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Utility Cost of Capital Tutorial By

SUTHERLAND + ASSOCIATES

Welcome to the Utility Cost of Capital tutorial. The purpose of this site is to provide a quick and simplified tutorial on utility cost of capital, specifically cost of common equity capital for regulated power utilities. There are links to various on-line sources of information that can be obtained either for free or at a small cost to employ the various models described. This will allow the user to calculate at least a quick and dirty estimate of the range in which a utility's cost of equity should be under current market conditions.

Why is utility cost of capital interesting (at least to some of us)?

Even in this age of deregulation, most electric utility rates, especially for retail customers, are still set based upon the cost to produce electricity, rather than just what the market will bear (i.e. market based rates). One of the biggest costs in such a capital intensive industry is the cost of capital. Furthermore, while the power generation business is being deregulated in many parts of the country, the consensus is that the power distribution business will remain regulated indefinitely.

Why is utility cost of capital such a puzzle?

The cost of capital, specifically the cost of equity capital, is the most subjective cost element in any public utility rate case. There is no single correct way to calculate cost of equity capital. Rather, there are various generally accepted ways, each of which has pros and cons associated with it, and each of which yields different results.

The most common methods for calculating the cost of equity, more or less in order of regulatory acceptance, include:

Please click on any cell in the above table for additional detail.

* Indicative results are order of magnitude results for the electric utility industry as a whole, calculated by looking at approximately 50 of the largest companies, using recent, publicly available data.

Importance of Financial Integrity

Regardless of which model, or combination of models, is used to establish an appropriate cost of equity, the result should be tested with respect to maintenance of financial integrity. The landmark Bluefield (1923) utility regulation case decision stated that the allowed return on equity should be sufficient for the utility to maintain financial integrity and attract capital (both debt and equity) on reasonable terms.

This means, for example, that a utility should not have to sell equity at below book value. With respect to debt, a utility's debt credit rating should not be below investment grade (i.e. below BBB). Therefore, calculations of proforma interest coverage should be made to see if the proposed ROE is consistent with an investment grade bond rating, and likewise with a market-to-book ratio greater than unity. Exactly how much above unity and how much above investment grade may be appropriate is a matter of judgment. Clearly, however, a utility with a AA bond rating will have a lower cost of both debt and equity compared to one with a BBB bond rating.

General Caveat

Most electric utilities these days are no longer pure regulated utilities. They are combinations of regulated and unregulated, energy related and diversified operations. Therefore, if the purpose of the cost of equity exercise is to find the appropriate cost for regulatory rate making, then some adjustment may be necessary especially with the DCF or Risk Premium models to account for the risk differences between the regulated and non-regulated businesses that contribute to the price of the company's stock.

In general, companies that are more regulated have less business risk and consequently lower cost of equity. However, low business risk can be offset by higher financial risk if the company has a more leveraged capital structure. Also, regulated companies in areas where regulation is changing or where the regulations are not well defined can have higher business risk.

Further Reading

The best reference book I have found on the subject of utility cost of capital is the following, which can be ordered directly from the publisher:

Regulatory Finance: Utilities' Cost of Capital

If you have any interest in the subject matter at this site and would like to discuss it, or if you are looking for an outside expert witness, please e-mail me at paul.sutherland2@comcast.net .

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