A recent conversation:
"When was the demise of the regulatory bargain? What you say is true, but at some point you had to know the bargain was over."
(em A state utility commissioner
"Beats me, it doesn't seem to be over yet. The electric industry still has a duty to serve all customers, and it must charge below-market rate confiscatory for many of our services because of the regulatory bargain. When these duties go away, I'll let you know the date of the demise."
(em The author
When Intel had to replace thousands of Pentium chips that might misfire once every million calculations, it took the loss (em about several hundred million dollars. When Ford built the Edsel, it also lost money. No one (to my knowledge) has ever sued Ford for a shortage of Edsels, or Intel for not making enough Pentium chips. But then again, no government agency ever forced Ford or Intel to build a certain number of cars or chips (em enough for everybody in the U.S. under all conditions (em only to recant and then announce a new set of rules: "Ooops, sorry, just kidding, something better came along."
We, the electric industry, however, still have a duty to serve. We are still required to build plants, transmission and distribution to serve everyone in our territory. We call this commitment the Regulatory Compact. Because of this compact, the electric industry is now stuck with outdated assets built under government mandates. Power plants built using old technology are now priced above market.
Who should pay for these "stranded" assets? Utilities, customers, shareholders? Despite the lessons learned by Ford and Intel, I believe utilities should be allowed to recover their stranded costs, and for a very practical reason (em a quick transition to a competitive market.
I believe in competition. In fact, I believe that the benefits of competition are so great as to outweigh the cost of stranded assets in the long run. Thus, the electric industry should proceed as quickly as possible with deregulation and full competition in generation. A cooperative plan allowing for certain recovery of stranded costs would best secure a quick transition. Unfortunately, however, some regulators or customers may hope for a short-term advantage. They may push through deregulation plans with no provision for recovery of stranded costs. And without recovery, the road to competition could prove long and difficult.
Preserving Incentives
Anyone who believes that the Regulatory Compact is dead should try to find a recent case where service deteriorated to the point of brownouts without sparking an investigation by the state or local utility commission. Regulators may ponder a free market, but the duty to serve still continues.
Without the Regulatory Compact, no one would invest in 40-year, single-purpose assets. Coal companies don't build 40-year, dedicated coal plants without long-term contracts. In fact, perhaps the best indicator of this is the independent power producer industry. No IPP yet builds merchant plants to any great extent: They require a contract with an ultimate user. Yet, some claim the electric industry had no contract. Why do they think the electric industry built a plant with no contract when no reasonable business would? The electric industry has always viewed the Regulatory Compact as an implied contract. In the future, IPPs will build many merchant plants because the market will be open, and transmission will be available to send the power across whole regions. These conditions did not exist in the past.
IPPs should recognize that often the largest share of stranded assets comes from contracts signed under the Public Utility Regulatory Policies Act. If the IPPs wish to enforce these contracts, they should support utilities who seek to recover stranded costs. The law is well established in the U.S. that once a party to a contract has fulfilled its bargain, the other must reciprocate (em even the U.S. government. %n1%n
The alternative may be a utility bankruptcy, which doesn't help IPPs. Thus, although damages claimed by IPPs under rejected PURPA contracts are probably equal in priority to claims by unsecured creditors in a Chapter 11 bankruptcy against a utility, such equality offers little solace to IPPs, who won't get paid their contractual rate for three years while the proceedings are pending, and won't collect interest as an unsecured creditor.
So who pays for these stranded assets? Is it the customer's duty to pay for the assets the electric industry constructed to fulfill its duty to serve? By analogy, should the host utility in a competitive market retain a duty to serve customers that no one else wants? Once a utility begins to serve these customers, will it have the opportunity to recover its prudently incurred costs if someone cheaper comes along? If the Regulatory Compact is not all it was supposed to be, perhaps utilities should demand an answer on stranded cost recovery as a condition to serve. Or perhaps these unwanted customers should form a pool, similar to an uninsured motorists' pool, and require each utility serving an area to serve a proportionate share of the pool.
Today, an analyst might well describe our service territories at Tucson Electric Power as next to worthless. Many competitors have called on our largest customers in an attempt to "cream skim." Such attempts have forced us to lower prices to these large customers. Meanwhile, the Regulatory
Compact implores us to continue serving our "less-desirable" (less-profitable) customers at below cost.
Some would acknowledge that the Regulatory Compact once existed, but say they will now do away with it. That is fine; regulators should enjoy the right to change the rules on a prospective basis. In fact, to achieve competition, it should be encouraged.
Just Compensation
Even today, the Regulatory Compact limits utility earnings (the rate of return) on prudent investments dedicated to public use. If a utility builds a plant or a transmission line that operates at below-market costs, it is only allowed to earn a regulated return on its actual cost. An electric utility is never allowed to charge a market rate and hit a "home run" for its investors, as do their unregulated competitors. This mandate (em to sell products below market (em
clearly constitutes a constitutional "taking" of property for a public purpose. But you will not see the utility industry condemn the taking as unconstitutional. Why not? The answer is simple: The industry believed that the Regulatory Compact yielded "just compensation" for the "taking." First, electric utilities received their service territory. Second, the electric industry received the right to earn the regulatory return on all prudent investments, even if something better came along.
The electric industry believed it had given up the "home runs" in exchange for a promise of a
compensatory return on all prudent investments. For example, the U.S. Supreme Court stated in Duquesne Light Co. v. Barasch: %n2%n "Under the prudent investment rule, the utility is compensated for all prudent investments at their actual cost when made (their "historical cost") irrespective of whether individual investments are deemed necessary or beneficial in hindsight."
Now, however, some would say that the electric industry has given up the upside, but should forfeit its protection against downside risk, to level the field against other firms. Many of these same people, however, are opportunists, not true free-market advocates. They still argue for continued regulation in those sectors where electric industry costs are below market (i.e., in transmission), forcing utilities to forgo upside opportunities. It's only where utility prices climb above market that they would unleash the genie of competition.
In the electric industry, we would never have allowed any governmental entity to "take" our assets and appropriate them for public use without the Regulatory Compact. A bargain was struck; one side alone cannot abrogate it. In fact, such abrogation amounts to an unconstitutional taking of property.
Fundamental Fairness
Some commentators have gone
as far as to suggest that recovery of stranded costs may be "un-American." If recovery of costs that governments mandated and approved for an industry that has already built one of the most reliable and currently cheapest electric systems in the entire world is un-American, then I will readily admit to being a socialist. Fundamental fairness and equity and paying for items specifically built to serve a customer, when a legal duty existed to build them, is American; the alternative is not.
In fact, the Uniform Commercial Code contains a specific section (2-201) dealing with goods made specifically for a customer that cannot be sold elsewhere. The section requires the customer to pay for the goods. That is exactly the situation the electric industry has here, except that the Regulatory Compact is implied and not explicit.
Some may say that the traditional regulated rate of return on prudent investment compensated utilities for the risk that a plant would have to be abandoned. Rate case opinions often run hundreds of pages, but the record is clear: The electric industry was never compensated for this risk.
Not only is stranded asset recovery legally correct in this specific instance, it also is desirable for the long-term good of the nation's economy. People should feel comfortable relying on government's rulings and promises. The government has the ability to change the law. If 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 Sense
Society is better off when the electricity is produced using the least additional amount of assets. Public utility consumers should make decisions based upon what is good for society, not what is good for any one customer. Arguments will be made that competition is good for society so PUCs should permit competitors: I couldn't agree more. But, the electric industry can encourage competition in a manner where society bears a huge cost of constructing unnecessary plants, while abandoning old plants with a lower marginal cost. Or the electric industry can encourage competition in a manner that has the lowest economic cost and favors the most rational allocation of resources. I prefer the latter.
The adoption of a non-bypassable stranded asset charge also provides a remedy for an economic trap, mixing and matching economic systems. The U.S. has two major economic systems: the free market and the regulated market. In the free market, prices are set by the market and the "invisible hand" does allocation. In the regulated market, regulators set prices. Because there is no market allocation mechanism, the U.S. has adopted such allocation mechanisms as least-cost planning, integrated resource planning, certificates of convenience and necessity, etc. To mix and match the two systems by allowing regulated prices to escape to the free market without the correct allocation pricing mechanism is to invite disaster. New York and Maine proved it with PURPA prices.
One of the first things business school teaches is not to consider sunk costs when pricing. Yet the electric industry bases its pricing model almost entirely on sunk costs. These costs, let loose in the free market, dramatically signal the need for a new, cheaper capacity. Ironically, the electric industry has an oversupply of capacity in many regions. The electric industry simply cannot let regulated costs loose in the free market without chaos. The adoption of a non-bypassable transition charge will quickly remedy this and allow the market to receive the correct marginal cost signals.
If unneeded plants are built, the cost will be spread to other people. Economic theory demands that someone pay that cost. Higher demand for new plants will raise the cost of material for their plant. Higher demand for natural gas will raise its cost, which will be felt by other industries and home-heating customers. The customers escaping regulation may benefit, but others will pay. From an economic point of view, a non-bypassable, stranded cost recovery mechanism leads to the best result for society as a whole; and that should be the test for regulation.
In the long run, competition makes the best regulator for electric generation. There still remains a need for technical regulation for system stability and reliability, but for cost control, competition is unequaled. But before regulators open the floodgates, there is one last task left: To fulfill bargains made and the promises granted. Only then allow the swift sunrise of competition. t
Charles E. Bayless is chairman, president and CEO of Tucson Electric Power Co.
1See, United States v. Winstar Corp., et al., 116 S.Ct. 2432 (1996).
2483 U.S 299, 109 S. Ct. 609, 102 L.Ed.2d 646, 98 PUR4th 253.
3See note 2, supra.
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