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Linking Risk and ROE

Financial-risk coverage is falling short in utility returns

Fortnightly Magazine - January 2008

One obvious concern is the implications of these findings for raising capital for utilities if the regulatory process does not recognize apparent financial risks. For example, virtually all reputable analysts are predicting major capital investment requirements for gas and electric utilities based on increasing demand, the need to replace older infrastructure, and meeting new environmental standards. Given increasing capital requirements, a reasonable policy question is whether the gap between identifiable risk and allowed return is sustainable. Linking allowed returns more precisely to investors’ risks may become imperative if the predicted, incremental demand for equity capital becomes a reality.

 

Endnotes:

1. Frequently cited sources of this equivalent risk standard are two decisions by the United States Supreme Court: Bluefield Water Works and Improvement Co. vs. Public Service Commission, 262 U.S. 679 (1923), and Federal Power Commission vs. Hope Natural Gas Co., 320 U.S. 591 (1944).

2. The bond rating organizations incorporate a number of risk indicators, including common equity and debt ratios, when determining a rating. For example, Standard & Poor’s identifies funds from operations (FFO) to interest coverage ratio, FFO to total debt ratio and total debt to total capital ratio as important factors influencing bond ratings (see Standard & Poor’s Corporate Ratings Criteria 2005, p.45, McGraw Hill, New York).

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