Wednesday, November 01, 2006

Regulation Destroys

As an investment professional focused on the electric utility industry, the most regulated industry in the United States, I have accumulated numerous examples over the past 12 years of the inanity of regulation.

My experience, based on frequent personal interaction with both the regulators and the regulated, is that regulators, nearly to the person, are less competent than the people they regulate.

Imagine a 50-something highly educated and accomplished CEO of a $25 billion market capitalization company kowtowing to a 30-something attorney and political hack who happens to hold life-and-death regulatory power over his business. I've seen it, and variations of it, many times.

Executives of regulated companies have to flatter the regulators at conferences and meetings, spend countless hours educating the regulators on the simple basics of how their industry operates (so as to reduce the destructiveness of new regulations), and regularly second-guess their own actions for fear that a regulator or his political boss will be offended by them.

The results are several, the least of which is the many man-years of wasted time and unproductive employment at large corporations (e.g.: the full-time regulatory affairs teams at utilities and every other large corporation).

More ominously, innovations are delayed many years or never implemented at all. For example, in the utility world, numerous innovative technologies that could be deployed on the electric transmission infrastructure, such as high-speed Internet access, are never deployed because they require regulatory approval, and to get that the utilities must agree to "share" profits because, under the principle of regulation, the transmission lines really belong to the "utility ratepayers."

Even if the regulator is well-meaning (many of them actually are) and accomplished/intelligent (a rarity), by virtue of existing at the behest of politicians, they end up being destructive (which is why the only honest regulator would have to immediately quit his job). As an example, during the height of the California power crisis, a federal regulator appointed by Bush who publicly denounced price controls, imposed them anyway when he got a personal phone call from Bush. He knew the price controls would cause blackouts, and they did. He implemented them anyway.

A whole body of economic and philosophical literature provides good reasons why regulation is bad. Regulators are disinterested or "mis-interested" (corrupt), they are risk-averse, they cannot hold all the relevant information in their heads to regulate properly, etc.

I agree with all that, and add to it the image of a highly successful chief executive clapping with eager obsequiousness at the conclusion of a meaningless speech by a well-meaning but ignorant regulator who would never be hired by the utility she is regulating.

I hate to end on such a negative note, so I will add that quite a lot of innovation still gets pushed through eventually despite such regulation (even in the utility industry, thankfully). But the cost of the lost innovation and waste is enormous and growing.


Anonymous said...

good post.

Burgess Laughlin said...

"... the electric utility industry, the most regulated industry in the United States, ..."

How did you reach this conclusion?

I ask because I am interested in how to measure a society, either its parts or as a whole -- as a prelude to better determining its direction.

Galileo Blogs said...

You ask a good question. In brief, here are the ways utilities are regulated:

(1) Most prices, including the price to distribute electricity, and in a majority of cases, the price of electric energy, are set by state, federal and/or local utility boards. The proportion of prices that are directly set by these boards constitutes approximately 80% of the total revenues of utilities. The remaining prices, which are of "unregulated" electric generation, are allowed to be generally determined by market forces, except that prices are capped and even where there is no explicit cap regulatory officials can decide after-the-fact that prices were "too high" because they reflect "market power." So, even in the "unregulated" 20%, prices are still more tightly regulated than nearly all other sectors of the economy. For the strictly-regulated 80% of prices, they are set by the utility boards according to a formula that reimburses utilities for their cost of operation, along with a fluctuating, bureacratically determined "adder" that is the allowed profit.

The basic regulatory pricing principle is "cost-plus". Utilities are provided reimbursement of their costs with an allowance for a pre-determined, acceptable "profit".

(2) All investment decisions are regulated by the utility boards. This includes any upgrades of distribution and transmission infrastructure, as well as the majority of generation investment. Essentially, you can't build most infrastructure unless it is pre-approved. For generation infrastructure, pre-approval is not always required, but it does always require going through a bruising "NIMBY" (Not In My Back Yard) political fight with sundry local and state officials who do not want "eyesore" infrastructure built in their neighborhoods. In this aspect, utilities are no less disadvantaged than other large capital intensive industries that have to build large objects that politicians don't want in their districts (e.g.: oil refineries, gas terminals, etc.). However, the additional involvement of state utility boards in the process makes it even more difficult for these things to be built by utilities.

As indicated by my description above, these are the two key metrics by which I would measure the degree of regulation of an industry: (1) How freely can companies set their own prices? (2) How freely can companies invest in their business? The latter question also includes mergers, divestitures and other strategic decisions, such as whether to go private. Utilities also suffer extra layers of regulation in this area. In addition to the normal approvals for these activities that a typical industry faces (such as federal antitrust approval by several agencies), utilities must gain approval of often more than one state regulatory body and at least one additional federal regulator (the Federal Energy Regulatory Commission).

A result of all this regulation, specifically the "cost-plus" method of reimbursing expenditures, and the need to gain prior approval for major investments and strategic decisions, utilities have become incredibly conservative, risk-averse organizations. Chiefly, you can see this in their failure to innovate aggressively. I describe just one example in my post of such a failure to add high-speed Internet capability to the grid. Other examples include the failure to computerize the grid, which would massively improve its efficiency, or to try more radical new technologies, such as micro-generation. Micro-generation is where buildings or houses produce their own power. If utilities were completely free, and could earn unrestricted profits and charge prices solely determined by the market, it could pay to have a system consisting of a combination of large generating plants (like we have now), with peaking power supplied by small, local generators that would also serve as back-up generators and improve the grid's reliability.

Because of all the regulation, utilities operate as a bureacratic organization, in the classic sense as defined by Ludwig Von Mises. They are devoted to following rules, and changing rules when necessary, rather than taking entrepreneurial risks. There is still some market forces at work with utilities (more now than in the 1970s due to some modest deregulation in the 1980s and 1990s) so that they are more efficient and entrpreneurial compared with a truly government-operated enterprise, such as public education. Yet they are closer to that end of the spectrum than a truly entrepreneurial organization.

The only other industries that were regulated in a similar manner as utilities historically were telephony and insurance. All three industries were primarily regulated by 50 different state jurisdictions, with a layer of regulation at the federal level. Of these three hyper-regulated industries, utilities are the most regulated, with insurance second, and telephony having broken free of most of the shackles.

I can't think of any nominally privately-owned enterprises that are more regulated than utilities (I am open to your input on this). Certainly, public schools or the post office face more government control, but they are government-owned and operated.

As a final thought on the issue you are interested in, the direction of society, I think it is important to distinguish between rules/regulations and technology. America keeps moving forward because its technology and entrepreneurial innovation are free enough to flower, despite the existence of multiplying, oppressive rules. In essence, entrepreneurs are able to "work around" rules faster than they can be enacted by government. Needless to say, this process is uneven, with some areas more heavily squelched by government than others. I also would not imply that America's progress is inevitable, that despite whatever fascist rules are imposed, society will advance. That is certainly not true, and is a mistake made by "empiricist" observers of America's economy. (A good friend of mine is an example of this type of observer. He seems incapable of seeing any rule as being bad, because he keeps pointing out how far and fast our standard of living keeps improving. Of course, the argument he can't seem to understand is that America's economy progresses ***despite*** these rules!)

As a final, final thought, I do think that much of our global growth is attributable to the unleashing of entrepreneurial energy caused by the collapse of communism. Almost anything is better than the suffocation of communism, so that even in Russia, with its drift toward a new statism, there are enough cracks in the sidewalk for some entrepreneurial flowers to blossom. Of course, China has much more fully moved away from communism, and it is becoming an economic juggernaut. The rest of the world, including America, benefits tremendously from trading and investing with this emerging economic giant.

Burgess Laughlin said...

"I can't think of any nominally privately-owned enterprises that are more regulated than utilities (I am open to your input on this)."

I offer this only as a suggestion for further research: The railroad industry.

I would keep in mind that regulation of an industry can be direct (setting prices and territories, for example), but it can also be indirect. An example of indirect regulation is government support for particular unions which in turn affect the behavior of a company (everything from length of breaks to the amounts contributed by the company to retirement benefits).

If I were doing further research, I would ask -- based on a vague memory from many years ago -- whether there is a special federal retirement program for railroad employees. And, are there other federal and state regulations tailored to the railroad industry in particular?

If (lack of) innovation is a measure of regulation, then you might look into the level of innovation in the railroad industry in particular.

Galileo Blogs said...

You are right. The railroads are heavily regulated. However, indirect regulation is better than the direct regulation that utilities face. As far as I have observed, railroads still have measurably more freedom to set prices and invest in new routes, rolling stock, etc. Like utilities, they have indirect controls on their pricing, through some after-the-fact roll-backs of their rates due to "over-charging". However, they face no direct controls on prices and none at all on their profit levels, which utilities face.

Like utilities, railroads certainly face "NIMBY" issues when they build new lines. However, railroads aren't building many new lines and when they do, they are usually in areas such as coal fields where not many obstructionist people live.

As for the railroad unions, they are notorious for "featherbedding", i.e. work rules that hamper the railroads' efficient operation. However, these rules have been considerably relaxed in the past two decades.

Finally, in terms of the sheer number of regulatory bodies that harass railroads, there are fewer of them than utilities face. Railroads are primarily regulated by several federal entities. Utilities face a significant amount of federal regulation, but they also face micro-managing state regulators in all 50 states.

In sum, railroads are a good contender for the title of most regulated industry, but I still think they are a runner-up to utilities!