Linking Risk and ROE


Financial-risk coverage is falling short in utility returns

Financial-risk coverage is falling short in utility returns

Fortnightly Magazine - January 2008

When setting the allowed returns on common equity of jurisdictional utilities, state regulatory authorities apply the virtually universal standard that the allowed returns should be similar to returns on common equity investments in companies of equivalent risk. 1 Such returns generally are accepted as fair if they are no higher than necessary and still sufficient to attract investment. It follows that the greater the risk, the greater the required return, and that a return that meets the risk-equivalency standard will be sufficient for the utility to operate successfully, attract capital, maintain financial integrity and compensate investors for the risks they assume.

Despite the universality of this regulatory standard, our investigation of recent allowed returns by state commissions shows that a key risk—financial risk—as measured by accepted, measurable metrics, has not been a factor affecting the level of allowed returns in the United States in recent years.

Financial Risk

Precedent claims on revenues to cover fixed-cost obligations are the source of financial risk. The benefits to common stock holders come from dividends, retained earnings, and stock price appreciation. However, returns to common stock are available only after the utility makes all preferred stock and interest payments.

Generally, a lower equity ratio implies that a company has greater fixed-cost obligations to holders of securities that have precedence to revenues, which means that a lower common equity entails greater financial risk for the common-stock holders. Consequently, the common-equity percentage is a direct measure of financial risk.

Bond rating agencies acknowledge that they consider many factors, including the common equity ratio, when determining ratings. Bond ratings are another generally accepted measure associated with financial risk. 2

A bond rating summarizes the raters’ opinions regarding the security of the contracted interest payments, and, as previously stated, common-equity returns are subordinated to the interest payments. Additionally, the rating agencies have developed other measures of risk, such as the Flow of Funds from Operations to capital interest payments, which is a more direct measure of the funds available to meet interest payments. (A higher flow of funds from operations to interest payments ratio implies more funds will be available to common equity returns.)

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For these reasons, common-equity ratios and bond ratings are both measurable metrics signifying levels of financial risk, and statistically we can isolate the relationship between them and the allowed returns by state commissions.

Econometric Analysis

To test the direct relationship of the financial-risk variables—namely the common-equity ratio and the level of bond ratings on the allowed return on common equity during this period—we estimated the following regression equations for the electric utility and the natural-gas distribution decisions: