Chapter 12: Natural Monopoly Regulation

Natural monopoly industries: natural gas distribution, electricity distribution, in some cases water distribution, and to a rapidly diminishing extent, local telephone service.

Federal regulatory agencies: FERC regulates interstate wholesale electricity and natural gas transactions. FCC regulates interstate telephone service. States regulate intrastate electricity, natural gas, telephone industries through public utility commissions.

Regulated firms apply for rate increases, and these applications are heard by the relevant agency in a manner similar to a court proceeding, including expert witness testimony by economists and others.

Traditionally, natural monopolies subject to public utilities-style regulation can recover allowed expenses (such as the costs of producing the good or service), and a return on prudent investment, through the rate structure.

Once a new rate structure is set by the regulatory agency, it typically remains in force until a new rate hearing.

A big question has to do with the firm's expectations of how the next rate hearing will go. It used to be more common than it is today for a firm to be able to justify large (though perhaps dubious) capital expenditures to the regulatory agency, implying that rate payers would absorb much of the financial risk associated with questionable projects. The case of nuclear in California is prominent; rate payers will be paying a special decommissioning fee for failed plants (Humboldt). The case of Diablo Canyon, in which PG&E was required to absorb 4/5 of the capital costs, provides an example of a tougher stance based on alleged poor management decisions (you can see how cozy relationships between government and business can lead to financial disasters a la the Asian Contagion). This is the agency problem revisited. If the regulatory agency can credibly commit to a price cap, then the regulated firm will have an incentive to move toward being more economically efficient.

How does one value the capital investment of a public utility? One relatively less controversial way is to value the capital at original cost less depreciation. This valuation method tends to bias rates in favor of consumers since inflation raises the current or replacement cost value of the capital. This is good for the consumers today, but when the firm must replace plant and equipment, consumers will experience a discrete jump in rates because the firm has not been able to fund the investment with retained earnings.

Once capital investment is valued, the firm and the regulatory agency can negotiate a rate of return on that capital. The essential economic element here is that the rate of return must reflect the (risk-adjusted) opportunity cost of capital.

Federal Power Commission v. Hope Natural Gas Company (1944): rates should be set to enable the company to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risks involved.

If the rate of return is set below the risk-adjusted opportunity cost of capital, then the value of the firm will decline (as reflected in the decline in the PDV of dividend earnings on equity capital) because existing equity investors are not being adequately compensated for the risks (and thus the equity market will reduce share prices), or bond markets will assign a higher default risk (diminished financial integrity) and thus demand a higher interest rate on borrowed capital.

Sliding Scale Plan (Joskow and Schmalensee): Incentive regulation…

Ra = Rt + h(R*-Rt)

Where R* is the target rate of return, Rt is the actual rate of return based on the initial rate schedule at time "t," and Ra is the actual rate of return after the sliding scale plan adjusted rates. "h" is commonly a fraction between 0 and 1, where if h = 0 all risk is borne by the firm and rates are fixed, and if h=1 then the rate structure is essentially a cost-plus arrangement whereby all risk is borne by rate-payers. Thus at h = 0.5 there is an equal sharing of risk. Sliding scale plays a minor role in regulatory practice.

Price Caps and Performance Standards:

Increasingly the way that agencies are regulating natural monopolies. Note textbook observation that this is how recently privatized gas, telephone, and water utilities are regulated in Great Britain, and telephone service in Canada (as of March 1998). Price-cap has also been recently used by the FCC. The purpose of price-cap regulation is to create the credible precommitment by the regulatory agency to a cap on prices so that the firm has a meaningful incentive to pursue profit by lowering cost rather than by increasing capital investment.

Example: Since 1989 the FCC allows AT&T to raise its prices no more than the rate of inflation minus the anticipated rate of productivity gains in the industry. More common is to have declining price caps, reflecting the rapid pace of innovation, particularly in telecommunications.

Complications associated with price-cap regulation include preventing firms from raising profit by reducing quality, and pricing for multiple products.

A closely related regulatory approach is called rate-band regulation, in which firms are allowed to raise or lower their prices within some band without regulatory intervention for either monopoly power or predatory pricing.

Averch-Johnson Effect: The failure of economic efficiency that occurs under rate-of-return regulation when the risk-adjusted rate of return is set above the opportunity cost of capital. The obvious problem is that the firm has an incentive to overinvest in capital, leading to higher average costs. A-J assumed that other inputs (such as labor) were costed out as expenses. A-J effects were more likely to have occurred prior to OPEC-spurred inflation in the US, when rates (and rates of return) were more closely monitored than before.

Fully Distributed Cost Pricing: Regulatory agencies must figure out how to use a rate structure to recover variable and fixed costs. Some fixed costs are common to multiple products or services. A common way to do so is to set so-called fully distributed cost prices. There is no reason to believe that the way that regulatory agencies set FDC prices will either reflect efficient two-part tariffs or efficient Ramsey prices. FDC pricing also creates disputes among different customer classes over what is the appropriate way to distribute costs (example: residential vs. Large industrial consumers of electricity and the common costs of nuclear plant deconstruction, distribution network, etc.).

Peak-Load Pricing: The marginal cost of providing energy tends to be higher during peak demand periods. One reason is that most costly "peaking facilities" must be brought on line. The difficulties of assuring reliability (i.e., no blackouts) rise with peak demand. Thus serving an electricity customer during peak periods implies higher marginal costs than during off-peak periods. Peak-load pricing is a way to have a pricing scheme that more closely approximates allocative efficiency by having higher prices during peak periods, and lower prices during off-peak periods. The effect is similar to congestion pricing, where the marginal user of highway and bridges, mainframe computers, public transportation, and telephone service during high use times imposes a congestion cost (a negative network externality) on other users, and so one can internalize these congestion externalities by charging higher prices during times of congestion.