Challenge

When a utility’s regulated Return on Equity (ROE) for investors exceeds the market cost of capital, they are overcharging ratepayers and the public for the cost of their services. In 2023, the average ROE for utilities (9.6%) was 30 percent higher than the average long-term expected rate of return in the US stock market (6.7%), even as utility equity is lower risk on average.¹ By one estimate, excessive RORs costs roughly $50 billion per year, or $300 per household.² By another estimate ROE accounts for nearly 17% of customer bills and for every 1% reduction in authorized ROE electricity customers could save an estimated $4 billion annually.³

Policy Solution

Legally establish, via statute or regulatory policy,  that a utility’s authorized ROE generally should not exceed the market cost of capital, or set a specific percentage (“hard”) rate cap on utility profits. In addition to lowering electricity rates, other policy benefits of controlling ROE include 1) reducing utility incentives to over-invest in high-return capital projects that may not be cost-effective for customer needs or overall system improvement;  2) limiting rate increases that will slow the clean energy transition by deterring residential and commercial electrification investments; and) creating more spending “headroom” for addressing other regulatory goals such as customer efficiency and incorporating customer-owned DERs for grid reliability and resilience needs–spending which contributes less to ROE but could be incentivized by other means such as Performance Incentive Mechanisms.⁴‘⁵  

Model Policy Features

• Legislation directing utility commissions to adopt a rule requiring that utility ROEs (as authorized in rate cases) are equal or closely matched to the market cost of capital, or utility commissions adopt the same concept by other means such as policy guidance. It should be noted that ROE for regional transmission projects is not regulated by state utility commissions but by the Federal Energy Regulatory Commission.  
• Alternatively, legislation could require setting a hard cap on utility profits, not subject to utility-influenced discretion of state regulators; this approach invites more consistent emphasis on cost-effective spending and cost-containment because capital expenditure (CAPEX) bias is limited by the cap on profits. 
• Regulatory guidance is also needed to establish a common framework of financial principles, modeling assumptions, and data sources to be used in setting utility profit rates and, potentially, addressing specific circumstances of utilities that could justify deviation from the general policy of limiting ROE to the market cost of capital.

Potential Policy Drawbacks and Pitfalls

• If legal requirements or authority to limit ROE are not clear, or if such a policy is only advisory in nature, utilities will continue to have a substantial technical advantage in rate case, including the hiring of expensive consultants who specialize in winning higher ROEs, often by relying on flawed assumptions in modeling  “risk-adjusted” costs of capital.⁶ 
• Overly restrictive measures could adversely impact customer service and system

Complementary Policies

To protect ratepayers from utility profiteering, additional policies to address related aspects of the problem are needed: 

• Rising executive pay, with compensation paid in company stock and thus linked to stock prices, can in part be driven by excessive ROEs,⁷ so policymakers should consider setting limits on stock-based executive compensation in the utility sector; further delineation of such a policy could require executive pay incentives to be performance-based as related to improvements in customer service, cost containment, or achieving system-wide goals for energy efficiency and GHG emissions reductions.   
• Return on Equity could itself be subject to Performance-Based Regulation, for example by adjusting ROE basis points up or down depending on performance in achieving specific goals for system improvements. According to the Rocky Mountain Institute’s database of Performance Incentive Mechanisms (PIMs), out of 297 PIMs in 27 states and the District of Columbia, 93 are based on ROE.  

Additional Information: No state currently has a policy of limiting ROE to the market cost of capital or otherwise setting specific limits on utility profits rates, but some states have examples of lower than average ROEs for reasons that vary by rate case.  For vertically integrated utilities, in 2023 the lowest ROE was granted by the Minnesota Public Utilities Commission (MPUC) to Xcel Energy, at 9.23%, but an Xcel subsidiary sued the MPUC after its appeal for an ROE of 10.2% was denied.⁸