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Stranded Cost Recovery: Fair and Reasonable

Fortnightly Magazine - May 15 1995

is obviously detrimental to the interests of consumers and the efficiency of the economy. Demand will be channelled to less- efficient suppliers, leading to unnecessary resource use, reduced productivity, and higher real costs. This inefficient bypass is a clear impediment to a competitive economy. In the long run it must impose higher costs on consumers.

The proper manner of dealing with this issue is to arrange for recovery of stranded costs in a way that can be described as "competitively neutral." The policy must be such as to permit rival firms to succeed only on the basis of relative efficiency, undistorted by asymmetrical obligations inherited from the past. In our new book, we describe an arrangement that we believe to be an appropriate and efficient way to deal with the matter.

Recovery of stranded costs can ensure that regulators never take any step that will return the invested capital and lead investors to question whether long-run earnings will yield a competitive rate of return.

Under regulation as it was conducted in the past, regulators tried to offer investors the same sort of actuarially expected return that a competitive market provides, but were forced by other rules to diverge from the competitive model. That divergence was found in earnings ceilings. Unlike the enterprise in an unregulated competitive market, the regulated utility was prohibited from earning (aside from small and temporary deviations) any more than a "fair rate of return" on its rate base. This meant that, whatever the firm's performance, investors could rule out a large and lucrative return. But regulators made up for this lack. They implicitly committed themselves to protect the regulated firm from a broad class of losses in return for preclusion of large profits. Since the firm was generally selected for regulation because it characteristically possessed market power, the regulator could offset unexpected losses or cost increases by loosening constraints on the firm's market power, allowing prices to rise.

It is this arrangement, which we call the implicit regulatory compact, that enabled regulators to reconcile their earnings ceilings with a rate of return high enough to compete in capital markets. Failure to allow recoupment of stranded costs will clearly violate this implicit regulatory compact.

And aside from inequity, the failure to recoup could also deter capital investment. Of course, it will be too late for current utility investors to respond. But investors may come away with the lesson to avoid investing in partially regulated electric utilities. More important, other prospective investors, seeing the compact abrogated, are certain to become wary. They may take their money elsewhere.

Some argue that investors have short memories (em they will soon forget a once-and-for-all abrogation of the regulatory compact. But we have no confidence that future investors will simply ignore past mistreatment and the risk that it can occur again. If stranded costs were only modest in amount, that hypothesis might be credible. That their magnitude threatens to cut deeply into the equity of current shareholders makes such a hypothesis implausible, and certainly one that cannot be relied upon with any degree of