Public Utilities

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Public Utilities

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