Rebalancing “Return on Equity” to Accelerate an Affordable Clean Energy Future

The document examines the financial mechanisms of utility regulation, specifically the gap between the allowed return on equity (ROE) and the cost of equity (COE). It argues that current ROEs are excessively high, creating a 'capex bias' that incentivizes expensive capital projects over cost-effective solutions like energy efficiency. By analyzing price-to-book ratios and applying discounted cash flow models, the authors estimate that the required return for investors is significantly lower than currently approved rates. The guide provides a framework for stakeholders to challenge inflated COE estimates by correcting flawed model assumptions regarding interest rates, growth rates, and historical means. It further dismisses common industry claims that lower ROEs would limit access to capital or increase customer costs via credit rating downgrades.

• Current allowed ROEs for US utilities are significantly higher than the return investors actually require (COE), as evidenced by the fact that the 20 largest investor-owned utilities trade at an average 81% premium to their book value.
• Excessive ROEs create a 'capex bias,' where utilities are incentivized to prioritize system-expanding capital expenditures over more cost-effective alternatives, such as energy efficiency, because they earn a profit on invested capital but not on other cost-saving measures.
• Reducing authorized ROEs could lead to substantial annual savings for US electric consumers; it is estimated that every 1 percentage point reduction in ROE could save consumers $4 billion annually.
• The authors estimate the implied cost of equity (COE) to be approximately 7.9% using a discounted cash flow model based on median values from the 20 largest utilities, which is notably lower than the 9.7% average approved ROE in 2024.
• Commonly used COE models often produce inflated results due to flawed assumptions, such as using arithmetic means instead of geometric means for historical returns, or applying growth rates that exceed long-term nominal US GDP growth (estimated at 4.0% per year).
• Claims that lower ROEs limit access to capital are contradicted by historical data from 1973 to 1985, during which typical utility stocks traded below book value yet the industry continued to add plants and raise necessary debt and equity.
• Potential credit rating downgrades resulting from lower ROEs do not necessarily increase costs for customers, as the reduction in ROE can outweigh the increase in the cost of debt.

APA

RMI (2025). Rebalancing “Return on Equity” to Accelerate an Affordable Clean Energy Future. https://rmi.org/resources/rebalancing-return-on-equity-to-accelerate-an-affordable-clean-energy-future/

Chicago

RMI. Rebalancing “Return on Equity” to Accelerate an Affordable Clean Energy Future. 2025. https://rmi.org/resources/rebalancing-return-on-equity-to-accelerate-an-affordable-clean-energy-future/.

Wikipedia

{{cite report |author=RMI |title=Rebalancing “Return on Equity” to Accelerate an Affordable Clean Energy Future |date=21 February 2025 |url=https://rmi.org/resources/rebalancing-return-on-equity-to-accelerate-an-affordable-clean-energy-future/ |access-date=17 August 2026 |via=Climate Insights Directory}}

BibTeX

@techreport{rmi2025rebalancing, author = {{RMI}}, title = {{Rebalancing “Return on Equity” to Accelerate an Affordable Clean Energy Future}}, institution = {RMI}, year = {2025}, month = feb, url = {https://rmi.org/resources/rebalancing-return-on-equity-to-accelerate-an-affordable-clean-energy-future/}, urldate = {2026-08-17}, note = {Indexed by Climate Insights Directory} }