Rates set ignoring risk bad for LA consumers, investors

My friend Public Service Commissioner Foster Campbell pitched an idea to members of the press concerning electric utility rates in Louisiana. Here’s why in the long run it would be injurious to both Louisiana ratepayers and (some of whom are also) investors.

Campbell mused that the average rate of return allowed by the PSC, the five-member board that sets these rates in Louisiana, at 10 percent allowed too great of a return to providers. He thought more like 8 percent would do, but, of more interest, he thought then pegging that rate of return on equity (even with the state’s current average being in line with regional and national averages) to other investments’ rates of return would do a better job of producing what he considered a reasonable rate of return for utilities, with the implication that today’s allowed rates were too high.

(As a side note, the figures he quoted as comparison benchmarks – 1 percent return on a certificate of deposit and 3.5 percent on a mortgage – if that’s what he gets, he’s got some pretty sweet deals. The average 30-year rate on a mortgage yesterday was 3.96 percent, while the average 1-year CD earned 0.75 percent.)

But this view ignores the reality that risk differs among instruments, and, relative to each other, varies over time. For example, CD rates are based upon instruments that are considered even closer to being risk free (despite the presidency of Barack Obama), treasury paper. As these are essentially risk-free, their basic risk does not vary (their rates thus reflecting only the time value of money). However, mortgage rates do vary in risk over time, creating larger and smaller spreads between the 30-year T-bond and 30 year fixed mortgage rates.

As of yesterday, the spread between the average mortgage and T-bond was 0.914 percent. But earlier this year at its beginning, it averaged 0.478 percent. But when Obama took office, the spread was nearly 2.65 percent. In the beginning of 2007, it was around 1.42 percent. In the beginning of 2000, it averaged about 1.6 percent. Ten years earlier, it was at 1 percent. But at the start of 1983, it averaged about 3 percent.

Simply, because the relative risk of mortgages varies independently from Treasury-backed instruments, tying the two together makes little sense. Even trying to create bands around rates, where spreads could fluctuate, largely is futile because sometimes the spreads have represented very large portions of the actual rates (for example, in early 2009 the spread was almost half of the mortgage rate, and almost as large as the Treasury rate, while earlier this year it was less than a quarter of the Treasury rate and a fifth of the mortgage rate). And mortgages are considered among the safer instruments; equities such as utilities, even if having lower relative volatility compared to other equities, are much riskier still with wider swings in risk relative to other much less risky investments.

Campbell’s scheme could cause imposition of rates of return, when relative low-risk instruments are in periods of lower risk relative to equities, to be so artificially low that they cause providers to cut back on maintenance, service, and expansion, inconveniencing customers and retarding economic growth, and hurt the return of investors, few of whom are wealthy and some of whom may also be customers. It also could backfire, in that in periods of low relative risk of equities to fixed-income, utilities might get “excess” returns.

The current regulatory regime that has analysts prepare for commissioners their best guess about what profit a utility would earn in a competitive market seems more than adequate to take into account complex factors that a simple formula cannot. That Louisiana rates appear on par with others demonstrates no “excess” profits exist in the system. Campbell’s flawed idea is an inferior solution looking for a nonexistent problem.