What would be your reaction if, after you shipped a package by Federal Express, the U. S. Postal Service sent you a bill? What would you say if a postman knocked on your door, arguing not only that the post office had been harmed by your actions but also that it deserves to be compensated? You might find it difficult to take your postman seriously, but not everyone shares your skepticism: a Pennsylvania utility just captured more than a billion dollars from consumers by making that kind of request.
Across the nation, electric utilities are demanding that consumers who switch to lower-cost power producers compensate the more expensive incumbent utility. For example, Peco Energy Company has requested more than $3.6 billion in compensation from Pennsylvania electricity consumers to pay for their facilities’ future loss in value caused by customers’ switching to Peco’s competitors. The Pennsylvania Public Utility Commission recently awarded Peco $1.1 billion of its request.
Such compensation awards are misguided for two reasons.
First, stock markets compensate investors at the time of purchase for any future risks, regardless of whether the risks are publicly or privately created. Stock prices at any given moment are fairly priced bets on the future benefits and costs associated with owning a company. Compensation for an unsuccessful bet is both unfair and destructive to the rationale for profits (the willingness to incur risk). Second, because the market prices for stocks are continuously updated, no mechanism exists to separate those investors who deserve compensation from those who do not.
Current market prices of assets always reflect investors’ best estimate of the present value of the future costs and benefits of owning the asset, including the possibility of policy changes that negatively affect investor earnings. Consider the bond market, which gives investors a higher yield, compared to taxable Treasury bonds, on 20-year tax-exempt bonds than on 1-year tax-exempt bonds. Because the probability of changes in the tax-exempt status of the bonds is greater over the long term, investors in tax-exempt bonds demand a premium to compensate them for the risk that the privilege will be repealed or its value reduced.
The repeal of electric utility regulation is just like the possibility of repeal of a tax exemption. The prices of utility stocks at any point in time are a fair bet about the gains and losses that accompany ownership of an electric utility. Of course, if no compensation is paid after retail electricity deregulation, the owners of the affected stock lose money. But those losses are just like those of people who bet on the horses: they suffer when they bet on the wrong horse. In horse-racing, the payoffs before the contest are fair (they’re derived from the horse’s probability of winning and the amount of prize money available, minus the cut the track takes). After the race, though, almost all of the ticket holders have lost. If the losers asked for their money back, we’d laugh at their request: horse-racing bets cannot work if you keep the winnings when you win but get your money back when you lose. The requests for compensation for policy change are just like requests for refunds by those whose horses lose.
One implication of the role that expectations about the future play in asset prices is that changes in asset prices occur long before policies actually change. Because we cannot identify exactly when expectations form in investors’ minds, we cannot identify whom to compensate for the losses of wealth that occur if policy change actually takes place. The electricity industry provides an excellent example.
The prospect of changes in the regulation of electric utilities first surfaced with changes in natural-gas prices and natural-gas turbine technology in the late 1980s. Those changes lowered the relative cost of electricity produced with natural gas compared to that of electricity produced by coal and nuclear power.
The possibility of deregulation of the retail electricity market has grown. As investors realized that, utility stock prices suffered. The total return for the period 1986 through January 1997 (not including dividends) on the S & P 500 was 321 percent, but only 32.9 percent for the Dow Utility index. As the prospect of retail deregulation dramatically increased during 1996, utility stocks rose only percent, compared to 45.2 percent for the market as a whole.
Losses of wealth for utility stocks in general (and Peco in particular) that arise from changes in expectations have occurred whenever significant changes in political or economic facts have prompted a change in market expectations about future cash flows. For example, Peco stock lost nearly a quarter of its value in early 1996 as the Pennsylvania legislature considered the deregulation of retail electricity markets. But when the PUC ruled that $1.1 billion would be paid by ratepayers, the stock rose from $19 to $20.50.
If we were to compensate shareholders, how would we decide which ones to compensate? Which investors suffered losses from a roll of the dice that really wasn’t fair? Utility stocks are now seen as risky, but the transition from the old view to the new view has involved a gradual change in expectations. At each step of the transition, the purchasers of utility stocks were making fair bets, but after the fact they may turn out to have been unrewarding.
To compensate current shareholders for deregulation would be to overcompensate many people who bought utility stocks knowing that they are more risky now than they used to be. That kind of compensation is a great deal for stockholders, who win whether the company loses money (because they get compensated anyway) or makes money the old-fashioned way. But it’s a terrible deal for the people who bear the costs of this massive wealth transfer: other stockholders, electricity consumers and the public at large.