Stranded Costs: Is the Market Paying Attention? (A Look at Market-to-Book Ratios)
Investors are taking stock
of utility exposure to price competition.The utility trade press and even the general financial press have featured the views of regulators, utility executives, legislators, and various consumer advocates on the stranded-cost question. Stranded costs easily represent the most contentious issue facing the electric industry as it moves to an era of competition. The financial analysts have weighed in as well, from the fixed income as well as the equity side of the house.
But rarely does one find evidence of what utility shareholders are saying about stranded costs and competition. That's because they speak with their wallets and not with their mouths. Utility stock performance in 1995 provides evidence that equity investors are taking serious account of the exposure of utilities to stranded costs and competition. Those utilities most exposed saw their stocks trading at lower market-to-book ratios.
Just as electric producers compete for sales, analysts compete to develop methods to estimate exposure to stranded costs. In this case, we started with data on stranded investment contained in recent reports from Moody's and Standard and Poor's, and used that information to study the 1995 year-end, market-to-book (M/B) ratios of stock prices for some 69 utilities. We found that we could explain approximately 20 percent of the differences among the M/B ratios in terms of estimates of stranded costs. Moreover, when we considered differences across utilities in earned returns on equity, we could then explain fully half the variance among M/B ratios.
One added point might come as a surprise: We found we could not explain any additional variance in M/B ratios by considering incremental kilowatt-hour production costs, or the percent of power generating output sold to industrial customers.
Timing is Everything
Currently, the power-supply component of retail rates lies significantly above new wholesale power prices, while embedded costs exceed marginal costs substantially. Contributing to these higher-than-market retail rates are a number of factors: large sunk investment in nuclear generating plants, decommissioning liabilities, costly purchased-power (QF) contracts, and various mandated social programs, such as demand-side management (DSM). Prices on new wholesale power contracts, on the other hand, have been falling due to increased competition, low fuel prices, and technological advances that make combined-cycle generation turbines competitive with larger baseload plants.
An end to the exclusivity of the utility franchise - permitting access to market-priced power - would tend to drive retail power rates down to a level that would create "stranded costs." Potential stranded costs may or may not be currently incorporated into rates. Stranded costs currently allowed in rates customarily include generation assets, long-term purchased power and fuel contracts, and mandated social programs. Stranded costs not currently in rates can include regulatory assets that have been deferred to mitigate short-term rate effects, or simply deferred costs of generation plant and DSM. Recovery of any costs above market may be jeopardized by the transition to a more competitive electric industry.
In addition to the big policy questions - whether some or all of these costs should be recovered, and what mechanisms should be used to recover them