The electricity and water utility industries are mirror images in a way. Government agencies service roughly 85% of water consumers and investor-owned companies the rest. Investor-owned utilities serve roughly 85% of the electricity market and government agencies serve the balance. Government agencies provide both essential commodities at a lower cost in both markets. This is not because they are operationally more efficient but for two other reasons: very low tax rates and significantly lower capital costs.
Regarding capital costs, financial theory tells us that when stocks sell above book value (a dubious concept except for regulated industries where it is relevant) the companies that issue equities are earning more than their cost of capital. They should earn more than their cost of capital to have a buffer for emergencies such as wildfires, droughts, and economic downturns. But as monopolies, rates should not produce a return to shareholders that is so high as to take advantage of their captive customers.
Figure 1 shows the market/book ratio for water and electric utilities for five year periods beginning in 1965. Note that the stocks sold well above book value for all but the high inflation-high interest rate period of the early 1970s to mid 1980s.
Notes to figure one: Water index has small sample size and components have changed, so caution is warranted on magnitude of movement within index. See Leonard S. Hyman, The Water Business, for historical data.
For historical data, see Leonard S. Hyman and William I. Tilles, America’s Electric Utilities.
For most of the period shown, shareholders in both industries earned total returns close to that of the market as a whole, despite both industries being substantially below the market in terms of risk. That is a polite way of saying that the company management convinced regulators to let them overcharge customers consistently. How? By blurring the assessment of risk in the regulator’s determination of equity returns. And speaking of risk, the equity percent of utility capitalization is also way high for a low-risk, regulated business —providing another avenue for excessive earnings. Well, aren’t managers paid to do that? Good for them.
The past 10 years have not been different. Using S&P indexes to illustrate the point, we find:
Table 1. Ten-year annual total returns as of 15 March 2024 for water and electric utility stocks, for the stock market and for bonds (%)
During the past ten years, corporate bonds yielded 3-4%. Taking that as the risk-free return upon which investors build their expectations, they should have been satisfied with total returns (meaning current income plus price appreciation) of 6-8% for low-risk utility investments. But investors did far better. Looking ahead, with bonds now yielding 5%, the acceptable total return needed to entice capital to the business may have moved up to 8-9%. Regulators will, no doubt, continue to set much higher numbers for allowed utility equity returns. Whether this is due to regulatory capture or other forms of undue corporate influence we have no idea but the ongoing pattern is suggestive.
Over the coming decade electric utility companies face two challenges. They will lose major customers because they will be unable or unwilling to furnish the quality of service these customers require. And customers will have the ability to contract out for a “premier” utility service or own and operate the assets themselves. As a result, the legacy franchise-owning electric companies may lose revenue. This will occur while electric companies are attempting to raise huge sums in the capital markets to upgrade and expand plant and equipment, replace aging assets, and decarbonize and upgrade the grid. Financing that program will require a steady stream of rate hikes for customers, some of which may drive away business dependent on low energy costs or adversely impact the neediest customers. We expect regulators to meet these challenges in the way to which they have become accustomed. They will cut back on rate increases. And if we are right in our analyses of cost of capital, regulators have a fair amount of room to cut back before they start to affect the utilities ability to raise capital. We don’t see the water companies running out of capital, do we? However, years of big capital spending (as we’re facing now), coupled with adversarial regulators holding down the allowed equity returns, could definitely depress the utility market/book ratio, as occurred in the 1970s-1980s. Not a bullish thought for electric utility investors.
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But the real question is this: does the equity investor in the investor-owned utility serve a function that is worth the additional cost? The investor-owned utilities do not seem better run, but all the extra taxes and higher capital costs probably add 5-10% to the customer’s utility bill. The bulk of the nation’s water consumers get the benefit of lower capital costs and taxes via public or municipally owned entities while the bulk of the nation’s electricity users do not. With capital becoming a bigger part of product cost as the electric industry moves to decarbonized generation, that question is worth considering. In other words, why do we still have investor-owned utilities, which charge higher prices, for identical services, while using public money to lobby for further rate increases? Maybe governments at various levels should simply finance the big-ticket items of electricity decarbonization themselves and reap the savings.
By Leonard Hyman and William Tilles for Oilprice.com
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