Equity return requirement in a time of inflation

The current and recent high rate of inflation, which affects all aspects of the production and distribution of utility service, has greatly compounded the problems facing regulatory authorities. Not only has the number of utility companies seeking regulatory review and rate adjustment increased greatly over the past several years, but the matter of determining what constitutes a fair return is now much more difficult to resolve in the face of high and highly fluctuating rates of inflation. Although the required revenue approach to utility regulation means that the regulatory authority must review and approve all elements of cost of service, the area that causes most difficulty and attracts the greatest attention is the cost of capital, which includes interest on debt, dividends on preferred shares, and return on common equity. Of these, by far the most contentious is return on common equity. This article describes a procedure for estimating the required return to common equity which takes explicit account of inflation and makes provision for varying rates of inflation over the forecast period. Particular attention is paid to the required rate of growth of earnings per common share, and the result is stated not as a percent return on capital,more » but in terms of required dollar returns to shareholders expressed in earnings per share. This dollar requirement, together with forecast amounts of other elements of cost, can be used directly to determine the total revenue requirement of the utility and the schedule of rates for service.« less