Difficult Thinking About Institutional Change I: A Claim And A Question

Lynne Kiesling

Those of you who read KP for commentary and analysis of electricity regulatory policy (and I thank you sincerely for doing so!) have probably noticed a relative dearth of such commentary and analysis in the past couple of months. I can’t speak for Mike, but the truth is that for my part, I have been trying to think clearly about and analyze a dizzying array of ideas. Instead of continuing to do so in private, and by inflicting my extroverted-thinker half-baked ideas on the KP Spouse over dinner, I am going to use KP as a means of helping me to organize these sometimes overwhelming and disparate ideas into something that I hope will become coherent. I also think these issues generalize to other contexts and other industries. Please be patient and give me comments that will help me to refine my arguments.

Let’s start with this claim: in the U.S. electricity industry we have had 85 years of symbiotic codependency between the regulator and the regulated. Over this time technology and economic activity have changed the underlying physical and economic fundamentals of the industry, making traditional natural monopoly regulation increasingly obsolete. We find ourselves in a situation in which the only part of the historically vertically integrated value chain that has any remaining claim to “natural monopoly” status is the wires network (and even that claim will erode over time). Generation’s “natural monopoly” characteristics have eroded, as have those of the retail/marketing/end-use customer interface part of the value chain. Thus the traditional regulatory institions have outstayed their welcome.

Yet we have inherited this regulatory system specifically and consciously designed to address the specific issue of economic efficiency in a vertically-integrated “natural monopoly”. It’s a complex system, with 51 state-level regulators and a federal regulator with divided jurisdictions between retail and wholesale, and another organization (NERC) that establishes voluntary industry standards for network reliability and safe operation. Much of the institutional roadmap on which this regulatory system rests derives from the Federal Power Act of 1935, a piece of New Deal legislation that may itself be obsolete in many ways. Although technology and economy have wrought changes in regulatory institutions, they remain inertial and woefully obsolete, but still in place, alive and kicking.

One reason for the persistence of obsolete aspects of regulatory institutions must be rent seeking and the ability of special interests to perpetuate arrangements beneficial to them. Over the 85 years of this symbiotic codependency’s evolution, there has been plenty of time for various parties to the traditional institutions (in particular I have in mind regulated investor-owned utilities) to adapt to the regulatory system and learn how to maximize profits within its context. Rule #1 of economics is that people respond to incentives, and utility executives are people. So are regulators. The public choice model illuminating the persistence of obsolete regulatory institutions also has to include the incentives of regulators, well-meaning civil servants who choose to work in the public interest, and who believe that regulatory control and management of utilities is the most effective means to do so. [Note that I could have made more cynical assumptions about the motivations of regulators and the ensuing public choice implications, but those assumptions are not necessary for my argument. I want to make the most generous assumptions possible that will still permit my argument.] I know of several counter-examples, utility executives and regulators who are forward-looking dynamists and are taking the small steps that they can within their constraints to promote insitutional change. But I also know of others who want the old system to persist, and the old system is persisting. Those interests reinforce the inertial trajectory of the system.

So, here’s the question: given the complexity of the system of regulatory institutions, the difficulties (technical, political, and economic) of changing them, and the ability of long-standing interests to increase the system’s persistence through their political power, what is the most effective way to bring about valuable, meaningful, forward-looking, robust, evolutionarily adaptive institutional change?