Deregulation of the Electric Power Industry: The Earnings, Risk, and Return Effects

Abstract

This study tests whether recent reforms of the electric power industry reverse the predicted effects of regulation on profits, risk, and return for electric utilities. The analysis also considers potential variation in the effects of the reforms across utility sizes. The empirical predictions are derived from theories of economic regulation which argue that regulation reduces earnings variability and risk, and enhances share value by buffering the regulated firms against the profit effects of cost and demand shocks and by shifting the burden of inefficiencies to consumers. These views motivate an opposite argument that reductions of regulation would reverse the predicted effects of regulation. The results reveal (1) a reversal of the buffering effects of regulation, (2) the existence of subsidies attributable to regulation, and (3) a redistribution of shareholder wealth during the reforms. The electric utility industry has undergone several reforms designed to lower entry barriers in the electricity markets, increase reliance on market-based output prices, and allow customers a choice of power suppliers. These reforms represent a major shift towards open competition in the industry, modifying the traditional regulatory regime that protected utilities from the profit effects of cost and demand shocks. The shift towards open competition in the industry has generated debate among utility experts and policymakers on the economic merits of the reforms and the effects of the reforms on the financial integrity of traditional utilities. This study analyzes the effects of the reforms on profits, risk, and return for the utilities. The analysis is particularly relevant as legislatures debate the effects of the reforms on traditional utilities and the propriety of further reforms. The first aspect of the study analyzes the effect of the reforms on earnings variability. The analysis relies on the premise that reductions in entry barriers and increased reliance on market-based output prices expose utility profits to the effects of cost and demand shocks that, in turn, lead to increased earnings variability. Such an analysis has import because an increase in earnings variability has predictive as well as valuation implications. In particular, an increase in earnings variability reduces the ability of earnings to predict future cash flows and, in that sense, diminishes the valuation relevance of earnings.