Regulators should stick to their guns on APS profits
In Arizona, and the West broadly, we get our electricity from monopolies. Those entities include Salt River Project, Tucson Electric Power and Arizona Public Service (APS).
To prevent the monopoly from just picking any price to charge – which could gouge customers – the Arizona Corporation Commission, which regulates Tucson Electric Power and APS, evaluates many factors and decides on a profit margin called Return on Equity (ROE) that the monopoly utility is allowed to earn for its investors while providing a high level of reliable service.
The Corporation Commission essentially sets the price we pay for electricity and protects customers from potential abuses a monopoly could otherwise commit.
Many such commissions around the country are unwilling to push back on the utilities they regulate and often rubber stamp the will of the utility at the expense of its customers. However, last fall, the Arizona Corporation Commission became a national leader when it decided APS’ fair return of equity should be 8.7% instead of the 10.15% APS sought.
APS is owned by a publicly traded company, Pinnacle West Capital Corp. Its investors want the ROE as high as possible and have decided to appeal the decision in court. APS’ opening brief with the state Court of Appeals is due today.
The decision is one of a few recent commission actions nationwide that seem to be updating return of equities to a more normal and fair level.
APS claims that a lower return of equity means less cash flow, which will result in higher cost of debt as rating agencies view their business as riskier to buyers of their bonds. What’s missing in that line of thinking is the fact that customers save more money on their electricity rate than the increase in cost of debt being passed on to them.
The argument that accessing capital markets may be at risk is also not compelling. The market will adjust the price of the stock or bond yield to the proper level. If a troubled utility like Pacific Gas and Electric has had no trouble placing billions of dollars of bonds recently while it faces a possible third bankruptcy for starting wildfires, APS is unlikely to have a problem either.
The drop in allowable return on equity from 10.15% to 8.7% is important. This reduction breaks a general trend where rates for APS and almost all regulated utilities across the country have held allowable ROE rates relatively flat for many years.
Utilities like APS have had another advantage on other businesses in recent decades, as the cost of capital (investor required returns) dropped and remained low.
The drop in cost of capital creates conditions for most companies and their investors to better survive lower prices and greater price competition.
While other industries use lower costs of capital to offset price competition, utilities such as APS achieve steady or even improving profits by keeping approved ROEs stable or rising.
An 8.7% ROE can and has been well within the range of many financial analysis tools used in the industry.
Some states, like Illinois, use a simple premium percentage above the risk free rate offered by the U.S. Treasury 30year bond. Currently, the premium is set at 5.8%, so the ROE for their utilities becomes 8.6%, not too far off the APS 8.7% just announced. This system has worked just fine in keeping shareholders happy and also keeping the lights on.
Arizona does not often receive positive national recognition for important policy decisions. But this noteworthy energy policy decision stands out.
Monopoly utilities have long reaped high returns with a guaranteed customer base and no competition. The Arizona Corporation Commission has taken bold action and demonstrated courage to lead the country in protecting customers as the system is designed to do.
The APS rate case decision is still lingering before the commission with some aspects like updated time of use rates still pending.
And APS is expected to file another rate case this year. With an upcoming election for commissioners in November, it’s important that regulators not backpedal on this important decision.
Autumn T. Johnson is an Arizona native, APS customer and an energy policy consultant at Tierra Strategy, based in Phoenix. Albert Lin is executive director of the Pearl Street Station Finance Lab, which provides financial analysis on energy policy impacts. Reach them at autumn@tierrastrategy.com and albert@pssfinancelab.com.