Understanding Utility Rate Structures: Why Business Energy Costs Keep Rising
A conversation with Mark Ellis on utility economics and the factors driving rate increases
I recently spoke with Mark Ellis, a former Sempra executive turned utility finance analyst and fellow at the American Economic Liberties Project, about the underlying economics of utility regulation and why business energy costs continue to escalate faster than inflation.
After 30 years in the energy and utility industry, including work advising California during the 2000-2001 energy crisis, Mark now focuses on utility rate-setting mechanisms and their impact on customers. His analysis reveals significant structural issues that affect every business paying utility bills.
How Utility Profits Work
Most business leaders know utilities are profitable, but the specific mechanics are worth understanding. Mark explained the basic formula:
Utility Profit = Amount of Equity Invested × Return on Equity (ROE)
Utilities can increase profits by investing more capital (raising the equity base) or by securing higher authorized returns from regulators. This creates incentives to pursue both strategies.
"Sempra went from the 14th largest U.S. utility to the fourth over 10 years by focusing on regulated businesses," Mark noted. "They just announced a five-year capital plan for Oncor of over $50 billion. The model is straightforward: you invest capital and it generates returns based on regulatory approval."
The key issue Mark identifies is that regulators have historically authorized returns above what financial markets would require for comparable investments.
The Rate Impact
Mark's analysis suggests this translates to approximately $50 billion annually in additional costs nationwide. In California, he estimates fixing return on equity rates could save customers over $6 billion per year.
"The return on equity plus taxes represents about 25% of customer bills," he explained. "When authorized returns exceed market-based costs of equity, customers pay more than the economic cost of service."
You can observe this in utility stock prices, which typically trade at 2-2.5 times book value. Basic finance principles suggest this premium reflects returns above the actual cost of capital.
Why Rate Increases Are Accelerating
Several factors are driving faster rate growth:
Increased Investment Pace: Utilities are adding infrastructure at unprecedented rates, potentially 20% annually versus the historical 5% replacement rate.
Equipment Cost Inflation: New infrastructure costs significantly more than historical averages.
New Demand Sources: AI data centers, electrification, and other factors are driving electricity demand growth for the first time in decades.
Investment Incentives: When utilities earn returns above their cost of capital, they have strong incentives to increase investment levels.
A Market-Based Alternative
Rather than just critiquing the current system, Mark is developing a solution: competitive equity markets for utilities.
Currently, utilities raise debt through competitive bidding but obtain equity from parent companies at regulator-approved rates. Mark's proposal would require utilities to compete for equity capital, similar to debt financing.
"When utilities need debt, they naturally seek the best market rates. There's no reason equity couldn't work the same way," he explained.
This approach could potentially reduce the equity component of utility bills by 30-40% while maintaining service reliability and credit quality.
Business Implications
This rate structure affects all utility customers:
Manufacturing facilities with high energy usage face significant cost impacts
Multi-location businesses deal with varying rate structures across territories
Energy-intensive operations see substantial impacts on operational costs
The dynamics also help explain why onsite energy systems are becoming more economically attractive. When utility rates include returns above market costs, distributed alternatives become competitive even without subsidies.
Regulatory Reform Efforts
Mark's work through the American Economic Liberties Project has contributed to legislative proposals in five states aimed at establishing market-based return standards. The challenge is largely political rather than technical.
"This has been recognized as an issue since the 1970s," Mark noted. "Economists like Alfred Kahn wrote about it decades ago. The challenge is implementation within existing regulatory frameworks."
Practical Considerations
For business leaders managing energy costs:
Understand rate components: Recognize that utility bills include returns on capital that may exceed market rates
Evaluate alternatives: Assess whether onsite energy systems make economic sense given your rate structure
Participate in rate proceedings: Large customers can engage in regulatory processes that set these rates
Monitor regulatory developments: Rate-setting reforms could significantly impact future energy costs
Looking Forward
The current system creates a feedback loop where higher authorized returns incentivize more investment, leading to higher rate bases and increased customer costs. Breaking this cycle requires regulatory changes that align utility returns with actual market costs of capital.
Mark's competitive equity proposal offers one pathway, but implementation would require regulatory approval and political support. The economic logic appears sound, but changing established regulatory practices takes time.
For businesses facing rising energy costs, understanding these underlying dynamics helps inform both near-term budgeting decisions and longer-term energy strategy development. This is where VECKTA steps in to support you to understand the risks of inaction, what to build, where to build it, when to deploy, how to finance and who to partner with to realize the highest returns on investment with the lowest risks.