Part 1:  Basics of Stranded Assets and Securitization   [Download PDF]

Across the United States, states are switching from a traditional cost-of-service utility business model, where payments to investor-owned utilities are based on a simple mark-up of the utilities' costs, to a market-based model, where generating companies compete to provide electricity to end-users based on price and quality of service. The transition from a cost-of-service model to a market-based model is known as "restructuring." Restructured states all face decisions on how to manage the transition to the new business model.

The market-based model is generally considered to reduce consumer costs (and increase customer choices), which means that incumbent utilities see lower and less-certain revenues and lower profits under the new model. In turn, the value of the incumbent utilities' assets declines and many of their long-term contracts, which were signed based on a more certain regulated environment, may no longer be economically viable. The difference between the value of assets and contracts before restructuring and after restructuring is the largest component of what is known in the industry as "stranded costs."

The question faced by the states, therefore, is who should bear the burden of the losses that result from the transition from one legislated business model to the other, and how should the transition be designed to ensure economic efficiency and fairness to all stakeholders that will be affected by the change. Since electric market restructuring began in earnest in the late 1990s, most legislators, utilities, regulators, and economists have generally agreed that it is important to honor the regulatory compact made in the past between the utilities and the stakeholders they serve. This, along with many other considerations, has led legislatures to assign to consumers the responsibility to cover the stranded costs, but also to allocate to the consumers the benefits of lower rates arising out of restructuring. Fortunately, consumer gains are expected to outweigh consumer losses. If this were not the case, the restructuring would not make political sense. Some states have even gone so far as to mandate that post-restructuring rates be set well below the rates that existed prior to restructuring, during a reasonable "adjustment" time period. Consumers, therefore, end up with net positive benefits even after covering the costs of restructuring.

One common tool employed by states and financial markets to pay back affected utilities for their stranded costs is "securitization." Fundamentally, securitization is a financing mechanism through which an independent enterprise is established to 1) issue bonds; 2) sell the bonds to investors; 3) use the proceeds from the bond sales to buy out the utilities' stranded assets (which removes the stranded assets from the utilities' rate bases); and 4) place charges on consumers' electric bills for a limited amount of time to re-pay the bond investors. Such securitization mechanisms require legislative action at the state level to establish the securitization enterprise and provide the legal authority for it to collect and make payments to the parties involved.

Many states euphemistically refer to the bonds issued through securitization as "rate reduction" bonds. This label presumes that some economic benefit is gained through the issue and pay-down of the bonds. That economic benefit stems largely from one important concept: Interest rates paid to bond investors are substantially lower than the cost of capital provided to incumbent utilities prior to restructuring. The interest rates are lower because the payments are mandated by law, thereby reducing the risk that the bonds will not be repaid. This often allows these securitization bonds to be rated as high as AAA by the bond rating agencies. As a result, the bonds can be sold to investors with much lower interest rates. The difference is substantial – cost of capital rates for investor-owned utilities can range from 7% to 10%, while rates for municipal or AAA-rated bonds can range from 3% to 5%. Essentially, the consumers no longer pay the utility for the stranded assets, but instead pay the bond investors (at lower rates that arise from the securitization's lower interest payments).

While this overview of securitization presumes its use for restructuring, there are many examples over recent years where the mechanism has been used to pay down utility assets that are no longer deemed "used and useful" by state regulators. Examples include nuclear power plants built on geologically unstable ground; coal plants where the cost of mandated emissions controls are higher than the value of the plant; or coal plants whose operating costs now exceed the value of the electricity they produce. We may expect to see more use of securitization as electricity business models evolve over the next several years to accommodate developments in technology, environmental concerns, and economic conditions.

Sources

Congressional Budget Office.  "Electric Utilities: Deregulation and Stranded Costs."  October 1998.   [PDF]

Mauro, Chris F., CFA, RBC Capital Markets.  "Municipal Securitization – A New Financing Trend in the Municipal Market?"  November 2014.   [PDF]

Ramsey, Kim E., Akin Gump Strauss Hauer & Feld LLP.  "Electric Utility Securitizations."  January 2014.

Virginia State Corporation Commission staff report. "Chapter 4 Stranded Costs." September 2007.

Part 2:  Summary of CBO report on stranded costs  [Download PDF]

In 1998, the Congressional Budget Office issued a white paper entitled "Electric Utilities: Deregulation and Stranded Costs" in response to questions about states' moves to restructure electricity markets and provide more competition and choice for electricity consumers. The paper covers much material in its 27 pages. What follows is a brief review of the paper's key points.

The paper addresses three main questions:

• What are stranded assets and where do they come from?
• How can they be measured?
• What are the pros and cons of making different groups – consumers, taxpayers, utilities, and their stockholders – pay some or all of the stranded costs?

Stranded costs can be defined as "the decline in value of electricity-generating assets due to restructuring of the industry" (the definition assumes that retail prices will be lower after industry restructuring).

The paper cites three main sources of stranded costs:

1. Uneconomical plants: Gap between value of assets in competitive market and pre-restructuring value. This basically boils down to a difference between accounting value and market value of the assets after restructuring. The market value can be affected by many things, such as expected revenues, efficiency, economic conditions, etc.
2. Lower prices: Effect of more efficient providers entering market.
3. Lower demand: Loss of revenues due to customers leaving incumbent utility

Stranded costs fall into five main categories. While we tend to think of just the first of these in our discussions, the second and third are also quite consequential:

1. Unrecoverable costs of generation-related assets.
2. Long-term contracts for power or fuel that would cause the utility to lose money when market prices for power decline.
3. "Regulatory assets," such as deferred income tax liabilities, that regulators would have eventually allowed but that would not generate returns in a competitive market.
4. Capitalized investments in social programs.
5. Employment transition costs.

Measurement of stranded assets can follow either of three methodologies:

• Administrative ex ante estimates: the difference between the present value of revenues with and without competition.
• Market valuation, such as an auction mechanism, to value sold-off assets.
• Ex post measurements: record actual market prices after the fact and compare to pre-restructuring book values.

The question as to who should pay for stranded costs depends on the following factors:

• Economic efficiency: whether the proposed structure encourages efficient uses of resources (primarily hard assets, capital, labor).
• Fairness.
  • Does the restructuring disrupt the regulatory compact?
  • Does non-recovery of stranded costs constitute a legal "taking"?
  • Are costs higher because of state/federal mandates that could not be avoided?
  • Were past returns held down by regulatory agency? This argument was put forward by the Clinton administration, the administration at the time of the CBO paper's publication.

How should money be collected to pay for stranded assets? Note: In each case presented here, fees are non-bypassable and temporary until all costs are recovered.

• A per-kWh surcharge on customer bills.
  • Some leeway exists as to how costs are allocated among service classes.
  • This is the most popular method, as of the 1998 report.
• A fixed-amount surcharge on all existing customers.
  • Generally takes the form of fixed monthly charges for a specified period.
  • Would not affect ongoing usage like a per-kWh charge might.
  • Allocation based on past usage, perhaps?
• A one-time exit fee paid by those who switch away from the incumbent.
  • Tends to protect the incumbent and lessen competitive opportunities.
  • Employed by Michigan in their restructuring in the late 1990s.

How should payments be distributed to Utilities?

• Securitization is a way to provide the incumbent utility with a one-time lump sum and then spread ratepayer payments over time:
  • Basically, a refinancing whereby the utility's cost of capital is replaced with a lower rate closer to those seen for municipal bonds, due to the mandated (low-risk) and steady stream of cash flows (ratepayer payments). State legislators authorize securitization, which takes the form of a state infrastructure bank who sells bonds and takes over rights to income streams from ratepayers.
  • May allow utility to accept lower lump sum due to benefits of tax deferral.
  • Still subject to vagaries of stranded-cost determination.

The report closes with this paragraph, copied here in its entirety:

"On this issue (economic efficiency vs. fairness), economic efficiency plays second fiddle to fairness and politics. Economists can recommend ways to estimate stranded costs, ways to pay them, and ways to collect fees for stranded costs that are the least distorting and least costly to the economy. Economists can also estimate the benefits of restructuring and identify likely winners and losers. But the decision to compensate – to ease the financial burden of restructuring on the owners and creditors of utilities – is ultimately one for regulators and legislators."

Source

Congressional Budget Office.  "Electric Utilities: Deregulation and Stranded Costs."  October 1998.   [PDF]