The conventional wisdom about utility spending is correct, but key factors affecting customer satisfaction aren't obvious—and are tricky to control.
21st Century ROEs: What Is Reasonable?
How to benchmark return on equity (ROE) and depreciation expense in utility rate cases.
Let's face it. Despite industry restructuring and the advent of alternatives to traditional cost-of-service regulation, the determination of allowed returns on utility investments still remains among the contentious tasks faced by many utility regulators. Opposing estimates of investors' required rates of return easily can translate into disagreements worth tens of millions of dollars in a utility's annual revenue requirement. Because disputes of similar magnitude can arise in determining appropriate depreciation rates, these two investment-related cost-of-service items-the return on investment and the recovery of investment-often represent the largest, most disputed policy issues in regulated utilities' rate cases.
The complexity of the subject areas-cost of capital and depreciation studies-also tends to present significant challenges for regulatory decision makers. However, allowed depreciation rates and rates of return have important implications for a utility's ability to finance needed infrastructure investments and ensure adequate and reliable service to their customers. A utility's ability to recover these two investment-related cost-of-service items is critical to its credit rating, which, in turn, is an indicator of the utility's cost and ability to access capital markets and fund needed infrastructure investments.
Unregulated industry participants have sharply curtailed their capital spending, and even regulated utilities have been struggling with severe financial pressures and an unprecedented industrywide credit crunch. As the NARUC president and EEI chairman pointed out in a joint statement:
The electric power industry is now facing a financial crisis perhaps more acute than any in its modern history. ...All but a few electric power providers have found access to capital increasingly costly and enormously difficult to acquire. … Left uncorrected, these problems likely will further impede the financing and construction of critically needed infrastructure, particularly high-voltage transmission and local distribution systems.
Significantly, this is a crisis affecting not just companies and their shareholders-customers themselves and the U.S. economy are at risk if the industry cannot build out or even maintain its generation and delivery infrastructure." 1
These financial woes are not solely the result of companies' financial difficulties in the unregulated segments of the industry. As Standard & Poor's (S&P) stresses, "insufficient regulated authorized returns" are one of the most significant factors contributing to the current "downward pressure" in credit quality and the credit rating agency's "decidedly negative" view of the future rating trends of the electric industry. 2 S&P further notes that "the allowed returns…are typically less than what Standard and Poor's targets [and it] is disconcerting to find that utility credit quality … is not near the top of the agenda for state regulators." 3
Only last year, for example, S&P downgraded a vertically integrated traditional electric utility from "A-" to "BBB" specifically because of regulatory actions marked by "low allowed ROEs" and "low plant depreciation allowances." 4
Benchmarking recommended rates of return and depreciation rates against the returns and depreciation rates allowed in the rest of the country can help regulators in their efforts to assess the reasonableness of such recommendations. Analyzing recommended returns and depreciation rates relative to what has been