Sound Financing Delivers Lower Utility Bills
Executive Summary
U.S. utility bills have been rising in an already inflationary environment over the past five years, catching the attention of consumers, regulators, advocates, and numerous state governors. Rising energy costs are also drawing attention to utility finance.
Simply stated, utility rates are meant to cover all costs incurred in providing service, including fuel, operating, and maintenance expenses. Rates paid by utility customers also include the cost of financing the assets used in the business, which includes interest on debt plus a reasonable return on shareholder equity, also known as return on equity or ROE.
In response to legitimate affordability concerns, some stakeholders have proposed reducing utilities’ allowed ROE or increasing the use of debt financing as a way to curb bills. These proposals deserve careful evaluation because financing policy affects customer costs for long periods of time. While simple on the surface, these narratives ignore the critical relationship between perceived risk and the return that investors expect. If adopted, these proposals could undermine access to the capital needed for investment in critical energy systems by driving financing costs higher and taking consumer energy prices with them.
This report explores the relationship between risk and investor expectations, the synergies between debt and equity (stockholder) financing, and the importance of having access to both to ensure safe, reliable, resilient, and affordable energy delivery. Rate regulation is a unique and significant risk consideration for those who invest in the utility sector, and actions that heighten that risk will raise the cost of financing—which is ultimately recovered from customers through rates.
Key topics include:
- Utilities are entering an unprecedented period of capital investment, driven by rapid growth in energy demand and the need to strengthen system reliability and resilience against extreme weather, wildfires, physical security risks, and rising cybersecurity threats. Policymakers and regulators must carefully balance sustaining reliable utility services against affordability goals and the need to attract and retain investor capital.
- Financing (i.e., capital) cost is determined by risk vs. expected returns. U.S. Treasury bonds are widely viewed as having minimal risk, and that’s reflected in their low rate of interest—or yield—in the market. At the other end of the spectrum, riskier investments, such as investments in technology start-up companies, offer the opportunity of substantial returns if they succeed. Utilities have historically been viewed on the lower risk end of that spectrum.
- Utilities have access to two primary forms of financing—debt and equity—and they typically depend on both.
- Debt has a stated, contractual cost. Interest rates are defined, as are terms and timing
of repayment, and are directly observable. - Equity capital (i.e., stock financing) has no comparable contractual price. Because companies are not obligated to pay dividends and shares don’t come with a repayment promise, equity investors expect a higher return (i.e., a higher cost of capital) than creditors do.
- Debt has a stated, contractual cost. Interest rates are defined, as are terms and timing
- Equity supplies substantial funding for utility investment—including new pipelines, grid modernization, and clean energy projects—beyond what could be raised through debt alone. As such, maintaining the confidence of equity investors is critically important.
- Both forms of capital finance are essential. They work together as an integrated foundation to finance investments that maintain safe, reliable, and affordable service. Equity provides a buffer for debt, similar to the implicit government support that sustains municipal utility credit. A strong equity base supports higher credit ratings and lower borrowing cost. Debt capital is cheaper because interest is tax-deductible, but having too much debt and little to no equity weakens credit strength and leaves a company with minimal financial flexibility—like an overextended consumer with maxed-out credit cards and no savings.
- Few utilities generate enough internal cash flow to fund their ongoing investments, driving an ongoing need to access external capital.
Definitions:
Allowed return on equity (ROE) is determined in a regulatory setting, based on a factual inquiry into the level of risk present in the regulated utility market. Allowed ROE remains fixed until changed in a rate case. Allowed ROE does not guarantee that the company will earn that return or make a profit.
Earned ROE is a company’s net income divided by its book value (defined below). Earned ROE is a historical accounting measure determined as financial results are reported (typically quarterly for U.S. companies).
Cost of capital is determined by investor perception of the risk/reward relationship for a given investment opportunity, such as investing in U.S. Treasury bonds or buying a share of stock. Cost of capital may be determined in private or public markets and is subject to constant change.
Book value is the accounting value of a company, calculated as what it owns (assets) minus what it owes (liabilities), representing the net value left for shareholders.
- Allowed ROE, earned ROE, and cost of capital are related but distinct concepts that are sometimes conflated in public debate. ROE is often used as a proxy for utility profits. This can lead to claims that allowed ROE creates shareholder windfalls or that reducing allowed ROE would not affect a utility’s ability to raise equity capital by selling shares of stock. Such claims overlook the distinction between the return authorized by regulators, the return a utility actually earns, and the return investors require to provide capital.
- Importantly, allowed ROE does not guarantee a certain profit, but instead sets a level of revenue giving the utility the opportunity to earn a fair return.
- Reducing ROE below market expectations increases utilities’ financing costs and can undermine long-term affordability. Lowering ROE reduces utility revenues, lowering cash flow and undermining debt coverage ratios that are key to credit rating determination.
- Forcing overly debt-heavy capital structures might briefly reduce utility rates by a very modest percentage, but only by sacrificing long-term utility financial health. Lower allowed returns shrink earnings and cash flow, pressure credit ratings, and can increase the cost of debt. When investors lose confidence, they “vote with their feet” by selling shares or demanding higher returns for higher perceived risk. Either way, utilities end up with higher financing costs which will not lower customer bills.
- If policy choices make one utility significantly less attractive, investors simply redeploy their capital to other sectors or jurisdictions, leaving the utility struggling to fund its operations and growth.
Since the mid-20th century, investor-owned utilities have financed the world’s most robust energy transport and delivery networks by drawing on both debt and equity capital. Much of that capital comes from investors seeking to protect their invested assets (principal) while also earning interest or dividends. These investors include not only individuals but also insurance companies, pension funds and retirement plans, state and local governments, and not-for profit foundations and endowments.
As discussed in the full report, rate regulation was conceived as a substitute for competition in the utility industry’s formative years to restrain the exercise of monopoly power. However, the regulated monopoly model also plays a critical risk-management role that helps ensure access to the financing needed to maintain the extensive and complex networks that move electricity, natural gas, water, and wastewater—infrastructure that’s working harder today than ever. A balanced regulatory approach is needed—one that addresses affordability while preserving a financing framework that sustains utilities’ access to capital.