BSP-UP Professorial Chair Lectures 19-20 October 2015

Bangko Sentral ng Pilipinas Malate, Manila

Lecture No. 1

Corporate Income Taxes and Utility Rates in the Philippines

by

Dr. Helena Agnes S. Valderrama BSP UP Centennial Professor of Accounting

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CORPORATE INCOME TAXES AND UTILITY RATES IN THE PHILIPPINES

Helena S. Valderrama, Ph.D.1 U.P. Cesar E.A. Virata School of Business, Diliman, Q.C. 1101 Philippines

Should the corporate income taxes (CIT) regulated utilities pay be considered a recoverable

expenditure and therefore part of the rates that consumers of their services are charged? The

decision of the Metropolitan Waterworks and Sewerage System (MWSS) in 2013 to disallow CIT in

the approved rates of the 2 water concessionaires has again put a spotlight on this issue and

triggered the filing of several international arbitration and Supreme Court cases. The MWSS

decision also brought back to the public’s attention the Supreme Court decision in 2002 that the

MWSS Regulatory Office and its Board of Trustees had anchored their controversial decision on. In

a landmark ruling, the Supreme Court in that year disallowed CIT in the rates the Manila Electric

Company (Meralco) had charged to electricity consumers and ordered that over P30 billion the

utility had already collected be refunded to its customers.

Instead of settling the controversy in the water sector, two international arbitration panels formed

in 2014 came up with diametrically opposed decisions. The different conclusions reached by the

two panels on the issue of CIT in water rates highlight the fact that this matter cannot be considered

settled in the Philippines.

This paper elucidates and endeavors to put a framework to the arguments on the appropriate

treatment of income taxes in regulated rates in the Philippines. It identifies changes in regulatory

conditions since the 2002 Supreme Court decision and differences between electricity and water

rates determination that should inform current thinking on this issue. Finally, the paper presents

analysis on the performance of Meralco pre and post the 2002 Supreme Court decision to attempt

to determine what have been the financial effects on the company of the inability to pass on its CIT

in electricity rates.

1 Ver 2 (25 Sep 15). Correspondence: helenvalderrama@gmail.com. Financial assistance from the BSP Professorial Chair Fund and the research assistance of Toni Lei Uy are gratefully acknowledged.

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CORPORATE INCOME TAXES AND UTILITY RATES IN THE PHILIPPINES

1 Introduction and Objectives of Paper

Should the corporate income taxes (CIT) regulated utilities pay be considered a recoverable

expenditure and therefore part of the rates that consumers of their services are charged?

The answer seems evident. After all, for profit-seeking firms, all costs have to be covered by

revenues derived from customers in order for it to stay viable. The aforementioned costs include

production costs, selling costs, administrative costs, financing costs, the cost of capital invested in

the business, and yes, even the costs relating to taxes and other compulsory levies on the firm.

Where else will payments for these costs ultimately come if not from the price customers pay for

the product or service it sells?

Yet, in the Philippines, the Supreme Court has declared that CIT is not allowed to be part of

electricity utilities’ revenue requirement which is the basis for the rates they can charge. CIT in the

rates of the Metro Manila Water Concessionaires has been described as “immoral”, “beyond

unconscionable”, “scandalous”, “unethical”, “unconstitutional”, and an “abuse of consumers”, not

just by consumer groups but also by media and even by several members of the Philippine

Congress. On the other hand, while their voices are not as loud or as emotion-filled, the business

sector and the academe have generally been on the side of the Concessionaires on this issue.

Two international arbitration panels to which the question of recoverability of CIT in the water

rates of the Metro Manila Concessionaires was asked came up with diametrically opposed

decisions. One said yes; the other one said no.

Clearly, the issue is far from settled and not completely understood by many.

This paper aims to help clarify the debate by first elucidating the expressed arguments for and

against the recoverability of CIT in the rates of regulated utilities. More importantly, it puts the

issue in the context of the regulatory regimes in power and water, which, as will be shown later, is

material input to the resolution of this debate. This study does not aim to settle the matter, as the

question on whether or not CIT is allowed to be recovered in the rates of the Concessionaires is a

legal one and is now pending at the Supreme Court. Nonetheless, a decision by the Supreme Court

either way has important implications on the regulation of Philippine utilities that will also be

discussed in this paper. Finally, the paper presents the results of an exploratory investigation on

the pre and post 2002 financial condition and performance of the Manila Electric Company, the

company most affected by the SC ruling on non-recoverability of CIT which came out in 2002.

The paper proceeds as follows: Section 2 describes the current situation in the water sector where

the issue of recoverability of CIT in rates is “live” and the cause of several cases pending before local

and international courts. The arguments for and against the recoverability of CIT in water rates as

well as the reasons given by the Supreme Court in Republic v Meralco for its ruling that CIT is not

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recoverable in Meralco’s rates are set out here. Section 3 analyzes the Meralco ruling in light of the

different rate-setting regimes in power and water. It also presents the analysis on Meralco’s

financial condition and performance pre and post the 2002 Supreme Court ruling. Section

concludes and identifies areas for further study.

2 The Current Standoff in the Water Sector

2.1 The Third Rate Rebasing Exercise

As is already well-known, the provision of water and sewerage services in the Metro Manila

franchise area of the Metropolitan Waterworks and Sewerage System (MWSS) was turned over to

the private sector in 1997 via the execution of two separate but identical Concession Agreements

(CA) with winning bidders Manila Water Company, Inc. (MWCI) and Maynilad Water Services, Inc.

(MWSI).

The CA provides that water rates will be re-set every 5 years after the conduct of a “rebasing

exercise” that involves reviewing the historical performance of the Concessionaires as well as their

future operating and capital investment plans, and, for rate determination, these activities’

resultant cash flows.

According to the CA: “… the rates for water and sewerage services … shall be set at a level that will

permit the Concessionaire to recover over the 25-year term2 of the Concession operating, capital

maintenance and investment expenditures efficiently and prudently incurred, Philippine business

taxes and payments corresponding to debt service on the MWSS Loans and Concessionaire Loans

incurred to finance such expenditures, and to earn a rate of return on these expenditures for the

remaining term of the Concession.”

The third rebasing exercise was undertaken in 2013 and was supposed to determine the rates for

2013-2017. In September of that year, the MWSS Board of Trustees adopted the recommendation

of the MWSS Regulatory Office (RO) to deny the proposed water tariff hikes of both Concessionaires

and instead require a decrease of P1.46 and P7.24 per cu. m. in the water rates of MWSI and MWCI,

respectively.

Not in agreement with the action of the MWSS, which included denial of the recovery of CIT in the

recommended water rates of the two Concessionaires, the latter commenced separate arbitration

proceedings at the ICC International Court of Arbitration.

The decision in the MWSI case was rendered on 29 Dec 2014, while that in the MWCI case was

rendered on 21 April 2015.

2 The concession periods for the MWCI and MWSI were extended in 2009 and 2010, respectively. Thus, both Concessions are currently set to expire in 2037.

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Table 1 below summarizes the dispositive portions of the two arbitration decisions3:

Table 1

Arbitral Awards Maynilad vs. Manila Water

Maynilad Manila Water

Arbitral Award “By majority, finds that the Claimants is entitled to include its Corporate Income Tax in its Future Cash Flows for each year of operations”

/a

“A) Corporate Income Tax is not an allowed Expenditure under the Concession Agreement; B) The Appropriate Discount Rate should not be computed fully pre-tax”

/b

Rate Adjustment Php4.06/cu.m. “By majority, upholds Claimant’s alternative Rebasing Adjustment for the Fourth Rate Rebasing Period of 13.41%, which means an average basic water charge of Php30.28/cu.m., resulting in an adjusted rate of Php34.34/cu.m. for every Charging Year of the Fourth Rate Rebasing Period”

/a

(Php2.77/cu.m.) “(We) order that the Rate Rebasing Adjustment for the period 2013 to 2017 be set as a negative adjustment of 11.05% of MWCI’s 2012 average basic water charge of Php25.07 per cu.m., or negative Php2.77 per cu.m. to be implemented in 5 equal tranches of negative 2.21% per charging year”

/b

Sources of basic data: /a

Final Award UNC141/CYK: Maynilad Water Services, Inc. v. MWSS and the Regulatory Office /b

Final Award UNC136/CYK: Manila Water Company, Inc. v. MWSS and the Regulatory Office

As a result of the conflicting decisions and mindful of the mandate to set “just and equitable rates”,

the MWSS Board of Trustees resolved to approve the RO’s recommendation to partially implement

the MWSI Arbitral decision by carving out the CIT portion of the rate. By this time, cases had

already been filed at the Supreme Court on, among others, the CIT issue. Thus, this “compromise”

was believed by the MWSS RO and the Board to be the best course of action to take while awaiting

the SC resolution.

The rate adjustment in the MWCI Arbitral Award was implemented. MWSI, however, decided not to

accept a partial implementation of its Arbitral Award and have instead pursued further legal action

against MWSS, including another international arbitration case to call on the National Government

undertaking in the CA.

2.2 Opposing Positions on CIT Recoverability

Table 2 below summarizes the main arguments of the MWSS and of the two Concessionaires on the

CIT recoverability issue:

3 MWSS-RO Public Information Department Press Release (28 May 2015)

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Table 2 MWSS’ and the Concessionaires’ Arguments on the CIT Recoverability Issue

MWSS’ Position4 Concessionaires’ Position5

As stated in Sec. 32.7, 1985 of the COA State Audit Manual and affirmed in Republic v Meralco (G.R. No. 141314, 15 Nov 2002, hereinafter, also referred to as Meralco ruling), for purposes of rate fixing, income taxes paid by a public utility or the operators of a public utility who are the recipients of the income, cannot pass on the same to consumers in the form of operating expenses. This rule applies with equal force whether the utility is one with a franchise or one with other form of authority. While the Concessionaires are not public utilities (since only MWSS has the franchise), they are … bound by the same laws and rules applicable to their principal, MWSS. The MWSS cannot legally contract with Concessionaires for the recovery of income taxes paid by the latter, since the Concessionaires are merely performing the functions of MWSS which is prohibited from doing so. [OGCC Opinion No. 116 series 2013 dated 4 Jun 2013]

Concessionaires are not public utilities but only agents and contractors of a public utility; therefore, the Meralco ruling does not apply to them. This has been settled between MWSS and the Concessionaires since 20046. There is no law that decrees that regardless of the terms and conditions of their CA, the agent is subject to every limitation or restriction governing the principal. MWSS, by Charter, is exempt from the payment of income taxes so the principle that the agent cannot rise above the principal is inapplicable. Inclusion of CIT as recoverable expenditure is merely an exercise by the Concessionaires of their contractual rights under the CA.

A contractual provision that is contrary to law is null and void. The right to set up the defense of illegality cannot be waived. (Art. 1409, New Civil Code) Thus, previous interpretations, such as the 2004 resolutions of the RO and MWSS, could neither bind nor estop the RO from issuing a new resolution correcting such interpretations.

MWSS and the RO cannot overturn the 2004 resolutions as the parties to the settled or resolved dispute are bound forever to the outcome of the dispute resolution, that outcome having the force and effect of law upon them. MWSS and the RO cannot arbitrarily disregard the conclusions of the 2004 TWG that were adopted by the MWSS as these have been fully implemented and rights have already vested.

CIT is not among recoverable expenditures of The CA, issuances relating to the MWSS

4 RO Resolution No. 13-005-CA dated 7 Jun 13 and letters to MWCI and MWSI dated 19 Jun 13 and 10 Jul 13. 5 MWCI and MWSI Comments dated 25 and 26 Jun 13 and 29 Jul 13 on RO Resolution No. 13-005-CA 6 In 2004, the MWSS Board of Trustees directed the creation of a Technical Working Group (TWG) consisting of representatives from the RO and the two Concessionaires to study the implications of the then recently promulgated Meralco ruling on the concession agreements. The MWSS subsequently adopted the TWG’s findings and recommendations, most significant of which was the determination that it was the intention in the CA for MWSS to remain the public utility and that the Concessionaires, as their agents, would not be considered public utilities. Therefore, the Meralco case does not apply to the two Concessionaires.

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the Concessionaire according to the CA. As a direct tax, CIT is not the same as Philippine business taxes, a form of indirect tax, which is a recoverable expenditure under the CA.

privatization, and the financial model supporting Maynilad’s Rate Bid and Technical Submission which accompanied its bid in 1997 confirm the express agreement and intention of the parties to the CA that income taxes form part of the Expenditures that may be recovered by the Concessionaires through the Standard Rates. MWSS has, until 2013, considered CIT as part of Philippine business taxes in rates determination as well as in the financial model used to bid out MWSI in 2006.

2.3 Republic v Meralco: Public Interest versus Private Profits

The above “debate” between the MWSS and the two Concessionaires on the CIT issue can be said to

be of a purely legal nature involving the correct interpretation of the two parties’ contractual

agreement. The resolution of the conflict has material impact on water rates, however, as can be

shown in the diagrams below:

Composition of Rate Determinations7

7 MWSS-RO Public Information Department Press Release (28 May 2015). The figures corresponding to the yellow triangles in the diagram are those eventually approved by the two Arbitration panels.

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The crux of the dispute is the applicability of the Meralco ruling rendered in 2002 by the Supreme

Court to the Concessionaires. A timeline of events leading to this Supreme Court decision is

reproduced below8:

Table 3 Timeline of Events Leading Up to the SC Decision in Republic v Meralco

Salient portions of the SC ruling follow:

The Energy Regulatory Board correctly ruled that income tax should not be included in the computation of operating expenses of a public utility. The burden of paying income tax should be Meralco’s alone and should not be shifted to the consumers by including the same in the computation of its operating expenses.

8 Mendoza ( ), The Politics and Dynamics of Electricity Regulation: The Case of ERB and Meralco http://www.ombudsman.gov.ph/UNDP4/wp-content/uploads/2013/01/PoliticsDynamics_FeMendoza.pdf

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In regulating rates charged by public utilities, the State protects the public against arbitrary and excessive rates while maintaining the efficiency and quality of services rendered. However, the power to regulate rates does not give the State the right to prescribe rates which are so low as to deprive the public utility of a reasonable return on investment. Thus, the rates prescribed by the State must be one that yields a fair return on the public utility upon the value of the property performing the service and one that is reasonable to the public for the services rendered. The fixing of just and reasonable rates involves a balancing of the investor and the consumer interests.

MERALCO has not adequately shown that the rates prescribed by the ERB are unjust or confiscatory as to deprive its stockholders a reasonable return on investment. In the early case of Ynchausti S.S. Co. v. Public Utility Commissioner, this Court held: “[t]here is a legal presumption that the rates fixed by an administrative agency are reasonable, and it must be conceded that the fixing of rates by the Government, through its authorized agents, involves the exercise of reasonable discretion and, unless there is an abuse of that discretion, the courts will not interfere.” Thus, the burden is upon the oppositor, MERALCO, to prove that the rates fixed by the ERB are unreasonable or otherwise confiscatory as to merit the reversal of the ERB. In the instant cases, MERALCO was unable to discharge this burden.

The Supreme Court upheld the decision of the Energy Regulatory Board, noting that the exercise of

judicial review is limited to a determination of whether the administrative order is unlawful,

unreasonable, a grave abuse of discretion or rendered in an arbitrary or capricious manner.

However, the SC also framed the issue in the case as one pitting public interest against private

profits and posited that it is the duty of the State to protect the public against arbitrary and

excessive rates. It also made explicit that the determination of whether rates are “reasonable and

just is a purely judicial question and subject to the review of the courts”.

Materially, the SC described as well the process by which “just and reasonable rates” are to be

determined. As quoted below:

In determining the just and reasonable rates to be charged by a public utility, three major factors are considered by the regulating agency: a) rate of return; b) rate base and c) the return itself or the computed revenue to be earned by the public utility based on the rate of return and rate base. The rate of return is a judgment percentage which, if multiplied with the rate base, provides a fair return on the public utility for the use of its property for service to the public. The rate of return of a public utility is not prescribed by statute but by administrative and judicial pronouncements. This Court has consistently adopted a 12% rate of return for public utilities. The rate base, on the other hand, is an evaluation of the property devoted by the utility to the public service or the value of invested capital or property which the utility is entitled to a return.

The process described by the High Court is what is known as the Rate on Rate Base (RORB) methodology which was the one in use to set rates for electricity distribution utilities at the time of the Meralco case.

RORB has since been replaced as a rate setting methodology in the electricity distribution sector.

Rates in the water sector based on the Concession Agreement are not set in the same manner as

those in electricity. The rate setting methodologies in these two sectors are described in the next

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section. As will be shown in this section, the difference in methodology may be material input in

the resolution of the CIT issue in the water sector.

3 CIT and Electricity and Water Rates

In Republic v Meralco, the Supreme Court noted that the power to set rates is a legislative function

which may be delegated to administrative agencies such as the Energy Regulatory Board (now

Energy Regulatory Commission or ERC). While the Court referred to the ERB in its ruling, by the

time it rendered a decision, ERB had already been abolished by a then recently passed law that will

cause fundamental changes to the country’s electricity industry. That law is the Electric Power

Industry Reform Act (EPIRA).

Among the mandates given by EPIRA to the power sector regulator was the authority to prescribe a

rate-setting methodology for the regulated sectors of the industry.

3.1 Shift from RORB to Performance Based Regulation (PBR) Methodology in Setting

Electricity Distribution Rates

In 2004, ERC promulgated the Guidelines for the Setting of Distribution Wheeling Rate Guidelines9 and replaced the RORB with a Performance Based Regulation (PBR) methodology. PBR is similar to the RORB in that the distribution utility’s (DU) rates are set at a level that allows it to recover just and reasonable costs of service and earn a fair rate of return on its investment. Four essential differences, however, are the following: (1) Instead of a fixed basic rate that changes only with a subsequent rate application, the PBR rate is in the form of a price cap with annual adjustments for identified factors (e.g., inflation), (2) The cost of service components are forecast, rather than historical, amounts over a four-year regulatory period, (3) The rate of return is prescribed to be the DU’s weighted average cost of capital (WACC) rather than a fixed amount by law, and (4) A performance incentive factor is explicitly included in the rate model. The setting of DU rates begins with the determination of the DU’s annual revenue requirement (ARR) for the four-year regulatory period based on the following building blocks:

1. Operating and maintenance expenditure 2. Taxes other than corporate income tax 3. Regulatory depreciation 4. Return on capital 5. Corporate income tax (set to zero in ERC rate decisions, following the SC ruling in Republic

v Meralco)

9 Amended to Rules for Setting Distribution Wheeling Rates in July 2006, December 2006, and December 2008 corresponding to the last 3 entry points to PBR

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In equation form:

Where: ARR = annual revenue requirement; Opex = nominal operating and maintenance expenditure; Taxm = taxes paid, other than corporate income tax; RegDepn = regulatory depreciation; RAB = regulatory asset base; WC = working capital allowance; WACC = weighted average cost of capital; and Taxp = corporate income taxes paid. The two biggest components of the ARR, regulatory depreciation and return on capital (denoted by the term in brackets in the above equation), depend on the valuation of the regulatory asset base. Under both RORB and PBR regimes, the RAB is allowed to be periodically revalued (i.e., not measured at historical or acquisition cost). It has been shown, in a previous study by this researcher, that the use of a revalued rate base distorts the incentive structure in the industry. It results in wealth transfers from electricity consumers to utility shareholders beyond that which is supposed to be earned by the latter based on its regulatory-prescribed rate of return.10 The present value of the ARRs for the regulatory period is computed, translated into a Maximum Annual Price (MAP) cap in PhP/kWh and allowed to be adjusted annually for changes in inflation, the USD-PhP exchange rate, a performance incentive factor to reward/penalize the DU for achieving/failing to achieve specified targets, a smoothing factor to reduce price shocks, and for revenue over/under recovery in the previous regulatory period. In equation form:

Where: CWI = change in weighted index (based on inflation and the USD-PhP exchange rate); X = a smoothing factor that may be positive, negative or zero; S = performance incentive factor; K = revenue over/under recovery correction factor; and ITA = adjustment for corporate income tax over/under recovery.

3.2 Setting of Water Rates

The determination of water rates in the Metro Manila franchise area is based on the Concession

Agreements between the MWSS and its two Concessionaires. Quoting from the CA:

Art. 9.4. … the rates for water and sewerage services provided by the Concessionaire shall be set at a level that will permit the Concessionaire to recover over the 25-year term of the Concession … operating, capital maintenance and investment expenditures efficiently and prudently incurred, Philippine business taxes and payments corresponding to debt service on the MWSS Loans and Concessionaire Loans incurred to finance such expenditures, and to earn a rate of return (… “Appropriate Discount Rate”) on these expenditures for the remaining

10 Valderrama, H. (2011), The Rationale for Revaluation of the Regulatory Asset Base in Electricity

Rate Setting in the Philippines, BSP Professorial Chair Research

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term of the Concession in line with the rates of return being allowed from time to time to operators of long term infrastructure concession agreements in other countries having a credit rating similar to that of the Philippines.

The CA mandates the MWSS RO to determine the rate adjustment limits to be applied during a regulatory period based on the expenditures made by the Concessionaire as well as the future cash flows arising from its planned activities.

Quoting again from the CA:

Art. 9.4.2 For the purposes of determining the Rates Adjustment Limit to apply to Standard Rates to come into effect on a Rate Rebasing Date commencing with the second Rate Rebasing Date, and the Rates Adjustment Limits for the following four charging years, the Regulatory Office shall, by taking into account all information available at the time, and by making reasonable projections of all factors relevant to the future Cash Flows of the Concessionaire, determine:

(i) The Net Present Value, which may be positive or negative, of the Opening Cash Position, as at June 30 following that Rate Rebasing Date;

(ii) The amount, either positive or negative, which if made to the Rates Adjustment Limit for the following Charging Year would cause the Net Present Value of the Future Cash Flows, as at June 30 following that Rate Rebasing Date, to be equal but opposite in sign to the Net Present Value of the Opening Cash Position as determined in (i) above (the “Rebasing Adjustment”).

Thus, while the principles of prudent and efficient cost recovery and fair return are to be followed

in setting the rates in both electricity distribution and water and sewerage services supply, the

manner by which these principles are implemented differ in the two sectors. In water, (1) both

historical and future cash flows are considered, (2) recovery and return are to be determined over

the life of the Concession, and (3) the rate of return is applied to all expenditures. In electricity, the

rate of return is applied to the rate base, which is a measure of the “value” of the invested capital of

the utility.

3.3 Determination of Fair Return

A commonality in the current methods to set electricity and water rates in the Philippines is the use

of a market-based weighted average cost of capital (WACC) (the term used in the Concession

Agreement is Appropriate Discount Rate or ADR) to determine the fair return to the investors of the

regulated entities.

WACC/ADR estimation is far from a uniform, straightforward exercise and is arguably the least

precise among the inputs to water and electricity rates as it is supposed to be forward looking and

yet dependent on historical data arising from a variety of sources and time periods. Moreover,

there are alternative methods in determining the costs of debt and equity, which are the main

components of the WACC/ADR. Nonetheless, in past regulatory decisions for both sectors, there

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appears to be a convergence in the formula and the principal inputs used to determine WACC/ADR.

These are shown in the equation below:

Where: re = cost of equity; rd = cost of debt; rf = risk-free rate in the Philippines; (rm – rf) = market risk premium; DM = debt margin or premium; Betae = equity beta; E/V = proportion of equity funding in the capital structure of the regulated entity; D/V = proportion of debt funding in the capital structure of the regulated entity.

As mentioned previously, a crucial difference in the use of WACC/ADR between the two sectors,

however, is that in the electricity sector, the WACC/ADR is multiplied to the regulatory asset base

to determine the “fair return” to the capital providers. In water, the WACC/ADR is applied to the

cash flows of the Concessionaire. Moreover, as part of its efficiency incentive, the electricity utility

gets to “keep” any excess actual revenues (it is regulated based on a price cap, rather than a

revenue cap). This is not the case with the water Concessionaires where any excess/shortfall in

actual cash flows is “corrected” by the use of the Opening Cash Position (OCP) adjustment.

In short, the return to the water Concessionaires is clearly and actually determined by their

approved ADR. In the electricity sector, what the utility actually earns is likely not equal to its

approved WACC.

What does the above mean as regards the treatment of CIT in rates determination?

As mentioned in the introduction of this paper, companies need to generate sufficient revenues to

cover all costs they incur and payments they need to make in relation to the business as well as

provide a sufficient net return to their investors to compensate the latter for the risk their capital

was subjected to.

If CIT is not considered as recoverable expenditure and investors are not given a return sufficient to

cover the business’ tax obligation plus their risk-adjusted net return (i.e., a fully pre-tax WACC or

ADR), then the latter receive less than their required or “fair” rate of return as represented by their

approved WACC/ADR. This conclusion is more certain in the water supply sector than it is in the

electricity distribution sector.

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3.4 Financial Performance of the Manila Electric Company pre and post 2002

The interest in looking at the financial effects on Meralco of the 2002 Supreme Court ruling is

triggered by the statement of the SC that Meralco, in 2002, was unable to prove that the rates fixed

by the ERC are “unreasonable or otherwise confiscatory (as it will) deprive its stockholders a

reasonable return on investment”.

At the outset, it has to be mentioned that the findings in this section are initial and exploratory at

best. Additional statistical procedures are required in order to make more definite and robust

conclusions on the effect of the 2002 SC decision on the financials of Meralco.

It is good to begin with how Meralco itself described the impact of the SC decision on its 2002

financials11:

The discussion in this section will focus on measures of risk and returns of Meralco (MER) from

1997 to 2014.

As measures of risk, shown below are 2 charts: Chart 1 presents estimates of the equity beta of

MER for the last 18 years annotated with significant corporate milestones over this period. Chart 2

presents estimates of MER’s cost of debt over the same period (see Annex A for details of how the

beta was derived).

11 Note 1 (d), p.3, Notes to the 2003 Financial Statements of Manila Electric Company & Subsidiaries

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Chart 1

Chart 2

The 2002 SC ruling appears to have had a significant impact on the debt premium and equity beta

of the company. Both measures of risk began to trend higher beginning 2000 to 2006-2008, with

equity beta going from below 1.0 to over 2.0 during this period, and a measure of MER’s debt

premium reached over 20% within this time horizon as well. Aside from the impact of the SC

decision, Charts 3 and 4 below may also be instructive as to the reasons for this development:

Chart 3

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Chart 4

As can be seen in Chart 3, MER’s distribution price per kWh hardly changed from 1997 to 2007, and

increased significantly only in 2008 as a result of the implementation of its first PBR-determined

rate. Despite relatively flat revenues, MER began to implement its SC-mandated refund beginning

2003. As a result, the company’s cash flows had deteriorated significantly and began to recover

only beginning 2008 when MER’s rate was allowed to increase. Notably, both measures of risk

tracked in this study began to show a trend reversal from that time.

For measures of return, the study used accounting-based and market-based variables, as shown in

Charts 5-8 in the next page.

Accounting measures of return show a consistent pattern of deterioration until 2007 and the

“catastrophic” effects on the company of the 2002 SC decision (the improvement in 2006 was a

result of a provisioning reversal and is non-cash in nature). As with its cash flows, MER’s

accounting measures of return began to improve only when it increased rates beginning 2008.

Chart 5

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Chart 6

Chart 7

Accounting returns can be affected by discretionary and subjective reporting practices, however, so the study investigates market-based returns as well. As can be seen in Chart 8 below, for most of the last 20 years, MER shares did not perform well in the market, and its worst performance was during the period 2002-2007. A clear positive trend can be discerned beginning 2008. Frequent trading in MER shares would not have been as profitable as a buy and hold strategy, although one would have needed to have a really long investment horizon. In particular, if one had acquired MER shares when EPIRA was promulgated, he would have earned an annual compounded return of approximately 15%. If he had purchased the shares around the time when MER first implemented its PBR rate, the return is approximately 22%. This is not to say, of course, that EPIRA and PBR were surely the reasons for the returns experienced during this period. Recent changes in MER’s share price may be a reflection of the company’s strategic decision, announced in 2010, to re-enter the generation business. MER began to make significant investments in this sector in 2013. Clearly, however, share price data from the last 20 years show that the milestones of the SC decision and MER’s first rate hike and succeeding price adjustments had affected the market-based returns on the company as well.

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Chart 8

What may be the gleaned from this exploratory investigation conducted on MER’s finances? It seems likely that MER’s risks and returns were affected by the Supreme Court decision disallowing CIT in their rates. However, the exclusion of CIT in the rates of MER appears not to have caused rates that are so low as to be considered “confiscatory” since the shift to the performance based regulation methodology, despite the non-recoverability of CIT, allowed MER’s finances to improve significantly in recent years.

4 Concluding Remarks and Areas for Further Study

The debate is far from over, and as stated in the beginning of this paper, can only be settled in a

judicial forum.

However, there are certain conclusions that can be made from the data and analysis presented in

this paper.

First, how public interest (the reason that CIT is not allowed to be recovered in regulated rates) is

best served, or even defined, is not a straightforward exercise. It can be argued that public interest

is promoted more by ensuring adequate investment in vital public services such as water and

electricity. The latter is achieved by ensuring that investors in these services are compensated

fairly for their invested capital. It must be noted, however, that adequate investment does not

necessarily follow from fair compensation. Regulation in water and electricity to date has focused

on rate determination, and has given less emphasis on the equally important issue of adequate and

appropriate investment in the sector. Looking again at Chart 4, it can be seen that capital

expenditures for MER have been relatively flat in the last 15 years, and increased only recently as a

result of the foray into generation. Has there been adequate and appropriate capital investment in

water and power? This is an important area of investigation.

Second, the marked and substantial increase in the risk measures of MER from 2000 to 2008 can be

argued to be at least partially due to its lack of a significant rate adjustment over this period. It is

no secret that the rate adjustment processes regulated sectors in electricity undergo are time-

18

consuming, adversarial, and lawsuit-prone. Considering that increasing the risk of MER and other

regulated utilities raises its cost of capital and ultimately results in the higher prices being opposed

to in the first place, how can the rate adjustment process be improved to avoid this?

Third, the rate setting methodology does matter in the resolution of the issue on CIT recoverability.

Applying the rate of return on a revalued asset base, as allowed in electricity, obfuscates the return

earned by investors. It is submitted that in the water sector, disallowing CIT in water rates will

have a direct effect on the returns earned by its investors. Is the CA model better in this sense for

use in determining the rates of regulated entities? More specifically, can it be used to set the rates

in the electricity distribution sector?

It is also worth repeating at this point that our current methods for determining what is a “fair” rate

of return are not without significant shortcomings. Thus, even without CIT, a utility may be able to

earn an adequate return if it obtains a “favorable” WACC/ADR from its regulator. Improving the

way WACC/ADR is determined for water and electricity utilities is also clearly an area for further

study.

Finally, to what extent did the non-recoverability of CIT affect Meralco’s finances? A more robust

investigation into this question is needed and may be useful in the resolution of the current issue of

CIT in water rates determination.

19

Appendix A

Derivation of Beta

Equity beta of Meralco was derived using the Capital Pricing Asset Model (CAPM),

re = rf + (rm – rf ),

where re is the equity return (return of Meralco for a given period), rm is the market return (return

of PSEI in a given period), rf is the risk free rate (91-day Treasury Bill rate), and is equity beta.

Meralco stock and PSEi historical prices were obtained from Data Stream and Wall Street Journal

databases, respectively. Monthly returns,

r = (rend of month/rstart of month) – 1,

were obtained for both Meralco stock and PSEi. For each year, ordinary least squares regression

was performed on the preceding 30-month historical returns of both securities in order to obtain ,

with the following form:

Y = + X,

where Y is Meralco's risk premium, re – rf and X is the market risk premium, rm – rf . A 30-month period,

corresponding to 2 ½ years, was used to determine to enable comparison with the most recent beta

value for Meralco, as provided by Datastream, Thomson Reuters. Datastream uses at the minimum, 30-

month time series of stock prices to arrive at values.

In August 2015, the of Meralco was 1.1, as obtained from Datastream.

Data Sources:

Data Source

MERALCO stock price Datastream, Thomson Reuters

PSEi price Wall Street Journal website

http://quotes.wsj.com/index/PH/PSEI/historical-

prices

91-day Treasury Bill rate Bangko Sentral ng Pilipinas website. “Selected

Domestic Interest Rates”

http://www.bsp.gov.ph/statistics/efs_fsa1.asp