Utilities and their regulators are often protected by a "force field of tedium," but in this episode, I pierce the veil to discuss the complex machinery of utility profit-making. I’m joined by Joe Daniel of RMI to unpack the critical distinction between "return on equity" and "cost of equity," and why the former is almost always higher than necessary. We discuss how regulators can close this gap to lower consumer costs without hindering essential grid upgrades.
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Text transcript:
David Roberts
Greetings, everyone. This is Volts for February 11, 2026: “Are utilities making too much money?” I am your host, David Roberts.
Democratic politics these days is hyper-focused on affordability, specifically energy affordability. This has prompted a great deal of policy discussion about how to bring energy prices down. One proposal — recently outlined in The Atlantic by previous Volts guest Leah Stokes — is to cut back on the amount of money utilities are allowed to make through their capital spending on new infrastructure, what’s known in the biz as their return on equity, or ROE.
Matt Yglesias responded to this proposal by characterizing it as a kind of backdoor degrowth move from the dastardly green groups, as though they just don’t want the utility building anything because they hate energy and prosperity. That is a borderline deranged but I fear perhaps somewhat common misunderstanding.
Ironically, Stokes’ proposal is a quite mild form of what can be a much more radical critique. Longtime energy analyst and expert Mark Ellis released a paper last year arguing that utility rates of return are dramatically, systemically too high and should be pegged to utility cost of capital. While somewhat complicated to explain, this reform would dramatically slash utility profits.
So … what’s the deal here? Who determines these rates of return and how do they do it? Are those rates, in fact, too high? Who might actually lower them, and what would happen if they did? Is this all a devious degrowth plot by the greens?
To talk through all of this, I have with me today Joe Daniel, a longtime veteran in this space — once a fixture on Energy Twitter, RIP — who helps run carbon-free electricity work for RMI. He and his colleagues recently released a paper on rebalancing ROE, so I thought he would be a good guide through what can be a dauntingly complex topic. We’re going to walk through it piece by piece so that ordinary people — even political pundits — can understand the real motivations and stakes involved.
With no further ado, Joe Daniel, welcome to Volts. Thank you for coming.
Joe Daniel
Thank you for having me.
David Roberts
It’s been a long time, Joe. I was certain that you had been on before and I googled and I guess this is the first.
Joe Daniel
Yeah, no, this is the first time I’ve been able to be on the pod, but I’m excited about being here. I’ll tell you what though, I’m not sure I’m excited about the emails that we’re going to get after this pod is released.
David Roberts
That’s pod life.
Joe Daniel
Yeah, this is a spicy topic in our communities.
David Roberts
Yeah, it’s pretty funny. It’s spicy in our community and utterly impenetrable from outside our community. There are lots of issues like that. But this, I think even more than most. I once wrote that utilities and utility regulators are protected by a force field of tedium. And I still stand by that. We’re going to penetrate that force field today because this really does matter. It’s very obscure and technical, but it really matters now. We’re going to catch people up so ordinary people, as I said, can understand this. It’s not really that complicated once you understand what the terms mean.
I’ve got a slight preamble to set you up here. People who’ve listened to Volts for a long time know we’ve done a lot of pods on utilities, the utility regulatory setup, et cetera. But I just want to quickly run people through the logic that has led us to this point, and then I’ll hand it off to you.
When you’re creating an electricity system, you discover pretty quickly that you don’t want multiple companies building wires all over your city. You figure out, “This seems like a monopoly. This seems like a natural monopoly.” We’re just going to assign a particular territory to a utility, and that utility will be the monopoly provider of electricity in that territory.
But for obvious reasons, with the railroad mess fresh on our minds, let’s not let the monopoly sell the product they have a monopoly over. That would be crazy. That would invite corruption. They could just set the price however they wanted, etc. They have to sell electricity at cost. They have to sell it to ratepayers for whatever it costs them to produce it.
Then you have a question. How do they make money? If you want to attract private capital into this sector, if you don’t want the government to have to pay the whole freight to electrify the country, if you want private capital to come in, how do you give them returns? How do you attract private capital? The answer to this question was, “Okay, we won’t let them profit on the sale of electricity, but we will let them get a rate of return on investments into electricity infrastructure.” That is how utilities make their money.
So then what is that rate of return on their investments? Normal businesses operating in markets — that is determined by the market, but this is not a market, this is monopolies. How much they get on their investment? The rate of return they get on their investments is established by regulation by public utility commissions.
That, I think, is in as compact form as humanly possible the background we need to understand why you’ve got these public utility commissions setting the rates of profit for utilities. That’s why we have this situation. Now, having set that up, maybe you can tell us in a little more detail what it looks like for a PUC to do this. The utility comes to the PUC with a case, the PUC hears it. Tell us a little bit about how this actually works in practice.
Joe Daniel
Sure. It’s called a rate case. You said that they come in for a case. We call it a rate case because its ultimate goal is to go through the rate-making process that results in the rate sheet being determined — how you and I get charged for electricity. How the utility is allowed to calculate our bill.
The first step in that process is a calculation of revenue requirements. As you well know, and I think most of your listeners know, every state, every utility jurisdiction is slightly different. In some states, they use a historical year to determine revenue requirements. In some states, they use a future test year to determine revenue requirements. However they do it, they essentially say, “All right, we think that in order to operate the electric grid, it’s going to cost this amount of money.” I
Included in that is the operating costs of... let’s say you’re in a vertically integrated jurisdiction where the utility owns the generation, the transmission, and the distribution. It might include the fuel costs to run the power plants. It might include the purchased power prices to trade electricity across borders. It will include the remaining plant balance, the remaining value of that power plant that will eventually be depreciated over time, which represents a former capital expenditure. It includes essentially interest on that because in order to raise money to finance that power plant or the transmission line or the distribution lines, the utility had to raise money. Embedded in that is the interest rate. You can think of return on equity — again, we’re trying to keep this simple, and for the other experts out there, this is a simplified analogy.
David Roberts
We’re doing the 101 version.
Joe Daniel
Yeah, this is just the 101, folks. It’s the interest rate that the utility gets to earn, or their investors, more accurately, get to earn and gets baked into the revenue requirements. Those revenue requirements then get allocated through cost allocation to different customer classes: residential, commercial, industrial. The utility says, “All right, we expect those customer classes to use this much electricity. We want to charge them this number of dollars per kilowatt hour.” Baked into that rate is implicitly a certain amount of costs, including profits.
David Roberts
What the utility is saying to the utility board is, “Here’s the amount of money we need to A, run the system and B, have a little bit of profit, enough profit to attract the capital we need to do this. Basically, our revenue requirements, plus a little bit of return.”
Joe Daniel
I want to take this moment to dispel one common mistake about ROE. Some people think of it as a profit margin, that this is the utility’s profit margin, that they tack this on to your electric rate. But it’s not quite that because profit margin is essentially profit divided by total costs. If you sell a widget for $100 and it only costs you $90 to make...
That’s a 10% profit margin. But a 10% ROE does not translate into a 10% profit margin. This is where the confusing math of that revenue requirement comes into play. A 10% ROE translates into a 16% profit margin.
David Roberts
Why is that?
Joe Daniel
I’m glad you asked. Let’s go back to that analogy of the interest rate on a loan. If you were to take a loan for $10,000 on a 10-year payback period with a 10% interest rate, you would be paying over the lifetime of that loan, 36% of the costs would be going to interest. You’re not paying $1,000 over 10 years, you’re paying almost $4,000. The same thing happens in the revenue requirement calculation where the utility is investing every year in new capital and depreciating that capital and recovering on interest.
A 10% profit margin on the return on equity — that’s the other thing we can dig into — it’s just the equity portion of the investment. You have operating costs and capital costs, and the capital costs are raised through debt and equity. It’s a portion of a portion of a portion of the costs that you get a return on. Still, it represents a higher portion of the bill than the number itself.
David Roberts
I see. I think an important distinction here that we should get out of the way is the distinction between return on equity. As you say, they have operational costs and they have capital costs, and we’re only talking about capital costs, and we’re only talking about the capital that they raise through equity, not through debt. We’re talking about the return on equity. What sort of rate of return do they get on that?
There’s also another term, cost of equity. It turns out that the distinction between cost of equity and return on equity is crucial here. This is technical and a little wonky, but this is, I think, a load-bearing distinction here that we have to keep in our mind.
Joe Daniel
Absolutely. This is really, really important. If ROE is not profit margin — that’s the first myth we’re going to bust today — the difference between ROE and COE has to be the next myth that we bust.
David Roberts
Let me run my crude understanding by you and see if it’s roughly right. When we say return on equity is a number, you can see on paper, it is how much money you’re getting back from the equity. Cost of equity is not a specific objective number. It is the amount of return that will be required to attract the capital. I think, because as I understood it, when we talk about the regulatory compact, maybe people have heard of the regulatory compact.
Joe Daniel
Don’t let Ari Peskoe hear you say that.
David Roberts
I know, I know. I hear Ari in my head. To be clear, the regulatory compact is not a legal document. It’s not written down anywhere. Nobody is legally bound by it. It’s just a descriptive account of the logic of utility regulation here. The idea is, as I said, you don’t want utilities to profit off electricity, but you want to attract capital. You need to offer a return that attracts enough capital. But I think also implicit in that is anything you offer beyond that is just draining ratepayer money into investor pockets — basically, it’s just pure, piratic profit for the investors.
I think that part of the regulatory compact is you’re supposed to offer a rate of return that attracts capital, but no more than that. Is that a fair account of the implicit contract here? Because what we’re coming back to, I think, kind of what the whole pod ends up revolving around is that the cost of equity that would be required to attract capital — utilities are getting more than that. They’re getting return on equity that is substantially exceeding the cost of equity. That is the problem here. Tell me, is that a fair account of what cost of equity means?
Joe Daniel
I’ll start off with a caveat because you had a fantastic podcast on performance-based regulation with my colleague Kara. If you haven’t heard that podcast, for your listeners who haven’t heard it, they should go back and listen to it, because there are situations where we do want to create an incentive for utilities to earn a little extra to “do the right thing,” but not —
David Roberts
Just for doing the normal thing.
Joe Daniel
That caveat aside, I think your explanation is better than many that I’ve heard. I was reading a testimony in a proceeding, and it’s not the first time, and I wish it was the last — it won’t be — where experts, supposed experts in this field have said, “I’m going to use ROE and COE interchangeably.” As you’ve correctly identified, that is fatally flawed.
David Roberts
The delta between them is the whole substance of this critique. I think this is implied in what I said about COE, but maybe just to draw it out: how much return is required to attract investor money is not an objective, factual number that you can just look up. There’s a little bit of opportunity psychology to it. There’s some estimation to it.
Joe Daniel
The way to think about cost of equity is as the opportunity cost for investors who would be investing in some other similar risk profile, similar investment. It’s the stock returns investors forego. The other thing that we need to unpack in what you just said is that there are actually two ROEs we’re talking about. There’s the authorized ROE and the realized ROE, and those two things are not the same. The authorized ROE is set administratively by a regulator, and the realized ROE is what appears on the utility accounting statements at the end of the year and is what the utility actually earns.
David Roberts
The PUC can’t dictate what it actually earns because there’s markets involved and uncertainty, etc.
Joe Daniel
This goes back to — this is going to be, I guess, the theme of today’s call — myth-busting ROE, because a lot of folks talk about the guaranteed profit or guaranteed ROE.
David Roberts
Yeah.
Joe Daniel
That is, strictly speaking, not true. I think it’s important to bring a little data to that conversation because I think it informs that breakdown that you had earlier, which is the exact way that I think about it: authorized ROE, realized ROE, and then the delta between that and cost of equity.
David Roberts
Quickly tell us what happens. The utility comes to the Public Utility Commission, makes its case, Public Utility Commission says, “Fine, you get an ROE of 10%,” and then they go out to do whatever they do in the market and for whatever reason there’s an uptick in the market or something, and they end up earning, I don’t know, 11% or 12%. What does the PUC do? What happens?
Joe Daniel
First, I would love to, because I went up and I pulled up the RMI Utility Transition Hub, which is an amazing database made possible through the amazing work of Catalyst Cooperative and one of our analysts named John Ray. Essentially what we’ve done in one of those many data sets is collect every utility’s authorized earnings and their actual earnings.
David Roberts
Can I guess before you reveal — are the realized earnings reliably higher than the authorized earnings?
Joe Daniel
They are not.
David Roberts
What!
Joe Daniel
I was surprised by this too. The first cut of the data that I looked at, I was like, “Okay, maybe I’m just looking at it incorrectly.” I cut it a lot of different ways. The only thing I can say is I have never felt or personally experienced the phrase “lies, damn lies, and statistics” more.
David Roberts
Wait, is it reliably lower or is it just more or less random?
Joe Daniel
I think there’s two stats that I’ll bring out to give you a sense because there’s a lot of different ways you could cut it. The first is number of utilities that over a 15-year period — in fact, it holds true whether you look at it over a 15-year period or 10-year period. It remains true whether you remove the outliers or not. Basically, on average, about 60% of the utilities are over-earning and 40% of the utilities are under-earning. But in aggregate, as an industry, the utility industry earns about 95% of what their allowed ROEs would imply.
David Roberts
What is the lesson that we should take from that? What is the implication?
Joe Daniel
To circle back to what you said earlier, if the allowed ROE average in the industry is about 10%, which it is — it’s about 10% right now, a little bit higher actually — we can infer that the industry average realized ROE is 9.5. We could say, “Oh, well, the utilities are earning less than they’re authorized,” but if cost of equity is 7.5, they are actually still over-earning by 2%.
David Roberts
Assuming you accept the premise that the return on equity should be roughly equal to the cost on equity. We’re going to discuss that more directly later. If you look at realized ROE versus authorized ROE, they’re under-earning slightly. But if you compare earnings to COE, to the cost of equity, to what would be required to induce their investment in the first place, they’re over-earning substantially. Before we talk about the implications, like why it matters, let’s just make sure we establish, because the main case here is that ROEs are systematically too high.
When we say too high, just to be clear, what we mean is an ROE that exceeds COE, a return on equity that exceeds cost of equity. Is that what you mean by too high?
Joe Daniel
What I mean is that the ROE could be lower and the utility would still attract reasonably priced capital and therefore could still make the investments it needs to.
David Roberts
If that’s true, then all that extra money is just pure profit. It’s just pure skimming profit for the investors. It’s not serving any purpose.
Joe Daniel
It’s certainly driving up costs for customers.
I want to double-click on an important part of this because we could have just said, “COE is this ephemeral market-based opportunity cost,” but it’s driven by market conditions. It’s really intuitive that cost of equity and return on equity can’t be the exact same. You can’t use ROE to set COE. This is why the word “equals” always gives me a little bit of anxiety. In mathematics, if A equals B, then B equals A. That’s not the case for ROE and COE.
If the cost of equity increases, if the cost to attract capital increases, you would expect stock prices to lower, but if the return on equity rises, you would expect stock prices to increase. When I hear somebody say ROE and COE are the same thing, it’s sort of like saying, “Pressing the accelerator and the brake at the same time will move a car forward.” It doesn’t make intuitive sense. That is a really important element of this discussion.
David Roberts
It certainly makes no sense to take it as a premise. It might be that you could show that in practice they are coming out the same, but conceptually they’re not the same. Empirically they’re going to vary. The whole point of this is that you can show that ROEs are higher than COE — maybe not across the board, but very frequently. What is the evidence for that? What type of studies would show that and what have they shown?
Joe Daniel
There’s been a lot. You mentioned Mark Ellis’s paper. He documents it a little bit in his paper. We do as well in ours. Two studies that I’m really familiar with: one came out of UC Berkeley — in fact, it was just updated last year — that looked at the risk premium, which is essentially the difference of the weighted average return on equity that utilities are granted and other similar low-risk benchmarks. What it found was in the early 1980s, the utility returns and a 30-year T-bill or 10-year T-bill roughly moved lock and step.
Then in the late 80s and in the 90s, the treasury bill returns went way down. The yields went way down, down a lot. ROEs went down a little bit. They went from 15% to 13%, but they weren’t reduced nearly as dramatically as some of these historical benchmarks. This study was essentially replicated — I actually don’t know which study came out first. Carnegie Mellon University also had a study. They came out at roughly the same time. The UC Berkeley one was updated. We’ve seen even entities like S&P Global track the risk premium.
They had a big story last year about this that showed that risk premium peaked in 2020. At the height of the pandemic, that premium that utilities were earning was at an all-time high. It’s worth noting that generally speaking, the way academics talk about this is, utilities are not zero risk. It’s not a true guaranteed rate of return. It would make sense for there to be some delta between a 30-year Treasury bill and a utility’s ROE.
David Roberts
Yes, but — and this gets to a question I wanted to ask — it’s not zero risk, but it’s pretty low. It’s about as low as you can find for investors. It’s hard to think of big investments that are more reliable, lower risk than this. It’s a little crazy to me that they’re getting rates of return that exceed what people get in actual markets where there is way more risk.
Joe Daniel
The academic papers that I’ve seen tend to say three to three and a half percent is the economic equilibrium that they would expect. RMI is going to be releasing — I hate to scoop myself, but we’ve been working — my colleague Christian Fong, who has really been leading a lot of our analytical work on ROE and cost of capital and cost of equity, all of these. He’s working with a ROE expert from Wisconsin CUB, a guy named Steve Keim.
We’re about to release a report on cost of equity and the myths of cost of equity. In that report we come up with a range of what we think the industry’s real cost of equity is. It’s, I think, going to be in line with that. Treasury bills right now are at about 4.2%. So, 3, 3.3, 3.8, 3.5 — all those numbers make sense.
David Roberts
Those numbers are very different —
Joe Daniel
Yes.
David Roberts
— than 10%, Joe. Considerably lower than 10 and a half or 11. Less than half, one might even say.
Joe Daniel
Yeah.
David Roberts
Let me just sum this because we got a bunch of stuff we need to move on to. Just to summarize this: the cost of equity, as we say, is not an objective, factual number. There’s a little bit of estimation to it, but there are market indicators you can look at to estimate it. Basically, any which way you estimate it, it comes out substantially lower than the return on equity that utilities are actually making. There’s a substantial body of empirical evidence and analytical evidence and studies that say that utility ROEs are too high in the sense that their ROE is substantially exceeding the cost of equity.
The money they’re getting back is more than they need to get back to induce the investment. That is well established, empirically well established.
Joe Daniel
Well established in both academia and by practitioners. Also importantly, it wasn’t always that case. There was a time when these things were much closer.
David Roberts
Over time as they drift out of... let’s talk briefly then about why that’s happened. If it is possible to roughly estimate COE, and the logic of regulation is that you’re setting ROE roughly at COE, why have they been drifting up beyond COE steadily for 20 to 30 years now? Why is that happening?
Joe Daniel
It’s what I like to call the utility home court advantage. In most states, the utilities — again, not every state, because some states have requirements that the utility has to come in for a rate case every two years — but in most states, the utilities get to pick and choose when they come in for a rate case. It would only make sense for them to come in for a rate case when there’s favorable conditions.
David Roberts
They choose the timing of their rate cases to maximize this.
Joe Daniel
You can’t fault them. Of course they would.
David Roberts
If you think of a business as what it does to make money, then the utility business — what you need to be good at to make money as a utility is sweet-talking PUCs. That’s the business skill you need to rise above in the utility world.
Joe Daniel
I don’t know how much sweet-talking does, but I know that being able to go into that case when you want to and getting as much prep time as you want to build —
David Roberts
Huge information asymmetry too. You have all the information, you have all the money —
Joe Daniel
And they get to choose. There’s a couple of different models that are used to estimate COE and to estimate what a good allowed ROE should be. They get to go in and make their case and then you respond to their case. They had however much time they needed. They had their internal staff and external experts build this case —
David Roberts
And lobbyists and legislators on their side. Just the power to bully you — PUCs are rarely particularly powerful or well staffed or well paid. The utilities have more power basically.
Joe Daniel
Once that case is filed, if you are the consumer advocate, you’ve got a clock. In some states it’s 60 to 90 days to file your discovery and then 30 days after that you have to file your direct testimony and then 30 days after, so you’re on a clock immediately. Most states only have a consumer advocate office with a relatively underfunded, understaffed team —
David Roberts
If they have it at all.
Joe Daniel
— and you might be dealing with three or four rate cases at a time.
David Roberts
Another thing I want to mention, which was the most jaw-dropping thing in Mark Ellis’s paper, is that the PUCs are using this procedure to set ROEs that basically takes for its raw data what other PUCs are granting to other utilities. You can easily see why this all rises together if they’re all just referencing each other.
Joe Daniel
Yeah.
David Roberts
If your only reference for an ROE is what are the other guys giving as an ROE, you see how ROEs in all the PUCs just sort of drift, slowly drift up over time. The way Ellis describes that is so jaw-dropping that I had trouble believing it. Is that genuinely true that PUCs are doing this, are setting ROE based on what other PUCs are offering?
Joe Daniel
Not all states, but it is one of the methods that is sometimes used.
David Roberts
That is just insane.
Joe Daniel
If you think back to the example earlier, the situation earlier where in the late 80s treasury bill yields were declining, the first utility to go in for a rate case, the commission might have said, “Treasury bills were declining, why shouldn’t we reduce your ROE?” They said, “You can lower our ROE, but look at our peers, so you can’t lower it that much. You can’t make us so much lower than our peers.”
It kind of creates a cushion so that there’s a little bit of first-actor disadvantage there. They might have needed to go in for a rate case if they had a big capital plan or whatever it was. You get insulated by the other utilities and then which utilities are you going to pick? Most utilities that I’ve seen use peer metrics don’t pick the five highest ROE utilities. They try to pick three or four that are above and one or two that are below.
David Roberts
Maybe they’re trying to make this absurd model appear more reasonable than it is. But if that’s your model, you pick your own ROE by the comparison set that you pick.
Joe Daniel
This is why in our paper we wholeheartedly agree with this idea that anything that relies on peer metrics or referencing to peer utility groups probably shouldn’t be the basis for setting an ROE. If a utility wants to compare themselves to other utilities, I have no objection to that in principle, but using it to set their returns just does not hold water.
David Roberts
Maybe one thing to draw out about this is the socio-political dynamic, which is, do you want to be the PUC who says to a utility, “Yes, it’s true that all the other PUCs are offering their utilities too high rates of return, but we’re not going to do that. We’re going to be the one PUC to not do that.” Any PUC that does that is inviting a world of pain.
Joe Daniel
I disagree with this because...
David Roberts
Oh, really?
Joe Daniel
Yeah. Utility commissions did that for years. Utility ROEs used to be 15%, they’re now 10%. We’ve been able to reduce utility ROEs in the past and the industry didn’t collapse. It’s still here, it’s still chugging along.
David Roberts
The central thing that people need to understand about this: why are we talking about this? Why does it matter that all these utilities are getting rates of return that are substantially in excess of their cost of equity? This gets back to Matt Yglesias and his reaction to this piece. There’s an intuition that might say the higher a rate of return you give them, the more they’re going to want to build. Right now we’re in a time in the utility sector, in the electricity sector, where we need a lot of building, where we desperately need a lot of building.
What’s the problem if we give them excess incentive to build? We need them to build a lot. What is the problem with return on equity being too high?
Joe Daniel
From my vantage point, if this idea that the higher the ROE, the more the utility is going to just invest in whatever CapEx spending, there is some evidence that there is a correlation between spending and ROE. However, let’s think about what they’re spending their money on. If the high ROEs resulted in utilities only building the most capital-intensive thing available, then every utility would be building nothing but wind and solar and batteries. Those have no operating costs. If you’re going to spend $40 or $35 a megawatt hour on solar versus that same dollar per megawatt hour over the lifetime of that asset on gas, you don’t get any recovery on the gas part of the gas plant.
Yet utilities still invest because the ROEs are so high they could still get enough money, enough value, enough dividends to their investors by investing in a gas plant. This idea that they’re just not high enough and that’s why they’re not investing in the things that we want doesn’t seem to have empirical truth to it. It doesn’t hold up for me.
David Roberts
I think what Matt would say is, “We don’t just want them to invest in wind and solar and batteries. We also want them to invest in transmission lines and gas plants and everything else. We need more electricity infrastructure.”
Utilities have operational spending and capital spending — maintenance and stuff, the kind of stuff you need ongoing — and then new stuff. It’s important here that the return on equity only applies to the capital part. This is what you call what many people call, what I have called on the pod a million times, a CapEx bias — they would rather spend money on the stuff that they can get a return on. One of the obvious flaws here is that this incentivizes them to underspend on maintenance.
Joe Daniel
Yes.
David Roberts
And operation.
Joe Daniel
Yes. You talk about this again — to reference my colleague Kara’s conversation with you on performance-based regulation — there’s all sorts of options available on that. But there’s other issues with this idea of, “Oh, well, utilities will spend more if we just give them a higher ROE,” because they can’t raise infinite dollars. If they could, they would do it at any ROE.
There’s only so much money that they can raise and deploy in a year. Lowering the ROE increases the headroom so they can build more megawatts of whatever resource. At a lower ROE, they can build more transmission for the same cost. You can build more for the same price when you lower the ROE.
David Roberts
In the expert understanding, lowering ROE is not intended to slow buildout and would not have the practical effect of slowing buildout. Is that accurate?
Joe Daniel
That is fair. I even have a hypothesis that — I don’t think this is universally held by all folks that are in this space — but I wonder sometimes that if you lowered the utility ROE because they’re so inflated right now, if you moved the ROE down to closer to the cost of equity, would the utility actually have a reason to spend more? The way utilities deliver value to investors is through dividend payments. That’s based off of the total number of dollars of returns that they produce.
They would earn more returns if they invested in more capital-intensive projects. There is this counterintuitive possibility. There’s not good empirical evidence of whether this is or isn’t true. If somebody were to have pushback on this, I would completely understand it and would welcome to hear it. But I think there is a hypothetical, a theoretical, wherein reducing the utility forces the utility to find more projects that it needs to invest in in order to deliver the same amount of returns, the same amount of dividends to its investors.
David Roberts
You think it might actually accelerate investment?
Joe Daniel
It’s very counterintuitive. The question is, would that outpace the savings that you get from the increase? Second- and third- and fourth-order effects are completely unknown.
David Roberts
Another thing you say about the impact of high ROEs is that they make the transition more expensive overall. This is what irritated me about Matt’s thing. If you are a business in a competitive market, you have natural incentives to economize, to do the most possible with the least possible resources. That’s a natural market pressure. But these utilities are not in markets — they have no such market pressure. If you want them to economize, if you want them to do the most they can with the resources they have, you have to incentivize them to do so.
If all the grid’s problems are solved by just building more stuff instead of using the stuff we’ve already built better, that’s going to be the most expensive conceivable way to do the energy transition. Even if you just want a rapid transition, the cost-effective way to do it is to utilize your —
Joe Daniel
I just want to put it a slightly different way, which is — and I didn’t read Matt’s response, I haven’t read, I read Leah’s initial thing — but right now the utilities are spending a ton on transmission, on distribution, on new resources. There is no shortage of spending from the utilities and it’s actually resulting in a lot of commissions starting to push back, saying, “We have an affordability crisis, we can’t raise rates.” There is a backlash to just unfettered expenditures, which is another reason why utilities don’t do it.
It is complicated. There are all of these second- , third-order effects. There is a lot of theory, there are a lot of differing opinions. It is never as simple or as unnuanced. Maybe this is why we never got into it on Energy Twitter. Even in an hour, we are not going to — we are 50 minutes into this thing and we are not even close to scratching much more than the surface.
David Roberts
Another thing you say about excess ROEs is they make utilities less competitive. Explain that briefly because I thought that was a significant one.
Joe Daniel
In a handful of states, utilities that want to build new resources have to go through competitive procurement processes. You want to build whatever resource it is — gas, wind, solar, batteries, whatever — you have to put it up for bid and you can bid on your own RFP, but the decision has to be at least heavily weighted towards costs. If a utility is earning 10.5% on their investment and an independent power provider or independent developer is willing to accept a 6% or 7% return, then all other things being equal, who’s going to be at a lower cost?
Particularly in states where there’s competitive procurement processes, if you’re a fan of the utility and you want them to compete in these things, they’ll be more competitive. If you want these utilities to have fair competitive processes, just fair procurement processes, if they can’t compete, then I think it’s hard to expect that process is going to be executed in a fair way.
David Roberts
If you’re saying the return on equity we’re giving you is so high that it basically prices you out of the market and all these other developers are going to be able to come in and build cheaper than the utility, is that not extremely obvious, de facto evidence that the rate of return is too high? You’re setting it higher than what the market is telling you it ought to be. It seems like that alone is very obvious evidence that it’s too high. Am I misinterpreting that?
Joe Daniel
That’s why we’re talking. I agree.
David Roberts
Obviously, a lower return could attract capital. You can prove that by pointing out and showing that it’s happening in your own auction. This is as clear a demonstration as you could ask that the cost of equity is lower than what these utilities are getting because there’s a bunch of private entities who are competing and succeeding with that lower rate of return.
What we come to now is what would happen if we reined this problem in. On either end of this, on one end, you have the utilities themselves who, as you know, if a PUC so much as twitches in the direction of trying to rein in their returns or trying to rein in their rate increases or trying to rein them in at all, they go nuclear, they go to war, and they have a lot of power.
We saw what happened in Connecticut with Marissa Gillett. She tried to fight against some rate increases, and the utilities mounted a smear campaign against her that got so intense that the governor had to boot her out. The utilities will say, “I f you mess with our returns at all, investment in your state will collapse. We’ll go invest elsewhere. You won’t be able to have the electricity you’ll need. You’ll have blackouts. The sky will fall,” etc.
Then on the other end of that debate, you have Mark Ellis who’s saying, “Just make the ROE same as the COE, and that will just make utilities market participants like any other market participant, and things will go fine.” Things will go fine if you do that.
That would mean, as we’ve gone over extensively, really substantial — like 50% plus — cuts in their margins they’re making. Mark Ellis says that would be fine. All that would happen if you did that is you would reduce the surplus profits of investors and everything else would be fine.
Where in between those two options should we land here? How should we think about what would happen if you lowered the ROE to COE, which again would mean reducing ROE from like 10.5, 11% down to something more like 4 or 5%?
Joe Daniel
It would, I think, probably be closer to 7.5%, but that’s still a pretty substantial difference to 11 or 10 and a half, which I think is about where the average is last time I looked. I think it depends on how you get there. It’s path dependent. If one regulator in one state for one utility makes that change, there is a market available to investors that they can pick and choose where their money goes. I can understand the reluctance. The reductions to get from 14, 15% ROE that we had in decades past down to 10% didn’t happen overnight. It didn’t happen with one commission making that choice. If all the National Association of Regulated Utility Commissioners, if all of them, all 200 of them were to agree, all at the same time, which seems like a very daunting task — implausible.
David Roberts
But is that legal, I wonder? Are they allowed to, sort of, like, collude?
Joe Daniel
They pass resolutions.
David Roberts
I have no idea what the legal regime is.
Joe Daniel
In that hypothetical, in that wave-a-magic-wand world, Mark is probably right.
David Roberts
If they were all as a collective moved back, if ROE at every one of the 50-whatever state commissions were, say, dropped by three points, a uniform three points across the nation, investors and utilities relative to one another, the position would stay the same. They would all be suffering the same thing. They would all be in the same relative position. I don’t think any of them would stop investing. If you could do this all at once, it would be fine.
Joe Daniel
The other thing that I think is important to acknowledge is utilities have gone through bankruptcies and come out the other side very able to attract capital. Attracting capital is not something that has historically been a challenge for rate-regulated electric utilities.
David Roberts
Let me ask you about this because Mark — I forget if this is in his paper or if it was in conversation or something else he wrote — but basically Mark is like, “I would be fine getting rid of the pretense of PUCs setting rates of return at all. This whole regulatory construct is kind of silly. Financial markets have evolved to the point where there are many, many different ways of raising money. Utilities could just go out and raise money and invest it like normal market participants and they would be just fine.”
I think he thinks the whole regulatory construct has been rendered pointless by events. I’m guessing that is not a super popular or widely held position.
Joe Daniel
It is really innovative. This idea of putting — we talked earlier about resources getting put up for competitive procurement, a reverse auction essentially — doing the same for finance is an amazing, innovative idea. I have had more than one commission staffer and more than one commissioner come up to me and ask me what I thought of this idea. I was like, “I think it’s one of the most interesting ideas I’ve read about in a long time.” Then they ask me, “How do we do this? How do we actually operationalize and implement this?”
I regrettably have said, “I don’t know.” I really hope that is the — Mark, if you’re listening to this pod, I hope that’s the next paper you’re writing, because we need somebody as smart as him to map out exactly the steps and processes necessary to make that happen.
David Roberts
I’m sort of wondering, who is the legal... Who would do that? Is it an individual PUC that would sort of vote itself out of operation? Could an individual PUC do that? Would it have to be a legislative decision at the state level? Would you have to do something federal? Would FERC have to get involved? It’s all unclear to me how that would...
Joe Daniel
I think you would still have the returns baked into rates. I think it’s just the amount of the returns would not be administratively set by the regulator. This was my interpretation. It would be —
David Roberts
By market conditions.
Joe Daniel
We’ve signed a loan agreement with Axe Capital or whoever. This was the lowest bid. We need to give these returns. Instead of the ten and a half percent, it’s now six and a half or seven and a half or eight and a half, whatever it is.
David Roberts
This is a hypothetical, Joe, obviously, but I can’t believe that if you’re a big utility, you’re in a time of massive demand growth, etc., you’re out on the market trying to raise capital, I would bet my eye teeth you can raise capital for cheaper than 11 percent. If you’re out on the market doing this in the finance markets.
Joe Daniel
I think cost of equity is around seven and a half. So, yeah, I think you could do it for about 250 basis points less.
David Roberts
If you reduce these, as we said, you would undo some of the impacts. You would, to some extent, undo the CapEx bias. Although there is an interesting solution to this that I think we should at least mention somewhere that I think they’re doing in the UK, which is: the basic flaw here is that they’re getting return on capital investments and not on operational investments, which to me, just very obviously, the problems that are going to arise from that seem obvious to me. I’m a little puzzled at what they were thinking at the time, but...
What the UK has done is rather than divide up CapEx and OpEx, they are setting rates based on what they call Totex, which is total expenditure — the two combined. That seems like a good idea to me, albeit I’m in a fog of ignorance about most of this stuff. How does that strike you? Is that idea catching on at all?
Joe Daniel
RMI wrote a paper about exploring the options for Totex ratemaking. We did some exhaustive research on whether or not state law would allow for it, which we weren’t able to find definitively that they couldn’t. The way I phrased that was quite legally. Full disclosure: failed to prove the negative. Full disclosure: not a lawyer. If you Google search RMI and Totex ratemaking, you’ll find a really interesting report that we’ve written on it. I think it’s hard to square Totex ratemaking with Ellis’s idea for raising capital.
David Roberts
It’s a different direction, almost the opposite direction. It’d be putting more in PUC hands.
Joe Daniel
At the beginning when you had me on, I said I’m not looking forward to the emails. That’s because this is such a sensitive topic.
David Roberts
Help listeners understand who are the fighters here. It’s sensitive. There are factions that are kind of at war with one another. Who are the interests here who are going to be the authors of the angry emails?
Joe Daniel
I hope nobody. I think I’ve tried to lay it out not to try to paint a picture one way or the other, but to try to take a neutral snapshot of where we are today. There are three folks that when ROE comes up, they immediately get energized. You could decide what direction the energy is going, but there’s the utilities who have a fiduciary to their investors and it is not in the fiduciary interest of investors for the ROE to be lowered.
David Roberts
It’s such a perverse incentive. We should just dwell on that for a second. That is the business. They’re in the business of convincing PUCs to give them lots of money. Of course they have no incentive at all to be honest about this. Their duty to their shareholders is to squeeze their PUCs as hard as possible. They’re doing their fiduciary duty by bullying PUCs.
Joe Daniel
You have a very well-established position on how you view utilities. I think mine’s... We’re not going to get to the exact same page there, but I work in these proceedings. I historically used to be an expert witness. I now advise commissions and consumer advocates, and I tend to work with the realities that are in front of me today. The realities are we should expect the utilities.. It’s very easy to understand where they’re coming from.
David Roberts
Let me ask you this, though. I understand for obvious reasons why they’re going to use their power to fight against this. That’s clear enough. But do they — you cited these studies, there’s a lot of empirical work showing that ROE is way above COE. Do the utilities have counter studies? Do they have an empirical argument of their own, or are they just saying, “Nuh-uh, leave us alone”? Have they mounted an actual credible counter case?
Joe Daniel
This brings us to the second group of individuals who tend to get sensitive around ROE, and that is commissioners and commissions themselves, because they’re the ones approving this.
I’ve met commissioners I agree with. I’ve met commissioners I’ve disagreed with. I have never met a commissioner who didn’t want to do a good thing, the right thing. Every commissioner I’ve ever met wants to work in the public interest and thinks that they are working in the public interest. They are subject to rules and regulations and laws that require them to make decisions based off of evidence in the proceeding. In some states, if one expert said it should be 10.5% and one expert said it should be 7%, those are the only two things the Commission can do. They have to choose one of those two things.
David Roberts
Oh, really? They can’t just say, “Oh, nine sounds like a good compromise to us.”
Joe Daniel
In some states they can, but in some states they can’t. In other states, it almost never gets to that. They get settlements and all of the parties agree to the settlement and the commission can only approve the settlement.
There’s precedents like, “We’ve used this methodology for decades.” The commissioner’s been there for two years.
David Roberts
They would have to... I think PUCs, especially, like traditionally very quiet backwater of public administration, expecting PUC commissioners to do notably radical or brave things is probably futile.
Joe Daniel
Let’s circle back to that, because the thing that I have learned that I had zero appreciation for when I first worked in this industry and now I think it’s the most undervalued yet most important thing is utility commissioner soft power.
David Roberts
Interesting.
Joe Daniel
I want to circle back to that. The third group of people are the consumer advocates. The members of the National Association of State Utility Consumer Advocates (NASUCA), the attorneys general, state consumer advocate, Office of Public Affairs — they all have different names. Citizens Utility Board. They were telling us this in the 90s.
David Roberts
I would think they would be all over this. This is kind of their whole bailiwick.
Joe Daniel
They’ve been talking about this forever and they get really energized. I’m sure they will. I hope that they do reach out to me and say, “Here’s a great example of this. Here’s an example that counters the illustrative thing that you said.” They have been in the trenches for years and in many cases decades.
David Roberts
Are they as a collective sympathetic to Ellis’s view? It does seem like it would be the most consumer-friendly. I don’t know the history.
Joe Daniel
It didn’t help that he includes an entire section saying that they’re —
David Roberts
Oh, right, they’re idiots.
Joe Daniel
Unwilling participants.
David Roberts
I forgot about that. Yes, he does take a few swipes at them in the paper.
Joe Daniel
There are a lot of things in his paper that I agree with and there are some things that I disagree with and that’s at the top of my list of things I disagree with. Yes, consumer advocates hire the same experts that testify for utilities. But that’s because expert testimony is like theater. The first thing you do, the first five to ten pages of an expert witness’s testimony is them bragging about themselves and creating pomp and circumstance establishing credibility. You have to be a credible witness.
“Hey, I helped set the utility ROEs for these other ones and I think yours is too high” is a really credible argument to be making. Mark Ellis, by the way, also has loads of credibility. You don’t have to use those witnesses. There are other witnesses available. That’s why RMI, my team, has just launched Ratepayer Lab, which is an entire platform dedicated to providing technical assistance to consumer advocates.
Why would a consumer advocate have dedicated — if they only have one rate case every three years, which is the case in some states — why would they have an on-staff expert on the topic? They might not. We want to build in-house expertise that we can then serve in the interest of the consumer.
David Roberts
What would you like to see? One thing that’s unclear to me is if the world became convinced of the correctness of Mark Ellis’s take on this, exactly what the sort of sword of Damocles reform is — what’s the one big step you could take to do all this at once? Not clear to me. I’m guessing that RMI has in mind a more incremental, a gentler way of nudging these ROEs down over time. Is that kind of what you are after?
Joe Daniel
There’s a couple of things. First of all, it makes total sense to discontinue the use of authorized ROEs to estimate cost of equity. We need to throw that right out the window. We need to discontinue the practice of using authorized ROE of other utilities and the use of peer groups to set ROE. Throw that out the window. Then I think it’s really important to start thinking about using differentiated ROE to say there are some investments that are just regular maintenance capital expenditures that you have to make, and there are some that are in service of specific state-mandated public policy goals. You can differentiate the ROE on those things and that will make a difference.
David Roberts
But then you’re really getting into policy. Then you’re getting into straight-up policy.
Joe Daniel
Utilities are subject to policy.
David Roberts
Basically, your PUC is making policy, though.
Joe Daniel
I would imagine that would have to be done in service of, you know, New York State has XYZ goal or has implemented... I live in D.C. — in D.C. we have public policy goals for the utility.
David Roberts
Why not reflect them in ROEs? Is anyone doing that?
Joe Daniel
There are very few examples, differentiated ROEs, very few examples. We’re starting to see it come up in gas utilities.
David Roberts
Bruce Nilles actually wrote me and wanted me to ask about this. Is anyone — one thing you might want to do with one of these blended utilities is raise the ROE on their electric investments and lower the ROE on their gas investments to nudge them over time toward electricity, for instance.
Joe Daniel
If you were in a state where you have decarbonization goals, that would make a lot of sense.
David Roberts
Who, in your mind — there are these reforms you can do, but how do you solve... This was the last question on my list here, and in some sense is the most important question, which is how do you solve this first-mover problem? I guarantee everybody in the PUC world saw what happened in Connecticut. It’s real clear where the power balance currently lies. I’m skeptical you’re going to get a brave PUC. Is it a legislature? Who’s taking the first step here? How do you get a network?
How do you get a group movement started here?
Joe Daniel
One is we have to get smarter about the evidence we put in front of the commission because, again, the commission is held to making decisions based off of... In fact, I believe in a letter that that commissioner wrote, she mentioned when she was making decisions, if one party told her the sky was red and the other said it was green, she couldn’t decide that it was blue. I thought that was a fantastic line.
David Roberts
That’s wild.
Joe Daniel
We need to get better information in front of the commissioner.
David Roberts
That one seems like an easy problem to solve. There’s a lot of information that you could just have ready to go and just file it everywhere. That seems like a very solid one.
Joe Daniel
You would need a centralized platform.
David Roberts
Who’s doing that?
Joe Daniel
That’s the goal of Ratepayer Lab.
David Roberts
Ratepayer Lab is where...
Joe Daniel
We hope to build those resources that any consumer advocate or, in a lot of states, the commission themselves have public staff that can file testimony in a rate case, can pull that information and use it. Establish the fact that, “Hey, ROEs have gone down. They used to be 15, they’re now 10. It’s not the end of the world.” Make sure you put all of that into the record.
David Roberts
You could almost argue that no PUC has really fairly considered this yet because all of this evidence that we’re talking about has not been put all in one place in front of one.
Joe Daniel
There are states that already don’t allow some of these practices that have resulted in the drift. I don’t think there’s any state that has really solid, differentiated ROE plus all... I don’t think anybody’s doing it perfectly, but this is not a new... If you’re in this world, this is not completely new. I give full credit to Mark’s paper for launching it into the mainstream. This was a topic that only a handful of folks that I was aware of really —
David Roberts
I would say it’s a combination of Mark’s paper, which did shake a lot of things up, but also just the immense political pressure currently to bring down energy costs, bring down rate costs. There’s a lot of ways to do that that are difficult. But reducing the profit margins of big utility investors seems like politically one of the easiest. If you’re trying to find money to give back to ratepayers, that seems like the most politically popular way to do it, at least.
Joe Daniel
In 2020, when the risk premium was at its all-time high, there was a lot of fat to cut. Utility ROEs have remained relatively flat since then, but the cost of equity has arguably gone up a little bit simply because treasury bills, interest rates have gone up quite a bit. There’s less fat to trim from ROE. But doing it now sets up that long-term win. You can’t do nothing. There is a real important element of what do you do in a situation where you have somebody like Mark with bulletproof calculations that says the cost of equity is 7.5. That first-actor disadvantage is a real problem. We have to remember and remind ourselves that this is the — what’s the Boeing of hardwood? It’s a slow grind.
David Roberts
We’re in kind of a crisis situation here, Joe. We need a lot more electricity. We need to electrify everything. It’s way too expensive. Climate, etc. There’s so much pressure here, there’s so much speed pressure here.
Joe Daniel
That’s why we can’t rely on any one lever. We’re talking about ROE, we’re talking about investments. No financial — I’m not a financial advisor, I’m not giving financial advice here — but no financial advisor I’ve ever heard or talked with or read about has ever said only invest in one thing. It’s all about diversifying your portfolio. We need to do the same for affordability. We need to rein in the financing costs. Absolutely. We can do that through lowering ROE. We can do that through the debt-equity ratio. We can securitize things.
David Roberts
Just to make your point that you’re making right here, lowering ROE from 11% to 7% would reduce ratepayer bills in a meaningful way. This is not purely marginal. This is a real chunk of costs here. I just want to establish that.
Joe Daniel
If we’re talking about affordability for a low-income customer, their bills are about five times higher than they can afford. We’re not going to reduce costs by 80%. Yes, we need to do all of these things that reduce total costs, but we also need to look — if affordability is your goal, we can’t just look at ROE, we can’t just look at reining in utility overall spending. We have to do that. That is a necessary thing to do, but it is not sufficient.
David Roberts
There’s a bunch of stuff to do. But this is an important piece and I think Leah including it as one of her three reflects the fact that the Democratic Party is sort of swinging around to what’s happened here. The political dynamic is the Democrats went all in on affordability before they had really fully thought out the program behind it. It’s getting filled in now. But I do think this is one that is substantively correct for the reasons we’ve discussed. I think it is true that ROEs are too high and it is true that reducing them would probably put some money back in ratepayer pockets with no undue impacts on this.
I also think it’s politically, I think it sounds good. “We’re going to cut back on piratic utility profits” is a very good populist — it sounds good populist. This is only a piece of the agenda, as you say. But I do think this is a good one. It’s where substance and politics come together, I think, here.
Joe Daniel
I need to say two things to that. One is my role as a principal on the RMI electricity team is not political. We wrote a whole menu of options, the electricity affordability toolkit. It is available to folks of all political persuasions and affiliations. I need to say that.
David Roberts
Everybody knows this about RMI by now, Joe, but we’ll say it again, it’s important.
Joe Daniel
If you go to that toolkit, you will see there are a lot of options. It’s not a thin list of things. One of the things that I want to just name on there because we didn’t get a chance to talk about this, is that while ROEs have remained at fairly high levels, the intrinsic risk to the utility has dropped because of things like cost trackers and fuel pass-through and all these other things that the utility has done to insulate it from risk, which is one of the reasons why it is a low-risk investment.
Those things have driven volatility and higher costs to customers. Bringing some of those things in should be paired with — if you’re going to pass a wonky regulatory legislative action, please can I interest you in some additional regulatory actions and fully fund your consumer advocate, fully fund your commission.
David Roberts
Fully fund your PUC.
Joe Daniel
Absolutely. Let them have a budget so that they can hire.
David Roberts
I meant to say that earlier, but I want to say, I say that every time PUCs come up on the show, which is, as you know, quite frequently. A lot of the problems that beset them — and this is true of public administration generally and NEPA and, you know, go down the list — a lot of these problems could be solved if you just fully staffed and funded the agencies involved in administering this stuff.
Joe Daniel
The consumer advocate is effectively the oversight. They also provide a really important balance to the conversations. They’re in every single one of those proceedings. Yes, fund up the commissions, let them staff up, but also do the same for consumer advocates. We’ve seen states let go of consumer advocates and close those offices. That is something that needs to get revisited.
David Roberts
I just want to stress this one more time because I don’t know how common this misconception that Matt has is out there. Just to say it one more time, these reforms we’re talking about — specifically lowering ROE, there’s a bunch of reforms for affordability that you’ve touched on, there’s a million — but this one in particular, there’s no conflict between implementing this reform and having utilities build out power infrastructure rapidly. Those are not at odds.
Joe Daniel
If anything, I think they might be mutually inclusive, but they are certainly —
David Roberts
Yes, I think they are complementary.
Joe Daniel
They are certainly not contradictory.
David Roberts
Joe, this is, as you say, as anyone who’s involved in utilities knows, we could spend 10 hours just discussing the basics of how rate cases work, etc., but I think we’ve done a pretty good job here of giving an overview. Basically, utility investors are making more money than they need to make. One way of reducing costs on ratepayers is transferring a little bit of that excess profit back into ratepayer pockets. That is both substantively defensible, I think, and a good political plank, and not beyond human ken. I think people can understand basically what’s going on here, the dynamics going on here, especially after this discussion.
Thank you.
Joe Daniel
Thank you for having me.
David Roberts
Thank you for listening to Volts. It takes a village to make this podcast work. Shout out, especially, to my super producer, Kyle McDonald, who makes me and my guests sound smart every week. And it is all supported entirely by listeners like you. So, if you value conversations like this, please consider joining our community of paid subscribers at volts.wtf. Or, leaving a nice review, or telling a friend about Volts. Or all three. Thanks so much, and I’ll see you next time.
