How curbing the rate of return on equity will help accelerate the energy transition
Everyone knows interest rates have risen over the past few years. Utilities — including Georgia Power, WE Energies, and many others — are using rising interest rates to justify requesting higher rates of return in their requests to regulators. However, it seems like no matter what the economic conditions are, utilities would like a higher return on equity (ROE).
Obtaining a higher rate than what other companies can achieve in the marketplace has created a gap where utility returns far exceed reasonable risk premiums as measured by the very large and liquid bond market. In fact, the ability to have regulators preserve steady rates of return when the rest of the world experiences falling rates indicates customers are overpaying tens of billions of dollars a year. This is why consumer advocates in utility proceedings have fought rising ROEs for decades.
But high ROEs aren’t just a customer issue; they can also prevent climate progress.
1. High ROEs perpetuate “capex bias”
Utility companies earn a return based on the capital expenditures (capex) spent to build an asset like an electricity generating plant; most operating costs (like fuel) are passed to customers without profit. This means, when a utility is faced with a choice to spend capital to build a power plant or to spend operating budget to help customers conserve energy, the utility will be biased to build the power plant. Hence “capex bias.”
When a utility is faced with a choice to spend capital to build a power plant or to spend operating budget to help customers conserve energy, the utility will be biased to build the power plant.
Thus, utilities’ capex bias translates into ignoring or avoiding cost-effective activities like conservation or efficiency improvements leading to an expensive system for consumers and businesses. There have been attempts to create an improved motivation structure away from capex bias to one that focuses on total expenses (capital and operating expenses (totex), but the movement is young and only narrow reforms (like shared saving mechanisms have been implemented. As of yet, no U.S. jurisdiction has authorized the use of totex ratemaking. Until such changes arrive, the higher the ROE that is allowed, the stronger the bias for capex, which could slow the adoption of cost-effective strategies to reduce carbon emissions, like energy efficiency.
2. High ROEs make the energy transition more expensive
It is entirely possible that the transition to clean energy will save customers billions of dollars and make energy more affordable. With the passage of the Inflation Reduction Act (2022), hundreds of gigawatts of renewables are poised to be built over the next decade, costing hundreds of billions of dollars that will get paid for in energy bills.
There is a political economy to ensuring renewables get built at the lowest cost. As renewables have become more affordable, they have become more appealing. If we can keep the cost of the energy transition down, then support for it will remain or even grow. Small changes in allowed ROE can have outsized impacts on customer bills. Just a 1% reduction in ROE can save customers nearly $4 billion nationwide each year. But if the energy transition fails to deliver material financial benefits to families and consumers because utility ROEs remain too generous, popular support will quickly erode.
If the energy transition fails to deliver material financial benefits to families and consumers because utility ROEs remain too generous, popular support will quickly erode.
3. High ROEs make utilities less competitive
Inflated ROEs slow the buildout of renewables and decarbonization technologies, because high ROEs make utilities less competitive with third-party developers. Utilities are increasingly being asked (or forced) to engage in competitive procurement when meeting new demand. All-source competitive procurement allows solar, wind, efficiency, and other carbon-free technologies to compete with gas-fired power to replace coal plants or meet new load. It also helps make sure new resources are procured at the lowest possible price. But rate-regulated utilities are at a distinct disadvantage when it comes to competitive procurement, because they have an ROE of 8, 9 or even 10 percent while renewable energy developers operate on returns aligned with market conditions, which are much lower. Holding all other costs equal, a rate- regulated utility with an inflated ROE is unable to build renewables at a lower cost than most third-party competitors.
Why would making utilities more competitive with third-party developers be good for the climate? Because utilities will be far less resistant to renewables if they think they can be the owners (and ones profiting from) renewables.
Regulated utilities are an undeniable force in the industry and getting more utility companies on board with renewables will hasten the energy transition.
Bottom line
Without a doubt, allowed returns for regulated utilities should be reasonable given the risks. Climate players should care about utility ROEs because utilities currently emit 30 percent of total carbon emissions and will either resist or facilitate the energy transition. ROEs that are in line with competitive markets and aligned with actual cost of capital will hasten the transition and decarbonize the economy more quickly than the status quo.
It might be helpful to think of this in one of two ways. Lower ROEs mean utilities will build the same amount of renewables at lower cost or build more renewables at the same cost. But either way the climate benefits.
And this is not to say that utilities should be the only ones allowed to own and profit from renewables, or even that they should be the default. But regulated utilities are an undeniable force in the industry and getting more utility companies on board with renewables will hasten the energy transition.
This article was first published by RMI, an independent, nonpartisan, nonprofit that transforms global energy systems through market-driven solutions
