Rational estimates lead to reasonable valuations.
Steve Kihm is a chartered financial analyst and research director at the Energy Center of Wisconsin.
When setting returns on equity, regulators might be doing the right thing, but for the wrong reason. The U.S. Supreme Court in 1923 established that regulators should set rates of return that sustain investor confidence in the integrity of the utility, and that enable the utility to maintain its credit standing so it can raise the funds necessary to provide service to its customers.1 Regulators seem to be meeting these pragmatic requirements. The problem arises from the manner in which regulators arrive at the authorized returns.
This isn’t a problem in the rate case per se, as the Court has also said that the end result of the process is what’s important, and not the method used to set rates of return.2 However, consequences of a faulty process manifest themselves elsewhere, and with critical impact. An incorrect cost of equity estimate makes it impossible to derive accurate financial valuation estimates.
Failure to understand the actual situation in this regard could cause executives and regulators to make serious valuation errors when analyzing utility resources. Those errors could cost utility investors billions of dollars.
Fallacy of Common Practice
Many rate-of-return witnesses suggest that in principle a utility’s cost of equity (k) can be estimated by the following formula, or by a multi-stage variant of it: