INFLATION RISK AND REGULATORY LAG

Rate of return regulation in principle suggests strong linkages betwen interest rates, utility return on book equity (ROE), and stock price/book equity ratios: ceteris paribus, changes in interest rates should be quickly transformed into changes in ROEs, and stock prices should tend toward book value. Absent lags in the process, it also suggests that utility investors are minimally exposed to the risks of unanticipated changes in interest rates, notably those associated with inflation. In this paper we examine the financial implications of electric utility regulation from 1971-1980. Over this period, which was characterized by inflation-related rises in interest rates, we flnd that the gap between allowed and earned ROEs, on the one hand, and interest rates, on the other hand, increased. Since this outcome is in contradiction of the conceptual model of regulation and investors' exposure to inflation risk, we test the hypothesis that investors respond to the reality of regulation by imposing risk premiums which are functionally related to interest rates. The basic idea is that an ROE shortfall leads to an expectation that regulation will respond in the future with a higher earnings level, but this "IOU" in the implicit social contract is risky. And the question addressed in this paper is whether the degree of riskiness is related to the level of interest rates. Using two valuation models we conclude that at least during the 1970s risk premiums were not related to the level of interest rates.