Why Fuel Cost-Sharing Does Not Justify Higher Utility ROEs

As electricity bills continue to rise, state policymakers are looking for new ways to improve affordability. One policy receiving growing attention is fuel cost-sharing, which gives utilities stronger financial incentives to manage fuel costs while helping protect customers from unnecessary price volatility.

Under a fuel cost-sharing policy, the utility sets a “fuel budget” based on expected fuel costs. At the end of the term, if actual costs are greater than expected, the utility pays a percentage of that difference, saving customers money by reducing the amount they would have paid otherwise. If actual costs are lower than expected, the utility retains that difference as a reward, and customers save money from the reductions in fuel costs overall.

North Carolina recently introduced legislation that would implement fuel cost-sharing, and RMI analysis shows the policy could save customers $89 million over 5 years. Similar conversations are taking place in Utah, Nevada, New Mexico, Georgia, and Virginia, where regulators and lawmakers are exploring ways to better align utility incentives with customer affordability.

Whenever fuel cost-sharing enters the conversation, however, one familiar argument is never far behind. Critics often contend that if utilities are required to absorb a share of fuel cost volatility, regulators should compensate them with a higher authorized return on equity (ROE). If regulators accepted that argument, some of the customer savings from fuel cost-sharing could be offset by higher financing costs. Which raises the logical question: should utilities receive higher ROEs when fuel cost-sharing is adopted?

A new report commissioned by RMI concludes they should not.

Prepared by Vereda Advisory, Fuel-Cost Sharing and Utility Returns: Why Higher ROEs Are Not Justified examines the most common arguments for increasing authorized ROEs under fuel cost-sharing. The report finds that those arguments are not supported by financial theory, regulatory precedent, or utility practice.

Fuel cost-sharing addresses a longstanding gap in utility incentives

In most states, utilities recover 100% of their fuel and purchased power costs through Fuel Adjustment Clauses (FACs). These mechanisms ensure utilities can recover fuel expenses in a timely fashion, but they also insulate utilities from the financial consequences of poor fuel cost management. Customers bear essentially all of the risk when fuel costs rise, while utilities have relatively little financial incentive to minimize fuel costs or reduce exposure to volatile fuel markets.

Fuel cost-sharing changes those incentives. Rather than passing every dollar of fuel costs directly to customers, utilities share in both fuel cost savings and cost overruns. When utilities reduce fuel costs, they can retain a portion of the savings. When fuel costs exceed expectations, they absorb part of the increase. The result is a stronger financial incentive to make prudent fuel purchasing, dispatch, and resource planning decisions.

The policy is hardly experimental. Nine states already use some form of fuel cost-sharing, and regulators in Idaho, Montana, and Wyoming have recently reviewed their existing mechanisms and concluded they continue to benefit customers.

The evidence doesn’t support increasing authorized ROEs

The primary argument for raising ROEs is straightforward: if utilities face greater earnings variability under fuel cost-sharing, investors will require higher returns to compensate for that additional risk. However, when the underlying arguments are unpacked, this dynamic isn’t so clear.

Conflating the definition of risk

In our everyday language, we often use the word risk interchangeably with words like volatility and uncertainty. Colloquially, the term risk is almost always used as a negative. And so any potential volatility to short-term earnings is described as risk even if it doesn’t actually translate to long-term systemic risk that actually determines a utility’s cost of equity.

While fuel cost-sharing may cause earnings to fluctuate somewhat from year to year, those company-specific fluctuations can be diversified away by investors. They do not fundamentally change the market risks utilities face. And if the utility did face material risk as a result, it would show up in cost of equity models regulators use when establishing authorized ROEs.

This distinction is also reflected in regulatory practice. Commissions establish authorized ROEs based on a utility’s overall business risk profile, not by making automatic adjustments every time an individual ratemaking mechanism changes. Fuel cost-sharing is no exception.

Utilities have more influence over fuel costs than critics acknowledge

Another common argument is that utilities should not bear fuel cost risk because fuel prices are outside their control. This is partially true; commodity prices are driven by markets forces, but customer fuel costs are influenced by decisions utilities make. Utilities determine how much gas-fired generation to build, negotiate fuel supply contracts, decide how plants are dispatched, and choose whether to invest in resources such as wind, solar, battery storage, energy efficiency, and demand response that reduce fuel consumption altogether. These decisions directly affect how much customers ultimately pay.

Fuel cost-sharing does not penalize utilities for market conditions they cannot control. Instead, it strengthens incentives to make the decisions they do control in ways that reduce customer costs. And at the end of the day, utilities have far more influence over fuel costs than the individual customer.

Fuel cost-sharing does not penalize utilities for market conditions they cannot control. Instead, it strengthens incentives to make the decisions they do control in ways that reduce customer costs.

Concerns about credit quality are also overstated

Opponents have also argued that exposing utilities to a portion of fuel cost risk could weaken credit quality and increase borrowing costs. The report finds little evidence to support that conclusion. This is because credit ratings depend on many factors beyond fuel recovery mechanisms, including affordability, regulatory stability, and overall financial performance. Moreover, a well-designed fuel cost-sharing mechanism tends to limit utility exposure through features such as deadbands, sharing caps, and symmetrical sharing that allow utilities to benefit from fuel savings as well as share in fuel cost overruns.

Utilities already manage many forms of operational and financial uncertainty without jeopardizing their ability to access capital. Fuel cost-sharing represents only a small portion of a utility’s overall risk profile and does not materially alter its financial position.

As more states debate fuel cost-sharing, regulators should scrutinize claims that higher ROEs are necessary

Fuel cost-sharing is attracting renewed interest because it addresses a simple problem: utilities have limited financial incentives to minimize fuel costs even though customers bear nearly all of the risk. As more legislatures and public utility commissions consider the policy, regulators will likely continue hearing arguments that utilities should receive higher authorized ROEs in exchange for accepting fuel cost-sharing. The available evidence suggests otherwise. Fuel cost-sharing does not materially increase utilities’ cost of capital, weaken their credit quality, or fundamentally change their overall business risk. Regulators should therefore carefully scrutinize proposals to increase authorized ROEs alongside fuel cost-sharing. When properly designed, fuel cost-sharing can better align utility incentives with customer interests, encourage more prudent fuel cost management, and improve affordability without increasing the financing costs ultimately paid by customers.