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Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…
The CEO of America’s largest utility, EXELON, foresees blackouts in the US in 2027. To boost power supply Calvin Butler wants states to allow his utility to build new power plants. Opponents will object, saying this would saddle utility consumers with the risks. Whereas now, the builders take the risks.
Meanwhile, we are scratching our heads because economists have long theorized that utilities build excess rate base in order to raise earnings. We would amend this to argue that utility managers only deploy excess capital when they can earn more than their cost of capital (would you invest to earn 8% if you had to pay 10% for the borrowed money?), and we are absolutely convinced that utilities have been earning more than cost of capital for decades. In other words, they should be over- investing like crazy in facilities that would prevent things like electricity blackouts.
But they aren’t. Back before COVID we presented a paper saying that the electric industry was underinvesting by close to 50%. Capital expenditures have risen substantially, but they still look too low. And if EXELON’s CEO is right, we will know soon enough.
We examined industry investment for 2004-2024, the period following the corporate reorganizations resulting from the restructuring of the industry. ( Data was not yet available for 2025.) Sure enough, we found that utilities increased their rate base by about 5.5% per year, although sales rose only 0.5% per year. Meaning a lot of extra investment is not required by customers, a sure sign of padding the rate base? Not so, because after adjusting for the cost of inflation, we estimate that the utilities added only 1.2% per year to the rate base in real terms. That’s not much padding. Probably not enough to replace the old plant, no less prepare for the expected demand and environmental challenges.
We’ve been trying to figure out why an industry that thrives on rate base expansion in a regulatory environment didn’t spend more. Perhaps managements were too focused on short term financial results calculated in current dollars, or because most of them don’t have engineering or construction expertise anymore, or because they fear the political pushback of approaching their regulators with the bad news (need to raise prices), or because they plan to let their successors handle the problems, or because they take their cues about the world around them from their comforting trade organization. We leave the answer to the psychoanalysts.
The warning from the boss of EXELON, Mr. Butler, however, hints at a different line of inquiry. In the transmission region (PJM) served by EXELON, many of the states bar regulated utilities from owning or operating regulated power plants, in order to foster competition in the generation market and to protect consumers from the risks of power plant construction and operation. (In the old days, consumers got stuck with the bill if the local utility overspent on a construction project. In the competitive market, the builder or operator has no fallback buyer who will pay the costs for their error.)
But there is a fallacy in that reasoning. The financial risk does not go away, and the power plant builder, who no longer has the backup of the utility ratepayer, has to be compensated for the greater risk by earning a higher return on both debt and equity, perhaps one-third higher. If potential builders don’t see a good chance to earn that higher return, they will put their money elsewhere, that is, not build power plants where potential returns do not reach their cost of capital. Keep prices down artificially, and don’t expect new supply to fill the capacity gap. In other words, all utility customers pay to cover financial risks already through a pricing mechanism rather than through the regulatory process. If not, no new investment.
At the same time, local governors are upset by already high prices. And while they can influence state regulators, the regional transmission organization reports to the Feds at the FERC. So what’s the solution, especially if it looks as if the market will not provide the needed reliable energy?
Okay, doomsayers, by and large, warn people in order to prompt action to prevent or mitigate disastrous events. They hope to evade Cassandra’s fate. Maybe the lights won’t go out on a colossally large scale in 2027, but based on degrading reliability trends, they will go out in many places. Is it time to look for new remedies before we have to tell consumers not to expect electricity service when the temperature rises above 90 Fahrenheit or on alternate Thursdays? Just a thought.
By Leonard Hyman and William Tilles for Oilprice.com
Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…
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