Dr. Zhu has served as a cost of capital expert witness before numerous state regulatory commissions, and the Federal Energy Regulatory Commission (FERC). These engagements have involved evaluating complex capital market conditions, developing independent ROE recommendations, and critically assessing the methodologies employed by utility witnesses.

Dr. Zhu’s cost of capital analyses are grounded in modern financial theory, empirical capital market evidence, and regulatory precedent. His testimony also addresses broader regulatory issues affecting investor risk and customer costs, including capital structure, formula rates, multiyear rate plans, regulatory lag, affordability, and emerging utility investment trends.

In addition to his consulting practice, Dr. Zhu is a Professor of Economics with expertise in financial economics and energy markets. His academic research on energy markets, commodity pricing, and financial risk enhances the analytical rigor of his regulatory work. This combination of academic scholarship and practical regulatory experience enables him to provide independent, well-supported, and technically sound opinions that assist commissions and consumer advocates in determining fair and reasonable rates of return while protecting the long-term interests of utility customers.

Please contact Dr. Zhen Zhu for more information.

The following article draws on nearly two decades of Dr. Zhu’s research on utility risk, return on equity, and regulatory finance.

How Do You Know Whether a Utility’s Cost of Capital Is Fair?

What nearly two decades of research suggest about risk, assumptions, and asking better questions.

Customers want affordable and reliable service. Utilities need access to capital to maintain and improve the systems that deliver that service, respond to changing demands, and support long-term reliability. Regulators, consumer advocates, and state agencies are often asked to balance affordability with the need for utilities to attract the capital required to serve their customers.

Disagreements usually begin long before anyone debates a specific cost of capital issue, especially the one concerning Return on Equity.

Part of the debate centers on how much return investors should earn for providing capital to the utility. A major component of cost of capital or rate or return is  Return on Equity, or ROE, the concept reflecting the compensation equity investors expect in exchange for the risks they assume. ROE affects a utility’s overall cost of capital and ultimately influences the rates customers pay. Investor-owned utilities argue that they must earn returns comparable to investments with similar risks in order to attract capital. Consumer advocates and watchdog groups may question whether customers are being asked to pay more than necessary.

Those disagreements are not new, and they do not necessarily reflect bad faith. Even if everyone agreed on the underlying goals, determining a fair rate of return would remain difficult. Measuring risk is not as straightforward as it first appears, and seemingly small assumptions can influence the answers.

Research involving Guernsey economist Dr. Zhen Zhu and his coauthors has explored these questions for nearly two decades. Taken together, the papers suggest that debates over Return on Equity are often less about formulas and more about how risk should be measured, how evidence should be interpreted, and whether commonly accepted methods still reflect economic reality.¹

Agreement on Principles Does Not Guarantee Agreement on Results

At first glance, the principle seems straightforward. Utilities facing similar risks should earn similar returns, and those returns should be high enough to attract capital without imposing unnecessary costs on customers.¹

Translating that principle into a specific Cost of Capital is considerably harder.

Research examining regulatory decisions involving natural gas, electric, and water/wastewater utilities found that market interest rates appeared to influence allowed returns, but the connection between measured risk and those returns was less clear.² That finding did not suggest that risk was unimportant. Instead, it suggested that applying the principle consistently may be more difficult than the principle itself implies.

For people evaluating a utility filing, this distinction matters. The challenge is not deciding whether risk should influence returns. The challenge is determining how risk should be measured and how much weight should be placed on competing evidence.

The Real Debate Often Lies Beneath the Number

Return on Return discussions often focus on the recommended percentage. Yet Zhu’s research points somewhere else.

It points to the assumptions behind the recommendation.

Two analysts may use similar approaches and still arrive at different conclusions because of seemingly small differences in methodology.

Research published in 2022 examined one example involving the Hamada beta adjustment (a method used to account for the effect of borrowing on investment risk). Beta is a measure of how sensitive a stock’s returns are to movements in the overall market and is widely used in cost-of-capital studies.³ Zhu and his co-author concluded that using book-value debt-to-equity ratios (an accounting measure comparing borrowed money to owners’ investment based on values reported on financial statements) rather than market values can inflate beta estimates and produce higher estimates of Return on Equity.⁴

The broader lesson extends beyond one formula. Familiar methods and sophisticated models do not eliminate judgment. They simply move the debate to the assumptions embedded within the analysis.

That matters because methodology can influence customer rates, investor returns, and regulatory decisions.

History Is Helpful. It Is Not Infallible.

Historical data plays an important role in cost-of-capital studies. It provides context and helps analysts understand how markets have behaved over time. But historical data does not interpret itself.

Extraordinary events can continue to influence the numbers long after the event itself has passed.

Research examining utility stock risks during and after COVID-19 found that the pandemic had a significant but temporary effect on measured risk.⁵ Zhu and his co-author concluded that conventional five-year beta calculations may overstate current utility risk because unusual market conditions experienced during the early stages of COVID-19 remain embedded in the historical data.⁶

That finding does not mean historical information should be ignored. It means historical information should be interpreted carefully.

Numbers that accurately describe the past do not always provide an equally accurate picture of the present.

Why Reasonable People Disagree

Disagreements over Rate of Return are often portrayed as battles between those seeking higher returns and those seeking lower ones.

Zhu’s research suggests a more complicated reality.

Determining a fair Rate of Return is difficult because measuring risk is difficult. Reasonable experts may rely on different assumptions. They may interpret historical evidence differently. They may place greater weight on some risks than others. They may disagree about whether unusual events should influence long-term estimates.

Disagreement, by itself, is not evidence that someone is wrong.

It is often evidence that the question itself is difficult.

That reality helps explain why debates over cost of capital frequently focus on methodology, assumptions, and evidence rather than formulas alone.

What Should You Expect from a Cost of Capital Expert?

Most organizations do not deal with cost of capital issues every day. Attorneys, analysts, and commission staff are often asked to evaluate highly technical testimony outside their primary areas of expertise.

Decision-makers do not need to become economists. They do need to understand what separates a well-supported recommendation from one that depends heavily on assumptions that deserve closer scrutiny.

When selecting an expert or reviewing competing analyses, consider questions such as:

Can they explain their conclusions in plain language?

A recommendation should not depend on equations that only another economist can understand. If an expert cannot explain the key drivers behind the recommendation, decision-makers may struggle to evaluate the testimony.

Do they discuss competing approaches?

Strong analyses acknowledge alternative methods and explain why one approach was preferred. Be cautious when a recommendation appears to depend heavily on a single model or assumption.

Do small changes produce large differences?

If minor adjustments to assumptions cause large swings in the recommended rate of return, decision-makers may want to understand why the analysis is so sensitive.

Does the analysis recognize unusual circumstances?

Historical information is important, but unusual events can distort the picture. Experts should explain whether extraordinary conditions continue to influence the results and why.

Are the conclusions consistent across multiple methods?

No single model provides all the answers. Greater confidence may be warranted when different approaches point toward similar conclusions.

Do they follow the evidence?

One of the recurring themes in Zhu’s research is the importance of questioning assumptions. Strong analyses do not begin with a preferred answer. They begin with a question and allow the evidence to determine the conclusion.

Better Questions Lead to Better Decisions

The papers do not argue that rate of return should always be higher or always be lower. Nor do they suggest that one formula provides all the answers.

Most people responsible for evaluating cost of capital issues are not economists. They do not need to be.

They do need to understand what questions deserve attention, what assumptions drive the answers, and when additional expertise may be warranted.

Better questions do not eliminate disagreement.

They do lead to better decisions.

Notes:

1. Donald Murry, Zhen Zhu, and Michael Knapp, “Linking Risk and ROE,” Public Utilities Fortnightly, October 2008. Based on abstract and published excerpts.
2. Donald Murry, Zhen Zhu, and Michael Knapp, “The Equivalent Risk Standard and Allowed ROEs in the Gas and Electric Utility Industries,” Journal of Applied Economics and Policy, Vol. 30, Spring 2011.
3. Scott Linn and Zhen Zhu, “The Hamada Beta Adjustment and the Cost of the Capital for the Regulated Utilities,” IAEE Energy Forum, Third Quarter 2022.
4. Linn and Zhu (2022) conclude that applying the Hamada adjustment with book-value debt-to-equity ratios can bias beta estimates upward and produce higher estimates of Return on Equity.
5. Breandan MacMathuna and Zhen Zhu, “COVID-19, Utility Stock Risks and Return on Equity,” working paper, 2026.
6. MacMathuna and Zhu (2026) conclude that conventional five-year rolling beta estimates may overstate current utility risk because abnormal conditions experienced during the early stages of COVID-19 remain embedded in the data.

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