Indiana University Research & Creative Activity January 1998 Volume XX Number 3

"Looking Over Their Shoulders"
Monitoring the Utility Industry and the Regulatory System
by Shawna Brynildssen

Thomas Lyon, an associate professor of business economics and public policy at Indiana University Bloomington, sometimes describes his research in energy regulation as "looking over their shoulders." His projects examine the key players in the utility industry--both the companies and the government regulators--to make sure they are doing what they are supposed to do. "My research is based on the belief that even though we have a good regulatory system in the United States, it is still not perfect," he says. "One of the things we, as academics, can do is to watch public utility companies and regulators to make sure they're doing a good job."

Lyon's interest in energy dates back to his undergraduate years--the years of the energy crisis and the Arab oil embargo. While working on his bachelor's degree in engineering management at Princeton in 1977-81, he dedicated himself to exploring energy use and its environmental impact. He still speaks with nostalgia of a senior project most of us would find daunting--donning a protective suit and hefting a radiation counter to observe the cleanup of Three Mile Island. "My advisor was working with an environmental group that was overseeing the cleanup process," he says. The visit to the damaged nuclear reactor gave Lyon a personal perspective. "It was a way to get a clearer sense for myself of how large the nuclear wastes were, where they were being disposed of, and how," he says.

It also gave him a taste of what it was like to play the role of watchdog. "I was first drawn in from the environmental angle. I became interested in whether the government was doing an adequate job of protecting the public from the dangers that energy production poses," Lyon says. "That is why I got involved in energy issues to begin with."

After graduating, Lyon went to work for the National Audubon Society, developing recommendations for policies that would ameliorate the environmental impact of energy use. At Audubon, however, Lyon realized that many energy policies were essentially economic, rather than environmental. "At the time, the head of the project was a physicist and I was an engineer," Lyon says. "As we worked on policies, it became quite clear that one of us should be an economist. We were dealing with economics, trying to predict how the market would respond to our policies, but neither of us had training in it." To bridge this gap between energy and economics, Lyon returned to school and completed his Ph.D. in Engineering­Economic Systems at Stanford University.

His main area of interest and expertise has now shifted from the environmental aspects of energy production to its economics. Today, Lyon researches how government regulations affect natural gas and electricity distributors and how regulatory policy can be improved.

Beginning in the mid 1980s, changes in regulatory policy caused a restructuring of the entire gas industry. For many years, producers had sold to pipelines, pipelines to distributors, and distributors to consumers in a strictly regulated vertical market. In 1984, however, the Federal Energy Regulatory Commission (FERC) began to open access to the pipeline network and allowed producers to sell directly to distributors, turning pipelines into transporters rather than merchants of natural gas.

One issue arising from this regulatory reform was the financial burden imposed on pipelines still bound by long-term contracts with natural gas producers. "These contracts had prices built in to increase over time, because everyone thought the cost of natural gas was going to rise forever," Lyon says. "Once FERC allowed distributors to buy gas from sources other than the pipeline, however, the high-cost contract gas became unmarketable." The costs of these unmarketable supplies, sometimes dubbed "stranded costs," became a major point of contention between the pipelines and the FERC.

As one of his early postdoctoral projects, Lyon researched how the design of contracts changed with the advent of open access in the gas industry. What he saw was the emergence of a huge "spot" market, with gas trades lasting thirty days as opposed to the old twenty-year contracts. "The spot market quickly rose to over 50 percent of gross sales," he says. "Long-term contracts were used much less often- although they are still used sometimes because they ensure reliability."

Now, with the natural gas industry ironing out the kinks and settling into its new structure, the electric industry is moving into the early phases of a similar deregulation process. Currently, individual states are determining whether and how they will allow access to the electric grid. Deregulation of the electric industry, however, is moving slowly. One of the reasons for this slow pace is that regulators are struggling with how to treat the stranded costs that will inevitably result from opening the market. In the electric industry, the issue of stranded costs is much bigger than in the natural gas industry, according to Lyon. "People estimate the level of stranded costs in the electric industry at $200 billion," he says. "Failure to recover these costs could bankrupt some of the utility companies." Problems of cost recovery have long been an issue for electric utilities, and this is what Lyon's most recent research has explored.

Until the mid-1980s, electric utilities had come to feel comfortable making capital investments. The traditional "regulatory contract," while restricting utilities' profits, also reduced their risk of loss; any investment costs "prudently incurred" were passed on to ratepayers. In the 1980s, however, many nuclear power plants turned out to have costs far beyond initial projections and, as a result, a number of state public utility commissions responded by refusing to let utility companies pass on these costs to consumers.

These disallowed costs have been significant: during the 1980s, public utility commissions disallowed roughly $19 billion in electric power plant investments that would otherwise have become part of utilities' rate bases. Industry members have alleged that these large-scale disallowances amount to purely opportunistic "hindsight" review, in which politically motivated regulators have defaulted on their end of the regulatory contract. Defenders of the regulatory commissions' actions, however, argue that the cost disallowances reflected not an abrogation of the regulatory contract, but the protection of consumers from the bad judgment of certain electric utilities. Lyon focuses on how these disallowed costs have affected the utilities' investment decisions. "I'm asking what happens when regulators make these disallowances, how the electric firms respond," he says. "In particular, do cost disallowances imposed on one firm spill over and affect the investment behavior of other firms?"

Historically electric power has been provided by regulated monopolies with specified service territories. Customers unsatisfied with the service or price offered by their local monopoly had no real alternatives. This situation is changing, however, as states consider laws that would allow new entrants to compete for electricity customers.


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In several papers, Lyon has explored the theoretical possibilities of how cost disallowances might affect utilities' behaviors. He points out that although utilities may respond by reducing investment, this does not necessarily translate into underinvestment relative to what would be most socially desirable. If firms, fearing disallowances, reduce their investments too much, that can eventually result in an unreliable power supply, manifested in blackouts and brownouts. On the other hand, if electric utilities have overinvested, a reduction in investment spurred by the hindsight review is economically desirable. Theory alone, however, cannot determine what has actually happened.

A second, related theory is that the threat of cost disallowances may keep utilities from investing in innovative technologies. Because hindsight reviews tend to punish investments that have unfavorable outcomes, they may discourage firms from gambling on new technologies. With the threat of unrecoverable costs hanging over their heads, utilities may be more likely to opt for safer, more proven investments. Lyon's current project expands upon earlier research, compiling empirical results to address the question of whether regulatory cost disallowances have, in fact, led to reduced utility investment. "I'm currently looking at investment practices of 156 of the largest utility companies in the country between the years 1970 and 1991," he says. "This project helps put in perspective the theoretical papers that went before."

Lyon premises his study on the hypothesis that cost disallowances may affect subsequent investment behavior in three different ways, depending upon how utility companies perceive them. If utility companies perceive disallowances to be caused by a regulatory regime shift, then all firms subject to the same state regulator should reduce investment after a disallowance in that state. If disallowances reflect "bad luck," such as unexpectedly low demand, then they should have no effect on any firm's propensity to invest. Finally, if firms perceive disallowances to be the result of bad judgment on the part of the disallowed utility, then that firm should reduce its investment, but other firms should not. "What we have found is that the firm that gets 'dinged' (disallowed) definitely does reduce its investment very substantially," Lyon says. "The next question, then, is what do the other firms do? Do they follow suit? What we find is that they do, but not very much."

Real Investment by Electric Utilities, 1970-1991

During the 1980s, regulators often refused to allow electric utilities to charge consumers the full costs of over-budget power plants; these "cost disallowances" totaled more than $19 billion. The firms that suffered disallowances typically had initiated massive investment programs that peaked in the late 1980s. In contrast, those utilities that never suffered a cost disallowance have been gradually reducing their investment levels since the 1973 Arab oil embargo.


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The study results suggest that the electric companies, for the most part, do not think that utility commissions have broken the regulatory contract. "The perception is that the regulators have punished the bad plants and left the good ones alone," Lyon says. "Basically, the reviews are not causing underinvestment. They are serving as a corrective measure."

Lyon points out that the study also suggests regulators are holding themselves in check so they don't create an underinvestment backlash. "I expect regulators in the future largely to continue to allow firms to recover their prudently incurred stranded costs," Lyon says. "I don't expect to see any wholesale abandonment of stranded costs." The implications of these findings are positive, then, both for electric utilities and for consumers who would eventually suffer the consequences of utilities' underinvestment.

Ultimately, what Lyon's findings indicate is that the regulatory system is working approximately as intended. "The regulatory contract is in better shape than we might have thought," he says. "During a very difficult time for the industry, it has held up surprisingly well."

In future research, Lyon plans to explore the impact of giving regulators jurisdiction over multiple industries and multiple companies. "States vary a bit, but most commonly one state utility regulatory commission has jurisdiction over natural gas, electricity, telecommunications, and water--and there are typically several firms in each one of these industries," Lyon says. "Oddly enough, however, economic research has focused almost exclusively on situations where there's a single regulator and a single firm. For some reason, we haven't addressed the question of expanded jurisdiction." Lyon's preliminary theory is that giving regulators authority over several industries may serve to promote fair decisionmaking. "If a regulator is responsible for lots of different firms, maybe even lots of different industries, he may be less likely to go too far, to make a politically influenced decision in one industry, because it could have repercussions in the other industries as well," he says.

To test his theory, Lyon plans to study the origins of state regulation of electric utilities. Until the very early 1900s, electricity in the United States was regulated by cities, rather than states, in a system similar to the "one regulator-one firm" of the current research models. Between 1907 and 1920, however, thirty-five states switched from municipal to state-level regulation, and the remaining states followed suit soon thereafter. Lyon says that a number of prior studies on this switchover have argued that it was a political move on the part of the utilities, a move designed to raise prices. He points out, however, that while electric rates did increase after the change to state-level regulation, this increase might indicate that utilities operating under city regulation had been underinvesting. If this were the case, then, it could point to misuse of the original system not by the utilities, but by the municipal regulators. "It's possible that the municipalities were corrupt," Lyon says. "It may be that the state-level regulations opened up a whole new level of trust that enabled the utilities to adequately invest without the fear that their investments would be confiscated by the regulators. For me, this is another opportunity to look back over the shoulders of the state legislatures to see whether they were unduly influenced by pressures from the utilities or whether they were acting in the best interest of the public." E

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