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Financial News

Fortnightly Magazine - February 1 1996

a utility must weigh the benefit it will derive from recovery funds against the damage to its competitive position that will be caused by the recovery of rival utilities. To maximize the risk-adjusted present value of its future cash flows, a utility should not support liberalization of stranded investment recovery beyond the point where the incremental damage to its competitive position begins to exceed the benefits from the funds it obtains.

For example, suppose a utility has moderate exposure to stranded investment and its rivals have large exposure. If only modest recovery of stranded investment is allowed, the utility would derive some benefit from recovery, while the recovery due to rivals might not help them enough to undermine the utility's competitive position materially. The utility would be a net beneficiary of stranded-investment recovery. However, if recovery were substantially liberalized, the utility might realize only modest incremental benefits from the additional funds it obtains. But the additional recovery might help its rivals enough to undermine the utility's competitive position severely. The liberalization would damage the utility. Partial stranded-investment recovery would be optimal for this utility. For others, optimality could mean full or no recovery.

The attitudes of utility managements toward stranded-investment recovery should reflect these disparities in optimal recovery. But this is not the case. Apart from a rather quiet minority, utility managements strongly support full stranded-investment recovery, which in many cases runs counter to the best interests of shareholders. This erring support appears to stem from a failure to think through the implications of head-to-head competition. Utility managements expect competition to place pressure on electric rates, but they largely ignore competitive interaction. In effect, managements think of themselves as price-takers who have no market influence, instead of as oligopolists. Besides leading them to undermine their own competitive position, their attitude also creates a real dilemma for investors.

What's in the Public Interest?

There is also an optimal level of stranded investment recovery for the public. The main objective of public policy should be to provide high-quality service at as low a price as possible. Since recovery of stranded investment will increase the price of electric power, it can be justified only if accompanied by improved quality of service. Recovery of stranded

investment would produce such improvement in some cases.

For instance, a utility with large stranded investment exposure might face a financial crisis that would cause its quality of service to deteriorate in the absence of recovery. In this case, stranded-investment recovery may be a cost-effective way of avoiding the deterioration. From the public's standpoint, stranded-investment recovery is justified to the extent that it is at least as cheap as other ways of achieving a desired quality of service.

Self-righteous arguments in favor of stranded investment recovery have no merit apart from

their value in extracting funds for a particular

utility. They belong to the land of corporate welfare arguments. t

Charles M. Studness is a contributing editor of PUBLIC UTILITIES FORTNIGHTLY. Dr. Studness has a PhD in

economics from Columbia University, and specializes in economics and financial research on electric utilities.