Determining stranded costs—constitutionally

GUEST EDITORIAL

Craig G. Goodman,

Esq.

Determinin g Stranded Costs~onstitutionallv

J

t is nearly a decade and a half

tory compact,” which has been

ever, an equally valid argument

since the Federal Energy

the cornerstone of regulated util-

exists that the tax code is the ulti-

Regulatory Commission first or-

ity economics. This article pre-

mate regulatory compact between

I

dered competition on the inter-

sents a novel method by which to

government and industry and

state gas transmission lines, yet

determine the amount of unrecov-

that it governs all investment cost

only the largest consumers of

ered capital at issue when a utility

recoveries, economic or not. This

natural gas have benefited from

asset is claimed to be “stranded.”

multi-trillion dollar regulatory

deregulation. Approximately 85

Once stranded costs, if any, are

compact has been changed often

to 90 percent of all customers

properly defined and measured,

over the last 15 years.

have no choice from whom they

only then can an intelligent dis-

purchase natural gas (or electric-

course on the proper vehicle(s) for

ity) or at what price.

stranded cost recoveries begin.

Customer choice and price competition can create enormous social

Until retail energy markets are open for competition, estimates

The Tax Code Is a Constitutionally Valid Measure of Stranded Costs Because utilities would likely

wealth and increase both produc-

on what will be uneconomic in a

challenge for many years any ap-

tivity and competitiveness. Ironi-

competitive market are highly

proach that ignored their

cally, the most important policy issue that may either facilitate, delay

speculative and possibly meaningless. Only after markets are open,

stranded cost claims as an uncon-

or distort the future benefits of cus-

stranded costs mitigated and as-

compensation, there is merit in fo-

tomer choice and competition is

sets competitively priced can the

cusing the federal policy debate

rooted in the past: development of

investment in plant and equip-

on what is “just compensation.”

a simple, fair, accurate and work-

ment that remains truly unrecov-

While many doubt that denial of

able way to identify, measure and

ered be measured properly and

stranded cost recoveries would

recover stranded costs.

recovery mechanisms designed.

necessarily constitute an unconsti-

had a rather limited focus regard-

Before regulators force consumers to purchase uneconomic utility in-

lay in restructuring would be det-

ing the basic tenets of the “regula-

vestments by imposing transition

rimental to many public interests.

Until now, policymakers have

charges of $100 to $200 billion on electricity bills, it would be pruCraig G. Goodman is senior vice president of law, regulation and public policy for Equitable Resources, Inc. Mr. Goodman served as Director ofOil Policy and the Ofice of Energy Tax Policy during the Reagan and Bush Administrations. He also was vice president for regulatory and government aflairsfor Mitchell Energy and Development Corp.

88

stitutional taking without just

tutional taking, the resulting de-

M

any valid arguments-legal, constitutional, equita-

dent to consider other stranded

ble and political--support

cost measurement and recovery

the excess of the tax basis ofun asset

options.

over its competitive

using

market value as

Utilities argue that there is an

the maximum amount of invest-

immutable “regulatory compact”

ment in plant that can be deemed

which guarantees recovery of uneconomic investments and a return on such investments. How-

See Editorial, page 86.

The Electricity Journal

From Editorial, page 88.

tax liabilities. If the sale of worth-

The Tax Code Can Speed

less “stranded” assets can result

Stranded Cost Recovery

in substantial profits and tax liabilto be unrecovered by utility share-

ity, this should clearly force a de-

holders (“stranded”) in a competi-

bate in the federal legislative re-

tive environment.’ This should be

structuring process as to whether

the definition of the amount of

the tax basis or regulatory book

stranded costs that is recoverable

basis of these assets should be

under federal restructuring legis-

used to define the amount of

lation, in the event one is per-

plant that is truly stranded.

suaded by a constitutional taking argumenL2

From an efficiency standpoint, the tax code is designed to place

From a legal and constitutional

the maximum motivation on all

perspective, the U.S. income tax

companies to become as profit-

code was designed to measure the

able as possible, in order to speed

amount of investment in plant and

investment cost recoveries. Impor-

equipment that is recovered (and

torting competitiveness.

U

nlike the imposition of new regressive energy taxes, the

tax code contains several low-cost options for competitively-neutral stranded cost recovery. Each represents an efficient, fair and politi-

market.

way of obsolescence or diminished market value, so as to constitution-

’

ally guarantee that all companies

equipment, federal restructuring legislation should define the maxi-

tal,” is constitutionally subject to “income” taxation. ince the incident at Three SM ile Island, the tax code has permitted utility shareholders to recover stranded costs by way of both accelerated depreciation and investment tax credits. Consequently, it is very likely that assets that are tmly stranded have a significantly lower cost-basis remaining on tax records reported to both shareholders and the IRS than the cost basis which is shown on financial books and used for PUC ratemaking purposes. If this is true, then divestiture of so-called stranded assets could re-

1.Permit expense treatment for diminished value of uneconomic

assets. As with obsolete plant and

is

because only “income,” not “capi-

86

nificant drag on the economy, dis-

tioning to a competitive energy

ments that are tmly stranded by

capital gains taxes and deferred

regressive and would place a sig-

nomic assets as the price for transi-

cry mechanism for capital invest-

sult in utilities owing significant

ies are on energy, non-bypassable,

geographical area to pay for uneco-

was designed to provide a recov-

0fcapitdThis

gress several years ago. Both lev-

ing consumers within a small

come generation. The tax code also

afi4Zlretwn

with the Btu tax rejected by Con-

tally at&-active alternative to forc-

recoverable) in the course of in-

receive

It is hard to ignore the striking similarity of transition charges

mum amount of stranded costs as tantly, it places an even greater

the amount by which the tax basis

motivation on companies with

of utility assets exceeds market

“stranded costs” to become as

value. Federal law could permit

competitive as possible, as

immediate expensing of this de-

quickly as possible. When Ford

fined amount for those portions

builds an Edsel, it has the oppor-

of assets state regulators deter-

tunity to recover its investment in

mine are stranded in a competi-

the Edsel plant only in the tax

tive market.” This very low cost

code. Even though there are only

policy option also would moti-

three auto-makers in the country,

vate significant efficiencies.

there is no commission to raise the price of cars to ensure Ford recovers its investment. Recovering amounts in excess

Federal law would define stranded costs, thereby setting a ’ uniform national standard for

capital cost recoveries that is con-

of the tax basis up front, before

sistent with 85 years of federal tax

the market is truly competitive,

policy and constitutional law

significantly compounds the in-

without preempting state PUC ju-

equitable, regressive, Btu-tax-like

risdiction. Investment costs that

impacts of stranded cost recovery.

remain truly unrecovered by utilThe Electricity Journal

ity shareholders would be passed

fined and measured, significant

along into the economy in the

economic rents will continue to be

most uniform and equitable man-

captured, the smallest consumers

ner possible, over the largest base

will fail to be served and the pub-

possible.

lic interest easily will be confused

2. Allow Tax Credits for Uneconomic Investments Defined as ‘Stranded.’ This option is more

ated depreciation of $20 per year, then the tax basis of the asset after three years

’ would be $40 and the book basis would be $70. If, because of competition, the plant only produces half the revenues generated before competition, the asset may

with shareholder cost recovery is-

have a reduced fair market value of $50.

sues.

The utility would argue that it has a

There are significant constitu-

costly and politically charged

tional, legal, political, policy and

stranded cost of $20, because the asset has a regulatory book basis of $70 and was sold or had a fair market value of $50.

than expensing. Utilities argue

economic reasons why the in-

that tax deductions are only

come tax code is an appropriate

would have $10 in capital gains plus de-

worth $0.36 on the dollar, because

vehicle to define, measure and re-

ferred tax liabilities associated with the as-

of the tax rate differential. How-

cover uneconomic investments

set. This difference is significant. Indeed,

ever, all other investments made

during the move toward a com-

one also could argue that using the tax ba-

in a competitive economy are sub-

petitive energy market. If struc-

sis to account for stranded assets would

ject to the same laws, and one

tured properly: (1) states’ rights

could argue that immediate ex-

However, if forced to divest, the utility

more accurately allow investors to identify utilities that are better prepared to compete in a restructured energy market.

pensing (versus recovery over 40

2. This argument solely addresses the con-

years) is very generous. Some also

stitutional “return of capital” issue. How-

may argue that tax credits have

ever, the tax basis also should be used to

an economic value in excess of

determine the amount of capital that

one dollar and, therefore, might

shareholders have at risk in a stranded as-

be an over-recovery.

set when computing the return on capital. In addition, if a return on capital is guar-

3. Eliminate Deferred Tax Li-

anteed by a state PUC through non-by-

abilities on the Portion of Assets

passable charges, than the rate of return

Proven to Be Stranded. This op-

on capital should be set at a lower, no-risk

tion needs more research, but it

interest rate.

may hold a very equitable and ef-

3. The Financial Accounting Standards

ficient solution to the recovery of costs that are truly stranded. Typically, companies plan their business affairs with deferred tax liabilities in mind. Moreover, many companies seem to be able to defer tax liabilities indefinitely. Eliminating deferred tax liability as a quid pro quo for elimination of associated stranded costs could accelerate the deregulation of the U.S. energy markets, .yet have little more than a bookkeeping impact on federal tax revenues.

and laws need not be preempted; (2) stranded costs can be recovered fairly and quickly; (3) utilities would be treated like any

As noted above, if stranded investments are not properly de1997

latory” liabilities of a separable portion of operations to be written-off, when it is concluded that the separable portion no longer meets the criteria for applying

other competitive business and

Statement No. 71. Generating assets in a

motivated to become as profitable

competitive market may no longer qual-

as possible, as soon as possible;

ify, because a “regulated” enterprise can

and (4) competition would be ac-

recognize items as assets and liabilities

celerated without the economic drag of a non-uniform, regressive, Btu-like tax imposed by way of non-bypassable charges. n Endnotes:

Conclusions

August/September

Board Statements (FASB) Nos. 71 and 101 require all “regulatory” assets and “regu-

“only if same are not recognized as such by enterprises in general.” This issue is the subject of significant new attention by FASB as a result of deregulation. It also should be noted that a FASB adjustment may reduce the impact on the equity markets of the transition to a com-

1. Consider the case where a utility has a

petitive market, as all utilities would need

$100 asset which is subject to accelerated

to make the adjustment simultaneously,

depreciation. If one assumes straight line

and presumably the markets will have dis-

depreciation of $10 per year and acceler-

counted the impact.

87