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Yesterday's gone: the risk associated with tomorrow's electric utility infrastructure.

Public utility regulation has entered a new phase. Today, the principal concerns facing utilities and their customers are coping with competition, allocating risk and deploying new technologies. The regulatory framework for this new phase, however, remains unclear and is filled with uncertainty. Much of that uncertainty revolves around choosing an infrastructure for the industry and an architecture for regulation. This means making fundamental technological choices centered around the fact that a public utility's mass market does not exist and it is becoming more difficult to design a system that will optimally support services with many different requirements. In this environment, the questions become, who decides which choices are to be taken and when are these choices to be made? But before we can even ask these questions, shouldn't there be a better appreciation of the paradigm in which these choices are made?

The old public utility infrastructure was designed to provide mass market service. Today's infrastructure is becoming more specialized. This fundamental shift in capability has not been matched by a shift in regulatory thinking.

A comparable example of how past thinking creates future problems is found in the "arms race." Like public utility assets, weapons procurement is based upon spending in the present in order to be prepared for the future. As a consequence present-day planners make forecasts without quite knowing what will happen in the future. Since, their only experience is with the past; sometimes their predictions are right; sometimes they're wrong. It is not an exact process. The role of the regulator in this drama is similar, he or she is suppose to make decisions that make societal and economic risks more manageable. Today, however, the regulator's role has taken a terrible tangent and evolved into the assignor of fault, and like the oracle at Delphi, their ability to influence events does not depend upon the clarity of their pronouncements, but upon, how their words are interpreted in the mass media.

Like deploying new weapon systems, building public utility infrastructure is a costly task. Once costs are undertaken you pay whether or not you have correctly anticipated the future. Sometimes, who pays and how much you pay differs, but payment is nevertheless required. The intent of the process is to plan for the needs of the future, not allocate the costs. A historical example of my point can be found in the Washington Naval Conference of 1921.

On the eve of World War I, Congress passed the "Big Navy Act of 1916." The purpose of the Act was to make the U.S. Navy second to none. An admirable goal for a nation on the brink of war. But also one that committed this nation to using military force and the battleship as an essential part of our foreign policy. That commitment cost million of dollars and did upgrade the fleet. It also led to other nations accelerating their investment in battleships. All of this construction proved beneficial in war time, but at war's end a new reality emerged. Public opinion did not support building a new battleship every year, it did not support a global perspective and it would not pay for any foreign involvements.

This shift in pubic attitude lead the United States and other nations to think about reducing their fleet construction. At the Washington Conference the countries thought they could regulate battleship competition. People were convinced a gentlemen's agreement could be reached and that arms competition could be regulated. The Conference proved to be a self-fulfilling prophecy. It was a huge success. A formula for new battleship construction was reached and peace prevailed. History, however, remembers the conference in a different light, not as a great step toward peace, but as an event that contributed to the overall false sense of security that prevailed between the World Wars.

This lesson of history is something we should all keep in mind, you can't regulate competition and you can't predict the future.

Deploying any new technological infrastructure in a free market creates risk, that risk is usually allocated among those that risk deployment. Like any new venture, technological deployment should be premised upon some sense of "vision" of the future and a plan. Your plan, however, really depends upon what you are willing to risk.

In the movie, "Field of Dreams" a farmer decides to build a baseball field on his land because he had a "vision." His plan was simple, plow down the crops and build a baseball diamond. Such stories provide a real inspiration for "vision," but upon closer examination, what is the real issue? Vision is not the issue. Planning is not the issue. Who bears the risk is the issue. The key factor in most undertakings is the allocation of risk. Since the farmer owned the land, he clearly realized the risk of taking it out of production. Ownership provides you with the ability to put your own assets at risk. You then reap the rewards or suffer the consequences of your "vision" and planning. Ownership, I submit is the essential and overlooked element in the allocation of risk. Only those that take a personal risk can really appreciate its undertaking. Visions and plans do not require risk, ownership does.

Recent theories on management have adopted this ownership component to risk taking. Companies under the competitive gun, keep demanding productivity gains and greater resourcefulness from their managers. Managers in such an environment are required to think like owners. This provides an incentive for action and the responsibility for success or failure.

The premise for rate-of-return regulation, however, is not ownership but the "obligation to serve." Traditionally, utilities undertook capital development not because of innovation, technological advances, or economic development, but because they had an "obligation to serve." The unwritten regulatory bargain was that utilities would address their "obligation to serve" and in return they would have the opportunity to earn a reasonable return on those assets committed to the public interest.

As plant costs increased, regulators sought ways to stretch this bargain without altering the basic "obligation to serve" principle. Invariably they reduced the burden on some ratepayers by postponing rate recovery through phase-in programs or disallowing cost recovery through prudence disallowances. Both of these methods were legitimate attempts to restructure the regulatory bargain within the context of the "obligation to serve." As costs continued to increase regulators focused on cost avoidance rather than the fundamental problems associated with the "obligation to serve." Likewise, as markets become competitive the regulatory focus is on tinkering with rate-of-return regulation and not restructuring the "regulatory bargain." As a consequence the old "used and useful" disallowance reappeared and has been used in a manner that effectively ignores the regulatory "obligation to serve." The result is an end to the regulatory bargain without a theoretical replacement.

How important is a theoretical underpinning for public utility regulation? We may go about our lives without any philosophical justification and be no worst off. Institutions, however, must have a philosophical, as well as, a legal purpose in order to exist. The absence of a theoretical justification can lead to disaster. If a corporation's purpose is to make money for its investors, its primary obligation is to them. But, if a corporation is "affected with the public interest," where does its obligation lie?

Consider the cost recovery of nuclear power plants, each project begins with a certificate of public necessity and convenience. What is the purpose of that certificate if not to approve the undertaking of such construction. Doesn't issuance of such a certificate, finding construction to be in the public interest, mean such an undertaking is "used and useful"? And, if such a certificate is granted by regulators haven't they, in effect, found the utility's demand forecast reasonable? In this light, the certificate process is intended to act as a surrogate for the market demand in determining whether a new facility is needed.

The certificate process also demonstrates how ownership is removed from the equation. A utility's commitment to building is not based on its ownership or assumption of risk, but upon its "obligation to serve." Regulators, who have approved an undertaking as evidenced by a Certificate must bear some responsibility for their approval; it is hypocritical for regulators to approve a certificate determining need and then later impose a "used and useful" disallowance.

This interrelationship between "used and useful" and the "obligation to serve" can be extended to other areas of public utility endeavor. Afterall, the proof of a good theory is whether it has broader adaptability or not. A fundamentally equivalent to the construction of nuclear power plants is the deployment of a broadband fiber optics infrastructure. Is fiber optics deployment based on a "vision?" Yes, it could provide unlimited services and capabilities to the public switched network. Is there a deployment plan? No one is quite sure how much fiber should be laid and where, but let us assume that a plan exists. Why then shouldn't telephone companies go forth and deploy as much fiber optics as possible. Well, maybe, they should, but shouldn't the risk allocation rules be clearly established. Remember the farmer in Iowa who puts his own assets at risk. He borne the risk of success or failure. Who bears the risk for deployment of fiber optics? Under rate-of-return regulation, the ratepayer does. Under alternative regulation, the answer is less clear. Allocation of risk is, however, clearly a matter that should be resolved between telephone companies and regulators before fiber is deployed.

If the risk is to be borne by company's shareholders, then the utility has no "obligation to serve" and as such is acting in a truly competitive manner. But, if the utility is acting within the perception of a regulatory safety net, it invokes the "obligation to serve" and regulatory scrutiny. That scrutiny, right or wrong now includes "used and useful" disallowances. What is clear is yesterday's gone, the future is here and we have no framework for dealing with it. The danger is not bankrupting utilities, but further eliminating the traditional "obligation to serve" without articulating an alternative premise for regulation. That "obligation" is more than a perception of who is responsible. It is the framework for allocating risk.

Under rate-of-return regulation the responsibility for power at the flip of a switch, instantaneous communication, clean running water and abundant natural gas belongs to the public utility. Likewise, in the past, construction risks were the responsibility of utility executives. Today, that responsibility has shifted. Competition is everyone's favorite buzz word. But talk's cheap, few regulators, utilities and ratepayers actually appreciate the implications associated with the shift of responsibility from a utility's management to its regulators. Through "used and useful" disallowances public utility regulators have destroyed the "obligation to serve."

Today's circumstances requires not only knowing where we've been, but also where we're going. As the infrastructure for public utilities change, public perception of utility service must also change. We live in a society that wants service on demand. In the future satisfying that demand will become the responsibility of vendors reacting to consumer choices. Today, however, that demand is artificially controlled by regulators through policies such as "used and useful" disallowances. As technology is deployed and competitive services emerge a new framework for allocating risk must be established. The critical issue today is not coping with competition or deploying new technologies, but how do you allocate risk and who is responsible for future deployment. The farmer in Iowa who built a ballfield, the admiral in Washington who gave up a battleship, and even the utility executive who built assets for the public interest all understood risk and responsibility; they also thought they knew the rules of the game. In each case risk was perceived differently and the circumstances determined their courses of action. Today, it is unclear who bears responsibility for our building the future infrastructure and who will bear the risk of deployment.

My thesis, you may recall, is you can't regulate competition and you can't predict the future, requires a solution. Clearly the only choice is a regime of consumer sovereignty, faith in the individual consumer's ability to be informed and in control of the market through his/her exercise of selection and purchase. If you can't regulate competition and you can't predict the future, your only recourse is to market your services and your capabilities with some sense of what the market will bear. To the extent market conditions have emerged, regulators should step back and allow market economics to control.

In the early 1980s, one long distance company claimed microwave technology was the future of long distance service, its investment in that technology was tempered by its sense of ownership. As a result MCI exercised flexibility in technological deployment. Today, its flexibility and understanding of the market has made it a success. MCI proved you can't predict the future of technology. You can, however, use technology and the competitive market to benefit the consumers. This approach further recognizes that increasing market size is more important than struggling to maintain market share.

Curiously, the "obligation to serve" has been met in the competitive long distance market. Consumers, through their power of choice and purchases, influence infrastructure construction, product development and technological deployment. Today, the long distance markets has an estimated 300 per cent excess capacity in deployed fiber optics. Ironically, if long distance companies were still under rate-of-return regulation much of their assets could be declared not "used and useful." In which case we wouldn't have a competitive long-distance market.

In the local market use of facsimile machines is an example of consumer sovereignty. The advent of faxes was unpredicted and unanticipated by telephone companies, but nevertheless emerged because of consumer demand.

We are now on the verge of major fiber optic deployment by local exchange companies. To what standard are they to be held? A competitive one, based on ownership and full assumption of risk or the traditional "obligation to serve," which includes "used and useful" disallowances? The answer should be provided before costs are incurred.

In 1954 Lewis L. Strauss, chairman of the Atomic Energy Commission spoke to a group on the future of nuclear power. He was dazzle by the claims of what nuclear power could do for the economy. He thought plentiful electricity would create economic development. Instead his legacy is the quote, "Our children will enjoy in their homes electrical energy too cheap to meter."

Regulators cannot regulate competition, they cannot predict the future. Both questions are better left for consumers to answer through their power of choice and purchases. If fiber optics is to be deployed, let the rules be set before costs are undertaken. Afterall, the alternative is to apply "used and useful" disallowances, after the fact. In which case regulation has not acted as a market surrogate, but as a post hoc allocator. Such action does not promote confidence in the system, credibility in the process or even solve the problem. It is clear that yesterday's gone, but what will emerge is still uncertain.

* Calvin K. Manshio was a commissioner on the Illinois Commerce Commission for eight years, directing the telecommunications policy discussions, analyzing and interpreting energy and telecommunications issues and supervising the motor carrier transportation policy agenda. Other than when he served on the Commission, Calvin has practiced law since 1979 and was also administrator of Asian Human Services of Chicago in 1984 and 1985. His professional affiliations

include the Illinois State Bar Association, the Chicago Bar Association and the John Marshall Law School Minority Retention Committee. He has delivered numerous speeches and has had several articles published related to his regulatory, legal and academic endeavors.

Manshio is a graduate of the University of Illinois and the John Marshall Law School.
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Author:Manshio, Calvin K.
Publication:Management Quarterly
Date:Mar 22, 1993
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