EBF 483
Introduction to Electricity Markets

5.1 The Regulatory Compact


5.1 The Regulatory Compact

The early days of the electric utility business were marked by intense competition. Following the resolution of the "War of the Currents" (see Lesson 1 if you don't remember what that was) and the establishment of AC power as the dominant technology for generating and distributing electricity, a large number of electric light companies sprung up in major cities across the United States. Duplication of infrastructure was rampant. Multiple sets of power lines were strung through city streets, each owned by a different company trying to capture business.

Usually, in economics, we think competition is actually a good thing and so we should have been happy with the competitive state of the early power business. The problem was that all of this duplicate infrastructure represented a massive waste of resources. Power lines (whether they are high voltage transmission wires or lower voltage distribution wires) exhibit economies of scale - the average cost goes down as more demand is served through a single wire.

This is very intuitive. Power lines feature very high fixed costs but practically zero marginal cost. Once a power line is erected, the marginal cost of serving an additional household with that same line is basically zero (yes, there will be some additional losses as more current is pushed through the power transmission or distribution wire, but this is a really small number compared to the capital cost of the wire). So the more households that can be serviced with a single wire, the lower the costs will be because the capital cost is spread out over more customers.

As it turns out, it is also cheaper (per unit of electricity sold) to build higher-capacity power lines that serve a lot of demand rather than a large number of lower-capacity power lines. The table below provides some relevant data from modern times, but this was also true in the early days of the electricity business.

Table 5.1: Typical Costs and Thermal Capacities of Transmission Lines
Cost Capitala
(thousand $/mile
(million $/GW-mile)
230 480 350 1.37
345 900 900 1.00
500 1,200 2,000 0.60
765 1,800 4,000 0.45

a Improving Asset Utilization of Transmission Lines by Real Time Rating, presented at T&D Committee Meeting, IEEE/PES Summer Power Meeting, Edmonton, Alberta, July 22, 1999. They include the cost of land, towers, and conductors. We increased these estimates by 20 percent to account for the costs of substitutions and related equipment.

Source: Eric Hirst and Brendan Kirby, "Key Transmission Planning Issues," Electricity Journal 2001.

Until very recently, power generation also exhibited economies of scale, meaning that it was cheaper to build a small number of large power plants to serve a single city than to build a large number of small power plants. According to Statistical Cost Analysis, published by John Johnston in 1960, a power plant needed to be at least 200 MW in size (roughly enough to serve the entire US state of Wyoming) in order to be economically efficient to operate. While this has changed more recently and the costs of small scale power generation like rooftop solar and small turbines have plummeted, it is important to realize that bigger really was better in electricity for almost one hundred years.

The person who is most famous for realizing that electric utilities could operate more cost effectively if they were larger and if there was less competition was a British-born businessman in Chicago named Samuel Insull. Insull was one of the first people to open up electric light companies after Thomas Edison's initial demonstration of electric power generation in New York City. One of the first companies he founded, the Commonwealth Edison Company, still exists today as the electric utility serving Chicago.

Insull saw municipalities around Chicago establishing their own publicly-owned electric light companies in response to high prices from private utility companies and feared that his own profit-driven electricity companies in and around Chicago would be taken over by city and town governments. While Insull's tendencies were undoubtedly to protect his own business interests, he also recognized that the model of a large number of small electric light companies was wasting money and making power prices unnecessarily high.

So Insull approached the Chicago city government with a deal: let his Commonwealth Edison company be shielded from any competition by granting it an exclusive license (i.e., a monopoly) to provide electric light service in Chicago. In exchange, Insull would allow the city to regulate the prices that his utility charged and the service that it provided to residents and businesses in Chicago. Insull justified this deal, which spread quickly and came to be known as the "regulatory compact," by raising the specter of what he called "ruinous competition." The argument that Insull made was that publicly owned and cooperatively owned utilities were able to use the power of city and local governments to subsidize electricity service at below-cost prices, thus pushing the for-profit utilities out of business (which, remember, Insull owned several of). But such below-cost pricing could not persist forever and eventually, the public power model would collapse on itself, harming residents and businesses.

The regulatory compact, under which a for-profit electric utility was given a monopoly to provide electricity service in a specific location in exchange for being regulated by a state or city, became the dominant form of providing electricity service in the US by the early part of the 20th century and is still with us today in the United States. Publicly owned electric utilities have survived and some large cities (like Los Angeles) are notably served by city-owned utilities rather than a for-profit company. But by and large, for-profit electric utilities became the most prominent companies in the industry.

The regulatory compact employed by the United States turns out to be unusual. Many other countries adopted electricity by establishing a power company that was owned and run by the national government. Even though many other countries have national electricity companies, the way that governments internally regulate how these companies operate and the prices that they charge was highly influenced by Insull's regulatory compact.

You may wonder why Samuel Insull isn't as well known today as, say, Thomas Edison or even the major industrialists of his time like the Carnegies or the Rockefellers. Despite the business innovation that Insull brought to the electricity industry, his numerous business interests could not escape the weight of the Great Depression in the 1930s. Many of Insull's companies lost a lot of money, and in response, Insull created new companies that were set up to lend money to the existing companies. Eventually, the pyramid scheme collapsed and Insull was charged with fraud but fled to Greece (which refused to extradite him back to the United States). He died a poor man in Paris in 1938.