Recovery of stranded investment is clearly the central point of contention in the debate over utility competition. Customers oppose competition and utilities favor it (em for what appear to be clear-cut reasons. Recovery would delay the benefits of competition for customers, but would give utilities additional cash and temporary protection against competitive price pressures. The battle has unfortunately turned into a morality play that centers on the right to recover stranded investment. Utilities argue that the "regulatory contract" entitles them to full recovery; customers claim that no such entitlement exists.

These polarized positions obscure complicated self-interests that often conflict with public positions. Stranded investment, recovered or not, will have a major impact on the competitive positions of utilities relative to each other, which will also affect customers. Accordingly, both utilities and customers must consider recovery in terms of what is optimal. The optimal amount of recovery for utilities will vary from full recovery to partial recovery to no recovery.

Recovery and Cash Flow

Shareholder interests require that utility managements maximize the risk-adjusted present value of future cash flows. The historical cost of a utility's assets has nothing to do with this. What matters is future cash generation. Since utilities will be competing head-to-head with each other, a utility must consider the impact that recovery of stranded investment by rival utilities will have on its future cash flow. Recovery of stranded investment by a utility will increase a utility's future cash flow; recovery by rivals will diminish it.

A utility could obviously use the cash flow from stranded investment recovery in many ways that would benefit

shareholders. For instance, it could transfer the funds directly to shareholders through dividends or by buying back stock. It could use them to strengthen its balance sheet by retiring debt or preferred stock, thus strengthening its competitive position. It could also invest them in its core business, enhancing its future cash flow stream and improving its competitive position.

Conversely, a utility's competitive position could be undermined by the extent to which a rival invests recovery funds in its core electric business or uses them to retire debt or preferred stock. A utility's competitive position will be more seriously undermined 1) the greater the rival's stranded investment recovery, 2) the more directly the rival competes with the utility, and 3) the more the rival employs the funds to attack the utility.

No matter how it is handled, stranded-investment recovery will be a dominating factor in the transition to competition. The question is who the winners and losers will be. If there is no recovery, some of the utilities with the greatest stranded investment exposure will probably face financial crises. With full recovery, on the other hand, the competitive position of some of these utilities will improve to a point where they will be strong enough to create financial distress for some of the utilities that have little or no stranded investment exposure. Stranded-investment recovery could turn a patsy into a fearsome predator, and vice versa.

How Much Recovery is Enough?

In determining the optimal level of stranded-investment recovery, a utility must weigh the benefit it will derive from recovery funds against the damage to its competitive position that will be caused by the recovery of rival utilities. To maximize the risk-adjusted present value of its future cash flows, a utility should not support liberalization of stranded investment recovery beyond the point where the incremental damage to its competitive position begins to exceed the benefits from the funds it obtains.

For example, suppose a utility has moderate exposure to stranded investment and its rivals have large exposure. If only modest recovery of stranded investment is allowed, the utility would derive some benefit from recovery, while the recovery due to rivals might not help them enough to undermine the utility's competitive position materially. The utility would be a net beneficiary of stranded-investment recovery. However, if recovery were substantially liberalized, the utility might realize only modest incremental benefits from the additional funds it obtains. But the additional recovery might help its rivals enough to undermine the utility's competitive position severely. The liberalization would damage the utility. Partial stranded-investment recovery would be optimal for this utility. For others, optimality could mean full or no recovery.

The attitudes of utility managements toward stranded-investment recovery should reflect these disparities in optimal recovery. But this is not the case. Apart from a rather quiet minority, utility managements strongly support full stranded-investment recovery, which in many cases runs counter to the best interests of shareholders. This erring support appears to stem from a failure to think through the implications of head-to-head competition. Utility managements expect competition to place pressure on electric rates, but they largely ignore competitive interaction. In effect, managements think of themselves as price-takers who have no market influence, instead of as oligopolists. Besides leading them to undermine their own competitive position, their attitude also creates a real dilemma for investors.

What's in the Public Interest?

There is also an optimal level of stranded investment recovery for the public. The main objective of public policy should be to provide high-quality service at as low a price as possible. Since recovery of stranded investment will increase the price of electric power, it can be justified only if accompanied by improved quality of service. Recovery of stranded

investment would produce such improvement in some cases.

For instance, a utility with large stranded investment exposure might face a financial crisis that would cause its quality of service to deteriorate in the absence of recovery. In this case, stranded-investment recovery may be a cost-effective way of avoiding the deterioration. From the public's standpoint, stranded-investment recovery is justified to the extent that it is at least as cheap as other ways of achieving a desired quality of service.

Self-righteous arguments in favor of stranded investment recovery have no merit apart from

their value in extracting funds for a particular

utility. They belong to the land of corporate welfare arguments. t

Charles M. Studness is a contributing editor of PUBLIC UTILITIES FORTNIGHTLY. Dr. Studness has a PhD in

economics from Columbia University, and specializes in economics and financial research on electric utilities.

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