Will Rising Customer Bills Constrain Utilities’ Rate Base Growth?

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Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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October 3, 2018

Will Rising Customer Bills Constrain Utilities’ Rate Base Growth?

We expect the publicly traded utilities to realize 7.5% average annual growth in electric plant rate base over the next five years (2017-2022), a material increase from 6.5% p.a. over the last five years. What will be the implications of for average electricity rates and customer bills? In this note, we present our forecast for the period 2018-2022.

We expect the increase in utilities’ cost of service over this period to drive average system rates higher by 2.9% p.a. Expected customer growth, however, will limit the increase in average residential bills to only 2.1% p.a. – in line with expected inflation over the period. (See Exhibits 5 & 6). For many utilities, the near term need for rate increases will be even lower as they refund their non-rate base related excess deferred taxes, but that will only be a temporary reduction and we expect that by 2022 rates will need to reflect fully the underlying growth in revenue requirements.

Such modest annual increase in rates and bills are unlikely to represent a material impediment to rate base growth, although rate increases could accelerate once the deferred tax refunds are complete. The impact on individual utilities’ rate and bills will vary widely, however, putting some utilities at risk (Exhibits 8 – 11). Additionally, the response of ratepayers and regulators will be conditioned by their past experience of modest rate increases: over 2012-2017, average bundled electricity rates rose by 1.2% p.a. and average customer bills by just 1.0%, less than half the rate of increase we are forecasting and below the 1.3% annual increase in the CPI over this period (Exhibits 12 – 17).

  • To achieve growth in regulated earnings commensurate with the expected 7.5% growth in rate base over 2017-2022, utilities must secure revenue relief over the next five years sufficient to recover the increase in their cost of service. We have modeled for each utility the revenue it would require to cover its increase in depreciation expense, pre-tax return on rate base, and non-fuel O&M expense that could be expected if its five-year capex plan were realized. We then calculated the impact of this required revenue increase on the utility’s average system rate and residential bill.
    • We assume non-fuel O&M expense per customer rises in real terms at the average rate experienced by the utility industry as a whole over the last five years, to which we add 2% annual price inflation.
    • As implied by forward markets, we assume that coal and natural gas prices remain stable over the next five years, so that the cost of fuel and purchased power also remain broadly unchanged.
    • We have assumed no change in the earned ROE, cost of debt or rate of depreciation at each utility.
    • Finally, we assume that customer and load growth continue at the same annual rate realized at each utility over the last five years.
  • On this basis, we estimate that our forecast of 7.5% annual growth in rate base will require a 2.9% annual increase in the average system rate over the years 2018-2022. Customer growth, however, will limit the required rate of increase in average residential bills to 2.1% p.a. – in line with expected inflation over the period. (We use 2018 as our base year to avoid the distortion caused by the reduction in regulated utility rates brought about the Tax Cut and Jobs Act of 2017, which cut utility tax rates from 35% to 21%. See Exhibits 5, 6, and 8).
  • Annual increases in rates and bills of this modest scale are unlikely to represent a material impediment to rate base growth.
    • For many utilities, the near term need for rate increases will be even lower as they refund their non-rate base related excess deferred taxes, but that will only be a temporary reduction and we expect that by 2022 rates will need to reflect fully the underlying growth in revenue requirements.
  • The impact on individual utilities’ rate and bills will vary widely, however, putting some utilities at risk. The ten utilities whose rate base we expect to grow most quickly over 2017-2022 are AGR, DTE, PCG, D, PNM, WEC, XEL, PEG, AEP and ETR. Of these, we expect that:
    • AGR, PNM, WEC and AEP will require increases in average residential bills in excess of 3.0% p.a. through 2022 (see Exhibits 5 – 8); and
    • All ten will require increases in average system rates in excess of 3.0% p.a. through 2022.
    • We expect the regulated utility subsidiaries of the following companies to see their average residential bills increase at an annual rate of 3.0% or higher over 2018-2022: AGR (3.6%), PNM (3.6%), EE (3.5%), ALE (3.3%), AEP (3.2%), WEC (3.1%) AVA (3.1%), and NEE (3.1%).
    • By contrast, we expect the utility subsidiaries of the following companies to require the smallest annual increases in average residential bills: FE (1.3%), POR (1.1%), EVRG (1.1%), NWE (1.0%), EXC (0.9%), IDA (0.9%), ED (0.5%) and SCG (0.1%). (See Exhibits 5 & 8).
  • Facing the largest annual increases in average system rates will be PNM (5.1%), AVA 4.6(%), AEP (4.2%), D (4.1%), WEC (4.0%), ALE (3.7%), PCG (3.5%), DUK (3.5%), and LNT (3.5%).
    • Facing the smallest annual increases in average system rates, we expect, will be NWE (1.9%), EXC (1.8%), SCG (1.7%), ED (1.7%), and FE (1.6%). (See Exhibits 6 & 8).
  • We note, moreover, that the response of ratepayers and regulators will be conditioned by their past experience, which has been one of far more modest growth in rates and bills: over 2012-2017, average bundled electricity rate rose by only 1.2% p.a. and average customer bills by only 1.0%, below the 1.3% annual increase in the CPI over this period. (See Exhibits 15 & 16).
  • To minimize rate increases, many utilities have focused on slowing the growth of O&M expense, but we caution that O&M reductions may have limited impact on rate increases. Our analysis suggests that, on average, a 50 basis points reduction in O&M expense growth reduces average annual rate and bill increases by ~11-12 basis points. (See Exhibits 9 & 10).
    • For the average utility, holding total O&M expenses flat through 2022 would reduce rate and bill increases by ~60-65 basis points.
  • Finally, we note that the long-term relationship between rate base growth and the corresponding required increases in rates and bills tends to reflect certain fundamental characteristics of individual utilities and their service territories that are unlikely to change markedly in the short to medium term. These include:
    • The rate of growth in electric deliveries (MWh) and number of customers, with more rapid growth rates tending to alleviate the impact of rate base growth on average system rates and average customer bills; and
    • A utility’s ratio of EBITDA (a proxy for the return of and on capital invested) to bundled electricity revenues, with a high ratio requiring larger increases in rates and bills for any given level of rate base growth (see our analysis of Sept. 6, Which Utilities Are Best Positioned for Rate Base Growth? How the Cost Structure of Utilities Can Benefit or Constrain Growth in Rate Base).
    • The political sensitivity of rate increases also tends to reflect factors that change little over time, like electricity use per customer and household income. The ratio of average residential bills to median household income in a utility’s state of operation can be used to gauge the political difficulty of increasing customer bills.
    • In Exhibit 11, we rank the publicly traded utilities into quintiles based on these characteristics.
  • Among our preferred utility stocks (see Exhibit 1), four combine rapid forecast growth in rate base with low to moderate projected increases in residential customer bills and average system rates. These are ETR, EXC, FE and PCG (see Exhibits 7 & 8 and discussion on page 8).

Exhibit 1: Our Preferences Among Utilities, IPPs and Clean Technology Companies

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Source: FERC Form 1, company reports, SNL, SSR analysis

We Expect Rate Base Growth to Accelerate to 7.5% p.a. over 2017-2022

Based on the announced capital expenditures plans of the U.S. publicly traded utilities, we estimate the compound annual growth in these companies’ aggregate electric plant rate base, including construction work in progress, at ~7.5% p.a. over 2017-2022, up from 6.5% p.a. over the last five years (2012-2017) (see Exhibit 2). Taking into account non-plant rate base, and allowing for historical rates of equity issuance during prior periods of comparable rate base growth, we expect 7.5% annual growth in rate base to drive ~5.0% to 5.5% growth in earnings per share. (See our note of Sept. 21, Utilities Offer Robust Growth, High Yields, Low Betas and Compelling Risk-Adjusted Returns; Rate Base Growth Accelerates on Surge in Planned Capex and Tax Reform.)

Exhibit 2: Historical & Estimated Growth of the Aggregate Electric Plant Rate Base of

U.S. Investor Owned Utilities, Including Construction Work in Progress (2007-2022E) (1)

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1. Growth estimates for 2018-2022 reflect the announced capital expenditure plans of those publicly traded utilities that have provided such forecasts in their SEC filings and investor presentations. The aggregate electric rate base of the companies providing such capex forecasts is equivalent to ~80% of the aggregate electric rate base of the U.S. investor owned utilities as a whole.

Source: FERC Form 1, SEC Form 10-Q, SNL, SSR analysis

Given the 3.5% dividend yield of the sector, we see regulated electric utilities offering the potential for ~8.5% to 9.0% compound annual returns, absent a significant change in sector PE. We believe these returns compare favorably with long run expected returns for the S&P 500. The forward earnings yield of the S&P 500, based on 2020 consensus eps, is currently 6.7%. Inflation expectations are ~2.1%, based on the difference between the yield on 10-year U.S. Treasury notes and 10-year TIPS, suggesting that investors expect long run nominal returns of ~8.8% on U.S. equities.

While regulated electric utilities appear poised to offer returns competitive with the S&P 500, the three-year beta of the sector is only 0.25. Adding regulated utility stocks to a diversified equity portfolio can thus reduce portfolio volatility without sacrificing returns.

Rate Base Growth Will Drive Increases in Average System Rates and Customer Bills

If utilities are to achieve these expectations for growth in rate base and regulated earnings, they must secure revenue relief over the next five years sufficient to recover the increase in their cost of service. We have therefore modeled for each utility the revenue it would require to cover its increase in depreciation expense, pre-tax return on rate base, and non-fuel O&M expense that could be expected if its five year capex plan were realized. We then calculated the impact of this required revenue increase on the utility’s average system rate and average residential bill. Our assessment of these required increases in utilities’ revenues, rates and bills spans the years 2018-2022 to avoid the distortion caused by the reduction in regulated utility rates brought about the Tax Cut and Jobs Act of 2017, which cut utility tax rates from 35% to 21%.

Importantly, the key assumption underlying our base case analysis is for little to change in the trajectory of the industry. We assume non-fuel O&M expense per customer rises in real terms at the average rate experienced by the utility industry as a whole over the last five years, to which we add 2% annual price inflation. [1]As implied by forward markets, we assume that coal and natural gas prices remain stable over the next five years, so that the cost of fuel and purchased power also remain broadly unchanged. We assume no change in the earned ROE, cost of debt, or rate of depreciation at each utility. Finally, we assume that customer and load growth continue at the same annual rate realized at each utility over the last five years.

On this basis, we estimate that our forecast growth in rate base will raise the revenue requirement of the publicly traded utilities at a pace consistent with a 2.9% annual increase in the average system electricity rate through 2022. Expected customer growth, however, will limit the required rate of increase in average residential bills to only 2.1% p.a. – in line with expected inflation over the period.

Such limited increases in average system rates and residential bills, particularly when measured in real terms, are unlikely in our view to represent a material impediment to rate base growth. Moreover, in the near term, the need for rate increases for many utilities will be even lower as they refund their non-rate base related excess deferred taxes, but that will only be a temporary reduction and we expect that by 2022 rates will need to reflect fully the underlying growth in revenue requirements over the period of 2018-2022.

Sensitivity Analysis

We tested the sensitivity of this result to alternative assumptions as to the rate of growth in MWh sales volumes and non-fuel O&M expense, as well as to changes in allowed returns on equity. We found that changes in the rate of growth in non-fuel O&M expense and allowed ROE have a limited impact on the forecast rate of growth in the average system rate and average residential bill, reflecting in part the limited contribution of these variables to the total revenue requirement of U.S. investor owned utilities (see Exhibit 3). Our analysis suggests that, on average, a 50 basis points reduction in O&M expense growth reduces average annual rate and bill increases by ~11-12 basis points. A 50 basis point change in utilities’ allowed after-tax ROE has a similarly small impact on the rate of increase in the average system rate and average residential bill. In contrast, changes in the assumed rate of growth in volume sales have a more substantial impact on our forecast, with an 0.5% increase/(decrease) in the average annual rate of growth in MWh sales being associated with an 0.3% decrease/(increase) in the average system rate and average residential bill. (See Exhibit 4.)

Exhibit 3: Approximate Breakdown of the Aggregate Revenue Requirement of the U.S. Investor Owned Electric Utilities, by Category of Cost

2017 2018 Est.

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Source: FERC Form 1, SNL, SSR analysis

Exhibit 4: Sensitivity Analysis — Impact on Estimated Increases in Average System Rate

and Average Residential Bill of 0.5% Increases in the Annual Growth Rate of MWh Sales and Non-Fuel O&M Expense, and an 0.5% Increase in Allowed ROE (1)

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1. Sensitivity analyses are independent of each other. The results show are for increases in the variables; decreases in the variable would produce similar changes in the opposite direction.

Source: FERC Form 1, SNL, SSR analysis

Company Specific Forecasts

Our utility-specific forecasts of average system rates and residential bills vary widely, and the scale of these increases may put some utilities at risk.

Specifically, we expect the regulated utility subsidiaries of the following companies to see their average residential bills increase at an annual rate of 3.0% or higher over 2018-2022: AGR (3.6%), PNM (3.6%), EE (3.5%), ALE (3.3%), AEP (3.2%), WEC (3.1%) AVA (3.1%), and NEE (3.1%). By contrast, we expect the utility subsidiaries of the following companies to require the smallest annual increases in average residential bills: FE (1.3%), POR (1.1%), EVRG (1.1%), NWE (1.0%), EXC (0.9%), IDA (0.9%), ED (0.5%) and SCG (0.1%). (See Exhibits 5 & 8.)

Facing the largest annual increases in average system rates will be PNM (5.1%), AVA 4.6(%), AEP (4.2%), D (4.1%), WEC (4.0%), ALE (3.7%), PCG (3.5%), DUK (3.5%), and LNT (3.5%). Facing the smallest annual increases in average system rates, we expect, will be NWE (1.9%), EXC (1.8%), SCG (1.7%), ED (1.7%), and FE (1.6%). (See Exhibits 6 & 8).

Exhibit 5: Forecast Annual Increase in Average Residential Bills, 2018-2022

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Source: FERC Form 1, SNL, SSR analysis

Exhibit 6: Forecast Annual Increase in System Average Rates, 2018-2022

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Source: FERC Form 1, SNL, SSR analysis

In Exhibit 7, we rank the publicly traded utilities by their forecast growth in the electric plant rate base, including construction work in progress, of their regulated utility subsidiaries. The ten utilities whose rate base we expect to grow most quickly over 2018-2022 are AGR, WEC, D, PNM, DTE, PCG, ETR, CMS, AEP and PEG. Of these ten utilities, six will require substantial annual increases in average residential bills through 2022: AGR (3.6% p.a.), PNM (3.6% p.a.), AEP (3.2% p.a.) WEC (3.1% p.a.), D (2.9% p.a.) and DTE (2.9%). At eight of these ten utilities, moreover, we expect annual increases in average system rates of 3.3% or higher through 2022. (See Exhibits 5 & 6).

Among the ten most rapidly growing utilities, there are two where we expect more limited annual increases in average residential bills and average system rates. These are CMS, with forecast growth in electric rate base of 8.6% p.a. over 2018-2022, but projected increases of 2.2% p.a. in residential bills and 2.5% p.a. in average system rates; and ETR, with forecast rate base growth of 8.7% p.a. through 2022 but annual increases in residential bills and average rates of only 2.3% and 3.0% p.a., respectively. PCG is also notable, in spite of projected increases in system average rates of 3.5% p.a., because declines in residential customer usage result in projected annual growth in residential bills of only 1.7%.

Also potentially attractive on this basis are EXC, with forecast growth in rate base of 7.6% p.a. through 2022, but projected increases of only 0.9% p.a. in residential bills and 1.8% p.a. in average system rates; and FE, with forecast rate base growth of 7.8% p.a. through 2022 but annual increases in residential bills and average rates of only 1.3% and 1.6% p.a., respectively.

Combining low forecast rate base growth with high projected increases in average system rates and residential bills are ALE and LNT. ALE combines forecast growth in rate base of only 3.4% p.a. through 2022 with projected increases of 3.3% p.a. in residential bills and 3.7% p.a. in average system rates. Similarly, at LNT we expect rate base growth of 5.2% p.a. through 2022 based on current capex guidance, but annual increases in residential bills and average rates of 2.8% and 3.5% p.a., respectively

Exhibit 7: Estimated Annual Increase in Electric Plant Rate Base Plus CWIP, 2018-2022

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Source: FERC Form 1, SNL, SSR analysis

In Exhibit 8, we rank the publicly traded utilities into quintiles based upon their estimated annual increase in electric plant rate base, including construction work in progress, through 2022, and the corresponding annual increases in average system rate and average residential bill.

Exhibit 8: Quintile Ranking of the Publicly Traded Utilities on (i) Estimated Annual Increase in Electric Plant Rate Base Plus CWIP, 2018-2022 and (ii) the Corresponding Required Increases in Average System Rate and Average Residential Bill

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Source: FERC Form 1, SNL, SSR analysis

As noted above, we have tested the sensitivity of our forecast increases in average system rates and average residential bills to alternative assumptions as to the rate of growth in MWh sales volumes and non-fuel O&M expense, as well as to changes in allowed returns on equity. In the exhibits below, we present the results of this sensitivity analysis by utility, first with respect to average system rates (Exhibit 9) and then with respect to average residential bills (Exhibit 10).

Exhibit 9: Expected Annual Increase in Average System Electricity Rates, 2018-2022,

With Sensitivity Analysis to Increases in MWh Sales, O&M Expense & Allowed ROE (1)

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1. Sensitivity analyses are independent of each other. The results show are for increases in the variables; decreases in the variable would produce similar changes in the opposite direction.

Source: FERC Form 1, SNL, SSR analysis

Exhibit 10: Expected Annual Increase in Average Residential Customer Bill, 2018-2022,

With Sensitivity Analysis to Increases in MWh Sales, O&M Expense & Allowed ROE (1)

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1. Sensitivity analyses are independent of each other. The results show are for increases in the variables; decreases in the variable would produce similar changes in the opposite direction.

Source: FERC Form 1, SNL, SSR analysis

Finally, we note that the long-term relationship between rate base growth and the corresponding required increases in rates and bills tends to reflect certain fundamental characteristics of regulated utilities and their service territories that are unlikely to change markedly in the short to medium term. These include the rate of growth in load (MWh delivered) and number of customers, with more rapid growth rates tending to alleviate the impact of rate base growth on average system rates and average customer bills. Another important factor is a utility’s ratio of EBITDA (a proxy for the return of and on capital invested) to bundled electricity revenues, with a high ratio requiring larger increases in rates and bills for any given level of rate base growth (see our analysis of Sept. 6, Which Utilities Are Best Positioned for Rate Base Growth? How the Cost Structure of Utilities Can Benefit or Constrain Growth in Rate Base). The political sensitivity of rate increases also tends to reflect factors that change little over time, like electricity use per customer and household income. The ratio of average residential bills to median household income in a utility’s state of operation can be used to gauge the political difficulty of increasing customer bills. In Exhibit 11, we rank the publicly traded utilities into quintiles based on these characteristics.

Exhibit 11: Risk Factors that Could Aggravate the Impact of Rate Base Growth on Customer Rates and Bills

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1. Residential bill as % of state median state is calculated as the ratio of 2017 average residential bill to 2016 median household income (the latest available), weighted by the percentage breakdown of each utility’s residential revenues across the states in which it operates.

2. Return of and on capital as % of 2017 revenues is calculated as the ratio of EBITDA (pre-tax earnings, interest expense and depreciation) to bundled revenues (i.e., transmission, distribution and generation revenues, including third party generation revenues collected by T&D utilities).

Source: FERC Form 1, SNL and SSR analysis

Is the Golden Age of U.S. Electric Utilities Coming to an End?

Importantly, the response of ratepayers and regulators to utilities’ future requests for rate relief will be conditioned by past experience, which has been one of far more modest growth in rates and bills that we are forecasting for the next five years. Over 2012-2017, the average bundled[2] electricity rate in the United States rose by only 1.2% p.a. and average customer bills by only 1.0%, below the 1.3% annual increase in the consumer price index (CPI) over this period. By contrast, our forecast is that U.S. publicly traded utilities will require 2.9% annual increases in the average system rate over the years 2018-2022, and 2.1% annual increases in average residential bills. Not only are these forecast rates of increase more than twice those seen over the last decade, but they equal or exceed the ~2% annual rate of inflation anticipated by the financial markets.

As illustrated in Exhibits 12 through 16 below, the last decade have been halcyon years for the U.S. regulated utility industry. From 2007 through 2017, the aggregate electric plant rate base of U.S. investor owned utilities increased by 90%, far outstripping the 35% growth in U.S. nominal GDP over the period (see Exhibits 13 & 15). The scale of regulated utility investment in the U.S. power grid over the last decade is even more remarkable when we consider that MWh of electricity delivered actually declined slightly over these years (see Exhibits 12 & 15). Revenues per customer rose only modestly, increasing by 10% over the decade even as the consumer price index rose by 18% (see Exhibits 14 & 15), implying a real drop of some 7% in the average customer bill.

Exhibit 12: Aggregate Electric Plant Rate Base, Including CWIP, of the U.S. Investor-Owned Utilities vs. MWh Delivered and Electric Revenues per Customer (2007 = 100)

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Source: FERC Form 1, SNL, SSR analysis

Exhibit 13: Aggregate Electric Plant Rate Base Exhibit 14: Bundled Electric Revenue per Customer

Compared to U.S. Nominal GDP (1) Compared to U.S. Consumer Price Index

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1. Aggregate of U.S. investor owned utilities

Source: FERC Form 1, SNL, Bureau of Economic Analysis, Bureau of Labor Statistics

Exhibit 15: CAGR in Electric Plant Rate Base, MWh Delivered, Average

Bundled Electric Rate and Average Electric Revenue per Customer, 2007-2017 (1)

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1. Aggregate of U.S. investor owned utilities. Electric plant rate base included construction work in progress.

Source: FERC Form 1, SNL, Bureau of Economic Analysis, Bureau of Labor Statistics, SNL analysis

Exhibit 16: Growth in Electric Plant Rate Base, MWh Delivered, Average Bundled

Electric Rate and Average Electric Revenue per Customer, 2002-2017 (1)