On the Use of the CAPM in Public Utility Rate Cases: Comment Author(s): Dennis E. Peseau and Thomas M.

Zepp Reviewed work(s): Source: Financial Management, Vol. 7, No. 3 (Autumn, 1978), pp. 52-56 Published by: Wiley on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665011 . Accessed: 08/02/2013 07:25
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Utility

Regulation and

the

CAPM:

Discussion

On

the

Use

of

the

CAPM Cases:

in
Comment

Public

Utility

Rate

Dennis E. Peseau

and Thomas M. Zepp

The authors are Senior Economists on the staff of the Oregon Public Utility Commissioner.

* In a recent issue of Financial Management, Professors Eugene Brigham and Roy Crum called for caution when using the Capital Asset Pricing Model (CAPM) to estimate the cost of equity capital of a regulated utility [2]. While it is hard tp question the wisdom of caution in using any method of cost of capital estimation, it is unfair to single out the CAPM method as a biased mechanism for estimating a utility's fair rate of return. This note shows that, had Brigham and Crum (B-C) heeded their own caveat and cautiously reviewed the basics of the CAPM, they could not have made such a strong indictment of this model. A thorough analysis of beta and other indispensable aspects of the CAPM framework provides the analyst or regulator with proper signals that make it possible to detect changes in a stock's fundamental risk and the accompanying changes in the cost of equity capital. Any method that attempts to account rigorously for risk and return can be misleading if the analyst is not aware of potential biases. CAPM estimates are no exception. Although recent studies by Vasicek [8] and Klemkosky and Martin [4] show that expected bias in

beta estimates may be sharply reduced with appropriate statistical procedures, some random error remains. B-C do not address the question of precision in beta estimates nor do they attempt to show that adjusted-beta estimates are too imprecise for regulation of equity costs. Instead they make the unsupported contention that recent beta estimates for telephone and electric utility stocks systematically understate beta risks. B-C begin their paper with hypothetical examples of changes in the fundamental relationship between a company's stock return and the average return on the stock market. Not surprisingly, the estimated regression line, based on historical data, does not immediately adjust to reflect the new relationship. From this rather basic point, B-C are apparently preparedto abandon the CAPM concept, concluding that the method "could potentially cause seriously biased and grossly misleading estimates of the cost of capital" [2, p. 8]. B-C give two hypothetical examples of changing risk that involve, in one case, a severe random shock that, overnight, changes beta risk of a company from 1.0 to 2.0 and, in the second example, a gradual
52

Association 1978 FinancialManagement

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PESEAUAND ZEPP/COMMENT ON THEUSE OF THECAPM

53

change in a company's true systematic risk from .75 to 1.3.

value of the market return, E(kM),is kM,which B-C indicate will leave beta unchanged [2, p. 9].

Random Shocks and Systematic Risk

B-C maintain that, because a random shock that changes the true beta risk cannot be immediately measured by an estimated beta, the CAPM method must be misleading. This is simply not true. Since a random shock cannot be expected, this shock cannot in the first instance be systematic, as B-C assume. Capital asset pricing analysis would predict that any unanticipated increase in risk would cause the share price to fall, resulting in below market risk-adjusted returns for investors holding shares at the time of the shock. All subsequent investors, however, should expect to receive the new risk-adjusted return. The important question is, given that the estimated beta will not immediately respond to a shock, does the CAPM framework provide enough information to warn the investor or analyst that beta may have been changing during the sample period? The answer is yes, both in the B-C hypothetical examples and in their later actual examples for REITs and bankruptcies. In their first hypothetical example, B-C represent initial systematic risk for a stock with fx = 1.0 and allow a dramatic random shock that drives the stock's beta to 2.0 [2, p. 8]. Note that B-C's exposition of the CAPM explanation of stock returns, kx = RF + Ox (kM - RF), may also be written as
k, - RF = q + bx (kM - RF)+ e (1)

Gradual Change in Risk?

B-C also contend that the true risk for a utility might have increased gradually during the prolonged market gain from 1965 to 1975 even though estimated betas for that utility decreased or did not change. The only support for their contention comes from the results of the authors' second hypothetical example. These results, however, are determined solely by hypothetical data that B-C supply. To assess the relevance of this exercise for conclusions about bias in estimates of utility betas during this period, we compared the data B-C constructed with actual monthly New York Stock Exchange (NYSE) market returns (reported by the Center for Research in Security Prices at the University of Chicago) for 1965 to 1975. The comparison indicates two crucial shortcomings in the hypothetical data: each and every hypothetical market return is positive after the base period, and the constructed variance of hypothetical market returns is unrealistically small. In the 1965-1975 period, actual average NYSE returns were distributed randomly and were negative in 61 of 132 months. Actual monthly rates of return ranged from -11.7% to +16.7% whereas B-C's constructed quarterly returns range from -0.0% to 7.0%. Even during the rapid market recovery of 1975-1976, 8 of the 24 NYSE monthly returns were negative. Since the alleged market conditions sufficient for biased estimates of utility betas cannot be observed for the 1965-1975 period or even during the rapid market rise of 1975-1976, there is no support for the B-C contention that true utility betas might have increased when estimated betas did not. Has beta, as a measure of market risk, failed to reveal a general change in riskiness of utilities in recent years? B-C cite several factors over the period 1965-1975 which might have increased true utility risk, although estimated betas remain constant or decrease. Exhibit 1 gives a value-weighted composite of betas for electric utilities listed on the NYSE during 1951-1975. The constancy of the composite from 1966 through 1975 is consistent with the B-C results. Our results, however, indicate a rather substantial increase in risk of over 45% occurring between 1960 and 1965, as the composite beta increased from .54 to .79. A more plausible explanation than the "arithmetic phenomenon" that B-C advance would be simply that investors perceived a change in the relative risk of electric utilities prior to 1965.

where q would be zero in equilibrium and e is a random error term. When the hypothetical random shock causes the share price to fall, the intercept term, q, becomes negative, indicating immediately to the analyst that during the sample period used for beta estimation a disequilibrium return was experienced below the market return required.This occurs whether or not the estimated beta has fully adjusted to the new true beta. B-C indicate other statistics that would signal a change in fundamental risk. This makes their contentions about the CAPM even more puzzling. If the analyst has available statistics that indicate the precision of the CAPM analysis, why would he or she not use this.information to avoid using misleading betas? Even more misleading is the impression given in the BC paper that the likely result of a random shock is a decrease in the estimated beta. The most likely result of a random shock will be to leave estimated beta unchanged. This follows from the fact that the expected

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54

1978 FINANCIALMANAGEMENT/AUTUMN

Exhibit 1. Systematic Riska of NYSE Electric Utility Stocks, 1951-1975

Stocks Continuously Traded for the 25-Year Period # of Stocks 56 56 56 56 56 Weighted Betab .49 .54 .79 .82 .81 Stocks Continuously Traded for the Respective Periods # of Stocks 59 71 71 83 92 Weighted Betab .49 .54 .79 .80 .79

Period 1951-955 1956-1960 1961-1965 1966-1970 1971-1975

(a) Estimates based upon monthly returns, company values, and value-weighted market index returns reported by Center for Research in Security Prices (CRSP), December 1977. (b) Weighted Beta N n T
( 2

t=l

N T 2 Vnt) n, where Vt / / n=l t=l

T number of months, N = number of utilities, Vnt = monthly market value of stock n during month t, and /n = beta for the nth utility.

Since 1965, beta risk has been somewhat constant for the industry as a whole. These results do not, of course, imply that the cost of capital for all utilities has remained constant for the recent period. The dramatic increase in the inflation rate has increased substantially the risk-free rate of interest (Treasury bills) and therefore the cost of capital for the utility industry. Nor should Exhibit 1 be interpreted as evidence that betas for particular utilities have been constant during the period. Our review indicates that risks (as perceived by investors) for individual utilities traded on the NYSE have in some instances increased, while in others decreased or stayed the same. Is The Problem Less Than Hypothetical?

whether a company's stock price and rate of return were in equilibrium during a recent period makes the model extremely useful in regulatory proceedings. In order to be useful in a regulatory setting, the parameters of the CAPM, beta in particular, must satisfy at least two important criteria. First, beta for a utility must be statistically estimable at a confidence level acceptable to the regulator or analyst. This important empirical aspect of the CAPM has been explored thoroughly in the finance literature, and it is fair to conclude that betas for most utilities can be estimated reasonably accurately. Second - and really the point of contention here beta measured ex post, with historical data, must be a meaningful predictor of risk in the next holding period if it is to be the basis for ex ante expectations. If estimated betas are poor predictors of risk for electric utilities, and if they are used by investors ex ante to formulate expectations on market returns, one would expect disequilibrium in the market for electric utility common stock, as these expectations are not realized. But, as Myers [5] points out, beta instability is not a necessary condition of disequilibrium; a number of factors can cause a discrepancy between anticipated and realized returns. Whatever the source of disruption, the analyst has statistics available to assess any potential change in CAPM estimates. To fully consider this, a more basic exposition than given by B-C is necessary. The market model of the CAPM equilibrium framework is, in terms of investor expectations: E(kx)RF =

f/ (E(kM)- RF)

(2)

While we offer evidence that the hypothetical examples posed by B-C are extremely unlikely, and that they could not have occurred for the utility industry from 1965 through 1976, an important question remains. If disequilibrium occurs as a result of a shock, will the CAPM framework allow the investigator to detect this situation? B-C cite the specific situations of REITs and bankruptcies as evidence that betas would lead one to compute erroneous costs of capital. While it is true that the CAPM is an equilibrium framework, it is capable also of signaling disequilibrium situations. If disequilibrium exists, the CAPM and virtually all methods of cost of capital estimation must be used with caution. But the ability of the CAPM to test

where E represents a statistical expectation, q and e of Equation (1) are absent because their expected values ex ante are zero, and E(bx) = ox. Equation (1) is the form from which the parameters q and bx can be estimated to determine if, in fact, investor expectations were nearly realized. The extent to which returns are not realized is reflected by the intercept term, q.1 (A more complete discussion of the relationship between the CAPM ex ante and ex post is contained in Myers [5].) As discussed above, the CAPM involves estimation of beta and an intercept term. In equilibrium, the intercept term in Equation (1) is expected to be zero and
'Some researchersand analysts have mistakenly interpretedex post estimates of regression intercepts as valuable tools for identifying beta instability or determining stocks which are underpriced or overpriced. (See Breen and Lerner [1].) Ex ante, however, the best estimate of the intercept is zero. (See Myers [5] and Sharpe and Sosin [7].)

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PESEAUAND ZEPP/COMMENT ON THEUSE OF THECAPM

55

when estimated is not expected to be statistically significantly different from zero. We use two of the BC examples of REITs and bankruptcies to show that careful examination of the CAPM results permits detection of disequilibrium situations and, consequently, that the CAPM is also a useful tool to indicate possible changes in risk. This is not to say, however, that the CAPM (being an equilibrium concept) is capable of predicting the abrupt shocks given in the B-C examples. No method of financial analysis is this prescient. The point in contention here is whether the CAPM, in a disequilibrium situation, would be misleading. Exhibit 2 gives, for C. I. Mortgage Group and W. T. Grant Co., summary statistics typically estimated for the CAPM. As B-C observe, in these two instances, the estimated betas decrease slightly as the abrupt change in risk begins to occur. Note, however, that in each instance the intercept term (which is zero in equilibrium) becomes significantly negative (indicating that market realized returns are less than required returns), and the fit (r2) becomes poorer. Also,

the lower beta of C. I. Mortgage has an insignificant tvalue and coefficient of determination. The poorer fit signals an increasing importance of unsystematic risk - a perfectly plausible outcome given the extreme financial situations of each company. Despite the inability of beta estimates to respond immediately to a change in true market risk, careful analysis would make the investigator aware of disequilibrium and thus potential changes in systematic risk. Our examination of individual NYSE electric utilities, however, indicates that utility stocks have not experienced statistically significant disequilibrium in recent periods. A close examination of Moody's 24, a subset of the stocks making up the composite considered in Exhibit 1, reveals betas that are statistically significantly different from zero, intercepts that are not, and r2 values that are reasonable for each stock for various periods. Exhibit 2 also includes results for one of the electrics we examined, an obvious candidate for individual analysis overlooked by B-C, Consolidated Edison Company of New York. A recent study by Pettway [6]

Exhibit 2: CAPM Statistics for C. I. Mortgage Group, W. T. Grant, and Consolidated Edison Co.

Sample Period Ending C. I. Mortgage Group Dec. 1973 Dec. 1974 Dec. 1975 Dec. 1976 W. T. Grant Dec. 1971 Dec. 1972 Dec. 1973 Dec. 1974 Aug. 1975 Consolidated Edison Mar. 1972 Mar. 1973 Mar. 1974 Mar. 1975 Mar. 1976

Intercept Estimate (T-Value) Estimate

Beta (T-Value) r2

-.012 -.046 -.010 -.015

-1.08 -1.97** - .42 - .61

.68 .58 2.53 2.89

2.26** 1.24 4.14** 4.74**

.14 .03 .31 .32

.011 .003 -.012 -.037 -.033

1.29 .37 -1.19 -2.97** -2.04**

1.42 1.23 1.69 1.38 1.52

7.07** 5.60** 7.14** 5.67** 4.85**

.46 .35 .47 .36 .29

-.004 -.005 -.004 -.003 .005

.58 .73 .56 .15 .27

.42 .42 .53 .96 1.14

2.94** 2.84** 3.59** 2.93** 3.64**

.16 .15 .22 .16 .22

different fromzeroat the .05 level. **Significantly Source:Estimates baseduponmonthlyreturns andvalue-weighted marketindexreturns reported by the Centerfor Researchin SecurityPrices(CRSP), December1977.

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56

FINANCIALMANAGEMENT/AUTUMN 1978

provides a detailed analysis of the impact of Con Ed's dividend omission on other utility betas.2 Exhibit 2 gives statistics for the company for periods before and after the April 24, 1974, announcement of the passed dividend. The statistics presented contain sufficient information to alert one to a change in risk. In this instance, the response of beta to the change in dividend policy was almost immediate. The Pettway study is consistent with our findings in that it also finds a rapid - although transitory - response of utility betas to the shock induced by Con Ed's decision. The results for Consolidated Edison and other utilities examined provide no reason to assume that the statistically significant disequilibrium experienced by some REITs and by some firms that went bankrupt applies to electric or telephone risk estimates. It is our conclusion therefore that CAPM estimates should provide a useful foundation for estimates of equity costs of utilities.

leading estimates of cost of capital for the utility industry is, however, simply not supported. Whenever cost of capital estimates must be made for the future, one must assume the formidable task of projecting risk and investor expectations. In an uncertain world, the estimates will seldom be perfect. Several years of empirical research on the capital asset pricing model at least allay some of the analyst's fears about the difficulties of quantifying risk. This is not to say that CAPM analysis supplants other keen financial judgment; it cannot. But, used in conjunction with consideredjudgment, the CAPM offers a systematic basis to estimate the cost of capital in utility regulatory proceedings.

References
1. W. J. Breen and E. M. Lerner,"On the Use of f in BellJournal and Regulatory Proceedings," of Economics Science (Autumn1972),pp. 612-21. Management 2. EugeneF. Brighamand Roy L. Crum,"On the Use of the CAPM in Public Utility Rate Cases," Financial (Summer1977),pp. 7-15. Management 3. EugeneF. Fama, Foundations of Finance,New York, Basic Books, 1976. 4. RobertC. Klemkosky andJohnD. Martin,"TheAdjustmentof Beta Forecasts," Journalof Finance(September 1975),pp. 1123-28. 5. Stewart C. Myers, "On the Use of f in Regulatory A Comment,"Bell Journalof Economics Proceedings: and Management Science (Autumn 1972),pp. 622-27. 6. RichardH. Pettway,"On the Use of d in Regulatory An EmpiricalExamination," Bell Journal Proceedings: of Economics(Spring 1978),pp. 239-48. 7. WilliamF. Sharpeand HowardB. Sosin, "Risk, Return and Yield:New York Stock Exchange CommonStocks, 1928-1969,"FinancialAnalysts Journal (March-April 1976),pp. 33-42. 8. OldrichA. Vasicek,"A Note on Using Cross-Sectional in BayesianEstimation Information of SecurityBetas," Journalof Finance(December1973),pp. 1233-39.

Conclusions
The capital asset pricing model (CAPM) has received increasing attention in recent years, owing to its explicit consideration of risk and return. It is not a panacea, nor can it be used in a vacuum. There is little to be gained by rejecting the CAPM as a useful tool, however, when no other method of risk-returnevaluation serves as a serious competitor. Professors Brigham and Crum offer good advice in their call for caution in application of the CAPM. Their insinuation that the CAPM probably gives misEdison's examinesthe impactof Consolidated announce2Pettway of otherelectric menton betasof a composite utilities. Sinceweekly of short-term areconsidered, estimates holdingperiods impactsare beta estimatessmooth computed.His conclusionthat longer-run movements [6, p. 247],makinglongerrunbetasstable,is transitory with our findings consistent for the utilityindustry. See Fama[3], for discussion of longer-term beta esespeciallythe bibliography, timates.

EASTERN FINANCE ASSOCIATION Call for Papers

The Eastern Finance Association will hold its annual meeting in Washington, D.C., April 19-21, 1979. There will be papers and discussions by academicians, business professionals, and government specialists on almost all aspects of domestic and international finance. Those wishing to present a paper should send a two-page abstract before November 27, 1978, to: Professor Michael Keenan (Vice President, Program), Graduate School of Business Administration, New York University, 100 Trinity Place, New York, New York 10006.

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