ROE and Interest Rates, by Branko Terzic and Brad Cornell

Branko Terzic, a former Commissioner at the FERC and Wisconsin PSC, and Brad Cornell, Emeritus Professor of Finance at UCLA, with a short essay on return on equity and declining interest rates:

Rate of return on rate base, one of four cost categories in estimating a public utility's annual revenue requirement, contains two of the most contested issues in any public utility rate case. Firstly, the capital structure meaning ratio of debt to equity. Secondly, the return on equity (ROE) itself.

The reason the ROE is so publicized and contested is not that it is the largest expense item for a public utility. It’s far from it as labor expenses, fuel expense and even the lowly depreciation expense is usually significantly larger.

No indeed, ROE is contentious because it’s the easiest to understand as “the profit the monopoly utility would be allowed to make,” compared to say depreciation which no one but experts understand. And, its level or magnitude is comprehensible by the average citizen and the newly appointed regulator, who frequently the day before was the average citizen. And, most can guess, as one hapless regulator did in an open meeting, that the level of the ROE must be somewhere between what one pays as interest on a credit card and what the bank pays you for your savings deposit. Pretty much everyone can opine on the topic of the “fair return on equity.”

Two specific periods in which ROE discussions come to the fore are during periods of low interest rates or of high inflation. We are now in a period of low interest rates. Hence public discussion and suggestions that it is time for regulators to lower authorized ROE as interest rates on U.S. Treasury bills — assumed to be zero risk — have fallen to new lows.

The strongest argument for a higher ROE is that the equity risk premium has spiked. That argument makes perfect sense given the immense economic uncertainty and the falling stock market. However, it is difficult to produce evidence.

The long-run average return on equities is little affected by very short-run events, and to the extent that it changes it would fall. This is a common problem with averages. When ROE rises, so that discount rates are higher, stock prices fall bringing down averages. A better approach under such circumstances is to calculate the implied equity risk premium using current market prices and analyst earnings forecasts.

The problem is that given current market conditions, earnings forecasts are highly uncertain as well making reliable estimates of the implied equity risk premium difficult to obtain. It is for all these reasons that careful analysis is required.

With respect to a utilities systematic risk, usually measured by Beta, there is not much reason to argue that this would increase. In fact, it could even fall if commercial and industrial firms were impacted more than utilities. The equity risk premium argument is the strongest.

This is to remind the casual reader that, according to a series of U.S. Supreme Court cases, the standard for a “fair return” in the public utility industry is that regulators must allow a level of earnings which “… should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties.” Bluefield Water Works, 1923.

The Supreme Court later explained that the rate of return “involves balancing of the investor and consumer interests while insuring that the … return to the equity owner should be commensurate with the returns on investments in other enterprises having corresponding risks …” Hope Natural Gas, 1944.

Unfortunately, the courts did not explain exactly how that rate of return would be calculated. It left that decision to the system of “scientific regulation” embraced by state governors and legislatures at the beginning decades of the twentieth century when independent regulatory commissions were established across the nation. That system has worked well in the past and, if it’s not politically tinkered with, it should come up with the right answers in the future as well.