In the wake of recent actions by Congress and the Federal Energy Regulatory Commission (FERC) initiating deregulation of the electric power industry, government-owned electric utilities are using taxpayer subsidies and special preferences to short circuit marketplace competition. Municipalization is the inelegant term describing attempts by government-owned electric utilities to seize markets from private, investor-owned systems. Coming before the rules of the game are set and the playing field leveled, these attempts threaten successful restructuring of the electric power industry.

Successful deregulation and restructuring ultimately will allow customers to choose their electric power provider and allow businesses in the electric utility industry to do what businesses in other sectors have always done: Compete on the basis of established market criteria -- price, quality, service, and innovation. It can't all happen overnight. The details are still being worked out. Indeed, a couple of these "details" represent issues so major that their resolution is as important to the success of restructuring as the original Congressional action in 1992 that started the ball rolling. These issues are:

1. Defining "stranded investment costs" and determining the extent to which they will be recovered by existing utilities, and
2. Eliminating the taxpayer subsidies and preferential treatment currently enjoyed by government-owned utilities, which allow them to offer significantly lower rates than their private competitors.

The first issue, although complex, is moving rapidly toward resolution. The other, regarding government financial preferences, has received less public attention and will be the primary focus of this paper. In addition, a parallel move to deregulate the telecommunications industry shares some of the same problems as the electric utility industry and complicates further the public policy concerns for both electricity and telecom. All of these issues are discussed below. First, however, some historical perspective is provided on electrical power.

Electric Power Industry Originally Considered a Natural Monopoly

Government has played an extraordinarily dominant role in the electric power industry since the lights were first turned on late in the 19th Century. Primarily because electrical power generation and distribution have been considered "natural monopolies," government has closely regulated private electric companies, and it has owned and operated some municipal and rural systems. Typically, natural monopolies have been associated with situations where the capital investment required to do a project is so great that densely-populated market areas are required for the project to be economically viable. In addition to electricity, natural monopolies have historically been considered to exist in telecommunications, water and sewer systems, and more recently, in cable television.

Regulations Favored Government-Owned Utilities

Government programs and regulations at the federal and state levels have routinely favored government-owned utilities, especially in the West. For example, whereas the investments and rate-setting of private utilities require review and approval from a state utility commission, government-owned utilities report only to their individual local governing boards. Not only is public utility decision-making more independent, but their revenues are not subject to federal taxation, their capital projects are eligible for tax-exempt bond financing, and their power is often provided at below-market prices from federally owned power facilities. These preferential policies and practices, defensible perhaps in an earlier time, result in unfair advantages in a competitive environment.

1978 Public Utility Regulatory Policies Act

Many analysts cite the 1978 Public Utility Regulatory Policies Act (PURPA) as the first of several regulatory actions that spurred the electric utility industry to move away from a system of regulated monopolies. In response to energy shortages during the 1970s, PURPA required utilities to purchase power from non-utility producers of renewable energy resources. Electric energy from alternative sources, such as windmills, solar collectors, and cogeneration facilities, became popular experiments throughout the country. While somewhat successful in promoting development of these alternative energy sources, PURPA played a major role in pushing the electric power industry toward market competition. Once independently generated energy was successfully integrated into the electrical transmission grid, pressure increased to open access to all transmission lines, so that all energy producers could sell their wholesale power to the highest bidder.

Energy Policy Act of 1992

The Energy Policy Act of 1992 was the result. Under the Act, FERC has the authority to force utilities to open their transmission lines, allowing their competitors (private and government-owned), as well as non-utility energy producers, to move their power to their wholesale customers. Called "wholesale wheeling," this allows producers to compete for sales on the wholesale market. In April 1996, FERC adopted rules directing electric utilities to open their transmission lines to competitors. In doing so, a new player in the world of electric power has emerged in the form of power-marketers - brokers that purchase electric power for resale to electricity retailers. Enron Corporation, a large Houston-based natural gas pipeline company that delivers wholesale gas and electricity nationwide, is such a firm. It agreed to acquire Portland General Corporation in 1996, promising Enron direct access for the first time to residential customers. More recently, the company has announced plans to form an alliance with a group of 11 small cities in northern California to compete with Pacific Gas and Electric, the private energy provider in that area. According to a January 15, 1997, Wall Street Journal article, Enron President Jeffrey Skilling sees strategic alliances like this as the best way for Enron to compete for retail customers. He hopes to make Enron a "household name" over the next five years.

The 1992 Act and subsequent FERC rulings, so far leave this and other retail issues to state governments and their utility commissions. With states such as California, Rhode Island and Massachusetts in the lead nationally, experimentation has begun on how best to allow all customers - industrial, commercial and residential - open access to energy providers.

So, although simple in concept, competition, the 1992 Act, and new state initiatives alter dramatically the rules under which electric utilities have operated for most of this century. Complicated by the effects of telecommunication-industry restructuring, this issue will require the intellect and energy of lawmakers and regulators, industry experts, and the public for many years to come.

Stranded Cost Recovery

In a regulated environment, where service territories are fixed, the higher rates required to cover these costs don't represent a competi-tiveness problem...there is no competition. With competition, however, these stranded costs require special attention. Stranded costs apply to three main categories of investment made by utilities: 1) The costs of building nuclear plants and other generation facilities; 2) the continuing operating costs of nuclear plants; and, 3) the cost of buying out long-term contracts for purchasing alternative power under PURPA. Utility companies made these investments - often as a result of federal requirements (including alternative energy purchases required under PURPA) - but always in anticipation of an ability to recover their full costs through their regulated rates. In April 1996, FERC directed states and their utility commissions to implement restructuring in ways that will assure full recovery of "stranded costs" by existing power companies. Left to be decided, however, is how these stranded costs will be specifically defined. For example, whereas generating capacity improvements might be automatically allowed, PURPA-related alternative energy contracts - whose current market value is uncertain without actual sales - might be questioned.

In a regulated environment, where service territories are fixed, the higher rates required to cover these costs don't represent a competiveness problem...there is no competition. With competition, however, these stranded costs require special attention.

The stranded cost experience from utility to utility is uneven. Some utilities have them, some don't. In a regulated environment, where service territories are fixed, the higher rates required to cover these costs don't represent a competitiveness problem: there is no competition. With competition, however, these stranded costs require special attention. Aggressive competition by municipal utilities, whose rates are heavily subsidized, and by new players in the energy industry (like power marketers, who are largely unregulated and may not be subject to current state and local utility taxation) will place traditional investor-owned utilities at a disadvantage. These private firms have made significant, good-faith investments under a different set of rules, requiring them to charge higher rates in order to recoup their investments. With competition already at work at the wholesale level and imminent at the retail level, and since the 1992 Act did not make clear how recovery of these investment costs would be handled, those utility

companies with heavy stranded costs are in danger of losing customers to their lower-priced competitors. In recognition of this concern, FERC, in September of 1996, ruled that utilities would be able to recover fully their stranded costs. FERC, however, left to states and their utility commissions the task of figuring out exactly how to accomplish this. States like California, Rhode Island and Massachusetts are taking the lead in experimenting with the details of concepts like "non by-passable transition charges" and auctioning of PURPA contracts in order to establish current market values.

Public Power Subsidies and Preferences

Nationally, investor-owned utilities deliver about 75 percent of the energy sold to end users, with public utilities, including cities, PUDs and cooperatives, making up the remaining 25 percent. The tax exemptions, subsidies, and costs of preferential treatment enjoyed by government-owned utilities, therefore, are paid for by 75 percent of the nation through higher electric rates.

These costs are substantial. In a national study done for the Edison Electric Institute, Putnam, Hayes & Bartlett, Inc. (PH&B) estimates that the cost of these subsidies nationwide totaled more than $11 billion in 1992 (1). The major burden was carried by the federal government, which lost $8.4 billion that year - $4.8 billion in taxes and $3.6 billion in federal utility revenue. Local governments lost another $2.7 billion in taxes.

To place these costs in perspective, PH&B says that in order for the average subsidized government utility to pay the same taxes and interest as a private utility pays, it would need to increase its rates by about 16 percent. On average then, only if government utilities raised their rates by about 16 percent would the competitively unfair rate advantage between government and private utilities disappear, according to the study.

Government utility advocates claim that their lower rates are only partially due to subsidies. About 60 percent of the difference, asserts the American Public Power Association (APPA), exists because government utilities operate more efficiently. They point to a study conducted for them that reviewed the PH&B methodology and calculations. Based on its strongly worded conclusion that public subsidies only represent a portion of the rate difference between government and private utilities, APPA concluded that the balance must be due to better operational performance by government utilities. If their assertions were true, government power providers would constitute a novel exception to the general rule of monopolies. Even pro-government advocates David Osborne and Ted Gaebler, authors of Reinventing Government and founders of the "entrepreneurial government" craze that has spawned much mischief by public managers, do not promote government-owned business monopolies. At best, their work suggests, such monopolies may equal the performance of their private sector counterparts.

Even pro-government advocates David Osborne and Ted Gaebler, authors of Reinventing Government and founders of the "entrepreneurial government" craze that has spawned much mischief by public managers, do not promote government-owned business monopolies.

Regardless of the APPA claims, there is no better basis for comparing operating efficiency than fair, market competition. Once preferential policies are removed, everyone can compete on the basis of operational efficiencies. The 1996 Annual Report of President Clinton's Council of Economic Advisers (CEA) anticipated the problem. Referring specifically to energy deregulation, CEA said,

"... competition will be distorted if producers are given selective privileges, or subjected to selective obligations imposed to further even legitimate social goals...As competition grows, increasing distortions may result from some entities having access to special privileges such as federally tax-exempt bonds or other preferential treatment."(2)

An examination of the subsidies enjoyed by government utilities is instructive. According to PH&B, they include: (3)

Exemption from federal and state income taxes
Exemption from other taxes (including property, gross receipts, and excise taxes)
The ability to issue tax-exempt securities
Access to low-interest government loans and loan guarantees
Preferential access to low-price federal power
In recent months the Rural Utilities Service, with the blessings of the Justice Department, has forgiven about $1.5 billion in low-cost government loans made to rural electric cooperatives across the country. According to the Edison Electric Institute (EEI), of the approximate $33 billion in outstanding loans made to cooperative-owned utilities, about $10 to $11 billion are "in trouble". These troubled loans are almost exclusively loans that have been made to power supply cooperatives (cooperatives owned by groups of cooperatively-owned utilities) to build generating and transmission facilities. In addition, with legislation passed in 1996, the Agriculture Secretary can now forgive these loans without Justice Department approval, says EEI.

The competitive edge that these subsidies allow government utility providers is substancial and is increasingly attractive to major power users.

In Washington state, where public power dominates, the issue promises to be more difficult. Three investor-owned utilities - Puget Sound Power & Light (now called Puget Sound Power), The Washington Water Power Company, and PacifiCorp (headquartered in Portland) - deliver only 40 percent of our state's electric power. The remaining 60 percent of the power delivered to ultimate consumers in the state is delivered by government-owned utilities and co-ops. Consumers in the cities of Seattle, Tacoma, and Everett, as well as 16 other cities, 24 PUDs, and 15 rural cooperatives (4), receive more than 30 percent of the nation's public power (7.5 percent of total electric power delivered nationally) at rates subsidized an estimated 20 percent or more(5).

The lower prices enabled by subsidy send a misleading signal to the market. When the cost of production and distribution is subsidized, lower prices encourage consumers to use more electricity than they would otherwise use. Joseph Graves, a PH&B director, states the matter clearly:

" ... government subsidies to public utilities and coops have long outlived their usefulness and, in fact, distort the power market in ways that directly harm the vast majority of electricity customers and work to reduce economic efficiency. Moreover, these subsidies exacerbate the national debt and pressure already tight state and local government budgets."(6)

Free-market advocates like the American Legislative Exchange Council (ALEC), an association of state legislators, says

"...subsidies provided to government-owned electric utilities...contradict federal policies designed to further competition in electricity supply. Clearly, in order to maximize the benefits of a competitive electricity market, federal policies which grant subsidies to electricity suppliers must be reformed."(7)

It won't be easy. The competitive edge that these subsidies allow government utility providers is substantial and is increasingly attractive to major power users. The potential for some of the nation's largest industrial power users to be enticed by lower rates to switch to government-owned utilities or to threaten to do so, only exacerbates the problem. Following the expansion of wholesale competition for electric utilities, the CEA said:

"Pressure is growing to allow retail competition as well... This pressure comes mainly from large customers, who, among other things, can credibly threaten to bypass their local utility by generating their own electricity using small natural gas plants, or through municipalization." (emphasis added).(8)

In the context cited by CEA, munipalization was considered an option primarily as a consequence of the price distortions resulting from subsidies and tax breaks.

Private utilities would then have to raise rates on their remaining residential and commercial customers to cover their sunk capital and on-going operational costs. With retail competition anticipated to follow closely on the heels of wholesale competition, these remaining customers would eventually figure out how to take their business to government utilities in order to receive subsidized rates. Left unabated and carried to its logical extreme, these subsidies would eventually spell the end of privately delivered electricity.

The difference between costs and prices is a substantial tab that is being picked up by the consumers and taxpayers.

Competition between government utilities, however, is not the kind of competition envisioned by the 1992 Congress. Congress anticipated that competition would result in lower costs and eventually in lower consumer prices. Government inefficiencies can be masked by taxpayer subsidies, however, so that they can charge low rates, even though they have higher operating costs. A 1996 audit of the Los Angeles Department of Water and Power (DWP) illustrates the point.(9) The audit concluded that,

"DWP's electric costs exceed the average costs of each of three comparison panels - California Utilities, urban investor-owned utilities (IOUs), and publicly-owned utilities."

Even so, its average electric rates were consistently lower in all consumer categories. The audit concludes,

"The inconsistency between having low rates and high costs is largely explained by DWP's favorable tax status and its low cost (subsidized) generation mix."

The difference between costs and prices is a substantial tab that is being picked up by consumers and taxpayers.

Telecom Deregulation

On a faster track that could turn into a collision course, the telecommunications industry is also moving toward market competition. Following the Telecommunications Act of 1996, the move is on by long-distance, cable, satellite and wireless telecom companies to compete for the long-awaited local markets. Until now, these have been the sole domain of the Baby Bells and other regional telephone companies, like GTE in Washington state. Regional phone companies are allowed to compete reciprocally in the long-distance markets, according to the new Act, as long as they open their local markets to competition. As with energy, much of the detail of implementation was left to the Federal Communications Commission (FCC) to enact through regulation. The FCC has, in turn, acted aggressively with controversial rules that have been challenged in court. Although there is considerable disagreement about how the details will be finalized, opening of these local markets has telephone companies evaluating whether and how to get into cable TV service, cable TV providers eyeing telecommunications, and wireless telecom services with designs on both.

So, how does this relate to electric power? Electric utilities - and, in particular, government-owned electric utilities - are also considering providing telecom services. If government utilities are allowed to compete (and there's nothing currently to prevent them from doing so), the same tax exemptions and financing preferences, historically available to public electric utilities, would apply, with similar competitiveness problems. In spite of risk and volatility, the highly profitable world of telecommunications is increasingly irresistible to government utility providers. Many cities already provide one or more utility services, like electricity, water, sewer, garbage. As the distinction between public and private providers blurs, adding one more service won't be viewed as much of a problem by most bureaucrats and lawmakers. In the case of older, more fully developed cities, many of these services have either crested in their ability to produce revenue or have already begun to produce less revenue per unit of activity. Cities, public utility districts, even rural utility cooperatives, originally established to electrify rural farms throughout America, see in telecom a springboard of opportunity, with potential for nearly unlimited revenue growth well into the foreseeable future.

Consider the example of Tacoma Public Utilities (TPU): Following the guidance of California-based SRI Consulting, TPU is currently "evaluating the opportunities, benefits, costs and risks of playing a significant role in the advanced communications business."(10) SRI has advised the city utility that telecommunications deregulation "opened the door ... and yes, even [government] utilities are now reasonably free to enter the full range of telecommunications businesses." SRI recommends that Tacoma enter the cable television business, aggressively operating to capture market share from the current cable franchise holder, with a view toward other services, including "competitive local and long-distance telephony." Top on the list of reasons for the utility's "increased involvement" in telecom is to offset "a flat or decreasing revenue stream from energy production and distribution."

Unfortunately, SRI's willingness to have government compete aggressively with the private sector is not unique.

Cities, public utility districts, even rural utility cooperatives, originally established to electrify rurual farms throughout America, see in telecom a springboard for opportunity, with potential for nearly unlimited revenue growth well into the forseeable future.

Pacific Telesis, the Bell operating company for most of California, offered to make the city of Milpitas, California, its model city for telecom technology by laying fiber optic cable throughout the city. Instead of embracing the proposal and expediting permit approval processes, however, the city opted to study the feasibility of building a municipal telecom utility to be owned and run by the city and to compete aggressively with private telecom providers. PacTel has since withdrawn its Milpitas proposal and offered a similar plan to San Jose, where the project is now well underway.

And, in San Diego, California, the city-owned garbage utility actually considered using its access to low-cost capital to compete and displace its private competition. Although charging higher rates than private providers, the county-owned utility was losing money, due to an unsuccessful waste-to-energy facility. To repair its flagging financials, it proposed that a special assessment be charged to all county residents, suggesting that the resulting revenue be used to lower garbage rates and to undercut competing private garbage haulers.

Rather than be involved as a player, government's more appropriate role is one of referee.

Multiple-city utility services are not unusual. As a front page story in the Wall Street Journal describes, however, mischief can ensue when government expands its range of utility services. The Journal's June 3, 1996 article: "Power Play, Little Town Becomes First Municipality Sued by U.S. for Antitrust," cites the case of a real-estate developer told by the city of Stilwell, Oklahoma, that "if he didn't buy the town's electricity, they would deny him water and sewer service, which he couldn't buy elsewhere."(11) The city, which relies on utility revenues to fund its general services, was exercising its monopoly clout to prevent the developer from purchasing his electricity from another local electric co-op. In doing so, it fell afoul of federal antitrust law barring sellers from using monopoly power over one product to force purchase of another.

In a similar example, the city of Anaheim, California, requires any utility wishing to lay new fiber optic cable not only to obtain permit approval and pay permit fees, but also to lay several lines of fiber optic cable for the city for its future use and probable competition.

As new technology blurs the distinctions between who can feasibly compete in telecommunications, cable television, and electricity, such service bundling under government umbrellas could lead to even greater distortions. The following outlines only a few of the possibilities:

1. Privacy (Tacoma's consultant suggested that the city could "monitor and manage energy consumption." What does this mean?)
2. Security (How would public records be protected from computer hackers and others with potentially more venal intent?)

Civil rights, affirmative action, and individual rights of expression (How might politics or social objectives influence or dictate the types of programming appropriate or allowable through public cable?)
Political activism (Will hunting and fishing programming be sacrificed to animal- rights advocates? How much time would be allowed each type of program? How and by whom would these decisions be made?)
Church-state separation (Would public cable franchises go the way of the schools, where cable offerings could not include programs with religious content?)
Rather than be involved as a player, government's more appropriate role is one of referee. In its 1996 annual report, President Clinton's Council of Economic Advisors (CEA) advised that:

"With so much uncertainty about the shape of the communications networks of the future and with significant potential for competition, the best course is to leave their evolution to be determined by the private sector."

Conclusion

The same wisdom applies no less to electric utilities. In a prescient 1988 discussion of the use of federal tax-exempt financing to support government takeovers of investor-owned utilities, Dennis Zimmerman of the Congressional Research Service questioned the continued justification for government provision of power:

"In economic terms, electric and gas utility services do not possess the characteristics that require provision by the public sector...The subjective judgment of taxpayers in a state or a local region may be that public provision of electricity is justified. This does not, however, necessarily imply that it makes sense for the Federal Government to tax its taxpayers [through federal loan programs and tax exemptions] to help pay for this State or local decision."(12)

Circumscribing government's current involvement or eliminating it from the mix of competitive choices, however - whether for electricity or for telecommunication - won't be easy. The "reinvented, entrepreneurial government" concept adds a patina of respectability to what are otherwise straightforward examples of unfair competition. And inevitably, when government drives out its competition, it will resort to monopoly pricing. Further, when government has achieved or re-achieved monopoly status, it can and (if history is any indicator) likely will impose politically motivated regulations on consumers.

At a minimum, jurisdictions that regulate particular activities should not also be allowed to compete in those activities. Ultimately, however in order for real competition to succeed and for the cost-saving efficiencies in both electricity and telecommunications to be enjoyed by all consumers, we may need to question the continued wisdom of government-run utilities.

As utility deregulation enters its next phase of sorting out the rules for the retail side of the industry, states and their utility commissions will be responsible for building an important piece of the foundation for future competition. Deliberations must consider the current roles and authorities of publicly elected leaders and their appointed officials. The current ability of public entities to exert political control on marketplace decisions, to influence regulations, to tax, subsidize, and condemn through their power of eminent domain, would so skew a competitive marketplace that any further expansion of direct government service provision must be vigorously resisted. At a minimum, jurisdictions that regulate particular activities should not also be allowed to compete in those activities. Ultimately, in order for real competition to succeed and for the cost-saving efficiencies in both electricity and telecommunications to be enjoyed by all consumers, we may need to question the continued wisdom of government-run utilities.

Bibliography

Subsidies and Unfair Competitive Advantages Available to Publicly-Owned and Cooperative Utilities, Putnam, Hayes & Bartlett, Inc. for Edison Electric Institute, 1994. Costs represented as foregone government revenue in 1992 dollars.

1996 Annual Report, Council of Economic Advisors (CEA), page 186.

Additional evaluation of state and local utility taxation in Washington State has been published recently by the Washington Research Council.

Electrical World, Directory of Electric Power Producers, 1996 104th Edition, The McGraw-Hill Companies.

WIPS Senior Research Fellow, Elaine R. Davis, 1996, unpublished, preliminary analysis of the value of tax exemptions and low interest loans available to public power providers in Washington.

Joseph Graves, "The $8.4 Billion Drain," Electric Perspectives, May/June, 1995. Page 20.

"Reforming Electric Utility Subsidies to Enhance Competition," The State Factor, April 1995, American Legislative Exchange Council Foundation. Page 4.

CEA, page 183.

A Diagnostic Audit of the Los Angeles Department of Water and Power, Barrington and Wellesley Group, Inc., May 1994, conducted for the Los Angeles City Council.

SRI Consulting, Telecommunications Strategy Assessment, prepared for the Light Division of Tacoma Public Utilities, May 21, 1996.

Bryan Gruley, The Wall Street Journal, June 3, 1996, page 1.

About the Author

Economist Elaine R. Davis has spent more than 20 years in public policy research and program development. She is a Senior Research Fellow for the Washington Institute for Policy Studies.