Return on equity, also known as ROE or the cost of equity capital, describes the return on the equity portion of the rate base that regulated utilities are allowed to collect in rates.
To understand this concept, one must first grasp that the cost-of-service utility model is designed so that utilities cover their expenses by passing them on to customers in rates with no mark-up or profit. But doing so does not provide the utilities with a source of cash to pay for capital investments. Rather, utilities get a portion of their capital needs from debt, and the remainder comes from shareholder investment called equity. For investor-owned utilities to show a profit for shareholders and pay back debt, there needs to be an additional line item in rates. This item is called return. Return has two components: return to pay debt and return to provide earnings for equity investors.
A key question for utility investors and utility customers is the allowed level of return on equity (ROE). The ROE is approved by the appropriate regulator during a general rate case or in a separate cost-of-capital proceeding. We will now explore the rather complex question of how to reasonably set the ROE.
The ROE is set so that the return is sufficient to attract the capital needed for the utility to construct and maintain a safe and reliable system while not charging utility customers more than is necessary. Hence the concept of capital attraction is key in setting an ROE. Investors who buy utility stock are foregoing the option of using those funds for an alternate investment. To invest in the utility, they require a return that is commensurate with the risk associated with their investment. Investors will accept a lower return than that associated with a start-up technology company because the start-up company is more risky. But they expect a higher return than a government bond because a government bond is less risk than investing in a utility. As stated in the U.S. Supreme Court Federal Power Commission versus Hope Natural Gas decision in 1944:
“[T]he return to the equity owner should be commensurate with other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and attract capital.”
Of course, it is easier to state the concept behind ROE than it is for the regulator to pick the actual correct number. The first step is to select comparable firms. The group of firms chosen is called the proxy group. Most commonly, firms in the proxy group are publicly traded so financial information is readily available, are from the same or a similar industry, are similar in size, pay dividends, have similar bond ratings, and are not in the middle of a merger.
Once a proxy group is selected, it is necessary to determine how the proxy ROEs should be adjusted based on differences between proxy companies and the company for whom the ROE is being determined. There are four common methodologies:
Proxy Method
This method simply uses an average of companies that you have deemed to be appropriate proxies.
The Discounted Cash Flow (DCF) Model
The DCF model assumes that a rational market will set a company’s stock price equal to the expected value of all future cash flows associated with owning the stock including dividends paid out to owners plus appreciation in the stock’s price. But the most common form used for utility ROEs assumes the stock is held forever, so it bases the ROE on the expected growth in dividends. But since growth in dividends are hard to forecast, it assumes that growth in earnings per share are a proxy for growth in dividends. To set the weighted average cost of capital, which then allows a determination of ROE (since debt costs and capital structure are known), a cash flow calculation is used that would result in investors receiving a discounted cash flow (one that accounts for time value of money) equal to the expected growth in earnings per share. Thus, the ROE for a target company can be set by comparing their expected cash flow to proxy companies.
The Capital Asset Pricing Model (CAPM)
The CAPM is based on the relationship between portfolio risk and return. The expected return on a security is directly proportional to its risk relative to a market portfolio. This typically results in setting an ROE based on long-term Treasury bond rate (a “risk-free” investment) plus a risk premium to account for a) the overall risk of the stock market relative to Treasury bonds, and b) the risk of the specific company relative to the overall stock market. The ROE for the target company can then be set comparing the target company to the risk premiums assumed for other proxy companies.
The Risk Premium Model
The Risk Premium Model sets a return based on the relationship between the return associated with the specific company’s debt and the risk associated with investing in company equity rather than debt. So the ROE is set based on the actual cost of debt plus a risk premium. The target company risk premium can be set comparing their risk to other proxy companies.
The process of choosing an ROE can become quite contentious because shareholders want higher earnings, customers want lower rates, and the regulator needs to ensure that the utility is financially viable without overcharging customers. Some regulators have established periodic automatic adjustments based on Treasury rates or indices plus a fixed premium; others hold a cost of capital case every few years. Either way, the final outcome is an important factor in both attractiveness of investing in a specific utility and the costs that the utility’s customers pay to consume natural gas or electricity.