Q: Should consumers pay the `stranded costs' of utility companies?

0 Comments | Insight on the News, Nov 9, 1998 | by J. Gregory Sidak, | Peter Van Doren

Yes: The government can't change the rules and force utility shareholders to pay the cost.

In recent years, a number of supposedly market-oriented think tanks, including the Cato Institute, have published papers criticizing the recovery of "stranded costs" in the electric-power industry. For the uninitiated, stranded costs are the prudently incurred costs the utility cannot recover through its allowed rates because regulators have opened the market to competition. Some critics assert that stranded costs are just bad investments by another name, and that denying utilities the opportunity to recover such costs would have no adverse consequences for consumers.

The latest example of this argument is Peter M. VanDoren's October 1998 paper for the Cato Institute titled, "The Deregulation of the Electricity Industry: A Primer." VanDoren says that the issue of compensation for stranded costs raises two questions: Does the policy change involve a taking of property requiring just compensation under the Fifth Amendment? Is compensation required to ensure economic efficiency? He answers both questions: "No."

VanDoren's analysis purports to examine -- but leaves unremarked -- the scholarly research by economists and lawyers on the subject, including Deregulator), Takings and The Regulatory Contract, a 600-page book that Professor David Spulber of Northwestern University and I published with the Cambridge University Press in 1997. That research shows that the regulatory contract contains three essential terms -- price regulation, entry regulation and the obligation to serve -- that simultaneously constrain the private exercise of market power and ensure that the utility will have a reasonable opportunity to recover the economic costs of the long-lived, nonsalvageable investments that it made to serve its customers. It is pertinent to note the conclusions of President Clinton's Council of Economic Advisers -- certainly not a group plausibly to be accused of having been coopted by the electric utilities -- as expressed in its January 1996 Economic Report of the President. The council reports:

"[T]here is an important difference between regulated and unregulated markets. Unregulated firms bear the risk of stranded costs Out are entitled to high profits if things go unexpectedly well. In contrast, utilities have been limited to regulated rates, intended to yield no more than a fair return on their investments. If competition were unexpectedly allowed, utilities would be exposed to low returns without having had the chance to reap the full expected returns in good times, thus denying them the return promised to induce the initial investment (emphasis added). A strong case therefore can be made for allowing utilities to recover stranded costs where those costs arise from after-the-fact mistakes or changes in regulatory philosophy toward competition, as long as the investments were initially authorized by regulators."

This is a succinct statement of what is meant by the regulatory contract. The theoretical economic arguments for the existence of the regulatory contract comport with observed fact, for many unanimous Supreme Court decisions from the late 19th and early 20th centuries -- none of which VanDoren appears to have examined -- interpreted and enforced the utility's franchise against the government in explicitly contractual terms.

Moreover, the Supreme Court's 1996 decision in the savings and loan case, U.S. v. Winstar Corporation, indicates how the court likely would view a case involving recovery of stranded costs arising from breach of the regulatory contract in a regulated network industry. Seven justices -- Stephen Breyer, Anthony Kennedy, Sandra Day O'Connor, Antonin Scalia, David Souter, John Paul Stevens and Clarence Thomas -- supported their divergent legal conclusions in Winstar with the same economic reasoning that stressed cost recovery, incentive for investment, opportunism and the government's need to make credible commitments. In that important respect, Winstar builds on the intellectual foundation that such justices as Oliver Wendell Holmes, Charles Evans Hughes, John Harlan and William Howard Taft laid more than a century earlier to construe the fights and remedies of public utilities under their regulatory contracts with municipalities. Winstar confirms the continued vitality of the reasoning in those early decisions. VanDoren cannot pooh-pooh the regulatory contract without pooh-poohing the reasoning of seven justices in Winstar.

VanDoren's discussion of takings jurisprudence shows a lack of awareness of the legal issues that courts and regulators actually have been addressing for several years in the network industries. VanDoren argues: "Utility owners are not like independent contractors dealing at arms length with the state who now want the terms of their contract upheld. They are more like `conspirators' who were given a privilege that is being taken back. "For him to dismiss the takings questions with the ease that he does is misleading and embarrassing. I showed in our book that the abnegation of the regulatory contract would effect a taking of private property for public use -- namely, the promotion of open-access competition in a regulated industry -- without just compensation. That result holds whether one casts a deregulatory taking as a physical invasion of property, as a confiscatory setting of public utility rates or as a noninvasive regulatory taking.