Utilities & the Regulatory Compact: The Legal Basis for 100 Years of Steady Returns
Michael Roomberg, CFA
Portfolio Manager

Michael Roomberg, CFA brings considerable expertise in the energy, infrastructure, and water sectors to our firm's portfolio management team.

About the Video

Utilities offer relative earnings stability, and it has nothing to do with our essential needs for water or power. It has to do with the law. Utilities are the only sector of the market where the right to earn an adequate and reasonable return is actually enshrined in federal law via Supreme Court precedent. .

Utilities & the Regulatory Compact: The Legal Basis for 100 Years of Steady Returns

Commentary

Utilities are often considered a safe haven in times of upheaval in the markets. Society's basic needs for clean water, a steady supply of gas for heating or cooking, or electricity to turn the lights on transcends economic cycles of boom and bust, expansion and recession.

But there is another reason that utilities offer relative earnings stability, and it has nothing to do with our essential needs for water or power. It has to do with the law. Utilities are the only sector of the market where the right to earn an adequate and reasonable return is actually enshrined in federal law via Supreme Court precedent.

In the United States, utilities are considered natural monopolies: It would be inefficient for example, to have two power lines running to your house or four different water pipes competing for your business. So in a series of court cases at the turn of and during the first half of the 20th century—most notably the Minnesota rate cases in 1890 and Hope Natural Gas vs. the Federal Power Commission in 1944—the US Supreme Court found that in return for utilities' accepting an obligation to provide safe and reliable service to customers, that governments should promise to approve and allow rates that allow utilities to earn a "just and reasonable" return on the "prudent and useful investments" they incurs to meet that obligation. This is what is known today as the "regulatory compact."

In Smythe vs. Ames in 1898, the Supreme Court assigned the role of determining what constitutes "just and reasonable" to independent state level commissions.

Here's how this all works today: Let's say a utility determines that it needs to spend $1 million to replace the gas pipes in your neighborhood. It petitions approval to the local state commission.

If the utility commission determines that that $1 million is "prudent and useful," investment it then determines how the utility should pay for it, and what return on this investment is "just and reasonable" to both the ratepayer AND importantly to the utility's OWNERS—all of which is prescribed by federal law.

Typically, commissions direct utilities to finance about 50% of these investments using cash—oftentimes retained earnings in the business—and 50% with debt, often long-term corporate utility bonds. The commission then determines a reasonable return on the 50% of the investment that was paid with shareholder cash, known as an "allowed return on equity." This is customarily about 10%. So on a $1 million investment paid half with shareholder cash (or $500K), the utility is given the ability to increase its annual bottom line net income by about $50 thousand.

The commission then reviews all of the related costs for things like labor, benefits, insurance, maintenance, taxes, and finally the interest on the debt that was borrowed to arrive at a revenue number that the utility will need to achieve to earn that $50k bottom line result, each and every year going forward. This is known as a "cost of service" approach to ratemaking.

In this example, grossing up all of the expenses might equate to an allowed revenue increase of $150 thousand. The commission then divides this money due to the utility by the number of customers that it serves, and each customer's individual usage, to determine the new, higher per kilowatt, or gallon, or cubic foot rate that the utility can charge you, rate increases that are protected by federal law. This regulation is one reason why utility earnings have historically been reliable in both good times and in bad.

SOURCES: www.law.uchicago.edu; www.raponline.org; www.eei.org; Miller/Howard Research and Analysis.

© 2018 Miller/Howard Investments.

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Past performance does not guarantee future results.

DISCLOSURE

Investment products: are not FDIC insured - May lose value - Are not bank guaranteed

Opinions and estimates offered constitute Miller/Howard Investments' judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. All investments carry a certain degree of risk, including possible loss of principal. It is important to note that there are risks inherent in any investment and there can be no assurance that any asset class will provide positive performance over any period of time. The material may also contain forward-looking statements that involve risk and uncertainty, and there is no guarantee they will come to pass.

The information above is from sources deemed to be reliable and is provided strictly for the convenience of our investors and their advisors. These materials are solely informational. Legal, accounting and tax restrictions, transaction costs and changes to any assumptions may significantly affect the economics of any transaction. The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances; accordingly, you should consult your own tax, legal, investment or other advisors, at both the outset of any transaction and on an ongoing basis, to determine such suitability. Any investment returns, past, hypothetical or otherwise, are not indicative of future performance. Do not use this report as the sole basis for investment decisions. Do not select an allocation, investment discipline or investment manager based on performance alone. Consider, in addition to performance results, other relevant information about each investment manager, as well as matters such as your investment objectives, risk tolerance and investment time horizon.

Past performance does not guarantee future results.

© 2018 Miller/Howard Investments.