FTC Staff Comment Before the California Public Utilities Commission Concerning Electricity Industry Restructuring

Y'1'1UU/~
UNITED STATES OF AMERICA
FEDERAL TRADE COMMISSION
WASHINGTc5:"",. DC. ::0580
Office of the Director
Bureau of Economics
COMM\SS\ON 	~Ul"OR\IED
June 8. 1994
The Honorable Kim Malcolm
Administrative Law Judge
Public Utilities Commission of the
State of California
505 Van Ness Avenue
San Francisco. CA 94102
Dear Judge Malcolm:
On April 20, 	1994, 	the California Public Utilities COIrunission ("CAPUC") 	invited
comment on R.94-04-031 and 1.94-04-:032, which contain the CAPUC's "Proposed Policies
Governing Restructuring California's Electric Service Industry and Reforming Regulation. " We
believe that the issues raised by the CAPUC proposals are similar to those we recently addressed
in comments provided to the South Carolina Legislative Audit Council in connection with a
"sunset" review of the Public Service Commission statutes of that state. Consequently, we have
enclosed a copy of our South Carolina comment, and in this letter we highlight several aspects
of that filing.! In panicular, we draw your attention to the appendix of the comme~lt which
reviews the significant strucrural reforms instiruted in both the United Kingdom (U .l~.. ) and in
New Zealand. 2
1 "Comment of the Staff of the Bureau of Economics of the Federal Trade Commission to
The South Carolina Legislative Audit Council on the Statutes and Regulations Covering the
South Carolina Public Service Commission" (February 28, 1994). In addition to electric power,
this comment discusses two other regulated industries, motor carriers and telecommunications.
The South Carolina comment, and this letter, represent the views of the staff of the Bureau of
Economics. 	They 	are 	not 	necessarily 	the 	views 	of 	the 	Commission 	or 	any 	individual
Commissioner.
2 In "California's Electric Services Industry: Perspectives on the Past, Strategies for the
Furure," Division of Strategic Planning, California Public Utilities Commission (February 1993),
various reform options are outlined and several references are made to the reforms in the United
Kingdom. The comments submitted here discuss both the United Kingdom reforms and also the
extensive. and in places noveL reforms being undertaken in New Zealand.

The Honorable Kim Malcolm
Page 2
Four topics addressed in the appendix of our South Carolina comment. pp. 50-55. may
be of panicular interest in your considerations.
Ownership and Control of the Transmission Grid: 	Both the U.K. 	and New Zealand
refonns have emphasized separating the control of the transmission grid from control of the
generating assets. 3 A major objective of such refonns was to improve incentives for making
efficient, system-oriented decisions about expansion and modification of the grid system. 4 The
decision to separate the control of the grid from the control of the generating assets was a
response to the concern that venically integrated companies that controlled expansion of the grid
might have an incentive to discourage pro-competitive retail wheeling. s For example, a problem
might arise if the distribution capacity available in peak periods was" required" to serve "utility
service" customers first (i. e., those that purchase both power and transmission services from the
local utility) and "retail wheeling" customers second. The threat or risk that retail wheeling
customers would have only a subsidiary claim to distribution capacity, and that the franchised
utility would control when and if distribution capacity would be expanded, 	might serve to
discourage customers from switching from utility service to retail Wheeling service.
Treatment of Uneconomical Assets and Unconventional Energy Sources: In the U.K.,
a number of nuclear power plants were considered to be uneconomical because of their age and
their costs of operation, including environmental costs. To accommodate the transition to a
competitive environment, while simultaneously addressing certain noneconomic goals, assets that
produce power from nuclear and other non-conventional fuels 	(wind, 	sun, 	tides, 	etc.) are
maintained in a separate category, and distributors are required, as pan of the U.K.' s energy
diversification program, to buy a limited portion of their needs from these non-conventional
power sources. This approach allows the remainder of the U.K. 's electric power demand to be
met by more efficient. and competing, conventional sources.
3 The ownership arrangements differ. In the U.K., the grid is owned as a joint venmre of
the local distribution companies (equivalent to investor-owned utilities with assigned territories).
In New Zealand, the grid is a joint venmre of both generating firms and distribution companies.
In both cases, the organization of the grid's day to day management and investment decisions
is designed to promote independence from the ownership. Interestingly, in the U.K. pumped
storage facilities may be owned and operated by the grid.
4 Another major concern addressed by taking this approach was retaining strict, unifonn
reliability and comparability standards for all generating sources.
S In virmally all retail transactions, 	the end user purchases both the electric power and
transmission services from the local electric power utility. Retail Wheeling occurs when an end
user purchases power from 	a generation source not affiliated 	with the 	local utility, 	which
supplies only transmission services.

The Honorable Kim Malcolm
Page 3
Distribution Merchants: Although local distribution is generally understood to be a natural
monopoly, New Zealand's reforms have sought to minimize the regulation of retail power sales.
The reforms require that an owner of local distribution lines establish separate line use charges
and offer access at nondiscriminatory prices to 	.. power merchants." 	Power merchants will
contract for power from generating firms. 	but own no distribution lines themselves, relying
instead on the existing distribution network. 	The goal 	is 	to make 	retail electricity sales a
contestable market so that any effon by existing providers to increase retail charges above
competitive rates would be thwaned by the entry of power merchants who have no sunk costs. 6
The key to achieving this result is the separate charge for line use.
Use of Price Caps: In the U.K., the announced intention of the reforms was to bring the
benefits of competition to large electricity users without creating any harm to small customers.
The method of assuring no 	harm to small customers was to cap 	rates to captive, 	smaller
customers while at the same time allowing retail wheeling for large customers. 7 The price-cap
approach overcomes one of the problems of cost based rate regulation, namely its susceptibility
to biased asset allocations; the U.K. reforms show that the price-cap approach may also provide
a means for preventing harm to small consumers. In the U.K., the price cap increases with
inflation and declines with projected technological efficiency gains.
6 A contestable market is one in which frrms incur no costs in either entering or exiting a
market. In other words, there are no sunk costs in contestable markets. Where markets are
contestable, frrms have an incentive to enter whenever prices exceed the cost of providing the
service. Theory predicts that, as a result, incumbent firms would charge prices that equal cost.
7 The California proposal also includes use of the .. safe haven" concept for prices that the
investor-owned utility would be allowed to charge its captive customers. We have previously
commented on the benefits and costs from this type of regulatory flexibility in the context of
intra-state long distance telecommunication services. 	We have enclosed one such comment:
"Comments of the Staff of the Bureau of Economics and the Chicago Regional Office of the
Federal Trade Commission Before the Illinois Commerce Commission" (October 19, 1990).

The Honorable Kim Malcolm
Page 4
We appreciate this opportunity to submit these comments in this proceeding and we hope
that you find our comments useful. Please contact either John Hilke (202-326-3483) or Timothy
Daniel (202-326-3520), if you have any questions or if we can be of assistance in the future.
Sincerely,
/S 	IRonald S. Bond
Acting Director

V94
. 	COMMISSION 	AUTHORIZED
Comment of the Staff of the Bureau of Economics
of the Federal Trade Commission'
to
The South Carolina Legislative Audit Council
on
The Statutes and Regulations Covering the
South Carolina Public Service Commission
February 28, 1994
. This comment 	represents the views of the staff of the Bureau of Economics 	of the
Federal Trade Commission. They are not necessarily the views of the Commission or any
individual Commissioner. Inquiries regarding this comment should be directed to John C.
Hilke (electric power) at (202) 326-3483, Richard Shin (telecommunications) at 202-326-3495.
or Timothy Daniel (motor carriers) at 202-326-3520.

I.
II.
III.
IV.
v.
Contents
Introduction 	.
Expertise of the Staff ot the Federal Tracie Commission.
Motor Carriers 	.
A. 	Introduction. . . . . . . . . 	. 	.
B. 	Regulation of trucking. 	. . . .. 	. 	.
1. 	Arguments advanced in support of regulation. 	... 	. 	.
a. 	Predatory pricing. 	. 	.
b. 	Destructive competition. 	. 	.
c. 	Safetv.. . . . . . . . . . . . . . 	. 	.
d. 	Preserving service to small communities. 	. 	.
.., 	Effects of regulation. 	. 	.
C. 	South Carolina's motor carrier laws and regulations 	.
1. 	Entry regulations. 	. 	.
2. 	Rate regulation 	.
D. 	Comments 	on 	South 	Carolina's 	statutes 	and 	regulations 	concerning
motor carrIers. 	. 	.
E. 	Conclusion.. 	.
F. 	References.. 	.
Telecommunications. 	. 	.
A. 	Introduction and summary. 	. 	.
B. 	Changes in the telephone industry. 	.
C. 	Regulation of telephone utilities. 	. 	.
1. 	Natural monopoly justification. 	. 	.
2. 	Regulatory alternatives. 	. 	.
3. 	Entry and pricing regulation. 	. 	.
D. 	Suggestions to the South Carolina Legislative Audit Council. 	.
1. 	Consider allowing the PSC to use alternative forms of regulation
for providers of telephone services. 	. 	.
2. 	Consider authorizing the PSC to give pricing flexibility to LECs
for services where they face competitive entry. 	. 	.
E. 	Conclusion. 	. 	.
F. 	References. 	. 	.
Electric power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 	.
A. 	Introduction 	.
B. 	Erosion of the "natural monopoly" justification for regulating electric
supply 	.
C. 	Regulatory changes 	.
1. 	United States experience . . . . . . . . 	. . . . . 	. 	.
2. 	Foreign experience 	. . . . . . . . . . . . 	. . . . . 	. 	.
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3. 	Relevance of the C.S ..mo foreign experlence to South C.uolina
D. 	Comments 	on 	South 	Carolina's 	statutes 	and 	regulations 	concerning
electric power
E. 	Conclusion
Appendix A 	".
Appendix B
F. 	References
42
VI. 	Conclusion 	..... ..................................................
..
11
63

1. 	Introduction.
The South Carolina Legislative Audit CO'lncil ("Council") has requested comments on
the possible restrictive or anti-competitive practices contamed in the statutes and regulations
of the 	South 	Carolina Public 	Service 	Commission 	("PSC").l 	The 	staff of the Bureau 	ot
Economics ("staff") of the Federal Trade Commission ("FTC" or "Commission") appreciates
this 	opportunity 	to 	submit 	the 	following 	comment, 	\\'hich 	will 	discuss 	thre~ indu::ries
regulated by the PSC: motor carriers, telecommunicatic:ls. and dectri:: powe:-.
After an introductory description of the staff's experience and expertise in these three
areas, each industry is discussed in turn. Each of the industry sections discusses the underlying
rationales for regulating the industry's prices and entry conditions and examines the effects of
economic 	regulation 	on 	industry 	performance 	and on 	consumers. 	Each 	section 	includes
suggestions for how South Carolina's laws and regulations could be modified to promote
economic efficiency.
Experience shows that competitive forces promote economic efficiency and provide
tangible benefits to consumers, even in markets that have traditionally been regulated. Some
aspects of electric power and telecommunications retain "natural monopoly" characteristics,
and so will continue to require some form of economic regulation.~ We believe, though, that
consumers could benefit if the form of regulation in these industries were altered to rely more
on market forces. In the trucking industry, which is not, by any measure, a natural monopoly,
we believe that South Carolina may wish to rely to an even greater extent on competitive
forces, to create an environment that rewards sellers that provide lower prices and improved
services to consumers.
1 The Council's letter of August 12, 1993 also requested comments about the Manufactured
Housing Board, Real Estate Commission, Residential Home Builders Commission, Licensing
Board for Contractors, Board of Registration for Professional Engineers and Land Surveyors.
Board of Certification of Environmental Systems Operators, Board of Geologists, Board 01
Nursing Home Examiners, and Real Estate Appraisers Board. The staff of the FTC respondec
concerning that portion of the Council's request on November 16, 1993.
2 Here, 	"economic regulation" 	means 	regulations 	dealing with 	the 	prices 	charged b:
regulated firms and the conditions under which new firms can enter or existing firms car
expand their presence in the industry. This comment addresses issues relating to economic
efficiency and competition. It does not take a position on other policy considerations.
1

II. 	Expertise of the Staff of the Federal Trade Commission.
The 	FTC 	is 	an 	independent 	.1dminisrrative 	agencv 	responsible 	tor 	maintammg
competition and safeguarding the interests of consumers.: The staff of the FTC, upon request.
often analyzes regulatory or legislative proposals that may affect competition or the efficiencv
of the economy. In the course of this work. as well as in antitrust and consumer protection
research and litigation. the staff applies established principles and recent developments 	in
economic theory to competition and consumer p:-otection issues, including efficiency rationales
for rate and entry regulation.';
The staff of the FTC has submitted comments at both the state and federal levels on
many regulated industries. The staff submitted comments to the C?uncil in 1987 in response
to a request similar to this one. 	In the 	1987 comment. 	the staff examined a number of
regulated industries, including electric utilities and motor carriers. s Since then. the staff has
submitted a number of comments to state and federal agencies dealing with the telecommunica-
tions industry,b and has studic:! the effects of price and entry regulations on long distance
telephone service.:- The staff of the FTC has commented on the deregulation of trucking and
3 15 U.S.C. §41 ~ seq.
4 For example, the staff of the FTC submitted comments to the Postal Rate Commission
concerning recent advances in the economic theory of regulated monopolies. See Comments
of the Staff of the Bureau of Economics of the Federal Trade Commission, Before the United
States of America Postal Rate Commission, Monopoly Theory Inquiry, Docket No. RM89-4
(September 1, 1989).
S Comments of the Federal Trade Commission Staff to The Legislative Audit Council of
the State of South Carolina on Possible Restrictive or Anticompetitive Practices in South
Carolina's Public Service Commission Statutes (September 29, 1987).
(, See Comments of the Staff of the Bureau of Economics and the Chicago Regional Office
of the Federal Trade Commission, Before the Illinois Commerce Commission, In the matter
of The Blue Ribbon Telecommunications Task Force Outline of Purpose and Request for
Assistance (October 19, 1990). At the federal level, ~ Comment of the Staff of the Bureau
of Economics of the Federal Trade Commission. In the matter of Expanded Interconnection
with Local Telephone Company Facilities, FCC Docket CC 91-141, (March 5, 1993); Reply
Comment of the Staff of the Bureau of Economics of the Federal Trade Commission, In the
matter of Revisions to Price Cap Rules for AT&T, FCC Docket CC 93-197 (October 21
1993).
7 See Alan D. 	Mathios 	and Robert 	P. Rogers, 	The 	Impact 	of State 	Price and Entry
Regulation on Intra-State Long Distance Telephone Rates, FTC Bureau of Economics Staf:
Report (November 1988).
..,

the benefits resulting from an increased reliance on market. forces at both the federaP and
state 9 levels. 	The 	Bureau 	of Ecc:1omics 	01 the 	FTC 	has 	published 	J 	report 	on 	trucking
dereguhtion. including the relaxation of e nry restrictions and rate regulation.:: 11 Through
these activities. the staff of the FTC has accumulated considerable experience in analyzi!lg the
effects of trucking regulation.
8 See Comments of the Staff of the FTC on Pricing Practices of Motor Common Carriers
of Property Since the Motor Carrier Act of 1980, Interstate Commerce Commission, Ex Parte
No. 	MC-166 	(January 	1983); 	Exemption 	of Motor Contract 	Carriers 	from 	Tariff Filing
Requirements, Interstate Commerce Commission, Ex Parte No. MC-165 (1983); see also D.
Breen, 	Bureau 	of Economics, 	FTC, 	Regulatory 	Reform and the Trucking Industry: 	An
Evaluation of the Motor Carrier Act of 1980, submitted to the Motor Carrier Ratemaking
Study Commission (March 1982).
9 See Comments and Testimony before the Michigan Public Service Commission (likely
effects from entry restrictions) (November 5, 1992); Illinois Commerce Commission (likely
effects from entry restrictions) (March 18, 1991); Tennessee Comptroller ofthe Treasury (June
28. 1990); Director. Transportation/Gas Utilities Division, Railroad Commission of Texa!
(October 2. 1989); Texas House of Representatives (tow truck regulation) (April 18, 1989)
California Public Utilities Commission (impact of deregulation) (October 27, 1988); Ohic
House of Representatives (contract carrier motor freight rates) (February 16, 1988); Californi,
Senate (contract motor carrier rates) (December 31, 1987); and \Vashington State Legislatun
(March 7, 1985).
10 Diane S. Owen, Deregulation in the Trucking Industry, FTC Bureau of Economics Staf
Report (May 1988).
II In addition, the Commission has taken law enforcement action against trucking rat
bureaus for fixing the rates of their members. 	New En~land Motor Rate Bureau. Inc., 1L
F.T.C. 200 (1989), rev'd, 1990-2 Trade Cas. (CCH) 	~69.108 	(1st Cir. 1990) (Commission'
order finding violation dismissed with regard to Massachusetts, on grounds that price fixin
actions were actively supervised by state agency), modified as to New Hampshire, Septembe
4, 1991; see also Motor Transport Association of Connecticut, 112 F.T.C. 309 (1989) (pric
fixing found, but complaint dismissed because action was actively supervised by state agency
3

III. 	Motor Carriers.
.,"""1.. 	Introduction .
The staff of the FTC believes that relaxing restrictions on emry into motor carrier
markets and permitting motor carriers to adjust their prices with J minimum of regulatory
oversight benefits consumers and competition by increasing choices. improying service, and
reducing prices for the transportation of goods. Studies of motor carrier regulation, both state
and federal, show that consumers benefit most when operating authorities are broad and when
carriers can flexibly modify their schedules and rates. We recommend, therefore, that the
Council consider these principles in suggesting changes in the state's laws and regulations
concerning the motor carrier industry.
B. 	Regulation of trucking.
Several states have recently deregulated some segments of their motor carrier industry,
and eight states have deregulated their intrastate trucking industries completely. At the federal
level, motor carriers have been substantially deregulated since 1980 to permit much greater
competition on rates and much easier entry of new carriers. 12 The reasons for retreating from
pervasive economic regulation, that is, control over rates and entry into the industry, are
clarified by examining the arguments concerning deregulation and the experiences where
economic regulation has been relaxed. Studies have found that the usual rationales for motor
carrier regulation are unpersuasive and the economic consequences of rate and entry regulation
have been undesirable. (Winston et a1. (1990); Diane S. Owen (1988))
1. 	Arguments advanced in support of regulation.
Originally, regulation of motor carrier rates and new entry was intended, at least ir
part, both to protect the regulated railroads from comF~tition and to support the truckim
industry during the depression of the 1930's. (Nelson (1975)) The arguments usually advancec
now for continuing this regulation assert four goals: preventing predatory pricing, forestallin~
destructive competition, maintaining safety, and ensuring service to small communities.
a. 	Predatory pricing.
It is sometimes argued that rate and entry regulation is necessary to prevent predator
pricing. According to this line of argument, larger, better financed companies will attempt t
drive out competitors by selling their product or service at a 10ss.:.3 After the competitors ar
12 Motor Carrier Act of 1980, P.L. 96-296, 94 Stat. 793 (1980).
13 Whether a sale is predatory would be determined by comparing the price to cost. Und,
(continued.
4

driven out. the sun'lving "predators" 	,""auld rJ.ise their pnces above the competitive level.
eventually recouping their losses and increasing their profits.
The practical difficulty of this strategy, or losing money now in the hope of making
more later, is that when the "predators" try to raise prices to noncompetitive levels, other
firms mav enter, or re-enter. the market. Their entry should take business awav from the
"predato;" and force prices back to competitive levels. 	Unless that entry can be blocked.
predatory pricing is likely to fail. The Supreme Court has concurred in this analysis, observing
that "predatory pricing schemes are rarely tried. and even more rarely successful."14 Another
deterrent to trying this strategy, in addition to its risk of failure, is that it could be attacked
by public and private antitrust enforcement actions.
The ability to deter entry successfully might apply most plausibly to industries with
high 	"sunk costS."15 But 	entry 	into 	trucking 	is 	not 	difficult. 	except 	for the 	problem of
obtaining regulatory approval. and sunk costs appear to be relatively low. In the truckload
("TL") segment of the trucking industry, shipments usually go from shipper to consignee
without intermediate handling; the truck itself is the only equipment 	needed. Trucks are
highly mobile and can be transferred quickly to alternative uses, either by shifting them to
more profitable geographic markets or by selling or leasing them to other operators. Thus,
sunk costS are probably minimal in the TL segment. (Keeler (1989)) In the less-than-truckload
("Ln") 	segment, 	involving shipments 	of less 	than 	10,000 	pounds, 	shipments 	often 	are
transported 	to 	break-bulk 	facilities 	before 	reaching 	their 	destinations, 	so 	assets 	such 	as
warehouses and terminals are also employed. But, like trucks, warehouses and terminals can
easily be put to other uses. 	An entrant can often lease, rather than buy, warehouse and
terminal space, and even when it must be purchased, it can be resold or leased to others for
alternative uses.
13(... continued)
the test that the FTC has applied. sales at a price below average variable cost for a significant
period 	of 	time 	are 	presumed 	to 	be 	illegal, 	but 	the 	presumption 	can 	be 	rebutted. 	See
International Telephone & Telegraph Corp., 104 F.T.C. 280, 403-04 (1984); General Foods
£&m., 103 F.T.C. 204, 344-45 (1984).
14 Matshushita Electrical Industrial Co. v. Zenith Radio Corp., 475 U.S. 574, at 589-590
(1986), citing R. Bork, The Antitrust Paradox (1978) pp. 149-56. The Supreme Court recently
reiterated that establishing predation remains difficult. See Brooke Group Ltd. v, Brown &
Williamson Tobacco Corp., __ U.S. __ Gune 21, 1993).
15 See text at n. 111, infra. Sunk COSts are those that. once incurred, cannot be recovered
should the firm choose to exit the industry. Expenditures on assets that cannot be redeployed
easily to alternative uses would be considered sunk costs. An example of this kind of asset
might be gas pipelines.
J

Since predation is unlikely to be profitable or successiuL motor carriers are not likel!'
to attempt it. So lana as entry by new carners is not imreded by regulation. predatory pricing
in the trucking industr:' appears to be little mo:-e than a t~!eoretical possibilitv.:~ Others ~ 110
have 	concluded 	that 	predation 	in 	the 	trucking 	industrv 	is 	unlikely 	in 	a 	deregulated
environment 	include 	the 	General 	Accounting 	Office 	(GAO), 	the 	Interstate 	Commerce
Commission (ICC), the Motor Carrier Ratemaking Study Commission (MCRSC), and the
Department of Justice (DOJ).l~
b. 	Destructive competition.
It is also argued that. without regulation. motor carriers will engage in "destructive
competition." The setting for the "destructive competition" 	scenario is typically an industry
with fluctuating demand, high sunk costs, and a high ratio of fixed costs to total costs. These
conditions could lead to excess capacity and considerable pressure to cut prices when demand
falls. According to this argument. if firms compete on the basis of price. prices may fall below
the average total cost of providing services. and firms trying to reduce costs may diminish the
quality and reliability of service. to the detriment of customers.
The critical feature of this scenario is that, because so manv costs are fixed or sunk,
adjusting capacity in the face of (unpredictably) falling demand is difficult. But these conditions
conducive to destructive competition, of relatively high fixed and sunk costs, are unlikely to
characterize the trucking industry. Not only are few, if any, capital costs "sunk," but also fixed
costs are not a large percentage of total costs. Rather, the rrajor portion of total costs, sucn
as 	labor 	and 	fuel 	expenses, 	would 	generally 	be 	treated 	as 	variable. 	Because 	the 	usual
preconditions appear to be absent in the trucking industry, removing rate and entry regulation
would be unlikely to lead to destructive competition.· 8
c. 	Safety.
Next, 	it 	is 	argued 	that 	economic 	regulation 	must 	be 	retained 	to 	maintain 	safety
standards. It is feared that carriers facing stiff competition in rates or service would neglect
maintenance, postpone replacing vehicles, and overwork drivers. (Because safety is a dimension
16 For a review of the modern theoretical literature on predatory pricing, see Milgrom ane
Roberts (1990).
17 U.S. Gen. Acct. Off. (1987) pp. 8-10 discusses the positions of the ICC, MCRSC, ane
DOl The GAO report discusses entry barriers in LTL trucking, the most significant of whid
might be sunk costs involved in providing terminals. financial capital requirements for effective
entry, and impediments to entry imposed by state regulation. and concludes that these ar,
"moderate." Id. at 18; Diane S. Owen, supra note Ie. at 13.
18 See Kahn (1971) p. 178: "[D]oes trucking have the economic attributes of an industr
subject to destructive competition? It would be difficult to find one less qualified."
6

of service quality, this concern could be an element of the "destructiye competition" argument
too.)
Studies of the satet:' effects of removing economic regulation are. at best. inconclusive:
figures are cited apparently showing that deregulation led to more older trucks on the road
and more reported accidents involving truckers. but other literature suggests that deregulation
has not compromised safety. (Diane S. Owen (1988) pp. 18·21; Alexander (1992)) For example,
a California legislative studv was "unable to prove the hypothesis that the California Public
Utilities Commission (CPUC) economic regulation of trucking is significantly and positively
linked to improved highway safety." (Calif. Joint Legislative Report (1987) p. 3) At the federal
level, a recent report by the staff of the ICC concluded that economic deregulation did not
compromise safety, citing, among other things. 	1990 DOT figures showing that the fatal
accident rate per million miles driven by large combination trucks had fallen by one-third
since the 1978-79 period. (Office of Economics of the ICC (1992) pp. 60-67).
There is no necessary relationship between economic regulation and safety. Regulating
rates 	and entry 	would 	not 	ensure that 	profits 	;Ire spent 	on safe 	operations, 	nor would
removing economic regulation necessarily redu: ~ expenditures on safety. Addressing safety
concerns directly, through enforcement of safety regulations, would promote safety more
effectively than addressing those concerns indirectly through economic regulation.
d. 	Preserving service to small communities.
Finally, maintaining economic regulation is sometimes said to be required to preserve
service 	to 	small 	communities. 	According 	to 	this 	argument, 	motor 	carriers 	will 	find 	it
unprofitable to serve small markets, unless they are guaranteed, by rate and entry regulation,
a fair return on investment. The argument presumes that serving small markets is inherently
so unprofitable that carriers would not provide it, unless they were required to do so by
regulation and compensated for it by high profits earned in other larger markets. These profits
can be guaranteed only by protecting carriers from competition there.
In general, an unregulated trucking market can be expected to meet efficiently the
demands of shippers, whether they be in large or small markets. Studies of the actual effects
of deregulation have not revealed significant deterioration in service to small communities.
Surveys by DOT found that a large majority of shippers in rural areas reported either no
change, or an improvement, in the quality of service after interstate trucking was partially
deregulated. (U.S. DOT (1986a, 1986b)) A 1982 ICC study found that federal deregulation had
resulted in lower prices, less damage, and often more service options for shippers in small
communities. (ICC (1982)) In a survey following deregulation of intrastate trucking in Florida,
65 percent of respondents in small communities expressed a preference for deregulation, while
30 percent expressed no preference. (Beilock and Freeman (1983)) Thus experience suggests that
deregulation does not impair service to small communities.
7

2. 	Effects of regulation.
A comprehensive study by DOT of the ;mpact of state trucking regulation found that
state trucking regulations impose annual costS 011 the nation's economy, in the form of higher
trucking rates, of approximately S2.8 billion \1988 dollars). (Allen et al. (1990) p. 294) This
study allows some comparison between states that have retained economic regulation and states
that have relaxed or eliminated it. The study estimates the costs that result from state trucking
regulations 	by comparing deregulated interstate 	rates 	with 	regulated intrastate 	rates. 	The
study's methods estimated those costs for many states individually, but not for South Carolina,
which was included in a group with Tennessee, North Carolina, and Florida; for those four
together, the annual economic costs of state trucking regulation were estimated to be $99
million.
Several states have reduced or eliminated economic regulation. Their experiences attest
to the benefits to consumers that can follow. 	California, for example, experimented with
partial economic deregulation of trucking from 	1980 to 	1986. During that time entry was
virtually free, and rates, though regulated, were flexible. 19 According to one study, the result
was lower rates with no loss in service.~::: In April 1986, the CPUC reinstituted significant
economic regulation.'::1 But in April 1990, the CPUC reversed course again, implementing
significant deregulatory measures. l1 According to a 1991 assessment of these two 	regimes
conducted by the Transportation Division of the CPUC, "The rules governing price changes
prior 	to 	the 	(1990) 	Decision 	prevented 	carriers 	from 	responding 	to 	changing 	market
conditions.n The PUC also concluded that, in the year following the 1990 decision, prices in
the truckload sector fell by 10.3 percent (in real terms) while prices in the less-than-truckload
sector rose only 0.3 percent. Further, the assessment reported that a shipper survey conducte-
several months after the 1990 decision " ... indicated that the vast majority of shippers are
'happy' with their for hire trucking service (91 percent) and can get such service anytime they
ask for it (94 percent)."
19 Carriers were permitted to change rates, after a short waiting period, without having to
show the change was cost-justified. There was no waiting period to match a competitor's rate.
20 Simmerson, Analvsis of The Impact of Dere~lation of the General Frei~ht Truckin~
Industry) at 2Q..21 , Cal. Pub. Util. Comm'n, Investigation No. 84-05-048 (Aug. 10, 1984) (based
upon 	survey 	by 	CPUC 	of 	239 	general 	freight 	carriers 	and 	survey 	by 	California 	State
University, Hayward, Institute of Research & Business Development of 596 shippers.)
ZI Carriers had to cost justify proposed changes in rates (particularly rate reductions) and
carriers were required to increase some rates by 10 percent.
22 Common carriers were permitted to alter their rates within a "zone of reasonableness"
and contract carriage was largely deregulated.
8

In New Jersey, :l study concluded that deregulation 'worked well. (.-\llen. Lonergan. and
Plane (1979)) Shippers were satisfied with the available senrice, f.:ltes were about 1C percent
lower than they would have been u:1der regula~iol1. J.r.d intrastate carriers prospered.:)
In Florida, one study found that. J. year .:liter deregulation. SS percent of shippers
supported it, with most finding that senrice levels remained constant and that rate fluctuations
had posed no difficulties; indeed, even 49 percent of truckers supported deregulatic::. (Fre~man
(1982) p. 51) A DOT study.!4 found that 90 percent of Florida shipFers beli~ved that post-
deregulation senrice was at least as good as senrice before deregulation and 30 percent reported
improvements. A majority (58 percent) perceived that deregulation had held rates down. And
an economic studv found that deregulation led to a 15 percent average reduction in motor
carrier rates. (Blai~, Kaserman. and McClave (1986)r S
At the federal level, a recent study of federal deregulation of surface freight transporta-
tion 	(trucking and railroads) 	estimated that deregulation 	benefits shippers. Jnd ultimately
consumers, approximately 520 billion annually through reduced rates and improved service.
(Winston et al. (1990)) The net welfare gain to the economy as a whole is somewhat less-$16
billion annually-because deregulation reduces the profits of some carriers and reduces the:
wages of some workers. Still, the overv.·helming conclusion is that deregulation provides
substantial, ongoing benefits. The effect of interstate deregulation on prices of trucking services
is equally striking. A recent study concluded that "deregulation has reduced rates from the
very beginning and that the effect has grown over time. By 1983 reductions are conservatively
in the 15 to 20 percent range and in the 25 to 35 percent range by 1985." (Ying and Keeler
(1991))
In sum, 	deregulation 	of trucking appears 	not to 	have had the adverse impact 	on
competition or consumers that many critics of deregulation predicted. In fact, deregulation has
fostered lower shipping rates and improved service. Lower shipping rates and the reduced costs
from more efficient service would, in many ir~stances, be passed through to consumers in
lower prices for final goods.
2J Allen, Statement Before the National Commission for the Review of Anti-Trust Laws
and Procedures Ganuary 22, 1979).
24 Statement of Matthew V. Scocozza, Assistant Secretary for Policy and Intemationa
Affairs, U.S. Dept. of Transportation, Before the Subcommittee on Surface Transportation
U.S. House of Representatives Gune 20, 1984).
25 	A 	related 	finding 	comes 	from 	Maryland. 	for 	a 	period 	(1973-74) 	when 	interstat,
household 	goods 	movers 	were 	regulated 	but 	intrastate 	movers 	were 	not. 	The 	regulatet
household goods carriers charged 27 percent to 67 percent more than unregulated carriers fo
comparable moves. (Breen (1978)).
9

C. 	South Carolina's motor carrier laws and regulations. 2:
South Carolina's motor carrier statutes .nd regulations cover J. number of areas. This
comment wIll focus on two: entry requirements and rate regulation. ?\1any economic studies
have concluded that federal and state deregulation at trucking has ~'ielded sizable benefits to
shippers-and ultimately to consumers 	of final 	goods-through 	lower shipping 	rates 	and
improved service quality. We believe that South Carolina's consumers would benefit similarlv
were the state to deregulate its motor carrier industry,
1. 	Entry regulations.
Before beginning operations, motor carriers are required by law to 	obtain a valid
operating certificate from the PSC. 2:' A request for a new or modified operating certificate
may be approved if the PSC determines that the applicant is "fit, willing, and able to perform
appropriately the proposed service."28 This section of the statute. \\'hich became effective in
1984. continues. "If an inter:~.lOr shows or if the commission determines that the public
convenience and necessity is being served already. the commission may deny the application."
But an intervenor seeking to show that the "public convenience and necessity is being served
already" bears the burden of proving its case: the law does not require that the applicant prove
the negative. 29
Another 	part 	of the 	statute, 	§58-23-1020, 	prevents 	certain 	motor 	vehicle 	carriers
(including freight common carriers) from changing their routes or schedules without the PSC';o
express approval.
The PSC's regulations on entry requirements track closely the language contained in
the statutes. Some changes have been implemented as recently as 1990.JQ
2& Some 	additional 	detail 	on 	these 	laws 	and 	regulations 	IS 	provided 	tn 	the 	specific
recommendations discussed in section D. below.
2J S.C. Code Ann. §58-23-40.
28 S.C. Code Ann. §58-23-330.
29 Anderson Armored Car Service. Inc. v, South Carolina Public Service Commission
(1988, App) 295 S.C. 148,367 SE2d 444. By contrast, the previous regulation placed the burden
in the opposite direction, requiring a showing that the public convenience and necessity were
not being served in order to obtain the license. S.C. Code Regs. § l03-134(l)(A). Other rules
(§§(B), (C)) that made it harder for an applicant to establish public convenience and necessity
have also been repealed.
30 S.C. Code Regs. §103-130 - 141.
10

.,... 	Rate regulation .
Trucking rates are regulated ..-\ccorimg to statute.
The [public service] commission shall supervise and regulate every motor carrier in this
State 	and 	fix 	or 	approve 	the 	r;ltt'~ 	tares. 	charges, 	chssifications. 	Jnd 	regulations
pertaining to each motor carrier .... The rates once established remain in effect until
such time when, pursuant to complaint and proper hearing, the commission determines
that rates are unreasonable.:}
Under the regulations, the approved rates must be "just and reasonable" Jnd the PSC may give
due consideration in approving rates to the "need of such carriers for revenues sufficient to
enable them, under economical and efficient management. to provide such service. "32 Further.
motor carriers are required to charge only those rates that have been approved by the PSC;
rebates and discounts not approved by the PSC are forbidden.:: Finally, the PSC can, if it
chooses. hold public hearings prior to approving requests to change existing rates.3~
D. 	Comments on South Carol;na's statutes and regulations concerning motor
carriers.
The motor carrier industry's characteristics-numerous potential providers, relative:
low economies of scale, and minimal 	impediments to entry (except those resulting fron
regulation)-are those that typically yield well-functioning, competitive markets. Consequently
we believe that the Council should consider recommending that the South Carolina Legislatun
take steps to deregulate further the entry restrictions and rate regulations that now apply t(
the state's motor carrier industry.
Important steps to facilitate entry have already been taken. The legislative changes th,
went 	into 	effect 	ten 	years 	ago,3; 	J.nd 	the 	companion 	regulations 	that 	were 	modified 	z
31 S.C. Code Ann. §58-23-1010. The statute further provides that "the commission rna
approve joint rates, local rates, and rate agreements between two or more 	motor carrie:
relating to rates, classifications, allowances, and charges agreed to and published by individual
firms, corporations, or the Motor Truck Rate Bureau, Inc.", and that agreements so approve
are not in violation of a South Carolina antitrust statute. S.C. Code Ann. §39·3-10.
32 S.C. Code Regs. 103-191, 194.
JJ S.C. Code Regs. 183-280.
3-4 S.C. Code Regs. 103·193.
35 S.C. Code Ann. §58-23-330.
11

recently as 1990,3° could allow the PSC to appro\'e new and, modified operating certificates
relativel\' quickly, so that motor carriers could respond to new profit opportunities. But their
ability ro respond to market change:) is still ;nhibited b\' the requirement that motor common
carriers obtain the approval of the PSC pnor to altering their routes or schedules.;~ :\t the
federal level, operating certificates are now broad and schedules can be easily modified. Several
states also have loosened or removed 	restrictions on motor carriers' abilitv to alter their
operations. Studies of experience with motor carrier deregulation have conclud'ed that shippers
and 	consumers 	benefit 	when 	carriers 	can 	modifv 	their 	operations 	with 	a 	minimum 	of
regulatory oversight and delay. In an unregulated market, public demand for a particular
service is shown through consumers' willingness to pay for the service, and producers are
rewarded with higher sales and greater profits when they meet these demands more efficiently.
Motor carriers could meet them better if they were relatively free to respond in particular
circumstances. We recommend, therefore. that the Council consider recommending that §58-
23-1020 be deleted.
Rates continue to be regulated. Rate regulation diminishes the benefits that accrue from
relaxing entry regulation. When rates in a competitive industry like trucking are kept above
the level that would emerge in an unregulated market, but entry or other aspects of service
remain unregulated, firms will compete away any supra-competitive profits on other margins,
such as 	frequency 	of service. 38 Achieving the efficient 	combination 	of price and quality
requires that both entry requirements and rates be deregulated. Experience at both the state
and federal levels indicates that eliminating rate 	regulation tends to 	reduce, 	not increase,
trucking rates, without compromising service quality. We suggest, therefore, that the Council
recommend 	substantial 	changes 	to 	the 	laws 	and 	statutes 	that 	impose 	significant 	rate
regulation. J9 Specifically, 	we 	suggest 	that 	the 	Council 	recommend 	that 	§58-23-1010 	be
deleted. 40 The findings discussed in this section suggest that deregulating trucking rates is a
logical and appropriate step.
36 S.C. Code Regs. 103-130 - 	141.
37 S.C. Code Ann. §58-23-1020. The regulations are more flexible with regard to which
commodities a licensed motor carrier can transport. S.C. Code Regs. 103-210, 211 permit the
PSC to approve operating certificates that allow carriers to transport a relatively wide variety
of commodities.
38 Douglas and Miller (1974) discuss this inefficient result in the context of the regulated
airline industry.
39 South Carolina has already deregulated rates for bus service. S.C. Code Ann. §58-23-20
40 Should this statutory section be deleted. a number of the regulations would also neec
to be modified or deleted.
12

E. 	Conclusion.
Certain aspects of the txcking incustr'." )uve been deregulated at tne federal level and
In many states. Arguments typically advanced against trucking deregulation appear largely
unfounded. Instead. deregulation has brought lower pnces and often better service to shippers.
In particular, relaxing regulations that impede market entry and that limit rate flexibility has
benefited consumers and competition. \X' e suggest that the Council take these experiences into
account when formulating its recommendations concerning the motor carrier industry.
13

F. 	References.
A.lexander. :\10tor C.1frier Deregulation and Hl~h"'rl\' 5.11etv: :\n Empirical :\nalvsls, 5" So.
Econ. J. 28 (1992).
Allen et al., The Impact of State Economic Regulation at Motor C.lrriage on Intrastate and
Interstate Commerce. U.S. Dept. of Transportation (p./lay 1990).
Allen, Lonergan 	& Plane, Examination 	of the 	Unregulated Trucking Experience tn New
Jersey, U.S. Dept. of Transportation (July 1979).
Beilock & Freeman, Motor Carrier Deregulation in Florida, 14 GroW'th and Change 31 (1983).
Blair, Kaserman & 	McClave. !vlotor Carrier Deregulation: The Florida Experiment, 68 Re\'.
Econ. & Stat. 159 (1986).
Breen, Regulation and Household Movin~ Costs, Regulation. 53 (Sept.- Oct. 1978).
California Public Utilities Commission & California Highway PatroL AB 2678 Final Report
on Truck Safety, Joint Legislative Report (Nov. 1987).
Douglas and Miller, Economic Regulation of Domestic Air Transport: Theory and Policy.
Washington: The Brookings Institution (1974).
Freeman, A Survey of Motor Carner Dere~lation in Florida: One Year's Experiencp:., Ie'
Practitioners Journal (Nov.-Dec. 1982).
Interstate Commerce Commission, Small Community Service Study (1982).
Kahn. The Economics of Regulation 2, Cambridge: MIT Press (1971).
Keeler. Dere&Ulation and Scale Economies in the U.S. Truckin& IndustI"\': An Econometri,
Extension of the Survivor Principle, 32 J. L. & Econ. (1989).
Milgrom and Roberts, New Theories of Predatorv Pricin& in Bonanno and Brandolini eds
Industrial Structure in the New Industrial Economics, Oxford: Clarendon Press (1990).
Nelson, The Chan&in& Economic Case for Surface Transport Regulation, in Perspectives 0
Federal Transportation Policy, James C. Miller III. ed. (1975).
Office of Economics of the ICC. The U.S. Motor C.lrrier Industry Long After Deregulatic
(March 1992).
14

Diane S. 	Owen, Deregulation In the Trucking Industry, FTC Bureau or Economics Staff
Report (Ma:: 1988).
U.S. Dept. of Transportation. Third Follow-LJp Stuch' ot Shipper-Recel\'er :"lode Choice in
Selected Rural Communities. 1982-3 (1986a).
U.S. Dept. of Transportation. Fourth Follow-up Study of Shipper-Receiver l\·lode Choice in
Selected Rural Communities. 1984-5 (l986b).
U.S. Gen. Acct. Off., Trucking Regulation: Price Competition and !\'1arket Structure in the
Trucking Industry (Feb. 1987).
Winston et ai., The Economic 	Effects 	of Surface Freight Deregulation. 	\v,/ ashington: The
Brookings Institution (1990).
Ying and Keeler. Pricing in a Dere~lated Environment: The Motor CJ.rrier Experience, 22
RAND Joumal of Economics 264 (Summer 1991 L
15

IV. 	Telecommunications.
A. 	Introduction and summarv.
In the decade since the breakup of AT&T in 1984. there has been rapid and substantial
technological progress in telecommunications. :\s a result. in many states traditional regulatory
policies have been replaced by policies that attempt to account for this progress. Our comment
will discuss two areas where amendments to the existing South Carolina statues and regulations
could 	benefit 	consumers. 	These 	are: 	(1) 	pursuing 	alternatives 	to 	rate-of-return 	("ROR")
regulation for telephone utilities 41 ; and (2) 	permitting incumbent telephone utilities more
flexibility to adjust prices in response to new competition.
We 	believe that the changes 	we 	recommend 	would promote economic efficiency.
Regulatory approaches, such as price cap regulation, that encourage firms to minimize costs
may help induce telephone companies to provide telephone services more efficiently and lead
to 	reduced 	prices 	for telephone 	services. 	Studies 	have 	shown 	that states 	with 	price 	cap
regulation had lower prices for long distance service. Adopting similar types of regulations for
the services provided by local phone companiei (called "local exchange carriers" or "LECs")
would likely promote efficient input usage at the local level, reducing further the overall cost
of providing telephone service.
With some exceptions, permitting entry in markets for services traditionally provided
by LECs would likely promote economic efficiency. When competition is introduced for
services supplied by a LEC, the incumbent LEC should be given pricing flexibility for these
services, to minimize instances of entry by firms whose costs are higher than the incumbent's.
The LECs' prices for some services are set significantly above costS, so allowing competition
for these services could result in lower prices. Some services now provided by LECs are
proteCted by law from competition, so that they can be priced above cost. The resulting
profits are used, in part, to 	keep local residential rates low. The subsidy scheme will be
difficult to maintain in the long run. however. if entry occurs into services currently priced
above cost and if telephone service suppliers and end users devise alternatives to the services
traditionally supplied by the LEC.
This portion of our comment begins with a brief review of the competitive changes
that have occurred in the telephone industry since 1984. We then discuss the regulation of
telephone utilities, examining first the natural monopoly justification for regulating telephone
utilities, and discussing second the alternative "incentive" regulations now being adopted by
regulatory agencies at 	both the federal 	and state levels in response to changes in market
4\ 	For our 	purposes, 	telephone 	utilities 	include 	all 	local 	exchange 	carriers 	("LECs"),
interexchange carriers ("IXCs"), competitive access providers ("CAPs"), and any other tele-
phone service providers in South Carolina. For exact definitions. we refer to those used in S.C.
Code Ann. §58-9-10.
16

structure. 	Entry 	and 	pncmg 	Issues 	are 	also 	discussed. 	This 	will 	be 	followed 	by 	specific
observations about South Carolina's regulations and statutes that affect the provision of local
and long distance telephone services. WI e condlde: With J. discussion ot possible revisions to
South Caroiina's statutes and regulations.
B. 	Changes in the telephone industry.
The market for telephone services has become :::ore competitive, especially after the
breakup of AT&T in 1984. Because non-AT&T long distance carriers have improved their
networks and gained "equal access" 	to LECs' 	local networks. 42 quality differences between
AT&T and other long distance carriers 	(or "IXCs," standing for "interexchange carrier")
virtually disappeared by the late 1980s. As a result, competition for interstate long distance
services (known technically as interLATA-interstate long distance services) has intensified,4J
About 500 firms now provide interstate long distance service.~ .\T&T's revenue share of the
interstate long distance market declined from 90 percent in 1984 to 62 percent in 1991. In that
same period, MCl's 	revenue share increased from 	less than 	5 percent to 	15 percent. and
Sprint's share increased from less than 	1 percent to 	10 percent. The competition in long
distance telephone service has lowered real prices and increased the number of long distance.:
calls. 45
While the Federal Communications Commission regulates interstate-interLA TA long
distance service, the individual states regulate intrastate service. Every state, except Utah,
allows competition for the provision of long distance service within the state (technically,
intrastate-interLA TA service).46 Many states als::: now allow long distance carriers and other
firms to compete with the local phone companies for intraLA T A toll service. The extent of
H See infra n. 47 and associated text for description of "equal access."
~3 A LATA is a Local Access Transport Area. The 1984 divestiture of AT&T established
approximately 164 such geographic regions. LATA boundaries do not necessarily correspond
with state boundaries.
+4 According to FCC's Statistics of Communications Common Carrier, 1991-1992, there
were 489 long distance telephone carriers in September 1992, of which 379 were using equal
access.
45 According to the FCC's Statistics of Communications Common Carriers. long-distance
toll prices have dropped about 50 percent in real terms between 1984 and 1992, and total
interstate switched access minutes increased from 37.5 billion in the third quarter, 1984, to 87.9
billion in the third quarter, 1992.
46 The 1984 consent decree that split up the Bell system prohibits the seven Regional Bel
Operating Companies (RBOCs) 	from providing interLATA toll service and AT&T frorr
providing intraLAT A local service.
17

intrastate-intraLAT A toll competition is still limited. however, because carriers other than the
local phone company (collectively. the non-LEe suppliers) are not granted "equal access" to
inrraLAT A subscribers: instead. subscribers rrnst dial J. rive digit access code (referred to as
"l'JXXX") to use their services.;~ In 1992, 34 states allowed intraLA T A toll c~mpetition on
this limited basis.
The LECs also are facing more competition in the provision of some local services, For
example, 	connecting long distance subscribers to 	long distance carriers 	has become more
competitive. New firms, called "Competitive Access Providers" ("CAPs"), offer some end users
the option to connect directly with their long distance carriers, allowing those end users to
place long distance calls without using the local telephone network. In addition, the FCC has
made interstate "access" markets more competitive by requiring local phone companies to
interconnect third parties, such as CAPs and long distance providers, with the local network.
Such interconnections permit firms other than the local phone company (such as CAPs) to
provide services previously supplied solely by the local phone company:8 These competitive
forces are expected to lead to L ""er costs tor IXCs and subsequent reductions in long distance
charges.
A competitiv~ environment is becoming more likely even in the provision of local
"dialtone" service, According to the FCC, CAPs have dramatically increased the size of their
fiber optic networks and may soon compete in some dense urban areas to provide local
telephone service to large business users. ~9 Potential competitors, such as cable televisio~
companies, already have in place wired networks that could be used to provide local telephone
~7 Thus, the non-LEC suppliers are said to compete only on a "10XXX" basis. To use a
non-LEC supplier to complete an intraLA T A call, subscribers have to dial the supplier's access
code before dialing the regular telephone number. 	These access codes are in the form of
"lOXXX", where XXX represents a three digit number.
48 	Expanded 	Interconnection 	with 	Local 	Telephone 	Company 	Facilities, 	Federal
Communications Commission 	Docket No. 	CC 91-141. Report and Order and Notice of
Proposed Rulemaking (released October 19, 1992) and Second Report and Order (released
September 2, 1993). For an explanation of why economic efficiency would seem to require
LECs 	to 	provide 	interconnection 	to 	third 	parties, 	as 	opposed 	to 	relying 	on 	voluntary
arrangements, see Comment of the Staff of the Bureau of Economics of the FTC, FCC Docket
No. CC 91-141 (filed March 5, 1993) pp. 13-17. A copy of this comment is included with this
submission.
49 In 1987 CAPs had installed about 133 route miles of fiber; by the end of 1992, CAPs
had installed 3,320 route miles of fiber. Route miles of fiber refer to the total number of miles
of fiber routes as would be seen on a network map. For more detail, see Kraushaar, Federa;
Communications Commission, Fiber Deployment Update (1992). CAPs have petitioned tc
provide local telephone service in Illinois and N~w York. (See Wall Street Journal, August 24
1993).
18

service.;~ \'Vith many homes already ""ired into cable networks. cable companies can quickly
begin providing local telephone 	c~:-yice if ;:-:mted authority to 	enter the 	local 	telephone
marker. 51
Another set of potential competitors to the local telephone monopolies is the providers
of cellular telephone service. Cellular telep!:':'~e networks. which were once thought to be
complements to wired local telephone service. might, in time~ compete cost-effectively with
LECs' wireline telephone networks.::: :\lready over 13 million cellular phones are in use in
the United States. (Economist, Oerober 23, 1993) In addition. a new generation of mobile
telephone services known as "personal communications service", or "PCS," is being tested in
cities around the United States. PCS might compete with the wireline telephone service in
densely populated urban areas, as well as with existing cellular telephone providers.
Competition for local telephone service will not develop uniformly. States with very
few potential subscribers may end up with \'ery little competition, while states with large
urban centers may end up with substantial competition. Still, competitive forces will in many
instances reshape local telephone markets. and states can benefit from laws and regulations that
are sufficiently flexible to tacilitate effeeri... e ana smooth transitions in the local teiephone
market.
c. 	Regulation of telephone utilities.
1. 	Natural monopoly justification.
The LECs are regulated under the premise that the provision of local telephone service
is a natural monopoly, i.e., that telephone services are provided most efficiently when a singl~
firm supplies the market. The basis for believing that telephone service is a natural monopoly
has been eroding. The underlying economic rationale for the 1984 divestiture of AT&T wa:
that the pre-divestiture Bell System was not a natural monopoly. This expeeration has beer
borne out, as the long distance market has become increasingly competitive. Although loca
telephone service retains some natural monopoly charaereristics, even this situation is changing
50 The Cable Television Consumer Proteerion and Competition Aer of 1992 continued
prohibition on cable television companies having cross-ownership of telephone companies i:
areas where the cable television company provides service. 47 U.S.C. §531. In England, th
cable television company is the leading competitor to British Telecom in providing dialton
for local telephone service.
51 Recent developments in technology may even allow electrical lines to provide telephor:
service.
52 In faer, an entirely wireless digital telephone system has recently replaced the standal
wireline system in Quitaque, Texas (population: SOO). (Economist, Oerober 23,1993, and W;,
Street Journal, February 11, 1994)
19

The FCC's 1992 decision to require local telephone companies to interconnect CAPs and other
firms 	with the local telephone companies 	is predicated on the notion that 	LEC-provided
services may not be a natural monupolv.::;
A natural monopoly exists if having one firm supply the market (or markets) results
in lower total costs than having several suppliers produce the same level of Output. 54 \'X'here
there is only a single product, the existence of economies of scale is sufficient for a natural
monopoly to exist. Where there are many products involved. economies of scale alone are not
sufficient; 	instead, 	economies 	of scope 	are 	also 	required. 55 	Economies 	of 	scope 	exist 	if
producing two products jointly is less costly than producing the two products separately. If
scale economies exist for each of two products. but scope economies are absent, then having
a monopoly in each product market might be more efficient than having a single firm produce
them both. Because of these complexities, it will otten be a formidable task to determine if a
multiproduct firm is a genuine natural monopoly. (Evans and Heckman (1983) and Shin and
Ying (1992))
Recent empirical analysis of LEC cost conditions casts doubt on the proposition that
LECs, as configured. are natural monopolies. 	Using LEC-Ievel data, Shin and Ying (1992)
found that, prior to the 1984 divestiture, LECs 	may 	have had monopoly status in some
geographic markets, 	but they 	were 	not classic natural 	monopolies. 	That 	is, their results
suggested that, in many instances, the same output could have been produced at lower total
cost by two smaller LECs. To understand LEC cost conditions better, Shin (1988) estimated
the cost structure at the level of the LECs' central offices.56 At that level, he found scale
economies for three outputs: the number of end users connected, the volume of local calls, and
the volume of toll calls. 57 As expected, the results suggested there '\':ere economies of scope
between access to the local network and the volumes of local calls and toll calls; however, they
suggested diseconomies of scope between local calls and toll calls. Those findings imply it
could be efficient to 	permit 	non-LEC 	firms 	to provide some services that central offices
53 Expanded Interconnection with Local Telephone Company Facilities, Report and Order
and Notice of Proposed Rulemaking, supra n. 48, at 1.
54 In this section, we provide only a brief discussion of the cost and demand conditions
that are needed for an industry to be a natural monopoly. For a more complete discussion of
this issue, see Section V, Appendix A.
55 This is only a necessary condition (Sharkey 1982).
56 A central office aggregates the calls in a relatively small area, and is the first Oast) place
where outgoing (incoming) calls are switched. Local exchange carriers operate many central
offices. In both Shin and Ying (1992) and Ying and Shin (1993) the unit of observation is the
local exchange company and not the individual central office.
57 Toll calls include only the LEC portion of a toll call.
20

provide for toll calls. such as switching and local transport. But designing how to do this is
complicated by the finding of economies ot scope between local network access and toll calls.
If those economies of scope stem from switchin·: services rather than iOCdl transport services.
then permitting entry into local transport for toll calls could enhance economic efficiency.~g
2. 	Regulatory alternatives.
Generallv, states have regulated local exchange carriers using traditional rate-of-return
("ROR") regula~ion. Under this approach, a state public utility commission ("PUC") reviews
LEC costs to determine whether they are all justified. Then, the PUC establishes an allowed
rate of return for the rate base (capital stock minus depreciation) using "fair" rate of return as
the basis. Finallv, the PUC sets prices to generate revenues sufficient to cover costs and
provide the LEe this "fair" rate of return. These tasks require the regulator to estimate the
cost and demand conditions facing the firm. In some cases. a PUC may have discretion to
allow the LEC to earn a rate of return greater than the fair rate of return, but mav also set
prices that prevent the LEC from actually realizing that greater rate.;~ 	.
Traditional ROR regulation can give rise to inefficiencies. 60 First, when profits an::
directly linked to firms' 	rate bases (or net capital stock), the firm's incentive to minimize
variable costs diminishes. If the firm's earned profits are at the authorized rate of return, any
increases in profits from lowering the variable costs would be taken away by requiring the
firm to reduce its prices to restore its rate of return to the authorized level. Second, a firm
subject to ROR regulation may have an incentive to increase its rate base by distorting the
input and technology 	mix. 	Averch and Johnson 	(1962) 	showed that a profit-maximizing
regulated monopoly tends to invest in more capital than is socially desirable when its allowed
rate of return exceeds its cost of capital. Third, the informational requirements to implement
ROR regulation are substantial and impose costs both on the firm and on the regulators.
Given the problems associated with traditional rate-oi-return regulation, economists and
regulators 	have 	examined 	alternatives 	such 	as 	"price 	cap" 	regulation. 	Under 	price 	cap
regulation, prices, rather than profits, are the focus of the regulation. Firms may charge any
58 The recent decisions by the FCC compelling local phone companies to interconnect
with other providers of telecommunications services are consistent with this presumption. See
Expanded Interconnection with Local Telephone Company Facilities. Report and Order and
Notice of Proposed Rulemaking, supra n. 48, at 11: Second Report and Order, supra n. 48, at
3.
59 Utah, for example, follows this approach, State regulatory agencies also decide what to
include in a rate base. By excluding certain assets from the rate base. the effective rate-of-return
to the telephone company can be lower than the allowed rate.
60 For 	a 	detailed 	discussion 	of 	problems 	with 	ROR 	regulation. 	~, 	~., 	Berg 	ane
Tschirhart (1988).
21

price below the "cap." The JustificatiOn for price cap regulation is that. unlike ROR regulation.
it provides firms wiTh an incentive to minimize costs. because they can retain a portion of
their cost reductions. In addition. the informatiOnal reqUIrements mav be lower than u:-:.' er
ROR regulation, and the possibilities for inefficient cross-subsidization may be significantly
attenuated. 61
As a response to changes in the competitive environment and theoretical concerns
about ROR regulation, federal and state regulatory agencies have experimented with alternative
forms of regulation. In 1989. the FCC applied a form of price cap regulation to AT&T to
facilitate the transition toward full competition in the long distance toll market. 62 In a July
1993 report, the FCC concluded that "price cap regulation represents an improvement over
rate-of-return 	regulation, 	combining 	lower 	rates 	with 	effective 	incentives 	for 	improved
efficiency and innovative services."&3 In 1992, to provide LECs with incentives to become
more efficient, the FCC imposed price cap regulation on the interstate services provided by
the LECs controlled by the seven regional Bell companies and GTE. Six other large LECs have
chosen to be under price cap regulation for their interstate services. By 1993. over 90 percent
of the interstate portion of LECs' operations in the United States were subjected to price cap
regulation. Er4 Because the FCC's jurisdiction extends only to the interstate services pIOvided
by LECs and because the price cap regulation was imposed in 1992 and 1993, it is too early
to assess the impacts of price cap regulation on LEC performance.
State regulatory agencies also have adopted alternative forms of regulations for LECs.
Nebraska essentially deregulated all telecommunications servi ~es in 1986. Since October ~ 98'1,
the California PUC has applied to Pacific Bell and GTE California an incentive regulation that
includes a price cap component and a revenue-sharing component that shares earnings above
the allowed rate of return with the ratepayers. According to the National Association of
61 For a detailed discussion of possible advantages and disadvantages of price cap regulation
relative to ROR regulation, ~, ~, Braeutigam and Panzar (1989), Lewis and Sappington
(1989), Sibley (1989), Pint (1992), Sappington and Sibley (1992), Braeutigam and Panzar (1993),
and Liston (1993).
62 When British Telecom was privatized in 1984, the British government adopted price cap
regulation 	for British T e1ecom. 	The British experience with 	price 	cap 	regulation 	is well
documented by Beesley and Littlechild (1989). They concluded that price cap regulation is
preferred 	to 	ROR 	regulation 	in 	industries, 	such 	as 	telecommunications, 	where 	rapid
technological changes can contribute to significant productivity improvements.
63 Price Cap Performance Review For AT&T, Federal Communications Commission
Docket CC 92-134. Report (released July 23, 1993) p. 1.
Er4 See, Regulatory Reform for Local Exchange Carriers Subject to Price Cap Regulation.
Federal Communications Commission Docket No. 92-135, Notice of Proposed Rulemaking
(released July 17, 1992) p. 3.
.,.,...-

Regulatory Utility Commissioners, by 1992. 11 states had permanentlv adopted some forms
of incentive :-egulation: 2~ states had adopted alternative forms of regulation on a trial basis;
,md 	6 	states 	were 	reviewing 	alt.~rnative form~ 	of 	regulation.os These 	regulatory 	changes
involve classifying sen-ices by the level of competition. allowing pricing tlexibility, using price
caps, and sharing earnings above the benchmark rate of return with the ratepayer.
Evidence on the impact of incentive regulation adopted by federal and state regulatory
agencies suggests that price cap regulation leads to lower prices than does ROR regulation.
Mathios and Rogers (1989) found that AT&T's long distance prices in states that used price
cap regulation were significantly lower than in states that used traditional ROR regulation. For
example, the cost of a five-minute call during the day was estimated to be approximately seven
percent lower in states that allowed some form of pricing flexibility.ti6
3. 	Entry and pricing regulation.
One issue facing state 	regulators 	is 	wherher to 	permit 	non-LEC 	firms 	to 	provide
services that LECs supply. Restricting entry into services now supplied only by the incumbent
LEes might be justified if the result of that em ~'y would be to increase the LEC's costs of
providing service. Specifically, if the incumbent LEC could not set prices that would clear all
relevant markets, deter entry, and cover all costs, then barring competitors from its service
offerings might be justified. On the other hand, though, the full net effect of the proposed
entry, which must be considered in determining whether entry should be permitted, could also
include gains from lower prices that result from competition.
Competitive entry into previously monopolistic services typically provides powerful
incentives for the creation of an efficiently operating market. 67 In the short run, the threat
of losing a customer to a competitor provides incentives for the incumbent firm to maintain
prices close to costs. 	In the long 	run, competition 	provides 	incentives 	to 	become 	more
productive. Firms that use inputs more efficiently and continue to d~velop more efficient
production techniques can expect to be rewarded with 'greater profits.
The introduction of competition into a market tends to result in prices that closely
reflect 	costs. 	That 	tendency 	will 	be 	dampened, 	however, 	unless 	an 	incumbent 	whose
(regulated) prices are above its costs is allowed to reduce its prices in response to entry. Unless
it can set prices closer to the actual cost of service, J. LEC may provide a pricing "umbrella"
65 NARUC 	Report on the Status of Competition 	in 	Intrastate Telecommunications.
National Association of Regulatory Utility Commissioners (August 16, 1992).
66 Kaestner and Kahn (1990) showed that AT&T charged lower intrastate toll prices ir
states with longer histories of departures from ROR regulation.
67 For discussion of the technical conditions under which entry is and is not efficient, sel
Section V, Appendix A.
23

under which firms, such as CAPs and IXCs. could bypass the local network even though their
coSts substantiallv exceed the LEC's costs. Giv;ng the LECs pricin?; flexibilitv would allow
them to respond 'to entry by pricing st'rvices clo~er to costs. which would help' to ensure that
entry would be undertaken only when the entr.mt is at least as efficient J.S the LEC.b869
Regulators have traditionally set rates for business customers and long distance service
above their costs in order to keep local residential rates low,'-: Thus. in many states local
residential 	customers 	are subsidized 	by business 	customers and 	local 	telephone service is
subsidized by long distance telephone service. .t\1aintaining such subsidies will be made more
difficult bv the entrv of alternatives to the high-margin services. In the face of entry, the
regulated firm will have difficulty maintaining prices above costs. As prices andl or ~alling
volume fall, the source of the subsidy erodes. Because maintaining subsidies may not be viable
in the long run. the mechanisms that promote low residential rates may need to be reexam-
ined.
68 Palmer (1992) addresses the issue of efficient entry in local telephone service by assessing
the magnitude of the cross·subsidies that flow from low·cost high-priced local business service
to high-cost low·price local residential service. If entry were to occur, it would be isolated to
the business service where the divergence between prices and costs is large enough to induce
(potentially) inefficient entry. She concludes that if prices better reflected costs. entry would
occur only were the entrant had lower costs.
69 Even if the price umbrella is not eliminated, the social cost of inefficient entry must be
weighed against the social cost of price distortion. An inefficient entrant will produce at a cost
greater than the potential minimum, a difference that represents a social cost; however, the
entrant will also sell at a price below the LEC's, a difference that represents a social gain.
Depending on the actual market and cost conditions, entry by a firm less efficient than the
incumbent into a market with a regulated price umbrella could be welfare increasing.
70 The subsidy from toll service to local service is maintained by charging high access
charges to long distance telephone companies. In the comment filed with the FCC in March
1993, the staff of the Bureau of Economics at the FTC concluded that the price of local service
was less than half its marginal cost while the "switched access" price was approximately four
times its marginal cost.
24

D. 	Suggestions to the South CJ.rolinJ. Legislatiye Audit Council.
1. 	Consider :dlowing the PSC to use alternative forms of regulation for
providers of telephone services.
South Carolina has replaced traditional ROR regulation with price cap regulation for
interexchange carriers.~l In addition. the PSC authorized an Earning Sharing Phn ("ESP") for
LECs in 1990. Earnings above a threshold but below a c... iling were to be shared equally with
the LEC's ratepayers. Any earnings above the ceiling were to be fully refunded or credited to
the ratepayers. LECs were given the choice of remaining under traditional rate of return
regulation or participating in the ESP. Bell South and GTE chose to come under the ESP,
which was originally due to expire in 1994.
On August 9, 1993, the South CJ.rolina Supreme Court struck down the PSC's order,
holding that the statute required LECs to be regulated under a fair rate-of-return regulation.:"2
The decision would permit setting a range on the fair rate-ot-return, but ruled that applying
the same range for every LEC is "an abdication of the PSC's responsibility to set appropriate
rates."73 The ruling terminated all incentive plans for 	LECs 	in South Carolina and 	may
threaten the basis for the price cap regulation of South Carolina's interexchange carriers.
As a consequence of the ruling, the PSC must apply traditional ROR regulation, at least
to LECs. We recommend that the Council consider recommending amendments to the PSC's
authorizing statutes, to give the PSC the flexibility needed to apply alternative or incentive-
based regulation to all telephone companies (as long as there are no efficiency grounds for
disallowing such regulatory changes). Specifically, §58-9-570 could be amended so the PSC
could implement alternative (non-ROR) forms of regulation for interexchange carriers and
LECs.
We believe that incentive-based regulation, such as price cap regulation, could benefit
South Carolina consumers. Such regulation could lead to lower prices and induce telephone
companies to adapt more efficiently to a rapidly changing environment. As the telephone
industry becomes more competitive, regulated LECs and other telephone service providers
must become efficient in order to compete effectively. An incentive-based regulation approach
would reward efficient providers and help consumers realize the benefits generated by a more
. . 	.
cOmpetltive enVIronment.
71 In South Carolina, interexchange carriers provide interLA T A-intrastate toll service or
intraLA TA toll service, or both.
72 S.C. Code Ann. §58-9-570. South Carolina CJ.ble Television Ass'n v. Public Service
Commission, No. 23,917 (S.C. Sup. Ct., Aug. 9, 1993).
7) Id.

2. 	Consider authorizing the PSC to give pricing flexibility to LECs for
services where they face competitive entry.
We believe that allowing entry into many LEe-provided services would likely beneiit
South 	Carolina consumers. -4 Once 	entry 	is allowed 	in the 	provision 	of these telephone
services, we recommend that incumbent providers be given pricing tlexibilit~.: in these services.
to foster healthy competition with the entrants. While the PSC has allowed pricing tlexibility
for some services, we believe that even more pricing tlexibility, particularly for services for
which competition is feasible or already exists, would be efficient.
The 	PSC 	has 	detariffed 	only 	one such 	competitive 	service. 	Yellow 	Pages. 	Other
competitive services, such as intraLAT A toll service provided by non-LECs. -5 interLAT A toll
service, wide area toll service (WATS), 800 service. and intrastate 900 service. are still tariffed.
but are regulated under a form of price cap regulation.- o
Some services provided ~y the LEC that are not subject to direct competition (called
noncompetitive enhanced services), such as custom calling, call waiting, and call forwarding,
also are allowed some pricing flexibility under price cap 	regulation. The prices for these
services can be changed, within an approved band, on 14 days' notice. Any proposed change
to the price band or the price cap is treated as a general rate case, which can be filed once
every twelve months.
Long distance carriers can change their tariffs on 14 days' notice, provided that the new
rates are below the maximum allowed under the price cap regulation. Changing the price ca~
itself requires a rate hearing process, which can take up to six months and five days. With
regard to intraLAT A toll service. the PSC recently has allowed resellers and facility-based
carriers to provide service on a 10XXX basis, but has not allowed «equal access" competition
with the LECs. These non-LEC carriers are also under a price cap regulation, with similar
pricing flexibility.
74 To the extent that the recommendations stated below may conflict with the decision in
South Carolina Cable Television Ass'n v. Public Service Comm., !'Jo. 23,917 (S.C. Sup. Ct.,
August 9, 1993), we respectfully recommend that the legislature enact the necessary legislation
consistent with our recommendations.
75 IntraLA T A toll service provided by LEes is not under price cap regulation. Any price
change to these rates is treated as a general rate case, thereby limiting the LECs' 	pricing
flexibility on these services.
76 The PSC has granted some pricing flexibility by allowing prices to move freely withir
the approved price band or under the price cap. 	Interexchange carriers, 	LECs, 	and othe:
service providers can effectively change their rates on some services with a 14-day notice.
26

Where LECs face no direct competition-in local telephone service and imraLAT A toll
service-they have very little Dricir:g flexibilin' ..-\ny proposed changes in rates for service that
J.ffect d'e general body of subscribers, such .1S business and residentlal local telephone services
.md intraLATA toll service provided bv LECs ..He considered under a general rate cas~ that
can be filed only once in a twelve month period and rnav take up to six months and five days
to decide.
We suggest that the Council consider recommending that the statutes and regulations
be modified to permit the PSC to give LECs additional pricing tlexibility. Pricing flexibility
would enhance economic efficiency most if applied to services that affect the general body of
ratepayers and for which there is competition. For example, consumers likely would benefit
if direct competition were permitted for imraLAT A toll service, with the LEC's toll rates
being 	subject 	to 	price 	cap 	regulation. 	For 	other 	services, 	the 	Council 	might 	wish 	to
recommend 	that 	the 	PSC 	be 	given 	the 	authority 	to 	determine 	the 	appropriate 	pricing
flexibilitv.
E. 	Conclusion.
In view of the technological changes in this industry, LECs are likely to face increasing
competition 	in 	local 	telephone 	markets. 	This 	trend suggests 	that 	the 	natural 	monopoly
justification for regulating the LECs has been eroding over time and that applying incentive
regulation, which allows LECs to respond more effectively to new competition, would benefit
telephone subscribers. Allowing competitive entry into many services now provided by LECs
appears desirable, provided that the LECs are given pricing flexibility to move their prices
closer to costs.
Based on these conclusions, we have two recommendations for the Council. First, we
suggest that the Council consider recommending that the PSC be given the authority to apply
more flexible regulatory approaches, such as incentive regulation, to telephone utilities. Second,
we suggest that the Council consider recommending that the PSC be permitted to allow entry
into traditionally protected markets, and that the PSC should be given more authority to
permit pricing flexibility for services that face competition.
We believe that these changes likely would benefit South Carolina consumers. Prices
that more closely reflect costs would minimize allocative inefficiency, and allowing entry in
LEC-provided services and giving pricing flexibility to LECs would promote economically
efficient entry.
27

F. 	References.
Averch 	d.ud Johnson. 	Behavior 	of the 	F:Im 	under 	Reg-ulator, 	~onstr:lint. ;"'l 	American
EconomIc Review 1252-69 (December 1962).
Beesley and Littlechild, The Regulation of Privatized t\10nopolies in the l]nired King-dom, 2~
RAND Journal of Economics 454-472 (1989),
Berg and Tschirhart, Natural Monopoly Regulation, Ca.mbridge: Cambridge University Press
(1988).
Bradley and Hausman (ed.), Future Competition in Telecommunications, Boston: Harvard
Business School Press (1989).
Braeutigam 	and 	Panzar, 	Diversification 	Incentives 	under 	'Priced-Based' 	.:md 	'Cost-Based'
Re&Ulation, 20 RAND Journal of Economics 373-391 (1389),
Braeutigam and Panzar, The Effects of the Chan&e from Rate-of-Return Rewlation to Price
cap Re&Ulation, 83 American Economic Review 191-198 (1993).
Brock, The Telecommunications Industry: The Dynamics of Market Structure, Cambridge:
Harvard University Press (1981).
Brock, Bypass and the Local Exchange: A Quantitative Assessment, Federal Communications
Commission, Office of Plans and Policy, Working Paper Series No. 	12, Washington, DC
(September 1984).
Cain and MacDonald, Telephone Pricin& Structures: The Effects 	on 	Universal Service, 3
Journal of Regulatory Economics 293-308 (1991).
Crandall, After the Breakup, Washington, DC: Brookings Institution (1991).
Evans and Heckman, Multiproduct Cost Functions Estimates and Natural Monopoly Tests for
the Bell System, in D. S. Evans, ed., Breaking Up Bell, Amsterdam: North-Holland (1983).
Faulhaber, Telecommunications in Turmoil, Cambridge, MA: Ballinger Publishing Co. (1987).
Griffin, The Welfare Implications of Externalities and Price Elasticities for T elecommunica-
tions Pricin&, 64 Review of Economics and Statistics 59-66 (1982).
Griffin and Mayor, The Welfare Gain from Efficient Pricin& of Local Telephone Services, 30
Journal of Law and Economics 465-496 (1987).
28

Johnson, Competition and Cross-Subsidization in the Telephone Industry. Santa Monica. CA:
The RAND Corporation (1982),
Kaserman, Mayo. and Flynn. Cross-Substitution In Telecommunications: Beyond the Universal
Service Fairy Tale, 2 Journal of Regulatory Economics 231-249 (1990).
Kahn and Shew, Current Issues in Telecommunications Re~lation: Pricing, 4 Yale Journal on
Regulation 191-256 (1987).
Kwoka, The Effects of Divestiture. Privatization and Competition on Productivitv in U.S. and
U.K. Telecommunications, 8 Review of Industrial Organization 49-61 (1993).
Landes and Posner, Market Power in Antitrust Cases, 94 Harvard Law Review 937-996 (1981).
Larson, Markarewicz, and Monson, The Effect of Subscriber Line Charges on Residential
Telephone Bills, 13 Telecommunications Policy 337-354 (1989).
Larson and Mudd, Collocation and Telecommunications Policv: :\ Fostering of Competitio,:
on the Merits, 28 California Western Law Review 263-313 (1992).
Lewis and Sappington, Re~latorv Options and Price cap Re~lation, 10 RAND Journal of
Economics 405-416 (1989).
Liston, Price cap versus Rate-of-Return Re~lation, 5 Journal of Regulatory Economics 25-48
(1993).
Mathios and Rogers, The Impact of Alternative Forms of State Re~lation of AT&T on Direct
Dial Long Distance Telephone Rates, 20 RAND Journal of Economics 437-453 (1989).
Mathios and Rogers, The Impact and Politics of Entrv Re~lation on Intrastate Telephone
Rates, 2 Journal of Regulatory Economics 53-68 (1990).
Mitchell, Incremental Costs of Telephone Access and Local Use, Santa Monica, CA: RAND
Corporation (1990).
National Association of Regulatory Utility Commissioners, NARUC Repon on the Status of
Competition in Intrastate Telecommunications, \X'ashington. DC: NARUC (August 1993).
National Association of Regulatory Utility Commissioners, Update to the Maine and Missouri
Reports on Alternative Regulation Plans in Telecommunications, Washington, DC: NARUC
(June 1993).
Palmer, 	A 	Test 	for 	Cross-Subsidies 	in 	Local 	Telephone 	Rates: 	Do 	Business 	Customers
Subsidize Residential Customers~, 23 RAND Journal of Economics 415-431 (1992).
29

Pint. Price cap 	Versus Rate-at-Return 	Regulation In a Stochastic Cost 	l\Iodel, 23 	RAND
Journal of Econom;-s 564-578 (1992),
Sharkey, The Theory ot Natural l\Ionopoiv. ~ew York. )"'Y: Cambridge L-niversitv Press
(1982),
Shin, Econometric Estimation of Telephone Costs tor Local 	Exchange Companies, Ph.D.
dissertation. University of California. Berkeley (1988).
Shin and Ying, Unnatural Monopolies in Local Telephones, 23 RAND Journal of Economics
171-183 (1992).
Sappington and Sibley, Strategic Nonlinear Pricing under Price cap ReguLuion, 23 RAND
Journal of Economics 1-19 (1992).
Sibley, Asvmmetric Information. Incentives. and Price cap Re~lation, 22 RAND Journal of
Economics 392-404 (1989).
U.S. Federal Communications Commission. Statistics of Communications Common Carriers,
Washington, DC: U.S. Government Publishing Office (various years).
U.S. Federal-State Joint Board, Monitoring Report, Washington, DC Quly 1992).
Ward, Market Power in Long Distance Telecommunications, Bureau of Economics, Federal
Trade Commission (submitted to the Federal Communications Commission on FCC Docket
No. 93-197, In the matter of Revisions to Price Cap Rules for AT&T, filed Oerober 21,1993).
Ying and 	Shin, 	Costlv 	Gains to 	Breakin~ Up: 	LECs 	,md the 	Babv 	Bells, 	75 	Review of
Economics and Statistics 357-361 (1993).
30

V. 	Electric power
A. 	Introduction
This is an ideal time for South C.lrolina to be reviewing the regulation of electrical
utilities. The 1992 Energy Policy :\ct (EPAct) and FERC regulations have altered the context
of electrical utility regulation. presenting new challenges and new options.-- These institution-
al changes respond to technological developments that have increased the role of competition
in this industry, which has traditionally been treated as a natural monopoly. The changes in
the technology and economics of generating electric power are particularly important,78 but
the subsequent stages, of power transmission and local distribution, may also be affected. Our
1987 	comment 79 	predicted 	that 	new 	technologies 	and 	institutions 	could 	soon 	require
reexamining the natural monopoly justification for rate-of-return and entry regulation. By
1994, 	the 	electric 	power 	industry' s 	technologies 	and 	institutions 	have 	indeed 	evolved
considerably, 	and 	changes 	that 	facilitate 	increased 	competition 	continue. 	Several 	states,
including Virginia and Florida in the southern region. have taken steps to significantly increase
the role of competition in electricity generation.
The Council may wish to recommend changes in the statutes governing the P5C that
would enable the PSC to incorporate, as it or the legislature sees fit, the recent technological
and institutional developments in its regulation of electric utilities in South Carolina. This
comment 	will 	recommend 	such 	changes, 	after 	reviewing 	the 	technical 	and 	institutional
developments and the experiences of other jurisdictions.
B. 	Erosion 	of the 	"natural 	monopoly" 	justification 	for 	regulating 	electric
supply
Industries that are natural monopolies 	have historically been subject to 	economlC
regulation, that is, to controls on entry and rates ot return (or, mOl c recently, prices). A
market is said to be a "natural monopoly" when it is less costly for the market to be served
by one firm than by several competing firms. When a market is thought to be a natural mono-
poly, economic efficiency may be enhanced by regulating the price that the monopolist may
charge to guard against the exercise of monopoly power. It sometimes may also be efficient
to restrict entry into that market to preserve the benefits associAted with monopoly produc-
n For a review of utility regulation leading up to the EPAct, ~ Costello (1992) pp. 1-15.
78 Generation accounts for about two-thirds of the price that final customers pay in the
U.S. 	(Federal Energy Regulatory Commission Staff (1993) 	p. 21) 	Generation accounts for
approximately 40 percent of capital investment in electrical utilities. (U.S. Congress Office of
Technology Assessment (1989) p. 47)
79 Supra n. 5, at 28.
31

tion. s: When these conditions do not (or no longer) apply to an industry. however, economic
efficiency and consumer welfare will be enhanced by introducing competition through new
entry and expansion of the geographic rJnge of competition.
Natural 	monopoly 	conditions 	do 	not 	.1ppear 	to 	exist 	in 	power 	generation. 	For
transmission and distribution. 	however. economies 	of scale continue to 	be an important
consideration. However, the sunk nature of transmission and distribution investments mav
reduce the need for restrictions on entry, and implementing new approaches designed to
introduce competition even 	where 	economies 	of scale exist 	may 	diminish 	the efficiency
rationale for rate (or price) regulation.
The historical treatment 	of generation as 	a natural 	monopoly 	has 	rested on twO
primary considerations. First, generators were investments that exhibited significant economies
of scale relative to local demand. Second. because transmission losses increased to such a great
extent with distance, utilizing generators at discant locations involved higher costs and lower
reliability. Such distant generators were thus poor substitutes for local generators, causing the
geographic range of competition to be localized. Both of these factors have been weakened by
technological and organizational changes.
Generators still exhibit economies of scale, but it is common 	now for these scale
economies to be exhausted far short of local demand in major load centers. Generating plants
now routinely contain more than one generating unit. Further, demand in major load centers
now often exceeds the capacity of a single generating plant, and such areas may be (or could
be) served by several plants. (Smith (1993) pp. 132-33; Schmalensee and Golub (1983))81 Other
developments have reduced the size criterion for an efficient generating unit or increased the
number of potential suppliers. Slower growth in electricity demand8z (Costello (1992) p. 18;
South Carolina Public Service Commission (1992) pp. 67, 69), increased interest in alternative
energy 	sources 	and 	energy 	conservation 	(institutionalized 	in 	the 	1978 	Public 	Utilities
Regulatory Policy Act (PURP A) and integrated resource planning (IRP) processes (Costello
(1993) 	p. 1-1-18)), 	and 	introduction 	of 	alternative 	generation 	technologies 	with 	smaller
economies of scale than nuclear or coal units (Costello (1993) p. 37. Costello (1992) p. 17) have
80 The conditions under which It IS efficient to Impose legal restnctlons on entry are
discussed in Appendix A.
81 To be sure, there may be economies of owning multiple generating plants, resulting
primarily 	from 	coordination 	of 	investment, 	maintenance, 	and 	fuel 	inventory 	decisions.
replication 	of 	management 	and 	contracting 	costs, 	and 	borrowing 	costs. 	(New 	Zealand
Electricity Task Force (1989) pp. 82-87)
82 Capacity is installed in anticipation of future demand; however, because of economie~
of scale, investment is lumpy. When demand growth is slow, there are increased costs becaUSE
excess capacity must be held longer before demand grows enough to fill the capacity. Thi~
creates incentives to make smaller generator investments, ~, less lumpy investments.
32

reduced the average size of incremental capacltv expansions. 	Slower demand 	growth 	and
continued scale economies 	in nuclear and coal units have led to 	joint ownership of new
generating plants. which increases the number f)f pote:1tial sellers . .1lthough not the number
of generating locations. oj
Transmission losses remain a factor in electrical supply costs, but technical improve-
ments 	have 	reduced 	their 	impact. 	both 	by 	extending 	the 	range 	of 	econorr:i:::d 	st:?ply
relationships and improving the measurement of transmi::sion ser:ices. (Einhorn (1990) p. 173;
FERC Staff (1993) p. 1.; U.S. Congress Office of Technological Assessment (1989) pp. 117-121)
Computerized dispatching technology has reduced transmission losses and capacity reserve
requirements, through improved modeling of demand and transmission conditions within
single utilities, within regional pools. and across pools.84 (U.S. Congress Office of Technology
Assessment (1989) p. 119) Significant additional technological improvements in this area are
anticipated. (Hingorani and Stahlkopf (1993)) Moreover, growth in the density of power plant
sites makes more alternative generators competitive in serving individual load centers. S5
83 See Smith (1993) and Braman (1992) for further discussion of joint ventures to promote
competition 	in the face of economies of scale. For example, 	joint venture partners in a
generating facility could potentially compete for the same wholesale customers with their
respective shares of the output of the joint venture.
84 Regional reliability councils spanning areas broader than single pools were established
after the 1965 Northeast Power Failure. (FERC (1980) p. 12) Pools take various forms, from
tight mandatory central dispatch to loose bilateral arrangements for bulk power sales. Pools
allow 	some 	operating efficiencies 	and 	savings 	in 	investment 	in 	reserves; 	however, 	even
voluntary transmission contracting arrangements are already fairly effective in using existing
generating investment. (Gilbert. Kahn. and White (1993))
Improvements 	in computerized dispatching technology 	have 	been 	going on for 	a
considerable period of time. For a discussion of pooling technology, ill FERC (1980) Chapter
4, 	"Technical 	Characteristics 	of 	Coordination." 	See 	also 	Smith 	(1993) 	pp. 133-34. 	The
Carolinas-Virginia pool (CAR-VA), which applied to most of South Carolina, North Carolina,
and Virginia, originated in 1961, but was replaced in 1970 by VACAR, a subgroup of the
Southeastern Electric Reliability Council (SERC). (FERC (1980) Chapter 10) FERC's 1980
assessment suggested that additional economies could be obtained by closer coordination of
construction and transmission within the VACAR pool. (FERC (1980) pp. 184-85) Tighter
power pools or power broker systems may be able to provide such coordination, particularly
if they can operate with the cooperation of the relevant state authorities. (FERC Transmission
Task Force (1989) pp. lC-26)
85 The number of potential suppliers is an important competltlve indicator. If several
suppliers 	are available, 	anticompetitive 	behavior 	is 	less 	likely to 	occur, 	persist, 	or avoic
detection.
33

In electric power generation, technological changes are producing conditions more like
those in comoetitive markets than in a natural monopoly. By contrast. transmission and local
distribution ~till involve extensive economies of scale and large sunk costs. 	For example.
illustrative 	fIgures 	developed 	by 	Oak 	Ridge 	.\Jational 	Laboratory 	show 	that 	a 765 	kV
transmission line costs at least 30 percent less than a 500 kV line and at least 85 percent less
than a 138 kV line, on a cost per MW-mile basis. (FERC Transmission Task Force (1989)
pp. 215-216) 	In 	the 	face 	of 	cost 	differences 	this 	large, 	complete 	parallel 	networks 	of
transmission and distribution lines are unlikely.s6 (New Zealand Electricity Task Force (1989)
pp. 39, 55, 93) Institutional arrangements are being developed to permit vigorous competition
in these services without actually duplicating transmission and distribution lines. (Braman
(1992), Smith (1993))
If generation 	no 	longer 	fits 	the 	natural 	monopoly 	model, 	but 	transmISSIon 	and
distribution retain natural monopoly elements. then unbundling generation from transmission
and distribution becomes a policy option. Unbundling might lead to benefits of increased
competition within the indivic.·.~al unbundled segments. but those benefits must be balanced
against the potential loss of economies of vertical integration. Concerns about preserving
economies from vertical integration have focused on transaction costs and coordination of
investment decisions. (New Zealand Electricity Task Force (1989) pp. 105-107; Gilbert, Kahn,
and White (1993)) Unbundling of generation from transmission and distribution is most likely
to reduce overall costs if it permits a substantial increase in competition in the generation
market. (Gilbert, Kahn, and White (1993)) Institutional arrangements that can help to reduce
costs of unbundling include long-term contracting and cooperative planning programs. 87
86 Even here, though, in some transmission corridors, individual utilities have parallel lines.
(Smith (1993) pp. 132-33) While the number of localities in the U.S. with parallel distribution
systems has fallen over time, 	some of this decline may 	be due to regulation 	rather than
economic and financial considerations. (Primeaux (1985); Nelson and Primeaux (1988))
87 Econometric work by Kaserman and Mayo (1991), using a cross sectional sample from
1981, suggests 	economies from 	vertical 	integration between 	generation 	and transmission-
distribution of more than 10 percent. They included some extreme values in their sample
(average fuel costs for sampled utilities range from $3.14 to $88.83 per mwh and average prices
of purchased power range from $8.97 to $273.25 per mwh) and used very restrictive sample
selection criteria (only 74 firms qualified out of several hundred private utility firms); thus, the
results should be generalized only with caution. Actual experience with mandatory vertical
unbundling has not disclosed evidence of substantial efficiency losses. Unbundling generation
in the U.K. has been associated with lower prices for larger customers and stable prices for
smaller customers, although this could simply mean that efficiency gains from competition
exceed 	efficiency 	losses 	from 	unbundling. 	Voluntary 	unbundling 	undertaken 	by 	several
vertically 	integrated electrical 	utilities 	in the 	U.S. 	is 	consistent 	with 	the 	hypothesis that
sophisticated contracting can be an effective substitute, in at least some instances, for vertica:
. 	.' 	.
Integratlon mto generatlOn.
34

C. 	Regulatory changes
\t1ajor 	legislation 	to 	facilitate 	se 1l aratlon 	of 	generation 	from 	transmISSIon 	and
distribution was enacted by Congress in 1<792. Other countries also have instituted steps to
increase competition in the generation stage of electrical supply.88
1. 	United States experience
The 	1992 	Energy 	Policy 	Act 	made 	major 	changes 	in 	interstate 	electrical 	power
regulation. 89 Two changes deal directly with the separation of generation from transmission
and distribution, by making it easier for certain users of electricity to obtain wholesale electric
power from independent generating capacity.
First, FERC can now certify independent electrical generation wholesalers that use
conventional generating technologies. 90 Certification of these "exempt wholesale generators,"
or EWGs, significantly reduces the risk, cost, and time required for independents to enter the
power generation business. EWGs are not required to enter simultaneously into transmission
and distribution stages, nor to displace or duplicate incumbent vertically integrated utilities.
Relieved of unique regulatory risks and lags to building generating plants, independent EWGs
are then in position to compete with integrated utilities on an equal footing with regard to
cost, price, reliability, promptness of construction, and other critical elements of supply.
Second, FERC now has increased authority to order "wheeling" to promote open access
for wholesale electricity. Wheeling is high voltage transmission, most commonly by one utility
for another. Wheeling is common. In 1985, over one-third of retail power sales had been sold
previously at wholesale, although only about 14 percent originated outside the same control
area. 	(FERC Transmission Task Force (1989), p. 18)91 FERC's stronger mandate to 	issue
88 The World Bank is actively advocating privatization and competitive institutions for
electricity production in developing countries. Among industrialized nations, Great Britain and
New Zealand have been particularly active in electricity reorganization.
89 Our discussion of the EPAct relies primarily on Costello (1993).
90 Prior to the 1992 EP Act, FERC certification of independent generators was limited to
facilities 	using 	unconventional 	generating 	technologies 	as 	defined 	in 	the 	1978 	PURP A
legislation.
91 	Some 	utilities 	may 	provide transmlSSlOn 	facilities 	to 	enhance 	wheeling 	because 	of
requirements in Nuclear Regulatory Commission 	(NRC) 	licenses. The NRC conducts an
antitrust review before granting a license to operate a nuclear plant. FERC has also required
enhanced wheeling as a condition to allowing utility mergers. (FERC Transmission Task Force
(1989) pp. 36, 174, 197-198)
(continued...)
35

wheeling orders is intended to provide easier and more certain access to the transmIsSIOn
grid,9~ to facilitate the entry of EWGs as \·iable. efficient suppliers of wholesale electricity.
91( ...continued)
In Wisconsin, the Public Service Commission has required utilities to coordinate use
of the transmission grid in the state, and in some other states regulations or agreements deal
with access to the transmission grid. (FERC Transmission Task Force (1989) pp. 129-130,201-
206)
92 For a review of non-technical impediments to bulk transmission of electric power, ~
Kelly (1987), especially Chapter 6, on legal issues. The FERC Transmission Task Force (1989)
concluded:
... Two observations, however, must be a base on which FERC policy is built.
(1) Current transmission policies are not likely to be able to accommodate the
options needed by the industry to make efficient investment in generation assets
and probably not in transmission assets. One particular option, the emergence
of a competitive generation sector, may be frustrated by the lack of a coherent
and consistent transmission pricing and access policy. (2) The current market
power of transmission 	incumbents 	is so pervasive that 	independent power
producers are unlikely to be willing to take substantial financial risks in the
absence of assured access to the grid at reasonable prices. Without transmission
reform, the potential efficiencies of a competitive generation sector will not be
fairly tested.
In the leading antitrust case concerning wheeling, Otter Tail Power Co. V. United
States, (410 U.S. 366 (1972)), a utility's refusal to wheel wholesale power to a municipal power
system inside the utility's franchise territory was held to be an illegal exercise of the market
power that 	resulted 	from 	its 	control 	of an 	essential 	facility, 	namely 	the 	only 	available
transmission capacity. The Supreme Court based its decision on the antitrust laws and noted
that the Federal Power Commission (the predecessor agency of FERC) could not issue its own
wheeling orders. (Kelly (1987) pp. 81-89; Einhorn (1990) p. 175) The practical significance of
the 	antitrust 	laws 	in 	wheeling 	cases 	has 	been 	substantially 	limited 	by 	the 	state 	action
exemption. 	(Kelly (1987) 	pp. 88-89) In 	1978, PURP A gave FERC the authority to order
wheeling; however, some observers have noted that FERC has interpreted its power to issue
such orders narrowly. A 1988 GAO report indicated that of 57 requests for wheeling orders,
FERC granted eight. 	(FERC Transmission Task Force (1992) p. 36) The 1992 EPAct was
designed in part to clarify and strengthen FERC's mandate to issue wheeling orders with
nondiscriminatory rates. (U .5. House of Representatives (1992); Costello (1992) p. 49) The 1992
EP Act also explicitly preserves the role of antitrust precedent in litigation involving wheeling
issues. (U.S. House of Representatives (1992), No. 102-474(VII) pp. 6-8; Costello (1993) pp. 34-
35)
36

If 	economies 	of 	scale 	in 	transmiSSIOn 	are 	great 	enough, 'an 	EWG 	needs 	access 	to 	the
transmission system controlled by the surrounding franchised electric utility. 	Further, as
explained below, access prices may need to be r,cgulated when a verticallv Integrated electrical
utility contains a "captive" EWG within its franchise territory.93
When an EWG is a "captive" of one franchised utility, the utility could wheel the
EWG's output to the EWG's wholesale customer(s), buy the power itself, or even refuse to
deal with the EWG. With a monopoly position in transmission or a monopsony position in
purchasing the EWG's output, the utility may have the ability to charge a monopoly price for
transmission services or pay only a monopsony price in buying the EWG's output. Both
pricing policies would entail social welfare losses Oower output) compared to competitive
pricing and may also discourage other investments in EWG projects that would be attractive
under more open transmission conditions.
One remedy to the captive EWG problem may be to require the surrounding utility
to wheel the captive power for a regulated transmission price. The objective of this regulatory
system would be to avoid monopsony power in wholesale power sales by providing the EWG
with 	additional 	potential 	customers 	and 	simultaneously 	to 	avoid 	monopoly 	power 	in
transmission services by regulating the rate of return or price of this natural monopoly service.
Mandatory 	wheeling 	may 	not 	be 	the 	only 	way 	to 	ensure 	economical 	access 	to
alternative customers for independent EWGs. Other potential solutions to the access problem
include voluntary pre-entry contracting for wheeling services between the independent EWG
and the franchised utility and vertical unbundling of transmission facilities of the franchised
utility.94 	Mandatory wheeling 	orders 	presumably 	would 	be unnecessary 	if the 	vertically
93 FERC is now considering whether its pricing regulations for interstate transmission
should consider distance as well as quantity. FERC's transmission pricing follows the model
of first class postage rates, setting one price regardless of distance. (FERC Staff (1993) p. 2)
FERC transmission rates have also used the concept of the "contractual path" of transmission
which may not reflect the actual path that the transmitted electricity follows. Texas has tried
to account for actual current flows in rates for intrastate transmission. (FERC Staff (1993) p. 3)
The importance of transmission rate making policies has increased with the rising volume of
transmission, particularly of power from unintegrated generation sources. (FERC Staff (1993)
p. 4) FERC pricing policies have permitted higher rates (based on incremental costs) 	for
transmission 	requests that 	require 	incremental 	transmission 	facilities. 	(FERC 	Staff (1993)
pp. 10-12)
94 For discussions of these alternatives, see Smith (1993(a) and 1993(b)), Costello (1992)
pp. 47-49, Houston (1992), Joskow (1989), and Kelly (1987).
(continued ...)
37

integrated utility were required to unbundle generation from rransmission. Unbundling is the
basis of the econofT1ic reforms in Great Britain and New Zealand discussed in Appendix B.
Similarly, voluntary, long-run, pre-entry contracting between EWGs a,ld the franchised u~:' :ty
could eliminate or reduce the need for mandatory 'wheeling orders.
States 	have 	fostered 	competition 	in 	generation. 	from 	both 	E\'7Gs 	and 	traditional
vertically 	integrated 	electrical 	utilities, 	by 	opening 	new 	generating 	capacity 	(to 	serve 	a
franchised distribution area) to competitive bidding.9s .-\t least twenty states have done this.
A recent example is Wisconsin, where the state commission initiated a bidding requirement
for incremental generating capacity in 1992. 90 Wisconsin's system allows bids from both the
franchised utility and alternative suppliers, including utilities from 	other states. The state
commission 	sets detailed rules 	for evaluating the 	cost 	estimates 	of all 	bids 	on 	an 	equal
footing. 97 	Bidders 	are 	invited 	to 	critique 	other 	bidders' 	cost 	estimates, 	and 	the 	state
94(... continued)
Unbundling would provide the EWG with at least two independent outlets for its
power. This increased competition should reduce the monopoly power of the owner of the
transmission grid and the monopsony power of the owner of the franchise distribution system.
95 The discussion of competitive bidding for new generation projects is derived primarily
from Edison Electric Institute (1992a, 1992b, 1990).
96 The 	U.S. 	Congress 	Office 	of Technological 	Assessment 	(1989) 	report 	contains 	a
description of the competitive bidding systems in Virginia (pp. 137-138), California (pp. 139-
140), Maine (p. 141), and Massachusetts (pp. 221-222).
97 The other states with bidding systems are evenly split on whether the franchised utility
may bid for the capacity additions that are put out for bid. :=t'onsorin~ utilities are reportedly
excluded in eleven of the twenty-one states with competitive bidding, but these projects have
largely been limited to qualifying facilities (QFs) (generation projects involving unconventional
generation 	techniques 	under 	the 	1978 	PURP A) 	or 	projects 	that 	focus 	on 	demand-side
management (DSM) rather than on additional supply. For a discussion of DSM regulatory
incentives, ill Anderson (1993).
Wisconsin focuses its bid process on minimizing costs for the sponsoring utility's whole
system over a twenty-year period. Its system, and those of other states, may also take into
consideration other factors such as fuel 	supply diversity, environmental 	impact, 	and the
bidder's financial strength. Some states give specific weight to these additional factors. Several
states include bidding for new capacity as an element in their integrated resource planning
(IRP) programs, which many states require. These plans include load forecasts and proposed
means to meet load requirements. Planning and evaluation in IRP programs are often based
on a fifteen to twenty-year time horizon. (EEl (1990) p. 63) Having initiated consideration of
IRP in 1987 (Public Service Commission of South Carolina (1992), South Carolina has recently
implemented IRP requirements for its major franchised utilities. (Ryhne (1993))
38

commlSSlOn 	reserves the right to review the utility's selection of the winning bid.98 If an
independent supplier or utility from another area wins the bid. then the utility is obligated to
buy power at the bid price frorr. :he independt':1t. essen::ially under long-term contract.
When an independent wins, it becomes a new alternative source of supply for wholesale
customers from other areas and displaces some of the investment that the franchised utility
would otherwise have made in generation. To the extent that an independent wins with a
lower bid, generating costs are reduced from what the franchised utility would have provided
and customers will face lower prices since the franchised utility faces lower costs and must pass
such cost savings on to its customers.
Bidding out capacity additions is no longer unusual. A recent survey by the Edison
Electric Institute found 174 such generation projects,99 most of which drew multiple bids. 1oo
Competitively bid generation facilities 	are expected to 	provide at least 	10 percent of the
generating capacity for more than twenty investor-owned electric utilities in the near future.
(EEl (l992b), Table 2.32) In the southeast, Florida and Virginia use competitively bid capacity
additions extensivelv.
Major issues in establishing a bidding system that were identified in the Edison Electric
Institute survey include:
98 	Interview 	with 	Susan 	Stratton 	from 	the 	Wisconsin 	Public 	Service 	Commission,
November 29, 1993.
Although state commissions have been imposing bidding requirements, the modern era
of independent generation sources was initiated voluntarily, by apr: vately held utility in
Maine, Central Maine Power, which sought bids in 1984 to supply its incremental power
demands.
99 Often, independent generating firms provide power to franchised utilities without going
through a bid process. Utilities were commonly required to purchase power from QFs under
the Public Utilities Regulatory Policies Act legislation of 1978.
Projects involving competitive bidding rely less on coal than do most utility capacity
additions. Coal accounts for approximately 20 percent of bid projects, but nearly 100 percent
of major generation additions of traditional vertically integrated electric utilities.
100 Since the mid 1980s, competitive bids have been requested for approximately 15,000
MW of capacity. Bids have been received entailing more than 115,000 MW of capacity. Bids
have 	been 	selected 	for 	approximately 	9,000 	MW 	of 	capacity 	(EEl 	(1992) 	pp. 25-26),
approximately 7 percent of total U.S. capacity additions over the period. (Costello, Jennings,
and Viezer (1992) p. 17)
39

1) determining criteria for allowing firms 	to bid. including whether the franchised
utilit~l can bid and whether to require prior electric generation experience:
2) 	determining 	factors 	to 	be 	considered 	in 	selecting 	the 	","inning 	bid, 	such 	as
environmental effect, fuel diversification, and financial strength, and how these factors
should be weighted;
3) integrating the IRP process with decisions to put capacity increases up for bid;
4) establishing the basis for including contracted capacity in the utility's rate base, that
is, whether the utility is allowed a profit margin on contracted capacity; and
5) setting a time horizon for evaluating load increases and cost and revenue projections,
a decision that can materially affect the choice of projects by cutting off the income
stream of long-lived projects.
2. 	Foreign experience
Even 	more far-reaching 	reforms 	have occurred abroad, 	particularly in the 	United
Kingdom 	and 	in 	New 	Zealand. 	In 	both 	nations, 	generation 	has 	been 	unbundled 	from
transmission and distribution, and transmission has been made an independent joint venture.
In both nations, distribution has initially been organized as several localized monopolies;
however, elements of competition in localized distribution have been introduced by allowing
larger customers to contract directly with generators or distributors from other areas (UK) or
by separating line charges from electricity marketing in local distribution and encouraging
power merchants to compete with the local distribution company for sales to consumers. More
details of the reforms in the United Kingdom and New Zealand are contained in Appendix B.
3. 	Relevance of the U.S. and foreign experience to South Carolina
South Carolina's situation is substantially like that of many other stales. Unlike Britain
or New Zealand, South Carolina can take advantage of the potentially lower cost alternative
sources of wholesale power available through the transmission pooling system that reaches far
beyond its borders.
South Carolina has three major utilities with multiple generating plants serving the area
(South Carolina Public Service Commission (1992) pp. 12, 59-60) and interconnections with
other states provide additional potential sources of supply. (South Carolina Public Service
Commission 	(1992) 	p. 55) 	Planning 	requirements 	for 	franchised 	utilities 	already 	provide
opportunities for South Carolina to foresee demands for additional capacity (South Carolina
Public Service Commission (1992) pp. 56-58), which could be subject to bidding procedures.
As described above, opening entry to independent generators and distant franchised utilities
may 	reduce 	generation 	costs. 	\X'ith 	respect 	to 	transmission, 	franchised 	utilities 	in 	South
Carolina's SERC area maintain extensive transmission systems that already accommodate a
40

considerable volume of wheeling (FERC Transmission Task Force (1989) p. 19), including
wheeling to municipal power distribution systems under long-term contract arrangements.
(South Carolina Public Service Commission (1"192) p. 61) 'XTith respect to local distribution,
South Carolina already has regulations that go\"ern the separation of local distribution from
transmission 	and 	generation 	for 	municipal 	systems 	(§j8-27-41C 	to 	430, 	§j8-27-1330 	to
1360).101 Unlike states that share jurisdiction over a major load center with another state,
South Carolina need not delay reforms until it can coordinate local distribution r0!icies with
those of other states.
D. 	Comments on South Carolina's statutes and regulations concerning electric
power
This review of the PSC statutes and regulations comes at a turning point in the history
of electrical utility regulation. Technical and institutional changes have created an opportunity
to introduce significant elements of competition to lower prices in one or more stages of the
electrical utility business. South Carolina may wish to join other states and nations such as
New Zealand and the United Kingdom in revising its public service commission statutes and
regulations 	to 	recognize 	these 	opportunities. 	Four 	elements 	appear 	to 	be 	of 	partic:ula.
significance.
1) Reco~nition of increased competition as consistent with the ~oals of electric utility
re~lation: To provide a clear orientation toward opportunities for increased competition,
South Carolina may wish to state explicitly, in §S8-5-210 or elsewhere, that a goal of electric
utility regulation is to provide consumers with '"he benefits of competition to the maximum
extent feasible. The PSC statutes now do not include competition as an organizing principle
for electric utility regulation.
2) Provision for reducing or eliminatin~ regulation for competitive sta~es of electrical
utilities. To implement a competitive statement jf purpose, South Carolina may wish to create
a specific avenue for deregulation of different segments of the electrical utility business as
technology and institutional developments permit effective competition. One such alternative
may 	be to add a provision to §58-S-35 indicating that upon a finding by the PSC that a
segment of the electrical supply industry could be sufficiently competitive, that segment may
price under alternative, more flexible constraints, such as price cap regulation. 102 Another
101 The FERC Transmission Task Force (1989) notes (pp. 37-38) that municipalization is
one form of wholesale wheeling that can be a close approximation to retail wheeling, citing
a municipalization effort in which a small numbpr of industrial users accounted for the bulk
of electricity demand in the jurisdiction.
102 Rate regulation would continue to be relevant for the portions of the industry where
effective competition is not present. Otherwise, for example, the gains from more competitive
(continued ...)
41

alternative would be to allow the PSC to redefine:'electric utility" under §j8-27-10 to exempt
from rate-of-return regulation, in whole or in part, segments of the industr.: where effective
competition is present.
Similarly, 	to 	avoid a regulatory 	block to 	entry 	of independent 	generators, 	South
Carolina may wish to state explicitly that §58-27-640, providing for the assignment of suppliers
to service areas, does not necessarily apply to such facilities as generators, but rather is limited
to facilities directly involved with local distribution.
To recognize further the principle of promoting competition, South Carolina may wish
to state that 	the PSC 	encourages franchised 	utilities to 	seek 	bids from 	EWGs 	or other
franchised utilities for additions to supply/capacity because they may offer lower costs, greater
reliability, or other advantages. This encouragement also could be expressed by eliminating,
for competitive segments, the public convenience and necessity provisions of certification to
construct major utility facilities (§58-33-110), to the extent that these provisions permit actual
or potential competitors to ol-;~ct on the basis of their own economic self-interest.
3) 	Authorization to coordinate regulatorv 	policies with 	other states. 	To facilitate
efficient solutions to electric utility issues such as generating plant siting decisions, transmission
line expansions, and retail wheeling issues that cross state borders, South Carolina may wish
to provide statutory authority for the PSC to coordinate its siting, IRP schedules and time
horizons, wheeling, transmission access, transmission siting and expansion, and bid criteria
with those of other states, particularly states with utilities in the same pooling and reliability
council areas. 103
~ 	4) 	Reco~nition that even where natural monopoly exists, there may be attractive
methods of providin~ increased competition. To assure that the PSC provides the benefits of
competition to consumers as early as practicable, South Carolina may wish to direct its PSC
to 	examine 	(in 	conjunction 	with 	other 	states) 	the 	generation, 	transmission, 	and 	local
distribution aspects of electrical utility regulation on a regular basis to determine if additional
102( ••• continued)
generation 	could 	be 	captured 	through 	market 	power 	exercised 	at 	the 	transmlSSlOn 	or
distribution levels and no net price decreases would be experienced by consumers.
103 For a discussion of this issue, see Jones (1992), Kelly (1987) pp. 90-92, 150-155, and
National Governors' Association Task Force on Electricity Transmission (1987) pp. 16-23.
FERC encourages utilities to form Regional Transmission Groups that FERC anticipates will
obviate the 	need for FERC 	transmission 	orders. 	(FERC 	1993) 	Contract 	path 	pricing of
transmission, in particular, may distort transmission and generation siting decisions if these
decisions are not coordinated. (FERC Staff, 1993, pp. 15-16)
42

deregulatory 	steps 	can 	reasonablv 	be taken 	ba"sed 	on 	the 	experience 	of other states 	and
countries. 104
E. 	Conclusion
Technology and institutions in the d::tric power industry are changing rapidly. These
changes could open the electrical power industry to the cost minimizing, quality enhancing,
and product diversifying incentives of competitive markets. Experience, both in the United
States and abroad, supports the proposition that it may no longer be accurate to treat the
electrical power industry as a vertically integrated natural monopoly in which rate-of-return
regulation is uniformly essential to prevent monopoly pricing and other manifestations of
market power. New technology and institutions are providing significant opportunities to
introduce the benefits of competition in electric generation. Institutional innovations may also
permit effective competition in transmission and distribution of electric power. South Carolina
may wish to revise its PSC statutes to advance competition in generation and prepare for
adoption of techniques for advancing effective competition in transmission and distributicn
as they prove reliable.
104 Requiring the PSC to conduct such a periodic audit of its own could provide an
assurance that the general directive to increase competition is being carried out. The "sunset"
review process, focusing on problems with the statutes themselves, rather than on implementa-
tion, might not detect such difficulties.
43

Appendix A
The econcmic th·.:ory of entry protection
The traditional economic justification for regulating an industry with rate-of-return
limits and restrictions on entry derives from the assumption that the industry is a natural
monopoly.
If the costs of providing electrical services are 	minimized 	when these services are
provided by a single firm, then it could be efficient to allow the continuation of a monopoly.
However, even if costs are minimized by the existence of a monopoly, it does not necessarily
follow that the monopolist should enjoy statutory protection from entry. In this appendix we
review the cost conditions under which production 	by a single firm 	will minimize total
production 	costs, 	and 	the 	conditions 	under 	\':hich 	it 	would 	be 	efficient 	to 	protect 	the
monopolist from entry.
Entry protection when the firm produces only one type of output.
Recent developments in economic theory have revised and, in important 	respects,
narrowed the range of cost conditions that can justify protecting a monopolist from entry
through regulation. Up through the mid-1970s, it was commonly believed that a protected
monopoly could be justified if and only if the supply of such a product was subject to
"economies of scale" over the relevant range of production. 105 An economy of scale exists
when a proportionate increase in all of a firm's inputs leads to a more than proportionate
increase in its output. Economies of scale imply that the per unit cost of providing a single
good decreases as the output of that good increases.
More recent theoretical work shows, however, that monopoly may be the least-cost
industry structure even when scale economies (or decreasing unit costs) do not extend over the
entire range of likely output levels. 106 It is now recognized that monopoly is the least-cost
industry structure when the cost function has the property of "subadditivity." Costs are said
to be subadditive at some level of output if one firm producing efficiently can always produce
that level of output at lower cost than can two or more firms.
105 See Schmalensee (1979) pp. 3-7. For example, economies of scale may exist in providing
electric dispatching services. If the cost of installi flg and maintaining computer equipment used
for dispatching is the same, regardless of the amount of energy being dispatched (within some
range), then the dispatching cost per KW hour will fall as the quantity increases.
lOb This body of work is summarized in Baumol, Panzar, and Willig (1982) and Sharkey
(1982).
44

In a single product setting, continuously decreasing unit costs up to a particular level
of output are sufficient (but not necessary) to imply that costs are subadditive at that output.
In figure 1, for example, unit costs continue to fdll until output Ql is reacned. It can therefore
be concluded that costs are subadditive at any output level between C and Ql. What is not
immediately apparent, however, is that costs continue to be subadditi\"e (up to a point) even
for outputs exceeding QI, notwithstanding that average costs begin to rise once Ql is exceeded.
Monopoly therefore may be the cost-minimizing industry structure even when per-unit costs
do not fall continuously over the entire range of possible output levels.
This is an important principle, especially in its implications for the issue of entry
protection. Legal protection from entry is not necessary to ensure least-cost production when
scale economies exist over the entire range of possible output levels. For then, as one observer
has noted, "[l]arger firms always have lower costs than smaller competitors [when there are
scale economies]. The largest firm at any instant is thus in the best position to compete for
sales. If the largest firm is sufficiently aggressive, it will drive all rivals from the field and still
earn substantial excess profits." (Schmalensee (1979) p. 4) In this instance, the monopoly is said
to be "sustainable." Sustainability means that the market demand and cost functions make
available to 	the monopolist 	a price such that 	(1) the market 	clears (i.e., the 	monopolist
produces all that is demanded at that price); (2) the monopolist at least breaks even; and (3)
entry is unprofitable. When the existence of a monopoly rests entirely upon scale economies
(or decreasing unit costs), there is no need for a legal prohibition on entry to ensure lowest
cost production. 107
p" f----+-~-----"""""
po I--_~
POI---+-~--~~--+---:::;K
p' I----+-.;;...-----~~-
The 	case for 	legal 	protection 	from
entry is more compelling when monopoly is
the least-cost industry structure, and when
scale economies (or decreasing unit costs) do
not exist over the entire range of possible
Quantity 	0 0 	0' 	0°
Figure 1
107 Regulation may be necessary to ensure that such a monopolist charges a competitive
price. The literature on sustainability (see Tirole (1988) pp. 18-21; Baumol, Panzar, and Willig
(1982, 1986); and Sharkey (1982)) describes conditions under which the threat of entry will
provide a monopolist with an incentive to charge a competitive price.
45

production levels. For example (see figure l),IOS"suppose that the firm's long-run average cost
function ha:. a "u" ~~ape (i.e., average costs fall until they reach some minimum point, beyond
which they begin to rise). Suppose further that the market demand curve intersects thi:; ~ost
function to the right of its minimum point (but not far enough to its right to accommodate
two firms producing at minimum average cost.) As drawn, the cost function in figure 1 is
subadditive at output Q .. This set of circumstances will result in an unsustainable natural
monopoly. That is, given the market demand. total production costs would be minimized if
a single firm produces Q'. However, such a monopolist would not be able to charge a price
that both covers its costs and deters entry.
To see why, suppose this monopolist selects a price and output (denoted as p' and Q)
that allow it to cover exactly its average cost at the level of output where demand intersects
the cost function 	(i.e., it chooses a price exactly equal to average cost at output Q). The
monopolist is vulnerable to an entrant that produces less than Q' (~, output level QI, the
level of output at which average cost is lowest) and sells it at a price less than p', such as Pl.
Thus, if an entrant were to produce QI, selling at pi, what wC'uld remain for the monopolist
to produce is Q' - QI (-= Q~. The latter could be produced only at a cost of po, which is
above p'. In fact, if an entrant produced QI, the monopolist would not have available to it any
output between Q' - QI that it could produce and cover costs, whereas the total output Q'
could be produced if the monopoly is protected from entry. We note that if Q' is produced
and priced at p' by a protected monopoly, then Q' may be produced at lower cost than if Q'
is produced by more than one firm. If QI is produced by an entrant and QO is produced by
the incumbent, the total cost of Q' is (pI X QI) + (PO x Q~. With the market protected from
entry, the total cost of producing Q' is p' x Q'. The total cost of producing Q' will be higher
with entry if (as is the case in figure 1) shaded area (A) exceeds shaded area (B). Absent entry
restrictions, 	an 	excessive 	number 	of firms 	may 	exist 	along with 	a consequent 	waste 	of
resources.
If the monopolist initially charges a price below p', say pi, ami supplies the whole of
the amount demanded so as to deter entry, then total output would exceed Q', and price
would fall below cost, causing losses to be incurred. If, on the other hand, the monopoly
initially produces less than Q', charging a price above p', it will face a higher risk of entry
than if it had charged p'. If, for example, the monopolist were initially to produce QI and
charge pll, it would be vulnerable to entry by a firm producing Ql and selling at pi, If the
entrant charges pi and produces QI, there is no output that the monopolist could produce and
sell profitably, as noted before.
IDS This example was first presented in Baumol, Panzar, and Willig (1982) pp. 29-32; and
Sharkey (1982) pp. 88-9; and is discussed in greater detail in Brock and Evans (1983) pp. 69-76.
46

As Baumol et al. argue, 1~9 the case for-entry restrIctwns outlined above holds with
full 	force 	only 	when 	there 	are 	no 	sunk 	costs 	associated 	with 	entry 	into 	a 	market. liD
0therwise, ...~ they point out, th" nonsustainabdity of t!:e natural monopoly may only mean
that the incumbent cannot fullv exploit the advantages conferred on it (relative to the entrant)
by the existence of the sunk costs. The incumbent may still be able to set a price that allows
it to cover its costs and deter entry; this price may well be substantially below the price the
monopolist would charge if it enjoyed regulatory protection from entry.
This 	point 	can 	be 	better explained
with 	the 	aid 	of 	an 	example 	taken 	from
Baumol et al. (1982, pp. 221-2). In figure 2,
AC m 	and 	ACe 	are 	the 	respective 	average
costs of the incumbent and entrant, and D is
the 	market 	demand 	curve. lll The 	market-
clearing price that allows the monopolist to
exploit fully its cost advantage (relative to
the entrant) is Pm. This price is not sustain-
able. 	However, 	a somewhat 	lower 	price,
such as P e' is sustainable. At this price, the
monopolist could still satisfy total market
demand 	and 	cover 	its 	costs; 	the 	entrant,
however, 	would 	not 	be 	able 	to 	cover 	its
costs. This price is well below ~:le uncon-
strained monopoly price, p •.
p.
Quantity
Figure 2
Baumol et al.'s argument would seem to carry considerable weight when applied to
markets for electrical generation and transmission. Entry into these markets is characterized
by substantial sunk costs. Thus, even if electric utilities in some markets were nonsustainable
natural monopolies, it may make little sense to provide these firms with statutory protection
from entry, since the existence of substantial sunk costs may provide them with the ability to
deter inefficient entry.
109 See Baumol et al. (1982) pp. 221-4.
110 Sunk costs are costs that cannot be recovered if a firm elects to exit a market.
111 When an entrant must invest in industry-specific capital (i.e., incur sunk costs) to enter
an industry, it becomes more vulnerable to credible retaliation (~., post-entry price cuts) by
the incumbent. 	If capital were not 	industry-specific, such 	responses 	could 	not 	harm the
entrant, as the equipment could be costlessly diverted to another use. As Baumol et al. show
(pp. 296-301), the threat of credible post-entry retaliation is economically equivalent to raising
the entrant's cost of capital, which shifts the entrant's cost function upward. The magnitude
of this shift will be determined, in part, by the amount of industry-specific capital required for
entry.
47

Entry protection when the firm produces many types of output.
The analysis of entry protection become5 more complicated when a firm produces more
than one output. Prior to the mid-1970s, there was relatively little formal 	analysis of the
implications of multiple product production 	for 	industry structure and entry 	regulation.
Subsequent work has shown that, as in the case of single output firms, the existence of a
multiproduct natural monopoly rests upon the notion of subadditivity. Subadditivity has the
same meaning in a multiproduct setting as in the single output case-i.e., costs are subadditive
when the cost of producing some set of products is lower when it is produced by a single firm
than when the same set is produced by more than one firm. However, when a firm produces
several products, it becomes difficult to determine whether the firm is a natural monopoly,
and if so, whether the monopoly is sustainable. This difficulty arises because multiproduct
production makes costs dependent upon the mix, as well as the quantities, of the different
products produced.
A full discussion of the conditions under which a multiproduct natural monopoly
exists, and when it is sustainable, extends far beyond the scope of these comments. There are
numerous excellent discussions of this issue a\'ailable in the literature. 112 The chief implica-
tion of this literature can, however, be succinctly summarized: 	as in the case of a single
product firm, there is no efficiency basis for protecting a monopolist from entry unless there
is a good reason to believe that the industry is an unsustainable natural monopoly. Unless the
monopoly is unsustainable, market forces will induce and sustain the monopoly as the least-
cost industry structure.
To determine whether any particular industry, such as electrical supply, possibly merits
(on efficiency grounds) protection from entry, some empirical evidence should be brought to
bear on the subadditivity and sustainability issues. The theoretical literature on multiproduct
natural monopoly has developed a set of necessary conditions and sufficient conditions l13 that
must be satisfied if it is to be concluded that an industry is a natural monopoly. There is also
a set of necessary conditions and sufficient conditions to establish whether a natural monopoly
is sustainable. Whether the necessary conditions and sufficient conditions for the existence of
a natural monopoly are satisfied in any given industry can, in principle, be assessed empirically
112 See Baumoi, 	Panzar, 	and 	Willig (1982, 	1986), Bailey and F riedlaender 	(1982), 	and
Sharkey (1982).
1I3 There are unfortunately no analytically tractable conditions that are both necessary and
sufficient for determining whether an 	industry is 	a multiproduct 	natural 	monopoly. 	See
Baumol, Panzar, and Willig (1982) p. 170.
48

via 	the 	estimation 	of 	cost 	functions. 	However, 	the 	data 'requirements 	for 	conclusively
determining whether an industry is a sustainable natural monopoly are formidable. J14
Fortunately, one can often derive information of enormous practical significance to
policy 	makers 	without answering the sustainability question 	by 	focusing 	instead on the
conditions necessary for natural monopoly, 	i.e., the conditions for subadditivity. If cost,
output, and input price data are available for the various services provided by .Z1C elec~rical
utility, it should be possible to assess whether the nece:sary conditions for s'..lbadditivity are
met. 1IS If these conditions are not satisfied, the sustainability issue need never be addressed,
and a strong case can be made for allowing free entry. Conversely, if scale economies exist
over the whole range of output, 	no entry protection is 	necessary. 	If the conditions for
subadditivity do exist, but economies of scale do not cover the relevant range of output, then
the case for entry prohibition is strengthened, though not definitively established.
As discussed in the text, neither subadditivity nor economies of scale appear to be
critical considerations in generation. Still. economies of scale do appear to exist for the relevant
range of output for 	most 	elements 	of the transmission 	and distribution 	systems 	and, as
discussed in the text, there may be economies of vertical integration between generation ami
transmission/distribution to consider in determining whether entry restrictions would promote
economic efficiency.
114 Specifically, to establish subadditivity of ~he cost function, a researcher would require
enough data to estimate the properties of a cost function at all possible levels of the different
outputs. In practice, the investigator will only h;lve data on the output levels that the firm has
actually produced.
115 See Evans and Heckman (1983) for an example of this procedure.
49

AppendIx B
Electrical utility reform in the United Kingdom and New Zealand
United Kin~doml16: In the late 1980s. the United Kingdom unbundled the vertically
integrated nationalized monopoly into generation, transmission, and distribution tiers and
introduced competitior. 	into 	generation 	and distribution. 117 At the 	generation 	level, 	two
large, 	private 	generating 	entities 	were 	created, 	along 	with 	a 	government-owned 	entity
controlling all nuclear power generating stations. 118 The national transmission grid has been
maintained as a single entity separate from the generating organizations. 119 The grid is owned
as a joint venture by the twelve local distribution companies and is managed independently.
Local distribution continues to be a franchised monopoly for all customers with respect to
physical facilities, but larger customers are authorized to contract for power directly from
suppliers other than the franchise holder. Eventually, all customers will be able to "shop" for
power in this manner.
The heart of the British system is half-hourly competitive bidding from the generating
firms. 12o Generating firms 	submit a schedule of output 	and price combinations for each
production facility. The national grid then selects which offers to accept, starting with the
lowest priced capacity 	available. 	The 	grid 	pays 	generators 	the 	price 	of the 	most 	costly
generation bid that it accepts for that half-hour. Prices also include a payment meant to assure
an incentive to add capacity as demand grows. 121 Next, the grid sells to the distributors and
116 This section is based in part on conversations with and written materials from J. Mark
Hammond, 	First Secretary Environment, 	Energy 	and Telecommunications at the British
Embassy.
117 The system that has emerged bears considerable resemblance to the system in the U.K.
between World War I and World War II. For a discussion see, Hammond (1992) pp. 538-53.
118 The government has retained ownership of all nuclear power plants and sells this output
under a separate set of arrangements with the grid.
119 The grid retains ownership of pump storage capacity projects.
120 The grid must give access to licensed generating firms with capacity greater than 10 MW
and all generating plants over 100 MW must operate under the grid's schedule and dispatch
orders. (Sas (1990) p. 486; Green and Newberry (1992) p. 930) Graphs of the time-of-day peaks
and load durations for the British grid are shown in Green and Newberry (1992) at p. 935.
121 Legislators were initially concerned that prices would not cover the fixed costs of the
generating firms and therefore might result in lags in investment in new capacity. There is
some speculation that the charge has been set too high and may be inducing more entry than
is economically appropriate. (Smith (1993) pp. 15, 17)
50

other retail and wholesale customers at a markup above what it pays to generators, with the
markup paying for maintenance of the grid. Increases in the grid's mark-up are capped by the
rise 	in 	the 	retail 	price 	index 	minus 	an 	adjustment 	for 	technological 	improvements. 122
(Lamb en (1989) p. 16)
Each regional distribution company at first had a monopoly on retail sales in a specific
geographic area, but the statutory obligation to provide service to all customers applies only
if the customers are willing to pay the incremental cost of providing such service. Retail
customers with demand of over one MW have the option of contracting for power from any
generator or distributor and accessing this power by connecting to the national grid through
the 	franchised 	distributor's 	lines. l2J Non-discriminatory 	rates 	are 	levied 	for 	use 	of the
national grid and for the local distribution lines that the retail customer uses to connect to the
grid. (Sas (1990) p. 487) The rate of increase in these grid and connection charges is capped by
the general inflation index. 124 (Smith (1993) p. 16) The distribution companies and large retail
users 	are 	free 	to 	arrange 	to 	buy 	power 	through 	direct 	contracts 	with 	generators, 	or
constructing their own generating capacity. In addition, they may buy electricity futures on
the London futures market. 125 When the power is actually supplied. parties to the contract
settle by paying or receiving the difference !Jetwcen the pool price (charged by the grid) and
the contract price. (Sas (1990) p. 487)
Increases in prices of power for low volume customers (those who buy power from the
local distributor, rather than just connect through the distributor) are restricted by price caps
121 The combination of price caps on some elements of demand and pricing flexibility on
others has potentially advantageous. efficiency effects and may permit 	regulators to avoid
difficult measurement and detection problems. For a discussion, see Einhorn (1990).
I2J A higher threshold was applied initially.
124 The cap is also reduced each year by a technological improvement factor that is used
to make a downward adjustment in the allowed price related to productivity improvements.
The idea is to provide incentives for efficiency improvements that go beyond the norm. (Smith
(1993) p. 16)
125 Distribution companies are allowed to produce up to 15 percent of their own needs.
(Sas 	(1990) 	p. 486) Decisions of retail customers to 	by-pass the franchised 	distributor are
limited to a pre-established, but increasing, proportion of the distribution company's load prior
to the reforms. By the end of the decade, no restriction will be in place in this regard. (Sas
(1990) p. 487)
51

that are also tied to the retail price index minUS an adjustment for technological Improve-
ments. 126
The reformed electrici!y system began operation in March of 1990. Three significant
observations 	have 	been made to date. 	First, electricity prices for 	low 	volume users 	have
increased by less than the rate of inflation (which was treated as a price cap for increases in
franchised electricity prices). Second, prices of wholesale power have fluctuated substantially.
by season, time 	of day, and year, 	with 	peaks exceeding average price by as 	much 	as 20
times. 127 Third, electricity prices for large retail customers 	have fallen, 	on average, 	by 	10
percent in real terms as more such customers have opted to seek electricity directly from
generating firms, 	distributors outside their local area, or directly from the national pool.
(British Embassy (1993))
Evaluators of the British system have emphasized one major drawback in the manner
the reforms have been implemented. Although there are ten generator firms, the structure of
the 	generating 	industry 	is 	essentially 	a 	duopoly 	bec;;.use 	the 	government' s 	non-nuclear
generation capacity was divided into only two entities. 12s Consequently, these two firms may
be in a position to affect the market clearing price substantially, by withholding even a small
portion 	of their capacity. 	In an 	effort to discourage strategic capacity withholding, 	new
franchising rules require an operationally capable plant to offer a bid and require the major
126 In addition to price caps, the British system provides for a Director General with
potentially sweeping powers to alter rates and institution'll arrangements. These powers have
not been employed to date. (Smith (1993) p. 15)
127 Such peaks should lead to incentives to develop metering systems capable of varying
prices by the time of day, season, etc.
128 This structure is apparently an accident of history. The government originally intended
to sell its nuclear power plants along with the conventional units. By combining the nuclear
plants with a large proportion of conventional plants, the government hoped to make both
commercially viable. Shortly before the legislation was introduced, publicity about additional
risks associated with owning the nuclear plants caused the government to retain the nuclear
plants. 	This 	occurred, 	however, 	too 	late 	in 	the 	process 	to 	restructure 	the 	offering 	of
conventional plants. (Chessire (1992))
At 	present, 	power from 	the 	nuclear units 	is 	treated as 	a base 	load 	and 	all 	local
distributors are required to purchase a proportion of their power from the nuclear units (or
from other non-fossil fuel generating sources). (Chessire (1992))
52

generatIng companIes to offer for sale anv 	plants that thev 	are gOing to close or "moth
ball." 129
New 	ZealandlJ:): 	The 	electric 	power 	reforms 	in 	New 	Zealand 	entail 	a three 	way
dissolution of the government's electric power monopoly. As in the U.K., the grid is the
intermediary between generators and retail distributors in the spot market for electricity. In
New Zealand, the grid is jointly owned by distributors and generators. Generators provide a
bid schedule of price and output options for each generating facility and the grid equilibrates
supply with demand and then pays generators the price of the highest accepted bid for all
supply that is accepted. The spot market functions in tandem with longer-term contracts for
power between generators and power retailers. 1J1 All grid charges are publicly disclosed and
explained.
Privatization of the local distribution system is still in process, but the plan calls for
elimination 	of the "exclusive franchise" 	provisions that 	were previously 	in place. 132 New
129 The Director General undertook to add this restriction to generating licenses because
he perceived that peaks in wholesale electricity prices were higher than they would have been
with such rules in place. (British Embassy (1993)) Such a rule seems unlikely to curtail other
potential strategies of the major generating firms, such as submitting bids far above costs for
a portion of plants with the expectation that the plant at the margin will be one with a
significant price/cost margin. The reform act provides the Director General with authority to
take further steps if this licensing provision is deemed insufficient.
130 This section is based in part on conversations with and materials supplied by Len Muir,
Executive Officer, Embassy of New Zealand and discussions with Susan Braman, FTC staff
economist, who participated in formulation of the reforms in New Zealand.
131 The government anticipates that long-term contracts will be the primary mechanism
through which incentives for new capacity will take place. New Zealand's system has no
"uplift" charge on spot market prices to provide incentives for new capacity.
New Zealand's electricity generation system differs from that in most other developed
countries, because previously completed large hydro-electric projects are expected to meet New
Zealand's electricity demands through the end of the century without additions to capacity.
Hydro is by far the dominant source of generation in New Zealand (80 percent). 	(New
Zealand Electricity Task Force (1989) pp. 78-79) In contrast, SERC, the regional council that
includes South Carolina, generates approximately 60 percent of its power from coal and
approximately 	27 	percent 	from 	nuclear 	energy. 	(U.S. 	Congress 	Office 	of 	Technology
Assessment (1989) p. 158)
132 Historically I New Zealand did not regulate local electrical service rates because local
distribution 	was 	almost 	universally 	comprised 	of 	municipal 	systems. 	These 	municipal
(continued ...)
53

Zealand anticipates that local distribution will continue to be largely a single facility operation,
but leaves open the Dossibility of duplicate lines if prices get too far from the competitive
level. l3J Moreover, New Zealand is moving to foster cOiupetition within the context r( a
natural monopoly facility. Plans anticipate that the local distributing company will implement
separate charges for the use of lines, for connections to the distribution system, and for power
usage. Customers with high cost connections will be paying higher connection prices than
under the current system and vice versa. A potentially significant impact of separating line
charges from power use charges is that it opens the market to entry of independent electric
power 	retailers. 	A 	firm 	with 	no 	generating 	capacity 	and 	no 	distribution 	system 	could
nonetheless become an active distributor by contracting for power from a generating company
and paying the line use charges of the local distribution company in order to supply retail
customers. It is anticipated that different power retailers will compete, for example, by offering
different types of time-of-day metering and pricing, various types of interruption guarantees,
and different seasonal price premiums. (Smith 1993b) pp. 143-44)
New Zealand's efforts to provide competition in retail marketing of electric power take
the 	British 	reforms 	one 	step 	further 	by seeking to 	bring 	additional 	competition 	to 	all
customers. In designing its retail distribution system, New Zealand has had to face a r.umber
of important issues. With respect to the traditional requirement to supply power to customers
who ask for it, the New Zealand task force observed that there is no need for a separate
requirement if all customers are paying the full costs of connecting to the distribution system.
New Zealand has elected to start charging full connection costs to the customers (with some
allowance for an explicit subsidy provided by a rural electrification fund). 	(New Zealanu
Electricity Task Force (1989) p. 93) With respect to exclusive franchises, New Zealand's task
force 	observes that for 	many 	natural 	monopoly settings, 	no exclusive franchise 	right 	is
necessary to preclude entry. Given the high sunk costs of the distribution system, New
Zealand considers it unlikely that inefficient double wiring will be prevalent. There is less
certainty, however, about across the board economies of scale covering the merchandising of
electricity apart from the physical wiring investments.
With respect to merchandising of electricity, New Zealand's task force found no basis
for granting an exclusive franchise since there need be few sunk cost investments. Rather, it
envisioned extensive and rapid entry of power merchants whenever electricity prices charged
by 	the 	owner of the 	physical 	distribution 	system exceeded the 	competitive 	level. 	New
Zealand's task force envisioned uninhibited (mandatory) retail wheeling to any customers with
time and demand metering and with separate connect and electricity use charges. For other
132( ... continued)
distribution systems, as in South Carolina, have not been subject to ratemaking at the state or
national level.
133 As discussed in Section B, if local distribution is a natural monopoly with sunk costs
there is probably no need to protect the natural monopoly with legal entry barriers.
54

customers unable to participate in retail wheeling-, the Task Force recommended "yardstick
regulation" 	'"-'ith 	rate 	caps for 	connection 	cha:-ges 	based 	on 	mean 	connection charges 	of
similarly situated distribution firrs. 134 (New Ze;:!and Ele~tricity Task Force (1989) pp. 96-98)
Charges for electricity use would 	be unregulated, depending on existing by-pass options,
improvements in metering technology, decreasing metering costs to extend the range of by-pass
options to more and more consumers, and the threat of subsequent regulation to hold prices
to competitive levels. 135 (New Zealand Electricity Task Force (1989) pp. 98-99)
As in the U.K" 	New Zealand is experiencing difficulty in dividing the government's
generating assets into enough segments to provide a less concentrated market structure for
generation. 136 Even within the current structure, though, significant productivity gains and
lower costs have been achieved. 137
13-4 Yardstick regulation in this context depends critically on the existence of competitive
conditions in geographic areas other than the one being examined. Sucl. regulation would be
unlikely to be effective against a coordinated increase in prices by the several dozen local
distributors.
135 There are numerous significant issues if cross-subsidization is required under remaining
regulations. For a discussion of the major issues see, for example, Edison Electric Institute
(1992).
136 Because of New Zealand's heavy reliance on hydroelectric power, coordination of water
use decisions is an unusually important element in New Zealand's electricity supply costs.
137 Operating expenses per kwh declined by 17.7 percent during the first three years after
the initial reorganization of the generation element of New Zealand's electrical system while
sales per employee increased by 14.7 percent and average price declined by 9.8 percent (all in
real terms). For several years prior to the reorganization, costs and prices had been stable or
rising in real terms. 	Output per worker had been increasing, but at a much slower rate.
(Spicer, Bowman, Emanuel, and Hunt (1991) p. 169)
jj

F. 	References
Anderson, Incentive Regulation and Demand-Side Management, Working Paper #21, National
Economic Research Associates, Inc. (1 '193).
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Economic Literature 1024-48 (1982).
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56

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57

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59

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60

VI. 	Conclusion
We appreciate this opportunity to provide comments on the statutes and regulations
concerning certain industries regulated by the South Carolina Public Service Commission. \Y/e
hope the specific comments and suggestions contained in the sections on specific industries are
helpful to the Council in its review.
61