Financial-risk coverage is falling short in utility returns
Donald Murry is a vice president at C. H. Guernsey & Co. and a professor emeritus at the University of Oklahoma. Zhen Zhu is a consulting economist with C.H. Guernsey & Co. and an associate professor of economics at University of Central Oklahoma. Michael Knapp is an economist with C. H. Guernsey & Co. Contact the authors at (405) 416-8100.
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.
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.