Federal regulators’ recent move to change the criteria used to calculate regulated utilities’ allowed returns, a measure of profit known as return on equity (ROE), may be a small victory for income investors.

Over the past few years, regulators pared utility profits in response to ultra-low Treasury rates. But investors and energy executives have long argued that these historically low rates are a market distortion created by Federal Reserve stimulus and, therefore, do not accurately reflect utilities’ actual operating environment.

The order in late June by the Federal Energy Regulatory Commission (FERC), the agency that regulates the transmission and wholesale sale of electricity in interstate commerce, finally acknowledged this reality. Citing unusual capital market conditions, the agency wrote that Treasuries are “not necessarily a reliable one-for-one indicator of changes in investor-required returns.”

Typically, when interest rates fall during a normal economic environment, the cost of capital required to provide adequate utility service is expected to fall, meaning allowed returns (and cash flows) should also fall.

But with demands on utilities to modernize the grid, expand transmission and replace aging infrastructure, costs are rising at a time when utilities must increasingly compete for capital.

Chart A: Utilities Have Major Transmission Infrastructure Expansion Planned

Furthermore, new financial sector regulations are limiting banks’ ability to assume the same level of risk as they had previously, thereby further increasing the cost of capital.

Consequently, yield-hungry investors have had to take on more risk.

As the Bank for International Settlements (BIS), the Switzerland-based institution that essentially functions as the central bank for central banks, recently observed in its annual report, low interest rates coupled with low volatility have encouraged investors “to take positions in the riskier part of the investment spectrum.”

Additionally, the BIS argues that central banks’ stimulus programs “run the risk of addressing the immediate problem at the cost of creating a bigger [financial crisis] down the road.”

Meanwhile, utilities believe the effects of prolonged monetary easing could be undermining the discounted cash flow analysis FERC employs to calculate their allowed returns.

The Federal Reserve’s policymaking has kept rates at historic lows for an extended period, which has forced income investors into dividend stocks in lieu of fixed-income securities such as bonds. That’s pushed many utility stocks to new highs.

At the same time, the sluggish economy along with technological disruption mean growth in electric consumption has remained weak.

As Carmen L. Gentile, a renowned energy attorney, put it in a co-authored paper last year, the aforementioned factors could be causing DCF analysis to understate ROE risk and cost just as utility risk and cost and investment requirements are approaching all-time highs.

“[Utilities] find the ROEs resulting from some current applications of the DCF model to be inadequate, confiscatory, and below the minimum needed to undertake required new investments,” he noted.

Gentile adds, “[Utilities] make the hard-to-refute point that the low DCF results are the product of artificially low interest rates, which are pushing up common stock prices, and of depressed dividend growth rate expectations that arise out of the same economic anxieties that are fueling the government intervention to maintain low interest rates.”

But for many years, these arguments have fallen on deaf ears at state and federal public utility commissions (PUC).

According to a recent report on utility financial performance by the Edison Electric Institute (EEI), the association representing investor-owned utilities, the average allowed return in each of the past four years has set a successive record low.

Chart B: Will the Downward Trend in Allowed Returns Reverse?

During that same period, according to EEI, utilities increased their investment in transmission significantly, and are projected to spend an additional $54.6 billion on transmission infrastructure through 2015.

FERC Turns to Long-Term Growth

Federal regulators have historically applied different DCF methodologies in determining the allowed return for public utilities and natural gas and oil pipelines.

While there are multiple differences between the two approaches to DCF analysis, the most fundamental difference is that the methodology applied to natural gas and oil pipelines (i.e., the two-step DCF methodology) considers long-term growth projections in estimating a company’s cost of equity, whereas the methodology applied to public utilities (i.e., the one-step DCF methodology) considers only short-term growth projections.

However, FERC revisited its policy and decided that changes the industry had undergone since its last such review mean that it’s now appropriate to apply the two-step DCF methodology to electric utilities as well.

“We also make a tentative finding that the required long-term growth projection should be based on projected long-term growth in gross domestic product (GDP),” the commission wrote, adding that it will hold a paper hearing on whether long-term GDP should be used.

For utilities, it’s unclear whether using long-term GDP would increase allowed returns. In applying this revised methodology to the New England transmission owners whose complaint prompted the review, the commission tentatively set the range of reasonable allowed returns from 7.03 percent to 11.74 percent. By contrast, the previous range of allowed returns for this entity was 7.3 percent to 13.1 percent.

Despite the fact that both the upper and lower thresholds of the new range had been reduced, FERC opted to set the base ROE at 10.57 percent, which is substantially higher than the 9.7 percent that had previously been established as the minimum value for this period. 

Chart C: Will Wires Projects Mirror Pipeline Returns?

According to Gentile, the short-term effect of the commission’s decision in the New England proceeding is likely to be higher calculated ROEs. But over the long term, he said, “It does not follow that the results of the two-step methodology will be necessarily higher or lower than under the one-step DCF methodology–that will depend upon how the two methods react to the same set of financial data.”

Still, pipeline companies have generally earned higher allowed returns than utilities, and thus the switch to the same methodology bodes well for utilities.

An analysis of allowed returns for pipeline companies by the Natural Gas Supply Association shows that over a five-year period (2005-2009) the average after-tax ROE for 18 pipelines equaled or exceeded 12 percent. To be sure, pipeline companies’ allowed returns have been on the decline, but in many cases they are still higher than for utility transmission projects.

Overall, FERC’s new approach to calculating ROE for electric utilities could benefit large transmission owners and possibly regulated utilities themselves, if state regulators follow the lead of the feds in adjusting how allowed return is calculated. We will continue to monitor how these regulatory changes impact utilities’ profitability.