How Free Enterprise Returned to the Electric Power Industry

Looking back from the vantage point of 1984, it's hard to imagine that only 10 years have passed since the first state abolished its public utility regulation of power companies. As with many other relics of the past, people had grown so used to the idea that public utilities had to be regulated monopolies that it took an actual demonstration of the contrary idea to open their minds. Even then, it was quite awhile before people really noticed what was happening, and began to appreciate the differences between the energy suppliers in Shropshire and those in neighboring New Kent.

It all started back in 1974 in the Shropshire legislature. Unbeknownst to the public, George Nelson, one of Governor Miller's closest drinking buddies, was on the board of New Horizons Energy, a spin-off from the aerospace industry which was in the process of developing a commercially feasible solar power cell. In order to have more freedom to market the solar cells, Nelson wanted the state's Public Utility Commission to remove the power companies' exclusive franchises. Governor Miller was sympathetic, having studied economics as an undergraduate and being familiar with the University of Chicago studies demonstrating the ineffectiveness of public utility regulation. Miller quietly drafted legislation to remove all P.U.C. control over power companies, and Nelson worked with a few sympathetic legislators to bury it in the middle of a 30-page bill on school financing. It wasn't until the bill had been passed in a flurry of pre-adjournment legislation that the power companies realized what had happened—and by then the deed was done.

At first the consumerists raised a chorus of protests, only to be drowned out by the thunder of the power companies, warning of the dire perils of cutthroat competition. Alarmed that the power companies should be so opposed to competition, leading consumer groups backed off and adopted a wait-and-see attitude. That left only the power companies demanding a special session of the legislature to repeal the previous repeal—something the tax-weary public was not about to grant, especially in view of the power companies' tarnished image over the 1973-74 energy shortages. And since the legislature met only every other year, people settled down for at least a two-year wait.

Not very much happened the first year. Most power companies raised their rates somewhat to offset higher fuel costs, but none raised them to"monopolistic" levels—whether in hopes of rallying public support for a return to regulation or in fear of attracting competition is not clear. And New Horizons sold a few large solar cells to a new resort development. But otherwise things went on just about as always.

In the second year, though, things began to get interesting. In Edgeford, a city of 100,000, financially troubled Edgeford Electric Company raised its rates by 20 percent, setting off considerable public outcry. It wasn't long before neatly dressed salesmen began visiting Edgeford's homeowners, while a Boston lawyer paid calls on most of the city's commercial and industrial leaders. Just one month after the rate increase, the Boston lawyer (who represented Northern Edison Company) presented Edgeford Electric Company with signed contracts from 95 percent of its customers agreeing to switch to Northern Edison at the old rate level, should NE offer service there. Edgeford's management saw the handwriting on the wall and sold out to NE, which promptly extended its distribution system up the state to connect to Edgeford's lines. The old Edgeford generating plant was largely scrapped, except for a few peak-power turbine units that NE installed.

The Edgeford case attracted attention throughout the state. Several economists pointed out that although, economically speaking, the production of electricity was a natural monopoly, this did not mean there couldn't be competition in bidding to become the producer for an area. This was exactly what had occurred in Edgeford. Over the next few years the same situation occurred in other cities and towns, sometimes in response to rate increases, as in Edgeford, but in other cases as a result of the formation of consumer organizations which invited other utilities to come in and make bids. Many of these attempts were unsuccessful; where the existing utility was already operating very efficiently, the challengers could not offer significant rate reductions.

Overall, though, the fact that such challenges could occur shook the power company managements to their bones. Many executives took early retirement and more young MBA's from Harvard, Wharton, and Stanford were hired by Shropshire's power companies during those years than ever before. Obsolescent, inefficient generating equipment was retired; luxury office building projects were cut back, and executive compensation plans came in for considerable pruning. Electric companies discovered profit maximization.

CHANGES IN PRICING

By the end of the second year, the power companies' predictions of doom had proved so far off the mark that they could muster little support for their bill to re-establish P.U.C. control, despite the lobbying power of the P.U.C. and its fellow bureaucracies. The people were in no mood to give the companies back their monopolies. However, once the legislature had adjourned, and their PR efforts had failed, the power companies began their counterattack. In quick succession, companies throughout the state began revising their rate schedules to make the prices charged more closely related to the cost of providing the service. In particular, rural users found themselves facing sharply increased bills, while urban customers got rate reductions. The uproar from the farmers and other country dwellers was predictable. Governor Miller (whose analysts told him that farmers represented 10 percent of the voters) miraculously held firm against calling the legislature back into session, so once again there was a two-year trial period during which to evaluate the effects of the new scheme of things.

Some farmers sold out, since the increased electricity rates, on top of soaring property taxes, proved to be the last straw. Most did a lot of complaining but accepted the increased rates as yet another increased cost of doing business (and after all, electricity represented a rather small proportion of the farmer's total expenses). A number of land developers who had rural subdivisions planned reconsidered them, and several backed out completely. Real estate people noted a small drop in the sales of vacation home properties, but otherwise things went on about as before.

Soon after the distance-based rate changes, the power companies introduced yet another change in rate structure; they called it "peak-load pricing." The energy crunch of 1973-75 had abated somewhat by 1976, but still the threat of brownouts and blackouts remained ever-present, as companies struggled to keep pace with the growth in demand. Pointing to successful demand-based pricing policies in France, the companies began charging considerably more for electricity during high-demand times of the day, days of the week, and months of the year. There was plenty of complaining at first, about "disguised rate increases," and "profiteering," and people started muttering about returning to regulation in 1978. But soon a funny thing happened. The record heat wave of the summer of 1976 saw a string of brownouts and blackouts across all of New England—except in Shropshire. People there turned off their air conditioners and went swimming, or took vacations in Canada, or sweated a lot…holding down their demand enough to prevent even one brownout. After that, the complaints about peak-load pricing pretty much disappeared.

CHANGES IN LAND USE

By 1977 and 1978 the impact of distance-based pricing began to have some interesting side effects. Local water districts, under pressure from environmentalists to limit the growth of rural subdivisions, began to emulate the power companies' rate structures. No longer was it just as cheap to develop land out in the boondocks as it was in town; both power and water cost a great deal more the further the property was removed from civilization. The result was striking—in the short run five planned recreational communities were cancelled outright, and the developers of those under construction saw their projected profits sharply diminished, as the market value of their properties was reduced.

In the space of several years, however, the rate of development had returned to normal—only the location of most subdividing now tended to be adjacent to existing developed areas. Since these locations tended to be less naturally scenic than the more rural ones, the developers were forced to pay closer attention to "environmental" design. (Ian McHarg's DESIGN WITH NATURE became required reading for developers, much to the delight of environmentalists.) Instead of being just rows of houses, many new developments emphasized and took advantage of the land contours, the forests and natural vegetation, the cliffs and rock outcroppings. To further preserve the "natural" appeal, the builders began planning ways to make their developments more self-contained, and less dependent on the automobile. They did this by adding small shops and convenience stores, laid out within walking or bicycling distance of most homes; some even built elementary schools as part of their communities.

At the same time, there still remained a demand for property further away from already-settled areas. The problem was to reduce the cost of water and power enough to make development feasible; that, and meeting the increasingly stringent environmental restrictions relating to sewage disposal. What rescued the developers was a combination of aerospace technology and the increasing competitiveness of the energy market in Shropshire. In an attempt to derive earthbound benefits from the space program, NASA and HUD had undertaken a program known as MIUS—Modular Integrated Utility Systems. Various NASA grants supported research and development to apply space program life-support and recycling technology to the design of closed-loop utility systems. By 1979 the first viable systems began to be marketed, by Grumman, Airresearch, New Horizons Energy, Westinghouse, and others—just as the market for alternatives to costly central station electricity in Shropshire really began to boom.

The new systems worked on the principle of getting the maximum amount of energy out of fuel, and wasting as little water as possible. Oil or gas was used to run a set of engine-generators (much like those used in the late 1960's for standby and peak-power purposes), supplemented by solar cell power on sunny days. The "waste" heat resulting from electricity production was used to generate steam for use in heating homes in winter, and for air conditioning (via an absorption system) in summer. Additional steam was produced from the combustion of solid waste, both from sewage and from trash. Finally, all waste water from homes was recycled and treated for re-use, thereby reducing the net demand for fresh water to a fraction of previous levels. Overall a MIUS of this sort ended up consuming about 30 percent less energy than the fuel and electricity required from conventional systems. And by recycling water and solid waste, the MIUS allowed developments to meet the strict environmental regulations of the 1970's.

The availability of MIUS fully awakened developers to the idea of competing sources of power. Although the MIUS-equipped development was still dependent on an outside fuel supply, it could be completely independent of the local electric company. Its initial cost was higher (due to the small-scale powerplant and the complicated plumbing), but its lower energy and water costs allowed the property owners to realize long-term cost savings, in many locations. The application of MIUS was not limited to areas beyond the reach of cheap electricity and water; developers of urban shopping centers, office buildings, condominiums, and housing developments often found applications for them as well, in some cases hooking up to the power company as a backup energy source. The power companies countered with special rates aimed at large developments. Other power companies hedged their bets by acquiring oil or gas distribution companies. A whole new marketing psychology was forced upon the power companies, and once again, recruitment of young MBA's was stepped up.

TEN YEARS AFTER

Now that 10 years have passed, it is possible to take an arm's length look at the power industry in Shropshire, and see how it differs from that of states which have continued P.U.C. regulation of this industry. Compared to neighboring New Kent, for example, electricity rates in Shropshire average 5 to 10 percent less overall, though as noted previously, some rural rates are considerably higher in Shropshire, where all users pay their own way. Changes in rates, which don't have to go through long P.U.C. approval hearings (and possible court battles), are much more frequent than in New Kent, though usually of smaller size each time. Shropshire rates change rapidly in response to external events, such as changes in fuel prices and new antipollution regulations. Although power companies in both Shropshire and New Kent face the same federal pollution controls, the Shropshire companies have complied far more readily since they have the freedom to raise their rates to cover the cost of new equipment. And as noted earlier, Shropshire's peak-load pricing policy has almost entirely eliminated brownouts and blackouts, by providing strong customer incentives for conservation during periods of peak loads.

The effects on land use also show up in cross-state comparisons. Although Shropshire is one of the few states which has failed to adopt a State land use plan, it has more of a "planned" look than many of its neighbors. Its changed pattern of land use, which has left considerable land undeveloped, has attracted national attention. And although MIUS have become popular elsewhere as well, Shropshire is still the home of more of these systems, per capita, than any place else. Nowhere have the MIUS producers found a more receptive market than Shropshire, where power companies have to compete for their business.

And what of the power companies themselves? Despite their years of protestation, Shropshire's power companies are as profitable as those in other states. They work a lot harder at it, however. Their managements set the pace for the rest of the power industry, and since seven other states have recently ended power company regulation, Shropshire's companies are now providing competition-seasoned managers for other parts of the country. The older managers still long for the good old days of exclusive franchises and guaranteed profits, but the new breed of young, aggressive MBA's have found the Shropshire power industry an exciting business environment. They like the freedom to make their own pricing decisions, and enjoy having full-fledged marketing departments. They also enjoy the companies' improving public image, thanks to the absence of blackouts and strict adherence to pollution controls.

Public reaction in Shropshire is largely favorable. Despite the disgruntled farmers whose rates went up, most people are delighted at having the potential of a choice of power sources. They are proud of their state's new land use patterns, and their Yankee independence delights in the fact that it was done without the aid of a new government bureaucracy. They are also pleased with the absence of blackouts, and the relative absence of air and water pollution from Shropshire's power plants.

In short, Shropshire's quirk of an experiment in deregulation has been quite successful. So successful, in fact, that the 1984 legislature has taken the unprecedented action of wiping out the P.U.C. altogether. Nobody is really sure just what changes in the state's taxis, bus lines, commuter airlines, and telephone systems are going to result, but transportation and communication company people from all over the U.S. are flocking to Shropshire. The next 10 years should prove to be even more interesting than the last ten.

Robert Poole, Jr. received his B.S. and M.S. degrees in engineering from MIT. He is a contributor to the recently-published book, THE LIBERTARIAN ALTERNATIVE (Nelson-Hall 1974) and to a citizen's handbook on electric power issues (forthcoming) of the Institute for Liberty and Community in Concord, VT. He is currently REASON's Editor-in-Chief.

NOTES AND REFERENCES

Readers interested in a more technical discussion of the points raised in this article may wish to consult the following articles.
• "Capital Budgeting and Pricing in the French Nationalized Industries," Thomas Marschak, JOURNAL OF BUSINESS, January 1960 (discusses peak-load pricing as used in France).
• "What Can Regulators Regulate? The Case of Electricity," George J. Stigler & Claire Friedland, JOURNAL OF LAW & ECONOMICS, Vol. 5, October 1962 (discusses the ineffectiveness of public utility regulation, using historical data).
• "Why Regulate Utilities?" Harold Demsetz, JOURNAL OF LAW & ECONOMICS, Vol. 11 (I), April 1968 (discusses the various forms of competition in the delivery of electric power).