The first step in restructuring the US electric industry

Energy Economics 27 (2005) 225 – 235 www.elsevier.com/locate/eneco

The first step in restructuring the US electric industry A.H. Barnetta, Keith A. Reutterb, Henry Thompsonc,* a

American University of Sharjah, United Arab Emirates b Nathan Associates, United States c Economics, Comer Hall, Auburn University, AL 36849, United States Available online 11 November 2004

Abstract The electric industry lobbied for its first step in restructuring, from local franchises to regulated state monopolies during the early 1900s. The present paper examines this restructuring with an empirical model that includes the introduction of natural gas and steam turbine generators. The restructuring resulted in fewer firms, higher costs, and higher prices, consistent with increased monopoly power and captured regulators. D 2004 Elsevier B.V. All rights reserved. Keywords: Electric industry; Restructuring; Monopoly power

Electric industry restructuring is underway, if with halts and sputters. There is interstate wholesale competition and tentative steps toward retail competition. Congress has introduced national bills and the Clinton administration had a tentative proposal, but the Bush administration has taken no steps. As restructuring evolves, disagreement over its virtues is bound to persist. Several studies speculate about how a bderegulatedQ market might function, some pointing to market complexities that raise doubts about applying straightforward economics principles. Restructuring is an economic, legal, and political issue. There is perspective gained by looking back at the first restructuring of the industry, a move from its early days of local competition to regulated state monopolies. In its infancy, * Corresponding author. Tel.: +1 334 844 2910; fax: +1 334 844 5639. E-mail addresses: [email protected] (A.H. Barnett)8 [email protected] (K.A. Reutter)8 [email protected] (H. Thompson). 0140-9883/$ - see front matter D 2004 Elsevier B.V. All rights reserved. doi:10.1016/j.eneco.2004.10.001

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the US electric industry was a collection of competitive local franchises. Shortly after the turn of the 20th century and following industry lobbying, individual states began to establish regulated monopolies. By the 1930s, the industry was transformed. The present paper uses an empirical model to assess the impact of this restructuring on industry conduct and performance.

1. A competitive electric industry Commercial generation began in 1882 with plants opening in New York City and Wisconsin. By 1890, there were a thousand generating facilities producing direct current (DC). The cost of transmitting DC much beyond a mile was prohibitive, limiting the geographic area served by a single generator. During the late 1800s, alternating current (AC) was widely used in Europe but special interest groups slowed its adoption in the US. A prominent member of these groups was Thomas Edison, owner of many DC stations. The electric chair used AC and one argument of the DC lobby was that the bdeadly currentQ should not run through the walls of a house. Nevertheless, George Westinghouse demonstrated the advantages of AC with a system that transmitted electricity for several miles and by the turn of the century AC was the dominant power according to Hunter and Bryant (1991). In the early 1900s, there was loose regulation and electric firms paid local governments a typical franchise fee of 5% of revenue. Franchises were generally nonexclusive and many cities had multiple providers. As an example, Denver granted bgeneral electric franchise to all comersQ short of obstructing public thoroughfares. Behling (1938) notes that New York City had 6 electric companies in 1887 and Chicago had 45 in 1907. As cities and industry grew, electric firms became an important source of local government revenue. Multiple local franchises were a conscious policy to regulate through competition as pointed out by Glaeser (1957). Since each city had an independent franchising authority, electric firms trying to expand their areas found multiple negotiations and differing fees both costly and burdensome. As relief, the industry led by Samuel Insull of Chicago Commonwealth Edison advocated state regulation. McDonald (1962) points out that Insull led members of the National Electric Light Association, later Edison Electric Institute, in a call for state regulation. The first state to implement a public service commission (PSC) was Massachusetts in 1889, followed by Virginia in 1902. By 1912, there were 18 states with PSCs. The number of PSCs then increased dramatically, reaching 38 by 1922 and becoming almost universal by the 1930s as summarized in Table 1. PSCs regulated prices within state boundaries but Clemens (1950) points to the interstate pricing issue made clear by the Attleboro case of 1927. Narragensett Electric in Rhode Island sold a small amount of electricity to Attleboro Steam and Electric in Massachusetts. The Rhode Island Commission considered the low rate a burden on Rhode Island consumers and ordered a higher rate. Misery loves company. The Supreme Court, however, ruled that the mandated rate placed an unconstitutional burden on interstate commerce. The US Congress subsequently amended the 1920 Federal Water Power Act

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Table 1 Dates of state regulatory commissions Year

State

1889 1902 1907 1908 1909 1910 1911 1912 1913 1914 1915 1917 1919 1920 1921 1934 1935 1941 1949 1951 1956 1972 1975

MA VA NY, WI VT MI MD CA, CT, KS, NH, NJ, NV, OH, OR, WA AZ, RI CO, HI, ID, IL, IN, MO, MT, NC, OK, WV ME, PA AL, SC, WY UT ND, TN GA LA KY AR NM DE FL AK, MS NE SD, MN, TX

Source: NARUC Yearbook of Regulatory Agencies 1991–1992.

with the Federal Power Act of 1935 granting the Federal Power Commission jurisdiction over interstate wholesale rates.

2. Restructuring, 1907–1932 Table 2 presents some historical data, including the real price of electricity P e calculated as average revenue per kilowatt hour (kW h) in 1932 dollars. The raw data from the Census of the Electric Power and Light Industry includes industry total revenue TR, quantity of output Q, the number of firms F, and the horsepower of different types of generation. The price dropped dramatically between 1907 and 1917. By 1927, however, 34 Table 2 Evolution of the early electric industry Electricity price, P e Number of firms, N Millions mW h, Q % Generation steam, G

1907

1912

1917

1922

1927

1932

$0.45 4714 6 20%

$0.39 5221 10 38%

$0.22 6542 22 48%

$0.21 6355 33 58%

$0.20 4335 68 59%

$0.27 3429 80 68%

Source: Census of the Electric Power and Light Industry.

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states had regulated monopolies and the price of electricity began to rise. Similarly, the number of firms peaked in 1917 but with the increased prevalence of state regulation declined 48% by 1932. Output increased during this period, more than doubling from 1912 to 1917 and again from 1922 to 1927, as the number of customers grew exponentially. With improved technology and new steam turbines, electricity output per worker rose. The four main sources of power were combustion engines, steam engines, steam turbines, and hydroelectric generation. The new technology utilizing steam turbines supplied 20% of horsepower in 1907 but by 1932 that percentage had more than tripled. The share of hydroelectric power remained stable over the period. Between 1911 and 1920, most states replaced local franchises with state regulated monopolies, a shift from locally governed competition to state regulated monopoly. After 1920, industry output continued to grow but the number of firms decreased, and after 1927 the real price of electricity rose. Stigler and Friedland (S&F, 1962) study the period before the Federal Power Act of 1935 and examine the effect of regulation on electricity prices, differential pricing across customer classes, and prices of electricity stocks. They conclude that regulation had no effect on electricity prices in 1922. Comanor (1970) and DeAlessi (1974) point out that under the appropriate one-tailed test the S&F regulation coefficient is significant at the 10% level, suggesting the opposite conclusion. S&F examine the ratio of residential to industrial prices and predict that regulators would cater to the popularity of cross-subsidized or relatively low rates for residential consumers. They uncover evidence of the opposite for both 1917 and 1937. The ratio of residential to industrial prices was higher in the regulated states. They conclude that regulation had no effect but might have concluded that industrial lobbies had more influence on the PSCs than residential groups. Jarrell (1978) modifies the S&F analysis by separating bearlyQ states that established commissions between 1912 and 1917. Jarrell finds early states had lower prices and highest outputs, and concludes that the competition induced by local franchises induced producers to lobby for state monopoly regulation. Jackson (1969) uses 1917–1950 data to estimate the more recent impacts of regulation, and concludes that regulation lowered the relative residential price using a specification similar to S&F. Moore (1970, 1975) finds that state regulation resulted in a higher ratio during the 1950s and 1960s. The conclusion is that influence of large industrial buyers on state PSCs solidified by the 1950s.

3. Incentives and local franchises The move to state regulation reduced regulatory negotiations, increased information asymmetries with regulators, and dispersed the effects of regulation. State monopolies ended franchise fees for local governments, and the public paid costs of the PSCs. Of the 40 states with PSCs in 1941, only 23 had a provision for the utilities to pay regulatory commission expenses (State Commission Jurisdiction, 1941). The principal–agent problem underlies another motive for the industry to advocate state regulation as developed by Barnett and Sophocleus (1997). A regulated industry has

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incentive to distance itself from its regulator. Local nonexclusive franchises would seem likely to keep price closer to the competitive level. Kaserman and Mayo (1995) point out that state regulation involves an elected official, a legislative committee, and a regulatory commission staff. With this increase in the number of principal–agent relationships, there is more opportunity for agents to substitute their own agendas for those of customers. In contrast, local franchises would make customer wishes more prominent. By expanding the scope of regulation from the local to the state level, the industry dispersed the effects of regulation over more customers. This larger and more diverse customer base made it more difficult for customers to organize politically in opposition to regulatory rulings. This, in turn, gave both regulators and regulated firms more discretion. Similarly, Pelzman (1976) makes the point that the electric industry would now prefer federal to state regulation.

4. Restructuring I: an empirical multimarket model At the turn of the century, natural gas was a final product, providing lighting and a general substitute for electricity. Natural gas was also an input in electricity generation. The input of gas in electricity generation increased dramatically during this transition: 1.3 billion cubic feet in 1907, 20 billion in 1922, and 96 billion in 1932. Further, by 1932 steam turbines generated over 60% of all electricity. The following multimarket system of stochastic equations captures these market interdependencies. Two stage least squares estimates on the pooled data yield consistent unbiased estimators: lnD ¼ a0 þ a1 lnPe þ a2 lnY þ a2 lnPg þ a4 lnM þ a5 lnN þ a6 T þ e1

ð1Þ

lnS ¼ b0 þ b1 lnPe þ b2 lnPg þ b3 lnPc þ b4 lnP0 þ b5 lnF þ b6 G þ b7 lnH þ e2

ð2Þ

lnF ¼ c0 þ c1 lnE þ c2 R þ e3

ð3Þ

lnDg ¼ d0 þ d1 lnPe þ d2 lnPg þ d3 lnY þ d4 lnM þ d5 lnN þ d6 T þ e4

ð4Þ

lnSg ¼ e0 þ e1 lnPg þ e5 :

ð5Þ

Symbols in the model are: D S Pe Y Pg V N T Pc

quantity of electricity demanded quantity of electricity supplied price of electricity manufacturing wage bill (proxy for aggregate income) price of natural gas manufacturing value added state population year price of coal

230

Po F G H E R Dg Sg

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price of oil number of electric firms % steam generation % hydrogeneration electric industry revenue state PSC regulation dummy variable quantity of gas demanded quantity of gas supplied

The quantities of electricity demanded and supplied equal the quantity of output in market equilibrium, D e=S e=Q e. Price P e is average revenue per kW h, reported in the data for 1927 and 1932 and calculated consistently for previous years. To the extent that electricity was a substitute for gas in consumption, the relationship between its price P g and the quantity of electricity demanded D would be positive in Eq. (1). Aggregate income Y, the manufacturing wage bill by proxy, should increase demand if electricity is a normal good. Industrial demand for electricity, represented by manufacturing value added V, would also raise demand. Population N should increase demand, as should time T with the introduction of electric appliances during the period. On the supply side, a higher price for the inputs of gas P g, coal P c, and oil input P o should raise cost and reduce electricity supply S in Eq. (2). The effect of the number of electric firms F on quantity supplied would depend on output per firm. Variables on the percentage of steam generation G and hydroelectric generation H in Eq. (2) capture the introduction of these technologies. The number of firms F is the endogenous variable in Eq. (3). Electric industry profit should lead to entry, and industry revenue E is a proxy for profit. State PSC regulation R is an exogenous political variable in the model that imposes entry barriers and should reduce the number of firms F. Data for natural gas are from Mineral Resources of the United States. A system of pipelines developed during the period from the major producing states: Pennsylvania, West Virginia, Ohio, Texas, and Oklahoma. In some states such as California, consumption equaled production. For states without production, there is no reported price but the average price of neighboring states is a proxy for the price of gas. For example, Mississippi reported no production or consumption in 1907 but Louisiana, Arkansas, Tennessee, and Alabama produced gas that was in principle available in Mississippi for no less than some average of these neighboring prices plus a transmission cost. A similar procedure calculates a price for coal P c and oil P o in states without production. The manufacturing wage bill Y is from Earnings of Factory Workers and the Statistical Abstract after 1929. Manufacturing value added V and total state population N are also from the Statistical Abstract. Dates of state PSC regulation from the NARUC Yearbook differ in a few cases from Stigler-Friedland (1962) and Jarrell (1978). Both S&F and Jarrell assume regulation was effective 3 years following a PSC but they typically began after years of judicial debate. S&F use 1914 as the first year for a state commission in Virginia but there had been a state commission since 1902. Legislation creating an Illinois PSC passed in 1907 but

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implementation did not take place until 1913. Municipalities did not idly lose a major source of revenue. Shortly following establishment of the PSC in Illinois, municipal governments started the bHome RuleQ movement to regain their lost local franchises as reviewed by Hughes (1983). Given the high political profile of restructuring, the present study uses no time lag for the state regulation variable R.

5. Empirical results of the multimarket model Table 3 presents the model estimates. The demand for electricity D in Eq. (1) is price inelastic, suggesting regulatory constraints were binding. The price and quantity demanded rose over the estimation period but control variables should adjust for increased demand. Without binding regulation the state monopolies would have charged higher prices, but the regulated price might have been higher than it would have been with competitive local franchises. Higher income Y increased demand, indicating electricity was a normal good. The price of gas P g did not affect demand, suggesting electricity was not an effective substitute for gas in consumption. Manufacturing output V had a positive effect on demand. Population N and time T increased demand. On the supply side in Eq. (2), the price of electricity P e had a negative effect on quantity supplied. The trend toward regulated state monopolies during the period evidently undermined the economic relationship between price and output. Input prices of gas P g and coal P c had no effect on electricity supply in Eq. (2) but a higher price of oil P o lowered supply. More firms F raised supply. The percentage of steam generation G had no effect on supply but increased hydrogeneration H reduced supply, suggesting customers paid the construction cost. Electric industry revenue E had a positive effect on the number of firms F in Eq. (3). Revenue E is a proxy for profit, and higher profit would attract firms to the industry. State Table 3 Multimarket system, 1907–1932 (t-statistics)

lnP lnY lnP g lnP c lnP o lnV lnF lnN T G H E R

Eq. (1)

Eq. (2)

Eq. (3)

Eq. (4)

Eq. (5)

lnD

lnS

lnF

lnD g

lnS g

0.923 (8.77) 0.218 (4.89) 0.149 (0.88)

4.379 (8.49)

3.046 (4.39) 1.756 (1.36) 15.37 (3.14)

12.36 (2.83)

0.583 (0.54) 0.520 (0.82) 0.836 (2.03)

0.321 (7.74)

2.135 (1.78) 0.008 (2.53)

0.223 (3.79) 0.075 (15.8)

7.185 (4.22) 0.462 (3.36) 0.154 (0.64) 3.542 (5.09) 36.4 (3.32) 60.3 (2.20)

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PSC regulation R lowered the number of firms, most likely promoting consolidation or mergers as it inhibited competition. Regarding the demand for natural gas D G in Eq. (4), the price of electricity P e had a positive impact. Even though electricity was not a substitute for gas in consumption, gas was a substitute for electricity. Consumers were sensitive to the price of electricity, at the time newer and relatively expensive. The coefficient on the price of gas P g in Eq. (4) indicates highly price elastic demand. Higher income Y lowers demand for gas suggesting it was an inferior good (a marginally insignificant effect). The demand for gas increased with both population N and time T. The price of gas P g had a negative effect on the quantity of gas supplied S g in Eq. (5) due in part to the states reporting no production and the imputed positive price. Previous studies have reported inconclusive evidence on the effect of state regulation on the price of electricity. Price was falling during the early period but the decline stopped at about the time a substantial number of states had regulatory commissions. Increased regulation lowered the number of firms, reducing supply. Solving Eqs. (1) and (2) in Table 3 for lnP, the elasticity of price with respect to the number of firms is dlnP e/ dlnF=0.002. Given dlnF/dR=60.3 from Eq. (3), it follows that dlnP e/dR=0.061. State PSC regulation led to a higher price of electricity. It is possible to calculate the entire set of price elasticities in a similar fashion. In equilibrium, lnD=lnS in Eqs. (1) and (2). Dropping insignificant coefficients and solving for lnP e, lnPe ¼ 0:173lnPg þ 0:045lnY þ 0:067lnV  0:002lnF þ 0:046lnN þ 0:015T þ 0:730H:

ð6Þ

Every 1% increase in the price of gas P g raised the price of electricity by only 0.173%. Elasticities of price P e with respect to income Y, manufacturing value added V, number of firms F, and population N are very small.

6. The effects of restructuring on cost and profit The present section examines the effect of regulation on cost and profit using data from 1907 to 1922. After 1922, the Department of Census quit reporting bexpensesQ perhaps due to pressure from the evolving monopolies. There might have been an assumption that revenue and cost would be equal for rate-of-return regulated firms. Of the 40 states that had regulated monopolies by 1932, all but two had made the transition by 1922. Let C e represent the average cost (price) of producing 1 kW h of electricity, calculated as total expenses divided by output. Average output per firm is q. Table 4 presents an estimate of the cost function at the firm level, lnCe ¼ f0 þ f1 lnPg þ f2 lnPc þ f3 lnP0 þ f4 lnq þ f5 G þ f6 H þ f7 R þ f8 T þ e7 :

ð7Þ

An increase in the price of gas P g raises cost C e, while prices of coal P c and oil P o have no effect. Cost C e declines with output per firm q, evidence of decreasing cost at the firm level.

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Table 4 Cost and profit functions, 1907–1922 lnC lnP e lnP g lnP c lnP o lnq G H R T

0.119 0.618 0.511 0.254 0.087 1.073 0.189 0.027

lnp (1.67) (0.43) (0.59) (7.84) (0.55) (8.79) (2.42) (3.14)

1.065 0.049 0.004 0.096 1.050 0.256 0.394 0.125 0.034

(10.3) (0.78) (0.03) (1.27) (28.4) (1.81) (2.77) (1.79) (3.87)

A higher percentage of hydroproduction H lowers cost C e. Its positive effect on price in Eq. (2) suggests that regulated monopolies enjoyed lower costs but charged higher prices when they moved to hydrogeneration. Regulation R raises cost due to the lack of competitive pressure and the incentive to overstate cost to regulators. Cost C e declines over time T. Profit p E is income less expense, and the following profit function focuses on the effect of regulation R on profit, lnpe ¼ g0 þ g1 lnP þ g2 lnPg þ g3 lnPc þ g4 lnP0 þ g5 lnq þ g6 G þ g7 H þ g8 R þ g9 T þ e:

ð8Þ

The estimate of Eq. (8) is also in Table 4. A higher price of electricity P e raised profit p E , and by about the same percentage. Input prices P g, P c, and P o have no effect on profit p E , suggesting electric customers paid fuel costs. Larger firms have higher profit, every 1% increase in output per firm q resulting in slightly more than 1% increased profit p E . Firm size q does not affect cost in Eq. (7) and must have stimulated revenue. The consolidation and mergers of restructuring paid dividends. Increased percentage use of steam plants G lowered profit p E slightly even though costs in Eq. (7) are not affected. Firms were evidently not able to raise revenue with the increased use of steam. Increased percentage hydrogeneration H raised profit p E in Eq. (8) and lowered cost in Eq. (7). Over time T, profit p E fell. The negative coefficient for regulation R in Eq. (8) might suggest that it was successful in controlling profit p E . Regulated monopolies, however, have the incentive to overstate costs and report low profit. Combining the results for R in Tables 4 and 5 indicates that regulation led to higher cost and lower profit. Higher costs could have been due to relatively high worker perks, overcapitalization, or inefficiency of the new state monopolies. To examine the effect of regulation on profit over time, split the 1907–1922 data into two subsets with the break at 1912 corresponding roughly to what Jarrell (1978) calls early and late regulation. Only 18 states had commissions in 1912 but there were 30 by 1917, and Jarrell uses 1917 as the break date. A dummy variable D for the profit function in Eq. (8), D=0 in 1907 or 1912 and D=1 otherwise, is interacted with each term in Eq. (8) and reported in Table 5.

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Table 5 Determinants of profit, pre- and post-1912 lnP e lnP g lnP c lnP o lnq M H R

0.978 0.012 0.084 0.207 0.980 0.721 0.279 0.249

(6.89) (0.18) (0.49) (2.02) (19.4) (3.14) (1.37) (2.62)

lnPD lnP gD lnP cD lnP oD lnqD MD HD RD

0.306 0.064 0.207 0.088 0.118 0.555 0.392 0.168

(1.33) (0.47) (0.65) (0.57) (1.49) (1.93) (1.27) (1.19)

Price had a strong effect on profit p E up to 1912. Prices of gas P g and coal P c had no effects on profit p E during either period, evidence electric customers paid fuel costs regardless of industry structure. Competition ensured lower fuel costs resulted into lower electricity prices. A higher price of oil P o increased profit p E for electricity producers before 1912, suggesting that electricity and oil were substitutes in consumption. Output per firm q had a strong positive effect on profit during the early period, again suggesting that restructuring paid dividends. The negative effect of percentage steam generation G on profit p E occurred before 1912. The new technology was not profitable during the more competitive era. Competition may have encouraged the new technology but firms were not able to translate that technology into higher profits. Increased percentage hydrogeneration H, however, raised profit p E during the competitive early period. Higher profit is consistent with the lower cost in Eq. (7). However, over the entire period in the multimarket model, increased hydrogeneration resulted in lower cost and higher electricity prices. Hydrogeneration was cost effective but consumers did not benefit over the entire period, perhaps due to monopoly pricing. There is a negative relationship between regulation R and profit p E during the competitive period up to 1912, but regulation encouraged firms to report lower profit. Firms lobbying for a monopoly franchise would want to appear unprofitable. The coefficient of R for the late period is the sum of coefficients of R and RD: 0.249+0.168=0.081. The t-statistic is calculated by dividing the coefficient estimate by its standard error [var( G)+var(GD)+2cov( G, GD)]2=0.105. The insignificant t-statistic is 0.762. After 1917, regulation did not affect profit.

7. Conclusion In the early years of the US electric industry, a successful industry lobby led to restructuring from local franchises to state regulated monopolies. The present study finds that this first step in restructuring reduced the number of firms, raised cost, and raised the price of electricity. Regulation had less effect on profit as the monopolies matured. The present results support the theory that the new monopolies captured the regulators. At present, there is an opposite move of sorts, from regulated state monopolies toward retail competition. Reversing the results of the present study, the implications are more

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firms, lower cost, and lower price. There are complicating issues and historical differences from the earlier restructuring, including lower energy consumption shares, higher per capita consumption, better technology, telecommunication, more local pollution, increased awareness of pollution, highly organized interest groups, increased government involvement at various levels, and federally regulated interstate wholesale competition. Still, it is safe to say that a move away from regulated state monopolies toward increased competition will increase the number of firms, lower costs, and lower prices in the electric industry.

Acknowledgements The authors thank Randy Beard, Dave Kaserman, and John Jackson for comments.

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