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What determines a state’s regulatory climate, and what should investors do about it?
Whether a state is traditionally regulated or partially deregulated, its regulatory climate should be considered by electric utility investors. Even in states that have deregulated the generation function and allow customers to choose their energy supplier, the incumbent utility still distributes the power to customers. Every distribution company eventually has to file a rate case with the state regulatory commission.
We rank each state’s regulatory climate (and those of Washington D.C. and the Federal Energy Regulatory Commission) as Above Average, Average, or Below Average. Investors should note that a state’s regulatory climate isn’t influenced solely by the regulatory commission, although this is certainly the most important factor. We also consider the state legislature, courts, and executive branch. If a state government enacts legislation that is favorable (or unfavorable) for electric utilities, then it would be unreasonable not to incorporate this into our rankings, even if the regulatory commission had nothing to do with the new law.
What factors affect a regulatory climate? We examine the outcomes of recent rate cases. We consider regulatory consistency. We look at historical practices. Does a state typically allow companies to maintain common-equity ratios that are above the industry average? Does a state allow tracking mechanisms for volatile expenses such as pension costs? Nonfinancial considerations can also affect the rankings. How heavy-handed is a state’s environmental regulation?
Regulatory climates can and do change from time to time. For example, Michigan was long considered a state with a below-average regulatory climate. Then, a law was passed in 2008 that was more favorable for electric companies in the state. Among other things, it allowed utilities to self-implement an interim tariff hike six months after filing a rate case. So, we raised the regulatory climate to Average. But in February of 2011, Consumers Energy, a unit of CMS Energy (CMS), was not allowed to self-implement a gas rate hike, as it had expected. This alone wouldn’t make us lower the regulatory climate to Below Average, but it is an example of the kinds of things we consider in our rankings.
Where else should investors focus in 2011? There is a lot of regulatory activity in Missouri, due in part to the completion of a coal-fired generating unit at the end of 2010. There has been some talk in Kentucky about switching to an elected commission, instead of one that is appointed by the governor, with approval of the state senate. Such a switch might not be good for utility investors, although elected commissions aren’t necessarily bad.
Even “nonregulated” assets can be affected by a state’s regulatory climate. Entergy (ETR), which owns nuclear facilities in New York and Vermont, is dealing with antinuclear attitudes of some politicians and some members of the public. There is customer choice and deregulation of generating assets in Ohio. So far, this is working well (too well, in fact) for utility customers. Some utilities have filed applications with the Ohio commission to change the rules about customer choice so that the outcome isn’t so unfavorable. Without any changes, there will be little incentive for companies to add generating capacity when the state needs it.
This topic is important enough that, from time to time, The Value Line Investment Survey devotes an Electric Utility industry report to an examination of regulatory climates, including a listing of each state’s regulatory climate. And the footnotes of each electric utility’s full-page report show the regulatory climate. We do not suggest that investors consider only stocks of utilities that operate in an above-average regulatory climate, or avoid those in a subpar regulatory climate, but it is one more tool that may be used when evaluating a prospective electric utility investment.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.