July 1, 2001
L.A. Loves a Loophole
There's no getting around it...
The process of determining how to implement utility competition is often cast as a struggle between two opposing camps: shareholders and ratepayers. There are, of course, two other major players, managements and regulators. The bipolar view tacitly assumes that shareholder and management interests coincide, and that regulators have customer interests at heart. Neither assumption is altogether valid. Shareholder interests deviate from management interests in important ways, just as the interests of the entrenched regulatory bureaucracy diverge from the public interest. Therefore, shareholder and management interests must be considered separately.
In the past, managements have often pursued their own interests, with devastating financial impact on shareholders. Competition offers shareholders an opportunity to increase their leverage over managements, thereby increasing their returns as well.
The failure of utility managements to defend shareholder interests has cost shareholders a lot. The extent of that cost is evident in the low net return that utilities have earned for shareholders, measured as the sum of the dividends paid and the increase in investment per share. The cost can also be expressed as the dividend-to-book value ratio plus the percent increase in the book value. We will call it the earned shareholder return.
Utilities have historically produced meager earned shareholder returns. Between 1974 and 1993, the consolidated return for the 78 utilities we follow averaged only 10.3 percent. The annual dividend-to-book value ratio averaged 8.8 percent, while book value grew only 1.5 percent per year. The 10.3-percent return stood 2.2 percentage points below the return on equity (ROE) before writeoffs of 12.3 percent. In effect, although
the 12.5-percent ROE and 8.8 percent dividend-to-book value ratio provided a basis for book value growth of 3.7 percent per year, writeoffs and book value dilution cut it to 1.5 percent (see table).
The earned shareholder return for utilities has been far below the earned return for industrial companies, as measured by the Standard & Poor's (S&P) index of 400 industrials. The ROE for the S&P 400 averaged 14.5 percent between 1974 and 1993. Neither stock sales or writeoffs should have caused the earned shareholder return for the S&P 400 to differ materially from its ROE. Indeed, stock sales no doubt enhanced book value growth, since the stock price-to-book value of the S&P 400 was continuously above 1.0 and averaged about 2.0 during these two decades. The industrials also did not have to face the huge systematic writeoffs that utilities endured. It is, therefore, reasonable to assume that the earned shareholder return for the S&P 400 was roughly equal to its ROE of 14.5 percent.
Thus, the 10.3-percent earned shareholder return for utilities lies 4.2 percentage points below the estimated earned return for industrial companies. Of this difference, only 2.2 points is attributable to utility writeoffs and book value dilution.
The Regulatory Shelter
The current regulatory framework gives managements the latitude to disregard shareholder interests. Utility managements are not under as much incentive and pressure to pursue shareholder interests as managements in most industries. Regulation limits the ability of a management to create shareholder wealth and the consequent ability to be