The Federal Reserve has told the world that it will increase interest rates four times this year. Nobody knows how much and nobody knows how corporate interest rates will move. But rates going up seems to be the likely direction.
Utility stocks usually underperform when interest rates rise, so this issue matters to utility stock investors. Okay, in the current state of economic turmoil, the market may not believe that the Fed will carry out its plans, but let’s assume that the Fed’s Board of Governors knows whereof it speaks, and remember that utility dividend yields tend to move with interest rates, which means that when interest rates rise, stock prices tend to decline.
When an Administrative Law Judge (ALJ) at the Federal Energy Regulatory Commission (FERC) starts talking about lowering a utility’s return on equity, pay attention. For years now, the FERC has granted extraordinarily high returns to its charges. The judge thinks 10.3 percent is high enough. That’s a comedown from the 12 percent plus returns the FERC has granted recently.
But let’s not dwell on the FERC’s methods or motivations, or even whether the full commission will accept the recommendation. Instead, look at the recommendation as one more indicator that regulators have begun to bring down returns on equity in earnest. Considering that cost of capital is closely tied to interest rates, doesn’t the ALJ’s recommendation seem out of sync with market trends? Utility stock investors who fear the impact of an interest rate increase on their stocks should at least get some offsetting relief because regulators usually raise allowed returns when interest rates rise. So what is going on? Related: Is This The Riskiest Oil Stock In The World?
Between 1965 and 2014, regulators set returns on equity at roughly 3.7 percentage points above the Baa bond yield, the bonus being an equity risk premium. History, however, shows that regulators raise returns more slowly when bond yields rise and lower them more slowly when bond yields fall.
Furthermore, regulators tend to give a bigger equity risk premium when interest rates are low and a smaller one when they are high. That makes sense because in low interest rate periods inflation is also low, and the utilities are under little pressure to raise prices. So the regulator can allow them a relatively high return because doing so does not require contentious rate hikes that get regulators into political hot water.
On the other hand, during inflationary periods, when interest rates usually are high, utilities whose costs are escalating rapidly must seek rate hikes. Regulators have to find ways to cut back on the rate increase, and what better way than reduce the equity risk premium?
In 1965-69, a period of rate reductions, regulators set returns an average of 4.6 percentage points above bond yields. During 1980-84, when the industry was in bad shape and constantly asking to raise prices, the equity premium fell to 1.1 percentage points. And in 2010-14, with only moderate need to raise prices, equity risk premium rose to an astonishingly high 5.0 percentage points, possibly 1.0-3.0 percentage points above most company’s cost of capital. Related: Oman Offers to Slash Oil Production If OPEC Follows Suit
As of now, bond yields stand at 5.5 percent and the average allowed return is 9.9 percent, meaning that the equity risk premium stands at a relatively high 4.4 points. With higher interest rates on the horizon rather than here, regulators may continue to lower rates of return. What is worse, they might lower the returns even if interest rates rise, thereby diluting the economic impact of potential rate increases by lowering the equity risk premium.
They might even notice that many pension funds have reduced their expectations of return to under 8 percent, meaning that the authorized regulatory return of 9-10 percent may even exceed a utility’s cost of capital. Professor James Bonbright, the man who wrote the classic book on utility regulation and finance argued that rate of return established in a rate case be viewed as a minimum, not a maximum.
But not many regulators seem ready to accept that view. So, the odds are that allowed returns could sink further before turning up. Prudent investors might prepare themselves for a likely reduction in utility stock prices caused by rising interest rates before they experience some compensatory rise in equity returns from regulators.
Figure 1. Return on equity granted in rate cases tends to follow interest rates
Now for the good news. Over the past half century, utility stocks tended to provide a dividend yield of roughly 2.1 percentage points, on average, below the bond yield. Equity investors accepted less current income because they expected to more than make up the shortfall through capital gains as the company grew. Related: Iran’s Eagerness To Export Sees Oil Tanking Again
However, in recent years, equity investors have demanded a higher dividend yield relative to the bond yield, and the current dividend yield is only 1.7 percentage points below the bond yield. Perhaps that change in pricing indicates that utility investors have few illusions about the industry’s ability to grow as fast as in the past.
Figure 2. Electric dividend yields tend to follow interest rates.
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Electric stocks stand between the proverbial rock and hard place. If interest rates rise, the stocks decline. If interest rates do not rise, then regulators will continue to lower their returns. The only way to run the business, under those circumstances, then, is to stay away from regulators and don’t raise prices. Regulators usually don’t bother utilities that don’t bother them.
By Leonard Hyman and William Tilles for Oilprice.com
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