Utility Stocks and the Return Squeeze

Electricity companies, over the next five years, will spend far more than they had planned to meet rising power demand and to shore up a creaking network. That means selling far more stock than anticipated, too. (The Hidden Math Behind Electricity Prices, OilPrice, 26 February 2026). The utility’s ability to sell that stock at favorable prices depends on the returns that it can earn on the money invested, which, in turn, depends on whether regulators permit it to earn the return dictated by market conditions. That is a long-winded way of saying that if regulators do not take into account market indicators of return, that big financing program could run into trouble, as it did during the nuclear spending binge a half-century ago. Regulators tend to skimp on the authorized return for shareholders (RoE) and downplay market indicators when faced with the need to hand out big rate increases for what seems like very lengthy capital expansion programs. (This situation is exacerbated if fuel prices rise as well.) We have entered another era of big rate increases. So beware.

First, let’s do a quick review of the cost of capital, the return required to make a particular investment. (Skip these three paragraphs if you understand the topic.) First example: a builder puts up a shopping center for $1 million, signs up tenants who will pay $100,000 a year, and looks for a buyer. You come along, check out the leases, consider that as an alternative, you can collect 6% by buying a corporate bond, figure that you need another 4% for taking the ownership risk, so you calculate your cost of capital for the investment at 10%. You pay the owner $1 million for the property, not because it cost $1 million to build, but because at a 10% cost of capital ($100,000/$1,000,000 = 0.10 = 10%), that’s what it is worth to you. The property sells at its original cost (book value).

Second example: Before buying the property, you discover that the anchor tenant has financial problems and might have trouble paying the rent. That prospect makes the investment riskier. You conclude that you need a 12% return to cover that extra risk. The income remains $100,000, but the property is now only worth $833,000 to you ($100,000/$833,000 = 0.12 =12%). The property sells at a 16.7% discount to its book value.

Third example: When doing your due diligence before buying, you discover that a new luxury apartment house will go up next door, making the prospects for the shopping center more certain, so you’d be willing to settle for an 8% return. The income remains at $100,000, but the property is now worth $1,250.000 ($100,000/$1,250,000 = 0.08 = 8%) to you. The property sells at a 25% premium to its book value.

For regulated utilities in the US, both state and federal regulators set a return on the original cost (book value) of the utility’s property, say $1,000,000. They may determine that shareholders should earn 4% more than the 6% that those same investors can earn on a less risky bond, so they set the return at 10% to produce a $100,000 profit. That 10% is the cost of capital, that is, the return needed to attract new shareholder money. If regulators set the financial return correctly, the utility’s stock will sell at its book value. If they misread the market and set too low a return (the investor sees a higher risk than the regulator), the stock price could sink below book value. If they grant too high a return (thinking that risk was higher than investors believed), the stock will sell above book value.  Most regulatory agencies set rates to produce a “fair rate of return,” which means the cost of capital.

Let’s simplify the analysis. We will divide the return earned into two parts: a base of what the investor could earn from a relatively risk-free bond, and the extra return (equity risk premium) needed to make the equity investment. Regulatory decisions affect the latter number.  We divide the price of stock into two parts, the book value and the premium over book value, which results from earning more than the cost of capital. Again, the latter number is what counts in determining the impact of regulation. In our calculations, we divide the period 1985-2024 into eight five-year periods, and use the averages for each period as our data points.. Figure 1 shows that the stock price premium over book value is related to the size of the equity risk premium, but one of the data points seems to be in the wrong place. 

Figure 1. Unadjusted Premium over Book to Premium over Bond Yield

We don’t like to adjust data to produce the results we want to see, but by examining the year-by-year numbers, we found the problem year, 2002, when the industry took such massive one-time write-downs of unregulated and stranded investments that it lost money, the only loss since the end of World War II. We doubt that investors are pricing the stocks on the basis of a repeat of such losses, so we believe it is justified to eliminate that outlier year from the analysis. Figure 2 strengthens the argument that earning a higher equity risk premium is associated with a higher market-over-book premium. 

Figure 2. Adjusted Premium Over Book to Premium Over Bond Yield

Note for both figures: Book value, market value, and earnings are of Edison Electric Institute member companies. Bond yield is Moody’s Baa seasoned corporate, data from the Fed. Res. Board of St. Louis. Year-end for all figures.

The charts back up the notion that the difference between the return that shareholders earn and what they could earn as bondholders (an approximation of the equity risk premium) influences the stock price’s premium over book value. Not exactly a startling revelation. How about this observation, though? In this 40 year period, the stock price consistently stayed well above book value. (None of the 40 readings reached or fell below book value.) James Bonbright, the legendary scholar of public utility regulation, argued that utilities should earn more than the cost of capital, so that new share offerings sell at a price above book, in order not to dilute the interests of current shareholders, but how much more is too much? Given the consistently high premium over book at which the shares sold over the 40 years, either the theory is completely wrong, or regulators have allowed utilities to earn far more than the cost of capital.

Now, put yourself in the place of a regulator. Consumers and politicians raise the issue of affordability. Regulators can control those price increases, can’t they? So control them! On the other side, politicians who are beholden to AI interests and want to ease the entry of AI into their jurisdictions will lobby for good deals for AI, which will raise everyone else’s energy prices (which subsidies tend to do). What to do? Well, do what regulators always have done when under pressure. Trim the rate hike by finding that the utility has exaggerated its expenses and minimized the revenue it will collect, and overestimated its capital expenditure requirements, and on top of that, find a lower rate of return. The latter finding may be the least important, because the regulator can reduce the return earned by utilizing those other tools, and thereby avoid the need to explain the arcane and dubious methodology of the rate of return. In other words, the danger to the utilities is not what the regulator says about the rate of return, but rather what their entire package of numerous possible negative financial adjustments does to the rate of return actually earned.

Here is the problem for the utilities. A lower return earned leads to a lower market/ book ratio, which may not matter when the utility does little financing, but does when it has to sell a lot of stock. A lower stock price means it has to sell more shares of stock, which reduces the earnings per share growth. Considering the present level of returns, regulators have room to let the return slip before reaching the cost of capital. Without doing a complicated model that will only get you a ball park figure anyway, we estimate that a one percentage point drop in the return on equity (and the equity risk premium) might reduce the earnings per share growth rate from selling new shares by close to one percentage point, and the growth from retained earnings by the same, cut stock prices by 10% and reduce the price of energy to consumers by 1-2 % as well, the latter being a real attraction in this era of consumer discontent.

Those outcomes would reduce investor prospects from superior, in light of the cost of capital, to perhaps only reasonable for investors seeking steady earnings growth and a decent dividend. We might want to wait until the affordability crisis peaks before buying, though.

By Leonard Hyman and William Tilles for Oilprice.com

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