Public utilities in the energy industry

Summary: Public utilities are essential services provided by the government to citizens, either directly through the public sector or indirectly by financing private provision of services subject to regulation.

The term utility usually means a company that maintains the infrastructure for a public service, often providing a service using that infrastructure. Opinions differ as to the characteristics that an industry must possess to merit classification as a public utility, since all industries in a sense serve the public.

Originally, the concept of a public utility originated in the United States as a means of providing the government and social controls required to prevent abuse of private market power by firms supplying essential services in energy, water, the environment, sanitation, health, education, transportation, infrastructure, information, and knowledge.

Public utilities can include economic infrastructures, such as those supporting telecommunications, electricity, gas, water, postal services, and transportation (roads, railways, buses, ports, airports, and so forth), and social infrastructures, such as education and health. These utilities satisfy the vital needs of large populations, and their absence would negatively affect public health and welfare. They are therefore “public goods,” resources that are collectively owned or shared between or among populations; hence, they are affected by “externalities.”

These essential services provided by government are “institutional commons” and belong to the larger category of “commons,” which include biodiversity, physical or environmental commons, and the knowledge commons. The commons are fundamental for the sustainable development of a community, in terms of endurance, independence, and identity. Because of the intrinsic nature of these essential services, Adam Smith’s well-known metaphor of the invisible hand, arguing for the free markets, does not work well.

Public utilities in the energy industry in the 2020s faced pressure to reduce their carbon footprint and work to achieve net zero in the coming decades. Utilities had to combat additional competition as small renewable energy firms emerged, such as solar and wind power companies. To manage renewable energy sources, public utilities needed to expand their infrastructure.

Public Control and Regulation

The existence of commons requires that people operate on a collective rather than an individual basis, as magnificently highlighted by Garrett Hardin in his 1968 essay “The Tragedy of the Commons.” This pioneer study demonstrated the dilemma underlying the concept of commons, arising from the situation in which multiple individuals, acting independently and rationally and consulting their own self-interest, will ultimately deplete a shared limited resource, even when it is clear that it is not in anyone’s long-term interest for this to happen. As a result, public utilities are usually subject to forms of public control and regulation, ranging from local community-based groups to statewide government monopolies. The first typology includes cooperatives, usually found in rural areas. Cooperative utilities are owned by the customers they serve.

Publicly owned utilities are often government monopolies, because it is very expensive to build and maintain the infrastructure required to produce and deliver these services. As such, public utilities are not prevented by competing companies from charging exorbitant prices. These utilities usually operate under a license or franchise whereby they enjoy special privileges, such as the right of eminent domain.

Investor-Owned Utilities

Private utilities, or “investor-owned utilities,” are owned by investors. Unlike public companies, private utilities may be listed on stock exchanges. Private, in this context, means not owned by the public or the government.

In most European nations, utilities have often been owned by the state, although many have been privatized in recent years. In addition, the network infrastructure used to distribute most utility products and services has remained largely monopolistic. In the United States, however, many public utilities are privately owned. If privately owned, the sectors are specially regulated by public utilities commissions, such as the Federal Energy Commission, the Nuclear Regulatory Commission, the Federal Communications Commission, and the Securities and Exchange Commission.

A concern about public ownership is the governments’ lack of economic orientation. Governments demonstrate paternalistic or political behaviors insofar as they seek to protect employment. In some countries, government or state provision of utility services has therefore resulted in inefficiency and poor service quality. It is well known that public ownership generates inefficiencies, because it encourages governments to subsidize money-losing firms. Since less efficient firms are allowed to rely on government funding, they lack the financial discipline required for efficient management. By hardening the firm’s budget constraints, privatization helps restore investment incentives. The transfer of public to private ownership is therefore often advocated as a remedy for the poor economic performance of public enterprises.

and Privatization

In the 1990s, state regulators began to end utilities’ monopolies by permitting business and residential consumers to select utilities (primarily electricity and gas suppliers) based on rates and services. However, such deregulatory efforts have not always resulted in lower rates. Privatization of public utilities from traditional government monopolies has also started to take place as a consequence of recent developments in technology of services, such as electricity generation, electricity retailing, and telecommunication. As a result, new services and lower prices were often introduced. Increased competition among investor-owned utilities also has led to mergers and acquisitions and a concentration of ownership.

Privatization brings well-known economic costs when industries are characterized by strong economies of scale. Infrastructure and utility owners benefit from market power. By giving up the direct control of firms’ operations, governments lose control over prices, to the disadvantage of consumers.

Rates are subject to review by the courts, which have held that they must provide a “fair” return on a “fair” valuation of investment. The commission holds public hearings to help decide whether the proposed schedule is fair. That a utility may not earn excessive profits is an established principle of regulation. The means of regulation include supervision of accounting and control of security issues. The commission may also require increased levels of service from the utility to meet public demand.

Government plays an important role in ensuring safe operation, reasonable rates, and service on equal terms to all customers. Many politicians and economists argue that the marketplace, not government regulation, should determine utility prices. Many consumers also seek lower prices through deregulation. The real debate today is about finding the right balance between the market and government (including the third “sector,” nongovernmental nonprofit organizations).

The privatization decision depends on the value of opportunity costs of public funds and on profitability in the market segment where the firm operates. Since the opportunity cost of public funds is higher in developing countries than in developed countries, optimal privatization policies are likely to differ between those countries. In poorer developing countries, public utilities are often limited to wealthier parts of major cities, but in some developing countries utilities do provide services to a large share of the urban population. In countries such as those of Latin America, liberalization, competition, and regulatory policies are very recent developments. The empirical evidence is limited and case studies offer the only scientific approach available. Although the economic theory relevant for developing countries is still very vague, some general considerations can be provided, as follows:

• A public firm is the natural option in a low-density area, typically secondary road or electrification projects. This market segment can have a such low profitability that no private firm is able or willing to cover it.

• Privatization with price liberalization dominates regulation if the opportunity cost of public funds is large enough. Examples can be found in Africa, where urban dwellers (the middle class and the poor) rely on private providers for water service. In the telecommunications industry in Africa and in Latin America, privatization combined with an independent regulation does yield improvements.

• Privatization of profitable public utilities, such as fixed lines or international telecommunications services, is not efficient in very poor countries, which are plagued with financial problems and welcome the potential revenues that can be extracted from a public firm.

• Privatization with price liberalization is not optimal when the market is so profitable that a second firm is able to enter the market.

Bibliography

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Booth, Adrian et al. "Winner Takes All? Digital in the Utility Industry." McKinsey & Company, 27 Mar. 2023, www.mckinsey.com/industries/electric-power-and-natural-gas/our-insights/winner-takes-all-digital-in-the-utility-industry. Accessed 31 July 2024.

Hardin, Garrett. “The Tragedy of the Commons.” Science 162, no. 3859 (December 13, 1968).

Lai, Loi Lei. Power System Restructuring and Deregulation. Hoboken, NJ: Wiley, 2001.

Miller, E. S. “Is the Public Utility Concept Obsolete?” Land Economics 71, no. 3 (2009).

Warkentin, Denise. Electric Power Industry in Nontechnical Language. Tulsa, OK: PennWell, 1998.