Transcript Regulation and Efficiency in the Electric Utility Industry

Regulation and Efficiency in the
Electric Utility Industry
LEON COURVILLE
Introduction : Rate of Return Regulation
 Rate- of – return regulation is a distinct feature of
the public utility environment. More than ten years
ago, it was argued that this form of regulation might
induce utility companies to operate inefficiently. This
idea has been characterized via economic relation by
the “Averch- Johnson effect.”
Averch- Johnson Effect
 The Averch-Johnson effect is the tendency of
companies to engage in excessive amounts of capital
accumulation in order to expand the volume of their
profits. If companies profits to capital ratio is
regulated at a certain percentage then there is a
strong incentive for companies to over-invest in
order to increase profits overall.
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In spite of being the subject of widespread discussion, this has
never been assessed through formal quantitative analysis. Such an
analysis and evidence on the existence of the A-J effect was
investigated via cross- sectional analysis of electric power plants.
How the A-J Effect applies
 Theoretical implications assert that the regulated
monopolist will not be efficient in choosing its
inputs.
 Much of the discussion of the Averch and Johnson
proposition has been theoretical in nature. No formal
quantitative evaluation of either the existence or
importance of the A-J effect was attempted2.
Where the Heck is the Empirics Dued?
 Surprisingly enough, the authors go on to lecture
that “given the frequent appeal by some writers to
the necessity of such investigation, and given the
causal empiricism to which it was subjected, and
given its denial by public utility officials,” this
has..STILL, never been done? Hence the motivation
behind Leon Courville’s approach. 

The aim and underlying motivation of the study was to examine
the Averch- Johnson proposition and relate this hypothesis to the
regulatory context it assumes so as to verify empirically and
quantify its importance.
Key Issues Discussed
 The effect if a rate- of return constraint on the
monopolist’s decision process is to render optimal,
from the monopolist’s point of view, a form of
behavior that is yet inefficient.
 To see that the marginal productivity of any capital
input to the marginal productivity of any “noncapital” input is smaller than the ratio of their
respective prices.
Paper Outline
 1) Introduction
 2) Presentation of the A-J model (constrained by
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monopolist rendering inefficient behavior)
3) Electric Utility Choice
4) Approach for testing and Evaluating A-J approach
5) A-J Proposition is actually tested: test confirms
existence of inefficiency of inputs
6 and 7) Conclusive findings and remarks
Kid In the Toliet
Electric Companies Activities
 An electric company is basically engaged in three
activities:
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Generation of Electricity
Transmission of Electricity
Distribution of Electricity
 It is argued that in order to infer the existence of
input distortion one need only consider the
generation of electricity.

This is done namely to examine the relation between marginal
productiveness of the inputs to electricity generation and their
respective prices.
Averch- Johnson Approach
 Details of this approach was not reviewed in great
detail, since it has already been widely discussed.
However, it is appropriate to consider its empirical
proposition on input combination.
 The original analysis concerns a monopolist whose
decision process is constrained by the imposition of a
constraint on the rate of return it can earn on its
capital.
The Firm’s Monopolist’s Problem: Profit
Maximization
Continued…
Section 3: The Electric Utility Industry
 The regulation of electric utilities is for most
purposes carried out at the state level. At present, 47
State Commissions have jurisdiction over electric
companies.
Electric Industry Structure
 The Electric utility industry has a complex structure:
there exists a wide variety of suppliers ranging from
small rural cooperatives usually providing power
service for their community exclusively to large
corporations distributing power to a huge network
of residential and commercial users and to industrial
users whose activities depend on electricity.
Overcapitalization
More on the Model….
Section 4: Testing
 In testing the overcapitalization proposition, we shall
consider the power plant as an entity that sells
output to the other activities of the utility company.
Since overcapitalization is expected to be present in
the generation of electricity, the objective of the
plant manager is to minimize costs with respect to
some output level associated with relevant transfer
prices.
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Overcapitalization is tested by comparing the ratio of the
marginal productivities to the ratio of prices. The null
hypothesis is represented by equation (6) and Ha by (7).
The Problem
 Authors Perspective of “the problem”
 Recognize that for a given input consumption, the higher
would the annual output be, the lower the variability in output,
or that, for a given annual output level, the smaller the input
consumption would be, and the smaller the variations in
output.
 THUS, variability in output affects factor
productivity.
Section 5: Cobb- Douglas Model Used
Further Assumptions
Results
More Results
Annnnnnnd More Results…
Test and Measure of Overcapitalization: Super
Size Me!
Table Results: H0 Rejections
Differences
 The only difference between Table 4 and Table 5 is
that overcapitalization tests presented in Table 4
correspond to the empirical production function
estimated using the deflated measures of capital,
while Table 5 test’s are based on using the deflated
measure of capital.
Conclusive Findings
 The Averch- Johnson proposition attempts to
describe the behavior of monopolists under the rate
of return regulation.
 The results are consistent with the hypothesis that
this form of regulation induces overcapitalization.
These results have been obtained by estimating a
production function for electricity generation and by
comparing the implied ratio of the marginal
productiveness of capital and fuel to the ratio of their
relative prices.
Conclusion
 Presumably, regulation induces benefits by forcing
firms to operate at a greater output than the pure
monopoly output. Thus, in principle, one should
compute the gains to consumer due to regulation
and compare them to the increased costs generated
by inefficient production induced by rate- of- return
regulation.
The End