Chapter 1
Public Utility Regulation
Large swaths of energy law occur in regulated industries. The generation and distribution of electricity, the distribution of natural gas, the production of hydropower, and the generation of alternative energy all are subject to public utility regulation. [more areas? Look at Wikipedia here / any E&E or nutshell on regulated industries?]
What is public utility regulation? In a nutshell, it is government regulation of the price and terms of service when economic activities are so invested with the public interest that regular market forces are inadequate to lead to socially desirable results. Often public utility regulation arises when the economic activity constitutes a natural or other monopoly – such as a running a power grid. To ensure that pricing and service terms are “fair,” government regulation becomes a substitute for market forces.
This chapter considers the basic issues arising in public utility regulation:
· When is a commercial activity considered a “public utility”? [give answer]
· What are the basics of public utility regulation? [give answer – cost of service]
· What are the alternatives to cost-of-service regulation? [give answer]
1.
Chapter 1 – Public Utility Regulation [this will be internally hyperlinked]1.1 What is a public utility?
1.1.1 Common law of “public utilities”
1.1.2 Illustrative case: Charles River.
1.1.3 Why regulate public utilities?
1.2. Traditional (Cost-of-Service) Regulation of Public Utilities
1.2.1 Basics of public utility regulation
1.2.2 Cost-based price regulation
1.2.3 Constitutional limits on cost-of-service regulation
1.2.4 “Just and reasonable” standard
1.3 Evaluation and Alternatives to Cost-Based Rate Regulation
1.3.1 Problems with cost-based regulation
1.3.2 Alternatives to Cost-Based Rate Regulation
1.3.3 Utility Market Power and Antitrust Laws
1.4 Examples: Modern Public Utility Regulation
1.4.1 Texas: A Deregulated Market
1.4.2 Electric Deregulation: California power crisis
1.1 What is a public utility?
[introduction here]
[These questions should be reformulated as issues that will be addressed – with answers! This is not a hide-the-ball casebook] What are modern examples of the conflict between (claimed economic) constitutional rights and public policy concerns, like those in the Charles River Bridge Case?
1.1.1 Common law of “public utilities”
Before most utility regulation was dominated by the states, the courts had established a warren of common law rules for public utilities. These rules, standards, and limits applied to protect consumers while also preserving the rights of public utilities, encouraging technological innovation, and allowing beneficial change to advance:
· Monopoly power in fixed territory -- the company has the legal authority to prevent other businesses from competing in a limited geographical area
· Duty to serve -- the company has a duty to provide service to all members of the public within its area, but that duty only extends to the specific service for which the company has a monopoly
· Reasonable prices -- rates charged by public utilities must be reasonable, and can be regulated by legislatures
· Technological limits -- the company’s monopoly will be narrowly construed so as not to stymie or infringe on new technologies
1.1.2 Illustrative Case: Charles River
[needs intro]
The Charles River Bridge Case (Proprietors of Charles River Bridge v. Proprietors of Warren Bridge, 36 U.S. 420 (1837)) illustrates both the meaning and origin of a public utility. In 1786, the Massachusetts legislature granted a charter to entrepreneurs who built a toll bridge connecting Boston to Charlestown. The financiers would recoup the expenses of the bridge with the proceeds of tolls over the span of 40 years. Six years after the initial charter was issued, the legislature extended it for an additional 30 years. In 1828, the state chartered a second bridge that directly competed with the original bridge, cutting into its profits. The legislature, however permitted the new company to charge tolls for only 6 years, after which it was required to turn the bridge over to public use.
The investors of the original bridge sued to reclaim their rights, hiring Daniel Webster to press their claims: first, that the bridge charter granted exclusive privileges to the corporation and thus the 1828 act impaired the state’s obligation and was unconstitutional; second, that the chartering of the new bridge destroyed the projected tolls and thus was a taking by the government without compensation, in violation of the Massachusetts constitution. The Massachusetts state court dismissed the claims and the investors appealed to the U.S. Supreme Court. The Supreme Court ruled in favor of the “free bridge” advocates.
The case involved both constitutional and public policy considerations. Advocates of the free bridge argued that the state had not bartered away its right to charter competing franchises and that the state retained the power to provide improvements for public necessities. Supporters of bridge investors argued that the charter guaranteed an exclusive right to tolls that could be abrogated only on payment of proper compensation. As for public policy concerns, free bridge proponents contended that charter rights should be strictly construed, so that privilege would not hamper opportunity or the pressing needs of the community. The investors maintained that the state must act scrupulously respecting existing titles and interpret their investment rights to ensure a favorable investment climate for future private enterprises. Stanley I. Kutler, Privilege and Creative Destruction: The Charles River Bridge Case, The Johns Hopkins U. Press (1989).
This case demonstrates the role and limits states face in allowing and encouraging new technologies when established interests compete with new, more efficient technologies. The bridge illustrates our concept of modern utilities because the bridge provided a more efficient service for an activity that people had the ability to achieve already -- namely, ferries already took people across the river, but the bridge allowed such transit quicker and cheaper. Compare the “utility” of having a toll bridge instead of a ferry to the “utility” of having water piped into your house instead of having to walk outside to a well to acquire it. In both cases, you have access to the water. But when you pay a service provider to pipe water into your house, it is much more accessible and easier to use than when you have to fetch it yourself.
1.1.3 Why Do We Regulate Public Utilities?
[introduction]
Natural monopolies. A perfectly competitive market is called a price-taker, because the market price and quantity are determined by the supply and demand in the market; on the opposite end of the spectrum is a natural monopoly.
A natural monopoly is called a price-maker, because as the only firm in the market it will set its price and quantity based on what yields the most profit, rather than based on the supply and demand of the market. As a result, the price will be higher, and the quantity will be lower, than they would have been in a perfectly competitive market. Therefore, in the context of public utilities, which are granted monopoly power by the government, it is imperative that we regulate! Price regulation is designed to yield the mix of price, output, and profits approximating those produced by a competitive market.
The basic rule today is that the government may regulate the prices or rates charged by an enterprise if it is “clothed with the public interest” (Munn v. Illinois) - any such business is called a “public utility.” There are a number of rationales for regulating public utilities. We primarily regulate, primarily, for political, economic, and public interest reasons.
· Political: interest groups (i.e., industry representatives, environmental groups, and consumers) all have an interest in the manner and extent to which public utilities are regulated.
· Economic: In order to correct the market failures introduced by a natural monopoly, we regulate public utilities so that the prices and quantities of their products emulate those in a perfectly competitive market.
· Public Interest: Public utilities are very closely linked to public welfare
[there should be much more about Munn – turning point in US economic history]
Public utility as “monopoly franchise.” In exchange for its promise to provide a utility to any customer within its service territory at a reasonable rate, public utilities franchises will be protected against competition within that geographic area - known as a “horizontal monopoly”.
There are two economic reasons for a government granting a monopoly franchise. First, the market can be served at a lower average cost by a single firm than by two or more firms; a single firm in the market could increase its production at a lower average cost than if a new entrant were to enter the market - think “economies of scale.” Production efficiency occurs because, once a firm has built an electricity transmission network to serve a base of customers, it is cheaper to increase its customer base incrementally than for a new firm to begin a network from scratch to serve those same additional customers. A network efficiency occurs when a single firm is able to more efficiently operate than multiple firms because it is better able to coordinate interdependent aspects of an industry’s operations and is able to process information more efficiently (i.e., distribution network, delivery schedule, gather and process market info). The second reason for government to grant a monopoly franchise is for the efficiencies to be gained by integrating different market services - “vertical integration.” A single electric utility firm can more efficiently transport and distribute energy if it serves other market functions, such as power generation.
1.2. Traditional (Cost-of-Service) Regulation of Public Utilities
[Introduction[ Include question - What interests do you think regulators should consider in the “just and reasonable standard”?
1.2.1 Basics of public utility regulation
Who regulates utilities? The concept of public utility has common law roots, but today most utility regulation begins with a provision of a state constitution or statute that designates the enterprises to be regulated and the type of regulatory powers that may be exercised over them. Public utilities may be controlled by a series of statutes, for each type of utility, or, as is often the case today, by a single, consolidated Public Utilities Act.
Public utilities were originally often regulated by municipal governments, but that resulted in a decentralized, piecemeal regulatory process. Today, public utilities regulation is largely controlled by state agencies known as Public Utilities Commissions (“PUCs”) or Public Service Commissions (“PSCs”). A commission usually has the following five basic powers:
§ Assign territory: to assign territories through “certificates of public convenience and necessity.”
§ Set service standards: to enforce the duty to serve by establishing standards of service.
§ Regulate rates: to review the utility’s rates and reject those that are not “just and reasonable.”
§ Approve spending: to review the utility’s major capital expenditures, including borrowings, against a standard of “prudent investment.”
§ Control abandonment: to prevent the utility from abandoning service without its approval.
At the national level, public utility is implemented by the Federal Energy Regulatory Commission (“FERC”). While both FERC and state PSCs have the power to initiate actions on their own, they are generally reactive regulatory bodies.
Setting the price. [more introduction info here]. First, a public utility must meet some general requirements set by the respective state’s commission. Typical requirements include:
· Certificate of Convenience and Necessity: The business must obtain permission to enter into and operate within the regulated market. This is achieved by securing a “certificate of convenience and necessity.”
· Monopoly Franchise: As part of this licensing process, the government often creates a monopoly by establishing an exclusive geographic franchise. Within this service area, the utility has the right to serve the market free of competition.
· Duty to Serve: In return for this exclusive service territory, the government often requires the utility to provide a certain level of service to all customers within the service territory. The utility has a duty to serve customers and cannot selectively choose its customer base for its own private gain.
· Price Regulation: The regulatory body will allow the utility to charge only “just and reasonable” rates to customers. This is normally done on the basis of the cost of providing service to each class of customers.
1.2.2 Cost-Based Price Regulation
[Introduction Info here]
First, regulators determine a utility’s aggregate “revenue requirements” - the amount a utility must earn in a given year to cover its variable and fixed costs, including its cost of capital. This is best displayed in the following formula: R = O + B(r). “R” equals a company’s revenue requirements (this is what a company needs to be profitable). “O” is the annual operating expenses (i.e., costs that vary with production levels such as salaries and fuel, like coal and natural gas). “B” is equal to the rate base (i.e., fixed costs, such as capital resources, rent, and monthly fixed overhead). “r” is equal to the rate of return allowed on the utility’s rate base (i.e., interest paid on debt). Once these variables are determined, the “R” is then divided by the number of energy units consumed by a class of consumers (P = R/units). “P” is equal to the price a consumer pays per unit of energy.
The rate of return represents the utility’s cost of capital -- the opportunity it forgoes by using its capital to provide utility services rather than engage in some other profitable activity. The cost of capital has two main components:
§ Cost of money that is borrowed on long and short term basis = debt
§ Money received by the utility in exchange for its stock = equity (preferred and common, like in other corporations)
Due to the uncertain nature of stocks and the inputs that determine investors’ prices, regulators find it difficult to determine the value of equity for public utilities. Regulators use two method to estimate the cost of equity capital:
§ The market-determined standard: focuses on investor expectations in terms of the utility’s earnings, dividends, and market prices
§ Comparable earnings standard: focuses on what capital can earn in various alternative investments with comparable risks.
There is an additional “x-factor” in measuring the cost of capital: determining the appropriate capital structure. Some utility capitalization decisions are made based on rate regulation. In these cases, maybe regulators should look to the ideal rather than actual capital structure, so that they can remove the utilities’ incentive to base capitalization decisions on rate regulation.