Stranded cost recovery in electricity market reforms in the US

Energy 28 (2003) 1–14 www.elsevier.com/locate/energy

Stranded cost recovery in electricity market reforms in the US C.K. Woo a,∗, D. Lloyd a, R. Karimov a, A. Tishler b a

Energy and Environmental Economics, Inc., 353 Sacramento Street, Suite 1700, San Francisco, CA 94111, USA b Faculty of Management, Tel Aviv University, 69978 Ramat Aviv, Tel Aviv, Israel Received 26 April 2002

Abstract An important element of an electricity market reform is stranded cost recovery. This paper explains the cause of stranded costs, describes four recovery mechanisms, evaluates these mechanisms using the criteria of recovery certainty, economic efficiency and equity, reviews the financial performance of 12 utilities in the US in connection to stranded cost recovery, and shows why the mechanism used in California has contributed to the reform failure in that state.  2002 Elsevier Science Ltd. All rights reserved.

1. Introduction The world trend of electricity market reform has raised many issues (e.g., market power mitigation, transmission pricing and access, grid operation and congestion management, and the scope and pace of reform), one of which is the post-reform collection of stranded costs. The debate on stranded cost is contentious. The following summarizes the major arguments that support and oppose stranded cost recovery in the US [1–2]: Supporting Arguments

Opposing Arguments

Under the ‘regulatory compact’, legislators and While legislators regulators might have acted regulators entered into an agreement with as a surrogate for consumers, few (if any) utilities that granted certain rights and consumers actually signed and agreed to the ∗

Corresponding author. Tel.: +1 415 391 5100; fax: +1 415 391 6500. E-mail address: [email protected] (C.K. Woo).

0360-5442/03/$ - see front matter  2002 Elsevier Science Ltd. All rights reserved. PII: S 0 3 6 0 - 5 4 4 2 ( 0 2 ) 0 0 0 9 0 - 7

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responsibilities to the utilities. The compact gives the utilities the right for full stranded cost recovery.

‘regulatory compact’. Full stranded cost recovery slows market entry and denies consumers the immediate benefit of competition. Deregulation without compensation represents The Taking Clause provides no constitutional a ‘taking’ of property that is restricted under guarantee that a regulated industry will never the Taking Clause of Fifth Amendment of the subject to deregulation, market reform, and US Constitution. competition. Unanticipated breaching of the regulatory Deregulation has occurred in other sectors compact financially harms utility investors and (e.g., transportation, banking, and telecom). can discourage future investments in the power Rational investors should have anticipated the sector. forthcoming power market reform. Moreover, post-reform investment continues in other sectors, and there is no reason to believe that investment would stop in the post-reform electricity sector. Financially weak post-reform power companies Stranded cost recovery protects the financially can cause deterioration of service reliability weak post-reform power companies, frustrates and quality to the detriment of consumers. market entry and competition, and perpetuates the inefficiency in the electricity sector. While acknowledging the debate regarding stranded cost recovery, the sole aim of this paper is to examine the nature and effectiveness of various recovery mechanisms. Therefore, the paper presupposes the need for stranded cost recovery, should such costs be found to be valid. Both federal and state regulators in the US permit stranded cost recovery. Explicitly, Order 888 issued in 1996 by the Federal Energy Regulatory Commission, which promotes wholesale market competition via open and comparable access to transmission, affirms “…our preliminary determination that the recovery of legitimate, prudent and verifiable stranded costs should be allowed” (p. 451). Market reform legislation at the state level espouses a similar view. A stranded cost recovery mechanism typically is designed with two key assumptions. The first assumption is that a pre-reform regulated utility is currently under cost-of-service regulation with average embedded (or accounting) cost rates sufficient to collect the return on and of the utility’s investments1. The second assumption is that the market price for the output of the assets affected by the reform is below the average embedded cost of those assets2. Stranded cost recovery typically focuses on generation assets because market reform often aims 1

The return on investments is the allowed rate of return multiplied by the rate base—the net book value of the utility’s regulatorapproved investments. The return of investments is the depreciation of the rate base which is included as part of the utility’s total embedded costs. As a result, the utility’s revenue requirement for full embedded-cost recovery is the sum of total operation cost, taxes, depreciation, and the allowed return on investment. To be sure, the regulated utility may have been subject to performancebased regulation (PBR) that implements a price or revenue cap. Stranded costs can still occur if the price (or revenue) cap was designed to yield the return on and of investments. 2 If the utility has been subject to a price (or revenue) cap, this condition rather requires that the market price for the assets affected by the reform be below the unbundled regulated rates of those assets.

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to introduce competition in the generation segment of the electric sector. Generation competition is commonly believed to cause stranded costs because the reform is usually conceived at times of excess generation capacity. It is expected that initially market prices will be below the regulated average-cost rates and subsequently will gradually rise to match the long-run average cost of entry—the all-in cost of a combined-cycle combustion gas turbine. This anticipated market price scenario led California regulators to use a ‘headroom’ mechanism to recover a utility’s generation stranded costs. The headroom is the difference between the average-cost rate of a regulated utility (which in California was frozen by the state’s market reform bill, Assembly Bill 1890 of 1996) and the market price for generation. The market price for generation in California was expected to be low and the headroom mechanism was expected to yield a positive fee (or charge) collected by the utility. However, such a market price scenario can vanish when capacity shortage develops. To see this point, consider Fig. 1 that illustrates how the post-reform price path can be above or below the long-run average cost of new entrant. While the presence of a stranded cost recovery mechanism assumes the path under capacity surplus, a subsequent unexpected capacity shortage can lead to a post-reform price path above the long-run average cost of new entrant. A recovery mechanism designed solely with the capacity-surplus scenario in mind could fail miserably, should the capacity surplus vanish. A persistent and large market price spike would eliminate the positive ‘headroom’ and replace it with a negative charge or a transfer from the utility to customers. If the utility is purchasing a large portion of generation at market prices for resale to customers (as was the case in California) then the transfer causes a financial loss that the utility has to absorb. The California experience proves that this loss can be financially ruinous, as evidenced by the bankruptcy of the state’s large utility (Pacific Gas and Electric Company (PG&E)) and the need for a state agency (California Department of Water Resources) to buy power on behalf of the financially strapped utilities [3]. To maintain the financial viability of the utility, a prudent recovery mechanism must allow for the possibility that the market price can exceed the average-cost rate over a prolonged period of time. The California experience underscores the importance of identifying the pitfalls inherent in

Fig. 1. The importance of excess capacity. The post-reform price paths can be above or below the long-run average of cost of a new entrant. Stranded cost recovery assumes the path under capacity surplus. However, a subsequent and unexpected capacity shortage can cause a price spike, resulting in a path above the long-run average of cost of new entrant.

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stranded cost recovery mechanisms prior to their implementation. The goal of this paper is to evaluate four recovery mechanisms, three of which have been adopted in the US. The fourth one, involving a fixed per unit charge on historic consumption, has not been adopted by any jurisdiction to date because of its perceived unfairness whereby an electricity consumer’s stranded cost payment remains unchanged, even if the consumer reduces his/her electricity consumption. We consider it for comparison because it has the least distortion on current consumption decisions made at the post-reform prices for generation and rates for transmission and distribution. Our enquiry proceeds as follows. Section 2 defines stranded costs, identifies recovery mechanisms and describes their operation. Section 3 evaluates each mechanism using the criteria of collection certainty, efficiency and equity. Section 4 reviews the financial performance of 12 utilities under alternative recovery regimes. Section 5 concludes. 2. Stranded costs, basis for collection and recovery mechanisms 2.1. Stranded cost We define stranded cost as the difference between the present value of a utility’s return on and of the assets under the extant regulatory regime and the market value of those assets under a competitive market environment newly created by the market reform. These assets are considered stranded when their expected returns are lowered by the reform. They typically fall into three categories: 1. Generation assets whose output price in the post-reform market is expected to be less than the regulated rate; long-term power purchase contracts whose price exceeds the expected market price for generation; long-term fuel purchase contracts whose prices exceed the projected market prices for fuel; above-market wage of labor contracts for generation workers; and other above-market O&M costs. 2. Transmission and distribution assets that cannot produce a revenue stream comparable to the pre-reform level if they are bypassed by some customers (e.g., via self-generation) under the new market environment. 3. Assets related to customer services (e.g., billing, metering, call centers, and information system) that can become obsolete and non-competitive under the new market environment. The size of stranded costs depends on the scope and pace of market reform. Limiting the extent of reform exposes fewer assets to market competition, thus reducing stranded costs. For example, if the reform aims to implement wholesale generation competition, the stranded assets will be mostly generation-related because the post-reform regulated monopoly providing transmission and distribution services will collect its return on and of investments using a cost-based tariff3. Stranded costs also diminish when the pace of reform slows. If generation competition applies only to the new generation that will serve load growth, the output of existing generation assets

3

Even if the T&D utility is subject to a PBR price cap, the initial cap is typically the utility’s average embedded cost rates [4].

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will be sold at the embedded cost rates and these assets obviously will not be stranded. Alberta provides an example of limiting competition to new generation during the initial stages of reform [5]. Alternatively, limiting customer eligibility (as in the UK and Alberta, where retail competition was phased in starting with retail access for industrial customers) would allow the utilities to continue collecting average-cost rates from their remaining franchise customers who are ineligible for generation market access [4]. Since there are no stranded costs associated with servicing these franchise customers, the size of total stranded costs is diminished. A common method for reducing and quantifying stranded costs is the divestiture of generation assets. Often required to mitigate the incumbent utility’s dominance and potential abuse of market power in the post-reform generation market, divestiture of generation assets at prices above book value reduces the utility’s stranded costs. Generation divestiture also helps discover the market value of generation assets and quantify the stranded costs of the utility’s remaining generation assets. 2.2. Basis for collection The design of a recovery mechanism begins with the basis for collection. Several parameters define the basis for collection: 앫 Billing component: energy (kWh) vs demand (kW). The most often used billing component among the utilities reviewed in Section 4 is energy, resulting in a $/kWh charge. However, there are examples of utilities that include a $/kW charge for stranded cost recovery in their tariffs that already have demand charges (e.g., Boston Edison of Massachusetts and Niagara Mohawk of New York). 앫 Level of measurement: at transmission vs at end-use consumption. Stranded costs can be recovered at the transmission level (e.g., Pennsylvania) or the end-use consumption level (e.g., California, Massachusetts and New York). When levied at the transmission level, the charge is applied to kWh (or kW) transmitted. When levied at the end-use consumption level, the charge is applied to kWh (or kW) consumed by end users. As electricity transmission encompasses electricity trading and end-use consumption, a transmission-based charge is smaller than a consumption-based charge for the same amount of stranded costs to be recovered. 앫 Timing of billing component: current vs historic. In general the stranded cost charge is applied to current consumption, implying that an electricity consumer can avoid paying stranded cost by reducing consumption. In contrast, recovery based on historic kWh consumption (or kW demand) makes stranded cost payment by consumers unavoidable, notwithstanding the common criticism that such recovery is unfair to customers who can and are willing to reduce consumption in the post-reform market environment. 앫 Incidence: all customers vs selected customers (e.g., small users only). The typical incidence is all retail customers (e.g., California, Massachusetts, and New York) or all transmission users (e.g., Pennsylvania). The UK restructuring, however, provides an example of how elements of the industry’s stranded costs were collected from the small franchise customers who were ineligible for generation market access during the initial stages of restructuring4. 4

There were two main sources of stranded costs in the UK: nuclear power plants and coal contracts [4]. While a fuel levy was

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Using the above parameters, Table 1 previews the four recovery mechanisms considered in this paper5. Some of these recovery mechanisms address the issue that a customer’s consumption and load can suddenly drop by a very large amount. For example, a large industrial firm may install behind-the-meter generation after the reform has taken place. If the billing component is monthly metered demand, the amount of stranded cost collected from the firm can drop significantly. But if the billing component is the historic kW demand, behind-the-meter generation does not reduce the firm’s monthly stranded cost payment. To be sure, if the firm departs due to relocation, recovery of stranded cost from the firm becomes impossible without an exit fee provision in the market reform legislature. Such an exit fee provision has been adopted in New York, as explained in Rule 52 of Niagara Mohawk’s Service Schedule. The recovery of stranded costs through the mechanisms in Table 1 may only be partial due to limits on the recovery period or the amount to be collected. A market reform granting full recovery ex ante may not guarantee full recovery ex post. A case in point is California where PG&E and SCE failed to make full recovery due to the unexpected and persistently high prices during May 2000–June 2001. 2.3. Recovery mechanisms To explore the four recovery mechanisms, we employ the accounting of stranded cost recovery. Suppose at market opening, R 0 is the net book value of the assets eligible for recovery. For ease of exposition, we assume these assets are generation-related. This assumption is justified by the fact that stranded cost recovery in the US is largely driven by market reforms at the state-level Table 1 Summary of stranded cost recovery mechanisms Mechanism

Billing component Level of measurement

Timing of billing component

1. CA-style headroom mechanism 2. Surcharge on current retail consumption or load 3. Surcharge on historic retail consumption or load 4. Surcharge on kWh or kW transmitted

kWh kWh or kW

End-use consumption End-use consumption

Current Current

kWh or kW

End-use consumption

Historic

kWh

Transmission

Current

put in place by the UK Government to cover the costs of nuclear energy and was paid by all customers, the cost of the overpriced coal contracts could only be passed on to the regional electricity companies’ remaining franchised market. 5 Table 1 does not include mechanisms that may provide a stimulus to a utility for rate reduction to customers in exchange for the opportunity to recover stranded cost. While a thorough exploration is beyond the scope of this paper, an example is a PBR price cap for a post-reform transmission utility which is a subsidiary of the newly formed holding company that was the pre-reform utility. The price cap has two components. The first component escalates at the inflation rate based on consumer price index (CPI) less the productivity target X. The second component is the stranded cost recovery charge. Before market opening, the utility would choose from a menu of options proposed by the regulator, with each option being a combination of the productivity target and the stranded cost recovery charge. If the utility chooses an option with a large productivity target, it can have a large stranded cost recovery charge. Thus a suitably designed menu may yield a price cap formula that can offer a rate reduction to electricity consumers and give the utility a reasonable opportunity to fully recover the stranded cost.

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to create competitive generation markets. Further suppose r is the permitted rate of return on R 0. The balance of the stranded cost account at the end of year 1 since market opening is: R1 ⫽ R0(1 ⫹ r)⫺D1⫺A1⫺G1⫺H1⫺S1.

(1)

We explain each term on the right-hand-side of Eq. (1) below. 앫 The first term R 0(1 ⫹ r) is the initial balance of the stranded cost account grown at the permitted rate of return. It captures the return on investment for the eligible assets. 앫 At the depreciation rate d, the second term D 1 ⫽ d R 0 is the first year’s depreciation of the eligible assets. 앫 The third term A 1 is the proceeds from asset sale and it reduces the balance of stranded costs on a dollar-for-dollar basis. 앫 The fourth term G 1 recognizes that the retained generation and power purchase contracts can affect the utility’s stranded cost. It is the first-year market-based revenue for the electricity from retained generation and power purchase contracts, less the costs for fuel and O&M used by retained generation and contractual power purchase. If the generation market price is high (low) relative to the per MWh cost of retained generation and contracts, G 1 is positive (negative). 앫 The fifth term H 1 captures the financial effect of retail ratemaking by a state regulator in the transition from a regulated generation market to a competitive one. To be specific, H 1 is (w 1⫺p 1)Q 1 where w 1 ⫽ per MWh retail rate, p 1 ⫽ per MWh market price, Q 1 ⫽ MWh retail sales. If the post-reform retail ratemaking is strictly market-based, w 1 ⫽ p 1 and H 1 ⫽ 0. However, market reforms at the state level often commence with the post-reform retail rate frozen at the pre-reform average embedded cost for generation. Since the embedded cost computation includes depreciation, a large and positive H 1 provides the return of investment for the eligible assets. In the context of the California reform, (w 1⫺p 1) is the headroom for stranded cost recovery. When the market price is high relative to the post-reform retail rate, the headroom is negative, resulting in a negative H 1 that increases the balance of the stranded cost account. Removing the rate freeze would have stopped the escalation of the stranded cost balance and provided market-based price signals to induce energy conservation and demand management. 앫 The last term S 1 is the first-year stranded cost recovered via a per unit charge. To be specific, S 1 ⫽ z B 1 where z ⫽ per unit charge set at market opening, and B 1 ⫽ aggregate billing component to which z applies. An example of B 1 is total end-use consumption when the billing component is the kWh consumed by a customer. The following example shows how Eq. (1) works. Example. This simple example is characterized by the following assumptions: (1) R 0 ⫽ $100M, (2) r ⫽ 7%, (3) D 1 ⫽ $5M, (4) A 1 ⫽ $20M, (5) G 1 ⫽ $10M, (6) H 1 ⫽ ⫺$20M, (7) S 1 ⫽ $10M when z ⫽ $1 / MWh and B 1 ⫽ $10M MWh of aggregate billing energy. The ending balance of the stranded cost account in year 1 is R 1 ⫽ $82M (= $100M × 1.07 ⫺$5M ⫺ $20M ⫺ $10M + $20M ⫺ $10M). Based on the discussion of Eq. (1) and using Dt to denote the depreciation of the remaining unsold assets eligible for recovery, the balance of the stranded cost account in year t of the recovery period of T years is:

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Rt ⫽ Rt-1(1 ⫹ r)⫺Dt⫺At⫺Gt⫺Ht⫺St

(2)

Recovery ends when R t ⫽ 0 or t ⫽ T, whichever comes first. We now detail the four recovery mechanisms: 1. California ‘headroom’ charge. Under AB 1890, stranded cost recovery in California relies on the margin due to post-reform ratemaking (i.e., H t ⫽ (w t⫺p t) Q t in Eq. (2)). The per unit surcharge z is zero, resulting in S t ⫽ 0. When the market price is low (as it was in April 1998– March 2000), H t is positive and aids stranded cost recovery. Unfortunately, when the market price is very high (as it was in May 2000–June 2001), H t is negative and increases the balance of the stranded cost account. The positive gross margin (G t ⬎ 0) cannot offset the negative recovery (H t ⬍ 0) because, following generation divestiture, which was encouraged by the financial incentive provided in AB 1890, a utility such as PG&E has total retail sales that far exceeds the output from its retained generation and power contracts. Thus the “ headroom” approach to stranded cost recovery is the primary cause for the financial insolvency of PG&E and Southern California (SCE)6. 2. Surcharge on current consumption (or load). The amount recovered each year is the per unit surcharge set at market opening times the aggregate current MWh (or MW). Since S t is always positive, it reduces the balance of the stranded cost account. However, unexpected consumption (or load) decline can reduce S t, and full recovery may require an upward adjustment of the per unit surcharge. 3. Surcharge on historic consumption (or load). The amount recovered each year is the per unit surcharge set at market opening times the aggregate historic MWh (or MW). Note that S t is always positive. Moreover, it is very stable because without departing the grid, a customer cannot avoid paying the stranded cost. The mechanism is often viewed as unfair because stranded cost payment by a customer does not decline even if his/her consumption decreases. 4. Surcharge on energy (or power) transmitted. The amount recovered each year is the per unit surcharge times the aggregate MWh (or MW) transmitted. While S t is always positive, unexpected decline in transmission usage can reduce S t, and full recovery may require an upward adjustment of the per unit surcharge. 3. Evaluation We apply the following criteria to evaluate a recovery mechanism: (a) recovery with high degree of certainty, (b) economic efficiency (i.e., minimal distortion of production and consumption decisions that would have been made under marginal cost pricing), and (c) equity (i.e., no significant redistribution of income between the utility and its customers). Though used in this paper, these criteria are by no means exhaustive. For example, we could replace the criterion of equity with one that balances the financial interests of the utility and its customers. Doing so would diminish the relative merit of a mechanism that could achieve the highest certainty of full 6

The California Public Utilities Commission raised retail rates in early 2001 to provide some financial relief to PG&E and SCE. But the rate hike was too little too late to stop PG&E from filing for bankruptcy in April 2001.

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stranded cost recovery because such a mechanisms would keep customers’ post-reform electricity bill almost identical to their pre-reform level. Table 2 summarizes each mechanism’s performance in terms of collection certainty, efficiency and equity. This table shows that the first mechanism using the ‘headroom’ charge is a poor approach to collect stranded cost, price electricity and maintain equity. In contrast, the second mechanism of a fixed per kWh energy charge on current consumption or a per kW demand charge on current load can collect stranded cost with a high degree of certainty, with minimal distortion and reasonable degree of equity. Moreover, if a customer can reduce its consumption and load, it can avoid paying the stranded cost charge. Thus the second mechanism is more acceptable to both regulators and customers when compared to the third mechanism whose billing component is the historic consumption (or demand). The third mechanism is more efficient than the second mechanism because the stranded cost recovery charge does not distort current consumption decisions that would be made under a competitive (marginal cost) pricing regime [6]. However, the use of historic consumption or load to collect stranded cost also implies that even if a customer’s consumption and load drops due to energy conservation or lower economic activity, the customer cannot avoid the stranded cost charge without disconnecting from the system. Thus the third mechanism is often viewed as highly unfair and therefore politically infeasible. Table 2 Mechanism evaluation Mechanism

Collection certainty

1. Headroom charge Poor, because of the potential for negative headroom that increases stranded cost.

Efficiency Poor, because the frozen retail rates prevent customers from seeing market prices and discourage market entry by retail service suppliers.

Equity

Poor, because the utility’s shareholders are at best made whole but can have substantial downside risk due to a negative headroom. 2. Surcharge on Good, especially when the per Reasonable, if the per kWh Good, for it preserves the current consumption kWh surcharge can be adjusted to charge is relatively small and financial health of the and load offset the financial effect of consumption is priceutility and consumers have consumption changes. If a kW insensitive. Efficiency a chance to gain from demand surcharge is used, it improves if the surcharge is market competition. should be imposed on the nonon kW-demand because kWcoincident peak demand to prevent demand is less price-sensitive customers from avoiding paying than kWh consumption [7– the stranded cost by load shifting. 8]). 3. Surcharge on Excellent, because it is like a Excellent, for it has little Similar to that of historic consumption property tax. Unless a premise is effect on current consumption Mechanism 2. and load abandoned altogether, full and production decisions [6] recovery is certain. 4. Charge on current Similar to that of Mechanism 2. Reasonable with little effect Similar to that of transmission usage on consumption. But it can Mechanism 2. discourage energy trading that is price-sensitive to transmission cost.

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By imposing a charge on kWh (or kW) transmitted, the last mechanism’s ability to collect stranded costs is similar to the second one’s because the total amount of kWh (or kW) transmitted to serve the end-use loads is stable and price insensitive. Moreover, its effect on end-use consumption should be small because consumption is relatively price insensitive. However, it distorts electricity trading that is highly price sensitive. The mechanism is equitable in that it does not substantially alter the income distribution of the utility shareholders and electricity consumers. 4. Financial performance of utilities in stranded cost recovery We survey the amount of stranded costs collected by 12 utilities, chosen based on geographic coverage and the availability of financial data from the pre- and post-restructuring periods. The survey demonstrates how a poorly designed stranded cost recovery mechanism can have a disastrous effect on the financial health of an electric sector. Table 3 describes the 12 utilities, their post-reform return on equity (ROE), and balance of stranded cost to be collected at the end of 2000. The major findings from Table 3 are as follows. First, the utilities vary significantly in size and customer mix. The utilities with large stranded cost estimates typically have costly nuclear plants and expensive power purchase agreements (e.g., PG&E, SCE, Niagara Mohawk, PECO Energy Company). Second, PG&E and SCE have large negative returns on equity (ROE), the direct result of undercollection of stranded costs caused by the prolonged price spike in May 2000–June 2001. Their stranded cost balances greatly exceeds the initial estimates for their generation plants in service. Under AB1890, the recovery period for these stranded costs ended in March 2002. How to resolve the under-collection is a subject of on-going litigation. Third, SDG&E’s 12.2% ROE is similar to the pre-reform level, primarily because SDG&E completed its stranded cost recovery in 1999 and had its retail rates unfrozen before the prolonged price spike in May 2000–June 2001. Fourth, the initial estimates of stranded cost and the balance of uncollected stranded cost do not adversely affect the ROE of utilities outside California. This is because these utilities can fully collect their stranded costs with a high degree of certainty. Fifth, the utilities in Pennsylvania did not start collection of stranded costs until 2000, which is why the balance of stranded costs is still so high compared to the original forecast. Finally, the ⫺1.6% ROE of Niagara Mohawk in New York is not caused by its stranded cost recovery because it was earning 2.8% in 1996, before the New York market reform. 5. Conclusions Our evaluation of recovery mechanisms in Table 2 suggests the use of a per kWh charge on historic consumption or a per kW charge on historic load to fully collect a utility’s stranded cost. This suggestion is partly driven by the evaluation criteria that we chose to use. Adopting the criterion of balancing the financial interests of consumers and the utilities would alter our suggestion to one that relies on a per unit charge on current electricity usage or transmission. Indeed, the electricity market reform experience in the US indicates the adopted recovery surcharge is a

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Table 3 Examples of stranded cost recovery by utility based on (1) Energy Information Administration, Financial Statistics of Major US Investor-Owned Electric Utilities, Washington D.C., 1996; (2) Company Annual Reports and 10-K filings with the Security Exchange Commission, various years; and (3) communications in Summer 2001 with the staff of public utilities commissions in California, Massachusetts, New Hampshire, New York, and Pennsylvania Utility

Size (annual Average rate: Return on Initial estimate MWH sales, # industrial, equity of stranded of customer commercial, 2000 assets accounts) residential $/MWh

Pacific Gas & Electrica California

82 Million MWh 4.6 Million Accounts

30.07 84.80 104.60

(52.3%)

San Diego 18 Million Gas & Electrica MWh California 1.2 Million Accounts

118.49 121.96 115.77

12.2%

Southern California Edisona California

55.44 91.82 113.49

(67.6%)

Boston Edison 14.5 Million Company MWh Massachusetts 688 Thousand Accounts

86.24 91.18 117.20

12.3%

Public Service Company of New Hampshire

96.28 117.22 143.59

83 Million MWh 4.3 Million Accounts

7.1 Million MWh 434 Thousand Accounts

10%

Balance of stranded costs 12/31/2000

Remarks

$2.6 Billion net $6.6 billion generation plant in service.

Reduced allowed ROE for stranded assets to 6.77% The balance of stranded costs represents under collection of power purchase costs

$121 Million None net generation plant in service.

Reduced allowed ROE for stranded assets to 6.75% Completed recovery of stranded costs in July 1999. $388 million of surplus bond proceeds returned to customers

$1.1 Billion net $2.9 Billion Reduced allowed ROE generation plant for stranded assets to in service. 7.22%

$975 Million

$714 Million

Not available Restructuring delayed

(continued on next page)

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Table 3 (continued) Utility

Size (annual Average rate: Return on Initial estimate MWH sales, # industrial, equity of stranded of customer commercial, 2000 assets accounts) residential $/MWh

Balance of stranded costs 12/31/2000

Remarks

Net divestiture gains from sale of generation facilities used to reduce stranded costs from independent power producers (IPPs).

Central Hudson 4.7 Million Gas & Electric MWh New York 274 Thousand Accounts

59.64 86.28 114.92

10.4%

Not available

Stranded cost for over-market power purchase agreements not available

Consolidated Edison Company of New York

32 Million MWh 3.1 Million Accounts

123.13 156.47 184.73

12.7%

Not available

Stranded Collected 2x book cost for value on sale of over-market generation assets. power purchase agreements not available

Niagra Mohawk New York

36 Million MWh 1.5 Million Accounts

50.52 102.86 120.64

(1.6%)

$8Billion of $3.5Billion which $2 Billion was absorbed by Niagara Mohawk in reduced equity return for shareholders

$6Billion of original Stranded cost estimate was due to government mandated IPPs

Orange and Rockland New York

3.9 Million MWh 205 Thousand Accounts

65.90 93.53 131.74

11.8%

Not available

Net divestiture gains of $5Million

Divestiture gains credit (DGC) paid to customers ($/kWh)

PECO Energy Company Pennsylvania

35 Million MWh 1.3 Million Accounts

32.14

14.1%

$5.3 Billion

$5.2 Billion Allowed rate of return reduced to 7.47% for stranded assets.

57.95 95.96

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Table 3 (continued) Utility

Size (annual Average rate: Return on Initial estimate MWH sales, # industrial, equity of stranded of customer commercial, 2000 assets accounts) residential $/MWh

Balance of stranded costs 12/31/2000

Remarks

Pennsylvania Power Company Pennsylvania

3.8 Million MWh 135 Thousand Accounts

49.58 76.45 92.22

9.0%

$236 Million

$232 Million Collection did not start until the year 2000.

Pennsylvania Power & Light Company (PPL)b Pennsylvania

33 Million MWh 1.3 Million Accounts

79.9 58.4 40.3

18.4%

$2.8 Billion

$2.4 Billion Allowed rate of return of 10.86% on the unamortized balance of stranded costs.

a The balance of stranded costs shown for the three California utilities does not include the stranded costs that can be recovered beyond the transition period, i.e., above market purchased-power contracts, nuclear decommissioning, etc. b PPL’s sales and average rates are from 1999

per kWh charge on current end-use consumption, a per kW charge on current end-use demand, or a per kWh charge on energy transmitted. Our survey of recovery mechanisms confirms that a poorly designed mechanism like the California ‘headroom’ charge can doom the once financially healthy utilities like PG&E and SCE. In contrast, utilities in other states had ROE comparable to the pre-reform levels, largely because they could recover stranded costs from all customers with almost certainty. Their post-reform ROE do not depend on whether the recovery surcharge is a fixed per kWh charge on end-use consumption or a fixed kWh charge on energy transmitted. Finally, the California experience shows that the ‘headroom’ mechanism’s rate freeze, once in place, is difficult to remove, even in the face of persistently high market prices. Indeed, this rate freeze was one of the major factors contributing to the failure of the California electricity market reform [3].

Acknowledgements We thank Professor Lior and three referees for their constructive comments that have greatly improved the paper’s exposition. All errors are ours.

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C.K. Woo et al. / Energy 28 (2003) 1–14

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