You've got to reinvest the proceeds (em and not just anywhere.
Recovering stranded investment is sometimes equated to preserving shareholder wealth. In fact, full recovery of stranded investment by itself will not preserve shareholder wealth in most cases.
What is missing all too often in discussions of stranded investment is the role that capital investment plays in the creation of shareholder wealth. Full preservation of shareholder value requires more than recovery of stranded investment; it demands new investment that replaces the original earning power of the impaired assets.
To fully preserve shareholder wealth, any resolution of the stranded investment question must leave the utility's valuation equal to what it would have been if the matter had never come up. That means no net change in: 1) the present value of a utility's prospective stream of risk-adjusted earnings, and 2) the way the market values that earnings stream. Investors must remain just as confident about future earnings as they were before the stranded investment issue arose.
Capitalizing the Income Stream
The effect of stranded investment recovery on shareholder wealth can be illustrated with a numerical example. For this purpose, assume that a steady state exists under regulation in which all earnings are paid out as dividends and the utility's equity investment and earning power are both in constant perpetuity. Specifically, suppose that the utility's equity investment is 200 and that it earns its allowed return on equity of 12 percent. Earnings are thus 24. Since rates are set at a level that enable the utility to earn its allowed return, book value and regulatory economic value coincide. (See table.)
Next, assume competition is introduced and the resulting decline in power prices cuts the expected perpetual earnings from 24 to 12. With earnings halved, the economic value of the plant would also be cut in half from 200 to 100. The difference of 100 would be stranded investment, which is assumed to be recovered in full from customers. Thus, book equity is still 200, but it is now divided between the new economic value of the plant of 100 and recovered stranded investment of 100.
Shareholder wealth, of course, depends on the discount rate at which the market capitalizes the utility's earning power. This rate is assumed to be 8 percent, which implies shareholder wealth of 300 under the initial regulatory conditions, that is, annual earnings of 24 capitalized at 8 percent. Shareholder wealth, after the stranded investment is recovered, is the sum of the capitalized values of the earning stream from the recovered stranded investment and the earning stream from utility operations. Again, an 8-percent discount rate is assumed.
The assumed 8-percent discount rate represents the going financial market
rate at which funds can be invested or acquired. The market value of funds invested at this rate is equal to book value. Assuming the utility undertakes all investment projects with a return above the going market rate, independently of stranded investment recovery, the recovered funds can either be invested at the going market rate, or returned to shareholders who can invest them at that rate. The value of the recovered stranded investment is thus equal to its book value of 100.
The market value of the utility's earnings under competition is 150: 12 capitalized at 8 percent. This brings the total ending shareholder wealth to 250, a decline of 50 from the original wealth of 300. Thus, full, stranded-cost recovery does not preserve shareholder wealth in this case.
Investing the Recovered Funds
Full preservation of shareholder wealth involves two factors in addition to recovery of stranded investment: 1) investment that replaces the stranded equity, and 2) the stock market's valuation of the impact of stranded investment.
First, reinvestment stands largely independent of the amount of stranded equity that is recovered. However, reinvestment does remain subject to normal capital budgeting constraints, which would ordinarily require company management to reject a particular investment unless its return exceeds the cost of equity. Only investments with a return above the cost of equity will enhance shareholder wealth. The supply of such investments does not depend on the ability to recover past investment.
Second, shareholder wealth is determined in financial markets. The stock market's valuation of a utility is the ultimate arbiter of the impact of stranded investment on shareholder wealth. Thus, it is possible that investor perceptions or apprehensions about the threat of stranded investment might affect shareholder wealth (em even if no portion of utility investment ever actually becomes stranded.
In this sense, shareholder wealth has already shrunk; it has been discounted by the threat of stranded investment. Rightly or wrongly, investors expect that some impairment of earnings is unavoidable for some utilities. This expectation is already reflected in depressed price-earnings ratios and market-to-book ratios (stock price divided by book value) for those utilities that carry the heaviest exposure to stranded investment.
Finding a High-Enough Return
The investment principle for fully preserving shareholder wealth remains simple enough. Corporations must recover the equity portion of stranded investment and reinvest that amount at a rate of return that matches the risk-adjusted return that would have been earned in the absence of exposure to stranded investment. With equity returns for utilities now hovering at between 12 percent and 14 percent, preservation of shareholder wealth will require reinvestment of recovered stranded equity at comparable rates of return.
This range of earnings exceeds the returns currently offered by investment-grade financial instruments, which implies that reinvesting recovered funds at financial market returns will not preserve shareholder wealth. As the example illustrates, when a utility's market-to-book ratio already stands above 1.0, the recovery of stranded investment by itself only sets the stage for preserving shareholder wealth. Unless the utility exhibits a separate ability to invest at a return above the financial market return, the value of recovered equity will not exceed its book value, and shareholder wealth will decline.
The difficulty will arise in finding good investment opportunities. Returning recovered funds to shareholders is akin to investing at a financial market return, and will not preserve shareholder wealth. Acquiring other companies, unfortunately, is not very promising either. On the one hand, the acquisition of a regulated electric or gas company is not likely to preserve shareholder wealth, since the target utility will be priced to provide a financial-asset return, while the regulators all too soon will pass along to customers any benefits of synergies gleaned from the consolidation. On the other hand, the acquisition of an unregulated business may appear more promising, but again the target company will be priced to provide a financial-asset return. The utility will enjoy a free hand in retaining the benefits of any efficiencies it introduces, but its lack of experience with unregulated businesses casts doubt on the prospect that it will succeed in creating or realizing any such efficiencies.
The most promising way to achieve the returns required to preserve shareholder wealth lies with the development of new business operations. The problem will come with earning a return on invested equity on the scale needed for full preservation of shareholder wealth. Indeed, it seems doubtful that utilities will prove successful outside of closely related energy areas, such as bulk power, marketing and energy services given their dreadful record in diversification. And questions remain about how successful utilities will be in energy services. Moreover, size constraints will likely limit the number of utilities that will succeed in generation and bulk power marketing. t
Charles M. Studness is a regular contributor to PUBLIC UTILITIES FORTNIGHTLY. Mr. Studness has a Ph.D. in
economics from Columbia University and specializes in conducting economic and financial research on electric utilities.
Earnings Dictate Value
Not the other way around.
• Regulatory Distortions. Regulated electric prices at times have exceeded market levels to make high-cost plants appear economically viable. (High enough to create a discounted stream of prospective earnings equal to the cost of the plant, no matter how high.)
• False Value. Regulated prices equated economic value to book value.
• Day of Reckoning. Market prices will cut earnings of high-cost plants; economic value will fall from the inflated regulatory value to market value. This reduction is stranded investment.
TABLE. Numerical Model of Full Recovery of Stranded Investment*
Return on Equity (Actual) 12.0% (Equals allowed ROE)Book Value of Equity 200
Economic Value of Equity 200 (Earnings capitalized at 12% regulatory ROE)
Restructured Earnings 12 (Decline in power prices halves earnings)
New Economic Value 100 (New earnings capitalized at 12%)
Stranded Investment 100 (Book equity less new economic value)
Stranded Recovery 100 (Assume 100 percent stranded investment
Ending Equity 200 (100 of earning assets and 100 of cash)
Starting Wealth 300 (Earnings of 24 capitalized at 8% (em 1.5 P/B)
Competitive Earnings 150 (Market value of competitive earnings of 12,
capitalized at 8%)
Stranded Cost Recovery 100 (Cash recovered at face value)
Ending Wealth 250 (Value of restructured earnings plus recovered
Decline in Wealth 50 (Starting wealth less ending wealth)
*In the true sense, and as intended in the example and in this article, the term "stranded investment" refers only to the sunk plant costs rendered uneconomic by competition. Stranded investment arises when regulated prices deviate from the competitive norm and thus excludes uneconomic purchased power costs and nuclear decommissioning costs, which represent future cash liabilities.
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