California utility regulators have ignored a strategy that’s long been within reach to control ratepayer monthly bills: reducing the double-digit return that investor-owned utilities earn on each dollar they invest in power plants, power lines, energy storage, electric charging stations and wildfire reduction plans.
Lowering this profit, known as the Return on Equity, to a reasonable level has become even more urgent as customers get more financially stretched by continually escalating utility bills.
This return for California’s investor-owned utilities adds 10-10.45% annually to their capital expenditures, which diminishes for a given asset over time as it depreciates. California is at the high end of utility returns across the nation.
Putting California utilities’ rate of return closer to the average in the U.S.– 9.5% –“would save ratepayers $400 million this year,” according to Katy Morsony, staff attorney at The Utility Reform Network.
Compared to the billions of dollars of utility rate increases, the $400 million in savings may seem small. “But every dollar makes a difference, especially to California ratepayers facing a high cost of living and rate increases,” she said.
Also of concern to TURN, other ratepayer advocates, environmental organizations and others, is that utilities oppose lowering their 2021 return. This issue is central to the cost of capital proceeding at the California Public Utilities Commission. Under CPUC rules, a review of the return gets activated when interest rates go up or down beyond a set bandwidth. Last year they fell, triggering the mechanism for adjusting last year’s return.
Intervenors also objected to the amount of profit regulators allowed utilities to reap in the last three-year cost of capital proceeding. But discussion of the matter was deferred to the upcoming cycle that starts in April.
Regulators have largely resisted lowering the Return on Equity because of pressure from the four investor-owned utilities and Wall Street. About a decade ago, they did agree to lower the return from a higher 11-12% range to today’s 10% range for Pacific Gas & Electric, Southern California Edison, San Diego Gas & Electric and Southern California Gas.
There also is growing pressure to link utility bill affordability to decarbonization; using the return to motivate utilities to decrease emissions from fossil power, including by electrification of buildings and vehicles.
Lowering the profit awarded on capital expenditures would make bills more affordable and “line up shareholder incentives for new investments with climate change objectives,” said Michael Colvin, director of regulation and legislation for EDF’s California Energy Program. He was an advisor to former CPUC Commissioners Mark Ferron and Catherine Sandoval.
Colvin participated in a conference last week at the CPUC on high utility bills. Participants there made a range of suggestions, including having taxpayers cover some of the utilities fixed costs and tying rate increases to residential income. Reducing utility profit, or ROE, got virtually no traction.
You would think that lowering the ROE would get a lot of attention given bullish outlooks recently expressed by utility executives. During earnings calls with financial analysts, representatives from each of the major California companies touted rising revenue requirements–the total amount of revenue they are allowed to collect from customers each year–and increasing rate bases, which cover operating expenses.
Sempra Chief Executive Officer Jeff Martin told financial Feb. 25 that the rate base of San Diego Gas & Electric, Southern California Gas and its Texas utility, Oncor, have tripled. The rate bases include capital investments plus the profit on these expenditures. Martin also noted there will be record-high capital expenditures of $36 billion (including the return), through 2025.
Pedro Pizarro, president and CEO of SCE parent company Edison International, projected 9–11% total return between 2021 and 2025. During a Feb. 24 call with financial analysts, he highlighted the expected surge in building and transportation electrification for the all-electric SCE, higher revenue approved by the CPUC, new transmission investments, and the return on its $2 billion in wildfire-reduction work over two years.
“The state understands the need for financially healthy utilities,” Pizarro stressed.
Residential energy costs and rates began rising faster than inflation in 2013 and bills continue to grow annually, CPUC staff reported last year. Average utility rates between 2009 and 2020 rose a total 57% for PG&E, 15% for SCE and 47% for San Diego Gas and Electric, according to energy economist Richard McCann, with M.Cubed.
Cost of capital and general rate cases
The cost of capital proceedings are tied to the CPUC’s “general rate cases” that decide the sum total of revenue the utilities are allowed to collect. The cost of capital proceeding decides how much each utility may profit from its slice of this pie. It also decides how much the utilities can borrow, which is tied to market rates, and their equity-to-debt ratio. But controversy has focused on the double-digit ROE, which goes directly into the pockets of utility shareholders.
Currently, the rate of return is being contested as part of the cost of capital for last year.
SCE and PG&E, in particular, object to having their ROE lowered and are pushing to raise it back up to the 11% range, on grounds this is needed to make up for losses during the pandemic even though the companies were authorized to sell bonds backed by ratepayers with lower yields and thus save money.
“The government’s financial response to the COVID-19 pandemic increased money supply and drove down the cost of debt,” PG&E spokesperson James Noonan told Current. However, he added, “utilities in general and California’s utilities in particular, are still viewed as potentially high-risk investments by the market, meaning the cost of equity has increased more than the overall financial markets, and their cost of capital has remained about the same or increased.”
SCE’s Bente Villadsen argued in testimony filed at the CPUC on Feb. 14 that during the pandemic, “electric utilities’ stock market performance deviated substantially from that of the overall market.” The company claims its stock rose less than other stocks. But it all depends on which benchmark dates you apply, with SCE using ones that support its argument.
PG&E earnings fell below the Dow Jones industrial average before and during its recent bankruptcy. But that was caused by massive fires its equipment sparked. It’s the role of the bankruptcy court to have approved a reorganization plan that created a financial safety net for the company. Making up insufficient profits because of utility fault is not the function of return on equity.
EDF, TURN and several other intervenors refute the utilities’ claims of need.
California regulators have eliminated riskiness from the financing equation, said EDF’s Colvin. “The market has no problem funding California utilities,” he added.
Since 2012, the return, also known as a risk premium–essentially the difference between the ROE and the baseline return–for California utilities has exceeded the premium earned by other U.S. utilities in the Dow Jones Utilities Index since at least 2012, added EDF economic consultant McCann.
The intervenors also noted that the CPUC has allowed the utilities to recover pandemic losses with ratepayer-backed bonds and ensure that ratepayers are on the hook for other utility costs, including wildfire prevention. PG&E and SCE together have issued billions of dollars in bonds. The parties also highlighted state law that created a ratepayer and shareholder fund to cover wildfire liability costs.
Not requiring utilities to lower their ROE, or worse, agreeing to raise it, “runs directly counter” to the state mandate to decarbonize, McCann argued on behalf of EDF, in testimony submitted to the CPUC Jan. 22. He pointed out that municipal power and water utilities in the country earn less than half what California investor-owned utilities earn, some 4-5%.
The guaranteed return is of growing importance because if it remains too high, it drives up utility bills and undermines efforts to decarbonize the system. It is also why there are big efforts to give shareholders a stronger stake in investments in low emission technologies, including increasing electrification and phasing out natural gas.
EDF is also arguing to the CPUC that returns for electricity infrastructure should be higher than for new gas pipelines and related fossil fuel infrastructure. It points to the effort and need to decarbonize the energy system and avoid stranded assets due to new gas investments. (The term stranded assets refer to fossil infrastructure that is phased out well before the end of its useful life.)
Time is of the essence and regulators should use the tools they already have to lower the utility returns on equity. That would help lower utility bills, which they proclaim is of key importance, and decrease carbon pollution while providing utilities a reasonable profit.