Utility Authorized ROE: Setting the Regulated Return

Key Takeaways

• Utility authorized ROE is set in rate case orders using DCF, CAPM, and risk-premium methods; the national average for US electric utilities was near 9.75 to 9.80 percent in 2024 through 2025.
• Most utilities underearn their authorized ROE by 50 to 150 basis points because regulatory lag means rate cases are backward-looking and cost inflation occurs between filings.
• A common mistake is treating authorized ROE as a guaranteed return; it is the opportunity to earn a given level, not a floor, and S&P Global data showed the underearning spread widening through 2024 and 2025.
• Authorized ROE is far stickier than market interest rates; when Treasury yields rose 300 basis points between 2021 and 2023, average authorized ROE moved less than 15 basis points.

What It Is

The authorized ROE is set in a rate case order by a state public utility commission (PUC) or, for interstate assets, by the Federal Energy Regulatory Commission (FERC). It is applied to the equity share of the utility's ratemaking capital structure, which together with the authorized cost of debt produces the overall allowed rate of return on rate base.

Authorized ROE is not a guaranteed return. It is the return the utility has the opportunity to earn. Earned ROE can be above or below the allowance depending on cost control, sales volumes, regulatory lag, and storm events.

The Intuition

A utility cannot raise equity if investors expect a return below the cost of capital. Shareholders in a Midwest electric utility demand compensation comparable to what they would receive from other assets of similar risk. The regulator's job is to approve an ROE high enough to attract capital but not so high that customers pay more than necessary.

The U.S. Supreme Court established the legal test in two 1940s cases, Bluefield and Hope. A fair return must be commensurate with returns on investments of corresponding risk, sufficient to support the utility's credit, and adequate to attract capital. Those three tests still frame every rate case today.

How It Works

The allowed rate of return is a weighted average:

Allowed Return = (w_d * r_d) + (w_e * r_e)

Where w_d and w_e are the debt and equity weights in the approved capital structure, r_d is the embedded cost of debt, and r_e is the authorized ROE.

Regulators estimate r_e using three standard methods, typically blending them:

• Discounted cash flow (DCF): r_e = D1/P0 + g, using the dividend yield of a proxy group of utilities plus expected long-term growth.
• Capital asset pricing model (CAPM): r_e = rf + beta * (rm - rf), using a long Treasury rate, a utility sector beta, and an equity risk premium.
• Risk premium method: the authorized ROE equals a long Treasury yield plus a historical premium of utility ROE over that yield.

The final number lands in a range. A typical order describes testimony from the utility's witnesses (higher ROE estimates), staff witnesses (middle estimates), and intervenors (lower estimates), then picks a point inside the overlap.

Worked Example

According to Regulatory Research Associates at S&P Global, the average authorized ROE in U.S. electric utility rate cases was 9.78 percent in full-year 2024 and 9.68 percent in the first half of 2025. Median values in 2025 hovered near 9.70 percent. Gas utilities ran roughly 20 to 40 basis points higher.

Consider a utility with:

Rate Base                      $8,000 million
Capital Structure:
  Debt weight                    48 percent, cost 4.5 percent
  Equity weight                  52 percent, ROE 9.75 percent

Allowed overall rate of return:

Allowed Return = (0.48 * 4.5%) + (0.52 * 9.75%)
               = 2.16% + 5.07%
               = 7.23%

Return on Rate Base = 8,000 * 7.23% = $578 million
Equity earnings portion = 8,000 * 0.52 * 9.75% = $406 million

If the utility has 1.1 billion dollars of common equity in its capital structure and earns the full authorized amount, book ROE is 9.75 percent. Most utilities underearn by 50 to 150 basis points because of regulatory lag and cost inflation.

Common Mistakes

1. Treating authorized ROE as a guaranteed return. It is an opportunity, not a floor. S&P Global data shows gas and electric utilities increasingly underearning their authorized ROEs through 2024 and 2025, as rising capex and inflation outpace rate case timing.

2. Assuming ROE follows interest rates in real time. Authorized ROE is much stickier than the 10-year Treasury. When Treasury yields rose 300 basis points between 2021 and 2023, the average authorized ROE moved less than 15 basis points. Regulators smooth, both up and down.

3. Ignoring capital structure. Two utilities with identical 10 percent ROEs but 45 percent versus 55 percent equity ratios produce very different overall returns. The capital structure decision is just as consequential as the ROE decision, and also contested in the rate case.

4. Skipping performance incentives. Many states now layer performance-based ratemaking on top of the base ROE, with basis-point adjustments for service reliability, safety, or clean energy milestones. These riders can shift realized returns by 25 to 75 basis points.

5. Using authorized ROE as the discount rate for the utility's equity. Authorized ROE is a regulatory construct. The investor's cost of equity depends on the stock's risk profile and capital markets, not on a commission order. They can differ by a percentage point or more.

Frequently Asked Questions

Q: What is utility authorized ROE in simple terms? Utility authorized ROE is the percentage return a state or federal regulator allows an investor-owned utility to earn on the equity portion of its rate base. It is set in a rate case order using methods like the DCF model and CAPM. The authorized ROE applied to the equity share of rate base determines the maximum equity earnings the regulator will let the utility recover from customers.

Q: How does utility authorized ROE affect investment decisions? Authorized ROE is the primary link between regulatory outcomes and utility earnings. A 25 basis point increase in a rate case can add 15 to 30 million dollars of annual equity earnings for a mid-size utility. Investors track authorized ROE trends at the national and state level to assess whether the regulatory environment is tightening or improving.

Q: What is a real-world example of utility authorized ROE? In the worked example, a utility with $8,000 million rate base at 52 percent equity weight and 9.75 percent authorized ROE earns $406 million annually from the equity return component alone. The national average of about 9.75 percent in 2024-2025 set the broad benchmark from which individual state outcomes are measured.

Q: How can investors use utility authorized ROE analysis? Monitor Regulatory Research Associates data or S&P Global rate case summaries to track recent authorized ROE decisions in a utility's state. Compare the authorized ROE to the utility's embedded cost of equity and check how much of the authorized return is actually being earned, since regulatory lag typically reduces the earned return by 50 to 150 basis points.

Q: How is utility authorized ROE different from the investor's cost of equity? Authorized ROE is a regulatory construct set by a commission based on testimony and regulatory methods. The investor's cost of equity is set by capital markets based on the stock's risk and expected return. They are not the same number. A utility can be authorized a 9.75 percent ROE while investors require 8 percent or 11 percent depending on rate risk, regulatory quality, and growth expectations.

Sources

1. Federal Energy Regulatory Commission. "Cost-of-Service Rates Manual." https://www.ferc.gov/sites/default/files/2020-08/cost-of-service-manual.pdf
2. NARUC. "Rate Case Training, Rate of Return." https://pubs.naruc.org/pub.cfm?id=538E730E-2354-D714-51A6-5B621A9534CB
3. Jamison, M. Public Utility Research Center, University of Florida. "Rate of Return Regulation." https://bear.warrington.ufl.edu/centers/purc/docs/papers/0528_jamison_rate_of_return.pdf
4. S&P Global Market Intelligence. "Underearning spread widens for gas, electric utilities in ROE analysis." https://www.spglobal.com/market-intelligence/en/news-insights/research/underearning-spread-widens-for-gas-electric-utilities-in-roe-analysis

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.