Transition Bonds for Stranded Costs

J. Gregory Sidak


Through their policies on pricing, entry, exit, service quality, and the obligation to supply unbundled network access to competitors, public utilities commissions or other sector-specific regulatory authorities influence the ability of an investor-owned regulated firm to recover its fixed and common costs. A major regulatory transition involving any one of those policy instruments can materially impair the regulated firm’s ability to recover its sunk costs and thus give rise to the problem of stranded costs. Consequently, a legal battle will inevitably erupt between the regulated firm and its regulator over whether the perpetuation of an unchanged regime of price or cost-of-service regulation in the newly changed regulatory environment of impaired cost recovery is confiscatory and, therefore, contrary to statute or even the U.S. Constitution.

This scenario unfolded time and again with a predictability that might have led one to wonder whether regulation was the sole activity in the American economy impervious to innovation. Then, remarkably, a brilliant idea emerged in the 1990s: authorize the regulated firm to securitize its stranded costs and issue “transition bonds” to be serviced by a competitively neutral surcharge that end users would be unable to bypass. In the United States, a number of electric utilities successfully used transition bonds to recover the stranded capital costs of infrastructure whose value had fallen as a result of a change (or the expectation of a change) in the government’s policies or regulations that would impede the electric utility’s ability to recover the cost of its sunk investment. As of August 2019, utilities in the United States had issued nearly $55 billion of transition bonds. Yet, despite the success of transition bonds in the electric power industry over more than two decades, scholars on regulation have evidently shown no interest in studying the use of this innovative financial instrument. It is also puzzling why both regulators and regulated firms in the telecommunications industry ignored this public-policy success story unfolding in the electric power industry.

In this article, I explain how regulators have used transition bonds to defuse incumbent opposition to major regulatory transitions that threaten to impair the ability of the incumbent regulated firm to recover the costs of its sunk investments prudently made in expectation of providing regulated service to the public. Transition bonds elicit a credible commitment from the government to allow the incumbent utility to recover its stranded costs in its network. Specifically, the capital market quantifies the expectation of regulatory opportunism through the price and rating of the transition bonds, much as risk premiums quantify political risk in a country with an unstable political regime. In effect, the regulated firm’s issuance of transition bonds to recover stranded costs enables the capital market to regulate the regulators.

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