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Thus, we assumed in the study that a utility's M/B ratio should decline if shareholders doubt that regulators and/or the market will provide 100-percent recovery of stranded costs. (Conversely, utility-specific stranded costs should not affect the M/B ratio if investors perceive that regulators can guarantee 100-percent cost recovery.) A competitive environment that forces utility write-offs would strain earnings and reduce investor expectations of higher future dividend growth. This negative expectation should cause equity prices to decrease, thus causing a decrease in M/B ratios, all else equal. Therefore, investors who anticipate stranded costs in the future would expect the benefits of holding the stock to decrease.

Utility M/B ratios were regressed on three estimates of stranded cost. The first equation used Moody's estimates (standardized from the original report of stranded cost as a percentage of total book equity at risk). The second used S&P reasonable-case estimates (reported initially as lost revenue as a percentage of total revenues). The third used the S&P severe-case estimates (also expressed originally as lost revenue versus total revenues). Three separate equations were developed, one for each estimate of stranded costs.

The data indicated a statistically significant negative relationship between a utility's M/B ratio and the stranded-cost estimates.5,6 Regardless of which estimate of stranded costs was used, an increase in a utility's exposure to stranded costs was associated, on average, with a decrease in a utility's M/B ratio.

The first equation (Moody's estimates) revealed that a 10-percentage-point incremental increase in a utility's stranded cost as a percent of equity (e.g., from 50 to 60 percent) produced a 1.7-percentage-point decline in the M/B ratio. A 1-percentage-point incremental change (e.g., from 10 to 11 percent) in lost revenue exposure (S&P reasonable case) led to a 4.3-percentage-point decline. Finally, a 1-percentage-point change in revenues lost (S&P severe case) produced a 1.4-percentage-point decline in M/B ratio.

Interestingly, the three stranded-cost exposure estimates each explained approximately the same amount of M/B variability across the 69 utilities covered in the sample: 19.3, 19.1, and 20.6 percent, respectively (see Table 1).

Other Factors? Return on Equity

As seen above, stranded-cost estimates taken alone can explain one-fifth of the variation in M/B ratio among the 69 sample utilities. The next question becomes: What about the other 80 percent? Is it possible that other variables better explain the behavior of M/B ratios? In an attempt to capture some of the other 80 percent or to displace the stranded-cost explanation, we tested three other independent variables with each of the three stranded-cost estimates: 1) earned return on equity (ROE), 2) production costs, and 3) percent of load accounted for by industrial customers.7 Neither of the last two variables proved statistically helpful. However, when ROE was introduced alongside the stranded-cost estimates, we found we could then explain fully one-half of the variation in M/B ratio.

With these three new independent variables, added to each of the three model runs noted earlier, we assumed three hypotheses. First: ROE measures profitability so, all else being equal, higher ROE should be associated with a higher M/B ratio. Second: Production costs reflect a utility's