NEW YORK--(BUSINESS WIRE)--The median authorized return on equity (ROE) for utility distribution companies (UDCs) and integrated utility companies (IUCs) has continued to inch downward in response to persistently low interest rates, according to Fitch Ratings.
The combined 9.60% ROE observed in 2015 was 15bp lower than 2014 and 20bp lower than 2013. Fitch does not expect the projected rise in Treasury rates to have a meaningful effect on authorized ROEs in the short run. We also expect the long-term downward trend of authorized ROEs to stabilize at near-current levels, based on our analysis of 162 rate decisions spanning 36 months from 2013-2015.
Weak growth and external concerns have seen the Fed delay further rate hikes, but recent communications point to a hike in December 2016. Unit labor cost growth has exceeded 2% for five consecutive quarters, and core inflation has been picking up over the past year. Fitch has revised downward the pace of potential interest rate increases and now projects a one-time, 25-bp rise in Treasury rates in 2016, compared with prior expectations for the Fed to implement two rate increases.
The spread of median ROE to the 30-year Treasury rate approximated 721bp YTD, an increase of about 63bp over 2015 and 138bp in 2013. The widening spread illustrates a material decline in Treasury rates of close to 170bp YTD relative to 2013. By comparison, the median authorized ROE dropped by approximately 30bp. Adjustments to cost of capital in rate design will continue to be gradual and will be dependent in part on the pace of interest rate increases.
Due to the sustained low interest rate environment, utilities continue to face pushback on authorized ROEs in regulatory proceedings. Xcel Energy Inc. (rated BBB+/Stable by Fitch) highlighted the downward pressure on ROEs reflected in rate cases during its second-quarter 2016 earnings call. Fitch expects Xcel and peers to continue focusing on cost control to delay rate case filings and mitigate any EBITDA pressures.
The IUCs typically fare better than UDCs. The median authorized ROE for IUCs was 9.70% in 2015, approximately 15bp higher than the ROE measured for UDCs. Fitch expects this to persist, as illustrated by the outcomes of 21 general rate cases YTD in 2016, where IUCs continued to receive higher ROEs than UDCs. Fitch believes the incremental compensation provided by regulators reflects the inherently higher operational risk and typically greater capital requirements associated with ownership of generation assets.
Regional disparities in authorized ROEs continue to persist. Median ROEs were highest for utilities serving the South at 9.84% in 2015. The Northeast recorded the lowest authorized median ROEs at 9.47%, driven primarily by New York at 9.15% and Connecticut at 9.17%. New York held the lowest median authorized ROE in the nation. Illinois held the second-lowest median-authorized ROE at 9.16%. This largely reflects the formulaic rate-making mechanism employed in the state for electric UDCs, under which ROEs are based off the average 30-year Treasury rate plus a 580bp spread.
While the level of authorized ROE is not the sole driver in Fitch's assessment of regulation and utility credit quality, 'A' rated utilities have typically had relatively higher authorized ROEs than lower rated peers. Utilities with Issuer Default Ratings in the 'A' rating category had a median ROE of 9.78%, compared with a ROE of 9.56% for utilities in the 'BBB' rating category.
Additional information is available on www.fitchratings.com.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
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