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The Skinny on Caps and Stranded Costs

Rate caps and stranded cost recovery – 2 large government interferences in the pricing of electricity – will end in nearly all states between now and 2010. Both measures have distorted the retail price of electricity, with stranded cost recovery raising rates above competitive levels. Yet, these policy tools have played a necessary role during the transition period from retail monopolies to competitive markets.

When it comes to rate caps and stranded costs, size does matter. Bigger stranded cost charges sooth utilities and hurt consumers, while longer rate caps reassure consumers but increase risk and possibly pain for utilities.

Our review of stranded cost charges and rate caps in Pennsylvania reveals that normally the charges are big and the caps are long (see the chart below).

For example, in the case of PECO, the system average stranded cost charge is a whopping 26 percent of the total rate. To put it another way, PECO’s regulated rates are on average 26 percent above the market price for electricity. But, PECO’s generation charges are capped until 2010.

The numbers
The six largest Pennsylvania utilities requested over $18 billion in stranded costs and were authorized to collect $11billion in the restructuring case settlements (PECO, PPL, Met, Ed, Penelec, and West Penn) and decisions (Duquesne). PECO ($5.26 billion) and PPL ($2.97 billion) had by far the highest stranded cost awards, primarily because of uneconomic investment in nuclear power plants. Penelec received the least ($386 million).

It is critical to understand that none of these charges were or are new. All these dollars had been placed in rates by regulators prior to restructuring in 1996.

Consumer impact
PECO has the highest system average CTC/ITC payment of 2.43 cents/kwh, while Duquesne’s was 2.24 cents/kwh, and PPL’s is 1.3 cents/kwh. The CTC/ITC comprises a whopping 26 percent, 25.5 percent and 19 percent of the total customer rate for PECO, Duquesne and PPL respectively.

Even for the utilities with much lower CTC rates, the CTC creates a significant impact on bills. For West Penn, the system average rate of 0.54 cents/kwh still comprises 9.8 percent of the total consumer rate, while the 0.53 cent/kwh system average CTC for MetEd comprises 7.5 percent of the total rate, and the Penelec CTC charge of 0.14 cents/kwh comprises 2.1 percent of the total rate.

These rates translate to large monthly payments. In the PECO territory, a residential customer who used 600 kWh last month paid $16.44 in CTC/ITC charges (2.67 cents for the first 500 kWh and 3.09 cents for the next 100 kWh).

For a larger commercial customer in the PECO territory requiring about 1MW with a 60 percent load factor, the CTC/ITC costs are about $11,410 monthly, or $136,920 for the year.

To put these rates in perspective, the PECO system average CTC/ITC of 2.43 cents/kwh is higher than the system average distribution charge of 2.35 cents/kwh, much higher than the system average transmission charge of 0.45 cents/kwh, and more than half as much as the system average price of default generation of 4.56 cents/kwh that is actually sold to customers.

Thar’s gold in that thar pain
Always looking for the bright side, customers paying the highest CTC rates will see the greatest rate reduction when they are eliminated. All Duquesne customer classes completed payment of the CTC by June 2003, receiving a system average rate reduction of 25.5 percent. For residential customers, the rate cut in March 2002 was about 20 percent. For residential heating customers, the rate cut in March 2003 was about 40 percent.

PECO customers can look forward to system average rate cuts at the end of 2010 of about 26 percent, while PPL customers can look forward to system average rate cuts at the end of 2009 of about 26 percent. While both rate caps and stranded cost charges certainly are conceptual horrors to utilities and consumers respectively, the pain really hasn’t been so bad. They are together a reasonable “package deal” to ease the transition to a competitive market.

From the consumer point of view, the rate caps guarantee that consumers spend less and less of their income for electricity. Rates today are no higher than in 1996 and more than 13 percent lower in inflation adjusted dollars.

For the utilities, stranded cost collection facilitated a much easier adjustment to the competitive market, too. Without stranded cost charges, many of Pennsylvania’s electric utilities would have gone bankrupt with unknown effects on service. Of course, even with stranded cost payments, Allegheny Energy has come close to Chapter 11 as a result of a series of misjudgments and bad deals.

With revenue reductions ranging from 2 percent to 26 percent, will utilities survive the end of CTC collections? The utilities should have used the transition period to write down uneconomic costs and pay off debts on the uneconomic generating plants. With lower debt to carry on their books, they should be able to maintain healthy debt to earnings ratios.

The generation portfolios or other financial and investment decisions by the utilities may or may not be profitable depending on what happens in the market. Yet, the risk of being wrong, and the profits from being right will rest with the company. For stranded cost payments must be a once-and-done-forever deal.

Consumers no longer will be required to pay generation owners for poor investments. Of the thousands of MWs of generation that has been built since restructuring, exactly 0 MW will qualify for stranded costs in retail restructured states. These generation projects rest solely on their ability to sell their output at competitive prices and be more efficient than the power plant down the street.

Effects on competition
The reasonable and generally successful trade-off of rate caps and stranded cost recovery has one substantial downside. Both rate caps and stranded cost charges have made it more difficult for competitors to enter retail markets. Put simply, they have slowed the development of retail competitive markets and will continue to do so until they end. Despite the addition of stranded cost charges to their electric prices, competitive suppliers at times have offered consumers savings of 5 percent, 10 percent or even 20 percent. During these periods the amount of load served by competitive suppliers increases.

But when wholesale prices increase, the combination of the capped retail rate and the addition of large stranded cost charges to the prices offered by competitive suppliers make it impossible to deliver savings to retail customers. At those times, retail customers return to the utility and default service or don’t switch, causing the total load served by competitive suppliers to decline.

So as rate caps and stranded cost recovery end, Pennsylvania should make sure that aggregation, demand response, competitive bidding to serve default customers and other measures to make sure that the local utility does not dominate the retail market are in place. The transition is going well but more work lies ahead. That is the skinny on rate caps and stranded costs.

John Hanger's picture

Thank John for the Post!

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Discussions

James Schneider's picture
James Schneider on August 8, 2003
John,

Great article. I truly believe PA did a much better job with restructuring than Texas or any other state. It will not be realized until the stranded cost recovery is done.

Jim Schneider (Former IECPA President)

David Knowles's picture
David Knowles on August 12, 2003
"Always looking for the bright side, customers paying the highest CTC rates will see the greatest rate reduction when they are eliminated. "

Wow, what a statement! Do you work for the Government? I guess you'd take a 50% paycut just to feel better when the boss restored your pay level (?)

Bob Kwartin's picture
Bob Kwartin on August 12, 2003
John/Peter - I remember your courage during the PECO restructuring proceeding and won't forget how you got the rest of the commission to throw down the gauntlet and give the competitive market a chance. It is because of those memories that I find this article a bit surprising. Looking backward, I would have expected you to be more critical of the size of the stranded cost claims, and of how the windfall (after securitization) has been put to use (some useful investments interspersed with empire building and trading boondoggles). Were the assets actually stranded?

On the rate cap side, there is a need for an eloquent defence of uncapped retail generation rates if society really wants competitive generation markets, which is by no means certain unless someone wants to guarantee permanantely falling prices at the same time. Given the folk memories concerning California, what do you expect your successors at the PAPUC to do when prices spike in the generation market? Maybe NJ will lead the way on this one...

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