Transcending the “Regulatory Compact:” Parsing the Legal Facts and Fictions of Stranded Assets and Cost Recovery

Jan 18, 2021 Written By Conor J. May

Parsing the Legal Facts and Fictions of Stranded Assets and Cost Recovery

Xcel Energy’s largest, newest, and most expensive coal plant in Colorado opened in Pueblo in 2010. Xcel’s local subsidiary, Public Service Company of Colorado (PSCo), projected that they would be able to profitably operate Pueblo Unit 3 until 2070. However, as the costs of renewable energy plummet and state policies focus on zeroing out greenhouse gas emissions, Unit 3 looks more and more like a fiscal and environmental dead weight. And PSCo is not alone in this predicament. Many utility companies across the U.S. find themselves in possession of fossil fuel plants—some built well after the climate crisis became common knowledge—that are “stranded.” This means that they have not yet fully depreciated in expected value but for financial reasons, environmental reasons, or both, they face early retirement. Now, in a competitive market, these businesses would be forced to absorb the financial loss associated with risky investments. But in the majority of U.S. states that operate under a regulated monopoly system, it is up to public utilities commissions (and sometimes legislators) to decide how much of the loss will be borne by the utility, and how much can be recovered from their customers. 

Xcel’s coal-fired power plant in Pueblo, Colorado. Photo courtesy of Alan Best.
Xcel’s coal-fired power plant in Pueblo, Colorado. Photo courtesy of Alan Best.

Fights about cost recovery and who will shoulder the cost of stranded assets are nothing new. States looking to replace or supplement their regulated monopoly systems with more competition also confront the stranded asset question because some incumbent power plants are unlikely to turn a profit if they have to operate in a competitive market. And just as the energy transition gains momentum, states across the U.S. are expressing renewed interest in competition, further increasing the likelihood that fossil fuel assets will become stranded in a market awash in cheaper sources of (largely renewable) energy.

With climate and competition advocates both pushing for systemic change, cost recovery will likely remain a frequent point of controversy in the years to come. One tool frequently deployed by utility companies in these debates is the notion of the “regulatory compact.” The version of the regulatory compact related by industry representatives typically goes something like this:

In return for being allowed to operate as monopolies, utilities submit to regulation. Public utility commissioners, ostensibly representing the people of their states, must approve new projects and expenditures before they can go forward. Therefore, if a project was approved by regulators, the utility has an inviolable right to earn a profit from that investment. In short, “you approved it, you have to pay us for it.”

While this version of public utilities law is frequently invoked by industry advocates and proponents of full cost recovery, it bears little resemblance to legal reality. The language of the “regulatory compact” can be found nowhere in statute or case law. The concept of a binding contract that obligates regulators to provide utilities with a profit has in fact been specifically denounced and refuted by numerous federal courts.

If public utilities law can be said to have a single underlying mandate, it is that regulators must serve the public interest, and the public interest is best served by striking a “just and reasonable” balance between the interests of ratepayers and utility investors. This balancing must always be done in context, including taking into account the utility’s own behavior and the behavior of its managers. But far from applying strict formulas to determine how much utilities are owed, courts give states a great deal of deference when it comes to striking the appropriate balance.

So in state capitols the nation over, the debate should not begin and end with governments admitting that they have an absolute obligation to protect the profits of the utilities they regulate. Rather, the debate should examine the decisions that led to these stranded assets: when were these decisions made, who advocated for them, and what did their proponents know or what should they have known at the time. Because in many cases, new investments in fossil fuel assets were made, often over fervent objections from ratepayers, at a time when the failure of those investments was utterly predictable. In this context, regulators should not feel obligated to assign the full cost of these stranded assets to ratepayers. Rather, they should embrace the long legal tradition of carefully balancing utility and ratepayer interests, factoring in each party’s responsibility for—and ability to bear the cost of—bad investments, to arrive at the most equitable and publicly beneficial result.  

For a more detailed discussion, readers are encouraged to download a recently released research paper that examines these questions in greater depth. This paper explores the tension between environmentalists, many of whom are open to utility demands in order to retire plants as quickly as possible, and consumer advocates, who prioritize competition or who question the broad and deep financial commitments made to utilities in return for closing plants early. This tension is founded in part on the belief that ratepayers will have to pay for assets that become stranded due to state policy, even when these policies are designed to improve the system or to rectify the utility’s own errors in judgment. The paper then traces the history of cost recovery debates in American jurisprudence and concludes that, despite frequent invocations of the “regulatory compact,” no such strict obligation in fact exists. Public utilities commissioners and legislators have all the authority they need to equitably apportion the costs of stranded assets. And they should use it.

Download the research paper Transcending the “Regulatory Compact:” Parsing the Legal Facts and Fictions of Stranded Assets and Cost Recovery.

For further reading, see:

Jan 13, 2021 Written By Leslie Glustrom, Clean Energy Action Senior Advisor

How to TRULY Retire Coal Plants and Fossil Fuel Assets Early AND More Equitably

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As coal plants and other fossil fuel assets retire earlier than expected, the question quickly arises, “Who will pay off the debts associated with these fossil fuel assets?” In June 2020, the Rocky Mountain Institute (“RMI”) issued a report “How to Retire Early” that fundamentally assumed that utility customers should pay off the remaining debt associated with utility coal plants that are retired early and then proposed several financial tools to use in paying off the utility’s debt.

While Clean Energy Action certainly shares RMI’s desire to accelerate the retirement of coal plants for both environmental and economic reasons, the CEA White Paper “Privatizing the Risks and Not Just the Profits,” argues that utilities should bear some accountability for their stranded assets and that future generations of utility customers should not be responsible for all of the utility debts associated with coal plants (and other fossil fuel assets) that are retired early.

The CEA White Paper, unlike the RMI report, notes that utility claims of a “regulatory compact” are not necessarily on solid ground and should be treated with healthy scepticism. As Harvard Professor Ari Peskoe has noted,

While several PUCs have used the term “regulatory compact” as a shorthand description of regulation, no court or PUC has concluded that a utility is legally entitled to relief, such as cost recovery, under a “regulatory compact.” On the contrary, PUCs and courts have explicitly rejected such arguments.

The CEA White Paper response suggests that to ensure that coal plants (and other fossil fuel assets) are retired more equitably and that the risks are not just socialized, advocates and regulators should ensure that the process of allocating responsibility for utility stranded assets does the following:

  • Engages a broad sector of utility customers including low-income and communities of color.
  • Considers holding utilities accountable and require at least partial write-offs of mistaken fossil fuel expenditures.
  • Considers the need for adjustments to a utility’s Return on Equity (“ROE”) if a stranded asset is taken off the utility’s books. If utilities are not bearing the risks of their mistakes, then regulators should consider lowering the ROE to reflect the lower risk of utility investments.
  • Takes a careful look at impacts on low-income customers and their energy burden and the effect of any regulatory decision on these more vulnerable customers.
  • Considers the likely benefits of opening electricity markets to new entrants and more competition rather than maintaining primary control of electricity markets by incumbent utilities from the last century.
  • Recognizes that the structural decline of the US coal industry likely means that retiring coal plants is not, in many cases, a matter of choice, but is rather an imperative due to lack of a long-term coal supply.
  • Considers alternative allocations of the responsibility for paying off stranded assets, including:
    • Utility write-offs of the stranded asset
    • Careful prudence review for any expenditures made on the coal plant
    • Splitting the responsibility for paying off the stranded assets based on the age of the plant. The older the plant, the more responsibility customers would have; the younger the plant, the more responsibility the utility would have. For example, for a plant that was only a third of a way through its life, customers would be responsible for paying off one-third of the stranded asset and the utility would be responsible for paying off two-thirds of the asset.
    • Having customers pay off any portion of the stranded asset that they become responsible for at the cost of debt, without including any profit for the utility on the remaining portion of the stranded asset.

Download CEA’s White Paper “Privatizing the Risks” here

Listen to John Farrell of the Institute for Local Self Reliance and Clean Energy Action Senior Advisor Leslie Glustrom discuss how we can equitably transition to a clean energy future here

For more on the “regulatory compact,” see Transcending the Regulatory Compact: Parsing the Legal Facts & Fictions of Stranded Assets and Cost Recovery.