State regulation of electric utilities began in earnest about 1907 and by around 1920 almost all states had begun state regulation. Prior to state regulation, most electric utilities were regulated through city-issued franchise agreements. Was state regulation of privately-owned electric utilities efficiency enhancing relative to the municipal franchise regulation of electric utilities that preceded it?
Thomas Lyon and Nathan Wilson, in the Journal of Regulatory Economics (2012, full cite below), write, “Electricity is perhaps the quintessential regulated industry, yet the historical roots of its regulation remain imperfectly understood. This lack of clarity exists despite the existence of a small but fascinating literature on the subject.”
Two main opposing lines of thought are supported: a public choice story of regulatory capture, and a transactions cost/contracting story of efficiency enhancing state regulation. Lyon and Wilson begin with a quick survey of this literature:
In a pioneering paper that initiated the empirical study of regulation, Stigler and Friedland (1962) argued that the behavior of electric utilities subject to state regulation was not significantly different from that of other utilities. Jarrell (1978) pointed out that interpreting this result was difficult, since utilities not subject to state regulation remained subject to municipal franchise contracting, which had preceded state regulation historically. He showed that not only was state regulation adopted earlier in states with lower rates, these early-adopting states subsequently saw their electric rates fall more slowly than those in other states; he thus characterized state regulation as a classic example of capture by the regulated industry.
More recent work suggests that because municipal franchise contracting was rife with corruption, state regulation was seen as more likely to protect the massive quasi-rents created by large-scale investment in generation capacity. If so, then the relative increase in prices under state regulation could have been necessary to support investment, and state regulation can be seen as a better form of long-term relational contract. Knittel (2006) used an empirical hazard model to shed new light on the drivers of early adoption of state regulation, and found they included not just low prices, but also capacity shortages and low residential electricity penetration rates.
This suggests that a desire to increase investment may have been an important factor driving the adoption of state regulation. Neufeld (2008), in a similar empirical analysis, finds that states with a higher level of capacity per capita (proxying for larger appropriable quasi-rents) adopted state regulation earlier. This suggests that a desire to protect existing investments may have been an important factor driving the adoption of state regulation. Both papers imply that state regulation was expected to provide better protection for investment than did municipal franchise contracting.
Lyon and Wilson note that both the capture and contracting explanations are consistent with Jarrell’s finding of relative price increases after a move to state regulation, but that the explanations differ with respect to their implications for investment. The capture theory suggests that utilities would raise prices to allow owners to take more profits (with higher prices resulting in slower consumption growth, implying slower capacity growth), while the contract story suggests utilities would raise prices to invest in additional capacity once they had been relieved of the risk of municipal predation.
Lyon and Wilson examine investment in capacity over the period 1902 to 1937 to determine what effect, if any, state regulation had on investment. While data limits challenge the analysis, the authors find a fairly consistent pattern of state regulation being associated with slower rates of investment. That is to say, the authors conclude investment data supports the capture theory of regulation.
From their conclusion:
This paper has tested whether state regulation did indeed result in a stronger propensity to invest on the part of electric utilities. We found no support for this hypothesis. Instead, we found robust evidence that state regulation actually reduced the investment propensity of investor-owned utilities, controlling for existing levels of capacity per capita. From the perspective of enhancing investment, any protection against regulatory opportunism conferred by state regulation was apparently outweighed by its vulnerability to capture by regulated firms.
Jarrell, Gregg A. “The Demand for State Regulation of the Electric Utility Industry.” Journal of Law & Economics 21 (1978): 269.
Lyon, Thomas P., and Nathan Wilson. “Capture or contract? The early years of electric utility regulation.” Journal of Regulatory Economics 42.3 (2012): 225.
Neufeld, John L. “Corruption, quasi-rents, and the regulation of electric utilities.” Journal of Economic History 68.04 (2008): 1059. [Article discussed earlier on KP here.]
Stigler, George J., and Claire Friedland. “What can regulators regulate? The case of electricity.” Journal of Law & Economics 5 (1962): 1.