What if I were to tell you about an obscure clique of consultants that concoct dubious economic analysis to convince regulators to side with corporations, enabling a massive rip-off of ordinary Americans? I think your curious, cautious response might be, “You’re going to have to be more specific.”
OK, so this obscure clique has a name. They’re called the Society of Utility and Regulatory Financial Analysts, or SURFA. And they are a large part of the reason why you’re paying way too much for electricity.
SURFA features prominently in a fascinating report from the American Economic Liberties Project that was just featured on the podcast I co-host, Organized Money. You can listen to the episode, “The Pocket Picking Machine,” with the report’s author Mark Ellis, on Apple or wherever you get your podcasts.
Ellis has an unusual profile for an anti-corporate crusader: He was the former chief economist at Sempra Energy, a consultant with McKinsey, an analyst for ExxonMobil, and an engineer for SoCal Edison. But in his current position as an independent expert witness who testifies before state public utility commissions, he has found an unusual set of circumstances where investor-owned utilities are applying their own bespoke economic logic to win themselves large electricity rate increases. According to Ellis’s estimates, this translates to $50 billion in excess costs for utility customers every year, or about $300 per household.
The problem specifically involves investor-owned utilities, which provide 70 percent of the electricity in the U.S. These private utilities have increased residential electricity rates over the past three years at a rate 49 percent higher than inflation. Over the same period, publicly owned utilities have increased their rates 44 percent less than inflation.
Such a discrepancy should not be possible, and indeed it hasn’t been over the prior 40 years. Utilities in the U.S. have by and large made a basic bargain: They get monopoly access to a coverage area to provide power, in exchange for a commitment to universal service and rate regulation by a state public utility commission. When utilities want a rate increase, they must face a hearing with a PUC, where the utility has to prove that the increase only affords them a “just and reasonable” profit, known as the rate of return.
Not only does this allow utility companies to set rates higher than just and reasonable levels, it also biases capital expenditures.
Utilities have two kinds of costs: operating costs to cover salaries, maintenance, rent, and other overhead, and capital costs for the building of power plants, transmission lines, and other physical facilities. Utilities pay out to build capital up front and then get paid back throughout the useful lifespan of that expenditure. Utility rates, then, are supposed to cover total operating costs, plus the portion of capital costs, plus the permissible rate of return.
So capital costs became a key variable. More capital expenditures can translate into bigger profit, because the utility also gets a return on their own equity, essentially a subset of the value of the money they put into the capital investment. It’s like a bank earning interest on a loan. And this is where the shenanigans come in.
A tiny group of experts give testimony to PUCs in these rate-setting proceedings, estimating among other things how much return on equity utilities should receive. Four consulting firms provided 90 percent of the testimony in the sample of 60 proceedings that Ellis reviewed; in more than half of those proceedings, just two people gave the testimony.
The experts use four different economic models to construct their estimates, Ellis explains in the paper. Two of them—the “risk premium” model and the “expected earnings” analysis—are used nowhere in any other area of finance. And the calculations are perfectly circular: The “just and reasonable” rates in the expected earnings analysis are based on future forecasts, in other words, on the future rates of return that the company expects to receive! The Federal Energy Regulatory Commission stated in 2022 that these two models “def[y] general financial logic,” and prohibited them from use in federal proceedings. But they are still used routinely at the state level. The other two SURFA-used models, Ellis claims, are polluted with wild assumptions that make them as unusable as the two novel ones.
Where this gets really crazy is that the other side of the table—ratepayer advocates, large energy customers, and the like—are using the same models and assumptions. Indeed, their experts are typically trained by SURFA, which was set up by the utility industry as a certification organization for this analysis. “Through SURFA and the promulgation of flawed financial models, the utilities have effectively co-opted their potential opponents,” the paper explains.
Sometimes advocates go outside of SURFA and hire their own witnesses with different methodologies, who often come to very different conclusions. But because this more accurate testimony is so different, Ellis found that it’s usually thrown out by the PUC. There’s no desire to get out in front of the herd.
Despite their near-ubiquitous use, the consensus models look, and are, blatantly wrong, because utilities are seeing much higher stock growth than one would anticipate for a low-risk industry with tightly regulated, stable profits. The long-term return for the broader stock market is roughly 6 to 7 percent annually. Investor-owned utilities were bringing back 9.6 percent in the first half of 2023, a rate that’s 30 percent above the total market. If anything, they should be bringing in less than the market average. The only reason they aren’t is because public utility commissions are allowing this “financial alchemy,” as Ellis calls it, to rule the day.
Ellis’s view is that you don’t need any real expert analysis to determine the proper rate of return for utility rates. “There are very long-standing principles of finance that literally a first-year finance student, undergrad, will learn,” he said. “One of them you can calculate in your head, the other one, you need a spreadsheet, but it’s literally just a few lines in a spreadsheet to calculate.” This is encapsulated in the title of the report: “Rate of Return Equals Cost of Capital.”
This shell game isn’t the only thing creating a windfall for utilities: PUC commissioners are often either elected or appointed by governors, so money and politics can govern the decision-making. But to at least some degree, public regulators have been bamboozled by a cult of economic consultants using a set of charts and graphs no better than tea leaves to make major decisions about consumer electricity rates.
Not only does this allow utility companies to set rates higher than just and reasonable levels, it also biases capital expenditures. That may sound like a good thing, because we need a ton of upgrades for the energy transition. But since any capital cost will do, the kinds of changes that might benefit consumers or the environment aren’t necessarily the ones that utilities opt to spend on.
Ellis recommends that the rate of return/cost of capital standard be codified into law in the states so it cannot by avoided. This would prevent the primacy of SURFA consultants and their models. He has some other recommendations about compensating independent financial analysts and advocates for participating in regulatory proceedings, information-sharing across regions, and preventing utilities from being able to cover lobbying expenses as an operating cost (!).
What he doesn’t say is that we should have more publicly owned utilities, even though the data show a huge difference in how they operate relative to their investor-owned counterparts. That seems to me to present a clear alternative to the current wave of overcharging. It will be much easier to have utilities play by the rules if they are publicly owned and therefore more publicly accountable.
In the end, this is a familiar story about a small sect of self-appointed enlightened technocrats routinely abusing a system on behalf of the people who pay them. It will take a lot of dedicated digging to find these problem-makers, who beset many of our major industries. With utilities, now we at least have a start.
