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  • Utility Rate of Return

    Posted by Carl from Chicago on March 23rd, 2013 (All posts by )

    The utility industry in the United States has made a giant return to traditional rate-making in many parts of the country. For someone who is unfamiliar with the concept, here is a brief summary:

    1. Utilities receive a “monopoly” on services in a particular region (a city or county) which means that they are the only company allowed to provide service (thus you don’t have 2 sets of power lines going to your house)
    2. The utility submits their expenses and capital requirements to a state regulator, who approves the spending plan
    3. For the portion of the utility funding that is provided by equity (shareholders), the company is allowed to earn a “rate of return” that gets included on rate-payers bills

    When I was fully engaged in the industry in the 1990’s, there was massive talk of “de-regulation” and traditional “cost of service” regulation as described above was seen as an archaic relic to be disposed of as quickly as possible with newer, more innovative models. If you would have told someone in the mid 1990’s that here, 20 years later, utilities would be HAPPY to still be part of a guaranteed return on their regulated investments, you’d have been greeted with a blank look of incredulousness.

    The most famous critique of this model was a CEO who was said to have stated that “this is the only industry where I can make more money by remodeling my office” which of course was technically a true concept. This sort of talk was endemic in the 1990’s.

    To be fair, the entire energy business used to be run this way (except for the municipal entities which were completely owned by some part of the government), and now much of the generation and parts of customer services are run using other methods involving some sort of at least partial competition. The generation of power, for the most part, has been financed using alternate methods (auctions, price caps, etc…), but it is notable that the only utilities going forward with nuclear plants are those with the old-school rate of return regulation (Southern Company in Georgia and SCANA in South Carolina).

    For those entities that are still primarily regulated (non-competitive) or whom have substantial portions of their business subject to this regulation, one item coming under fire is the “rate of return” that they receive on their equity capital. When I was in the industry this number was in the 12% – 14% range; per this WSJ article “Utilities’ Rates of Return Draw Flak”:

    In 92 major rate decisions last year, regulators… granted gas and electric utilities returns of 10%, compared with 10.21% the prior year and 11% a decade ago.

    These rates of returns, however, conflict with the type of risk profile and links to debt interest rates that traditionally anchor utility rates of return. Today interest rates are famously low, so why is it reasonable that utilities should earn 10% or more on returns when that sort of return is far out of reach in a 401(k) for investors, for example?

    Further pressure on this model seems inevitable, although rate of return is rarely so simple because if a utility spends more than they plan, in most cases this essentially comes out of the return bucket, although their are exceptions like “pass through” increases for fuel which can be made depending on the jurisdiction. This sort of item should be watched by those who have utility investments, since a serious re-appraisal of this rate would likely push it down further.

    As a long-time watcher of the industry, however, the continuing existence of this sort of rate of return regulation is astonishing, given how much it was ridiculed for so many years. It is sad that we haven’t come up with anything better in the interim. The issue with monopolies is not so much the rise in costs, but the lack of innovation, I once heard. This is the case with the rate of return model that continues to exist, today.

    Cross posted at LITGM

     

    10 Responses to “Utility Rate of Return”

    1. Roy Says:

      The theme of public utilities has intrigued me for decades. It almost always will eventually surface in any extended discussion of econ, usually in the form “What about the roads?” As if that question alone squashes the possibility of a free market understanding. Reminds me also of a Chicagoboyz post sometime in the last year, iirc, wherein someone showed pictures of wiring plugged onto a utility pole in a city in India.

    2. Mike K Says:

      California has, as usual, an innovation. It is now requiring utilities to acquire up to 25% of power from wind and solar. Since that is impossible, I expect brownouts this summer. Rates are already high and service so so.

    3. Whitehall Says:

      Here’s a pertinent piece on nuclear power and electric utility deregulation from 10 years ago:

      http://www.energypulse.net/centers/article/article_display.cfm?a_id=214

      Probably needs to be updated.

      I’ve never seen the advantages to the public of electric deregulation EXCEPT where the existing regulatory mechanisms had become hopelessly corrupt, as the did in California. Here, flat out extortion by politician was common. The Speaker of the State Assembly was caught getting %50,000 cash handed to him under the Capitol Dome from a representative of the largest utility in the state. “Affirmative Action” at the utilities meant preferential hiring of certain ethnic voting blocs (hint – they weren’t white males.)

      One exception was in innovation. Highly efficient combined cycle gas turbine generation was delayed in adaptation due to regulatory stiction and deregulation did spur it replacing older rate-base investments.

      Utilities do not necessarily make money on rate base ROE. In our state, they get 10% of EXPENSES for energy conservation measures as a off-the-top markup. Utility management has become another tool of the ruling party and can be GIVEN profits in return for doing the Democratic party’s bidding.

      As will always happen, innovative corruption will replace old-style corruption unless both government is transparent AND the citizenry is vigilant. California has neither. In California, utilities have

      As much as I support free markets, certain deep infrastructure activities could still work better with conscience central planning and control at come level.

      But yes, regulated utility approved rate of returns at 10% will, over time, come down.

    4. snopercod Says:

      “I can make more money by remodeling my office”

      Boy, isn’t that the truth. In my young and naive days I worked for a major California utility company. I don’t want to name any names but their initials were PGE. Like a fool I thought that I was supposed to save them money by working fast and coming up with ways to spend less money yet still get the job done safely.

      Boy, was I mistaken. Later in life I realized that their game was to hire as many people as possible, do things as slowly as possible, and spend as much money as possible since they were guaranteed a rate of return on every dime they spent.

      The unions loved it as well. The employees got triple time to come in on a weekend and fix things that should have been fixed during the week.

    5. Whitehall Says:

      You’re incorrect, Snopercod, in that a regulated utility makes money on every expense (such as labor).

      They are allowed to make money (a return) on equity that is used and useful, in other words, on the stockholders’ equity in utility plant that serves the public. Even then, a utility can have a bad year and fall short of the full allowed return, especially if the regulator finds fault with the management and how they spend ratepayer funds.

      Expenses are usually straight flow-through to the rate payers and subject to scrutinization by the Public Utility Commission.

      Utilities are seldom paragons of efficiency, I will completely grant, having spent over a decade at an anonymous utility that also shares the same initials. But if you think a private investor-owned utility (IOU) is inefficient, get a job a government utility!

      One needs to remember this about utilities and labor. Most of the work is done by installed process equipment – pipes, wires, generators – that needs oversight and some tending, but if everything works as installed, little human intervention is needed.

      But when things don’t go as usual, after an earthquake or a big ice storm, it’s all-hands-on-deck and you the customer wished they had twice the head count. That’s why you often see five utility guys standing around a hole and one guy digging in nice weather. after a big disruption, EVERY single one of those guys will be working 18 hour days and customers will still be screaming for faster restoration of service.

      In my time at a utility, what struck me was the organizational resemblance of utility management with the Communist Party. They had no exterior accountability and promotion was by mutual back scratching or back stabbing. Who knew how you got on the Politburo? They didn’t have a market, they only needed a foreign policy (lobbyists and regulatory lawyers.)

    6. David Foster Says:

      I’d expect that labor goes into the rate base when it is capitalized, as with construction projects.

    7. Whitehall Says:

      David,

      That’s true about the labor of capitalized projects. Very few utilities do their own major design and construction anymore but contract the work out except for its overall management. Even new distribution and transmission projects are contracted out here in Northern California.

    8. Mrs. Davis Says:

      That’s why when I needed to upgrade my electric to 400 amps as a result of adding a mother-in-law my utility gave me a dedicated transformer and a 200 foot underground connection. It’s just like Ma Bell. I’ll be paying through the nose for it every month.

    9. Marty Says:

      From the rates quoted it sounds like there is a consensus to have utilities earn a premium return on equity of about 6-7% over 30-yr Treasuries.

    10. Whitehall Says:

      One task for the public utility commission is to set the allowed rate of return at a level that the utility can attract just the amount of capital it needs in competitive capital markets, but no more.

      That is partially a factor of the risks to the dividend the utility faces.

      Starting a big construction project, like a new nuke, adds risk and increases the risk premium.

      Having no load growth and little need for new capital for construction, lowers risk and lowers the risk premium.

      The bigger problem is that the greatest risk most utilities face is POLITICAL risk, including the meta-risk of the public utility commission getting their determination of the risk wrong.