[BETA] Fortnightly

Intense though it has been, the debate over stranded electric investment has addressed only half of the issue. What the utilities will do with the money is as important as whether they should recover anything at all.

Retail competition will accelerate the decline of utility-owned generation; utilities will rely less on their own production and more on purchased power to serve their remaining customers. Because the per-megawatt cost of most new generation remains quite low, utilities with stranded assets (as well as some restructured systems without any) can expect to receive more cash than they need for investments to fulfill their service obligations. No utility has stated that it will fully dedicate its stranding recovery to retiring debt, repurchasing stock, or shrinking the company by other means. Companies such as Edison International (formerly SCEcorp) and Pacific Gas & Electric are making substantial paydowns and repurchases, but they too will probably spend some stranding revenue on projects that would normally call for external finance.

The efficiency and fairness of recovery depend critically on what happens to the proceeds. Any metaphorical regulatory compact that warrants making customers pay for stranded assets must also apply to how such monies are spent by recovering utilities. As understood by its believers, the compact insulates the value of shareholder investments because they were made in the expectation of guaranteed cost recovery. However, the price of a share of stock reflects the market's

consensus about the future income (both dividends and capital gains) that it will produce. Even before a utility actually spends its stranding recovery, its share value will depend on how the market expects the money to be spent. If these expectations turn pessimistic, the stock price will fall; stranding compensation will fail to protect shareholders.

Financial economics gives good reason for concern about the disposition of stranding payoffs. Many scholars have found that corporations that receive free cash flows typically invest them in ways that do not maximize shareholder value. By contrast, companies that must persuade the capital markets of their projects' worth invest more productively and create more value for shareholders. If regulators accept the claims of utilities (and customers cannot find ways around them), over $200 billion might change hands over the next decade. For many utilities, a substantial part of today's income represents recovery of stranded assets (em in effect, if not in name. Never before has an industry seen such massive cash flows that it need not reinvest in its old lines of business. Only by a wonderful accident would utilities find superior investments large enough to soak up cash flows of this size.

Even if such projects appear on the horizon, regulators and shareholders should insist they be undertaken with the approval of the capital markets. Regulators, however, will enjoy limited powers to oversee unregulated investments that use the free funds. As always, shareholders will encounter difficulty in monitoring how well management is doing its job. Even if regulators exert some power over the funds, there is little reason to expect them to pick better investments.

Free Cash Flows: Who Knows