Utility Regulation: The bad, the ugly and the good.

Summary: in an attempt to solve one problem, the regulation of public utilities unwittingly introduces another, potentially much worse one. But there is hope – we also discuss a potential improvement.

The Bad: Unregulated Natural Monopolies

Water, electric and natural gas utilities are often used as an example of natural monopolies – a service where the economies of scale are so great that it is efficient to only have one supplier in an area. This company would then be incentivized to charge inefficiently high prices, causing deadweight loss, as they prevent some customers from purchasing who otherwise would have at a competitive price. As such, people argue, they need to be regulated by the government, to ensure they don’t charge so high a price. As an added benefit, the regulation can ensure that they serve everyone in the service area, including those in hard-to-reach rural areas.

Which sounds very nice in theory. Unfortunately, in trying to fix this problem, regulation introduces another problem.

The Ugly: How Utilities are regulated in the United States

At present utilities are basically allowed to earn a profit on whatever services their regulator thinks they should provide. So the utility identifies certain projects that need to be done – putting in new transmission lines, or substations, or generation1, and present these projects to their regulator. The regulator approves the projects, and approves an ROE – (Return on Equity) – for the utility. The collection of approved and completed projects is called the utility’s Rate Base. The utility is then allowed to charge its customers enough to cover its costs and earn that ROE on its Rate Base.

So if a utility identifies a $100m project, and is awarded a 10% ROE, they make the investment, and then can charge customers enough to cover both their direct costs (labor, fuel, taxes etc.) and earn a $100m*10% = $10m profit on top.

This profit is very stable – it’s been granted to you by the government, who won’t allow anyone to compete with you2 – so investors are happy to fund the project. In fact, they’d be happy to fund the project even at lower ROEs – why ROEs have stayed high while interest rates have fallen is a mystery with basically no explanation other than regulatory capture. Suppose investors required a mere 6% return – then the extra 4%, or $4m in the above example, is pure monopoly profit – exactly what regulation was meant to avoid occurring!

But that’s not the main problem.

Utilities are not really businesses.

Normal businesses make money by selling stuff to customers for more than it cost them to make. If they can cut costs – use less of the earth’s precious resources – they can make more profits, either by earning more per unit or charging customers less and selling more units. As such, firms are incentivized to be as efficient as possible.

With utilities, however, you’ll notice this is not true. They’re allowed to charge customers enough to cover their costs and make a profit – if they cut costs, their regulator will make them return the savings to customers by lowering price. So utilities don’t really have any incentive to cut costs.

Worse, if they cut costs they might end up over-earning – earning a higher profit than their regulator has allowed – in which case they’ll be made to give money back to customers. To avoid this happening, utilities are deliberately wasteful in their operating expenses to ensure they can control exactly how high their costs are. They deliberately waste resources.3

But this is not even the worst part.

Remember how we discussed the $100m project earlier? It’s well known that the cost of construction projects is hard to estimate – government projects routinely go 100% over-budget. Well, what happens if instead of a $100m project, it was a $500m project? The utility would be allowed to earn a 10% on its Rate Base of $500m, or a $50m profit. So by building a more expensive and less efficient project, the utility makes 5x as much profit. And this is not idle speculation – utilities deliberately do this.

As a result, utilities are basically on a constant mission to find as many capital projects as possible, and to pay as much for them as possible. They spend twice as much to build a power plant as competitive firms spend to build one of the same type and capacity.

So regulation has taken one problem – utilities charging a high price and earning high profits – and replaced it with a far worse one – utilities charging a high price, earning reasonable profits but wasting most of the money on unnecessary spending. At least with unregulated monopolies someone benefits!

It’s possible that a similar thing might be happening with healthcare insurance companies now, as maximum Medical Loss Ratios mean that spending on drugs/treatments/etc. increases the amount they’re allowed to profit, but this is a relatively new issue for them – only becoming nationwide with obamacare. Utilities, on the other hand, have had this trouble for about 100 years.

The Good: How to save money by allowing unlimited profits

The problem is that utilities basically operate on a cost-plus basis. Here’s a simple alternative.

  • The utilities is allowed to charge a certain amount – either a total revenue sum or a per-kWh amount. This will rise by 1% a year.
    • Slightly below the current rate of increase. Alternatively you could tie this to inflation, say CPI -1%
  • The utility is legally obliged to connect all customers within its service territory.
  • The utility is fined for every blackout, with the fine set by a formula (e.g. $15/kWh not provided, which is roughly 100x what they would have charged for that kWh).

Now the utility is incentivized to be as efficient as possible. It can’t raise prices, but every dollar of savings will increase its profits. All of a sudden it goes from being a sleepy and inefficient company, whose only purpose is corrupting the regulator, to being a lean cost-cutting machine, dedicated to supplying electricity as efficiently and reliably as possible.

How should the initial revenue allowance be set? As we already have utilities, it would probably make sense to keep their current revenue allowance. It will take time for them to reform their infrastructure and become more efficient.

But if you were building the system anew, you might auction off regions. So you’d ask different companies to submit bids for the right to become the utility for an area, and accept the company who asked for the lowest revenue requirement. You don’t have to worry about their cutting corners, because electricity is homogeneous, and they’re massively penalized for any lack of reliability.

Unfortunately this would be politically vulnerable. If a highly competent management team reduced costs by 50%, they could increase their profit margins from 20% to 60%, and raise their ROE from 10% to 30%. Customers would see their bills continue to rise (albeit below inflation) and blame the profit-gouging utility. Voters might then pressure the politicians to steal from the utility, which cannot threaten to leave the area. The only way the utility can respond is by lobbying and obfuscating their profits, which basically gets us back to where we are now – highly inefficient cost structures so that profits look small compared to costs. Still, it’s worth thinking about what an enlightened electorate, or benevolent dictator, could do. And actually this is a little like what FERC is doing with transmission in RTOs.


If you liked this post, you might also enjoy How not to reform the insurance industry and The Future of Socialism is Privatizing the Atmosphere.

 


  1. Outside of the North East and Texas, where generation is operates in a semi-competitive market 
  2. I hear you asking: “If it’s a natural monopoly, why does the government need to prevent competition?” 
  3. Source: conversations with CEOs, CFOs, regulators etc. of utility companies. 
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