Electric utility regulation is back…
Bond rating agency Moody's just released a study reviewing regulation worldwide. The report begins with “Prudent regulation key to mitigating risk…”. What follows is a lengthy enumeration of industry business risks: carbon reduction, distributed generation, to say nothing of flat sales. These risks, according to Moody's, can be mitigated at least to a degree by regulation.
American utility regulators themselves have begun to reexamine regulation. Experiments elsewhere, particularly in the UK, attempted to impose the supposed discipline of the free market to induce utility managers to operate their companies more efficiently. Then a hefty portion of the attendant savings would be passed along to consumers, rather than simply hoarded by management and shareholders. This in a nutshell describes the dubious premise behind British utility privatization efforts under Prime Minister Thatcher beginning in the 1980s.
Revising American regulation along British lines will likely have a beneficial financial impact, at least for some. But whether it also reduces business risk for an industry facing multiple existential challenges remains an open question.
Critics oppose American-style cost of service utility regulation for its emphasis on the rate of return, i.e. how much the company actually earns on capital invested. In principle, the utility invests in assets dedicated to serving the public, and the regulator, in turn, sets prices designed to permit the utility to cover all operating costs plus a return on capital invested to serve the public.
They argue that utilities operating under rate of return regulation regime lack sufficient incentive to reduce costs. After all, return on prudent investments made and expenses incurred can be passed along to customers. This system, they say, encourages utilities to over-invest. Why? Because all that invested cash is typically permitted to earn a guaranteed return by regulators. And how good is that guarantee? As good as the willingness and ability of utility customers to pay their monthly bills.
Economists Harvey Averch and Leland Johnson published an article in 1962 that posited that cost of service regulation, by guaranteeing a return on regulated investment, would perversely (from the customer's perspective) incentivize management to over-invest in utility plant. Since then, the Averch-Johnson Effect has been treated as dogma in some circles.
To us, however, critics of rate of return regulation have missed a key ingredient in the argument. An ingredient that the economists understood, but seems to have gotten lost in policy circles in recent years. No matter how compliant or even corrupt the regulator, no sensible manager invests capital in a business unless that investment can be expected to produce a return in excess of the firm's cost of capital.
Think of it this way. If you could borrow money at seven percent (your cost of capital) and invest that sum to earn 10 percent, you might—with sound economic reasoning—make the investment. But if the situation were reversed, and funds borrowed at 10 percent could earn no more than 7 percent, no investment would or should be made.
Financial theory tells us that when a company’s stock sells at a price above book value (based on accounting costs), that company is earning more than its cost of capital. Successful companies generally do earn more than cost of capital, sometimes far more. But regulated utilities give up their ability to earn a potentially far higher profit in return for absence of competition. They can still be monopolies especially in the distribution business, but from a profit perspective, the regulators, at least in theory, take the place of the free markets.
Utility law in the U.S. generally calls somewhat ambiguously for regulators to set a "fair" rate of return, which most define today as cost of capital. However, the price of utility stocks in the post-war period declined below book value in only 14 of the 71 postwar years. (Twelve of those 14 years encompassed the post Three Mile Island, high inflation/nuclear new build disaster in the U.S. and the Energy Crisis prior to that.)
For most of our recent history, utility stocks have sold at prices far above book value. Successful companies should earn something in excess of their cost of capital, as a precautionary matter. But how much more? And just as important, given long term utility stock price behavior, have regulators become excessively generous at the expense of consumers?
One way to empirically answer this question is to look at the spreads between the risk-free rate of return (10-year U.S. Treasury bonds) versus the actual return on capital authorized by regulators. This spread presently is at all-time "wides"—when regulators appear particularly generous despite or perhaps because of the present low interest rate environment.
Perhaps, then, the question is not whether rate of return regulation itself encourages gold plating and expensive over-investment but whether regulators do a good job of setting returns, balancing the public interest with the interests of private management and shareholders.
Do alternative regulatory formulas make companies more efficient and cost effective? Yes. Studies show that utilities do operate more efficiently under alternative regulation, but their risk level also rises and that raises their cost of capital (and ultimately prices to consumers). Over the long term, greater operating efficiency has to offset higher capital costs, or the change in regulatory formula accomplishes little for consumers.
We understand the appeal of novelty and the desire of regulators and policymakers to try something different. So-called regulatory innovation always has a built in, supportive clientele of likely beneficiaries—an economic eco-system of sorts. But for the regulators, perhaps doing the job they presently have better would be a good start.
By Leonard Hyman and Bill Tilles for Oilprice.com
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