Utilities May Be Earning 3 Points Too Much on Equity

Investor-owned utilities have earned roughly 10% on equity over the past two years — an estimated 2 to 3 percentage points above their true cost of equity capital, a cushion that adds roughly 5% to a typical electric bill. That is the central claim of analysts Leonard Hyman and William Tilles, writing for Oilprice.com, and it frames a growing risk to utility shareholders: regulators, squeezed by affordability pressures, may target allowed returns next.

The cost-of-capital math is straightforward. A utility's cost of capital has two components: the return on a risk-free investment such as US Treasury bonds, plus an equity risk premium compensating shareholders for their subordinate position in the capital structure. Treasury yields recently hit 5%, their highest level in almost two decades, after the Fed raised its discount rate. State public utility regulators set allowed returns based on this two-part calculation.

The flexibility sits in the second component. Postwar equity risk premiums allowed by state regulators have ranged from 300 to 700 basis points over the risk-free rate. Trimming premiums toward the lower end of that range would give regulators a lever to provide consumers relief. The logic, as the authors put it, is blunt: "Receiving a generous equity risk premium in return for financing a low-risk, monopoly business is, as they say, nice work if you can get it."

Current market numbers make the case sharper. The 10-year Treasury yields about 5%. According to the latest figures from NYU, the equity risk premium for the average stock is about 6%, and that premium has ranged from roughly 5% to 7% over the past two decades. An investor buying an average stock today therefore expects about 11% a year. Utilities, however, are not average stocks: from a beta perspective, they are about half as risky as the overall equity market. Half the risk, the authors argue, should mean half the premium — an equity risk premium of 2-3% and a total expected return, and cost of equity capital, of 7-8% a year.

The actual numbers exceed that benchmark. Member companies of the Edison Electric Institute, which includes most large investor-owned utilities, earned about 10% on equity in the past two years. A second check points the same way: the industry's market/book ratio — long treated as an indicator of whether a stock earns its cost of equity capital — last stood in the 180-200% range, signaling earnings well above the cost of capital.

Why would regulators act now after decades of tolerance? Hyman and Tilles give a one-word answer: affordability. Regulators face rising costs on all fronts, pressure from hyperscalers demanding power, no help from what the authors call "a federal energy policy that is both visionless and chaotic," and sudden political heat from formerly complacent politicians. Allowed return on equity is the easiest number to cut. The authors acknowledge the savings will not amount to much in the big picture, especially if fuel costs keep rising, but the impact on shareholders would be direct: every one percentage point removed from return on equity cuts earnings for common stock by 10%.

That arithmetic points to a broader downward revaluation of utility shares. A re-ignition of inflation is a strong negative for the sector, the authors argue, because every cost rises at once, the cost of money rises too, and then "the regulators get mean." The implied rerating could be large — a 20-30% reduction in the price/earnings ratios of utility stocks.

Three conditions make this cycle different, according to the analysis. First, equity percentages of capital structures are high. Second, equity risk premiums are also high. Third, the industry learned to operate very well in a low-growth environment with compliant regulators. In plainer terms: utilities carried too much expensive equity, earned too much on that excessive equity, and faced no pushback because regulators felt no pressure to rein in capital costs when they did not have to raise prices. Inflation forces all three favorable trends into reverse — the market will simply pay less for a dollar of utility earnings.

The endgame, the authors suggest, is when regulators propose cutting allowed returns and utilities respond by pulling back on rate base investment, citing their shareholders' financial requirements. That standoff, Hyman and Tilles write, "is when things get interesting."