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Structural change and the future of regulation.

I. INTRODUCTION

The papers contained in this special issue of Land Economics reflect the wide range of topics associated with the changes that are transforming both the public utility industries and the institutions of social control. Whereas in the past the public utility sector was viewed as a discrete classification of industries, juxtaposed between the public and private sectors, the current changes tend to dramatically reconfigure these industries and place many of their functions in the unregulated market. This paper will examine (1) why these changes have gained wide support, (2) special features of the new, market-oriented public utility model, (3) the need to reconsider public utilities as tight oligopolies within the context of the structure-conduct-performance paradigm, (4) the adequacy of regulatory tools in dealing with the problems of oligopoly, and (5) options for regulatory reform.

II. PRESSURES FOR CHANGE

There appear to be six major factors which explain the widespread willingness to move from traditional regulation to the market-oriented public utilities model. The first is the impact of technological change on the provision of service. This is particularly true in telecommunications and electric power generation. In telecommunications, the advent of computers, satellites, fiber optics, digital switching, and new forms of wireless communications has had a particularly dramatic impact on customer usage patterns. The traditional distinction between local and long-distance telephone service is fast disappearing, as is the demarcation between voice, record, data, and video services. Comparable changes are taking place on the international scene as the conventional separation between local, national, and global communications is being eroded and integrated telecommunications usage readily transcends national boundaries. In electricity, the combined cycle, gas-fired turbine currently enjoys a comparative cost advantage over coal- and nuclear-fired base load generating units. This advantage is enhanced by excess capacity in base load supply and low fuel prices. As a result, combined cycle units have become cheaper to build and potentially cheaper to operate, thereby opening a new market for power generation.

A second factor promoting change has been the performance shortcomings of the established firms in telecommunications, electricity, and gas over the past 30 years. Without doubt, the corporate technostructure performed poorly on a number of occasions, demonstrating something less than superior planning and responsiveness to changing markets. For example, AT&T had the advantage of vertical integration and virtually complete control over the domestic communications market, yet it failed to exploit Bell Labs' invention of the transistor in 1947. It also failed to take the initiative in developing microwave transmission for long-distance communications. In electricity, poor planning in power generation led to cost overruns and excess capacity that were sufficient in many cases to deny the industry its status as least-cost supplier. Indeed, Forbes characterized the U.S., nuclear program as "the largest managerial disaster in business history" (Forbes, 11 February 1985, cover). In natural gas, poor pipeline performance in acquiring gas for the interstate market led to a period of shortages and curtailments. These difficulties were compounded by Federal Power Commission (FPC) adoption of take-or-pay contracts, minimum bills, and cost pass-throughs that shifted all risk to the final user. As a result, when conservation and the collapse of OPEC led to a period of oversupply, the FPC turned to price discrimination between core markets and industrial markets in a solution that was both painful and unacceptable to the courts.(1)

Third, there has been a general loss of consumer confidence in the ability of commissions to protect captive customers. As a consequence, consumer advocates turned to the promotion of competition as a constraint on retail prices whenever possible. In telecommunications the potential rivalry between local exchange carriers (LECs) and cable companies appeared to hold the promise of playing one against the other to lower local telephone rates. Furthermore, many consumers apparently believed that the recurrent price wars that have characterized airline service since deregulation in 1976 could be transferred to the public utility industries and thereby promote a pattern of lower prices.

The fourth factor promoting departures from traditional regulation has been the emergence of large customers seeking to exercise monopsonistic power. Roughly 15 percent of natural gas sales and electricity sales go to large industrial buyers having sufficiently strong bargaining power to get price concessions. In the case of natural gas, direct industrial sales also had the attraction of permitting the buyer to avoid pipeline transition costs, which were billed 100 percent to local distribution companies (LDCs) under Federal Energy Regulatory Commission (FERC) Order 636. In electricity, the 17 members of the Electric Consumers Resource Council (ELCON) account for 4 percent of the total U.S. load, giving them a powerful bargaining position. In interstate telecommunications, the 80-20 rule holds that 80 percent of business revenues comes from 20 percent of business customers, enhancing the ability of these users to get special discounts. When carriers or utilities have excess capacity, the monopsony power of these groups will be even greater.

A fifth factor is the change in attitude of utility management over the past five to ten years. The older concept premised on a commitment to provide reliable service at just and reasonable rates has given way to a bottom-line, profit orientation. Management sees the utility as a cash and profit center capable of fostering diversification into new domestic and international markets. At the same time, management believes that regulation no longer provides a safeguard against competition. Interestingly, the drive for diversification applies to both deregulated firms in the U.S. and privatized firms in Great Britain. British Telecom (BT) and British Gas are prime examples of enterprises that have moved to establish an international presence.

Finally, regulatory agencies and their supporters have been less than successful in establishing public acceptance of a new role for social control in the face of changing market structures. A highly vocal, politically active group of neoclassical economists has built up strong arguments purporting to show that the substitution of competitive markets for regulation will promote efficiency.(2) The commissions have been largely unsuccessful in countering these arguments. Instead they have relinquished more and more of their responsibilities as they attempt to define what their role should be in the face of growing criticism. This is particularly evident in the case of the Interstate Commerce Commission, which is confronted by almost certain abolishment.(3)

III. MAJOR FEATURES OF THE NEW MARKET-ORIENTED MODEL

In response to these pressures for change, FERC and the Federal Communications Commission (FCC) initiated major deregulation programs. These were reinforced by the Energy Policy Act of 1992 and will be further expanded by the pending rewrite of the 1934 Communications Act. In areas where federal authority has been limited, several states, such as California, have moved aggressively to promote competition at the retail level. The various deregulation programs that have been put in place (many of which are discussed in this collection) have four features in common. A review of these shared features provides an insight into both the strengths and weaknesses of the new model.

The first is the separation of the product from the network. Traditionally, a public utility service has been defined as a necessity where the supplier has the potential to set extortionist prices. Accordingly, regulation would be imposed on the supplier--without differentiating between the end product or service and the means of production. Under the new approach, much greater emphasis is placed on the consumer's freedom to choose a kWh, a therm of gas, or a telecommunications service from a variety of suppliers. As a result, the previous connection between the regulated firm and the service is broken. It now becomes the responsibility of the consumer to buy that product or service on the best available terms and to pay for that degree of reliability deemed appropriate.

Second, the network that still remains under regulation has been significantly diminished in scope and its obligation to serve is being narrowed. In electricity there is a strong move toward deregulated generation and the promotion of new entry into generation through exempt wholesale generators (EWGs). In natural gas, the regulated network is confined primarily to pipeline transmission and local distribution. It excludes gathering lines, storage, marketing, and, of course, gas production. These functions have been deregulated, spun off, or transferred to separate affiliates. In telecommunications, only the local loop and the central office switch appear to be viewed as part of the inherently regulated network, but even these are assumed to be vulnerable to bypass by competitive access providers (CAPs), or rival networks. Across the board, there is a clear movement toward narrowly defining the regulated network and, whenever possible, assuming that network prices can be constrained by market forces or yardstick regulation.(4)

Third, there is a strong tendency to shift what heretofore has been the utility's responsibility to provide reliable and adequate service to secondary markets. Buyers are now expected to look to independent marketers, resellers, brokers, and utility marketing affiliates to fulfill their individual needs. This is seen most clearly in natural gas, where the spot and futures markets allegedly give buyers an opportunity to hedge against price increases while producers or sellers are given an opportunity to hedge against falling prices. Furthermore, buyers must rely on direct contracting or secondary markets for transport capacity and storage. Small buyers will become almost completely dependent on independent marketers and brokers.

Fourth, the basis for regulation is shifting from cost-of-service to the direct fixing of prices in residual monopoly markets. The most obvious example is the pure price cap, where the existing price is indexed for inflation with a productivity offset, and there is no review of profits or underlying cost-of-service characteristics. Price regulation is assumed to provide a strong incentive for efficiency since a dollar saved goes directly into profits.

IV. VIABILITY OF THE MARKET-ORIENTED MODEL

The prospect for success of the new approach depends almost entirely on the level of competition that can be expected to emerge. If one assumes a reasonably smooth transition to workable competition, then the chances are good. If one assumes a transition to tight oligopoly, then the resulting markets will be flawed and a new form of regulatory oversight will be required. Given the high level of concentration prevailing in the public utility industries, the case for competition will depend on the applicability of contestable market theory or threat of potential entry. Shepherd (1984, 1995) and Reid (1987) have set forth conditions necessary for contestability to function effectively as a constraint on price discrimination, excessive profits, and the exercise of market power. Shepherd believes that entry must be free and without limit in all markets, the new entrant must be free to establish itself before the incumbent can make a major retaliatory move, and entry must be perfectly reversible. Reid adds that the potential entrant must be able to sell to the same customers served by the incumbent without hindrance, that the entrant's departure must be costless (i.e., sunk costs must be minimal), and the potential entrant must be able to base its pricing decisions on those prices charged by the incumbent before entry since it was assumed that exit is costless. Both Shepherd and Reid place great emphasis on the existence of sunk costs as a deterrent to easy withdrawal from the market.

In examining the applicability of potential entry, it is necessary to differentiate between the facility-based utility or carrier and the host of brokers, marketers, and resellers that utilize the network under a policy of mandatory open access. In natural gas, these marketers and resellers must compete with the marketing affiliates of the pipelines which provide merchant service. Either the marketer or the pipeline affiliate can provide a bundled offering of transport, storage, and gas supply, or a single service. During periods of excess transport capacity and an oversupply of gas, all of these players should be able to participate. The difficulty occurs when capacity is constrained and natural gas is in short supply. At that time, only the largest buyers (LDCs and industrial buyers), major oil companies, and pipeline marketing affiliates will be able to survive. The independent brokers and marketers would have to contract in advance for capacity and gas at market-based prices to assure their viability during such periods. Since virtually all of their business consists of short-term (30-day or less) contracts, it is difficult to see how they would be in a position to make such commitments over time. Furthermore, profits will undoubtedly be lower for these players during periods of excess capacity and oversupply, and it will be difficult for them to finance long-term commitments for transport and storage, or to acquire gas on the spot market to meet peak requirements. The prospects for marketers and brokers are also diminishing when the LDCs create their own marketing affiliates to buy and sell gas and capacity for their customers. In short, it is difficult to see how brokers and marketers can exercise a constraining influence on the practices of large pipelines, LDCs, and producers.

In electricity, the assumption might be made that cogenerators, which have low capital costs and high heat rates, might possibly serve as potential entrants. But they are vulnerable to promotional prices by electric utilities, fuel cost increases, exclusion from the network, the imposition of utility standby or back-up charges on prospective customers, and utility purchasing practices during periods of excess capacity. More sustainable are the EWGs, who construct combined cycle gas-fired power plants. However, these units are characterized by significant sunk costs and highly leveraged debt structures. In fact, the feasibility of EWG entry is dependent entirely upon long-term contracts with the purchasing utility which, in turn, permits a high proportion of debt financing. It should also be noted in passing that more than 50 percent of the new EWGs are constructed by affiliates of established electric utilities. The one area where contestability may be applicable involves the sale of off-peak power by brokers and marketers to large industrial customers. But this is only a form of niche competition which is hardly effective in constraining the market power of the incumbent firm.

In telecommunications, the prospects for potential entry would appear to be much greater because of the proliferation of rival networks. The difficulty is that rivalry between such networks, for example, cable versus local telephone, wireless versus landline, etc., violates the sunk cost requirement and can be better considered within a structure-conduct-performance (SCP) context. Nevertheless, potential entry by value-added carriers and resellers who purchase or lease capacity from the underlying network can still serve as competitors in retail markets. These entrants are counted by those who argue that AT&T faces 450 rivals in the long-distance market. The difficulty is that such resellers face the classic threat of a vertical price squeeze. They are vulnerable to an increase in network charges and a reduction in retail prices. Interestingly, AT&T does appear to welcome such firms when significant excess capacity, that is, dark fiber, exists. These brokers and resellers take capacity and sell it on a short-term basis with a clear recognition that they are not a part of the long-term picture.(5)

In each of the public utility industries it is evident that a form of bounded contestability exists in niche markets, but this is far from a satisfactory constraint on the pricing practices and profits of the incumbent firm--nor does bounded contestability satisfy the Shepherd-Reid conditions.

V. INCORPORATING PUBLIC UTILITY FEATURES INTO THE SCP PARADIGM

The SCP approach argues that market structure will influence conduct (behavior) and performance. Market structure is particularly affected by concentration, diversification, product differentiation, barriers to entry, and scale/scope economies. Conduct reflects, among other things, pricing, marketing, planning practices, and profit goals. Performance includes allocative, dynamic, and x-efficiencies, as well as equity and employment considerations. When concentration is high and reinforced by structural features, the SCP paradigm indicates that oligopoly will result. This, in turn, will suggest a pattern of conduct that reflects (1) a strong reciprocal interdependence between the actions of rivals (Fellner 1949; Scherer and Ross 1990); (2) continuing attempts to set prices that strive for industry-wide profit maximization--perhaps culminating in monopoly pricing without formal collusion (Chamberlin 1929; Rothschild 1947; Scherer and Ross 1990); (3) an incentive to monitor the actions of rivals to prevent cheating (Scherer and Ross 1990); (4) a propensity toward rigid prices (Blair 1972; Fellner 1949), limit entry pricing (Bain 1956), and price leadership (Markham 1951); and (5) bilateral bargaining between few buyers and few sellers (Fellner 1949). Items (4) and (5) require elaboration. Price rigidity typically means that prices will be maintained while output will fall when demand declines. Limit entry pricing, as distinct from predation, does not attempt to destroy rivals, but rather to foreclose new rivals in an effort to move toward long-run profit maximization. Price leadership may arise in the absence of any type of formal collusion--especially when the industry is tightly oligopolistie, sellers' products are close substitutes or output is homogeneous, cost curves are similar, demand is inelastic, and barriers to new entry exist. Bargaining will determine the distribution of industry-wide profits between players and it will be influenced by each participant's ability to take and inflict losses. Firms possessing superior cost advantages or better marketing practices will have relatively greater bargaining strength.

Variants of these forms of oligopolistie conduct will take place in public utility industries whenever inherent economies promote concentration, but such conduct will also be influenced by the requirement that it accommodate these economies. Networks will tend to be large relative to the size of given markets when there are significant economies of scale, scope, joint production, and pooled reserves in network design and operation (Trebing 1994). This, in turn, will lead to high market concentration and tight oligopoly with a typically greater degree of freedom in setting prices, defining markets, and investing in services. In addition, the incremental cost of new services will be low so that the incumbent is placed at an advantage relative to new entrants. However, to be successful, these network economies must be matched by full utilization of capacity which necessitates high load factors, high diversity factors, high capacity factors, and a strong growth in demand. Accordingly, management will be confronted with a balancing act that requires juxtaposing plant capacity, new investment, demand configuration, and demand growth. Achieving this balance will require both a minimum efficient market share and adroit pricing and marketing practices. Failure to achieve full system utilization will result in rising unit costs and the familiar "death spiral."

The market structure for public utilities also reflects consumer groupings that are readily differentiated. Customers may be classified on the basis of residential, commercial, and industrial usage or on the basis of firm and interruptible usage. There is clear evidence in the field of railroad transportation that market differentiation and differential pricing will persist even in the absence of regulation (Kwon, Babcock, and Sorenson 1994). When the differences between markets cannot be erased by arbitrage, the stage is set for price discrimination and cross subsidization.

The conduct of oligopolists will also be affected by the comparative advantage that each firm enjoys at its place in the production and distribution process. This may involve control of monopoly focal points, such as the local loop, extra-high-voltage transmission grids, or proximity to low cost gas reserves. On the other hand this comparative advantage may arise because of size, preeminence in a particular market, and attendant network coverage. For example, AT&T has over 1,000 points of presence for its nationwide network, and its large market share (60-65 percent) permits it to take advantage of open access arrangements and discounts in access pricing in a fashion that would not be readily available to new entrants. This, in turn, gives it superior bargaining power in dealing with rivals and garnering a major share of joint industry profits.

The general characteristics of oligopoly behavior will be considered within the context of the structure of public utility industries. With respect to interdependence--that is, the actions of one firm initiating a major response from a rival--there are numerous domestic and international examples in telecommunications. AT&T's acquisition of McCaw Cellular for $11.4 billion in 1994 triggered a response on the part of rival Sprint. Shortly afterward, Sprint and three major cable companies (TCI, Comcast, and Cox) announced the creation of a joint venture to provide comprehensive nationwide wireless communications. Similarly, the anticipated entry of cable companies into local telephone service has initiated an aggressive response on the part of LECs to provide video-dial-tone and broadband services in their local telephone markets. Perhaps the most dramatic example of interdependence arose when AT&T announced the formation of "World Partners," which included alliances with telephone systems in the Pacific Rim (Singapore, Hong Kong, and Japan's Kokusai Denshin Denwa), as well as alliances through Unisource in Europe that included systems in Holland, Sweden, Switzerland, and Spain. The objective was to establish a community of interests between AT&T's comprehensive international network and various national networks. This move initiated a prompt reaction on the part of other carriers. British Telecom purchased 20 percent of MCI for $4.3 billion to facilitate establishment of a global network. France Telecom and German Telekom announced plans to purchase 20 percent of Sprint for $4.2 billion to create jointly owned European and global networks. Thus, AT&T's initial action triggered a matching reaction by rivals not wishing to be excluded from the global market. An intriguing consequence was to move the structure of international communications toward an even tighter oligopoly. The same tendency toward concentration is evident in power generation. As soon as Mission Energy (an affiliate of Southern California Edison) became the largest entrant into the EWG market, other established utilities found it advantageous to enter this field, thereby significantly diminishing the share of the market served by autonomous independent generators. Interdependent actions would appear to promote tight oligopoly in the public utility field.

Pricing conduct directed toward industry-wide profit maximization without implicit collusion appears to be more closely identified with power pooling arrangements and the establishment of joint telecommunications offerings over disparate networks. In each case, firms will have to meet and agree upon standards for service, cost reimbursement, and the division of revenues. This would set the stage for an implicit recognition of programs designed to maintain a target level of industry-wide profits. Insofar as collusive behavior is concerned, one of the few known examples is Project Acorn,(6) in which AT&T and the Regional Bell Holding Companies (RBHCs) met secretly for more than a year to see if they could agree upon a mutually acceptable basis for promoting the removal of restrictions placed on the RBHCs by the Consent Decree (particularly their entry into long-distance markets). The project collapsed, suggesting that agreements to allocate markets may be difficult to negotiate.

Behavior designed to monitor cheating would seem appropriate in the public utility industries where the product is essentially homogeneous. The pooling arrangements and joint services just described would permit such oversight, but perhaps the best example occurred in MCI v AT&T (1994). The FCC had previously held that AT&T was the only dominant carrier in the long-distance market and that permissive detariffing of MCI and Sprint was appropriate. AT&T argued that both MCI and Sprint should be required to file tariffs in a prompt fashion. The Supreme Court agreed, and as a result AT&T will now have full information on the prices filed by rivals for all tariffed services.(7)

With respect to rigid pricing and price leadership, it is necessary to recognize the role of differentiated markets. There is empirical evidence of price leadership in the long-distance market, where AT&T acts as the leader to be followed by MCI and Sprint.(8) Indeed, the Supreme Court recognized this possibility in the MCI case, noting that full reporting by MCI and Sprint might facilitate price leadership.(9) However, price leadership appears only in the traditional tariffed services and not in the rates negotiated with large industrial buyers. In those areas, bilateral oligopoly, not price leadership or rigid prices, appears to prevail. A further factor weakening a policy of overall rigid prices in public utility industries is the need to promote high load and diversity factors which mandate that prices adjust to differences in service between firm and interruptible or peak and off-peak customers.

With respect to limit entry pricing, there is no doubt that in electricity the so-called industrial attraction rates, market retention rates, and promotional rates are designed by incumbent utilities to set low prices that will foreclose customer switching to EWGs, cogenerators, or self-generation. Comparable practices exist when communications networks charge low incremental rates after plant modernization has been excluded from an estimate of incremental cost. Such practices among oligopolists will undoubtedly foreclose a new generation of entrants.

Bilateral bargaining between few buyers and few sellers is prevalent in the utility industries. The results are apt to be determined by relative bargaining strength and are indeterminant within broad limits. Electricity, gas, and telecommunications are replete with such arrangements. An excellent example is provided by dealings between AT&T and the RBHCs. AT&T would like to bypass the RBHCs' tandem switch and interoffice transport by taking advantage of collocation. AT&T would also like to exploit its high-capacity DS3 capability to get as close as possible to the end office or to reach large buyers. Both steps would reduce AT&T's cost of access. With open access, AT&T's dominant position would permit it to acquire a lion's share of a local office relative to other interexchange carriers (IXCs). As a bargaining chip, AT&T would have the option of turning to competitive access providers whenever possible. It is vulnerable in that it is totally dependent upon the RBHCs' local loop to reach a majority of final customers. On the other hand, the RBHCs control the local loop and the central office. They also do all of the billing for AT&T, control customer numbers, and control the 800 data base. The RBHCs are vulnerable to mandatory collocation, number portability, and competitive bypass. Given the bilateral monopoly nature of these bargaining transactions it is difficult to understand why Cave (1994, 221) looks favorably upon the determination of access prices by the bargaining process.

A final structural feature not typically included as part of general oligopoly theory is the vulnerability of the holding company concept to manipulation. The holding company becomes an organizational form, for integrating utility and affiliate properties. By combining the utility and the affiliate, the composite cost of capital is lower than that which would prevail in the nonregulated market, thereby providing an incentive for diversification. The holding company format also permits participation by affiliates in sales to the utility or in marketing its products.

VI. THE CONSEQUENCES OF OLIGOPOLY

There appear to be at least four major effects of oligopoly on industry performance. One of the most significant is that prices will no longer necessarily track costs. Given the structural features previously discussed, there will be a strong incentive for price discrimination, cross-subsidization, and risk shifting. Furthermore, cost reductions will not necessarily be translated into across-the-board price reductions under tight oligopoly. An example from telecommunications illustrates this point. Before 1990 the FCC flowed through lower access charges by the RBHCs to the consumer through lower IXC prices, but when price caps were introduced in 1989 for AT&T, this flow-through was no longer strictly enforced. Between January 1990 and January 1994, access charges by the RBHCs were reduced three times, but AT&T raised its price six times, MCI raised its price three times, and Sprint raised its price six times (Bolter 1994, chart 10). This pattern of behavior is especially significant since access charge payments account for approximately 40-50 percent of IXC costs.

Another example where cost savings may not be flowed through to the final consumer arises with deregulation of EWGs. The EWG will sign long-term contracts with electric utilities. This has the practical effect of rate basing their plant for the life of the asset, and since it is then placed beyond the control of the state regulatory agency, the commission is not able to apply a prudence, used-and-useful review should the plant no longer be the least-cost source of supply.

A second consequence of tight oligopoly relates to the distribution of the technological dividend, as measured by the difference between the imbedded cost of old plant and the incremental cost of new services. When the incremental cost (or perhaps stand-alone cost) of the new plant is substantially lower, the oligopolist will be under little pressure to pass this forward to markets where demand is relatively inelastic. This will be reinforced if patterns of price leadership or conscious parallelism prevail. On the other hand, those markets that are demand inelastic are more apt to be expected to bear the amortization of stranded investment arising from deregulation. In effect, the more elastic markets will receive the lower incremental cost of new plant, while the write-off of old plant will be assigned to inelastic markets. In the Cajun decision (1994) the D.C. Court of Appeals was extremely critical of FERC's willingness to permit the stranded cost of generation to be assigned to the transmission function (where demand was most inelastic and monopoly power strongest); the Court condemned this practice as nothing more than a tie-in sale.(10)

A third result of tight oligopoly is the prospect that profit levels will be higher than those which would have prevailed under competition or stringent rate base/rate-of-return regulation. The pattern of market-to-book ratios for all of the major utility industries strongly suggests that this has been the result of partial deregulation in oligopolistic industries.(11)

Finally, there is the inherent conflict between the type of public utility network that is apt to emerge under tight oligopoly and that which is required if the network is to serve as an integral part of the nation's infrastructure and as a platform for promoting the general growth of productivity and income. The network is a form of commons and the societal goal should be to permit the greater participation of everyone in this facility, with prices reflecting the costs for which each user is causally responsible. The danger is that the discretion inherent in tight oligopoly will make the design and planning of the network more responsive to the monopsony power of the large user, or to the strategy of the incumbent firm as it seeks to enter new markets.

VII. HOW ADEQUATE ARE THE NEW REGULATORY TOOLS?

The first modern price caps were introduced in Great Britain in 1984 for British Telecom, and were followed by British Gas in 1986, and electricity transmission and distribution in 1990. Price cap regulation was established for AT&T in 1989 and for the RBHCs in 1991. Essentially, price caps are designed to constrain price increases in markets with residual monopoly power while providing an incentive for efficiency. They are largely ineffectual in constraining price leadership, conscious parallelism, limit entry pricing, the retention of cost savings greater than the productivity offset, and assuring an equitable distribution of gains from technological advance across all classes of consumers. In fact, price caps may tend to reinforce the oligopolist's propensity for rigid prices for tariff services since they do nothing to compel experimental price reductions in markets that are perceived to be demand inelastic. It is also clear that price caps may do little to constrain oligopolistic price manipulation between services within a given market basket--particularly when one of the services is monopolistic. This is evident in the RBHC market basket for switched services, where the rates for interoffice transport are low, reflecting a potential loss of traffic, while rates for switching are high, reflecting a greater degree of monopoly.

Price caps are also difficult to manipulate or administer if the objective is to establish performance standards for oligopolistic firms. At most, the regulatory agency can proceed as Oftel did by raising the productivity offset from 3 percent in 1984-89 to 7.5 percent for 1993-97 in the face of continuing dissatisfaction with BT's quality of service and high earnings. Similarly, the California Commission sought to hold Pacific Bell to a given standard of performance by raising the productivity offset from 4.5 percent to 5 percent in 1994 in the belief that this would establish a performance goal or target for which the company should strive. In either case, the productivity offset is an awkward approach for coming to grips with the problems of oligopolistic conduct.

However, there still remains the question whether a shift to price-based regulation (as embodied in price caps) has a discernible affect on industry performance. Unfortunately, empirical research to date presents conflicting results and it is not possible to make a clear cut case for the argument that abandonment of rate base/rate-of-return regulation in favor of direct price-based regulation will enhance performance.(12)

Interconnection is also a major tool of the new market-oriented public utility model. The assumption is that mandatory interconnection will maximize consumer choice and negate the exercise of market power. There are a number of problems with this approach. First, interconnection must afford consumers an opportunity to combine all relevant services if a rational decision is to be made on the basis of price, quality, and reliability. In telecommunications this means going beyond interconnecting with the LEC, to embrace interconnection between all types of landline and wireless networks. But even this may be irrelevant if most small volume consumers prefer to minimize transactions costs by purchasing bundled service. There appears to be growing evidence that bundled offerings are growing in popularity in the natural gas industry since consumers show a preference for one-stop shopping rather than separate negotiations for blocks of gas, transport, and storage. A form of rebundling is also taking place in telecommunications as AT&T offers outsourcing (or consolidated private network management) to large customers.

Interconnection, of course, cannot be divorced from interconnection pricing and network pricing. but even if these two problems can be resolved, there still remains the less obvious question of the market power inherent in the management and ownership of the network. This is most evident in the power pool or the grid. In this case, control of the grid becomes the monopoly focal point and the administration of the grid the means for exploiting that advantage. But the same problem is also inherent in the collective interties and transfers between natural gas systems. The network cannot be administered by agreement among private parties; rather there must be complete transparency so that all parties utilizing the network become involved in planning the network arrangement. The Wisconsin Commission's planning model, whereby the power grid is treated as a natural monopoly with shared risk and open access to all parties, could serve as a prototype for such an approach.

Finally, open access cannot be divorced from the impact of dominant players for whom the network becomes a vehicle for enhancing market power. This is evident in Great Britain, where two generating entities control 72 percent of power sales to the grid,(13) and it is potentially evident in U.S. telecommunications where AT&T by its size can preempt collocation and access to local network data far more effectively than its smaller rivals and any potential entrant.

VIII. OPTIONS FOR REFORM

Regulatory intervention designed to incorporate SCP reforms would focus on the network as the centerpiece for providing adequate service. Essentially, it would involve an expansion of the network as an integrated infrastructure rather than a restriction of the network as currently advocated. The goal would be to achieve all inherent network economies while minimizing the transactions costs associated with the management and use of the network.

In electricity, the network would not be confined to a passive role since transmission is integrally tied to least-cost generation and distribution. In those cases where transmission is a superior substitute for additional generation, the network must be free to expand. In those cases where centralized dispatch and operation of the network require control over all generating units, regardless of ownership, the network must have this authority in order to apply the equimarginal principle for loading units. In addition, the network must be free to accept or reject power from individual units and to decline power from those which are no longer low-cost suppliers. In natural gas, there could be a potential conflict between the management of the network and the user's right to contract for transport and storage. To the extent that individual contracts give rise to transaction costs by fragmenting the network and thereby reducing overall capacity to serve everyone, the management of the network must supersede all user rights in order to assure least-cost flow routing and the scheduling of storage.

Since these steps would vest significant authority in those operating the network, network planning and administration would have to be completely transparent, with full participation on the part of all users in decisions regarding oversight and governance. Networks would have common carrier status, access would be cost-based, and interties between separate systems should be mandatory--with the scope of the network limited only by evidence of diminished network economies.

The problem of defining the fundamental network in telecommunications is complicated by the prevalence of well-established, individual entities that often provide duplicative and parallel service. Two steps would seem appropriate toward developing an efficient network infrastructure. The first would be mandatory interconnection between different systems to give consumers access to complementary forms of telecommunications (e.g., wireless and landline). The second would involve regulation of conduct to prevent umbrella pricing designed to protect inefficient suppliers. According to Huber (Huber, Kellogg, and Thorne 1993), AT&T may be applying umbrella pricing to shield rivals for fear that capturing most of the long-distance market would bring about further antitrust action or a reinstatement of traditional regulation of prices and earnings.

Establishing the primacy of the network as a point of reference also requires proper costing and pricing of the network. Assigning all fixed costs on a peak responsibility basis, such as FERC's application of the straight fixed variable concept for pipelines, may have the effect of forcing consumers to utilize off-peak service, but it penalizes firm requirements consumers by failing to recognize that all users benefit from network economies. A much preferred alternative would involve application of the Glaeser model (1939) in which costs are causally assigned to those customers in direct proportion to the benefits that they derive from use of the network. This involves a comparison between the cost of the next best alternative and the cost of using the network. The Glaeser model would have the advantage of eliminating uneconomic bypass of the network and providing a strong incentive to maximize use of the complete network--especially when service can be provided under conditions of increasing returns to scale.

The Rochester Plan provides the framework for incorporating much of this approach to treating the network as an integrated whole. Under the Rochester Plan (approved by the New York Commission for Rochester Telephone in 1994), the network remains under regulation with an obligation to sell comparable service to all buyers on equal terms. It also has an obligation to provide basic service to those who demand it, and it is structurally separated from a deregulated marketing affiliate which is able to buy and sell all forms of communications services. The network has its own debt financing and its own board of directors. The New York Commission can impose full reporting requirements on the network to assure that investment and quality of service are maintained. The deregulated marketing affiliate of Rochester Telephone is free to buy from the network or from any other source of supply--thereby inducing the threat of bypass as a stimulus for network innovation and efficiency. All IXCs, resellers, and brokers would have the same bypass option and would be treated by the network on comparable terms with Rochester's marketing affiliate.

This innovative approach to realizing all of the economies inherent in the network while giving the marketing affiliate freedom to promote new service offerings could be readily adapted to electricity and gas. It would assure provision of basic service by the underlying network or as part of a package of deregulated services. It would also lend itself to network pricing of the type embodied in the Glaeser model.

Regulatory reform would also have to come to grips with the structural issues inherent in affiliate transactions and the operation of secondary markets. Affiliates should be subject to strict separations as in the Rochester approach. Where affiliate transactions appear to represent the exercise of market power to exploit equal access or to gain an advantage from noncompetitive transactions, then regulation should consider application of the ban against affiliates contained in the Hepburn Act of 1906. Market concentration in secondary markets would have to be monitored on a continuing basis with a measure such as the Landes-Posner or Hirschman-Herfindahl indices. There is a strong possibility that future and spot markets may be shallow in the sense that there are few players and these markets could be vulnerable to manipulation by marketing affiliates of pipelines, major oil companies, and others. Market concentration among major oil companies on a per-field basis in natural gas would likewise have to be monitored--particularly since the ten largest producers control 70 percent of proved reserves.

With respect to conduct, the proposed regulatory model could deal with price leadership by adopting the bellwether approach. That is, the prices of one oligopolist could be brought into line with costs and others would be certain to follow. With respect to limit entry pricing, regulation could establish standards for minimum prices and anything below that could be shifted entirely to the shareholders. Finally, with respect to rigid prices in inelastic markets, the network could mandate retail price experimentation and price reductions whenever justified. In this fashion the network could serve much like TVA does in monitoring the behavior of the retail distributors of TVA power. In examining the relationship between structure and the exercise of market power, regulation in this setting would have the advantage of considering market power in a holistic structural context rather than going on a case-by-case basis to determine whether an individual firm had the ability to raise prices in a specific situation.

Insofar as performance criteria are concerned, regulation could monitor the entire industry in terms of the attainment of social policy goals such as universal coverage, conservation, and the maintenance of environmental safeguards. Such policies are best administered through the network under regulatory surveillance. Where subsidies are required, they could be imposed as a surcharge on all classes of consumers. This approach would appear to embody Tool's (1990) concept of progressive regulation.

It is difficult to speculate on the prospects for regulatory reform based on SCP. It would certainly be strongly opposed by those who stand to gain from the current deregulation movement and those who believe that a hands-off policy is synonymous with competition. However, the concept does deserve closer scrutiny by institutional economists in particular, for as Mason (1957, 60) advised, the study of oligopoly is the "ticket of admission to institutional economics." (1) For a critical review, see U.S. Court of Appeals for District of Columbia, Maryland People's Counsel v Federal Energy Regulatory Commission, et al., Nos. 84-1019 and 84-1090, May 10, 1985. Also see paper by Gorak and Ray (1995) in this collection.

(2) For example, see: Poole 1985. Interestingly, the new market-oriented model for partial deregulation gives no credence to one of the fundamental neoclassical arguments for bypassing regulation, notably that auctioning the monopoly facility can serve to control profits without direct regulation. For the original explanation of this form of auctioning, see, Harold Demsetz, "Why Regulate Utilities?," Journal of Law and Economics 11 (April 1968):62.

(3) For what may be the ICC's last testimonial, see: Interstate Commerce Commission, Study of Interstate Commerce Commission Regulatory Responsibilities, Washington, DC, October 25, 1994. The ICC advocates retaining independent agency regulation over railroads and commodity pipelines. (Gas and oil pipelines are regulated by FERC.) It would eliminate virtually all regulation of trucking, water carriage, and statutory restrictions on rail control of motor and water transport, but with some oversight of potential intermodal abuses.

(4) FERC staff has suggested yardstick comparisons between pipeline transport rates when more than one pipeline serves a pair of points. For example, Louisiana to Tuscola, IL and Leidy, PA. However, market concentration (measured in daily capacity) still remains extremely high. The top two pipelines have 82.6 percent of the former, and 76.3 percent of the latter. See: Federal Energy Regulatory Commission, Report of FERC Pipeline Competition Task Force on Competition in Natural Gas Transportation, Washington, DC, May 24, 1993.

(5) This is particularly true for international networks where small, fast-growing companies buy up "dark fiber" at wholesale rates and resell it to selected customers at substantial discounts. When AT&T, Sprint, and MCI eventually move into this segment of the retail market, these resellers will simply move into other areas. Resellers include USA Global Link, Flash Telecommunications, and International Discount Telecommunications.

(6) Project Acorn involved secret meetings between AT&T and the seven RBHCs for approximately one year aimed at an agreement on terms for urging the federal court to dissolve the Consent Decree. See: Keller, J. J.,and D. Neale, "Battle Lines Harden as Baby Bells Fight to Kill Restrictions," Wall Street Journal, July 22, 1994, A-1, A-4.

(7) MCI Telecommunications Corp. v American Telephone and Telegraph Co., Nos. 93-356 and 93-521, reported in United States Law Week, 62LW4527, June 14, 1994.

(8) For a general discussion of price leadership patterns and attendant rates of return for intrastate / interLATA toll traffic after deregulation, see: Loube and Pilalis 1994. For a continuing study of intrastate price leadership patterns after interLATA toll dereguration in Virginia, see: Virginia State Corporation Commission, The InterLATA Market in Virginia, quarterly reports prepared by the Division of Economics and Finance, VSCC.

(9) Footnote 7, supra, at 62LW4532. (10) FERC had authorized Entergy to recover stranded investment because of an open access transmission tariff that allegedly mitigated Entergy's market power in transmission. The U.S. Court of Appeals held that this form of recovery was a tying arrangement, since losses incurred when a generating capacity customer goes to a competitor will be recovered through a charge to the same customer when using Entergy's transmission grid. The charge for transmission "will include not only costs directly associated with it, but also the cost of Entergy's generation capacity idled by the switch." See: U.S. Court of Appeals for District of Columbia, Cajun Electric Power Cooperative v Federal Energy Regulatory Commission, No. 92-1461, July 12, 1994, p. 9.

(11) The traditional measure of an acceptable level of profits under regulation was a market-to-book ratio of 1.05-1.10. AT&T's market-to-book ratio averaged 1.05 between 1969 and 1978. For the twelve months ending June 1994, MB ratios were 1.32 for electrics, 1.33 for combination electric and gas utilities, 1.88 for gas pipelines, 1.49 for LDCs, and 2.65 for telephone companies. (AT&T was 4.87.) C.A. Turner Utility Reports, September 1994, Moorestown, NJ.

(12) Three papers presented at the 26th annual conference of the Institute of Public Utilities, Michigan State University, at Williamsburg, VA, on December 12-14, 1994, set forth the conflicting findings. Lawton et al. conclude that the type of regulation is not an especially important determinant of how much telecommunications infrastructure investment will take place. Montgomery concludes that LEC gross plant additions and access line growth were lower in states with alternative regulation (i.e., price caps and incentives). Greenstein, McMaster, and Spiller conclude that price regulation (particularly price caps) had a stronger beneficial effect on LEC investment in new technology than earnings-sharing schemes.

(13) Under pressure from the regulatory agency (Offer), the two privatized power-generating entities agreed to sell off 10-15 percent of their capacity to increase the number of suppliers. At the same time regulators compelled a price reduction of 7 percent for generation sales, with price caps imposed. See: M. Smith, "Generators in Deal to Sell Plant and Reduce Prices," Financial Times, February 12,1994, p. 1.

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The author is professor of economics, emeritus, Michigan State University, East Lansing.
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Title Annotation:Special Issue: Public Utilities Regulation
Author:Trebing, Harry M.
Publication:Land Economics
Date:Aug 1, 1995
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