Regulation and Energy Transport; J. Semmens

If such assertions be true, one must wonder how study after study can continue to uncover a recurring pattern of regulation-bred stagna tion, corruption, inefficiency, and protectionism. A revealing defense of regulation was made in 1974 by the General Counsel of the In"' terstate Commerce Commission.

REGULATION AND ENERGY TRANSPORT 91 Four arguments were raised on be half of regulation. First, that the regulatory agencies usually yield, sooner or later, to the inevitable changes in the business environ ment. Second, that the delays oc casioned by the ICC, for example, were not that bad. Third, that the waste engendered by regulation is not as bad as it could be. And finally, that regulation will not be as wasteful in the future as it has been in the past; the ((new" waste mandated by government controls will not be as gross as the ((old" waste. Despite its indefensibility, regula tion persists. The impact that the regulatory system has upon station ary transportation conveyances, primarily for shipment of energy products, will be the focus of the remainder of this report. Imperfect Competition and Incompetent Regulation In approaching the issue of com petition, or rather, its imperfections, as a rationale for government in volvement, many proponents begin by constructing an abstract perfect competition. This perfect version in cludes such notions as an infinite number of buyers and sellers in the market, as well as instantaneous information on supply and demand conditions. Under such a system, it is agreed that no regulation would be necessary. However, no such system exists. What does exist is imper fect competition. The role of regula tion then becomes clear. By careful adjustments to this imperfect envi ronment, it is claimed, the regula tory commission can remove the de trimental consequences and more nearly satisfy all needs.

To be sure, the interveners have the best of the phraseology. After all, the government is seeking to correct the imperfections of the mar ket, to insert deliberated planning and controls in place of the implied chaos of unplanned and uncontrolled markets, to insure fair competition. While phraseology may be useful as propaganda, it is impotent to deal with the economic realities. The unplanned and uncontrolled market is something of a misnomer. Actually, the market is a reflection of the continuous give and take of numerous participants, each of which is making its own plans and exercising its own controls. This very multiplicity of plans provides the flexibility that regulation lacks. And this is why unregulated mar kets consistently exhibit superior performance in meeting the needs and wants of consumers. Contrary to official dogma, it is the planned and controlled seg ments of the economy that are most chaotic. The only competition that has been ~~improved" by regulation is that between the growing number of government agencies and bureaus 92 THE FREEMAN February fighting over jurisdictional author ity. The major result of this achievement has been to divert ef fort from productive activities to legalistic wrangling between the regulated businesses and the vari ous regulatory bodies. The net re sult, of course, is a reduction in the aggregate wealth of the community.

This is no mean accomplishment, but it is questionable whether a reduction in wealth is socially de sirable. It certainly is not the objec tive sought by the intervention. Like some automaton gone ber serk, the regulatory commissions have frequently transformed their initial programming from preserva tion of competition to preservation of selected competitors. There are two predominant techniques. One is paternalism. The other is bureau cratization. Paternalism is evi denced when, in order to prevent ((predatory" or ((cut-throat" competition, the regulatory agency bars new entrants into the field and restricts or discourages innovations. The case-by-case methods followed pro duce no clear guidelines for the reg ulated industry. At the same time, vested interests of existing firms in market shares are treated as a prop erty right. A would-be competitor's proof that it could provide more effi cient service is not considered a rea son for allowing such a firm to enter the controlled market.

Bureaucratization is a more invidious force in the destruction of competition. Even those on guard against paternalistic inclinations fall prey to this vice. The key man ifestation of this phenomenon is the government's voracious appetite for paper. Not only do bureaucracies produce mountains of paper, but they consume them as w~ll. The regulated firm is constantly be sieged to produce more reports, pro vide more statistics, complete more forms. Smaller firms are hardest hit by this imposed cost of doing business. Not too surprisingly, the larger firms may be the only ones able to meet these costs. The reduced competition brought about by the· very actions of the regulatory authorities then becomes their reason for increasing regula tory powers. Nor can the heretofore protected competitors feel at ease. The regulatory agency may, at any time, turn on them with accusations of attempted restraint of competi tion or monopolistic practices, though, in truth, they may only have been following the dictates of the regulatory authorities.

It is apparent that regulation, to date, has been incompetent to achieve improved competition. In capable of assuring good perfor mance in the monitored industries, regulation thrashes about in aim less fashion lopping off consumer options, raising the costs of doing business, insuring misallocation of 1978 REGULATION AND ENERGY TRANSPORT 93 scarce resources, rewarding inefficiency-all to the detriment of the general welfare. The Price Is Not Right The prospects for transmission corridors over the next twenty years are anything but clear. With only limited proven reserves foreseen, the anticipated Hneed" for transport facilities is largely a shot-in-the dark. It is not irrational to ask why we need new pipelines if we only have ten more years' worth ofnatu ral gas to pump through them. Un disclosed in these estimates of re serves are the assumptions regard ing price. If current pricing policies are continued, the prognosis is in deed bleak. On the other hand, studies have indicated that with higher prices, the supply of gas would be stretched out for centuries.

There is nothing magical about this. Neither is it evidence of a vast conspiracy to withhold supplies. It is merely .the working out of the sim ple economic law of supply and de mand. Supply varies directly with price, while demand varies in versely with price. Therefore, if the price is .held below the uncontrolled market level, the quantity de manded will be stimulated and the quantity supplied retarded. Such is the current policy, which inevitably has led to depletion of.reserves and the forecast shortages. Analyses which purport to demonstrate that the supply of natural gas or oil is not sensitive to changes in prices are absurd. Yet, such analyses have spawned a so-called compromise solution based upon ttrolled-in" pricing and the vintaging of oil and gas. Periodically, the vari ous governmental agencies involved in this price control will classify various sources of supply as cCold" or cc new" based upon the initial year of production or discovery. The conse quence, over time, is a plethora of classifications, including ttold new,"

ttnew new," ad nauseam. Once a source of supply has been classified, its price is fixed, based upon the costs incurred in finding and produc ing it. This, its advocates explain, will enable the producer to recover his investment without allowing him an Hunearned windfall" profit-thus preserving incentive while preventing price gouging. Historical cost as a basis for de termining the necessary price to in sure incentive for futureinvestment isa fallacy. Investments must earn replacement costs if the product being generated is to continue to be supplied. If, during the time span that the investor is recovering. his original cost, the replacement cost of the necessary capital equipment doubles, the ttrecovered" capital will only purchase half the replacement resources. In an inflationary envi ronment, controls such as those im posed in the rolled~ in price system 94 THE FREEMAN February result in the consumption of capital.

This consumption of capital will in evitably result in shortages and di minished future potential. Capital Punishment The long-term consequences of price controls and rates of return based upon historical cost have been dramatic. The inability of regulated firms to earn replacement costs on their investments in capital equip ment has led to continual trips to the capital markets. This heavy bor rowing has boosted debt/equity ratios, raised the cost of borrowed funds, and lowered the credit rat ings of the heavy borrowers. A sam ple of electric utilities showed a drastic decline in credit ratings in the ten years between 1965 and 1975. In 1965, 19 per cent of the utilities sampled had AAA bond rat ings. By 1975, there were none. It is an unhealthy trend, if the services provided by these firms are deemed to be necessary. It is obvious that the ((fair" rate of return policies have been inadequate to maintain the levels of service to which we have become accustomed. For example, in the decade of the 1960's, the average return on investment among Standard and Poor's 500 cor porations was nearly 13 per cent.

The average return on investment for oil and gas producers was 6 per cent-this despite the Federal Power Commission's nominally allowed rate of 15 per cent. Obviously, with such a ratio persisting over time, it is inevitable that capital will flow out of oil and gas produc tion and into other ventures. It is a sorry state when public policy has the effect of channeling scarce resources away from the pro duction of necessities in order to make them available for what may be considered more frivolous enter prises. However, the proposed re medy of mandatory credit allocation or government loan guarantees is no solution. Government absorption of available credit has been a large contributor to the problem. In 1960, government borrowings accounted for less than 13 per cent of total borrowings. By 1975, government borrowing amounted to more than 25 per cent of the total. Increasing government intervention into the credit markets, even for such seem ingly salutary purposes of securing funds to finance production, trans mission, and distribution of heating oil, natural gas, electricity, and the like, can only worsen this problem.

Need For Economic Calculation As regulation displaces the mar ket allocation of resources, the gov ernment will have no means of cal culating investment priorities, no means of assessing the cost/benefi t returns, no rational method of al locating resources. Government takeover of pipelines or government 1978 REGULATION AND ENERGY TRANSPORT 95 backed loans would not really lower the cost of financing. Such ma neuvers only result in shifting the burdens of finance onto third par ties. Economic goods have costs, re sources are limited. The selection of one set of alternatives precludes the use of those resources on another. Access to government credit or the Federal printing press does not create wealth, it merely transfers it from one holder to another. Under the complex system of reg ulation that pervades the economy, there ·is no way of knowing which transfers serve to redress and which serve to perpetuate imbalances and distortions created by previous waves of interventions. It is safe to say, though, that public policies will be conservative and cautious when it comes to innovations. The regula tory concept is inextricably tied to the continuation of the present into the indefinite future. In fact, one might go so far as to say that the idea of regulation cannot concep tualize innovation.

Each successive wave of transpor tation technology has found a sepa rate regulatory body set up to con trol all or part of a particular mode of transport. There is no comprehen sion of the generic service per formed by all modes. Consequently, there can be no comprehension of unforeseen methods of accomplishing the same ends. Public policy is firm ly founded upon this myopia. When new techniques come along, they are almost invariably opposed and, at the very least, delayed by regula tory policies. As the regulatory com missions intrude more and more into the economic activities of the nation, capital for innovative ven tures will disappear. Socially Unacceptable In the final analysis, the deliber ated controls that regulation seeks to insert as a substitute for market forces, far from being a stabilizing factor that aids long-term planning, have the effect of creating chaos and aborting l6ng-term planning. The multiplicity of government agen cies, bureaus, commissions and de partments, each having a veto over a regulated firm's proposed mea sures to meet the needs of its cus tomers, insures a lack of coherence to public policy. In the pipeline transportation system, some lines come under ICC regulation, some under FPC. It doesn't stop here, though, as other agencies-FEA, EIA, EPA and ERDA-playa direct role in blocking various operations of these transport modes. On top of this, the Federal Departments of Transportation, Commerce, Justice, Labor, and now Energy, each have their own fiefdoms of regulatory au thority. Add to this the various com parable state agencies and the judi cial system and it is plain to see that nothing will ever be done easily or 96 THE FREEMAN February quickly, if in fact it ever gets done at all.

The path of the regulated firm is strewn with obstacles. Cataclysmic changes in public policy on short notice are a frequent source of dis ruption to a firm's planning efforts. Short-term political considerations have also played a prominent role in the making of regulatory decisions. And it is not unusual to find that a business's rational efforts to provide for its future needs will serve as the impetus for government-imposed penalties. Firms which were perspicacious enough to anticipate the shortages of natural gas and make provisions for supplementary sources of power were among the first to be curtailed by regulatory mandate, while profligacy and lack of future planning on the part of others were rewarded by special dis pensation in government allocation decrees. Of course, the distortions brought about via the regulatory system are not confined to business firms. The ills of this system have spilled over into all segments of society, ag gravating social and economic prob lems. The price controls on sales of interstate gas have had the effect of encouraging industries to move out of the populous northern cities to relocate in the sun belt where in trastate gas is available. Left in the wake of this migration are worsen ing unemployment and economic decline in the central cities. Mean while, the ceiling on prices of domes tically produced oil and gas has had a net economic impact of shifting the production, and the jobs and capital that go with it, to overseas produc ers. This also aggravates un employment problems, creates mas sive debt obligations to foreign countries, and places enormous cap ital investment in areas vulnerable to capricious and unstable foreign regimes.

Why Proposed Remedies Are Bound to Fail Few people will deem these social and political repercussions desirable by-products of regulatory policy. Yet, the remedial actions currently under consideration hold forth no indication that anything has been learned from the unpleasant conse quences of past regulatory interven tions. On the one hand, the Carter Administration is proposing to penalize consumption,while many critics are urging subsidies to pro duction. Each of these measures alone uses only half of the market mechanism. Utilized together, we would enjoy the ludicrous charade of bureaucrats attempting to simu late market conditions by a com bination of taxes and subsidies. In their comprehensive study, The Economics of the Natural Gas Shor tage, 1960-1980, MacAvoy and Pin dyk demonstrate that of the options 1978 REGULATION AND ENERGY TRANSPORT 97 discussed, deregulation, by far, pro vides the most efficient solution to ending the shortages of natural gas.

A Iittle further down the line of ridiculous ((solutions" to regula tion-caused problems are the forced conversion to coal and the sharing of shortages. Spreading the shortages around will only serve to entrench the problem. Allocations by government dictate override the ability of anyone or any firm to plan for its own needs. Enterprise is stifled while everyone must await the latest government decrees. The incentive for foresight is diminished and reliance upon the vagaries of chance is propagated. Under prior ity systems which favor r~sidential use of gas, sections of the country will face 90 to 100 per cent curtail merit of industrial users by 1980. Coal cannot always be substituted for gas. But unemployment and re duced output can be, as the events of last winter have shown. The evidence is clear; regulation has produced negative conse quences. Misallocation, waste, un employment-all have regulation to blame for at least part of the problems. Acknowledging this, though, it is difficult to know where to begin.

So enormous is the mess that it is easy to imagine conspiracies that have perpetrated Hfake" shortages for sinister purposes. Unfortunately, this line of thinking has gained some credence. Energies that ought to be directed at dismantling the barriers to production and satisfac tion of urgent needs are, instead, directed at devising suitable punishments for the ((guilty." The prevention of ((windfall profits" has taken on such overwhelming dimen sions that its proponents seem pre pared to insure a net loss to society in order to guarantee that no one will gain inordinately from the widespread economic benefits that would follow even partial deregula tion. UntH the regulatory ills can be cured, or at least ameliorated, the prognosis for the industries involved will remain bleak, long-term plan ning an exercise in futility, .and so ciety forced to bear unnecessary economic costs without substantive benefit. @ Editor's Note: Mr. Semmens offers a 3-page bibliography of books and articles docu menting his study. That bib liography is available from The Freeman on request.