*Public Utilities Fortnightly*, and gain access to the entire Fortnightly article database online.

Is Too! Is Not!

In the August 1995 Mailbag, Mr. Michael Yokell claims our May 15, 1995, article ("It Ain't in There: The Cost of Capital Does Not Compensate for Stranded-cost Risk") "is simply wrong" and "nonsensical on its face" because we fail to distinguish between the cost of capital before and after the stranded-cost issue arose.

In fact, it is Mr. Yokell who fails to distinguish between the cost of capital (by definition the average rate of return shareholders require over all possible outcomes) and whether the allowed rate of return granted by regulators affords investors an unbiased opportunity to earn the cost of capital. In our example, the 12.5 percent (which Mr. Yokell wrongly considers the cost of capital before stranded-cost risk arises) is in fact the average rate of return investors require after stranded-cost risk arises. The 20 percent (which Mr. Yokell wrongly considers the cost of capital after stranded-cost risk arises) is the allowed rate of return regulators must grant on the equity rate base if investors are to expect to earn 12.5 percent on average, given that there is a 1-in-4 chance they will earn 30 percent less than the allowed rate of return if costs are stranded:

(3/4 x 20%) + [1/4x(20%-30%)] = 15%-2.5% = 12.5%.

*Public Utilities Fortnightly*, and gain access to the entire Fortnightly article database online.