It’s the question that’s on every income investor’s mind: Which utilities will perform best in a rising-rate environment?

One answer, of course, is utilities that have a strong earnings growth trajectory. Given the technological changes that are upending the sector’s century-old business model, stodgy utilities are going to have become much more entrepreneurial.

In our first article of this two-part series, “Battle of the Smart Grids,” we described what a more aggressive approach to winning customers will look like in this new era.

Another big factor, which we’ll explore in this article, is which states have the most constructive regulatory environments.

After all, it’s the regulators who ultimately decide what constitutes a fair return on utility investments.

In some ways, utilities and regulators have had it pretty easy since the downturn.

Falling commodities prices and historically low interest rates have given utilities considerable latitude to upgrade existing assets while pursuing a massive infrastructure buildout.

Because utilities simply pass along the cost of fuel to ratepayers, low energy prices give them room to boost spending (and rates) in areas where they can actually earn a return, such as investments in new plants and other infrastructure.

And cheap debt has enabled them to load up on such growth projects, while leveraging earnings growth thanks to the spread between the cost of borrowing and their authorized return on equity.

These two factors have also kept regulators from balking at this spending spree.

But rising rates not only push up borrowing costs, they also typically lead to higher energy prices.

From the regulators’ standpoint, that means something will have to give, or they could face blowback from ratepayers. And that something could be some of the projects that utilities are hoping will drive future earnings growth.

At the same time, regulators don’t want to do anything that might undermine the dependability of the essential services that utilities provide. In other words, they have a strong incentive to stoke utilities’ financial engine.

As such, even in a more constrained operating environment, regulators can give utilities opportunities to generate more earnings when they deliver greater value to ratepayers. They can also create a rate regime that increases the predictability of returns on certain key investments.

Put all these factors together, and regulators are going to assume far greater importance in a rising-rate environment than they did when the living was easy. In particular, we believe utilities subject to performance-based regulation have a big opportunity to outperform their peers.

Ranking the Regulators

In recent years, income investors have had the luxury of not having to worry too much about whether their favorite utilities had good relationships with regulators.

But that could be about to change. Consequently, Investing Daily’s Utility Forecaster is considering creating a ranking that would show which states have the most constructive regulatory environments.

Some of the criteria that we would be looking at include whether state regulators are elected or appointed; offer performance-based rates; allow higher-than-average returns on equity (ROE); and move quickly on rate cases.  

Naturally, there are other entities that compile such rankings with varying methodologies.

One recent ranking created by the Pacific Research Institute showed that Alabama, Alaska, South Dakota, Texas, and Delaware are in the top tier for the efficiency of state energy regulations.

Interestingly, the accompanying report noted that there is a geographical pattern to state regulation.

“States on the West Coast, in the Northeast, and in the upper Midwest have the most economically inefficient energy regulations. By contrast, states in the South and the heart of the country have regulatory environments more conducive to efficient allocation in production and consumption of energy.”

Perhaps that’s one of the reasons why the biggest utilities in the country are based in the Southeast, including Dominion Resources Inc. (NYSE: D), Duke Energy Corp. (NYSE: DUK), Southern Company (NYSE: SO), and NextEra Energy Inc. (NYSE: NEE).

In the next issue of Utility Forecaster, we’re planning to take a look at some of the other factors that could help utilities outperform in a rising-rate environment.