Saturday, February 26, 2011

profits and regulatory regimes

Warren Buffett's annual letter to the shareholders of Berkshire Hathaway is out, and includes the following paragraph, in the discussion of the regulated utilities Berkshire Hathaway owns:
In its electric business, MidAmerican has a comparable record [to those of gas pipelines discussed in the previous paragraph]. Iowa rates have not increased since we purchased our operation there in 1999. During the same period, the other major electric utility in the state has raised prices more than 70% and now has rates far above ours. In certain metropolitan areas in which the two utilities operate side by side, electric bills of our customers run far below those of their neighbors. I am told that comparable houses sell at higher prices in these cities if they are located in our service area.
I presume that the prices charged by regulated utilities with different "service areas" are set by a regulator, likely based on appeals by the utility to raise rates once in a while. "Cost-plus" contracts are not uncommon, even in purely private-market agreements, but they are pretty much ubiquitous in utility regulation, where regulators will set prices to insure some predetermined return to investment on capital by the utility. The reason for its use in both circumstances is that comparatively easy to negotiate, especially if the seller (i.e. the agent initially bearing this cost) is somewhat risk averse.

It also has terrible incentive effects, and, while I think it appeals to some people's sense of fairness, it grates terribly against mine. I have thought that if I were regulating utilities in New York, I would tell them I'm going to tie their prices to the costs of regulated utilities in California, Florida, Montana — not necessarily to say that the cost in New York should be the same as elsewhere in the country (I would allow a multiplicative factor, and perhaps an additive one, rather than simply use the average cost elsewhere), but if the costs go up uniquely in New York, I'm inclined to think the New York utilities are doing something wrong, and if they drop uniquely in New York, I think they're doing something right. So, Con Ed, cut your costs, and you get to keep the bulk of the savings as added profits; if your costs get out of line, don't call me in off the golf course to bail you out of your mess.* This encourages cost reduction, but it also frankly seems fairer to me than the current system where any cost controls are a function of the regulator micromanaging the utility or being reluctant for political reasons to raise prices too quickly.

Even within Iowa, rural areas surely cost more per kilowatt hour to serve than urban areas, and there may be factors between neighborhoods that affect costs, but I wouldn't expect any of these to change by a differential factor of 1.7 over the course of a decade — as Warren Buffett implies, it seems reasonable to infer that at least some, and probably most, of that change is attributable to factors under the control of the respective managements of the two utilities. It would make sense to me for the regulator to raise prices by 3% for MidAmerican, cut them by 7% for the other utility — assuming they're more than 20% different or so in apparently similar neighborhoods — and say to the higher-cost utility, "you figure it out."

Ideally, this is how a competitive market would work. There are reasons to believe that this sort of market can't be made competitive per se, but the textbook ideal of the competitive market gives us an ideal to aspire to when we're forced to step in, even to the point of setting prices for natural monopolies. In the ideal competitive market, a company is given the price at which it can sell its output and the prices at which it can buy its inputs, can enter and leave the market easily, and gets to produce as much as it can produce profitably. If it can't produce anything profitably, it drops out, leaving the market to firms that can; if it can produce profitably, those profits represent exactly the extent to which the firm is better than the "marginal" firm — one that's right on the edge between entering the market or not, or leaving the market or not — at doing what it's doing. This ideal is, of course, not going to be exactly met, especially in the case of regulated utilities (for which free entry and exit isn't going to be anywhere near true), and it would be a good idea at least to figure out how a bankruptcy would be handled if a company is run into the ground, but I think this sort of approach would yield fewer problems than the regulatory system we have now.

* Figuratively. I don't golf.

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