Electric utilities often have above average dividend yields. A distinctive characteristic of many utility companies is that they pay a high percentage of earnings as dividends, while periodically issuing new equity to invest in the many projects necessitated by the capital intensive nature of their business. This practice of financing dividends with new equity appears unwise because new equity is expensive. Researchers17 examining a set of U.S. based electric utilities, however, have demonstrated that there may be a good reason for paying dividends and then issuing equity: the mitigation of the agency problems between managers and shareholders and between utility regulators and utility shareholders.
Because electric utilities are typically monopolies in the sense that they are usually the only providers of electricity in a given area, they are regulated so they are not able to set electricity rates at monopolistically high levels. The regulators are expected to set rates such that the company’s operating expenses are met and investors are provided with a fair return. The regulators, however, are usually elected, or are political appointees, and view ratepayers as potential voters. Thus, utility shareholders, in addition to facing potential manager–shareholder agency issues because managers have incentives to consume perquisites or to over invest, also face a regulator–shareholder conflict, in which regulators set rates low to attract the votes of individuals being served by the utility.
In the utility industry, therefore, dividends and the subsequent equity issue are used as mechanisms to monitor managers and regulators. The company pays high dividends and then goes to the capital markets to issue new equity. If the market does not think that shareholders are getting a fair return because regulators are setting rates too low, or because managers are consuming too many perks, the price at which new equity can be sold will fall until the shareholder expectations for returns are met. As a result, the company may not be able to raise sufficient funds to expand its plant to meet increasing electricity demand—the electric utility industry is very capital intensive—and, in the extreme, the lights may go out. Faced with this possibility, and potentially angry voters, regulators have incentives to set rates at a fair level. Thus, the equity market serves to monitor and arbitrate conflicts between shareholders and both managers and regulators.