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Stranded Cost Recovery: Fair and Reasonable

Fortnightly Magazine - May 15 1995



Economics does not teach justice or equity. Nevertheless, the issue of stranded cost-recovery raises inescapable questions of fairness.

Some advocates of competition argue that equitable considerations are irrelevant (em that, just as competitive markets do not guarantee recovery of costs (sunk or otherwise), so utility companies will enjoy no such entitlement either. Thus, to the extent that competition strands costs, the utilities should be forced to write them off. Utility managers, conscious of their responsibilities to shareholders, naturally disagree.

We have already set forth the several ingredients of the case for full recovery on equity grounds. The most recent regulatory reforms that have played so large a role in admitting competition into the industry (em including both the Public Utility Regulatory Policies Act (PURPA) and the 1992 Energy Policy Act (em retained that same arrangement and assurance: The model they envision is one in which the utility companies serve as "resource portfolio managers," responsible for the supply of electric services to their retail customers, whom they continue to serve on an exclusive basis, with the continuing implicit regulatory promise of the opportunity to recover their approved costs.

The consequent allocation of risk between investors and customers is, of course, different from its allocation in unregulated industries. Unregulated markets impose on investors the full costs of investments that turn out badly but allow them to retain all the profits of ventures that turn out well. Under traditional utility regulation, investors have neither borne much of the risk nor enjoyed much of the benefits. But this allocation of investment risk has worked to the benefit of ratepayers for many decades. Even among present utility portfolios, most investments have been economically successful. The desire of ratepayers and their representatives in the present circumstances for shelter from the costs of past commitments that have not met expectations is, of course, understandable. But so far as equities are concerned, the offer of such shelter by policymakers will break the symmetry. The game becomes heads-we-win, tails-you-lose. A failure now by policymakers to permit some reasonable recovery of costs imposed under regulation in any transition to competition would leave investors, in effect, with a very large part of their property value expropriated by the change in the rules of the game.

The possibility that the firm's investors will be precluded by regulation from obtaining a reasonable return can suggest that a "taking" of the utility's property has occurred, in violation of the Takings Clause of the Fifth Amendment. Purely as an economic matter, it is confiscatory to take someone's property by decree and without adequate compensation. That rule applies equally to stockholder property.

Ultimately, of course, whether confiscation has occurred in the economic sense by virtue of change in regulatory policy is a question to be decided by a court. Yet, the relevant legal issues are fundamentally economic matters, and ones that economic analysis can illuminate. Indeed, the conclusions that emerge from economic analysis are entirely consistent with the criteria enunciated by the Supreme Court in 1989 in Duquesne Light Co. v. Barasch, 488 U.S. 299 (1989).