Electricity transmission assets are regulated by the Federal Energy Regulatory Commission (FERC) and the current allowed return on equity ROE has been under attack by state governments in the Northeast. Spearheaded by the Massachusetts Attorney General, in 2011 the FERC was sued by several New England states for setting the ROE too high.
The AG's contention was that a "zone of reasonableness" for allowed returns should be between 7.03% and 11.47%, with a middle point of 9.36% to be an appropriate allowed return. The current allowed ROE is 11.14%, plus incentives, and has remained unchanged since 2006. The states argued the utility's cost of financing has been dramatically reduced since 2006 and needs to be referenced in a lower allowed ROE.
Last year, the states won the court battle and the FERC was order to rework their allowed return calculations. The FERC has recently announced its decision on the new rate structure, based on the zone of reasonableness. However, the FERC decided to set the base rate at ½ the difference between the midpoint (9.36%) and the top (11.47%) and settled on an allowed ROE of 10.57%. More importantly, the FERC has capped the maximum allowed ROE at 11.47%.
In addition to the base rate, the Energy Policy Act of 2005 directed the FERC to develop incentive-based adjustments to the base rate. For example, there is a 0.50% incentive if the utility is part of a Regional Transmission Organization, or ISO, and a 1.00% incentive if the utility is an independent company.
The bottom line is the "average" allowed base ROE in the Northeast would decrease by 0.57%, and will not exceed 11.47%. This decision will reverberate to other segments of the grid as well, with the Midwest MISO having a 12.38% base ROE. The reduced allowed base ROE in the Northeast could become the standard across the country. If the same formula is implemented, Midwest utilities could experience a 1.81% drop in allowed base ROE. This decline would equate to a 14.5% reduction in profit for Midwest transmission assets.
Below is a table of the quarterly average allowed ROE granted by state PUC, from the Edison Electric Institute eei.org. In the fourth qtr. 2013, the average allowed ROE was 9.90%. This is on the low end of a two-decade decline in allowed ROE, peaking in 1990 at almost 13%.
As shown, the new FERC-regulated base ROE rate for transmission assets are almost the same as for non-transmission assets regulated by state PUCs - 9.90% vs. 10.47%. It seems the profit advantage for transmission assets is slowly slipping away.
The goal of the Energy Act of 2005 was to encourage higher investments in transmission projects by providing a higher profit motive. And it worked. Annual investment increased from $5.3 billion in 2001 to $15.1 billion in 2013. The graph below from the White Paper published by eei.org titled Transmission Investment: Adequate Returns and Regulatory Certainty Are Key outlines cap ex for transmission projects from 2001 to 2015. In addition, according to an EEI report, shareholder-owned electric utilities are planning to invest more than $64 billion on transmission construction between 2013 and 2016.
While a measly 0.57% difference in allowed returns seems too small to matter, it really does. Using the $64 billion projected investments between 2013 and 2016, if half is funded from equity and half from additional debt, the 0.57% difference would equate to an annual $182 million reduction in profitability. Much like Senator Evert Dirksen once said, "A $182 million here, a $182 million there, and pretty soon you're talking real money".
Morningstar's take on the announcement is:
The most exposed to the new methodology that will likely result in lower ROEs include ITC Holdings (ITC), Northeast Utilities (NU), Westar Energy (NYSE:WR), and Public Service Enterprise Group (NYSE:PEG), which have large FERC-regulated rate bases and allowed returns above the ROE resulting from the new methodology. The lower allowed ROE could dampen earnings growth for American Electric Power (NYSE:AEP) and FirstEnergy (NYSE:FE), which are planning significant investments in FERC-regulated projects. The least exposed are Edison International (NYSE:EIX) and Xcel Energy (NYSE:XEL), which have significant FERC-regulated investment plans but FERC-allowed ROE near or below the new base.
Southern Company (NYSE:SO), Duke Energy (NYSE:DUK) and PG&E (NYSE:PCG) also have substantial investments in transmission assets. The only probable "winner" will be ITC. They are members of regional transmission organizations and are the only independent transmission company. This would equate to ITC being eligible for the highest allowed return at 11.47%. However, this is a decrease in their current allowed ROE of between 12.16% and 13.88%.
Electric utility investors need to review their company's transmission assets and the rates of returns currently allowed. Investors should monitor the FERC decisions concerning the Midwest ISO as these utilities could be negatively impacted as well. It seems the profitability of transmission investments will become not as lucrative as in the past. This had been a crown jewel in many utility cap ex budgets, but will be no longer.
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Disclosure: The author is long AEP, ITC, SO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.