Silviase/jgov_v1.4_full_ann huggingface dataset:
where the cost of service was much lower. Attention drawn to these rate-cost disparities as well as potential profit opportunities for new entrants accentuated the pressure for deregulation. $ ^{16} $

#### 4.4. Implications

The observation that regulatory reforms in all of these industries have been and are being driven, at least in part, by imbalances between rates and incremental costs lends itself to a number of alternative interpretations. The imbalance between rates and costs inevitably raises questions about the ultimate efficiency of these reforms. Since rates do not reflect the existing industry's incremental cost, competitive entry may occur even when the cost of the added supply exceeds the existing firms' long run costs of added supply. Competitive entry in these cases may ultimately prove uneconomic as low rate but high cost supplies are substituted for those with lower costs but higher rates. Here we should perhaps distinguish between two forms of uneconomic entry.

First, even where competition is ultimately both feasible and economic, the wide gap between costs and rates imposed by regulation may mean that the transition from a regulated monopoly to a more competitive industry will be accompanied by temporary capacity excesses. Second, and ultimately more troubling, these rate-cost disparities may encourage competitive entry even in the presence of substantial scale economies. In this case, the most efficient means of supply may be a single producer, but the gap between price and cost nevertheless makes competitive entry appear economic. All of this suggests that substantial rate rebalancing should precede, or at least accompany, regulatory reforms designed to encourage competition. In practice, however, this rebalancing is politically difficult to achieve.

Initial imbalances between rates and costs also make it difficult to evaluate the benefits of competitive entry. As Professor Harris points out in his essay, many observers have interpreted the dramatic declines in toll prices occurring since divestiture as evidence of the effectiveness of competition in the toll markets. On the other hand, as Professor Harris also notes, others maintain that the declines in toll prices have simply mirrored declines in the access charges which interexchange carriers pay to the pervasively regulated local exchange carriers. From this perspective, the declines do not reflect either the benefits of competition or evidence that competition has been effective, but rather rate rebalancing, which in principle could have occurred without either industry restructuring or competitive entry.

It is also possible, however, to take a more serendipitous view of rate-cost imbalances as a cause of regulatory reform and competitive entry. Even where competition is both feasible and
economic, it may simply not occur because of substantial institutional barriers. Certainly the history of regulatory reform suggests that strong pressures exist to maintain the status quo even when entry is economic. For example, in telecommunications, the incumbent regulated carriers and the regulator strongly resisted the entry of equipment manufacturers into the market for customer premises equipment on grounds which now seem entirely specious. $ ^{17} $ Similarly the FCC, now viewed as a champion of regulatory reform and competitive entry, initially opposed the entry of MCI and other competitors into the toll markets on the grounds that their entry would erode the regulated carrier's scale advantages. Equipment manufacturers and competitive toll suppliers gained entry to these markets only through legal challenges by both competitive entrants and the Justice Department and not, in the first instance, through reforms initiated by the regulators. While airlines may present a counter example, in both electricity and telecommunications, pressure for reform has come primarily not from regulators but from competitive entrants seeking to profit from high rates or from customers seeking to avoid those rates. $ ^{18} $ And the profit opportunities from entry stem not from any inherent cost advantage of the entrants over incumbents, but primarily from rates which are set artificially high by regulation. Since the pure efficiency gains from competitive entry may be relatively modest, these large price-cost disparities may be an accidental but necessary precondition without which neither regulatory reform nor competitive entry, efficient or not, would occur. Where strong independent evidence exists that competitive entry is beneficial, perhaps the regulatory reforms which permit competitive entry should be welcomed irrespective of their proximate cause.

#### 4.5. Stranded Investment

Disparities between rates and costs, which have served as a strong incentive for reform in both telecommunications and electricity, can also present an obstacle to reform. This is clearly the case today within the electricity sector. Were the electric industry reformed to permit (or require) existing generators to compete among themselves or with new entrants for retail loads, the resulting competitive rates for generation would not permit those existing generators to recover their historic costs. The shortfall would be sufficiently large that many, if not most, existing utilities would be
bankrupted by the decline in rates. $ ^{[19]} $ The result is to make incumbent utilities extremely wary about any efforts toward regulatory reform, unless the issue of stranded investment is resolved first. Even utilities which expect to thrive in a competitive environment will resist the reforms which bring those changes about until the issue of stranded investment is resolved.

From a policy perspective, the issue of reforming the industry to permit competitive entry and the issue of recovering stranded investment should be delinked. The existence of stranded investment does not in any way imply either that historically the industry has operated inefficiently or that competition is warranted. Moreover, the benefits from competition, if they exist, result not from allowing consumers to avoid the cost of stranded investment, but from prospective efficiency improvements which occur when future investments and existing operating costs are subjected to market tests.

Nevertheless, political realities suggest that for the electricity sector, the issue of stranded investment and the issue of regulatory reform are likely to remain inextricably intertwined. Without some opportunity to capture the gap between embedded and incremental cost, either in the form of profits to entrants or rate reductions to existing consumers, much of the political pressure for regulatory reform would evaporate. On the other hand, as long as the likelihood of recovering historic investment is held hostage to the reform efforts, incumbent utilities will oppose reform with all the resources they can muster. Only a political compromise which resolves the stranded investment to the mutual satisfaction of existing utilities, entrants and customers is likely to be the precursor to reform in the electric utility industry.

### 5. Diversity in Regulatory Policy

As the discussions in the ensuing essays make abundantly clear, trends toward deregulation in the U.S. have not been governed by a single consistent policy. Deregulation, which occurred suddenly and completely in the airline industry, has proceeded much more gradually in telecommunications and still more slowly in electricity.

In large measure, these differences reflect the differences in the structure of these industries. In airlines, most analysts examining the industry in the 1970's could see no significant barriers to creating workable competition throughout the industry. Consequently, since there were no strong entry barriers and no sources of scale economy, there was no obvious reason to impose price restrictions or to continue regulatory restrictions on entry.

The situation in telecommunications and electricity is quite different. In both cases, these industries were vertically integrated and, while there were clearly prospects for competition in
portions of these industries, other portions were, or appeared to be, natural monopolies. Thus, in telecommunications the initial pressure to introduce competition occurred in customer premises equipment and in intercity service rather than in network access or exchange service. Similarly, in electricity the pressure for competition has occurred primarily in the generating sector with broad recognition that transmission and distribution are likely to remain natural monopolies and, hence, require continued regulation.

These distinctions, of course, have made the process of deregulation vastly more complicated in telecommunications and electricity than in airlines and trucking. In airlines, no changes in industry structure were necessary prior to deregulation, and since the entire structure of economic regulation was vested in a single agency -- the CAB -- regulation could be eliminated relatively simply. Once the decision to deregulate occurred, the regulatory agency was simply eliminated without affecting continuing need for safety standards which were and are the province of a separate Federal agency -- the FAA.

In contrast, for both telecommunications and electricity, reform involves changing the structure of regulation to deregulate some services while continuing to regulate others. Moreover, regulation in these industries involves numerous agencies, all of which must act in order to change regulatory structure. Both of these factors have made regulatory reform vastly more complicated in these industries than in airlines.

Consider first the problems of industry structure. In both of these industries the precise boundaries between competitive and noncompetitive services are ambiguous. Moreover, the optimal approach to regulating firms which produce some services in competitive and some in deregulated markets is unclear. Consequently, the pace of change has inevitably been slow and halting with numerous detours taken before settling on an appropriate structure.

In addition, many observers have argued that achieving effective deregulation in both electricity and telecommunications requires some vertical deintegration of the existing firms in these industries. Certainly the breakup of AT&T has been widely viewed as a necessary prerequisite to achieving effective competition in the intercity toll market. $ ^{20} $ Similarly, many observers have argued that the unbundling of transmission and distribution from generation will prove a necessary precondition for introducing competition into the electricity sector. $ ^{21} $ Once such structural changes are made, however, additional reforms are necessary to preserve the economics of scope which were facilitated by vertical integration.

In addition to these broad policy issues, the regulatory structure itself has made the process of deregulation much more complex and less uniform in electricity and telecommunications than in airlines. In airlines, a single federal agency controlled much of the regulatory process. In contrast, telecommunications and electricity are regulated both by federal agencies (FERC for electricity and the FCC for telecommunications) and by 50 separate state
would consequently be less ambiguous. Nevertheless, there is little evidence that frequent flyer programs to date have had any effect in increasing industry concentration nor do they appear to afford larger carriers the ability to raise rates.

Finally, the use of computerized reservations systems to favor the flights offered by the developers of these systems raises the age-old dilemma of how competitive markets allow developers to capture returns from their innovations. Clearly, computerized reservations systems provide efficiency benefits to the industry. They allow customers and their travel agents to more easily determine the alternatives available to them, to compare the characteristics of these alternatives, and to quickly and reliably make reservations on the chosen alternative. Moreover, in a competitive era, such systems provide an essential aid to searching available discount options.

On the other hand, only a large carrier or a collection of smaller carriers would have the financial incentive to develop such a system since a smaller carrier would find it impossible to amortize development costs over its small number of available flights. Moreover, it seems inevitable that the developer of such a system, even where the system purports to evaluate all possible options, would use the system to favor, however subtly, its own services. In fact, if every carrier were guaranteed free access to such a system once it was developed, the free rider problem might inevitably mean that such systems would never be developed at all. Achieving a balance of incentives to assure that such systems are developed without giving undue advantages to dominant carriers has proven to be one of the interesting challenges for case law in this area. For better or worse, the net effect of these decisions has been to eliminate any ability which developers otherwise might have had to use the computerized reservation system to bias choice in favor of their own flights.

#### 6.2. Telecommunications

In telecommunications, the initial vision of regulatory reform was in many ways quite different from the industry structure which seems to be emerging now. At the time of divestiture, the perception was that intercity toll service was potentially competitive, but that access and local exchange services were not. The theory underlying the divestiture of AT&T was that competition had been impeded in the past by the vertical integration of the local exchange carrier (which possessed a bottleneck monopoly) and interexchange service which may have had no natural monopoly properties.

Consequently, AT&T was divided into an access and local exchange portion served by the seven Regional Bell Operating Companies (RBOC's) and an interexchange portion, which was to be served by AT&T in competition with other carriers. The dividing line between local exchange and interexchange service was drawn by creating Local Access and Transport Areas, or LATA's, which typically include large cities and their surrounding suburbs, but are much broader in some areas, particularly where population density is low. In some places an entire state might constitute a single LATA.
The theory is that this regulatory approach will accomplish several changes needed to accommodate the influx of competition in some markets:

1. by eliminating rate of return constraints, it provides the regulated carriers pricing flexibility to operate in competitive markets;

2. by eliminating reference to historic investment in setting rates, it shifts responsibility for investments from consumers to the carriers;

3. by eliminating reference to current costs in setting rates, it increases the incentive for firms to control costs; and

4. by imposing price caps on basic, presumptively noncompetitive telephone services, it continues to assure protection of monopoly consumers of these services.

5. by delinking rates and returns it eliminates the incentive to cross subsidize competition at the expense of monopoly services.

In addition to these reforms, many commissions are now proposing or undertaking hearings to address directly the terms under which competitive carriers will assure mutual access to the networks and continued joint support for universal telephone service. The form which those terms and conditions will take -- subjects addressed directly in Professor Harris' paper -- remain to be resolved.

#### 6.3. Electricity

While clearly at an earlier stage, regulatory reform in the electricity sector is also evolving in ways which were not predicted at the outset of the reform effort. In many ways the evolution in electricity mirrors that in telecommunications and illustrates the difficulty in predicting how competitive forces, once unleashed, will develop in an industry or how regulatory structure will need to evolve to accommodate competition within the traditional regulatory framework.

As detailed in Dr. Kahn's paper, the initial efforts at reform in electricity were embodied in PURPA regulations, the thrust of which was to create increased competition within the generating sector by requiring utilities to purchase power from cogenerators, renewable resource developers and small independent power producers at avoided cost.

But these reforms immediately encountered problems not anticipated by the reformers. Merely offering to pay constructors of new generation at avoided cost did not stimulate much investment. Since avoided costs could not be predicted in advance, it was impossible to obtain financing for investment in generating projects for which income was based on an indeterminate
market price. At some price levels IPP's might have built capacity in response to spot prices but not at the avoided costs emerging from the regulated structure of the industry. $ ^{24} $

Pushed by the incipient independent power industry, by environmentalists, and by others anxious to promote the development of smaller, more diverse resources, regulators responded to this problem by requiring utilities to offer both PURPA suppliers and other independent power producers long-term contracts, under terms sufficient to assure that these projects could obtain financing. $ ^{25} $ In some cases, prices for this power were to be set based on the utility's or commission's forecast of long run avoided costs. In other cases, legislatures mandated price floors at which power was to be purchased, even if those floors differed from estimates of long run avoided costs. $ ^{26} $ Even where price was tied to long run avoided costs, prices were allowed to exceed avoided costs in the early years as long as the levelized price over the life of the contract was no higher than levelized avoided costs over the same period.

Utilities were generally induced to sign these contracts by assurances that once approved, the cost of the contracts could be recovered in rates or by contract provisions which permitted utilities to escape the contracts if subsequent commissions denied rate recovery. $ ^{27} $ In still other cases, the inducement to enter into such contracts was the presumption that it would lead to favorable approval of existing rate requests.
With guarantees of long-term contracts, independent power succeeded beyond the greatest expectation of proponents. In some states, substantial portions of total generation were met through independent power and more than a third of all new capacity constructed after 1985 has come from independent power producers. $ ^{28} $ In fact, so much power was forthcoming under these bidding programs that in many cases the utility's avoided cost estimates were no longer used to determine the price paid. Instead utilities set up limits to the amount of capacity for which they would accept bids and took the lowest cost bids at which these requirements were met. $ ^{29} $

Although mandated long-term contracts for cogenerators and independent power producers clearly produced large supplies of such power, the power produced is turning out to be very expensive. Much of the power purchased under these contracts was acquired at prices which are well above the avoided costs which are now anticipated and consumers are likely to absorb these higher prices. Moreover, the relatively high costs which have resulted in this market do not simply reflect forecast errors by the utilities purchasing the power, but rather inefficiencies which are either inherent in the bidding process or were imposed upon it by an inefficient regulatory process.

First, in some cases the gap between the cost of these contracts and avoided cost has occurred because too much capacity was purchased. However, utilities often realized that they had contracted for excess capacity after contracts were signed, but before the capacity was constructed. Efficient contracting would have permitted cancellation of some or all of the contracted capacity in these cases. Certainly cancellations would have occurred had utilities been constructing the capacity themselves. But because the contracts afforded large profits to the bidders and because regulators were anxious to encourage these contracts, it proved impossible to cancel them in a timely fashion. $ ^{30} $
Second, there were often significant delays between the time avoided cost estimates were made and the time contracts were actually signed. During this time, avoided cost estimates fell, but utilities were not permitted to revise the contracts to reflect their new avoided cost estimates. $ ^{31} $ Independent power producers were awarded the higher price even though the contracting parties knew it exceeded expectations. This would not have occurred with an efficient contracting process, and it reflected strong political pressures to increase utility reliance on independent power producers.

Third, in some cases, legislative intervention required utilities to sign contracts for power at values that were in excess of avoided cost at the time the contracts were entered into. Given these flaws, utilities will undoubtedly end up paying more for this power than if the bidding process had been driven by competitive market forces. Further, it is not clear that the power will be any cheaper than power from utility-built units.

The central problem is that utilities have no strong incentives to contract for independent power. Under current regulatory convention they would rather construct capacity themselves. Consequently, regulators and, in some cases, legislators feel constrained to maintain steady pressure to assure that independent power is bought at prices sufficient to attract substantial supplies. But regulators have not proven to be a good substitute for the market in determining the appropriate terms for independent power contracts. For all of these reasons, the process by which utilities historically acquired power from independent producers is now widely regarded as flawed and a variety of efforts are underway to revise the competitive bidding process.

In part because of the failure of competitive bidding to produce low cost power and in part because of its success in bringing forth large supplies of independent power, this process is likely to induce further regulatory reforms resulting in far more radical changes in both the structure of regulation and the structure of the industry. Independent power producers, having gained entry to the industry, now wish to expand their markets by competing directly with utilities for sales to large industrial customers. As a consequence, independent power producers are among the most significant advocates of retail wheeling.

In addition, the relatively high cost of power resulting, in part, from competitive bidding itself is increasing the incentives which industrial customers have to seek retail wheeling. By increasing the extent of excess capacity and increasing the spread between embedded and
and an assessment of their effectiveness and feasibility is a principal theme of the essays which follow.