Encyclopedia of Law & Economics - 5940 PUBLIC UTILITIES

5940

PUBLIC UTILITIES

Rick Geddes

Assistant Professor, Department of Economics, Fordham University

© Copyright 1998 Rick Geddes

Contents

Abstract
1. Introduction
A. An Overview of Utilities and Regulation
2. The Structural Similarities of Utilities
3. The Rationale for Regulation of Utilities
4. The Effects of Regulatory Reform
5. Distortionary Effects of Regulation
6. Ownership Form
B. The US Electric Utility Industry
7. Regulatory History of the Industry
8. The Effects of Structural Change
9. Legislative Steps Toward Regulatory Reform
10. The Recovery of Stranded Costs
11. The Natural Industry Structure
12. Reliability
C. The Experience in Other Utilities
13. Telephone Utilities
14. Gas Utilities
15. Water Utilities
D. Utilities in Europe
16. Utilities in Europe
17. Summary and Conclusions
Acknowledgements
Bibliography on Public Utilities (5940)


Abstract

In this article, I review the literature on public utilities. Public utilities include awide range of industries, such as electricity, water, telecommunications, cabletelevision, and railroads, among others. These industries share similarcharacteristics. I first examine utilities generally, focusing on issues common tothem. In this section, I review alternative theories of why utilities havehistorically been either regulated or government-owned. In section 2, I examinethe effects of regulatory reform, and the distortionary effects of utility regulation.I find that the effect of utility regulatory reform in the US has been positive. Insection 3, I apply many of these general concerns to the US electric utilityindustry. I examine the regulatory history of this industry, the effects ofstructural change, the recovery of stranded costs, the natural industry structure,and issues of reliability. In section 4, I provide a brief overview of the literatureon other utilities, including telephones, natural gas, and water utilities. In section5, I summarize the literature on European utilities.

JEL classification: K23, L43, L51, L9

Keywords: Utilities, Network Industries, Regulatory Reform.

1. Introduction

The term "public utility" encompasses a wide variety of industries including,among others, airlines, telecommunications, oil, natural gas, electricity, trucking,cable television and railroads. These industries share a common "network"structure, in that they have an extensive distribution system of lines, pipes, orroutes requiring the use of public rights-of-way, often with strong physicallinkages between component parts. In some cases, such as airlines, governmentowns a part of the infrastructure. Public utilities typically have substantial sunkcosts because of the need for extensive infrastructure. Historically, utilities,where privately owned, have been rate-of-return regulated. Utilities aregovernment-owned in some jurisdictions. In almost all cases, utilities have beengranted legally enforced monopolies over their service territories.

Public utilities have, in many jurisdictions, experienced regulatory reform.Reform has typically been in the form of increased competition through moreliberal entry. In some cases, the oil price shocks of the early 1970s de-stabilizedthe regulatory process. In others, new technologies made the old regulatoryregime untenable. The paradigm for utility regulation has therefore changeddramatically. Where once regulated or government-owned monopoliesdominated because of the belief that most utilities were "natural monopolies,"there is now a growing consensus that competition can perform a broader andmore effective role.

The social importance of public utilities collectively is huge, and the literatureon them is correspondingly vast. I therefore focus on several salient issues. Insection A below, I survey several areas of the literature which are relevant for allutilities, including their structural similarities, the rationale for regulation, and theexperience with regulatory reform. In section B, I examine a more specific case,that of US electric utilities, and indicate how these general concerns apply in thatindustry. I then follow in section C with brief discussions of telephone, naturalgas, and water utilities. In section D, I review the literature on European utilities.Section E summarizes and concludes.

A. An Overview of Utilities and Regulation

In this section, I provide an overview of literature concerning regulation andutilities generally. I first discuss the structural similarities shared by utilities. Ithen review the literature on the various rationales for government interventionin these industries. This includes the "public interest," "capture," "economic,"and "contestability" theories. In section 4, I survey the distortionary effects ofregulation, and then move on to the effects of regulatory reform. I conclude thesection with a brief review of the literature on ownership form.

2. The Structural Similarities of Utilities

Utilities typically create a good or service at one location, and then distribute itover a "network" where it is delivered to numerous customers for end use. Theuse of a network structure creates special issues for utilities. The network oftenexhibits economies of scale and involves substantial sunk costs, so the issue ofnatural monopoly has played an important role in utility literature. The networkmay require the use of public streets or other rights-of-way, so governmentinvolvement is of particular concern. Since several firms often utilize the network,there are "network externalities" or congestion if its use is not properly priced.

The activities of utilities can be broken down into three components:production, transmission, and distribution. While the production componenthas, in the US, been almost exclusively privately owned, the transmission anddistribution stages have been either private or government-owned. For example,in trucking and airlines, government-owned street, highways and airports areutilized. A useful way of describing this common structure in six utilities isillustrated in Table 1.

Table 1: The Three Components of Six Utilities
IndustryProductionTransmissionDistribution
AirlinesAirplanesAir traffic controlAirports
TruckingTrucksHighwaysLocal streets,distributioncenters
TelecomsTelecom terminalequipmentLong-distance cos. and localtelcosLocal telcos
ElectricityGenerating plantsHigh-voltage linesLocal powerlines
NaturalGasGas wellsInterstate pipelinesLocaldistributioncompanies
RailroadsTrainsTrunk linesLocal sidings
Source: Crandall and Ellig (1997, p. 70)

In some regulated utilities, the firm is fully "vertically integrated" into allthree activities, and a salient issue is the "unbundling" of these functions undercompetition. Most commentators now agree that the production stage isinherently competitive in most utilities, so that different firms may perform theproduction and transmission/distribution functions (Crandall and Ellig 1997).The focus is then on the proper structure for the transmission and distributionsegments of the business, with particular attention paid to the question of entryby competitors, or "access" to transmission and distribution infrastructure.

3. The Rationale for Regulation of Utilities

As noted above, government entities have historically regulated utilitiesextensively. The debate in the academic literature over the rationale for thisintervention has accordingly been considerable. The literature falls into twobroad categories: positive and normative. The normative, or "public interest"strand provides rationales for how and why government ought to intervene inutilities, typically pointing out "market failures," or situations in whichgovernment intervention could, in theory, improve market operation. Accordingto this approach, government enacts regulation in response to a market failure.This view was dubbed "normative analysis as positive theory" (or NPT) byJoskow and Noll (1981) since it purports to explain what regulation ought to do.

Natural monopoly theory has historically provided perhaps the mostimportant public interest rationale for utility regulation. This theory holds thatan industry is "naturally monopolistic" if its product can be produced at leastcost by a single firm. Traditionally, this was thought to be the case where a firmproduces a single good and its long-run average cost curve is decliningthroughout the entire range of output. Therefore, to achieve productiveefficiency, it is necessary to have only one firm operating in the industry (thusjustifying legally protected, monopoly service territories). At the same time, thismonopoly had to be regulated to prevent price gouging and to ensure it earneda "fair" rate of return on its investment (Moorehouse 1995, p. 423). Alternatively,this could be achieved through state ownership of the utility, as was morefrequently the case in Europe. In this way, regulation (or ownership) wouldensure both productive and allocative efficiency.

There are at least four reasons why scholars, over time, became dissatisfiedwith the normative approach to utility regulation. Perhaps most importantly, itis at odds with empirical evidence. The incidence of regulation appears to beunrelated to the incidence of the observed characteristics of natural monopolyPosner (1974). Regulation occurs in many industries where the normativeapproach provides no rationale for it, such as potentially very competitiveindustries, including trucking and taxicabs. Second, since a firm's profits arelikely to be reduced if they are regulated in the public interest, the normativeapproach implies that firms are unlikely to favor regulation. Yet history showsthat many regulated utilities actually lobbied for regulation Viscusi, Vernon, andHarrington (1995, p. 326). Third, empirical evidence suggests that the prices ofregulated firms do not behave as suggested by the normative approach. Ifregulation is designed to prevent monopoly gouging, then prices should declinewhen regulation is imposed. Stigler and Friedland (1962) examined electric utilityprices from 1912 to 1937 and found that regulation had an insignificant effect onoutput prices. Fourth, this approach has been criticized because of its lack of amechanism to translate market failure into regulation. That is, no model isprovided of the economic behavior of regulators and interest groups whichwould lead to the suggested outcomes. Many bodies of research have dealt withthese issues. I discuss two below: the "economic theory of regulation" and"contestability theory."

The shortcomings of the normative approach led to the development ofalternative theories of utility regulation. The initial attempt was provided by whatcame to be known as "capture theory" Jordan (1972). Whereas regulation underthe normative theory was presumed to be in the interest of consumers, undercapture theory it was presumed to be in the interest of producers. This theorywas able to provide answers to criticisms one, two and three, and was moreconsistent with available data. However, it also suffered from the fourth criticism.The capture theory did not provide any theoretical underpinnings of regulatorybehavior.

This led to a series of papers which attempted to provide a theoretical modeland generate refutable hypotheses about the effects of regulation. This bodyof work became known as the "economic theory of regulation (ET)". Itsliterature includes, among others, and Coase (1959), Stigler (1971), Posner (1971),Posner (1974), and Becker (1983). An excellent summary of this debate and itsliterature is provided in Priest (1993).

Perhaps the most comprehensive theoretical treatment was provided inPeltzman (1976). While there are several implications of the theory, three arecritical: (i) in a regulated environment, groups with low organization costs arelikely to receive a disproportionate amount of economic rent, (ii) cost-basedcross-subsidization is a likely outcome of the regulatory process; and (iii) ingeneral, rents are likely to be spread among several competing groups, includingpolitically influential consumers, rather than captured by only one constituencygroup, such as producers.

Perhaps the most important prediction of the economic theory is that small,highly organized groups will be net winners in the regulatory process. Stigler(1971) emphasized the information and organization costs that groups face indelivering benefits to regulators. Groups that are low-cost providers of thesebenefits enjoy a comparative advantage in the regulatory process. Thenumerically smaller group will tend to face lower organization costs. Typically,the number of buyers is less than the number of sellers, so the theory predictsthat regulation will benefit producers at the expense of consumers, as isfrequently observed.

An additional refinement of the ET in Peltzman (1976) is that regulators willallocate rents across both consumer and producer groups so as to maximize theirtotal political support, and rents will likely fall into the hands of some consumersas well. Rent-spreading among consumers manifests itself through prices whichattenuate differences in marginal cost across consumers. The ET predicts thatthere will be a tendency for high-cost consumers to receive a relatively lowprice-marginal cost ratio, which constitutes a cross-subsidy from low-cost tohigh-cost consumers. Indeed, a substantial empirical literature bears out manypredictions of the economic theory, but inconsistencies with the data remain.Viscusi, Vernon, and Harrington (1995, p. 341) provide a summary.

A second line of research, which also questioned the "natural monopoly"rationale for regulation began with Demsetz (1968). He showed that there is atheoretical inconsistency in natural monopoly theory: the existence of a singleproducer in the market need not lead to monopolistic pricing. It is possible forcompetitors to bid for the right to serve the market. The threat of potential entrymay discipline markets which have very few, or only one, producer actually inthe market.

Demsetz's work highlighted the notion of what is now termed "potentialcompetition." This basic concept was vigorously analyzed in a series of papersdeveloping "contestability" theory. Willig (1980) first examined this notion indetail by applying it to postal markets. His inquiry led to a benchmark idealizedmarket termed a "contestable" market. As Baumol, Panzar, and Willig (1988, p.xiii) state, "A perfectly contestable market is defined as one in which entry andexit are easy and costless, which may or may not be characterized by economiesof scale or scope, but which has no entry barriers . . ." This notion was furtherdeveloped in a series of papers, including Baumol, Bailey and Willig (1977) andBailey and Panzar (1981). Eventually, Baumol, Panzar, and Willig (1988)published this body of work in a book entitled Contestable Markets and theTheory of Market Structure. This work called into question the original notionof natural monopoly and therefore the justification for monopoly rate-of-returnstyle regulation of these firms.

This theoretical approach encouraged a number of studies of thecontestability of natural monopolies, including Coursey, Issac and Smith (1984)who used an experimental approach and concluded that (p. 111):

The most significant result . . . is that the behavioral predictions of thecontestable market hypothesis are fundamentally correct. It is simply nottrue that monopoly pricing is a 'natural' result of a market merely becausefirms in the market exhibit decreasing costs and demand is sufficient tosupport no more than a single firm.

Moreover, serious theoretical problems with the traditional natural monopolyview arise when multi-product firms are considered. Almost all utilities producemore than one product. For example, utilities produce both peak and off-peakpower, and telephone companies provide both local and long-distance phoneservice.

In an important article, Baumol (1977) investigated the relationship betweeneconomies of scale and natural monopoly. He showed that the correct definitionof natural monopoly is not that long-run average costs decline, but that the costfunction is "sub-additive." Briefly, subadditivity asks the question of whetherit is more or less costly for two or more firms to produce the output rather thanone firm. This is, therefore, a more appealing definition of natural monopoly. Thecost curve is subadditive if one firm can produce a given output more cheaplythan two or more firms. This analysis pointed out that economies of scale are asufficient but not a necessary condition for the existence of natural monopoly.In the multi-product case, Baumol showed that economies of scale are neithernecessary nor sufficient for the sub-additivity of costs. This is because of theinterdependence of outputs in the multi-product case. An industry is a naturalmonopoly only if the firm's cost function is subadditive over the entire range ofoutputs (Baumol, Panzar, and Willig 1982, p. 17). Inspired by Baumol, Panzar,and Willig and other contestability literature, Gilsdorf (1995) tests for thesubadditivity of vertically integrated electric utilities, and finds that there is noevidence for subadditivity in this industry. Gilsdorf thus concludes thatintegrated utilities are not multistage natural monopolies, thereby casting furtherdoubt on the natural monopoly status of electric utilities.

In interpreting the contestability literature, Moorehouse (1995, p. 425)concludes, "Thus this research suggests that competition can be substituted forgovernment regulation and state ownership to assure good performance in, atleast, the generation of electricity." These literatures have led to a widespreadchange of perceptions in the need for and rationale for utility regulation. It isprobable that they helped promote regulatory reform in many industries. Animportant question is the consequences of reform, which I discuss below.

4. The Effects of Regulatory Reform

The term "regulatory reform" itself has a variety of meanings. Here I focus on"deregulation," using it in the sense of Stigler (1981) and Winston (1993): thewithdrawal of the state's legal powers to direct the economic conduct ofnon-governmental bodies. While this can occur in a variety of ways, mosttypically in utilities it refers to the relaxation of price, entry and/or exit controls.A wave of deregulation begun in the mid-1970s and which continues today hasswept aside some of the most restrictive regulatory structures created in the USin the late 19th and early 20th centuries. Regulated industries produced 17 percentof US GNP in 1977; by 1988 this had fallen to 6.6 percent (Winston 1993, p. 1263).Continuing deregulation of electric utilities in some states, and of some aspectsof telecommunications, further reduces this proportion.

In this section, I review US deregulation's effects in six industries, includingairlines, trucking, telecommunications, cable television, railroads, and naturalgas. Winston's (1993) survey of the literature provides an excellent overview ofthe outcomes. Since most economic deregulation in the US was complete by thattime (and had a chance to have its full effect) it is possible to study its impactmeaningfully. Winston compiled estimates of deregulation's effects across a vastliterature, and presented the range of estimates in the form of billions of annual1990 US dollars. More recently, Crandall and Ellig (1997) summarized a largebody of evidence on five industries (natural gas, telecommunications, airlines,railroads, and trucking), examining evidence on price, quantity, and quality. HereI report Winston's estimates for selected industries and variables, and reviewCrandall and Ellig's results, where applicable.

In Table 2 below, I summarize estimates from Winston (1993) on the effectsof deregulation on prices and, in some cases, service. A positive number incolumn 3 indicates a gain for consumers due to lower prices or improved service.With the exception of the lowest estimates for railroads, US consumers uniformlybenefited from deregulation. For example, airline customers gained between $4.3billion and $6.5 billion per year (in 1990 dollars) through lower fares fromderegulation of airlines. They gained approximately $8.5 billion from greaterfrequency of service, but lost $3 billion from increased travel restrictions.

Table 2: Summary of the Assessed Effects of Regulatory Reform on Pricesand Service
IndustryEffect on:Outcome ($ bill.)
AirlinesFares

Service Frequency

Travel Restrictions

(4.3, 6.5)

8.5

-3.0

TruckingCommon Carrier Rates

Private Carrier Rates

7.8

6.0

Long-Distance

Telecommunications

Rates(.73, 1.6)
Cable TVPrice & Service(.37, 1.3)
RailroadsRates(-2.1, .43)

Source: Winston (1993, p.1274-5). Positive values indicate consumer gains.Values are in billions of 1990 dollars.

In terms of percentage declines in airline fares, Crandall and Ellig (1997, p. 34)note that "yields" (the average amount of revenue received per passenger mile)are commonly used by analysts to measure fare trends, and state:

. . . the average yield fell from 21.65 cents in 1977 to 13.76 cents in 1995,a 37-percent reduction. Much of this decline occurred during the first 10years of deregulation, when the yield fell by 29 percent, from $21.65 to$15.32. Interestingly, yields fell almost immediately in response toderegulation.

Crandall and Ellig (1997) also document the fall in the price of natural gasafter deregulation. Adjusting for inflation, they find that wellhead prices fell by60 percent between 1984 and 1995. They discovered that the prices actually paidby various classes of consumers (e.g. residential, commercial, electric utility) alsodecreased significantly. Regarding interstate telecommunications rates, they findthat after the AT&T divestiture in 1984, the Consumer Price Index for interstatelong distance rates decreased from approximately 60 in 1984 to about 30 today.The intrastate rates have also fallen, but somewhat less rapidly.

In Table 3, I report the findings of Crandall and Ellig on percent pricereductions in five utilities two, five, and ten years after deregulation. For tenyears, they range from a low of 27 percent to a high of 57 percent, but they wereuniformly positive. Collectively, these results suggest that deregulation ofutilities provide benefits for consumers.

Table 3. A Summary of Price Reductions from Deregulation in the UnitedStates
IndustryPercent price reduction after . . .
2 years5 years10 years
Natural Gas10-38%

(1984-'86)

23-45%

(1984-'89)

27-57%

(1984-'94)

Long-Distance

Telecomm

5-16%

(1984-'86)

23-41%

(1984-'89)

40-47%

(1984-'94)

Airlines13%

(1977-'79)

12%

(1977-'82)

29%

(1977-'97)

TruckingN.A.3-17%

(1980-'85)

28-56%

(1977-'87)

Railroads4%

(1980-'82)

20%

(1980-'84)

44%

(1980-'90)

Source: Crandall and Ellig (1997, p.2)


Winston also examined the effects of regulatory reform on profits. In Table4 below, I report the effects of US deregulation on profits. Positive numbersrepresent profit gains.

Table 4: Summary of the Assessed Effects of Regulatory Reform on Profits
IndustryOutcome ($ bill.)
Airlines4.9
Trucking-4.8
Long-Distance

Telecommunications

Small change
Cable TVIncrease
Railroads3.2

Source: Winston (1993, p.1278-9). Positive values indicate a profit gain. Valuesare in billions of 1990 dollars.

Most utilities experienced a profit gain from deregulation, with airlinesenjoying the largest gain of $4.9 billion annually. The trucking industry is ananomaly, since it lost $4.8 billion annually from deregulation. The politicaleconomy behind trucking deregulation remains a mystery, since the economictheory of regulation predicts that the relatively small number of highly organizedtrucking companies would have successfully blocked deregulation, but did not.For most industries, then, deregulation increased profits, or at least did notsignificantly reduce them.

In Table 5 below, I present Winston's summary of the estimates ofderegulation's effect on wages and employment. Positive numbers indicate again to labor. While airlines experienced a small decline in wages, deregulationthere led to an increase in employment, most likely due to an increase in thefrequency of flights. Trucking experienced a decline in both wages andemployment, suggesting that firms and workers shared the lost monopoly rents(Rose, 1985). Railroad workers also suffered a substantial decline in wages, whileemployment was not affected.

Table 5: Summary of the Assessed Effects of Regulatory Reform onWages and Employment
IndustryEffect on:Outcome ($ bill.)
AirlinesWages

Employment

Small decline

Increase 6%

TruckingWages

Employment

(-1.1,-1.9)

Decline

Long-Distance

Telecommunications

Wages (comm.)

Wages (equip.)

No change

Decline

Cable TVWages

Employment

No assessment

Increase

RailroadsWages

Employment

Decline 20%

No Effect

Source: Winston [1993, p.1282]. Positive values indicate a gain to labor. Valuesare in billions of 1990 dollars.

Given that some groups benefited while others lost, it is important toconsider the net effects of deregulation. In Table 6, I report findings fromWinston (1993) on the overall effects of regulatory reform in the US. This tablesums the effects on both consumers and producers to obtain a total or "net"effect of deregulation in that industry. Positive numbers in the "Total" columnindicate that deregulation overall produced a welfare gain. For all six industriesexamined here, the net effect was clearly positive, indicating that any welfareloss by producers (e.g. truckers) were outweighed by consumer gains. Net gainsthus suggest improvements in economic efficiency, most of which were capturedby consumers. Winston notes that, when gains are summed across industries,society gained at least $36 to $46 billion annually from deregulation. Estimatesof total social gains are higher if firms are assumed to adjust optimaly toderegulation.

Table 6: Summary of the Assessed Effects of Regulatory Reform Overall
IndustryConsumersProducersTotal
Airlines(8.8, 14.8)4.9(13.9, 19.7)
Trucking15.4-4.810.6
Long-Distance

Telecommunications

(.73, 1.6)___(.73, 1.6)
Cable TV(.37, 1.3)___(.37, 1.3)
Railroads(7.2, 9.7)3.2(10.4, 12.9)

Source: Winston (1993, p.1284). Positive values indicate a gain to labor. Valuesare in billions of 1990 dollars.

These estimates suggest that deregulation of numerous utilities in the USproduced substantial social gains. It is therefore probable that utility regulationcreated a variety of economic distortions, which I discuss below.

5. Distortionary Effects of Regulation

Several branches of research relating to utilities have focused on thedistortionary effects of rate-of-return regulation. Here I review two branches ofthis extensive literature. One branch studies the effect of rate-of-returnregulation on the firm's input mix. In a seminal article, Averch and Johnson (1962)developed a model which implied that rate-of-return regulation would cause anindustry to utilize a greater than optimal amount of capital. Early studies,including those by Baumol and Klevorick (1970), and Bailey and Malone (1970)and Zajac (1970), generalized the Averch-Johnson conclusions and found thatthere is an incentive for overuse of the rate-regulated input and over-productionof output. Studies by Courville (1974), Spann (1974) and Boyes (1976) foundempirical support for the Averch-Johnson predictions. These models were oftenbased on certainty of demand and price, and were subsequently criticized forthis. A new series of papers by Perrakis (1976), Meyer (1976), Peles and Stein(1976) and Das (1980) introduced uncertainty, and concluded that the existenceof the effect was dubious. Baron and Taggart (1977) found under-capitalization.The results appear to be susceptible to the type of uncertainty introduced.

A relatively new area of inquiry involves the question of the effect of theregulatory process on the internal structure of the firm. While this research itselfhas several branches, a main focus is regulation's effects on senior executivebehavior. Important variables considered include CEO pay and turnover.Alternative views of regulation's effect on CEO pay include a "productivityhypothesis," in which regulation reduces the complexity of the tasks performedby managers (Peltzman 1989). Under these circumstances, it is efficient for firmsto pay CEOs less, and to hire less able CEOs. An alternative is a "politicalpressure" hypothesis, which suggests that the regulatory process politicizescertain firm choices, including CEO pay. Joskow, Rose and Shepard (1993) forexample, argue that there are political constraints on executive compensation.

A body of research has established that CEOs of regulated firms are, in fact,paid significantly less than those of unregulated firms. Joskow, Rose, andShepard (1993), after controlling for firm size, firm performance, andcharacteristics of the CEO find that the chief executive is paid less if the firm isregulated. Carroll and Ciscel (1982) find that regulation reduces the basic annualcompensation of the chief executive. They suggest that lower risk, less CEOdiscretion, and political constraints may all help explain the lower observedcompensation.

Joskow, Rose, and Wolfram (1996) attempt to distinguish between theseexplanations by examining differing regulatory environments. They evaluatealternative environments by how "pro-consumer" they are as rated by aninvestment bank. They find that CEOs are paid less in relatively pro-consumerenvironments, and conclude that a political pressure view is supported.

Regarding turnover, Geddes (1997) examines the turnover of seniorexecutives of regulated firms and finds that it is not sensitive to the financialperformance of the firm. This is important since researchers examiningnon-regulated firms have found such a relationship. Turnover of utilityexecutives is, however, related to changes in the price of output. Higherelectricity prices increase the probability that the identity of the CEO will change.This result is consistent with estimates in Joskow, Rose and Wolfram (1996)which show that pay is inversely related to the rate of growth of electricityprices. These latter results are also consistent with a "political pressure" viewof CEO behavior.

In addition to regulation, the effects of and correct type of ownership formfor utilities has been a matter of much discussion. Below I review literature in thisarea.

6. Ownership Form

The debate over government versus private ownership of utilities has alwaysbeen a lively one. Early economists believed that there was a strong case forgovernment ownership, which was dependent on their "natural monopoly"structure, as discussed above. As Hausman and Neufeld (1991, p. 414) state,"Prominent founding members of the American Economic Association, includingRichard T. Ely, Henry C. Adams, E. W. Bemis, Edmund J. James, and E. R. A.Seligman, rejected laissez-faire public policy and advocated governmentownership of a class of businesses which they designated 'natural' monopolies,including municipal gas companies, water-works, and electric utilities." Whilethere appears to be no generally accepted formal model of the effects ofownership form on firm behavior, Boardman and Vining (1989, p. 2) state ". . . thedominant positive model of the effect of ownership is the public choice, orproperty rights, model."

Some authors have argued on theoretical grounds that privately owned firmsshould exhibit greater internal efficiency in the production of goods and servicesthan publicly owned firms. De Alessi (1974, 1980) suggested that this was dueto the inability of the owners of public enterprises to effectively incorporate thebenefits of additional managerial monitoring into current transfer prices of thefirm:

The crucial difference between private and political [publicly owned]firms is that ownership in the latter effectively is nontransferable. Sincethis rules out specialization in their ownership, it inhibits thecapitalization of future consequences into current transfer prices andreduces owners' incentives to monitor managerial behavior (De Alessi1980, p. 27-28).

Owners of public firms thus have less incentive to monitor managers, and thecost to public managers of taking additional non-pecuniary benefits, includingshirking, is lower. De Alessi argued that public managers have more job securitywhich will be manifested in longer tenure periods. He tested this proposition inDe Alessi (1974) and found that public managers did exhibit longer tenureperiods. Geddes (1997), however, re-estimated the De Alessi tests with a largerdata set and more control variables, and found no significant difference in tenureperiods across the two ownership forms.

Spann (1977) attributed expected efficiency differences to two factors. First,public firms do not have the incentive to minimize costs as do private,profit-maximizing firms. Second, private firms naturally gravitate to the optimalsize while public firms are restricted by political boundaries. Alchian andDemsetz (1972) and Frech (1976) suggested that there is a greater incentive forpublic employees to shirk since their wealth is not as closely tied to the workdecisions they make. Other researchers have argued in a similar vein, including,among others, Davies (1971), Davies (1977), Moore (1970), and Crain andZardkoohi (1978). The available evidence indicates that the relative performanceof public and private enterprise is also dependent upon the structure of theindustry in which they operate, as well as ownership form. For example,Boardman and Vining (1989) examine the effect of ownership form on profitabilityand efficiency in a number of competitive industries. They find that dummyvariables for both mixed and state-owned enterprises exert significant andnegative effects on profitability and other measurers of performance. Forvaluable surveys of this literature, see De Alessi (1980) or Boardman and Vining(1989).

Numerous researchers have examined the question of the efficiency of publicversus privately owned electric utilities in particular. The literature has beencharacterized by increasing rigor in the econometric tests of efficiency used aswell as changes in the conclusions of these tests. Moore (1970) used a modelwith linear input and cost equations and found that private electric utilities arefive percent more efficient than municipal utilities. Meyer (1975) used a quadraticfunction to estimate costs for public and private utilities, and concluded thatpublicly owned utilities are more efficient. Neuberg (1977) estimated that publicfirms are six to twenty percent more efficient, and Pescatrice and Trapani (1980)estimated public firms to be 33 percent more efficient.

Using a variety of econometric methods, more recent investigations ofrelative cost efficiency have indicated that the two ownership forms display few

significant differences. This list includes DiLorenzo and Robinson (1982), andFare, Grosskopf, and Logan (1985). Atkinson and Halvorsen (1986) estimatedrelative efficiency using a translog cost function and reached a similarconclusion. As Vickers and Yarrow (1988, p. 41) state:

Taken in conjunction with the research on U.S. electric utilities, we aretherefore led to the conclusion that, where firms face little output marketcompetition and are extensively regulated, there is no generally decisiveevidence in favor of one type or the other type of ownership.

A unique alternative approach is taken in Hausman and Neufeld (1991). Theyexamine the very early period in the industry's history (1897/98) in order toexamine the relative efficiency of government versus privately owned utilitiesprior to state rate-of-return regulation. Using a non-parametric approach, theyfind that in this period government-owned utilities were relatively more efficientthan their privately owned counterparts. They suggest that this finding isinconsistent with the property rights view of ownership, and attribute theobserved difference to a greater "public spirit" associated with the operation ofgovernment-owned utilities.

The question of ownership and efficiency is still very much alive. Mostrecently, Pollitt (1996) in the Oxford Economic Papers examines government andprivately owned nuclear power plants in the U.S. and U.K., using dataenvelopment analysis. He found that, when vintage effects and poor investmentdecisions were taken into account, there was some evidence that privatelyowned nuclear plants had lower costs.


B. The US Electric Utility Industry

In this section, I examine a particular utility industry in detail. I focus on theelectric utility industry in the United States. Many of the issues discussed abovethat are common to many utilities are particularly important in the electric utilityindustry. I first examine the history of regulation of this industry, and someinterpretations of it.

I focus on electricity for four reasons. First, as measured by total assets, itis an extremely large industry. In the US, it is the largest. Second, of all theservices, electricity may be the most "fundamental" in that most other utilitiesrequire it for their operation. Third, it is often considered the industry with themost "natural monopoly" characteristics. Finally, many of the issues in electricutilities (such as the unbundling of services and the distortionary effects ofrate-of-return regulation) are similar to those in other public utilities.

I examine several aspects of the industry. I first review the regulatory historyof the industry. This history is particularly pertinent today, since regulatoryreform is underway in many places and under consideration in others. It is alsoillustrative of the application of the economic theory of regulation. In part 8, Iexamine the effects of the economic shocks of the early 1970s on the industry,and discuss institutional changes that occurred as a result. In part 9, I look atlegislative acts which affected the industry, including the Public UtilityRegulatory Policies Act of 1978, and the Energy Policy Act of 1992. I then moveon, in part 10, to summarize the current thinking on a critical policy questionresulting from deregulation: whether or not utilities should be allowed to recoverthe cost of investments that are "stranded" through open access to thetransmission grid. In parts 11 and 12, I examine the issues of industry structureand reliability, respectively.

7. Regulatory History of the Industry

The founding of the electric utility industry is generally placed at 1879, whenelectricity was first used to light streets and some buildings (Bradley 1996, p. 60).In its earliest stage, neither the states nor the federal government regulated theindustry. Since cities and towns had to grant utilities the right to use publicstreets, the regulation of entry was de facto controlled by municipalities. Jarrell(1982) argues that at this time there was competition between firms, as citiesoften granted franchises to numerous companies in the same area. Indeed, thisera of contending municipal franchises is known as "regulation by competition"(Bradley, 1996, p. 60).

With the passage in New York and Wisconsin in 1907 of landmark statuteswhich granted utilities monopoly power and created strong state utility

commissions, the states entered the regulatory arena. The justification for thisearly state regulation of the industry has spawned substantial controversy,which continues today. Economists such as John R. Commons enjoyedformulating justifications for powerful regulation (Michaels 1996, p. 48). Theseearly economists explained that the industry had been regulated in order tocorrect "natural monopoly-style" market failures, as discussed above.

Questioning such a view, Jarrell (1982) argued that state electricity regulationwas not designed to counter natural monopoly problems, the theory of whichwas developed later (Bradley, 1996), (Priest, 1993). Instead, he asserted thatutilities sought out the state's regulation in order to protect them fromintensively competitive conditions under municipal franchising. Jarrell thusrelies on the economic theory of regulation to explain the evolution of electricityregulation.

To test these alternatives, Jarrell divided states into two groups: those whichpassed regulation in an early wave of state reforms from 1912 to 1917, and thosewhich passed regulation later and more slowly, after 1917. The normative theorypredicts that regulation will be supplied earliest in states where naturalmonopoly problems are the most severe; where prices and profits are thehighest, and output the lowest, since these states were most in need ofregulation. The economic theory predicts the opposite; since regulation wasestablished to create economic rents by shielding firms from competition,regulation will occur first in those states where prices and profits were thelowest. Jarrell found that those states which adopted regulation early had, onaverage, 45 percent lower prices, 30 percent lower profits, and 25 percent higherper capita output before regulation than the states which adopted regulationlater. This and other evidence lead Jarrell to conclude that regulation was passedin order to shield firms from competitive conditions prevailing whenmunicipalities were the sole regulators.

Bradley (1996) also examines the origins of state regulation of electricity. Hefocuses on the effect of utility interests (e.g. Samuel Insull) pushing forregulation and suggests that it was an act of political opportunism designed toprotect utilities from competition. Bradley concludes that, because the originalmotivation for government intervention in the utility industry was not due tomarket failure, the case for the industry's deregulation today is stronger.

8. The Effects of Structural Change

Regardless of their justification, these regulatory arrangements were relativelystable until at least the late 1960s. Joskow (1989) presents a comprehensiveanalysis of the changes in the industry through the 1960s, 70s and 80s. Hedocuments the economic forces which led to major changes in the industry'sregulation. The same basic economic forces were operating on utilitiesthroughout the world. Joskow's discussion is briefly summarized here.

The decades of the 1950s and 1960s were relatively uneventful for the electricutility industry. The industry benefited from technological progress andeconomies of scale in generation, which led to falling nominal and real prices forelectricity. Utilities performed well financially and rarely filed for rate increases,but instead often voluntarily decreased their rates. The regulatory system ofextensive price and entry review by state and federal agencies worked wellduring this period. Electric utilities were able to keep their part of the regulatorybargain by providing reliable power to their customers while regulators allowedthem an adequate return on investment. Public involvement in the regulatoryprocess was minimal and rate changes were infrequent.

Several factors worked in concert in the early 1970s to change this situation.Productivity gains slowed due to the exhaustion of scale economies in electricgeneration, while the cost of fuel and capital increased. The OPEC oil priceshocks had a substantial effect on utilities. State public utility commissions,responsible for regulating electricity rates, were slow to respond to thesechanging factors. Rate increases often required a full year from inception at theutility to approval by the commission (Joskow 1989, p. 159). Also, manycommissions relied on a historical test year, which reflects outdated input costs,to set future rates. This regulatory lag resulted in inflexible rates which, in theface of rising costs, caused electric utilities to become less profitable. Ratehearings became more frequent after 1973 as utilities faced rapid fuel priceincreases.

At the same time, numerous consumer groups were organizing to resistincreases in electricity rates. This ratepayer activism made it increasingly difficultfor utilities to adequately adjust to unexpected fuel price changes. Additionally,demand growth slowed in response to the rate increases that had occurred.Electricity demand grew at a 7.3 percent annual rate from 1960 to 1973, butslowed to 2.5 percent a year from 1973 to 1985 (Joskow 1989, p. 150). This hurtthe financial performance of many electric utilities, as construction projects wereundertaken with the expectation of continued demand increases, thus decreasingcapacity utilization. Under pressure from consumer groups, regulators were loathto include these new, under-utilized plants in the rate base. Traditionalcost-of-service regulatory arrangements began to erode as public utilitycommissions adopted new tests for inclusion of capital in the rate base, such asrequiring the economic value of the plant to be greater than its accounting cost,called the "used and useful" test (Joskow 1989, p. 161). Under these new rules,regulatory disallowances became more common, especially for nuclear capacityafter the 1979 Three Mile Island accident. Electric utility profitability declinedeven more. After 1975, electric utility common stock price to book ratios fellbelow one, and earned rates of return fell far below allowed rates (Joskow 1989,p. 157). The difference between utility return on equity and the yield on new debtfell from 1974 onward, reaching -3.91 percentage points by 1981. The financialcondition of utilities did not improve until 1985. Under these pressures, it becameclear that substantial reforms of the regulatory process were necessary.

Reform came in several ways. In order to deal with regulatory lag, a numberof states instituted fuel adjustment mechanisms (FAMs) which allowed utilitiesto adjust rates without a formal rate hearing when fuel costs changed. Manystates embraced these mechanisms in the mid-1970's, so that by 1979 all but fivestates had adopted some sort of FAM. This reform shifted the risk of fuel costchanges from the utility to the consumer.

A number of economists have studied the effects of FAMs. For example,Kendrick (1975) developed a framework of automatic adjustment clauses toprotect utilities from general price increases. Gollop and Karlson (1978)empirically tested the effect of FAMs by estimating translog functions. Baronand DeBondt (1979) provided a history of FAMs and analyzed their effect onincentives for efficiency. Clarke (1980) examined the effect of FAMs on inputchoice and showed that the effect is in the opposite directions of therate-of-return distortion. Isaac (1982) examined their impact when input prices areuncertain.

Despite the adoption of FAMs, however, utilities confronted a number ofsignificant problems. Regulatory disallowances made utilities reluctant to plannew capacity. Environmental concerns resulted in legislation which greatlyincreased costs. Additional reforms, therefore, were clearly needed. These cameat the federal level and dealt chiefly with the emerging wholesale power market.Two important laws were the Public Utility Regulatory Policies Act of 1978(PURPA), and the Energy Policy Act of 1992 (EPAct).

9. Legislative Steps Toward Regulatory Reform

An important result of the political and economic upheavals of the 1970s was agrowing wholesale power market. Heightened opportunities for wholesale tradein electricity materialized as a result of unanticipated price differences betweenalternative fuels, as well as excess generating capacity Joskow (1989). A criticalpiece of legislation which encouraged the growth of the wholesale market wasthe Public Utility Regulatory Policies Act of 1978 (PURPA). Title I of PURPAdirects the states to consider introducing time-of-day rates and interruptiblerates, which are alternatives to traditional ratemaking methods. The moreimportant section, Title II, requires utilities to purchase power from companiesthat attach generation equipment to an existing heat source (cogeneration) orcompanies that use renewable sources and waste fuels. Small independentgeneration facilities are included in this section if they meet certain guidelineslaid out in the Act. These cogenerators and independent power producers arereferred to as "qualifying facilities." While PURPA was passed in 1978, it did nothave significant effects until the mid-1980s. The FERC did not issue regulationsregarding PURPA until 1980, and several key issues were not resolved untilcourt rulings in 1983.

PURPA gave little guidance as to how these transactions were to be carriedout, aside from stating that utilities had to purchase excess electricity fromqualifying facilities at a price that could not exceed the "incremental cost to theutility of alternative electric energy." PURPA was important because it createdan independent generation sector, not subject to rate-of-return regulation thatprovided alternative energy sources at a time when established utilities werereluctant to construct their own additional generating capacity. This law, alongwith economic change, provided the first real opportunity for independent firmsto produce electricity without encumbering rate and entry regulations. Availableevidence reveals that the resulting wholesale power market is quite competitive.Joskow (1989, p. 189) summarizes:

The experience since the enactment of PURPA indicates that there existsa very elastic supply of capacity that independent producers are willingto offer at attractive prices. In addition, active markets for short- andmedium-term power in excess of the current needs of integrated utilitieshave emerged in most areas of the country. These markets are subject toonly very loose FERC regulation. As a result of extensiveinterconnections, coordination arrangements, and voluntary wheeling,the anecdotal evidence suggests that these markets are often verycompetitive.

This independent generating sector has become an important component ofthe industry. As Baumol and Willig (1995) note, additional units of generatingcapacity are now just as likely to be provided by non-utility generators (NUGs)as by utilities. During 1990-91, NUGs added more net capacity then did utilities.Furthermore, forecasts suggest that the importance of NUGs will increase in thefuture. Michaels (1993) notes that, in 1983, NUGs provided only 2.5 percent oftotal US generating capacity. By 1991, however, NUGs were constructing overhalf of the new capacity installed in the US and provided over 9 percent of thetotal.

More recently, the Energy Policy Act of 1992 facilitated wholesalecompetition. This act gave the FERC expanded authority to order utilities toprovide wheeling services, thus further opening the wholesale power market(Baumol, Joskow, and Kahn, 1995, p. 14), (Walters and Smith 1993). Pursuant tothis provision, the FERC issued an order that requires all transmission-owningpublic utilities to open their transmission lines to eligible wholesale customerson a non-discriminatory basis. Providing access to the transmission network willincrease competitiveness at the wholesale level and make the state regulator'sjob easier and their regulation more effective. However, it also createsconsiderable problems regarding utilities' existing investments, as discussedbelow. Importantly, the Energy Policy Act did not promote retail wheeling, whichwould enable retail customers to purchase power directly (Baumol, Joskow, andKahn, 1995, p. 14).

The Act also removed barriers to acquisitions contained in the Public UtilityHolding Company Act of 1935 (PUHCA). It defined a new class of wholesalegenerators which are exempt from regulation under PUHCA, called "exemptwholesale generators" or EWGs. It permits any person, including a registeredholding company, to acquire an EWG, wherever located, or a foreign utilitycompany (FUCO) without seeking prior approval from the Securities andExchange Commission (which would have been required under PUHCA). Thus,owners of EWGs are exempt from PUHCA regulation. The exempt wholesalegenerators now constitute an important source of non-utility generation.

Therefore, the unintended consequence of PURPA was to move towardincreasing competition in US wholesale electricity (Moorehouse 1995). TheEnergy Policy Act then substantially strengthened this trend. In these laws,states retained much discretion to restructure their energy markets. Asdiscussed in Lenard, Geddes, and Block (1996), 46 states are currently studyingoptions for restructuring their energy markets. California instituted a plan underwhich all consumers were able to choose their electricity provider on January 1,1998. Massachusetts legislators recently announced that, beginning March 1,1998, electric utilities will have to compete for customers. A rate reduction of 15percent is guaranteed in the bill, and power companies are allowed to recover allof their past investments in generating facilities. Many other public utilitycommissions or state legislatures are close to adopting specific restructuringplans.

Each of these states is proposing that retail customers buy electricity directlyfrom generators or other alternative suppliers. In such transactions, thetraditional franchise utility would merely transmit and distribute power. Thebenefits to customers of such market arrangements are obvious: consumers willnot be captive customers of a franchise utility, relying on regulators to assurethat their utility does not charge excessive prices. Instead, consumers will beable to shop for power the same way they shop for long distance telephonecarriers.

Competition between generators ultimately will lead to lower prices. Forexample, Maloney and McCormick (1996) estimated that retail competition would,in the long term, reduce the average residential customer's bill by 43 percent, orabout $30. They also predicted large price reductions for commercial andresidential customers. They estimate that the total gains to consumers arebetween $422.1 and $107.6 billion annually.

As a result of the growing competition in the industry, there has beenincreasing consolidation. As McLaughlin and Mehran (1995) document, for theentire period from 1960 to 1986 there were only 9 hostile takeover attempts in theindustry, and none were successful. In the five years from 1986 to 1990, therewere 13 takeover attempts, with one being successful. Recently, a number ofutility mergers have been announced.

There has been much discussion of the importance of repealing old lawswhich encumber the industry in preparation for eventual complete deregulation.It is important that firms have the ability to optimally adjust to new marketconditions. One focus of this research is on the Public Utilities HoldingCompanies Act. PUHCA was passed during the Great Depression in responseto the failure of a number of utility holding companies and subsequent investorlosses. The Act defines a utility holding company as "any company whichdirectly or indirectly owns, controls, or holds with the power to vote, 10 percentum or more of the outstanding voting securities of a public utility." (Section2(a)(7)(A) of PUHCA). Numerous holding-company activities are subject toregulation under PUHCA, including the acquisition and sale of securities, theacquisition of utility assets, intercompany transactions, service, sales andconstruction contracts, and reports and accounts. Importantly, PUHCA placesrestrictions on mergers involving registered holding companies.

PUHCA remains a major barrier to utility takeovers. Numerous authors havediscussed economic inefficiencies associated with the Act. For example, Geddes(1996) emphasizes its effects in inhibiting the market for corporate control.Lenard et. al. (1996) emphasize its effects on limiting experiments in deregulationon the state level, as well as its redundancy. For additional analysis in a similarvein, see Joskow (1992) and Gordon (1992).

10. The Recovery of Stranded Costs

A prominent aspect of the electric utility deregulation debate involves thequestion of the recovery of utilities' "stranded investments." These areinvestments made under regulation which electric utilities, in a fully deregulatedsetting, would be unable to recover through prices. This question is relevant formany utilities that are facing regulatory reform.

Electric utilities estimate that they own between $100 and $300 billion ofthese investments, and almost one-third of the average electric bill in Californiais dedicated to paying off these costs (Michaels 1996, p. 47). In some cases thepotentially stranded costs exceed the entire equity value of the firm (Baumol,Joskow, and Kahn 1995, p. 36). This issue is crucial because it affects the paceand structure of deregulation.

There are several perspectives on the recovery of stranded costs. Accordingto one view, (see e.g. Baumol and Sidak (1996); Sidak and Spulber (1996)) in thecourse of state regulation of utilities, the utility and the state formed an implicit"regulatory compact." Regulators imposed a burden on utilities to serve allcustomers and to construct plants in expectation of demand growth. In return,the utility received a legal monopoly and a "fair" rate-of-return. This view impliesthat utilities are deserving of compensation for investments that were madeunder the compact which, in a deregulated setting, would not receive a fairrate-of-return. These authors thus contend that deregulation constitutes a formof breach of contract. They also suggest that (even if one does not accept thenotion of a preexisting "regulatory compact") utilities deserve compensation forwhat amounts to a "deregulatory taking."

Arguing in a somewhat different vein, Baumol, Joskow, and Kahn (1995)present arguments in favor of the recovery of stranded costs. They suggest thatboth equity and efficiency considerations work in favor of recovery. In terms ofequity, they argue that utility shareholders have not been previouslycompensated through allowed returns for such "deregulatory risk," and thatregulators approved these risk-allocation arrangements. They also contend thatratepayers benefited from the previous regulatory arrangement, in that much oldequipment produced substantial value for ratepayers, even while some relativelynew equipment has not. On the efficiency side, they submit that withoutstranded cost recovery it is unlikely that the most efficient supplier of electricitywill prevail, since incumbent firms will be burdened by disproportionately largehistoric costs, and may not be able to effectively compete even if they are theleast-cost provider. In other words, in order to provide a "level playing field" forutilities in a deregulated setting, it is necessary to share these historical costs ona non-discriminatory basis. Otherwise the true efficient supplier will not berevealed through the market process.

On the opposite side of this debate, commentators, such as Michaels (1996),reply that there never was a regulatory compact and that utilities thereforeshould not receive compensation for stranded investments. They argue that,unlike typical contracts, there is no indication that a voluntary agreement wasmade between utilities and customers, whom the regulation was ostensiblycreated to serve. Indeed, Michaels (1996, p. 49) notes that the term "regulatorycompact" first appeared in 1983 in a legal decision. They also point out thatmany of these now stranded investments were made at utilities' urging. Theconclusion here is clear: utilities should not be compensated for lossesassociated with stranded investments.

In an interesting third view, Niskanen (1996) suggested that the problem ofstranding is only necessitated by forcing utilities to provide access to theirtransmission services, a policy which does not respect property rights to thegrid. That is, stranding of investment is created by the legislated deregulationof electricity markets through forced "open access." This has been recognizedby other commentators as well. As Baumol, Joskow, and Kahn (1995 p. 35) state,"The possibility of these costs being 'stranded' would obviously be greatlyincreased if franchised utilities were required to offer competing generatorsdirect access to their retail customers via the utility-owned transmission anddistribution systems." Such a requirement is an element of recent legislativeproposals.

Consequently, these writers maintain that concerns about deregulationconstituting a "taking" are justified only if access to the network is forced.Niskanen (1996, p. 17) states, "Mandatory wheeling, whether at the wholesaleor retail level, should be recognized as a restriction, a taking, of the propertyrights of a utility." Regarding stranded costs, Niskanen's view is that propertyrights consist of the right to use, exclude, partition and sell property, but theproperty owner does not have a right to the value of his or her property. Bysuggesting that deregulation requires compensation because of a preexistingregulatory compact, utilities are asserting a right to the value of their property,which overextends their true property right.

Both the stranded investments and the takings issues could then be solvedsimultaneously if government would simply divest itself from the institutionalsetting. By eliminating state-enforced monopolies, and by letting utilities openthe grid on their own, there would be no takings and no stranding. As anintermediate solution, this would allow utilities to recover some of their coststhrough the market process while respecting private property rights. Regardlessof the approach that is ultimately adopted, it is likely that the "strandedinvestments" issue will be central to the utility deregulation debate. Usefulsummaries of these views are contained in Baumol, Sidak, and Michaels (1995)and Brennan, et. al. (1996).

Interestingly, very similar issues of cost stranding are now arising in otherindustries which are in different stages of deregulation. In railroads, an importantstranding issue arises when captive shippers of coal are given access to rails. Awave of mergers in this industry has brought about this concern. A similar issuearises in local phone networks between long-distance and regional carriers.Long-distance carriers are seeking access to the local carrier networks at agovernment-determined fee. Local phone companies respond that such accesswould strand much of their sunk investment. Therefore, the stranding ofinvestment is an important issue in deregulation which cuts across numerousindustries.

11. The Natural Industry Structure

There has been considerable debate over the "natural" market structure ofelectricity provision, and therefore the expected structure if completecompetition were allowed. It has long been supposed that natural monopolycharacteristics inherent in the industry, as discussed above, precluded effectivecompetition, and that regulated, legally granted monopolies were necessary.Moorehouse (1995, p.423) concisely summarizes this perspective:

The traditional economic justification for the regulation or stateownership of electric utilities is that utilities are natural monopolies.Economies of scale and scope, and the economies associated withvertical integration mean that unit costs decline throughout the relevantrange of production as output increases. Such economies precludecompetition, according to the conventional view, because a single firmcould supply the entire service area at lower cost than could two or morefirms. Given its cost structure, an established utility could undercut itsrivals and drive them from the market. Moreover, attempted entryrepresents a waste of resources either because of an unnecessaryduplication of facilities or because such investment would not be viablein the face of undercutting. Secure from competition, the monopolistwould exploit the consumer if not for regulation or state ownership.

This view implies that important variables for empirical examination includethe degree of economies of scale and scope. Thus a number of studies of electricutilities involve these questions. For example, Hulbert (1969) concluded thateconomies of scale could be achieved in systems up to 25,000 megawatts.Alternatively, Johnston (1960) and Nerlove (1963) determined that scaleeconomies were exhausted even for firms of relatively small size. Barzel (1964)used a input demand model which showed scale economies at the plant level.Galatin (1968) found both scale effects as well as technical change. Atkinson andHalvorsen (1976) used a profit function specification. Cowing and Smith (1978)provided a survey of the literature on estimates of production technologies.

In their landmark study, Christensen and Green (1976) examined economiesof scale for U.S. electric utilities and found that, in 1955 there were significanteconomies of scale for almost all firms, but that by 1970 these economies hadbeen virtually exhausted, and by then almost all utilities were operating in theflat portion of their average cost curves. Importantly, given how early this paperappeared in the deregulation debate, they submit that: "We conclude that a smallnumber of extremely large firms are not required for efficient production and thatpolicies designed to promote competition in electric power generation cannot befaulted in terms of sacrificing economies of scale."

12. Reliability

A related branch of research focuses on the question of reliability. It deals withthe "public good" nature of reliability, as well as the optimal level of reliabilityfor an electrical system. This question is particularly relevant under competition.Telson (1975) examined the question of the optimal level of reliability and foundthat current levels in the US were excessive. Munasinge and Gellerson (1979)developed a model for finding the optimal level of reliability. Bental and Ravid(1986) and Sanghvi (1983) discussed methods to measure the costs of outages.

There is a set of articles which emphasize that price, reliability, and capacityshould be jointly determined. Reliability is a feature of papers by Brown andJohnson (1969), Crew and Kleindorfer (1976, 1978), Sherman and Visscher (1978)and Chao (1983). Reliability is uniform throughout an electrical system, butcustomers differ according to their outage costs. Some articles have examinedhow prices should be set for customers with differing outage costs, but whoconsume the same level of reliability. Such studies include Chao (1983), Chao et.al. (1986), Chao and Wilson (1987) and Woo and Toyama (1986).


C. The Experience in Other Utilities

In this section, I review literature focusing on several utilities besides electricity.I first review selected work on telephone utilities. In part 14, I describe severalstudies in natural gas, and in part 15, I review work in water utilities.

13. Telephone Utilities

Numerous interesting aspects of utility regulation are illustrated by the phoneindustry. I first briefly describe the regulatory history of the industry, and thenreview several important studies. In the US, the Mann-Elkins Act of 1910 firstgave the Interstate Commerce Commission (ICC) the authority to regulate theintercity telecommunications market. Through entry control by the ICC,American Telephone & Telegraph (AT&T) obtained monopoly power inlong-distance telephony, and was treated as a "natural monopoly" Viscusi,Vernon, and Harrington (1995, p. 487). It was believed that the need to stringopen-wire line (or coaxial cable) between cities raised the fixed costs of enteringthe market to the point were economies of scale were realized by single-firmoperation. The Communications Act of 1934 transferred the power to regulateprice and entry into the inter-city phone market to the Federal CommunicationsCommission (FCC), which continues to regulate telecommunications today.Thus, AT&T was a rate-regulated monopolist until the late 1950's.

The impetus for regulatory reform in this industry came from newtechnology: microwave transmission. This technology can transmit largeamounts of information via radio beams, i.e. without the use of extensivenetworks of wire or cable. Therefore, physical connection between two pointswas no longer needed for communications. In the 1950s, many firms beganasking the FCC for permission to build private networks Viscusi, Vernon, andHarrington (1995, p. 488). These requests led the FCC, in 1959, to issue the"Above 890 Mc" decision, in which frequencies above 890 megacycles wouldbe shared with private users. However, other users were not allowed to selltelecommunications services, so true competition was not established.

In 1963, Microwave Communications Incorporated (MCI) petitioned the FCCto allow it to enter a specific inter-city market (St. Louis-Chicago), as acompetitor to AT&T. It was not until 1969 that the FCC approved the request.This decision began a process of partial deregulation of the industry by the FCC,but with extensive built-in cross-subsidies and AT&T as the dominant supplier.After seven years of antitrust litigation by the US Department of Justice, AT&Twas broken up into seven holding companies, called the regional Bell operatingcompanies. AT&T is now no longer involved in any monopoly markets.Additionally, local phone companies face competition from several sources,including cellular phones. Below, I review several specific studies of thetelecommunications industry.

Oum and Zhang (1995) examine the effect of competition on the productiveefficiency of the US telephone industry. Their model predicts that competitionwill reduce allocative inefficiency in the use of inputs, as caused byrate-of-return regulation (i.e. the Averch-Johnson effect, discussed above). Thisis in addition to the usual improvements in technical efficiency observed whencompetition is introduced. They examine data over the 1951-90 period, and findthat competition did in fact improve the allocative efficiency of incumbent firms.

There are several studies which examine the effect of "incentive regulation"in telephones. Incentive regulation suggests alternative regulatory approaches,such as "sliding scale" plans and "price cap" regulation, as reviewed by Joskowand Schmalensee (1986). Some studies have found efficiency improvements fromthese methods. For example, Majumdar (1997) examined the effectiveness ofincentive regulation on the productivity of US local exchange carriers. He foundthat there was a lagged but substantial effect on technical efficiency from a pureprice-cap scheme. He also found positive effects on scale efficiency. However,Kridel, Sappington and Weisman (1996) conducted a survey of studies on theeffects of incentive regulation in the telecommunications industry. Collectively,the studies examine productivity, investment, profit levels, new service offerings,and regulatory proceedings. They find no strong evidence that incentiveregulation significantly reduced the costs of providing telephone service, norhas it substantially streamlined regulatory proceedings.

As suggested above, a critical policy issue is whether or not thepre-divestiture Bell System was a natural monopoly. This requires detailed testsof the subadditivity of the cost function, as mentioned in Section 2. Previousstudies of this issue, such as Evans and Heckman (1983), suffered from poordata quality (as they note). However, Shin and Ying (1992) attempt to overcomethese data problems by focusing on local exchange carriers (which allow moredegrees of freedom than previous tests). Their global subadditivity testsdemonstrate that the cost functions of these firms are definitely not subadditive.Their results suggest that permitting entry and increasing competition in thelocal exchange market would enhance efficiency.

There have been many studies of the local telephone market, where there hasbeen rapid regulatory change. For example, Green and Lehn (1995) suggest thatrecent developments in the telecommunications industry have increased thelikelihood that the regional Bell operating companies (RBOCs) will face newcompetition in the local telephone service market. They detail majordevelopments in these markets, including the FCC's decision to facilitate entryand application of new technology to the local telephone market, as well asstrategic decisions by AT&T, MCI and Time-Warner to enter the market. Theyuse event-study methodology to estimate the announcement effect of severalevents on the equity values of the RBOCs. They find that there is a negative andsignificant collective effect on their values. Cramer (1994) focuses on access andcable competition in local telephone systems in the US. He provides an overviewof the development and scope of local phone competition, and some predictionsas to the future of local service. In particular, he believes that policies will evolveto encourage cable companies to enter the telephone business.

14. Gas Utilities

In this section, I review several studies of the natural gas industry. Crandall andEllig (1997) provide a summary of natural gas regulatory reform in the 1980s and90s. Barcella (1996) provides an overview of the current structure of the industry.She finds that competition is well entrenched in the production sector of theindustry, and is moving downstream into the transportation sector as well. Shefinds that there is increased "unbundling" in the industry, as gas production isbeing separated from the sale of pipeline transportation services and localdistribution services. "Gas marketing" has emerged as a new industry, which willlikely be affected by upcoming electric utility deregulation, and transformed intoa multi-fuel marketing industry.

DeVany and Walls (1994) examine recent regulatory changes in the gasmarket. Their article describes the institutions that were developed to supportexchange in gas markets, and studies the performance of these institutions. Theyfind that spot gas prices have converged and become highly correlated. Doaneand Spulber (1994) examine the spot market in natural gas. They focus on thewellhead spot price of gas from 1984 to 1991 to see if open access affected thegeographic scope of the spot market. They apply three statistical tests, includingspot price correlations, Granger causality, and cointegration, and find that openaccess integrated the regional markets into a national competitive market for gas.King and Cuc (1996) also study the degree of price convergence in the US spotgas market since deregulation. Using a Kalman Filter (time-varying parameters)approach, which allows measurement of the strength of price convergence, theyfind that the degree of price convergence has increased significantly sincederegulation in the mid-1980s. However, they emphasize that it is not yet correctto speak of "one price" in North American gas markets.

In reference to Europe, Grais and Zheng (1996) examine the potential benefitsof East-West gas trade within the context of a game-theoretic model. Theyemphasize that economic change in the former Soviet Union and Eastern Europehave heightened uncertainties in this gas trade. Their model shows how tomodify the trade contract to accommodate changes in the economicenvironment.

15. Water Utilities

Water utilities have been somewhat less frequently studied than other utilities.Nevertheless, there are many interesting contributions, several of which I reviewhere. Many of these focus on the proper pricing for water services. For example,Zarnikau (1994) examines economically efficient water rates. He advocates theapplication of short-run marginal cost or spot market pricing principles to thepricing of water resources. Kim (1995) also examines the pricing of waterservices. The article's focus is on current pricing systems relative to marginalcost and second-best pricing rules. He estimates a translog multi-product costfunction for US water utilities, and finds that the existing price structure does notdepart significantly from second-best pricing principles, but does depart frommarginal cost pricing. Similarly, Renzetti (1992) examines water supply costs anddemands using data from Vancouver, Canada in order to estimate the welfaregain from altering water prices. His results show that a move to seasonallydifferentiated pricing raises aggregate surplus by four percent, which is higherthan previous estimates. Raffiee et. al. (1993) examine the efficiency of publicversus private water providers by calculating the difference between theobserved cost and the optimum cost. The latter is found using the "Weak Axiomof Cost Minimization" for each water utility. They find that privately ownedwater utilities are more efficient than public.


D. Utilities in Europe

16. Utilities in Europe

In this section, I briefly review several contributions to the literature onEuropean utilities. Since Europe is introducing competition in several utilities,this literature is rapidly growing. With regard to environmental issues, Burtraw(1993) discusses the use of international tradable sulfur dioxide emission permitsin Europe, with an emphasis on electric utilities. Because tradable permitsprovide agents with powerful economic incentives to reduce emissions at leastcost, this method of controlling for acidification has met with great success inthe US. Environmental goals have been met at low cost. Burtraw argues that,because of economic unification and the liberalization of energy markets inEurope, permits have wide potential application there. However, he points toseveral institutional features of the European electric utility industry that mayundermine the effectiveness of transferable permits.

Grohnheit and Olsen (1995) discuss the consequences of introducing acompetitive electricity market in the Nordic countries. They note that Britain andthe Nordic countries are instituting many competitive reforms in their powersectors, and argue that opening up a competitive electricity market has thepotential to create substantial efficiency gains. They focus on the use ofcombined heat and power for district heating, and demonstrate that it would becompetitive in an open electricity market.

Percebois (1994) focuses on natural gas markets in Europe. He finds thatnatural gas is being increasingly used in the generation of electricity, andexamines the likelihood and desirability of deregulation of the industry. Heargues that the prospects for its growth in Europe are promising, but only withcontinued government involvement. Monnier (1993) focuses on the electricitymarket in Europe. The first part of his article provides a survey of the economicsof electricity, and an overview of the structure of the industry in Europe. Thesecond part examines the debate over electricity restructuring in Europe, butfocuses on three questions: (1) What is the future of the electric utility industryin Europe; (2) How will competition evolve in Europe, and (3) How will this affectgovernment versus private ownership of utilities.

Doyle and Maher (1992) also focus on electricity. They find that electricitysupply is under increasing pressure to become competitive, and that theexperience in the United Kingdom demonstrates the feasibility of regulatoryreform in Europe. They examine the relationship between the generation,transmission, and distribution sectors of the industry, and find that open accessto the grid is desirable if accompanied by common carriage requirements and acompetitive generation sector. They also examine the pricing of transmissionservices under open access.

Amundsen and Singh (1992) examine risk-sharing arrangements which allowconsumers and producers to hedge their price-risk in European electricitymarkets. Specifically, they examine the feasibility of establishing futures marketsin electricity in Europe, with a focus on the United Kingdom and Norway. Whilethere is sufficient price uncertainty to justify such arrangements, they areskeptical about the competitiveness of new spot-markets.

17. Summary and Conclusions

In this article, I have attempted to provided an overview of the utility literature.Since the term "utility" has been used to refer to a broad range of industries, thisliterature is quite large. I discuss several issues important for utilities generally.These issues include a discussion of the original justification for utilityregulation, a comparison of alternative theories of regulation, an examination ofthe distortionary effects of regulation, an overview of the effects of utilityderegulation, and a discussion of ownership form. These issues were thenapplied to the specific case of the electric utility industry. This industry is ofparticular importance today, perhaps most importantly because it is very largeand is now undergoing substantial regulatory change.

It appears that reform of utility regulation has been very successful, withlarge net welfare gains accruing to society. While many studies focus on the UScase, the results have important implications for utilities in Europe andelsewhere. Utilities face differing ownership structures across countries, butthey share common structural characteristics. Thus, it is likely that utilityregulatory reform will have similar beneficial effects in other institutionalsettings.

Acknowledgements

I am grateful to William Niskanen, Juri Hwang, and two anonymous referees forhelpful comments, and to Yi Luo for capable research assistance.

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