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Themes In Utility Markets & Regulation: 2016 & Beyond February 3, 2017

The following post is an excerpt from a report by Regulatory Research Associates (RRA), a group within S&P Global Market Intelligence. To learn more about the full report, please request a call.

In many respects, the themes prevalent in utility regulation during 2016 were consistent with those observed in recent years. There was capital spending in the power, gas and water utility sectors driving regulatory trends for those sectors; merger activity continuing at a steady pace; regulators and legislators scrambling to address the challenges presented by these traditional issues, as well as those arising from the evolution of new technologies and resources; and, industry stakeholders responding to the need for improved safety (both from physical and cyber threats to utility systems), reliability and environmental concerns.

However, in 2016, industry stakeholders had yet another nuance with which to contend: the general election. For most of the year, it was commonly thought that the Democrats would retain the presidency and that the new administration's policies would largely be a continuation of those that prevailed under the Obama administration. The election of President Donald Trump and the Republican party's retention of control in the Congress caused many commonly held beliefs about the direction of the industry to be called into question.

Capital Spending

While final data is not available for 2016 yet, as of October 2016, capital expenditures were expected to reach $116 billion for the 43 power and gas utility holding companies followed by Regulatory Research Associates, an offering of S&P Global Market Intelligence. RRA's current thinking is that 2016 cap ex will reach $120 million in 2016 and exceed that level in 2018 and 2019.

About two-thirds of capital spending will be dedicated to regulated operations, with spending driven by pent-up demand to replace and modernize aging infrastructure from decades of under-investment, system hardening and storm restoration costs, environmental compliance, new resource needs and the transmission to accommodate new sources of capacity, as well as new technologies.

In stark contrast to the power and gas sector, in the gas midstream sector, the consensus view is that capital spending will fall significantly across all business models over the 2016 to 2019 time frame. Unstable energy prices and the expectation that oversupplies of oil and natural gas will persist are largely driving this trend.

With respect to the water industry, the need for significant investment to upgrade the nation's water infrastructure has been clear for some time, with water quality issues such as those that arose recently in Flint, Michigan raising public awareness of the topic.

Rate Case Activity

The sustained growth in capital spending has, and will continue to, lead to a robust level of rate case and regulatory activity, particularly at the state level.

Recent activity nationwide reached a peak in 2010, when there were about 130 rate cases decided. The level of activity has moderated somewhat since then, but remains substantial, with about 100 cases decided per year since then.

In 2016, RRA tracked a total of 114 rate cases—59 electric and 55 gas. (For additional information, refer to RRA's Past Rate Cases and Pending Rate Cases databases.)

There have been only a handful of water cases that RRA has followed in each year since the team initiated coverage in 2014, but this is largely due to the fact that only 15% of the industry is investor-owned.

The ratemaking framework at the federal level is not conducive to the same type of statistical analysis, but for the majority of the companies that RRA covers, the electric transmission operations regulated by the FERC are subject to formula-based rates that adjust annually.

FERC sets rates for interstate gas pipeline services in a number of different types of proceedings, but rates are most often set when a company seeks to construct a new pipeline.

(For additional information concerning FERC's regulatory framework for electric transmission and gas pipelines, refer to RRA's FERC Review.)

ROE Trends

At the state level, perhaps the single most controversial issue in any rate case is the determination of the appropriate authorized return on equity. While it is true that most commissions rely on well-known formulas, it is also true that the inputs used in these formulas can vary widely, resulting in large differences of opinion between the utilities, representing investor interests, and intervenors largely representing customer interests.

Average authorized ROEs for electric and gas utilities have been trending downward since peaking at close to 16% in 1982.

In 2016, RRA reported the average authorized ROE for electric utilities at 9.77% for gas, and 9.5% for utilities. Excluding incentive returns approved in limited-issue rider cases, the electric ROE average was 9.6% in 2016. (For additional information, refer to RRA's Major Rate Case Decisions Quarterly Update.)

While RRA has not yet compiled an authorized ROE average for the water sector, anecdotally, it appears that state commissions generally accord water utilities ROEs that are somewhat higher than their energy counterparts.

For electric transmission operations, in many instances, FERC-approved ROEs include incentives for participation in a regional transmission organization, or RTO, and for specific reliability-focused projects, resulting in ROEs as high as 13%.

With respect to gas pipeline ROEs, the majority of cases are resolved by "black box" settlements that do not specify the underlying components. However, in two 2016 fully litigated rate cases, FERC approved ROEs of 10.55% and 11.55%.

In RRA's view, this era of aggressive capital expansion according a reasonable opportunity to earn the authorized return is even more important than the ROE itself. Hence combatting regulatory lag has been, and will continue to be, a predominant theme.

There are several "remedies" that have been part of the traditional regulatory construct for decades. For example, a few states permit inclusion of construction work in progress, or CWIP, in rate base for a cash return. Other remedies include use of forecasted test periods, recognition of known and measurable changes to test year expenses and rate base, interim increases, deferral/tracker mechanisms and settlements to shorten the rate case duration.

Non-traditional regulatory constructs

In recent years there has been an increasing reliance on more innovative approaches to addressing regulatory lag and RRA expects the proliferation of these constructs to continue in the future, namely rider mechanisms, alternative regulation plans and rate design innovations.

Rider mechanisms, also known as adjustment clauses, allow the company to adjust rates between rate cases for certain limited-issue items. Among energy utilities, the most prevalent of these are for fuel/purchased power and gas commodity costs, which have been in use since the 1970s. In the ensuring years, the user of riders has expanded to include other types of expenses and also certain types of new capital investment.

For additional information concerning rider mechanisms, refer to the RRA Topical Special Report, Adjustment Clauses: A State-by-State Overview, and to the Adjustment Clauses sections of RRA's Commission Profiles.

Alternative regulation plans can be broadly or narrowly focused. Broad-based plans include formula based ratemaking frameworks, where authorized return parameters are set at the inception of the plans, and rates can adjust automatically on an annual basis within a certain range to reflect certain changes. Other plans provide for overall earnings sharing. More narrowly focused plans provide for innovative treatment of a specific asset or class of assets, or provide earnings enhancement opportunities for performance, with respect to certain operational metrics.

In addition to a trend toward reducing intra- and inter-class subsidies, utilities and commissions have been focused on addressing declining sales growth. There are two "rate design" solutions to this problem – decoupling mechanisms and straight fixed variable rate design. Over the last several years there has been broader use of revenue decoupling mechanisms, with some states, such as Massachusetts virtually requiring companies to file for implementation of such mechanisms. While not many jurisdictions employ a full straight-fixed-variable rate design, with Ohio being the only one, and then only for gas utilities, there has been a movement over the last few years to increase fixed charges to recover a greater portion of fixed costs.

Merger Activity

The level of merger activity has ebbed and flowed over the years, but in recent years the appetite for strategic combinations has been steady. However, the drivers of the deals are changing. See RRA's Topical Special report entitled Electric and Gas Utility Mergers and Acquisitions ─ Timeline of Transactions 1985-2016 for additional details.

In the late-1980s and early-1990s, the desire to achieve "synergy savings" that allowed companies to expand their operations and avoid frequent rate case filings largely drove mergers.

In the wake of electric industry restructuring in the late-1990s, the focus changed somewhat and the perceived need to reach a particular level of critical mass, with respect to generation portfolio expansion, largely drove merger activity.

In the wake of the 2008 financial crisis, many companies adopted a back-to-basics strategy that saw ownership of generation assets becoming even more concentrated. More recently as power market prices have receded, the emphasis has shifted to reducing exposure to market price risk.

Private equity investors have also become more prevalent in recent years and there has also been an increased interest in the acquisition of U.S. utility businesses by foreign entities. Other recently completed mergers were designed to capitalize on convergence opportunities in the electric and gas sectors, as well as the expansion opportunities in the gas midstream space.

As these deals have become more complex, scrutiny by regulators has intensified, and the related proceedings have become somewhat more contentious and protracted.

What does this mean for 2017?

*RRA expects capital spending in the power, gas and water utility sectors to continue to rise."

*State-level rate case activity will remain robust."

*ROEs may continue to fall, even as interest rates rise due to 'regulatory inertia.'"

*The fundamental structure of the industry is changing from a monopoly "build-it-and-they-will-come" structure to one driven by competitive markets and customer preferences. The regulatory framework will need to adapt to accommodate these changes, raising new challenges for utilities and regulators."

*Merger activity will continue to be steady and varied, and regulators will seek to extract increasing benefits for ratepayers."

What about Trump?

*While Trump will have little direct influence on state-level regulation, his support for infrastructure improvements to spur economic growth is compatible with utility spending plans."

*Trump's emphasis on reducing regulation could prove supportive of merger activity in the utility sector."

*With the appointment of a new FERC chair, three vacancies, and a fourth commissioner's term expiring in mid-2017, there is certainly the potential for Trump to change the composition of the commission. However, policy changes at FERC will likely occur gradually regardless of who Trump names to these vacancies, as the FERC staff is highly precedent-oriented."

*Despite Trump's antipathy for renewables and skepticism with respect to global warming, renewables proliferation will continue, even if the Clean Power Plan is ultimately overturned, as these initiatives have support at the state and regional level."

*By and large, tax policy will be the driver of energy policy. RRA finds it unlikely that an overarching federal energy initiative or legislation would garner much sufficient support, even with the Republican majority in Congress, as, again, these issues tend to run along regional lines rather than party lines."

*Lower corporate tax rates are likely to become a reality, and will most likely generate a good deal of regulatory activity as state commissions assess the impact on revenue requirements. Much depends on the specifics of how such a change is implemented and what other changes there are. Consequently, the ultimate impact is hard to assess at this juncture. But one thing is certain, regulators will want to capture any net cost savings at the utility level for ratepayers.

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