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Linking Risk and ROE

Financial-risk coverage is falling short in utility returns

Fortnightly Magazine - January 2008

In each of the equations the interest-rate variable serves as a scalar that isolates the financial-risk variables, and reveals more directly the statistical relationship between financial risk and the allowed return on common stock. In other words, we controlled for the influence of the level of interest rates on allowed returns when we quantified the relationship between financial risk and allowed returns. Based on the regulatory standard of allowed returns sufficient to attract investment, we hypothesized that interest rates, as representative of alternative investments, were directly or positively related to allowed returns. Based on financial theory, we hypothesized that the allowed returns negatively were related to levels of financial risk, as measured by either common-stock equity ratios or bond ratings.

When we estimated the four regression equations, the statistical results in each instance were very similar ( see Table 1 ). For example, in both the electric and gas industries, the level of interest rates was, as we hypothesized, a statistically significant, positive influence on the level of allowed returns. Even though our data set is not a pure time series, the estimated results still suggest that the allowed rate of return significantly was influenced by changes in the level of interest rates over time. The changes in allowed returns were less than the changes in the level of interest rates, however. According to the parameter estimates of a2, for the electric utility industry, a 1 percent higher interest rate level translated into an estimated 0.51 percent to 0.61 percent higher allowed return on common equity. For the gas-distribution utilities, the estimated parameters indicated that a 1 percent higher interest rate resulted in an average increase in the allowed returns on common equity in the range of 0.44 percent to 0.49 percent.

The regression results linking allowed common-equity returns and financial risk did not conform to our hypothesis, however. Neither of the financial risk measures— i.e., common stock-equity ratios nor bond ratings— significantly was related to the level of allowed common equity returns granted in these industries during this period. Contrary to our hypothesis based on financial theory, the relationship between the common-equity ratios and the allowed returns statistically was positive at a 99 percent level. Illogically, this result suggests that the allowed returns were generally higher for firms with lower financial risks, not the other way around. Our estimated results further indicated that for every one level increase in the bond rating, the allowed rate of return would be about 0.35 percent higher, rather than lower.

Risk-Return Gap

We identified common stock equity as a percentage of capital and bond ratings as measures of financial risk. Contrary to financial theory and the principle of setting returns associated with equivalent risks, we found no significantly negative relationship between allowed returns and the risk measures among the 209 allowed returns in gas and electric utility rate cases during the 2001-2007 period studied.

Although the policy implications of this finding are not readily apparent and require further investigation, these estimates indicate a current, conceptual gap between allowed returns granted and important, recognized risks.