(September 2006) Consistent performance over time is the Holy Grail of corporate management, and a focus of many of the executives who made this year’s Fortnightly 40 ranking. Who...
Stranded Investment: Utility Estimates or Investor Expectations?
Ask this question: Are Investors today earning what they thought they would, back when they last had faith in regulation?
As their customers discover more competitive prices, many utilities remain saddled with the costs of uneconomic plant and power purchase contracts approved under regulation. They seek compensation for these costs, but the amount deserves a close examination.
Some utilities seek remuneration that exceeds the market value of their common stock. Such a settlement seems overly generous for investors, who will continue to own their shares after the payoff. Some utilities with large claims also want a once-and-for-all regulatory determination of the settlement. These utilities want the amount frozen by securitization plans, like those promised in new laws enacted in California and Pennsylvania.
Of course, before regulators can begin to determine how much compensation utilities deserve for stranded costs, they must first determine whether to award any compensation at all. They must also decide which assets deserve payoffs and how utilities ought to dispose of the amounts recovered. The last step, however, is often overlooked: Regulators must design a method of calculating the payoff that promotes efficiency and fairness.
We argue for a reorientation of the stranding debate that emphasizes the fortunes of investors and de-emphasizes the booked costs of utilities. In fact, recovery of expected investor returns should be the basis for a reasonable armistice in the stranded cost wars. If investors are the central actors of the stranding drama, calculations that disregard their fortunes have little claim to primacy in a debate whose stakes are measured in the hundreds of billions.
The calculation, then, should start from forward-looking market data rather than the historical constructs that underlie the lost-revenues and market-to-book methods. Calculations based on investor expectations are conceptually clear and consistent with the realities of finance and power markets. They are already familiar to utilities, regulators and financial analysts, and offer a consistent treatment for the diverse situations of individual utilities.
The Impact of the "Compact"
As the importance of stranded investment became apparent, advocates of full recovery typically faced off against advocates of zero recovery. Those with views between those extremes usually saw a partial payout as a politically expedient strategy rather than a matter of principle. %n1%n The intellectual foundation of full recovery was a metaphorical "Regulatory Compact" that advocates claimed had long governed the industry. Supposedly, this compact guaranteed the returns of utility investors in all but extreme circumstances, because they had forsaken the high risks and high rewards of ordinary stocks for the low risks and low returns of a regulated industry.
On the other side, advocates of zero recovery also noted that the real returns earned by utility investors could hardly be described as "low." They also questioned the veracity of allegations that regulators had at times compelled utilities to make uneconomic investments. If so, as competition arrives, regulators should have no reason to further protect investors from the consequences of decisions by utility management who served at the sufferance of those investors. By contrast, proponents of the Regulatory