Assessing deregulation: the clash between promise and reality.

Author:Trebing, Harry M.

There is a general consensus that public utility services such as electricity, natural gas, telecommunications, and water are an integral part of the infrastructure of modern society. These services are typically provided by complex systems of capital-intensive networks that link centralized supply with a wide range of diverse customer classes. Accessibility to these services becomes critical if each sector of society is to realize the maximum potential gain to be derived from the employment of these services to enhance productivity, income growth, and the attainment of societal goals. While there may be agreement on the relationship between public utilities as infrastructure and the gains to society, there is no consensus regarding the appropriate organization and governance of the industries supplying these services. For more than 100 years there has been a sharp dichotomy between those who would have government play a major role through direct intervention and regulation, and those who would leave the development and operation of these industries to private initiative within the context of free market incentives and penalties.

Among the earliest proponents of government regulation were the institutional economists who played a significant role in shaping the content and form of regulation during the Progressive and New Deal eras. Institutionalists participated in developing new regulatory commissions, the methods of control, and the adaptation of the regulatory process to changing industry structures. By the 1940s, the work of the institutionalists had become well accepted as a part of the regulatory framework that had been put in place at the federal and state levels. A central feature of the institutionalist approach continues to be a belief in the need for government intervention to constrain market power and assure full access to utility services for all types of consumers. Institutionalists perceive regulation to be an evolutionary process that must change in order to be responsive to evolving industry structures, new technologies, and new corporate strategies. (1)

The critics of regulation represent a diverse group of academics and others who share a common belief in the supremacy of free markets over any form of regulatory intervention. They draw upon revisionist theories of government and regulatory history to demonstrate the impossibility of public interest regulation. In contrast to the institutionalists, the critics of regulation share a libertarian desire to limit, constrain, or reduce the influence of government. (2)

Beginning in the late 1960s, a series of major industry-wide problems arose that createdconditions that would eventually lead to public demands for a drastic change in regulatory policy. The rapid fly-up in energy prices, the continuing threat of an energy crisis, the growing shortage of natural gas in interstate markets, the massive cost overruns associated with new nuclear plants, and the bitter resistance of AT&T to new entrants employing new technologies that promised improved service at lower prices combined to create pressures for access to a greater range of supply options. Concurrently, there was growing evidence of managerial incompetence in these industries. Regulation was blamed, at least in part, for many of these problems.

Three major pressure groups moved aggressively to take advantage of this situation and actively promote deregulation. These were the large industrial buyers of energy and telecommunications seeking to extract major price concessions from utilities and carriers, a number of new entrants anxious to gain access to markets that were perceived to be potentially lucrative, and a new class of utility managers that envisioned the utility as a cash cow that could be milked to support entry into deregulated markets. For these groups, the largely academic arguments of the critics of regulation provided an ideal conceptual framework for promoting their cause. Free markets would provide (1) increased innovation and efficiency, (2) lower prices, (3) greater consumer choice, (4) rapidly diminished incumbent market power because of new entry, and (5) a superior infrastructure capable of serving all sectors of society.

The late 1970s and 1980s saw the relaxation or abandonment by state and federal regulators of many of the practices closely associated with the institutionalists' approach to regulation. Transitional price caps replaced rate-base/rate-of-return regulation, merger policies became increasingly permissive, and regulatory agencies sought guidelines that would aggressively promote competition. It was assumed that passage of the Energy Policy Act of 1992 and the Telecommunications Act of 1996 would open the doors to an even greater range of free market opportunities. By 1999, more than a dozen states sought to promote retail competition in electricity to complement efforts by the Federal Energy Regulatory Commission (FERC) to promote wholesale competition in generation. The Federal Communications Commission (FCC) essentially deregulated the large long distance interexchange carriers (IXCs) while endeavoring to promote entry into local exchange markets by requiring the resale of services or the leasing of local plant facilities to competitive local exchange carriers (CLECs).

By the 1990s it began to appear that free market proponents were achieving a significant measure of success. New energy trading markets for electricity and gas appeared for the first time, and trading volumes grew at an exponential rate. New entrants began building deregulated generating plants based on combined cycle gas turbine technology. Market structure turbulence also appeared as utilities sought to move into new service territories or to cross industry borders. The most remarkable example of the latter was the Montana Power Company, which sold its entire electricity complex and reinvested the proceeds in Touch America--a telecom entity. (3) In telecommunications, there apparently were 300 new CLECs anxious to challenge incumbent local exchange carriers (ILECs), and there were claims that intermodal rivalry between wireline, cable, and wireless technology would soon wipe away traditional centers of market power. In each of these cases, the financial markets stood ready and willing to provide funds to new entrants and incumbents alike.

Traumatic Collapse

Beginning in 2000, an unsuspecting public was shocked to learn that a massive, unprecedented wave of corporate failures and bankruptcies had occurred in the public utility industries. The bankruptcies of WorldCom (2002) and Enron (2001) constituted the first and second largest bankruptcies in U.S. history. This news was accompanied by widespread exposes of fraudulent corporate behavior, dramatic falls in stock values, debt payment defaults, downgraded credit ratings, and large corporate layoffs. The magnitude of this collapse was overwhelming. The Wall Street Journal estimated that the market value of the entire telecom sector had fallen by almost $2 trillion and that more than 500,000 telecom workers had lost their jobs (R. Blumenstein and S. Thurm, "Telecom Sector's Bust Reverberated Loudly across the Economy," Wall Street Journal, July 25, 2001). Standard & Poor's estimated that seventy-four telecoms defaulted on $112.6 billion in debt between 1999 and 2003. Questions were also raised about the $306 billion in debt for telcos and cable, 21 percent of which would mature by 2005 (S. Young, "Telecom-Sector Debt May Claim More Victims," Wall Street Journal, April 21, 2003, C-1). Finally, the stock values of the twenty-eight largest CLECs dropped by 94 percent, and many of these CLECs were in bankruptcy or reorganization. The electric and gas companies most heavily involved in deregulated markets suffered an approximate 90 percent decline in stock values between 2000 and 2002. By 2003, the credit ratings of 16 percent of the firms in this industry had been reduced to junk status (R. Smith, "Utility Sector's Credit Quality Deteriorates as Borrowing Jumps," Wall Street Journal, July 31, 2003, A-13). Even El Paso, the world's largest natural gas company, found that fraudulent behavior had driven its stock price from $75 to $7 per share. Nor was California, which had pioneered in electricity deregulation in 1986, spared the consequences of extreme price volatility and a massive debt burden incurred in the hope of securing price stability and an assured power supply. In 1999-2000, the spot price for electricity in California increased from $30 MWh to more than $1000 MWh. The state entered into a ten-year contract to buy power at $69 MWh to protect its retail customers. But this price subsequently fell to $30 MWh, and the state has had only modest success in renegotiating these contracts even though there is considerable evidence of price manipulation by traders.

The public utility industries had traditionally been perceived as the bedrock of conservative investment--but now many of these firms were publicly disgraced. What made matters worse was the fact that traditional free market safeguards and constraints proved to be largely ineffectual. The auditing review of corporate books and records, (4) the oversight of executive behavior by boards of directors, and the ability of financial markets to detect fraud ex ante failed to provide the requisite degree of protection. Simply put, executives wanted to keep stock values high by creating the illusion of growth even if this meant breaching ethical boundaries and falsifying documents and reports. Edythe Miller has asked, "Where were those protectors that had been relied upon to forestall such activity? Out to lunch, it would seem." Continuing, she noted that "economic regulators appear to believe that their real job was deregulating ... [or they were] starved for funds and resources" (Miller 2003).

Congress reacted to the crisis with passage of the Sarbanes-Oxley Act of 2002...

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