Lesson 4 of 7
Reading a regulated utility
A regulated utility's earnings come from a rate base, an equity share and an allowed return set by a regulator, not from demand for what it sells.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- A regulated utility's allowed earnings are close to formulaic: what it has invested, times its equity share, times a return a regulator agreed to.
- Regulatory lag is the gap between spending the money and the rates catching up, and it can turn a large capital plan into a weak year for reported earnings.
- Graham's defensive criteria fit a regulated utility unusually well, because its earnings are designed to be stable rather than won in a market.
A regulated utility's earnings are set less by how much electricity or gas it sells than by a formula a regulator agreed to: what it has invested in the system, the share financed by equity, and a return on that equity allowed for the risk of the business.
What the allowed return does to earnings, one rate base held fixed
- Allowed return of 8.0%$400m
- Allowed return of 9.5% · the regulator's decision$475m
- Allowed return of 11.0%$550m
The formula regulators use
Example$10,000m rate base × 50% equity × 9.5% allowed return = $475m
The rate base is the value of the plant and equipment the utility has put into service to serve customers, agreed with the regulator. The equity share is the portion of that base financed with shareholder capital rather than debt, set in the same proceeding. The allowed return on equity is the rate the regulator lets the utility earn on that equity slice, meant to be enough to attract capital without overcharging customers for a monopoly service. Multiply the three together and the result is close to what the utility is allowed to earn, before operating performance moves it up or down at the margin.
Regulatory lag
A utility spends money on new plant continuously, but its rates only rise when a rate case is filed, argued and decided, which can take a year or more. In between, the utility is earning the old rates on a rate base that has already grown, which is regulatory lag: an actual return below the allowed one until the case catches up. A period of heavy capital spending therefore often shows reported earnings growing more slowly than the rate base. That is not because the business weakened, but because the rate case has not been decided yet. Item 7 of Form 10-K, management's discussion and analysis, is where a utility explains the state of its open rate cases, the capital plan driving them, and how much of the gap it expects the next decision to close.
Why Graham's criteria fit here
Graham's seven tests for the defensive investor in chapter 14 of The Intelligent Investor ask for adequate size, a strong financial condition, stable earnings, a long record of dividends, earnings growth and moderate price ratios. A regulated utility's earnings are set up by design to be steady: the rate formula exists precisely to give the utility a predictable return in exchange for accepting a regulator's ceiling on the upside. That is also the boundary. The allowed return is an opportunity to earn, not a promise: nothing guarantees the floor, while the regulator does set the ceiling, and a utility that earns above its allowed return can expect the next rate case to lower its rates.
Berkshire Hathaway's 2007 shareholder letter groups its regulated utilities among "the good" businesses precisely because a growing rate base needs a growing pile of capital to earn a steady return, unlike a business that compounds without asking for more money each year. Utilities also run more leverage than most industrial companies, financed against a rate base regulators have already approved rather than against a cyclical business.
Do it on a real 10-K
- Open Item 7 and find the utility's open rate case: the requested return, the requested rate base and where the case stands.
- Compare the utility's actual earned return on equity with its allowed return, disclosed in the same section.
- Check the capital expenditure plan against the rate base already approved, to see how much regulatory lag is likely.
Check yourself
A regulated utility's rate base is $10,000 million, its equity share is 50 percent and its allowed return on equity is 9.5 percent. What are its allowed earnings?
- $950 million
- $475 million
- $95 million
Show the answer
Answer: B.
10,000 times 0.50 times 0.095 is 475. Each of the three inputs has to be multiplied through, not just the last one.A utility is spending heavily on new plant, but its last rate case was decided two years ago. What is the most likely effect on its reported return?
- It rises immediately as the new plant is built
- It runs below the allowed return until the next rate case catches up, which is regulatory lag
- It is unaffected, since allowed earnings are fixed regardless of spending
Show the answer
Answer: B.
Regulatory lag is the gap between spending on the rate base and the rates catching up to it, and heavy capital spending between rate cases widens that gap.Why might Graham's defensive criteria in chapter 14 fit a regulated utility better than most industrial companies?
- Utilities have no debt
- A regulated return is designed to produce stable earnings and dividends, which several of his criteria test for directly
- Utilities are exempt from his size and financial-condition tests
Show the answer
Answer: B.
The rate-setting formula exists to give a utility a predictable, regulator-approved return, which lines up with the stability Graham's criteria on earnings and dividend record are checking for.Sources
- Item 7 of Form 10-K, management's discussion and analysis: where cost structure, volumes, prices and rate cases are explained.
- Graham, The Intelligent Investor, revised edition 1973, chapter 14: the defensive investor's seven criteria.
- Berkshire Hathaway shareholder letter, 2007: businesses, the great, the good and the gruesome; regulated utilities named among "the good," earning more by investing more.
What this leaves out
- The rate base, equity share and allowed return come from the utility's own regulatory filings and the commission's orders, and each varies by jurisdiction and by type of utility.
- A single formula abstracts a real rate case, which also sets depreciation rates, incentive mechanisms and pass-through cost recovery that move earnings apart from the formula's three inputs.
- The bar chart and worked example use round invented numbers so the arithmetic can be checked by hand.
- Nothing here is advice about any security.