Public utilities are firms that are sometimes synonymous with natural monopolies. Some examples of public utilities include the Tennessee Valley Authority and Illinois Power.
These organizations are generally so called because there is structurally no room for market competition— one firm can “naturally” produce at lower costs than competitors who are eventually priced out of the market. Thus, natural monopolies tend to be regulated by governments in the public interest. However, being a natural monopoly is not a necessary prerequisite for government regulation. Industries that are not natural monopolies may be regulated for a number of reasons, including service reliability, universal access, and national security.
Public utilities generally supply goods or services that are essential, like water, electricity, telephone, and natural gas. For example, the transmission lines for the transportation of electricity or natural gas pipelines have natural monopoly characteristics in that once these lines are laid by one utility, duplication of such effort by other firms is wasteful. In other words, these industries are characterized by economies of scale in production.
Left to themselves, private utility companies would make decisions that are most profitable for them. Such decisions generally involve too high prices and relatively little service compared to competitive conditions. These decisions may or may not be in the best interests of the society. The government or the society would like to see these services being economically accessible to all or most of the population.
Not all utility companies are in the private sector. In many countries, utilities are owned by the government. Generally, in these cases, the government creates autonomous bodies for government utilities to prevent them from day-to-day political interference. In such instances, the government utilities’ goals are better aligned with societal goals; however, they tend to be less efficient than their private sector counterparts.
Two main issues facing public utilities are coverage of service area and pricing. Alternately stated, the regulators try to balance the competing aims of economic efficiency and social equity. Economic efficiency generally requires that markets be left to work by themselves with little intervention. Such instances are usually not equitable or fair (some consumers might be priced out of the market). Equity issues demand that everyone gets the service at a “just” price. However, these instances can turn out to be inefficient (think about the cost to an electric utility of having to run cables a number of miles especially to serve one or two remote fishing cabins that are used sparingly).
In general, the pricing of the services of public utilities is problematic. As mentioned above most public utilities are structural monopolies, implying that there is no room for competition in the market for services they provide. However, if they are left alone to price like monopolies, the resulting price is too high and a large part of the market area may not be served. While the utility companies have no complaints about such arrangements, given the essential nature of the services they provide, the society would like to provide such services to all or most of the population. Think, for instance, about the undesirability of denying heat to someone in the winter. Hence, their pricing actions are regulated.
However, these decisions are somewhat problematic. If these utilities are mandated to set prices at the low competitive levels, they generally end up making losses. So there continues to be an ongoing tussle between regulators and the utility companies regarding a “fair” price between the monopoly and competitive levels.
Common alternate pricing actions include (1) setting prices equal to average production costs and serving the maximum area possible; (2) rate of return regulation; and (3) price cap regulation. Under average cost pricing, the utility is assured of breaking even, since the prices equal average costs. The equity aspects are somewhat met since most of the market is being served. However, the regulated firm lacks incentives to minimize costs. Under rate of return regulation, the regulators let the firms charge any price, provided the rate of return on invested capital does not exceed a specified rate. Whereas such regulation is flexible in allowing pricing freedom and frees the regulators from monitoring prices, a key drawback is that such regulation can lead to overcapitalization. In other words, when the rate of return is fixed at 5 percent, then the firm can charge higher prices by investing more in capital than it would otherwise (i.e., 5% of $10 million is greater than 5% of $6 million). Price cap regulation directly sets a limit on the maximum price charged by regulated firms. This type of regulation can result in a loss of service area. A (somewhat debated) plus point of price cap regulation is that such regulation induces firms to seek cost-reducing technologies because they offer a way to increase utility profits.
With technological changes over time, the nature of regulation changes in that some functions of the utility companies are “unbundled” and thrown open to free competition. New technologies might make it possible to break up the different stages of the electric generation process or natural gas transmission such that competition might be allowed to function in some stages. For example, in twenty-first-century United States and elsewhere the electricity generation market is relatively competitive and consumers are able to purchase electricity from competing vendors (generators). However, the transportation of electricity still remains a natural monopoly and continues to be regulated. Further, often times the deregulation of some or all functions of public utilities might occur over time due to political-economic compulsions.
In practice, however, both deregulation and increased regulation are plagued by uncertainties, both for regulators and the firms they oversee. For instance, the firms do not know when and whether they will face additional regulation (or deregulation). The regulators, on the other hand, are unaware whether new technologies would mandate additional regulation. Another related issue facing nations involves how to make the regulations somewhat consistent across international borders so that utilities from one nation do not have undue advantages over utilities from other nations (U.S. and Canadian utilities have faced such issues following the North American Free Trade Agreement [NAFTA]).
There is some criticism of public utility regulation in that over time the regulated utilities tend to take over the regulatory agencies that oversee them (called the capture theory of regulation). Thus the societal interests that the regulatory agencies are supposed to further are somewhat compromised. The evidence regarding the capture of regulatory agencies is mixed, however. Further, some researchers, including John Galbraith in his 1973 work, have questioned the supposed underproduction by monopolies.
To summarize, whereas over time changes in environment and technology warrant changes in regulation of public utilities, the nature of markets that utilities serve generally warrants they be overseen in some form or another by government bodies.
SEE ALSO Energy; Energy Industry; Public Sector
Berg, Sanford V., and John Tschirhart. 1998. Natural Monopoly Regulation. Cambridge, U.K.: Cambridge University Press.
Galbraith, John K. 1973. Power and the Useful Economist. American Economic Review 63: 1–11.
Kahn, Alfred E. 1971. The Economics of Regulation: Principles and Institutions. 2 vols. New York: Wiley.
Rajeev K. Goel
Businesses that provide the public with necessities, such as water, electricity, natural gas, and telephone and telegraph communication.
Morgan Stanley Capital Group Inc. v. Public Utility Dist. No. 1
In June 2008, the U.S. Supreme Court resolved a dispute that arose about energy contracts that California utilities and others signed during the state's energy crisis in 2000 and 2001.
Officials in several states, including California, Washington, and Nevada, had asked officials with the Federal Energy Regulatory Commission (FERC) to allow utility companies to nullify or renegotiate deals that were struck when electricity prices were dramatically inflated due to illegal trading by Enron Corp. and other companies. The Court remanded the case so that FERC could reevaluate the contracts under standards that the Court established.
The Federal Power Act (FPA), 16 U.S.C. §§ 824 et seq. gives FERC (and its predecessor, the Federal Power Commission) the authority to regulate the sale of electricity in interstate commerce. Under the FPA, regulated utilities must file rate schedules, or tariffs, with FERC. FERC is also involved with setting the terms and prices for services to electricity purchasers. Utilities may additionally set rates with individual electricity purchasers through bilateral agreements. Both the rate schedules and the contracts must be filed with FERC.
Under the FPA, wholesale-electricity rates must be “fair and reasonable.” When FERC considers a rate change, either through a new rate schedule or through a contract, FERC may take up to five months to investigate whether the rate is fair and reasonable. On the other hand, the commission may allow the rate to go into effect without making a determination that the rate is fair and reasonable. This occurrence does not prevent FERC from concluding later, in response to its own motion or in response to a complaint, that the rate is not fair and reasonable. The Supreme Court has traditionally given FERC and its predecessor great deference in setting the utility rates.
In 1956, the Supreme Court decided two cases that together establish the principles that apply when the commission considers modifications through rates established bilaterally by contract rather than unilaterally through a rate schedule. United Gas Pipe Line Co. v. Mobile Gas Serv. Corp. (Mobile), 350 U.S. 332, 76 S. Ct. 373, 100 L. Ed. 373 (1956); Fed. Power Comm'n v. Sierra Pac. Power Co. (Sierra), 350 U.S. 348, 76 S. Ct. 368, 100 L. Ed. 388 (1956). These cases resolved the question of how the commission may evaluate whether a contract rate is just and reasonable. According to the Court:
[W]hile it may be that the Commission may not normally impose upon a public utility a rate which would produce less than a fair return, it does not follow that the public utility may not itself agree by contract to a rate affording less than a fair return or that, if it does so, it is entitled to be relieved of its improvident bargain…. In such circumstances the sole concern of the Commission would seem to be whether the rate is so low as to adversely affect the public interest-as where it might impair the financial ability of the public utility to continue its service, cast upon other consumers an excessive burden, or be unduly discriminatory.
The Court, as well as lower federal courts , has further refined the Mobile-Sierra doctrine during the more than fifty years since it was decided. This doctrine stands for the principle that FERC must presume that an electricity rate established through a freely-negotiated, bilateral contract meets the “just and reasonable” requirement set forth in the FPA. This presumption may be overcome only if FERC determines that the contract causes serious harm to the public interest.
During the 1990s, California underwent a massive restructuring of its electricity market. This effort resulted in a program where the energy providers entered into short-term contracts (in a market known as the “spot” market), giving the providers only limited ability to enter into long-term agreements. The limitation on long-term contracts later caused problems when the State of California suffered through an energy crisis beginning in the summer of 2000. A variety of factors caused energy prices to skyrocket by as much as fifteen times their normal rates, and this price increase hit the spot market hard. The result was that utilities became buried in debt, and several parts of the state experienced rolling blackouts.
In response to the energy crisis, FERC effectively eliminated the reliance on the spot market and encouraged utilities to enter into long-term contracts. FERC likewise capped the price of wholesale electricity. Although prices fell to normal levels by June 2001, the long-term contracts that were executed prior to that time caused significant problems. Several utilities agreed to long-term contracts under which the utilities were required to pay several times the normal rate, even though these rates were much less than they were at peak times during the energy crisis. For example, one utility company purchased power from Morgan Stanley (the petitioner in the Supreme Court decision) at a rate of $105 per megawatt hour, compared with the historical average of $24 per megawatt hour.
After the energy crisis ended and the prices fell, several utilities were unhappy with the prices established in the long-term contracts. (The Supreme Court noted that “buyer's remorse set in”). The utilities asked FERC to modify the contracts, arguing that the commission should not presume the rates to be just and reasonable under the Mobile-Sierra doctrine. FERC determined that the Mobile-Sierra presumption applied and that the utilities were not entitled to have the contracts modified.
The Ninth Circuit Court of Appeals reviewed FERC's determination. A panel of the appellate court concluded that FERC had misapplied Mobile-Sierra because FERC had not provided sufficient oversight for the long-term contracts. Moreover, the court held that FERC had not properly considered the public interest of any of these long-term contracts. The court thus remanded the case to FERC for further consideration. Public Utility Dist. No. 1 v. FERC, 471 F.3d 1053 (9th Cir. 2006).
Morgan Stanley and other energy suppliers sought review from the U.S. Supreme Court, which granted a writ of certiorari . In a divided decision in which two justices did not participate, the Court disagreed with the Ninth Circuit's rationale but essentially agreed that the case should be remanded to FERC. Writing for a majority of four, Justice Antonin Scalia concluded that the Mobile-Sierra doctrine required the Ninth Circuit to presume that the contracts were just and reasonable. According to Scalia, the only circumstance where FERC could set aside the type of contract at issue would be where the commission found “unequivocal public necessity” or “extraordinary circumstances.” The Court's opinion directed FERC to review the contracts to determine whether unlawful market activity directly affected contract negotiations. If so, then the Mobile-Sierra presumption would not apply, and FERC could reform the contracts. Morgan Stanley Capital Group Inc. v. Pub. Util. Dist. No. 1, Nos. 06-1457, 2008 WL 2520522 (June 26, 2008).
Justice Ruth Bader Ginsburg agreed with the judgment but wrote a separate concurrence. She believed that the Court should have waited for FERC to reconsider the case before reviewing the commission's final decision . Justice John Paul Stevens, joined by Justice David Souter, argued that the Court “mangle[d] both the governing statute and precedent” in reaching the decision. Chief Justice John Roberts and Justice Stephen Breyer recused themselves from the case.
Businesses that provide the public with necessities, such as water, electricity, natural gas, and telephone and telegraph communication.
California Approves Measures Designed to Reduce Greenhouse Gases
The California Public Utilities Commission in January 2007 approved a regulation that prohibits utilities from purchasing electricity that is produced by power plants that produce greenhouse gases. The rule was adopted pursuant to an emissions control bill that the California Legislature passed in 2006. Under the new rule, utilities will not be able to purchase power from most coal-burning plants, because few of these plants are able to meet the new guidelines.
Scientists have proven that carbon dioxide and other greenhouse gases contribute to the problem of global warming. Despite this fact, increased use of alternative energy sources has been slow. In 2006, plans for more than 20 power plants had been introduced for construction in the Rocky Mountain states as well as the southwest. Plans called for these plants to burn coal, which is plentiful and relatively inexpensive, and much of the energy produced by the plants would be sent to California. These coal-burning plants would produce high quantities of carbon dioxide. As of 2001, California ranked second in the nation among states, behind Texas, in the production of carbon dioxide.
Members of the California Legislature introduced a bill entitled the Global Warming Solutions Act of 2006, which directly addressed the problem not only associated with gases produced by these power plants, but also the gases produced by oil refineries and cement plants. Under the legislation, the state aimed to reduce industrial carbon dioxide emissions by 25 percent by 2020. Although other states, such as New York, have considered proposals, the California legislation was the most aggressive proposal for attacking the problem of the production of greenhouse gases.
The State of California has taken a number of steps to reduce its energy consumption and to reduce the emission of greenhouse gases. For a number of years, the state has required that home devices such as refrigerators, air conditioners, and water heaters become more energy efficient. The state has also targeted chargers for cell phones and computers, as well as remote-controlled devices. Consumers in California also reportedly have begun to trade in their sport utility vehicles for more energy efficient models, including newer hybrid vehicles.
The proposal was not uniformly applauded. California has introduced several initiatives designed to address the causes of global warming, but critics say that these efforts could hurt consumers in California due to the increase in energy costs. In 2002, California became the first state to enact legislation that regulated emissions of carbon dioxide from automobile tailpipes, but that law has been challenged in federal court by members of the automobile industry. More recently, California Governor Arnold Schwarzenegger approved a proposal that requires builders to offer roofs that can convert sunlight into electricity.
Schwarzenegger signed the Global Warming Solutions Act in September 2006. The specific provisions of the act resulted from negotiations between the Democrat-controlled legislature and the governor, who is a Republican. In addition to establishing the goals for reducing greenhouse gases, the legislation also granted new authority to the California Air Resources Board, which was charged with setting specific emissions targets for various industries.
About four months after the passage of the act, the California Public Utilities Commission considered a proposed rule that would prohibit California utilities from buying electricity from power plants that exceed state emissions standards. Under the rule, California utilities could not make "new long-term commitments" with facilities that produce more than 1,100 pounds of carbon dioxide per kilowatt-hour. Such commitments include new construction, "major investments" in existing plants, and contracts lasting five years or longer. At the time of its adoption, coal-burning plants located outside of California supplied about 20 percent of the state's electricity.
The commission unanimously approved the proposal in January 2007. Members of the commission said that the regulation was necessary in order to implement the provisions of the 2006 legislation. According to commissioner Dian M. Grueneich, "The Emissions Performance Standard is a vital step towards achieving the emissions reduction goals of [the Global Warming Solutions Act] and protecting our ratepayers against the risk of high carbon prices in the not-too-distant future. At the same time, this decision leaves the door open to new, advanced technologies and carbon sequestration projects that will allow the energy industry to develop clean and sustainable sources of power."
Utility companies also praised the new standard. "The CPUC's greenhouse gas emissions performance standard is an essential step to addressing climate change. PG&E applauds the CPUC's vision and leadership in designing an aggressive and pragmatic policy, which encourages all of California's energy providers to invest in long term renewable energy sources," said Thomas B. King, Chief Executive Officer with Pacific Gas and Electric Co. "We are committed to doing our part by continuing to develop our renewable energy portfolio and providing our customers with among the cleanest energy in the nation."
At the time of the signing of the new standards, more than 220 companies had registered their emission levels with the California Climate Action Registry, which is a voluntary project that allows companies to register their levels of greenhouse gas emissions. The legislation passed in 2006 provided incentives for companies to submit these emission levels.
PUBLIC UTILITIES. In the United States, public utilities supply consumers with electricity, natural gas, water, telecommunications, and other essential services. Government regulation of these utilities considered vital to the "public interest" has waxed and waned. In the nineteenth century, canals, ferries, inns, gristmills, docks, and many other entities were regulated. However, in the early twentieth century, emerging electric companies initially avoided regulation These rapidly growing power companies often merged, creating monopolies that controlled the generation, transmission, and distribution of electric power. By 1907, entrepreneur Samuel Insull of Chicago Edison had acquired twenty other utility companies. He and others argued that building multiple transmission and distribution systems would be costly and inefficient. Nevertheless, reformers clamored for state regulation of the monopolies. By 1914, forty-three states had established regulatory polices governing electric utilities. Insull and other electric power "barons" found a way past regulation by restructuring their firms as holding companies. A holding company is a corporate entity that partly or completely controls interest in another (operating) company. Throughout the 1920s, holding companies bought smaller utilities, sometimes to the point that a holding company was as many as ten times removed from the operating company. Operating companies were subject to state regulation, holding companies were not. Holding companies could issue new stock and bonds without state oversight. This pyramid structure allowed holding companies to inflate the value of utility securities. Consolidation of utilities continued until, by the end of the 1920s, ten utility systems controlled three-fourths of the electric power in the United States. Utility stocks, considered relatively secure, were held by millions of investors, many of whom lost their total investment in the stock market crash of 1929.
Public Utility Holding Company Act
With strong support from President Franklin D. Roosevelt, Congress passed the Public Utility Holding Company Act (PUHCA) in 1935. PUHCA outlawed interstate utility holding companies and made it illegal for a holding company to be more than twice removed from its operating subsidiary. Holding companies that owned 10 percent or more of a public utility had to register with the Securities and Exchange Commission and provide detailed accounts of all financial transactions and holdings. The legislation had a swift and dramatic effect. Between 1938 and 1958 the number of holding companies fell from 216 to eighteen. This forced divestiture continued until deregulation of the 1980s and 1990s.
Many politicians and economists argued that the marketplace, not government regulation, should determine utility prices. Many consumers also sought lower prices through deregulation. Near the end of the twentieth century, while government oversight of safety remained, price and service regulation were removed from several industries, including telecommunications, transportation, natural gas, and electric power. As a result, new services and lower prices were often introduced. The increased competition among investor-owned utilities also led to mergers and acquisitions and a concentration of ownership. Deregulation is also credited with the rise of unregulated power brokers, such as Enron, whose historic collapse in 2002 laid bare the vulnerability of consumers and investors when corporations control essential public services. About a dozen states repealed or delayed their deregulation laws; many consumer groups maintained that PUHCA's protections should be reinstated.
Euromonitor International. "Electric Power Distribution in the United States." http://www.MarketResearch.com.
Lai, Loi Lei. Power System Restructuring and Deregulation. New York: Wiley, 2001.
Warkentin, Denise. Electric Power Industry in Nontechnical Language. Tulsa, Okla.: Penn Well Publishers, 1998.
Businesses that provide the public with necessities, such as water, electricity, natural gas, and telephone and telegraph communication.
A public utility is a business that furnishes an everyday necessity to the public at large. Public utilities provide water, electricity, natural gas, telephone service, and other essentials. Utilities may be publicly or privately owned, but most are operated as private businesses.
Typically a public utility has a monopoly on the service it provides. It is more economically efficient to have only one business provide the service because the infrastructure required to produce and deliver a product such as electricity or water is very expensive to build and maintain. A consequence of this monopoly is that federal, state, and local governments regulate public utilities to ensure that they provide a reasonable level of service at a fair price.
A public utility is entitled to charge reasonable rates for its product or service. Rates are generally established according to statutes and regulations. The utility usually files a proposed rate schedule with the state public utility com mission for approval. The commission holds public hearings to help decide whether the pro posed schedule is fair. The commission may also require increased levels of service from the utility to meet public demand.
Until the 1930s public utilities were subjected to minimal regulation. The enactment of the Public Utility Holding Company Act of 1935 (49 Stat. 803 [15 U.S.C.A. §§ 79–92z-6]) signaled a change. A holding company is one that owns stock in, and supervises management of, other companies. The law regulates the purchase and sale of securities and assets by gas and electric utility holding companies and limits holding companies to a single coordinated utility system. The law ended abuses that allowed a small number of public utilities to control large segments of the gas and electricity market and to set higher utility rates.
Public regulation of utilities has declined since the late 1970s. Public policy is now based on the idea that competition rather than regulation is a better way to manage this sector of the economy. Airline and telephone deregulation are the most prominent examples of this shift in philosophy. Telephone deregulation was enabled by a 1982 agreement between American Tele phone and Telegraph Company (AT&T) and the federal government. The federal government had sued AT&T, alleging that its monopoly on virtually all telephone service in the United States was illegal. AT&T agreed to divest itself of all local telephone companies, while retaining control of its long-distance, research, and manufacturing activities. This resulted in the creation of seven regional telephone companies with responsibility for local telephone service. Other companies now compete with AT&T for long-distance service.
At the federal level, numerous commissions oversee particular types of public utilities. These include the Federal Energy Commission, the nuclear regulatory commission, the federal communications commission, and the securities and exchange commission.