The Effect of Regulation on Ohio Electric Utilities

Introduction During the pioneering days of the electric utility industry, it was believed that utilities were natural monopolies, meaning that one utility could service a geographic area more cheaply than any combination of smaller utilities. More recently, the economic viability of transferring or wheeling electricity over long distances, the development of small-scale generators and efficient windmill and solar power, and the increased use of cogeneration have undermined the view of electric utilities as natural monopolies. Nevertheless, electric utilities continue to be monopolies because regulatory agencies, such as the Public Utilities Commission of Ohio (PUCO), give them exclusive rights to produce and distribute electricity in designated markets. These regulatory agencies also attempt to impose profit ceilings on electric utilities in order to push the price and consumption of electricity away from monopolistic levels and toward competitive levels. This is accomplished by regulating the rate of return on capital of electric utilities. The regulator determines a "fair" rate of return that is sufficient to allow a utility to cover its capital costs. With production costs and the demand for electricity, this "fair" rate determines the price of electricity. The impact of this type of regulation on the production decisions of regulated utilities was first described by Averch and Johnson (1962). They argued that this regulation gives utilities the incentive to overcapitalize, that is, to employ a capital-labor ratio that is larger than one that minimizes costs for a given output level.' Thus, utilities operating under this constraint are not producing electricity as cheaply as they could. Virtually all empirical tests of regulatory bias to date have adopted the Averch and Johnson (A-J) model, and most have found an overcapitalization bias2 The major challenge to the A-J model concerns the nature of the regulatory environment. Implicit in the A-J model is a regulator that constantly monitors capital returns and adjusts electricity prices to keep capital returns at "fair" levels. Joskow (1974) argues that regulators are more concerned with nominal electricity prices than with the rate of return on capital. As long as nominal electricity prices do not increase, regulators will not actively enforce the rate-of-return constraint, thereby eliminating the source of the A-J bias. Moreover, utilities face additional constraints, such as fuel-cost-adjustment clauses, environmental regulations, strict rules about what capital is allowed in the rate base, and the requirement to meet all demand at given electricity prices. When these additional constraints are taken into account, the net impact on a utility's production decisions is not clear. Atkinson and Halvorsen (1984) developed a generalized cost model that allows for the impact of additional regulatory constraints and found empirical evidence of their impact on .........................................