U.S. investor-owned electric companies will spend 17 percent more on new equipment in 2016 than in 2015 despite slow-to-no sales growth, according to the Edison Electric Institute. Perhaps even more concerning, we calculate that the industry requires almost one-third more in external financing than the previous year. And even if capital spending moderates relative to current projections, the industry will retain its traditional reliance on capital markets for significant outside financing.
Here is what the numbers look like. But we would not draw too many conclusions about projected capex levels for 2017 and 2018. The companies still have plenty of time to revise their forecasts.
Figure 1. Capital Spending and Required External Financing ($billions)
Note: Capital spending, EEI estimates. Internal funds, authors’ estimates.
From a financial perspective this projected level of utility capital spending has both positive and negative aspects. From the utility investor's perspective, larger capital budgets increases rate base along with the opportunity for increased earnings. But from the consumer side, more expenditure on rate base, without a commensurate increase in kwh sales volume to pay for the bigger capital base, means asking regulators to raise prices. Someone has to pay for this incremental investment or earnings will suffer.
When utility net plant increases 4-7 percent per year and sales are flattish that spells trouble. Regulators don’t just look at the return on the increased investment in plant. They can use the opportunity of a rate case to look at the profitability of the entire regulated business. (The projected sales growth increases may also prove optimistic, which further compound the problem.)
Regulators may decide that while a utility's rate base has increased, the entire rate base deserves a lower return than before. Bond yields have been declining after all and perhaps authorized equity returns should come down as well. That’s the risk utilities take when they ask regulators for money. (Figure 2)
Figure 2: Percentage Increase in Electric KWH Sales and Net Plant (%)
Note: Sales estimates from EIA, 2015-2017, 2018 by authors. Increase in net plant, authors estimates.
The problem in stirring up the regulators lies in current estimates of cost of capital being made outside the regulatory arena. For instance, in the USA from 1871 to 2014, shareowners earned a real (after subtracting out the impact of inflation) return of 6.7 percent per year compared to a real return on Treasury bonds of 3 percent. That is, in return for taking some additional level of financial risk, stockholders were compensated 3.7 percent a year more than bondholders.
If that is still the appropriate "spread" over the risk free rate of return, and U.S. ten-year Treasuries yield 1.6 percent, this implies utility shareholders may soon be looking at a 5.3 percent return on their equity. A big comedown from return levels presently authorized by regulators. Related: Saudi Arabia Just Boosted The Odds Of An OPEC Deal
If so, that is cost of equity capital. As a corroboration of sorts, investment pros using a classic cost of capital model concluded that equity holders need only a real return of 3.6 percent now. Assuming an additional inflation rate of about 1.5-2.0 percent also equates to a similar 5.1-5.6 percent return on equity. Regulators are currently granting returns on equity in the 9 percent area. Something's gotta give.
What if regulators or simply aggrieved customers notice the low equity return estimates being bandied about in the financial sector? (Regulators, being lawyers acting in a semi-judicial manner, tend not to consider anything not presented formally to them as evidence.) That would create a real potential for a dramatic downward revision in utility earnings potential. But it is likely that regulators, unburdened by financial theory, will permit utility rates of return to fall modestly and incrementally, without making any big moves.
Fortunately there are some offsets. Utility stocks currently trade at such high prices and multiples of earnings that utilities can finance their capital needs with stock issuance above book value that does not reduce per share earnings. They can also sell debt at low interest costs as well. If fuel costs (mostly natural gas, some coal) stay low, this may continue to mask the impact of price increases from consumers. But if this presently ideal situation reverses (low interest rates, low fuel costs) then this seemingly ideal investment climate may begin to deteriorate. Even then investors may take some comfort in that regulators have been habitually slow to reflect current data in decisions.
In most businesses, spending more than the firm takes in (a Pickwickian problem) is not good. In the utility business, however, it depends. But for electricity consumers, more spending on rate base without a commensurate increase in sales is not good news.
By Leonard Hyman and Bill Tilles
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