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It Ain't in There: The Cost of Capital Does Not Compensate for Stranded-cost Risk

Fortnightly Magazine - May 15 1995

the utility has an unbiased opportunity to earn that new cost of capital. The only way to compensate shareholders for the risk of stranded costs is to permit the utility to expect to earn more than the cost of capital if no costs are stranded, whatever the cost of capital is and regardless of whether it has gone up.

Finally, stranded-cost compensation does not disappear in the ordinary "noise" of rate regulation. The difference between the cost of capital and an allowed rate of return high enough to provide compensation for stranded-cost risk can easily get quite large. For example, suppose that stranded-cost risk for a particular utility can be summarized as a 0.25 probability that a transition to more competition would result in a write-off that reduces the utility's actual return on equity by 30 percentage points in the year the transition occurs. Once this happens, if it does, the stranded-cost risk is resolved once and for all. Finally, suppose that investors are fully aware of the risk, and that the utility's cost of equity capital given this knowledge, and measured perfectly, is 12.5 percent (which, without loss of generality, we could suppose had moved up from, say, 11 percent as a result of the higher market-correlated risk). The issue is, what allowed rate of return provides adequate compensation for the stranded-cost risk?

So What Would it Take?

As the Figure illustrates, 12.5 per- cent (the cost of capital) clearly does not offset the risk. If the allowed rate of return equals only the cost of capital, given the 0.25 chance of stranding, the weighted average rate of return expected over both the "good" (12.5 percent) and "loss" (12.5 percent - 30 percent = -17.5 percent) outcomes is only 5 percent, well below the cost of capital. Adequate compensation instead requires an allowed rate of return of 20 percent. With a 20-percent rate of return in the "good" outcome and a -10-percent (20 percent - 30 percent = -10 percent) rate of return in the "loss" outcome, investors expect a 12.5-percent rate of return overall.

And so, have investors automatically been compensated for the risk of stranded costs when regulators equate the allowed rate of return to the cost of capital? The answer is "no," because stranded costs affect not only (potentially) the size of the cost of capital, but also (definitely) the odds that investors will earn the cost of capital. Stranded-cost risk compensation "just ain't in there." t

Lawrence Kolbe and William Tye are principals of Brattle/IRI, an economic and management consulting firm headquartered in Cambridge, MA, which was recently formed by the merger of The Brattle Group and Incentives Research Inc. Over the years, Messrs. Kolbe and Tye have contributed frequently to PUBLIC UTILITIES FORTNIGHTLY. Their last article, "Who Pays for Prudence Risks?," appeared Aug. 1, 1992, p. 13.

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