Electrical Utilities: The Final Deregulatory Frontier

The Electricity Sector Is Facing Revolution Rather than Reform

Doug Bandow, this month’s guest editor, is a senior fellow at the Cato Institute and the author of The Politics of Envy: Statism as Theology.

Up into the 1970s electrical utilities were one of the least likely candidates for deregulation. The industry was littered with local and regional government enterprises and state and federal subsidies. Private power companies were thought to be “natural monopolies” and therefore were established as monopoly franchises regulated by government commissions. The public interest was thought best served by suppressing competition and guaranteeing a set rate of return.

Since then the world has changed greatly. In the United States controls have been lifted or reduced in the airline, banking, broadcasting, citrus, energy, natural gas, oil, rail, telecommunications, telephone, and trucking industries. The move to freer markets has been even more significant abroad, affecting not only Third World states but also the one-time communist empire.

Moreover, states, the federal government, and foreign nations have begun to apply the same principles to power generation. A test group of New Hampshire residents has been bombarded with offers from some 30 different power producers as part of a New Hampshire pilot program; bills have dropped by an average of 15 to 20 percent. Potential savings from full competition could range up to 40 percent. Merely a one cent per kilowatt-hour drop would save $28 billion nationally. Pressure is growing to transform the entire industry through competition. Observes Elizabeth Moler, chairman of the Federal Energy Regulatory Commission, “The future is here, and the future is competition.”

The Electricity Market

Monopoly provision of power was not inevitable. Early power companies, which date to 1879, relied on public streets to transmit electricity. Many municipalities granted competing franchises. In 1905, however, New York and Wisconsin began the shift toward government control. What Robert Bradley of the Institute for Energy Research terms “the cumulative march of regulation” reflected the reigning Zeitgeist of the Progressive Era, with its belief in public management.

The formal justification was that competition was wasteful. Electrical generation and transmission, it was said, was a “natural monopoly.” In fact, regulation turned into a happy meeting point for activists philosophically predisposed to government control, if not ownership, and businessmen who preferred guaranteed returns to the vagaries of the marketplace. Research indicates that regulation was first imposed where electrical rates and producer profits were lowest—suggesting vigorous competition. The result of regulation was to raise both.

The ultimate outcome of this shift from competition to regulation was a mixture of government enterprises, government-subsidized cooperatives, and regulated monopoly franchises. As early as 1882 municipalities had begun to establish their own utilities. Federal power generation began in 1909, after President Theodore Roosevelt ended private access to public waterways. In 1933, Congress created the Tennessee Valley Authority, which combined federal power with economic development and pork-barrel politics. Also important are rural cooperatives, which were originally established to bring power to America’s less developed areas.

But still most important are the investor-owned utilities (IOUs). The IOUs were granted geographically exclusive franchises and subjected to extensive state review, usually by an independent commission whose members were appointed in some states and elected in others. Nevertheless, state authorities had trouble controlling interstate power transfers and regulating multi-state holding companies. In response to these perceived problems, Congress passed legislation authorizing the Federal Power Commission to regulate interstate transmission of power.

The process worked relatively smoothly until the so-called energy crisis of the 1970s. In large part this reflected the fact that until then electricity prices had been generally falling or rising only slowly. That changed in the 1970s, however. Rates began to move upward with successive oil price shocks. Compliance costs with the Clean Air Act, passed in 1970, and other environmental regulations significantly affected the cost and pace of new plant construction. Rising interest rates had a particularly injurious impact on the capital intensive electricity industry. Higher electricity charges sparked public opposition.

As the existing industry structure shuddered, some regulators and politicians began to look at the possibility of relying on market forces. By the end of the 1980s, proposals for deregulation were percolating in more than 20 different states. Congress passed the Energy Policy Act of 1992, which allowed the Federal Energy Regulatory Commission (FERC) to require IOUs to “wheel” bulk power (wholesale to other utilities) on their transmission lines. Thus, independent power producers could produce energy for sale to utilities. In 1994 the California Public Utility Commission voted to take the logical next step of retail competition. A number of states are now proceeding with plans to test retail wheeling. Some of the same ideas have been advanced overseas, particularly in Europe.

Even industry executives, many of whom remain fearful of such changes, recognize that deregulation is coming. Exactly what form that should take for utilities remains highly controverted. Nevertheless, the end point is clear: market forces should be allowed to determine the generation and provision of power.

Government-Owned and Subsidized Power

The first step in any deregulation program should be to level the energy playing field. While IOUs have, at least until recently, benefited from their status as protected monopolies, they have faced competition from public and quasi-public entities with even greater advantages. Government-subsidized power comes in several forms.

One is the roughly 1,800 municipally owned utilities across the nation, which account for about 15 percent of power distribution. Local public systems typically charge less than their private equivalents, but this reflects government favoritism, not economic efficiency. Being exempt from most state and federal taxes, municipals face an overall tax burden about one-seventh that of IOUs.

Municipalities also can issue tax-exempt bonds, which require lower interest rates. Many states provide subsidized credit, further advantaging municipals. The federal government provides preferential access to power generated by its power-marketing authorities, which sell power for 2.5 cents per kilowatt-hour, barely 40 percent of the national average. Finally, urban systems are usually exempt from regulation by state commissions. These generous subsidies go to wealthy cities like Aspen and Los Angeles.

Similar in certain ways are the 900 cooperatives (owned by their customers), which account for about eight percent of the country’s energy demand. They are also generally exempt from state and federal taxes and receive preferential access to federal power. Moreover, they have their own federal agency, the Rural Utility Service, formerly the Rural Electrification Administration (REA), with no purpose in life other than to transfer taxpayer resources to the co-ops.

Even when the REA was created in 1935 the agency’s primary justification was political. Although only 12 percent of American farms then had electricity, IOUs were steadily expanding service in rural areas. The REA became a political behemoth constantly in search of new tasks to fulfill, expanding into phone service, and, briefly during the Carter administration, cable television. Unfortunately its activities have come at high cost: as much as 40 percent of its roughly $43 billion loan portfolio may have to be written off.

The agency has lost all pretense of purpose. Today more than 99 percent of farms have electricity. Co-ops now largely serve urban and suburban America. Indeed, supposedly rural co-ops service exotic Hilton Head Island and elite Vail, as well as the suburbs of Atlanta, Dallas, and Washington, D.C.

All told, it has been estimated that municipal and cooperative utilities receive about $8.7 billion worth of government aid every year. Looking at the subsidies from a different perspective, the federal government alone is forgoing revenues—taxes on municipalities/co-ops and their investors, and charges for federal power—of about $8.4 billion annually. State and local governments are yielding up a similar $2.7 billion in revenue. The rates of municipals and cooperatives would have to rise by 17 percent and 16 percent, respectively, without the subsidies.

The federal government runs six major power generation and distribution systems. Created first, in 1933, was the Tennessee Valley Authority, which was to provide power to citizens within its own region. Congress financed the construction and initial operation of what has become a multi-billion-dollar system. Again, the initiative was pre-eminently a political move, since the federal government had consistently rejected proposals to allow comparable private power development. Although no longer the recipient of annual appropriations, the TVA can still borrow at below-market rates through the Federal Financing Bank. It is also not subject to the same taxes as are IOUs.

Similar in purpose, if somewhat more limited in scope, were five other regional enterprises, known as power marketing administrations (PMAs). The first was the Bonneville Power Administration, created in 1937 to provide power to the Northwest. Here again the federal government financed power construction and operation and offered preferential access to its cut-rate power to public utilities or private cooperatives. Today the PMAs encompass 129 power plants and produce about six percent of the nation’s electricity.

As America moves toward a competitive system, cities should simply sell off their public power systems—collectively worth an estimated $17 billion. These systems, along with the co-ops, should be stripped of their preferential treatment, both exemption from taxes and access to federal power.

All of the federal enterprises should also be privatized. Doing so could bring in between $20 billion and $40 billion. At the very least, Congress could begin privatizing individual dams and plants and circumscribing the operation of the PMAs. It certainly should cut off new taxpayer subsidies—$312.5 million last year. The PMAs should sell their power at market rates, which could bring in up to $3.6 billion. Congress should cut off the PMAs’ subsidized borrowing, worth about $1.2 billion a year.

Subsidies to Alternative Producers

The so-called energy crisis of the 1970s sparked federal interest in both alternative sources of power and conservation. Support at times veered toward fanaticism—federal controls over office temperatures, massive subsidies for uneconomic energy sources like synthetic fuels, and more. A more moderate manifestation of this sentiment was the Public Utilities Regulatory Policy Act of 1978 (PURPA).

Utilities were required to buy energy from “qualifying facilities,” co-generators and independent producers that met specific criteria, at the “avoided costs” of building new generating facilities or purchasing elsewhere, the interpretation of which was largely left to state regulatory commissions. Today the contribution of co-generation remains modest, while that of other non-utility generators has become significant.

Although the law forbade commissions from setting prices higher than the “avoided cost” of additional generation capacity, they had significant discretion in deciding what constituted avoided costs, and some set unrealistically high prices. Among the QFs that sprang forth were “windfarms,” solar power projects, and small hydro systems across the country. Many of these contracts live on, with long-term prices set well above market rates. The result is to inflict high-cost energy on IOUs, costs which must be passed on to consumers. All told, Resource Data International, Inc., figures that PURPA will inflate utilities’ costs by $37 billion through the year 2000. Some estimates run higher.

PURPA should be repealed. There is no reason to continue requiring utilities to purchase inefficient, wasteful, high-cost energy. The only issue is whether to grandfather in existing QFs. Some $40 billion has been invested in independent power projects across the country, a substantial portion of which would be a risk without government protection. However sympathetic their case—they did, after all, make their investments in reliance on the existence of PURPA—vesting property rights in an existing regulatory regime risks imposing losses on even more innocent parties (in this case, consumers and utilities) and ossifying whatever system happens to exist (since the compensatory costs are potentially so high).

Promoting Other Social Objectives

One method politicians use to win votes at other people’s expense is to require utilities to promote a variety of social objectives. For instance, concern about the poor has led to special “lifeline” rates, subsidized by other ratepayers. Environmentalists have been assuaged by the requirement that utilities offer mandatory energy audits, subsidize energy conservation, and the like.

Unfortunately, mixing purposes (energy production and poverty relief) almost always gives the worst of both worlds—more costly service and worse policy-making. For instance, utilities have no more responsibility than supermarkets to lower their prices for lower-income people. Moreover, hiding poverty alleviation in utility rates distorts public decision-making.

Mandatory energy conservation also makes no sense. There is no energy shortage; supplies of recoverable petroleum reserves, for instance, have been increasing. The crisis of the 1970s reflected perverse government policy, not lack of energy. Nor is there any reason that the consumer who desires an audit—which will, of course, primarily benefit him or her—should not pay for it. Or a utility, believing such a program to offer a financial or competitive advantage, could offer such a service gratis. States should drop their mandates and the federal government should avoid imposing its own. In short, deregulation should mean deregulation.

Holding Company Regulation

In 1935 Congress passed the Public Utility Holding Company Act (PUHCA). The legislation broke up large holding companies that controlled multiple utilities. The basic justification for the Act reflected more New Deal ideology than genuine economic problems. Observes Richard Gordon of Pennsylvania State University: “The evidence suggests, however, that the holding company development process was one of competition to effect what seemed a badly needed rationalization of the then-prevailing structure.” PUHCA disassembled economical operations and encouraged other, less economical integration. Equally important, the statute hampered future integration, forcing IOUs to rely on voluntary cooperation, which, though often successful, lacked the legal certainty of formal integration.

The law makes no more sense today and should simply be repealed. If utilities are going to be subject to competition, they need the freedom to structure themselves to best meet the new competition.

The Electric Grid

The development of a national transmission network, or grid, has helped make an electricity free market possible. Within the larger regional networks (east, west, and Texas) exist smaller networks and power pools of cooperating utilities. This electricity superhighway is, of course, privately owned by the IOUs. However, their ownership is often recognized only in the breach. PURPA allows QFs, essentially competitors of the private utilities, to request that FERC require one or more utilities to wheel their power. Later legislation did the same thing for additional independent power producers. In 1996 FERC issued two orders further opening up transmission lines to competitors.

A move to retail wheeling would likely extend this control far further. This is not an economically inevitable outcome of deregulation—the market could be left to develop with IOUs in full control of their transmission facilities, which would obviously limit competition until alternative grids were established. But alternatives would arise, absent the existing government monopolies: already cable TV, gas, and phone companies, railroads and other enterprises own significant rights of way. In fact, William Niskanen of the Cato Institute suggests that the government not mandate access, and instead allow utilities to charge the market price for transmission; provide “the same access to public rights of way that have been granted to the utilities”; and allow other companies with their own rights of way, such as railroads, to develop transmission facilities. Major consumers and groups of consumers would also have an incentive to develop their own grids.

Moreover, a range of academic research raises serious questions about the ability of regulation to ultimately have much impact on industry profits or services. Competition is a much better protector of consumer interests.

Nevertheless, legislators are unlikely to leave IOUs with even a temporary unregulated monopoly. Thus, most proposals for moving to retail wheeling would expand government control by mandating that utilities carry power for their competitors. In the short term (until the construction of alternative distribution facilities), retail competition is possible only through regulation. However, such regulation would amount to a takeover of the utilities’ resource, effectively an exercise in eminent domain by government which, under the Fifth Amendment, should require compensation. (Such an action would not necessarily meet the current court test of the Fifth Amendment, which allows a plethora of de facto takings through regulation.)

The issue is not the cost to the individual utilities involved, though wheeling is not free. There is a more basic question: the right to property, which requires a legal ability to exclude others. Forcing IOUs to transmit electricity on behalf of others, particularly their competitors, obviously circumscribes the right of utilities to their transmission systems. For such a violation, or “taking” (if only partially) at the hands of government, they deserve compensation. Moving to a free market means just that, and one important aspect of which is to respect private property, even that owned by utilities.

“Stranded Costs”

Although competition would prove enormously beneficial to consumers, its impact is likely to be less benign on existing producers. The most important problem of reconciling the old order with the new is the treatment of past utility generation investments which were to be paid off through regulated utility rates in coming years.

The basic difficulty is quite simple: investment decisions made in a system of guaranteed contracts for wholesalers, protected monopoly for retailers, and political interferences by legislators and regulators, will not necessarily be the same as the best decisions in a free market. As a result, warns a study by the Edison Electric Institute: “if utility rates were ‘brought to market’ immediately by competition, some costs associated with generation investments, purchased power commitments and other deferred costs would be ‘stranded’.”

In fact, stranded costs occur throughout the economy in the sense that competition and technological innovation constantly make some investments uneconomic. These are almost always uncompensated. However, stranded costs that result from changes in government policy, such as deregulation, raise additional issues. After all, investors in competitive markets understand the risk of change better than investors in regulated industries.

Estimates of the value of utility assets that would be “stranded,” and not likely to be recovered, once prices are competitively set, range from $20 billion to $500 billion, with $100 to $160 billion the most common. In an industry with $175 billion in shareholder equity, even a partial write-down would result in significant shareholder misery. It would also have a major impact on investors holding utility bonds.

Not surprisingly, the IOUs argue on behalf of recovery of stranded costs. They mix equity and efficiency arguments, grounded in what economists William Baumol and J. Gregory Sidak call an “implicit regulatory compact.” That is, utilities agreed to invest in exchange for the promise of a reasonable rate of return.

Although utilities understandably desire full coverage for investments devalued by deregulation, as a general principle it is neither fair nor practical to turn regulatory expectations into property rights. The very pervasiveness of regulation makes fiscally infeasible any uniform attempt to compensate for regulatory expectations. Nor would it seem appropriate to dump that burden on consumers who were the very people paying artificially high prices in the past. Indeed, the basic principle might be termed: he who lives by the sword dies by the sword. That is, investors who put money into a regulated industry must understand that the regulations are artifacts of government policy and not property rights. That means they can be changed. And those changes are a risk of the investment.

Nevertheless, the utility industry presents some special circumstances that make the case more difficult. Although industry regulation is pervasive, it usually has not been structured to so consistently encourage high-cost capital investment. Government limits on profit-taking also raise issues not present with simple restraints on competition. Since IOUs were denied the ability to make potentially lucrative returns on those investments when regulated, they reasonably argue for recovery or mitigation of the losses as government lifts the regulation. On the other hand, however unfair deregulation might seem in such a case, the IOUs and their investors always knew that the law and rules could change. Indeed, the 1970s should have brought that lesson home to some degree, since once-routine rate increase proceedings became increasingly contentious. A fair bottom line would suggest showing some sympathy for the utilities’ position, but leaving them with the majority of the downside risk for their investments.

Another issue involves particular obligations imposed on the industry but not new competitors. For instance, to maintain PURPA in an otherwise deregulated market would force utilities to pay above-market prices for energy, hardly a prescription for effective competition. Similar are energy conservation programs, low-cost “lifeline” initiatives, and other money-losing initiatives now imposed on utilities but for which the costs have been recoverable when competition is banned and rates are regulated. As argued earlier, government should end its forced exactions. If not, the utilities deserve compensation.

In short, distinctions should be drawn based on responsibility (utility decision or regulatory change) and potential for mitigation (also by utility or government). The presumption should be that in cases where government caused or failed to mitigate the stranded costs (like PURPA), they are recoverable. Where the stranded costs were caused or not mitigated by industry, the presumption would be only limited reimbursement.

The utility market, especially with the advent of wholesale retailing, is a national one. Over the years Congress has intruded in a number of ways. Thus, deregulation requires at least some action at the national level.

Whether Washington should establish the basic framework or draft the detailed blueprint for deregulation is less clear. At one level, it makes sense to provide for a consistent development of the national electricity marketplace. Thus, the case for federal preemption is strong.

Nevertheless, federalism is an important principle. Although today honored more in the breach than in practice, there is a principled argument for devolving policy decisions and shrinking the power of the Leviathan now centered in Washington. In this case the federal government might bar barriers to interstate commerce (such as excessive “exit” fees for current customers to switch utilities), but allow states to impose a variety of regulations (such as DSM programs and stranded cost recovery) on any company serving residents. Allowing states to test different policy options would be particularly helpful in cases where the best policy outcome is unclear.

Where Do We Go from Here?

The electricity industry is almost certainly heading into a period of unparalleled change. Given changing demand, economics, and technology, the electricity sector is facing revolution rather than reform. At such a time every government statute, regulation, and preconception should be put into play. Whatever the exact transition, the ultimate goal should be a deregulated free market of the sort that characterizes most of the rest of the economy. Said Alvin Duskin of U.S. Windpower: “There has to be some solution to the regulatory process that doesn’t include more regulation.”

The prescription of a free market does not mean that government should design the market. Only by freeing up both consumers and producers will we likely reach the most efficient end-point. But getting from here to there, wherever it is, will not be easy. The policy ideal is relatively simple: repeal most everything. Politics is likely to get in the way, of course, and compromise is inevitable. But there’s no reason for pre-emptive surrender, offering supposed deregulation measures that would impose new restrictions.

Deregulation’s time has come. Then the American people will eventually enjoy the benefits of freedom when they turn on the light or heat just as they do now when they purchase the lamps and furnaces which run on electricity.

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