The Staff of the State Corporation Commission ("SCC") submits the attached draft legislation relating to stranded costs and benefits to the Stranded Cost and Related Issues Task Force. As noted on the attachment, legislation of this type will be appropriate only if the General Assembly makes the affirmative public policy decision that stranded costs should be recovered by electric utilities. If the General Assembly decides that at least some portion of stranded costs should be recoverable, we suggest a legislative approach to the determination and recovery of such costs that is specifically aimed at maintaining reasonable and necessary flexibility with respect to policy implementation and administration. We believe that this flexibility is critical to serving the public interest of Virginia in that such a process entails substantial complexity and uncertainty, poses potentially significant public impacts, and must address the unique circumstances of each utility.

In developing stranded costs and benefits policy and supporting legislation, the following key factors should be considered:

Stranded costs and benefits policy may significantly impact the development of a competitive market. As we have previously stated, we believe that electric industry restructuring will be a lengthy and evolutionary process. Therefore, it is essential that rigidity not be incorporated in one component of the transition process that may unintentionally undermine the ultimate objective. In addition to directly impacting the prices that electric consumers pay and, thereby, the economic incentives for choosing an alternative supplier, stranded costs and benefits policy will have a significant impact on the competitive cost positioning of individual utilities and consequently on the development of a competitive market, or lack thereof. For example, to the extent stranded cost recovery allows a utility to write-down existing investment to below the full cost of new generation capacity, the utility has gained a competitive cost advantage that may effectively serve as a market barrier to new entrants and tend to perpetuate any existing market power concerns.

Stranded costs and stranded benefits are symmetrical policy issues. Stranded costs recovery protects the utility's existing investment from competitive market risks by making consumers financially responsible for ensuring that the utility recovers the costs of its existing investment. The justification for this policy is that the utility was required to make this investment on behalf consumers to provide reliable service. However, if utilities are to be protected from competitive market risks and consumers are financially liable for the costs of existing asset investment, we believe that consumers should be afforded symmetrical protection from competitive market risks by having access to the embedded cost output of the assets for which they are being held financially liable. Further, it should be noted that stranded benefits associated with existing assets exist largely because utilities have historically recovered a large portion of the asset's investment from ratepayers through front-end loaded embedded cost rates. To transfer to shareholders all the future benefits of largely depreciated assets that have been, in effect, "prepaid" by consumers under the "Regulatory Compact" is no more equitable than requiring shareholders to absorb the cost of undepreciated assets acquired on behalf of consumers. In other words, the same policy justification underlying stranded costs applies equally to stranded benefits.

We believe the most practical method of affording consumers symmetrical treatment with respect to protection from market risks and the return of stranded benefits is through the provision of an extended embedded-cost rate freeze or rate cap. Such an approach would preserve the earnings integrity of utilities that have net stranded benefits while returning at least a portion of such benefits to consumers. It should also be noted that if a competitive market produces prices that are lower than embedded cost rates as many restructuring advocates have suggested, this consumer protection measure would have no impact on utilities.

Stranded costs and benefits are dynamic and cannot be accurately determined at this time, or even closely approximated. Proper estimation of stranded costs and benefits requires projecting market prices and costs over the remaining useful life of each existing asset or contract. In some cases existing utility assets may have a remaining useful life of over 30 years. As has been painfully learned from the PURPA experience of estimating avoided costs, locking-in long-term projections is extremely risky. Despite the incorporation of the ratepayer neutrality provision within PURPA, in hindsight, it is difficult to objectively conclude that ratepayers have not been significantly harmed. Projection of stranded costs and benefits is exponentially more difficult than projection of avoided costs. Long-term market prices of a currently non-existent market structure, characterized by severe infrastructure limitations and a capital-intensive, non-storable essential product with highly volatile weather-sensitive demand, simply cannot be estimated within the bounds of reasonable accuracy.

As noted in a previous SCC Staff report, a 15 percent change in market prices in an example stranded cost calculation provided by one utility would either double or eliminate a $2.5 billion base estimate of stranded costs. Cost projections of existing assets are also extremely questionable due to factors such as potential life-extensions and significant new environmental regulations with disparate impacts. An additional complication will be the allocation of embedded costs between competitive services and services which may continue to be subject to some form of price regulation such as certain generation-related ancillary services or must-run units. In short, reliance on a one-time up-front estimate of stranded costs and benefits presents the potential for a public policy disaster.

In view of the foregoing concerns, the SCC Staff offers the attached legislative approach for the consideration of the Task Force.

ATTACHMENT
Stranded Costs/Benefits Legislation --
Draft by the Staff of the
State Corporation Commission
July 23, 1998

The Staff of the State Corporation Commission submits the following draft legislation relating to stranded costs, as requested by the SJR 91 subcommittee task force dealing with this issue. As a preliminary matter, however, the Staff wishes to emphasize that legislation of this type will be appropriate only if the General Assembly makes the affirmative public policy decision that stranded costs should be permitted to be recovered by electric utilities. The Staff is not endorsing such a concept by submitting this draft.

Second, it is also important to note that legislation dealing with stranded costs cannot and should not be considered in isolation from all other issues affecting restructuring of the electric industry.

§ 56-576. Policy of Article. -- The General Assembly declares that it is the public policy of the Commonwealth that public utilities supplying electric service in this state as of the effective date of this Article under a certificate of public convenience and necessity issued by the Commission shall have the opportunity to recover their net stranded costs, if any, caused as a result of developments which occur due to the passage of this Article, and customers of such utilities shall have the opportunity to be provided the net stranded benefits, if any, caused as a result of developments which occur due to the passage of this Article, each as determined and quantified by the Commission pursuant to the provisions of this Article.

§ 56-577. Definitions. -- The following terms, whenever used or referred to in this Article, shall have the following meanings, unless a different meaning clearly appears from the context:

(a) "Net stranded costs" means the jurisdictional amount of verifiable, prudent, and necessary book costs, determined pursuant to the provisions of § 56-578 hereof, of the total net asset investments and financial obligations of an electric public utility, considered as a whole, which the Commission finds:

(1) cannot or are not likely to be recovered by the utility from the competitive market, or decreased through prudent and effective efforts of the utility, over the remaining useful life of such assets and obligations;

(2) have resulted from prior legal or regulatory obligations of a utility to provide a service which the General Assembly declares, or the Commission finds, to be a competitive service pursuant to the provisions of § 56-____; and

(3) are properly allocable to such service.

(b) "Net Stranded Benefits" means total electric utility revenues, net of prudent variable costs, earned in the competitive market which the Commission finds are in excess of the jurisdictional amount of verifiable, prudent and necessary book costs, determined pursuant to the provisions of § 56-578 hereof, of the total net asset investments and financial obligations of an electric public utility, considered as a whole, which the Commission finds:

(1) have resulted from prior legal or regulatory obligations of a utility to provide a service which the General Assembly declares, or the Commission finds, to be a competitive service pursuant to the provisions of § 56-____; and

(2) are properly allocable to such service.

(c) "Book costs" means the costs of all assets and related credits properly documented in a utility's accounting records and other financial obligations existing as of the effective date of this Article.

(d) "Electric public utility," or "utility" means ____________________________.

§ 56-578. Determination and Recovery of Net Stranded Costs and Benefits. -- (A) Upon its own motion, or the motion of any electric public utility, customer of such a utility, or other interested party, the Commission shall, after notice and hearing, determine, monitor, and adjust, from time to time as it finds appropriate, net stranded costs and net stranded benefits for each class of customers for each such utility, and shall also determine, monitor, and adjust, from time to time as it finds appropriate, a mechanism that provides each utility a reasonable opportunity to recover net stranded costs from its jurisdictional customers as of the effective date of this Article, subject to such exceptions as to customers or customer classes as may be reasonably determined by the Commission, and that reasonably provides for provision of net stranded benefits to such customers. The Commission shall incorporate adequate protective measures to seek to ensure that neither the utility nor its customers suffer undue adverse impact in the determination, recovery or provision of net stranded costs and net stranded benefits, and that such determination and recovery is not unduly discriminatory against any electric public utility, customer or customer class, or detrimental to the public interest.

(B) An electric public utility seeking recovery of net stranded costs shall bear the burden of proving such costs and their reasonableness, and the reasonableness of the recovery mechanism it proposes for such costs.

(C) In determining net stranded costs or net stranded benefits and establishing a recovery mechanism therefor, the Commission shall give due consideration to the following factors:

(1) the degree to which federal and state requirements have imposed competitive burdens on the utility, or have provided competitive advantages to such utility;

(2) the degree to which discretionary utility management decisions have decreased or increased potentially unrecoverable costs in the past, and the degree to which reasonable programs and procedures are proposed by the utility to decrease such costs in the future;

(3) the degree to which discretionary utility management decisions have resulted in costs that are below market;

(4) the degree to which recovery of net stranded costs will provide an incentive or disincentive to utility management to decrease net stranded costs in the future;

(5) the degree to which utility management has fostered the effective development of a competitive market in the past and proposes reasonable programs and procedures to foster such market in the future;

(6) the degree to which utility management has maintained adequate and reliable electric service in the past and proposes reasonable programs and procedures to maintain such service in the future;

(7) the degree to which customers have previously supported depreciated plant;

(8) the degree to which the allowance of recovery of net stranded costs or provision of net stranded benefits balances potential market risks and benefits for the electric public utility and its customers;

(9) the degree to which the allowance of recovery of net stranded costs or provision of net stranded benefits is likely to impact the development of a competitive market;

(10) the degree to which the allowance of recovery of net stranded costs or provision of net stranded benefits gives due regard to the likely full useful life of all prior investments and obligations of the utility;

(11) the degree to which earnings of the electric utility have exceeded or fallen below the authorized return on common equity for the utility's price-regulated services since the effective date of this Article;

(12) the degree to which the rates previously established by the Commission have adequately compensated shareholders of the electric public utility for business risks, including the risks of not recovering net stranded costs;

(13) for those costs which the electric public utility had the discretion to incur, the degree to which the level and type of those costs compare to the level and type of such costs of similarly situated utilities;

(14) the degree to which the allowance of recovery of net stranded costs or provision of net stranded benefits may impact the public health, safety, welfare or environment; and

(15) such other factors as the Commission may find appropriate which are consistent with the public interest and not inconsistent with the other provisions of this Article.