Imagine if you could put your savings into an investment where you were guaranteed a safe 10% return. That would be a good deal, considering that the Federal funds rate at which banks borrow as I’m writing this post is 4.33%, which is about what the top savings banks pay, and roughly what the 10-year Treasury rate is. If that sounds like a deal that’s too good to be true, then you don’t work in the electric utility industry. Because that’s how utilities make their money, and why utility bills to consumers are so high.

That statement might seem too simplistic, so it helps to start by explaining the business model of an investor-owned utility. The company that runs the power line connected to your home is not like a normal business. It’s a natural monopoly, since having two sets of wires to each home would be foolish and wasteful. But that doesn’t mean it can charge whatever it wants. In America, investor-owned utilities have a political deal with the public they serve. Utilities face no competition, but they must supply electricity to all-comers in their region. And their prices are set by public commissions. To raise prices, a utility has to ask the government for permission.

How does a commission make such a determination? Well, the basic idea is the consumer price incorporates what it costs to run a utility, including a reasonable profit. Ongoing costs, like employees, fuel, management, and so forth, get passed along to customers directly. Longer-term assets are treated differently. When a utility builds a new power plant, transmission or distribution line, they recover the cost over the equipment’s useful life, often a decade or more. Of course, if an investor puts in a bunch of money into a new piece of equipment, they expect a return on that capital, to compensate for the return they might otherwise have gotten had they invested it elsewhere, like bonds or the stock market. So utilities are also allowed to recover this “cost of capital,” equal to the return investors would receive on investments of comparable risk to utilities. That’s how Louis Brandeis and the Supreme Court defined “just and reasonable” rates for utility rate-making, that the rate of return utilities could pass through to customers should be equal to the market-based cost of capital.

In practice, what that means is electric utilities make money in a simple and predictable manner. They invest in machinery and other equipment, and are allowed to get paid a fixed profit margin of the cost of that investment. So far, so good. Now, here’s the problem. That fixed return on equity amount is 10%, which is much higher than the “just and reasonable” market-based cost of capital. This excess ROE creates two problems. First, it’s effectively an unearned surcharge on your monthly bill, on the order of 10%. Second, and worse, it creates a perverse incentive for utilities to over-invest. This “goldplating” incentive compounds year after year and is why utility bills have skyrocketed in recent years.

One way we know this: public utility rates, for decades, have been ~15% lower than Investor-owned utilities. Over the last 4-5 years, publicly owned utility rates have lagged inflation by ~40%, whereas investor-owned utility rates have exceeded inflation by >40%. Publicly owned utilities don’t have the same incentive to over-invest.

But internally, a utility holding company gets money from investors at a much lower rate, something like 5-6%. That screws two different sets of people. There are of course the consumers, you and me, who pay higher and ever-increasing rates. But it also screws investors, who are getting a 5-6% return from holding companies, missing out on the extra 4-5% that comes from the 10% regulatory guarantee. There are trillions of dollars in pension money that would flood into the utility sector with a much lower guaranteed return than 10%, but they can’t invest their capital directly into the sector.

This rent extraction explains why stocks in electric utilities are worth roughly twice their actual investment in equipment. It’s just pure extra pointless profit to Wall Street driven holding companies, paid for by consumers on the one hand, and today’s investors on the other.

It wasn’t always thus. In February, I wrote a piece on this dynamic called Power Moves: How Electric Utility Monopolists Broke Their Bargain with America. In it, I put up a chart from an article titled What Went Wrong with Rate of Return Regulation? You can see that prices came down from the 1890s to the 1970s, except for a blip in the 1920s when robber barons took control of the industry. We just got better at delivering electricity over time. But in the late 1970s, a set of inflation spikes and credit crunches led policymakers to re-imagine the regulatory state. Americans became convinced that we had to be nicer to capital to allow firms to make the investments that could unlock supply and stop the persistent spiraling upward of prices.

Specifically, utility lobbyists decided to make a broad persuasion case that shareholders weren’t being sufficiently rewarded, and so the industry couldn’t get enough capital for equipment. The industry formed a new trade association, originally called the “National Society of Rate of Return Analysts” and now called the Society of Utility Regulatory Financial Analysts (SURFA), to convince regulators they needed more money to entice shareholders to invest.

Rates started going up. And since this chart was created, it’s gotten worse. In other words, utilities have managed to convince regulators that they need a guaranteed 10% return on equity, or else they won’t be able to raise any money to invest in keeping the lights on or doing a green transition or building the power for a new data center, or whatever. So prices to consumers have to be high enough to cover that amount. Often the actual utility is owned by a holding company, which can confuse regulators, leading to unnecessarily higher rates.

America is now at a boiling point on this problem. Like you, I get a monthly electricity bill. And like you, I have been noticing that it is really high, unusually so, and not just because of the weather. Axios just reported that the price per kilowatt/hour went up by 6.5% over the past year, framing the cause as the rise in data centers and the resulting competition for electricity. Here’s the U.S. Energy Information Administration’s chart demonstrating the pain that each of us feel when we get a bill.

The New York Times did a long piece with lots of scare stories about how AI and data centers is going to drive up rates. Here’s the paragraph conveying the key misimpression.

Nationally, the average electricity rate for residents has risen more than 30 percent since 2020, after years of relatively modest increases. Much of that increase has been driven by utilities’ catching up on deferred maintenance and hardening grids for extreme weather. In the coming years, A.I. could turbocharge those increases.

It’s certainly true that data centers are competing for energy and water resources; Tucson just voted down an Amazon data center, to the cheers of the town. But you can tell that the story isn’t coherent because the reporters blame previous massive increases on “catching up on deferred maintenance and hardening grids for extreme weather.” If that were true, then we should see a better more reliable grid. We don’t. According to the North American Electric Reliability Corporation, a very polite regulator that tracks electric power reliability, the U.S. electric grid faces “mounting resource adequacy challenges.”

But the rate of return problem is really what’s hitting us and driving up rates while not putting the money to work where it needs to be. In fact, the data centers which are increasingly villainized for a variety of reasons are themselves consumers of electricity, and would benefit if the utilities had a lower return on equity. Most of the charge we get from utilities isn’t actually the cost of electricity, it’s the monopoly charge for distribution of that electricity to our homes. And that charge, for investor-owned utilities, is set by public utility regulators

With some exceptions, these regulators get very little scrutiny from the public or elected leaders, and so they tend to side with utilities for rate increases even when it doesn’t make sense to do so.

California Public Utilities Commission

It’s useful to offer an example of feckless regulators too timid to stand up to nonsensical analysts explaining why they should be allowed to extract from the public. And keep in mind these decisions are cumulative; an excessive rate hike gets built into the new base rate, so a new rate hike incorporates the old excess amount and builds on top of it. And what I’m showing below is just one example. There are many.

From 2021-2022, during the Covid crisis in California, utilities faced something they were not used to - the prospect of having to reduce utility bills. Utility holding companies get to cover their cost of capital with rates to consumers. But in California, if the cost of capital has some sort of radical change, because bond rates go up or down by more than 100 basis points, there is an automatic shift of utility bills through what’s called a Cost of Capital Mechanism.

In 2021, the Fed printed a few trillion dollars, the economy seized up, and interest rates collapsed. So this mechanism kicked in. The cost to utilities of raising capital dropped, so their rates should have dropped as well. They should have lowered the rate of return and utility prices for consumers, cutting revenue to three main utilities: Pacific Gas & Electric (PG&E), Southern California Edison (SCE), and San Diego Gas & Electric (SDG&E). The return on equity - that’s the guaranteed amount for shareholders - should have gone from 10.3% to 9.72%, or about $400 million in customer savings. At 13.6 million households in the state, that’s around $30/per household.

These three utilities, however, applied to the the California Public Utilities Commission and said there were special circumstances. And those circumstances were… that California utility stocks didn’t do as well as the S&P during the stock market recovery. That’s it. Keep in mind that interest rates were at near zero percent, and the rate of return they claimed was too low to entice capital to invest was 9.7%.

That was ridiculous. And the CPUC was told it was ridiculous. Former Sempra and McKinsey executive turned expert witness Mark Ellis testified in the proceeding, and pointed out that the holding company of one of these utilities in its filings to investors estimated the cost of equity that it used when calculating executive compensation was “on the order of 2-3%.” That’s versus a guaranteed return of 10%. Moreover, he noted, each utility told investors that the pandemic had not affected their operations or profits, and that California’s particular regulatory framework protected them from earnings loss.

Ellis’ point was that the utilities were telling Wall Street and the SEC (if you lie to the SEC, you go to jail) something different than what they were telling the state regulators. Did it matter? Nope. The CPUC said that though cutting the ROE from 10.3% to 9.7% would “reduce customer bills via corresponding reduction in revenue requirements,” utilities might be unable to attract capital. So they accepted the utilities’ appeal and kept rates higher than they would otherwise be.

There are many examples like this, and ultimately each is tedious, but they cumulatively result in excess rates on the order of $50 billion a year. There is, however, a backlash.

Minnesota Power and Blackrock

Last May, private equity firm BlackRock struck a deal to buy ALLETE, the parent company of Minnesota Power, for $6.2 billion, including an equity premium of $1.5 billion, or twice what ALLETE has invested.

Already, Minnesota Power has been making far too much, growing its charges at 6.4% a year for the last 9 years, which is more than twice as fast as inflation. And yet Blackrock was willing to overpay for the utility on top of its already assumed high profits, while promising to keep the existing management in place. That’s suspicious; the only reason BlackRock would overpay so much is if it thinks it can get the Minnesota Public Utility Commission to keep granting higher-than-deserved rates. And there’s reason to imagine that would be the case, because the Minnesota PUC is notoriously feeble. On July 11, the Minnesota Department of Commerce reached a settlement with Blackrock, agreeing to approve the deal if the company spent more money on clean energy, and agreed to a one year rate freeze.

But a few days later, an administrative law judge recommended that the PUC not approve the deal, arguing that BlackRock was likely to use financial engineering strategies that would result in demands for higher rate hikes. It’s not clear what happens now, but while the public is clearly unhappy with utility mismanagement, the Minnesota PUC is known for its timidity and willingness to accept rate increases, as long as it is framed around a clean energy transition.

This one, however, is in the public spotlight.

The Upside of Financial Engineering

Ironically, the solution isn’t complex at all. Let’s go back to what I suggested at the top, which is the ability to put savings into a guaranteed 10% return. I would certainly put whatever savings I have into that if I could. Many people would. More importantly, large pension funds would do the same. They would do it for 9%. Or 8%. Maybe even 7%. It’s a great deal! CalPERS had a 10 year rate of return of 7.1% across all of its assets, including stocks and private equity; a riskless 7% investment would be amazing.

In fact, the more you think about it, the more we should ask why we have under-equipped public utility commissions guessing what rates investors need to offer capital to utility holding companies. These companies could just hold an auction, like financiers do in every financial market for virtually every financial instrument. There’s trillions of dollars on the sideline in capital that would likely go into these utilities if they could do so without the middlemen in the holding companies grabbing some with their sticky hands.

Such an auction would wipe out the entire reason for these absurdly bloated public utility holding company empires, bring down prices, and allow for pension funds and savers to get a little higher return. Imagine that, we could have nice things again.

Thanks for reading! Your tips make this newsletter what it is, so please send me tips on weird monopolies, stories I’ve missed, or other thoughts. And if you liked this issue of BIG, you can sign up here for more issues, a newsletter on how to restore fair commerce, innovation, and democracy. Consider becoming a paying subscriber to support this work, or if you are a paying subscriber, giving a gift subscription to a friend, colleague, or family member. If you really liked it, read my book, Goliath: The 100-Year War Between Monopoly Power and Democracy.

cheers,

Matt Stoller