Deregulatory Takings and the Regulatory Contract: The Competitive Transformation of Network Industries in the United States.

• Author: Hovenkamp, Herbert
• Position: Review

Deregulatory Takings and the Regulatory Contract: The Competitive Transformation of Network Industries in the United States. By J. Gregory Sidak & Daniel F. Spulber. Cambridge: Cambridge University Press, 1997. Pp. 656. $54.95.

1. INTRODUCTION

   Over the past twenty years, Americans have turned their backs on one of the New Deal's most important legacies by deregulating nearly every market to which regulation has been applied. At one time the markets for interstate trucking and air transport were subject to strict cost-of-service ratemaking and government controls on new entry. Now, however, both trucking(1) and air tickets(2) are priced by the market, the same way as potatoes or lumber, and anyone who can obtain access to the necessary facilities can enter. The telecommunications system was once a regulated monopoly from top to bottom, with price regulation applying to everything from long distance service to the mandatory rental rate of a telephone instrument.(3) Now long distance rates are set through competition by numerous firms, the instruments are purchased off the shelf from any of a number of retailers, and significant competition for local telephone service appears imminent.(4) Wholesale transfers of natural gas and electric power have also become substantially competitive, and the market for the delivery of retail electricity to residences may soon become competitive as well.(5)

   This deregulation has produced tremendous gains for the United States economy. Prices for most deregulated services have dropped significantly. Following deregulation, the rate of innovation has increased substantially, with telecommunications providing only the most visible example. And, of course, we have saved many of the costs of operating the regulatory system itself--a set of pure transaction costs, or deadweight loss. Society is probably better off as a result.(6)

   But while society as a whole may be better off, deregulation has undoubtedly diminished the welfare of the once-regulated firms. On the one hand, at least some of these firms have seen the removal of various regulatory restraints that prevented them from expanding into other markets. On the other hand, the rigors of competition have produced lower rates of return, greater risks, and occasionally the premature retirement of assets.

   The main concern of Sidak and Spulber's provocative Deregulatory Takings and the Regulatory Contract(7) is the state's duty to compensate regulated firms that encounter these losses. The authors give most of their attention to the problem of "stranded" costs: investments in specialized, durable assets that may have seemed necessary, or at least justifiable, when constructed and placed into service under a regime of price and entry controls but that have become underutilized or even useless under deregulation.(8) The superfluous electric generation plant is a paradigmatic example of this kind of asset.(9) In the former regime of tight wholesale and retail regulation, utilities were typically regarded as being self-sufficient. To a significant extent, they produced their own power for their own customers. Furthermore, they needed to have a certain amount of excess capacity to protect their customers against unusually high demand or a temporary generation plant shutdown. But in the deregulated environment three things are happening.(10) First, utilities can freely purchase wholesale electric power from elsewhere, thus giving an advantage to efficient producers who have lower costs; further, the high degree of interconnectivity necessitates fewer backup resources.(11) Second, many utilities have been required to purchase electricity from alternative low-cost sources, thus forcing their own higher-cost sources to lie idle. Third, certain "dedicated" equipment that was designed with a single producer and distributor of power in mind is unsuitable in the modern environment of free switching among numerous power sources.

   The result is that, under deregulation, some of the plants and other equipment in which the utilities made significant investments either can no longer be operated profitably or cannot be operated at all. This problem is exacerbated by extreme specialization. An electric generation plant that has become unproductive as a result of mandatory power wheeling among utilities cannot profitably be converted into another use. In the extreme case of a completely useless plant, the owner may be able to obtain no more than the facility's salvage value, which is typically only a tiny percentage of the unrecovered investment.(12)

   To be sure, the nature and extent of the stranded cost phenomenon varies greatly from industry to industry. For example, deregulation in the airline industry has led to greatly increased demand for air travel.(13) Not only did the deregulated airlines not have to retire significant numbers of aircraft in response to deregulation, but the demand for aircraft has been so great that the carders have tended to fly airplanes far longer than their manufacturers designed them to be flown.(14) Further, mobile assets such as aircraft and trucks do not face the "stranded" cost problem to the same extent as, say, electric generation plants. If an airplane or a truck becomes superfluous in one market, it can readily be shifted to another.

   The full costs of assets that are stranded by deregulation remains to be determined. As the case of airline deregulation suggests, one anticipated effect of deregulation is lower prices, which produce increased demand. To the extent that deregulation increases demand, fewer assets are "stranded," and indeed, even older, less efficient plants may continue to find a use. So deregulation of telecommunications and electric power will shift a great deal of production toward more efficient producers, thus decreasing the demand on less efficient producers. At the same time, deregulation may increase total demand and leave a market even for higher cost producers. Indeed, some recent power plant sales made after Sidak and Spulber's book was published suggest that the problem of stranded costs in the electricity industry is not nearly as great as was once thought. Power plants that had been written off as stranded by deregulation are in fact finding strong market demand.(15)

   Part II of this Book Review examines the notion of the "regulatory contract," that is, a unique bargain between the sovereign and the regulated firm. This presumed bargain provides the foundation for the Sidak/Spulber claim that a deregulated utility is entitled to compensation for its stranded costs. But the historical domain of the regulatory contract is not nearly as broad as Sidak and Spulber argue, and even when such a contract exists, it does not necessarily have the meaning that they assign to it. Further, while the argument for compensation based on a regulatory contract might make some sense when a regulated firm makes its investment in reliance on a government promise of regulated monopoly status, a great deal of regulation did not develop in that way. Rather, it was imposed ex post on firms that had already made their investments and thus could not have relied on any such governmental promise.(16)

   Part III then continues this argument by explaining that the case for compensation is particularly weak when the private utility itself--often acting with only nominal governmental supervision--made its regulatory investments on its own initiative. This is indeed what occurred in a great majority of regulated industries.

   In Part IV, I assess the notion that changes in regulatory policy rather than changes in technology are mainly responsible for the predicament in which some regulated firms find themselves. No one compensates a firm for technological obsolescence resulting from ordinary market forces. But an essential premise of the Sidak/Spulber argument is that deregulation policy rather than technological change has caused this obsolescence, and since the government, unlike markets, is responsible for the destruction in property values that it imposes, compensation must be paid.(17)

   Finally, Part V challenges the Sidak/Spulber notion that compensation should be based on losses anticipated at the time competition is introduced, rather than on ex post measurements of losses that actually occurred. The method one chooses is of great importance, as anticipated losses have often failed to materialize. Sidak and Spulber's endorsement of the former method is inconsistent with the way damages are ordinarily measured in takings cases, and there are persuasive reasons for not deviating in these situations.

2. THE REGULATORY CONTRACT

   Sidak and Spulber argue that public utilities that face "stranded" costs as a consequence of the deregulation process generally should be compensated for their losses. They point out that deregulation is a government act, which in this case has "taken" the property of the deregulated utilities, thus giving them a constitutional right to compensation under the Fifth Amendment's Takings Clause.(18)

   That deregulation is a government-initiated process is thus central to the Sidak/Spulber argument. The market itself frequently makes older facilities obsolete or unprofitable, yet one who invests in soon-to-be-outmoded technology is not entitled to compensation. For example, if I have the misfortune to invest in a slide rule production plant that opens just days before a breakthrough allows scientific calculators to be produced cheaply for the mass market, no one will compensate me for my improvident investment. Indeed, the competitive market is filled with the abandoned facilities and other debris that rivals' innovations have made obsolete.(19)

   Further, as a general matter, forcing firms to bear the costs of obsolescence is wise policy because doing so encourages efficient risk-taking. If an entrepreneur contemplating a new investment knew it was entitled to compensation from the government...