[BETA] Fortnightly

Stranded costs are those costs that electric utilities are currently permitted to recover through their rates but whose recovery may be impeded or prevented by the advent of competition in the industry. Estimates of these costs run from the tens to the hundreds of billions of dollars. Should regulators permit utilities to recover stranded costs while they take steps to promote competition in the electric power industry? On both efficiency and equity grounds, we argue, the answer to that question should be yes.

To begin with, we take issue with a particular rhetorical device commonly employed in this debate. Some imply that those who favor recovery fear competition in the electric power industry. That is not our position. Competition in generation is desirable. And more to the point, it's inevitable.

Stranded costs represent expenditures incurred by a utility in the past in meeting its obligation to serve all customers within the area for which it held an exclusive franchise granted under the traditional regulatory regime. Costs that face stranding include, among others:

1) Assets used for electricity generation

2) Costs for purchased power and fuel required under long-term contracts

3) "Regulatory assets" (expenses deferred to keep rates low temporarily)

4) Outlays for social goals, such as subsidies to low-income users

5) Incentives for renewable energy.

Regulatory agencies approved these outlays. Many were imposed on the utilities; some served to hold down prices to electricity customers. However, the entry of competitors who are not burdened by such inherited expenses can prevent utilities from recovering those costs. Such a scenario has been questioned both on the basis of equity and economic efficiency.

Moreover, a policy preventing recovery of stranded costs can lead to at least two major categories of inefficiency. First, business can be diverted to less-efficient suppliers, whose higher operating costs are offset by freedom from obligations imposed on utilities. Second, investment can be deterred, condemning efficient suppliers to obsolescence and inadequate capacity.

Efficiency

Even if no arrangement were adopted to enable utilities to recover the bulk of their stranded costs, some portions of these costs would remain inescapable. With regulatory consent and encouragement, utilities have entered into long-term contracts that require them to use high-cost sources of energy and to purchase electricity from high-cost suppliers. They are expected to maintain capacity to serve unexpected increases in demand. These, and the costs of a number of social obligations, count among the expenditures that utilities likely will not escape, even though, under current arrangements, other electric generators carry no such burden.

This disparity in obligations between the utility and its competitors in electric generation undermines efficiency in the competitive market. Competitors may face barriers to entry, but the utility serving the market faces "incumbent burdens." Suppose that

a utility can generate electricity

at an incremental cost, say,

10 percent lower than its rival's cost. If the utility's inherited and inescapable cost obligations are 20 percent of its incremental costs, its less-efficient rival will clearly be able to underprice the utility, despite the rival's substantially higher incremental cost of producing electricity. This form of bypass