Articles

From Streetcars to Solar Panels: Stranded Cost Policy in the United States

Author: 1 | September 2015 – Volume 3, issue 3 2015

Introduction: Definition and Causation

A utility’s obligation to serve includes an obligation to invest—in the generating plants, transmission networks, pipelines, compressors, switching equipment, wires, poles and pumping stations that are necessary to fulfill its obligation to serve. A utility’s shareholders assume that their company’s obligation to invest will be matched by its customers’ obligation to pay—to pay rates that both recover the utility’s investment over some reasonable period, and produce a reasonable return on the investment that remains unrecovered during that period.

But mismatches have occurred—situations where the utility has made an obligatory investment but the customers have not paid for that investment, thereby creating a risk of “stranded cost.” Here are seven possible examples:

Obsolescence: Streetcars are replaced by automobiles, leaving the streetcars with insufficient customers to pay off its costs.

Mis-projections of demand: A utility builds capacity based on reasonable projections of demand growth that turn out to be wrong, leading to abandonment of the plant or excess capacity.

Rate discounts: The utility’s regulator allows the utility to grant large, mobile customers discounts below fully allocated cost.2 Doing so ensures some contribution to fixed cost, but leaves the utility potentially unable to recover the portion of fixed cost represented by the discount.

Energy efficiency programs: Where a utility’s rate design collects fixed costs through variable charges, the decline in consumption resulting from energy efficiency programs leaves the utility with unrecovered fixed costs.

Elimination of exclusive franchise: Based on an exclusive franchise, the utility builds infrastructure, but before that investment is fully recovered from customers, the government eliminates the grant of exclusivity. The utility’s traditional customers migrate to new suppliers before paying off the past costs.

Elimination of utility’s control of monopoly facilities: Where a utility controls a natural monopoly facility, like a distribution or transmission system, it can leverage that control to prevent competition in other markets, like electricity or gas sales. The utility then incurs infrastructure costs to serve its captive customers. When the government removes the utility’s control of the monopoly facilities, the formerly captive customers migrate to new entrants, leaving the utility with unrecovered costs.

Customer self-supply: Self-generation by customers (individually, as with solar panels, or in groups, as in micro-grids) for whom the utility historically invested in infrastructure leaves the utility unable to recover the investment historically incurred on behalf of those customers.

In each of these examples, events occurring after the utility’s investment have left the utility unable to recover that investment, at least from the customers on whose behalf the investment was made. The result is stranded cost. Stranded cost is defined as the excess of book value3 over market value, where book value represents that portion of the utility’s original prudent investment not yet recovered from customers as of the time they cease paying regulated rates, and market value refers to the market value of the assets attributable to that investment.

While all seven examples are versions of stranded cost, the modern debate focuses mostly on the final three: elimination of the exclusive franchise, elimination of the utility’s control of bottleneck facilities, and customer self-supply. In these three contexts, stranded cost typically arises from the confluence of five factors:

  1. Utility service is capital-intensive.
  2. Load growth is incremental, while major infrastructure additions are lumpy. These additions come on line in large chunks, ahead of actual demand, because economies of scale reduce their long-run per-unit cost. These factors mean that at nearly any point in time, the utility will have surplus capacity.
  3. Under traditional ratemaking, the investment cost of infrastructure capital additions is amortized; that is, allocated to ratepayers over the plant’s useful life. If regulators expect a plant to last 30 years, they set rates to recover 1/30 of its original cost in each of those years. This annual fraction, multiplied by the original cost, is the depreciation expense. (The rates also are designed to recover a reasonable return on the not-yet-recovered cost.)
  4. If the government introduces competition prior to the year in which the original investment has been fully recovered from customers through depreciation expense (as will always be the case for at least some of the utility’s infrastructure), part of the utility’s original investment will not yet have been recovered from ratepayers. If all of the utility’s customers then find new sellers, the utility would have unrecovered book cost.
  5. The utility will be able to recover its unrecovered book cost only if it can find buyers for the infrastructure (or for the output from that infrastructure), at a market price that equals or exceeds the unrecovered book value. If the anticipated recovery, i.e., the market value, is below the unrecovered book cost, the difference is called stranded costs.

In the United States, the stranded cost issues have arisen across the decades, from streetcar obsolescence in the 1940s to nuclear power plants and gas purchase contracts in the 1980s to current debates over solar installations and shuttered coal plants. Common to all these circumstances is this fact: whether as a result of government decisions or economic forces (which themselves can be encouraged or tolerated by government decisions), an investment made by a utility entity, based on an obligation established by government entity, is no longer certain of recovery from ratepayers.

Part I of this article addresses the main legal question: What are shareholders’ legitimate expectations with respect to the government’s treatment of their utility’s prudent investments? The answer to that question lies in the Takings Clause of the U.S. Constitution, in the small number of cases applying that provision to utility industries, and in statutes that operate within the constraints created by the Clause.

Part II describes how regulators have applied these legal principles over the last three decades, focusing on three categories of industry transitions: the elimination of exclusive retail franchise in electricity and natural gas; the unbundling of electric transmission service from wholesale sales; and the unbundling of natural gas transportation service from wholesale gas sales.

Part III examines the contrast between (a) the traditional approach to stranded investment, which deals with costs after the fact, and (b) modern approaches, which seek to assign responsibility and risks before the fact.

I. The Legal Question: What are Shareholders’ Legitimate Expectations?

A. The Takings Clause of the U.S. Constitution

The U.S. Constitution’s Fifth Amendment provides in part: “[N]or shall private property be taken for public use, without just compensation.”4 Applying this language to the public utility context, Justice Brandeis described what property is “taken,” for which “just compensation” is due:

The thing devoted by the investor to the public use is not specific property, tangible and intangible, but capital embarked in the enterprise. Upon the capital so invested the Federal Constitution guarantees to the utility the opportunity to earn a fair return.5

The private property “taken” is the shareholder investment prudently incurred by the utility to fulfill its public service obligations. The “just compensation” is the dollar amount received by utility when it charges the rates set by the regulator. The “just compensation” problem arises if the utility is unable to recover its investment, or is denied an appropriate return on that investment. Suppose a utility with an exclusive franchise prudently invests $90 million in an asset having a 30-year life. After ten years, the utility has recovered $30 million through rates, while earning a return on the unrecovered amount. If the government then frees customers to buy from others, is there a failure to provide “just compensation”? The answer depends, in part, on the market value of the asset. If the market value of the asset is only $45 million, while its book value (the unrecovered amount of the original cost) is $60 million, there is stranded cost of $15 million. Whether there is a constitutional right to recovery of that $15 million has never been decided by a federal court. What follows is the judicial guidance we have.6

B. Case Law Under the Takings Clause

The U.S. Supreme Court has held that the Takings Clause analysis must consider the “economic impact of the regulation on the claimant and, particularly, the extent to which the regulation has interfered with distinct investment-backed expectations.”7 The line of cases applying the Clause to public utilities establishes this principle: within some vaguely defined boundaries, utility investors enjoy no constitutional guarantee of stranded cost recovery.   Rather, government regulation can place a utility at risk of not recovering its prudent investment. But the judicial guidance is blurry, leading policy makers to make compromise calls that have survived judicial challenge. After describing four oft-cited cases, we will discuss the policy compromises made in the electricity and gas industries.

1. Charles River Bridge v Proprietors of Warren Bridge8

In this hoary dispute, the parties fought over the best ways to cross the Charles River in Massachusetts. First the facts, then the court’s reasoning.

First, the ferry: The Massachusetts Legislature allowed Harvard College to run a ferry service over the Charles River between Charlestown and Boston and to keep the profits from the operation.

Then, Bridge #1 (the Charles River Bridge): To make river crossing more convenient, the Legislature granted Thomas Russell a charter to build a bridge at the ferry’s location. The forty-year charter allowed the new company, The Proprietors of the Charles River Bridge, to charge tolls. During the forty years, the bridge owner would have to pay Harvard reasonable annual compensation for the income Harvard would have received from the ferry had the bridge not been built. After forty years the bridge would belong to the Commonwealth of Massachusetts. The bridge opened in 1786; its charter was later extended to seventy years.

Next, Bridge #2 (the Warren Bridge): In 1828, midway through the Charles River Bridge’s charter term, the Legislature chartered a second company, The Proprietors of the Warren Bridge, to build a second bridge nearby (about “fifty rods” away from the Charles River Bridge). This charter required the builders to turn the bridge over to the state after it recovered its costs, but no later than six years after beginning operation. After the state received ownership, it ended the tolls, making passage on the Warren Bridge free.

Then, the lawsuit: The Charles River Bridge owners sued the state, because the now-free Warren Bridge “destroyed” the value of their bridge, for which their charter was, they thought, exclusive and perpetual.

Finally, the decision: The Supreme Court found that plaintiff Charles River Bridge could prevail only by showing that the State had breached a contract.

It is well settled, by the decisions of this court, that a state law may be retrospective in its character, and may divest vested rights; and yet not violate the constitution of the United States, unless it also impairs the obligation of a contract. Here, there was no breach because the Charles Bridge charter never surrendered the Legislature’s continual power to do what is necessary to promote the happiness and prosperity of the community by which it [i.e., the government] is established.

Chartering a second bridge, even if doing so destroyed the value of the first one, was the government’s way of promoting the public good:

[I]n a country like ours, free, active and enterprising, continually advancing in numbers and wealth, new channels of communication are daily found necessary both for travel and trade; and are essential to the comfort, convenience and prosperity of the people.

If plaintiffs like Charles River Bridge could block legislative decisions like the Legislature’s Warren Bridge grant, public improvements would be impossible, with dire consequences:

[Y]ou will soon find the old turnpike corporations awakening from their sleep, and calling upon this court to put down the improvements which have taken their place. The millions of [dollars] which have been invested in railroads and canals, upon lines of travel which had been before occupied by turnpike corporations, will be put in jeopardy. We shall be thrown back to the improvements of the last century, and obliged to stand still, until the claims of the old turnpike corporations shall be satisfied; and they shall consent to permit these states to avail themselves of the lights of modern science, and to partake of the benefit of those improvements which are now adding to the wealth and prosperity, and the convenience and comfort, of every other part of the civilized world.9

2. Market Street Railway Co v Railroad Commission of California10

Market Street Railway operated streetcars and buses in and around San Francisco. Due to competition from municipal transportation companies and other transportation modes, the company was losing customers. The state commission lowered Market Street’s rates, finding that the lower fare (six cents) would stimulate traffic sufficiently to leave a six percent return on the rate base. The utility challenged the rate reduction as an unconstitutional denial of just compensation.

Upholding the rate, the Court explained that the Constitution has no sympathy for a company whose services are no longer needed:

[I]f there were no public regulation at all, this appellant would be a particularly ailing unit of a generally sick industry. The problem of reconciling the patron’s needs and the investor’s rights in an enterprise that has passed its zenith of opportunity and usefulness, whose investment already is impaired by economic forces, and whose earning possibilities are already invaded by competition from other forms of transportation, is quite a different problem. . . . The due process clause has been applied to prevent governmental destruction of existing economic values. It has not and cannot be applied to insure values or to restore values that have been lost by the operation of economic forces.11

The Court added:

Normally, a utility would be entitled to rates sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital and to enable the company to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risks assumed. But these assurances obviously are inapplicable to a company whose financial integrity already is hopelessly undermined, which could not attract capital on any possible rate, and where investors recognize as lost a part of what they have put in.12

3. Jersey Central Power & Light v Federal Energy Regulatory Commission13

After prudently spending $397 million on a nuclear plant, Jersey Central prudently abandoned the project. The utility then asked the Federal Energy Regulatory Commission (FERC) to approve higher wholesale rates to recover its costs. FERC applied its then-existing policy on prudent abandoned plant: recovery of, but not return on, the investment.14 FERC made its decision summarily, i.e., without a hearing into how it would affect the utility financially.

On review, the Court of Appeals for the District of Columbia Circuit voted 5-4 to return the case to FERC for a hearing on financial effects. The majority opinion first held that requiring utilities to absorb costs associated with prudent-but-unuseful investment did not inherently violate the Takings Clause. That finding is consistent with Market Street Railway and Charles River Bridge. But the majority also held that the utility must have a chance to show at hearing that the policy leaves it unable to maintain its financial integrity, a test required by Federal Power Commission v Hope Natural Gas.15

4. Duquesne Light Co v Barasch16

Anticipating demand growth, Duquesne began constructing a nuclear plant. When demand growth slowed, the utility changed its plan and stopped construction. The Pennsylvania Commission found the utility prudent throughout: its forecast of demand, its decision to build, its decision to choose nuclear, its decision to stop and all costs incurred in between—all prudent. But the Pennsylvania Legislature had passed a statute requiring the costs of abandoned plant to be absorbed by shareholders, because an abandoned plant was not “used and useful” to customers.17 Duquesne argued that the Takings Clause required recovery.

The U.S. Supreme Court disagreed, and upheld the statute. Pennsylvania was free to enact laws that put the risk of prudent-but-unlucky costs on shareholders. “[A] state scheme of utility regulation does not ‘take’ property simply because it disallows recovery of capital investments that are not ‘used and useful in service to the public.’” Further, applying the “end result” test required by Hope Natural Gas, the Court found the economic effect of disallowance (0.4 percent of the utility’s annual revenue requirement) non-confiscatory because it was so small.

An intervenor, the Pennsylvania Electric Association, separately argued that the Constitution necessarily requires recovery of prudent costs, regardless of their usefulness and regardless of the economic effect of a disallowance. That argument, if accepted by the Court, would have prohibited regulators from allocating to shareholders the risk of prudent but uneconomic outcomes. The Court rejected the argument as inconsistent with Hope:

We think that the adoption of any such rule would signal a retreat from 45 years of decisional law in this area which would be as unwarranted as it would be unsettling. Hope clearly held that “the Commission was not bound to the use of any single formula or combination of formulae in determining rates . . . .18

The Court thus reaffirmed a line of cases holding that that the Constitution does not insulate a utility from uneconomic outcomes, whether in the form of market forces, obsolescence or bad luck, even when the utility has acted prudently. 19 If an asset is not “used and useful,” the Constitution does not make customers pay.

Exception for explicit government promise: One Supreme Court decision did find a constitutional right to recovery of stranded cost. But it first found an explicit government promise that it deemed to be a contract. An 1877 state statute authorized the City of New Orleans, Louisiana to (a) establish a private corporation, New Orleans Waterworks Company; and (b) to grant that company an exclusive privilege, for 50 years, to supply the City and its residents with water, including building and installing any necessary infrastructure. The grant included an obligation to serve: to lay sufficient pipes and procure sufficient water “as the wants of the population required.” Under the law, after 50 years the City had a right to buy the physical plant; if the city did not, the grant would extend for another 50 years, but without any exclusive privilege. The statute also allowed the company to set its own rates, provided the “net profits should not exceed ten percent per annum.”

As authorized by the statute, the City granted the franchise to New Orleans Waterworks Company, which started service. But two years later, Louisianans added to their state constitution this provision: “[T]he monopoly features in the charter of any corporation now existing in the state, save such as may be contained in the charters of railroad companies, are hereby repealed.” Acting under this provision, the City eliminated Waterworks’s monopoly and authorized Robert C. Rivers to lay pipes under City streets to provide water to his hotel.

Waterworks sued to stop Rivers, and won. The City’s exclusive grant to Waterworks was a contract, which even a state constitution could not impair:

The permission given to [Rivers] by the city council to lay pipes in the streets for the purpose of conveying water to his hotel is plainly in derogation of the state’s grant to [Waterworks], for, if that body can accord such a use of the public ways to [Rivers], it may grant a like use to all other citizens and to corporations of every kind; thereby materially diminishing, if not destroying, the value of [Waterworks’] contract, upon the faith of which it has expended large sums of money, and rendered services to the public which might otherwise have been performed by the state or the city at the public expense.20

The City still could break Waterworks’ monopoly, but it would have to pay:

The rights and franchises which have become vested upon the faith of such contracts can be taken by the public, upon just compensation to the company, under the state’s power of eminent domain . . . . In that way the plighted faith of the public will be kept with those who have made large investments upon the assurance by the state that the contract with them will be performed.21

The U.S. Supreme Court thus viewed (a) a statutory promise of monopoly status as a contract, (b) the expectation created by the contract as a property right, and (c) the state constitution’s breach of that monopoly as a breach of contract, requiring compensation because of the damage to the property right. Note that the Court’s construction of the relationship as a contract was crucial to its finding of constitutional protection under the Takings Clause. The modern reality, though, is that the relationship between regulator and utility is not a contract. As a leading treatise states:

[C]ourts should not rule that the government has entered into a contract . . . unless it is clear that a governmental entity with authority to do so has contracted with the private party in a way that restricts the power of the government to act in the future. Governmental actions relating to the use of property or business activity normally will be regulatory and not contractual in nature. 22

* * *

Stranded cost refers solely to what economists call sunk costs—the costs previously incurred that the utility is unable to recover. The same circumstances that lead to stranded sunk cost also means the utility loses out on the relatively secure profit flow that came with those purchases by t hose captive customers.23 These two shareholder disappointments—unrecovered sunk costs and foregone future profits—are sometimes conflated into the term “stranded costs,” but they are different. Courts and commissions take seriously the former but not the latter. A closer look at the economics shows why. When the utility receives its unrecovered sunk costs, it can invest those dollars in any enterprise, earning therefrom the profit that it no longer earns from its formerly dependent customers. Were the government to award the unrecovered cost dollars plus lost profit dollars, the utility would receive the “foregone” profit twice: once through the government award and again through its investment of the compensation received.

II. Electricity and Gas: Three Decades of Applications

A. Elimination of exclusive retail franchises

When a state introduces retail competition into a market historically served by a franchised utility, the utility faces the classic stranded cost risk: unrecovered sunk costs, where the associated investment’s market value falls below book value. In the electricity context, examples of stranded cost categories are:

  1. generation-related assets;
  2. long-term purchase contracts for power or fuel;
  3. regulatory assets like deferred income tax liabilities;
  4. capitalized investments in some social programs that were made at the direction of a commission;24
  5. the unfunded portion of the utility’s projected nuclear generating plant decommissioning costs25; and
  6. costs of employee severance, retraining, early retirement, outplacement and related expenses, at reasonable levels, for employees who are affected by changes that occur as a result of the restructuring of the electric industry.26

The shareholders’ constitutional entitlement to these costs depends on the Penn Central test, i.e., whether the shareholders had “legitimate, investment-backed expectations” of recovery. Applying that test requires an inquiry into the nature of the franchise relationship. An exclusive retail franchise arises when the state (a) defines a geographic area, (b) prohibits retail competition within that area, and (c) appoints a company to be the sole seller within that area of services mandated by the state. In that situation, a shareholder can legitimately expect that its obligation to invest will be matched by a customer obligation to pay.27 But while the term “exclusive” sounds absolute, it is in fact a theme with variations. Statutes or case law can leave openings for competitive entry, or customer self-service, thus signaling that utility investments are at risk, i.e., undermining any shareholder expectation of full stranded cost recovery. Consider two examples:

1. Inadequate service:

In the early 1980s, Maine, a public utility’s service territory could be invaded by a non-incumbents on a showing that the incumbent’s service was inadequate. When a non-incumbent telephone company offered discounted, low-quality phone service (customers would have to dial extra numbers and sometimes wait for a line), the Maine Public Utilities Commission allowed it to compete within the incumbent utility’s formerly exclusive territory. The Maine Supreme Judicial Court upheld the Commission:

[I]nsofar as inadequacy of existing service may be a factor relevant to the granting of a certificate of public convenience and necessity, the finding of a public need for an additional type of service not being currently provided is in itself a finding that the existing service is inadequate.

. . .

[W]e believe it fair to assume that the public always desires (and, therefore, there is a public need for) comparable service at lower costs.28

2. No exclusivity:

During the 1930s, the U.S. Government loaned money to municipalities to construct electric distribution systems within areas already served by an investor-owned utility. Each loan would be secured by the municipality’s revenues from retail power sales. Alabama Power, an investor-owned utility, sued the U.S. Government, arguing that the new municipal systems would invade its service territory. The U.S. Supreme Court found no constitutional injury:

[T]he mere fact that [Alabama Power] will sustain financial loss by reason of the lawful competition does not equal a constitutional violation. Since the utility had no exclusive franchise, [i]f its business be curtailed or destroyed by the operations of the municipalities, it will be by lawful competition from which no legal wrong results . . . . What [the utility] anticipates, we emphasize, is damage to something it does not possess—namely, a right to be immune from lawful municipal competition.29

Given the lack of case law clarity, and the need to smooth the political path to retail competition, retail electricity competition statutes in the U.S. typically offered utilities a chance to recover stranded costs.30 The recovery mechanism was usually a non-bypassable charge attached to the still-monopoly service of physical distribution. By requiring all customers of physical distribution service to pay their pro rata share of legacy costs, this device ensured that a customer’s decision whether to shop the market or stay with the incumbent would focus on prospective facts rather than past costs,31 thereby avoiding “uneconomic bypass.”32

B. Unbundling of electric transmission service from wholesale sales

Investor-owned utilities make most of their sales to retail customers, but they also have wholesale customers, often small companies owned by municipalities or rural cooperatives. Prior to the era of open transmission access, those wholesale customers that were distribution-only entities (i.e., entities that owned no generation or transmission) depended on their local investor-owned utility for wholesale power supply. The utility would provide that wholesale supply from its own generation or through purchases from third parties.

Then came FERC’s Order No. 888. This 1996 issuance required transmission-owning, investor-owned public utilities to provide transmission service to eligible customers, including these transmission-dependent, municipal or cooperative systems that historically had depended on the investor-owned utility for generation supply.33 Order No. 888 freed them to shop for generation from alternative suppliers. Their shopping decisions, FERC found, could leave their legacy utility supplier with unrecovered generation costs, incurred prior to Order No. 888 on the assumption that the customers would remain dependent. FERC therefore invited the utilities to apply for extra-contractual recovery of stranded costs associated with certain pre-existing wholesale contracts, if the costs were “legitimate, prudent and verifiable.” (Why was this recovery extra-contractual? A dependent customer’s contract obligation might require purchases for only, say, 11 years. But the utility might be amortizing its generation costs over 30 years, based on its reasonable expectation that the customer would renew its contract—because it had no access to alternative supplies—and thus pay off the generation costs over the remaining 19 years.) FERC justified this extra-contractual recovery on the grounds that the incumbent utilities could not have foreseen that the Commission would require them to “alter the use of their transmission systems in response to the fundamental changes that are taking place in the industry.” FERC did caution that its offer of extra-contractual recovery will not “insulate a utility from the normal risks of competition, such as self-generation, cogeneration, or industrial plant closure, that do not arise from the new availability of non-discriminatory open access transmission.”34

C. Unbundling of gas transportation service from wholesale sales

Prior to the 1980s, a local distribution company (LDC) typically depended on a single interstate pipeline for supply, because (a) the pipeline bundled gas supply with transportation service, and (b) the LDC did not have physical and economic access to alternative pipelines. To serve their dependent LDCs, pipelines bought gas from producers under long-term contracts. In Order Nos. 43635 and 636,36 FERC encouraged (Order 436) and then ordered (Order 636) pipelines to unbundle transportation service from wholesale sales. These actions freed LDCs to buy gas directly from producers. This change in market structure left the pipelines with existing long-term obligations to buy gas from producers, but no assured LDC customers who would pay for that gas. The resulting stranded costs took two forms: stranded assets and take-or-pay liabilities.

Stranded assets: The pipeline industry’s stranded assets, as defined by FERC, included upstream pipeline capacity for which a downstream pipeline could not find a buyer, plus storage capacity that a pipeline no longer will need when its sales volume shrinks.37 FERC allowed pipelines to recover the costs of these stranded assets, if the costs were prudently incurred but no longer used and useful.38 Costs are stranded only if book value exceeds market value. The pipelines therefore had to net positive values against negative values:

[T]o the extent that [a pipeline] recognizes gains on sales of stranded facilities and later has losses on sales of facilities that it seeks to recover as stranded costs, [the pipeline must, if it files for recovery of stranded costs,] detail the prior gains and reduce the proposed stranded-cost recovery amount by the amount of those gains.39

FERC then gave the pipelines two paths to compensation: “spin-off” or “write-down.” If the pipeline spun off its asset (i.e., transferred ownership to its shareholders), it could apply for stranded cost treatment for any amounts below the book value of the facilities it received. These amounts would, of course, be offset by any amounts received in excess of book value.40 If the pipeline retained ownership, it could write down the asset’s value to an “economically viable level” (meaning a level reflecting market value), and then “propose [for recovery from customers] the difference between the net depreciated original cost of the plant and the lower market value, as a stranded cost.” The pipeline could recover “this written down amount over a reasonable period of time, such as five years.” Finally, consistent with its policy on abandoned plants (see the discussion of Jersey Central, Part I.B.3 above), FERC would allow recovery of, but not a return on, the stranded cost: “A rate of return on the amount of written down facilities would be inappropriate since this allows a return on facilities that are not economically viable, and may also result in a competitive advantage for the pipeline.”41

Take-or-pay costs: The gas transition involved billions in take-or-pay costs—pipelines’ obligations, entered into prior to unbundling, to pay producers for gas the pipelines needed to serve their dependent LDC customers:

Take-or-pay costs are incurred when a pipeline, in order to maintain inventories for its sales customers, enters into a contract with the producer in which it promises either to take or to pay for the gas it has contracted to buy. Pipelines that have built up such inventories find them hard to sell once they have granted access to the pipeline to carry the gas of their competitors; as a result, they are hit with billions of dollars of costs.42

FERC required the LDCs to bear part of these costs, a decision the Court of Appeals for the D.C. Circuit upheld as “an acceptable cost-spreading decision requiring those who benefit from the transition to a competitive natural gas market to absorb some of the costs.”43

III. Traditional Approaches vs. Modern Responses

A. Traditional approach: After-the-fact discretion, subject to constitutional constraints

The line of cases addressing stranded cost has, by definition, dealt with costs after they have been incurred. The foregoing discussion has demonstrated the breadth of regulatory authority over these costs—authority granted by traditional statutes as interpreted by the courts. As required by the Supreme Court’s opinions in Hope and Barasch, the courts have declined to reject or anoint any specific rule. They look instead at whether the regulator’s decision is “based on substantial evidence and . . . adequately balances the interests of investors and ratepayers.”44 The results range from no recovery to full recovery, with various points in between.

No recovery, no return: A pipeline spent $13 million on unsuccessful synthetic gas supply projects. FERC disallowed both amortization and return. Upholding FERC, the Court of Appeals distinguished between imprudence and bad luck: “[T]he problem of risk allocation in this case is not a problem of fault. . . . The Natural Gas Act simply does not guarantee the shareholders of even a prudently managed utility that ratepayers can always be stuck with the bill for supply projects that turn out to be total failures, however praiseworthy the utility’s motives for undertaking those projects may have been.” The court cited a prior FERC decision holding that to be included in rate base (and thus to earn a return), “expenditures must satisfy not only the necessary condition of prudent investment but must also be ‘used and useful’ in providing service.”45

Amortization but no return: FERC’s decisions to unbundle pipeline transportation service from pipeline gas sales left the pipelines with stranded costs. State commissions argued that because the costs were not “used and useful,” the Natural Gas Act bars their recovery from customers. The Court of Appeals disagreed, describing a middle ground: The Act allowed FERC to remove non-used-and-useful assets from rate base (where they would have earned a profit) but allow recovery of the cost through amortization expense. Granting a profit on non-used-and-useful facilities “would be inappropriate since this allows a return on facilities that are not economically viable, and may also result in a competitive advantage for the pipeline.” But allowing cost amortization “will keep the pipeline whole for the direct cost of its investment in the facilities. . . . Investor interests have not, therefore, been entirely ignored.”46

Full recovery and return: The Court of Appeals also has said that the Commission “might also allow the pipeline to recover not only the amortization, but also interest, i.e., the ‘cost’ of the unamortized portion of the investment. The Commission could further decide to include stranded investments in the utility’s rate base and thereby generate a profit for investors.”47

This broad discretion is, however, subject to constraints. Here are the main ones:

Honour legitimate shareholder expectations: When commissions allocate the risk of prudent but uneconomic outcomes, they must do so clearly and consistently over the life of an investment. If the commission commits, pre-investment, to full recovery of prudent costs regardless of the outcome, it must honour that commitment when setting rates. Failure to do so risks reversal under state law (“arbitrary and capricious” decision making) or the U.S. Constitution (undermining “distinct, investment-backed expectations” created by the prior regulatory commitment).48 As the Barasch Court warned:

The risks a utility faces are in large part defined by the rate methodology because utilities are virtually always public monopolies dealing in an essential service, and so relatively immune to the usual market risks. Consequently, a State’s decision to arbitrarily switch back and forth between methodologies in a way which required investors to bear the risk of bad investments at some times while denying them the benefit of good investments at others would raise serious constitutional questions.49

Reflect shareholder risks in the authorized return on equity: Investors legitimately expect higher returns for higher risks. A commission that assigns to shareholders the risk of prudent but uneconomic outcomes must compensate for that risk when it determines the authorized return on equity.50

Allow for “lumpiness”: A new investment will rarely match existing demand perfectly. Major capacity additions come on line in lumps that create surplus. To treat this surplus automatically as not used and useful, and then deny recovery and return, ignores physical reality. As the Wisconsin Supreme Court declared:

[A] public utility, being required to provide service when and as demanded by the public, must have some latitude with respect to plant management; . . . in determining the rate base, property should not be excluded merely because at the moment it is not in actual service. We held that the commission could not construct a hypothetical plant which would theoretically render equivalent service and on that basis hold that any portion of the existing property was excess.51

B. Modern Responses: Assigning Responsibility and Risk Upfront

From statutes and case law, the main message is that regulators have flexibility. But regulatory flexibility can create investment uncertainty, which leads to increases in the utility’s cost of capital. To address this problem, a range of solutions exists. These can be placed into two main categories: solutions that assign responsibility for known costs, i.e., costs that have occurred or will occur; and solutions that allocate the risk of unanticipated costs.

Assigning responsibility for known costs: Commissions can calculate a customer’s pro rata share of the utility’s book costs, and then require the customer to pay that cost on departure—either in a lump sum, or as an adder to the customer’s continuing purchases of whatever monopoly service the customer still needs. A related measure is “decoupling.” In the U.S., most rates have a fixed customer charge that recovers only per-customer costs; most of the utility’s fixed costs are recovered through a per-kWh rate—a variable charge. This practice creates unnecessary tension between two non-debatable goals: using less energy, and providing the utility a reasonable opportunity to recover, and earn a return on, its prudent fixed costs. Recognizing the conflict, some states have introduced “decoupling”: insulating fixed charge recovery from variable sales. One approach is to remove all fixed costs from the variable charge and placing them in a fixed charge. The principle is simple: If the customer wants the utility to stand ready to serve, the customer must bear the costs that support the utility’s readiness to serve.

Allocating the risks of unanticipated costs: Some state legislatures have authorized their commissions to insulate shareholders from certain risks. These commissions have the power to issue pre-investment orders that commit ratepayers to cost recovery for specified major capital investments. Each of the situations is distinct from the traditional approach, which is to defer decisions about recovery, and actual recovery, until the plant is used and useful, i.e., operating for the customers. Here are four examples:

  1. Indiana’s Environmental Compliance Plan Pre-Approval Act authorizes the Commission to approve a utility’s costs in advance, if those costs support an Environmental Compliance Plan that “constitutes a reasonable and least cost strategy over the life of the investment consistent with providing reliable, efficient and economical electric service.” The Commission can also limit rate challenges to utility-incurred costs to issues of fraud, concealment or gross mismanagement.52
  2. A Florida statute authorizes cost recovery, prior to a plant’s commercial operation, for the siting, design, licensing and construction of electric generating plants based on either nuclear or integrated gasification combined cycle power technologies.53
  3. A North Carolina statute authorizes recovery, before a plant’s commercial operation, of “project development” costs for nuclear plants, subject to certain conditions on types and timing of activities. Eligible activities include (but are not limited to) “evaluation, design, engineering, environmental analysis and permitting, early site permitting, combined operating license permitting, and initial site preparation costs.”54
  4. Mississippi’s Baseload Act authorizes the Commission to allow recovery, prior to a plant’s commercial operation, of all or some of prudent costs (both pre-construction and construction) associated with a baseload electricity plant. The statute also authorizes periodic Commission reviews and approvals of construction prudence, to reduce further the uncertainty associated with future cost recovery.55

Conclusion

Stranded cost situations always combine two key facts: prudent investments, and post-investment circumstances not anticipated at the time of the investment. Those factual developments can be reductions in demand, increase in input costs, obsolescence, and changes in regulatory policy. The question is always: When prudent actions produce uneconomic outcomes, who bears the unrecovered costs: shareholders or customers? Readers hoping for clear “dos” and “don’ts” will be disappointed; those hoping for broad regulatory discretion will be pleased. The consistent principle is this: Regulators have a range of options, from full recovery plus profit, to no recovery and no profit, and all points in between. What matters, constitutionally, is honoring shareholders’ legitimate expectations—as those expectations are influenced by regulatory actions made clear in advance.

  1. Scott Hempling is an attorney and expert witness, he has advised regulatory and legislative bodies throughout North America, and is a frequent speaker at international conferences. Hempling is an adjunct professor at Georgetown University Law Center, where he teaches courses on public utility law and regulatory litigation. His book, Regulating Public Utility Performance: The Law of Market Structure, Pricing and Jurisdiction, from which portions of this article are drawn, was published by the American Bar Association in 2013. He has also authored a book of essays on the art of regulation, Preside or Lead? The Attributes and Actions of Effective Regulators. Hempling received a B.A. cum laude from Yale University in (1) Economics and Political Science and (2) Music, and a J.D. magna cum laude from Georgetown University Law Center. More detail is at www.scotthemplinglaw.com.
  2. Fully allocated cost, sometimes called “fully distributed cost,” refers to rates designed to recover all costs of production, both variable and fixed.
  3. Book cost is original cost of an asset less accumulated depreciation. Accumulated depreciation is the amount already recovered from customers through the depreciation expense included in the utility’s annual revenue requirement.
  4. US Const amend V.
  5. Missouri ex rel Southwestern Bell Telephone Co v Public Service Commission, 262 US 276, 290 (1923) (Brandeis, J., concurring).
  6. This discussion has assumed that the market value will be less than the book value, leading to stranded cost. But the opposite is also possible, producing what is sometimes called “stranded benefits.” On the day competition begins, the utility might be sitting on a gold mine: a well-running, book-depreciated nuclear plant in a capacity-short region with high market prices. Shareholders then would have no constitutional concern. There would be, however, a statutory question: Who, as between shareholders and customers, should receive the excess of market value over book value? Commissions have decided this question in a variety of ways, from providing that full gain to the ratepayers, to letting shareholders keep the gain fully, to sharing the gain between shareholders and ratepayers. As this article is about stranded cost, we will not address the “gain” example further. For a discussionof treatment of the gain, see Scott Hempling, Regulating Public Utility Performance: The Law of Market Structure, Pricing and Jurisdiction at Chapter 6.C.3.b (American Bar Association 2013).
  7. Penn Central Transportation Co v New York, 438 US 104, 124 (1978).
  8. Charles River Bridge v Proprietors of Warren Bridge, 36 US 420 (1837) [Charles River Bridge].
  9. Ibid at 551-553.
  10. Market Street Railway Co v Railway Commission of California, 324 US 548 (1945) [Market Street Railway].
  11. Ibid at 548, 554, 557, 567. By the Due Process Clause, the Court means the Fourteenth Amendment, which provides in relevant part: “Nor shall any State deprive any person of life, liberty, or property, without due process of law. . . .” The Fourteenth Amendment clause applies the Fifth Amendment’s Takings Clause to the states.
  12. Market Street Railway, supra note 10 at 566 (quoting Hope Natural Gas v Fed. Power Comm’n, 320 US 591, 603 (1944)).
  13. Jersey Central Power v Federal Energy Regulatory Commission, 810 F.2d 1168 (DC Cir 1987).
  14. This approach split the pain roughly 50/50 between shareholders and ratepayers. FERC announced this sharing policy in New England Power Co, 8 FERC 6 61,054 (1979), aff’d sub nom. NEPCO Mun Rate Comm’n v FERC, 668 F.2d 1327 (DC Cir 1981) (1982).
  15. Federal Power Commission v Hope, 320 US 591 (1944). In Hope, the Court emphasized the utility investor’s constitutionally protected interest in the utility’s “financial integrity.” Financial integrity requires “enough revenue not only for operating expenses but also for the capital costs of the business.” The capital costs, in turn, “include service on the debt and dividends on the stock.”   The equity owner’s return, further, “should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital.” Ibid at 603.
  16. Duquesne Light Co v Barasch, 488 US 299 (1989) [Duquesne].
  17. 66 Pa Cons Stat § 1315.
  18. Duquesne, supra note 16 at 315 (citing FPC v Hope Natural Gas, 320 US at 602).
  19. See Denver Union Stock Yard Co v United States, 304 US 470 at 475 (1938) (upholding Agriculture Secretary’s exclusion from rate base of “land and improvements used for a stock show and for trackage and facilities for unloading and loading livestock” because they were not “used and useful” for the regulated service); and Market Street Railway, supra note 10.
  20. New Orleans Waterworks Co v Rivers, 115 US 674 at 682-83 (1885).
  21. New Orleans Gas Co v La Light Co, 115 US 650 at 673 (1885).
  22. Ronald D Rotunda, et al, Treatise on Constitutional Law: Substance and Procedure 2d ed (St Paul, Minn: West Pun Co, 1986) § 15.8, at 103 n74. See also Parker v Wakelin, 937 F. Supp 46 at 52 (D Me 1996) (quoting Nat’l Railroad Passenger Corp v Atchison, Topeka & Santa Fe Railway Co, 470 US 451 at 465–466 (1985) (“Analysis of this question must begin with the well-established proposition that absent some clear indication that the legislature intends to bind itself contractually, the presumption is that a law is not intended to create private contractual or vested rights but merely declares a policy to be pursued until the legislature shall ordain otherwise.”) (internal quotations omitted).
  23. I use the term “relatively secure” because traditional cost-based ratemaking does not guarantee a profit; it provides only a reasonable opportunity to earn a fair profit. See Scott Hempling, Regulating Public Utility Performance: The Law of Market Structure, Pricing and Jurisdiction (American Bar Association, 2013) at Chapter 6.B.
  24. Congressional Budget Office, Electric Utilities: Deregulation and Stranded Costs (1998), online: <https://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/9xx/doc976/stranded.pdf>.
  25. 66 Pa Con Stat § 2808(c)(1).
  26. Ibid § 2803.
  27. See, e.g., this South Dakota statute, SD Codified Laws § 49-34A-42:
    Each electric utility has the exclusive right to provide electric service at retail at each and every location where it is serving a customer as of March 21, 1975, and to each and every present and future customer in its assigned service area.
  28. Standish Tel Co v Pub Util Comm’n, 499 A.2d 458, 459-64 (Me 1985).
  29. Alabama Power Co v Ickes, 302 US 464 at 478 (1938); See also Tennessee Electric Power Co v Tennessee Valley Authority, 306 US 118 at139 (1939) (rejecting utility’s claim that TVA’s entry into their territory violated the Fifth Amendment’s Takings Clause. Absent express language granting perpetual exclusivity, the utility’s existing franchises “confer[red] no contractual or property right to be free of competition either from individuals, other public utility corporations, or the state or municipality granting the franchise”).
  30. See, e.g., 66 Pa Consolidated Stat § 2804(13) (“[T]he commission has the power and duty to approve a competitive transition charge [for the recovery of transition] or stranded costs it determines to be just and reasonable to recover from ratepayers”).
  31. See, e.g., Del Code tit 26 § 1010 (authorizing commission to impose a nonbypassable charge, so as to protect standard offer customers “from substantial migration away from standard offer service, whereupon they may be forced to share too great a share of the cost of the fixed assets that are necessary to serve them”).
  32. Uneconomic bypass occurs when the self-generating customer’s total incremental cost (the one-time cost of building the plant, plus the operating costs) is (a) less than the total rate it pays the utility, making it a positive move for the customer; but (b) greater than the utility’s marginal costs (i.e., the cost of producing one more unit of energy), making it a negative result for society. Uneconomic bypass wastes society’s resources by increasing “the total industry costs of providing a given level of service.” J. Gregory Sidak & Daniel F. Spulber, Deregulatory Takings and the Regulatory Contract (Cambridge, UK: Cambridge University Press,1998) at 78; see also ibid at 30–31 (discussing uneconomic bypass).
  33. Promoting Wholesale Competition Through Open Access Non-Discriminatory Transmission Services by Public Utilities, Recovery of Stranded Costs by Public Utilities and Transmitting Utilities, Order No 888, 75 FERC ¶ 61,080 (1996), order on reh’g, Order No 888-A, 78 FERC ¶ 61,220, order on reh’g, Order No 888-B, 81 FERC ¶ 61,248 (1997), order on reh’g, Order No 888-C, 82 FERC ¶ 61,046 (1998), aff’d in relevant part sub nom Transmission Access Policy Study Group v FERC, 225 F.3d 667 (DC Cir 2000), aff’d sub nom New York v FERC, 535 US 1 (2002).
  34. Order No 888, 75 FERC ¶ 61,080 at text accompanying notes 581-588.
  35. Regulation of Natural Gas Pipelines After Partial Wellhead Decontrol, Order No 436, 125 FERC ¶ 61,190, order on reh’g, Order No 436-A, 33 FERC ¶ 61,448 (1985), order on reh’g, Order No 436- B, 34 FERC ¶ 61,204, order on reh’g, Order No 436-C, 34 FERC ¶ 61,404, order on reh’g, Order No 436-D, 34 FERC ¶ 61,405, order on reh’g, Order No 436-E, 34 FERC ¶ 61,403 (1986), vacated and remanded sub nom Associated Gas Distributors v FERC, 824 F.2d 981 (DC Cir 1987), cert. denied, 485 US 1006 (1988).
  36. Pipeline Service Obligations and Revisions to Regulations Governing Self-Implementing Transportation; and Regulation of Natural Gas Pipelines After Partial Wellhead Decontrol, Order No 636, 59 FERC ¶ 61,030, order on reh’g, Order No 636-A, 60 FERC ¶ 61,102, on reh’g, Order No 636-B, 61 FERC ¶ 61,272 (1992), reh’g denied, Notice of Denial of Rehearing, 62 FERC ¶ 61,007 (1993), aff’d in part and remanded in part sub nom. United Distribution Co v FERC, 88 F.3d 1105 (DC Cir 1996), cert denied sub nom Associated Gas Distribs v FERC, 520 US 1224 (1997).
  37. See United Distribution Cos v FERC, 88 F.3d 1105, 1178 (DC Cir 1996); see also Order No 636, 59 FERC ¶ 61,030 at text accompanying n.281 (describing stranded assets as “[c]osts of a pipeline’s assets [historically] used to provide bundled sales service, such as gas in storage, and capacity on upstream pipelines, that cannot be directly assigned to customers of the unbundled services”).
  38. United Distribution, supra note 37; see also Order No 636-B, 61 FERC ¶ 62,272, at p 62,041.
  39. Trunkline Gas Co, 95 FERC ¶ 61,337, at p 62,241 (2001).
  40. National Fuel Gas Supply Corp, 71 FERC ¶ 61,031, at p 61,138 (1995).
  41. Ibid.
  42. Pub Util Comm’n of Cal v FERC, 988 F.2d 154, 157, 166 (DC Cir 1993).
  43. Ibid at 169; see also Associated Gas Distribs v FERC, 824 F.2d 981, 1027 (DC Cir 1987) (upholding stranded cost recovery because pipelines were “caught in an unusual transition” due to regulatory changes beyond their control, having “entered into the now uneconomic contracts in an era when government officials berated pipeline management for failures of supply and constantly predicted continuing energy price escalations”).
  44. United Distrib Cos, supra note 37; See also Permian Basin Area Rate Cases, 390 US at 792 (“Judicial review of the Commission’s orders will therefore function accurately and efficaciously only if the Commission indicates fully and carefully the methods by which, and the purposes for which, it has chosen to act, as well as its assessment of the consequences of its order for the character and future development of the industry.”).
  45. Natural Gas Pipeline of America v FERC, 765 F.2d 1155, 1163-1164 (DC Cir 1985) (citing Transcontinental Gas Pipe Line Corp, 58 FPC 2038 (1977), aff’d in relevant part and remanded on other grounds sub nom Tenn Gas Pipeline Co v FERC, 606 F.2d 1094 (DC Cir 1979)).
  46. United Distrib Cos v FERC, 88 F.3d 1105, 1179-1180 (DC Cir 1996) (quoting Equitrans Inc, 64 FERC ¶ 61,374, at p 63,601 (1993), National Fuel Gas Supply Corp, 71 FERC ¶ 61,031, at p 61,138 (1995), and Jersey Cent. Power & Light Co v FERC, 810 F.2d at 1192 (Starr, J, concurring)). See also NEPCO Mun Rate Comm v FERC, 668 F.2d 1327, 1333 (DC Cir 1981) (holding that “FERC’s refusal to include project expenditures in the rate base, while allowing their recovery as costs over time, is a valid approach to allocating the risks of project cancellation”).
  47. United Distrib Cos v FERC, supra note 32 at 1179.
  48. See Penn Cent Transp Co v New York, 438 US at 124 (Takings Clause analysis must consider the “economic impact of the regulation on the claimant and, particularly, the extent to which the regulation has interfered with distinct investment-backed expectations”).
  49. Duquesne Light Co v Barasch, supra note 16 at 315. See also Verizon Commc’ns Inc v FCC, 535 US at 527 (“[T]here may be a taking challenge distinct from a plain-vanilla objection to arbitrary or capricious agency action if a rate making body were to make opportunistic changes in rate setting methodologies just to minimize return on capital investment in a utility enterprise”).
  50. See, e.g., Duquesne Light Co v Barasch, supra note 16 at 312 (Pennsylvania’s statute “slightly increases the overall risk of investments in utilities over the pure prudent investment rule. Presumably the PUC adjusts the risk premium element of the rate of return on equity accordingly”). See also Scott Hempling, “Riders, Trackers, Surcharges, Pre-Approvals and Decoupling: How Do They Affect the Cost of Equity?” (January 2012) online: ElectrcityPolicy.com <http://www.scotthemplinglaw.com/files/pdf/ppr_riders_oge_hempling112711.pdf>.
  51. Milwaukee & Suburban Transp Corp v Pub Serv Comm’n of Wisconsin, 108 NW2d 729, 733-734 (Wis 1961) (reversing commission disallowance of costs of “shops and yards” rendered unused due to conversion of transportation system from streetcars to trackless trolleys and buses) (citing Wisconsin Telephone Co v Public Service Comm’n of Wis, 287 NW 122 at 158 (Wis 1939)).
  52. Ind Code § 8-1-27-8(1)(B).
  53. Fla Stat § 366.93.
  54. NC Gen Stat § 62-110.7.
  55. Miss Code Ann § 77-3-105. For additional discussion of regulatory issues associated with “preapproval,” see Scott Hempling and Scott Strauss, Pre-Approval Commitments: When and Under what Conditions Should Regulators Commit Ratepayer Dollars to Utility-Proposed Capital Projects? (2008), National Regulatory Research Institute, online: NRRI <http://nrri.org/pubs/electricity/ nrri_preapproval_commitments_08-12.pdf>.

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