Utility Shares and the Pressure on Returns

Electric Utilities Face Major Investment and Regulatory Challenges

In the coming five years, power companies are expected to significantly increase their spending to address growing electricity demand and to reinforce aging infrastructure. This surge in investment will likely require issuing much more equity than previously projected. The success of these stock offerings depends heavily on the returns utilities can generate from their investments, which are, in turn, influenced by whether regulators allow returns that reflect current market realities. If regulatory bodies ignore market signals and set returns too low, utilities may struggle to raise the necessary capital—similar to the difficulties experienced during the nuclear expansion era decades ago. Regulators often approve lower returns for shareholders (Return on Equity, or RoE) and may overlook market benchmarks, especially when faced with approving substantial rate hikes for extended capital projects. This issue can worsen if fuel costs also climb. We are now entering another phase of significant rate increases, so caution is warranted.

Understanding the Cost of Capital: Three Scenarios

Let’s briefly revisit the concept of cost of capital—the minimum return required to justify an investment. Consider these examples:

• Scenario 1: A developer constructs a shopping center for $1 million, secures tenants paying $100,000 annually, and seeks a buyer. If you could earn 6% from a corporate bond but require an extra 4% for the risk of ownership, your cost of capital is 10%. You would pay $1 million for the property, not because of its construction cost, but because the expected return matches your required rate (10%). The property sells at its book value.
• Scenario 2: Suppose you learn the main tenant is financially unstable, increasing the investment’s risk. You now require a 12% return. With the income unchanged, the property’s value drops to $833,000 ($100,000/$833,000 = 12%), representing a 16.7% discount to book value.
• Scenario 3: If you discover a new luxury apartment complex will be built nearby, making the shopping center’s future more secure, you might accept an 8% return. The property’s value rises to $1,250,000 ($100,000/$1,250,000 = 8%), a 25% premium over book value.

How Regulation Shapes Utility Returns

In the United States, both state and federal regulators determine the allowed return on the original cost (book value) of utility assets. For example, if a utility’s assets are valued at $1,000,000, regulators might decide that shareholders deserve a 10% return—4% above the 6% available from safer bonds—resulting in $100,000 in profit. This 10% figure represents the cost of capital, or the return needed to attract new investment. If regulators set this return appropriately, the utility’s stock should trade at book value. Setting it too low (underestimating risk) can push the stock below book value, while setting it too high (overestimating risk) can drive the stock above book value. Most regulatory agencies aim for a “fair rate of return,” essentially aligning with the cost of capital.

Dissecting Returns and Stock Valuations

To simplify, the return for investors can be split into two parts: the base return from a relatively safe bond, and the additional equity risk premium required for investing in utility shares. Regulatory decisions primarily impact the latter. Similarly, a utility’s stock price can be divided into its book value and any premium above book value, which arises when returns exceed the cost of capital. This premium is crucial in assessing regulatory impact. Analyzing data from 1985 to 2024 in eight five-year segments, it becomes clear that the premium over book value correlates with the size of the equity risk premium, though some anomalies exist.

Figure 1. Unadjusted Premium over Book to Premium over Bond Yield

Accounting for Outliers in Utility Performance

While it’s generally best to avoid manipulating data, a closer look at annual figures reveals that 2002 was an outlier year. That year, utilities recorded substantial one-time losses from writing down unregulated and stranded assets—the only loss since World War II. Since investors are unlikely to expect such losses to recur, it’s reasonable to exclude 2002 from the analysis. Doing so strengthens the link between higher equity risk premiums and greater market premiums over book value.

Figure 2. Adjusted Premium Over Book to Premium Over Bond Yield

Note: All figures are based on data from Edison Electric Institute member companies. Bond yields refer to Moody’s Baa seasoned corporate rates, sourced from the Federal Reserve Board of St. Louis. All data is as of year-end.

What the Data Reveals About Utility Stock Prices

The charts confirm that the gap between shareholder returns and bondholder returns (the equity risk premium) plays a significant role in determining the premium of stock prices over book value. Over the past 40 years, utility stocks have consistently traded above book value—none of the annual readings fell to or below book value. James Bonbright, a renowned expert in public utility regulation, argued that utilities should earn more than the cost of capital so that new share issues trade above book value, thus protecting existing shareholders from dilution. However, the persistent high premiums suggest either a flaw in this theory or that regulators have allowed utilities to earn well above the cost of capital.

The Regulatory Dilemma: Balancing Affordability and Investment

Imagine being a regulator facing pressure from both consumers and politicians. On one hand, there’s a push to keep electricity affordable; on the other, political interests may advocate for favorable terms for emerging sectors like AI, which could drive up energy costs for everyone else. Regulators often respond by trimming proposed rate increases—questioning utility expense estimates, projected revenues, and capital spending needs, and sometimes lowering the allowed return. However, the most significant impact may come from these cumulative financial adjustments, not just the headline rate of return.

Implications for Utilities and Investors

For utilities, earning a lower return translates into a reduced market-to-book ratio. This may not be a concern when little new capital is needed, but it becomes critical when large equity sales are required. A lower stock price means more shares must be issued, diluting earnings per share growth. Based on current returns, regulators have some leeway to reduce returns before hitting the cost of capital threshold. Rough estimates suggest that a one percentage point drop in return on equity could decrease earnings per share growth from new share sales by about one percentage point, similarly reduce growth from retained earnings, cut stock prices by 10%, and lower consumer energy prices by 1-2%—an appealing outcome in times of consumer dissatisfaction.

Such changes would shift investor expectations from exceptional to merely satisfactory, especially for those seeking stable growth and dividends. It may be wise to wait until the affordability crisis reaches its peak before considering new investments.

By Leonard Hyman and William Tilles for Oilprice.com