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

Fortnightly Magazine - May 15 1996

while minimizing anticompetitive effects - there is a major timing issue. How much time do we have - not only to answer these questions, but to implement solutions in an orderly way? Shareholders are already reacting to new market realities and discounting stocks with stranded-cost exposure. It remains to be seen how they might respond to specific stranded-cost phase-in plans in the states.

The Problem: Cost or Revenue?

Two recent reports by Moody's and S&P highlight the stranded-cost debate and present different methods of calculating the magnitude of the problem.

The Moody's report (released in August 1995) estimates potential stranded costs for 114 U.S. investor-owned utilities at $135 billion.1 The report adopted a method of calculating stranded costs that assumes a utility can be compensated in the market for both an energy and a capacity component. Thus, any margin earned from selling energy above variable cost is applied to the recovery of fixed costs. The report compares each company's capacity charge for covering fixed costs with the competitive market price for capacity, which is based on the marginal cost of the most expensive unit needed to satisfy expected peak demand in differing regions of the country. Stranded costs equal the difference between the margin over variable cost and the capacity charge for fixed costs.2

The S&P report (released in November 1995) focuses instead on a utility's potential revenue loss from retail competition, positing a severe as well as a reasonable case.3 The severe case assumes immediate direct access for all customers and no regulatory mechanism for the recovery of stranded costs. The reasonable case assumes immediate direct access for commercial and industrial users only and a 50-percent stranded-revenue recovery mechanism. S&P isolated revenues associated with generation and sales of electricity and the purchase and resale of power, excluding revenues and costs from transmission and distribution. For each customer class (i.e., residential, commercial, and industrial), S&P assumed a market-clearing price for generation sold, then compared that price to each utility's production costs, and then multiplied the difference by the 1992-94 average sales volume to determine each utility's potential lost revenue.

Our analysis covered a sample of the 69 utilities that were common to both studies. We used the Moody's estimates of stranded costs as a percent of equity for each utility, and S&P's reasonable and severe estimates of lost revenues as a percent of total revenues. In the select cases where a holding company owned more than one electric utility, we aggregated and standardized the estimates of stranded costs and lost revenues for the applicable utility subsidiaries.

Three Models: A Correlation

A simple, ordinary least-square (OLS) regression equation was used to determine whether stranded costs, as measured by the Moody's and the S&P reports, can explain variability in equity performance, as expressed by the M/B ratio.

We selected M/B ratios (a utility's stock price divided by its book value) as a useful variable to measure investor perceptions of the value of utility company's assets on December 31, 1995.4 Higher M/B values are associated, all else being equal, with greater expected value and profitability.