Why Utility Profits Could Be the Next Target

Why Utility Profits Could Be the Next Target

Leonard Hyman & William Tilles

Tue, September 22, 2026 at 6:00 PM GMT+3 5 min read

Electricity prices are heading up. Utility operating costs, raw materials, and fuel (obviously), are all heading up and no sign of stopping. Now higher capital costs courtesy of the Fed can also be expected. All we can say is that it seems like inflation is back, baby.

The Fed recently raised its discount rate and Treasury bond yields hit 5%—their highest level in almost two decades. A utility's cost of capital consists of two parts: 1) the return earned on a risk-free investment (like US Treasury bonds) plus 2) an extra amount added to compensate for the additional risk assumed by equity holders, who take a subordinate role in the capital structure. Does this imply cost of capital has to rise with these costs inevitably passed along to consumers, leading to still higher rates? Well we do know that state public utility regulators set a return based on cost of capital. However, as we pointed out above, there are two parts to the cost of capital determination. The risk-free interest rate, like Treasury's, which is clearly rising, and the equity risk premium. It is the latter figure which allows regulators to have some flexibility. The equity risk premiums allowed by state regulators have ranged broadly over the postwar years from 300-700 basis points over the risk-free rate. Simply lowering equity risk premiums (towards the lower end of their traditional range) would allow regulators to provide consumers some relief. Also, the logic here is kind of obvious. Receiving a generous equity risk premium in return for financing a low-risk, monopoly business is, as they say, nice work if you can get it.

At present, the risk-free return (10-year Treasury) yields about 5%. According to the latest numbers out from NYU, the equity risk premium for the average stock is about 6%. Over the past two decades, that premium has ranged from about 5% to 7%. In other words, equity investors today buying an average stock hope to earn about 11% (5% risk-free yield + 6% equity risk premium) per year. However, utility and power stocks are not average. They are about half as risky as the overall equity market (from a beta perspective). Consequently, investors should be satisfied with an equity risk premium of 2-3%, half that of the broader equity market. (Half the risk equals half the equity premium portion of the return.) Therefore, according to financial theory, utility investors should expect to earn maybe 7-8% per year. That is the cost of their equity capital. In the past two years, the member companies of the Edison Electric Institute (most big investor-owned utilities) earned about 10% on their equity. In other words, they may be earning 2-3 percentage points over their cost of equity capital, which adds roughly 5% to a typical electric bill. From the perspective of a Progressive political agenda, this should be regarded as low-hanging fruit.

Okay, those cost of capital formulas are imprecise. But as a double-check, calculate the industry's market/book ratio, always considered as an indicator of whether the underlying stock was earning its cost of equity capital. Last we looked, the number was in the 180-200% range, indicating earnings well over cost of capital. But why quibble? High means high, and leave the rest of the debate to expert witnesses.

At this point, you would be justified to counter: "What's the big deal? Electric companies have been over-earning their implied equity return for decades. What could possibly jolt the regulators out of their lethargy? For that question, we provide a one-word answer: affordability. Regulators, viewing higher costs, pressure from hyperscalers, expecting no help from a federal energy policy that is both visionless and chaotic, and suddenly under attack from formerly complacent politicians, now have to find meaningful financial offsets to rapidly rising costs they now face from all sides. There is no easier number to cut than return on equity, especially now. Simple as that. Admittedly, this type of cut won't amount to much in the big picture, especially if fuel costs keep going up. But the impact will be felt most keenly by current utility shareholders. Every one percentage point off return on equity cuts earnings for common stock by 10%. That's a lot. This suggests to us the potential for a broader, downward revaluation of utility shares.

Let's reexamine that last point. First, recognize that a re-ignition of inflation is a really big negative for utilities. Every cost increases at the same time, and the cost of money increases too. Then the regulators get mean. This by itself should cause a rerating of the group. But the implied rerating looks large (maybe a 20-30% reduction in the price /earnings ratios of utility stocks). But what is it different enough this time to lead to such a market reaction? Three things stuck out: 1) equity percentages of cap structure are high, 2) equity risk premiums are also high, 3) the industry learned to do very well operating in a low-growth environment with compliant regulators. (Translated into simpler terms, the utilities had too much expensive equity in their capital structures, earned too much on that excessive equity, and got away with it because regulators felt no pressure to do anything to rein in capital costs because they didn't have to raise prices.) An ignition of inflation forces all three of these favorable trends to go in reverse. That's the source of a possible group rerating (which is a fancy way of saying that the market will pay less for a dollar of earnings). But what happens when regulators propose to cut allowed return on equity and the utilities pull back on investment in the rate base, citing the financial requirements of their shareholders? That's when things get interesting.

By Leonard Hyman and William Tilles for Oilprice.com

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