With no need for new capital, utilities have lost political pressure, exposing the regulatory compact as an illusion.Recovery of stranded investment today marks the central issue in the debate over electric utility competition. Unfortunately, the utility argument in favor of recovery is flawed. It assumes that utilities invest in plant to meet a public need; that a regulatory compact guarantees cost recovery; that the public must acquiesce. But consider the circumstances that prevailed when the utilities took on the investments now deemed at risk for stranding. Those circumstances suggest no such public need. Moreover, the idea of a regulatory compact presents a self-serving view. It does not square with the hard realities of ratemaking politics. The utilities stand on weak ground.Investment at Risk
In general, only the newest and most expensive plants face exposure to stranding, in part because cost-of-service ratemaking loads capital costs at the front end. The capital cost included in rates is derived by multiplying a plant's undepreciated cost by an allowed return. Since a plant's undepreciated cost declines to zero over its life, so do the capital costs included in rates. All else equal, new plants will carry higher capital costs for ratemaking purposes than old plants.
For the most part, nuclear plants make up the newest and most expensive of generating facilities, while fossil-fueled plants tend to be older and less costly. As a result, exposure to stranded investment rests almost exclusively with nuclear plants. Can we place a value on this exposure? Capitalizing the reduction in overhead costs needed to make a plant cost competitive produces estimates of overcapitalization (stranded investment) of $50 billion for nuclear plants and a $30 billion estimate for fossil-fueled plants (see, PUBLIC UTILITIES FORTNIGHTLY, Dec. 1, 1994, p. 40).
Almost all of this stranded nuclear investment stems from 34 nuclear units that went into service after 1984. These 34 units account for about 70 percent of the industry's undepreciated nuclear investment-about half the entire investment in generating assets. The case for the recovery of stranded investment thus hinges on whether the electric utilities built these plants in response to a public need.Lingering Construction
Construction on all but two of these 34 nuclear either started or was restarted between 1974 and 1978-that is, after the energy crisis of 1973 (see sidebar). During the 15 years that preceded the energy crisis, the electric industry had enjoyed very stable electric demand growth of about 7 percent a year. Capacity increases were keyed to meet this growth (the industry had not been troubled with sustained excess capacity). Reserve margin averaged 19.4 percent during the five years before the energy crisis, reached 20.8 percent in 1973.
The rise in electric rates that accompanied the energy crisis produced an abrupt decline in the long-term growth rate of electric demand. Electric rates surged 28.3 percent in 1974. Peak demand growth plunged from 7.8 percent in 1973 to 1.6 percent a year later. Reserve margin jumped from 20.8 percent in 1973 to 27.2 percent in 1974. With peak demand rising 2.2 percent in 1975, the reserve margin reached 34.3 percent, reflecting an excess capacity of 12 percent based on a targeted 20% reserve margin at the time. Because electric generating facilities take a long time to build, this initial emergence of excess capacity appears unavoidable.
The important question, however, relates to the speed with which the utilities eliminated the excess capacity. In an unregulated industry, such excess capacity would have forced prices down precipitously. Producers would have quickly ceased adding capacity until the excess disappeared and the price recovered. In the electric industry, however, utilities failed to cut back enough to bring capacity into line with demand, and regulators did not force the issue. Reserve margin remained above 30 percent until 1988. Excess capacity of 10 to 15 percent persisted for 15 years. Construction activity continued to draw powerful support from within the organization. Management did not want to shrink it any more than necessary.
Despite the adverse economic climate, demand growth projections remained excessively high. For instance, as late as 1978, managements in aggregate were forecasting that electric demand would grow 5.2 percent a year between 1978 and 1987, even though demand had grown only 3.2 percent annually over the previous five years. Demand actually grew only 2.2 percent between 1978 and 1987. Utility managers also ignored financial signals telling them to retrench.
Mushrooming capital spending and intense inflationary pressure forced large rate increases. Capital spending spiraled from $17.2 billion in 1974 to $27.1 billion in 1979 and $35.6 billion in 1982. Annual inflation ran 5.5 percent during the late 1970s. These cost pressures forced regulators to boost electric rates 12.8 percent a year between 1974 and 1979. Nonetheless, rate decisions were miserly; return on equity averaged only 11.2 percent during these years. Utility stock price-to-book value ratios came in consistently below 1.0, implying a return on equity below cost. This low ratio clearly called for a cut in construction.
The strongest signal to cut back could be seen by the devastating effects on shareholders. Between 1974 and 1979, sale of common stock increased the number of shares outstanding by 9.5 percent a year, while almost all of the stock was sold below book value. This new equity diluted industry book value by 18 percent from 1974 to 1983. It was obvious that something was very wrong. Yet construction and stock issues continued until the mid-1980s.
We noted the problem in this column in the issue of June 19, 1980 (p. 56): "The initial emergence of excess capacity must be viewed as a product of unforeseeable events. But almost seven years later such an explanation no longer suffices. . . . Managements have . . . failed to be aggressive in slowing down and rescheduling construction . . ." In the March 12, 1981, issue (pp. 40-41), we discussed the likely consequences of the failure to cut reserve margins. The comment again acknowledged that excess capacity was initially unavoidable, but then pointed out:
"Eventually there will come a point, probably not too far away, when the persistence of excess capacity will become widely viewed as avoidable. As such a time approaches, a number of troublesome issues can be expected to come to the fore. These will surely include the questions of who is really responsible for the excess capacity, who should bear the unnecessary costs of it, and to what extent the industry is serving the best interests of investors, ratepayers, and the public. . . . Excess capacity can be expected to become generally viewed as the result of either misguided conscious choice or faulty planning [by management]."An Illusory Compact
Then came the 1980s and a new term-the "prudence review." Utilities countered the risk by claiming protection under a "regulatory compact." Unfortunately, the concept was based more on hope than precedent.
Excess capacity stood as high during the mid-1980s as in the late 1970s. The industry's reserve margin reached 35 percent in 1985, 12 years after the energy crisis. With construction programs winding down, excess capacity made disallowances feasible. Enough plant remained in operation to serve customers well for some time to come. For the time being, a rate disallowance would not compromise a utility's access to capital markets. The question arises: Does a regulatory compact really exist?
Some observers point to the Supreme Court's famous 1944 Hope decision for the source of the compact. See, FPC v. Hope Natural Gas Co., 320 U.S. 591 (1944). But that case offers little support. The Hope case set up an "end result" test. The proof lay in access to capital markets. Ratemaking was thrown open to political forces. To gain the political advantage, utilities would add capacity to avoid service deterioration, prompting need for capital. But when excess capacity arose-and need for capital fell-utilities could not raise support for rate requests. The political consensus fell apart. The "regulatory compact" proved illusory.
The present situation in some respects marks an extension of the mid-1980s. The plants that were then added to rate base are the same ones that today lie exposed to stranding. Utilities carry scant leverage with which to induce favorable rate treatment from the regulators. As was true in the mid-1980s, utilities today do not need to build new capacity. That role has largely passed to independent power producers. Access to capital markets has likewise diminished in importance.
Accordingly, shareholders will likely bear most of the cost of stranded investment. This prospect lies rooted in the failure of managements to defend shareholder interests when excess capacity emerged in the 1970s. Shareholders have paid the price twice over-first with book value dilution in the 1970s, then with prudence reviews in the 1980s. A third accounting looms with stranded investment.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.
Plants Added to Service After 1983
Start or Restart DatesDiablo Canyon Nos. 1 & 2 1968
Susquehanna Nos. 1 & @ 1973
Beaver Valley No. 2 1974
Byron No.2 1974
Comanche Peak Nos. 1 & 2 1974
Grand Gulf 1974
Millstone No. 3 1974
San Onofre Nos. 2 & 3 1974
Waterford No. 3 1974
Braidwood Nos. 1 & 2 1975
Nine Mile Point No. 2 1975
South Texas Project 1975
Wolf Creek 1975
Palo Verde Nos. 1-3 1976
Fermi No. 2 1977
Hope Creek 1977
Limerick Nos. 1 & 2 1977
St. Lucie No. 2 1977
River Bend 1978
Shearon Harris 1978TABLE
Selected Industry Financial Statistics (1974-83)Electric Rate Change % Kwh Sales Change % Peak Reserve Margin % Capital Spending Amount ($ Billion) Change % Capitalization Change % ROE % Stock Price/Book (X) Common Stock Sold Share Change % Book Value Impact %1974 28.3 (0.9) 27.2 17.2 9.7 11.0 10.5 0.64 8.6 (2.9)
1975 17.5 1.8 34.3 16.2 (5.8) 11.3 11.1 0.89 11.6 (2.8)
1976 5.7 6.6 34.5 18.5 14.2 10.2 11.5 .1.02 10.3 (1.0)
1977 11.6 4.6 30.2 21.0 13.5 9.8 11.5 0.99 8.9 (0.4)
1978 7.3 4.1 33.7 23.7 12.6 8.2 11.3 0.85 8.3 (1.0)1979 8.1 2.7 36.1 27.1 14.3 9.8 11.2 0.75 9.0 (1.8)
1980 17.3 2.7 36.1 27.1 14.3 9.8 11.2 0.71 11.0 (2.9)
1981 14.7 1.9 33.3 31.3 9.0 9.0 12.6 0.74 11.0 (3.0)
1982 11.5 (2.2) 41.0 35.6 13.7 10.4 13.6 0.92 11.6 (1.9)
1983 3.4 2.5 33.3 35.8 0.6 8.6 14.3 0.91 8.6 (0.9)
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