The Regulatory and Physical Climate is Transforming for Utility Return on Equity

Published: March 25, 2022

By: Concentric Staff Writer

The regulatory climate around utility return on equity (“ROE”) proceedings is rapidly changing amid a reconsideration of both near-term and longer-term industry risks. Factors affecting today’s regulatory environment include the continuing impact of the COVID-19 pandemic, extreme weather patterns, the clean-energy transition, inflation, and increasing concerns around cybersecurity, a roundtable of experts from Concentric Energy Advisors (“Concentric”) said in a recent interview session.

Concentric is involved with a variety of ROE proceedings at the state/province and federal level, including gas and electric distribution, electric transmission, oil and gas pipelines, and water infrastructure, both in the U.S. and Canada. A utility may have several types of ROE cases, including retail rate cases regulated by the local authority and transmission rate cases overseen by the Federal Energy Regulatory Commission, which sets ROE for transmission owners.

“At least in the rate cases that I participated in,” said Jennifer Nelson, an Assistant Vice President at Concentric, “there certainly was a strong position among intervenors and customers around the effects of COVID-19 and rate impacts to customers.” Nelson is an expert witness on cost of capital and alternative ratemaking proposals. Some utilities that had postponed rate cases in 2020 due to the COVID-19 pandemic rescheduled in 2021. Factors driving the average range of ROE include which utilities go in for a rate case in a given year, and the regulatory environment in the state or jurisdiction, she said.

The trend of declining interest rates for government bonds over the past 15-20 years is another factor in utility rate cases, according to John Trogonoski, also an Assistant Vice President at Concentric and former commission staffer. Trogonoski has filed expert testimony for U.S. and Canadian utilities on return on equity and performs risk analysis for Canadian and U.S. utilities, including reviewing peer groups to study relative risks and regulatory protections that help to mitigate those risks. Two decades ago, 30-year treasury bonds yielded about 6 percent, but they are now about 2.5 percent, Trogonoski said during the discussion. Treasury bond rates are often used in calculating ROE, plus a risk premium.

“That’s one of the factors that gets taken into account in the models that we use to estimate the ROE for a utility,” he said of government bond yields. “It’s not the only factor, but it’s an important factor, and it’s one that’s easy for utility commissioners to look at and digest.” Commissioners want to know if treasury bond yields are declining, why a utility’s bond ROE wouldn’t also decrease, he said, adding that there are reasons why there isn’t always a direct relationship between the two.

The impact of climate change is another risk factor that is increasingly being considered in utility ROE cases, according to Jim Coyne, a Senior Vice President and Board Member at Concentric who regularly testifies in utility rate cases and cost-of-capital proceedings. “We’re seeing the nature of the discussion surrounding utility rate cases has shifted significantly in the last several years to include discussions around new risks to the utility industry,” including wildfires in the West and natural disasters in areas such as the Southeast and Florida, Coyne said.

The rating agencies and equity investors are keeping a close eye on these risks and “they are becoming a more important part of the dialogues about what is the appropriate cost of capital for utilities. Most regulators are not at the point of making specific ROE adjustments based on these risks, depending on the progressiveness of a particular jurisdiction. But all parties are beginning to understand that they need to be considered because they affect access to capital and cost of capital,” Coyne said.

Gas utilities are also facing a public policy environment with strong carbon reduction goals as early as 2030, and states with stronger environmental mandates understand that those policies have some impact on gas utilities.

“I’d say we’re at the early stages of that dialogue,” Coyne said, as regulators are just beginning to understand these climate impacts.

“ESG and sustainability are becoming a bigger part of the dialogue,” said Lisa Quilici, a Senior Vice President and Board Member at Concentric. Quilici has expertise in M&A, regulatory analysis, policy formation, and resource planning. There is a growing sensitivity to those issues, she said.

“These are big issues that are having a holistic effect on the industry,” Quilici said, adding that holistic considerations are very important to looking at ROE recommendations and benchmarking. There is a balancing act that takes place when formulating an ROE recommendation driven by sound analytics and methodological results, she said.

In 2019, a California electric and gas utility was trying to decompose the specific cost of wildfires in a cost of capital proceeding, according to Coyne, which required looking at other risk-exposed sectors such as oil and gas companies and what types of returns their investors require. There is a huge risk-return tradeoff with exposure to new downsides that are difficult to quantify, he said.

Insurance premiums also help estimate the premium on the cost of capital and the cost of risk-reduction through those insurance premiums, Coyne said. California regulators recently found that a risk premium was not justified in a utility proceeding but approved an ROE at the upper end of the scale to account for these risks.

There is an expectation among debt and equity investors that the commission will provide reasonable rate recovery of prudent plans to mitigate and address issues that occur as a result of extreme weather, Quilici said. Climate change is similar to other adjustment mechanisms that, a decade ago, were just starting to be considered and were uncommon, but over time were embraced as part of the normal course of business, she said.

Utilities are also planning more than ever for wholesale changes to their generation mix, such as bringing on large amounts of renewables to replace fossil-based generation, Coyne said. New methods of generation require significant investments due to a growing number of proposals to build renewables and more directives from the state level to retire fossil-fuel assets.

Renewables integration is also leading to new levels of cooperation between players that were previously more adversarial, Coyne said.

“We’re seeing a bit of an alliance between environmental groups that want those investments made, utilities that want to make the investments, and ratepayer advocates that understand customers need to be protected by ensuring utilities can make investments in a way that is acceptable to them from a rate perspective,” Coyne said. There is also more agreement around retiring assets earlier than planned and negotiation in these matters in the regulatory process, usually through settlements.

Utilities are facing many of the same issues other sectors are facing when it comes to COVID-19, such as supply chain issues and labor shortages. Interest rates and inflation are also increasing and causing more frequent rate cases, according to Coyne.

“I think utilities and regulators, for the most part don’t like more frequent rate cases,” because of the time and resources involved, he said. There will be more multi-year rate cases and certain costs will be indexed between rate cases to help manage those risks, he said.

There have always been technological risks with generation assets, but policy risk is also rising in terms of these assets. Generation carries more risk than transmission and distribution, as utilities move into compliance with federal, state, and corporate emissions-reductions plans.

Cybersecurity is also increasing costs, with regulators seeming to understand these are reasonable expenses and part of the modern ROE environment. But cybersecurity is not yet a central item in ROE proceedings, according to Coyne.

On the issue of formula-based rate determinations, some commissions rely on formulas to set rates. Despite the benefits of a formulaic approach in rate cases, “in general it hasn’t worked that well,” Coyne said. The formulas are often tied to government or utility bond yields, but government bond yields have decreased while equity costs have moved in a different direction. The federal government’s stimulus policies and Federal Reserve policies have driven interest rates lower.

It is no longer the case that one can easily predict the movement in a utility’s equity costs using a government or utility bond yield, Coyne said. Since 2009 the Canadian province of Ontario has used an approach including government bond yields and a spread between utility bonds and government bonds that has worked pretty well, with limitations, he said.

The political make up of an agency such as FERC and/or what kind of administration is in the White House are also factors in federally regulated ROE. Incentives and policies put in place years ago have promoted greater infrastructure investment such as electric transmission lines.

But there has been an evolution of a movement among ratepayer advocates that argue on a consistent basis that FERC should revisit some of the policies and evaluate whether they are too generous, Coyne said. There is a chance that investors will pull back from transmission investment because of incentives being reduced, but so far, that has not been prevalent.

“FERC’s policies by and large seem successful for promoting an environment for infrastructure investments,” Coyne said.

In February, FERC revised its policies for considering proposed natural gas infrastructure, expanding consideration of economic and environmental impacts, including greenhouse gas emissions. The policy statement covers infrastructure such as interstate pipelines and liquefied natural gas terminals. Proposed projects with greenhouse gas emissions of 100,000 metric tons annually or higher will now require an environmental impact statement.

The policy statement is part of an ongoing shift at the federal and state level where it is more difficult to build new infrastructure, especially on the gas pipeline and gas distribution side, Coyne said.

“It sends a signal to investors that these projects are more difficult to get built, and the inevitable result is increased cost of capital for infrastructure investment,” Coyne said, adding this is not yet a well-understood or well-litigated factor in cost of capital. Required returns and equity ratios need to edge up to provide ongoing capital, he added.

With so many new factors in play, utility ROE cases are only becoming more complex. A changing and evolving world requires constant change, however gradual, in determining a utility’s costs and what is a fair return on its investments.

To learn more about Concentric’s ROE services and meet our team of ROE experts, please click here.

All views expressed by the contributors are solely the contributors’ current views and do not reflect the views of Concentric Energy Advisors, Inc., its affiliates, subsidiaries, or related companies. The contributors’ views are based upon information the contributors consider reliable at the time of publication. However, neither Concentric Energy Advisors, Inc., nor its affiliates, subsidiaries, and related companies warrant the information’s completeness or accuracy, and it should not be relied upon as such.

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