Utilities

Utilities

Utilities are often described as businesses so "affected with the public interest" that they must be regulated by government regarding entry into (and exit from) the market, rate charges to customers, rate of return allowed to owners, and for the requirement to serve all customers within their area of operation (see REGULATORY PROCESS). Businesses engaged in the production and distribution of electricity, the distribution of natural gas, the distribution of water, telecommunications (particularly telephone service) and pipelines (gas, oil, commodities) are considered public utilities. Cable-television service is also described by some as a utility. In earlier times, railways, grain elevators, ferries and privately owned bridges were considered public utilities.

Utilities may be owned by private investors or by governments through, for example, CROWN CORPORATIONS. Distribution of electricity is provided by provincial crown corporations in most provinces, while that of natural gas to businesses, households and pipelines are almost entirely privately controlled. Telephone services in the 3 Prairie provinces are provided by crown corporations, but in the rest of Canada by privately owned firms (subject to government regulation).

Rationale for Government Intervention

The most common argument for regulating public utilities is that such businesses are subject to very important economies of scale; that is, the unit cost of supplying a product or service declines as output increases. Because a large enterprise can more easily spread these costs over many customers to lower the per unit cost, natural monopolies are created. While a monopoly may result in greater efficiency, its power may be used to exploit consumers (businesses and households) in at least 2 ways. First, prices may be set well above the total costs of production, allowing the utility owner to earn excess profits.

Second, the utility may engage in discriminatory pricing, eg, charging different customer groups different prices when the cost of serving each group is the same. In response to these potential problems, government regulators often control entry to the extent of granting a monopoly franchise for a specific market area to one firm, but the regulators are responsible for ensuring that rates charged by the utility are "just and reasonable" and are "not unduly discriminatory or unfair" to different classes of customers.

It is also argued that since public utilities supply essential services to industries and households, all those willing to pay the price must have access to such services. Regulation is therefore necessary to ensure the maintenance of essential services.

Moreover, utilities are capital intensive, ie, the value of their assets is several times their annual revenues and the incremental costs of serving additional customers (up to a point) are small once the utility's network is in place. The 3 largest electric utilities in Canada (which are among the 5 largest nonfinancial enterprises in Canada measured by assets) control assets of 5 to 6 times their annual revenues. The ratio for telephone companies is much lower (3 to 1) while the ratio of total assets to annual revenues for natural-gas distributors and pipelines is about 2 to 1.

In most cases, utilities provide a nonstorable commodity or service which must be available to the customer on demand. For example, electricity must flow into the house when the lights are turned on; otherwise it has little value. Customers cannot store the product to accommodate fluctuations in demand. Moreover, most utility customers cannot obtain alternative sources of supply. While large-scale industrial buyers can, in time, find alternative sources of supply, households have less opportunity to switch if prices are too high or service is poor.

The rationale for regulating utilities is not constant, and a utility's status may evolve over time. For example, railways, until the growth of truck and airline transport just before WWII, were considered public utilities. Rapid technological change has severely undermined the argument for the monopoly-supply of another utility: long-distance telecommunications services. While entry of competitors into the market in Canada has been limited to nonvoice services, federal regulators in the US have permitted competition in the supply of long-distance voice services. Even the status of local-exchange telephone service, considered a classic natural monopoly, is threatened by cellular radio and by direct transmission to satellites that bypass the local exchange.

Alternative Forms of Intervention

Government intervention takes 2 forms. First, governments can assume public ownership of the means of production through the creation of crown corporations. As owners, governments can establish the firm's prices directly and determine the conditions of service. Public ownership, however, does not necessarily entail control over entry. Second, governments can leave ownership of utilities in private hands while establishing a regulatory agency (commission or board) to monitor and control the utilities' activities. Public ownership is chosen more on practical than ideological grounds and has often been adopted after private ownership has prevailed for years. For instance, the fact that provincial crown corporations paid no federal corporate income taxes was a major determinant in the nationalization of electricity in both BC and Québec in the early 1960s.

It is important to note that public ownership has not been used as a substitute for government regulation. With very few exceptions (Saskatchewan Telephone, HYDRO-QUÉBEC), government regulation has been imposed on both publicly and privately owned utilities.

Regulation of Public Utilities

Governments regulate utilities through specialized agencies (eg, CANADIAN RADIO-TELEVISION AND TELECOMMUNICATIONS COMMISSION, the National Energy Board and the various provincial public utilities commissions), which receive their mandates directly from government through statutes specifying many of the rules by which they operate. Most regulatory agencies operate in a quasi-judicial fashion (see ADMINISTRATIVE TRIBUNAL), their most important task being to make impartial decisions on matters such as the level of rates or tariffs, the allowed rate of return the owners may earn, and entry into the relevant markets.

The decisions of such agencies are usually subject to appeal to Cabinet. The agencies themselves are less independent than their American counterparts, and their role in policymaking is usually more restricted.

First, an agency decides who is allowed to operate in a given market, such as the extension of a pipeline into a new territory; when the decision was taken to build the gas pipeline from Montréal to Halifax, the NEB chose Trans-Québec and Maritimes Pipelines from among various candidates. Second, the agency must decide to whom the service is available upon demand, the implication being that utilities are not free to withdraw the service, once it is established, without the regulator's approval. Most of the work of utility regulators, however, involves determining the prices a utility is allowed to charge for its services. In establishing "just and reasonable" rates, the agency must determine the total amount of revenue that the enterprise may receive and how much the various classes of customer must pay for a service. Through public hearings the agency seeks to determine the normal costs incurred by the utility in providing the required level of services, in particular, what level of capital expenditure is deemed appropriate and what should be the allowed rate of return on the company's "rate base" (usually the depreciated value of plant and equipment used to provide the commodity or service). In this respect, the agency must regulate monopoly profits while ensuring that the rate of return is sufficient to attract and retain capital in the enterprise. Once the overall level of revenues has been determined, the agency must ensure that no class of customers is treated unfairly, eg, in the case of telephone regulation, a perennial question is how much businesses (as opposed to households) should pay per month for local-exchange service.

Problems with Utilities and Their Regulation

The regulation of utilities by quasi-independent agencies is a time-consuming process subject to considerable criticism. First, because utilities appear able to pass higher costs on to their customers, they are not forced to be as efficient as enterprises that have to contend with competition. Second, some classes of customer may pay rates that are lower than the real costs of the services they receive, while other classes bear the difference; there is evidence that such cross-subsidization is part of the design of telephone regulation in Canada, eg, long distance versus local exchanges.

Third, it is frequently argued that consumer interests are not well represented before utility regulators and that they are insufficiently taken into account in the regulators' decisions. Fourth, technological change provides opportunities either to substitute the discipline of the competitive market for the regulation of utilities or to make greater use of competition in some degree to ensure that such firms are as efficient as possible and are responsive to changing economic conditions, yet regulators are reluctant to make greater use of competition.

Fifth, utility regulators are accused of devoting too much time to establishing the allowed rate of return rather than to determining whether the utility's actual production costs are the lowest attainable (which involves the difficult task of judging whether the utility has adopted the most appropriate new technology). Sixth, in establishing the prices that utilities may charge, regulators usually focus on historical average cost of "embedded capital" (eg, many hydro dams were built 30 years ago) rather than on the current level of incremental costs.

See also ELECTRIC UTILITIES.