Don’t Settle for A Historical Risk Premium
Joy Nicdao-Cuyugan is the Director of Utility Research and Analytics at the Illinois Commerce Commission’s Public Utilities Bureau. Half of her three decades at the ICC was in overseeing the Accounting, Finance, and Rates Departments as Director of the Financial Analysis Division. Joy has a Bachelor of Arts degree in Psychology and a Bachelor of Science degree in Business Management from De La Salle University. She earned her Master’s degree in Business Administration from the University of Illinois in Springfield.
Rochelle Phipps is the ICC’s Assistant Director of the Financial Analysis Division. She was previously a Senior Financial Analyst at the ICC’s Finance Department. Rochelle has a Bachelor’s degree in Finance from Illinois College. She earned her Master’s degree in Business Administration from the University of Illinois in Springfield.
The Capital Asset Pricing Model (CAPM) is widely used to estimate the cost of equity component of a firm's cost of capital in public utility rate proceedings, corporate finance, and asset allocation. The CAPM posits that the required return of a company's stock is equal to the risk-free rate (often proxied by a U.S. Treasury security yield), plus the product of that company's beta (a measure of the company stock's volatility relative to the market) and the expected risk premium for the market (a diversified portfolio of all assets often proxied by the S&P 500 Index).
The expected return on the market above the risk-free rate of return is the market risk premium. An expected return is, by definition, forward looking. Yet, historical (realized) stock returns are often used to estimate the market risk premium even though it is unlikely to reflect return expectations of investors and can lead to inaccurate results.
This is a critical issue in public utility rate setting, where determination of a just and reasonable rate of return on the utility's used and useful property is often highly contested, as one basis point more in the authorized cost of capital can result in millions of dollars collected from customers.