Legal Definitions - cost-of-capital method

The cost-of-capital method is a financial calculation used primarily by government regulatory bodies to determine how much it costs a utility company to raise money for its operations and investments.

Utility companies, such as those providing electricity, water, or natural gas, need significant funds to build and maintain infrastructure, deliver services, and expand. They typically acquire this money in two main ways:

• Debt capital: Borrowing money, often by issuing bonds.
• Equity capital: Selling ownership shares in the company to investors.

The cost-of-capital method measures the combined expense of acquiring both debt and equity capital. Regulatory commissions then use this calculation to set the rates that utilities can charge their customers. The goal is to ensure that the utility can earn a "fair rate of return" for its investors – enough profit to cover its financing costs and attract new capital for future projects – without overcharging consumers.

Here are some examples of how the cost-of-capital method is applied:

• Example 1: Financing a New Power Plant

  A regional electric utility proposes to build a new, large-scale solar power plant to meet growing energy demand. To fund this multi-billion dollar project, the utility plans to issue new bonds (debt) and potentially sell additional shares of its stock (equity).

  The state's Public Utility Commission (PUC) will use the cost-of-capital method to analyze how much the utility must pay to borrow money and to compensate its new and existing shareholders. This calculation helps the PUC determine the appropriate electricity rates that customers will pay. The rates must be high enough to allow the utility to recover its financing costs and provide a reasonable return to investors, ensuring the project can be funded, but not so high that they become an unfair burden on consumers.

• Example 2: Upgrading Water Infrastructure

  A municipal water utility needs to replace its aging network of underground pipes and modernize its water treatment facilities to comply with new environmental standards. This extensive infrastructure upgrade requires substantial capital investment.

  The regulatory board overseeing water rates for the municipality would apply the cost-of-capital method. They would assess the utility's expenses for securing the necessary funds, whether through municipal bonds or other financing mechanisms. This assessment helps the board approve water rates that allow the utility to cover its borrowing costs and attract the investment needed for the critical upgrades, while ensuring the rates remain affordable and justifiable for residents and businesses.

• Example 3: Expanding Natural Gas Service

  A natural gas distribution company wants to extend its pipeline network to serve a newly developed suburban area that currently lacks access to natural gas. This expansion project requires significant upfront investment in materials, labor, and new pipeline construction.

  Before approving the company's request to adjust rates to cover the cost of this expansion, the state's energy regulatory commission would employ the cost-of-capital method. This method helps the commission understand the financial burden on the company to raise the capital for the pipeline project. By calculating the cost of debt and equity, the commission can ensure that the approved rates allow the company to attract the necessary lenders and investors for the expansion, while simultaneously protecting new and existing customers from excessive charges.