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Electric utilities sometimes find themselves unable to earn an adequate return on equity (ROE). This can occur even after a company receives a rate increase. Even though rates are designed (in theory) to allow a utility to earn a specified ROE, this doesn’t necessarily happen in practice. Some utilities can do no better than getting within a percentage point of the allowed ROE. In some cases, the gap is even wider. This is known as regulatory lag.

There are various reasons why regulatory lag occurs. Some states base rates on historical (rather than forward-looking) test years. This makes it hard for the companies to keep up with rising expenses, despite their cost-cutting efforts. (Expenses can be lowered only so much before the reductions hurt system reliability and customer service.) Avista (AVA) has been hurt by historical test years. In many cases, a utility’s capital spending isn’t reflected in its rate base until after the utility has received a rate order. In May of 2011, a gas-fired plant of NV Energy (NVE) began operating, but the utility didn’t receive a tariff hike until the start of 2012. If electric or gas volume falls short of the expectations when a rate order was granted, this can make it tough for a utility to earn its allowed ROE. The utility subsidiary of CH Energy (CHG) has faced this problem. Finally, some companies’ kilowatt-hour sales are declining due to economic factors and conservation efforts. As a result, the three utility subsidiaries of Hawaiian Electric Industries (HE) have earned low ROEs in recent years.

Here are ways to address this problem:

• More frequent rate filings. Avista just received a rate increase in Washington state at the start of 2012, but filed another application as soon as it was allowed to do so, in early April. The utility subsidiaries of Great Plains Energy (GXP) are employing the same strategy in Missouri and Kansas.

• Immediate recovery of certain capital expenditures. In Minnesota, capital spending for environmental upgrades and renewable-energy projects is recoverable immediately. This has helped Minnesota Power, a subsidiary of ALLETE (ALE), in the past few years. Kentucky has a similar regulatory mechanism for costs arising from provisions in the federal Clean Air Act. This is good for PPL Corporation (PPL), which in 2010 acquired two utilities in the state. Illinois has enacted a law that will benefit the utility subsidiaries of Exelon (EXC) and Ameren (AEE) in the state, which will be able to recover costs through a formulaic approach.

• Tracking mechanisms for certain kinds of expenses. Most utilities have had fuel adjustment clauses for many years, in order to track fluctuations in fuel and purchased-power costs that aren’t reflected in base rates. These mechanisms are going beyond just fuel, however. ITC Holdings (ITC), the only publicly traded transmission-only utility, has a regulatory plan that enables it to recover the projected increases in most kinds of expenses, with a true-up at the end of each year. (The regulatory mechanism also enables the utility to recover capital spending on an ongoing basis, which was mentioned in the previous section.) Thus, regulatory lag isn’t a problem for ITC. For most utilities, however, the tracking mechanisms are much less broad. One example is a property tax tracker that NorthWestern (NWE) has in Montana, although it covers only 60% of the increased taxes.

• Mechanisms that decouple revenues and volume. The electric companies in California have had such a policy in place for many years, in order to encourage conservation that would otherwise hurt a utility’s profits. Instead, the growth of utilities there occurs through expansion of their rate bases, rather than rises in kilowatt-hour sales. Hawaii has enacted such a mechanism for Hawaiian Electric’s utilities. The new rules also provide for annual rate adjustments for capital spending and rising operating and maintenance expenses. CH Energy’s utility subsidiary resolved its aforementioned sales problem through a decoupling mechanism.

The measures discussed above generally reduce the effects of regulatory lag, but do not eliminate them. Even so, they are clearly a boon for electric companies, and their use is likely to increase as utilities request similar mechanisms in additional states.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.