All Commentary
Thursday, October 1, 1998

Energy: Ending the Never-Ending Crisis

Is Regulatory Restructuring a Step Toward Deregulation?

Jerry Ellig is a professor of economics at George Mason University, Fairfax, Virginia.

This highly readable book undermines both the economic and constitutional rationales for federal regulation of energy markets. The truly amazing thing is the sheer amount of information the author packs into 125 pages.

The economics of energy regulation take up just a little more than half of the book, but Paul Ballonoff, an attorney and president of a consulting firm that specializes in energy issues, covers a wide range of free-market scholarship that supports his position. For the past 100 years, U.S. energy firms have been regulated for two conflicting reasons: to prevent monopolists from charging too much, and to prevent excessive use of fossil fuels whose prices are supposedly too low. Ballonoff presents arguments and evidence that attack both assumptions.

In the petroleum industry, for example, there is virtually no evidence of monopoly by any measure. The industry does not fit the static model of perfect competition found in economics textbooks, because some firms do seem to enjoy superior profit margins. But such profits, Ballonoff argues, are a sign of dynamic competition; firms that are especially skillful at locating or producing oil tend to earn superior returns as a reward.

Nor do doomsayers’ common assertions that we are running out of fossil fuels hold up to scrutiny. The real, economic limit to fuel supplies is not the amount in the ground, but the human know-how employed in finding, producing, and using oil, gas, coal, and other fuels.

“Each advance in computer processing capability,” Ballonoff argues, “causes the supply curves for petroleum exploration, development, and production to fall by a noticeable percentage.” Productivity figures support this assertion. Between 1970 and 1990, for example, the number of barrels of oil found per foot of well drilled doubled! Even falling reserves are not evidence that we are running out of oil, because new technology makes it easier and cheaper to add to reserves when needed. In effect, oil companies are practicing something like “just in time” inventory management for their raw material, substituting better information technology for expensive drilling.

The author applies similar types of arguments to the gas and electric utilities. The traditional rationale for regulation in these industries is “natural monopoly”—because of high fixed and sunk costs, it is less expensive for one firm to serve the entire market, and so consumers get cheaper service when the government grants a monopoly to one firm and then regulates its rates.

Ballonoff grapples with the natural-monopoly dragon, but never quite slays it. He notes that annual depreciation accounts for less than 20 percent of the total costs of gas and electric transmission and distribution, implying that fixed costs are not nearly as high as most people assume. But the relevant measure of fixed costs is the total cost of fixed capital, not the annual amount that is charged off each year as depreciation.

Another, more original argument he offers is much more persuasive. A significant part of the fixed cost of providing utility service is the cost of the right of way, not the poles or wires or pipes. Natural monopoly or not, most homes are already served by as many as six different utility providers using their own rights of way—gas companies, electric companies, telephone companies, cable TV companies, and so forth. If indeed the right of way is the principal fixed cost, then competition would be quite feasible if government grants of monopoly were removed.

Even if some energy utilities are natural monopolies, Ballonoff presents ample evidence that regulation in practice actually leads to higher, not lower, prices.

The author offers three policy conclusions based on his analysis. First, all monopoly regulation of energy companies should be repealed. Second, if some degree of regulation must be retained, regulatory commissions should function solely as specialized antitrust courts with a duty to promote competition, not protect monopoly. And finally, policymakers should avoid “regulatory restructuring,” such as occurred in the natural-gas and telecom industries and is proposed for the electric industry.

No doubt these conclusions will be hotly debated. Even the staunchest supporters of free markets can honestly disagree over whether regulatory restructuring is a step toward deregulation. But such disagreements should not detract from the truth of Ballonoff’s central thesis, which is restated most forcefully in the book’s conclusion: “Many of the ideas that justify and govern traditional American energy regulation are simply wrong.” He’s right.