Stranded Benefits Versus Stranded Costs in Utility Deregulation

Abstract

The shift to competition in utility generation is likely to generate "stranded investments," which are wealth transfers between investors and utility ratepayers. Stranded investments can take either of two forms: (1) "stranded costs" are a transfer from investors to ratepayers that occur when revenues are insufficient to compensate utilities for investments approved and undertaken under the pre-existing regulatory regime; (2) "stranded benefits" are a transfer in the opposite direction, from ratepayers to investors, that occur when (a) utilities are allowed to charge market prices for electricity based on investments previously paid for by ratepayers in the regulatory process and (b) market prices exceed regulated prices.

Utilities have successfully lobbied the Federal Energy Regulatory Commission and several state legislatures to permit them to recover stranded costs in the process of utility deregulation. But they have been rationally silent about the converse problem of stranded benefits, which benefits them and their investors at the expense of electricity consumers, who have had little voice in deregulation negotiations.

If equity requires that utilities and their investors be compensated for stranded costs in deregulation, then equity must also dictate that ratepayers be compensated for stranded benefits. Data and forecasts from several sources provide no basis for believing ex ante that stranded costs are likely to exceed stranded benefits. Consequently, there is no reason - aside from public choice - for states to provide for stranded cost recovery while ignoring stranded benefits.

As a normative matter, stranded cost recovery should be allowed only where a utility's stranded costs exceed the sum of stranded benefits and the transaction costs associated with any compensation scheme. Similarly, electricity consumers should be allowed to recovery stranded benefits when those benefits exceed the sum of stranded costs and the transaction costs associated with compensation. Where the difference between expected stranded costs and benefits is small, then the best policy may be to allow no recovery of either. Indeed, given the substantial ex ante uncertainty about who will gain and who will lose from investments stranded by deregulation, the best overall policy, from a transaction-cost perspective, may be to leave stranded costs and benefits where they fall.

JEL Classification: K0, K2, K23, L5, L51, L9, L94