Despite two years of debate, little progress has been made toward a solution to the issue of stranded costs. And since the two sides have almost no common ground, any accommodation seems unlikely. Utilities that seek stranded-cost recovery appear to have the upper hand at present, but the stiffest resistance still lies ahead. The Federal Energy Regulatory Commission's Order 888 clearly favors utilities, but customer reaction signals a shift to another venue. In addition, opposition to stranded-cost recovery from utilities with little or no stranded-cost exposure has become increasingly vocal.
What provokes surprise is that utilities in favor of stranded-cost recovery have fared so well, given the issues involved. The heart of the problem is that utilities seeking recovery ask for a disposition that violates the way the American people believe their economic system should work. This breach of faith makes it unlikely that utilities can prevail in the end. Accordingly, utilities would probably be best served by settling for indirect financial benefits during the transition in lieu of identifiable recovery.
Consumer Entitlement
Stranded cost is not the parochial industry issue it may seem at first blush. On the contrary, the issue directly challenges the sovereignty of the competitive market, running afoul of what might be called the great consumer entitlement: the right to purchase goods and services at a competitive free-market price.
The desirability of competitive market prices has its foundation in economic theory and lies embedded in the nation's laws and policies. According to economic theory, a society's welfare is maximized by the competitive market price and output. When market power raises the price above the competitive level, society's welfare suffers and income is redistributed away from the customer. The competitive outcome has been ingrained as a social norm. It is the basis for the antitrust laws and has fostered a common feeling that it is unfair to be charged more than the competitive price. Americans believe they have a right to buy at the competitive price.
A price above the competitive level is considered indicative of a market failure that demands corrective action. The policy response is to create economic forces that will bring the price down to the competitive level, to reduce market power by changing the structure of the market. There may be disagreement over the proper policy, but the desirability of achieving the competitive price is never in question.
It is generally agreed that current electricity prices are above the competitive level. In the context of American social values, customers are being charged an unfair price, and fairness demands a price reduction. In a sense, the excessive price reflects a failure of regulation, and the prospective restructuring of the electric power industry can be viewed as an effort to correct that failure.
In seeking stranded-cost recovery, utilities are asking regulators to create artificial mechanisms that will hold the price of electricity above the competitive price in the face of downward pressure from restructuring. Utilities that seek recovery will obviously encounter resistance in justifying such efforts to their customers. They must convince customers to acquiesce in suspending their right to buy at the competitive market price. In effect, they are asking customers to redistribute funds to the utilities without receiving anything in return.
Justifying Recovery
The rhetoric of stranded-cost recovery tends to obscure the fact that four separate types of commitments are at issue: nuclear decommissioning costs, uneconomic purchased-power contracts, regulatory assets, and stranded investment. Nuclear decommissioning and purchased-power contracts involve future cash obligations; regulatory assets and stranded investment involve sunk costs. Purchased-power contracts were forced on reluctant utilities; nuclear plants exposed to stranded investment were willfully built by the utilities despite excess capacity, and sometimes even despite discouragement from regulators. Thus, the task of justifying stranded-cost recovery varies enourmously.
The strongest case can be made for recovery of nuclear decommissioning costs. These costs are unavoidable and socially necessary. They must be paid by someone. If the owner of a nuclear plant goes into bankruptcy, they will become a public obligation. These costs should be billed to the distribution customers for whom the plants were built.
The uneconomic purchased-power costs, on the other hand, are contractual costs that can be renegotiated. After all, 1) regulators and legislatures forced these contracts on utilities, and 2) the power producers often undertook obviously uneconomic projects that carried inherent risks. At the same time, however, the producers responded to the incentives and risks of the free market; the workings of the system should not be suspended to protect them. The public interest demands that these contracts be restructured, and a case can be made for sharing the costs between the utility, its customers, and the power producers.
Regulatory assets and stranded investment are sunk costs, often carrying a questionable pedigree. In effect, they form part of the residue of a system that allowed utilities to earn healthy returns despite widespread inefficiencies and abysmal technological progress. Every announcement of cost-cutting is a testimonial to past inefficiencies, and the failure of the industry's heat efficiency to improve over the last 30 years speaks volumes about utility indifference to innovation. And yet, some utilities want regulators to construct special mechanisms that shield them from market forces and deny customers the right to competitive prices.
Most likely, utilities will lose the greater part of the battle to collect stranded costs. Therefore, utilities would be wise to strike deals that treat current rates as price caps and free their companies from the constraints of allowed returns as compensation for stranded investment. Utilities would retain the benefits of all cost reductions during the transition (em those from transmission and distribution as well as from generation. At the same time, utilities would carry the risk related to customers that took advantage of freedom of choice. By rapidly cutting costs, a utility could realize net savings equivalent to substantial stranded-cost recovery over three to five years. 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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