Nobody likes being overcharged for a service, especially when they don’t have choices. Data on electric utility rates show that is exactly what has been going on for decades. The Pearl Street Station Finance Lab, using data from RMI’s Utility Transition Hub estimates utility regulators have authorized “Return on Equity”, or ROE. ROE rates above similarly credit-rated industries could be costing American utility customers up to $214 billion over the last 10 years and $34 billion in 2020 alone. We’ve made a fun and handy calculator for you to figure out how your utility compares to the real world or other utilities at the end of this post.
The setting of an ROE determines your electricity bill. If it is set too high relative to the real world, your monthly bill will be too high. Worse, an artificially high-profit rate achieved with a high ROE makes all real-world ideas hurt the profit margins of the utility so adopting conservation, new technologies, demand response, etc. becomes entirely unattractive to consider.
A reasonable Utility ROE should move in relation to prevailing bond yields. Bond yields declined in recent decades, yet somehow utility ROEs have broken that relationship. According to a widely-cited study from Rode & Fishbeck, utilities used to earn just under 3% more over US Treasury Bonds but with a growing gap over time, now earn nearly 8% more! That means utility customers are granting their utility a much great risk-adjusted return on equity than historically experienced.
Another preliminary UC Berkeley Economics Department recent study points to further evidence of this phenomenon, showing that utility ROEs have not moved lower when measured against various financial metrics and products like corporate bonds and stock risk premia. The academic literature is clear: utility ROEs are too high on a risk-adjusted basis and relative to historical norms.
We compiled data for all companies within RMI’s Utility Transition Hub going back 10 years and estimated the revenue impact of the regulator-approved ROE and compared it to different levels of allowed ROE. At the low-end of our estimates, we used a 2.9% premium to the average 10-year US Treasury yield in each year, consistent with the risk premium in the 1980’s. For an upper bound estimate we used the approach employed by Illinois regulators which adds 5.9% to the average 30-year US Treasury yield. Both approaches to ROE link returns to interest rates yet result in lower returns than what utilities are actually awarded in practice.
Turns out, small moves in these percentages add up to significant sums. Just a 1% change in the allowed ROE can impact customer bills by up to $4 billion nationwide each year.
We calculated the revenue impact of an ROE estimate consistent with historical relationships between risk & return across the industry. The ROE estimate in each year is compared to the allowed ROE, then grossed up for taxes, and multiplied by reported equity. A company authorized to earn 10% that we estimate should earn 7.5% on each $100 of equity investment could have resulted in increased costs to customers by $3.33. This analysis is conducted for each utility in each year. For the industry, our findings are summarized below:
We estimate utility bills to customers could be $63.59-$214.22 billion too high over the last 10 years and $13.72-$34.29 billion for 2020 alone. Regulated utility companies in the United States have been allowed by their regulators to earn returns higher than the much riskier average S&P 500 company for many years – despite being a protected legal monopoly.
We examined some of the utilities with the most outsized ROEs for year 2020 and calculated the “overcharge” to customers when compared to both baseline methods:
Utilities often claim high returns are necessary to attract capital to build and operate a strong business. We would simply point out that almost all lower ROE utilities are able to provide reliable service while charging customers less. There are even some utilities that are larger, have been bankrupted, carry far lower credit agency ratings, and have invested more aggressively in new technologies. Even these entities have been able to keep the lights on and have ready access to the capital markets. The problem is not one of good versus evil, but the degree of efficiency and balance between the stakeholders.
Unlike many other changes to utility regulation, ensuring ROEs are in-line with financial analysis of other industry sectors does not take a legislative act. It simply requires utility regulators insist that allowed ROEs are supported by financial market conditions and based on accepted financial principles, logic, and perhaps a dose of best practices. The ROE setting process occurs every few years or whenever a major party asks for it so adjustments can match even turbulent market conditions. Savings from reducing ROEs flow straight through to customers and businesses.
The numbers we present in this blog are meant to be illustrative. We know that it is unreasonable to assume that every utility in the country would have the same ROE. We also know that if utilities had a lower ROE they probably would have made different investment choices, which we don’t account for. But that is also the point. Going forward, utilities should feel the need to make different investment decisions and know regulators and customers are becoming aware that an inflated ROE crowds out options and better ideas while raising costs for customers.
The fun and handy calculator for ROE impact!
To see how an approved ROE for select utilities can have a mighty impact on customer bills, download and distribute this calculator and simply pick a major utility from the drop-down menu or plug in your own assumptions. You may be surprised at how much money is at stake from small deviations away from history and/or other industrial sectors.