The conventional wisdom about utility spending is correct, but key factors affecting customer satisfaction aren't obvious—and are tricky to control.
Rational estimates lead to reasonable valuations.
When setting returns on equity, regulators might be doing the right thing, but for the wrong reason. The U.S. Supreme Court in 1923 established that regulators should set rates of return that sustain investor confidence in the integrity of the utility, and that enable the utility to maintain its credit standing so it can raise the funds necessary to provide service to its customers. 1 Regulators seem to be meeting these pragmatic requirements. The problem arises from the manner in which regulators arrive at the authorized returns.
This isn’t a problem in the rate case per se , as the Court has also said that the end result of the process is what’s important, and not the method used to set rates of return. 2 However, consequences of a faulty process manifest themselves elsewhere, and with critical impact. An incorrect cost of equity estimate makes it impossible to derive accurate financial valuation estimates.
Failure to understand the actual situation in this regard could cause executives and regulators to make serious valuation errors when analyzing utility resources. Those errors could cost utility investors billions of dollars.
Fallacy of Common Practice
Many rate-of-return witnesses suggest that in principle a utility’s cost of equity (k) can be estimated by the following formula, or by a multi-stage variant of it:
k = dividend yield + nominal GDP growth rate forecast.
The typical utility dividend yield today is about 4.5 percent; long-range annual GDP growth forecasts currently lie in the 5 to 6 percent range. Adding the two components produces a utility cost of equity estimate of about 10 percent, and regulatory decisions match that model result quite closely; the industry’s median authorized return on equity in 2010 was 10.2 percent. 3 Who could argue with such a straightforward process, especially since it’s so widely used?
However, the fact that this is a popular procedure isn’t compelling. Appeal to common practice is a logical fallacy, one that offers no support for the proposition at hand. As logic scholars teach:
If one understands the true relationship between GDP growth and utility growth potential, and if one embraces the essential nature of the cost of equity concept, a 10 percent utility cost of equity estimate is too high to be reasonable. No rational investor would expect utility growth to come close to GDP growth over the long run, and therefore the commonly used model is flawed.
Furthermore, corporate finance officers suggest that the cost of equity for the typical U.S. corporation today is only about 8 percent. The finance literature provides similar results. If that’s the case, again utility costs of equity can’t be 10 percent.
A 10 percent figure nevertheless is likely in the range of reasonableness for the return-on-equity measure, which is the variable that matters in the rate case. Under proper regulation, one that replicates the results observed in competitive markets, the return on equity should lie above the cost of equity.