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Cross-Subsidies: Getting the Signals Right

CROSS-SUBSIDIES:
Fortnightly Magazine - December 2004

CROSS-SUBSIDIES:

Should regulators care about the inefficiencies?

With the first wave of legislative utility deregulation largely complete, the bulk of market restructuring is now happening in the much less public, but just as important, realm of utility rate-making proceedings. Inside these proceedings, utility commissioners address the basic economic and contractual framework for electric utility services.

By setting the absolute rate and the rate structure under which electric service is provided, these proceedings affect all future capital allocation in the electric sector on both sides of the meter. Where the first wave of deregulation focused on wholesale power markets, this second deregulation wave directly affects retail markets. It is therefore critical that regulators carefully consider the long-term impacts of the proposed rates on the broader retail market.

Within these proceedings, commissions strive to avoid cross-subsidization of one ratepayer by another. Economic theory teaches that optimal economic efficiency occurs when costs and benefits are aligned, and thus cross-subsidization is widely considered a symptom of economic inefficiency to be avoided in utility rate design.

But is a dogmatic opposition to cross-subsidies appropriate? We argue that it is not. Step back in time for a moment and ask yourself a question: Why did society decide to create regulated utilities? Given the free-market, competition-friendly principles on which our economy is based, why did we decide years ago to grant monopoly rights to the electric, gas, airline, railroad, and telephone industries?

There are many answers to this question, but all ultimately derive from a belief that the benefits created by these utilities were too important to be left to the vagaries of a free market. Would a profit-seeking business electrify rural areas or expedite repair crews in the middle of an ice storm? In the early part of the last century, Samuel Insull convinced the Illinois state legislature they would not, and negotiated for his utility to guarantee service in exchange for a regulatory cap on profits. Other states rapidly followed, and today all utility regulators grapple with the same conundrum: how to respect the integrity of a for-profit, private business while at the same time ensuring that those businesses deliver the public benefits for which they were created.

But look at the implication: The reason we have regulated utilities is to create cross-subsidies. The first rural customer did not have to pay the full cost of stringing transmission cables to the home, and a customer in an ice storm is not expected to pay overtime fees to the linemen reconnecting the system the next day. In all cases, the costs of such services are subsidized by other ratepayers. Indeed, the cross-subsidization concept is found throughout utility rates: From discounted rates to low-income families to systems benefits charges, there are huge swathes of customers who pay less than their full cost of service, thus being subsidized by other customers who pay more to make up the difference. We tolerate and encourage such rate setting out of the belief that the social benefits created by such subsidization outweigh the resulting economic inefficiency.

In this context, one cannot logically

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