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Perspective

A decade of restructuring has not affected the financial integrity of the average regulated utility.
Fortnightly Magazine - November 15 2003

or regulators decided to enforce such separation (known as "ring-fencing") does not matter. 2 A decade of restructuring has not affected the financial integrity of the average regulated utility, even though it has allowed business decisions that have damaged the parent holding companies.

Attracting Capital

The decision requires that the utility have the opportunity to earn a return that will attract capital. 3 Admittedly, utilities have not raised large amounts of capital in recent years, and regulators have enjoyed a reprieve from the disagreeable task of raising prices. Nevertheless, spending numbers could soon turn upward. 4 The generators and traders appear to have taken big risks and reaped unsatisfactory returns. The consolidated power companies have compiled an erratic and unimpressive record that should affect their ability to raise capital.

What about the regulated utilities? Table 2 focuses on return on equity as the measure of profitability. The table shows that the regulated utilities maintained a relatively steady return, although one below the returns set by regulators in rate cases. Regulators, furthermore, kept the allowed returns close to 11 percent for the entire period, despite a trending downward in interest rates.

Consolidated entities, however, usually earned a lower return than the regulated utility. Despite the hype about extraordinary business opportunities opened up by deregulation, the evidence indicates that the unregulated activities, after deducting incremental costs, did not contribute to corporate coffers. (Most companies showed unregulated operations as earners, after allocating expenses and corporate overhead and separating extraordinary expenses. The calculations in Table 2 subtract utility net income from total consolidated net income to determine the non-utility contribution, and they do not distinguish between ordinary and extraordinary income.)

One might ask how the consolidated entities managed to make so many unproductive investments without damaging their core holdings, the regulated utilities. Simple: They borrowed heavily for unregulated investment. In the period 1993 to 2002, the companies may have borrowed more than $150 billion while investing roughly $20 billion of equity money. That equity investment represented less than 15 percent of consolidated equity, a sum easily raised through retained earnings and occasional stock offerings.

Recent studies show that equity investors should expect to earn a risk premium of 2 to 4 percent above the bond yield on the market value of the investment. 5 With long-term government bonds yielding roughly 4 percent, the investor should expect to earn 6 to 8 percent on market value of investment, which at a price of 150 percent of book value (not uncommon for a high quality utility) translates into roughly 9 to 12 percent on book value. Data from Regulatory Research Associates show returns on equity granted in rate cases stayed close to 11 percent for the entire period, and current returns granted (not shown) are close to 10 percent. (Rate orders, however, have had only a minor impact on prices during the period shown.)

Satisfying Shareholders

As much as they might want to, shareholders cannot buy stock in the utility as opposed to the holding company. In the decade since restructuring began, electric utility shareholders have suffered, despite