It Ain't in There: The Cost of Capital Does Not Compensate for Stranded-cost Risk
possible remaining outcomes (that is, given that costs are to be stranded) lies below the cost of capital.
Refuting the Automatic Compensation Theory
We now have all the ingredients needed to refute the automatic compensation theory. The reasoning is simple, given the proper definition of the cost of capital.
Under the automatic compensation theory, the utility will expect, on average, to earn the cost of capital (the allowed rate of return under traditional regulation) during the period prior to a transition to greater competition; if costs are to be stranded, the utility will expect to earn less.
From the law of averages, the average of these two expectations
(em (a) the rate of return expected prior to the transition (equal to the cost of capital), and (b) the rate of return expected after a transition with stranded costs (less than the cost of capital) (em must itself fall below the cost of capital. Since the utility cannot expect to earn the cost of capital averaged over periods when costs are and are not stranded, shareholders cannot have been automatically compensated for the risk of stranded costs by an allowed rate of return equal merely to the cost of capital.
The heart of the flaw in the automatic compensation theory is a failure to distinguish between 1) the cost of capital, the return investors require on average, and 2) whether the regulatory process affords investors an unbiased opportunity to actually earn the cost of capital on average. Put differently, setting the allowed rate of return equal to the cost of capital is compensatory only if that figure represents the rate of return the utility actually expects on average. With the risk of stranded costs and an allowed rate of return equal merely to the cost of capital (and regulation that otherwise is unbiased), this condition fails by definition.
A "junk" bond offers a good analogy. The bond's cost of capital is its expected rate of return (em the weighted average with and without default. However, the bond must promise a rate of return above its cost of capital if it does not default.
Some additional points require discussion.2
First, the conclusion that the expected return (averaged over all time periods) is below the cost of capital holds regardless of the specific mechanism by which investors determine the cost of capital. In particular, it holds even if the cost of capital is determined in efficient capital markets that (by now, at least) have full knowledge of the risk of stranded costs. No market imperfections are necessary for our conclusion.
Second, the automatic compensation theory fails independently of whether the risk of stranded costs also increases the cost of capital itself. For example, increased competition ordinarily increases the sensitivity of a company's earnings to the business cycle. The result may be a bigger risk of stranded costs in bad times. That higher market-correlated risk should lead to a higher cost of capital. But an allowed rate of return equal to the new, higher cost of capital by itself remains insufficient to ensure that