Episode Summary
Executive Summary: The episode explains how utility profits are set through regulated ROE, why ROE is distinct from cost of equity, and why many analysts believe utility returns are systematically too high. Guest Joe Daniel argues that lowering ROE toward true financing costs could cut ratepayer bills without stopping grid investment, while also reducing capex bias and improving affordability.
Main Topics: How utility rates and profits are set (Priority: 5/5): David Roberts and Joe Daniel explain the regulated utility model: monopoly utilities sell electricity at cost, but earn returns on capital investments approved in rate cases by public utility commissions (PUCs). ROE vs. cost of equity (Priority: 5/5): The conversation emphasizes that authorized return on equity (ROE) is not the same as cost of equity (COE). ROE is the regulated profit rate; COE is the return required to attract capital, and the gap between them is the central issue. Evidence that utility ROEs are too high (Priority: 5/5): Daniel cites academic and practitioner research showing utility allowed returns have drifted above market-based benchmarks, with typical utility ROEs around 10% while estimated COE is far lower. Why ROEs drift upward (Priority: 4/5): The episode discusses structural reasons for high ROEs: utilities choose the timing of rate cases, have better information and resources than consumer advocates, and often rely on peer utility ROEs to justify future returns. Effects on affordability and investment behavior (Priority: 5/5): High ROEs raise bills, encourage capital-heavy spending, and can distort utility incentives toward new infrastructure over operations and maintenance. Daniel argues lowering ROE would not necessarily slow buildout and could even improve affordability. Policy and regulatory reform options (Priority: 4/5): The discussion covers alternatives like TOTEX rate-making, differentiated ROEs for policy-relevant investments, stronger consumer-advocate funding, and rethinking whether commissions should administratively set returns at all. Political dynamics and first-mover problem (Priority: 3/5): Both speakers note utilities are powerful political actors and commissions are cautious, making reform hard unless evidence improves and multiple jurisdictions move together.
Key Arguments: Utilities are monopolies, so public utility commissions must regulate their prices and allowed profits to prevent abuse. ROE should roughly track COE; when ROE substantially exceeds COE, the excess becomes unnecessary profit for investors and higher costs for customers. Authorized ROE and realized ROE are different; utilities do not earn a guaranteed profit and may under- or over-earn relative to what regulators authorize. Empirical studies from Berkeley, Carnegie Mellon, and S&P suggest utility risk premiums have been too high for years, with allowed returns far above low-risk benchmarks. Utilities’ home-court advantage—controlling the timing and evidence in rate cases—helps keep ROEs elevated over time. High ROEs do not solve affordability or buildout problems by themselves; they can worsen capex bias and encourage expensive overbuilding instead of efficient use of existing assets. Lowering ROE would increase headroom for investment dollars and could let utilities build more infrastructure for the same total ratepayer cost. A pure peer-comparison method for setting ROE is flawed because it tends to ratchet allowed returns upward by benchmarking against other regulated utilities. Consumer advocates and underfunded commissions need better data, staffing, and technical support to challenge utility filings effectively. Differentiated ROEs could align returns with public policy goals, such as higher returns for electric investments and lower returns for gas in states pursuing decarbonization.
Data Points: Typical current utility allowed ROE: about 10% to 10.5%, sometimes a little higher - Used as the rough average authorized return discussed for regulated utilities. Estimated utility cost of equity: about 7.5% (with references to a 3.3%–3.8% range in some academic framing and about 4.2% current Treasury context) - Daniel argues this is the financing cost utilities would need to attract capital, substantially below authorized ROE. Illustrative profit margin equivalence: 10% ROE can translate to about a 16% profit margin - Roberts and Daniel explain that ROE is not the same as a simple profit margin. Loan analogy interest cost: 36% of lifetime loan costs going to interest - Used to explain how a 10% interest rate on a 10-year loan compounds over time. Utility realized earnings vs authorized earnings: Industry earns about 95% of allowed ROEs in aggregate - RMI data set discussed by Daniel comparing authorized and actual utility earnings. Share of utilities over-earning: about 60% over-earn and 40% under-earn over a 10–15 year period - Pattern in the RMI utility transition hub data. Historical utility ROEs: roughly 15% in past decades, later falling toward about 10% - Used to show commissions have lowered ROEs before. Performance of low-risk utility benchmark studies: Utility ROEs once moved in lockstep with Treasury yields in the early 1980s, then diverged in the late 1980s and 1990s - Cited as evidence that allowed returns did not fall as much as market risk benchmarks. Risk premium peak: 2020 - S&P Global story noted utility risk premium reached an all-time high during the pandemic. Potential reduction under Ellis-style reform: from roughly 10.5%–11% down to about 4%–5% - Roberts frames this as the scale of reduction if ROE were pegged closer to COE. Alternative plausible equilibrium: around 7.5% - Daniel suggests COE is likely closer to this level than to 10%+ authorized returns. Affordability burden example: low-income customer bills are about 5x higher than they can afford - Used to emphasize that affordability solutions need multiple levers beyond ROE.
Pivotal Quotes: "the difference between ROE and COE has to be the next myth that we bust" — Joe Daniel: Daniel underscores that authorized return and financing cost are not interchangeable. "if utilities are getting more than that, that is the problem here" — David Roberts: Roberts summarizes the core critique: excess return is pure cost to ratepayers. "The utilities have more power, basically." — David Roberts: Used when discussing why utility rate cases and commission proceedings are structurally tilted toward incumbent utilities.
Implications: If ROEs are lowered toward true capital costs, ratepayers could see lower bills and utilities would face less incentive to overbuild capital projects. But reform likely requires better evidence, better-funded commissions and advocates, and gradual or coordinated action.