Getting it Right: Filling the Gaps in FERC’s Stranded Cost Policies

May 1999

© 1999, Elsevier Science Inc., 1040-6190/99/$–see front matter PII S1040-6190(99)00029-9

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Getting it Right: Filling the Gaps in FERC’s Stranded Cost Policies

Major gaps in the wholesale stranded cost policies of the Federal Energy Regulatory Commission (FERC) threaten to introduce inefficiencies during the transition to competition in the form of uneconomic bypass and uneconomic new entry.

Kenneth Gordon and Wayne P. Olson

I. Introduction

he Federal Energy Regula-tory Commission’s (FERC’s)

efforts to introduce full wholesale competition have required sweeping changes in its regula-tory policies—in effect Order 888 establishes a comprehensive strategy that provides for open-access, nondiscriminatory trans-mission while addressing the stranded cost and other transi-tional issues that this fundamen-tal change presents. The concur-rent and related efforts in many states to introduce retail competi-tion are leading to even more fun-damental changes in the “regula-

tory compact.”

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Legislators and regulators have in most cases rec-ognized that achieving the real benefits of competition is inher-ently a long run process and that society has a responsibility to meet past regulatory commit-ments.

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Almost all legislators and regulators have concluded that they can accelerate the pace of change to competition by design-ing competitively neutral, nonby-passable mechanisms to recover legitimate wholesale and retail stranded costs.

The broad policies and princi-ples that FERC and most of the states have set forth can provide a solid foundation for promoting

Kenneth Gordon

is Senior VicePresident at National Economic

Research Associates (NERA),Cambridge, MA. Dr. Gordon

previously was Chairman of theMassachusetts Department ofPublic Utilities and the Maine

Public Utilities Commission.He holds a Ph.D. in Economicsfrom the University of Chicago.

Wayne P. Olson

is a consultant atNERA. He earlier served as Director ofFinance for the Maine Public Utilities

Commission. He holds an M.A. inEconomics from the University of

North Dakota and is both a CharteredFinancial Analyst and a Certified

Public Accountant.

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The Electricity Journal

competition.

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While implementa-tion has inevitably been imper-fect, a generally efficient and politically pragmatic electric restructuring framework has begun to be constructed. The much-talked-about but infre-quently achieved notion of co-operative federalism seems in many ways to be working fairly successfully, as FERC and the states cooperate to increase the robustness of wholesale com-petition and to introduce retail competition.

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till, gaps remain and FERC must remain alert to ensure

that utilities’ reasonable opportu-nity to recover legitimate, pru-dent, and verifiable wholesale stranded costs is not undermined by jurisdictional or other “gaps” in recovery mechanisms. For example, because retail competi-tion can lead to the stranding of wholesale costs, FERC must assert jurisdiction where neces-sary to ensure that wholesale costs are not stranded. Failure to close such gaps is likely to lead to their expansion, as stakeholders seek to avoid their stranded cost recovery responsibilities.

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More fundamentally, such a failure would undermine the consensus that underlies the cooperative nature of important elements of restructuring. Absent a reason-able assurance that legitimate, prudent, and verifiable whole-sale costs that are stranded as a result of wholesale or retail com-petition will be recovered, the comprehensive and balanced approach that Order 888 provides is simply not credible.

II. FERC Must Fill the Gaps in its Wholesale Stranded Costs Policies

A. Gaps in FERC’s Wholesale Stranded Cost Policies

In Order 888, FERC dramatically increased purchasing utilities’ access to alternative power sup-plies by requiring that supplying utilities provide open-access, non-discriminatory transmission ser-

have appeared, which could result in costs being “trapped.” Trapped costs arise when differences in ratemaking methodologies between federal and state regula-tors result in some prudent costs being unrecovered from cus-tomers. The danger of trapped costs is greatest when ratemaking methods or accounting structures change. To avoid the trapping of legitimate, prudent, and verifiable stranded costs as the implementa-tion of Order 888 proceeds, FERC must move to close these gaps in economically efficient and credible ways.

FERC stated in Order 888 that utilities are entitled to recover the legitimate, prudent, and verifiable costs imposed on them by depart-ing wholesale customers, provided that they take reasonable steps to mitigate these costs. FERC allows recovery of these costs through an “exit fee” charged to departing customers that is equal to the esti-mated total differential in utility revenues incurred because of the customers’ departure.

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Wholesale stranded costs can also be created if a state or local government forms a publicly owned distribu-tion company and transfers the franchise to the new utility. In Order 888, FERC allowed utilities to charge an exit fee for costs that are stranded as a result of such “municipalization.” The supplying utility, however, only receives exit fees if its transmission system is still used by the departing cus-tomer to purchase power from another supplier.

Regarding wholesale require-ments contracts, FERC Order 888

FERC must ensure thatutilities’ reasonable

opportunity to recoverstranded costs is

not undermined by“gaps” in recovery

mechanisms.

vice that is fully comparable to the service that they provide them-selves. FERC also acknowledged in Order 888 that greater open access could potentially strand prudently incurred wholesale util-ity costs and developed policies that provide a utility with an opportunity to recover reasonably incurred costs that arise because open-access use of the utility’s transmission system enables a gen-eration customer to shop for power.

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As retail competition begins, however, and the imple-mentation of Order 888 unfolds, significant gaps in wholesale stranded cost recovery policies

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limits stranded cost recovery to cases where: (1) a requirements customer completely terminates its contract to purchase power from another power supplier; and (2) the former wholesale customer uses the transmission system of the utility to reach the new source of generation. These requirements create the possibility that whole-sale stranded costs could become trapped.

s an example of a situation where costs become

stranded despite the fact that a contract is not completely termi-nated, the introduction of retail competition in New Hampshire could allow New Hampshire Elec-tric Cooperative’s (NHEC’s) retail customers to “leave” NHEC with respect to their day-to-day genera-tion needs. Thus, while they remain “customers” of NHEC, they have reduced generation requirements (indeed, their actual generation usage could go to zero if all end-use customers find alter-native competitive sources of gen-eration). The result is that Public Service New Hampshire Company (PSNH), which provides NHEC’s power based on a requirements contract, would experience losses in its wholesale volumes as a result of retail competition even though its contract with NHEC continues. Because the requirements contract between PSNH and NHEC would remain in force with zero require-ments, PSNH would be unable to recover wholesale stranded costs under FERC Order 888. Additional perverse incentives are present because PSNH is required to stand ready, under its contract with

NHEC, to serve any prodigal cus-tomer of NHEC who later decides to return to NHEC.

FERC initially contributed to the problem by unilaterally modify-ing the contract between PSNH and NHEC. In doing so, FERC tampered with those contract pro-visions that formed the basis of PSNH’s reasonable expectation that the customer would remain on its generation system. PSNH,

stranded because the former wholesale customer may not use the transmission system of the util-ity to reach the new source of gen-eration in the future. Fifty years ago, at the insistence of New Hampshire utility regulators, CVPS established its wholesale arrangements with Connecticut Valley. Now, in the course of intro-ducing retail competition, New Hampshire regulators are ordering that these relationships be severed. Because Order 888 only allows for recovery of wholesale stranded costs if Connecticut Valley uses CVPS’ transmission grid to reach its new supplier, CVPS’s wholesale stranded costs may be trapped unless FERC closes this regulatory gap by allowing CVPS to recover its stranded costs through FERC-jurisdictional transmission rates, or some other FERC-imposed charge, such as an exit fee.

he implementation of whole-sale and retail competition are

closely intertwined—and retail competition can lead to the strand-ing of wholesale costs. FERC may need to step in to ensure that dis-tribution utility customers honor the commitments made on their behalf. In some cases, FERC will have an important remedial gap-filling role because there may be no entity (other than the courts) available to ensure that distribu-tion customers pay for appropri-ately specified wholesale stranded costs that result from the imple-mentation of retail competition. In a number of states, state regula-tors’ jurisdiction over publicly owned and cooperative utilities is limited or even absent.

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As a result,

The implementation of wholesale and retail competition are closely intertwined—and retail competition can lead to the stranding

of wholesale costs.

therefore, was in danger of bearing wholesale stranded costs that were “trapped” as a result of New Hampshire’s retail access program applying to NHEC’s customers. Although FERC has since agreed to revisit this contract modifica-tion, FERC needs in the future to avoid exacerbating wholesale stranded costs resulting from the introduction of retail access by the states.

A stranded cost case involving Central Vermont Public Service Company (CVPS) and Connecticut Valley Electric Company (Connect-icut Valley) provides an example of a situation where costs become

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utility regulators may not regulate consumer-owned utilities or may allow consumer-owned utilities to “opt out” of state regulation.

B. The Economic Consequences of Inefficient Stranded Cost Recovery Policies

As a result of the increased wholesale competition that Order 888 has unleashed, sometimes in conjunction with retail competi-tion initiated by a state, some of the long-term contracts that FERC had approved (and in some cases required)

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have become uneco-nomic and unsustainable. FERC faces serious challenges with re-spect to implementing its stranded cost policies in ways that encour-age efficient competition as a result of: (1) the strategic/opportunistic positions that purchasing utilities (and their customers) have already taken and are likely to take in the future; (2) the long-term nature of the investments that supplying utilities have made to support long-term requirements contracts with purchasing utilities; and (3) the difficulties that the interaction of wholesale and retail competi-tion present with respect to ensur-ing that appropriately specified wholesale stranded costs are re-covered. Given FERC’s initial re-luctance to assert its authority on wholesale stranded cost issues, there is a risk that the gaps in its policies could lead to behavior that is inefficient. These inefficiencies result from:

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“Tax Avoidance” Types of Behav-ior.

Absent a high level of certainty that appropriately specified wholesale stranded costs will be

recovered from the “departing” utility and its end-use customers, “departing” utilities and those who represent them will have strong (private) incentives to find and use creative new ways to avoid paying the stranded costs. Any failure by regulators on implementing and then following through on enforcing appropri-ately specified stranded cost poli-cies runs the risk of encouraging uneconomic bypass and inefficient

must be nonbypassable. Other-wise, given the magnitude of the wholesale stranded costs that could be bypassed, distortions in the efficiency of the competitive process, which would distort con-sumers’ energy consumption choices, are inevitable.

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Delays in the Transition to Effi-cient Competition.

If the stranded cost recovery disputes that arise are not unequivocally resolved at the outset of competition, the tran-sition will inevitably be delayed while the issues are disputed. Any delay in the realization of the potential long-term productive efficiencies that competitive mar-kets can provide would, of course, be costly.

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Inefficient Entry.

Competition will not succeed in lowering over-all economic costs in the electricity generation and marketing busi-nesses if competitors do not have appropriate incentives to enter these markets. If a firm’s entry into a market is driven by its ability to find ways to avoid paying the stranded costs rather than on the firm’s real efficiency relative to its rivals, the competitive process will be distorted, and the firm’s entry runs the risk of being inefficient. Inefficient entry will ultimately raise costs for consumers and society generally.

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The Creation of a New Class of Stakeholders.

A long-term danger of policies that create inefficient entry is that the new entrants—once they have entered a market—will have strong incentives to maintain the

status quo

in order to protect their economic interests. As a result, once inefficient entry occurs, it will

For stranded costrecovery to be

competitively neutral,the obligation to

pay the costs must

be nonbypassable.

institutional arrangements. Simply put, major investment decisions could be driven more by the desire to avoid bearing the cost of appro-priately specified stranded costs than by the real underlying costs of the various investments. Arrange-ments that are inefficient to vary-ing degrees will be the likely result.

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Lack of Competitive Neutrality.

Competition will be distorted and/or costs stranded if buyers are able to avoid paying for wholesale stranded costs. For stranded cost recovery to be competitively neu-tral, the obligation to pay appro-priately specified stranded costs

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be difficult for policymakers to change the rules of the game to be more efficient. This is a major rea-son why it is important to design an appropriate regulatory struc-ture, including appropriate stranded cost recovery policies, before competition unfolds.

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Burden Shifting.

Inevitably, if the burden of stranded cost recov-ery is avoided by the party that caused those costs to be incurred in the first place, and who should therefore bear these costs, the costs will be shifted to other customers of the utility or to the utility’s shareholders.

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This shifting of burdens would be inequitable and, as we have seen, inefficient as well.

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Incumbent Burdens.

Burden shifting will create perverse incen-tives and distortions in competi-tion if the incumbent retains an obligation to serve “prodigals” that have “departed” in ways that do not trigger the FERC’s whole-sale stranded cost policies. If buyers can depart from day-to-day use of the incumbent’s generation and take advantage of low-priced off-system power that is available elsewhere, while retaining the option of returning to the incum-bent whenever they wish and demanding service without pen-alty, the incumbent utility will in essence be providing a costly-to-provide back-up service without appropriate compensation.

s FERC recognized in Order 888, competitively neutral

and nonbypassable mechanisms for recovering wholesale stranded costs can be designed and imple-mented to allow competition to proceed efficiently on a going-

forward basis. Recovery of whole-sale stranded costs thus supports (and could accelerate)

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the transi-tion to a competitive market.

C. How to Fill the Gaps in FERC’s Wholesale Stranded Cost Policies

At this point in the restructuring debate, the basic principles of stranded cost recovery are no longer in serious dispute. If it chooses to do so, FERC can

stranded costs without distorting efficient competition. Once an appropriately designed stranded cost mechanism is in place, genera-tion suppliers would compete based on their relative incremental costs, undistorted by differences in sunk costs.

ERC can easily make small modifications to its Order 888

stranded cost policies to eliminate gaps and trapped costs. FERC should:

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Ensure that utilities have the opportunity to recover wholesale stranded costs that arise from retail wheeling. To do so, FERC should relax its rule that requirements contracts must be terminated. FERC should allow supplying util-ities to file for stranded costs if wholesale load merely diminishes as a result of retail access.

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Avoid one-sided contract mod-ifications unless stranded costs resulting from that contractual modification are simultaneously addressed. If contracts are modi-fied, competitively neutral and nonbypassable mechanisms for recovering the resulting wholesale stranded costs should be required.

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Ensure that supplying utilities do not retain an obligation to serve once customers have effectively departed under a contract as a result of the introduction of retail competition. To the extent that a supplying utility retains an obliga-tion to provide power to a pur-chasing utility that has effectively exited a requirements contract from a day-to-day standpoint, the supplying utility should be able to supply that prodigal customer from the spot market and should

Competitively neutral and nonbypassable mechanisms can be designed to allow competition to

proceed efficiently.

develop and implement competi-tively neutral and nonbypassable cost recovery mechanisms that provide a reasonable opportunity to recover the wholesale costs that become stranded as a result of wholesale or retail competition. Given the gaps that have begun to emerge (and which could grow as stakeholders find additional ways to widen those gaps), FERC must now complete its stranded cost policies or the movement toward efficient competition will be delayed or distorted. Competi-tively neutral and nonbypassable mechanisms can be designed to recover appropriately specified

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not be required to engage in resource planning on behalf of that customer.

Implementing stranded cost recovery in economically efficient ways will not be an easy task. Nevertheless, the evolution of the industry toward a genuinely more efficient structure, rather than one dictated in whole or in part by stranded cost avoidance, depends on it.

III. Measurement and Other Implementation Issues

Order 888 specified a revenues-lost formula that utilities are to use in calculating stranded costs. To determine what the annual stranded cost will be under its revenues-lost approach, FERC deducts the competitive market value estimate (CMVE) for each year from the revenue stream esti-mate (RSE) that the utility would have earned in the same year had the customer remained. After net-ting out transmission and distribu-tion revenue, FERC multiplies the remainder by the length of time during which the utility had a rea-sonable expectation of serving the customer, a factor known as L, because the customer would remain on its generation system. The CMVE and the L factor are forward-looking variables; the RSE is simply the average of the reve-nues earned in the previous three years.

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While recognizing that all of these factors are, at best, esti-mates of future conditions, FERC decided against allowing a true-up or other mechanism to alter the stranded cost calculations when

more information becomes known. This means that FERC will have only one chance to get the details right.

While FERC’s stranded cost methodology seems quite straight-forward, the actual implementa-tion of these policies will be chal-lenging. Because a wide range of participants can use the regulatory process strategically to defend their interests,

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the regulatory pro-

neutral and nonbypassable mecha-nisms for recovering wholesale stranded costs can be designed and implemented. Where this is undertaken, recovery of whole-sale stranded costs is not anti-competitive.

espite this, in a case involv-ing the City of Alma, MI, and

Consumers Power Company, FERC trial staff has recommended truncating the L recovery period to 10 years because of an assertion that a longer recovery period would delay the transition to a competitive market. As has already been explained above, and as is widely recognized in the literature, it is possible to col-lect stranded costs in ways that allow competition to proceed efficiently on a going-forward basis. Artificially reducing the L recovery period because of “anti-competitive” concerns could lead to stranding of wholesale stranded costs with no competitive benefit, and possibly some harm, in exchange.

B. The Appropriate Term for the L Period

Order 888 specifies that the rea-sonable expectation (L) period should reflect the time during which the utility had a reasonable expectation of serving the cus-tomer.

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In performing its analysis of the appropriate L recovery period, FERC should carefully con-sider the requirements and obliga-tions of the regulatory framework that was in place prior to the adop-tion by Congress of the Energy Policy Act of 1992 (EPAct) and FERC implementation of Order

cess can allow a seemingly straightforward set of issues to be turned into a complicated and convoluted muddle. As a result of the slow, unwieldy, costly, and inefficient nature of the regulatory process, FERC’s ability to imple-ment Order 888 is in danger of being derailed.

A. Appropriately Designed Stranded Cost Recovery is Not Anti-competitive

The L period should not be trun-cated because of the belief that stranded cost recovery is somehow anti-competitive. As FERC recog-nized in Order 888, competitively

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888. Given that regulatory frame-work, the planning period used in utility/regulatory planning pro-cesses in a particular jurisdiction provides a useful starting point, and the remaining useful life of the assets that were put into place to support a contract provides a rea-sonable upper bound for deter-mining the reasonable expectation period in most cases.

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A careful analysis, however, of the specific circumstances in each particular case is necessary

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with an empha-sis on reviewing the specific facts in each case. Because wholesale costs can become stranded in dif-ferent ways (e.g., as a result of the straightforward termination of a requirements contract, the intro-duction of retail competition in a state, or as a result of the “munici-palization” of a portion of a util-ity’s distribution system), FERC’s analysis of the reasonable expecta-tion period will need to take these different fact situations into account.

rior to EPAct and Order 888, FERC’s actual implementation

of the Federal Power Act (FPA) reflected the notion that the actual terms of the contract may not pro-vide a useful indication of the rea-sonable expectation period of the supplying utility.

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In essence, a “regulatory compact” supplanted the actual requirements contract between a supplying utility and a purchasing utility.

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Under this regulatory compact, once a utility undertook requirements service it could not expect to abandon that service, even at the end of the term of the FERC-approved require-ments contract.

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As a result, the

specific terms of a requirements contract, especially termination provisions, were sometimes con-sidered “irrelevant.”

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Determining the appropriate L period is fundamentally a factually grounded question that can best be answered by the facts in each case. FERC needs to consider carefully the conditions that led to the origi-nal signing of the requirements contract and whether the supply-

FERC would artificially truncate the L period in just such a fashion by relying on an inappropriate metric to estimate the reasonable expectation period. In that case, involving the City of Las Cruces, NM, and El Paso Electric Com-pany, FERC trial staff has pro-posed, and an Administrative Law Judge has recommended, to estab-lish El Paso Electric’s L period based on the recommended North American Electric Reliability Council (NERC) planning horizon of 10 years. Using the NERC plan-ning horizon, however, would ignore the long-term arrangements that were in place and the unique set of facts that led to the actual investment decisions made by El Paso Electric in order to provide reliable service to its customers, including end-use customers in the City of Las Cruces. NERC’s 10-year planning horizon, while per-haps quite appropriate for NERC’s own purposes, has little relevance to the utility’s resource planning horizon, which helps guide the investments that utilities actually make to serve load. Moreover, it ignores the complexity of the resource planning processes that utilities and regulators use to ensure reliable and cost-effective service over the long run.

ERC needs only a relatively short planning horizon

because it is primarily focused on ensuring that electricity demand is somehow met. It therefore only reflects the amount of time needed to plan and build new generating facilities. This has little or nothing to do with specific investment decisions of investors. Utilities

ing utility had the practical ability to abandon the contract. FERC is likely to find that the supplying utility had to make actual invest-ments to serve the requirements contract over a long period of time. This is particularly true in cases where FERC required that a sup-plying utility satisfy the public interest requirements of the FPA before terminating service with a purchasing utility.

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The FERC also needs to eschew “cookie-cutter” regulatory approaches that artifi-cially truncate the L period in one case, based on the facts in another.

A case that is currently before

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actually have typically invested in generating assets with lives of 30 or more years and use 15- to 20-year planning processes to ensure that power needs are reliably and cost-effectively met over the life cycle of the resources.

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As a result, in determining the appropriate L period, the 10-year NERC plan-ning horizon is simply irrelevant with respect to the utility’s reason-able expectation period.

C. Avoid Beginning the L Period Too Early

FERC will also have to consider when the reasonable expectation period begins. In most cases the L period should begin sometime near the time that a customer actu-ally departs.

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For example, in a case involving the “municipaliza-tion” of El Paso Electric Com-pany’s utility activities in the City of Las Cruces, FERC staff recom-

mends that the L period begin in January 1993, even though it was not clear—as of the writing of this article—whether Las Cruces will ever actually depart from El Paso Electric’s system. The FERC trial staff recommendation (in combina-tion with the artificially truncated recovery period) ignores the reali-ties of the contract renegotiation process. Historically, requirements contracts have been revisited peri-odically—and have usually been renewed. Yet bargaining and pos-turing about departing are very much a part of that process.

It is simply unreasonable (and would lead to inefficient resource planning) to assume that a supply-ing utility was put on notice that a contract would

not

be renewed at the very beginning of the contract renegotiation process. By assum-ing an unrealistically early begin-ning point for the L recovery

period, FERC could, in effect, deny the recovery of legitimate whole-sale stranded costs and shift responsibility for those costs to the utility’s other customers or its shareholders. This would severely reduce the credibility of FERC’s stranded cost policies, which could in turn lead to delays in the emer-gence of efficient wholesale competition.

n setting the beginning of the L period, FERC needs to distin-

guish between a utility’s com-mencement of prudent actions to mitigate its retail customers’ and shareholders’ exposure to poten-tial stranded costs,

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and the point when a utility genuinely began to have a reasonable expectation that a contract would not be renewed. A utility should begin to take advantage of any reasonable opportunities to mitigate stranded cost exposure at the beginning of

FERC is currently at a crossroads: Implement its stranded cost policies properly or the approach Order 888 represents will not be credible.

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the contract renegotiation period, but the reasonable expectation period should not begin until some point closer to the end of the contract renegotiation period, when it has become much more likely that the requirements cus-tomer will actually depart. At the earliest, the L period should not begin prior to the customer giving credible notice that it is terminat-ing service by a given date. Unless these points are distinguished in this way, a perverse incentive for utilities to delay taking prudent actions to mitigate exposure to stranded costs could be created. This would be harmful to custom-ers and would tend to delay the transition to competition.

roperly structured and imple-mented, the recovery of

wholesale stranded costs that result from the introduction of wholesale and retail competition can be accomplished without dis-torting efficient competition. The challenge will be to: (1) develop and implement policies that do not leave broad gaps in the recovery of wholesale stranded costs; and (2) use appropriately specified inputs when implementing the lost-revenues approach. Failing to meet either of these challenges could lead to the actual stranding of legitimate wholesale costs.

IV. Conclusion

Policymakers and regulators now recognize the importance of pursuing policies that allow mar-kets to emerge where regulation had previously been paramount. The pace of change in policy-

makers’ views of the role of regula-tion has been breathtaking. Even the most impatient believer in competitive markets has to be impressed by the fact that at least 17 states have already made the decision to implement electric restructuring, with a number of others currently in the process of analyzing whether to do so.

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This has occurred in the short period of time since FERC issued its Orders aimed at promoting open-access,

failure to fully reconcile — and properly implement — the recov-ery of these costs with efficient competition distorts the competi-tive process and could hamper the transition to efficient competition.

Rather than effectively stranding wholesale costs, FERC should: (1) design competitively neutral and nonbypassable stranded cost recovery mechanisms that ensure that stranded cost recovery is not anti-competitive; (2) identify an L period that accurately reflects the period of time during which the supplying utility had a reasonable expectation to serve the customer; and (3) if stranded cost recovery over a more rapid timeframe is desired, allow the accelerated recovery of an equivalent amount (on a present value basis) of stranded costs.

ERC is currently at a cross-roads: It must implement its

stranded cost policies properly or the comprehensive approach that Order 888 represents will not be credible. In this context, it is important to remember that public policies aimed at introducing com-petition into electricity markets will proceed more quickly and effectively if the regulatory bargain is kept. Thus, any plan to intro-duce competition in electricity must honor existing commitments and provide utilities with a reason-able opportunity to recover pru-dently incurred investments. By closing the gaps in its stranded cost recovery policies in economi-cally appropriate ways, FERC can reaccelerate the movement to effi-cient competition in generation markets.

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nondiscriminatory wholesale com-petition on April 24, 1996. As this process continues, FERC will need to be vigilant in implementing its policies in economically appropri-ate ways.

Absent policies that ensure that recovery of appropriately specified wholesale stranded costs cannot be evaded by customers, significant inefficiencies will be introduced during the transition to competi-tion in the form of uneconomic bypass and uneconomic new entry. By leaving major gaps in its whole-sale stranded cost policies, FERC has failed to fully settle the ques-tion of stranded cost recovery. This

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Endnotes:

1.

Some refer to this as a regulatory con-tract. Sidak and Spulber note that the three primary components of the regula-tory contract are entry controls, rate reg-ulation, and utility service obligations. J. Gregory Sidak and Daniel F. Spulber,

Deregulatory Takings and the Regu-latory Contract: The Competitive Transformation of Network Indus-tries in the United States

(Cam-bridge, England: Cambridge University Press, 1997), at 113.

2.

In a paper that surveys deregulatory activities in a number of industry sec-tors, Clifford Winston begins by noting that “Economic deregulation does not happen overnight. It takes time for law-makers and regulators to dismantle reg-ulatory regimes, and then it takes more time for the deregulated industries to adjust to their new competitive environ-ment.” See Clifford Winston,

U.S. Indus-try Adjustment to Economic Deregulation

, 12

Journal of Economic Perspectives

, Summer 1998, at 89–110. See also Ken-neth Costello and Robert J. Graniere, Lessons Learned from Restructuring of Former Comprehensively Regulated Industries, National Regulatory Research Institute, Ohio State University, July 1996.

3.

Major gaps in the wholesale stranded cost policies of the Federal Energy Regu-latory Commission threaten to introduce significant inefficiencies during the tran-sition to competition in the form of uneconomic bypass and uneconomic new entry. Of course, the devil is in the details. Specific implementation plans have sometimes delayed the develop-ment of competition. For example, set-ting the standard offer price below mar-ket will discourage consumers from seeking alternatives that are, in prin-ciple, available.

4.

See Charles G. Stalon and Reinier H.J.H. Lock,

State-Federal Relations in the Economic Regulation of Energy,

Yale J. of Regulation

, Summer 1990, at 427–497 for a discussion of a different era in state-federal relations.

5.

States too have a gap-filling role to play in implementing retail competi-tion—but it is already clear that the

FERC needs to act in some cases to ensure that utilities have a reasonable opportunity to recover legitimate, pru-dent, and verifiable costs. State actions already taken on the retail front will otherwise lead to the stranding of wholesale costs.

6.

In Order 888, FERC stated that “we are faced with an industry transition in which there is the possibility that certain utilities will be left with large unrecover-able costs or that those costs will be unfairly shifted to other (remaining) cus-tomers. That is why we must directly and timely address the costs of the tran-

sition by allowing utilities to seek recov-ery of legitimate, prudent and verifiable stranded costs.” Order, mimeo, at 454. The Order can be found on the Internet at:

http://www.ferc.fed.us/news1/rules/data/rm95-8-00w.txt.

7.

FERC decided to employ a one-time (i.e., without true-up) “revenues-lost” approach to estimating stranded costs. For an additional discussion of this methodology, see Section III below.

8.

Because consumers and owners are one and the same, there has been little need for state regulators to govern their rates.

9.

For a discussion of FERC’s (and that of its predecessor, the Federal Power Com-mission) use of its authority to order interconnections and the sale or exchange of energy prior to EPAct, see J. A. Bouknight, Jr. and David B. Raskin,

Planning for Wholesale Customer Loads in a Competitive Environment: The Obligation to Provide Wholesale Service under the Fed-eral Power Act

, 8

Energy Law J.

(1987), at 237–264.

10.

Increased stranded cost exposure tends to lead to a decrease in a utility’s market-to-book ratio. For a discussion, see Agustin Ros, John L. Domagalski, and Philip R. O’Connor,

Stranded Costs: Is the Market Paying Attention

,

Public Utilities Fortnightly,

May 15, 1998, at 18–21. It seems likely that this market-to-book ratio decrease is in part due to investors’ perceptions of the risk that stranded costs will be borne by utility shareholders rather than the cost causer.

11.

See Philip R. O’Connor and John L. Domagalski,

The Path of Least Resis-tance: Accelerating the Movement to Electric Industry Competition Through Transition Cost Compensa-tion

(Washington, DC: Edison Electric Institute, Sept. 1997).

12.

FERC’s use of a three-year average should provide a plausible measure of the estimated revenue stream that would be lost as a result of the exit of a require-ments customer in most cases. Estimat-ing the appropriate CMVE for the stranded capacity and energy raises empirical and other issues, which will not be explored in this paper.

13. Bruce M. Owen and Ronald Brae-utigam, The Regulation Game: Stra-tegic Use of the Administrative Pro-cess (Cambridge: Ballinger, 1978).

14. FERC’s revenues-lost stranded cost methodology is based on the assumption that utilities have a reasonable expecta-tion to serve. Despite Order 888’s explicit language, however, FERC trial staff and the City of Alma have argued in litigated proceedings that a utility that is continu-ing to serve retail customers either never had a reasonable expectation of serving that load (because, among other things, the cities could have municipalized at any time) or that the utility had a reason-able expectation but lost it sometime in the past. The arguments are particularly pernicious as they amount to “reinvent-ing history” in order to, in effect, deny a utility from recovering wholesale stranded costs. It is particularly impor-

May 1999 © 1999, Elsevier Science Inc., 1040-6190/99/$–see front matter PII S1040-6190(99)00029-9 79

tant to remember that under the FPA, prior to its amendment by EPAct in 1992, utilities were not generally obligated to provide wholesale wheeling services. As FERC properly recognized in Order 888, the institutional arrangements that were in place at that time gave utilities a reasonable (and high) expectation that their customers would renew their con-tracts and would pay their share of long-term investments and other incurred costs. The purpose of case-by-case liti-gated proceedings should be limited to implementing this understanding, rather than rearguing the basic policy questions that have been settled in Order 888.

15. Beginning with a careful review of objective data of this sort is likely to be more reliable and useful than efforts to subjectively determine the “reasonable expectation” that utility executives had in mind in the past.

16. For example, if it is demonstrably the case that specific investments in genera-tion facilities were made to support a requirements contract, that is important factual evidence that should be carefully considered in determining the appropri-ate L period.

17. While the Federal Power Act left the decision to purchase or sell wholesale power, like the decision to wheel, to “voluntary commercial relationships,” FERC regulation supplanted the terms of the requirements contract when neces-sary to remedy market power. See Bouk-night and Raskin, supra note 9, at 259. See also Floyd L. Norton, IV and Mark R. Spivak , The Wholesale Service Obligation of Electric Utilities, 6 Energy Law J. (1985), at 179–208.

18. Regulation can economize on the transaction costs associated with con-tracting by providing a governance structure that joins buyers and sellers in a continuing bilateral contract trad-ing relation. Prior to EPAct and Order 888, contracting between supplying and purchasing utilities was fraught with contracting hazards as a result of: (1) the long-term generating assets that were required to support the contracts; (2) the potential for a requirements cus-tomer to become a competitor to the supplying utility; (3) the possibility

that a supplying utility would take strategic/opportunistic actions that raise its rivals’ costs; and (4) the possi-bility that control of transmission could be used to foreclose a purchasing util-ity’s access to the wholesale market. In this context (and given FERC’s actual implementation of the FPA), the “terms” of the regulatory compact are likely to be a better indicator of the supplying utility’s reasonable expecta-tion period than the actual requirement contract’s terms.

19. FERC’s policies were asymmetric in that a supplying utility could not assume

that it would be allowed to abandon a requirements contract at the end of the contract’s term but a purchasing utility could select another provider at the end of a contract term if it chose to do so. See Bouknight and Raskin, supra note 9.

20. For example, in a 1980 case involving Indiana & Michigan Electric Company, the Commission stated: “That the rate schedules provide that they will termi-nate on a date certain is irrelevant. The statutory requirements of Sections 205(d) and (e) apply regardless of the rate schedule’s, or underlying contract’s terms.” [Emphasis added.] 12 FERC ¶ 61,007 at 61,016 (footnotes omitted). [Expiration of the contract is not suffi-cient to terminate under Section 205; FERC must instead consider whether termination would be just and reason-able and consistent with the public in-terest.] In support of its decision in this

case, FERC relied on its decisions in Sun-ray Mid-Continent Oil Co. v. FPC (364 U.S. 137 [1960]) and Pennsylvania Water & Power v. FPC (343 U.S. 414 [1952]). For a cogent discussion of FERC’s use of its authority to compel continuation of wholesale services, see Norton and Spivak, supra note 17, at 187–196.

21. For example, FERC found that Penn Water had to satisfy the public interest requirements of the FPA prior to termi-nating service with Consolidated Gas Electric Light & Power Company. Penn-sylvania Water & Power Co. v. FPC, 343 414, 421–22 (1952). For discussion of how this case helped to shape FERCs policies prior to EPAct, see also Bouknight and Raskin, supra note 19, at 255.

22. A 20-year planning period is often used, as it can adequately reflect the life-cycle cost of a resource addition (i.e., high capital costs during the early years, which would eventually be outweighed by fuel savings if the resource addition is economical). The planning period is often shorter than the actual potential operating/economic lives of potential resource additions, in part because of difficulties associated with forecasting power supply and demand long into the future. As a result, the planning period may not necessarily be a good indicator of the L period in some cases.

23. This is another fact-specific variable that will depend on legal obligations to serve and on the customer’s giving notice that it will depart on a given date.

24. While it is very clear that utilities should take reasonable actions to miti-gate stranded costs, it should be remem-bered that in many cases utilities’ ability to mitigate is limited from a practical standpoint once the stranded costs have been sunk. A major danger, given the case-by-case litigation process that FERC uses, is that the widely divergent posi-tions that are likely to come before FERC could lead to confusion about whether a utility has made adequate efforts to miti-gate costs.

25. Wayne P. Olson, From Monopoly to Markets: Milestones Along the Road (Columbus, Ohio: National Regu-latory Research Institute, Aug. 1998), at 54.

Getting it Right: Filling the Gaps in FERC’s Stranded Cost Policies

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