The End of a Natural Monopoly

Deregulation and Competition in the Electric Power Industry

Daniel H. Cole, Peter Grossman

• Publisher: Routledge
• Year: 2003
• eBook ISBN: 9781135697006
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book addresses the fundamental issues underlying the debate over electric power regulation and deregulation. After decades of the presumption that the electric power industry was a natural monopoly, recent times have seen a trend of deregulation followed by panicked re-regulation.

1. INTRODUCTION

Peter Z.Grossman and Daniel H.Cole

For a hundred years, economists, other scholars, and government officials understood, or thought they did, the electric power industry. Electric power, based on a single, large service provider, connected by wires to all of its customers, was thought to be an industry that could only operate efficiently as a monopoly; indeed it was something called a “natural monopoly.” Since it had to be a monopoly, with all the attendant inefficiencies and potential market abuses monopoly entails, there was no question about the propriety of government regulation (Lowry, 1973).

These basic assumptions, which at times seemed to conflict with observed facts during the first decades of the industry’s existence at the turn of the twentieth century, remained largely unquestioned for the better part of 75 years. Then, changing institutional and technological circumstances led economists (e.g Demsetz, 1968, Primeaux, 1986) to question the basis in fact of the theory of natural monopoly, and the regulatory system it entailed. As other industries, previously deemed natural monopolies, such as telecommunications, adjusted to the new reality of post-natural monopoly theory, the electric power industry and government regulators remained reluctant to concede that anything fundamental had changed. Movement toward a deregulated electric power system did not occur until the last decade of the twentieth century, and then it was undertaken haltingly and piecemeal.

While the U.S. electric power industry and government regulators dithered, their counterparts in other countries, notably the U.K., were, by the late 1980s, embracing more completely a competitive market-oriented model of electric power generation and, to a lesser extent, distribution (Ruff, 1989; Lester, 1991). In the U.S., the public-policy debate over marketization and other deregulatory policies aimed at the American electric power industry continued on through the decade, and only gradually did states began to make policy changes. These were intended ostensibly to deregulate the electric power industry and foster competitive markets, but the changes varied from state to state reflecting the peculiarity of the American regulatory system for electric power, which endows individual states with the bulk of regulatory responsibility. Consequently, regulatory proposals and changes varied widely from minor regulatory amendments to major overhauls of the system. However, few states instituted changes that could legitimately be described as “deregulatory.” The process was largely one of re-regulation rather than deregulation.

The result of this crazy quilt of regulations, re-regulations, and deregulatory proposals has resulted in more costs than benefits for the regulated industry, consumers, and the economy as a whole. Indeed, because of the most infamous case of California’s regulatory miasma, which will be examined in Chapter 10, the entire enterprise of regulatory change has been called into question. The process of de- or re-regulation in several other states has ground to a halt because of fear of repeating California’s mistakes (e.g. Banerjee, 2002). And many observers have raised California as a cautionary tale, from which they extrapolate that deregulation is bad policy. In their view, the California experience proves that electric power production and distribution remain a natural monopoly, which must be heavily regulated by government (e.g. Bradley, 2001). As one energy consultant was quoted as saying, “I don’t think one can have a deregulated electricity system if one wants reliable power” (Francis, 2001). These arguments are based, however, on the presumption that California had truly deregulated its electric power industry. As we will argue in Chapter 10, there was no actual “deregulation” of electric power in California. In fact, nothing that happened in California bears on the arguments about the necessity or desirability of monopoly electric power systems.

This book addresses some of the fundamental issues underlying the debate over electric power regulation and deregulation. Only by understanding these questions and exploring a variety of possible answers to them can we hope to move the debate over the proper structure of the electric power industry in the United States. This requires a comparative institutional and organizational analysis of alternative structures of electricity production and distribution. Note that we are not promoting a completely laissez-faire conception of electric power production and distribution, devoid of government oversight. In our economy, legal boundaries are necessary for the any market, including the power market, to operate efficiently (Eggertsson, 1989). However, the huge and unwieldy structure of the old natural monopoly approach to electric power production and distribution is plainly obsolete (if it ever did make sense). Its institutional and organizational structures are out of tune with both contemporary economic theory and the economic and technological realities of the twenty-first century.

Here are some of the questions this book will address in attempting to determine the proper institutional and organizational structure of electric power production and distribution. First, what is meant by a natural monopoly, and is there really any such thing? If you pick up any textbook on the principles of economics, and look in the index, you will find a reference to natural monopoly. Now flip to that page, and you will likely find a very clear and concise definition of natural monopoly, perhaps including a graph showing a single, downward-sloping average-cost curve. A firm with such a cost-curve, the book will tell you, is a natural monopoly. ¹ But just what kind of firm has this structure? The example in the book is based on nothing but a “production function,” a kind of economic black box with only hypothetical, not actual, inputs or outputs. It bears at best a stylized resemblance to any real firm operating in the real world. The text will often go on to say, however, that this kind of configuration will be determined by the technological characteristics of an industry, that is, that industrial organization is merely the inevitable outcome of scientific realities. ²

Then the textbooks will go on to say that real-life examples of the phenomenon they’ve labeled natural monopolies include electric power producers, telecommunications companies, and transportation providers, particularly railroads (for example, O’Sullivan & Sheffrin, 2001). In recent years, some authors have removed these examples, recognizing that changing conceptions of industrial organization have raised serious doubts about whether they are, or ever have been, natural monopolies (for example, Case & Fair, 2002). Yet, the electric power industry remains firmly based on some conception of this often elusive, ill-defined, and poorly understood concept. And serious arguments continue to be put forward to the effect that electric power production, transmission and distribution really are of such a nature that they require extensive government regulation (see Chapter 10). In Chapter 2, we will explain what is meant by a natural monopoly, and provide a frame of reference to assess the arguments about electric power deregulation.

A second issue addressed in this book concerns the institutional structure of electric power regulation, and how that structure has evolved over time. It may seem to the casual observer that electric power production has always been the province of a single, monopolistic firm, controlling the market in its particular region of the country, and strictly regulated by state public utility commissions. For most people alive today, regulated monopoly is the only system of power production and distribution they have ever known. As we will discuss, however, the structure we take for granted did not emerge fully formed with the birth of the industry. It is a creature both of deliberate, economically and politically-motivated policy decisions and of historical contingencies or accidents. In fact, the original state of affairs when the industry first emerged was largely unregulated competition. The utilities themselves first argued in favor of monopoly control mitigated by government regulation, to prevent “ruinous competition,” ostensibly for the sake of consumers. However, as discussed in Chapters 3 and 4, the utilities had other concerns besides consumer welfare, namely their own rents derived from protection against competition. In sum, the utilities relied on the natural monopoly theories of economists not to maximize social welfare but to maximize their private profits.

Of course, it takes two to create a monopoly out of a competitive environment. The utilities could not have obtained monopolistic control of electricity markets without the active participation of, first, state and local governments, and, later, the federal government. Why did governments agree to this structure? Chapter 3 will explore this question, and explain what governments had to gain from agreeing to what came to be called the “regulatory contract.” Whatever the explanation, the fact of the matter is that the so-called “natural” monopoly of power production and distribution did not arise naturally, but was deliberately instituted by political agreement between governments and utilities.

The next question, addressed in Chapter 4, is what constituted the precise nature of the “regulatory contract” between electric utilities and state governments? Was this contract really designed to enhance the welfare of consumers, as some scholars have argued (Sidak & Spulber, 1997)? Historical research suggests that this was not the case. Rather, the regulatory contract appears to have been created predominantly for the benefit of certain, powerful utilities and local politicians they supported. No matter who was intended to benefit from the regulatory contract at the time it was created, the nature and composition of that contract remains a highly charged issue because of its implications for proposed changes to the regulatory system, which would, in effect, alter the terms of the “contract.” Alterations to the terms of the contract -redistributing rights and duties as between utilities and governments—could give rise, in some circumstances, to legal liability. One provision of the regulatory contract is the so-called “duty to serve”—the requirement that utilities, as a quid pro quo for their regional monopolies, must serve the entire region, regardless of the marginal costs of providing service to outlying customers. The implications of this requirement are considered by Jim Rossi in Chapter 7. Another provision of the regulatory contract entitles utilities to a fair return on prudent and productive investments. If deregulation (or reregulation) terminates current “rate-of-return” regulation, and the competitive market “undervalues” earlier investments, the question arises whether utilities have been deprived of the benefit of past bargains. In other words, must utilities be guaranteed recovery of costs for investments undertaken under the old regulatory regime, but which become uneconomic in the new competitive market system? Reed Cearley and Daniel Cole take up this issue in Chapter 8.

If it is true, as this book will argue, that natural monopoly is not natural, and that monopoly arose through an agreement of industry and government, then the question becomes: why did that system last as long as it did? Once the natural monopoly regulatory approach was institutionalized beginning in the early years of the 1900s and codified fully in the 1930s, it persisted more or less unquestioned until the 1960s. Why did it remain largely unchallenged for more than 50 years? These questions are considered in Chapter 5. The key to the answer lies in the functionality of the natural monopoly conception. As Chapter 2 explains, the most efficient form of organization for any industry is highly contingent on a variety of technological and institutional factors. There is no reason why an industry cannot temporarily be better off, or at least as well off, as a single firm, and ostensibly have some of the characteristics of a “natural” monopoly. And given the state of the electric industry and technology generally, the form of single firm, regional monopolists was, if not ideal, at least serviceable especially during the period after World War II. The regulatory system, though never capable of actually monitoring and analyzing the details of the industry it supervised, nonetheless allowed for expansion and development of the electric system that served a rapidly growing U.S. economy. In other words, the basic institutional form was for a time at least a stable equilibrium. However, Chapter 5 shows that early on there were reasons to doubt the long-term efficacy of such a system and the assumptions on which it was based. The fact that so many in industry and government had invested in the natural monopoly system, however, guaranteed that it would prove resistant to change.

What finally led to a reexamination of the economic model and the underlying legal structure that supported it? This is an issue that Joseph Tomain takes up in Chapter 6. As he points out, regulation inevitably goes through a “life cycle,” so change, be it evolutionary or revolutionary, is inevitable in any regulatory process. But the changes in perceptions about electric power also developed from exogenous forces in the larger economy. The energy crisis of the 1970s in particular led government and industry officials to reexamine some of their beliefs relating to the organization of the power industry. This, in turn, led directly to new policies that in very real ways undermined claims that monopoly was a necessary form of organization for the socially efficient production and distribution of electricity. Failures within the industry, for example the catastrophic cost overruns in power plant construction, led to tension between government and industry, and inevitably disturbed the fragile coalition supporting natural monopoly. With each change, critics argued, there were more and more reasons to doubt the assumptions of the model of a regulated natural monopoly.

Changes in industry structure and the overlying regulatory system have been numerous but incomplete. Often, they have involved the application of piecemeal reforms in response to specific, local issues or isolated problems. Only rarely, at least until the 1990s, did regulators and the regulated community contemplate wholesale changes to industry structure. Nevertheless, some of these changes have had important impacts, not all of them positive by any stretch of the imagination. Still, the changes have led to important rearrangements of political forces, legal structures, and industrial organization. These changes and their effects, which are best viewed as reregulatory rather than deregulatory, are examined in Chapters 6 through 10. For example, as discussed in Chapter 8, efforts to address utility demands for recovery of so-called “stranded costs”— unrecov-ered costs of investments undertaken under the old regulatory system—have led regulators to propose market prices on the one hand but guaranteed profits on the other. In other cases, state governments have loosened the single, vertical monopoly structure of utilities by forcing separation between production and distribution units. However, often the terms on which this separation has been affected require at least as much government oversight and intervention as the previous regulatory system required. For the most part, states have not proposed, let alone implemented, policies that would truly deregulate the electric power industry. In a few states, wholesale and retail electricity prices are now more or less determined in competitive markets, and consumers in those states can choose between power providers. But in most states, electric power production remains highly, if differently, regulated. In Chapter 9, Andrew Morriss explains why, for the most part, electric power production has been reregulated rather than deregulated, and he considers the outlook for the future of the American electric power industry. His view is pessimistic, based on his perception that public choice pressures are likely to impede true deregulation. In Chapter 10, Peter Grossman offers an alternative, and somewhat more optimistic, vision of the power industry’s future, this despite his dour analysis of California’s disastrous experience with regulatory reform. Like Morriss, Grossman appreciates the institutional difficulties of real deregulation; but unlike Morriss, he sees at least the possibility that efficiency-enhancing change will emerge in the long run.

Still, we do not doubt the basic difficulty that institutional change entails. As Nobel-laureate Douglass C.North (1990) has explained, institutional change is a problematic, haphazard, and usually incremental process. The result is sometimes less socially efficient than the pre-existing situation those changes were designed to improve upon. In North’s work, institutions are defined strictly as “the humanly designed constraints imposed on human interactions,” (North 1991). That is, institutions are the formal laws, cultural norms and the mechanisms of enforcement of both formal and informal rules that bound, structure and focus social interaction. ³ All societies by definition are bound by sets of rules (“rules of the game,” to North) since human interaction requires structure. These rules create and determine political and economic incentives, reduce uncertainty for everyone in society and channel social forces in specific directions. As North points out, if a society values piracy, it will structure institutions to reward that activity and produce people adept at piracy.

But while institutions play a part in controlling human behavior, they are alterable and indeed, economic and political actors in any society might see the potential for a more favorable distribution of costs and benefits by changing the institutional framework to their own benefit. There is likely to be a tension in a social system whereby some forces act for preservation of existing institutions and others act for their change. In general the force for institutional change will predominate when there are increases in uncertainty or in the cost of transacting, arising from changes in technology, ideology and other dynamic factors confronting society. As change occurs, there are changes in relative costs and benefits, which lead to an examination of existing rules and the distribution of social and economic benefits.

But the demand for change and in fact actual change in the institutional structure does not guarantee greater efficiency of the result. Social actors may see a need for a reduction of uncertainty and hence change in the institutional structure. But uncertainty may be reduced at the expense of efficiency. So for example, free markets may be more efficient in the long run but the dislocation that is produced as a consequence of their creation may lead in turn to inefficient, but more certain, kinds of rules, for instance totalitarian dictatorship and/or centrally planned economic systems. There are many examples in human history—the Russian Revolution comes to mind—where institutional change was demanded and change affected, but the result was highly inefficient, producing a decline in living standards or long-run stagnation. In other cases, the result embodied compromises among groups for the...

Table of contents

• COVER PAGE
• TITLE PAGE
• COPYRIGHT PAGE
• LIST OF CONTRIBUTORS
• THE ECONOMICS OF LEGAL RELATIONSHIPS
• 1. INTRODUCTION
• 2. IS ANYTHING NATURALLY A MONOPOLY?
• EDITORS’ FOREWORD TO CHAPTER 3
• 3. THE ORIGINS AND DEVELOPMENT OF ELECTRIC POWER REGULATION
• 4. THE “REGULATORY CONTRACT
• 5. THE ZENITH OF THE NATURAL MONOPOLY SYSTEM
• EDITORS’ FOREWORD TO CHAPTER 6
• 6. WHITHER NATURAL MONOPOLY? THE CASE OF ELECTRICITY*
• 7. UNIVERSAL SERVICE IN COMPETITIVE RETAIL ELECTRIC MARKETS: REFIN(ANC) ING THE DUTY TO SERVE FOR A POST-NATURAL MONOPOLY ERA
• 8. STRANDED BENEFITS VERSUS STRANDED COSTS IN UTILITY DEREGULATION
• EDITORS’ FOREWORD TO CHAPTERS 9 AND 10
• 9. WHY THE MUSIC IS OFF-KEY WHEN LAWYERS SING FROM ECONOMISTS’ SONGBOOKS OR WHY PUBLIC UTILITY DEREGULATION WILL FAIL
• 10. DOES THE END OF A NATURAL MONOPOLY MEAN DEREGULATION?