Emergence of Electrical Utilities in America
Edison & the First Power Station
The modern electric utility industry in the United States can be traced to the invention of the practical light bulb in 1879 by Thomas Alva Edison. Always looking toward the marketplace, Edison realized that his light bulb would mean nothing unless he developed an entire electric power system that generated and distributed electricity.
By 1882, he had developed such a system, and he installed the world's first central generating plant on Pearl Street in New York City's financial district. Reciprocating steam engines provided the motive power to generators, which produced direct-current (DC) electricity to shop owners and other businesses that used electric lighting as a novelty to attract customers.
But soon after introduction of central station power, Edison and others introduced appliances that made electricity more versatile and valuable. Electric motors found use in fans and as replacements for bigger, more expensive, and more difficult-to-maintain steam engines in factories; electric irons quickly became a best seller for home-use, substituting for the heavy and cumbersome irons that needed frequent reheating on coal or wood stoves. Cities such as New York quickly introduced electrically operated street cars, which could be controlled more easily and operated more cheaply than their horse-drawn counterparts.
Electricity won popular praise as a new technology that would revolutionize home and industrial life. As entrepreneurs saw a large market for electricity consumption, they sought franchises from municipal governments to build power stations that would dot city landscapes. In many cities, numerous companies produced power for customers, because the power plants of the time were limited by the technological constraint inherent in direct current transmission. Produced and distributed at relatively low voltages--around 110 volts--direct current electricity weakened substantially as it traversed the copper distribution lines. In practice, customers needed to be within one mile of a generating plant to receive power. As a result, the emerging paradigm of electric power production appeared to consist of cities being populated by numerous power plants, each selling to customers within a small radius. Typically, the large investment required for the plant prohibited one company from owning all of them. But the firms often tried to win lucrative customers in the others' turfs.
Samuel Insull and Chicago Edison
When Samuel Insull arrived in Chicago in 1892, the town hosted more than twenty companies producing electricity. The British-born secretary of Thomas Edison, Insull assumed the presidency of the small Chicago Edison company, one of many Edison franchises around the country. Because of his work in Chicago, Insull is remembered for his many managerial and technological innovations that transformed the utility system into its modern structure.
Quickly learning at his new job, Insull realized that his company could make more money by increasing what became known as the "load factor"--the ratio of average daily or annual power use to the maximum load sustained during the same period. Since Insull needed to purchase equipment to meet the peak load of use during a day--typically in the evening when customers used electric lights--he was stuck with power generating technology that sat idle most of the rest of the day. But Insull understood that if he could find customers who would use electricity during off-peak times, he could increase his company's income while avoiding new capital purchases (though he would still incur marginal expenses related to increased fuel use). Those customers existed, though many generated power for themselves. By enticing customers such as street railway companies, ice houses, and other businesses with low rates for off-peak power usage, Insull increased his load factor dramatically. He also found that lower-cost power stimulated demand, while still earning healthy profits for his company.
Samuel Insull and Economies of Scale with Steam Turbines
Insull also realized how to exploit new technologies. For example, during the late 1880s and 1890s, a few power companies in Europe began using a steam turbine to power generators instead of reciprocating steam engines. Large, bulky, noisy, and hard to maintain, the reciprocating engines of the day converted up-and-down motion to rotary motion for use by electric generators through the use of a large flywheel. But by the end of the 19th century, these behemoths were reaching limits to their productive capacity. The new steam turbines, invented by Englishman Charles Parsons in 1884, on the other hand, produced rotary motion directly, as steam passed through vanes on a long shaft. Much smaller in size, simpler mechanically, and more quiet than reciprocating engines, steam turbines produced a great amount of power from a small package. More importantly, the turbines could be scaled up to produce even more power with proportionally less investment in material. In other words, the steam turbine exhibited great "economies of scale" such that larger units produced electricity at lower unit cost.
Taking a great risk at the time, Insull ordered a turbine-generator set from the General Electric company in 1903 that produced 5,000 kilowatts (kW) of power (5 megawatts [MW]). Pleased with the unit's performance, he ordered other turbines that generated 12 MW in 1911. Power costs plummeted, allowing the company to sell more electricity at still lower rates.
Using steam turbines would not have been a successful strategy had it not been for Insull's use of an associated new technology--alternating current (AC) transformers. Developed in the 1880s, AC transformers overcame the technical limitation of transmitting low-voltage direct-current to distances beyond one mile. When power produced with already existing AC generators was transformed up to high voltages, current could flow for many miles without significant degradation. In 1896, for example, Edison competitor Westinghouse Electric built a system of water-turbine generators at Niagara Falls that produced power for transmission to Buffalo, 20 miles away. The AC power illuminated lights, just like direct current, and it powered the new AC motors that recently came to market. Since it could do everything direct current could do--with the important plus that it could be transmitted long distances--AC quickly won the day, leading to the demise of Edison's direct current systems.
Insull quickly realized that competition in the electric power supply business would never allow him to exploit the scalable turbine-generators and AC transmission systems. After all, if many companies divided the market for electricity, none would have the demand for power that could be met by the bigger turbine-generators. To remedy the problem, Insull sought to consolidate his company with others. After buying the firms, he often turned their generating stations into substations, relegating the generating equipment to back-up spares, and he used large, efficient steam-turbines to produce power for all customers. He also sought new customers, even some rural customers outside the city limits, to help him diversify the company's usage patterns and increase the load factor. Successful in his efforts, Insull acquired 20 other utility companies by 1907 and renamed the firm "Commonwealth Edison." By that time, the company had already become known as one of the most progressive--and lowest cost--utilities in the world. As a result, Insull's strategies became emulated by utility entrepreneurs in other cities throughout the United States.
Seeds of Regulation: Railroads and Electric Utilities
As successful as Insull's company may have been, it was not universally loved. A virtual monopoly in Chicago, the company reminded many public-spirited politicians and individuals of other monopolies that rubbed people the wrong way, with railroads being the most notorious. Becoming the life blood of American commerce, the railroad industry by the 1870s had become effective monopolies within their markets, after enduring a period of heated and destructive competition. In several cases, railroad companies spent lavishly to lay down duplicate rail lines between lucrative markets and invested heavily in engines, cars, and other equipment, only to find that they could not make sufficient profits because of intense price competition. Eventually, railroad owners realized that merging operations with competitors allowed them to increase rates and make more money. Attempting to eliminate monopoly abuses of the railroad companies, several state legislatures and the federal Congress passed legislation for creation of bodies that would regulate rates. Unfortunately for railroad customers, most of these regulatory bodies proved ineffectual.
Notion of "Natural Monopoly"
Regulation gained a more substantial foundation during a period of political agitation known as the Progressive era, which lasted from around 1896 through World War I. At the heart of regulation was the acceptance of the notion that some industries, such as the railroad business, constituted "natural monopolies." According to academic economists, such businesses exhibited tremendous economies of scale or the necessity of huge capital investment (and usually both) such that only one company would dominate a market. In the railroad business, the large investment in equipment meant that duplication of facilities would incur great waste of financial and material resources, thus leading to overall higher costs for companies and higher prices to customers. Thus, monopoly appeared to be the natural outcome of such a situation, where one company could minimize the waste of resources to serve customers. In short, the railroad business was a "natural monopoly," one in which big technology and the high cost of investment led companies to move to a non-competitive environment.
The situation seemed similar to what was occurring in the electric utility business. As electric power firms consolidated with others to exploit the benefits of large-scale turbine-generators and alternating current transmission, they increasingly looked like the epitome of natural monopolies. They were joined by other "public utilities," such as water and transportation industries that constituted, according to Richard T. Ely, an economist writing in 1903, "monopolies because, we know from experience, we cannot have in their case effective and permanent competition."
Models for Regulation during the Progress Era
The big question for progressive reformers was how to gain for society the benefits of natural monopoly without suffering the abuses common among monopolist owners? The answer actually took two forms--municipal ownership and state regulation of companies. By purchasing firms providing essential services and commodities, cities could ensure that the benefits of natural monopoly would flow directly to the people (or so it was hoped). In the electricity supply business, customers would enjoy lower rates as the city-owned utility exploited economies of scale and increased sales to greater numbers of people and businesses. Since cities have no stockholders demanding dividend payments or returns on investment, they could pass on savings directly to their citizens.
While municipalization of electric utilities enjoyed growing popularity, they did not win universal approval. Progressive reformers, for example, had been strident opponents of corrupt city governments. Why should political officials all of the sudden gain enlightened management skills when operating power systems when they so blatantly stole from the public coffers in so many other situations? And in attempts to maintain low prices, for political reasons, managers might neglect maintenance, refrain from necessary investment in capital equipment, and offer low salaries that would discourage hiring of superior engineers and staff. Moreover, several critics of municipal systems viewed them as attempts to socialize American industry at a time when private enterprise still carried much popularity in society--the existence of abusive monopolies notwithstanding.
As an alternative, many progressives looked to state regulation. Though several states had created regulatory bodies to oversee the activities of railroad companies--with Massachusetts' railroad commission created in 1869 being one of the most notable--few had the power to enforce their recommendations nor could they establish rates and fares. But the new type of regulation, promoted by progressive Republican governors in Wisconsin and New York in the first few years of the 20th century, was different. In 1905, for example, Wisconsin's Governor Robert La Follette pushed through creation of a railroad commission that had full jurisdiction over a railroad's rates, schedules, service, and operations of the state's transportation companies.
Two years later, in July 1907, the Wisconsin legislature extended regulation to the state's electric companies. The commission used its powers to compel utilities to develop standard accounting techniques, and it had the right to investigate companies' books as part of the process for determining rates based on the physical valuation of a company's properties. Just a month earlier, New York governor Charles Evan Hughes, signed into law a similar measure to create a regulatory body for the Empire State. Though the Wisconsin statute proved more sweeping in several respects, both states deservedly take credit for initiating the idea of state regulation of electric utilities. Gaining support from politicians and civic reform groups, state regulation of utilities became commonplace, such that by 1914, 43 more states followed the example of New York and Wisconsin by establishing government oversight of electric utilities.
Despite the move toward state regulation, the idea that city-owned utilities could better derive the benefits of natural monopolies for their citizens continued to hold some appeal. In fact, the number of municipal utilities peaked in 1922, with more than 2,500 "munis" in existence. Only accounting for about 5% of the nation's total generating capacity and less than 4% of the total electrical energy produced, municipal ownership has remained a fixture on the utility landscape, even into the 1990s.
Roles of Regulation
The overall purpose of regulation, as viewed by its founders, was to serve as a body that would enforce the responsibilities and rights of electric power companies and their customers. For example, utility companies were required to serve all customers without discrimination who sought to buy power. To fulfil this "obligation to serve," they would need to raise capital and build plants to meet projected loads. Moreover, utilities could charge customers "reasonable" rates for service--rates based on the value of their investments in equipment plus a fair rate of return on the so-called "rate base"--and they must do their best to provide service with as few interruptions as possible.
But utility companies earned valuable rights as part of the political consensus that created regulation. Perhaps most importantly, regulatory bodies legitimated the utilities' status as natural monopolies within their service territories and protected them from interlopers. Utilities also earned the right of eminent domain, formerly a power reserved by the state, so it could obtain property for their generating plants, transmission towers, and other equipment that was necessary for supplying an increasingly necessary commodity.
Utility customers, on the other hand, undertook the responsibility, overseen by regulators, to pay rates that helped maintain the financial integrity of utility companies. Unlike politicians in municipal systems that might reduce rates to curry favor among voters, regulators would insist (in theory) that rates be sufficiently high to keep utilities financially healthy. Sometimes, this obligation meant that customers had to pay higher rates than in previous periods.
Benefits of Regulation to Utility Companies
Astute utility managers such as Samuel Insull anticipated the benefits of regulation to power companies. As early as 1898, he pointed out that regulation would legitimate the monopoly status of utility companies and would keep at bay those who harbored distrust and antipathy for non-competitive industries. In other words, regulation gave the utility industry a special place in the American political economy and protected it from those who saw evil in the big oil and railroad trusts of the day.
On a practical level, regulation allowed utility companies to raise money more easily, in the form of stock and bonds, than before the imposition of regulation. Since investors knew that regulators oversaw the financial accounts of utilities--in an era before public disclosure of accounts was made obligatory--they could feel that their investments in utility company securities was not as speculative as those in unregulated companies. Hence, utility companies could pay lower interest rates than more risky investments. Meanwhile, regulators helped guaranty the financial integrity of companies, meaning that utility bonds paid interest at regular intervals, and that utility stocks paid healthy-enough dividends to attract investment in what became the most capital-intensive industry in the United States. Without a doubt, utility stocks and bonds only became securities for the "widows and orphans" after regulation helped ensure their safe and secure status.
Expansion of 1910s and 1920s
During the two decades after regulation appeared, utility companies expanded to provide increasing amounts of electricity, at lower unit cost, to a greater number of customers. The electrical output from utility companies exploded from 5.9 million kWh in 1907 to 75.4 million kWh in 1927. In that same period, the real price of electricity declined 55%.
To help finance the great expansion, the utility industry exploited a financial innovation known as the "holding company." Begun by equipment manufacturers, this type of company started by accepting the relatively unattractive stock and bond issues of utilities in exchange for generating and associated equipment. Thus, nascent utilities could therefore retain cash for their operations. After accepting the securities from several utilities (known as "operating companies"), the holding company issued stock and bonds using the subsidiaries' securities as collateral. Investors preferred the securities offered by the holding company, because they provided diversification and more secure returns than did offerings from individual companies. A favorite holding company investment among many was the Electric Bond and Share Company, created by the General Electric company in 1905, to market the securities it acquired while selling equipment to utilities.
Because the holding company now had a stake in the operating companies, they offered management and engineering services that the smaller firms could not have afforded themselves. Moreover, the holding company often consolidated the equipment and management of smaller companies into larger ones, and it helped them interconnect transmission facilities to ensure higher levels of reliability. Overall, the holding company innovation appeared to facilitate expansion of the utility industry.
Abuses of Holding Companies
During the go-go years of the 1920s, however, some of the beneficial principles of the holding company concept got lost in the desire to exploit its business structure. Holding firms assessed high fees for arranging financing for their operating companies, and they provided engineering services at levels way beyond their cost. Meanwhile, the companies pyramided one sub-holding company on top of another, none of which did anything but to hold securities of the companies below it. The scheme allowed stockholders of the top company to control the assets of operating companies with very little investment. Samuel Insull was one of the kings of these empires. In 1930, his capital investment of $27 million allowed him to control electric companies and assorted other businesses in 32 states having assets of at least $500 million.
So lucrative was the holding company structure that their number increased from 102 to 180 between 1922 and 1927, while the number of subsidiary operating companies actually declined from 6,355 to 4,409. By 1932, only eight holding companies controlled almost three-quarters of the investor-owned utility business. Perhaps best of all for the holding companies, their operations usually were exempt from the investigation of state regulatory commissions, since so much of their business crossed state boundaries.
The abuses of holding companies invited a six-year investigation pursued by the Federal Trade Commission beginning in 1928. Public antagonism toward the companies intensified after the stock market crash of 1929 decimated the values of holding company securities. Campaigning for the presidency in 1932, Franklin Roosevelt lashed out against the "the Ishmaels and the Insulls, whose hand is against everyman's," and he vowed to reform the industry if he won election.
Public Power for Rural Customers
Keeping his word, Roosevelt created (with the consent of Congress) government agencies that generated and distributed electricity to segments of the American public neglected by investor-owned utilities (IOUs). IOU executives had previously argued that electrifying rural areas would be too expensive and would not provide adequate returns on investment, but the Tennessee Valley Authority (created in 1933) and the Rural Electrification Administration (1935) proved otherwise. These and other institutions demonstrated that electrification of even the poorest households could raise standards of living of the inhabitants and produce good income to electricity suppliers. (In 1930, only 10% of American farms had electrical service; by 1945, almost 45% of them were wired up.) As a result of these actions, investor-owned utilities have been deprived, to this day, of a significant portion of the country's customers--customers who are served by municipal utilities or rural cooperatives.
Public Utility Holding Company Act of 1935
Beyond embarrassing utility executives with these initiatives, the federal government imposed new rules on the investor-owned utility industry. By passing the Public Utility Holding Company Act of 1935, Congress outlawed the pyramid structure that had been at the core of financial abuses. Holding companies could remain, but they could only have two levels--one holding company on top and one or more operating subsidiaries below. Meanwhile, the law dissolved holding companies that did not contain contiguous operating utilities; earlier companies held operating companies that were scattered about the country and could not take advantage of consolidated or interconnected operation. Moreover, all interstate holding companies and practically all businesses that produced a substantial amount of electricity would be forced to register with the newly created (in 1935) Securities and Exchange Commission. Furthermore, they were required to follow its strict rules about submitting financial reports, and they needed to obtain approval to issue stock and bond securities.
By not outlawing holding companies altogether, these New Deal initiatives recognized the engineering and management value that holding companies could provide to operating companies. Nevertheless, the number of holding companies declined, from 216 to 18 in the period between 1938 and 1958, while hundreds of operating companies became separated from holding companies altogether. The landscape of the utility industry remained fairly consistent since then: about 77% of generated kilowatt-hours were produced by investor-owned companies in 1970, while municipal and government utilities (and rural cooperatives) produced the remaining 23%.
Assessment of FDR's Reorganization
During the early years of his presidency, President Roosevelt had the opportunity to transform forever the utility industry. Having public and political support behind him after the holding company abuses became widely known, he could have urged that state and federal power agencies (such as the Tennessee Valley Authority and the Bonneville Power Authority in the Pacific Northwest) assume the assets and activities of privately owned utility companies. But this was not what he did. Instead, the President sought to impose safeguards, in the form of government oversight of holding companies and securities issuance, to prevent abuses in the future. As in other areas of his New Deal, the President sought to preserve the sanctity of the private capitalist economy and not destroy it. In the process, he gave investor-owned utility companies another chance to demonstrate that their natural monopoly industry could indeed provide benefits to society.