decarbonize and modernize. Even if there were no pressure to retire fossil-fuel generation, the electric industry would have to spend money for a simple reason. The average age of utility assets in the U.S. exceeds thirty years. This implies three things: 1) the average utility plant is already old; 2) it will soon have to be replaced; and 3) due to inflation, the cost of new assets will exceed the cost of original equipment. So on top of an already expensive capital replacement cycle of the industry, it also has expeditiously decarbonize.” data-reactid=”12″>The is some big spending ahead for electric utilities. More than the politicians and policymakers expect. Electric utilities have to decarbonize and modernize. Even if there were no pressure to retire fossil-fuel generation, the electric industry would have to spend money for a simple reason. The average age of utility assets in the U.S. exceeds thirty years. This implies three things: 1) the average utility plant is already old; 2) it will soon have to be replaced; and 3) due to inflation, the cost of new assets will exceed the cost of original equipment. So on top of an already expensive capital replacement cycle of the industry, it also has expeditiously decarbonize.
Electric companies, then, will have to attract increasing amounts of equity and debt capital. The returns on that capital are set, largely, by regulatory commissions. If regulators permit the state’s utilities to earn “excessive” returns in an essential, monopoly business, then consumers overpay for electricity. If the reverse becomes true and authorized returns are slashed severely then the utility’s shareholders will suffer.
But what constitutes an excessive return? In the U.S., regulators set returns based on the book value of utility investment dedicated to serving the public. The regulator’s task here is something of a balancing act. Establish a level of return adequate to attract private capital but at the same time not enough to permit excessive returns in this low risk, essential monopoly business.
Academic theorists argue that equity returns that exceed the cost of capital push the stock price above book value. James Bonbright, the legendary regulatory theorist, said, more or less, that earning more than the cost of capital, as indicated by stock price selling above book value, was necessary in order to provide a reserve for contingencies. The ratio of stock price to book value exceeded 2.6x in 1965 before a 20-year decline. It now stands at 1.9x (vs an average of 1.7x in 2016-2019). So, stock price seems to say that electric companies make more money than necessary.
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Now let’s look at it another way. Equity investors want more than the risk-free return (represented by return on long term government bonds) to compensate them for the business and financial risks they incur. In 2016-2019 U.S. regulators granted regulated utility companies an average return on equity of 9.7 percent compared to a risk-free return (10 year Treasuries) of 2.4 percent. That 7.3 percentage point equity risk premium (9.7 – 2.4) is extraordinary by historical standards. The historic equity risk premium since World War II has been closer to four percentage points. Again, the present level of authorized equity returns looks like extraordinary generosity by state and federal regulators towards privately owned, monopolies.
Taking a different tack, the capital asset pricing model (CAPM), the bedrock of modern investing, uses a standard formula to determine the cost of equity capital. NYU’s Stern Business School estimates, with the CAPM formula, the appropriate cost of utility equity is about 3 percent now (versus the 9.7 percent actually authorized over the past four years). Ouch! That can’t be! Well, it can. The formula looks at the return investors want on the market value of the company’s stock, not its book value. Since utilities sell at roughly twice book value, that number translates into a 6 percent return on book equity. In 2018 and 2019, the average electric company earned about 11 percent on book equity, probably a lot more than needed to attract capital.
What are we getting at? Utility regulators have a tremendous amount of discretion and the drift in regulatory policy in recent decades, based on returns on equity, has been in a decidedly pro shareholder direction. We would not underestimate the potential for political pushback in the opposite, pro-consumer direction. Regulators, after all, are either elected or appointed by the governor or legislature. They are clearly part of the political process and behave accordingly. And if the political pendulum swings back hard in an anti-monopoly direction, we expect new regulators to obey the wishes of the electorate.
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For example, they could offset the write-offs of fossil-fuel assets against excessive earnings as opposed to raising prices to pay for the write-offs. Companies faced with the prospects for possibly lower earned returns will have to come up with a convincing rationale for why they need the money for something, such as immediate climate-related projects.
We don’t expect equity returns to come down to 6 percent or lower (from almost 10 percent at present). The management of utilities will come up with reasons to raise and spend money they would not have spent otherwise. That is, they will make a plausible case that the world has changed. Immediate action is required and they will remain capable of providing reliable service even under the present, increasingly difficult circumstances.
None of this represents good news for U.S. utility equity investors. The industry will want higher electricity prices to pay for modernization and decarbonization. As the need for capital investment expands, the pressure for rate increases risks pushback from consumers who are also voters. If utility rates become election-year issues, the industry risks having its financial needs politicized. This in turn might force a dramatic repricing of utility equity return authorizations back towards their long term average.
As we said earlier, the long term average utility equity “spread” over the risk-free bond rate is about 4 percentage points. Today a ten year U.S. treasury bond yields about 0.7%. Are we ready for 5% returns on utility equity? Perhaps we should be.
By Leonard S. Hyman and William I. Tilles
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