The public interest is the foundation of utility regulation, yet regulators cannot agree on how it should be defined, measured, or fulfilled.
For utility regulators, their mission is to act in the public interest. The late economist and utility regulator Alfred Kahn defined the public interest as promoting economic efficiency, protecting consumers from discriminatory and insufficient access to utility service, and emulating competitive market outcomes in sectors where competition is not possible.
As practiced universally over several decades by both federal and state utility regulators, promoting the public interest involves a careful balance between protecting utility customers from excessive rates, subpar service, and unduly discriminatory practices while ensuring that utilities can attract sufficient capital to build and maintain safe, reliable service. Regulators pursue this so-called balancing act by considering three major factors: legal constraints, which require that utilities have a reasonable opportunity for financial viability, and customers receive just and reasonable rates; the regulator’s perception of fairness; and the public interest or the collective interests of the stakeholders participating in the regulatory process.
The balancing act serves as a standard by which regulators weigh, either implicitly or explicitly, the positive and negative aspects of decisions on various stakeholders, aiming to advance the broader interest. One cannot dismiss the possibility, however, that in attempting this balance, regulators may end up serving their own interests, such as avoiding political backlash from extreme regulatory actions, instead of the public interest.
Defining the collective interest of society, or what some analysts call the common good, boils down to a value judgment. Each individual or group has unique preferences, available information, and a position in society. Even if everyone agrees on objectives such as fairness, a pollution-free environment, and an efficient utility, they are likely to disagree on the relative priority of those objectives. Taking the example of a regulatory agency, each member is likely to have disparate positions on what weight to place on the different resource-planning objectives. One member may rank cost-effectiveness as the most important objective, while a second member may consider fairness as the most important objective, and a third member may rank mitigating climate change as the top objective. Consequently, each member would likely favor a different decision while arguing that it is in the public interest.
The reality is that utility regulators operate under statutes that are rather imprecise, setting only boundary conditions for their actions. These statutes regularly stipulate that regulators establish “just and reasonable” rates and assure universal service, without specifying how utilities should achieve those goals. Some thresholds, however, do exist: Constitutional law prohibits confiscation of utility investors’ property, and some state statutes prohibit excessive or undue price discrimination. Otherwise, regulators have wide discretion in making decisions.
In today’s world, balancing the interest of stakeholders involves the recognition of a growing list of demands: Utility competitors want a level playing field; many customers no longer want just plain vanilla service, such as lower rates and reliable service, but want such things as more control over their utility bill, the ability to self-generate electricity, and real-time information from their utility; utility providers want rates that allow them to be financially healthy; and environmentalists want clean energy and energy efficiency. Engaged customers tend to better exploit increased competitive conditions, have access to more information and new technologies, and have greater awareness of market conditions. Such customers place greater demands on utilities to provide a wider array of products and services, and greater opportunities to control their electricity usage and the price they pay for electricity. All of these new balancing demands have complicated the lives of regulators to make decisions that are commensurate with the public interest.
A big challenge for regulators is to weigh or prioritize those objectives underlying utility actions and measure the effect of those actions on each objective, as well as on the overall public interest. Assigning weights requires regulators’ judgment, while examining the effect demands data and other unbiased information derived from sound analytical methods. If a regulator assigns a top priority to economic efficiency, for example, that regulator would tend to favor rate mechanisms compatible with marginal-cost principles and strong utility incentives for technological advances and productivity. But switching from average-cost pricing to marginal-cost pricing could have a large negative effect on certain utility customers—a real-world example where regulators have to make trade-offs among different objectives.
Even when two regulators have access to the same information, as experience has shown, they can disagree on a particular rate mechanism. This can happen because they assign different weights to individual regulatory objectives. They might also disagree over which objectives are relevant. For example, one regulator might believe that the legislature is the appropriate forum for addressing utility affordability to low-income households. Another regulator might believe that affordability falls within a regulatory agency’s purview.
Examples abound in which a particular rate mechanism advances some regulatory objectives while hindering others. The reality is that all rate mechanisms have mixed effects on the public interest. The premise is that when a rate mechanism impedes a regulatory objective, it diminishes the public interest, whereas advancing that objective improves it.
Cost trackers provide a prime example of a tradeoff between timely utility recovery of costs and robust incentives. Under a tracker, a utility adjusts its rates to collect certain costs from its customers without a formal, comprehensive, and detailed rate review of revenues and expenses, as in a general rate case, where a utility asks regulators to set new rates in light of changing costs and financial needs. These costs associated with a tracker typically include those that deviate from the test-year level, or the costs assumed by a regulator for its calculations when setting utility rates—for example, fuel costs that exceed the level implicit in base rates determined by the regulator in the last rate case.
Cost trackers enable utilities to recover their costs more quickly and with greater certainty, lowering their financial risk. One rationale for trackers is to prevent utilities from earning a rate of return intolerably below what the regulator authorized in the last general rate case.
Trackers can create incentive problems, however. One such problem occurs when regulators fail to adequately scrutinize those costs and the methods utilities use to calculate raising costs to cover their expenses differ across different utility functional areas, such as generation, transmission, and distribution, creating the possibility of perverse incentives. Historically, utility regulators have frowned upon utilities passing on costs to consumers through mechanisms outside a general rate case—even when subject to prudence review—unless “extraordinary circumstances” exist. Regulators consider whether to pass through costs in light of the possible downside consequences. One such consequence is utilities earning an excessive utility rate of return when a cost tracker allows a utility to increase rates between general rate cases to cover increased costs in one area like for energy efficiency while ignoring cost decreases or revenue increases elsewhere.
Since each regulator has her own definition of public interest, unbiased analysis cannot say which is most correct. How then can one say that a particular regulatory decision violates the public interest or best advances it?
One response is that regulatory decisions that cause discernibly bad outcomes—such as frequent and prolonged service outages, undue price discrimination, massive cost overruns of large capital projects, severely weakened utility finances, and grossly uneconomic rate design—breach the public interest. But such outcomes are uncommon. What seems more relevant for regulators is achieving tolerable outcomes. If society is content with utilities keeping the lights on, heating homes, delivering safe drinking water, and providing cheap communications, so what if utilities could do better—the marginal benefits probably do not matter that much. Why sweat the little stuff? Have critics of regulation exaggerated the problems of utility performance?
Regulators face two major obstacles in advancing the public interest. The benefits of individual regulatory objectives toward the public interest is sometimes impossible to quantify. Second, there is no consensus on the specification of the proper public-interest curve—what parameters to include, as well as its shape. How much does a more financially healthy utility promote the public interest? Does lowering a utility’s financial risk transfer risks to its customers, thereby triggering a fairness or moral hazard problem? Do utility regulators’ demands that utilities achieve clean-air standards beyond those set by environmental agencies serve the public interest? In addition to core objectives such as non-discriminatory access to utility service, fairness, and just and reasonable rates, what other objectives should regulators consider in their decisions?
Where does this all lead us? The most regulators can do is to deal with trade-offs and make subjective judgments, since they are unable to measure the public interest or even agree on what it is. All in all, the verdict is that regulators enjoy much freedom to do what they want and can rationalize their decisions to be in the public interest—a disheartening thought that leads to the obvious question: What are the social benefits of utility regulations? Are they necessarily positive?
