Local natural gas distribution companies (LDCs), like electric utilities, are regulated in each state by entities called Public Utility Commissions (PUCs). “Ratemaking” is a term used to describe how regulated utility companies set customer rates. To “make the rate”, utilities submit an official request, expressed as a “revenue requirement”, to the state’s PUC who then audits the request and supporting documentation. The commission issues a formal ruling and announces approved rates which are then integrated into customer billing.
The amount of money an LDC needs to cover its costs and make a reasonable profit can be expressed in a simplified formula:
Capital structure is an important component of determining a fair and reasonable return on equity and authorized rate of return. If a utility has a capital structure of 50% debt, as regulators encourage, then the allowed rate of return can be calculated as follows:
Allowed Rate of Return = (.50) x Return on Debt + (.50) x Return on Equity
So, if a utility is allowed an 8% overall rate of return and obtains debt for 5%, its return on equity will be 11%. If the rate of return is raised to 9%, then the resulting ROE will be13%. If the cost of debt decreases, the ROE will increase which helps compensate equity holders for the increased risk should debt fluctuate.
A final and important key takeaway is that the utility’s allowed return on equity is the only portion of the revenue requirement that a utility ultimately retains as profit.
ROE Performance for Today’s Natural Gas Utility
Looking across the entire U.S. market for all industries, the average ROE was 12.7% in 2019. This sharply declined to 8.5% through 3Q 2020 and the long-term average for S&P 500 companies held steady at 14%. As one might expect, utility ROEs consistently fall on the lower end as the utilities sector is considered a less risky investment.
Since 2001, ROEs for gas utility companies have averaged 9.3% with combination (gas and electric) companies faring slightly better than gas-only firms with an average percentage-point difference of 1.9.
As shown above, actual returns have been relatively flat with slight downward performance for the past several years. During this downward trend, rate case activity has increased as companies seek to bolster return on capital investments through thoughtful filings.
ROEs approved by public service commissions are no guarantee. There are many factors that come into play to turn an allowed ROE into actual profits. Capital structure and profit margin can materially impact return on equity. Other financial levers can be pulled; however, such leverage is limited in the highly regulated utility industry. Rate continuity is as important today than it ever has been given the current economy and LDCs cannot arbitrarily sell more product, precipitously increase price, or make recurring shifts in debt and equity capital.
As gas utility leaders prepare for the year ahead, there will unquestionably be challenges along the way. Some challenges will feel familiar while others will be new – particularly in our ‘new normal’. Financial performance will be as important as it ever has been following a year consumed by delayed investments, reduced demand, and the likes of politics never seen before.
Remember that financial performance is an ‘outcome’ and operational discipline is the ‘process’. All too often, leaders get distracted by outcomes and lose sight of the people, processes, and technologies to achieve them. Financial performance is driven by operational discipline. Disciplined attention to safety, capital investments, and people – all people. Be bold with agility and be willing to adopt new technologies and exploit the ones you already have.
See more in our FPH Insights article Improving Financial Performance through Operational Discipline.
Comments