Five Tactics for Fighting Utility Rate Gouging – Episode 226 of Local Energy Rules

Mark Ellis:
There’s a very famous regulatory economist named Alfred Kahn, and he actually worked as an advisor to Jimmy Carter, and he’s kind of considered the godfather of deregulation back in the day with airlines and trucking and eventually electric power and utilities. But he actually wrote a book, a very famous textbook about utility regulation, and he very clearly says like, Hey, when market to book ratios are greater than one, it’s very clear that the regulator’s authorizing returns greater than the cost of equity. Interestingly, even when you read utility experts writings on this issue, they will themselves say, yeah, market to book ratio greater than one means that the authorized rate of return is greater than the cost of equity. But they try to bury that in the actual regulatory proceeding, but they themselves will concede that fact.

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John Farrell:
What if we could lower electricity rates by 10% tomorrow with no meaningful impact on reliability? Recent research cited in ILSR’s report Upcharge has exposed that electric customers in the US are overpaying investor owned utility shareholders by as much as $50 billion each year because state utility regulators are approving rates of return on capital investments by these utilities far above what it costs these companies to raise equity from the stock market. Joining me in November, 2024 to talk about right-sizing utility rates of return is Mark Ellis, an independent consultant and senior fellow on utilities for the American Economic Liberties Project, and who previously served as former chief economist and chief of corporate strategy at Sempra, one of the country’s largest investor owned utilities. I’m John Farrell, director of the Energy Democracy Initiative at the Institute for Local Self-Reliance, and this is Local Energy Rules, a podcast about monopoly, power, energy, democracy, and how communities can take charge to transform the energy system. Mark, welcome to Local Energy Rules.

Mark Ellis:
Great to be here. Thanks for hosting me.

John Farrell:
Mark, I just want to start off like I do with all my guests asking how did you get into this space? How did you get into utility finance and economics? What was interesting or motivating to you about that work?

Mark Ellis:
There’s kind of three nouns in there. There’s utilities, finance and economics. So I guess it started with utilities. My very first job between high school and college, I worked for LADWP, Los Angeles Department of Water and Power, actually worked on the water side as a seasonal waterworks labor and basically were charged with clearing brush around their reservoir facilities in the San Fernando Valley. And it was my first exposure to infrastructure and I was just fascinated by these massive investments and all this activity that goes on that we basically kind of take for granted. Like, oh, where does your water come from? Where does your power come from? Water comes out of the faucet, power comes out of that little socket in the wall and kind of just don’t know everything that goes on upstream of that. And I’ve always just been fascinated by these public services and their interaction between private business and the public interest.
And so that was my first exposure to utilities. And in college I studied mechanical engineering because where I went to school, they did not have civil engineering. I was always attracted to STEM-y type things, and so engineering was a good fit. And my very first job out of college, I ended up working for Sanyo Electrics in Osaka, Japan in a research lab in Osaka, Japan. And so most people of my generation know of Sanyo for their boom boxes in dorm fridges, but in Japan, they’re known for their commercial and residential HVAC air conditioning and ventilation like the Tokyo Dome, which is this. The roof is suspended by air pressure, that’s their HVAC system. And so this was in the early nineties and the big environmental issue at that time was the ozone hole, not climate change. And the Montreal protocol had just been signed and all these refrigeration companies were researching alternative refrigeration technologies.
And so that was what I was doing. I was in a lab in Osaka, very interesting experience. I was the only foreigner in the dorm and in the lab, real immersion, and I had some spare time. The lab had a library and I found these pamphlets from an organization called the World Watch Institute. I just read through all these different pamphlets and about half of them focused. They focused on social issues and environmental issues, and about half of them focused on the energy, economic and environment nexus. I just found that so fascinating. And after reading, I probably read 30 or 40 of these pamphlets over the course of the year, and I decided that’s what I want to do. I had this engineering background and I cared about the environment, and I liked the fact that sort of economics explained how things work in the real world.
So I just decided that’s what I wanted to do. And it was at that time I decided, hey, I want to go back and go back to graduate school. And I ended up going to MIT’s technology and policy program, but when I came back from Japan, I had about nine months before I went back to school and I ended up working for Southern California Edison in the first utility sponsored demand side management program. So this is going, this novel idea descended from Amy Levins in the concept of megawatts. California actually implemented as policy and I worked with industrial customers to help them reduce their energy usage and also their emissions. So California had a big initiative there to reduce smog, and so it was a lot of using electric technologies to help them reduce their various emissions. So that was my exposure to utilities was both at DWP and then at Edison.
And then at MIT was really my first exposure to economics and finance. And so what I liked about economics is they said it’s kind of explains the way things work, and then finance gives you the tools to make decisions around the way things work. So discounted cash flows and NPV and so forth. Interestingly, I kind of took my first finance course just because a friend of mine said, Hey, I’m going to take it, you should take it with me. And I said, oh, there’s this accounting prerequisite and I don’t have that. And he said, oh, the teacher will wave it. You should take it. And I took this class and I just loved it. I just loved how it helped you, like I said, helped you put numbers to things and quantify things and make economic decisions. So that was sort of the introduction to the introduction.
After I graduated from MIT, ended up working for Mobil and then ExxonMobil in International Gas and Project Finance, so developed a lot of skills around valuation and project modeling and economic analysis and projects and markets, and just refining my toolkit after the merger, I ended up joining McKinsey for a number of years and worked in their energy practice, both oil and gas and electric power and natural gas. Probably the most notable project I worked on was during the California energy crisis in 2000, 2001, we had a team working for the governor in Sacramento, and that was really exciting to get an inside perspective and be a part of that process. In 2003, we had two kids and the third on the way, and my wife, who was enough traveling, you need to find a job. We were in Texas and my wife and I are both originally from California and she really wanted to move back and I got this opportunity to join Sempra.
And so I joined them in the beginning of 2004, and my very first project was a strategy review that went to the board of directors in two and a half months or three months after I got there. And I guess it went really well because after that just sort of the workflow to me, and it was very much, I was there for 15 years and for most of that time basically ran the strategy function while I was there. So anytime there was a novel question that the organization hadn’t encountered before, it kind of came to me to help them figure it out. So I did a lot of work on climate change, renewables, a lot of technology stuff, project valuation, understanding the economics of different markets and so forth. So that was sort of my career and my interest in utilities and finance and economics.

John Farrell:
So one of the things that is so valuable about your experience compared to many of the advocates who’ve been on this podcast, but also who we work with is that you have this insider perspective as a chief of corporate strategy for Sempra. I’m just curious, was there a particular moment when you were working there that you realized just how much the regulator approved rate of return for a utility motivated its behavior?

Mark Ellis:
That’s an interesting question. I think many things in life, you don’t really fully understand something until you have some distance, and it was one of those things where you have observations and you have experiences and you do research. It wasn’t until I left and had time to reflect and do some more research that like, oh yeah, this is really a big issue. But I did get some inkling probably the first major data point was during the financial crisis in 2007, 2008. So Sempra like most companies, they do project valuation and they have a discount rate or a hurdle rate that they use to evaluate their projects. And it’s interesting, when I was at Exxon and Mobil is the same thing. They have a corporate number for that, and there’s not a lot of you just accept it, right? It’s just, oh, that’s the hurdle rate or that’s the discount rate you use and you just kind of run with it.
You don’t really ask it, well, where did that number come from and what’s the logic and analysis behind it? And so when I joined Sempra, they had these hurdle rates or discount rates that they use for project valuation that were kind of just like, oh, they didn’t change ’em from year to year. It was like, oh, for this business it’s this, and then for that business it’s that. And it was what it was. And so during the financial crisis, markets took a nosedive and people were really risk averse. And so the treasurer is like, Hey, we have these hurdle rates that we use for all our project evaluation, and with all the changes in the market, they must’ve gone up, so what should they be revised to? And so that was at that time I was the chief economist, and that was my job to go chase that down.

John Farrell:
I have some experience with discount rates and the way that they can influence economic decisions. So the fact that you’re at this moment in time when so much is churning in the economy and being able to ask to figure this out is just what a fascinating assignment.

Mark Ellis:
Yeah, no, it was very interesting. And I’m one of these people who’s very thorough and you go back, tell, read the analytical all the research, and then, okay, I see this research that they did, but it’s from 1997, let’s update it to today kind of thing. So you pull all the data and replicate the studies and so forth. And long story short, I went back to the, I said, yeah, our cost of gone up, but it’s much lower than we ever thought it was. It took a long time to convince people because they’re used to just like, oh, it’s this number that they pulled out of a hat a few years ago and they’re anchored to that. And it came back and it’s like, no, it’s a lot lower than we thought it was. And you’re going through the organization and kind of syndicating with different people.
And I remember very distinctly having the conversation with the CFO at the time and telling him, Hey, our cost of capital is whatever it was, it’s gone up, but it’s so much lower than we thought it was. And then there was this conversation around, oh, the utilities. And he’s like, oh, they just earned their cost of capital. There’s nothing there. I’m like, no, no. Their rate of return is much higher than their cost of capital. And you could almost see the wheels spinning in his head. He was staring at me and thinking, and long story short, at that time, Sempra was the 14th largest utility I think in the country. And really when I joined the company in 2004 until that time, the focus was really on the unregulated side. So the Sempra adjusted merch and that energy crisis near bankruptcy really pulled in their horns and it was just like, oh, the utility is just a slow growth, sleepy business kind of runs itself.
So long story short, over the next decade, Sempra doubled down on the utilities and jettison almost all their unregulated businesses because they realized, oh, these utilities, they’re like the value generator in the company. And so Sempra poured a ton of capital, particularly in SDG&E, tried to put as much capital as they could into SoCal gas. They bought ONCOR, then they kept the Mexico business, which has a lot of utility like infrastructure and also the LG, which is very utility, but trading midstream pipelines, renewables, they got in and they got out. But really it was just like, okay, this rate of return really is a value generator. It really drives behavior in the company, and it’s not just around like, oh, this is how we create stock market value. It actually translates directly into individual people’s compensation in terms of how executives are compensated and so forth. So you just saw like, okay, this is a big deal. This rate of return is the thing in utility regulation.

John Farrell:
So several recent studies have shown that utility regulators have been granting utilities greater returns on equity investments than returns for similar low risk investments in a competitive market, maybe even several percentage points higher. What is the cost to consumers, to the industry of the failure by utility regulators to keep utility rates of return in sync with the cost of capital?

Mark Ellis:
I think you’re referring to the Carnegie Mellon and UC Berkeley papers?

John Farrell:
Yes.

Mark Ellis:
I think both of them give some estimates on the on order of 10 billion. I think the Berkeley one was like, oh, on average 10 billion or 7 billion a year over the last 20 years or something is historical. Look, I actually think both numbers are both those estimates are quite a bit lower. Actually in my testimony. I actually summarize like, okay, here’s what the cost is. I’ve looked at it three different ways. So when I actually testify in these proceedings, I routinely come up with, Hey, if you instead of accepting the utilities requested 10% plus or minus, you actually use their true market-based cost of capital. It comes out to around 10%. I’ve had 11%, I’ve had 9%, but on average it’s about 10%. Another way to think about the cost is in terms of an aggregate, it’s about 50 billion a year. And another way to think about how to arrive at that is when you look at the stock market value of all the utilities, like the s and p 1500 utilities index, I did this analysis in August.
It was about $1.2 billion, 1.215 billion in August, and the market to book ratio at that time was about 2.15. And so what that means, the market to book ratio above one, all the increment above one is basically sort of surplus above the cost of capital. So that 1.15 over 2.15 times a market cap of 1.2 works out to about 650 billion of market cap attributable to this excess ROE utilities trade at a price to earnings ratio of about 18. So you take that six 50, divide it by 18, it works out to about 37, 30 8 billion a year, but that’s after tax. So the ROE is grossed up for taxes. When you gross it up for taxes, it comes out a little bit above 50 billion a year. So you can see that this is the excess that customers are paying per year to sort of line the pockets of utilities that’s above the true cost of capital.
There’s some wrinkles to that analysis because it’s like for the utilities index and they have some unregulated businesses, so it’s overestimating, but the unregulated is only about 10%. And then the utilities index does not include a lot of companies like Berkshire Hathaway Energy is not in the utilities index because it’s part of this big conglomerate Puget Energy. There’s a bunch of utilities that just aren’t included because they’re either privately owned or they’re subsidiaries of companies that are non-utility businesses. So that’s another way to think about it. It’s about 50 billion a year. Finally, you can just say, oh, utilities are earning a certain ROE every year. And then if they were actually what their true cost of equity is, and you can look at that difference and that’s about seven or 8%. So you can calculate it different ways, but it’s a big number on the order of tens of billions of dollars a year on the market cap. Think about this, it’s 650 billion of market cap is just this sort of excess earnings. So the market value, the discounted present value of these future excess profits at 650 billion. It’s not Nvidia, but that’s still a lot of money. Six 50 billion is a lot of money.

John Farrell:
So you probably do this for folks all the time, but kind of a 101-level lesson in how most investor owned utilities get paid, how does this inflated rate of return and the excess market capitalization that we can see, these measures that you have to see that in the market, how does that translate into higher bills for electric customers? Specifically, how do I as a customer of Excel energy in Minnesota end up paying more because the utility has a rate of return that’s too high?

Mark Ellis:
So I just mentioned just the starting point. It’s about 10%, right is the excess, but utility rate making 1 0 1, so there’s a principle, it’s called cost of service regulation. So utilities are entitled and should earn their actual costs in terms of, so what they do is they take all their actual costs and they roll them up and they say that’s your annual revenue requirement. And then there’s another process to allocate them to different customer classes and then to the rate structure in terms of how much is a fixed fee and how much is for the energy versus capacity or a fixed monthly fee, but just determine the revenue requirement. It’s just supposed to be equal to their actual costs. So what are their actual costs? So we can think of the ongoing operating costs that are consumed as they’re paid for things like salaries or rent or fuel or purchased energy.
There’s kind of like, okay, I’m paying for them and then I’m just delivering them to customers and they’re kind of buying them and I turn around and I sell them on. And basically the principle is, okay, whatever you paid, you just roll that up and pass it through in rates. So like I said, fuel, rent, salaries, things like that. But utilities don’t just have these ongoing operating expenses. They also make major capital investments like pipelines and power plants and distribution, transmission lines and so forth and those, so they’re a big investment upfront, but they don’t recover them as they’re incurred because they’re actually consumed over many years. If you build a pipeline, it might run for 40 years. And so the term they use is they depreciate it over 40 years. So they’ll take, the initial investment is 2 billion over 40 years, that’s $50 million a year, 50 million.
So they’ll just depreciate it over $50 million a year over 40 years. That depreciation, they recovering rates as well. But if you think about it, nobody’s going to invest like, oh, I’m going to put in 2 billion for this pipeline and I’m going to get 50 million a year. Nobody would do that. There’s a concept of the time value of money you have to compensate people for investing upfront and then earning money over time. So you can think of the depreciation as the return of capital, and then there’s a return on capital, and we’re all familiar with this. We pay an interest rate on our loan. We don’t just pay the principal, we pay the interest. So the concept of the return on capital is analogous to the interest you pay on your loan. So you have the operating costs, you have depreciation, and then you have the return on capital.
So that’s the component of the rate base, all those components, the operating costs and the depreciation, they’re just kind of like you can look at invoices and accounting rules and you can figure them all out. So let’s just focus on the return on capital and how do they calculate that? So basically for the return on capital, it’s a function of how the utility finances that spending. So they have to raise money in the capital markets, both equity and debt. And for a variety of reasons, and I think these very sound reasons, the regulators want the utilities to have very strong credit ratings. So they say You can’t put on too much debt. We want to make sure you have a very strong credit rating. So they tend to limit how much debt. And in practice today it’s about 50-50 debt and equity. So the return on capital for the debt component is just the interest rate.
So they go and they issue bonds or they issue debt, and then there’s loan agreements that say this is your interest rate. And they kind of say, okay, that’s what you’re allowed to recover whatever interest you’re paying, you can recover that from customers. And there’s some wrinkles there, but that’s the basic principle. And then the last part they raise in the stock market. So they go and they issue equity. The interesting thing about the stock market is you can’t just look up what the cost of equity is. People give you capital and they’re going to get paid out over time, but it’s not like you can go and if I want to look at the interest rate on a treasury bond or a corporate bond, I can just go to Bloomberg or Yahoo Finance or whatever and find that rate. But for equity, there is no analogous rate that you can look up.
It’s sort of embedded in investor expectations. So they have to come up with a return on equity for that last bit. And so that’s the last component in the rate making process. And I know it’s a bit long-winded, but that return on equity is gross up for taxes and accounts for about 20% give or take of the overall rate. Just the return on equity plus the taxes that are grossed up is about 20% of the overall rate. So you can envision like, okay, if that is too high, it adds up to a significant chunk of the rate.

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John Farrell:
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John Farrell:
I saw a presentation that you gave, Mark, where you described utility finance as having customers pay off at 30 year mortgage, but in the end, the utility still owns the house. So I know this is a little bit of a tangent, we’re going to come right back to rate of return, but why is it that in the way that we finance this stuff, that the utility still has title to all of the grid assets when the customers are done paying for them?

Mark Ellis:
So first, I can’t take credit for that analogy that came from Matt Stoller, who’s one of the founders and the research director at AELP – the American Economic Liberties Project. He’s a very clever and creative and thoughtful guy, so I have to give him credit for that analogy, but the reasons why the utility ends up owning everything, even though its customers have already paid for it. I’m sure there’s a bunch of legal reasons and has to do with the franchise agreement and so forth that frankly I don’t have a lot of insight into. But just from a purely financial perspective, let’s stretch the analogy a little bit further from the house. Imagine you have a house, but then you’re constantly adding to and investing more in it. So, oh, I’m going to add on a room or I’m going to add on the story, and then you go back to your bank and you get some more loans.
So you’re constantly, even though you’re paying off the old loan, you’re constantly going back to the bank and getting more loans, and essentially that’s going on. The utility’s always reinvesting and the rate base is always growing, so they always have this sort of like, okay, we’ve put up this capital and therefore we own this asset because our capital is invested in it. So there’s just this ongoing, they’re always reinvesting and, stretching the analogy, they’re adding stories or they’re adding square footage or they’re replacing the roof, all these capital investments that they’re making over time that sort of keep their ownership intact.

John Farrell:
Well, thanks for taking that tangent with me. I want to come back then to the rate of return. So we’ve talked about how the rate of return is set by regulators. You can’t just look it up, like you can an interest rate, it can have a very big impact on cost for customers because that payment to utilities is something like 20% of the total revenue requirement. So it’s a big deal. How do we find the appropriate rate of return for a utility company that has captive customers? How do I know if I’ve found the right number?

Mark Ellis:
The good news is utilities are not the only place where you care about the cost of capital. This is something that’s used throughout finance in the first year MBA student. One of the first things they’re going to learn about is cost of capital and methodologies to calculate the cost of capital. Now in practice, it’s a little more nuanced. If you become a professional and do what I do, it’s a little bit more complicated than what you learned in your first year MBA class, but not much. It’s actually pretty straightforward. And there’s well-established models going back that were set up in the 1970s that were empirically validated and they’re used throughout corporate finance. This isn’t rocket science, it’s nothing new or unique to utilities. There’s well established frameworks and models and methodologies and data sources that are available to do this. The two main models that are used in corporate finance are one is called the capm or Capital Asset Pricing Model.
It basically estimates the expected rate of return or cost of capital. Those two terms are synonymous as a function of the risk. There’s a basic premise and foundational principle of finance that the more risk you take, the higher the expected return. And I think we’re all kind of familiar with that. That’s kind of commonsensical, but it’s been proven empirically. You can look at the data and it’s true higher risk assets earn higher returns. So you leverage that insight and theory to estimate the cost of capital. With the Cap M, there’s estimates, there’s methodologies to figure out, well, how do you measure the risk and so forth. So that’s one methodology. Another one is called the Discounted Cash Flow Model, where you can come up with, okay, what are the expected cash flows over time into perpetuity for this business? And then you can say, well, what am I paying for today?
And IE the stock price? And you can figure out, okay, what’s the discount rate that equates the discounted cash flows to the current stock price? And that’s another very commonly used methodology in corporate finance. Those are the two basic methodologies that are used to estimate the cost of capital for the discounted cash flow. One thing that’s interesting because you could say, well, the discounted cash flow is really challenging because I don’t know what the growth rate is going to be over the long-term for this company. Think of Tesla. Does anybody know what Tesla’s long-term growth rate is? It’s like somebody could say it’s going to be negative and somebody could say it’s going to be 10%, and both of them are probably equally valid. Interestingly, for utilities, we have a hundred years of data on utility growth rates. And what you find is basically they all grow at inflation.
Their dividends grow at inflation, they have grown at inflation for a hundred years. And you think about it, it kind of makes sense. The utilities just grow with the economy overall. And we can get into the details about why it doesn’t grow, why they don’t grow with GDP. But for utilities, we have very high confidence that their growth rate is going to be bounded over the long term. And so there’s not a lot of dispute around what the valuation should be. So you can use these two models to come up with, okay, here are my cost of capital estimates. And one thing is if you’re using these two different models and you’re getting dramatically different results, then that tells you something’s wrong with your analysis. So you have these models that come up with an estimate and then you can corroborate them using different methodologies. So one is, like I said, the utility industries are not the only place that people care about the cost of capital.
So Wall Street firms like BlackRock and JP Morgan, Wells Fargo and asset managers, they produce these things that are called Capital Market Assumption Reports, and they produce them at least annually, but sometimes as frequently as every quarter, even every month, on their expected return for the market as a whole. And one of the things I do periodically is I do a survey of all these. I literally pull hundreds of these reports and I wind up what are their forecasts for the market return? And they routinely fall between four and 8% and they average around six or 7%. So these are companies or firms that collectively are managing trillions of dollars of other people’s money, and they have very large staff of sophisticated economists and analysts producing these reports, and they have a huge incentive to be accurate. They don’t have an incentive to overstate or understate because their investors are going to judge them on their accuracy.
And so they come up with these numbers around 6% for the market, six to 7% for the market as a whole. Now everybody recognizes that, hey, utilities are lower risk than the market as a whole, so their expected return, IE, their cost of equity should be less, right? Is it a hundred basis, is it 1% less, 2% less, 3% less? You can refine, you sharpen your pencil to figure that out, but it’s not nine or 10%, which is higher. In fact, when you run these surveys, nobody’s higher than like 8% for the market as a whole. And yet utilities are saying, oh no, our cost of capital is 10% even though we’re lower risk. So there’s a huge disconnect just there. So that’s a way to corroborate. So you have these models and then you can corroborate it with what the experts are saying.
And then another way to corroborate is to look at what is called the market to book ratio, which is the ratio of essentially what the market price is for the market capitalization for the utility stock. In other words, what investors are willing to pay versus how much equity, how much capital the utility actually invested, and that’s referred to as the market to book ratio. And you look at, and you can compare the two, and as I mentioned before, it’s about 2.15 as of August, it’s been hovering around two for 15 years. And essentially what that means is very intuitively, if I paid a hundred dollars for an asset that pays out $10 a year into perpetuity, my return is 10%. Now, if somebody comes along and says, Hey, I’m going to pay $200 for that, just mathematically we know their return has to be lower, right?
They’re paying twice as much for the same $10 a year cash flow screen, then their return can’t be 10%. Mathematically it has to be lower. So essentially the market to book ratio is telling us that hey, investors are willing to accept a return dramatically lower than that 10% ROE, right? So the investor expectation is the true cost of equity, not what the regulator assigns. So that’s another thing. The market to book ratio is the key, what’s directly observable? It’s unequivocal. You can look at that and say, are investors expecting something, a lower return or a higher return? That tells us is the authorized rate to return higher or lower than the market expectation? And this is not something new. There’s a very famous regulatory economist named Alfred Kahn, and he actually worked as an advisor to Jimmy Carter, and he’s kind of considered the godfather of deregulation back in the day with airlines and trucking and eventually electric power and utilities. But he actually wrote a book, a very famous textbook about utility regulation, and he very clearly says, Hey, when market to book ratios are greater than one, it’s very clear that the regulator’s are authorizing returns greater than the cost of equity. Interestingly, even when you read utility experts’ writings on this issue, they will themselves say, yeah, market to book ratio greater than one means that the authorized rate of return is greater than the cost of equity. But they try to bury that in the actual regulatory proceeding, but they themselves will concede that back.

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John Farrell:
We’re going to take a short break When we come back, Mark and I talk about how excessive rates of return shape utility behavior, whether utility regulators have ever gotten this right and five key steps advocates can follow to start winning fairer rates of return. You’re listening to a local Energy Rules interview with Mark Ellis, an independent consultant and senior fellow on utilities for the American Economic Liberties Project, and who formerly served as chief economist and chief of corporate strategy at Sempra, one of the country’s largest investor owned utilities.

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Now back to the program.

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John Farrell:
I really appreciate you laying this out in such detail Mark because for someone who has worked a long time on the policy side of things and thought about how do we motivate utilities to do things, I think it’s kind of like you were saying about your fascination with economics and finance and realizing economics can explain how things are happening and finance is a tool you can use to manipulate it. And here we have very clearly this financial tool that is very clearly driving investment in a particular direction. And actually that’s one of the things I wanted to ask you about here is not only does an excessive rate of return increase costs for customers unnecessarily, but it also motivates utilities to behave in a certain way. And can you talk a little bit about

Mark Ellis:
That? Yeah, so I’m going to use the market to book as a launching point again. So in practical terms, what does this mean? So in practical terms, it means for every dollar of shareholder capital that the utilities invest, it turns into $2 plus 2.15 currently in their share price. So if somebody came to you and said, Hey, give me a dollar, I’ll give you two in your retirement account, you’d be like, okay, can I give you two? Can I give you 10? Can I give you a million? So essentially that’s what the utilities are doing. That’s what the utilities do. It’s like if I spend a dollar and it turns into two, I’m just going to do that as much as I can. So that has a number of incremental impacts. So one, it’s just an incentive to invest as much as possible, and then two, it crowds out other things, right?
So attractive, nobody has a deal. That’s two for one deal, no other business, virtually no other business, and it’s almost guaranteed. So other companies have opportunities to invest in like, oh, if I invest this, I’m going to double my money, but it’s not as it is for the utilities. It’s not totally risk-free, but virtually risk-free for utility once it’s approved by the regulator, as long as they operate it safely and so forth, they’re going to make that value. And it’s very clear. You can see it like, oh, when a utility gets regulatory approval for something, their stock price will go up correspondingly. So two things. One, it creates this incentive to spend more, which creates this rate spiral, but two, it crowds out other things. So if you, oh, I want you to do efficiency or I want you to focus on other things that don’t necessarily entail capital expenditure, it just is not very attractive.
Nothing like, oh, I spent 2 billion on the new transmission line and that’s a billion dollars of shareholder equity, which turns into 2 billion in my market cap. That’s just an amazing deal. So it’s just the huge driver. I’ve been syndicating this idea with various parties, try to get people more interested in rate of return because it’s such a big driver of utility behavior, and one of our colleagues, Dave Pomerance from Energy and Policy Institute, I think you know him, he referred to it as, oh, rate of return is the skeleton key, kind of unlocks everything else you’re trying to do with utilities. And the idea is if you can get, reduce that incentive, so it’s not two for one, it’s 1.1 or 1.05 for one, right, or one, so they’re just neutral, then all of a sudden can all these other things you want them to do start to look more interesting, you can have more influence over that and they will prioritize them more appropriately.

John Farrell:
One of the things that amazed me, I think it was a chart from one of your presentations looking at the historic market to book ratio, and then they’re also in the Carnegie Mellon and the Berkeley studies, both of them have kind of a time analysis. Those ones go back to the seventies. I think your market to book went back to the 1940s, and if I look at those two things, I’m left with this question, have utility regulators ever gotten rate of return rate? Because it seems like there was this moment in the 1970s when the rates of return weren’t excessive, but that was sort of a unique moment in history when inflation and interest rates had skyrocketed. Was that just a coincidence that it seemed like it was in line at that time? Was there any real strong action? Do we have a point in time to look back at and say this is when they got it right? Or is it just that just happened because of the unique circumstances of the time?

Mark Ellis:
Yeah, I don’t know the exact answer. My personal perspective was just a coincidence. When you look at the data, there’s never a period where the market to book is hovering around 1.0. It’s either well above or well below. So that period in the seventies, the chart is a little misleading because it’s hovering around 0.5, 0.7, that’s too low. And the utility said like, Hey, this is a legitimate concern. I believe they had a point. Now, I was a child then, so I don’t know all the regulatory history. There was rapid inflation, there were cost overruns related to nuclear and other things. So who knows, maybe it was deserved at that time. But interestingly, the utility experts all at that time were saying, I have a book here, and it says, the market to book ratio is a guide to regulators. These were experts testifying on behalf of utilities saying, got to be at least one.
Got to get it up to one. Got it. That was the argument at that time. Interestingly, one person who wrote a paper on this is Peter Navarro, the Trump advisor, who’s now under consideration for the National Economic Council. I have a paper from him, and he’s like, yeah, the market to book ratio of 1.0, that’s where we need to be. He wrote in 1981 when they were trading below that 1.0 is the standard. I think the regulators have just never, when you look at the data, they never were able to get it right. It doesn’t mean, I don’t know why this isn’t rocket science finance. In other words, sort of the regulatory groundwork around like, oh, the rate of returns should be equal to the cost of capital. The rate base should be equal to the actual investment. That all dates to the forties, and discount of cashflow all dates to the 1930s.
So you think from the fifties on, they should be able to kind of drive by braille like, oh, when market to book is too high, we’re going to reduce the ROE. When the market to book is too low, we’re going to increase the ROE. But they haven’t been able to do that. And my experience in regulatory proceedings, I’ve only been doing this for four or five years today, the state of the art and the quality of the testimony just isn’t very good. They don’t emphasize this very much. This idea like, oh, the market to book is a guide to regulators. It’s like, come on people. This is basic finance, but you actually have to introduce it. As I mentioned before, for example, there’s two basic models that are used in corporate finance, the DCF and the CapM. In regulatory proceedings, they have these whole other models that are only used in regulatory for the cost of capital, for the cost of equity that are only used in regulatory proceedings.
Nowhere else do you find these in finance. And the crazy thing about them is what are they doing? What they do is they’re models that are basically looking at the authorized ROE from other regulatory proceedings and saying, that’s our cost of equity. And it’s like, well, anybody who has any logical sense, no, that’s the authorized rate of return. It may or may not be equal to your cost of equity. There’s no reason to assume that it is. These are still widely used in regulatory proceedings and widely accepted in regulatory proceedings, and not only the widely used by the utilities, they’re widely used by experts testifying on behalf of consumer advocates and third party intervenors. And I look at this and it’s just like I want to pull my hair out to its credit. The FERC did a very extensive review of all these models a few years ago, and they basically said, oh, those models that are referencing other authorized ES from other proceedings, they’re circular.
I think the language they use defies general financial logic, and they said, you can’t use these anymore. So there’s two models. One is based on authorized es. One is based on forecast ROEs, which are essentially authorized ROEs called the risk premium model and the expected earnings model. And they said, you can’t use these anymore in FERC proceedings. FERC still has some room to do, but at least they recognize these circular models, just toss them out. They defy general financial logic, but sadly, they’re still widely used and widely accepted in these regulatory proceedings. So I don’t understand why given the stakes, right, 10% of rates, 50 billion a year, why the state of the art is so poor, and that’s something I’m trying to change, just like this isn’t complicated. This is, like I said, a first year MBA student knows how to do this. We just got to up our game and start bringing some 50-year-old finance into the modern regulatory arena.

John Farrell:
I want to ask you two more questions in the time we have. One is because you said this in your presentation, not just the dollars that are at stake, but kind of like what could we do if we fix this? Because one of the things that you said I thought was really helpful is you could just reduce rates, which in some places like California obviously would be a huge relief given the upward pressure they’ve been under, but it also, you could make big investments in other things. So I just wanted you to touch on that briefly. How else could we be using those resources that are right now just giving excessive benefits to shareholders? What else could we be doing with the money that is being spent this way?

Mark Ellis:
I talked before about, oh, the buildup of the revenue requirement. There’s sort of ongoing operating costs, and then there’s the capital. So when you run the numbers, the ongoing operating costs are about 50% of the rate, give or take, and vary. And then the capital, the return of an on capital is about 50% of the rate. And so if the potential savings is about 10% of the rate, then it’s about 20% of the total capital. So if you can reduce your capital cost by 20%, that means when you take the inverse of that means every dollar of revenue you raise for capital investment could go 25% further. So the idea is I could take the same amount of revenue and I can get billed 25% more stuff, whatever that stuff is, upgraded distribution or EV charging or what have you. Every utility is going to be different and every jurisdiction is going to make those decisions, and those are a separate decision. But you can expand the pie and build more stuff, and you can do anything in between like, oh, I’ll take half of the savings and I’ll reinvest it, get 10% more or 12.5% more stuff, and then the other 10% I’m going to reduce rates 5%. You can adjust that knob any way you want, but 25% more stuff is pretty compelling for the same amount of money.

John Farrell:
Absolutely. So let’s come back to this issue of how do we get this right? So you have commissions right now that are maybe looking at models that FERC described or defying general financial logic in terms of making decisions. You have sometimes consumer advocates, people on our side of affordability and good investment, maybe even referencing those same bad models. What is it that we need to do to correct this problem? Obviously we need to be advocating in rate cases when this stuff is coming up, but what do we need to do in order to get it right and how could we be coordinating? Because it sounds like this is happening everywhere, not just in one particular place.

Mark Ellis:
So in addition to testifying on this, this is something that I’m actively pursuing and I have a whole inventory of different projects I’m working on to try to fix this problem more systematically. So the first one is just better testimony. Consumer advocate witnesses testifying on behalf of consumers and environmental organizations, whether they’re public or third party, should not be using the risk premium model. And if you are hiring an expert who uses the risk premium model, they should be disqualified. They clearly do not understand the most basic principles of finance and regulatory economics and the legal standard of the rate of return should be equal to the cost of capital. So just better testimony. Interestingly, I had a recent experience in California, which the decision didn’t go my way, but in the meeting approving the decision, one of the commissioners got up and gave a six minute speech basically endorsing, yeah, market to book ratios are telling us that our authorized rates of return are too high and we need to bring them down.
People are interested. It was in California, it was on October 17th, and there’s a video and you can watch it. It’s at 47:20 on the video. If you want to hear it, hear it yourself. But that was very rewarding. It’s like, okay, the message got through at least to one commissioner. Interestingly, one of the stock analysts covering California utilities noted, Hey, we’re happy with the decision, but the commissioner’s comments were not helpful, specifically saying like, oh, reintroducing the market to book ratio into the regulatory discussion is not helpful. So that’s progress to me. It’s like, Hey, the message is getting through, so better testimony can make a difference.
Second, I’ve observed in various proceedings as you will find in California, I think in this recent proceeding, there were six different parties submitting testimony on rate of return. Now all these parties want the same thing. They want a lower rate of return, and I suspect that one party turn doesn’t have a dramatically different view than EDF on what the beta should be or the equity risk premium. It’s just like an artifact that they hired different experts. To me, that just doesn’t make any sense. Pick one expert because inevitably what the utility will do is say, Hey, we’re asking for 10, and these intervenors are all over the map. They can’t even agree among themselves, just go with what we say. It just makes the utilities job easier. It makes the regulator’s job harder because they have so much more evidence to review this. Just like how are they to decide like, oh, whose beta estimate or equity risk, premium estimate or growth forecast in the discounted cash flow is better. It’s just, why don’t you coordinate? Put all your wood behind one arrow, pick the best expert and go with that. So stop fighting among yourselves, and it’s really silly. They can coordinate better.
Another thing is, unlike other issues, rate of return is the same from utility, utility within the same state and across states from state to state. It doesn’t change. Every state is going to have very different policies around rooftop solar and energy metering and so forth, and you need to have state specific knowledge to participate in those proceedings. Rate of return is cookie cutter. Literally, you can take my testimony, you could take the utility expert’s testimony from one state to the next, and it’s virtually identical. The only thing that changes is the peer groups, but it’s a lot of finding, replacing the testimony, it’s very similar. So there’s huge economies of scale and scope and just learning. In my experience there are a lot of intervenors, they’re lawyers and they’re lawyers because they don’t like numbers. It’s like a relay race where you are handing off the baton. So I can do really good testimony, but if my lawyer doesn’t really understand the material, they can’t write good briefs and they can’t do a good cross. And it’s sad because it’s like you roll up your sleeves and spend the time on one or two proceedings, you’re good to go. You can do a great job on hundreds of proceedings after that. And it just seems to me like there’s a real opportunity to build more expertise internally on this issue so that you can be more effective. And obviously you can’t do this on every issue, but rate of return, 10% of rates, it’s like I challenge you to find anything that comes remotely close to even 1% rate reduction, and here you get 10% rate reduction. So there’s huge value in building expertise. So that’s what the intervenors can do a little bit better I think, is coordinate and just build their internal expertise and be more judicious in really getting good testimony fighting this issue.
Another thing they can do is they could appeal these decisions. In my experience, the utilities will definitely appeal a rate of return decision they don’t like, but the intervenors almost never do. They kind of just say, oh, we tried and they move on, right? Oh, the utility asked for 10.5%. We submitted erroneously 9% and the regulator approved 10, and oh, we got 50 basis points out of it. Great. And it’s like, yeah, but you’re still overcharging customers by a billion dollars a year. Like this is crazy. Appeal it and keep appealing it and build a war chest to appeal it. To me, that just seems like you got to keep fighting, so that’s something that intervenors can do a little bit better. I have a bunch of ideas about things that sort of outside the regulatory arena that can be done, but I’ll pause there.

John Farrell:
That’s really great. I’m just going to review those really quickly. I think you gave a really concise example of what people who want to intervene in the regulatory proceeding. First of all, testify. Disqualify experts that use bad models. Coordinate with others on cases. Coordinate nationally because as you say, this is cookie cutter. And appeal bad decisions. That’s a pretty solid five things that we can all be doing better to win on this. I’d love to hear some of your ideas for doing this outside the regulatory system. What else can we do to move people?

Mark Ellis:
I’ve talked to a number of attorneys around. Are there potential lawsuits on this? It’s really challenging to have a lawsuit to second guess a regulatory decision. There’s something called the filed rate doctrine and the state action doctrine, but something we continue to explore. I’m really working with just one attorney on the class action, but I’ve talked to a number of them and so when they do these class actions, they run it through two filters. One, is there a case and how do I get paid? And so like, oh, I have a product liability or real page or collusion or whatever. It’s very clear, okay, the remedy is you get the claw back from passed over charges, right? That’s the remedy. And then you get a percentage of that.
And when they think about it, they do it in the reverse. They think, how do I get paid? And then they’ll figure out whether they get a case. They look at utilities like state action filed rate doctrine. There’s no way for me to get paid. And so they just stop. The one I’m most interested in, and this is kind of the newest idea, is when utilities were created, they kind of adhered a monopoly on the equity financing to the operational monopoly. And that kind of made sense back in Thomas Edison’s day when capital markets were not sophisticated and you needed these big holding companies that could raise a lot of capital and deploy a lot of capital quickly. But that’s not the case today. And you think about it when the utility goes and says, oh, I’m going to go raise debt. It’s just assumed and it’s just expected like, oh, you’re going to go to market.
It’s not like you go to your parent company and say, Hey, lend me money, tell me what the interest rate is, and I’ll ask for that from the regulator. It just doesn’t enter anybody’s head to do that. They’re like, of course you’re going to issue bonds and the market will determine the interest rate on the bonds, or you’re going to go, maybe you go to a bank or a lender, private lender, but you’re still going to shop it. There’s an expectation. You go to market. You don’t just go to the parent. Why don’t they do the same thing for the equity? We know that investors are willing to accept a lower rate of return, not just from the market to book ratio. We also know from transactions about this elite right owner of Minnesota Power is being sold right to GIP and CPP. So GIP is a private equity and CPP is a Canadian pension fund and they’re paying, I think 1.6 times book.
So think about what’s going on with that transaction. You have this private entity coming in and saying, Hey, we’re going to pay 1.6 times book, and I think it ends up being over a billion dollars over book value that flows to elite shareholders. So they get this billion dollar windfall if this transaction goes through. So what is that billion dollar windfall for? It’s not for past performance because they already got rewarded for the past performance in the rate of return that 10% that they were earning all those years. It’s not for future performances. They’re selling, they’re not doing anything in the future. So they’re giving this the billion dollar windfall purely as an artifact. That billion dollar windfall is just the present value of the cash flows that are coming out of customer pockets that are above the actual cost of capital. That billion dollar windfall, that’s just a regulatory decision.
So CPP and GP are revealing through their willingness to pay that they’re 1.6 times book, that they’re willing to accept a much lower rate of return than the 10% authorized ROE, right? In these transactions, one of the issues that they found her on is they don’t get regulatory approval. They can’t demonstrate any customer benefit, right? So CPP and GIP aren’t saying things like, oh, I’m going to reduce rates. They’re not promising that at all. They’re just saying, I’m just going to take over the business as it is, right? So there’s no real customer benefit. So why doesn’t a third party come in and say, Hey, I will contribute equity, but I book value and I will accept not 10%. I will charge you just 7% plus a tax gross up, which may or may not be the same as whatever, and the difference between the 10% that you’ve authorized in that 7% will go to reduced rates.
It all flows to customers like what’s the regulator going to say? No, I don’t want your cheaper money. I want to keep rates high. And again, they do this for debt. There’s no legal or regulatory prohibition from a regulator requiring a utility to go to market for their equity. And so to me, this seems like a very interesting idea is like there’s this concept that regulation is a surrogate for competition, but implicit in that is competition where you can have it is always better. That’s the norm. Well, you can have competition for the equity and so just create an auction process. I mean, there’s all kinds of ways you can create market competition for the provision of equity. They just don’t do it. That’s an idea that I’m particularly intrigued about and just trying to, talking to people from a legal perspective and from an investing perspective. Could this work and what would it take and so forth. And I hope to make some progress on that in the new year.

John Farrell:
It’s amazing. It reminds me of a great conversation I had a couple years ago with Scott Hempling, who was recently a judge at FERC, and he and I talked about it in the context of municipal takeover bids where cities are trying to create a public power agency and buy out the incumbent private utility. And he said that these acquisition prices are essentially just the utility profiting off the publicly granted monopoly. It’s the writ of having captive customers that they are selling to the next bidder to no benefit for the ultimate consumer. So I am really intrigued to see where your work comes out of that, because I think it’s such a persistent problem, this idea that we have sort of privatized this public service and we are letting shareholders essentially ring value out of that that could be returned to customers ideally, and that we should have regulators really looking out for opportunities to return to customers.

Mark Ellis:
Yeah. Scott Hempling. Great admirer of his writing and he’s been a huge inspiration for a lot of my thinking. I’m glad that you brought him up. The last idea about this private investment, that one it sounds like so natural. Yeah. If CPP and GRP are willing to put money in it, why wouldn’t they do this? Why don’t they just do this interim? So I have an old college dorm mate and teammate who works at GIP. And so I met with him and I asked him about this and he says it makes sense, but he says, we don’t hold the utility for the long term, so we’re going to buy it. We’re going to try to put as much capital into it as we can, and then we’re going to sell it because it’s all based on whether they get their money back if they can put more capital, right?
Because it’s earning that 10%. That’s how they grow the value. He said, interestingly, he said CPP, they’re probably going to hold it long term. Basically his point was like, this makes sense. But the investor who would do it, it’s like a needle in a haystack because you need an investor who’s going to hold it for the long term, which means it’s a retirement fund basically. But two, they need to have a team internally that can do this work. Most retirements, like CalSTRS and CalPERS, partner with GIP. They don’t do direct investing themselves. They partner with other firms to do it for them. And so he says it’s really, that’s going to be your challenge is finding some renegade. And then they said, the third one is, we do deals with utilities. We’re not in the business of doing hostile deals. We know this is poking the bear. And so he says, you need somebody who’s has a lot of money, has a long-term investment horizon and has internal capability and doesn’t mind rocking the boat. So it’s a challenge, but I think the good thing is if you can get one, the floodgates will open. Because once one firm does it and proves like, yeah, this works, every other firm’s going to be like, okay, I can do it now because it’s a proven model.

John Farrell:
Well, Mark, thank you for taking so much time with me to talk through this issue about rate of return giving us these hallmarks of market to book ratio and other ways that ordinary folks can use Yahoo Finance to find out more information about where their utility is, but also for helping to provide some inspiration for advocates that are working on these issues of energy and affordability and thinking about clean energy investment. There’s a big opportunity here like money being left on the table for shareholders in excess of what would be necessary to bring that capital into the utility sector. So I think there’s so much we can learn from what you’re doing and just so appreciate the work that you’re putting in.

Mark Ellis:
Thank you very much. It’s been great to speak with you. John.

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John Farrell:
Thank you so much for listening to this episode of Local Energy Rules discussing utility rates of return with Mark Ellis, an independent consultant and senior fellow on utilities for the American Economic Liberties Project, and who formerly served as chief economist and chief of corporate strategy at Sempra, one of the country’s largest investor owned utilities. On the show page, look for links to Mark’s recent testimony in California and the favorable reply from one of the utility commissioners regarding market to book ratio. We’ll also have links to ILSR’s report on monopoly utility abuses, Upcharge, which includes the two studies on excessive utility rate of return, and to my podcast with Scott Hempling. For those who want to get a deep dive, we’ll also include a link to the book on regulation by Alfred Kahn and the 1980s era paper by Peter Navarro, emphasizing the appropriate market to book ratio for regulated utilities.

Local Energy Rules is produced by myself and Ingrid Behrsin with editing provided by audio engineer Drew Birschbach. Tune back into Local Energy Rules every two weeks to hear how we can take on concentrated power to transform the energy system. Until next time, keep your energy local and thanks for listening.