Gas Distribution: Now a Higher-Risk Business

The rise in equity risk premiums for local gas utilities may come as a surprise.

Equity risk premiums for natural gas distributors have hit a ten-year high. Moody's Gas Distribution Index showed a jump to a 5.4 percent equity risk premium in December 2001 and has averaged an approximate five percent equity risk premium in 2002, while historically equity risk premiums have averaged 3.4 percent above the yield of 30-year Treasury bonds over the last 10 years. The variation in equity risk premiums over time and in relation to the level of interest rates, as shown in Figure 1, calls into question some commonly used analytical methods-particularly what is called the ex post risk premium analyses, or historical yield spread method, which typically uses extremely long 60- to 70-year periods.

Notwithstanding its widespread use, there is a serious conceptual problem with using the ex post or historical yield spread method to determine risk premiums.