On September 30, the Texas Senate Business and Commerce Committee discussed the return on equity the Public Utility Commission of Texas allows the state’s electric utilities. Barksdale English, the PUCT’s deputy executive director, put the average at about 9.6 percent. Mark Ellis testified at the same hearing, and we recorded with him the following week.
Return on equity is the one item in utility rates without an invoice. Customers pay it plus federal corporate income tax, so 9.6 percent costs them about 12 percent. The Supreme Court has tied utility return on equity it to what investors could earn elsewhere at comparable risk.
Utilities argue wildfire risk, inflation and growth justify higher returns. Ellis, who handled cost of capital at Sempra, Oncor’s majority owner, uses a capital asset pricing model common among utility expert witnesses, and gets 6 percent to 6.5 percent. He estimates the national excess is about $60 billion a year.
On this week’s Energy Capital Podcast, Joshua Rhodes talks with Ellis, now research director at MarketClear Utility Policy Research and an expert witness for consumer groups in rate cases. They discuss why the gap persists and how an auction could close it.
The rest of the conversation:
Credit ratings: why a lower ROE need not cost a utility its rating, and what Connecticut did by cutting both ROE and the equity ratio.
How commissions land near 10 percent: split-the-difference rulings, models benchmarked to other commissions’ awards, and, Ellis says, Illinois formula ROEs in the 7s.
Iberdrola’s two numbers: the U.S. discount rate it reports to investors, and why Ellis says it undercuts Central Maine Power’s 9.8 percent request.
The auction: offer part of each equity raise to bidders, stack the bids the way ERCOT stacks generator offers, and let the clearing return set the price.
What Ellis calls the bigger effect: a utility earning only its cost of capital stops gaining from every dollar of rate base, which he says makes performance-based ratemaking work and removes the reason to fight non-wires alternatives.
Plus: the Pennsylvania House’s unanimous vote on a market-based ROE bill.
Chapters
00:00 – Introducing Mark Ellis
00:57 – How utilities make money
07:08 – From Sempra insider to utility critic
12:53 – What makes a return fair
17:56 – The math behind a 6 percent return
22:39 – Lower returns and credit ratings
28:08 – Walking through a $10 billion project
33:15 – What utility stock prices reveal
36:49 – Why regulators keep returns high
42:12 – Letting investors bid: the MarketClear auction
45:11 – Who would invest, and how much
50:09 – How the utility business would change
54:12 – Why utilities resist non-wires alternatives
Resources
People & Organizations
Company & Industry News
Texas Scorecard - Reformers say Texas regulators are raising utility profits
Spectrum News Maine - Consumer advocates challenge Central Maine Power’s requested returns
The Maine Monitor - Iberdrola must open its books, regulator says
Inside Climate News - A former utility executive on why electricity bills are so high
Books, Articles & Filings Discussed
American Economic Liberties Project - Rate of Return Equals Cost of Capital
MarketClear - Proper utility ROE does not threaten credit ratings
Texas Senate Business & Commerce Committee - September 30, 2026 hearing
Related Podcasts by Energy Capital
Inside the PUC’s cost-allocation overhaul with Chairman Thomas Gleeson
Texas power companies and utilities see stellar 2Q on data center expansion
Transcript
Joshua Rhodes: Hey everyone, and welcome to another episode of the Energy Capital Podcast. I’m excited to have Mark Ellis here to talk about how utilities make money and talk about how he thinks that should change. Mark is— He’s got a BS for mechanical engineering from Harvard, so it’s great to have another engineer on the podcast. We rarely have other engineers on the podcast. And you have an MS from MIT’s Technology and Policy program. He was an engineer at SoCal Edison and Sanyo Electric, an analyst at ExxonMobil. He’s been a consultant at McKinsey before. He spent 15 years at Sempra, leaving as the chief corporate strategy. He also served as the chief economist. Now he’s a senior fellow at the American Economic Liberties Project, an independent consultant and expert witness in finance and utility regulatory proceedings. He’s also a co-founder of MarketClear Utility Capital, which we’ll get to. Mark Ellis, welcome to the Energy Capital Podcast
Mark Ellis: Thanks for having me. It’s great to be here.
Joshua Rhodes: When we talk about energy in Texas, a lot of the focus is on deregulation, like, you know, generation is independent, a lot of retail or generation is, has been unbundled, a lot of retail is in the competitive market. And so a lot of the times, if we’re not talking about munis and co-ops, you know, a lot of times if we’re talking about, you know, investor-owned utilities or if we’re talking about the concept of a regulated rate of return, we’re talking about the wires and poles, the transmission, the distribution networks. And so I think a lot of folks in Texas at least kind of understand the electricity market per se, but can we start with the basics of a lot of things that ratepayers don’t see? Like how does investor-owned utility actually, you know, make a profit when they’re in a regulated space?
Mark Ellis: Right. So as you mentioned, Josh, in Texas, for most of the market, there’s two components. There’s the wholesale generation part, which they typically call, you know, energy.
Joshua Rhodes: Right.
Mark Ellis: And then there’s a delivery charge. So the wholesale component is there’s a competitive market and plants and the owners of those plants compete against each other to provide the most competitive pricing. In addition to that, there’s a delivery charge, and that basically accounts for the poles and wires, the transmission and distribution that bring the energy, the electricity from the wholesale market to your home or to your business. And while the generation market is competitive, and there’s multiple parties competing for your business, the transmission and distribution part of it is still a regulated monopoly, and that business model really dates back to the time of Edison, right? It’s a more than a century-old business model.
Joshua Rhodes: Right.
Mark Ellis: And the basic ideas is Edison and his right-hand man, he had a business partner named Samuel Insull, and they convinced, uh, state authorities, legislators that they’re what they call a natural monopoly. It didn’t make sense to have multiple sets of wires running down people’s streets or through their neighborhoods. And so they said one company can control all of the transmission and distribution infrastructure within a geographic area. But when they granted that, they said, “Well, wait a minute. If you’re the only provider, we have to put some conditions around that to make sure that you don’t abuse your monopoly power.” And there’s basically two primary conditions. One is you have to serve every customer who’s willing to pay your rates, and then those rates will be regulated by the regulator, by a state commission, and the intent of that regulation is to ensure, what they called it at the time was just and reasonable, to make sure it’s fair to customers, that you’re getting a fair return on your investments in all this infrastructure, but you’re not taking advantage of customers. So the, the general principle is just and reasonable, and then there were a series of Supreme Court precedents in the 1920 and 1944 that codified, well, what do we mean? How do we actually implement just and reasonable in terms of calculating a number? So the general principle, though, is cost of service regulation.
Joshua Rhodes: Mm-hmm.
Mark Ellis: So not cost plus. And the idea is these are for-profit companies, so profit is considered part of their cost.
Joshua Rhodes: Okay.
Mark Ellis: And so that’s part of the cost that they recover. Basically, you can think of it as they take all the different costs, operating costs, fuel costs, labor, taxes, and then in addition, they add on their investments, which are recovered over time. So a portion of their investment is recovered each year. Then they add on a profit. They divide that roughly by the number of kilowatt hours, and then that’s what’s charged through to customers. In that calculation, every single item except for one, there’s basically an invoice or some traceable piece of paper that helps them determine what the cost is, right? So, you know, there’s accounting records that say how much they paid their employees, how much they paid for rent. The one item, how much they pay in interest on their debt.
Joshua Rhodes: Mm-hmm.
Mark Ellis: The one item that does not have a record behind it is their profit, and that profit level is determined in state regulatory proceedings. That is the most contested part of these regulatory proceedings. The technical name, they call it the return on equity, and it’s basically the profit on shareholder capital.
Joshua Rhodes: Okay. And so maybe if you use some of the terms a little different, is that regulated rate of return? Is that what you’re talking about, is it return on equity, regulated rate of return? Is that interchangeable there or—
Mark Ellis: Not quite. So the regulated rate of return is the interest plus the return on equity
Joshua Rhodes: Okay, got it. So it would be more?
Mark Ellis: Yeah. The return on equity is typically expressed as a percentage.
Joshua Rhodes: Okay.
Mark Ellis: Right? So it’s a weighted average co— a weighted average percentage, so the interest rate on their debt is typically lower than their expected return on equity. So the return, ROR, the rate of return is generally a little bit lower than the return on equity. One other wrinkle about this, that return on equity is the after-tax return to investors, so it’s typically grossed up. The taxes are passed through to customers.
Joshua Rhodes: Okay.
Mark Ellis: So what customers actually pay is higher than that authorized return. They pay the authorized return on equity plus taxes. To illustrate, so in Texas, if the authorized ROE is, it’s roughly about 9.6 in Texas.
Joshua Rhodes: Yeah.
Mark Ellis: And then the corporate tax rate is 21 percent, so that works out to about 12 percent is what customers are effectively paying.
Joshua Rhodes: That’s corporate taxes, not taxes on electricity, right?
Mark Ellis: Correct. That’s the corporate tax.
Joshua Rhodes: Okay. But the rate of return is on CapEx spend, ‘cause there’s OpEx is just pass-through, right? Like trimming the grass and maintenance and stuff like that. Do you know what portion of what shows up on people’s bills ultimately comes from, like, the CapEx versus, like, the OpEx?
Mark Ellis: Yeah. So the numbers are always changing. The CapEx portion or the T&D portion, the distribution charge is an increasing portion of the bill over time. I think the last I looked at the numbers for Oncor, I think it’s up, like, 60 percent since 2019 versus the wholesale energy charge has not gone up as much, so it’s a bigger fraction.
Joshua Rhodes: Yeah.
Mark Ellis: And then of that T&D charge, in Texas it’s a little bit different than other states, a little bit lower in Texas than other states. About 15 percent to 20 percent is the profit plus the tax on the profit in the delivery charge.
Joshua Rhodes: Okay. Well, I think I got it.
Mark Ellis: Yeah.
Joshua Rhodes: We’ll see. We’ll see as I ask more questions. I know it’s a complicated thing. Let’s take a step back. So you spent 15 years inside of Sempra, and you finished as its head of corporate strategy, and today you’re one of the most prominent critics of how utilities, you know, earn money. How did that happen? How did that switch happen there?
Mark Ellis: So I lived in Houston at the time. I was working for McKinsey. I worked for ExxonMobil and then McKinsey, and I joined Sempra in early 2004 when— At the time, this was like the beginning of the era of deregulation, and utilities all over the country were focused on their unregulated businesses. So Sempra had it, you know, they were a pioneer in LNG, they had a big trading group, they had an unregulated or merchant generation, unregulated generation. I’ve joined at the corporate center to really focus on, on those unregulated businesses, in particular LNG and wholesale generation, mostly in California, but also we had some coal plants in Texas and really focused natural gas pipelines and storage, just all the unregulated stuff. And that was like the first 10 years I was there was really focused on that. We built, you know, did a lot of really cool stuff. We built the first utility-scale PV project in North America of this sort of current generation. The very early ones were built by ARCO in the ‘70s, but like the current generation of these going out in the desert and putting gigawatts of panels, our site was outside Las Vegas and it was the first 10 MW, and now there’s like gigawatts out there, like the whole area is just covered.
Joshua Rhodes: 10 MW is like community solar now, right? Like—
Mark Ellis: Yeah. Then what happened is, is after the financial crisis, you know, and a lot of, based on a lot of the work that I did, they realized like, you know, these unregulated businesses, they have a lot more risk than we expect, and the returns are a lot lower precisely because they’re competitive. Those sleepy old utility businesses that we thought were just earning their cost of capital are actually, that’s where the value is. And over the next roughly decade, Sempra kind of jettisoned on their unregulated businesses. As I said, we were the first to build utility-scale PV. We built like a gigawatt and got out... Shouldn’t say we.
Joshua Rhodes: Okay.
Mark Ellis: Sempra built like a gigawatt, and then got out of it within like 3 years, I think, ‘cause just the returns got bit down. You know, they sold off the merchant generation business, just sort of jettisoned all that and doubled down on their utilities. Huge CapEx expansion in San Diego Gas & Electric. The icing on the cake was the purchase of Oncor in 2019, and basically the idea was, hey, you know, we kind of understand, like return on equity is much greater than our cost of equity. More CapEx means more shareholder value. We wanna replicate that in Texas. And the idea was Texas was, you know, Oncor was going through the Energy Future Holdings, so they were probably not investing ‘cause the parent was capital constrained, and when they’re going through a bankruptcy, when you are
Joshua Rhodes: Yeah
Mark Ellis: So the idea was, hey, there’s kind of a backlog of capital to spend. They were gonna go in there and provide the capital to expand the rate base, and I think, you know, the growth in oil and gas production and the transmission build out and now data centers, you know, it’s pretty much as they, maybe even better than was envisioned.
Joshua Rhodes: Yeah.
Mark Ellis: You know, I kinda give this long story is I came in to focus on all the unregulated stuff. The company had this transition to the regulated, and frankly, my skills weren’t needed that much, and kind of the work was starting to wind down. In addition, you know, they went through several CEOs. The most recent one who’s still there, I didn’t necessarily see eye to eye, and so when he came in, I kinda knew the writing was on the wall. There was cost-cutting study that I actually oversaw, and then one of the results of that was, “Hey, we don’t need you anymore. We’re gonna eliminate your job, but here’s a nice severance package.” And truth be told, it was blessing in disguise. From a personal perspective, I had four kids. First was just entering college. Not a good time to lose your job. But in terms of like pushing you out of the nest to find something new that you’re really passionate about, it was just awesome. I kinda fell into the expert witness work serendipitously just through a friend, a, a Sempra colleague who introduced me to one of the main intervenors here in California called TURN.
Joshua Rhodes: Yeah.
Mark Ellis: And my first case was related to the PG&E wildfire, sort of a... Basically, there was a stub of wildfire victim claims that was left unpaid, and they had this whole financing scheme that was very creative, and they asked me to provide testimony on it. I had never done any expert witness work and never been cross-examined. My very first time being cross-examined was the senior utilities lawyer at Munger, Tolles, which is a very, very high-powered litigation firm. Munger is Charlie Munger. And I was crossed for 5 hours. It was a, you know, baptism by fire, kind of like a boxer going up in their first match against Mike Tyson, but I felt like, “Hey, I held my own.” And kind of felt like this is my true calling. I know I’m getting a feel. So that’s how I kind of fell into the expert witness work. And in that first case, ROE was not the primary focus, but it was an issue. And I started digging into it, I’m like, “The expert witness testimony on this stuff is just garbage.” Even the consumer advocates are repeating the utility’s playbook. They don’t really understand finance.
Joshua Rhodes: Okay.
Mark Ellis: One of my jobs at Sempra was I was responsible for the cost of capital. So I knew, like, what they’re telling themselves internally was very different from what they’re telling the regulator. And so I decided, like, hey, you know, this is an area where my expertise and experience as a former insider could make a difference, and so that’s why I really started to focus on that.
Joshua Rhodes: Got it. And I’ll say, like, I’ve been in that expert witness seat, cross-examined for, you know, 5, 6 hours at a time. Hardest day you’ll ever work in your life. Just about having to be completely on and being so guarded with all the words you’re saying and be extremely precise. So been there, done that. So one of the things you’ve done recently is you’ve written a paper or you’ve got a paper called The Rate of Return Equals Cost of Capital.
Mark Ellis: Yeah.
Joshua Rhodes: What’s the difference between those two things? Why do you think the distinction matters so much in this conversation?
Mark Ellis: Yeah. So the rate of return refers to what the regulator authorizes, right? So I mentioned before there’s this one item in the revenue requirement that there’s no invoice, it’s set by the regulator, that’s the rate of return. And then I also mentioned there’s a series of Supreme Court precedents, 1920 and 1944, that basically said, “Well, what do we mean by a just and reasonable rate?” And in particular for that profit, that rate of return, the standard was, oh, it should be equal to the market-based cost of capital. The specific language they use refers to the returns available to investors on investments of comparable risk. In economic and finance parlance, that is the market-based cost of capital or the opportunity cost of capital. And so, you know, that is the principle, the rate of return should be equal to the cost of capital. That is codified in some states. Maine actually has... Their highest court actually had a decision in 1960 that codifies that, hey, the rate of return should be equal to the cost of capital. It’s just a given. Everybody agrees to that. NARUC agrees to that. Utilities agree the rate of return should be equal to the cost of capital. And again, it’s why? Because that is the cost of service regulation principle, right? It should be equal to... It’s not cost plus, it’s the actual cost. So the difference is, one is set by a regulator, right? The rate of return, the cost of capital is set by the market. The challenge is, we mentioned before, the rate of return is a weighted average of the cost of debt and the cost of equity. The cost of debt is easier to determine because there’s a contractual number, right? It’s the interest rate on the debt. So it’s a pretty perfunctory exercise to determine the cost of capital for debt. In contrast, the cost of equity, it’s not in the contract anywhere, you can’t look it up on the Bloomberg screen, so it has to be estimated. The good news is that this is one of the most thoroughly researched topics in all of finance, and the methodologies have won Nobel Prizes starting back in the ‘70s, and they’re very simple and straightforward. A first-year undergraduate finance student could estimate the cost of equity for a utility. But what we find is that what is done in regulatory proceedings is completely untethered to finance as practiced, you know, in academia or in corporations, or what’s taught in business schools and undergraduate institutions.
Joshua Rhodes: So one criticism of that is, like, you’re subbing in, like, a broad equity market return forecast for a utility-specific cost of equity, and I guess, like, some of the things with utility, like the obligation to serve, and, like, the wildfire risk and other types of things like that, also things have been used to kind of, like, push back, I guess, against some of your arguments. Like, what’s your response to those and when they say that we’re different than everyone else?
Mark Ellis: So first, just a correction. We’re not substituting in just the market-expected return.
Joshua Rhodes: Okay.
Mark Ellis: That’s a benchmark, and then everybody agrees utilities are lower risk than the market. So in principle, the cost of equity is lower than the expected return on the market. So market forecast, you know, the expected return on the market, you know, that’s a very widely studied number, and there’s lots of different sources for estimates of that. Federal Reserve does a survey. Financial institutions like BlackRock and Vanguard, Goldman Sachs, JP Morgan, they all publish their estimates of the cost of equity on a routine basis, update it annually, if not more frequently. So that’s a benchmark, kind of the ceiling, and then there’s adjustments. In terms of the methodology, in principle, you know, we’re using a CAPM, what they call the CAPM, which is the Nobel Prize methodology. It’s kind of the gold standard. They’re using a CAPM, it’s just whose assumptions are more reasonable. So the criticism around, you know, you’re not accounting for certain risks and so forth, it’s like we’re using the same methodology. If your methodology accounts for those risks, mine does too. You know, the fact that it may not account for certain risks, you know, it’s no different, right? The other point is a lot of times when they try to account for these idiosyncratic or company-specific risks, there’s a financial theory that says, hey, they shouldn’t be compensated. That’s actually called modern portfolio theory. Two, when they do the analysis, they actually just a hand wavy, “Oh, just add 100 basis points for risk.” And it’s like, well, how did you come up with that number? They don’t have an answer, and it’s like, well, maybe it’s 10 basis points. Maybe it’s zero basis points, right? But they’re adding 100, so it’s just not a very rigorous analysis. We’re getting kind of in the weeds, but the criticism like, “Hey, you’re using the market,” no, we’re not. We’re actually using the same methodology. We’re not accounting for the risk. Well, in general, we are accounting for the same risks. When add on adders, the onus is on them to justify them and quantify them, and they generally don’t.
Joshua Rhodes: So if you’re using the same equations, are you just like, do you have different values in those equations for various different risks? ‘Cause like you’ve argued that a fair return on equity would be about 6 percent or maybe a little bit over for like most utilities, and the 2024 like average electric gas utilities rates is, I think, 9.7 percent or so. So walk us how you get from, you know, the average right now being 9.7 down to, you know, 6 percent.
Mark Ellis: Yeah. So I’ll just start with the CAPM framework, right? So the CAPM, it’s called the capital asset pricing model. It’s a very simple model, and the whole idea is that it’s a model of compensation for risk. The idea is, at any given time, you know, you always have the option of investing in what they call the risk-free asset, which is like a Treasury. So in utilities, they say, “We’re interested in the long-term cost of equity,” so they typically benchmark it to a 10, 20, or 30-year Treasury rate. So it’s the Treasury, the long-term Treasury rate, plus some risk premium to account for the risk. And so you say, well, there’s a benchmark out there. The risk is relative to the market. This is the concept of the CAPM. You know, because utilities are lower risk than the market, the return has to fall somewhere between that Treasury return and the return on the market, right? And the level of risk where it falls along that line is what they call beta. And beta for utilities, it varies, but long-term average is about 0.5. The expected return on equity or the cost of equity for a utility should be somewhere, you know, halfway between the Treasury rate and the expected return on the market. The most recent Fed survey of expected return on the market, the median is 7.
Joshua Rhodes: Okay.
Mark Ellis: Treasury rates are 5 right now. When they did the survey, they were about 4, right? So if you were to take half the difference between 7 and 4, that’s 4 plus 1 and, 1.5 is 5.5. If you take half the difference between... And, you know, say, “Okay, we’re gonna take that same increment, and we’ll add it to 5,” so you get 5 plus 1.5, about 6.5 today because interest rates have gone up.
Joshua Rhodes: Okay.
Mark Ellis: So that’s how you get the, oh, we expect it to be about 6, 6.5 percent today.
Joshua Rhodes: I think you’ve estimated that 6 percent gap was roughly about 50 billion per year nationwide?
Mark Ellis: Yeah. So the numbers change. That number is from the ALP paper, and it’s based on data from the end of 2024.
Joshua Rhodes: Okay.
Mark Ellis: I’ve updated that methodology. It’s about $60 billion nationwide, including the tax gross up. That’s the excess profit, not the total profit.
Joshua Rhodes: Does that also have baked in there, like... I mean, one of the things we talk about a lot right now is we’ve actually talked for about 20 minutes and haven’t said the word data center, so I feel like we need to talk about them now. Okay. ‘Cause in energy conversation... No. Just in the context of, you know, with demand for electricity growing and supply chains being constrained, like everything just costs more. I’m no longer, but I was recently was a commissioner for Austin Energy, it’s local municipal utility in Austin, Texas.
Mark Ellis: Yeah.
Joshua Rhodes: And I would see like every transformer, you know, cost double, triple what it did a few years ago, every power line, everything costs more, and part of it’s just I think still hangover from COVID, but other parts of it is like there’s just so much demand for all of this stuff that like there’s pressure being pushed up that. So i— is that why your 50 went to 60, or would it go higher now, like if you were to redo—
Mark Ellis: The 50 went to 60 just because utilities have grown their rate base in the last almost 2 years since I did the last calculation. In other words, it’s just utilities have been growing a little bit faster than they have historically, so the number goes up. You would expect the number to go up over time just because the economy’s getting bigger, utilities are getting bigger kind of thing. They’ve gone up more because their rate base is expanding faster than it has historically.
Joshua Rhodes: Okay. So on that 50 billion you estimated that that save, that’s about 300 per household. Is that just dividing by kilowatt hours, like 1,000 kWh a month estimate or something like that?
Mark Ellis: That number was a very, very complex, trying to push it down in the residential bills how much it would be. That took a lot of work, and I don’t like to repeat that, so now typically the way we calculate it now is we just take that 60 billion divided by the number of households in the country Period. And assuming like, hey, even though an individual customer may not face that directly, ‘cause there’s industrial and there’s commercial users who also pay these inflated rates, it flows through to them for the most part, right? So restaurant prices are higher, rents are higher when they go to the dentist, and that gets passed through in their, you know, the fee that they pay the dentist, so forth. So 60 billion divided by 133 million households, it’s like 480 or 470. I don’t remember what the exact number is per household. Like, that’s the sort of the average cost per household net.
Joshua Rhodes: Got it. Okay. One of the things is like u— so utilities will argue that, you know, wildfire risk, inflation, enormous CapEx, growth of electricity all justify kind of these higher returns, and that cutting their returns would hurt their credit ratings and the ability to raise capital. And there might have been somewhat of an example of this, correct me if I’m wrong, this is your space more than it is, than it is mine, and some people point to the Connecticut tried, apparently tried to do this. They tried to cut or aggressively cutting these returns, and then ended up reinstating them back to somewhere closer to the national average. So is there anything to their claims? Like there’s anything that makes them different? Or what happened in, and then what happened in Connecticut, I guess?
Mark Ellis: Yeah. So you’re quickly getting into some, like, pretty technical stuff.
Joshua Rhodes: Sure. It’s dangerous for me, too.
Mark Ellis: You know, I’ll start at the high level. Whenever utilities always come in and they say, you know, “Oh, we want this ROE and we want this equity ratio,” and, you know, the equity ratio is the amount of equity in the capital structure. Just on its face, it’s a little strange because most companies, right, they don’t like to raise equity, right? Raising equity is just sort of like they scarce and they don’t like to raise it and accept it. But when you think about, like you mentioned data centers And when you look at how this dynamic is going, nobody wants it on their balance sheet, right? It’s like—
Joshua Rhodes: Yeah.
Mark Ellis: I don’t want to put up the capital, I want you to put up the capital. Utilities, they like to come in and say, “No, no, I want equity ratio to be as big as possible,” right? Which on its face tells you something like why would they do that? Well, the reason why is because that ROE is really profitable, right? So they come in and they say, “I want a high equity ratio.” Usually it’s, they want more than they currently have on both the equity ratio and the ROE. And then they say, “And if you don’t get what we want, it will adversely impact our credit rating and our ability to attract capital.” There is a tiny grain of truth to what they say. In other words, any reduction in ROE and/or the equity ratio at the margin will be adverse to their credit rating in and of itself. Like all else equal, they ask for X and you give them X minus on either or both of those, it is worse for their credit than what they requested. It doesn’t mean it’s worse than what their current credit rating is, ‘cause typically they’re asking for something more generous than what they currently have. You know, they typically do not clarify that. In other words, they have a certain credit rating, you know, based on wherever they are today, they ask for more.
Joshua Rhodes: Mm-hmm.
Mark Ellis: And they say, you know, “Oh, if we get what we want, it will improve our credit rating,” right? They don’t really clarify that, and then they just say, “And if we don’t get what we want, it will have adverse consequences for our credit.” So there’s a bit of like sleight of hand going on there. So that’s one point. The other point is there’s a trade-off between the ROE and the equity ratio. So you often hear and, and they, you know, I think this is a flaw that many regulators make is they kind of wanna do both. They wanna hit ROE hard, and they wanna reduce the equity ratio. And when you kind of run the numbers, ROE is a much more powerful lever to reduce customer costs than increasing the amount of debt or reducing the equity ratio. And so you’re much better off like, “Hey, let’s just focus on ROE to reduce the customer cost,” because remember, it’s high to start with and it’s grossed up for taxes, right? So that’s a very powerful lever. And then they say, “Well, what about the impact on credit?” And the counterintuitive thing, it’s counterintuitive in regulatory land, it’s not counterintuitive in finance to say, “Well, if I’m hitting your profits to keep your credit where it is, I actually have to reduce the amount of debt.” Right? It actually increased the equity ratio. They’ll say, “Well, wait a minute. You’re increasing the amount that they earn a profit on.” But the reduction in that ROE more than compensates for the increase. So it’s like a 20 to 1, like for any given credit metric or credit rating you’re trying to achieve, the benefit of reducing ROE versus the equity rate versus increasing the equity ratio is like 20 to 1. So you always would just say, “Okay, I’m gonna reduce the ROE, and if I have to give back a little bit on the equity ratio, it’s fine ‘cause I’m way ahead of the game. I get 95 percent of, you know, what I get just from the ROE and the credit.” So what happened in Connecticut is they kind of went after both and then, you know, the utilities were... They said, “Well, look, it adversely impacted our credit rating,” and made a big deal out of that. Of course, they exaggerate it. You know, most people don’t realize, like, a one-notch downgrade for utility credit rating increases their marginal cost of debt 10 to 15 basis points. And, like, when you run the numbers, it’s like, it doesn’t really affect customer costs. They say, “Oh, it’ll increase customer costs.” It doesn’t that much. That said, I’m an advocate like, “Hey, there’s a variety of reasons why utilities wanna maintain strong credit other than just the direct cost and the rate of return, because they have all kinds of counterparty obligations with their lenders and their trade credit.” So my approach is, we’re not gonna touch credit. Like, if you come in with a triple B plus, we’re gonna keep it a triple B plus. But we can reduce that ROE and make a, a modest increase in your equity ratio and, you know, investors are all happy, creditors are happy or happier because there’s less debt, right, which they tend to be happy about that, and equity investors are getting a fair return, not an excess return, and customers are way better off. Typically, it’s about a 10 percent reduction when you optimize the, you know, make the ROE quarter the cost of equity, and then make adjustment to the equity ratio. Realize that’s super technical. I’ve never had anybody g— get into that. When I testify, this is 30 pages of testimony just walking through all this.
Joshua Rhodes: Okay. So let’s just like zoom out for just a little bit and try to use some round numbers. All right? So you can tell me if these numbers are close. So like if a utility’s gonna build a project, say they’re gonna spend $10 billion on a suite of, you know, transmission lines or substations or whatever it is. Okay. You’ve talked about like equity ratios and then I guess the other side of that, well, there I guess there’s either cash or debt percentage that they’d go after, right? So can you give me a feel for like, how does that pie get sliced up in like, in terms of how does that $10 billion... We’ll try to keep them round numbers. Where does it go, and then what is this piece applying to? Does that make sense?
Mark Ellis: Yeah. I mean, that’s typically what happens. A utility comes in and says, “I wanna invest $10 billion,” and then there’s a negotiation around how much is financed with debt and equity. Typically, that is the capital structure, debt and equity. That’s just what, it’s long-term debt and equity. They don’t use cash per se, that’s equity.
Joshua Rhodes: Okay.
Mark Ellis: And generally 50/50. I think in Texas it’s 46 or 48 equity. They’re a little bit more debt heavy there. In this case, you’re talking about issuing new debt, so whatever the cost of debt would be right now, utility debt, I guess is, I don’t know the exact number what a newly issued utility bond would be. Somewhere in the sixes, I think.
Joshua Rhodes: Mm-hmm.
Mark Ellis: It’s just, okay, whatever the debt costs you to issue, you know, you have to make it competitive. You issue bonds and there’s a market out there that sort of determines it. You know, for example, Oncor would never go in and say, “I wanna get the debt from Sempra. They’re gonna charge me 7.5 percent.” They’d be laughed out of the room and kind of rightly so. It’s like, well, of course you issue bonds and let the market figure it out. It’s the equity, that 5 billion of equity in your scenario, where they say, “I’m gonna raise 5 billion of equity,” and then there’s the ROE. The ROE isn’t just on that incremental amount, it’ll be on everything that’s outstanding. If they had 25 billion already outstanding, and there’s 5 billion more, that return on equity that they’re negotiating with the regulator applies to the 25 that’s outstanding plus five that’s new.
Joshua Rhodes: Okay. There’s also depreciation happening in the background, right, on these—
Mark Ellis: Yeah. The way it works is you have this, what they call rate base, which is, you know, all the investment net of depreciation. So it’s cumulative net investment is roughly rate base. They also deduct from rate base deferred taxes, because deferred taxes are considered an interest-free loan from the government. So rate base is essentially cumulative net investment. In other words, everything you’ve ever spent, less depreciation, less deferred taxes. That’s rate base. And then how that’s financed is 50/50 debt and equity. Well, as you depreciate, you’re reinvesting that depreciation to keep the rate base where it is, right? ‘Cause, you know, constant... It’s not just the, the incremental, but there’s ongoing maintenance CapEx and so forth. So in general, rate base is always growing, and there’s just like this churn, right, where, as, you know, the depreciation gets reinvested, plus you’re building new stuff
Joshua Rhodes: Okay. I’m gonna try to ask it, like, a slightly different way in terms of, like, there’s debt and then there’s equity.
Mark Ellis: Yeah.
Joshua Rhodes: Right? Generally. It’s like generally, so there’s a 50/50 split, maybe it can be a few points either way. How is this treated differently? ‘Cause we’ve talked about rates. So this rate is about 9.7 percent. You said it should be 6 percent. Does that apply to both of sides of that, debt and the equity? Like, what is—
Mark Ellis: So it only applies to the equity component. In your hypothetical, there’s 5 billion of debt, 5 billion of equity.
Joshua Rhodes: Yeah.
Mark Ellis: The cost of the debt is just, you issued a bond, what’s the rate on that bond?
Joshua Rhodes: Okay.
Mark Ellis: You recover that from customers, and you pass it through to the lenders. It’s kind of frictionless. It’s just another cost. It’s just a pass-through. The equity is like, well, what’s a fair return on equity? There’s no contract anywhere. It’s just when they issue equity, there’s no promise in the issuance of the equity, like I’m gonna pay a certain amount based on what the regulator determines. So that’s the part that’s negotiated. So the, the ROE is just for the equity, return on equity.
Joshua Rhodes: Right. Okay. So I think, like, in conceptually, I can understand, like, the debt, like a bond. Like, you pay back... And I know that all the freshmen in project finance are gonna be laughing at, you know, me not, not, not knowing this, but what is that equity instrument? What is actually being either created or borrowed or what? Because at some point it’s 5 billion of something.
Mark Ellis: Oh, yeah.
Joshua Rhodes: Right? Like, what is that something?
Mark Ellis: So most utilities are held by, like, a holding company owns the common equity, but let’s just assume like, hey, you know, that equity is, that’s what stockholders own. Like, you take up that equity and you slice it up, and each one of those slices is a share of common stock. That ROE, the ROE times the amount of shareholder capital invested is their net income or their profit, right? Net income, profit, same thing. After-tax profit.
Joshua Rhodes: Yeah.
Mark Ellis: That’s the connection you’re trying to make. So this ROE, like, why should I care? It’s because that is the profit. ROE times the amount of equity is net income. These are for-profit companies, so that is the entire equation for a utility business. Simplest business model in the world, it’s this number that’s set by a regulator times the amount of capital the regulator allows you to invest, equals your net income. That’s it. Very, very straightforward.
Joshua Rhodes: Okay. Is there any way that, like, we could tie that to, like, equity? We brought it down to shares. So someone owns five shares of a company and they go up $2.
Mark Ellis: Yeah.
Joshua Rhodes: Can we tie those things together to just try to make it people understand. Yeah.
Mark Ellis: Now you’re getting into like, okay, how do we know that these ROEs are too high? So there’s a principle in finance called net present value or present value, right? So the value of an asset is the, you know, you take what the cash flows, right, the profits you expect in the future.
Joshua Rhodes: Mm-hmm.
Mark Ellis: And then you discount them today, right?
Joshua Rhodes: Right.
Mark Ellis: At what? At their cost of capital. So if it’s equity, you discount them at the market-based cost of equity to today. And just as like the foundational principle of finance, like if those cash flows are just equal to the return, equal to the cost of equity, then when you discount them back, the present value is equal to exactly what you have invested. So like if I buy a Treasury bond today, just today, right, and the interest rate today is 5 percent, right, then if I bought it for $100, it’s worth $100. If interest rates go down tomorrow to 4 percent and I’m still getting 5 percent, guess what? Now that bond is worth more than $100. Tomorrow, somebody who pays 100 is only getting four. I’m getting five. So my bond is now worth roughly 20, 25 percent more.
Joshua Rhodes: Yeah.
Mark Ellis: Right? So that’s a really important concept, is if you’re just earning your cost of equity, then whatever you have invested, that’s what the market value should be equal to. And so when you look at utility stocks, this is well known, this was articulated by economists, you know, in the 1970s, is how do we know if ROEs are being set appropriately? We look at their market value, the stock market price, relative to what they call the book value, which is the amount of capital actually invested, right? So that price to book value is like the benchmark on are we setting ROEs appropriately or not. This is like foundational finance, and this has been known, like I said, for over 50 years. Utility stocks routinely trade at twice book value.
Joshua Rhodes: Okay.
Mark Ellis: So that tells you on its face that the profits that they’re earning, the return, right, is much greater than the cost of equity.
Joshua Rhodes: Okay.
Mark Ellis: So a way to think about it is every dollar of shareholder capital that they invest in wires, because their cost is six but they’re earning 9 to 10 turns into $2 in their market price. So I like to give an analogy, “Hey Josh, I got a deal for you. Give me a buck, and I’ll put two in your retirement account. Do you wanna invest?” And I’m pretty sure I know the next two things you’re gonna say. One is, “Yes, I want to invest,” and the second one is, “Am I limited to a dollar? Can I do $10?” “Can I do a million dollars?” That is essentially the utility business model in a nutshell. And so when you look at this price to book, you know, it’s like you can go on Yahoo Finance right now and look up utility price to book. It’s not a mystery. This is just staring everybody in the face. You know, you can cite writing from Alfred Kahn, who was President Carter’s deregulation czar. He talked about this in his textbooks. Peter Navarro, the Trump advisor, wrote a paper about this, about, “Hey, the price to book tells us whether utilities are earning a fair return.” He wrote about this in the ‘80s for the DOE.
Joshua Rhodes: Mm-hmm.
Mark Ellis: One on the left, one on the right. This is all, like, very well-known, well-established sort of financial facts in utility regulation, and it’s just kind of staring everybody in the face and people ignore it.
Joshua Rhodes: So yeah, so you say it’s staring everyone in the face and people ignore it. I guess it’s like you’ve testified before a fair number of public utility commissions around the country, but it doesn’t seem like it’s moved that much off of, like, the 9 percent. So what’s the pushback you get, or, like, what does that conversation always look like then?
Mark Ellis: So it hasn’t moved that much but, you know, regulator never comes out and says, “There’s the utility, and there’s three or four intervenors, and I’m picking this one.” They kind of say, you know, “Utility said this, intervenor one said that, intervenor two said that, and I pick a number somewhere in between.” And you never get feedback on like, “Hey, is this argument making a difference or not?”
Joshua Rhodes: Okay.
Mark Ellis: So that’s one point. Another point is, unfortunately, regulators often don’t understand, like, basic Financial principles. I will give you an example. I mentioned before, like the CAPM is kind of the gold standard model. There’s another commonly used model called the discounted cash flow. It’s sort of mathematically legitimate. It’s kind of bespoke. It’s only used in regulatory proceedings, but it’s commonly used, and you can do it in a reasonable manner with reasonable assumptions. In utility regulation, they use two other models that are self-referential. They’re circular. They’re not based on a market-based cost of equity. They look at other authorized returns from other commissions. So FERC has come out and said, “Hey, those two models, you can’t use them anymore.” And their, their language was they’re circular, and they defy general financial logic, and they said they’re based on the book return, not the market return, and investors can’t buy at book value. I can’t say you’re trading at price to book of two, I only want to pay one, right? Can’t do that. You have to pay the market price. So FERC has banned these models But they’re still used all over the country. In fact, I testified in Texas last week in the Senate Business and Commerce Committee, and the chair of the committee asked the number two from the PUC, the Texas PUCT, “Do you use these models?” First, the PUC member was asked, “How do you determine ROE?” And he said, “We look at what other authorized ROEs.” He admitted that in the hearing.
Joshua Rhodes: Mm-hmm.
Mark Ellis: And it’s like, people who understand regulation know that’s not the standard. Then he was asked by the chair, “Do you use these models that FERC has banned because they’re circular and defy general financial logic?” And he said, “I don’t know.” And he says, “I know. I’ve actually looked into it,” and they do. And they say, “This is the primary model we use.” Primary risk premium model they use. You know, so if regulators don’t understand sort of the basic principles and are using defective models, it’s not surprising that they’re approving ROEs that are too high. Look at what they’re saying, look at the models they’re actually using. It’s no surprise that they’re ending up with really bad results. And I think just in general, regulators are very cautious, and, like, nobody wants to be the first to deviate from the pack. And, you know, you can look at the history of these ROE decisions, and they’re very, very tightly clustered around, you know, 9 to 10 percent for decades. Interestingly, there have been examples where authorized ROEs, there was a formulaic ROE in Illinois for a number of years, and they got into the sevens. And you’d think, oh, if what the utilities say is true, investors must have fled, and their credit must have tanked, and the lights must have gone out. And it’s like, their credit was fine. The parent company continued to invest. The lights stayed on. It’s like nothing happened.
Joshua Rhodes: Yeah.
Mark Ellis: It’s just, you know, how to explain why regulators are resistant to this, I don’t know. I mean, partly that’s why I do this because, you know, most of the other intervenors, even the ones who work for consumer advocates and the state, they’re all doing it wrong. And it’s like, well, I can try to introduce sort of corporate finance as it’s actually done by utilities. I’m working on another case just to kind of elaborate on this point. It’s, uh, in Central Maine Power. Central Maine Power is owned by Iberdrola, which is a Spanish company.
Joshua Rhodes: Mm-hmm.
Mark Ellis: They don’t report under GAAP, they report under IFRS. So IFRS has a different standard for impairment test reporting and—
Joshua Rhodes: What does IFRS stand for?
Mark Ellis: Oh, International Financial Reporting Standards.
Joshua Rhodes: Okay.
Mark Ellis: Yeah. In the US, they call it GAAP. IFRS is the international equivalent.
Joshua Rhodes: Okay.
Mark Ellis: So long story short, they have to report to their investors every year their internal cost of capital, so it’s the rate of return, not just the cost of equity. To their investors. It’s a number that’s audited by their independent auditor. It’s signed off by their board of directors. It’s reported to their investors and their securities regulator. So this is a public number and it’s specific to their US utilities, and it’s dramatically lower than what they’re asking from the regulator at the same time, right? So they’re saying one thing to their investors and another thing to their regulator. The one they tell to their investors, there’s all kinds of repercussions if you deliberately mistake that number, right? There’s, there are penalties, like, because you’d be lying to your investors and lying to your regulator, right? You can’t do that, right? Lying to your auditors.
Joshua Rhodes: Right.
Mark Ellis: But in the regulatory arena, it’s just advocacy. So if they ask for something egregious and the regulator says, “No, I’ll give you something less,” there’s no repercussions for that. It’s just like they move on to the next rate case and, you know, see you in a few years. So you have one that’s a very high standard of accuracy, and then another one where they can just ask for the m— you know, shoot for the moon, and if they fall short, so what? So we’ll see. That case is still ongoing. Iberdrola has a number of US utilities that this would apply to. National Grid also has a number of US utilities that this would apply to. They’re all dramatically lower than what they’re asking from their regulator.
Joshua Rhodes: Okay. Let’s turn to MarketClear. You and a business partner launched it to introduce competition into the utility financing.
Mark Ellis: Yeah.
Joshua Rhodes: So what is this product? How does it work?
Mark Ellis: Yeah. I wanna clarify the name. You know, you said MarketClear Utility Capital. That was an early effort. It’s now MarketClear Utility Policy Research, and it’s a 501(c)(3) nonprofit.
Joshua Rhodes: Oh, okay.
Mark Ellis: If you could clarify that. Yeah, so when you go on our website, it’s MarketClear Utility Policy Research. Again, some of this stuff is just serendipitous. So we started thinking like, “Hey, we’re gonna work with potential investors.” We had some early conversations. We know that if we were to create this security that we’re talking about, like... I’m sorry, I should just back up. What is the basic idea? Is the utility industry is the only industry in the entire economy where you have this major price, the price of capital is set by a regulator, not by some type of competition, right? There’s no other... And even, like, defense contractors, right, the government’s approving how much, but there’s a competition in it, right? So Lockheed has to compete against, you know, Boeing and so forth. There’s some kind of competition that determines the price that’s ultimately paid. Utilities is the only industry where you have a regulator setting the price, a major price in the economy, right? Why is that? It’s a vestige of, you know, this industry got set up over 100 years ago in the days of Edison and JP Morgan, right? And, you know, the example I give is, like, back in those days when the US went to finance the Panama Canal, they couldn’t just issue debt. The markets weren’t liquid enough and deep enough. They actually went to JP Morgan and he arranged the financing. But today, like, there’s markets on, like, what color shoes LeBron James is gonna wear in his next game. I mean, there’s markets in everything, right? So it’s trivial, right, to say, “Hey, we wanna create a market for utility equity.” Like right now, the way it works is the utility sets a certain profit and they said, “Oh, they bid up. We only pay twice book value for that stream of cash flows.” And what we’re saying is, like, why don’t we just say, instead of bidding up the price, bid down the return. So we say, “Hey, I’m issuing,” in your example, “5 billion of equity.”
Joshua Rhodes: Mm.
Mark Ellis: Right? And, you know, people can submit bids for all or a part of it, you know, 100 million or whatever, and here’s the return I want. And you stack up the bids, you know, whatever clears the market, right, that’s the clearing price. Very similar to how the bids are stacked up in ERCOT, right? And then there’s a clearing price where the demand and supply meet, you know, that’s the market-clearing price. Everybody gets the market-clearing price. So the basic idea is, like, why do we have regulators set this price? There’s no reason for it. It’s just this relic of the late 1800s. Let investors bid, you know, compete to provide equity. And it’s the fulfillment is the epitome of the Supreme Court cases were called Bluefield and Hope. It’s the epitome of satisfying that requirement, which is, has to be sufficient to attract capital. Well, that’s obviated, right? They are saying, “This is what I need to attract to provide capital, but no higher.” This kind of epitomizes, it’s the exact fulfillment of the Supreme Court precedent.
Joshua Rhodes: Who do you think the investors would be in that? Like, who would be submitting these bids?
Mark Ellis: Yeah. So it’s gonna be investors who are interested in long-term predictable returns, and it’s kind of somewhere in between a bond and a current utility investment.
Joshua Rhodes: So you have, like, like pension funds or other types of—
Mark Ellis: Yeah. It’ll be pension funds, you know, very long-term predictable returns. The way it’s designed is kind of unique. The instrument would be the 10-year Treasury plus a fixed margin. So you have this protection if interest rates go up, then your return goes up, they go down, but that’s the basic concept of the instrument. There’s another couple of interesting wrinkles where the distribution is, uh, income, and it’s the depreciation. So the balance goes down over time, right, so that you get this recycling of capital over time. But we have tested, reached out to potential investors, and there’s a lot of interest in this. You know, one of the things I like to cite is, I think it was his ‘24 or... ‘24 annual shareholders letter, Larry Fink, that chairman of BlackRock, he talked about, hey, there’s two big challenges facing our industry. In other words, investment and asset management. He says there’s this tsunami of retirement assets, and, you know, they’ve been pushed in the past into sel— sort of self-guided 401(k)s. It hasn’t worked out for them. We need to find home for those investments with long-term predictable returns. That’s on the supply side. And on the demand side, there’s this giant sucking sound of demand for capital for infrastructure, and in particular, electric infrastructure. And he basically said BlackRock’s next tr— transformation is to put those two together, and it’s like this is the ideal instrument to do that, right? This tsunami looking for long-term predictable returns invested in energy infrastructure and in... Or infrastructure, but particularly energy and electric infrastructure. So that’s kind of a proof point that there’s a huge demand for this type of investment.
Joshua Rhodes: It’ll be like turning a 401(k) into a pension, is what you’re—
Mark Ellis: Well, I mean, that’s not our job per se.
Joshua Rhodes: But using words that most people understand. Maybe like, it’s like the investors would be those types of people who would be doing that kind of thing.
Mark Ellis: Yeah, so that’s BlackRock’s business model, that’s Apollo’s business model, and then we would provide the assets that they could put into their portfolio. Like, not we. This auction process would provide the assets that they could put into their portfolios for retirees. That it wouldn’t be limited to pension funds, but you know, that’s kind of like the natural—
Joshua Rhodes: How much equity would need to be satisfied per year? Say tomorrow everything goes to this, this type of arrangement, all right? How many billions, tens of billions, hundreds of billions of dollars like would need to go through this process?
Mark Ellis: Yeah.
Joshua Rhodes: ‘Cause it’s an auction on the other side, right? I mean, it’s like, I guess in theory, the auction value could be high. Like it could be even higher, in theory, if there wasn’t enough to go into it.
Mark Ellis: Yeah.
Joshua Rhodes: Right?
Mark Ellis: Yeah.
Joshua Rhodes: So like is there enough appetite with that with the amount of money that needs to be spent, particularly with like growth and all this other kind of thing, too? Does that make sense?
Mark Ellis: There’s a couple of things. One, we kinda know that there’s appetite there because they’re building this stuff and they’re financing it through the public markets anyway, right? They are raising equity. Utilities are net issuers of equity, so we know like the capital is already there. The amount of capital that’s needed is growing more quickly than in the past. I forget the numbers How much equity utilities issue, it’s on the order of like 100 billion a year, but it could be 50 billion, it could be 200 billion, but it’s, it’s not 5 billion.
Joshua Rhodes: Yeah.
Mark Ellis: It’s, you know, that order of like, uh, 50 to maybe 200. It could be even higher than that. But it’s a big amount of equity that’s US utilities. Their current equity base is like 800 billion, something like that.
Joshua Rhodes: Okay.
Mark Ellis: Yeah, it’s c— about 800 billion, maybe a little bit less, 700 billion. So if you figure they’re growing at like 10 percent, right, right now, so that gets you to around 70 billion.
Joshua Rhodes: It wouldn’t be a niche product.
Mark Ellis: Yeah. So that’s one point, like, hey, they’re raising this equity, the equity’s being provided anyway, we’re just saying it’s not gonna be provided through purchases of the parent’s common stock, it’ll be equity provided directly to the utility operating company. That’s one point. The other point is if the utility comes in, in your hypothetical and says, “I wanna raise 5 billion of equity,” we could say, you know, “You’re only gonna auction a billion of that or half a billion of that.” Like, that’s a big enough auction to get a price. And then the price is, the rest of it is from the parent, you know, and they’re raising it in the public markets, but that ROE applies to the incremental equity or to all the equity anyway. We’re just trying to get the price. The auction doesn’t have to cover all the incremental equity. It can just be a sufficient fraction to get a good price signal.
Joshua Rhodes: Well, you leave for price discovery is what—
Mark Ellis: Yeah, that’s the entire point, price discovery.
Joshua Rhodes: Okay.
Mark Ellis: In the Texas hearing, one of the senators, Senator Kolkhorst, asked exactly that. It’s like, “How are we pricing this? Let’s talk about pricing the risk appropriately.” And there was a robust discussion around that.
Joshua Rhodes: Got it. Okay. We’ve kind of danced around a little bit, but like if you won this argument, what does the business look like in 10 years? What would the utility business model look like in 10 years?
Mark Ellis: Oh, that’s a good question. I should step back in terms of like, hey, we’ve made a quite a bit of progress. We have model legislation on our website, marketclear.org, and it’s been introduced in New York, in both houses, and in Pennsylvania in the House, where it passed unanimously, 102 Democrats, which we’re very proud of the bipartisan appeal of this, ‘cause it’s about affordability and it’s about free markets. You know, it’s about economic efficiency and economic dynamism.
Joshua Rhodes: Mm-hmm.
Mark Ellis: And it’s about reducing costs for all customers, not just one particular class, right? We’re shrinking that entire revenue requirement pie, and it doesn’t touch, like, hey, whatever policy goals you have around transmission, or renewables, or what have you, doesn’t have, doesn’t touch that. We’re just reducing whatever it is you wanna build, we’re just gonna make it a lot cheaper. That’s it. That’s all we’re trying to do. So what does the future look like? There’s one other element that we kind of touched on but really needs to be emphasized. So I said before, like, hey, reducing the ROE, when I testify, it works out to about a 10 percent reduction in the customer bill.
Joshua Rhodes: Yeah.
Mark Ellis: That’s kind of the immediate impact, but there’s a more important impact, which is it changes the utility incentive structure. So I talked about, hey, you know, give me a buck, I’ll put two in your retirement account. It’s like, what incentive does that create for the utilities? It’s like, I wanna maximize rate base. I wanna spend as much capital as I possibly can, right? Goes back to the very beginning, right? I want more equity. No other business wants to put in more equity. You know, equity is precious.
Joshua Rhodes: Yeah.
Mark Ellis: But theirs is like, “No, more equity, more equity.” So we completely remove that incentive. If they’re just earning their cost of equity, then every dollar of equity is a dollar in their market price. And the details of the instrument where the capital is, all the income is returned and the capital is returned as well, means each investor doesn’t benefit from growth. They just get their return on their initial investment. Every time the utility wants to grow, they have to go back to investors and the regulator and justify it. And so it completely changes the dynamic where, hey, if you’re not doubling your money, your incentive to just grow as much as possible goes away. And so you just invest what, you know... Then when the regulator says, “Hey, I really want to focus on your outcomes, performance-based rate making, customer re— you know, reliability, customer satisfaction, low cost,” now you can start to have meaningful conversations around that. Another example we give is, like, if you tell your kid, “I’ll give you a dollar if you take out the trash,” put down the VAVN controller, young kid, preteen, you know, he might be interested. But if you give that same kid a $50 a week allowance, they’d be like, “Nah,” you know? “The incremental money isn’t that meaningful to me.” And that’s kind of the existing business model. They make so much money just from investing that performance incentives just aren’t worth their while. It’s very hard to create a performance incentive that can compete. Take away the $50 allowance and now performance-based rate making, which is kind of a hot topic right now, can start to make sense, can start to be effective. The business model of the future is where utilities, you know, they’re rewarded and penalized for their performance, right? And not for just how much they invest. And you could, you know, talking, you know, there’s a lot of people out there, this is not my area of expertise, but others talk about, like, a distribution system operator, like taking the TSO model and putting it at a distribution level. This opens the way to that because, you know, under the TSO model, you separate ownership and operations in many instances, and this, you could start to affect that where, hey, somebody puts up the capital and then somebody else operates it, and you can create a performance contract around really efficient operations around that, and then somebody else is just providing the capital to keep the business going. So looks like long-term is we’ve completely obliterated this perverse incentive mechanism. I like to quote Charlie Munger, “Show me the incentive, and I’ll show you the outcome,” right? And then his corollary, “If you have a stupid incentive you get a stupid outcome.” And I think that’s the problem we have right now with this R— current ROE model.
Joshua Rhodes: Yeah, so one of the things, like, in my space that, like, that people often... I think is kind of, that brushes up against that or runs into that is like, uh, you know, non-wires alternatives, other types of, like, ways of, like, serving load flexibility, demand response programs, energy efficiency, all these other things find it hard to compete, I guess, with, like, the return on equity. And so I guess is what you’re saying is, like, those are on a better footing to compete—
Mark Ellis: Yeah, I’m glad you brought that up. My take on all of this is more efficient technology behind the meter resources, why do they find it so difficult? The typical refrain is the utility makes it really hard, right? Why? Because it competes with services that they wanna provide and that they wanna put in their rate base to earn this rich return. I’m not earning this rich return anymore, so you take away the reason for them to fight. Then all these arguments around technical issues and so forth, like, you kinda smoke them out a little bit. ‘Cause they make technical arguments around it’s difficult to integrate or what have you.
Joshua Rhodes: Yeah.
Mark Ellis: But at root, it’s like there is this incentive to hoard the capital investment opportunities, right? Like, EV charging, I wanna put it in rate base, what have you. But if you take away that incentive, obviously it’s never been done, so you can’t prove it. Like, there’s nothing you can point to and say, “Oh, they won’t care.”
Joshua Rhodes: Yeah.
Mark Ellis: But, you know, basic economic principles suggest, like, hey, if they’re not making, generating a lot of shareholder value from, you know, these opportunities because they’re just earning their cost of capital, they’re not gonna hoard them as much. One example I had at Sempra was, you know, in California they have something called CCAs, community choice aggregators. We don’t have a competitive retail market, but community said, “We wanna be more aggressive in our renewable portfolio standards, so we wanna do the procurement for local communities.” And, you know, at least at Sempra, they were kind of like, “As long as you step into our h— legacy contracts and make us whole on those, if you wanna take over procurement, procurement’s just a cost that we pass through. It’s not like we generate a lot of shareholder value, and there’s actually quite a bit of risk. So as long as we’re made whole, like, you can have it,” right? So utilities don’t wanna do things if they’re not making profit on it, right? Just like any other company, they don’t wanna do things if they don’t make a profit on it, you know, in terms of an economic profit, right?
Joshua Rhodes: Yeah.
Mark Ellis: Right, and their cost of capital. Another example I talked before about, you know, we were pioneers in building utility-scale PV and then got out of it very quickly. Why? Because the returns got bit down, and it was like, we could keep building these things, but we’re just earning our cost of capital.
Joshua Rhodes: Hmm.
Mark Ellis: We earn a much better return in the utilities, so we wanna redirect capital there.
Joshua Rhodes: Awesome. I think we’re at time. Mark Ellis, thank you for coming on the Energy Capital Podcast.
Mark Ellis: All right. This was great. Thanks for having me on, Josh.
