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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.


Mr. Harris Plutocrat said...

Amazing that you would cite the The Economist for the proposition that Obama has been bringing risk, especially for an article about one of the most disgraceful (among many) “achievements” of the ultra right wing. The entire world watched the Republicans carry our economy to the brink for their petty partisan careers. Only a fool like Jeff would suggest that this was the work of Democrats. But for professionally partisan hacks like Jeff, this is just par for the course. As noted in Time, “Republicans engineered this crisis by attaching unprecedented ideological demands to a routine measure allowing the U.S. to pay its bills. Finally, Obama and the Democrats keep meeting those demands—for spending cuts, then for more spending cuts, and even for nothing but spending cuts—but Republicans keep holding out for more.” And here’s the Washington Monthly’s take on what was plainly obvious to anyone not gripped by right-wing hysteria:
* Democrats asked Republicans to pass a clean bill, just as GOP leaders had supported many times in the past. Republicans said, “No.”
* Democrats invited Republicans to Biden-led bipartisan talks. Republicans quit.
* Democrats offered a $2.4 trillion debt-reduction package, 83% of which would come from spending cuts. Republicans said, “No.”
* Democrats sought a Grand Bargain, with more than $4 trillion in savings. Republicans said, “No.”
* Several Democrats offered some preliminary support for the “Gang of Six” blueprint. Republicans said, “No.”
* Many more Democrats signaled support for the McConnell/Reid “Plan B.” Republicans said, “No.”

Obviously, Republicans were willing to risk the economy and our credit rating simply because they could play it to their advantage with bedwetting tea party hysterics. And lets not forget that it was you idiots who got us into this mess. Really, your self-delusion is breathtaking.

Jeff Sadow said...

Leave it to my hysterical frequent commenter, trapped in a world where he must find comfort by being hermetically sealed off by a cocoon of liberal informants whose pablum he swallows uncritically to protect his ego from realizing the way the world really is, to seize upon a parenthetical comment very tangentially related to the post to launch a misinformed screed (and thoroughly mistaken in failing to understand the liberal spending and housing policies of the first decade or thereabouts of the 2000s created the economic mess liberal policy now exacerbate). And on this tangential issue, his jeremiad leaves one gaping question unanswered: why are tax increases, which have stifled economic recoveries time and time again, so necessary now to support unsustainable and unneeded spending?