Stranded cost recovery and competition on equal terms

Electricity Journal

Volumn 9, Issue 10, 1996, Pages 61-70

  Tye, William B ^a   Graves, Frank C ^a  

^a NONE

Author keywords

[No Author keywords available]

Indexed keywords

COST RECOVERY;

EID: 0003059073     PISSN: 10406190     EISSN: None     Source Type: Journal    
DOI: 10.1016/S1040-6190(96)80158-8     Document Type: Article

References (33)

1. By "stranded costs," we mean investments or cost commitments made by incumbents in the prior regime of cost-of-service regulation (i.e., "sunk costs") that cannot expect to earn their cost of capital and/or be recovered from customers under the proposed new rules of competitive access to utility systems. Stranded costs are also sometimes referred to as "transition costs." Note that these may include fixed costs which will continue to be borne in the future, such as out-of-market fuel contracts with strict take-or-pay provisions. They can also include unavoidable future adjustment or exit costs, such as labor severance costs. In general, any and all unavoidable "legacy" costs should be recognized, but no avoidable or discretionary future costs.
2. Holden Benjamin A. Shift To Deregulation May Cost Electricity Industry $135 Billion. WALL STREET JOURNAL. Aug. 7, 1995;B4.
3. Holden Benjamin A. Moody's Report Predicts $135-Billion in Stranded Costs Over Next 10 Years. ELEC. UTIL. WEEK. Aug. 14, 1995;3.
4. This figure represents 80 percent of the equity base of the electric utility industry, according to Moody's Investor's Service, Stranded Costs Will Threaten Credit Quality of U.S. Electrics (Aug. 1995). See also Holden Benjamin A. Power Plays: California's Struggle Shows How Hard It Is to Deregulate Utilities. WALL STREET JOURNAL. Nov. 28, 1995;A1.
5. Holden Benjamin A. California Regulators Approve Plan to Deregulate Market for Power by '98. WALL STREET JOURNAL. Dec. 21, 1995;A2.
6. Typical of these claims Penn David W. Where Have You Gone, Dr. Kahn? ELEC. J. Dec. 1994;2-3. Stranded cost payments have anticompetitive effects. They will delay or prevent desired new competition by erecting a barrier to entry for alternative suppliers and trades; by discriminatorily favoring and shielding certain individual competitors; by artificially giving an entrenched competitor a paid-off asset with which to compete with rivals; and by distorting transmission prices if such generation charges are placed there. ... Putting generation stranded cost charges on transmission is indeed a tying arrangement. ... asserts:
7. See also Michaels Robert. Unused and Useless: The Strange Economics of Stranded Investment. ELEC. J. Oct. 1994;12.
8. Navarro Peter. Electric Utilities: The Argument for Radical Deregulation. HARV. BUS. REV. Jan.-Feb., '96;113-125.
9. For a rebuttal of some of these claims, see Joskow Paul. Does Stranded Cost Recovery Distort Competition? ELEC. J. April 1996;31.
10. Joskow Paul L. Does Stranded Cost Recovery Distort Competition? ELEC J. April 1996;31.
11. Tye William B. The Pricing of Inputs Sold to Competitors: Response. YALE J. REG. 11:Wint. 1994;203-224.
12. Tye William B., Lapuerta Carlos. The Economics of Pricing Network Interconnection: Theory and Application to the Market for Telecommunications in New Zealand. YALE J. REG. 13:Summ. 1996;419-500. for further discussion of the distinction between strong and weak competitive neutrality.
13. The problems of a transition to competition from regulation almost always arise as a result of such legacies of the prior regulatory regime, which may create both competitive advantages or disadvantages to incumbents. See Meyer John R., Tye William B. Toward Achieving Workable Competition in Industries Undergoing a Transition to Deregulation: A Contractual Equilibrium Approach. Tye William B. THE TRANSITION TO DEREGULATION. 1991;13-18 Quorum Books. We assume here the principle of bifurcation, as discussed below, which means that competitive access pricing mechanisms are employed separately to address and rectify any anticompetitive advantages arising solely from incumbency. Bifurcation does not necessarily imply that stranded cost recovery mechanisms are necessarily separate from other cost recovery mechanisms, however.
14. More formally, weak competitive neutrality between two firms requires that the firm with the lowest marginal cost always be able to successfully compete for business against a higher marginal cost competitor in a winner-take-all contest. We accept this standard for evaluating transition mechanisms for the purpose of argument here while elsewhere questioning its validity in a competitive regime in the electric utility industry. See Tye William B., Graves Frank C. The Economics of Negative Barriers to Entry: How to Recover Stranded Costs and Achieve Competition on Equal Terms in the Electric Utility Industry. forthcoming in NATURAL RES. J. 37:(1):Dec. 1996.
15. Critics of stranded cost recovery sometimes claim that investors in electric utilities need not be afforded such an expectation during the transition because they have been previously compensated for the risks of stranded assets. For this claim, see Seltzer Irwin M. Stranded Investment: Who Pays the Bill? March 30, 1994;. (remarks delivered at Southwestern Electric Exchange, American Enterprise Institute, Wash., D.C.).
16. See also Stelzer. Restructuring the Electric Utility Industry: Further Tentative Thoughts. ELEC. J. Oct. 1994;36. for a revision of some of these views.
17. As it turns out, the economic principles of asymmetric risk imply that even if: (1) investors are fully cognizant of the risks, (2) capital market prices fully reflected such risks, and (3) regulators always set the allowed rate of return equal to the true cost of capital, it is mathematically impossible for investors to have been previously compensated automatically for these risks. See Kolbe A. Lawrence, Tye William B. It Ain't In There: The Cost of Capital Does Not Compensate for Stranded-Cost Risk. PUB. UTIL. FORT. May 15, 1995;26. Those wishing to pursue the matter further are referred to A. Lawrence Kolbe and William B. Tye, Compensation for the Risk of Stranded Costs (forthcoming in ENERGY POLICY).
18. "Robustness" is a term of art used by economists to describe a property that tends to be invariant with respect to assumed conditions.
19. Cajun Electric Power Cooperative, Inc. v. FERC, 28 F.3d 173 (D.C. Cir. 1994) (Cajun). The actual ruling of the Court went to the FERC procedures, not the substance of the issues: "We find that the Commission failed to adequately address these and other concerns raised by the petitioners and conclude that it was arbitrary and capricious in declining to conduct hearings. [footnote omitted.]"
20. Western Systems Power Pool, 55 FERC 61,099 at 61,317 (1991) (emphasis added).
21. Id.
22. Id.
23. Note in the discussion above that we are not necessarily assuming that the stranded cost recovery will be billed separately from other charges. The recovery might well be added to charges for transmission access to competing firms. Or, as discussed below, it might be assessed to all customers or to only departing customers. This bifurcation assumption lets us examine the consequences of the stranded cost recovery mechanism for competition on equal terms independent of the access mechanism.
24. In the spirit of this alleged counter-example we are assuming that Utility B is in fact the high total cost seller (from an embedded cost basis). More realistically Utility A might be a gas-fired utility with higher energy costs but lower fixed costs than Utility B, which might be a coal-fired utility where the reverse is true.
25. Tye and Graves, supra note 6.
26. This should be intuitively obvious. Fixed costs are indeed fixed, regardless of customer choice of supplier, so their total amount and their distribution among suppliers can have no effect on total industry costs. Every kWh in Utility A's service territory that switches to Utility B will generate (2.1-2.0=) 0.1¢ in true efficiency gains. Conversely, switches in the opposite direction will generate efficiency losses.
27. One way to think of the effect of opening up access to competition is to strengthen the incentives to bring in lower cost generating resources. The efficiency gains from competition in the proffered counterexample exist only because there is an assumed obstacle to an economy transaction between Utility A and Utility B in the prior regulatory regime. Alternatively, the counterexample might be interpreted to claim that competition under stranded cost recovery would obstruct the economy transactions that occurred in the prior regulatory regime from occurring in the transition, leading to efficiency losses.
28. We show below that the consequences for competitive neutrality are no different for this recovery mechanism as for the "revenues lost" method.
29. Baumol William J., Sidak J. Gregory. The Pricing of Inputs Sold to Competitors. YALE J. REG. 11:Winter 1994;198. Note, however, that it will happen only if there is a competitive market for power in our example, so that incumbents have no incentive to discount the recovery fee on their own sales. See also Tye and Graves, note 7, supra, for another potentially important exception. appear to have uncovered this imputation principle.
30. Tye and Graves, supra, note 7.
31. Id.
32. The Court's concerns about "tying" are partly just ill-founded. First, marking up the price of one good or service to recover an upstream cost is not tying; it is simply pricing to recover total costs. For instance, aircraft companies recover research and development costs in the price of airplanes, or insist that those design costs flow through regardless of quantity of airplanes actually taken. Take-or-pay charges in gas and coal contracts cover the stranded, i.e., sunk, costs of exploration and development. Second, the stranded cost recovery (access) charge does not require use of any other utility services beyond transmission; customers are free to choose a third-party supplier. As shown herein, the access charge does not distort this decision or encourage affiliate favoritism, as long as the charge is non-by-passable, due to the imputation principle. Thus, achieving strong neutrality eliminates all of the Court's concerns.
33. Tye and Graves, supra, note 7.