, the rates are oppressive to the utility's ratepayers. It is essential to achieve an equitable balance between investor and consumer interests. “Davenport Water Co. v. Iowa State Commerce Comm'n, 190 N.W.2d 583, 604-05 (Iowa 1971).

3. For a utility whose stock is publicly traded, the task is straightforward. You review the capital structure of the utility company and determine the weighted average cost of capital.

4. Double leverage is often necessary when a holding company exists because the holding company’s common equity investment in the subsidiary is leveraged twice, once with the holding company debt and a second time with subsidiary debt. For example, if the holding company only has common equity in its capital structure it must earn a 10% return from the investment in the subsidiary in order to provide the appropriate return on its common equity to its shareholders.

5. Because debt is usually less expensive than equity, a well-run company uses leverage in an attempt to arrive at a combination of debt and equity in its capital structure that results in the lowest overall cost of capital. For example, when the holding company invests in a subsidiary it uses equity and debt for its capital investment. Since a portion of the capital invested by the holding company requires less than a 10% return, a fair and reasonable return should be less than the highest cost of capital. An example of the true capital costs are shown below:

6. “The Commission, on the other hand, maintains the requirements of equal protection necessitate a double leverage adjustment when a holding company is involved in order to insure that utilities not so held are treated equally with respect to a rate of return determination. The Commission's position is well founded and is dispositive of the Company's contention. The existence of a holding company relationship, as here, produces a situation where the subsidiary's capital structure is not truly reflective of the actual debt-equity ratio therein. A double leverage adjustment is an attempt to more accurately present the capital structure of the subsidiary utility and, consequently, an attempt to insure a fair rate of return determination. “United Telephone Co. of Iowa v. Iowa State Commerce Comm’n, 257 N.W.2d 466, 479-80, 482 (Iowa 1977).

7. “[L]everage is the term used to describe “the advantage gained by junior interests through the rental of capital at a rate lower than the rate of return which they receive in the use of that borrowed capital.” (citations omitted) By leveraging their investment with debt, stockholders may effectively “own” a corporation which is worth more than their original investment. (citations omitted) “Thus, we see that by use of leverage [it becomes possible for] the equity owners . . . to earn an over all rate of return in excess of the cost of capital. The added earnings above the costs inure to the benefit of stockholders as they then receive a higher rate of return than if the institution had been financed entirely by equity.” (citations omitted) Regulatory bodies prevent such an excess earnings by analyzing a utility’s capital structure and allocating a different weighted cost to each of the individual elements of the capital structure, including debt so that the utility owners are allowed to earn on the debt only what it costs them to secure the leverage. (citations omitted) This is proper since a properly regulated utility should be allowed to recover only its true costs.” General Tel. Co. of the Southwest v. New Mexico Corp. Comm’n, 652 P.2d 1200,1205 (NM 1982).

8. This was recognized by the Tennessee Public Service Commission: [T]o ignore the effect of double leverage “could result in the parent’s shareholders earning more on their investment in the company than the market cost of equity.” The utility’s ambition to realize this windfall for its stockholders explains in part the heated atmosphere of the double leverage debate. As one economist noted, “We should not be too surprised at the vigor of their (the utilities’) opposition since they have a definite pecuniary interest in preserving the comparative advantage this form of corporate arrangement has over ordinary corporate arrangements. Presuming that regulatory authorities ignore the effect of double leverage in determining the rate of return to be allowed the subsidiaries of utility holding companies, the holding companies can, have, and will no doubt continue to earn millions of dollars of income in excess of their cost of capital. Their opposition to regulatory recognition of the effect of double leverage should therefore be taken for what it is worth.” General Tel. Co. of the Southeast, Docket No. U-83-7247, 60 PUR4th 469, 472 (Tenn. PSC, Feb. 21, 1984) (emphasis in original, citing Basil Copeland, “Double Leverage One More Time” 100 Public Utilities Fortnightly 19, Aug. 18, 1977).