Start with the obvious. You invest to earn a return on your money. And you want your investment to grow faster than the rate of inflation in order to protect its real value. You expect to earn an even higher return by taking bigger risks versus smaller risks. And you measure total return by the income received from the investment plus the change of the value of the investment—not by the numbers shown on corporate books, which are too easy for aggressive accounting departments to manipulate (as numerous accounting scandals have demonstrated).
Okay, now for the numbers. Let’s look for a global benchmark. The Government Investment Corporation (GIC), the giant sovereign equity fund of Singapore—a highly professional organization with a long-term, global investment horizon—provides such a benchmark. It just reported that over the past 20 years, it earned a nominal annual return of 7%, which translates to a 4.2% return per year over the rate of inflation. GIC, however, owns a large portfolio of bonds. So adjusting for that, we believe that the common stocks in its portfolio probably earned about 8.6% per year, or about 5.8% percent per over the rate of inflation, which is close to global equity returns over more than a century.
The U.S. stock market, as exemplified by the S&P 500 stock index (for almost but not quite the same period) produced a total return (dividends plus price appreciation) of about 9.7% per year, or roughly 7.4% a year over the rate of inflation. In other words, that is what the average stock, with the average risk level earned for investors. That will be our U.S. benchmark. The major oil and gas companies, which have roughly the same risk level as the overall equity markets, earned about the same annual return as the market over the past 20 years. Related: From Unknown To Unstoppable: New Traders Redefine Russia's Oil Landscape
Now for the interesting number. The one with some investment significance. US electric utilities also earned 9.7% (7.4% more than inflation) in the same time period. What’s the big deal? Well, electric utility stocks are about half as risky as the market, so they should have returned less to investors (less risk should mean fewer economic rewards). Using the standard formula for risk and return, we’d have to conclude that electric company investors earned roughly two percentage points of return per year more than the utility’s underlying cost of capital. That is, about 2% more than they should have. That bonus or excess return probably adds about $13 billion per year (about 3%) to customers’ bills.
Lest you consider this extra income an anomaly peculiar to the past 20 years, we estimate that utilities earned more than cost of capital in at least four out of every five years since the end of World War II. What accounts for this extra return? Regulation seems the obvious answer. Regulators, especially at the state PUC level, can prevent competition and they set the return on utility equity which comprises about half of the corporate capital structure. (The other half of the utility capital structure consists of bonds and preferred stocks over which the state PUCs have no discretion.) They are supposed to set a utility’s equity return at its cost of capital. But they don’t and have consistently erred on the side of generosity towards shareholders versus ratepayers. Why? Consider three possibilities:
Regulatory capture— The regulated utilities and their state regulators get too cozy. This can either take the form of outright corruption, as seen recently in Ohio and Chicago where criminal proceedings are underway, or a more subtle form of “cognitive capture” where the best jobs after being a regulator are only open to those who don’t rock the utility’s economic boat. Campaign contributions are an additional source of political influence perhaps distorting economics in the utility’s interest.
Financial inexperience— Regulators, largely lawyers, and former state legislators, really don’t understand the financial big picture. And we believe this is largely by design. As a result, they have to rely on a narrowly legal framework while they gather information in quasi-judicial proceedings in which well-paid expert witnesses representing utilities can frame the issues and choices to the exclusion of outside market information which might be more favorable to the public’s interest.
Regulators follow Bonbright’s advice— James Bonbright, a great scholar of regulation, argued that regulators should view their finding of rate of return (which is supposed to, mean the utility’s cost of capital) as a minimum, rather than a maximum, in order to assure that the utility earns enough to keep the economy supplied with adequate and reliable energy supplies. Rather than authorizing a minimal equity return barely adequate to keep the lights on so to speak.
All we can say is whatever motivates regulators has staying power. Given the enormous present pressure to enlarge and strengthen the electricity grid, they may have no choice but to stay the course. Cutting back on industry spending in order to cut a few percent off the electric bill looks like a case of penny-wise and pound-foolish, for sure.
Now, let’s get to the numbers, again. This year, US electric utilities and other electricity suppliers will spend over $150 billion on capital expenditures —that is, on assets that will earn a return for the utility. We have calculated, elsewhere, that this domestic spending has to rise to over $350 billion annually to get the industry in shape to meet new demand and prepare for climate change. And that’s just the US, which accounts for only 15% of global electricity production. In comparison, six global oil majors— ExxonMobil, Chevron, Shell, TotalEnergies, BP, and Eni — will, in total, spend only $110 billion on capital expenditures in 2023.
So when looking at investment opportunities over the next decade at least, we were struck by the magnitude of the actual versus potential spending to upgrade our electric grid and by the relatively good long-term potential investor returns. The highs and lows in alternative energy investments seem to even out. So far, the electric companies have offered fewer highs and lows, less aggravation, and a better risk-adjusted return. If we are right, that is another reason to believe that the electricity market will plow ahead gaining market share (versus oil and gas) because the electric market (with its compliant regulators) has a real advantage in raising new capital.
By Leonard Hyman and William Tilles for Oilprice.com
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