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Stranded Cost Recovery: A Practical Argument for Utilities

Fortnightly Magazine - June 1 1997

a government makes a contract, either express or implied, that people rely on, then if a law change renders specific performance impossible, the government should be held liable for damages.

If the government wants to open competition only in those segments of the industry where rates would fall, but continue to regulate those segments where rates would rise, then the government should let the industry transfer the cost of stranded assets from the newly competitive sectors to the regulated sectors. As the Supreme Court advised in Duquesne:3 "[A] state's decision to arbitrarily switch back and forth between methodologies in a way which required investors to bear the risks of bad investments at some time, while denying them the benefits of good investments at others, would raise serious constitutional questions."

Proving the Benefits

The proper question to keep in mind throughout the debate is not, "What is best for new entrants?" But, "What is best for society?" For example, consider a system with only old participants (OLDCO) that have plant (sunk) costs of 5¢/kWh and operating (avoidable) costs of 1¢/kWh and new entrants (NEWCO) with plant (avoidable) costs of 2¢/kWh and operating (avoidable) costs of 1¢/kWh (see Figure 1).

The NEWCO sales people go to customers and offer power at 4¢/kWh. The customer, seeing the utility's power costs are 7¢/kWh (profit is added to costs in both cases) immediately starts clamoring for open access. Aside from viewing the individual transaction where there are two winners (NEWCO and the customer) and one loser (the utility), there is the viewpoint of a transaction from society as a whole. For the incumbent utility to provide the service, a total of 1¢/kWh of society's scarce assets will be used up (fuel and labor). For NEWCO, because all of their costs are incremental, a total of 3¢/kWh of society's scare assets will be used up (the cost of the new plant plus fuel and labor).

Society is thus better off allowing OLDCO to furnish the electricity. Another way to reach the same conclusion is to consider that if NEWCO is allowed to supply the electricity, without stranded cost recovery, the customers are better off by 3¢/kWh and NEWCO shareowners are better off. But the utility shareowners are worse off by 5¢/kWh, a net loss to society of 2¢/kWh. Thus, the current battle is not over what is best for society. Society is clearly better off by letting OLDCO provide the electricity. The battle is between OLDCO shareowners and NEWCO shareowners. The benefit from competition is from the efficiency it will force on our industry and the innovation it will bring, and for this reason alone competition should be adopted. The benefits are not from allowing new plants to replace old plants.

By allowing OLDCO to charge a stranded asset charge, NEWCO can then produce only when its marginal costs are lower than OLDCOs marginal costs, which is the desired result for society (but not necessarily for NEWCO). Over time, as the OLDCO charges wind down, NEWCO will then have an easier and easier time competing.

Why It Makes