Stranded costs are those costs that electric utilities are currently permitted to recover through their rates but whose recovery may be impeded or prevented by the advent of competition in the industry. Estimates of these costs run from the tens to the hundreds of billions of dollars. Should regulators permit utilities to recover stranded costs while they take steps to promote competition in the electric power industry? On both efficiency and equity grounds, we argue, the answer to that question should be yes.
To begin with, we take issue with a particular rhetorical device commonly employed in this debate. Some imply that those who favor recovery fear competition in the electric power industry. That is not our position. Competition in generation is desirable. And more to the point, it's inevitable.
Stranded costs represent expenditures incurred by a utility in the past in meeting its obligation to serve all customers within the area for which it held an exclusive franchise granted under the traditional regulatory regime. Costs that face stranding include, among others:
1) Assets used for electricity generation
2) Costs for purchased power and fuel required under long-term contracts
3) "Regulatory assets" (expenses deferred to keep rates low temporarily)
4) Outlays for social goals, such as subsidies to low-income users
5) Incentives for renewable energy.
Regulatory agencies approved these outlays. Many were imposed on the utilities; some served to hold down prices to electricity customers. However, the entry of competitors who are not burdened by such inherited expenses can prevent utilities from recovering those costs. Such a scenario has been questioned both on the basis of equity and economic efficiency.
Moreover, a policy preventing recovery of stranded costs can lead to at least two major categories of inefficiency. First, business can be diverted to less-efficient suppliers, whose higher operating costs are offset by freedom from obligations imposed on utilities. Second, investment can be deterred, condemning efficient suppliers to obsolescence and inadequate capacity.
Efficiency
Even if no arrangement were adopted to enable utilities to recover the bulk of their stranded costs, some portions of these costs would remain inescapable. With regulatory consent and encouragement, utilities have entered into long-term contracts that require them to use high-cost sources of energy and to purchase electricity from high-cost suppliers. They are expected to maintain capacity to serve unexpected increases in demand. These, and the costs of a number of social obligations, count among the expenditures that utilities likely will not escape, even though, under current arrangements, other electric generators carry no such burden.
This disparity in obligations between the utility and its competitors in electric generation undermines efficiency in the competitive market. Competitors may face barriers to entry, but the utility serving the market faces "incumbent burdens." Suppose that
a utility can generate electricity
at an incremental cost, say,
10 percent lower than its rival's cost. If the utility's inherited and inescapable cost obligations are 20 percent of its incremental costs, its less-efficient rival will clearly be able to underprice the utility, despite the rival's substantially higher incremental cost of producing electricity. This form of bypass is obviously detrimental to the interests of consumers and the efficiency of the economy. Demand will be channelled to less- efficient suppliers, leading to unnecessary resource use, reduced productivity, and higher real costs. This inefficient bypass is a clear impediment to a competitive economy. In the long run it must impose higher costs on consumers.
The proper manner of dealing with this issue is to arrange for recovery of stranded costs in a way that can be described as "competitively neutral." The policy must be such as to permit rival firms to succeed only on the basis of relative efficiency, undistorted by asymmetrical obligations inherited from the past. In our new book, we describe an arrangement that we believe to be an appropriate and efficient way to deal with the matter.
Recovery of stranded costs can ensure that regulators never take any step that will return the invested capital and lead investors to question whether long-run earnings will yield a competitive rate of return.
Under regulation as it was conducted in the past, regulators tried to offer investors the same sort of actuarially expected return that a competitive market provides, but were forced by other rules to diverge from the competitive model. That divergence was found in earnings ceilings. Unlike the enterprise in an unregulated competitive market, the regulated utility was prohibited from earning (aside from small and temporary deviations) any more than a "fair rate of return" on its rate base. This meant that, whatever the firm's performance, investors could rule out a large and lucrative return. But regulators made up for this lack. They implicitly committed themselves to protect the regulated firm from a broad class of losses in return for preclusion of large profits. Since the firm was generally selected for regulation because it characteristically possessed market power, the regulator could offset unexpected losses or cost increases by loosening constraints on the firm's market power, allowing prices to rise.
It is this arrangement, which we call the implicit regulatory compact, that enabled regulators to reconcile their earnings ceilings with a rate of return high enough to compete in capital markets. Failure to allow recoupment of stranded costs will clearly violate this implicit regulatory compact.
And aside from inequity, the failure to recoup could also deter capital investment. Of course, it will be too late for current utility investors to respond. But investors may come away with the lesson to avoid investing in partially regulated electric utilities. More important, other prospective investors, seeing the compact abrogated, are certain to become wary. They may take their money elsewhere.
Some argue that investors have short memories (em they will soon forget a once-and-for-all abrogation of the regulatory compact. But we have no confidence that future investors will simply ignore past mistreatment and the risk that it can occur again. If stranded costs were only modest in amount, that hypothesis might be credible. That their magnitude threatens to cut deeply into the equity of current shareholders makes such a hypothesis implausible, and certainly one that cannot be relied upon with any degree of confidence.
Equity
Economics does not teach justice or equity. Nevertheless, the issue of stranded cost-recovery raises inescapable questions of fairness.
Some advocates of competition argue that equitable considerations are irrelevant (em that, just as competitive markets do not guarantee recovery of costs (sunk or otherwise), so utility companies will enjoy no such entitlement either. Thus, to the extent that competition strands costs, the utilities should be forced to write them off. Utility managers, conscious of their responsibilities to shareholders, naturally disagree.
We have already set forth the several ingredients of the case for full recovery on equity grounds. The most recent regulatory reforms that have played so large a role in admitting competition into the industry (em including both the Public Utility Regulatory Policies Act (PURPA) and the 1992 Energy Policy Act (em retained that same arrangement and assurance: The model they envision is one in which the utility companies serve as "resource portfolio managers," responsible for the supply of electric services to their retail customers, whom they continue to serve on an exclusive basis, with the continuing implicit regulatory promise of the opportunity to recover their approved costs.
The consequent allocation of risk between investors and customers is, of course, different from its allocation in unregulated industries. Unregulated markets impose on investors the full costs of investments that turn out badly but allow them to retain all the profits of ventures that turn out well. Under traditional utility regulation, investors have neither borne much of the risk nor enjoyed much of the benefits. But this allocation of investment risk has worked to the benefit of ratepayers for many decades. Even among present utility portfolios, most investments have been economically successful. The desire of ratepayers and their representatives in the present circumstances for shelter from the costs of past commitments that have not met expectations is, of course, understandable. But so far as equities are concerned, the offer of such shelter by policymakers will break the symmetry. The game becomes heads-we-win, tails-you-lose. A failure now by policymakers to permit some reasonable recovery of costs imposed under regulation in any transition to competition would leave investors, in effect, with a very large part of their property value expropriated by the change in the rules of the game.
The possibility that the firm's investors will be precluded by regulation from obtaining a reasonable return can suggest that a "taking" of the utility's property has occurred, in violation of the Takings Clause of the Fifth Amendment. Purely as an economic matter, it is confiscatory to take someone's property by decree and without adequate compensation. That rule applies equally to stockholder property.
Ultimately, of course, whether confiscation has occurred in the economic sense by virtue of change in regulatory policy is a question to be decided by a court. Yet, the relevant legal issues are fundamentally economic matters, and ones that economic analysis can illuminate. Indeed, the conclusions that emerge from economic analysis are entirely consistent with the criteria enunciated by the Supreme Court in 1989 in Duquesne Light Co. v. Barasch, 488 U.S. 299 (1989). There, the Court said that decisions regarding rates of return for regulated utilities "should be commensurate with returns on investments in other enterprises having corresponding risks" and should not "jeopardize the financial integrity of the companies, either by leaving them insufficient operating capital or by impeding their ability to raise future capital."
The Means
Regulators and courts dealing with stranded costs are enjoined to promote adequate and reliable service for consumers. Preclusion of recovery of stranded costs threatens service quality in the long run and thus serves consumers as well as investors badly.
The crucial issue for stranded cost recovery is the means by which it is done. Various devices have been suggested, including an "access charge" to be imposed on every electricity customer, an "entrance fee" to be paid by every current generation competitor of the utility and every entrant, and an "exit fee" to be paid by any customer that terminates service. Other suggestions include fuel charges and subsidies from the public sector. Most of these give rise to difficult issues such as how high the charge can be without impeding competition or distorting the market.
Another approach would add a stranded-cost component to electric transmission rates. As we show in our new book, a transmission price of this sort can be carried out in a manner compatible with economic efficiency and clearly neutral in its effects upon all competitors in electricity generation. A correctly constructed regime of transmission pricing may in fact achieve the efficiency and equity goals that justify the recovery of stranded costs. t
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