Turning On The Lights: Deregulating The Market for Electricity

Studies | Regulations

No. 228
Friday, October 01, 1999
by Vernon L. Smith and Stephen Rassenti

Evolution of State Electric Utility Regulation

Local electric companies were not always monopolies - firms with the power to make money by restricting production and raising prices. Before 1910, the United States had competing local electric companies:10

  • In 1887 alone, six electric companies organized in New York City.
  • By 1907, 25 electric companies were operating in Chicago.
  • Duluth, Minn., had five electric lighting companies operating before 1895, and by 1906, Scranton, Pa., had four.
  • As late as the 1930s, Cleveland and Columbus, Ohio, each had direct competition between two private electric companies.

"Local electric companies were not always monopolies."

Furthermore, power generating capacity was widely dispersed and broadly owned. Thus in 1900 over 59 percent of electricity-generating capacity in the United States was located at industrial sites.11 Electricity production surged from 4.5 million to 17.2 million megawatt hours between 1900 and 1910 while prices fell by more than 26 percent, and because of competition, consumers benefited from new services - offered without government help or mandates. For example:

  • Private companies began offering electric trolley service, balancing out the nighttime demand for electricity with a daytime market.
  • Unlike the regulated natural gas utilities, which offered service for a fixed monthly price, the electric industry introduced metering and pricing based on usage.
  • Through voluntary teamwork, a committee of the Institute of Electrical Engineers found ways to standardize electrical machinery, which lowered costs and improved service.
  • The National Board of Fire Underwriters, a private insurance association, helped develop safety procedures.

Development of State Regulation. States began regulating electricity pricing and market entry in the first two decades of the 20th century, for a variety of reasons.

  • As early as 1897, Samuel Insull, head of the Chicago Edison Company, president of the industry's National Electric Light Association and a persistent advocate of regulation, began calling for exclusive licensing of electric utilities and for "fair profit" price control by state governments.12
  • For many years, economists assumed that electrical service - like other utility networks such as water, natural gas and telephone service - was a "natural monopoly," which meant that having a single provider was the most efficient use of resources.
  • Technological innovations gave rise to economies of scale in generation and reduced the amount of energy lost in transmission, allowing a single firm to serve more and more customers at a lower average cost.
  • Proponents of regulation argued that when marginal costs are decreasing, a single firm could supply an entire market more cheaply than two firms and capture the entire market anyway - as bankruptcies and consolidations in the industry seemed to indicate.

Thus in exchange for monopoly franchises, many utilities were willing to accept regulated pricing - provided it was "fair." Utility executives argued that regulators who acted "scientifically" and had exceptional "social consciences" could determine rates better than the market could.13

"Utility executives argued that regulators could determine rates better than the market could."

By 1913, 27 states and the District of Columbia had state commissions regulating electricity rates - and cities began issuing exclusive franchises. After states began regulating electricity, prices increased and production decreased. In fact, a study of the period 1900-1920 shows that the first states to adopt regulation were those in which electric rates and profits were lowest and output highest - in other words, where competition tended to be vigorous.14

When progressive reformers in the 1920s tried to tighten regulation or substitute municipal for private ownership, the power companies fought back effectively. The companies had every incentive to protect their interests. Stockholders could receive up to 40 percent in profits. Utilities used a holding company structure that bewildered state regulators, making possible returns of 2,000 or 3,000 percent in exceptional cases.15

For decades, state regulatory commissions allowed utilities to earn monopoly profits. A well-known study by Harvey Averch and Leland Johnson found that in the 1960s utilities were allowed to earn a rate of return higher than necessary to attract needed investment. As a result, they argued, utilities had an incentive to build more generating capacity than they needed. Regulators allowed utilities to raise rates to cover the cost of the unneeded capacity, with allowance for profit, and consumers suffered.16

"Consumer Interest" Regulation. After the early 1970s, however, regulators tended to suppress rates below the level that allowed a fair return on invested capital. At about the same time, a belief that the supply of fossil fuels was disappearing and concerns in the wake of the OPEC oil embargo induced many utilities to build nuclear power plants. The cost of these plants skyrocketed to unprecedented levels due to environmental, safety and regulatory requirements. The oil embargo also brought an era of rising fossil fuel prices, and regulators did not increase the rates utilities were allowed to charge quickly enough to cover costs. Finally, consumer groups advocating lower rates gained new influence over regulatory commissions previously dominated by the electric industry and large industries.

"Holding rates down benefited consumers in the short run, but caused higher rates in the long run."

In the late 1970s and the 1980s, rate suppression caused utilities to invest too little, keeping older equipment on line longer. Meanwhile, their reserve capacity to meet emergencies and peak loads became thinner and thinner. While consumers benefited from lower rates in the short run, in the long run they paid fuel-cost penalties because utilities could not afford to replace old plants with more efficient ones or switch to lower-cost fuels. In the 1980s, Peter Navarro estimated rate suppression policies would cause rates to be 11 percent to 33 percent higher by 2000 than they would be had regulators permitted utilities to earn a fair rate of return.17

Although monopoly electric service providers are the norm, even today in Lubbock, Texas (pop. 186,000), two electric companies with separate poles and lines serve the entire city. Consumers in Lubbock pay less than customers in nearby Amarillo, a city of comparable size but with no competition. Some 22 other American cities have such competitive service.18

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