[BETA] Fortnightly

Ratemaking Special Report

Return on Equity:

Fixing an appropriate rate of return on equity (ROE) for electric utility investors marks a fundamental component of the typical cost-of-service rate case conducted across the nation by state public utility commissions (PUCs). The following survey demonstrates the results of such cases, as observed over the past year.

As usual, the debate over ROE centers on current trends in interest rates, plus changes in the overall pattern of industry risk-as affected by on-again, off-again efforts at utility industry restructuring. Consider a recent decision from Connecticut as a good example of the broad range of issues that arise. In a case setting rates for Connecticut Light & Power Co. (CL&P), the state PUC said it was unable to justify the company's then-current ROE allowance of 10.3 percent-last set in Connecticut in a 1998 rate order-since a number of changed circumstances had intervened. It lowered ROE to 9.85 percent-below the 10-plus level often awarded by other states for other utilities during the same period. It cited factors such as:

Lower interest rates. (20-year T-Bond yields down from 5.5 to about 5.3 percent.)

Improved financial strength. (Bond ratings up from Ba2 to A2 [Moody's], and from BBB- to A- [S&P]. Equity ratio up from 33.4 to 51.1 percent.)

Lower business risk. (Divestiture of all generating plants.)

Lower tax rates. (New federal rate caps of 15 percent on both capital gains and corporate dividends).

In other words, more equity in capital structure implies less investor risk and undercuts need for a higher ROE. And lower interest rates put downward pressure on what utility stockholders might expect to receive from competing investments.

But another important factor, beyond the simple financial indexes, is the question of intangible industry risk. State regulators worry about events such as last summer's Northeast blackout. They fear that the new market institutions imposed by regional grid operators may fall short of ensuring the degree of reliability of service that customers (and investors) have come to expect.

Consider a second recent decision, from Indiana, setting rates for PSI Energy.

In that case, the company argued that the utility industry faces many uncertainties that augment risk: Stricter environmental regulations, changes in ownership, a strained transmission grid, and continuing controversy over wholesale market design and operation. Yet the commission accepted arguments by opposing parties that the numerous cost trackers used by PSI had distinguished PSI from other utilities and mitigated any excessive regulatory risks.

"The inescapable fact," said the commission, "is that trackers reduce risk to a utility and PSI has many more trackers than its peers."

Other changes brought by restructuring may also trim risk.

In the CL&P case cited above, the state PUC stressed that the selloff of power plants (making CL&P a wires-only utility) had enhanced the company's business profile, with management able to turn it focus to the lower-risk transmission and distribution systems. Moreover, as the PUC noted, utilities now collect a higher proportion of distribution costs through fixed charges than in the past.

And lower utility ROEs mirror the general downturn in stock prices seen