A consideration of contracting and competitive bidding as alternatives to direct economic regulation in imperfect markets

A consideration of contracting and competitive bidding as alternatives to direct economic regulation in imperfect markets Edythe S. Miller

Enquiries into the origin and application of popular private market alternatives to economic regulation in the USA often take as referent certain governmental edicts that are themselves more effect than cause. The sweeping appeal of market-patterned activity, both within and beyond US borders, renders examination of both the roots and the fit within the overall pattern of specific practices a matter of more than parochial interest. It is important to recognize that the current policy agenda in the USA is the product of an interaction of ideology with a specific sequence of events. Keywords: regulation;

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Neoclassical economics is the applicable ideology: that is, the orthodox paradigm that specifies the pattern of adjustment. At its heart is a belief in the permanence and universality of individualism, maximization and rationality as fundamental behavioural characteristics. These are accepted as given a priori, axiomatically derived, and part of a regularity in nature; a body of ‘natural law’. From these regularities additional postulates are adduced: for example, that the end (presented as means) of economic activity is the maximization of individual efficiency, the achievement of which indirectly serves equity goals; that social condition is strictly the sum of individual results; that voluntarism supersedes compulsion as a guide to action, and, thus, that the provision of information is preferable to the setting

Edythe S. Miller was formerly with the Colorado Utilities Commission. Her address is 580 Front Road, Littleton, CO 80120, USA.

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of standards; and that a beneficient propensity (an invisible hand) controls the sequence of events. It follows that private-sector activity is of a higher order than public, and that a policy of laissez-faire will result in an optimal equilibrium state. This set of postulates has long been central to economic science in the Western world. The orthodoxy of classroom and text admitted of only a few exceptions to the controlling dominance of general principles. Among the exceptions was that a condition of natural monopoly required a suspension of traditional precepts. Mainstream economics viewed natural monopoly as limited to industries characterized by economies of scale: specifically, such core infrastructure industries as telecommunications, energy, and some forms of transportation. These industries were identified as subject to ‘market failure’, and designated public utilities. The approach was one of containment. Sectors that did not meet the test were posited as competitive, and orthodox standards deemed applicable. From its inception, traditional economics extolled limited government. At about mid-twentieth century in the USA, however, what had been a more or less steady stream of conservative commentary was transformed into a virtual torrent. Orthodox thought, particularly the variant recognized as ‘the Chicago School’, took as mission the chipping away at the narrow rationale for collective control of economic power. The critique is variously expressed, all to the same effect: that irrespective of market conditions, government activity in general, and regulation specifically, almost invariably is harmful if not corrupt. The genre takes shape as behavioural theory, presented in capture and life-cycle format, speaking to the inevitability of regulatory failure. Averch-Johnson representations are pervasive. Monopoly is depicted as temporary, and vulnerable to an inescapable dual 323

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assault of technological advance and entrepreneurial vigour . Two relatively recent extensions of neoclassicism, the theory of contestable markets and transaction cost economics, are interesting cases in point. Each blurs the distinction between positive and normative in industrial organization, obliterating the distance between actual and ideal. Contestability theory rejects the significance of economic concentration so long as the potential for competition exists.’ The simple removal of entry and exit barriers effectuates that potential. It follows that public control is not required. Transaction cost economics takes the transaction as the basic economic element, and private individual negotiation as the ‘natural’ ordering principle of the economy. The minimization of transaction costs is posited as the incentive underlying specific patterns of industrial organization, and is equated with the maximization of efficiency. It follows that existing market forms - spot market, long-term contract or vertical integration - are adopted for cost minimization (efficiency maximization) purposes? While purporting to account for vertical integration, and further demarcating itself from traditional neoclassicism on the basis of its recognition of certain real-world complexities and uncertainties, transaction cost economics nevertheless abstracts from the potential for the abuse of market power to validate the existing organization of industry on economic efficiency grounds. The implications are clear: ‘market failure’ by itself is insufficient to justify public action. Voluntary private action is inherently superior to state action with its implications of compulsion, and lack of incentives for cost control. Moreover, the potential for ‘government failure’ must be recognized.” The ‘high’ neoclassicism represented in the Chicago School literature rejects government involvement in imperfect markets almost entirely. Even in less pristine manifestations, the absence of government intervention is taken as norm and the burden of proof shifted to proponents of social control. Within a thus eviscerated regulatory sector, the use of ‘competitive’ tools - bidding and auction, negotiated contract, Ramsey and marginal cost pricing - is advocated so as, in a more or less ‘second best’ sense, to minimize costs and maximize individual efficiency. Articles by F.A. Hayek and Harold Demsetz are specifically relevant. A 1945 work by Hayek criticizes the assumption of symmetric information in traditional price theory.4 He notes that markets are characterized by knowledge dispersal and identifies

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the economic problem as that of achieving resource efficiency despite information asymmetry. Contemporary studies also identify asymmetric information as the ‘crucial element’ in the auction problem.” Hayek concludes that the price system is uniquely qualified to achieve the communication of dispersed information. A goal of current auction theory is to model markets characterized by asymmetric information, basically answering in the affirmative the question put by Hayek. Demsetz, in a 1968 article, raises the question of whether, in the event that competition in the field were impractical because of the existence of economies of scale, it would not be possible to substitute competition for the field by establishing a franchise bid process for natural monopoly.6 He thus raises the possibility of improvising a condition of competition at franchise award time, despite the existence of market failure. Contemporary formal bidding theory is essentially an analysis of alternative bidding processes, supported by traditional orthodox precepts and procedures. For example, models are based upon simplifying assumptions (for example, one buyer, one seller, a single product)’ and utilize static, partial and perfect equilibrium methods. ’ Risk neutrality commitment ability may be assumed. Costs of bid preparation and evaluation are often neglected or understated.’ Participants are held to be omniscient; only rational motives are recognized; the interdependence of private values is ign0red.l” Lack of realism, needless to say, does not inhibit prescription. It should be noted that over time the theory of exchange in imperfect markets has experienced something of a metamorphosis. As presented by Demsetz, the nature of the transaction was a franchise bid; the pact was essentially one between regulators and bidders. In the later transactions cost literature, as will be further developed below, the preferred market mode changes from bid to long-term contract, often based upon cost-of-service principles, in recognition of specific market complexities and uncertainties. At the same time, the major participants to the exchange are transformed from regulator and bidder to private purchaser and seller. It is noteworthy that the complexities for which the transaction cost literature adjusts are commonplace attributes of contemporary markets. For example, in electricity and other public utility markets asset for relationspecificity (that is, the requirement specific, non-fungible investment) is pervasive. The extent to which formal economic theory is perceived as capable of contributing to economic

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problem solution also has changed over time. Until quite recently, the elegance and rigour of the models of othodox economic theory did not translate widely into public perception of relevance for policy purposes. Economic science was viewed quite broadly strictly as academic exercise. In the immediate postGreat Depression, early post-World War II period, it was well recognized that orthodox precepts had not for many years been central to public policy formation; that is, that the ascription of a limited role for government did not comport with either the requirements or facts of recent history. In the period that followed, however, a perception of deterioration in economic and social condition created a demand for new approaches. The replacement of ‘government intervention’ in the economy with ‘market-based alternatives’ gained support. A brief description of the changing economic climate in the post-World War II USA and the public policy programme it engendered will both provide a contextual framework and illuminate the route traversed to effect the contemporary policy scenario.

The post-World War II USA experience For about a quarter of a century after World War II, utilities were characterized by technologial advance, increases in productivity and steady growth in demand. Economies of scale were reflected in falling real prices. Starting in the late 1960s and accelerating into the 197Os, war demands and oil shocks fed price inflation, with associated increases in capital costs. At the same time, an obligation to internalize external effects was increasingly recognized. As a result, costs and prices in the electricity industry increased sharply. Price levels in the natural gas industry followed a similar pattern. Substantial and repeated rate requests, often ‘pancaked’, seemed to have become a more or less permanent feature of the public utility landscape. Prices seemed caught in an inflationary spiral. The utility industry, long the beneficiary of ‘regulatory lag’, now felt itself its victim. In response to price increases and the conservation ethic, demand growth stalled. The electricity industry, slow to recognize painful realities, proceeded with programmes based upon outdated demand projections. The result was over-capacity and declining financial indicators. In some jurisdictions, regulators employed prudence reviews and ‘used and useful’ disallowances to remove investment from rate base. To many, events seemed out of control. Moreover, the rationale for deregulation in the doctrinal literature resonated across ideological boundaries.

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Groups ranging over the political spectrum increasingly viewed regulation as part of the problem rather than of the solution. High-volume users and potential entrants, eager to seize advantage or opportunity, pressed to end regulatory restrictions. Political liberals joined conservatives in questioning the usefulness of economic regulation. It became increasingly acceptable, even de rigeur, to seek the solution to the ‘energy problem’ in market forces.

The Public Utility Regulatory Policies Act The Public Utility Regulatory Policies Act (PURPA) thus was enacted in 1978 in an atmosphere of social unrest and increasing adherence to orthodox principles. The act sought to enlist market forces to promote efficiency, encourage conservation and reduce dependence upon foreign sources of supply. The rate structure reform for electricity enacted in PURPA, largely reflecting neoclassical principles, was intended to discourage ‘inefficient’ and encourage ‘efficient’ use. It was this aspect of PURPA that intially received primary attention. However, PURPA also included provisions to advance the production and use of alternative sources of energy. It is of interest that it is this, rather than the neoclassically patterned rate structure reform, that was to provide the basis for introduction of major market-oriented measures. The Federal Energy Regulatory Commission (FERC) was to formulate rules for the development of cogeneration (the sequential production of multiple types of energy from the same fuel source) and small power production (the production of 80 MW or less of energy using renewable resources as a primary source). Electric utilities were to be required to purchase the power provided by qualifying cogeneration and small power facilities (QFs) at rates not to exceed the incremental cost of alternative sources of supply (avoided cost), and to provide QFs with standby power. The equity interest of electric utilities or their affiliates in QFs was not to exceed 50%.11 FERC issued implementation rules in 1980. The rules specified the payment of full avoided cost, but left methods of calculation to the states. QFs of less than 30 MW were to be exempted from state and federal regulation. QFs between 30 and 80 MW were to be subject to relaxed FERC regulation, substantially deregulating them.” The FERC rules were upheld by the US Supreme Court in 1983. It was anticipated that the expansion of renewable resources and small power facilities would reduce reliance upon large-scale facilities, apprehended as

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substantially responsible for cost-overruns, overcapacity and rate acceleration. It was also reasoned that encouraging small projects and renewable resources would compensate for an anticipated energy gap, expected because it was believed that industry had become risk averse in the wake of regulatory denial of rate-base status to over-capacity.‘3 Finally, the measures received an almost reflexive approval as conforming to neoclassical ideals of decentralization. The rates set administratively by state commissions for the purchase of QF power received mixed reviews. Specific rates were criticized, both as too high (California is the almost universal example), attracting an oversupply of QF power, and too low, stifling economic QF development.14 Several states implemented a bidding process to replace administrative rate setting. The use of a bidding system thus made its entrance almost, as it were, through a back door as an adjunct of a programme intended to encourage alternative energy production and use. The bidding mechanism was both challenged and defended. It was contested on the basis of illegality: that is, that it is not contemplated by and is inconsistent with provisions of PURPA. It was justified on the grounds that one measure of incremental cost provided by PURPA is the purchase of power from another source, that state competitive bidding systems use incremental cost of the utility as a ceiling, and that competitive bidding permits the identification by utilities of lowest cost power.15 A number of state commissions requested FERC clarification.

The FERC notices of proposed rulemaking FERC responded to clarification requests in 1988 with three notices of proposed rulemaking (NOPRs) addressing the issues, respectively, of administrative determination of avoided costs, competitive bidding and independent power production.16 The first proposal established technical guidelines, reiterated the full avoided cost standard and specified that avoided capacity cost was to be set at zero if the utility had no need for additional capacity. The proposal also gave states the option of choosing between the use of the new administrative costing methods and the use of competitive bidding in determination of QF purchase rates.17 The competitive bidding NOPR attempted, first, to set to rest questions about conformance with congressional act and intent. FERC declared competitive bidding a means of avoided cost determination, and therefore by definition in accord with PURPA. The bid process was to be available for

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capacity only, thus retaining for energy PURPA purchase requirements. QFs not participating in, or not winning, a competitive bid, while not entitled to capacity payment, would be entitled to energy payment. Utilities could open the bid process to all or part of new capacity needs, but QFs must be allowed to fulfil any excluded needs. FERC viewed these provisions as putting the proposal in conformance with PURPA. The NOPR also provided that states would have the option of restricting bidding to specific groups (QFs, for example) or, and what was to prove particularly contentious, opening it to all source bidding. The proposal stated further, somewhat baldly, that self-dealing was to be avoided.‘* The independent power production NOPR defines an independent power producer (IPP) as a non-QF engaged in the sale of wholesale power from a facility not included in rate base. The IPP may not control transmission facilities required by the purchaser, and its sales must be outside the retail franchise territory subject to its control. The IPP category could be interpreted to include, for example, generation controlling non-QF industrial companies and public utilities. It is proposed that the FERC adopt a policy of relaxed regulation for entities meeting the requirements.19 The proposal to open the process to all source bidding focuses additional attention on the independent power production NOPR, because the potential pool of bidders is enlarged. The issuance of the NOPRs conveyed to many a signal of FERC pre-emption and piecemeal deregulation. It is suggested that, in combination, the competitive bidding and IPP proposals amount to virtual deregulation of electric generation2’ and may even be a harbinger of total deregulation21 The all-source bidding proposal is criticized as lacking clarity. It is contended that it is not discernible if the intent is to open the process to all non-QFs, including utility affiliates and subsidiaries. If affiliate participation is contemplated, it is suggested that such participation should be limited or conditioned (for example, legal separation requirements, divestiture with or without deregulation of generation). Also questioned is whether the proposal implies that the bid process is to be opened to utility self-generation and/or to conservation practices,22 practices referenced collectively under the clumsy rubric ‘demandside management’ (DSM). It is also noted that the IPP proposal could lead to forum shopping by vertically integrated, stateregulated companies. Oversight of the sale of power for resale and of generation costs of wholesale suppliers is jurisdictional to FERC. The ability of

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companies to create IPPs exempt from state regulation permits them to self-select between federal and state regulation of generation. State commissions, under what has come to be known as the ‘filed rate’ (or Narrangansett) doctrine, may not deny recovery of rates filed (and therefore deemed ‘just and reasonable’) with FERC, although where a less expensive source is available, a ‘prudence of purchase’ (or ‘Pike County’) exception could (the legal question is unsettled) permit exclusion.23 The ability of FERC to accomplish by rule what is precluded by law is also raised as an issue. Called into question is the legal authority of FERC under the Federal Power Act (FPA) and PURPA to propose competitive bidding24 or to include IPPs as participants in the absence of the elimination of restrictive provisions of the Public Utility Holding Company Act (PUHCA).25 It is alleged that sufficient safeguards are lacking to prevent utilities from favouring affiliates vis-ci-vis competing companies. Recent lax enforcement of PUHCA is seen as having created an environment favourable to illegal selfdealing.26 It is further asserted that permitting utility diversification and utility-contractor joint ventures creates conflicts and otherwise jeopardizes consumer interests.27 Moreover, it is claimed, the proposals are incapable of accomplishing their stated goals in the absence of mandatory wheeling and access to power poo1s.2s Without mandatory wheeling, a utility retains monopsony power, and suppliers are limited to exchanges with a single purchaser.29 That is, it is averred that equal access is essential to competition. It is the contention of the FERC, to the contrary, that it is not necessary to require bidding to be conditioned upon transmission access because bidding is simply an additional means of determining avoided cost and does not increase utility market power.30 Opposition to mandatory wheeling is also voiced. A primary basis of concern is the perceived potential for harm to native load customers. It is asserted that mandatory wheeling could result in a seesawing pattern of bypass and return to systems by largevolume users, increasing cost responsibilities of lowvolume users as well as planning difficulties of utilities.31 Misgivings are also expressed about effects of proposed changes upon service reliability. 32 Specifically, it is observed that reliance of utilities upon IPPs could result in capacity deficiencies and utility inability to fulfil obligations in the event of IPP default.33 Implicit costing and pricing disputes also emerge: the venerable and typically heatedly contested question, for example,

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of whether fully distributed cost or demand-based pricing is the appropriate methodology to utilize for pricing transmission access. An additional concern is that of the effect of decentralization upon economies of scope. The proposals are supported on grounds that decreased regulation will unleash entrepreneurial energies, stimulate innovation and decrease costs. It is suggested, however, that losses of economies of scope stemming from large-scale movements into IPP generation would have negative effects. Moreover, it is not possible, it is maintained, to determine whether these offsets will yield net gains or losses.

The Energy Policy Act of 1992 The enactment of the Energy Policy Act provided a legislative response to major observed legal defects. The bill clarifies questions of IPP status, the role of utility affiliates, and the legitimacy of intra-affiliate transactions. It also addresses issues of the applicability of PUHCA, mandatory wheeling, and DSM treatment. Title I of the energy bill amends PURPA to require all electric utilities to employ integrated resource planning (IRP) for new capacity. IRP includes and evaluates all alternatives in the planning and acquisition process, taking into account operational aspects such as reliability. State commissions are required to set rates to ensure that utility expenditures for conservation and other DSM measures ‘are at least as profitable’ as those for construction, with appropriate consideration to income lost from reduced sales because of conservation expenditures.34 Title VII of the Act amends PUHCA to create a new category of energy producer, the successor to and equivalent of IPPs, to be called ‘exempt wholesale generator’ (EWG). The term is applicable to entities engaged exclusively, directly or indirectly through affiliates, in the generation and sale at wholesale of electric power. The designation covers utility affiliated and non-affiliated producers, but applies only to non-rate-based facilities that lack a franchised territory and do not engage in retail sales. Entities found eligible by FERC for EWG status may build, own and operate power plants in one or more states unimpeded by PUHCA provisions.35 Affiliated EWGs may sell to utilities only if all jurisdictional state commissions make specific advance findings that include assurance of ability to monitor transactions, of access to books and records, of benefits adhering to consumers, and of conformance with the public interest.36 The FPA is

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amended to allow state commissions, upon their written order, broad access to books and records of jurisdictional utilities, of EWGs selling power to those utilities and their affiliates3’ If FERC finds that a rate is the result of affiliate or associate undue preference, the rate is to be deemed unlawful.38 The bill does not address the question of the ability of state commissions to invoke the Pike County doctrine (that is, to rule on the prudence of wholesale purchases by regulated utilities), except to note in an explanatory statement that state commission authority to review such prudence is unaffected by the law.39 The bill provides that FERC must enter into rulemaking within one year to establish guidelines for EWG qualification, and must issue, within 60 days of the application, its determination of whether requirements for EWG status are satisfied. In the case of ‘good faith’ applications, EWG status is to be granted pending determination. The law thus provides for streamlined acceptance;40 what appears, indeed, to amount almost to ‘self-certification’.41 The bill grants FERC authority to mandate the opening of transmission grids to wholesale wheeling by ordering utilities to provide point-to-point access, upon request of any wholesale generator of electricity. FERC may require increases in transmission capacity, unless the utility is unable despite ‘good faith’ efforts, to obtain required rights.42 In summary, the Energy Bill provides a major catalyst to utility diversification and deregulation by permitting regulated utilities to reconstitute themselves by creating generating affiliates not subject to state regulation. It sanctions, with some safeguards, infra-affiliate transactions. It ensures that utilities will ‘do well by doing good’ by providing for inclusion of DSM in resource planning. In the context of the criticisms of the NOPRs, the Energy Bill permits both self-selection between levels of regulation and self-dealing. Although state regulatory control is weakened, there is an attempt to buttress oversight. The major public-interest protection provided, however, is that of mandatory wheeling: the provision of what is referred to, in the context of contemporary, and not dissimilar, developments in US telecommunications, ‘open network architecture’. Space constraints preclude treatment of the natural gas industry, except to note that the trend of policy was similar to that in electricity. The passage of the Natural Gas Policy Act of 1978, prescribing phased decontrol and indexing of gas prices, and the subsequent adoption by FERC of related orders, ushered in an era of ‘unbundling’ (that is, vertical de-integration of services); of bypass and price dis-

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counts for consumers with options; of increased prices for low volume consumers, and intensified pressure for further deregulation. The gas market was restructured significantly, culminating in major separation of transport and merchant functions. In its 1992 Order No. 636, FERC removed pipelines from the merchant function. FERC considered adopting a bidding process for the allocation of natural gas pipeline capacity, with one of the alternatives prominently considered the archetypically neoclassical system of Walrasian turonnement. FERC finally abandoned a bidding approach in the face of inconclusive results from bidding experiments and extensive opposition,43 settling for easy entry and exit procedures, and expanded use of negotiation, private contract and ‘market-based pricing’.44

Bidding and auction theory and practice A recent survey indicates that by about mid-1991,28 states had adopted or were developing competitive bidding programmes for electric generation. In addition, 12 investor-owned utilities (in 10 states) were using bidding as a procurement tool without state commission prior approval. While the bulk of US generation, of course, is utility generation, 50% of all new generation in 1989 and 1990 was provided by non-utilities.45 State bidding programmes rely primarily upon two of four accepted general bid types: a first-price and a second-price sealed auction.46 In the former, the low bidder receives the award at the bid price. In the latter, the low bidder also wins the award, but at the price of the lowest rejected bid. The second-price sealed-bid auction receives predominant disciplinary for its perceived ‘truth revealing’ approva14’ that resultproperties, 48 albeit with the reservation ing interdependences will increase the potential for collusion. Bidders, it is believed, will bid true costs only if prices paid are higher than those bid. State procedures are not uniform; for example, Massachusetts uses a first-price and California a secondprice system. A disadvantage of the second-price system is that it has the potential to significantly increase costs. It should be kept in mind that cost saving is posited as a major bidding advantage. Lower prices also advantage purchasers. In California, industry opposition to the second-price process has led to efforts to substitute a first-price procedure. 49 The FERC camp etitive bidding NOPR proposes use of a second-price auction.” Additional differences should be noted: for example, the weight afforded to non-price factors such as

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project viability, dispatchability, and the extent of front loading varies in state programmes.51 For complex products the importance of non-price may exceed that of price factors. Electricity, of course, is such a product. Decisions will affect network coordination and integration and, in turn, influence system reliability and stability. It is also clear that the greater the weight assigned to non-price factors, the more subjective is the process. In addition, it is evident that the greater the importance afforded to non-price factors, the greater is the potential divergence of realized from lower cost. The bidding literature customarily employs a number of catch-phrases to describe potential sideeffects of bidding. These are different in kind from such extra-legal practices as collusion, bid-rigging, market sharing and out-and-out corruption, practices that often attend real-life bidding. The potential side-effects explored in the literature, in contrast, are problems endogenous to the bid process itself. The literature examines the existence and effects of adverse selection (concealment of information relevant to the terms and conditions of exchange), and moral hazard (the existence of perverse incentives to behaviour).52 ‘Buying in’ (a manifestation of the ‘hungry firm’ phenomenon), the not uncommon practice of submitting low bids in expectation of authorization of after-the-fact change orders and cost adjustments, is an example of the former. It is pointed out that, once undertaken, costs of project termination or changing suppliers are high, and bid awarders themselves may have a not inconsiderable stake in project success.53 The failure of a winning bidder on a fixed-fee contract to live up to promises by skimping on quality is an example of the latter. In either event, risks are shifted forward to consumers. Oliver Williamson identifies a ‘fundamental transformation’, in which a competitive situation is transformed into bilateral monopoly because of the presence of ‘asset specificity’: that is, of sunk, relationspecific costs of required non-fungible assets.54 Williamson criticizes Demsetz’ unassisted franchise bidding proposal on the grounds that it does not take such complexities into account.55 Asset specificity permits ‘holding-up’: that is, the exercise of opportunistic behaviour.56 Thus human and capital asset specificity gives a bid winner (for example, a cable television provider) a distinct advantage at bid renewal time.57 It gives purchasers, especially monopsonistic purchasers (for example, electric utilities) an edge over incumbent providers. Following Hayek, auction theory accepts that the price system is well constituted to correct for in-

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formation asymmetries. 58 It is proposed that adverse selection and moral hazard are, at bottom, specific aspects of information asymmetry,59 implying that they are susceptible to cure by market means. For example, because providers of services that require significant capital investment (as in electric generation) and that have only one or a few potential purchasers may be reluctant to participate in shortterm bid programmes, it is suggested that long-term contracts be substituted for bidding.60 It should be noted that although contracting is espoused to supplant the scorned rate-of-return regulation, the use of long-term contract in effect amounts to a virtual life of contract rate-basing of plant. It is also reasoned that the ability to attract bidders in such industries may be dependent not only upon the availability of long-term contracts, but also upon front loading of payments. Front loading, it is asserted, encourages capital intensity, enhances ability to capture economies of scale, and improves access to financing. Against this should be weighed an increase in consumer risk of project abandonment and inability to recover payments.61 The imposition of entry fees and penalties for abandonment is also advocated as a means of ratepayer protection, although it is noted that this may reduce the number of bidders and eliminate projects that are economically viable .62 The relative merits of fixed price, cost-of-service and incentive contracts are examined in terms of trade-offs between such competing goals as stimulation of competition and cost containment. Cost-plus contracts are often dismissed if only for their resemblance to regulatory pricing. The choice, then, comes down to one between incentive and fixedprice contracts. The incentive contract, in which payment depends upon both the bid and actual costs, is often viewed as the preferred alternative.63 It is not, however, free of moral hazard problems. Support for fixed-price contracts is based upon the cost control provided by contractor liability for cost overruns.@ In the case of either incentive or fixedprice contracts, quality of service may be jeopardized. An additional and well-recognized weakness of fixed-price contracts lies in the fact that the future cannot be anticipated with any certainty. Technological, cost and demand uncertainties may make the bargain struck today untenable when the time comes to pay the piper. For example, utilities in New York State, in a proceeding before the New York State Public Service Commission, are attempting to free themselves from terms of contracts signed with IPPs in the late 1980s. Since that time, the price of electricity has decreased and the spread between

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spot market prices and those specified in the contracts has widened.65 The role, if any, perceived for regulation in this changed environment is unclear. It is of interest that the FERC competitive bidding NOPR includes state commissions in bid formulation and certification of results to FERC, but not in evaluation. The utility selects the winning bidder(s). FERC grounds for proposing state certification are of interest. They include elimination of the necessity for state prudence reviews of winning bids, and provision to utilities of a ‘state action’ exemption from anti-trust laws,66 neither of which appears compatible with consumer interests. Bid theory holds that commitment (that is, the ability of parties to perform as agreed) is essential to successful closure. This suggests a residual role for regulation: that is, as guarantor of commitment.‘j7 It is also proposed, testing the limits of credulity, that regulation serve as a ‘surrogate for contestability’68 by, to the extent possible, equalizing access to network bottlenecks.‘j9 In addition, it is suggested that regulation could be employed to encourage non-QF market entry by ensuring them equal treatment with QFs under PURPA: a euphemism for exemption from rate-of-return regulation. Finally, it is proposed that to attract bidders despite the substantial investment required, life-ofplant, cost-of-service contracts with distribution utia lities be encouraged. 7o As if in confirmation, recent survey reveals substantial dissatisfaction among project developers with current bidding procedures. The process is criticized as overly focused upon price and biased against capital-intensive projects. It is suggested that price be de-emphasized in favour of negotiation based upon subjective criteria, and that a process for automatic pass-through of costs associated with regulatory compliance be developed. 71 The conversion of bid theory would seem to be well begun. It is apparent that bid theory has been influential in policy development. Bidding and private negotiation are increasingly viewed as viable alternatives to social control. That market imperfections remain, despite the discernible shift towards deregulation and deintegration, is ascribed primarily to three factors. First, it is viewed as the result of the remnants of regulation; an economy cannot survive, it is asserted, half regulated and half free. Next, responsibility is placed upon vestiges of prior regulation in current rates or attitudes: a failure to adopt marginal cost or Ramsey pricing principles, a lingering and inappropriate commitment to equity concerns.72 And, finally, it is suggested that the

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problems are the result of government failure to fulfil its competition-supplementing role: that is, the neglect by government of its anti-trust obligations.73 Distortions, that is, continue to be attributed to ‘government imperfections’.

Summary and conclusions Bidding and contracting are pieces in a mosaic of market policies proposed for utilization in imperfect markets. Other features include deregulation, deintegration and diversification. It should be noted that bidding may be viewed as a tool, or a wedge. It is undeniable that the bidding mechanism, selectively and appropriately applied within a regulatory framework, has the potential to benefit ratepayers. Even when viewed strictly as a tool, however, certain limitations and potential deficiencies should be recognized. As has been indicated, bidding may not be a least-cost solution; bidders may not live up to price or performance promises; they may ‘hold up’ or be ‘held up’; they may hold back in absence of long-term contracts. The movement from tariff to contract is also welcomed as market oriented. As noted, the deficiencies of contracting include the requirement for commitment over time, irrespective of future circumstances, and the potential for moral hazard, with attendant incentives to underperformance. In addition, it is recognized that for complex subject matters, contracts necessarily will be incomplete: that is, that periodic adjustment or after-the-fact negotiation may be required. This tends, however, both to violate basic tenets of the doctrine and to narrow the difference between contract and regulation. A central facet of regulation widely ignored in orthodox literature is its flexibility: its usefulness as an instrument of adjustment of complex matters to changed circumstances. 74 Moreover, contract terms, unlike those of tariffs that are in the public domain, typically are secret, 75 facilitating market segmentation and price discrimination. Effective control of market power requires that more, rather than less, information be publicly available and accessible to regulators. Alternatively, if bidding is viewed instead as a wedge, as a necessary component of a seamless web of market-directed activities, or even as a first step on a path to market utopia, problems may be compounded. It should be recalled that the FERC bidding proposal was presented as part of a package. It also should be kept in mind that the IPP proposal was widely viewed as auguring deregulation at least of generation, if not of electricity generally. Initial

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Contracting and competitive bidding as alternatives to direct economic regulation

proposals for deregulation of generation were grounded upon the belief that generation is not, or is no longer, a natural monopoly.76 The case for social control does not, however, rest solely upon the existence of economies of scale. The focus of orthodoxy upon categories of natural monopoly and competition obscures a realistic view of the market as structural spectrum, rather than simple dichotomy. The spectrum includes industries with characteristics, in addition to economies of scale, that encourage growth of oligopolistic power. Addition to the basic model of elements such as idiosyncratic investment, opportunism and bounded rationality, as occurs in the transaction cost literature, barely scratches the surface of market diversity. The potential for dominance in modern industry is also given by the existence of such characteristics as: pervasive externalities, interdependences resulting from cooperative requirements including the need to coordinate across markets, substantial joint and common costs in cost structures, localized markets, the potential for market segmentation and strategic pricing, and a vulnerability to control over access. These are common phenomena in contemporary economies and are typical of public utilities. The question of whether the abuse of power in partially deregulated markets can be prevented thus becomes a matter of valid concern. Market structure should not be determined on the basis of agreement with a prescribed model, but instead according to the facts of each case. It is also important to recognize the systemic nature of economies. The question of whether partial deregulation of an integrated system creates pressure to deregulate successive segments merits exploration. It is reasonable to ask whether specific market approaches deprive regulation of its ability to safeguard the interests of vulnerable consumers. For example, it is recognized that system bypass may result in adoption of cost allocation methods that deprive core utility customers of the benefits of joint production. Equity issues played an important role in the development of regulation in the USA and often translate into issues of systemic viability and integrity: in short, of systemic efficiency. Neglect of systemic efficiency not only impairs general economic well-being, but detracts from that desideratum of orthodox theory, individual efficiency itself.

‘William J. Baumol, John C. Panzar and Robert D. Willig, Contestable Markets and the Theory of Industry Structure, rev. ed, Harcourt Brace Jovanovich Inc., New York, 1988. ‘Oliver E. Williamson, Markets and Hierarchies: Analysis and

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Antitrust Implications, The Free Press, New York, 1975, pp 20-21. 301iver E. Williamson, The Economic Institutions of Capitalism, The Free Press, New York, 1985, p 327. 4F.A. Hayek, ‘The use of knowledge in society’, American Economic Review, Vol 35, No 4, Sep. 1945, cited in R. Preston McAfee and John McMillan, ‘Auctions and bidding’, Journal of Economic Literature, Vol 25, No 2, June 1987, pp 699-700, 732-733. ‘McAfee and McMillan, ibid, p 704. ‘Harold Demsetz, ‘Why regulate utilities?‘, reprinted in Chicago Studies in Political Economy, edited by George J. Stigler, The University of Chicago Press, Chicago and London, 1988. ‘Richard P. Rozek, ‘Competitive bidding in electricity markets: a survey’, The Energy Journal, Vol 10, No 4, 1989, p 119. sMcAfee and McMillan, op tit, Ref 4, p 733. 9R. Preston McAfee and John McMillan, ‘Bidding for contracts: a principal-agent analysis’, The Rand Journal of Economics, Vol 17, No 3, Autumn 1986, p 335 n 16. “Zbid, lot tit; David E.M. Sappington, ‘Incentives in principalagent relationships’, Journal of Economic Perspectives, Vol 5, _ No 2, Spring 199i, p 61. “John Wveth Griggs. ‘Comoetitive bidding and indenendent power producers: s-deregulaiion coming to- the elect& utility industry?‘, Energy Law Journal, Vo19, No 2, 1988, pp 425-426. “Zbid, pp 417, 426. 13Conflicting incentives should be identified in regard to reliance upon purchases vis-a-vis self-generation. Purchase expense is recoverable from ratepayers but, unlike construction investment, utilities earn no return on them. 14Paul L. Joskow, ‘Regulatory failure, regulatory reform, and structural change in the electrical power industry’, Brooking Papers on Economic Activity: Microeconomics, edited by Martin Neil Baily and Clifford Winston, Brookings Institution, Washington, DC, 1989, p 174. “Daniel J. Duann, Robert E. Burns, Douglas N. Jones and Mark Eifert, Competitive Bidding for Electric Generating Capacity; Application and Implementation, The National Regulatory Research Institute, Columbus, OH, November 1988, p 38. 161bid, p 35. 17Griggs, op tit, Ref 11, pp 433-436. “Ibid, pp 44&442. “Ibid, p 451. “Zbid, p 415. *lDuann, op tit, Ref 15, p 4. “For example, Rozek, op tit, Ref 7, p 134; Michael J. Zimmer, ‘Potential shortcomings in competitive bidding and departures from current avoidable cost standards’, in Alternatives to Traditional Regulation: Options for Reform, edited by Harry M. Trebing, Institute of Public Utilities. Michigan State University, E. Lansing, MI, 1987, p 322. ‘%cott Hemolina. ‘Coroorate restructuring and consumer risk: is the SEC enfor&g the-Public Utility HoTding Company Act?‘, The Electricity Journal, Vol 1, No 1, July 1988, pp 41-42, 57-58 n 10. 24Griggs, op tit, Ref 11, p 442. 25Hempling, op tit, Ref 23, pp 4749; Robert J. Keegan, ‘Competitive bidding: New England’s experience’, in Trebing (ed), op tit, Ref 22, p 295. Z6Hempling, op tit, Ref 23, pp 45-46. “Zbid, pp 49-50. **David W. Penn, ‘Comments’, in Trebing (ed), op tit, Ref 22, 401-403. F?Douglas R. Bohi, ‘Comments and Discussion’, in Brookings Papers, op tit, Ref 14, p 202. 30Griggs, op tit, Ref 11, p 441. 31Ronald Daniels, ‘Problems associated with open access to the transmission network’, in Trebing, op tit, Ref 22, p 388. 32William B. Conway Jr, ‘Comments’, in Trebing (ed), op tit, Ref 22, p 344. 33Griggs, op tit, Ref 11, pp 455-456. 34Energy Policy Act of 1992, Conference Report, US Government

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Contracting and competitive bidding as alternatives to direct economic regulation Printing Office, Washington, DC, 5 October 1992, pp 21-22. 351bid, p 137. 361bid, p 141. 371bid, p 143. 381bid, p 152. 39Zbid, p 388. 40Zbid, p 137. 41‘Energy bill passage likely to prompt big package of rulemaking at FERC’, Electric Uility Week, 12 October 1992, p 14. “*Energy Act, op tit, Ref 34, p 148. 43Rozek, op tit, Ref 7, pp 122-123. @‘636 - new way of doing business in natural gas’, The Chronicle, Federal Energy Regulatory Commission, Vol 2, No 4, Aug/Sep 1992, p 5. 45Robert T. Sherman Jr, Nancy H. Sutley and W. Harrison Wellford, Competing For Power: A Survey on Competitive Procurement Systems and Blueprint for the Future, National Independent Energy Producers, Washington, DC, July 1991, p i. 46The two additional bid types most frequently referenced in the theoretical literature are the descending bid or English auction, in which a high price for a product initially is pronounced, and the price is gradually decreased until a willing purchaser is found, and the ascending bid or Dutch auction, in which the process is initiated with a relatively low price and the price is gradually increased until it attracts a willing seller. See Rozek, op tit, Ref 7, p$l 119-120. 4 For example, ibid, pp 12&121; Sappington, op tit, Ref 10, pp 5&57. 48Rozek, ibid, p 136. 491bid, p 120. “Griggs, op tit, Ref 11, p 442. “Charles A. Goldman and Edward P. Kahn, ‘Competitive bidding for electric generation: comparing evaluation methods’, Energy Systems and Policy, Vol 13, No 3, 1989, pp 170, 173-175. “Nicholas Barr, ‘Economic theory and the welfare state: a survey and interpretation’, Journal of Economic Literature, Vol 30, No 2, June 1992, p 753. ‘301iver E. Williamson, ‘Franchise bidding for natural monopolies - in general and with respect to CATV’, The Bell Journal of Economics, Vol 7, No 1, Spring 1976, p 100. s4Cited from Williamson, op tit, Ref 3, in Michael H. Riordan and David E.M. Sappington, ‘Awarding monopoly franchises’, The American Economic Review, Vol 77, No 1, Spring 1976, p 377, n 7. 55Williamson, op tit, Ref 53, p 73. 56R. Glenn Hubbard and Robert J. Weiner, ‘Efficient contracting and market power: evidence from the natural gas market’, Journal of Law and Economics, Vol 34, No 1, April 1991, p 25. s’Williamson, op tit, Ref 53, pp 81, 83, 100. 58McAfee and McMillan, op tit, Ref 4, pp 732-733. s9Barr, op tit, Ref 52, pp 752-753. 60Joskow, op tit, Ref 14, pp 176178. 61Goldman and Kahn, op tit, Ref 51, pp 173-174, 188. e21bid, p 189. 63For example, McAfee and McMillan, op tit, Ref 4, pp 326,336. 64Duann, op tit, Ref 15, pp 61-62. 65Dave Kansas, ‘Bitter fight between power producers, utilities

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escalates in New York State,’ The Wall Street Journal, Vol 127, No 92, 6 November 1992, p B7A. &Duann, op tit, Ref 15, pp 61-62. 67Rozek, op tit, Ref 7, p 119. 68John R. Meyer and William B. Tye, characterizing the sense of the testimony of William Baumol and Robert Willig before the Interstate Commerce Commission in 1985, in ‘Toward achieving workable competition in industries undergoing a transition to deregulation: a contractual equilibrium approach’, Yale Journal on Regulation, Vol 5, No 2, Summer 1988, p 276 n 7. 691bid, p 276. “Joskow 7op tit 1Ref 14, pp 195-196. It should be pointed out that this amounts in effect to rate-basing plant in perpetuity, without any offsetting ability to employ used and useful criteria, or rudence reviews. P‘The position of the electric utility industry and state commissions in regard to some of these issues is also of interest. In general, utilities responding to the survey thought that contracting outside the bidding process should be extremely limited. Similarly, commissions would permit it only in very rare cases, and not if it would undermine the bidding process. Utilities were divided on the question of automatic pass-throughs of regulatory compliance costs, with some receptive to the idea that negotiation of the issues between utilities and developers should be permitted. State commissions, in general, opposed granting automatic passthroughs, except in unusual cases. Sherman, op tit, Ref 4.5, pp i-ii, 1415. 72Meyer and Tye, op tit, Ref 68, p 274; Alfred E. Kahn, ‘Deregulation: looking backward and looking forward’, Yale Journal on Regulation, Vol 7, No 2, Summer 1990, pp 33>334. 73Kahn, ibid, p 341. 74Victor P. Goldberg, ‘Toward an expanded economic theory of contract’, Journal of Economic Issues, Vol 10, No 1, March 1976, p 51. ‘sTransportation is a precursor industry in the USA when it comes to deregulation. A significant expansion of the use of contract ensued. About 60% of all rail freight traffic (86% of all coal traffic) is currently moving under contract provisions. Because terms are confidential, it is not possible to determine the overall effect of this change upon rate structure. An Interstate Commerce Commission (ICC) study has found that rail contracts resulted in significantly lower rates for large-volume shippers. There is little information available about motor carrier rate levels and structure. Published tariffs are not reliable indicators because many motor carrier contracts need not be filed with the ICC. It is known, however, that discounting is pervasive. See Laurence T. Phillips, ‘Contractual relationships in the deregulated transportation marketplace’, The Journal of Law and Economics, Vol34, No 2, Part 2, October 1991, pp 544554,545 n 24. ‘(It should be noted that this is a position that is not universally accepted, and is often hedged even by its proponents. See, for example, Joskow, op tit, Ref 14, pp 14&141. It is sometimes also suggested that generation deregulation be accompanied by open access and, for retail consumers, a telecommunications style ‘social contract’: for example, Frank M. Gollop, ‘Comments and discussion’, in Brookings Papers, op tit, Ref 14, p 205.

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October

1993