Understanding stranded-cost investments: Education and involvement help users stay informed on deregulation

In the beginning, long after the earth cooled and the warm and cold-blooded behemoths and prehistoric fauna became fossil fuels, vertically integrated electric utilities dominated the landscape.
By James L. Verna March 1, 1999

In the beginning, long after the earth cooled and the warm and cold-blooded behemoths and prehistoric fauna became fossil fuels, vertically integrated electric utilities dominated the landscape. Power delivery and electron flow were relatively straightforward. Vertical integration meant that power generation and distribution to users were carried out by the same entity over their own transmission and distribution wires.

Although the traditional power supply and distribution model still dominates today, deregulation may soon cause the vertical, unregulated utility to go the way of the dinosaur. In addition, traditional methods of recovering stranded (also called competitive transition ) costs are also experiencing a kind of financial Darwinism. Determining how much of its stranded costs a utility should be permitted to recover is a sticky issue. To ensure that a facility is receiving the best overall energy rates that it can, plant engineers must understand the debates behind stranded costs that are going on in their states.

Issue of deregulation

Creating power demands a utility to bear essentially two major liabilities: capital expenses to construct generation facilities (bricks, mortar, boilers, and turbines) and fuel expenses to fire the plants. Historically, demand charges are assessed to help the utility recover generation costs. Demand charges are levied on the basis of a user’s highest (peak) use during a specific time period.

Today’s industrial age is marked by a sharp increase in hungry electric motors, lights, and electromechanical machinery. As demand swelled, so did the need for generating capacity. That situation, in turn, increased the need to build additional generation facilities to deliver that capacity.

If regional economics determined a new generation facility was needed to meet the projected demand growth of an area, a state’s public utility commission (PUC) mandated that the utility construct one. In return, the utility was allowed to amortize the costs of those assets over a fixed period of time (usually 30 yr). The cost was passed on to the energy users in the area along with a reasonable rate of return on the investment (usually 11%).

Until recently, this cost was invisible to the user, who pays both market-based rates and competitive transition fees or access charges. However, deregulation demands that the utility unbundle (break down) all energy bills into transmission and distribution, generation, and competitive transition fees. With this change, each charge becomes sharply apparent to the energy consumer.

Economics of stranded-cost recovery

Quantifying stranded costs has become a hotly debated, often contentious, issue. Voices often heard in the debate include PUCs, utilities, regulators, user groups, environmentalists, power marketers, and various lobbying factions.

A utility’s compliance with a PUC’s mandate to build capacity was to be awarded a 30-yr cash flow. To remain viable in a competitive supply area, the utility still needs a mechanism for writing off these generating assets that may no longer be economical or which present an environmental liability. Stranded items present a significant barrier to a utility’s ability to compete successfully in an open market.

Unfortunately, there is no cure-all algorithm or mathematical elixir that can conjure up numbers and recovery terms that are mutually acceptable or financially agreeable to all parties. One major issue in stranded-cost negotiation is separating the part of the utility’s generating portfolio that is stranded or uneconomical from the prudent investments. This difficult accounting exercise is what ultimately determines energy user discounts as states prepare for the transition to a competitive market.

For example, deregulation legislation in Massachusetts required utilities give discounts of 10%-15% over the next several years to all customers in all rate classes. To provide that level of savings, the utilities had to divest themselves of nonnuclear generating assets. The Massachusetts Department of Telecommunications and Energy would then allow the utilities to recover 100% of the costs that exceeded the plants’ book value at the time of sale.

Both Boston Edison and Massachusetts Electric have had their sales approved. The New England Electric System is selling 18 power plants and a number of power contracts representing about 5100 MW to USGenNE for $159 billion. However, negotiations do not always go smoothly. A diverse cast of players — including accountants, lawyers, regulators, consumer advocates, large users, power marketers, and environmentalists — must have a voice in these decisions.

Some players argue a utility should recover little, if any, stranded costs. They argue that a private company’s shareholders are not liable for market vagaries and uneconomical investments. For example, when an auto manufacturer builds a new plant, there is no built-in bailout mechanism that lets it recoup its investment.

On the other hand, utilities were ordered to build additional facilities to meet forecasted energy requirements. They did not make “bad” business investments. They made investments mandated by the PUC.

In California and Massachusetts, referenda on fall ballots sought to repeal recent stranded-cost recovery legislation. In Massachusetts, the effort was backed by a grassroots campaign to set discounts at some 30% instead of the legislated 10%-15%. Both ballots resulted in defeats of the referenda, allowing the legislation to stand. Groups in California were lobbying to derail 100% stranded-cost recovery. California light commercial and industrial end users saw a 10% reduction in utility costs while larger users received a freeze in rates until the end of 2001. Sometimes compromises are made. One Pennsylvania-based utility will be allowed to recoup up to 85% of its stranded costs over 12 yr.

Strange and fascinating powerscape

Although there is some movement toward a unified federal plan, deregulation is still a state-by-state issue. At this point, 10 states have passed freedom of choice legislation. However, some do not call for open access until 2000 or later. Today, only California, Massachusetts, and Rhode Island have full access. About two-thirds of Pennsylvania energy users have access. New York and Michigan are developing retail access pilot programs without having passed legislation.

As each state moves at its own pace addressing its own issues, some experts predict it may take the utility industry 5-10 yr to pay off its debt (estimated at more than $250 billion). Until this issue is resolved, or plays out under the time allowed for recovery, the full benefits and cost savings possible through competition will not be easily or quickly discernible.

The evolution of the generation/ transmission and distribution/end user models will yield a strange and exciting new powerscape. The once-vertical utility will break into generation companies, transmission companies, distribution companies, and retail energy sales companies. Utilities will have to decide what their core business will be.

In the meantime, the best strategy for industrial users is education and involvement. Join a local industrial users group. If there is none near you, think about starting one. Read publications that regularly report on deregulation and energy management issues. The internet holds an array of helpful resources on these issues. Partner with an energy service provider or consultant who demonstrates expertise in deregulation and in problem-solving.

Unfortunately, deregulation and stranded-cost recovery are not one-size-fits-all issues. They are replete with nuances, complex jargon, and industry-specific regulatory details. Electric restructuring is a constantly evolving issue that tends to favor the survival of the fittest.

Don’t follow the dinosaur. Get smart, stay informed, and take action.

Jim Verna has been a key architect in the business strategy of Exelon Management & Consulting for more than a decade. His customer focus gives end-users straightforward, unbiased energy expertise designed to help them meet their energy objectives. He is a frequent presenter of information on deregulation to a variety of organizations including the American Management Association and is a recent recipient of the Edison Electric Institute’s Marketing Achievement Award. He holds a BS in electrical engineering and an MBA from Drexel University. The company web site is www.exeloncorp.com.