The case against re-regulating the electric industry.
The California debacle has sent ripples across the country throughout the electric industry, building a wave of enthusiasm for re-regulation, and at just the time that policymakers have forgotten why they wanted to deregulate in the first place.
California itself is revamping its restructuring plan in fundamental ways without any clear vision of where it wishes to go. Elsewhere, it is doubtful that many other states that adopted restructuring plans will proceed in the way they would have if California had not imploded first. The policymakers likely will follow one of two paths: (A) Go ahead with restructuring, but with some safeguards to prevent the kinds of problems that have plagued California, or (B) Retreat to re-regulation of some kind.
As a short-term solution, re-regulation appears quite attractive. But that strategy overlooks the long-term failures of regulation.
We Could Return to the Status Quo
I admit that traditional, cost-based utility regulation appears to offer at least some obvious short-run advantages, given the current climate in California.
In theory, setting rates according to cost yields the same short-term static market equilibrium as under competition—but only if we can assume that all buyers and sellers are price takers, and only if the costs are no different under regulation as with competition. Regulation incorporates all bona fide costs in rates, but excludes increments related to market power. Market power would be neutralized, and the incentive to game the system would be minimal, since regulators would have the power to punish transgressions. Moreover, there would be less price volatility than under competition, since prices are set by administrative process and remain fixed for extended periods of time.
Also, a return to cost-of-service regulation clearly would enable regulators to stop any undesirable exercise of market power, as long as the basic fabric of the industry has not been impaired as it has been in California. Rates would be cost-based, not capped. Producers would recover all of their costs, plus a return on investment. This phase could be temporary. The state could reintroduce restructuring once conditions were deemed appropriate. And the simple, constant threat of re-regulation certainly would exert the salutatory effect of limiting the extent to which generators would use market power under restructuring.
The Federal Energy Regulatory Commission (FERC) could have contained the California problem by re-imposing cost-of-service rates at any point until late January. It would have been an easy and effective solution last summer. Incidentally, the need to build power plants cannot be used as a reason for not re-imposing cost-of-service rates, since building new plants could be made attractive by authorizing transmission and distribution (T&D) utilities to enter into life-of-the-plant purchase power agreements with new combined-cycle gas turbines (CCGTs) that covered fuel costs, plus a return. The question is whether a temporary return to traditional regulation would be temporary.
And Repeat Our Mistakes
All the same, the appeal of re-regulation ignores the inherent long-term shortcomings of traditional regulation that originally led to restructuring.
In the short-run, regulation provides price stability and prevents prices from becoming de-coupled from costs, largely meeting the conditions of short-term economic optimality. Long-run optimality, however, requires that the industry under regulation must operate as efficiently and make as rapid technological progress as it would under competition. Regulation fails miserably at this.
The failure of regulation stems from vesting complete economic control of the industry in the hands of politically appointed or elected regulators, who have enormous freedom of discretion. Regulators set power prices administratively, and their decisions are only subject to oversight by the courts, which prefer to defer to the expertise of the regulators and intervene only when the regulatory decisions are capricious or confiscatory. The system creates an array of perverse incentives, which lead to wasted resources, operating inefficiencies, and little technological progress.
Wasted Resources. Regulation and the political pressures that can be brought to bear on it have a disorienting effect on utility corporate governance. Any group that can muster political influence has the requisites to become a stakeholder in the regulatory process, and many take advantage of the opportunity. Utility investors are only one of a number of competing stakeholders. Regulators justify their actions in terms of the public interest, which is little more than a cover for granting favors to stakeholders that market forces deny in other industries. Concern for economic optimality is lost in the shuffle.
The focus on the public interest is the flip side of a general lack of accountability throughout the regulatory process, which creates waste and works to the disadvantage of shareholders. Since a utility's financial fortunes are dominated by regulatory decisions whose standards are nebulous, management could readily blame their own failings on unsympathetic regulation. In addition, regulation intrudes on corporate governance and financial policy. In the process, shareholders are kept at bay, which provides management with latitude to pursue their own agendas, instead of shareholder interests.
The waste that regulation condones and its cost to shareholders can be illustrated with the penchant of utility management to build unneeded generating plants in the face of excess capacity and inadequate returns during the 1970s and 1980s. For the decade from 1975 to 1984, the industry was plagued with chronic excess capacity. The industry's reserve margin averaged 34 percent, and was never below 30 percent during these years, which implies excess capacity averaged over 10 percent for the decade based on the then-target reserve margin of 20 percent. Yet, management continued to build plants aggressively. The plants were financed by selling stock below book value, which reduced the industry book value by an average of 2 percent per year for the decade. Managements were building their empires, while shareholders suffered, and resources were wasted.
Inefficient Operations. Operating efficiency is optional under traditional regulation. By setting rates at a level that covers all of a utility's prudent costs, plus a return on capital, regulators guanatee that costs that are high, but, not high enough to be obviously imprudent, are included in rates. Regulators, from their vantage point outside a utility, are not in a position to distinguish between low costs of a very efficient operation and costs that were somewhat high, but not unreasonably so. Regulators simply do not have the tools to punish inefficiency and reward efficiency over a broad range of management effectiveness. A utility was not punished financially for failing to be as efficient as it could be, nor rewarded for being exceptionally efficient.
Regulation allowed unnecessary costs that competition would purge to creep into electricity prices without penalizing the utility. The utility's earnings and return on equity depend on how well it managed its rate cases more than anything else. In general, a utility earns a high return if it handles its rate proceedings well, and a low return if it mishandles them, irrespective of its efficiency.
While efficiency was a casualty under regulation, it should be noted that some utilities were far more efficient than others. Efficiency was left to the discretion of management and depended on professionalism and pride. Some managements developed traditions of excellence, others did not. Differences in efficiency between utilities grew over time, and resulted in enormous and growing disparities in electric rates among utilities.
The coefficient of variation—the standard deviation divided by the mean—can be used to measure the disparity in electric rates across utilities. The coefficient of variation of electric rates for 80 major utilities climbed steadily from 40 percent in 1975, to 85 percent in 1990. The increase cannot be explained by fuel prices, whose coefficient of variation shrunk from 45 percent to 33 percent between 1975 and 1990. By the early 1990s, stark differences existed in electric rates between nearby cities for no other reason than the fact that the cities were served by different utilities. In 1992, there were 10 pairs of major cities that were within 250 miles of each other for which electric rates were at least 55 percent higher for one than the other.
Stifled Innovation. The greatest shortcoming of traditional regulation undoubtedly is the deadening effect that it has on technological progress. As in the case for operating efficiencies, regulation fails to reward technological progress. If a utility raises its return on equity above the return allowed by regulators by undertaking innovations and cutting costs, the regulators respond by reducing the utility's rates. The financial benefits of innovation and cost cutting are thus commandeered by the regulator and bestowed on the customer.
There is also little or no incentive for a utility to build a power plant that improves efficiency. For instance, a utility would make the same return from investing in a plant that had a heat rate of 11,000 Btu per kilowatt-hour as one with 8,000 Btu if the two plants require the same investment. The failure to reward innovation translates directly into foregone productivity gains whose long-run costs to the economy have been staggering.
The industry's abysmal record of productivity growth is easy to document. There has been virtually no improvement in the thermal efficiency of the fleet of utility generating plants in the last 35 years. The heat rate was 10,438 Btu per kWh in 1963, and 10,360 in 1998. These numbers show virtually no change over the course of 35 years. Similarly, utilities still send an army of meter-readers to customer premises to collect their billing in formation instead of collecting it electronically. There has been no change in procedure in over 60 years.
And Lose What We've Gained
Restructuring has already made major contributions to improving the economic performance of the electric industry. In particular, it has introduced incentives into the ratemaking process and has changed the modus operandi of stakeholders, who now must anticipate the new rules that restructuring will impose.
Modest Rate Cuts. First, regulators have abandoned rate-of-return ratemaking in those states where restructuring plans have been adopted. Rates have typically been reduced modestly up front, and then fixed for an extended transition period, during which a utility's earnings are not constrained by an allowed rate of return. Consequently, the utility is allowed to retain all of the benefits of its cost cutting, instead of facing the threat that the benefits will be confiscated and turned over to ratepayers. Incentive has increased enormously, and has led utility management to strive for efficiency with an intensity that they have never shown in the past.
Greater Accountability. Second, the restructuring movement has sharply curtailed the power of the array of stakeholders that have attracted themselves to the regulatory process. There is much clearer accountability than in the past, and the governance of the utilities has taken on more of the characteristics of unregulated companies. The shareholder and economic efficiency have been the beneficiaries. The hidden agendas of utility managements are being superseded by agendas that emphasize shareholder interests.
New Thinking. Restructuring has already created a badly needed new atmosphere for the industry. There is an infusion of new thinking and vigor that portends bringing the industry's performance up to the standards of the rest of the economy.
In retrospect, we can see that traditional regulation was driven by private, political interests rather than striving for economic efficiency. It lacked incentives and stifled technological progress. Over time, it moved the industry further and further from economic optimality. The failings of regulation, of course, provided the initial impetus for the restructuring movement. The case was, and remains, compelling.
We have no reason to believe that regulation would fare better in the future than in the past. Let's go forward with electric restructuring. Unfortunately, however, it's turning out to be more difficult than we expected.
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