Full Title: Rebalancing “Return on Equity” to Accelerate an Affordable Clean Energy Future
Author(s): Joe Daniel, Ryan Foelske, Steve Kihm, CFA, and Narrative804
Publisher(s): Rocky Mountain Institute
Publication Date: February 21, 2025
Full Text: Download Resource
Description (excerpt):
Achieving a rapid, just, and affordable energy transition will take balance. There are a host of regulatory, legislative, strategic, and financial levers and tools worth exploring and using to realize this clean energy future. One component of utility regulation in which reform can play a crucial role is the allowed return on equity (ROE), or the allowed rate of profit (%) on capital investments made by regulated utilities.
As background, evidence suggests that allowed utility ROEs have become increasingly generous over the past few decades. In fact, since the 1990s they have fallen less than prevailing interest rates and costs of capital. Evidence also clearly suggests that ROEs are higher than the return investors require. These high ROEs create an incentive to prefer capital solutions instead of a level playing field of possible choices. High ROEs make utility service more expensive than it needs to be, adding pressure to the pace of transition due to affordability considerations. High ROEs also make utilities less competitive with market-based solutions. Restoring balance to allowed ROEs can accelerate the pace of the energy transition.
Why are ROEs so high? Flawed application of assumptions through models can add hundreds of basis points each to cost of equity (COE) estimates. These inflated COE figures then influence ROE recommendations and decisions.
This primer will discuss assumptions that follow best practices and sense-check COE model outputs against external estimates of expected stock market returns, thereby helping ROE experts confidently estimate the return investors require (COE) and confidently propose ROEs that provide balanced outcomes.