SJR 91

Task Force on Stranded Costs and Related Issues

July 30, 1998, Richmond

The Task Force on Stranded Costs and Related Issues met to hear specific and detailed proposals from stakeholders regarding stranded cost definitions and recovery mechanisms. These representatives offered views on which elements should be considered in any determination of allowable stranded cost recovery and how such stranded costs should be recovered in conjunction with the introduction of a competitive retail market for electricity. The task force also received further information regarding non-utility generator (NUG) contracts and an update on Virginia Power's rate case proceedings before the State Corporation Commission (SCC).

Virginia Power Rate Case

The general counsel for the SCC provided the task force with an update of Virginia Power's rate case. The SCC began its review of Virginia Power's rates, terms and conditions in November 1996. Negotiations between the SCC's staff, the Division of Consumer Counsel of the Office of the Attorney General, the Virginia Committee for Fair Utility Rates, and Virginia Power culminated in a stipulation that was before the SCC for consideration at the time of the task force meeting. On August 7, 1998, the stipulation was accepted by the SCC.

As a result of this settlement, Virginia Power customers will receive a refund of $150 million plus interest; a rate reduction of $100 million for the period of March 1, 1998, through March 1, 1999; and an additional $50 million rate reduction on March 1, 1999. Following the March 1, 1999, reduction, rates will be frozen at the resulting level through February 2002. Additionally, Virginia Power will use its revenues to eliminate $220 million in regulatory assets which the company would have otherwise been required to recoup from customers over a much longer period of time. Virginia Power is also given an earnings incentive to write off additional amounts. The SCC will ensure that customers benefit from these write-offs. The SCC's general counsel also noted that while the agreement does resolve revenue and allocation concerns, there still remain significant concerns relating to industry restructuring and the initiation of retail competition.

NUG Contracts

At the June 30, 1998, task force meeting, Virginia Power and the Virginia Independent Power Producers provided a historical overview and summary of Virginia Power's contractual involvement with non-utility generators for the wholesale purchase of electricity. An analyst explained how these mandated expenditures may, in a future competitive market, contribute to stranded costs. The July 30, 1998, meeting provided an opportunity for the Virginia Committee for Fair Utility Rates to offer an alternative perspective of such contracts and whether or not the associated above-market contract costs should be fully recoverable as stranded costs in a competitive market. The Virginia Committee for Fair Utility Rates is an association of 20 large industrial electric customers in Virginia. The committee has existed since the early 1970s and regularly participates before the SCC on matters pertaining to the regulation of Virginia Power.

The committee provided examples illustrating that estimates of stranded costs are speculative and stated that recoverable net stranded costs should be based on market valuations and not administratively determined predictions. The committee characterized any administrative attempt to quantify stranded costs as costly, judgmental, and difficult to project with any accuracy. The committee also stated that there is no obligation guaranteeing utilities full recovery of prudently incurred costs, and that customers are not required to insulate utilities against all business risks. An analyst appearing on behalf of the committee testified that Virginia Power's management appears to have adopted a business philosophy of being a strong advocate of NUG purchases. The committee also asserted that over one-third of the capacity purchased by Virginia Power during its active solicitation process did not involve qualified facility projects subject to PURPA mandates. The analyst further suggested that this business strategy should be considered when allocating the stranded costs associated with Virginia Power's NUG contracts.

SCC Proposal

The remainder of the meeting was devoted to hearing highlights of representative stakeholders' positions relative to determining and recovering stranded costs. The SCC continued to assert that (i) the restructuring process will be a lengthy and evolutionary process, (ii) the legislative proposal offered by the SCC is appropriate only if the General Assembly makes the affirmative policy decision that stranded costs should be recovered, and (iii) stranded costs and stranded benefits are symmetrical policy issues, meaning that the same policy justification underlying stranded costs applies equally to stranded benefits. The SCC also stated that the most practical method of affording consumers protection from market risks is by implementing an extended embedded-cost rate freeze or rate cap, thereby preserving the earnings integrity of utilities while returning at least a portion of such benefits to consumers.

The SCC's proposal assigns to the SCC the responsibility of determining, monitoring, and adjusting net stranded costs and benefits for each class of customers for each utility. Public utilities seeking stranded costs bear the burden of proving the costs and their reasonableness, as well as the reasonableness of the recovery method. The SCC would give consideration to enumerated factors in determining the net stranded costs or benefits and the allowable recovery method. Some of these factors include the degree to which federal and state requirements have imposed competitive burdens or advantages on utilities, the degree to which discretionary utility management has decreased or increased unrecovered costs, and the degree to which discretionary utility management decisions have resulted in costs that are below market.

Division of Consumer Counsel Proposal

The Division of Consumer Counsel, Office of the Attorney General, stated that upon the existence of effective competition, all just and reasonable stranded costs should be recovered, and all just and reasonable stranded benefits should be returned to customers. According to the Division of Consumer Counsel, determining the stranded costs or benefits will be a fact-intensive process that must be repeated for each existing utility, and the SCC should be given the flexibility to develop and implement a procedure for the direct recovery that ensures all customer classes share equitably in paying such stranded costs or receiving such stranded benefits. While the SCC is best suited for this determination, the Division of Consumer Counsel noted that the General Assembly may decide to provide factors for the SCC to consider in its deliberations and offered an illustrative list of such factors to the task force for consideration. The factors offered include the extent to which the utility was legally required to incur the costs and assets and allocations, the effectiveness of the efforts of the utility to increase market value or decrease the costs of obligations associated with the provision of potentially competitive services, and the degree to which customers have previously supported a depreciated plant.

Virginia Power Proposal

Virginia Power's proposal would permit utilities to recover net losses associated with the onset of retail competition. Such losses include the costs of increased consumer and employee benefits, mandated obligations (NUG contracts, nuclear decommissioning, and other governmental requirements imposed prior to competition), transition costs (including the formation of an independent system operator/regional power exchange, or ISO/RPX), and the net losses in the economic value of generation investments (stranded costs). The SCC would not have the authority to require a sale or divestiture of utility assets to determine stranded costs.

Each incumbent utility would recover these net losses during a three-year transition period through either (i) a guaranteed frozen generation rate or (ii) a "non-bypassable wires charge." The guaranteed frozen rates for each incumbent utility would be based on the rate-making methods and principles recognized and approved by the SCC and would be designed to allow the utility to recover stranded costs while the shareholders earned a reasonable rate of return. Those customers who stay with their incumbent utility would pay the guaranteed frozen rate throughout the three-year transition period and would not pay any non-bypassable wires charges during this period.

Under Virginia Power's proposal, those customers who decide to switch to a competitive supplier of electricity would pay a non-bypassable wires charge for stranded costs and other expenses associated with retail competition. These non-bypassable wires charges would be determined by the SCC and remain in effect for the three-year transition period.

Following the completion of the three-year transition period, all customers would choose a competitive supplier and would pay a non-bypassable wires charge or receive a credit for remaining mandated obligations, transition costs, and consumer and employee benefits, including consumer education, retraining, education and outplacement services, and public purpose programs. The non-bypassable wires charge or credit would be determined by the SCC, using the rate-making methodologies and principles approved by the SCC to recover only above-market costs. These charges would be determined and "trued-up" annually. Any cost reductions of mandated obligations through successful mitigation would be shared equally by customers and shareholders. Additionally, any retail customer who is later served by local or on-site generation would pay its fully allocated share of net losses associated with the onset of retail competition through an exit fee determined by the utility and approved by the SCC.

American Electric Power Proposal

American Electric Power's proposal envisions a transition period running from January 1, 2002, through January 1, 2005, at which time the retail market would be functional. For the duration of the transition period, electric utilities would freeze their retail rates. The rates in effect during the transition period are presumed to be sufficient to allow electric utilities to recover all costs associated with regulatory assets (previously deferred generation-related charges) and costs related to the transition to competition, including the costs of pilot programs, ISO formation, and the decrease in value of a utility's generation assets.

Customers would have the option, during the transition period, to purchase generation services from alternative suppliers. However, customers opting to switch from their incumbent utility would pay a competitive transition charge (CTC), approved by the SCC. The CTC would reflect the difference between (i) the revenue the incumbent electric utility could otherwise expect to receive from the customer during the transition period and (ii) the revenue that would be produced for the utility by application of an average market rate for generation service which would have otherwise been purchased from the utility by such customer. Additionally, electric utilities could collect, through a non-bypassable wires charge, unforeseen additional costs associated with (i) the establishment of an ISO, (ii) the establishment of a regional competitive marketplace, and (iii) public purpose programs required by law or regulation. The non-bypassable wires charge could be applied during or following the transition period, and would be applied in addition to any capped rates or CTC.

Allegheny Power Proposal

Allegheny Power's definition of stranded costs is calculated to include those costs, liabilities and investments otherwise recoverable in a regulated market, including regulatory assets and power purchase contracts; investments in generation facilities, including retirement, decommissioning and environmental costs; and other transition costs, including employee benefits, debt refinancing, reengineering or modification of existing business equipment, tax liabilities, and consumer education costs.

These costs would be recovered through a CTC determined by the SCC six months preceding the initiation of retail competition. Customers who do not switch suppliers would pay this CTC as part of a frozen rate. Customers who decide to switch suppliers would pay this CTC separately. With the exception of purchase power contracts and regulatory assets, stranded costs would be recovered over a five-year period. Regulatory assets and purchase power contracts would be recovered over a period not to exceed the remaining time of amortization or the remaining life of the contract, respectively. The SCC would annually adjust the CTC to account for recovery exceeding or falling short of the authorized amortization amount.

Electric Cooperatives Proposal

The unique characteristics of electric cooperatives' structure and operation requires that cooperatives' stranded costs be addressed separately from that of investor-owned utilities, according to cooperative representatives. The plan submitted by the cooperatives allows complete recovery of stranded costs and transition costs. Stranded costs, defined by the cooperatives as electric generation-related costs that would be recoverable under traditional cost-of-service regulation but are not recoverable in a competitive market, include net generation plant investments, nuclear generating plant decommissioning costs, and purchase power contracts. The cooperatives' plan defines transition costs as costs reasonably incurred during the transition from cost-of-service regulation to a competitive retail electric market, including the cost of developing and implementing an ISO or RPX, employee severance and other benefits for employees adversely affected by restructuring, the unrecovered costs of metering and billing systems if the cooperatives are no longer required to provide such services, and the costs of any physical plants rendered no longer used or useful because of the transition to retail competition, as well as any similar or related costs determined by the SCC to be recoverable.

Electric cooperatives would have a duty to mitigate these stranded costs and transition costs, which are to be recovered through a CTC, which would be included on customers' billing statements. Each distribution cooperative would file with the SCC a recovery plan for stranded and transition costs. The SCC would evaluate the recovery plan, establish procedures for periodic review and reconciliation of the CTC, and review these charges between two and five years after the transition to a competitive market. Cooperative customers who opt to install or operate on-site generation would pay their fully allocated share of stranded and transition costs through an exit fee approved by the SCC.

Consolidated Natural Gas Proposal

The proposal offered by Consolidated Natural Gas directs the SCC to determine how and over what period of time to allow recovery of stranded costs. Stranded costs include unrecoverable expenses from (i) unfunded nuclear decommissioning expenses, (ii) contracts entered into under PURPA, (iii) above-market fixed and variable generation costs, and (iv) regulatory assets. Principles to be used by the SCC in making these determinations should ensure that (i) a robust competitive market is created at the earliest practicable time and that such recovery does not delay the development of this market, (ii) a reasonable relation exists as to the costs actually stranded for each class of customer, and (iii) only costs recovered in regulated rates are recovered.

ALERT Proposal

The Alliance for Lower Electric Rates Today (ALERT) contended that stranded costs are the by-product of an effectively competitive retail electricity market and that their recovery should be conditioned upon an SCC finding that there is effective competition for the product or service at issue. ALERT defines stranded costs as the recoverable decremental net difference between embedded costs remaining after accounting for maximum possible mitigation and the market value of generation or other potentially competitive services, and stranded benefits as recoverable incremental net difference between embedded costs and the market value of generation or other potentially competitive services. According to ALERT, any decision to allow full recovery of embedded costs can negatively affect the efficiency of the developing market for retail electric goods and services by (i) reducing or eliminating a utility's incentives to lower its embedded costs and to mitigate those costs, (ii) acting as a barrier to market entry and exit, and (iii) allowing a utility to retain more profit than under regulation, while guaranteeing recovery of any losses from consumers.

According to ALERT, the SCC should consider several factors when determining the amount of recoverable stranded costs or benefits, including the extent to which the utility was legally required to incur the costs or obligations, the extent to which the market value of the assets and obligations relating to generation or other potentially competitive services exceeds or is less than the embedded costs of such services, the effectiveness of the utility in increasing market value of an affected asset or decreasing the costs of any obligations, and the extent to which the rates previously established by the SCC have compensated shareholders for the risk of not recovering the costs of the assets or obligations.

ALERT's plan would require the SCC to (i) adopt a just and reasonable method and procedure for affording the recovery of stranded costs or benefits, (ii) establish a recovery period, and (iii) assess just and reasonable charges or credits. These determinations should not unduly discriminate against a participant in the market, and no charges or fees should be imposed on retail customers who choose to self-generate electricity. ALERT's proposal would establish a continuous price cap for each customer class. This price cap would provide a mechanism to address stranded benefits and protect consumers from ineffective competition. The SCC would establish the appropriate price cap for each customer class based on the annual changes in (i) a price index, (ii) a productivity index, and (iii) an adjustment factor for idiosyncratic costs or benefits.

AARP Proposal

The American Association of Retired Persons (AARP) proposed that stranded costs be recovered in a time period not to exceed 10 years and that the recovery of stranded costs should not permit any shifts among customer classes. AARP's proposal would require the SCC to estimate the stranded costs for each utility and would allow the SCC to correct or adjust the stranded costs charges on its own initiative or upon petition. AARP's approach allows utilities to recover no more than 50 percent of legitimate, verifiable, prudent, and non-mitigatible stranded costs.

Perspectives from Other States

Enron Corporation, a national supplier of electricity, offered an overview of two different methods incorporated to recover stranded costs. Enron noted that one way of collecting stranded costs is through the use of a CTC, either as a variable or fixed charge. A variable CTC is structured to decrease as the price of power increases and to increase as the price of power decreases. Enron suggested that a variable CTC prevents suppliers from being able to compete in the market for generated electricity because suppliers cannot offer incremental savings. A fixed CTC, according to Enron, provides a known quantity that can be amortized over the length of the recovery period, allowing suppliers to offer savings to customers by offering below-market electricity.

In addition to its proposal for stranded costs in Virginia, Allegheny Power also provided the task force with an overview of the company's involvement with retail competition in Pennsylvania. Allegheny's representative discussed several aspects of the Pennsylvania restructuring law, including the phase-in to competition, the recovery of stranded costs through a competitive transition charge, and the annual reconciliation of the amounts collected by the CTC.

Next Meeting

Following the presentations and discussion, the chairmen set the next meeting of the task force for Friday, August 21 and announced plans to conclude the work of the task force prior to the September 23 meeting of the full joint subcommittee. At the September 23 meeting, scheduled to be held in Roanoke, the chairmen will deliver a report to the joint subcommittee highlighting the major policy concerns and describing areas of consensus and disagreement relative to stranded costs.

The Honorable Richard J. Holland, Co-Chairman
The Honorable John C. Watkins, Co-Chairman
Legislative Services contact: Robert Omberg