A Review of the Risk Premium Method for Regulated Electric Utility ROEs
In utility financial economics, the cost of capital, or rate of return, is the cost of an electric utility’s invested funds, both debt and equity. The cost of equity capital is the rate of return that common shareholders require on their investment, commensurate with the risks they assume and the expected returns from other similar investments (opportunity cost). In the regulatory process, the principles established in the US Supreme Court Bluefield1 and Hope2 decisions guide most state regulatory commissions in establishing returns. In particular, the Bluefield decision noted:
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.
From both the investor and company point of view, it is important that there be enough revenue not only for covering operating expenses, but also to pay a return on bondholders and stockholders providing the capital for the utility to invest. These funds are required to service debt and pay dividends on equity (common and preferred stock and retained earnings).
From both the investor and company point of view, it is important that there be enough revenue not only for covering operating expenses, but also for the capital costs of a regulated utility.
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 rating and to continue to attract capital.3 A long-term comparison of the rates of return on different sources of capital is shown in the Capital Market Line Figure 1, with data calculated by Morningstar. As shown, the data plots the realized rates of return from different investments versus their risk, as measured by the standard deviation of their returns. The resulting line demonstrates the relationship and positive correlation between risk and rates of return; investors require higher rates of return for an investment with more risk.
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 rating and to continue to attract capital.
THE ISSUE AT HAND
The Risk Premium Methodology, or analysis, is based on a comparison of allowed rates of return on equity from decided rate cases, as compared to various sources of debt capital and their corresponding costs. Like the Capital Asset Pricing Model, the risk premium methodology is an example of a build-up approach used to estimate a utility’s ROE. The cost of equity for a regulated utility (or any company) is composed of the following components:
The real rate of return
+ Inflationary return
+ Industry risk/return
+ Company-specific risk/return
Return on equity (ROE)
The examples in Figure 2 compare authorized ROEs of electric companies to long-term utility debt rates, between 2000 and 2018. As shown, the authorized rates of return on equity from various commissions are summarized into a quarterly authorized ROE on the vertical axis and are compared against the cost of utility debt (represented by Moody’s Utility BAA yield (“Triple B”) on the horizontal axis of the graph. In the lower right corner of the graph, the regression calculation is shown as a reference for all of the figures in this article. The first item of interest is that with a slope of approximately 35 percent, a utility’s allowed rate of return moves up and down at a slower pace as compared to changes in interest rates/debt costs.
Although the data above illustrates the correlation between authorized equity rates of return and the cost of debt, it ignores “regulatory lag.” Regulatory lag reflects the fact that a utility will file a rate case at a certain point in time but will not receive a final decision, with an allowed rate of return, for a period of time, approximately one year. Therefore, it is more appropriate to compare the authorized ROEs from commission decisions with interest rates as of one year prior.
ANALYSES OF AUTHORIZED RATES OF RETURN AND INTEREST RATES
In Figure 3, the timing has been shifted to compare authorized rates of return with debt costs from one year prior.
Regulatory lag reflects the fact that a utility will file a rate case at a certain point in time but will not receive a final decision, with an allowed rate of return, for a period of time, approximately one year.
Making this change to the “regulatory lag” timing assumed improves the coefficient of variability, or R-squared, of the analysis. In a “perfect world,” the R-squared from the analysis would be 1.0, indicating that 100 percent of the changes in authorized ROEs are due to changes in interest rates, but many other financial and economic risk factors exist. Considering the build-up approach mentioned earlier, a risk premium approach based on authorized rates of equity returns and utility debt costs would address the following return components:
RETURN ON EQUITY
Another debt index to consider is the cost of long-term US Treasury Bonds with a maturity of 30 years.4
Figure 4 is similar to the one based on Moody’s utility bonds, but it is “higher,” meaning it has a y-intercept that is 1.2 percent higher to account for the risk differential between risk-free Treasury bonds and a Triple- B utility bond index. The following are the build-up components for this analysis:
Although Figure 5 could be used to simply look up an implied ROE for a certain level of interest rates, some additional precision, and better correlation, can be gained by calculating the implied “premium” (the amount the authorized ROE exceeds the cost of debt) for each quarter and comparing that to debt costs 12 months prior. While the downward slope may look odd at first, recall that this is the equity premium, which is added to the cost of debt, to determine an implied return on equity. The downward slope reflects that as interest rates increase, the corresponding authorized returns on equity also increase, but at a lower rate.
A similar relationship is seen in the comparison of authorized rates of returns and utility bond yields in Figure 6:
INDICATED UTILITY ROES
Combining the two methodologies above with current interest rates, these models suggest an equity rate of return in the range of 9.7 percent to 9.9 percent. As previously discussed, the risk premium approach is one of the methodologies considered to determine a fair return on equity for regulated utilities. However, it is important to note that this methodology has relative strengths and weaknesses, like all simplified financial models taught in academia. The risk premium analysis does a reasonable job of capturing real interest rates, inflation, and industry risk factors. However, to determine a credible conclusion for a fair ROE, more analysis is required.
As illustrated in Figure 7, most of the data points lie within an approximate 125- basis point (1.25 percent) range around the trend-line indication. For public utility companies, these risks would be expected to reflect company-specific risk factors from their geographical concentration, state and federal regulation, and potential mergers and acquisitions, among other risk factors. For a utility that is not public nor owned by a public holding company, additional risk factors not reflected earlier would also need to be considered. The common stock of smaller private utilities is considered to be a riskier investment than a public utility’s stock, commanding higher returns from investors. Some of the key factors affecting this are a small utility’s lack of liquidity, less access to competitive debt financing, and geographical concentration, as well as company-specific factors such as aging infrastructure or litigation risk.
In summary, the risk premium methods discussed earlier provide a reasonable starting point for a utility’s ROE, but other risk factors and other financial models must be considered in concluding a fair return on equity for a utility. The analyses shown earlier provide another insight into what investors expect and what commissions authorize for allowed returns. Like all financial approaches to estimating an appropriate rate of return, however, this data and analyses are best considered in addition to other financial models.
1. Bluefield Waterworks & Improvement Company v. Public Service Commission of West Virginia, 262 U.S. 679, 692, 693 (1923).
2. Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944).
4. Although 10-year Treasuries are sometimes referenced, given the long-lived nature of utility assets, the longer-term bonds better match a utility’s underlying assets.
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