Why Utility Profits Could Be the Next Target

Electricity prices are heading up. Utility operating costs, raw materials, and fuel (obviously), are all heading up and no sign of stopping. Now higher capital costs courtesy of the Fed can also be expected. All we can say is that it seems like inflation is back, baby.

The Fed recently raised its discount rate and Treasury bond yields hit 5%—their highest level in almost two decades. A utility's cost of capital consists of two parts: 1) the return earned on a risk-free investment (like US Treasury bonds) plus 2) an extra amount added to compensate for the additional risk assumed by equity holders, who take a subordinate role in the capital structure. Does this imply cost of capital has to rise with these costs inevitably passed along to consumers, leading to still higher rates? Well we do know that state public utility regulators set a return based on cost of capital. However, as we pointed out above, there are two parts to the cost of capital determination. The risk-free interest rate, like Treasury's, which is clearly rising, and the equity risk premium. It is the latter figure which allows regulators to have some flexibility. The equity risk premiums allowed by state regulators have ranged broadly over the postwar years from 300-700 basis points over the risk-free rate. Simply lowering equity risk premiums (towards the lower end of their traditional range) would allow regulators to provide consumers some relief. Also, the logic here is kind of obvious. Receiving a generous equity risk premium in return for financing a low-risk, monopoly business is, as they say, nice work if you can get it.

At present, the risk-free return (10-year Treasury) yields about 5%. According to the latest numbers out from NYU, the equity risk premium for the average stock is about 6%. Over the past two decades, that premium has ranged from about 5% to 7%. In other words, equity investors today buying an average stock hope to earn about 11% (5% risk-free yield + 6% equity risk premium) per year. However, utility and power stocks are not average. They are about half as risky as the overall equity market (from a beta perspective). Consequently, investors should be satisfied with an equity risk premium of 2-3%, half that of the broader equity market. (Half the risk equals half the equity premium portion of the return.) Therefore, according to financial theory, utility investors should expect to earn maybe 7-8% per year. That is the cost of their equity capital. In the past two years, the member companies of the Edison Electric Institute (most big investor-owned utilities) earned about 10% on their equity. In other words, they may be earning 2-3 percentage points over their cost of equity capital, which adds roughly 5% to a typical electric bill. From the perspective of a Progressive political agenda, this should be regarded as low-hanging fruit.