ROE Envy

It must have been a masochistic moment. That is the only way to explain why I balanced my checkbook the same day I read Pacific Gas & Electric?s request to boost its return on equity and receive the same rate as Southern California Edison. It?s asking the California Public Utilities Commission in its cost-of-capital application to allow it to reap an 11.6 percent return on equity (ROE) next year, up from the 11.22 percent floor it received under the bankruptcy deal. San Diego Gas & Electric, which gets a 10.9 percent ROE, is expected to seek the same return as Edison. I can?t really blame them. I, too, would like that kind of return. My bank, however, offers a maximum 3 percent interest rate. That doesn?t mean I?m advocating allowing Edison to reap more than its neighboring investor-owned utilities, but the returns at issue do give me pause for thought. And, I might add, I don?t get any pleasure from the comparison. Call it ROE envy. The contrast in interest rates also made me start asking around about how investor-owned utilities got to where they are today. After all, those interest rates are mighty hefty, especially considering there are deflation fears and interest rates are at historically low levels?at least according to my junk e-mail and faxes. The returns are part and parcel of PG&E, Edison, and SDG&E debt-to-equity ratios?an issue that?s been given much attention since deregulation?s crash and burn. Since the early 1990s, the equity ratio has averaged around 50 percent, and long-term debt in the mid- to high 40s. (The preferred stock, usually a small percentage, brings the total to 100 percent.) The trio?s debt-to-equity ratios, however, went haywire when wholesale power prices went through the roof. Since then, the mantra has been to protect the ratio, specifically to keep the debt portion from rising. At the same time, there is continuing pressure to increase the amount of utility equity, which rubs ratepayer advocates the wrong way. Compared to most other companies, the utilities ?are equity rich,? said Bill Marcus, an economist with JBS Energy. ?Generally speaking, higher equity ratios and higher returns are constructive for cash flow,? said Philip Smyth, director in Fitch?s global power group. Rating agencies want utilities to have more equity and less debt to protect their bondholders. Utilities want higher equity levels to keep their shareholders, particularly the preferred ones, happy. They also want to keep downward pressure on the amount of long-term debt on the books to keep their borrowing costs down. Consumer advocates, on the other hand, push for lower equity levels because higher ones mean higher rates. ?There needs to be a fair balance between debt and equity, but it is a complicated matter,? said James Weil, director of the Aglet Consumer Alliance. You never hear from the utilities when they get the benefit of low interest rates on loans, but ?they squeal like pigs when they go back up,? he added. PG&E?s ratio of long-term debt is 48.2 percent, compared to 49 percent for its common equity and 2.8 percent for preferred stock. In its cost-of-capital application to the CPUC, it is seeking to bump up the equity to 52 percent for next year and reap an 11.6 percent return. Edison?s ratio is 47 percent debt, 48 percent equity, and 5 percent preferred stock. It wants to maintain its 11.6 percent return on equity. SDG&E?s debt ratio is 45.25 percent, its equity is 49 percent, and its preferred stock 5.75 percent. While some consider the equity ratio sacrosanct, ?it is not a magic number,? said Lynn LoPucki, University of California, Los Angeles, professor of bankruptcy law. ?There is a lot of variance in the debt-equity ratio, and the fear is that an increase in debt will cause interest rates to rise.? Higher debt creates a ?perception of increased risk,? Weil added. The issue then becomes how much ratepayers pay to avoid higher borrowing costs. Utilities? eyes have been on the rating agencies, which have gone to great lengths to protect their bondholders?the first in line to reap any gain from utilities. Just consider how credit ratings of Moody?s, Standard & Poor?s, and the like have changed. ?A single A rating in 1985 for utilities would be a junk bond today,? according to Marcus. He said that the less stringent credit ratings in 1985 allowed the utilities to build nuclear power plants, which would not be possible in today?s credit climate. In fact, even getting financing to build a private power plant is next to impossible. (For just a moment, imagine that the utility assets were a house you own. The special thing about this house is that while you pay off the mortgage, you reap a return on the equity?in the 11 percent range. At the same time, the interest rate on the remaining loan is about half the rate of your return on investment. Dream on, right. But this is a reality for utilities.) The utility rate of return on equity seems even more out of whack when you look at the average stock market returns, which are not expected to reach the 10 percent range for a good while. ?Utilities are less risky than the stock market, so why are they getting more on their rate of return?? Marcus asked. He also pointed out that few utilities beyond California?s three IOUs receive double-digit returns. In addition, the state?s investor-owned utilities? cost of debt is in the 6-7 percent range, well below their return on equity. The CPUC traditionally sets private utilities? debt-to-equity ratio. CPUC members? discretion to alter that ratio, i.e., to reduce the equity portion, was removed by the PG&E bankruptcy deal and the CPUC settlement with Edison. The debt-equity ratio is, however, one factor in ratings, which involve quantitative and qualitative factors. The rating key, according to Office of Ratepayer Advocates analyst Jim Reid, is the projected stability of the cash flow. ?The cash flow and interest and debt is something we watch closely,? Fitch?s Smyth said. Just to confirm what I already know?kind of like prodding a sore tooth to remind yourself of the pain?I took another look at my bank statement. I, too, keep a close eye on my cash flow, and my ROE envy is palpable.

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