Policies of price regulators in periods of high or increasing costs and their potential long-term effect on investment: The case of the electric utility industry in the 1970s and 1980s

This study presents and estimates a model of electric utility regulation during periods of high or rising costs. Regulators are viewed as utility maximizers, whose utility function is influenced by political pressure from consumers and the regulated firms. The model can also be interpreted as a reduced form bargaining model. Although regulators have frequently been modeled in the theoretical literature on regulation as having a well defined utility function, this is, to my knowledge, the first empirical study of electric utility regulation that takes this approach. This study also uses a far larger data set than previous studies on electric utility regulation. It is found that policies like those carried out by price regulators during the 1970s and 1980s can potentially lead to serious underinvestment. This underinvestment result applies to all states in my sample. The underinvestment bias, however, is likely to be mitigated if high cost periods are short in duration. Based on the estimation results of this study, states are ranked according to the regulatory climate for the regulated firms. Regulatory policies between states differed significantly. Policies like those in states with the least favorable regulatory climate appear likely to frequently jeopardize utilities' financial position during high cost periods, whereas policies in states with average to good regulatory climate (relative to my sample) are much less likely to do so. This study also examines the effect on regulatory policies of a few political variables commonly included in studies of electric utility regulators. The effect of these variables is found to be negligible. This result, as well as the underinvestment result and the ranking of states according to regulatory climate, is in general agreement with previous empirical work.