Transcending the “Regulatory Compact”
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.
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:
Clean Energy Action’s white paper and blog post Privatizing the Risks and Not Just the Profits
Jim Rossi, The Irony of Deregulatory Takings
Timothy Brennan & Jim Boyd, Stranded Costs, Takings, and the Law and Economics of Implicit Contracts
Ari Peskoe, Letter to the Quadrennial Energy Review Taskforce
Herbert Hovenkamp, The Takings Clause and Improvident Regulatory Bargains
Scott Hempling, What “Regulatory Compact”?