Ofgem, the UK’s energy regulator, characterized in the past as “feeble” and “toothless”, now has threatened in a recent proposal to halve the profitability of regulated utilities. This is likely more than a minor regulatory kerfuffle for UK investors. It looks like the handwriting on the wall for utilities on both sides of the Atlantic, portending a dramatic repricing downward of equity returns. First the numbers, translated into terms our American readers will appreciate. In the eight year pricing period beginning 2013, Ofgem allowed UK utilities to earn a 7-8% pre tax real return on their regulated assets ( rate base). Adjusted for the average rate of inflation in the period, that works out to a nominal 8.7-9.7% pretax return. This is a high level of guaranteed earnings for a low risk, monopoly business. Even more so when we consider that the risk free rate return, understood here as the yield on 10 year UK government bonds, was only 1.7% in the period covered. The UK regulator, then, permitted its regulated utility companies to earn about 9% or more on assets when risk free government yields were below 2%. That’s a pretax risk premium over government bonds of 7-8%. This is way over any historical precedent for returns on asset base or cost of capital.This level of return is uniquely generous to the utilities and their shareholders.
Ofgem, this time around appears to have had something akin to an epiphany, proposing a new baseline utility rate of return for the period beginning 2021 of 3.95%, half the return level authorized in the previous period. Including an estimate for inflation, that works out to a 5.8% return in current terms and a risk premium of “only” 5.6% over the UK 10 year bond yields of 0.2%. This still appears to be a generous return on capital especially on a risk adjusted basis.
British utilities have responded that the proposed low capital returns are bad for the country and imperil their ability to raise money to pay for better service and greenhouse gas reduction. Ofgem’s final decision comes at year end and utilities can appeal. The argument that new utility investment will cease due to lower returns has rarely proven to be the case by the way. And yet like a tired refrain the argument gets recycled, hoping to gain traction with the public.
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What would happen if US regulators adopted similar regulatory return principles in light of current market conditions? They use the same cost of capital formulas all over the world, remember? Using existing capital ratios, a 3.5% interest cost of utility debt and after tax allowed returns on equity at 9%, we calculate those numbers produce an allowed pretax return on capital of 6.9%. This compares with a 0.7% yield on 10 year US Treasury bonds. and produces a still generous risk premium of around 6.2%.
If US regulators lower risk premiums on capital to 5.6% as was just proposed in the UK, the allowed (after tax) return on utility equity will fall to 6.5% (versus 8-9% at present). As the kids say, that would leave a mark.
A historical record of stock market returns dating as far back as the 1800s, shows that equity investors typically earned within a range of roughly 2.5-4 percentage points over supposedly low risk government bond yields. With US 10 year government bond yields of 0.7% this implies a 3-5% cost of equity range—a number corroborated by NYU-Stern’s cost of equity calculations.
We believe that the 3-5% equity return range, while theoretically justifiable, will prove difficult to impose. Why buy utility equity if the company’s investment grade bonds are yielding a comparable 3.5%? Even though historical spreads justify it, investors, we believe, will require more than 5% on their equity investment. Regulators, in recognition, we expect, will settle on a 6-7% equity return range if low interest rates and weak economic conditions persist. With prospects for dramatically lower returns authorized by regulators on the horizon, it becomes difficult to justify the growth rates that some utility investors and analysts expect.
There is, however, one rather large bright spot on the horizon—the simultaneous demands of electrifying large swaths of the economy while at the same time decarbonizing the electric grid This implies an enormous increase in electrical demand (as electricity displaces gasoline/diesel in transportation) and a large increase in investment as well.
But there is another major expense shift underway as power generation utilities transition away from fossil fuel usage entirely. As the importance of fuel expense wanes, cost of capital (returns to fixed income and equity investors) will dominate customer electric bills in the future. As a result future regulatory squabbles will all focus primarily on cost of capital because that’s where the money is so to speak.
But these debates can open a real can of worms because they remind the public of a simple financial fact. Equity costs more than debt. And right now a lot more. To the untutored mind the question quickly comes up, “why does a utility need equity investors at all in a monopoly enterprise”? Especially when the equity investor is understood as the supposed risk taker in the corporate capital structure.
The corollary issue here is public versus private ownership of utilities. If utilities all deploy the same suite of technologies to produce clean energy, as we said earlier, the only differentiating factor becomes cost of capital. We are not suggesting a push for public ownership of power generation although it could happen. Rather these discussions reveal that utility equity returns have been generous on a historical basis and may be subject to increasing scrutiny. For equity investors this often means a bumpy ride especially during rate cases.
By Leonard Hyman and William Tilles for Oilprice.com
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