How to Make Deregulation Work

January 2002

How to Make Deregulation Work
Alfred E. Kahn, the father of airline deregulation, firmly defends it in an interview with IEEE Spectrum - but is less sanguine about the effect on electricity and communications

William Sweet - Senior News Editor & Elizabeth A. Bretz - Senior Associate Editor

All families resemble one another, but each unhappy family is unhappy in its own way." So runs the famous first sentence of Anna Karenina. With but a little poetic license, one might say that every regulated industry manifests the same rules, while each deregulated industry is unruly or even dysfunctional in ways unique to it. Figuring out how to fix each one's problems is in its own right a huge technological challenge - technological in the economist's sense of referring to all aspects of business organization.

In a regulated industry, services are provided by a single or a fixed few companies, monitored by some quasi-governmental authority set up to protect the public interest. In exchange for its accountability, the industry is assured of a modest yet still satisfactory rate of return, often made more attractive to investors with tax breaks. Though the authority is supposed to have an arms-length relationship to the industry, in point of fact, after working hand-in-glove over decades, regulators and regulated hardly ever see things differently. Innovation may atrophy, but everybody is happy, even most consumers, who scarcely can imagine things being any different, having never experienced an alternative.

Remove that regulatory body and plunge the industry into the bracing cold waters of competition, and good things are supposed to happen: new entrants appear, prices come down, and consumers are delighted with products and services previously unimagined. Thus, deregulation was the dominant trend in economic policy throughout most of the industrial world during the 1980s and 1990s, and initial results were often impressive. But recently, signs of trouble have been appearing all around, with some deregulated industries beginning to resemble Leo Tolstoy's unhappy families.

In electricity, even before California's debacle, reliability problems and price spikes were on the rise throughout the United States, coinciding uncomfortably with the period in which the U.S. Federal Energy Regulatory Commission (FERC) ordered the national transmission networks opened to competition [see figure, p. 53]. Critics complained that infrastructure was not being maintained because newly competing companies seeking to cut costs were uncertain how investments would be repaid in the long run.

Even in the UK, the pioneer of electricity restructuring, there were repeated assertions that the two big generators were rigging prices. Hardly anywhere in the world did homeowners find they were getting power at much more attractive prices than before. As for product and service differentiation, well, there were "green" electrons to be had from companies generating power form renewable sources.

The U.S. airline industry, even before 11 September, was suffering severe declines in profits [see figure, p. 54], which were bound to lead to a new round of consolidation, leaving it perhaps even more concentrated than when it was deregulated in the late 1970s.

After deregulation, fares did plummet for a while, with start-up airlines vying for passengers. But now, with congestion fouling all the busier airports, passengers are bemoaning intolerable delays, widening disparities in ticket prices, and a general sense of things going too far out of control. True, air travel is within reach of many more people than ever, but not just the rich are wondering about the price that has been paid in terms of convenience and comfort.

In communications, the U.S. public profited enormously in the 1980s and 1990s from competition in long-distance telephony, as rates plunged and new competitors offered all manner of special services. But when the 1996 Telecommunications Act tried to bring competition to local and regional markets, benefits were unexpectedly slow in appearing [see figure, p. 54, again]. A host of new companies were founded to provide digital subscriber line (DSL) connections, but after a short while they went under in droves, as the Regional Bell Operating Companies (RBOCs) reasserted their strangleholds on local markets.

Meanwhile, the seven so-called Baby Bells have merged into just four huge companies, while, worst yet, AT&T-the queen of all communications companies just 20 years ago-teeters on the brink of bankruptcy. What's going on? To gain some perspective, IEEE Spectrum sought out Alfred E. Kahn, the father of U.S. airline deregulation, at his offices in Ithaca, N.Y. Now an emeritus professor of economics at Cornell University, Kahn first come to national and even international prominence in 1977, when President Jimmy Carter picked him to head the Civil Aeronautics Board (CAB), the agency that regulated the U.S. air industry. Kahn's mission there was to abolish his own job, which he did to general acclaim.

Previously, Kahn had served as chairman of the New York State Public Service Commission, having pretty much written the book with his two-volume work, The Economics of Regulation (1970, 1971). Now 84 years old, Kahn continues to publish frequently on all aspects of regulation and to give testimony when his view are solicited, which they frequently are. In the interview that follows, Kahn expresses skepticism about introducing consumer choice in electricity, mounts a robust defense of airline deregulation, and expresses some optimism about the prospects of making local telephone systems more competitive.

SPECTRUM: What's happened in electricity deregulation? I don't see a decrease in my rates, and at least in New York, if I leave the incumbent utility for someone else, they're under absolutely no obligation to take me back.

Kahn: I've always been a skeptic about retail consumer choice in electricity. I'm not crazy about the choices I have to make among telephone service providers either; but we all have clearly benefited enormously from the deregulation of long-distance service, whose prices were in any case grossly inflated by regulation in order to subsidize basic local service. We clearly have to include the cost to consumers of making intelligent decisions when we reckon up the costs and potential benefits of introducing competition. I'm skeptical about how that balance will turn out in electric power at the retail level; the power comes out of a totally interconnected network, and it seems to me the possibilities of competition at the local distribution level are limited, it's such a narrow-margin business anyhow. In any event, the complications of the whole thing seem to me to make it essential that you first get wholesale competition right, and that means ensuring the inescapably essential integration between transmission and generation.

So California moved too fast?

California was a wonderful example of misguided populism exhibited by both political parties. The people in California - or their political leaders - were determined to reap the benefits of deregulation for small consumers, first. But unregulated electric markets would be subject to wide fluctuations, as the balance between demand and supply shifts hour by hour, day by day, and season by season. The only way competition could work, then, would be if prices to consumers reflected that constantly changing balance, so purchasers would vary their consumption accordingly - for example, by putting off their use of electric dryers, dishwashers, and hot water from day to night at times of shortage. But that requires real-time metering, and the overwhelming majority of customers in California are still not real-time metered.

In addition, the designers of California's deregulatory framework felt they had to micromanage the whole thing, and so they required that all transactions had to be through a spot market - a spot market that would be subject to huge fluctuations, although, of course, we didn't adequately perceive how serious the imbalance between capacity and peak demands was or would prove to be.

The other mistake that I'm just beginning to understand is that if you're going to put caps on energy prices to protect people from spikes (which may or may not involve monopolistic manipulation), then you also must retain requirements that the load-serving entities maintain some stipulated reserve capacity, so that those spikes don't get completely out of hand. In New York, under regulation, we required generators to maintain 18 percent reserve capacity. California didn't retain such a requirement, and when peak demands soared, there wasn't a guaranteed margin of surplus capacity to keep prices from exploding. And since consumers were never confronted with those price spikes - they were rolled into their monthly bills - they had no means of protecting themselves by curtailing their purchases at those particular times and places.

You caused quite a stir last year by signing on to a letter endorsing wholesale price caps in California. You argued that given extreme elasticities of supply and demand, aggravated by absence of metering, markets were not working very well. Couldn't those arguments in favor of price caps also be made for a windfall profits tax, the proceeds being fed into energy investments or just given back to consumers?

I think that's right - I feel stupid it never occurred to me. Had it occurred to me, however, I would almost certainly have rejected it, because it would have required legislation; and the last thing we wanted was to encourage legislators to get into the process. Such price controls as they would almost certainly have wanted to impose could well have been counterproductive, discouraging the investment in the expanded generation capacity that was the fundamental remedy. We concentrated on FERC because it could impose the caps on its own authority. In fact, I complained that the first draft of that letter advocating caps had the works "just" and "reasonable" at least 10 times, referring to the existing statutory authority. But just offhand, I would think that a carefully designed windfall profits tax would be preferable because it wouldn't interfere with the pricing system and the proceeds could be handed back to consumers in a lump sum, so as not to discourage efficient conservation.

At a Department of Energy hearing in San Francisco two years ago, a representative of Dynegy Inc., of Houston, suggested creating something almost like the Federal Reserve System, with sort of a federated structure of boards setting reserve requirements and enforcing them. Is that a good idea?

It would have sounded like it to me until about two weeks ago, when I read the latest manuscript by Sally Hunt [of National Economic Reserach Associates], in which she argues you don't need reserve requirements. It can all be done by energy markets, provided you have sufficient metering.

There has always been a popular tendency to underestimate the elasticity of demand. Even in California, without metering, there's been an extraordinary amount of recent demand response. And of course a lot of demand is industrial demand, where it doesn't take very much of a price increase for companies to be better off shutting down. Remember, it's not the majority of customers - but only the major portion of the total loads - that you have to have real-time metered, because most of the load is accounted for by large business customers.

(the remainder of the article discusses the airline industry and telecommunications, and is not reprinted here)