Intense though it has been, the debate over stranded electric investment has addressed only half of the issue. What the utilities will do with the money is as important as whether they should recover anything at all.
Retail competition will accelerate the decline of utility-owned generation; utilities will rely less on their own production and more on purchased power to serve their remaining customers. Because the per-megawatt cost of most new generation remains quite low, utilities with stranded assets (as well as some restructured systems without any) can expect to receive more cash than they need for investments to fulfill their service obligations. No utility has stated that it will fully dedicate its stranding recovery to retiring debt, repurchasing stock, or shrinking the company by other means. Companies such as Edison International (formerly SCEcorp) and Pacific Gas & Electric are making substantial paydowns and repurchases, but they too will probably spend some stranding revenue on projects that would normally call for external finance.
The efficiency and fairness of recovery depend critically on what happens to the proceeds. Any metaphorical regulatory compact that warrants making customers pay for stranded assets must also apply to how such monies are spent by recovering utilities. As understood by its believers, the compact insulates the value of shareholder investments because they were made in the expectation of guaranteed cost recovery. However, the price of a share of stock reflects the market's
consensus about the future income (both dividends and capital gains) that it will produce. Even before a utility actually spends its stranding recovery, its share value will depend on how the market expects the money to be spent. If these expectations turn pessimistic, the stock price will fall; stranding compensation will fail to protect shareholders.
Financial economics gives good reason for concern about the disposition of stranding payoffs. Many scholars have found that corporations that receive free cash flows typically invest them in ways that do not maximize shareholder value. By contrast, companies that must persuade the capital markets of their projects' worth invest more productively and create more value for shareholders. If regulators accept the claims of utilities (and customers cannot find ways around them), over $200 billion might change hands over the next decade. For many utilities, a substantial part of today's income represents recovery of stranded assets (em in effect, if not in name. Never before has an industry seen such massive cash flows that it need not reinvest in its old lines of business. Only by a wonderful accident would utilities find superior investments large enough to soak up cash flows of this size.
Even if such projects appear on the horizon, regulators and shareholders should insist they be undertaken with the approval of the capital markets. Regulators, however, will enjoy limited powers to oversee unregulated investments that use the free funds. As always, shareholders will encounter difficulty in monitoring how well management is doing its job. Even if regulators exert some power over the funds, there is little reason to expect them to pick better investments.
Free Cash Flows: Who Knows Best?
Like most other people, I will probably spend a cash windfall less productively than I will the proceeds of a loan. I obtain the loan only after showing
lenders that my project is better than others that they might finance. Economists may disagree about a lot, but most agree that the capital markets perform well in allocating savings to valuable uses. Capital markets offer investors an entire planet on which to go comparison shopping for the best returns. They promise wealth to those who make good judgments about profitability and risk, and ruin to those who do not.
In theory, management may invest free funds well because its specialization provides a deeper knowledge of good investments than is available to capital markets. In practice, however, managements do poorly for their investors. Managements that spend free cash flows on new lines of business usually create less shareholder wealth than those that return the funds to investors. The greater a firm's diversification, other things equal, the lower the return to shareholders.1
Even the expectation of diversification matters. A utility's announcement that it will reorganize as a holding company generally lowers its market value, possibly because analysts perceive an intent to diversify. Prices of shares in utility holding companies also usually fall when they make diversifying acquisitions.2
Apparently, very few managers know more about diversification than the capital markets. Investors see greater gains when management stays focused. However, managements's incentives may not match the desires of shareholders. Executives whose pay and social status depend on the size of their companies will be loath to downsize even when doing so creates the most value for stockholders. Unwarranted corporate growth becomes an even greater problem if management can spend retained earnings without taking its plans to the capital markets.
The temptation of poor investments is real. Economists have found that firms receiving windfalls are quite likely to invest them in unrelated ventures that ultimately fail or are sold at a loss. Instead of reducing debt, recipients of windfalls are likely to issue more to finance questionable activities.3 The experience of utilities is consistent with these findings. As construction programs topped out in the mid-1980s, some utilities put their newly freed cash into businesses distant from their core activities. The financial results for a sample of diversifications proved "horrendous in the aggregate," with a return on equity of -1.1 percent.4
In most markets, takeovers and other shareholder actions can stop uneconomic spending of free cash. The post-takeover management usually divests unprofitable assets and restructures a firm's finances to create greater value.5 Utility investors, however, probably cannot count on changes in corporate control to help them out. Laws like the Public Utility Holding Company Act and state regulatory
institutions stand in the way of takeovers, and bond indentures make utilities hard to reshape. Mergers offer no panacea (em especially the "friendly" kind that may save some expenses, but cannot deliver the shock treatment of a takeover.
What's There to Buy?
In one vision, today's utilities will expand into related businesses like power marketing and independent power production. Others will invest overseas (em in plant construction or in distribution systems. The liberalization of communications law will tempt still others into telecommunications and information services that exploit the network properties of their existing assets. Investors should question these notions.
Why should a tradition of monopoly distribution confer the acumen needed to market a commodity? Many manufacturers and service sector firms leave the selling to specialists. In independent power, utilities may in fact have no edge against the contractors that built some of their existing plants. Accustomed to the security of regulation, utilities may be disadvantaged in nations with high political risks. Those that acquire foreign distribution systems may not learn all that much about managing in a deregulated domestic industry. Telecommunications beckons as a new frontier, but electric utilities may not adapt well to a consumer business with a culture of breathless technological change. And, as utility information networks grow, regulators and antitrust authorities may treat them as essential facilities and mandate competitor access.
These pessimistic predictions are not necessarily my personal views, but they are opinions that the capital markets might give utilities seeking funds to enter these new areas. However harsh these judgments, the record shows that investor interest will be better served by the opinions of capital markets than by all but the wisest and luckiest of managements.
Performance-based compensation is relatively rare for utility managers. Some regulators may resist the idea. Nevertheless, to produce shareholder value in today's climate, the compensation awarded utility managers should reward sharper corporate focus and downsizing. It can be done, as when General Dynamics reshaped and shrunk itself to cope with lower defense expenditures. Compensation based on stock performance helped to create $4.5 billion in value for that company's shareholders, while the diversification and growth strategies of its competitors yielded considerably less.6
A Fair Payout
The regulatory compact provides a final reason to pay stranding inflows to investors. If investors deserve recovery because competition confounded their expectations, they alone should receive the cash. They have every reason to return those funds to utility managements whose telecommunications and power marketing proposals look like good investments, and no reason to return the funds to those touting more doubtful projects. Further, utilities that have paid out their recovery will enjoy no funding advantages over their future competitors.
Payout of stranding proceeds also provides a second dimension of fairness: The utilities that stranded the most investment will get the largest windfalls, but not a second chance to invest the money they lost. Fairness holds even where (as most commonly alleged) regulators compelled the construction of plants that management believed harmful to shareholder interests. Such perceptive managers might have an advantage in finding valuable investments after the stranding payoff, and the capital markets will willingly fund such projects. Companies that cannot attract external capital should properly go their way as smaller, wiser, regulated firms. t
Robert J. Michaels is a professor of economics at California State University, Fullerton, consultant in economics and finance with JurEcon, Inc., and adjunct scholar of the Cato Institute. The views expressed in this article are not necessarily those of his affiliations or clients.
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