Regulation and Energy Transport: An Unnatural Disaster

Mr. Semmens is an economist for the Arizona Department of Transportation and is studying for an advanced degree in business administration at Arizona State University. 

The regulation of pipelines for gas, oil and other substances is so complex that the regulation of other modes of transportation appears simple by comparison. Jurisdiction is scattered over a multiplicity of government agencies, any one of which can obstruct and delay, but no one of which can give full clearance to proceed. All this, in pursuit of the general welfare. Yet, few would maintain that the general welfare is being served by the collage of policies growing out of such regulatory efforts.

Regulation is born of the idea that the market is deficient in some way. These claimed deficiencies run the gamut from notions of consumer ignorance and impotence to producer ignorance and impotence. Proponents of increased regulation may be found simultaneously contending that without government controls producers not only would collude to gouge the consumer, but would engage in destructive competition as well. Only with the beneficent guidance of the regulatory commission can justice and economic efficiency be assured—or so the theory goes.

If such assertions be true, one must wonder how study after study can continue to uncover a recurring pattern of regulation-bred stagnation, corruption, inefficiency, and protectionism. A revealing defense of regulation was made in 1974 by the General Counsel of the Interstate Commerce Commission.

Four arguments were raised on behalf of regulation. First, that the regulatory agencies usually yield, sooner or later, to the inevitable changes in the business environment. Second, that the delays occasioned by the ICC, for example, were not that bad. Third, that the waste engendered by regulation is not as bad as it could be. And finally, that regulation will not be as wasteful in the future as it has been in the past; the "new" waste mandated by government controls will not be as gross as the "old" waste.

Despite its indefensibility, regulation persists. The impact that the regulatory system has upon stationary transportation conveyances, primarily for shipment of energy products, will be the focus of the remainder of this report.

Imperfect Competition and Incompetent Regulation

In approaching the issue of competition, or rather, its imperfections, as a rationale for government involvement, many proponents begin by constructing an abstract perfect competition. This perfect version includes such notions as an infinite number of buyers and sellers in the market, as well as instantaneous information on supply and demand conditions. Under such a system, it is agreed that no regulation would be necessary. However, no such system exists. What does exist is imperfect competition. The role of regulation then becomes clear. By careful adjustments to this imperfect environment, it is claimed, the regulatory commission can remove the detrimental consequences and more nearly satisfy all needs.

To be sure, the interveners have the best of the phraseology. After all, the government is seeking to correct the imperfections of the market, to insert deliberated planning and controls in place of the implied chaos of unplanned and uncontrolled markets, to insure fair competition. While phraseology may be useful as propaganda, it is impotent to deal with the economic realities.

The unplanned and uncontrolled market is something of a misnomer. Actually, the market is a reflection of the continuous give and take of numerous participants, each of which is making its own plans and exercising its own controls. This very multiplicity of plans provides the flexibility that regulation lacks. And this is why unregulated markets consistently exhibit superior performance in meeting the needs and wants of consumers.

Contrary to official dogma, it is the planned and controlled segments of the economy that are most chaotic. The only competition that has been "improved" by regulation is that between the growing number of government agencies and bureaus fighting over jurisdictional authority. The major result of this achievement has been to divert effort from productive activities to legalistic wrangling between the regulated businesses and the various regulatory bodies. The net result, of course, is a reduction in the aggregate wealth of the community. This is no mean accomplishment, but it is questionable whether a reduction in wealth is socially desirable. It certainly is not the objective sought by the intervention.

Like some automaton gone berserk, the regulatory commissions have frequently transformed their initial programming from preservation of competition to preservation of selected competitors. There are two predominant techniques. One is paternalism. The other is bureaucratization. Paternalism is evidenced when, in order to prevent "predatory" or "cut-throat" competition, the regulatory agency bars new entrants into the field and restricts or discourages innovations. The case-by-case methods followed produce no clear guidelines for the regulated industry. At the same time, vested interests of existing firms in market shares are treated as a property right. A would-be competitor’s proof that it could provide more efficient service is not considered a reason for allowing such a firm to enter the controlled market.

Bureaucratization is a more in-vidious force in the destruction of competition. Even those on guard against paternalistic inclinations fall prey to this vice. The key manifestation of this phenomenon is the government’s voracious appetite for paper. Not only do bureaucracies produce mountains of paper, but they consume them as well. The regulated firm is constantly besieged to produce more reports, provide more statistics, complete more forms. Smaller firms are hardest hit by this imposed cost of doing business. Not too surprisingly, the larger firms may be the only ones able to meet these costs.

The reduced competition brought about by the very actions of the regulatory authorities then becomes their reason for increasing regulatory powers. Nor can the heretofore protected competitors feel at ease. The regulatory agency may, at any time, turn on them with accusations of attempted restraint of competition or monopolistic practices, though, in truth, they may only have been following the dictates of the regulatory authorities.

It is apparent that regulation, to date, has been incompetent to achieve improved competition. Incapable of assuring good performance in the monitored industries, regulation thrashes about in aimless fashion lopping off consumer options, raising the costs of doing business, insuring misallocation of scarce resources, rewarding inefficiency—all to the detriment of the general welfare.

The Price Is Not Right

The prospects for transmission corridors over the next twenty years are anything but clear. With only limited proven reserves foreseen, the anticipated "need" for transport facilities is largely a shot-in-the dark. It is not irrational to ask why we need new pipelines if we only have ten more years’ worth of natural gas to pump through them. Undisclosed in these estimates of reserves are the assumptions regarding price. If current pricing policies are continued, the prognosis is indeed bleak. On the other hand, studies have indicated that with higher prices, the supply of gas would be stretched out for centuries.

There is nothing magical about this. Neither is it evidence of a vast conspiracy to withhold supplies. It is merely the working out of the simple economic law of supply and demand. Supply varies directly with price, while demand varies inversely with price. Therefore, if the price is held below the uncontrolled market level, the quantity demanded will be stimulated and the quantity supplied retarded. Such is the current policy, which inevitably has led to depletion of reserves and the forecast shortages.

Analyses which purport to demonstrate that the supply of natural gas or oil is not sensitive to changes in prices are absurd. Yet, such analyses have spawned a so-called compromise solution based upon "rolled-in" pricing and the vintaging of oil and gas. Periodically, the various governmental agencies involved in this price control will classify various sources of supply as "old" or "new" based upon the initial year of production or discovery. The consequence, over time, is a plethora of classifications, including "old new," "new new," ad nauseam. Once a source of supply has been classified, its price is fixed, based upon the costs incurred in finding and producing it. This, its advocates explain, will enable the producer to recover his investment without allowing him an "unearned windfall" profit—thus preserving incentive while preventing price gouging.

Historical cost as a basis for determining the necessary price to insure incentive for future investment is a fallacy. Investments must earn replacement costs if the product being generated is to continue to be supplied. If, during the time span that the investor is recovering his original cost, the replacement cost of the necessary capital equipment doubles, the "recovered" capital will only purchase half the replacement resources. In an inflationary environment, controls such as those imposed in the rolled-in price system result in the consumption of capital. This consumption of capital will inevitably result in shortages and diminished future potential.

Capital Punishment

The long-term consequences of price controls and rates of return based upon historical cost have been dramatic. The inability of regulated firms to earn replacement costs on their investments in capital equipment has led to continual trips to the capital markets. This heavy borrowing has boosted debt/equity ratios, raised the cost of borrowed funds, and lowered the credit ratings of the heavy borrowers. A sample of electric utilities showed a drastic decline in credit ratings in the ten years between 1965 and 1975. In 1965, 19 per cent of the utilities sampled had AAA bond ratings. By 1975, there were none.

It is an unhealthy trend, if the services provided by these firms are deemed to be necessary. It is obvious that the "fair" rate of return policies have been inadequate to maintain the levels of service to which we have become accustomed. For example, in the decade of the 1960′s, the average return on investment among Standard and Poor’s 500 corporations was nearly 13 per cent. The average return on investment for oil and gas producers was 6 per cent—this despite the Federal Power Commission’s nominally allowed rate of 15 per cent. Obviously, with such a ratio persisting over time, it is inevitable that capital will flow out of oil and gas production and into other ventures.

It is a sorry state when public policy has the effect of channeling scarce resources away from the production of necessities in order to make them available for what may be considered more frivolous enterprises. However, the proposed remedy of mandatory credit allocation or government loan guarantees is no solution. Government absorption of available credit has been a large contributor to the problem. In 1960, government borrowings accounted for less than 13 per cent of total borrowings. By 1975, government borrowing amounted to more than 25 per cent of the total. Increasing government intervention into the credit markets, even for such seemingly salutary purposes of securing funds to finance production, transmission, and distribution of heating oil, natural gas, electricity, and the like, can only worsen this problem.

Need For Economic Calculation

As regulation displaces the market allocation of resources, the government will have no means of calculating investment priorities, no means of assessing the cost/benefit returns, no rational method of allocating resources. Government takeover of pipelines or government backed loans would not really lower the cost of financing. Such maneuvers only result in shifting the burdens of finance onto third parties. Economic goods have costs, resources are limited. The selection of one set of alternatives precludes the use of those resources on another. Access to government credit or the Federal printing press does not create wealth, it merely transfers it from one holder to another.

Under the complex system of regulation that pervades the economy, there is no way of knowing which transfers serve to redress and which serve to perpetuate imbalances and distortions created by previous waves of interventions. It is safe to say, though, that public policies will be conservative and cautious when it comes to innovations. The regulatory concept is inextricably tied to the continuation of the present into the indefinite future. In fact, one might go so far as to say that the idea of regulation cannot conceptualize innovation.

Each successive wave of transportation technology has found a separate regulatory body set up to control all or part of a particular mode of transport. There is no comprehension of the generic service performed by all modes. Consequently, there can be no comprehension of unforeseen methods of accomplishing the same ends. Public policy is firmly founded upon this myopia. When new techniques come along, they are almost invariably opposed and, at the very least, delayed by regulatory policies. As the regulatory commissions intrude more and more into the economic activities of the nation, capital for innovative ventures will disappear.

Socially Unacceptable

In the final analysis, the deliberated controls that regulation seeks to insert as a substitute for market forces, far from being a stabilizing factor that aids long-term planning, have the effect of creating chaos and aborting long-term planning. The multiplicity of government agencies, bureaus, commissions and departments, each having a veto over a regulated firm’s proposed measures to meet the needs of its customers, insures a lack of coherence to public policy. In the pipeline transportation system, some lines come under ICC regulation, some under FPC. It doesn’t stop here, though, as other agencies—FEA, EIA, EPA and ERDA—play a direct role in blocking various operations of these transport modes. On top of this, the Federal Departments of Transportation, Commerce, Justice, Labor, and now Energy, each have their own fiefdoms of regulatory authority. Add to this the various comparable state agencies and the judicial system and it is plain to see that nothing will ever be done easily or quickly, if in fact it ever gets done at all.

The path of the regulated firm is strewn with obstacles. Cataclysmic changes in public policy on short notice are a frequent source of disruption to a firm’s planning efforts. Short-term political considerations have also played a prominent role in the making of regulatory decisions. And it is not unusual to find that a business’s rational efforts to provide for its future needs will serve as the impetus for government-imposed penalties. Firms which were perspicacious enough to anticipate the shortages of natural gas and make provisions for supplementary sources of power were among the first to be curtailed by regulatory mandate, while profligacy and lack of future planning on the part of others were rewarded by special dispensation in government allocation decrees.

Of course, the distortions brought about via the regulatory system are not confined to business firms. The ills of this system have spilled over into all segments of society, aggravating social and economic problems. The price controls on sales of interstate gas have had the effect of encouraging industries to move out of the populous northern cities to relocate in the sun belt where intrastate gas is available. Left in the wake of this migration are worsening unemployment and economic decline in the central cities. Meanwhile, the ceiling on prices of domestically produced oil and gas has had a net economic impact of shifting the production, and the jobs and capital that go with it, to overseas producers. This also aggravates unemployment problems, creates massive debt obligations to foreign countries, and places enormous capital investment in areas vulnerable to capricious and unstable foreign regimes.

Why Proposed Remedies Are Bound to Fail

Few people will deem these social and political repercussions desirable by-products of regulatory policy. Yet, the remedial actions currently under consideration hold forth no indication that anything has been learned from the unpleasant consequences of past regulatory interventions. On the one hand, the Carter Administration is proposing to penalize consumption, while many critics are urging subsidies to production. Each of these measures alone uses only half of the market mechanism. Utilized together, we would enjoy the ludicrous charade of bureaucrats attempting to simulate market conditions by a combination of taxes and subsidies. In their comprehensive study, The Economics of the Natural Gas Shortage, 1960-1980, MacAvoy and Pindyk demonstrate that of the options discussed, deregulation, by far, provides the most efficient solution to ending the shortages of natural gas.

A little further down the line of ridiculous "solutions" to regulation-caused problems are the forced conversion to coal and the sharing of shortages. Spreading the shortages around will only serve to entrench the problem. Allocations by government dictate override the ability of anyone or any firm to plan for its own needs. Enterprise is stifled while everyone must await the latest government decrees. The incentive for foresight is diminished and reliance upon the vagaries of chance is propagated. Under priority systems which favor residential use of gas, sections of the country will face 90 to 100 per cent curtailment of industrial users by 1980. Coal cannot always be substituted for gas. But unemployment and reduced output can be, as the events of last winter have shown.

The evidence is clear; regulation has produced negative consequences. Misallocation, waste, unemployment—all have regulation to blame for at least part of the problems. Acknowledging this, though, it is difficult to know where to begin. So enormous is the mess that it is easy to imagine conspiracies that have perpetrated "fake" shortages for sinister purposes. Unfortunately, this line of thinking has gained some credence. Energies that ought to be directed at dismantling the barriers to production and satisfaction of urgent needs are, instead, directed at devising suitable punishments for the "guilty." The prevention of "windfall profits" has taken on such overwhelming dimensions that its proponents seem prepared to insure a net loss to society in order to guarantee that no one will gain inordinately from the widespread economic benefits that would follow even partial deregulation.

Until the regulatory ills can be cured, or at least ameliorated, the prognosis for the industries involved will remain bleak, long-term planning an exercise in futility, and society forced to bear unnecessary economic costs without substantive benefit.

Editor’s Note: Mr. Semmens offers a 3-page bibliography of books and articles documenting his study. That bibliography is available from The Freeman on request.

Further Reading