Overcompensating shareholders is costing taxpayers billions, a new study shows.
Regulating an electric or natural gas utility is a tough job. You want utilities to get the funding they need to serve the public reliably and safely, while controlling rates and distributing the revenue burden fairly among customers. Setting rates and monitoring the service performance of utilities gets a lot of attention. One of the biggest challenges facing regulators has received little attention: calculating the cost of utilities.
For many costs, that seems trivial—regulators can see how much companies pay for everything from fuel to software to CEOs by simply looking at a utility’s books. Of course, there remains the question of whether utilities are paying too much or using too much (or too little) inputs.
But when it comes to the cost of capital, things get even more murky. Determining the rate of interest that utilities must pay lenders, or the rate of return they must pay shareholders when they finance an investment by issuing stock, has been a challenge since utility regulation began about a century ago. Unlike most other inputs to a utility operation, the cost of capital depends heavily on the utility itself, especially its finances and risks.
Regulators can see the rates utilities pay lenders or bond buyers, despite the constant concern that utilities aren’t getting the best deals in those thin markets. The bigger question, however, is how much to compensate shareholders who own shares in the company. These costs do not appear anywhere on the books and are not easy to estimate.
These numbers really matter. By the start of 2022, U.S. investor-owned power companies have nearly $1.4 trillion in assets, about half of which is financed by shareholder equity. That’s why a lot of time is spent in the utility rate case discussing the relatively obscure technical question of how much return investors need to buy utility company stock.
A New Energy Institute working paper by recent EI alumni Karl Dunkle Werner and Stephen Jarvis dives into the issue and shows that U.S. regulators are not doing a good job of monitoring these costs.
Karl and Stephen (K&S) did this by collecting data on more than 3,500 electric and gas utility regulatory rate cases between 1980 and 2021. They then compared the allowable return on equity to various cost-of-capital indices, including government and corporate bonds. As the chart below shows, the real (inflation-adjusted) returns that regulators allow equity investors to earn have been fairly stable over the past 40 years, while many different measures of the real cost of capital have been declining.
These trends can be explained if utilities have become increasingly risky over the past 40 years. But if so, it would affect bond ratings as well as the cost of equity. Equity bears more of the increased industry risk than debt holders, but it remains difficult to explain the significant shift in equity risk in utilities while their debt remains rock solid. As the paper shows, utility debt ratings have barely changed. This may surprise some in California — it’s easy to think of specific utilities that may be at more risk today than in past decades — but overall, those who rate U.S. utility risk haven’t looked at it lately. to systemic trends for decades.
All of these different benchmarks give different estimates of the difference in allowable returns on equity compared to 25 years ago, but the median is about 2 percentage points, when multiplied by about $700 billion in electric utility equity financing , this is real money. Still, there is a valid question of whether utilities are overcompensated today or undercompensated 25 years ago.
But K&S isn’t just comparing debt ratings. They also looked at direct economic models of the real cost of equity, building on the so-called capital asset pricing model (CAPM), the workhorse financial model for asset valuations often cited in regulatory hearings. This approach accounts for the company’s level of risk and the market compensation for taking the additional risk. Consistent with earlier research on utility stock returns, they found that there is also a large and widening gap between what regulators allow shareholders to pay and what CAPM says is required to attract investment. They also showed how sensitive the approach is to underlying assumptions, a fact that utilities are no doubt aware of, and that should keep regulators on their toes.
Along the way, the study uncovered an interesting empirical pattern of what might happen with these regulatory decisions. Returns on equity required by utilities and those granted by regulators respond more quickly to increases in market indicators of the cost of capital than to declines. In other words, when utilities can demonstrate that shareholders are under-compensated, utilities quickly get in there and demand higher returns, and regulators respond to those demands. But when shareholders are overcompensated, adjustments tend to take longer (consistent with research Paul Joskow did nearly 50 years ago), about twice as long as K&S estimates. Combining this slow response to overcompensation with the decline in the cost of capital over much of the past 40 years (at least until 2022) explains why the gap in stock returns has widened on average.
We worry that regulators are overcompensating shareholders because the costs are paid for by raising utility rates, which disproportionately hurts the poor, as Jim Sallee blogged last week.Higher electricity bills undermine decarbonisation of buildings and transport
But if utilities get outsized returns from these investments, they also have an incentive to overinvest in capital projects. Sure enough, the paper found that every one-percentage-point increase in the allowable return on equity resulted in an average 5% increase in the capital rate base for utilities. Overall, the paper estimates that the annual excess cost to consumers could be between $2 billion and $20 billion, with the most likely figure in the middle of that range. That doesn’t mean all the extra investment is wasted — capital is still doing something that might be useful, unless it’s being spent on gilded coffee mugs — but it should leave regulators arguing over specific utilities Carefully consider utilities’ motivations for new capital expenditures.
Obviously, we need electric facilities, we even need gas facilities for a while. Some might argue that the K&S results provide a case for state-owned utilities so no shareholders can compensate, but to anyone who has looked closely at the alternatives, it’s clear that each model has massive inefficiencies . I think this study should serve as another reminder that regulating utilities is not only a tough job, but also a reminder to invest in high-quality regulation—hiring enough high-skilled workers and paying them well enough to keep them The best employees in the workforce and giving them the resources they need to get the job done—could pay big dividends.
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