ISSUE #3: Transition or "stranded" cost recovery

There is no more controversial topic or issue central to the outcome of the debate over electricity restructuring than that of transitional or "stranded" cost recovery. 21 

The MPSC defines stranded costs as "(1) costs that were incurred during the regulated era that will be above market prices during competition, and (2) costs that are incurred to facilitate the transition from regulated monopoly status to competitive market status." 22  What does this mean in plain English? It means that some utilities made investments in the past that they might lose money on in the future. In other words, "stranded" costs are nothing more than future monetary losses. 23  And utilities want their customers, or new competitors, to pay for them—which means they want to force tens of billions of dollars of costs on consumers.

These potential future utility losses could be brought about by a number of factors. The largest category of stranded costs will be created by nuclear energy investments, especially nuclear facilities that are nonoperational for one reason or another. Another factor that could bring about future losses are contracts that utilities were forced to enter into under the Public Utilities Regulatory Policy Act of 1978 (PURPA). PURPA required utilities to purchase power produced from independent power producers (such as solar, wind, geothermal, and cogenerators) who became known as "qualifying facilities" (QFs) under the law. Utilities were forced to purchase QF-produced electricity at the same cost they would have incurred producing it themselves or purchasing it from another comparable provider. Many utilities remain locked into long-term QF-contracts, most of which they entered into only because PURPA required them to.

Utilities argue that their captive customer base has a duty to pay off any losses they sustain in the future since they always have in the past. One of the reasons Michigan power rates have been so high in the past is that Michigan has allowed the utilities to pass along the costs associated with inefficient investments to ratepayers in the form of artificially higher prices. Despite the fact that these customers did not demand that many of these inefficient investments be made, they simply had nowhere else to turn for service since they were served by a single monopolist. The utilities argue this arrangement was, and still is, the equivalent of a "regulatory contract" between them, their captive customers, and regulators. Essentially, they argue, an implicit deal was struck between these parties that they would serve all customers within their service territory at a fair and reasonable rate in exchange for freedom from competition and a guaranteed stream of revenues. In the future, however, when rates are freed to fluctuate and the profits utilities earn are not guaranteed by regulators, some utilities may lose money. The "regulatory contract" notion argues that someone besides utility monopolists and their shareholders should pay the price of their inefficient investments since that is the way things used to work.

No matter how one describes the "regulatory contract" arrangement among regulators, utilities, and the public, it should be obvious it turned out to be a bad deal for consumers overall. They have been held hostage to a system that has provided them with a relatively undifferentiated service at a price they simply had to settle for no matter how outrageous. Only the largest of industrial customers have had any real negotiating power since they could threaten to leave the state or go so far, as many of them have, as to construct their own power plants adjacent to their manufacturing facilities.

This begs the question: Even if a "regulatory contract" really existed, would not customers have the right to opt out of it at some point? Or, even if they did not, would not the contract have been of limited duration and have expired at some point in the past, or at least be open for renegotiation? But such questions need not be raised since the so-called "regulatory contract" is really only as good as the paper it is written on—which is to say it is worthless since no such literal contract exists.

Michigan regulators and policy makers must realize the stakes of forcing captive customers to pay for a massive, multi-billion dollar bailout of the utility industry based on the unsupportable legal foundation of regulatory contract theory. A bailout of this magnitude will

• destroy competition in its cradle. If every new rival that wants to enter a new service region and offer competing service is forced to pay a hefty stranded cost recovery tax to the incumbent utility, fewer firms facing the prospect of such a high entry fee will be likely to look to enter that market;

give less efficient utilities an unfair advantage. If inefficient incumbent monopolists are bailed out, their cost of capital (or the cost of raising or borrowing money for firms) would likely be artificially lowered, meaning new rivals would have a tougher time raising the money needed to face off against incumbent utilities. More importantly, if they are granted lavish loss recovery early in the process through a securitization plan (discussed below), then they will leave the starting gate of competition with an insurmountable advantage in terms of new cash flow with which to make investments. Finally, with fewer firms facing off against inefficient incumbents, the incentive to offer innovative services decreases and quality is unlikely to improve;

nullify the benefits of competition and prevent serious price competition. If fewer competitors choose to enter the market and compete, or if captive customers are forced to pay large ‘exit’ fees to their current provider before they are allowed to shop for service, prices are unlikely to fall significantly any time soon. While regulators might try to freeze prices or demand rate reductions by utilities, this is a poor surrogate for genuine price competition and ultimately may discourage competitive entry;

force consumers to pay for services they do not demand or may not ever receive. If existing customers are forced to pay off utilities before they can choose alternative suppliers, this will force many of them to continue to purchase power from their current supplier against their wishes since they will not be able to afford the switching costs. In effect, consumers will be stuck paying for losses incurred by multi-billion dollar corporations who never provided these customers with any benefits for the money;

represent "corporate welfare" of an unprecedented level. Bailing out utilities would constitute a massive transfer of wealth. And, amazingly, this wealth transfer would be going from the pockets of average Americans to wealthy utility companies who have already benefited from years of generous, guaranteed profits on the backs of captive customers. In this sense, stranded cost recovery is just another example of "corporate welfare." As Attorney General Kelley has argued, "[T]he proposal put forward in the staff report will not, in my judgment, [bring about a more competitive electricity market]. Instead, this plan, which was developed primarily by our state’s two largest utilities, amounts to a massive giveaway to . . . Detroit Edison Company and Consumers Power;" 24  and

• provide a frightening and disastrous precedent for the future. Granting electric utilities stranded cost compensation of billions or hundreds of millions of dollars as they move into a competitive environment would set a disastrous and disruptive precedent. If every industry or organization that is even tangentially regulated by the government is allowed to claim compensation once deregulation or reform occurs, it could result in a financial nightmare and a stifling of deregulation.

A bailout of the utility industry is not warranted. There is no historical precedent for such a move. Other regulated industries such as telecommunications, trucking, railroads, and aviation did not receive compensation for real or imagined deregulatory losses; neither should electric utilities. In fact, the very term "stranded costs" is of recent invention. Electricity industry officials coined the term in an attempt to shelter themselves from the onset of competition. The term has never been heard in any other previous deregulatory deliberations including last year’s contentious debate over telecommunications reform. Why might policy makers take seriously the "stranded cost" arguments raised by electric utility officials?

First, regulators are more attached to the utility industry and are more concerned about its future than that of other industries. 25  In fact, although the MPSC officials claim to have developed their recommendations on this subject after meeting with numerous parties, on the third page of their Staff Report they note that, "The specific details in this Report were developed primarily through discussion with Consumers Power Company and Detroit Edison. . . ." 26  It is likely these two large monopolies had a shaping influence on the MPSC’s thought process as the agency developed its recommendations.

When firms of this size, which have historically controlled such a considerable percentage of market share, warn that the sky will fall in the absence of a generous bailout, it is not surprising to see government officials buckle under the pressure and recommend such a move. As Barry Cargill, vice president for government relations at the Small Business Association of Michigan, argues, "The Public Service Commission plan seems to give the regulated utilities all that they want rather than requiring them to prove what they deserve." 27  Jack Mason, a 15-year veteran economist still with the MPSC, appears to agree, referring to the nearly $10 billion in stranded cost loss recovery requested by Detroit Edison and Consumers Energy alone as "gross overestimates." 28  In an internal MPSC memo dated January 22 nd that was obtained by The Detroit News, Mason argues that "it is difficult to be too critical" of the MPSC Staff Report since "Consumer interests are compromised completely or almost so." 29  He adds that, "Michigan’s effort on electric restructuring appears to show less balance, being completely favorable to utility interests, than in any other major state considering restructuring." 30 

The second reason the MPSC is seriously considering a stranded cost bailout has to do with its fears about the continuous future supply of power. The Commission is concerned that the future provision of electric power to consumers would be placed at risk if the financial health of the firms it regulates was not guaranteed. This is a legitimate concern, but one based upon a misunderstanding of how a competitive market might work. First, it is unlikely any firm will be forced to declare bankruptcy if full stranded cost recovery is denied. Most firms will be able to divest many unwanted or less efficient assets, restructure their business operations or creatively use mergers or acquisitions to retain market share and customers; continue to amortize debts as part of their regular depreciation schedules; and, pass along some costs to shareholders over time.

Even in the extreme case that a utility is forced into bankruptcy, it is important to note that this does not mean it will forever close its doors, close its plants, and cut off power to the communities it serves. Bankruptcy is a legal proceeding that allows many firms to reorganize their debts and their business operations while they get back on sound financial footing, albeit with strict court-imposed operating restraints. In the meantime, customers would continue to receive power. Frederick H. Abrew, CEO of Pittsburgh-based Equitable Resources Inc. recently told Business Week, "There have probably been a half-dozen bankruptcies in the last 10 to 15 years. I don’t know of any customer that failed to get energy." 31 

Furthermore, in a competitive future with open retail access, power could be sent to consumers from competing companies far away. Many of these companies could assume control of assets that other utilities could not afford to operate, thereby ensuring that service was continued. Despite the ‘Chicken Little’ fears utilities have placed in many people’s heads, predictions of loss of electric power service are greatly exaggerated.

What is the proper way to handle the difficult and controversial issue of stranded cost recovery and a utility industry bailout? The first recommendation is simple: Do not under any circumstances follow the California model. California legislators, who claim they have found the perfect model for deregulating electrical markets, plan to provide their monopolistic utilities with a $28.5 billion bailout. Amazingly, the total size of the market is only $23 billion. 32  This means California utilities will be getting a cash handout at the starting gate of competition that is larger than the aggregate size of the entire market! 33 

But what is most dangerous about the California plan is its use of a so-called market mechanism known as securitization to allow monopolistic utilities to recover stranded costs. Under securitization, utilities calculate their estimated future losses and then offer bonds on the open market equal to the amount of stranded costs they want to recover. This allows utilities to immediately collect the amount of compensation they desire and then pay back these new bond holders over a number of years. These stranded cost bonds are backed by the utilities’ promise that they will be able to collect on-going transition taxes from customers until the bonds are completely paid off.

The MPSC Staff Report recommends the use of securitization to recover future utility losses. These so-called stranded costs are nothing more than potential future losses. There is no way to determine the exact present value of a future loss. If utilities are given the ability to estimate their potential future losses up-front, as securitization would allow, they will have a strong incentive to greatly exaggerate these costs. It is unlikely these large utilities will actually lose as much as they currently estimate. The idea of preemptively providing these utilities compensation for losses they will not incur for some time makes little sense. If any recovery is provided, it must be done as the losses are incurred, not beforehand.

How much would stranded cost compensation raise electricity prices? The MPSC Staff Report estimates that the sum of the transition charge and securitization charge for Consumers Energy and Detroit Edison would be in the range of 1.2¢ to 1.3¢ per kWh. Although this additional expense sounds trivial, this securitization tax would place a substantial burden on customers when they are ordering thousands to millions of kilowatt hours of electric power. Conversely, the Commission predicts that securitization would actually help reduce rates slightly in the short term by arguing that utility losses would be paid for via the issuance of bonds.

This is illogical. Consumers would be offered much lower rates in a competitive market free of any utility bailout. In other words, if Michigan policy makers put their stamp of approval on a securitization plan today, they will be unable to do anything to alter their policy in the future since the money will flow to the utilities once the bonds are issued and ratepayers will be stuck paying off the holders of those securities over the long haul.

A recently released study of securitization by the Indianapolis-based utility IPALCO Enterprises, Inc. notes, "Under the promise of minimal rate reduction, securitization establishes, for the first time in history, a long-term, irrevocable consumer obligation to pay, in advance, for future business losses of the utility. Whether characterized as a consumer subsidy of inefficient and uneconomic utilities or as a massive corporate welfare program dwarfing all historical analogues, securitization of electric utility stranded costs promises to be the greatest swindle ever perpetrated on the American consumer." 34  "Moreover," the report states, " . . . the adverse effects of securitization on infant competitive power markets will be profound" 35  since inefficient utilities that receive such a generous bailout will be able to use their infusions of billions of dollars to buy out smaller competitors.

While policy makers or regulators can probably not stop utilities from issuing new debt securities independently, they can and should make it clear to these utilities that the repayment of these new bonds will not be guaranteed via transitional taxes and fees on captive customers. This would effectively end any attempt by the utilities to securitize their debt since they would no longer have the force of regulatory coercion behind them with which they could require the public to pay off their newly issued bonds.

The bottom line on this divisive issue is that stranded cost compensation is almost never justified. Even in the case of uneconomical nuclear assets, California State University Economics Professor Robert Michaels has argued, "Any utility that claims a nuclear stranding should show that regulators gave it no choice but to build or complete the plant despite the utility’s preference for an alternative." 36  If such a claim is made and proven by a utility, then some recovery may be justified. But, if the utility went along with a plan to build a nuclear plant, or any other plant or facility for that matter, it would be very difficult to argue they should not now be responsible for losses associated with the plants.

The only legitimate category of stranded cost recovery may be the PURPA contracts that were forced by regulators upon utilities against their strong resistance. One possible solution to this problem is to encourage renegotiation of above-cost PURPA contracts to bring them in line with more reasonable market prices for power. This would lessen the burden of the contracts on utilities while ensuring consumers or competitors are not stuck footing the bill for losses associated with the contracts. Still, some small amount of recovery may be justified where these mandated contracts have forced utilities to incur costs against their will and cannot be renegotiated.

A good test that regulators can employ to determine if any compensation should be considered is the following: If a utility can show that it made an investment at the insistence of regulators, and resisted the action but was forced to move forward anyway, then it has a better case for compensation. In a recent study advising Pennsylvania regulators, Dr. Jake Haulk, research director for the Pittsburgh-based Allegheny Institute for Public Policy, concurs but adds important qualifications to this simple test that are applicable for all state and federal regulators.

"Any utility which can show that it was ordered to make expenditures that it would not have undertaken on its own, and which other utilities were not ordered to make, should be given some opportunity to recover those outlays. The guiding principle here must be this; to what extent has the utility been uniquely disadvantaged by regulators or government agencies? If all utilities have been treated the same by regulators, the playing field will remain level after competition is introduced and hence there is no reason to allow stranded cost recovery.

This exception will require very careful language in legislation and scrutiny in practice at the PUC. This exception should not be allowed to develop into a loophole that results in endless clamoring for special treatment. We would rather not allow this very narrow recovery opportunity than have a situation in which movement toward true deregulation and competition is slowed or thwarted." 37 

Rarely have utilities fought proposals by regulators to mandate the construction of new facilities or requirements to undertake other activities. If utilities showed no reluctance to move forward with the projects regulators urged them to pursue, then they clearly have no grounds for recovery. And even in those few cases where limited recovery might be approved by policy makers, utilities should be asked to do everything in their power to mitigate these costs before they are absorbed by third parties. Regulators might even want to encourage utilities to divest themselves of certain assets for which they are claiming compensation. This would at least allow the utility to recoup some of the costs associated with the asset and would simultaneously ensure that customers or new competitors are not stuck footing an unnecessarily large bill.

Finally, no other costs associated with deregulation or restructuring, such as employee retraining or the creation of new billing systems or metering technologies, should be included in the definition of a stranded cost. These are future investments that will be made by existing and new market players in the future on their own. There is simply no need to mandate that incumbent firms be granted special compensation today to pay for such transitional items or investments.

Recommended Action #4: Disallow all stranded cost claims for compensation except in the rare cases where a utility can prove beyond doubt that the investment was forced upon them by the PSC or the legislature.

Recommended Action #5: Allow utilities to securitize their losses if they want, but do not guarantee them a revenue flow to pay back the bonds via additional transmission fees or charges on captive ratepayers.