Stranded Investment: Utility Estimates or Investor Expectations?
A firm, bottom-line number based on regulatory accounting mechanisms should appeal to those who still base their thinking on "revenue requirements." Utilities were once dependable sources of long-term returns, recovering the booked costs of their assets and reinvesting the proceeds to produce secure future income. As the industry moves to market, so must this insistence that it is booked costs rather than market returns that matter to investors. Utilities have one further responsibility about which little has been said: However compensation is paid, along with those payments, utilities must put shareholders on notice that they are now are on their own. t
Steven Isser is a consultant with Hagler Bailly Consulting of Arlington, Va. He holds a Ph.D. in economics from the University of Texas and is currently completing law school there. Robert Michaels is Professor of Economics and California State University, Fullerton, and senior advisor to Hagler Bailly Consulting. He holds a Ph.D. from the University of California, Los Angeles. The views expressed in this article are not necessarily those of the authors' affiliations or clients.
On Jan. 1, 1987, an investor buys one share of stock in Utility X for $100. Assume the stock earns a $10 dividend at the end of every year and is expected to do so forever. Regulators have conveniently set the utility's authorized return on equity equal to the rate on similar safe investments (em 10 percent. The market price of the share will thus be $100, equal to the discounted value of its long-lived stream of future dividends.
Then assume deregulation comes without warning at the end of 10 years of dividend payments, immediately cutting the stock price to $50. How much stranding compensation, if any, is due for stranded costs under each of three different scenarios: 1) constant (expected) end-of-year dividends of $10; 2) a higher (unexpected) annual dividend of $12; or 3) a lower (unexpected) dividend of $8?
1. Constant Dividend.
For 10 years, the stock fulfills the investor's expectations, with $10 dividends paid annually. The price remains steady at $100. (Capital gains are omitted here but can be included at the cost of algebraic complexity.) Just after the 1997 end-of-year dividend is paid, however, instant deregulation occurs and the $100 price falls to $50 on Jan. 1, 1998. If, on that date, the investor sells the share at $50 and receives $50 for stranded costs, he will still have $100 in assets, as expected on the purchase date of the stock:
[$10 ( 1.10] + [$10 ( (1.10)²] + ... [$10 ((1.10)10 ] + [($50) ( (1.10)10] + [($50) ( (1.10)10] = $100
The final three terms are the Dec. 31 dividend payment, the Jan. 1 sale price of the stock and the Jan. 1 receipt of stranding compensation.
2. Rising Dividend.
Next, assume that just after the investor bought the stock for $100 on Jan. 1, 1987, the utility raised its dividend to $12 per year while its cost of capital remained the same. (This situation is realistically more akin to