by Andrew Chamberlain
Chamberlain Economics, L.L.C

Michael Levi at the Council on Foreign Relations argues for a naive view of state and local utility regulation. He argues for a world in which municipal regulators have the ability to force utility managers to act against their own economic interests, passing forward the full benefit of free emission allowances to consumers rather than their own shareholders. Levi argues,

“The regulator knows the value of the free allowances: it is equal to the number of allowances given out for free multiplied by the value of the allowances at auction. If the LDCs cannot account for having spent that money on public purposes, the regulator will know… [I]t’s actually pretty simple.”

If only regulating public utilities were simple. Even in the absence of climate policy, there exists today a vast and complex network of utility regulatory boards, governed by millions of pages of regulatory guidelines, all designed to simply govern the ordinary business of utilities. The American Power Act would overlay a complex federal climate policy atop this arrangement. Saying anything about the behavior of regulated firms under climate policy is “simple” belies the complex reality of public utility regulation in the U.S.

There are several problems with Levi’s criticism. The most obvious is, why not distribute allowance values directly to electricity and natural gas consumers, rather than first granting them to utilities? As we have seen in recent financial and environmental disasters, regulators can, and often do, fail to fulfill their role as industry watchdogs. Other provisions of the bill, such as the “consumer relief” program, auction allowances and distribute cash payments directly to households. This could easily be done for electricity and natural gas consumers. Using a simple database of addresses for existing ratepayers, IRS administrators could distribute rebate checks to households, piggybacking on the infrastructure of the Earned Income Tax Credit with no danger of moral hazard, and no need for additional costly, complex regulations on LDCs. Why not make the system as simple as possible, rather than leaving it open to the possibility of regulatory failure? As we make clear in our study, lawmakers did not follow this approach. That suggests there exists instead a political dynamic at work that has more to do with compensating industries for losses from cap-and-trade than actually compensating consumers, as claimed by advocates of the bill.

Levi’s argument that shareholders will not economically benefit from free allowances is simply inconsistent with the fact that LDCs and their parent companies themselves have lobbied heavily for these provisions. U.S. Senate records show electricity LDCs have spent millions lobbying for provisions in cap-and-trade bills in recent years. Atlanta-based Southern Company, which covers 4.4 million residential customers with local utilities in four states, spent $9.8 million alone in 2008 on climate change lobbying. American Electric Power, which operates electricity LDCs in 11 states serving more than 5 million customers, spent $8.4 million. Other large electricity firms such as Duke Energy, FPL Group and Ameren spent similar amounts lobbying during the period in which both the Waxman-Markey and Kerry-Lieberman bills were being crafted on Capitol Hill. If shareholders are expected to receive zero benefit from free allowances, what explains these tremendous lobbying expenditures? Such behavior is simply not consistent with a naive view the American Power Act that simply assumes, with no microeconomic foundation, that utility consumers stand to benefit from free LDC allowances.

In fact, distributing funds directly to households rather than indirectly through free allowances to LDCs would have been a much more efficient way to provide consumer relief. If households are given cash rebates, these may be used for other purposes than electricity and natural gas, such as home weatherization, more efficient vehicles or other household expenditures. Instead, the American Power Act leaves open the possibility that utilities could simply be forced to offer households a credit on a utility bill. That is, rather than allowing consumers to choose how best to spend these benefits, LDCs would have the ability to restrict it for use on utility bills only—guaranteeing LDCs additional revenue they wouldn’t otherwise enjoy. Thus, even in the unrealistic scenario in which regulators are able to perfectly force LDCs to pass benefits on to consumers, the bill does this in a highly inefficient way that favors utilities over consumers.

In our study, we argue lawmakers cannot control the economic incidence of regulatory policy any more than revenue officials can control the economic incidence of business taxes. Levi argues this analogy is inaccurate since “those firms aren’t regulated.” But from the standpoint of revenue officials, they are very much regulated. Revenue officials are charged explicitly with enforcing the legal incidence of business taxes specified by lawmakers. This is a different form of regulation than cost-of-service price regulation, but it remains an explicit legal control over the behavior of firms backed by the force of law. The fact that this regulatory regime is unable to control tax incidence is highly relevant to understanding the behavior of regulated utilities under cap-and-trade.

Levi argues that since regulators will know the dollar value of the subsidy granted to each LDC, they can simply verify that an identical amount has been spent on “public purposes.” But this view is highly unrealistic. Anyone who has worked in a municipal regulatory rate-setting environment—which I have at the Seattle Department of Transportation—will tell you that accounting costs are not unique. Labor comprises the vast majority of costs within regulated utilities. Accounting costs for projects within LDCs are built from time-card data on employees’ allocated of time, along with various indirect and other allocated costs—all of which are subject to wide discretion by both employees and utility managers, little of which is observable by outside regulatory bodies.

Consider a simple example. Suppose that an electric utility receiving $12 million of free allowances is required by regulators to increase expenditures on “public purposes” by $12 million, as Levi argues. Suppose further that prior to cap-and-trade, this utility operated a $15 million energy conservation program, distributing energy-efficient light bulbs to households and conducting public education campaigns. What in the language of the American Power Act prevents utility managers from simply shifting funds internally, scaling back the energy conservation program to $3 million, freeing up $12 million of existing budget authority for “public purposes?” Because internal funds are fungible, managers can easily reduce ancillary services to households—effectively increasing electricity rates to consumers on a quality-adjusted basis—while leaving shareholders unaffected, thus shifting the full burden of climate policy onto consumers. Such behavior is common in the regulatory literature in economics, which is vast and brimming with examples of regulatory failure of exactly this type assumed away by Levi and the authors of the Kerry-Lieberman bill.

Levi argues utilities can be forced to spend the value of free allowances for “public purposes.” But what qualifies as a “public purpose”? The text of the American Power Act provides only vague guidelines, and does not require that utilities actually provide rebates to consumers as has been widely assumed by advocates of the bill. Does investing in clean energy sources qualify as a “public” purpose? What if doing so leads to somewhat higher profit margins for utilities? What if the value of free allowances is instead used to establish a “rate stabilization fund” to shield consumers from rate volatility? What if consumers are granted only a partial rebate check, with the remainder used to upgrade capital equipment that lowers costs and thus increases profits for the firm?

Levi assumes a clear distinction between “public” and “private” purposes for utility expenditures. In reality, the language of the American Power Act leaves the concept of “for the benefit of” ratepayers open to wide discretion—something utilities themselves are surely aware of, judging from their extensive lobbying efforts to secure those provisions.

Part II here.

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