Utility Returns on Equity: A Self-Fulfilling Prophecy?
Rising electricity prices have made energy affordability an issue of major public concern. Synapse recently completed reports for the Natural Resources Defense Council and Evergreen Collaborative about strategies to lower electricity prices in Virginia and New Jersey.
Return on Equity is essentially the amount of shareholder profit that investor-owned utilities are allowed to collect from customer bills. Calculating the ROE is an attempt to estimate the utility’s cost of equity. Think of cost of equity as the minimum return demanded by investors to supply equity to the utility, or as the opportunity cost to the equity investor: What did the investor give up the opportunity to invest in that is of similar risk to this utility investment?
One of the policy levers we examined in those reports was lowering the return on equity (ROE) for publicly regulated utilities. There has been a growing literature around the argument that regulatory commissions around the country have set ROE too high, resulting in a transfer of wealth from ratepayers to utility shareholders.
The stakes are high because ROE can make up a big portion of the customer bill. A paper from the University of California Berkeley’s Energy Institute at Haas calculated the costs to consumers from “excess” ROEs at an average of $7 billion per year.
There are many reasons why regulatory commissions have set ROE too high. These range from the fact that utilities control the timing of when they file for rate cases to the fact that consumer advocacy groups that push back against utility ROE requests tend to have fewer financial resources for engaging in regulatory proceedings than their utility opposition. But in this blog post, we explore another powerful reason:
high utility ROEs have become circular as utilities point to high ROEs as a reason regulators should award them a high ROE.
To put it another way, witnesses for utilities in rate cases frequently argue that the ROE should be set at a level no lower than other utility ROEs across the country. The result is a self-fulfilling prophecy where what one regulatory commission decides on ROE is a reflection of what other regulatory commissions have been deciding. Lost in that circular process is the fundamental question that should inform the ROE: What is the riskiness of this utility investment?
For example, the California Public Utilities Commission recently decided what the cost of capital, including equity, should be for the California investor-owned utilities. Several intervening groups, including the Utility Consumers’ Action Network (UCAN) represented by Synapse, argue that the ROE should be set significantly lower than what the utilities are proposing. San Diego Gas & Electric (SDG&E), for example, proposed an 11.25 percent ROE. In comparison, UCAN’s witness (Synapse Principal Associate Matthew Bandyk) calculated an 8.87 percent ROE in his testimony. Other intervenors calculated similarly low or even lower ROEs for SDG&E.
SDG&E’s witness responded in rebuttal testimony that any ROEs “well below all recently authorized ROEs for electric and gas utilities” should be rejected, including UCAN’s. The average national authorized ROE for utilities is most recently around 9.7 percent. The CPUC ultimately approved a 9.93% ROE for SDG&E – above average, but a decrease from SDG&E’s previous ROE of 10.23%.
SDG&E’s argument here mirrors that used by utility witnesses in many proceedings around the country: for a utility ROE to be fair, it must be comparable to returns that similarly risky companies are receiving elsewhere. This is called a comparable return standard. So, if regulatory commissions generally authorize utilities to collect a certain return from customers, anything below that amount violates this comparable return standard, or so goes the argument.
This line of argument shuts the door to the possibility of a lower ROE than those commissions have been approving, and it locks customers into the ROEs they have been paying. That’s a big problem for consumers because there are many reasons to think that commissions do not always get it right when it comes to ROE. Regulatory commissioners are just people—people who are subject to the same kind of biases as all humans. The UC Berkeley paper notes one behavioral bias where regulators tend not to allow ROEs to fall below 10 percent (10 being an easy-to-remember, though ultimately arbitrary number).
So are customers stuck paying ROEs around 10 percent, even if they are not justified? Is there another way forward?
It turns out there’s another way of looking at the comparable return standard—one that makes much more sense than the utility witness argument when we consider the legal thinking behind this standard.
Supreme Court precedents
The comparable return standard stems from a landmark U.S. Supreme Court case, Bluefield Water Works v. Public Service Commission, in which the majority opinion stated:
A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding, risks and uncertainties, but it has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures.
This comparable return standard was later expanded upon in another landmark case, FPC v. Hope Nat. Gas Co., in which the Court laid out the standards for what constitutes a “just and reasonable” rate of return for public utilities:
From the investor or company point of view, it is important that there be enough revenue not only for operating expenses, but also for the capital costs of the business. These include service on the debt and dividends on the stock... By that standard, the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital.
The phrase “other enterprises having corresponding risks” is important here. The utility witness interpretation of comparable return would have it that “other enterprises” means other utilities. After all, the argument from SDG&E’s witness and other utility witnesses is that authorized return is what matters when considering comparable returns. Most businesses do not have authorized returns. Their returns are simply what they make on the marketplace. Regulated utility companies are in the somewhat unique position of having their return decided by regulators.
Utility interpretations aside, it is clear from the Bluefield decision that the Court is talking about not just other utilities, but any other business that has similar risks to utilities (“other business undertakings”). That would include non-regulated businesses that do not have authorized returns the way regulated utilities do.
So looking only at the authorized returns of other utilities fails to meet the plain language of the Supreme Court decisions that created the comparable return standard. We cannot determine if the utility’s ROE is “commensurate with returns on investments in other enterprises having corresponding risks” by considering authorized return because authorized returns are unavailable for the “other enterprises” one needs to evaluate.
Cost of Equity
What's the alternative? There is another way to interpret what the Court meant by a return “commensurate with returns on investments in other enterprises having corresponding risks.” Recall that the ROE is supposed to be an estimation of the utility’s cost of equity. Recall also that the cost of equity is the opportunity cost to the equity investor.
In other words, the cost of equity is the same concept as a return “commensurate with returns on investments in other enterprises having corresponding risks.” The cost of equity represents the return an investor could have received on similar investments to the company in question.
The cost of equity is commonly estimated using several financial models that use market data to gauge how investors view an asset, such as the stock of a utility company. For example, the Capital Asset Pricing Model (CAPM) estimates cost of equity by calculating the expected return on an investment based on the riskiness of that asset relative to the overall market.
When properly implemented, these financial models often identify a cost of equity that is well below the ROE approved by commissions. For example, our testimony identified an 8.87 percent ROE for SDG&E, compared to the utility’s authorized ROE of 10.23 percent.
The next step is telling regulatory commissions that when it comes to ROE, their hands are not tied by what other commissioners in other states have decided. By focusing on the cost of equity, commissions can set ROEs that are supported by legal precedent and fair to consumers and utilities.