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Financial News

Fortnightly Magazine - March 1 1997

regulated electric or gas company is not likely to preserve shareholder wealth, since the target utility will be priced to provide a financial-asset return, while the regulators all too soon will pass along to customers any benefits of synergies gleaned from the consolidation. On the other hand, the acquisition of an unregulated business may appear more promising, but again the target company will be priced to provide a financial-asset return. The utility will enjoy a free hand in retaining the benefits of any efficiencies it introduces, but its lack of experience with unregulated businesses casts doubt on the prospect that it will succeed in creating or realizing any such efficiencies.

The most promising way to achieve the returns required to preserve shareholder wealth lies with the development of new business operations. The problem will come with earning a return on invested equity on the scale needed for full preservation of shareholder wealth. Indeed, it seems doubtful that utilities will prove successful outside of closely related energy areas, such as bulk power, marketing and energy services given their dreadful record in diversification. And questions remain about how successful utilities will be in energy services. Moreover, size constraints will likely limit the number of utilities that will succeed in generation and bulk power marketing. t

Charles M. Studness is a regular contributor to PUBLIC UTILITIES FORTNIGHTLY. Mr. Studness has a Ph.D. in

economics from Columbia University and specializes in conducting economic and financial research on electric utilities.

Earnings Dictate Value

Not the other way around.

• Regulatory Distortions. Regulated electric prices at times have exceeded market levels to make high-cost plants appear economically viable. (High enough to create a discounted stream of prospective earnings equal to the cost of the plant, no matter how high.)

• False Value. Regulated prices equated economic value to book value.

• Day of Reckoning. Market prices will cut earnings of high-cost plants; economic value will fall from the inflated regulatory value to market value. This reduction is stranded investment.

TABLE. Numerical Model of Full Recovery of Stranded Investment*

Traditional Regulation

Return on Equity (Actual) 12.0% (Equals allowed ROE)Book Value of Equity 200

Earnings 24

Economic Value of Equity 200 (Earnings capitalized at 12% regulatory ROE)

Competitive Pricing

Restructured Earnings 12 (Decline in power prices halves earnings)

New Economic Value 100 (New earnings capitalized at 12%)

Stranded Investment 100 (Book equity less new economic value)

Stranded Recovery 100 (Assume 100 percent stranded investment

recovery)

Ending Equity 200 (100 of earning assets and 100 of cash)

Shareholder Wealth

Starting Wealth 300 (Earnings of 24 capitalized at 8% (em 1.5 P/B)

Competitive Earnings 150 (Market value of competitive earnings of 12,

capitalized at 8%)

Stranded Cost Recovery 100 (Cash recovered at face value)

Ending Wealth 250 (Value of restructured earnings plus recovered

funds)

Decline in Wealth 50 (Starting wealth less ending wealth)

*In the true sense, and as intended in the example and in this article, the term "stranded investment" refers only to the sunk plant costs rendered uneconomic by competition. Stranded investment arises when regulated prices deviate from the competitive norm and thus