G. Kevin Spellman, MS, CFA Director, Hawk Center for Applied Security Analysis, University of Wisconsin Consultant, Inte

1. Finding Balance:Combining Theory and Psychology in Setting Regulated ROE How We Did It in Wisconsin? SeeWisconsin Power and Light Company, Docket No. 6680-UR-115 G. Kevin Spellman, MS, CFA Director, Hawk Center for Applied Security Analysis, University of Wisconsin Consultant, International Strategy & Investment Group

2. Outline • Theoretical Shortcomings • Psychology of Finance • Constituents • Investors • Utility Management • Consumers • The Right ROE

3. Theoretical Shortcomings • Definition of cost of equity capital (r) • r = rf + B * RP • r = D1 / P + g • r = interest rate proxy + risk premium • Theoretical Shortcomings • Very stringent assumptions • Those who set prices / interest rates are not rational • What do the proponents and challengers say?

4. Theoretical Shortcomings • Proponents • Beta does not describe cross section of returns (Fama and French) • Mean/variance analysis, important for CAPM, is a “special case” and this not “a happy state of affairs (for finance theories and what is taught)” (Sharpe, Nobel Prize for CAPM) • Challengers • Stocks under-react (Jagadeesh & Titman) and over-react (DeBondt & Thaler) • Because of efficacy performance spirals (Lindsley Brass & Thomas) • That result from extrapolating past events too far into forecasts of the future (Lakonishok, Shleifer, & Vishny) • Houston, We've Got a Problem(1974 television film)

5. Psychology of Finance • r = fundamentals • x is market psychology • Described in terms such as over and under-reaction, overconfidence, herding, framing, escalation of effort, loss aversion, confirmation bias, anchoring and many more • Behavioral finance studies psychology in finance + x = balanced view

6. Psychology of Finance • Consider 2 stocks, A and B • Identical in all aspects (g=5%, payout =50%, E1 = $1.00), except A has a P/E of 10X and B a P/E of 9X • A has a beta of 1.00 and B a beta of 1.11 • B is riskier, right? • B has higher returns, right? • Warren Buffet and empirical evidence show and explain that cheaper stocks with higher implied betas have higher returns and less risk Wrong! Wrong again!

7. Constituents • In our balancing act • We do not want to lose sight of theory (fundamentals) • But we must not ignore x (psychology) • Because x has implications for • Investors behavior (pricing) • Management behavior • Consumers • And, if x is ignored it will impact fundamentals

8. Constituents: Investors • Investors provide the capital to management to provide a product to consumers and, in exchange, they receive returns • Based on theory, the price (“P/B”) of what they pay is directly related to what they get (“ROE”) • P0 = [E0 * (1+ g) * payout] / (r – g) • So - P0 / B0 = [(E0 / B0) * (1+ g) * payout] / (r – g) • Or - P0 / B0 = [(ROE0) * (1+ g) * payout] / (r – g)

9. Constituents: Investors • In practice, the relationship is not so clear • Mispricing (R2 = .42) • Relationship not 1:1 (slope is 0.61) • For average ROE, P/B set according to theory • What does this imply?

10. Constituents: Management • Goal of management is to add value • Does earning ROE = r add value? • No! NPV of new projects = $0, stock stagnant • Investors fire management and pull capital from company (causing r to rise) • If ROE = r, no cushion • Managers (and investors) bear all risk • People do not behave rationally in loss situations (see prospect theory, Khaneman, Nobel Prize)

11. Constituents: Management • Consider two situations (prospect theory) • Situation A: Participants are asked to choose between sure gain of $800 or 85% chance of $1,000 and 15% chance of nothing • The second option better mathematically • People choose the first option (less “risky”) • Situation B: Participants are asked to choose between sure loss of $800 or 85% chance of losing $1000 and 15% chance of losing nothing • The first option better mathematically • People choose the second option (more risky)

12. Constituents: Management • People are risk-seeking in loss situations • Smaller losses result in a lot more utility but larger gains do not • May be destructive and raise r in the future

13. Constituents: Management • Tails of Eight Air Travel Excursions • Assume: Goal is to have MB > MC (ROE > r) • Assume: Fly because MB > MC • Travel 1 – car accident, $20K to replace car • Under-react to non confirming info, continue to fly • Travel 2 – plane late, missed connection, drove home • Travels 3-4 – cancelled flights • Worried - is MB > MC? MB = MC (ROE = r), escalate • Travel 5 – diverted flight, take bus • Travels 6-7 – cancelled flights, take bus

14. Constituents: Management • Tails of Eight Travels Excursions continued… • MC clearly > MB (ROE < r), must do something • Emotional, over-reaction, take dramatic measures (risk) • Cannot increase MB (ROE fixed), must cut cost • Travel 8 (to conference), book ticket on off-brand airline • Airline goes bankrupt! Cost a total loss, write-off • Scared to travel – I think I will drive home! • Not rational! • Lesson: Provide proper incentives or you may encourage irrational behavior and incur unwanted risks and … bankruptcy!

15. Constituents: Management • Should ROE be set = r? No! • Need cushion to avoid negative behaviors • Also • ROE based on historical book and r on market prices • Regulators have not set ROE @ r • Reduces incentives to invest and seek efficiencies • ROE @ r is not fair (relative to other industries) • Inconsistent with investor expectations • Could share cushion with consumers • See testimony for Application of Wisconsin Power and Light Company Docket No. 6680-UR-115 : concept being adopted • Raising bar of discussions • Eliminating past fights over what is r

16. Constituents: Consumers No! • Is lower net income good for consumers? • Price falls and, assuming dividends and growth are stable, r rises! (recall: r = D1 / P0 + g) • Chokes off capital investment, leading to shortages and volatility long-term, causing r to rise • Higher net income is bad as well • Hurts consumers’ wallets • Leads to management and investor overconfidence and overinvestment, which results in write-offs (e.g. 2001-3) and higher risk premiums (and r) long-term

17. The Right ROE • The right ROE is not too high or too low • Where irrational behaviors by management and investors are reduced for the benefit of consumers • Where management, investors and consumers all win • Where there is BALANCE!

18. Finding Balance:Combining Theory and Psychology in Setting Regulated ROE How We Did It in Wisconsin? SeeWisconsin Power and Light Company, Docket No. 6680-UR-115 G. Kevin Spellman, MS, CFA Director, Hawk Center for Applied Security Analysis, University of Wisconsin Consultant, International Strategy & Investment Group