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It Ain't in There: The Cost of Capital Does Not Compensate for Stranded-cost Risk
Electric utilities now face the risk that existing assets, costs, or contract commitments may be "stranded" by increased competition, leaving shareholders rather than customers to bear the costs. Have shareholders already been compensated for this risk?
Some argue that shareholders have automatically been compensated for this risk by an allowed rate of return equal to the cost of equity capital determined in efficient capital markets.1 If so, forcing shareholders to bear stranded costs may seem fair. However, this argument does not stand up to scrutiny, because the cost of capital by definition does not include such compensation.
Loose Definitions Create
Standard regulatory practice is to equate the allowed rate of return to the cost of capital and to set the rest of the revenue requirement so that if costs and sales are as anticipated, the utility will earn the allowed rate of return exactly. Differences between actual and anticipated costs and sales mean that the rate of return the utility actually realizes typically differs from the allowed rate of return, but the allowed and actual rates of return are supposed to be equal on average.
For the "automatic compensation" theory to work, it must hold true within this standard framework. The essence of the automatic compensation theory is that the cost of capital in and of itself offers adequate compensation for the risk of stranded costs.
Most of the confusion arises from failure to pay close attention to what the cost of capital used to set the allowed rate of return really is. Many assume that because capital markets are aware of a given risk when setting the cost of capital, compensation for that risk must somehow be "in there" when the cost of capital is measured. Straightening out the confusion involves only a pair of definitions (for the "cost of capital" and "stranded costs") and the law of averages (see sidebar).
The "cost of capital" has a standard meaning in corporate finance theory, which may be specified in two parallel ways: (a) The expected rate of return prevailing in capital markets on alternative investments of equivalent risk; and (b) The discount rate for determining the net present value of future uncertain cash flows by discounting their expected value. The key term in both definitions is
"expected," which is used in the statistical sense: the probability- weighted average over all possible outcomes. Thus, the cost of capital is not the "due course" or "single most likely" rate of return investors anticipate (em it is the overall average.
Standard definitions of stranded costs are harder to come by, but a simple definition can capture the essence of the concept: Costs are "stranded" when investments made under cost-of-service regulation cannot expect to earn the cost of capital due to a transition to greater competition, because either 1) the investments themselves cannot earn a sufficient return, or 2) other costs or prior commitments cannot be recovered.
Again, the term "expect" operates in the statistical sense: If greater competition creates "stranded costs," then by definition the utility's probability-weighted average rate of return over all