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Fortnightly Magazine - June 15 1997

In the electric industry restructuring debate lurks an important issue: If utilities recover some level of stranded costs, how do you design a cost recovery mechanism that minimizes stranded costs? This issue is important because, among other things, it will affect total customer savings.

One way to encourage utilities to mitigate stranded costs is to allow recovery of only a portion of costs. For instance, the California stranded cost recovery mechanism provides utilities with a "fair opportunity" to recover all of their stranded costs. The goal of California utilities will be to accelerate depreciation of their generation-related assets so that by March 31, 2002, the book value of remaining assets will approximate the market value of the assets. If the book value is greater than the estimated market value in 2002, the utility will need to write off this portion of stranded costs, thereby reducing shareholder value. To avoid this write off, the utilities will have a strong incentive to reduce costs. Allowing utilities to recover only a portion of stranded costs provides the same incentives to reduce overall costs as a "fair opportunity." It is important to note that a "fair opportunity" to recover stranded costs is very different from the Rhode Island legislation, which "guarantees" full recovery.

If utilities are guaranteed full recovery, as the FERC and Rhode Island have done, designing a cost recovery mechanism that minimizes transition costs becomes complex. Possible future scenarios for FERC-regulated contracts and Rhode Island customers provide good examples of some pitfalls to avoid. In the case of the FERC ruling, a departing customer must pay a stranded cost charge that is equal to the difference between the expected future revenue stream that would have occurred under regulated rates less an estimate of the market value a utility could receive for reselling the released energy and capacity. The future revenue stream is based on the average revenue paid by the customer during the three years prior to the date the customer leaves the utility's system. Because the future revenue stream is based on historical revenues and costs, a departing customer cannot benefit from any future cost decreases that would have lowered its contract price. In fact, it is possible that the FERC's formula for estimating stranded costs could increase rates for departing customers.

In the case of Rhode Island, customers will pay a stranded cost charge of 2.8¢/kWh from 1997 through 2000. In the year 2000 a "true-up" will be performed, based on an auction of assets, to determine the stranded cost charges to be paid by customers from 2000 to 2009. The true-up based on an auction of assets is the simplest method that ensures cost minimization. The bids for these assets will reflect the expectation of future cost reductions in a competitive market. However, during 1997 through 2000 it is not clear what incentives the utilities will have to reduce costs. During this period, utilities can bid low into the power market to keep existing customers. Utilities may even be able to bid below marginal cost, knowing that they will recoup their