Why Utility Profits Could Be the Next Target
Electricity prices are heading up. Utility operating costs, raw materials, and fuel (obviously), are all heading up and no sign of stopping. Now higher capital costs courtesy of the Fed can also be expected. All we can say is that it seems like inflation is back, baby. The Fed recently raised its discount rate and Treasury bond yields hit 5%—their highest level in almost two decades. A utility’s…
Electricity prices are rising across the nation. This increase stems from higher operating costs for utilities, including raw materials, fuel, and capital expenses due to the Fed's actions. Recently, the Federal Reserve raised its discount rate and Treasury bond yields reached a five-decade high of 5%, signaling the rising cost of capital.
For utilities, the cost of capital is composed of two parts: the risk-free interest rate (like Treasury bonds) and the equity risk premium, which compensates investors for taking on additional risk.
Regulators set a return based on the cost of capital, but they have some flexibility regarding the equity risk premium. Historically, this premium ranged from 300-700 basis points over the risk-free rate. If regulators were to reduce the premium towards the lower end of this range, it could provide some relief to consumers. Currently, the risk-free return is approximately 5%, while the average stock's equity risk premium is around 6%.
However, utility stocks are less risky than the overall market, implying an equity risk premium of only 2-3%, leading to an expected annual return of 7-8% for utility investors.
In recent years, investor-owned utilities have earned around 10% on their equity, exceeding their cost of equity capital by 2-3 percentage points. This overperformance translates to roughly 5% added to a typical electric bill. Progressive political agendas consider this a prime target for reform. Financial theory suggests that utility investors should expect a lower equity risk premium now, potentially resulting in a cost of equity capital of 7-8% per year.
Utilities have historically earned above the implied equity return for decades, but the current inflationary environment might compel regulators to address this issue. The group rerating of utility stocks could see a potential market reaction of 20-30% reduction in price/earnings ratios. This is primarily due to high equity percentages in capital structures, high equity risk premiums, and the industry's success in a low-growth environment with compliant regulators.
Written by urgent.news from OilPrice's reporting — not their text. Machine-written — may contain errors; check the original before relying on it.
