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Stranded Cost Recovery: All FERC'ed Up

Fortnightly Magazine - November 15 1996

contracts, the stranded-cost formula accounts for them appropriately. The fair-market value of the firm includes these purchased-power obligations. If the contracts involve obligations to buy power at above-market rates, then the fair-market value of the firm is consequently lower (em and stranded costs consequently higher. Stranded costs from PURPA contracts do not require special accounting or treatment under the market-valuation approach.

Measuring Stranded Costs

Notice that the firm may or may not incur stranded costs. In the rate regulation process, productive assets are written off as the assets are paid for by income. These assets are not necessarily unproductive. However, the regulated firm is not allowed to charge prices that reflect the economic value of these assets. The firm can recover only its out-of-pocket costs of operating this capital. Under competition, these assets will have value because they will produce net positive cash flows. The competitive price will reflect the opportunity cost of these assets. Their capital value will reflect the cash flows derived from the output generated at these plants.

In short, the stranded-cost question comes down to valuing the asset portfolio of each firm.10 Thus, we propose to measure stranded costs and base recovery on market transactions or some arbitrated valuation process. Let the financial market or reasonable experts value the assets and adjudicate the issue.11 If the financial market is the judge, then competition among investors will drive the fair-market value of the assets to their highest level. From this height, the true level of stranded costs will be revealed.

One method appears fair and simple to implement. Let any utility that claims to have stranded costs recapitalize itself. As of the utility's date of election, new shares of the company will begin trading. These shares will be exchanged one-for-one with the old shares. The new shares will have no claim to stranded-cost recovery of historical costs on the books prior to their issue. The value of the new shares is, then, the fair market value of the utility. The difference between the historical book value and the fair-market value, if positive, is the level of stranded costs. Shareholders of record on the day before the date of election will be entitled to whatever stranded cost recovery is provided for in the deregulation proceeding.

In the process of this recapitalization, a divestiture of assets into generation, transmission, distribution, and unregulated entities might make for a good policy choice. Why? Because the unregulated utility assets must be deducted from the fair-market value of the firm in assessing the level of stranded costs. Recapitalization marks the best time to invoke divestiture. If reintegration is efficient, and if it does not threaten the competitiveness of the market in the eyes of the antitrust authorities, then the separate firms can remerge.12 The stranded-cost issue is primarily a generation issue because most of the deregulation scenarios involve continued regulation of transmission and distribution activities.

Recovering Stranded Costs

The method of recovery is another matter, but one thing is certain: Utilities should recover stranded costs by means of an

access charge or fixed fee. Stranded-cost