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Stranded Investment: Utility Estimates or Investor Expectations?

Fortnightly Magazine - June 1 1997

Compact view incomplete recovery as an uncompensated taking that rises to the status of a constitutional question.

Extrapolating decisions on the regulation of real property to the regulation of utilities is difficult, but the Supreme Court has been generally reluctant to interfere with state-level actions that entail less than a complete taking of a property right or a physical invasion of that property. %n2%n Regarding utilities, the Supreme Court's decision on regulatory disallowances in Duquesne v. Barasch may apply to stranded costs. In that case, the court held that regulators enjoyed wide discretion regarding cost recovery, but suggested that a constitutional issue might arise if uncompensated stranded costs endangered a utility's financial integrity. %n3%n In one recent case, the New York Supreme Court rejected the compact as justification for full recovery, and instead ratified a regulatory decision to determine compensation on a case-by-case basis. %n4%n

If Recovery, How Much?

As a practical matter, regulators and legislators are now coming around to the view that some implied agreement once existed and that some stranded cost recovery is warranted. Given this assumption, one might conclude that ratepayers who left utilities to find their own suppliers breached their obligation to take service. If so, the departing customers could be required to pay "expectation damages" that leave utility investors no worse off than they would have been if the compact had continued to run unabated.

Few participants in the debate have tackled the question of how to compute stranded costs. Some utilities favor charging departing customers amounts that leave revenues intact if the customer had remained in the system. In fact, in its open-access Order 888, the

Federal Energy Regulatory Commission favors this policy for wholesale purchasers who unexpectedly leave utilities. Regulators and legislators have also proposed granting utilities the difference between the booked value of their uneconomic assets and the expected market value of those assets under competition. In California, an important determinant of a utility's compensation will be the amount it receives for plants being divested as part of the transition program.

The lost-revenue calculation and the market-to-book comparison both ignore the returns that investors expected to receive under continuing regulation, and neither examines the outcomes investors actually experienced. If fairness requires payments, then the amount should reflect how compensation affects investors' fortunes rather than how it affects the utility's books.

The Financial Expectations Method

To arrive at compensation to keep utility investors whole, begin with the financial expectations of those who bought utility stock when a consensus still prevailed that the old regulatory scheme would persist indefinitely. Call this idea the "Financial Expectations" method. Since stock prices embody these expectations, find the price as of the last date investors expected regulated returns to persist indefinitely. One possible date is the last state rate case in which neither the utility nor its regulators mentioned a threat of retail competition. Assume that this case was decided in 1989, and retail wheeling was set to begin in 1998. To determine stranded cost recovery, estimate returns to investors over a suitably long period (e.g., 20 years) that