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Compromise Is Worth The Cost for Utilities

Leave it to a utility owner like Sempra Energy to eke out a bump in its stock price after negotiating away tens of millions of dollars in core revenue.

The energy services holding company announced after trading closed Feb. 7 it had reached agreement with consumer advocates to scale back its California properties’ main source of profit, their return on equity.

If state regulators approve, San Diego Gas & Electric Co. and Southern California Gas Co. would see a combined, top-line reduction estimated at $68 million in 2018.

Investors took word of an agreement as a victory for San Diego-based Sempra. The next day, the company’s share price jumped 1.3 percent to its highest point in months. Two other utility companies that saw rate declines as parties to the same two-year agreement also saw stock price gains, even as the broader market remained relatively flat.

However counterintuitive, especially at a time of expectations for higher interest rates overall, the rate agreement’s immediate aftermath reflects the central role regulatory affairs play at Sempra, and how important it can be to work productively with opponents.

It also underscores Sempra’s consistency and reliability as an investment.

Dennis Sperduto, principal analyst at S&P Global Market Intelligence’s Regulatory Research Associates, said investors view the utility sector as among the least risky in the stock market. This particular agreement was significant, he said, because “more than anything, it removes uncertainty regarding the companies’ return on equity and cost of capital.”

SDG&E had a similar take, saying the agreement awaiting approval by the California Public Utilities Commission would ensure its access to low-cost capital while also cutting its customers’ energy bills.

“While there is a reduction in revenue, this agreement provides clarity to investors through 2020, which helps SDG&E/Sempra maintain a strong, investment-grade credit rating,” Amber Albrecht, senior communications manager at the utility, said by email.

The ROE

Under the agreement announced Feb. 7, SDG&E’s authorized return on equity (ROE) would drop 10 basis points to 10.2 percent on Jan. 1, and SoCalGas’s rate would fall 5 basis points to 10.05 percent.

Return on equity is a central concept for investor-owned utilities in California. They are not generally supposed to make money buying and selling energy. Rather, they are allowed to keep a certain share of the money the CPUC authorizes them to invest keeping their power distribution system safe and reliable.

These utilities used to earn substantially more on their money. In the 1980s, their return on equity typically topped 12 percent in California.

SDG&E’s authorized ROE was 10.7 percent as recently as 2007, when SoCalGas’s rate was 10.82 percent. Despite the declines of the past decade, their rates remain above the national average of 9.85 percent in 2015.

The two utilities are considered primary assets for Sempra, a Fortune 500 company that brought in more than $10 billion in 2015. But as a diversified company with some 17,000 companies, it also has operations in other states and in Latin America that are not subject to regulation in California.

It’s important to note that ROEs authorized by the CPUC don’t necessarily dictate profit levels, because utilities can adjust their operating costs, earn bonuses that boost revenues and face regulatory penalties.

In 2003, SDG&E’s authorized return on equity was 10.9 percent, but it ended up realizing an ROE of 27.7 percent. That same year, SoCalGas’s authorized ROE was 10.82 percent, but it recorded a rate of 15.6 percent.

It can go the other way, too: San Francisco-based Pacific Gas and Electric Co. had an authorized ROE of 11.22 percent in 2003, but its recorded return came in at just 7.34 percent.

Negotiated Outcomes

Utilities can try to change their rates by filing an application with the CPUC, which can result in a protracted legal battle as consumer advocates push for lower bills by engaging with the companies over complex financial calculations.

Or, as happened recently, utilities can try to negotiate directly with consumer advocates, in this case the CPUC’s Office of Ratepayer Advocates and San Francisco-based The Utility Reform Network, or TURN.

Mark Pocta, program manager at the ORA, said one reason California’s authorized ROEs are higher than the national average is a perception left over from the state’s 2000-01 energy crisis that utilities operating in the Golden State face greater risk than their peers elsewhere.

He asserted the reality is different, and so he and others at the negotiating table argued in favor of a reduction.

Ratepayer Benefits

Marcel Hawiger, a staff attorney at TURN, said the utilities’ profits are simply too high, and ratepayers should not have to bear such a burden.

“TURN did not feel like we could in good conscience continue the same cost of capital/equity returns as they had,” Hawiger said, referring not only to SDG&E and SoCalGas but also two other parties to the agreement.

Those other parties are PG&E, whose ROE would be lowered from 10.4 percent to 10.25 percent under the agreement, slashing its annual revenue by $100 million, and Southern California Edison Co., which would receive $66 million less per year if its rate is reduced from 10.45 percent to 10.3 percent, as proposed.

The agreement would take effect at the start of next year and extend two years. The negotiated ROEs would only be locked in for 2018, however, because of a built-in mechanism for adjusting rates depending on changes in utility bond indices and long-term debt costs.

Modest Win-Win

Despite the many millions of dollars involved, the agreement is not seen as having a major impact on any company involved.

Sperduto, the analyst at Regulatory Research Associates, said that in exchange for a “slight decrease” in return on equity, the agreement gives Sempra greater assurance it won’t have to go through the time and expense of litigation with consumer advocates in the near term.

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