Retail competition will render a substantial fraction of existing electric utility plant worthless. Some estimates are so large that the question of compensation for these so-called "stranded investments" overshadows debate on the value of retail competition. Advocates of compensation frequently appeal to a "regulatory compact." They claim that this compact justifies compensation for utilities on grounds of fairness. The case for fairness, however, is badly flawed. Moreover, compensation may adversely affect the efficiency of markets in which competition is emerging. Compensation forces power users to forego productive opportunities to make their own transactions while they finish paying for plants that utilities never should have built. Save for special cases, it is both fair and efficient that utilities take the losses on those plants.
Voltaire said that history was nothing but a fable that had been generally agreed upon. The fictitious regulatory compact that justifies stranding compensation makes for poor history and misleading fable. Despite frequent claims that its roots go back to Hope and Bluefield, the compact is a recent intellectual invention. According to a LEXIS(r) search, the first regulatory and court decisions to mention it only appear in 1983 and 1984. The legislative history of regulation is strikingly devoid of references to a compact, and no known regulation arose from a collaborative effort at which anything resembling a compact was on the agenda. "Stranded investment" carries a similarly short pedigree, and is to this day absent from textbooks on regulation and industrial organization.
The Compact's Fine Print
No industry has ever proposed recovering tens of billions in mistakes from parties on the other side of a metaphorical agreement, particularly one as incomplete and one-sided as the utilities' version of the regulatory compact. In that version, the compact obligates a utility to provide reliable, long-term service in return for a monopoly franchise. Regulators charged with balancing ratepayer and financial interests allow the utility to recover prudently incurred costs, including a reasonable return on capital. Why would a rational end-user sign on as a party to an agreement that offered so few alternatives and so little protection? That ratepayer (known in other industries as a customer) stands at risk of becoming a cash cow whose bills will subsidize those of others who are politically favored. If tapped for this cross-subsidy, the ratepayer's only options are to reduce load, lobby the regulators, or leave the area. Customers who discover more economic power supplies cannot leave utility service, and the utility usually incurs no obligation to negotiate with them. The compact contains no known provisions for termination by a customer, save in extreme cases of self-supply.
On the other side of the compact, the utility's obligation to serve is scarcely a burden if whatever costs the utility incurs are recoverable from customers who have no choice but to pay. Consumers signing onto the compact would have done well to obtain the right to make their own choices in the event that their utility did not "resource" itself at least cost. Instead of allowing users an exit option, the compact offers no relief beyond prudence reviews (em whose inspiration is often more political than economic.
That consumers can lose under the compact is becoming ever more obvious, as utility after utility facing competition suddenly discovers that it has hundreds or thousands of redundant employees. Despite these needlessly high costs, utilities have usually earned sufficient returns to keep them in the good graces of the capital markets. In no unregulated industry do inept sellers enjoy so low a probability of failure. In light of this long history of inefficient supply, why should customers be required to pay even more for the right to leave utility service?
The utility's obligation to serve cannot by itself rationalize any stranding recovery. Doing so requires a further showing that the duty to serve forced investment in uneconomic plants. The nuclear plants that make up the core of alleged strandings were inefficient, unneeded, and known to be so at the time of construction commitments. Utilities often decided to start or restart nuclear construction in the face of adequate reserves and slackening demand. If compensation is a matter of equity, why should those utilities with the poorest foresight collect the booked value of nuclear mistakes while those that had better vision recover nothing? Utilities that told investors the truth and wrote down their nuclear plants will go uncompensated, while those who kept those plants on the books will win. Posing as fairness, compensation for stranding gives the most to the least competent.
Competition and Disallowance: No Analogy
Regulators sometimes disallow certain "imprudent" (typically nuclear) investments from rate base. Critics attack these disallowances because of the asymmetry that arises when regulators average good utility projects with bad ones in calculating the allowable return. They argue that selective disallowance of projects gone bad lowers the realized return below the allowable level, impairing the utility's ability to obtain capital and confounding investor expectations.
William Tye and others have written that retail competition will affect utilities in the same way as a disallowance proceeding. In other words, for investors in regulated firms, the surprise emergence of competition will be financially equivalent to a disallowance. Again, because of asymmetry, this group argues that regulators should delay the arrival of competition, or else utilities should receive compensation for their writedowns.
Regulation indeed limits returns on assets that proved wise investments, but with no disallowances it also guarantees the same return on unwise investments because customers cannot go elsewhere. If there is competition, unwise investments will lose out; wise ones will earn little more than competitive profits (em that is, the rate of return that regulators should be setting. Suppressing competition throws uncompensated risks on ratepayers, requiring them to pay both the booked cost and authorized return on investments that could not be recovered by a competitive seller. In a competitive market, those who invest wisely (or luckily) survive and prosper. Regulated rates, by contrast, can be set to give even the most incompetent monopoly utility a return it can survive on.
But a more fundamental difference lies between a retroactive cost disallowance and the emergence of competition. Disallowances cause wealth transfers that can be eliminated if regulators simply choose not to impose them. However, suppressing competition simply wastes the world's resources by denying end users any access to power sources more efficient than the utility's. Worst of all, regulators with the power to suppress ("manage") competition will probably use it either incompetently or politically. Competition is about the opening of opportunities that even competitors cannot always anticipate.
An Inefficient Tax
More than just a matter of fairness, stranding compensation represents a tax on end-users. Like any other tax, it produces revenue at some cost to economic efficiency. That loss stems from under-consumption of power when users pay an after-tax price that exceeds the real resource cost of that power. If compensation must be paid by customers who wish to relocate or arrange their own power supplies, the stranding tax will discourage some economically warranted departures from utility service. The loss will be magnified if it also delays investments in efficient nonutility plants that would serve bypassers. This issue has already surfaced at the wholesale level. (In Cajun Elec. Co-op. v. FERC, 28 F.3d 173 (D.C.Cir.1994), the U.S. Court of Appeals remanded the stranding compensation provisions in Entergy Corp.'s open-access tariff to the Federal Energy Regulatory Commission because of their questionable effect on competition.)
Imposing compensation on a broader customer base also produces economic inefficiency. If compensation imposes a surcharge on the energy component of a two-part tariff, consumption falls below the economically warranted level. On the other hand, if compensation is added to the demand charge, it will misshape load patterns and perhaps generation investments by making capacity appear more costly. Another inequity is that customers who left or downsized before compensation was imposed will escape a tax that recovers investments made to serve them. Customers arriving now or in the future will find themselves paying for mistakes the utility made before they came along.
An Interminable Transition
Administratively, compensation will be anything but simple, and the investments to which it applies will be anything but obvious.
California's utilities have submitted lists of uneconomic assets to state regulators that contain more than just nuclear plants and overpriced qualifying facility contracts. As in economics, there is surely a supply curve of stranded assets. The bigger the reward for finding stranded investments, the more of them utilities will manage to find. As compensation arrives, the possibilities for gaming will multiply, particularly if the payments are based on comparisons between booked costs and market prices. California's current planning process for new resources provides a likely scale model of what will happen when the value of entire systems is at stake. In that process, disagreements over costs have turned into long-lived battles of attrition between computer models. The conflict has become so complex that California now has legislation regarding admissible models and their uses.
Once begun, compensation will surely perpetuate itself. Stranding dockets will become yet another forum in which parties can seek rate relief or otherwise special treatment. Having been compensated for one set of bad investments, utilities will have good reason to want such a mechanism in place for future recoveries. Credibly terminating the transition may require such extreme measures as the vertical breakup of utilities. Vertical de-integration is costly, entails problems with bond indentures, and will probably be governed by politics rather than efficiency. Instead of levelling the playing field, a vertical breakup artificially bars the formerly integrated utility from doing what it might eventually learn to do well.
What amounts are ultimately paid will depend on whose estimates regulators believe. Advocates for public power agencies and industrial users calculate figures that reach orders of magnitude below those proposed by utilities. With such a difference at stake, opposing parties might well entertain wasteful "rent-seeking" expenses. The amount at issue may make attorneys and consultants happy, but ultimately their standards of living will be gained at the expense of others, including captive ratepayers. Payment for up to $200 billion of strandings will only be politically palatable and economically bearable if spread over many years. Long-term payments will require long-term regulatory oversight, since stranding liabilities will change with market conditions in ways that are not predictable today.
Advocates of compensation fall oddly silent about what utilities are to do with the payments. Regulators who grant compensation should insist that it be earmarked to shrink the utility by retiring certain financial obligations and transferring ownership of the stranded facilities (at least the nonnuclear ones) to others. That is how firms in unregulated industries get rid of their stranded investments, usually at a loss. Without such restrictions, the temptation to spend stranding compensation inefficiently may produce little more than another generation of strandings. t
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