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Determining a fair rate of return for regulated utilities
The Alberta Utilities Commission has the responsibility to ensure that the delivery of Alberta’s utility services takes place in a manner that is fair, responsible and in the public interest. Included in this mandate is an obligation to determine the fair rate of return for regulated utilities. It is important to have the right incentives for these businesses so they continue to invest in Alberta’s utility services and infrastructure and provide important utility services to Albertans. Part of this includes allowing shareholders to receive a fair return on their investment, but this must be balanced against ensuring fair rates for customers.
The utility industry is what is known as a natural monopoly. This means that there is limited or no competition. While generally we think of monopolies as a bad thing, in this case there would be more negative economic and environmental impacts than benefits to having more than one set of wires and poles or pipelines to deliver energy to customers. Therefore, Alberta sets defined service territories for utility companies and regulates them. Part of regulating the utility companies includes determining the rate of return that is used in setting customer rates, since there is no competition and the regular market forces of supply and demand are absent.
Determining the fair rate of return for regulated companies in the absence of these market forces is not simple, and requires complex financial analysis. The AUC determines the rate of return through something called the generic cost of capital proceeding. In this proceeding, the utilities and representatives of residential and commercial consumers present to the Commission analysis, evidence and financial experts review of utilities’ finances, credit ratings, credit markets, economic trends and other influencing factors. These proceedings are held every few years to update and review economic and financial developments since the last proceeding.
Utility companies finance infrastructure investments (referred to as rate base) through a combination of equity and debt. Equity is the money received from private investors, including pension funds. Debt is the money borrowed from banks and other institutional lenders. In order to attract investors to invest in Alberta’s utility companies to finance infrastructure projects, the utility companies must be able to offer fair rate of return, or the investors would invest their money elsewhere.
Generic cost of capital proceedings set the approved rate of return for equity (also known as return on equity) that is used in setting customer rates. Return on equity is calculated to compensate investors based on other comparable types of investment alternatives. The 2021 return on equity, as determined in Decision 24110-D01-2020, was set at 8.5 per cent for all utilities.
Generic cost of capital proceedings also determine each regulated utility’s ratio of equity and debt that is also used in setting customer rates (also called the deemed equity ratio). In Decision 24110-D01-2020 the AUC determined that for 2021, all of the distribution and transmission utilities will have a deemed equity ratio of 37 per cent, with the exception of AltaGas, which will have a deemed equity ratio of 39 per cent. One of the factors the Commission considers in determining this deemed equity ratio is an assessment of the risks faced by the utility.
The cost of debt (or the interest rate a utility pays on debt) is not typically set by the AUC, but is determined in the market, based on who is willing to lend the utility money.