Utilities are increasing regulated returns exposure. So what?
The FT reported recently there has been a growing trend for the US utility business to rely on regulated returns, and Wall Street investors are rewarding these companies. Across the Atlantic ocean, the UK regulator, Ofgem has reduced returns for network companies to almost half at 3.9-4.2% citing a pricing error that allowed many UK utilities to earn double digit returns. The industry is, of course, not happy with this decision. Does this trend particularly in the US, indicate anything? What are its implications in the short and long run? What should the industry expect?
The linkage between regulation and economics is quite complex. Without going into the theoretical attempts to understand, what is clear is that the policy toward regulation and de-regulation have swung over the last 20 years or so. There are times when the industry moved toward deregulation and then swung back to regulated returns. As with any regulation, there are of course vigorous debates ranging from the woes of deregulation, failure of power markets, public interest, and regulatory capture. Indeed regulations are tied to economics as in placing price controls in limiting rent seeking behavior and allowing competition, and also to social matters like emissions, health and safety.
A clear trend toward regulated earning indicate one and only one thing at this point - that the returns are more favorable than unregulated markets. The conclusion to draw is the gap between price and marginal cost is much higher with allowed regulatory returns than unregulated. It is not hard to rationalize based on the market uncertainty, low gas prices, and even possible demand destruction from third parties. Allowed return on equities have come down a bit, but the equity risk premium has been quite high relative to broader market, given that risk free rates have been sustained at historical lower levels.
So are the regulators granting higher rents to the utilities than they should? Thats hard to prove. What matters however, is that utilities need to extremely careful to manage the public perception. The utility-customer relationship puts the utility at an advantage, not only to exercise in George Stigler’s words “regulatory capture”, but also the ability to stifle public interest with better and efficient means to organize against diverse customer groups, and lack of customer’s economic interest. (a customer’s electric bill is trivial to confront the economic interest at stake for the utility).
Access to windfall regulated returns can perpetrate adverse behavior that can result in long term problems.
Utilities can undertake ad-hoc projects to increase rate base growth at the expense of a coherent strategy. Asset refresh and upgrades and technology projects that lack future proofing and increases risk of stranded assets are common examples of such projects
Bias toward tested and proven technology in the interest of rapid “plant in service” can cause reluctance to incubate, deploy, and scale first of kind riskier and innovative projects
Reduced focus on building capabilities that encompass skill development, process redesign and organizational restructuring, in lieu of siloed projects and investments
Gold-plating the infrastructure or overbuilding capacity rather than projects like digitization that are harder to quantify costs and benefits and obtain regulatory approval
Utilities can get away in the near term under the pretext of their fiduciary duties of maximizing returns for the shareholders. However, doing so at the expense of long term customer and public interest may not go unnoticed. Covid-19 has exposed the fact that contrary to popular belief, defensive stocks like the utility stock do not necessarily outperform the S&P500 in a crisis. Even under a crisis, the stock market has been rewarding asset light companies that are nimble and flexible. Utilities can not only prevent such a risk, but use this market environment as an opportunity to double down on systematic investments to modernize the grid. The focus must be on future proofing, digitizing operations, and launching new services.
Policy and regulations are not static. When public pressure mounts, regulators can shift their positions and push the utilities in the defensive. The recent rate cases that rejected recovery of modernization projects and the development with Ofgem can be viewed as instances when the regulator is reacting to curb on utility rent seeking, and neglecting future benefit of the customers. Utilities and their investors have a responsibility of resisting the temptation of seeking short term rents at the expense of broader and longer term public interest. This will work out well for everybody.