THE EFFECT OF ECONOMIC REGULATION ON RISK AND FINANCIAL PERFORMANCE IN THE ELECTRIC UTILITY INDUSTRY (CAPM, BOND RATING, MARKET/BOOK RATIO)

The electric utility industry has historically been characterized by a low degree of operating and investment risk. Investment risk is an indication of the financial condition or health of a firm. Risk, as measured by the firm's market/book ratio and bond rating, increased dramatically between 1972 and 1982, demonstrating a deterioration in financial condition. Risk behavior, as measured in the Capital Asset Pricing Model beta, is less easily interpreted. Betas for electric utilities decreased between 1972 and 1982, normally evidence of decreasing risk. However, the declining beta was a response to increased risk as investors bid stock prices during a generally up market. Risk increased and indicated a deteriorating financial position for electric utilities.; The increase in investment risk can be traced to a number of factors. Inflation, interest rate increases, fuel cost increases, slow demand growth, corporate financial policies, and regulation have all been blamed for the increased risk. Regulation has often been cited as the major impediment to quick, efficient utility response to changing economic conditions. The quality of regulation, as assessed from an investor's viewpoint, has had an impact on the financial health of electric utilities. Firms with good regulation experienced a smaller increase in investment risk and a smaller decline in financial condition than utilities with poor regulation. While the purpose of regulation is not to ensure that utilities make profits, regulation is supposed to maintain the capital integrity of the firm. The eroding financial position of the electric utilities indicates that, in general, regulators have not maintained the capital integrity of the firms.; Regulators of above-average quality were only marginally more able to mitigate the damaging effects of a changing environment on electric utility financial condition than below-average regulators. The effect of regulatory quality on risk and financial performance was relatively small when compared to other operating and environmental factors that affect utilities. The fuel mix, dividend policy, accounting practices and economy have all affected utility stocks to a far greater degree than the regulatory environment. While regulatory quality did have some impact on the performance of utility securities frm 1972 to 1982, it was not the major factor affecting the securities.