Electric Industry Restructuring:
Opportunities and Risks for West Virginia
Interim Report No. 3:
Implications for Electricity Producers
Part IISubmitted to:
Director of Operations
Governor’s Office
1900 Kanawha Boulevard East
Charleston, WV 25305Submitted by:
West Virginia University
Electric Industry Restructuring Research Group
P.O. Box 6064
Morgantown, WV 26506
July 31, 1997
Table of Contents
PART I (Sections 3.0.0 through 3.3.3)
3.4.0 Stranded Costs In West Virginia
3.4.1 Description of Utility Data and Utility Stranded Cost/Benefit Model
3.4.2 Discussion of Utility Stranded Assets in West Virginia
3.4.3 Stranded Costs of Purchased Power
Table 3.1: Size of Selected West Virginia Industries (Appendix)
Table 3.2: Distribution of Coal Mined in West Virginia (1995) (Appendix)
Table 3.3 West Virginia Utility-Owned Coal-Burning Plants, 1995
Table 3.4: Average Variable Costs ($/MW hour)
Table 3.5: Assets and Costs of Power Plants in West Virginia (Appendix)
Table 3.6: Stranded Assets of Power Plants in West Virginia, Historical Production Basis (Appendix)
Table 3.7: Stranded Assets of Power Plants in West Virginia, Historical Production Basis (Appendix)
Table 3.8: Stranded Assets of Power Plants in West Virginia, Assumed Production Basis (Appendix)
Table 3.9: Stranded Assets of Power Plants in West Virginia, Assumed Production Basis (Appendix)
Table 3.10: Stranded Assets Price Elasticities, Historical Production Basis (Appendix)
Table 3.11: Stranded Assets Discount Rate Elasticities, Historical Production Basis (Appendix)
3.4.0 Stranded Costs In West Virginia
A major problem in the process of restructuring the electricity industry in the United States has been the disposition of the so-called "stranded assets" of electric utilities and consumers. Stranded assets can be defined in a number of ways but the term usually refers to the difference between the regulated and unregulated values of utilities’ physical or market assets or consumer’s benefits. Stranded assets may occur because of differences in value of physical assets, because of differences in contractual purchases and sales, or because of the discontinuance of social programs associated with providing electric power. Due to the low operating cost and book value of West Virginia’s generation plants, some studies have concluded that they are more valuable in a competitive market than under traditional regulatory cost recovery. This gives the debate an unusual flavor in West Virginia, since most states anticipate that book value of most assets is considerably above their free market value.
Since the generation activities of the utilities are to be deregulated, it is the stranded assets associated with generation, rather than transmission or distribution, which is of present interest. To discuss stranded assets, it is first necessary identify the variations of the notion of stranded assets.
From the viewpoint of the utilities, if the free market value of an asset is less than the regulatory book value, there are stranded costs experienced by the utilities as a result of deregulation. However, if market value becomes greater than book value as a result of deregulation, there are stranded benefits that would otherwise accrue to the consumers. The term "stranded benefits" is also applied to the social benefits now being distributed among electric utility customers by electric utilities that may be lost as a result of deregulation. To avoid confusion among these terms the following definitions are used:
Stranded cost is the difference between the regulated and unregulated values of utilities’ physical assets and contractual purchases of power and capacity. Stranded cost is positive if regulated book value exceeds market value, resulting in a loss by the utilities (but a gain to consumers) under deregulation absent any other regulatory action.
Negative stranded cost is the difference between the regulated and unregulated values of utilities’ physical assets and contractual purchases of power and capacity when market value exceeds regulated book value. These are benefits that would be gained by the utilities and lost by consumers under deregulation absent any other regulatory action.
Stranded social benefit is the amount of the transfer payment, consisting of subsidies and services that regulators have required utilities to pay in such plans as low-income customer plans, demand-side management, and other social welfare programs that have been common under traditional regulation. More correctly, the stranded social benefit should be measured as the social gain obtained through the transfer of benefits and costs in such programs. Equity benefits are almost always accompanied with a loss of economic efficiency in a free market. These types of social benefits and economic efficiency costs are difficult to measure and are often mistakenly ignored. Stranded social benefits represent transfer payments from one class of electricity consumers to another and do not represent any change in costs to the utilities.
Stranded costs of utility assets occur when past capital investments made by utilities and included in the present rate base exceed their current open market value. This difference occurs when expected future deregulated prices are lower than present regulated prices. The deficiencies in values are caused by approvals by regulatory agencies of capital expenditures that seemed to be in the best public interest at the time, but which turned out to be investments in unneeded capacity or unsound technology. Electric utilities argue that they should be able to recoup such past capital expenditures, which were made with regulatory approval, whether the generation sector is regulated or not. Consumer advocates argue that recovery of stranded costs by utilities is not necessary to achieve the higher level of competition and consumer benefits, which are the goals of the industry restructuring. Consumer advocates further argue that if utilities are allowed to recoup stranded costs, consumers should be allowed to recoup negative stranded costs, for the consumers have been paying for these stranded assets in the rate base.
There is a history in the United States of both allowing and disallowing stranded costs. When large chain grocery stores put the mom and pop corner grocery stores out of business, there was no payment of stranded costs to the small stores’ owners although stranded costs did certainly exist. On the other hand, there is a long history of repaying stranded costs to small farmers as a result of increased competition in the agriculture business. Whether stranded cost recovery is or is not allowed is largely a social decision since this represents a transfer payment. If society decides that it is preferable to prevent harm to utilities and utility stockholders, then utility stranded costs should be allowed. If society wishes to prevent harm to electricity customers, then the stranded cost recovery by utilities should be disallowed. More likely, society will be concerned with investors, producers and customers, and will allow some, but not all, stranded costs to be recovered by utilities.
The stranded asset issue applies only to the transition phase of electricity industry restructuring and is not a long-term problem. In West Virginia a number of generating facilities will experience negative stranded costs, which indicates that the market value of the generation facilities is greater than the regulated book value. This situation raises a number of problems, such as, how regulatory agencies can quantify the stranded assets and the appropriate distribution of recovered costs if utilities sell all or portions of generation facilities at prices greater than book value.
The following sections describe the methodology and assumptions used to determine stranded costs and benefits in West Virginia related to the valuation of physical assets of the utilities. Stranded costs associated with contractual power purchases by utilities are also presented. The issues of stranded social benefits in West Virginia are also discussed.
3.4.1 Description of Utility Data and Utility Stranded Cost/Benefit Model
There are several ways of measuring stranded assets. Perhaps the most direct and accurate way would be to hold an auction of all generation assets, after announcing a new policy of encouraging competition in generation. Since we lack the power or inclination to try such an experiment, we estimate the stranded assets of electricity generation plants in West Virginia by subtracting an estimate of the present value of future earnings from the average book value of each generation plant. The value obtained for each generation plant is then added to obtain aggregate value per utility and for the State. Of course, the present value of future earnings is unknowable, and subject to great uncertainty due to uncertainty over the future competitive price of electricity. Small changes in assumptions can result in large swings either way in the final calculation of stranded cost.
Purchased power obligations also contribute to the stranded assets of utilities. Any single purchase obligation, such as from a nonutility generator, may have either a positive or negative stranded cost, although most nonutility contracts are viewed as being stranded costs. Determining the value of these contractual obligations is rather straightforward once the contractual provisions are known. Stranded costs due to purchased power obligations are not determined in this investigation other than noting the estimated value of these stranded costs as determined by Allegheny Power.
This investigation computes the value of stranded assets on the basis of individual generation plants. Utilities claim the value of the generation plants should be computed on a system wide basis, for this is the basis the plants are installed and operated. However, the necessity of a system wide evaluation to obtain accurate evaluation of worth of individual plants means there are economies of scale that would be omitted otherwise. If this is true, the generation industry should not be deregulated, since the economic justification for the deregulation of generation starts with the premise there are no economies of scale in generation that can not be captured by the owner of a single plant.
The correct way to compute the value of stranded assets is therefore on the basis of individual generation plants, not a system-wide basis. The value of any single plant from an independent investor’s perspective is based on the value of individual generation facilities plus the overhead of the investor. The value of a utility’s shared operating costs and benefits and stranded costs due to purchased power obligations are not concerns of an individual investor.
The results of the model are given on the following seven tables. Table 3.5 identifies the base numbers used in determining the value for each utility generation plant in West Virginia. Tables 3.6, 3.7, 3.8, and 3.9 show the values of stranded utility assets under various assumptions based on historical and increased production rates. Tables 3.10 and 3.11 show the relative changes in asset value caused by changes in prices and discount rates.
Values of stranded utility assets are dependent upon the assumptions made concerning future operating rates, future prices, future operating and capital costs, and discount rates. The values and assumptions used to determine the values in this model are as follows:
All historical data are reported values from FERC Form 1 reports from 1989 through 1995. All calculations are based on 1995 as the beginning year.
All future values and discount rates are on a constant 1995 dollar basis.
All historical and projected values for all plants are based on 100 per cent of the capacity and production of each plant. No allowance was made for portions of plants located in West Virginia but included in the rate base of other states.
The book value of each plant equals the average reported book value from 1989 through 1995 as reported in the FERC Form 1 reports. Using an average reduces the uncertainty caused by fluctuating reported book values per year.
Future expenditures for capital maintenance per generation plant equals the book value divided by twenty. This estimate is based on the assumption that capital spent each year equals the amount of reduction in yearly book depreciation. This is not an unreasonable assumption for plants older than fifteen years of age. A valid argument can be made whether the appropriate life of the asset and divisor of book value should be twenty, or some other number, but twenty years represents a conservative estimate. No attempt was made to adjust reported book values or calculated future capital expenditures for inflation.
The maximum useful life of a generating plant is assumed to be fifty years. The value of each generation plant is based on remaining life determined by subtracting the date of the most recent construction of a generation unit at the plant from 1995.
The residual value of the land at the end of the useful life of the plant is not considered. This results in an overestimate of stranded cost.
Capacity of each plant is as reported in 1995.
The average historical capacity factor and average net mWh produced for each plant is based on reported data from 1989 to 1995.
An assumed capacity factor and net mWh produced for each plant, to account for increased production after deregulation, is based on a minimum default capacity factor of 60.
Average capital cost per plant equals average capital spent per year divided by average yearly production.
Average production cost per plant equals average production costs, which includes fuel, overhead, and maintenance per year, divided by average yearly production.
Average total cost per plant equals average capital maintenance plus average operating costs.
This production cost for each plant is used to determine the value of stranded assets in both the historical and assumed production rate cases. All costs are in constant dollars. This procedure assumes that real unit fuel and operating costs remain constant over time, are not affected by inflation, and are not dependent upon the quantity of power produced. This also assumes the price of coal remains unchanged over time, which is reasonable since the model also assumes a constant power price and the existence of a relationship between coal price and power price.
The future price of power after deregulation is not known. Values of stranded assets are determined for constant dollar market prices of $15, $20, $25, and $30 per mWh. We assume that the plant’s operator will continue to sell from the plant even when the price is less than variable cost, a simplification that results in an overestimate of stranded cost.
The appropriate discount rate to determine the present value of future income streams is not known since each investor will have a unique opportunity cost of capital. Values of stranded assets are determined on the basis of constant dollar discount rates of 8%, 10%, and 12%. These discount rates may be defined as including or not including risk and taxes, depending upon the interpretation of the reader. It is presumed that an investor may use the standard weighted average cost of capital (WACC) as an approximation of the opportunity cost of capital, but this is not a requirement. However, care must be taken when comparing the results of this investigation with other studies based on other discount rate assumptions. For example, if a specific WACC is related to one of the three discount rates used in this investigation, the WACC must be calculated on a constant dollar basis (i.e., subtract the expected rate of inflation from the nominal WACC). Also, it is noted that the WACC used by utilities to determine the present value of utility assets will probably be higher under conditions of deregulation and increased competition because risk (and returns) will certainly increase in the future. Consistency in use of constant and current and pre- and after tax dollars is absolutely necessary when comparing the results of the current investigation with those of others.
The above definitions and assumptions suggest that an exact value of stranded value for an individual generation plant is impossible to obtain. It is also clear there is sufficient uncertainty about the probable values of the variables that an asset may have either positive or negative stranded cost, depending on the assumptions.
3.4.2 Discussion of Utility Stranded Assets in West Virginia
An inspection of the tables of results of this investigation reveals a wide range of values of stranded costs and benefits depending upon the assumptions. For example, assuming a discount rate of 8.0 per cent, the sum of all stranded assets based on historical production rates ranges from $6.2 billion of stranded costs at a price of $20/mWh to $1.8 billion of negative stranded costs (stranded benefits) at a price of $30/mWh. Values for individual generation plants vary from large stranded costs at $25/mWh to very large stranded benefits at $30/mWh for the 8.0 per cent discount rate case.
Clearly, it is possible to dispute various assumptions concerning yearly capital and operating costs, future prices and operating rates, and discount rates. It is important to note that extreme variations in value of stranded assets can be caused by relatively small changes in any one of these factors. However, a number of conclusions can be reached by an analysis of the results of the investigation.
There are certain features in the value of selected plants that need to be noted. First, the large negative stranded asset of the Kammer Plant is caused by the low fuel cost at this location. If coal can continue to be supplied at this low price at Kammer, the indicated negative stranded asset is valid. However, if coal purchased in the future has a higher price in real terms, the value of the negative stranded cost will be less. Second, a few large plants in West Virginia have negative stranded costs that in aggregate are larger than the aggregate value of the stranded costs of the more numerous smaller plants.
In all cases, all of the 14 utility plants analyzed exhibit stranded costs at prices of $20/mWh or less. Also, in all cases, only 6 of the 14 plants exhibit negative stranded costs at a price of $30/mWh. The sum of the negative stranded costs at the $30/mW price for all 14 plants is significantly large in all cases except when a discount rate of 12 percent is used. This indicates that at any reasonable discount rate, some plants in West Virginia will exhibit significant negative stranded costs as a result of deregulation, and that at wholesale prices around $30/mWh, the total value of negative stranded costs in West Virginia will likely be greater than $1.0 billion.
The calculated value of stranded assets is highly dependent upon the discount rate and the price. Tables 3.5 to 3.11 show the results of sensitivity analysis using various prices and discount rates. For example, as shown in Table 3.7, a change in discount rate from 8.0 to 10.0 per cent, a 25 percent change, causes the total value of negative stranded costs at the $30/mWh price to change from $1.803 billion to $764 million, a 58 per cent change. To better illustrate the effects of changing prices and discount rates, price and discount elasticities are determined for the historical production case and are presented in the accompanying tables. The price elasticity is calculated by dividing the per cent change in asset value by the corresponding per cent change in price. For example, as shown in Table 3.11 a -58 per cent change in value caused by the +25 per cent change in the discount rate, as described above, results in an elasticity of -2.31 (58 divided by 25 equals 2.31). The larger the elasticity, the larger the relative change in asset value. A negative elasticity means the change in value decreases as the change in price or discount rate increases. An elasticity of –2.31 means that the value of the stranded cost declines 2.31 percent for every per cent increase in the discount rate.
An inspection of the elasticities for price and discount rates shows that price elasticities are generally larger than the discount elasticities. This indicates the values of the stranded assets are more sensitive to changes in prices than discount rates. The tables also show that for the State, elasticities are generally negative and generally increase as either prices or discount rates increase.
3.4.3 Stranded Costs of Purchased Power
Purchased power obligations may also constitute a stranded asset to a utility. In this case, the utility has obligated to purchase power at a price that will likely to exceed the price in a deregulated market. These stranded costs are usually associated with contractual purchases of power from nonutility generators operating under the provisions of PURPA. The only utility that has contract purchases from PURPA plants in West Virginia is Allegheny Power.
In a filing to respond to the West Virginia Public Service Commission’s Order dated May 8, 1997 Allegheny Power outlined the estimated stranded costs for the utility as a result of the utility’s contracts with three PURPA generating units. An outline of these costs, which extend from 1997 through 2034, and their present values at 8.0, 10.0, and 12.0 percent discount rates, is shown in the following table. The market price is $19.0/mWh in 1997 and is shown to increase at a rate of about 2.5 per cent per year, which is presumed to equal the rate of inflation. The levelized price is about $29/mWh. Under these price assumptions, the present value of the stranded costs due to purchased power in West Virginia is around $300 to $400 million. A higher assumed market price schedule would decrease the value of the stranded costs.
3.4.4 Stranded Social Benefits
A number of social programs are associated with the current electricity industry, such as the provision of subsidized electricity to the poor, winter moratoria on the payment of electricity bills, universal and minimum service standards, and programs designed to encourage the conservation of energy. These programs are valued by society and are funded by consumers of electric power through the current rate base. Under a deregulated and competitive electricity generation environment, buyers of electricity will choose to purchase power at the lowest price. Because of open access, sellers of electric power will no longer be obligated or able to provide social programs. This situation raises two questions. First, should the social programs be continued? Second, how should the social programs be funded?
The first question is easily answered in the affirmative. While questions concerning the size of the social programs, who should pay, and who should receive the benefits remain, it is apparent that social programs are desired and should be continued from a humanitarian perspective. Electricity has become a basic necessity in today’s society, and to deny individuals access to electricity would certainly cause severe hardship.
The second question is a more difficult to answer. Since social programs will no longer be funded through a rate base that includes generation costs, there are four remaining major sources of revenue. The first source is from a general tax on income or wealth to be redistributed by the state or federal government. This funding scheme avoids basing the payment for social services on the quantity of electricity consumed by others. Why should those who use the most electricity pay the most for social services enjoyed by others? It also avoids distortions in electricity pricing that reduces the efficiency of the electricity market.
The remaining three revenue sources are based on electricity user fees and include a national transmission charge to support federal programs, a state distribution charge to support state programs, and a sales tax to support state and local programs (Tonn and Schweitzer, 1997). Each source can be used to fund particular types of social programs.
3.4.5 Conclusions and Recommendations on Stranded Costs
The identification and quantification of stranded assets are significant obstacles in the process of deregulating the electricity generation industry. Although stranded assets issues are not long term problems, the monetary size of the assets and the various stakeholders involved make this a significant issue during transition from a regulated to a deregulated industry. Since the distribution of stranded costs and benefits represent transfer payments chosen by society on the subjective perception of equity, there is no single "correct" way to distribute the costs and benefits among the stakeholders. Furthermore, quantification of stranded assets is often difficult. Although the size of stranded assets is often difficult or impossible to determine and the distribution of the assets is subjective in nature, the feature of stranded assets exists and must be addressed if the restructuring of the electricity industry is to be achieved.
Some parties, notably WV Public Service Commission staff and Consumer Advocate, have advocated forced divestiture of generation assets to determine their market value and hence stranded cost. A forced sale of generation assets, while certain to provoke legal resistance from utilities, is being employed (under statutory authority) in other states including California, Maine, and New Hampshire, and could produce an accurate market valuation if done carefully. The valuation achieved by this method would be more trustworthy than other valuations, since the party estimating the plant’s market value would back that estimate with his or her own cash. Utility owners of these plants can not object on the basis that the plants are more valuable as part of the system, since as mentioned before they are advocates of a deregulation policy that is based on the premise that there are no such economies of scale in generation. The potential for this policy to be useful in mitigating market power is discussed elsewhere in this Report. However, the legal authority of the Commission to force such a sale unilaterally is questionable at best, and there may be other alternatives available. Certainly, such a radical solution should not be rushed into precipitously, especially when calculations do not support an argument that there are large stranded costs to be realized.
Solutions to the problem of stranded assets have been left by FERC to the jurisdiction of individual states. This is appropriate because each state has a unique set of problems best addressed at the state level. Problems of stranded assets in West Virginia involve the quantification of negative stranded costs of utility generating facilities and the distribution of these costs between utilities and customers. It may be more fruitful for the consumers and utilities to seek other indirect solutions to the stranded negative cost question rather than attempt to directly quantify the costs and devise an equitable distribution mechanism.