Feb 20, 2025
On February 6, The Capitol Forum hosted a conference call with American Economic Liberties Project Senior Fellow Mark Ellis to discuss his recent paper “Rate of Return Equals Cost of Capital,” how and why investor-owned utility profit models diverted from their initial design, as well as how much excess returns cost American households. The full transcript, which has been modified slightly for accuracy, can be found below.
TEDDY DOWNEY: Good morning, everyone, and welcome to our conference call today with Mark Ellis. I’m Teddy Downey, Executive Editor here at The Capitol Forum. Mark is a Senior Fellow at the Anti-Monopoly Nonprofit American Economic Liberties Project or AELP. I just found out he’s also an expert witness in a lot of these proceedings at the state level when it comes to utilities.
And today, we’re going to be talking about his recent paper, “Rate of Return Equals Cost of Capital: A Simple, Fair Formula to Stop Investor-Owned Utilities from Overcharging the Public”. Mark, thank you so much for doing this today.
MARK ELLIS: It’s my pleasure. Thanks for inviting me. Thank you.
TEDDY DOWNEY: And I think before we get into the paper, I would love to just ask you how you went from working in the industry to being an expert witness and working at AELP and writing this paper.
MARK ELLIS: Yeah. So, I was born and bred sort of an energy geek. I worked in the industry for about 30 years with—I guess the first job was with Sanyo, then with ExxonMobil, McKinsey, and then Sempra for 15 years.
I left Sempra in 2019 and sort of serendipitously I fell into expert witness work. And I work in regulatory proceedings on behalf of consumer and environmental groups. I’ve been doing that for about five years.
And my focus on finance and economics and rate of return is one of my focus areas. I also do a bit of work in wildfire risk management. But the connection to AELP came from studying a lot of economics in school. And I’ve had a longstanding interest in sort of corporate concentration and monopoly abuse and how markets work.
And I came across Matt Stoller’s work about five years ago and just started following his newsletter and the development of AELP. And I attended their first conference. They had a conference in D.C. in 2023, and I had a chance to meet these people that I admired so much.
And I said to Matt hey, you guys cover all these de facto monopolies like PBMs and big pharma, Big Tech, Amazon, and so forth. And I said, the idea is that, hey, the regulators, the antitrust regulators, aren’t doing their job, and that’s why we have all these concentrated industries and monopolies, these de facto monopolies. And I said, it’s just as bad with the de jure monopolies, the utilities, that, hey, the regulators aren’t doing their job there either. And I said, can you start focusing on that?
And long story short, over the course of a number of conversations and several months, they brought me onboard to help them understand and work on utilities. And it’s been great. They’re a great shop, and I really admire their work. And I tell people they punch above their weight. They have a lot of influence, a very small dynamic group, but a lot of influence. And just, they push my thinking, and it’s been really fun. I’ve been there about six months.
TEDDY DOWNEY: That’s great. Yeah, you don’t hear a lot of them. We just don’t have a lot of stories of industry people coming around and providing that industry expertise on kind of the less seemly corporate practices in the industry. We have a lot of writing about that. So, I was excited to read your paper. And let’s jump to that. To your mind, what are some of the highlights in the paper to you? And then we can kind of dive into some of these topics.
MARK ELLIS: Yeah, just to your point, yeah, I am pretty rare in these regulatory proceedings. There’s not a lot of folks who have sort of senior level—I was the Chief of Corporate Strategy and Chief Economist for the fourth largest utility in the country. There’s not a lot of folks who have that sort of insight and expertise. And the reception I get is somewhat mixed, but I enjoy it. It’s a lot of fun.
So, back to your question about the highlights from the paper. You know, it’s interesting. When I read the paper, when I wrote the paper, I’m like most of this stuff is not new, right? Like, the rate of return equals cost of capital standard. That was Justice Brandeis, a hundred years ago, came up with that. He was the first person to write that in a Supreme Court decision. It was in a—what’s it called when you agree with the majority, but it was not actually in the majority opinion? I forget. There’s a word for that. It’s not coming to my mind right now.
So, that idea, and then it was codified in Hope in 1944. Sort of like that’s old stuff. The rate of return should be equal to the cost of capital. There’s nothing new there. Price to book, which is a key piece of evidence. That’s 70 years old.
So, there was a very famous regulatory economist, Alfred Kahn, who worked for Jimmy Carter. He was the deregulation czar. Before that, he was a regulatory economist. He focused on utilities. And he wrote a very famous textbook. And he highlights like, hey, price to book greater than one. It means the rate of return is greater than the cost of capital.
So, that’s been out there 70 years. How to calculate the cost of capital, like CAPM goes back to the 60s. Modern portfolio theory to the 50s. Like all this stuff is 70 years old. So, really there’s not that much that’s new.
One of the interesting things is, after working with the intervenors, I think there’s a lot of opportunity there for them to collaborate. So, that’s kind of an interesting element. And I’m working with a couple of groups right now to say, hey, this is something that works across utilities, works across states. You really ought to think about collaborating and more and sort of putting all your wood behind one arrow. I call it swarm ball, like kindergarteners playing soccer. So, the intervenors sometimes feel like that.
And then the highlight that I’m actually most excited about actually got pulled from the paper. I’m writing a separate paper about it. I just testified in a proceeding in Minnesota on this idea. Basically, there’s this concept that when the utilities were created, there’s like, oh, it’s a natural monopoly. You know, there’s these old pictures of New York City with multiple wires running down the street. And like, this is dangerous and it’s uneconomic and so wasteful.
So, back in Edison’s time, he had a business partner, Samuel Insull, and they created this state regulated monopoly structure. And they said it’s a natural monopoly because you don’t want multiple lines running down the street. It’s a natural monopoly from an operating perspective, but they bolted onto it a monopoly or the financing, but only for the equity, not the debt.
So, when a utility needs to raise debt, they go to the market. They issue bonds or they go get banks to compete to provide the debt, and they get the lowest cost interest as a result of that.
But for the equity, it’s this weird thing. It’s like, oh, the parent company provides equity, and then they go to the regulator, and they say, I want ten percent. And the regulator may hem and haw and ask for other opinions or whatever. Oh, I’ll give you 9.8. But that’s weird. Like, the profit is just this negotiated agreement.
And that may have been necessary back in Edison’s day when capital markets weren’t so developed and it was a struggle to raise large amounts of capital, but that’s not an issue today. Now we can slice and dice risk and capital in any number of ways.
And so, instead of just saying, oh, we’re just going to allow the regulator to determine the profit in the parent company, provide the equity at some ten percent rate of return, why not require the utility to go to market for the equity as well? Say, oh, I need to raise a billion dollars, right, of equity. And then you have competing providers say, oh, the rate of return that I require is 6 percent or 6.5 percent or whatever the number is.
And that’s kind of the idea that I’m most excited about. It has a lot of interesting implications. But the idea is there’s a very longstanding regulatory principle that regulation is a surrogate for competition. This sort of goes back to the very, very beginnings of regulation.
And implicit in that is if competition is feasible, it’s always preferred. And utilities are always required to—not always, but are routinely required to use competitive procurement for all kinds of things. Like if they want to buy a fleet of trucks, they don’t just go to Ford like, hey, give me a bunch of trucks. They get bids from GM and Toyota and Ford. Or in many states, there’s competitive wholesale markets. They can’t even build power plants. They have to go to the market. They use competitive procurement for buying meters. If they want to enter into renewables in California, it was all done on competitive procurement. So, they had to enter into long-term contracts, but it was all with third parties.
And I was involved in that process when I was at Semper. And it was very, very competitive. They got the cost down dramatically for those renewables because of through competitive procurement.
And so, that’s a longstanding principle in regulation is to use competition where you can. So, the idea is use competition for the equity as well.
TEDDY DOWNEY: I want to come back to this, but maybe we can start off—I think the paper goes into a lot of detail on how the accounting games are done at utilities and how the utilities trick the regulators to let them make more money effectively off of just spending on whatever they spend on, spending projects. So, like a new power plant, things like transmission. But can you maybe just in layman’s terms discuss sort of the history of how they have sort of systemically tricked the state utility regulators to effectively over time allow them to be more profitable than what you can expect in the stock market basically?
MARK ELLIS: So, it’s interesting. The paper talks a lot about this rate of return equals cost of capital standard. And then it also shows this price to book ratio to show like, oh, when is the last time that it was actually there? And what you find, when you look at that chart, is there’s never been a time where it’s, oh, the price to book has been stably at one, which is where it should be.
And then you go back to the last time that it was below one, which was like in the 70s and 80s. And interestingly, if you go back and you read the expert witnesses on behalf of the utilities at that time, they’re all arguing that the price to book ratio should be one. It’s an indication that the rate of return is below the cost of capital.
Now, that was a period of relatively high interest rates and high inflation. So, the regulators were slow to raise. And so, they had a legitimate point. But they were all arguing, hey, for this standard, that the rate of return should equal the cost of capital. And how do we know it’s too low? It’s because the price to book ratio is below one.
Interestingly, Peter Navarro, right, the advisor to President Trump, he actually wrote a paper for the Department of Energy on this specific issue where he’s advocating, hey, when at the time it was too low. He was just one of many experts who were writing about this.
Then eventually in the late 80s, early 90s, they got inflation interest rates under control. And then the rates of return didn’t come down. And all of a sudden, you’ll see in that chart, the price to book goes from like .8 to one and then 1.5 within a span of a few years. And crickets from the utilities at that point about the price to book ratio.
And interestingly, as when you look at textbooks, cost of capital books, from that era, right, these experts for the utilities are talking about price to book should be equal to one. In the 2000s, they start publishing books like, oh, no, markets are irrational, and we can’t rely on price to book.
So, they start changing their tune. I mean, none of it makes any sense. Like, this is just finance one-on-one. You know, for a company like utilities, different for other types of industries.
So, part of it is just the experts change their tune. And how they get away with this, I don’t know. There’s a very famous psychologist, academic psychologist, named Jonathan Haidt. He wrote a book a number of years ago, and he talks about sort of two different mindsets. When we receive information that confirms our view, we adopt a can I believe this attitude? It’s like, can I believe this? Yeah. Then you accept it. If it conflicts with what we believe, we adopt a must I believe this? Like, we’re always looking for the holes. And I don’t know why this is the case.
But the regulators, when it comes to the utilities, their attitude is you put something in front of them and they say, can I believe this? And they don’t question it unless it’s somebody says the moon is made of cheese. Or the sky is green. They’re not going to question it. But when it comes to the intervenors and the public advocates, their attitude is must I believe it? And the standard of evidence is very high. So, I think there’s just this uneven playing field in the regulatory arena.
You know, like I said, this is not rocket science finance that is that hard to understand. Literally, if a regulator wanted to take the time to understand this, they could within a day. Like, oh, there’s something really wrong here. But they don’t because they just don’t have the mindset.
I think the utilities have done a very good job of sort of co-opting a lot of the interveners. In the paper, I talk about how many of these large intervenors, the federal government, some of the largest public advocates, are still using experts that basically just parrot the utilities playbook.
The utilities have set up a training school for cost of cap—it’s called SURFA, the Society for Utility Regulatory Financial Analysts—that teaches advocating intervenor witnesses how to do cost of capital analysis or rate of return analysis the way the utilities want them to do it, with a bunch of bogus models and things that you’d never find in a typical corporate finance book. But that’s what they are teaching. That’s what they use. And that’s what they’re teaching these analysts who are ostensibly working on behalf of regulators and consumer advocates to do.
TEDDY DOWNEY: So, if they just understood the accounting terms, basically, as they’re supposed to work, the utilities would be a lot less profitable, right? And they would be less rewarded for just spending money. You make a point in the paper that one of the other problems, if you make it so lucrative to do new projects, it’s really hard to then to incentivize the utilities to do anything else, right?
MARK ELLIS: Yeah.
TEDDY DOWNEY: I wonder if you could talk about that. Because that does seem to come up when states try to incentivize renewables, or what have you, efficiency. And then none of those goals are met. None of the project is taken up or it’s hard to get the utilities to buy into that. And I thought you had a really good insight in the paper of why they don’t do that.
MARK ELLIS: Yeah. So, this price to book that I keep referring to, why is it so important? So, basically, the price to book expresses the relationship between the value or the cost of the equity or investment, the equity investment, that the utility makes, and then the value it earns in the stock market.
So, essentially, the price to book, if it’s 2—right now it’s a little bit higher than to 2.2—means that for every dollar of shareholder equity that a utility invests, their market, the stock will be valued at twice that or a little bit over 2.2 times that. So, if somebody came to you and said, “Hey, give me $1 and I’ll put $2 in your retirement account”.
So, I’m pretty confident you’d respond by saying—two things would be the next things that come out of your mouth. The first one would be, “Yes, I’d like to do that”. And the second one would be, “Am I limited to $1? Can I give you $2? Can I give you $10? Can I give you a million dollars? That’s essentially the deal that the utilities have. It’s every dollar of their shareholders’ capital that they invest into a project turns into $2 in their stock market value. So, who wouldn’t want that deal? That’s an amazing deal.
So, they want to invest, say, a $2 billion transmission line. So, they finance it 50-50 debt and equity. That’s a billion dollars of shareholder equity. So, they invest that and then their stock market capitalization goes up by $2 billion.
So, think about that. If you get this project approved—and I saw this when I was at Sempra, the emphasis they put into getting these major capital projects approved—you get a billion-dollar windfall the day it’s approved. The stock market will value that even before you build it. They will attribute that value to your stock once it’s approved. You know, a billion dollars versus when you try to dangle an incentive for efficiency, which typically, are on the order of like a million dollars a year. It’s just, there’s no comparison.
This billion-dollar investment, the reason why it’s worth a billion dollars, extra dollars, in your stock prices, it’s going to be earning a bunch of money for 10, 20, 30, 40 years. These incentives are generally maybe they’re for one rate case, one year, three years. So, they don’t create a lot of value and they’re a lot of work.
So, it’s like if somebody says here’s a billion dollars, here’s a million dollars, you’re going to go for the billion dollars, right? That’s what you’re—either way, your costs are covered. So, that’s what you’re going to focus on.
And if you could do the other things, if you can earn those other incentives, you will. But your focus is going to be on the billion-dollar stuff, not the million-dollar stuff.
TEDDY DOWNEY: And just going back to Brandeis with this, I think you mean his concurring opinion, right?
MARK ELLIS: Yeah.
TEDDY DOWNEY: So, he’s saying, hey, it should be one to one.
MARK ELLIS: Yes.
TEDDY DOWNEY: He’s saying you put a dollar in, you should expect —
MARK ELLIS: Well, yeah. So, he didn’t necessarily refer to price to book, but he did lay down the law, hey, the rate of return should be the cost of capital.
TEDDY DOWNEY: Yeah. And explain that. Again, I just want to make sure for the people that aren’t expert in this, just going back to the very basics of it. And why does that make sense? And then why does the way that it currently works make no sense? I think let’s just try one more time on that, just so that we, the lay people, can be brought along here.
MARK ELLIS: Yeah. So, probably the most foundational principle of finance is discounted present value. So, when you have an asset that generates income over time, what’s it worth today? Well, you have a projection of the future cash flow stream and then you discount it to today and that gives you the value. So, that’s discounted cash flow.
And then the concept of present value is what’s the discount rate that you’re supposed to discount it at? You can discount it at any rate, but each cash flow stream, each cash flow profile, has a cost of capital associated with it based on its risk profile. That’s called the cost of capital.
So, for example, for a Treasury bond, low risk. So, it has a lower discount rate, lower cost of capital associated with it. General stock market, you know, Bitcoin, the other end, very high risk, very high discount rate. You have the general stock market which is somewhere in between. And then below the general stock market is utilities. Their discount rate is a little bit lower than stock market because they’re lower risk.
So, the corollary to that is you can tell if something is earning its actual cost of capital by comparing like what’s the initial investment to what it’s actually worth. So, if you invest a million dollars into something and then it’s suddenly valued at two million dollars, then the rate of return is greater than the cost of capital.
And then if you invest in something and it’s worth less, then the rate of return is less than its cost of capital. When it’s exactly equal to its cost of capital, whatever you invest, that’s what it’s worth. That’s sort of like how bonds trade. Like, the government goes and says, I need to issue debt. And then the market’s competing, offering, like, oh, I need five percent. Somebody else says I need 4.9 percent, whatever it clears at.
So, that’s the market-based cost of capital. That’s the general principle. So, when the initial investment and the current value are the same, then the expected rate of return is equal to the cost of capital. That’s like basic. That’s a very, very foundational principle of finance. That’s like the root of all finance. When people are trying to figure out what’s this asset worth, it starts with what is the cost of capital.
TEDDY DOWNEY: And then one more time. I know there were a bunch of schemes that sort of like, well, they just say something plausible that the regulators let them get away with. But when it comes to the actual numbers that they’re manipulating, how have the utilities gotten away with it? Was it just like a sudden change of how they change the numbers around? Or was it lobbying? What did they do to get it so that a very well understood way to pay the utilities got so dramatically changed, as your chart points out, in the—well, I guess there’s a time from the 50s and 60s and then again in the 90s.
MARK ELLIS: Yeah. So, in rate of return circles, there’s a famous chart that is in my testimony frequently. And it’s in a paper that I cite in my paper from Berkeley and also in a paper I believe I cite it from Carnegie Mellon University. And basically, it shows the difference between the authorized rate of return for utilities, like the average for each quarter, whatever was right authorized. And then, typically, they compare it to like a 20 or 30 year Treasury yield.
And it goes back to 1980. This is data that S&P—now it’s an affiliate of S&P—collects, but they’ve been collecting this data since 1980. And what it shows is back in the 80s, the ROEs were—that was when the price to book was less than one. And what it shows is like, oh, interest rates were high. And ROEs were relatively low. They were higher than the interest rate. But the spread between the ROE and the interest rate was like two percent. And then the utilities were trading a little bit below book value.
And then, as we know, since the 80s, since Paul Volcker, interest rates have just been on a pretty much monotonous decline for the last 30, 40 years. Very, very steady. Just in the last few years, they started to pick up, but nowhere near to what they were back then. And as interest rates came down, the utilities were very effective in preventing the ROEs from coming down in lockstep. So, this spread increases over time. And I think at one point, it was as big – it went from two percent to eight percent. And now it’s maybe around six percent.
So, I think a lot of it is just they have encouraged sort of stickiness in the regulators. Don’t reduce our– the argument is, oh, when you go back and you read all this testimony, they always argue interest rates are low, but they’re always going up in the future. They’re always going up in the future.
And one of the tricks that they use is they use these interest rates forecasts. And I show in my testimony it’s like they use these interest rate forecasts for the last 20 years and they’ve been systematically biased for the last 20 years. They always say interest rates are going to go up and they never do. And it’s like that’s like 100 basis points just in that.
So, the utilities are always creating this fear mongering, oh, don’t reduce our ROE because interest rates are going to go up. Or we won’t be able to raise capital. Or it’ll impact our credit rating. And all of this is just bogus. I mean, all these arguments when if you unpack them, they don’t make any sense. But like I said before, the regulator has this attitude of, can I believe it? Oh, if they say interest rates are going up, I can believe it. Nobody can predict interest rates. I can believe interest rates will go up. So, they let them go.
And then in addition, remember, these SURFA-trained analysts aren’t really set up to question them because they’re using the same model. So, everything’s blowing and kind of going in one direction. Like, believe what the utilities say. Believe what the utilities say.
TEDDY DOWNEY: So, it’s really these interest rate models. I mean, I think about imagine if there was more public awareness of this. Like, you would know if interest rates were coming down and your mortgage rate wasn’t coming down, right? You’d be much more—if it was the public, when it really hurts your pocketbook, you’re keeping pretty close tabs on how quickly rates are reflected—the lowering of interest rates. But here, there’s just a disconnect, right? Like, yeah, your bill might be going up. There’s way less accountability to your point. There’s corruption. There’s just a huge disconnect between the public awareness around a mortgage rate and this obscure accounting.
MARK ELLIS: Yeah.
TEDDY DOWNEY: You know, number that ultimately determines the incentives for the utility basically, right? Like, it determines what their incentives should be, right.
MARK ELLIS: Yeah, when you look at the data, interestingly, almost all of the benefit—like you think, oh, interest rates are coming down. That’s a big component of their costs. The rate should be going down sort of in real terms, inflation adjusted terms. And what you find is rates basically track inflation. So, basically, all the benefit of reduced interest rates went to utility shareholders, not to customers. Like, for over 30 years. It’s really just crazy.
TEDDY DOWNEY: It’s amazing.
MARK ELLIS: I mean, how much rent that they’ve extracted out of the system over all these decades.
TEDDY DOWNEY: Yeah, it’s incredible. And we talked a lot about—I think we’re good on incentives. They’re messed up. What are some of the solutions you think policymakers should consider as they rethink how to either regulate the investor owned utility models or come up with some alternatives or whatever solutions you think should be on the table?
MARK ELLIS: So, the first one—this is discussed in the paper—is like you could just legislate. Like, hey, the rate of return should be what are the costs of capital. You know, the Supreme Court precedent, every regulatory textbook, talks about this. The utilities themselves pay lip service to this. For example, they don’t refer to it – in these regulatory proceedings, they call it a cost of capital proceeding. And then the expert will say I am calculating the cost of capital and setting the rate of return equal to the cost of capital. But they’re just fudging the numbers. They’re playing all these games.
So, they pay lip service to this idea that the rate of return should be equal to the cost of capital. If you were to go to a regulator and say how do you set the rate of return, oh, we estimate the cost of capital. And then we set the rate of return even with the cost of capital. So, they all agree to this. But it’s actually nowhere codified in law. I mean, it’s sort of the Supreme Court—everybody interprets these decisions like that’s the right way. It should be interpreted like, yeah, the rate of return should be equal to the cost of capital.
NARUC, the National Association of Regulatory Utility Commissioners, is the umbrella for the state commissioners. They have a policy document that says the rate of return should be equal to the cost of capital. But for whatever reason, it’s still not enough. So, put it into law. But in addition, put in the law but don’t just say that’s the standard, but actually codify like, hey, this is the right way to calculate the cost of capital. You can’t use these bogus interest rate forecasts. You can’t use these bogus models that the utilities have promulgated.
FERC, for example, a couple of years ago did a very extensive review of the cost of capital proceedings. And they basically said these two models that are routinely used by these utility experts, they’re bogus. You can’t use them anymore. Actually, the terminology they use. they defy general financial logic.
And I described in my paper that they are still used ,widespread, throughout state regulation, even by consumer advocates and even working for the government and working for the federal government and working for the state regulators and working for large consumer groups. So, FERC said don’t use these models. But they’re still used by consumer advocates. So, make it 1aw, like you can’t just use bogus financing. You can’t do it.
So, make it the law. Make the standard, the law. Code if I had to do it in law. And then finally, put the responsibility in the hands of the regulator, not the utilities. Right now, it’s like the utilities hire these. They come in with these bogus numbers. And then the regulator has to push back. Flip it around and say, hey. Let the regulator calculate it, and then the utility has to prove that it’s wrong. Put the onus, the burden of proof, on the utility.
Interestingly, there is a bill in New York State to this exact effect. Hey, we’ve got to codify this. New York has more of like a routine process for how they calculate the rate of return. But it hasn’t been updated and so they want to codify this. Shelley Mayer, I think, is the State Senator’s name who sponsored this bill. So, there is some precedent for that.
So, those are some things that regulators can do. My personal favorite is what I alluded to before. It’s like, hey, take away this finance monopoly, force the utilities to go to market for all incremental equity. I think that that’s a huge opportunity. It has all kinds of interesting positive implications. So, that’s another thing that policymakers could do.
TEDDY DOWNEY: How would that work? Can you walk me through how that would work? So, you just basically say, hey, we’re not going to regulate how much you get here. And where would you? It’s not a debt market, but you, what is it for? For a capital raise, kind of like an IPO?
MARK ELLIS: Yeah.
TEDDY DOWNEY: Not an IPO, but like some kind of public offering?
MARK ELLIS: Yeah. So, I mentioned I just provided testimony. There’s ALLETE which is a utility in Minnesota. They own Minnesota Power, and they’re being sold to private equity firms, an American firm, now owned by BlackRock, and then a Canadian firm.
And essentially, ALLETE is a parent company. But Minnesota Power is like the core of the business. They have some other businesses. But essentially, what it is, is Minnesota Power gets an authorized rate of return. And their price to book is roughly 2.
So, what’s going on there is the Minnesota Power folks are walking away with this 2 is a big windfall right over one. It’s a billion-dollar windfall that they’re walking away with. Where did that windfall come from? It’s not like compensation for their past performance because they’ve already been richly rewarded with the authorized ROE of a little bit less than 10 percent. So, it’s not because they did anything like added all this value in the past, they’ve already been rewarded for that. It’s not for future performance. They’re selling. They’re not doing anything in the future.
That billion dollar plus windfall is purely an artifact of the authorized rate of return is greater than the cost of capital. Now, that’s kind of crazy. Who’s paying for that billion dollar windfall? Customers. Who’s deciding the customers have to pay for it? The regulator. To me, that just is mind blowing that that’s allowed and people are just like, yeah, that’s just how things are done.
So, if you think about capital markets like you say, well, how’s that different from an IPO or venture capital? Open AI is worth $300 billion. They don’t have $300 billion invested in it. But remember, Open AI, they took a bunch of risk, right? And they did a lot of innovation and creativity. And it wasn’t a guarantee that they were going to be compensated for that.
Utility regulation, they remove all the risk, right? They’re not taking any risk. They’re not innovating All it rewards—utility regulation just rewards regulatory capture. That’s all. The only innovation is how good they can be at regulatory capture. It doesn’t reward risk taking. It doesn’t incentivize innovation or all the things that we want sort of the free market to do. This is not a free market. It’s just a regulator deciding like, oh, you can earn 10 even though your cost of capital is 5 1/2 or 6 percent.
TEDDY DOWNEY: But how does introducing the capital market do that?
MARK ELLIS: Yes, you ask how would it work in practice?
TEDDY DOWNEY: Yes.
MARK ELLIS: So, this is a new idea, but conceptually here’s how it would work. A basic rate case is the utility say. here’s my demand forecast and here’s how much I need to spend for operating expenses and capital to meet the demand forecast. To make sure the lights don’t go out, meet whatever environmental, whatever safety and reliability, customer satisfaction, this is what it’s going to cost.
And there’s some wrangling and toing and froing and eventually they say, okay, yeah. Here’s the demand forecast. We’re going to allow you to go spend that. And spend this much operating and invest this much capital and you’re going to go finance it. And they’re like, great. I’m going to go finance it, roughly 50/50 debt and equity. I’ll go to market for the debt and I’ll go to my parent for the equity.
Minnesota Power goes to ALLETE. And the regulator says not so fast. For the equity, you go to market. What do you mean? He says, well, you need to raise, say, a billion dollars of equity. Go ask third parties what rate of return they would require on that equity. Hold an auction. And so, the idea is in an IPO or venture capital, basically the market bids up based on the expected profit. In the bond market, they bid down the interest rate based on how much capital you need.
So, basically we’re replacing the venture capital IPO market, which is what currently goes on—because it’s just rent seeking. They’re not actually creating any value other than, oh, they’ve convinced the regulator—to more of the bond market model where it’s like, hey, bid down and just raise the cost. And if it’s a market, if it’s competitors, the rate of return, the ROE, that clears that market, that is the cost of capital. That is the market based cost of capital. And one of the standards is sufficient to raise capital, right? You’ve just proven it’s sufficient to raise capital. People have said I will invest on these terms.
So, all these issues that the utilities, oh, we won’t be able to raise capital, it’s not something like that all. It all goes away. And it just goes back to this idea is like regulation is a surrogate for competition. You don’t need a surrogate. You can have real competition.
TEDDY DOWNEY: In that in that sense, who would be the people competing against each other? Would it be just investors?
MARK ELLIS: Yeah.
TEDDY DOWNEY: The banks?
MARK ELLIS: Yeah.
TEDDY DOWNEY: Like bond investors? They would basically be bond investors?
MARK ELLIS: It would still be equity. So, there’s some risk, right?
TEDDY DOWNEY: Yeah. What would the risk be? I guess that’s the part that I don’t quite understand. Because it’s like it’s a project that’s like approved, right?
MARK ELLIS: Well, you’re investing in the utility and the risk is the utility. But the utility risk profile, fundamentally it’s in between, you know. It is equity, but it’s very, very close to a bond, its risk profile. So, it’s still equity, but it’s kind of in between. Who would invest in this? So, there are plenty of investors out there who are interested in very, very long-term yields. So, think about endowments and pension funds and other types of retirement funds and some insurance as well. Basically, it’s like oh, they collect assets like for retirees. And then there, oh, I need to pay out over the next 30-40 years, right? I need to pay off a certain amount. I need to be very predictable.
Mostly what they’re relegated to is bonds. So, bonds are nice, but they don’t have very high returns. And you think, well, why don’t they invest in utility stocks? Utility stocks, they actually introduce a lot of noise. And what you find is basically it’s the parent that collects the money and then they invest in the utility. The utility returns the cash to the parent. The parent doesn’t necessarily return that cash back to shareholders. They only divvy out about half of what the utility generates.
The rest of it, like, oh, I’m going to save it for future growth. Or I’m going to reinvest it in other businesses that I have. When I was at Semper, they had a training company. So, they would take the profits from the utilities and use it to support the trading or renewables or what have you.
TEDDY DOWNEY: Or pay their executives.
MARK ELLIS: Put that to the side. Executives do have to get paid. Put that to the side. But just that’s sort of the business model introduces risk. It introduces risk that the underlying businesses – you know, in my recent testimony, I have a chart that compare. here’s the ROE of the S&P utilities index. It’s like rock. You know, it hovers between about .25 percentage points over the last 10 years. Around 9 1/2 percent, flat. But then you compare it to the stock returns and they’re all over the map.
So, you have this fundamental business that’s very, very low risk, very predictable, very stable. And you put this intermediary in there who’s like noising it all up, the market and public markets. There are plenty of investors who are like, no, I want exposure to just that yield. And they’re like, too bad. You’ve got to go buy the stock. It’s like, but I don’t want the stock. It’s too risky. There’s a huge pool of investors who would like exposure to that sort of risk profile.
You know, I spent some time looking at the shareholder letter of Larry Fink, the head of BlackRock. And he says, in that letter, the most recent one, he says there’s two major issues that are facing us in the first half of the 21st century. He says, savings for retirement and investing in energy infrastructure. And I’m like have I got the idea for you?
Apollo Global Management has a big insurance business. The same thing. I’m sorry, not insurance, retirement business. They sell annuities and other retirement products. So, they’re collecting assets from few people who are saving for retirement and then they need to invest. And again, it’s like they’re kind of relegated to bonds. It’s very hard to find things that produce a very long-term predictable yield. You know, companies, funds like that would love—my hypothesis is that they would love to invest directly in utilities. I call it competitive direct equity. Let them compete. And you solve so many problems.
There’s a retirement crisis in this country. And we say, I’ll go to these 401K’s these defined contribution plans, but they’re very risky, right? Their retirement is very uncertain because they’re relegated to the stock market. They don’t have opportunities like this.
We need to invest lots of money in infrastructure. The utilities sort of excess rent increases the cost of investing in infrastructure by 20 percent. So, that’s a big hurdle. If we want to build out, electrify everything and build all this new infrastructure. If everything is 20 percent more expensive than it needs to be, you’re just not going to build as much. So, this to me is like a very elegant solution that helps solve, resolve, a lot of problems.
TEDDY DOWNEY: Where across the country should we be paying attention to interesting rate cases? I think you mentioned New York. Are there other municipalities, localities, states that are pushing the envelope, understand the problem, pushing back, doing something interesting, innovating in any of the ways that you think are solution oriented?
MARK ELLIS: Yeah, I wish I knew the answer to that. You know, I look around and it’s just so—one of the things I talk about in the paper is the utilities all hire from the same four firms to do their expert witness work and they’re all like singing from the same playbook, singing from the same hymnal.
There’s a fellow named Roger Moore and you wouldn’t believe that he wrote this book. He wrote this textbook several years ago. I don’t if your viewers can see it, “The New Regulatory Finance”, but it’s him walking on a sea of $100 bills with his back to you. And he’s advising utilities on how to do finance in front of regulators like, oh, this is in the public interest, walking over a sea of $100 bills. I mean, it’s just shameless.
So, he’s kind of the godfather of all these bogus models that are used out there. And like I said, this has become the standard even among the regulators. And it’s just a long education process. When you go to a regulator and you say like, oh, this is what I do and you say you’ve been doing this wrong for 20 years.
TEDDY DOWNEY: How did FERC get it right?
MARK ELLIS: They haven’t got it right.
TEDDY DOWNEY: I thought you said they pushed back and said these models can’t be used anymore?
MARK ELLIS: They did. So, they did get it right in terms of, hey, these models are bogus. But then the models, the model they retain, there’s nothing inherently wrong with the models. The way they implemented them, and they codified how to implement them is garbage.
And so, it’s interesting because they said, don’t use these models. They’re systematically upwardly biased. Use these models instead and implement them this way. But they produce the same results as the systematically, upwardly biased models, and it eluded them. Like, oh, if these models we approve are producing the same flawed results as the models we disallowed, there must be something wrong with how we’re using these other models.
Nobody at FERC put that together, it appears. Like I don’t know how to, I mean, how do you explain something like that? I have no idea. I have no idea how to explain something like that?
TEDDY DOWNEY: So, you’re out there at these meetings. When you’ve been a witness, has anyone ever actually said, Mark makes some good points? We’re going to change this.
MARK ELLIS: No.
TEDDY DOWNEY: Not a single time.
MARK ELLIS: There’s other issues going on. One, there’s no meetings. The way the regulatory process works is there’s a court process. I’m sorry, it’s a court proceeding with a judge, typically. Sometimes the commissioners just oversee the whole process themselves. But typically, that’s the way it works in every state that I’ve worked.
So, in a court, you have testimony. Like, the witnesses can give testimony. Typically, like in a regular court, there’s oral testimony for the first round. Like you have oral testimony. So, your attorney will question your – you know, you question your own witnesses. And then you question the other witnesses. In a regulatory proceeding, you never question your own witness. So, the direct is just written. And so, you will never get a chance to speak up in one of these proceedings unless the utility calls you.
So, in a rate of return proceeding, I’ve been called once. I was dismissed after ten minutes, in Georgia Power. Because they don’t want me to speak. They don’t want to give me a platform to speak. So, a lot of it is just like, oh, if we never get this person’s face in front of the ALJ or in front of the Commission, he’s just this unknown entity. You know, they read his paper. He’s not a known quantity, not a real person.
So, it’s just that’s another way that it’s very hard. Like, this message getting through to regulators is very challenging because the process makes it just inherently makes it very difficult. You know, I don’t have a good explanation for it. I’ve given presentations to regulators and regulatory staff and intervenors and why aren’t they all over this? I don’t know. To me, it’s just like this is a no brainer. It’s costing—like in the paper, I said it’s costing $50 billion a year to the consumer. That’s a lot of money. It’s about $150.00 – or, I’m sorry, about $300.00 per household residential customer per year. That’s real money and to not do anything about it, to just pretend like everything’s hunky dory, I think is just unconscionable.
TEDDY DOWNEY: Well, the other confusing thing about this is how much money is thrown at research into efficiency, and connecting the electric grid. And there’s just so much money in all this and so much effort, from a policy standpoint, that you wouldn’t be more focused on the incentives at the utility level, which, obviously, is where the rubber meets the road when it comes to —
MARK ELLIS: Yeah.
TEDDY DOWNEY: And a lot of times transmission. And then you have this weird outlook for demand because of all the data centers and AI and everything like that. You would think there would be more focus on getting the incentives right. And if the only people that have are benefiting from it being this way are basically investors in the utility and then the stakeholders at the utility, you know. And then you have inflation as well, right? It would just strike me as this would be something that people would be paying more attention to. But you’re basically saying that, either because of corruption or just the holistic way that these models have been embraced, it’s a very hard long effort in the future to undo it because it’s so systematized.
MARK ELLIS: Yeah. So, I think one of the issues here is when you look at sort of utility reform, there’s two things. You know, most of the utility reform over the last decade, two decades, it’s been mostly from climate movement. That’s where the bulk of the activity is. There’s some around consumer protection, but it’s mostly around climate. And the utilities have done a very good job, in my opinion, co-opting that movement.
You know, one of the stories—so, I’m from California and AB 32 is California’s climate change law that basically said, oh, we’re going to reduce climate emissions. And, of course, the utilities were central to that. And there’s a story that basically that the head of the PUC at the time was a former President of Southern California Edison. He basically cut a deal with Schwarzenegger. He was governor when the law was passed. And he basically said, hey, utilities, you’re going to be central to this. And Schwarzenegger basically said you can do anything you want, spend as much as you want, as long as it’s green. And that was the green light for them to just go gangbusters.
So, like I live in San Diego. I have solar. So, I don’t pay these. But the rates in San Diego, the average residential rate average, not peak summertime, average residential rate in San Diego is $.45. It’s almost three times the national average. They just went gangbusters. PG&E is up in the 30s now, average residential rate. They just went crazy.
And I think what the utilities have done, they’ve convinced the environmental groups in particular, oh, we need these high profits to invest in renewables. It’s completely bogus. I was a founding team member for Sempra Solar business. And they got out of it after like three or four years because the rates of return were so low. It’s like cutthroat, competitive.
Like people invest in renewables at really, really competitive rates of return. But the utilities are like, no. We need these high profits or none of this stuff will get built. It’s just not true. It’s just not true. But they’ve convinced everybody of that. And sadly, when I speak with a lot of environmental organizations about rates of return, they parrot back, no, they need these high rates of return. Otherwise, they won’t invest in all this renewable stuff, we wanted to do. So, they’ve co-opted all of that. And it’s really sad.
I think now—I’m not so involved in the environmental side of it, but I’m hearing from friends and colleagues who are that, hey, these groups are starting to realize that affordability actually matters. You can’t just spend whatever you want for the climate crisis. People actually care about bill impacts. It’s starting to come around.
You know, if you’re an environmental organization and you’re like, hey, I want to get onboard with this. Like, I’d love to talk to you. Because I don’t think—to me, it’s really sad that the environmental groups have not embraced this more. Because I don’t know about you, but if you can make something cheaper, usually you get more of it. And it usually goes down easier. Like when you want somebody to do something, if you make it lower cost, they’re more likely to do it. And why the environmental community hasn’t embraced that, I just don’t understand it.
TEDDY DOWNEY: Yeah, yeah. I remember being at a recent event that you were at as well for Sandy Heisen’s book. You know, that was one of the critiques of the publicly owned utilities was that they bought into that too. They were like, well, we can’t have the rates go up. So, we can’t invest in any new projects. They’re like the opposite.
MARK ELLIS: Right. It varies by state. Like in California, SMUD and DWP put a lot of money into sort of greening their supply chain and their rates aren’t nearly as high as the investor in utilities in California.
TEDDY DOWNEY: I think that’s interesting. So, do you have anything hopeful for us to take away
here? I mean, is it just that we have the solutions and they’re ready to be used if we have a willing political opportunity, politician or something like that? Give us something a little hopeful to end the talk with.
MARK ELLIS: Yeah. So, I am very hopeful. Actually, the paper’s generated a lot of interest. I’ve gotten incoming inquiries from journalists, from lawmakers. So, I haven’t had any conversations with the lawmakers, but they’re on my schedule. So, I’m very excited about that. You know, just that people are interested in learning more.
I am particularly interested like it this competitive direct equity. You know, when you think about the political dynamics—and this is not my area of expertise. But at a very high-level, this is kind of how I think about it. Historically, reform has generally been environmental groups and consumer groups going against utilities and Wall Street. And utilities and Wall Street have lots of money. They’re very focused. And that’s just a losing battle.
This competitive direct equity, you’re kind of bifurcating Wall Street. There’s a huge sort of buy side community out there, like these big pension funds, these big retirement asset managers, who—my hypothesis and actually from conversations—want exposure, direct exposure, to utilities. So, now you’ve got consumer – hopefully, you’ve got consumer, hopefully environmental groups and sort of part of the buy side of Wall Street going against the utilities. And then the other parts of Wall Street. And maybe that’s a fair —
TEDDY DOWNEY: I push back a little bit on the buy side. Because there’s plenty of powerful people on the buy side who own the utility stock already, and they want the return to be higher. They want the stock price to be juiced every time there’s capital spent.
But what I am curious about, and maybe we can end on this. Does Goldman Sachs get a fee every time they put together—is there a bank that you would have to work with to pool all those investors together? And would they get a small fee? Or would you have it be that it would just be done by some kind of regulated offering? Are you letting Wall Street in on a little of that money on the transaction side?
MARK ELLIS: So, in my testimony—this is very, very high-level. But if you think about this, like you can very quickly envision where an intermediary—think about like BlackRock’s iShares where they buy a bunch of stakes in utilities and they pool them. Like, I’ve got a diversified portfolio of utilities and they pool them and then they create an ETF of these. And what do you get? You get this nice steady – like, you invest $100 and it gives 6 percent like forever. And then it adjusts with interest rates and so forth because it would change over time. Like, it would be indexed in the regulatory process. So, it’s kind of an interesting idea. But it would start, it has to start with –
TEDDY DOWNEY: But what about just the issuance? Like, if you’re in a competitive market and you’re just like who does that?
MARK ELLIS: What do you mean?
TEDDY DOWNEY: When the utility’s like, all right. I need $5 billion in equity for this project. And you’re saying it’s going to go to some kind of auction of investors?
MARK ELLIS: Yeah. So, this is nascent. Like, the nuts and bolts of that can be worked out. But the key thing if you’re not investing in a project, you can always project finance, like, that’s well known. And utilities don’t want to give that up. You’re investing in the utility itself. The general idea.
TEDDY DOWNEY: I see. I see. Okay. We may need to do another call where I better understand this proposal. But the basic thing is you’re opening it up to competition and you’re getting the capital markets involved to set the price.
MARK ELLIS: Yeah.
TEDDY DOWNEY: Just like on the debt side.
MARK ELLIS: Just like on the debt side. It is all regulation is a surrogate. You don’t need a surrogate. Have the real thing, right?
TEDDY DOWNEY: Yeah. Well, this was fascinating. I’m going to keep doing my homework here and learn more about it. Make sure I understand how my local utility is being tricked. Mark, thank you so much for doing this.
MARK ELLIS: Yeah, one last plug if any of your listeners, or I’m not sure if they view this as well, reach out to me. You can find me on LinkedIn, Mark Ellis. If you do AELP or Sempra, which is my former employer, I’ll come up. You know, if you have questions or just want to chat or learn more, I’m always interested in sort of spreading the word about rate of return. This is my personal mission.
TEDDY DOWNEY: Yeah, and if you haven’t read the whole paper, it’s rate of return equals cost of capital. It’s on economicliberties.us. Check it out, very interesting. And look forward to following your work, Mark. And I think we’ll be poking around on that New York proposal as well. That sounds interesting for us to keep tabs on. And hopefully, you’ll be giving us more policy stuff to cover going forward.
MARK ELLIS: I hope so too. Thank you very much for hosting me.
TEDDY DOWNEY: All right. Thank you. And thanks everyone for joining the call. Bye-bye.
