PRICE LEVEL REGULATION FOR DIVERSIFIED PUBLIC UTILITIES Topics in Regulatory Economics and Policy Series Michael A. Crew, Editor Graduate School of Management Rutgers University Newark, New Jersey, U.S.A. Previously published books in the series: Rowley, C., Tollison, R., and Tullock, G.: Political Economy of Rent·Seeking Frantz, R.: X-Efficiency Crew, M.: Deregulation and Diversification of Utilities Shogren, J.F.: The Political Economy of Government Regulation PRICE LEVEL REGULATION FOR DIVERSIFIED PUBLIC UTILITIES: AN ASSESSMENT Jordan Jay Hillman Northwestern University School of Law Ronald R. Braeutigam Northwestern University ., ~ Kluwer Academic Publishers Boston/Dordrecht/London Distributors for North America: Kluwer Academic Publishers 101 Philip Drive Assinippi Park Norwell, Massachusetts 02061 USA Distributors for all other countries: Kluwer Academic Publishers Group Distribution Centre Post Office Box 322 3300 AH Dordrecht, THE NETHERLANDS Library of Congress Cataloging-in-Publication Data Hillman, Jordan Jay. Price level regulation for diversified public utilities: an assessment I Jordan Jay Hillman, Ronald R. Braeutigam. p. cm. - (Topics in regulatory economics and policy series: 5) Bibliography: p. Includes index. ISBN-13: 978-1-4612-8900-5 e-ISBN-13: 978-1-4613-1629-9 001: 10.1007/978-1-4613-1629-9 1. Public utilities-Rates-Law and legislation-United States. 2. Public utilities-United States-Rates. I. Braeutigam, Ronald. II. Title. III. Series: Topics in regulatory economics and policy; 5. KF2103.H55 1989 343.7309'1-dc20 [347.30391] 89-34144 CIP Copyright © 1989 by Kluwer Academic Publishers Softcover reprint of the hardcover 1st edition 1989 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher, Kluwer Academic Publishers, 101 Philip Drive, Assinippi Park, Norwell, Massachusetts 02061. Contents Foreword and Acknowledgements Introduction and Statement of Purpose 1 The Inefficacy of Profit Level Regulation for ix 1 the Natural Monopoly Markets of Diversified Firms 5 A. AN ECONOMIC OVERVIEW 5 1. Economic Rationale for Regulation 2. Economic Goals of Natural Monopoly Regulation 3. Incentives Under Rate of Return Regulation B. A LEGAL OVERVIEW 1. A View from the MFJ: A Selective Approach to Intermarket Subsidies 2. A View from the FCC: Cost Allocation and Transfer Pricing 3. A View from the States: Transfer Pricing 4. The Uses and Abuses of "Stand Alone" Costs 5. Regulating the Structure of Diversified Utilities Under Profit Level Regulation 6. Summary: Profit Level Regulation and Diversification 5 7 9 13 13 15 16 19 25 35 v vi Price Level Regulation for Diversified Public Utilities 2 The Welfare Ingredients of Price Level Regulation: Incentives and Decisional Options 37 A. THE FIRM'S INCENTIVES AND THEIR WELFARE IMPLICATIONS 37 B. MAJOR DECISIONAL ISSUES IN A PRICE LEVEL REGIME 43 1. Defining the Market Scope of a Price Level Regime 2. Determining Initial Price Levels a. Aggregate Levels b. Price Relationships 3. Price Level Adjustments a. Programmed Adjustments: Inflation and Productivity b. Non-Programmed Adjustments: Material and Irregular Exogenous Cost Changes c. Adjusting for Differential Costs and Demand Factors 4. Price Structure and Relationships: Aggregate and Disaggregate Ceilings 43 45 45 48 49 49 53 55 59 3 Assessing the Efficacy of Price Level Regulation for the Natural Monopoly Markets of Diversified Firms 63 A. POTENTIAL BENEFITS OF PRICE LEVEL REGULATION 1. Productive Efficiency and Innovation in Natural Monopoly Markets 2. Allocative Efficiency a. Pricing in Natural Monopoly Markets b. Pricing and Output in Unregulated Markets 3. Reducing the Costs of Regulation 63 63 64 64 64 65 B. POTENTIAL PROBLEMS OF PRICE LEVEL REGULATION 1. 2. 3. 4. Potential Pricing Problems Potential Problems of Service Coverage and Quality The Potential Problem Of Errant Indices Potential Limitations on Efficiency from Oversight Standards and Monitoring Procedures 66 66 68 69 73 Price Level Regulation for Diversified Public Utilities Vll 5. Problems in Defining the Constitutional Entitlements ofInvestors and Consumers Under a Price Level Regime 78 4 Implementing a Price Level Regime for Diversified Public Utilities 83 A. AS APPLIED TO THE FIRM'S NATURAL MONOPOLY MARKETS 83 1. Structuring an Efficient Process for Efficacious Decisions 83 2. Maintaining Efficiency Incentives Through Minimal Recourse to Profit Level Standards 86 B. AS APPLIED TO RELATIONSHIPS BETWEEN THE DIVERSIFIED FIRM'S REGULATED AND UNREGULATED MARKETS 1. Responsibilities of the Diversified Firm for the Provision of Natural Monopoly Services 2. The Regulator's Antitrust Role in the Diversified Firm's "Unregulated" Markets 90 90 93 Conclusion 97 Endnotes 99 Afterword 131 Index 135 Foreword and Acknowledgements This book is the final product of a research project sponsored by the Corporate Counsel Center of the Northwestern University School of Law. The project was funded through a 1985 grant to the Center by American Information Technologies Corporation (Ameritech). The principal condition of the grant was that it be used to support research in regulatory matters. Within this broad purpose, the particular subject matter was determined by Professor Hillman, of the Law School, as principal researcher and Professor Braeutigam, of Northwestern's Department of Economics, as economic consultant. These authors appreciate the support provided by Ameritech's grant to the Center and the complete independence accorded to them in their work. They also wish to acknowledge the substantial contributions of Messrs. Erik F. Dyhrkopp and Steven M. Spaeth, as law student research assistants. A further condition of the grant was that the final results be presented at a Law School conference. This was held on November 18, 1988. Following the principal presentation by Professors Hillman and Braeutigam, responsive commentaries were made by two academic economists and two academic lawyers. The economists were Victor P. Goldberg, Thomas Macioce Professor of Law, Co-Director, Center for Legal and Economic Studies, Columbia University School of Law and Almarin Phillips, John C. Hower Professor of Public Policy and Professor of Law and Economics, University of Pennsylvania. The lawyers were Ian R. Macneil, John Henry ix x Price Level Regulation for Diversified Public Utilities Wigmore Professor of Law, Northwestern University School of Law and Richard J. Pierce, Jr., George W. Hutchison Professor of Law, Southern Methodist University. The inherent complexities and tensions of price level regulation, whether for diversified or non-diversified public utilities, were underscored in these responses. The Afterword to the book contains a brief summary of some of the major points made by three of the commentators. Professor Macneil preferred not to have his views stated in summary form. PRICE LEVEL REGULATION FOR DIVERSIFIED PUBLIC UTILITIES