Rate-of-return regulation versus price regulation for public utilities

Public utility regulation arose naturally in the nineteenth century for gas, water, rail, telegraph, and later, electricity and telephony because these utilities require a fixed network to deliver their services. These networks need access to rights of way which requires community or government approval, while the network is a natural monopoly that precludes efficient competition and confers potentially exploitative power on the owner that will inevitably lead to political demands for restraint. The durable, costly and irrecoverable nature of the network raises the fear that curbs on prices will prevent the investor recovering a fair return on his investment. Regulation evolved to balance the interests of investors and consumer/voters. Where a satisfactory balance could be achieved, utilities could remain under regulated private ownership. If private investors lacked confidence that they would be allowed to earn an acceptable return, or if the polity believed that it could secure a more satisfactory distribution of the benefits of the public utility, the outcome was public ownership. Britain and the US exemplified different solutions to achieving this balance of interest. Historically regulation arose as part of the contract with municipalities, who granted rights of way in exchange for quality standards and curbs on prices, starting with coal gas and piped water. Coal gas lowered the cost of lighting by two-thirds when introduced in Britain in 1806 (Falkus 1982). This appealed to municipalities, who granted the right to lay pipes and disturb roads in exchange for concessional street lighting. Economies of scale gave monopoly power and high profits to the first entrant. Early attempts to regulate prices were ineffective in Britain, and profits could only be restrained by entry, which created obvious inefficiencies by 1850 London had 14 gas companies (Foreman-Peck and Millward 1994: 30). In such a competitive environment, quality suffered, often with lethal consequences, making municipal ownership look increasingly attractive. The appeal of municipal ownership was that it kept prices reasonable, while the profits financed other local public goods and reduced local taxes. Parliament responded by creating limited life private franchises, which at their end could be bought at written-down cost by municipalities. By 1907, one-third of the net output of gas companies was public, as were 57% of trams, 64% of electricity, and 81% of water companies (Foreman-Peck and Millward 1994), and eventually all public utilities were nationalized. The US evolved a different institutional solution for these utilities. Initially, most cities offered a contractual franchise, starting with the introduction of gas in New York in the 1820s (Priest 1993). These contracts typically provided for access to public rights of way and a franchise monopoly in return for restraints on prices and concessional terms for supplying the municipality. The contracts were typically for 20-30 years, long enough to repay the large capital investments. Inevitably, they had to be renegotiated as circumstances changed. Soon contracts made explicit provision for renegotiation, subject to arbitration,