According to Aesop, the plodding tortoise beat the swift hare to the finish line. Reports just released by the Edison Electric Institute (EEI), the industry’s trade group, show the electric utility industry, considered by Wall Streeters a plodding performer compared to the dynamos of industry, has again done well for its shareholders, with electric utility shares outperforming the market (S&P 500) in the most recent and the last ten years. (See figure 1.)
Figure 1. Annual total return (dividends plus capital gains) per year for one year, five year and ten year periods (%)
Oddly enough, there is nothing unusual about these comparisons. For most of the post war period, utility stocks did as well as or outperformed the broad stock market indices, which they should not have done because financial theory says that risk determines return. And most people would agree that utility stocks are less risky than the market in general. In fact, using the standard measure of risk, beta, they are roughly half as risky as the market.
So, what might account for this disparity between theory and reality? Possibly, as regulated monopolies, regulators are too generous and allow utilities to earn equity returns that are higher than justified by the risks they incur. And that gap between cost of capital and allowed return has been growing.
As seen in figure 2, the gap between return allowed in rate cases and return on ten-year Treasury bonds (a good base on which to build cost of capital) has risen to levels rarely seen. Historically, collecting an equity risk premium of five percentage points over the Treasury yield would have more than satisfied stockholders. But, as shown in Figure 2, the gap between the return allowed by regulators and the Treasury bond yield has widened greatly. That extra return undoubtedly pushed up the total returns earned by shareholders. Will regulators continue to maintain the high equity premium? That is the big question. Related: U.S. To Sell 10 Million Barrels From Strategic Reserves This Month
Figure 2. Returns on equity allowed in rate cases vs ten-year Treasury yields (%)
Generous returns on capital should encourage spending on plant and equipment that will earn those relatively high returns. Since there has been barely any growth in demand for electricity, the industry has had to find other reasons to invest, and they have. Investments to reduce carbon emissions (perhaps less likely to get encouragement from the Trump administration) and to modernize the network, to make it more resilient and more interactive. Those spending programs have far exceeded depreciation and amortization expenses and have caused the industry to operate with a cash flow deficit for more than a decade, as shown in Figure 3.
Figure 3. Free cash flow, depreciation and amortization and capital spending ($ billions)
In essence, the U.S. electric utility industry has continued the strategy that worked so well for its shareholders over decades: spend as much as possible when regulators provide a sufficient return to make spending profitable, borrow the money if necessary, and pass on costs to consumers. For much of the industry’s history, that spending actually reduced prices to consumers. This capital investment purchased modern equipment that reduced costs. Nowadays, the industry must spend money on changes in fuel mix that may not reduce costs, and it has to sell the consumers on the value of the more modern grid. That is a bigger challenge.
By Leonard S. Hyman and William I. Tilles for Oilprice.com
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