We, the Regulators


The way forward, amidst new markets, technologies, and environmental imperatives.

Fortnightly Magazine - January 2016

Businesses these days don't often clamor for government regulation. Yet that's what public utilities once did - and it's served them well.

In the early days, as a start-up industry not unlike those of today, utilities found themselves mired in a competitive free-for-all. Demand was uncertain. Customers did not yet know they needed electricity. After all, retail electric service was something completely new. How should such a thing - a newly minted want that evolved quickly into a need - be priced?

That question was soon answered, but not through the orders of regulatory commissions. Rather, the market at first settled on a price in the usual way - through the fierce competition of scrappy enterprises that, in this case, had threaded the streetscape of American cities with a mass of wires and then had charged consumers whatever they could, hopeful that they would recover their costs, and then some, without being undercut by another firm.

And the industry might well have continued in this way, but for a coalition of industrialists, on one hand, and politicians, on the other, who joined forces to offer a different vision. These leaders decided to reorganize the Wild West of early utilities from the top down by remaking the industry into a legal monopoly.

Each group wanted something different. The developers? They sought a fixed service territory plus immunity from the sort of competition that might well destroy profits. Such a guarantee would allow utilities to reduce their fixed costs. The politicians? To be charitable, one might say they wanted to protect consumers from price gouging; or, if less so, then to build a new and loyal constituency.

“Be wary of any so-called ‘compromise,’ where interest groups line up for a dollar apiece of consumers’ money, for a job that should cost only half that.” - Travis Kavulla President, NARUC

Either way, however, the transformation of the utility industry into a government-regulated enterprise served as a key inflection point. The modern state would act in loco parentis for consumers, on the tacit if not express belief that they would need protection in this new market from abuse or inefficiency. And from this beginning utility regulation became the status quo for a century, growing into the predecessor of what we see today - the broad involvement of the State in the production and consumption of nearly every good of real significance, from the car you drive, to the food or medicine you consume, to your home mortgage.

Nevertheless, the time may have come for a skeptical re-evaluation of utility regulation, and for at least three reasons.

First, any case in which the industry itself champions its own regulation must give us pause. Put another way, utility regulation today perhaps has strayed from the ostensible motives of its inception. Second, the economic regulation of utilities is often so thoroughgoing in its reach that it exercises more control over the regulated object than other forms of regulation elsewhere in the economy. And, third, as utility regulation is founded primarily on the notion of promoting economic efficiency, it has become a form of government oversight and control that is unlike much of what else we color with the label "regulation." 

Being an economic regulator is a bit of a paradox. The job would not exist but for the decision to foreclose an industry to competition. Such regulators are therefore often called "a substitute for competition." Put another way, the central premise of utility regulation is that competition - if it could work with respect to the physical nature of an industry - would work better than these regulators do. That is a humbling thing, to be needed by default. And it begs the question: Can competition work? And if it can, what does that mean for the duty of regulators?

New Technologies

Today, virtually no one could argue that telephone users were better off in the days of Ma Bell. Families and businesses have benefitted enormously from the diversified market that has developed over the last two decades. And so the job has changed for regulators in the communications industry. Embrace the competition, Mr. or Ms. Commissioner, but make sure it won't lead to a retrenchment of characteristics of monopoly that at one time were the most pernicious, such as self-dealing, discrimination, and most particularly, denial of service. We expect basic service quality, so that dialing a number will produce a ring from the other side. We insist on the right to interconnect. But we police against unauthorized charges on customer bills.

Today, the question on everyone's mind is whether the energy utility industry will come full circle: Whether, like the communications industry, it will look something more like the free-for-all we saw at the start, and less like the monopoly that it eventually became.

Some say that rising retail prices from monopoly providers, combined with data-driven tools that unlock consumer behavior to interact directly with the market, and the falling cost of transformative technologies, will turn the retail energy sector on its head. Others argue that the physical properties of electricity mean that a natural monopoly is largely inevitable, and that the economics of central-station power are likely to be more favorable than any distributed alternative.

Both viewpoints deserve respect. Some regulators may side with one or the other. But it should remain a hallmark of each regulator's restraint not to presume to decide this future. The future, such as it may turn out to be, must be decided by the fundamentals that drive resource costs, and of the choices that lay with each consumer.

Technological innovation presents some novel questions. Yet it may serve only to reinstate the central question of regulation, the familiar dilemma that was the premise of its advent: How, in a system dominated by large, up-front capital costs, can we send efficient price signals? Put another way: How can we keep the door open to innovation, even while recovering the cost of the system on which those novel applications often rely? 

Those of us who regulate vertically integrated utilities these days will typically set an all-in retail rate that stands well in excess of the wholesale price of energy. Yet even regulators toiling in restructured states must cope with the many embedded costs of the distribution and transmission network, which remains a monopoly. Of this conflict between sunk costs and marginal prices, the economist and regulator Alfred Kahn remarked, with his trademark subdued wit: "Notice how, at once, the traditional practices of public utility price regulation diverge from economic principles." 

This debate may all sound a bit abstract or outdated. It is not. On the contrary, how utility commissioners resolve this basic question of economics lies at the core of nearly every rate proceeding, and at the core of essentially every significant "hot topic" surrounding the transformation of the utility industry today. 

The question of marginal prices and sunk costs is the debate over energy versus capacity markets. It speaks to how renewables play into our resource mix: to the future of baseload generation, especially nuclear power. The question is as central to how customer-owned electric generation is compensated, as it was to the pricing of unbundled network elements of Ma Bell's copper backbone.

The Pricing Frontier

Boil away the vast number of issue forums where regulators come together to debate "hot topics" with the staffs of utilities, vendors, and consumer and environmental advocacy groups, and you'll soon see that the real work of a utility commission is to set prices. These prices are either fixed by the decisions of regulators at the state or federal level, or they are arrived at through a kind of competition where arm's length bilateral transactions or centrally clearing markets have supplanted the state commissioner's role of command-and-control.

This latest development, occurring through the IT platforms of Independent System Operators and Regional Transmission Organizations, is especially important for state regulators to understand and participate in. Too often, state regulators are quick to categorize what an RTO or an ISO does as either too technical to understand, or as an unjustified usurpation of their prerogative.

State utility regulators should not allow themselves to become viscerally hostile to the notion that an RTO or an ISO can facilitate competition and the efficient use of resources. Insofar as these markets are about the optimization of assets that consumers are already paying for, whether operated efficiently or not, regulators should cheer them on. The worry is that these markets have become a leviathan - not just a kind of NASDAQ where bids and offers are lined up, but vehicles for long-term procurement of generating resources and transmission lines which may be skewed by the same uneconomic impulses that economic regulators are meant to counteract. In other words, one should be careful not to merely assume that these markets are free markets, which automatically result in efficient outcomes. After all, the decision-making process of these institutions' boards of directors are subject to some of the same political pressures that influence state commission proceedings, and they are subject to an even more complex system of regulation than cost-of-service regulation. 

Regulation may not fix the price of electric power in RTOs, as it does in traditional utility regulation, but regulations prescribe the definition of market products, the way in which those products are bid into and procured from the market, and even the amount of those products one needs to avoid penalties. Most state commissioners barely have time to keep up with their own dockets, but they owe it to themselves to better understand these wholesale markets. The National Association of Regulatory Utility Commissioners (NARUC), working together with the existing organizations of state regulators that advise RTOs and ISOs, can help in that role. 

Now let's circle back to a point where prices are fixed by state regulators. Even there, however, one sees an increasing number of transactions that in some ways resemble wholesale transactions but which are still subject to state regulation. For those customers who generate their own power, state regulators need to calculate clear and economic price signals that do not overcompensate or undercompensate those customer-side actions. If the U.S. Supreme Court upholds the decision by the U.S. Court of Appeals for the District of Columbia Circuit - that demand response is not within the aegis of the federal jurisdiction over RTO and ISO tariffs - then such questions will become only more prominent. 

In November of last year NARUC established a Staff Subcommittee on Rate Design to cope with the necessity of setting price elements for utility service. I hope this subcommittee will work to create a practical set of tools - a manual, perhaps - for regulators who are having to grapple with the complicated issues of rate design for distributed generation and for other purposes. What has been published on this topic is often not a paragon of impartiality. NARUC hopefully can make a valuable contribution on this matter and, through a staff subcommittee, can produce a practical, expert and most importantly ideologically neutral guide that offers advice to the dozens of states who are grappling with this question, and yet do not have the resources to do it themselves.

Environmental Concerns 

We can't ignore the fact that change is coming as much from environmental imperatives as from the new technologies that empower customers. Yet we should remember also that environmental regulators and economic regulators seek to accomplish two very different things.

Good economic regulations create incentives that cause regulated firms to act as if they were subject to the pressures of competition. Ideally, such rules can bring costs down for consumers. But environmental regulators are playing a fundamentally different game. Their regulations seek to constrain the freewheeling production that results from competition (or from the simulated competition created by economic regulation). We can best understand the difference if we take a moment to recall how environmental regulation got its start.

At one time in the past, the control of pollution unfolded through a system of tort law. When your neighbor's activities infringed on your land, you took them to court to sue for damages.

Today, however, the diffuse nature of aerial pollutants has engendered a system of positive regulation to supplant common law. We act instead on the modern notion that actors in a competitive market must bear the costs that are external to the relationship between the producer and the immediate consumer of a commodity. If economic regulators are trying to induce the results of competition, then environmental regulators are rowing against that current. That does not mean, however, that one is good and the other bad. Indeed, there are good and bad examples of both. And even if one believes in both as a matter of politics, or believes in neither, the ostensible purposes of either form of regulation are very different. 

Environmental regulations such at the Mercury and Air Toxics Standard (MATS) have imposed actual costs on the utility industry and its customers. But more importantly, the mere threat of additional environmental regulation has dramatically increased the uncertainty of operating fossil fuel assets. Why re-invest in a plant upgrade or spend a dollar complying with MATS (even if that rule is cost-effective in its own right) if the second or third dollar one will have to spend to comply with the Clean Power Plan (CPP) will doom the cost-effectiveness of the plant? 

Thus, the actual and potential costs of environmental regulation have now coupled with other government policies that promote rival technologies, including state renewable portfolio standards and federal tax subsidies for renewables. Together with phenomena that are related to but not directly caused by government policy - such as the falling prices of both renewable technologies and of natural gas as the cleanest of fossil fuels - it seems reasonable to conclude that environmental considerations now represent the major force driving the procurement of new resources in today's electric utility industry. Economic regulators need to contemplate the implications of that. 

When externalities take on a real cost - that is to say, when an emitter is required by an environmental regulator to spend money on something like an allowance in order to emit - then they join the ranks of other perceivable costs like labor and fuel. It always has been an economic regulator's job to ascertain the volatility of costs of key inputs. But until now, something like a carbon-dioxide emissions allowance did not have any real value outside of only a very few jurisdictions. That is changing, and some would say that economic regulators should be more environmentally conscious. But in fact, what we really mean is that economic regulators should be conscious of what they have always been conscious of - insisting on efficient outcomes, but with reference to these novel considerations. 

On balance, it should remain the job of an economic regulator to ensure that whatever environmental regulation may be the law of the land, it will be carried out in a manner as economically efficient as possible. That means searching out the best examples from the laboratory of democracy, the states. It also means seeking avenues of cooperation with other states to engage in trading so that as liquid a market for this commodity exists as possible. 

But economic efficiency also means resisting the kind of parochialism and rent-seeking behavior that will try to find a home in a state implementation plan of the CPP. Make no mistake: This EPA rule gives every governor the power to pick winners and losers. Under the Clean Power Plan, the states may allocate emissions allowances in a way that opens the energy sector to a degree of politicization that it has rarely been seen before. It is a chance for anyone with a so-called "jobs plan" to take it off the shelf and truss it up as a compliance plan.

Don't be tempted. Rather, as economic regulators, we must remain true to our roots. Our role must be that of playing the skeptical curmudgeon, scolding the political logrolling that is all too common in this industry. We need to be wary of a so-called "compromise," where interest groups line up for a dollar apiece of consumers' money in order to accomplish something that should only take half that.

As economic regulators, we have to insist on economic outcomes - efficient outcomes - to solve the mundane problems that each jurisdiction faces, as well as the common problems that face mankind.

Lead image © Can Stock Photo Inc. / vlaru