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Insull's Extraordinary Machine

I was looking at electric utility annual reports. And found in them some remarkable trends.

The net income of the utilities tended to be around one tenth of their operating revenue. Or not much more. That was one relationship that jumped off the page.

So, I undertook a thought experiment. I supposed that a utility’s net income is exactly one tenth of operating revenue. I supposed further, to keep things nice and simple, that the utility’s capital structure is exactly half and half. Half debt. And half equity, from which its net income is produced.

I then asked this question. What would be the impact on the utility’s operating revenue if the utility’s return on equity is cut quite considerably by a regulatory decision? Say, by one tenth.

Put aside, for the purposes of this exercise, complexities like allowed versus actual return. If the utility’s return on equity is cut by one tenth, doing the math, the utility’s overall return (on debt and equity) would fall by one twentieth. And the utility’s operating revenue would fall by one two-hundredth.

That is, by half of one percent. In other words, by not that much.

Assuming the utility’s operating revenue and its revenue requirements are highly correlated, which they tend to be, the utility’s revenue requirements and the utility’s customer bills on average should fall by about half of one percent. Again, by not that much.

In simple terms, customer bills are relatively insensitive to decreases or increases in utilities’ return. Bills decrease if return decreases but by not as much. Bills increase if return increases but also by not as much. The effect of changes in return are dampened for customers.

This exercise illustrates a fundamental characteristic of our one-hundred-seventeen-year-old regulatory model. Samuel Insull literally built this extraordinary machine to make utility investment in infrastructure affordable for a utility’s customers.

Indeed, he and others built it at a time when electric utilities weren’t utilities at all but competitive companies attempting to electrify the country. Realizing they could only do so if the companies both invested vigorously in electric infrastructure and yet were able to charge customers, of all economic means, amounts they could afford.

That is why when a utility spends a dollar investing in electric infrastructure, that dollar is diluted across decades, via depreciation, and across very many customers before hitting customer bills. A conservative capital structure and maintaining the confidence of capital markets also come into play to soften the impact on the bills sent to utility customers.

Thanks so much Samuel. Yes, you were born in London and passed away in Paris. But we prefer to remember you as a hero of our nation’s utility and regulatory community.