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Stranded Costs: Is the Market Paying Attention? (A Look at Market-to-Book Ratios)

Fortnightly Magazine - May 15 1996

ability to compete in a less-regulated market; thus, higher production costs, all else equal, should accompany a lower M/B ratio. Third: Percent of industrial load suggests how much of a utility's load may lie at risk in the early stages of competition; consequently, a lower percentage of industrial load, all else being equal, should attend a higher M/B ratio.

The model runs indicated that the three independent variables estimating stranded costs remained negatively associated with M/B ratios and remained statistically significant. Even after including the additional independent variables - ROE, production cost, and industrial load - the stranded-cost estimates remained

statistically significant.8 The only other variable besides the stranded-cost estimates in

the model to be statistically associated with M/B was ROE.

In the three multiple regression model runs, ROE was positively associated with M/B ratios and demonstrated high statistical significance. A 1-percentage-point incremental increase in ROE (from 10 to 11 percent, for example), led to approximately a 12-percentage-point increase in the M/B ratio for each of the three stranded-cost estimates. In combination with ROE, the Moody's estimate of stranded cost led to a 1-percentage-point downward change when there was a 10-percentage-point incremental increase in a utility's stranded cost as a percent of equity (such as from 50 to 60 percent). A 1-percentage-point change in lost revenue exposure in the S&P reasonable case (say, from 10 to 11 percent) led to a 3.5-percentage-point change in the M/B ratio. Finally, a 1-percentage-point change in the S&P severe case led to a 1-percentage-point change in the M/B ratio.

Running three multiple regressions substantially increased the ability to explain the variation in M/B ratios. As shown in Table 2, the multiple regression equations explain 50.7 (Moody's), 55.3 (S&P reasonable), and 54.8 percent (S&P severe) of the variation in M/B ratios among the sample utilities when ROE is introduced.

* * *

Increased utility exposure to stranded costs leads to a decrease in its M/B ratio. By year-end 1995, exposure to stranded costs had become a serious factor in investment decisions. The Moody's break-even approach and the S&P lost revenues approach provide equally powerful tools to explain equity investor preferences. t

Agustin Ros is an advisor to the chairman of the Illinois Commerce Commission and is currently working at the Federal Communications Commission on rules to implement the federal Telecommunications Act of 1996. Mr. Ros received his BA in economics from Rutgers University, and his MS and PhD in economics from the University of Illinois at Urbana-Champaign. John Domagalski is an associate of the utilities/energy

division of Coopers & Lybrand

Consulting/Palmer Bellevue. Mr. Domagalski has a BS in commerce from De Paul University. Philip O'Connor is a principal of Coopers & Lybrand Consulting/Palmer Bellevue. Prior to forming Palmer Bellevue in 1985, he served as chairman of the Illinois Commerce Commission. Mr. O'Connor earned an MA and PhD in political science from Northwestern University.

1 See, Moody's Investors Service, Stranded Cost Will Threaten Credit Quality of U.S. Electrics (August 1995).

2 Fixed production costs include nonfuel operating and maintenance expenses, fixed payments under long-term power contracts, interest on