Silviase/jgov_v1.4_full_ann huggingface dataset:
### 1. INTRODUCTION

Over the last 20 years, the United States has substantially altered its approach toward the regulation of the traditional “public utility” industries. There have been moves to reform regulation and industry structure to encourage more competition in these industries, and even to deregulate entirely industries that appear to be potentially competitive throughout. Where competition appears viable in some segments of these industries but not others, both industry structure and the structure of regulation have been reformed to encourage increased competition in the former while retaining regulation in the latter, and making the two compatible with one another.

Of course, the pace of change has not been the same in all sectors. For airlines and trucking, where pervasive competition appeared feasible, price regulation and regulations governing entry were simply eliminated. For similar reasons, regulation of the wellhead price of natural gas was eliminated in 1983. In telecommunications, in electricity, and in the transmission and distribution portions of the natural gas industry, where some portions of the industry seem potentially competitive while others do not, requisite changes in industry structure and the structure of regulation have been more complex and, hence, the pace of change has been slower. While dramatic changes have already taken place in these industries, reforms are still underway and, the ultimate form which regulation will take is still unclear.

The essays which make up this section of the book describe the changes which have taken place, and which are still taking place, in three of these industries -- airlines, telecommunications and electricity. Broadly speaking, the papers focus on three questions:

1. What are the forces which have given rise to regulatory reform?

2. What is the structure of the regulatory change which has occurred to date and is likely to occur in the immediate future?

3. What have been the effects on industry efficiency, prices and profits of the reforms which have occurred to date?

While all of these issues are addressed in each essay, as might be expected given the differences in the pace of deregulation, the principal focus of the discussion differs sharply among them. The essay by Steven Morrison, “The Effects of Airline Deregulation in the United States” focuses on the effectiveness of the policy in creating a competitive market, in improving efficiency and in lowering rates or improving the quality of service. The structure of Robert G. Harris’ paper, “Competition and Public Policy in U.S. Telecommunications” is somewhat different. For intercity toll service, where the process of deregulation is virtually complete, he reviews a number of studies of the impact of deregulation and competition on price. For access and intra-city or exchange service, where competition and deregulation are in more formative stages, the essay examines the changes in technological and market factors which are increasing the feasibility of competition, and the regulatory reforms necessary to make competition fully effective. Finally, Edward Kahn’s
paper “Privatization and Deregulation in the U.S. Electric Power Sector” concentrates on the changes in circumstances which are giving rise to changes in regulation. Because the scope of competition and regulatory change in the electricity industry has been more limited than in the other two, the discussion of the effects on price and performance is necessarily more limited.

It is not my purpose in this introductory essay to provide a detailed summary of these industry-specific essays. Each of them is clear and speaks for itself. However, a review of the three papers reveals a number of broad themes related to the forces governing regulatory change, the structure of regulatory response to competition, and the gains from regulatory reform. Some discussion of those themes may provide a useful introduction to the industry-specific essays.

### 2. THE CAUSES OF REGULATORY REFORM

Is it not remarkable that the trend toward deregulation has been so pervasive in the U.S.? While only airlines and trucking have been entirely deregulated, in telecommunications the intercity market has become virtually deregulated and state commissions throughout the U.S. are holding hearings to reconsider what form of regulation should govern the markets for intrastate toll, access and local exchange service. The trend in these hearings is a general shift from rate of return to price regulation. $ ^{1} $ This shift, in large measure, has been driven by the perception that many telecommunications markets are rapidly becoming competitive. Although some markets for telecommunications services may remain monopolies for the foreseeable future, traditional rate of return regulation is widely seen as an ineffective tool for dealing with this mixture of competitive and monopoly services. $ ^{2} $ Most regulatory commissions are groping for tools to:

1. promote competition in these markets where feasible;

2. provide traditional regulated carriers with sufficient pricing flexibility to respond to competitive pressures;

3. shift investment risk back to investors;

4. assure that monopoly control of bottleneck facilities does not inhibit the development of competition in monopoly markets;

5. assure that regulated firms have adequate incentives to invest effectively; and

6. avoid cross subsidies between monopoly and competitive services.

Although deregulation has not progressed nearly as far in electricity as in telecommunications, here too there is enormous ferment. As early as 1979, reforms were
introduced to mandate the purchase of independently generated power and thereby to increase the competitiveness of that sector. Although these reforms have been successful in accomplishing a dramatic expansion in the independent power industry, serious questions have arisen as to whether this entry has brought the benefits of competition to consumers. In part as an outgrowth of these reforms, however, there is now substantial political pressure to mandate “retail wheeling” which would allow industrial and large commercial customers to choose among generating sources and to permit independent power producers to compete with utilities, and utilities to compete with each other, for such loads. While to date most regulators have resisted such pressures, the discussion of retail wheeling has focused attention on the potentially competitive nature of the generating sector and, hence, interest in regulatory reforms which would permit all consumers to benefit from such competition.

What is causing this broad-based trend toward deregulation and regulatory reform? After all, each of these industries had been pervasively regulated for at least 50 years and industry performance in all of them was widely viewed as quite good. Prior to the divestiture of AT&T, the U.S. was widely regarded as offering high quality, low cost, reliable and nearly universal telephone service. $ ^{3} $ Similarly, airline service in the U.S. prior to deregulation was viewed as high quality and safe, and was widely lauded for its nearly ubiquitous network which provided service even to relatively small towns. $ ^{4} $ Electric utilities, while subject to sharply rising costs and substantial excess capacity following the Arab oil embargo in 1974, had consistently delivered reliable supplies of power at steadily declining costs, and their cost performance in the face of rising fuel prices is not any worse than that of many competitive industries. $ ^{5} $ Even today, despite marked
price increases from 1974 to 1986, U.S. electric rates are quite low and reliability quite high by world standards. $ ^{6} $

If the traditional regulatory approach has served so well, why are we moving away from it? There are two interrelated explanations. First, in each of these industries a variety of regulatory policies has caused relatively wide disparities between prices and costs in specific sub-markets. In some cases these disparities reflect distributional objectives of the regulators and in others the effort to assure the recovery of historic investments. Where prices have been set well above the incremental cost of production, these pricing policies provide substantial incentive for competitive entry in specific markets. These entrants have been a driving force pressing for regulatory reform.

Second, in at least some of these industries, growth in market size and technological change may have increased the technical feasibility of competition. Thus, even where regulation was initially necessary to constrain the market power of natural monopoly producers or to assure service in low density markets, growth in market size may make regulation unnecessary throughout the industry or in specific submarkets.

Each of these explanations has somewhat different implications for both the pace of regulatory reform and its ultimate efficiency. If the growth in market size alone has made competition feasible in previously regulated markets, the implication is that deregulation or regulatory reforms to accommodate these changes is likely to lead to unambiguous efficiency improvements. On the other hand, if price distortions are the principal source of competitive pressure, accommodating such competition without prior rate rebalancing can lead to uneconomic competition which ultimately is not sustainable. However, as we shall see below, even where competition is feasible, price distortions of the sort described above may be necessary to generate the political and market pressures necessary to accomplish regulatory reform. In the sections which follow we discuss both growth in market size and price distortions as causes of regulatory reform in airlines, telecommunications and electricity.

### 3. MARKET SCALE AND THE GROWTH OF COMPETITION

Growth in market size and technological changes have simply made competition more feasible than when the current regulatory systems were designed. As market size has steadily increased and technological change has ended scale economies, the ability of each market to support several competitors may have increased the feasibility of competition, at least in portions
of these industries. And since price regulation is widely viewed as a highly imperfect substitute for the competitive marketplace, the growing potential for competition inevitably creates pressure for deregulation and regulatory reform. Let's examine this hypothesis in a bit more detail.

#### 3.1. Airlines

It is hardest to make the case that growth in market size was the driving force for regulatory reform in airlines. This is because the threat of a single dominant carrier was never the grounds for regulating airlines. In fact, the initial rationale for regulation was that entry might be too easy and that restrictions were needed to avoid destructive competition. A second concern, however, was distributional -- the desire to encourage air service to smaller cities and towns where traffic density might not justify entry. $ ^{7} $ And in this regard, the growth of market size may well have increased the willingness to deregulate. By the time deregulation occurred, traffic volumes were obviously sufficient to support competition, not only between large cities but in less densely populated areas as well. As Professor Morrison points out, since the deregulation of the industry, the average number of airlines serving individual routes has increased. Moreover, the hub and spoke system of serving routes, which has grown with the elimination of regulation, has clearly increased the potential competitiveness of the market, even in smaller cities and towns, by increasing the number of different ways in which individual city pairs can be served and by increasing the sustainable load factor on individual routes.

#### 3.2. Telecommunications

Growing market size, at least in the intercity market has undoubtedly been a factor driving reform in telecommunications. When the regulatory structure for telecommunications was initiated, the predominant focus of telephone usage was intra-exchange or intra-city. In these markets, where loops constitute the primary investment needed to serve customers, it is obviously inefficient for more than a single carrier to serve each community. $ ^{8} $ However, over time the intercity market grew much more rapidly than the local market and by 1984 accounted for nearly 60 percent of total telephone revenues. $ ^{9} $ Although AT&T had managed to secure a virtual
meet emergency circumstances or to exploit permanent cost advantages, but to achieve greater economies through region-wide economic dispatch. In some cases (particularly in the Northeast), utilities have set up integrated pools to economically dispatch all the capacity in the region. In other cases, the same function is achieved through bilateral trading on a short-term basis and purchased power contracts on a long-term basis. The presence of these integrated networks has substantially expanded the market for power, enabling utilities to substitute for their own plants lower cost resources from neighboring territories which may exist because of temporary capacity excesses, or transitory or permanent differences in fuel prices.

Having created broad regional grids, existing utilities have created the potential for an effectively competitive generation market within each region. As an example, the PJM power pool, which serves customers in Pennsylvania, New Jersey, Delaware, Maryland and the District of Columbia, has effectively created a marketplace in which the 11 utilities making up this pool can, and effectively do, compete to decide who supplies how much energy to the consumers of the region. Since this network is also interconnected with networks in adjoining regions, for many hours of the year an even larger number of utilities can compete for these loads. Moreover, having once created such a network, there is no technical reason why other potential suppliers of power -- independent power producers or co-generators -- could not also compete to supply this regional market. Thus, the creation of these regional grids has expanded the size of the market and made aggressive competition among generating companies feasible. It is the realization of this potential with all it implies regarding regulatory cost and efficiency which underlies at least some of the pressure for regulatory reform.

In this context, the principal factor driving regulatory reform has been market expansion which permits competition. Differences in the pace of reform result almost entirely from the ease or difficulty with which the competitive portions of these industries can be separated from those portions which remain natural monopolies. In airlines, because there were never any significant barriers to entry and growth assured competitive service even for low density markets, reform could occur quickly through total and complete deregulation. For telephone, the reforms took longer to implement because they appeared to require vertical deintegration of the industry. $ ^{11} $ Moreover, controversy and change continue within this industry because the dividing line between the competitive and monopoly sectors is constantly shifting and the form of regulation which best suits an industry which is partially competitive and partially a monopoly is yet to be fully worked out.

Reforms in electricity have taken longer still. Given the degree of integration between transmission and generation planning, finding a mechanism to effectively assure competition in the generating sector while continuing to assure the efficient use and expansion of the transmission
grid is much more difficult. Viewed in this way, the pressures for regulatory reforms in airlines, telecommunications and electricity are all driven by the same basic forces -- a tendency for technological change and growth in market size and geographic scope to increase the feasibility of competition in all or portions of these industries. Differences in pace reflect primarily the extent to which the growth in market size affects the entire industry or merely portions of it.

### 4. Regulatory Pricing and Competitive Pressures

Leaving market growth and technological change aside, the pressure to open these markets to competition has also been driven by historic pricing policies in these industries. In each case, regulators have allowed industry prices to depart significantly from cost. These price-cost disparities have created substantial incentive for competitive entry, which may or may not be sustainable in the long run.

#### 4.1. Telecommunications

The case for this is clearest in telecommunications. Historically, regulators set the price of intercity telecommunications service high relative to its cost and used the resulting revenues to subsidize the prices charged for access and local usage. The motivation for this policy was twofold. First, the policy promoted universal service by making telephone service easily affordable for low income consumers and consumers in rural areas where usage was relative low.

Second, the policy permitted greater rate stability than would otherwise have been the case. Over time, technological change and rapid growth in usage markedly reduced the cost of toll service, while slower rates of growth in technology and usage increased the cost of access. If these services had been priced at incremental cost -- as they would have been in competitive markets -- toll prices would have fallen sharply while access prices rose. By simply allocating an increasing share of access costs to toll usage over time, regulators avoided the need to engage in unpopular rate restructuring.

Ultimately, however, the gap between intercity rates and costs created strong pressures for competitive entry. Even producers for which the incremental costs of supplying toll service exceeded those of the regulated carrier could earn substantial profits at the artificially high price of toll service. The imbalance also created substantial incentives for large toll consumers to seek out these alternative suppliers as a means of reducing their costs. This rate imbalance would have attracted competitive entrants even if the industry were characterized by substantial scale economies which give the regulated supplier a strong cost advantage. Of course, regulators could easily have eliminated these pressures by rebalancing rates; however, they long resisted such pressures since rebalancing was politically unattractive.

The importance of these pricing policies as a cause of competitive entry, and ultimately regulatory reform, cannot be overestimated. Reform in telecommunications did not occur because regulators or other policy makers woke up one day, realized that the industry was potentially
competitive and moved to reform it to accommodate that competition. In fact, initially the FCC and the state commissions strongly resisted competitive entry. $ ^{12} $ Reform occurred because competitors (like MCI), seeing profit opportunities, aggressively sought to enter the industry. In many cases, these competitors did not seek regulatory approval for entry, but entered and waited to be challenged. Where necessary, entrants challenged both regulators and the incumbents in court to secure continued entry on what they regarded as fair terms. Whatever the economic case for regulatory reform and competitive entry, it never would have occurred absent aggressive efforts by challengers to enter the industry. And, the motivation for these aggressive efforts lay largely in the wide imbalances between the rates charged for intercity toll service and the cost of that service.

#### 4.2. Electricity

Similar rate-cost disparities are also a driving force for regulatory reform in the electricity sector. Here, however, the disparities between rates and costs have a different cause. Following dramatic increases in the prices of oil and gas in 1974 and again in 1979, the industry sought to reduce its dependence on these fuels by constructing coal and nuclear capacity, with relatively high capital costs but low fuel costs. Failing to anticipate slowdowns in growth, the industry ultimately constructed more capacity than was needed to meet demand with adequate reliability. The extent of this excess capacity is documented in Dr. Kahn's paper below. Moreover, health, safety and environmental concerns surrounding both of these technologies, but nuclear in particular, drove the costs of these alternatives far above that anticipated when the commitments to these plants were made.

Further, when oil and gas prices began to fall after 1983, the industry found itself with both excess capacity and capacity with embedded costs far in excess of the incremental cost of production. Finally, disparities between incremental and embedded cost were further accentuated by technological changes which improved the operating efficiency and lowered the capital cost for new gas-fired combined-cycle plants.

Averaged across the U.S., embedded generating costs are nearly 5.5 cents per kWh. $ ^{13} $ In contrast, rates required to recover the capital and operating cost of new generation average about
3.5 to 4.0 cents per kWh. $ ^{14} $ Even wider disparities exist in some regions of the county where reliance on nuclear capacity is high or where regulators have imposed substantial investment in demand side management or in independent power producers. Moreover, because the industry has substantial excess capacity, the incremental costs of meeting new loads are under 3.0 cents in many regions of the country. $ ^{15} $ Since, under current regulatory conventions, rates for usage are set to recover embedded cost, the gap between incremental and embedded cost creates substantial competitive pressures. Independent power producers are tempted to compete with traditional utilities to serve industrial and large commercial customers. This incentive exists even where the IPP's incremental costs are higher than those of the utility, because the IPP sees a substantial profit opportunity in the gap between rates and its incremental cost. Moreover, at least on the margin, utilities have strong incentives to compete with each other for industrial and large commercial loads. Whereas utilities trade power with each other at incremental cost, they charge their customers, insofar as possible, embedded cost. In this context, each utility can increase its profits if it can capture industrial loads from its neighbors. Finally, the rate-cost imbalance creates strong incentives for customers to seek out competitive suppliers. Obviously, an industrial customer paying 5.0 cents per kWh for electric generation has a strong incentive to seek out a new supplier who offers competitive supplies at a lower price. And since the incremental cost of production is 3.5 to 4.0 cents, absent regulatory restrictions such opportunities abound. Since the existing system of regulation is seen as the principal barrier to capturing these opportunities, this creates substantial pressure for regulatory reform.

#### 4.3. Airlines

Rate-cost disparities were also a factor encouraging regulatory reform in airlines. To encourage ubiquitous service, the regulator required carriers to provide service to many small cities and towns where low load factors made service uneconomic. The regulator then allowed carriers to make up for losses on these low density routes through above-cost charges on high density routes.