Market Economics: The Push for Deregulation

Deregulation and Use of Market-Based Principles in Other Industries

Deregulation of Airlines

While the electric utility industry was being questioned about its status as a natural monopoly, other industries had begun to be stripped of their protective cloak of regulation. Under President Carter, for example, the commercial airline industry lost regulatory oversight of fares, cities served, and the ease of entry and exit from markets. Though some airline companies went bankrupt in the new environment, other air transportation companies emerged, and the flying public generally obtained good service at lower prices than under regulation.

Challenges to Price and Service Regulation

In general, economists, politicians, government officials, and much of the public began wondering about the value of regulation. In some industries, regulation had been imposed to prevent abuses that had previously been endured and to ensure that all parties had equal access to information and services (as was the case with the creation of the Securities and Exchange Commission in1935). Other regulation ensured that safety and health (in the food, drug, and aircraft industries, for example) would be maintained. Such regulation attracted little criticism, since it clearly appeared in the public interest.

But in other areas, such as in determining prices and business practices, regulation came under fire. Why not depend on the discipline of the marketplace, with numerous sellers and service providers competing against each other, to determine prices? In other industries, such competition delivered an abundance of new products and services, often at declining prices.

Deregulation of Other Industries

As this attitude became more prevalent in the 1980s, price and service regulation was removed in several industries. While maintaining some governmental oversight over safety and trying to prevent business abuses, price regulation was lifted in the securities and banking businesses, trucking, natural gas, and telecommunications industries. In most cases, customers watched as the competitive industries introduced new services and lower prices to gain market share. In a startling example of the natural gas industry, regulation had previously hindered exploration of new gas supplies, since prices were capped to protect customers. As soon as price regulation ended, companies actively sought new supplies. Successful in their pursuit, natural gas became abundant, and priced dropped precipitously. This and similar experiences in other countries, such as Great Britain, led politicians and policy analysts to suggest that the competitive market could discipline industries better than could the regulatory apparatus. Almost naturally, many people wondered why the electric utility industry should remain regulated?

Special Nature of Electric Utility Business?

Of course, utility spokesmen and others pointed out that the electricity business was different from other industries that had recently been deregulated. It produced a product that was vital to 20th century life, for example. If a electricity provider went bankrupt and could no longer provide service, as would be expected in a competitive business, or if a firm simply decided to leave a market, then customers would be deprived of a necessity. Such an outcome would be untenable in modern American society, a society that had worked so hard, especially during the 1930s, to ensure universal electrical service. Electricity was simply a "special" commodity, affected with the public interest as was no other product, and the industry that produced it required special considerations, or so this line of reasoning went.

Introduction of Some Competitive Principles into the Utility Business

Problems with Traditional Regulation

As much as utility executives may have protested deregulation of prices, many parties agreed that traditional regulation appeared flawed. In the golden years, when new construction of power plants reduced the average cost of electricity, regulation that set rates based on the value of the new equipment worked fine, since rates generally decreased. But in the 1970s and later, utility construction became increasingly costly, and rates reflected those higher costs. Moreover, regulatory rules encouraged utilities to complete long-delayed power plants even if the demand for power was not likely to warrant such a big plants or because poor management caused costs to escalate.

New Approaches

Energy Efficiency

Regulators in many states, however, tried to address this and other problems in creative fashions. Invigorated by greater public awareness of their activities and better funding from state legislatures, regulatory commissions in several states became more activist--in great contrast to their passive nature before the energy crisis. In several cases, regulators required utilities to sponsor energy efficiency programs that helped customers reduce their demand for electricity. In such a way, the growth rate of power use would slow or even decline, thus paring the need for new construction of power plants. With fewer generation plants being built, rates could stabilize rather than go up.

Competitive Auctions

In another approach, regulators came up with a competitive auction to determine the rates that utilities had to pay PURPA QFs. Originally, commissions determined the "avoided cost" of utilities--the cost that regulated utilities faced when generating new power and the price paid to QFs--using an administratively determined formula. But in California and elsewhere, assumptions about the future price of fuel and other factors that entered into the calculations proved false, thus making payments to PURPA producers too high in some cases. To alleviate the problem, regulators (or utilities themselves) sometimes determined only the amount of power that would be needed in the future, and QFs offered price bids and other terms in a competitive arena. In most cases, the unregulated generators bid lower prices than had been previously approved by regulators--a victory for the free market.

Pay for Performance

Regulators in California and elsewhere also introduced the market-place principle of "pay for performance." In unregulated markets, customers only paid for services actually received. But in the regulated electricity business, customers paid for the cost of power plants, even when they may not have been needed (due to slower demand growth) or when they performed poorly and had to be repaired and retrofitted frequently. However, in California and elsewhere, regulators tried to insulate customers from poorly performing power plants by allowing utility companies to charge customers only when the generators performed properly. If plants operated poorly, the companies' stockholders would pay the cost, not customers. In this way, regulators gave utilities a tremendous incentive to operate efficiently--an incentive that did not exist under traditional regulation, in which all costs were passed on to customers. It was the same incentive that unregulated companies faced daily: improved economic and operational efficiency meant they could lower their costs and compete better with other companies offering similar products and services.

Another energy crisis?

Gulf War

As the utility industry slowly underwent examination and alteration of its activities in the 1980s, new concerns intervened to speed adoption of competitive principles. After a near-absence of energy initiatives during the eight years of the Reagan administration (except for the dismantlement of many energy agencies created during the Carter presidency), President Bush in 1989 inaugurated a new policy review. He found that the United States had become more dependent on foreign oil producers than during the 1973 energy crisis, though oil now arrived from a greater variety of countries than earlier. While working groups studied the energy situation, Saddam Hussein's Iraqi army invaded Kuwait in August 1990, raising the dictator's control of world petroleum supplies to 20%. Shortages pushed the price of a barrel of oil to about $30--$10 more than before the invasion--costing the American economy about $21 billion over the next few months.

A Free Competitive Market

Within this environment, the President proposed a new energy policy that depended on the use of market-based principles when possible to encourage greater production of domestic energy resources and for more efficient use of existing resources. In classical economic theory, competition among many participants yielded lower prices to customers and a flurry of innovation among sellers to provide new services and goods. Overall, society benefited from a free competitive market as resources were used and allocated efficiently. In the energy realm, advocates of the free market expected economic efficiency to yield energy efficiency as well.

A Free Market for Electricity? Amending PUHCA

Electric utility use of petroleum had already dropped dramatically since the 1970s, as the industry converted to coal use. But President Bush's energy strategy still envisioned free-market approaches by which electricity could be produced and used more efficiently. For example, the plan called for amending the Public Utility Holding Company Act of 1935, which required companies producing electricity to register with the Securities and Exchange Commission and conform to numerous standards. While preventing a repeat of utility abuses rampant in the 1920s, the law also inhibited independent power producers--those working under the guidelines of PURPA and other non-utility producers using efficient gas turbine-generators, for example--from competing effectively with other producers, yielding lower prices.

As part of the plan to increase competition, the plan would make available transmission facilities, owned by individual utility companies, so the independents and other utilities could sell power across the country in a process called "wheeling." The plan differed from the arrangement made under PURPA, by which QFs sold power to a local utility for transmission over the utility's transmission lines. Under the new approach, independents could contract to sell power to distant purchasers and use the transmission lines of several utilities (for a reasonable fee) to get the power to them.