Electric utilities now face the risk that existing assets, costs, or contract commitments may be "stranded" by increased competition, leaving shareholders rather than customers to bear the costs. Have shareholders already been compensated for this risk?
Some argue that shareholders have automatically been compensated for this risk by an allowed rate of return equal to the cost of equity capital determined in efficient capital markets.1 If so, forcing shareholders to bear stranded costs may seem fair. However, this argument does not stand up to scrutiny, because the cost of capital by definition does not include such compensation.
Loose Definitions Create
Standard regulatory practice is to equate the allowed rate of return to the cost of capital and to set the rest of the revenue requirement so that if costs and sales are as anticipated, the utility will earn the allowed rate of return exactly. Differences between actual and anticipated costs and sales mean that the rate of return the utility actually realizes typically differs from the allowed rate of return, but the allowed and actual rates of return are supposed to be equal on average.
For the "automatic compensation" theory to work, it must hold true within this standard framework. The essence of the automatic compensation theory is that the cost of capital in and of itself offers adequate compensation for the risk of stranded costs.