The time-honored discounted cash flow method for determining appropriate utility returns falls short when interest rates are low. Inadequate ROEs ultimately increase cost of capital and wipe away...
Industry Evolution: Financial Pressures Ahead
Can utilities simultaneously manage rising costs and pressing capital investment needs?
of 2005, the below- investment-grade-rated portion of the industry still accounted only for approximately 40 percent of IPPs and energy-trading companies. The portion of IPPs and energy-trading companies rated “BBB+” or higher trended downward from more than 80 percent in 1996 to approximately 70 percent in 2000. The “BBB+” and higher rated portion of this market segment then declined to only 20 percent in 2002, before it recovered to a level of approximately 35 percent by the end of 2005.
Earned and Allowed Returns on Equity
Financial data for the operating utility sample also shows that utilities have been earning a median ROE that exceeded the median of allowed ROEs in recent years. Fig. 3 compares earned returns for the sample of utility operating companies with allowed ROEs and trends in utility bond yields. The figure shows that in the last several years, the median ROE for electric and combination utilities has been somewhat above allowed ROEs. However, the figure also shows that earned returns already have been trending down as the increase in utilities’ fuel and other costs exceeded growth in revenues. For 2003, 2004, and 2005, the median earned ROE was only slightly above median allowed ROE.
This downward trend in utility ROEs demonstrates that utility costs have started to outpace revenue growth, suggesting further financial challenges ahead. But while utilities’ median earned ROEs are declining, they are still (at least on average) within the range of allowed ROEs. So far, the decline in utility ROEs has been mitigated partially by declining interest rates, as shown in Fig. 3 by the trend in “Baa”-rated utility bonds. Allowed ROEs also have declined with bond yields, although utilities’ risks have increased. This decline in allowed ROEs has raised concerns of rating agencies.
Fig. 3 also shows that a sizable portion of the industry is earning returns well below investors’ required returns. One-fourth of utilities earn less than the earned ROE level shown with the line marked as “1st Quartile.” This means utilities’ earned ROEs in this bottom quartile are significantly below the bottom quartile of allowed ROEs and, in fact, sometimes not much higher than the return on utility bonds.
Similar to what can be seen from the bottom range of utility credit ratings, this shows that, compared with the “average,” a fairly sizable number of utilities are in a more vulnerable and relatively weak financial condition. Since the earned ROEs of these utilities have declined more quickly than the ROEs for the utility industry on average, regulatory policies that enable these utilities to recoup in a timely fashion their rising fuel costs and needed capital programs will be very important.
The downward trend of utility credit ratings documents the increase in utilities’ average credit risk, which raises their cost of debt. This means the decline in bond yields for “Baa”-rated utilities as shown in Fig. 3 partly is offset by the fact that utility credit ratings have been declining as well. A similar trend is occurring with respect to utilities’ cost of equity. The risks to which equity holders