Why Public Utilities Should Ignore Externalities

Janice A. Beecher* (beecher@msu.edu)

Spurred by the urgency of global climate change response, many an environmental activist has urged individuals and corporations to take into account the externalities associated with their actions.  A popular movement is to increase awareness of the ecological footprints associated with human activity, particularly the consumption of energy, water, land, and other resources.  Conventional currencies do not measure the full force of human consumption on the environment.  The reality that prices fail to capture externalities associated with today’s usage, which passes burdens to future generations, is a source of understandable frustration for advocates of environmental responsibility and sustainability.  Nonetheless, the heretical conclusion drawn here is that public utilities for the most part should ignore externalities.

 

Externalities as Market Failure

Externalities are among the archetypical forms of market failure (along with the existence of public goods, the challenge of managing the commons, the asymmetry of information, and the presence of monopoly).  Also known as spillover effects, and related to multiplier effects, externalities are costs and benefits that are not reflected in the normal market-based exchange of prices for goods or services between buyers and seller.  That is, indirect or diffuse costs and benefits of production and consumption can extend well beyond the immediate parties to, and timeframes of, transactions.  Positive and negative externalities essentially extend, defer, shift, or “socialize” benefits and costs, including opportunity costs and risks.  Various forms of ambient pollution (water, air, and noise) are prime examples.  Indeed, “noise” is an ideal metaphor for the problem of externality.

Externalities raise complex issues of culpability, compensation, and efficiency.  Externalities distort economic behavior, which in turn distorts resource allocation.  By definition, externalities have distributional consequences because someone’s gains come at someone else’s expense.  Estimating the economic value of externalities is imprecise, potentially arbitrary, and often controversial with regard to appropriate metrics (e.g., contingent valuation).  The calculus is easily biased by picking and choosing among negative and positive effects.  Controversy also arises over whether responsible parties should be penalized for the offense or compensated for the remedy.  Externalities are ubiquitous, and even with remediation, residual externalities remain in the economic system (that is, markets are perpetually imperfect).

Economists have recommended different methods for addressing externalities (see Externalities).  Expounding on Alfred Marshall (1890), Arthur C. Pigou (1932) argued for imposing taxes on activities resulting in negative externalities and awarding subsidies for activities resulting in positive externalities.  Ronald Coase (1960) posited that negative externalities are resolved or self-corrected through exchange if rationality prevails, property rights are well defined, and transaction costs are negligible.  These, of course, are conditions associated with “perfect competition” that are difficult to meet in the real world.  An efficient result does not require assigning liability.  In an imperfect world of positive transaction costs, efficiency is affected by how the legal system delineates rights.  In the Kaldor-Hicks rendition, compensation must be possible, but is not required to effectively account for an externality.  If market participants agree to a compensation mechanism, the designated “externality” is essentially “internalized” and in effect is an externality no more.  Conflicts that can be resolved by market exchange might not actually constitute true “externalities” in the first place.  Some environmental costs may be confined locally to parties engaged in exchange, and may be more properly defined as direct environmental impacts.  With regard to pollution, water-quality impacts can be more localized than air-quality impacts, although externalities clearly are problematic for both forms of degradation.

When transactional means fail, economists tend to view incentive-oriented methods as more efficient and effective than command-and-control policies.   Under some circumstances, command-and-control regulation is absolutely necessary for ensuring public welfare, social justice, and civil liberties, but incentive systems have a place as well.  Taxes, as well as permits and fees, are a form of pricing and prices guide economic choices.   A carbon tax, for example, places a price on greenhouse gas pollution, which facilitates cost allocation and pricing and also generates revenues for programs of compensation or remediation.  Cap-and-trade policies go further in addressing externalities by establishing a system of market exchange to promote optimal solutions.  Taxing, capping, and trading are superior to commands, controls, and subsidies that favor particular technologies, where regulators take on the considerable risk of choosing poorly.  Under market-oriented methods, private capital will migrate to economical and innovative approaches.  By achieving environmental goals more efficiently, social resources can be spared for other pursuits.

True externalities cannot be adequately assimilated by the market, self-regulation, or noble individual choices.  The presence of externalized benefits means that some services will be undersupplied by the market; the presence of externalized costs means that some services will be oversupplied by the market.  Individuals or corporations cannot realistically be expected to resolve externalities of their own accord.  Rational, self-interested market participants (sellers or buyers) will not voluntarily absorb costs or provide compensation because they are averse to placing themselves at a competitive disadvantage.  Firms and their investors are generally unwilling to sacrifice profits, lose market share, and drive price-sensitive customers elsewhere.  Socially beneficial or “goodwill” investments will be made only to the extent they also serve the brand’s financial interests.  Despite the rhetoric of a “triple bottom line” (people, planet, and profit), the latter will prevail.  Moral suasion, or appeals to “do the right thing,” have a limited and largely inadequate effect (see Reich, 2007).  In fact, persistent moralizing and calls for individual action can deflect attention from the hard work of responding meaningfully to externalities.

True externalities pose “wicked problems” (Rittel and Webber, 1973) and are addressed more effectively, efficiently, and equitably through collective action and the legitimacy and accountability of the state.  Redressing market failures and aligning private and public interests is in many respects the very purpose and essence of governance (see Reich, 2007).  Government’s tools for intervention include various systems for regulation, taxation, and subsidy that essentially put a price on externalities and compel market participants to change their behavior.  Given political will, democratically established policies and rules can impose and allocate burdens to all market participants for the greater good.  Indeed, only government can attend to the broader distributional consequences of both externalities and their solutions, including the withholding or allocation of resources.  Global externalities, such as climate change, necessitate owning the problem and solution at the national and international scales.

Externalities and Utilities

Arguably, no sector of the economy draws attention to externalities more than public utilities, perhaps due to their considerable footprints.  Utilities are a special case because the challenge of externalities is complicated by the presence of monopoly.  Public utility services are imbued with both positive and negative externalities, and a fair system of accounting considers both effects.  Positive externalities can be found in improved public health, safety, and welfare, which in turn support social and economic development.  Electrification, communication systems, and access to safe drinking water and sanitation enhance wellbeing and productivity.  Utilities and their suppliers also contribute substantially to economic output and employment.  Times of war and crisis illustrate the immediate and ongoing civil unrest that follows major disruptions of essential services.  Lack of services contributes to the human suffering that weighs heaviest on society’s least advantaged members, often including women and children.

Externality discourse almost invariably focuses exclusively on the negative; that is, the deleterious effects of consumption.  Negative externalities associated with utilities are primarily in the form of environmental degradation, exacerbated by scale and neglected in prices based on accounting costs.  The monumental problem of global climate change is perhaps the quintessential externality associated with greenhouse gases from fossil fuels used in energy production.  Utilities form networks that also are associated with both positive externalities (e.g., connectedness) and negative externalities (e.g., interdependency).

Utilities can and do consider environmental impacts and constraints in planning and ratemaking.  Utilities must comply with a variety of environmental standards and regulations.  Indeed, efficiency is well served by providing protective standards and appropriate incentives for meeting them at least cost.  Obviously, utilities tend to prefer certainty and stability in standards so that they can invest accordingly, but they are largely indifferent to stringency if cost recovery is ensured.   In fact, many standards provide regulated utilities with substantial investment, and, therefore, investment-return opportunities.  Beyond compliance, utilities might consider prospective standards when weighing and hedging resource options in the context of established processes for integrated resource planning.  The explicit application of environmental “adders,” however, can be distorting (see Joskow, 2002).  Utilities can also incorporate environmental considerations in rate design.  For example, prices based on marginal-cost principles will reflect cost escalation associated with resource constraints.  Nonetheless, rate design should be revenue neutral; once revenue requirements are established, rates should result in no more or less than the utility’s budgeted needs.

An obvious way to reduce environmental impacts is to reduce usage.  Some advocates believe that utilities should be in the conservation business, whereby they intentionally induce customers to use less of the product they supply either through prices or programs.  Efficient consumption has obvious social benefits, including resource preservation and externality reduction.  Conservation, however, can be at odds with business purposes and incentives, which is why many utilities have asked for extraordinary methods of compensation (such as decoupling sales from profits).  The role of public utilities in sustainability (wise use) is actually much clearer than for conservation (less use).  Rather than conservation, modern utilities should be expected to practice prudent load management for optimal infrastructure operations.  Efficiency-oriented investments and expenditures should be judged on the basis of avoided cost, as compared to environmental benefit.

In pursuit of protection and preservation, environmental activists also call for utility prices that reflect the “true” cost of service, including externalities.  Economic efficiency argues for prices that are neither below nor above total accounting costs, including returns sufficient to maintain the financial viability of the utility.  Both under-pricing and over-pricing are socially injurious.  Prices that are too low encourage excessive or wasteful usage, and can lead to excess capacity investment.  Prices that are too high discourage use and result in undue deprivation and harm, particularly consumer welfare loss and economic drag.  Just as under-pricing can be an insult to the planet, over-pricing can be an insult to the people who live there.

As monopolies, utilities cannot arbitrarily inflict prices that attempt to estimate and capture environmental externalities.  Logically, if utilities seek to address negative environmental externalities by assuming costs, they should also seek remuneration from beneficiaries of the positive externalities that flow from safe and reliable utility services.  The impracticality of this idea illustrates the futility of managing externalities at the individual utility level.

Utilities and Economic Regulation

Central to economic regulation is the idea that captive customers of monopolies lack choices and must be protected from monopoly abuse, including excessive, discriminatory, and capricious behaviors.  Customers can take their business elsewhere if they disagree with a competitive company’s business practices; utility customers have no such recourse.  For example, utilities may voluntarily choose to provide or purchase cleaner power at costs higher than conventional alternatives, but ratepayers will bear the burden of higher prices while benefits accrue to a larger social group.  The rates of the “greener” utility will compare unfavorably to those of other utilities, whose customers will be free riders.  The effective subsidy may be encouraged and rationalized on the basis of negative externalities (e.g., emissions) or positive externalities (e.g., jobs), but it also weakens market signals and performance incentives.

Utility regulators are concerned about environmental impacts because utilities make choices about costs, including those related to environmental mandates and activities that go beyond standards, but that are consistent with sound business practices and rational to the extent costs yield net benefits for consumers.  Regulation or public ownership substitutes for competition and holds monopolistic utilities accountable.  Regulators apply established legal standards to evaluate whether utility investments and expenditures are “prudent” and “used and useful” to customers, and whether resulting rates are “just and reasonable.”

Publicly owned and nonprofit utility systems are distinct in that they are democratically controlled and regulated at the local level.  Communities should generally be free to choose whether and how to respond to externalities and other market failures through pricing and other policies.  Obviously, however, a local response should not shift costs or risks to outsiders.  Even the most sincere community will face potential criticism for self-incurred costs that undermine economic prosperity and price competitiveness.  Again, any voluntary and delimited response is likely to prove inadequate for a problem of much larger scale.

The cost of compliance with established environmental standards is legitimately recovered from utility customers through rates.  Prices based on direct compliance costs serve to internalize at least some externalities and thus promote efficiency and equity, as well as sustainability.  All utilities, however, must be cautious about expenditures made in the absence of an authoritative government mandate, an established policy or standard, or the clear consent of ratepayers, regulators, and governing boards.  Similarly, legislators and regulators should be cautious about policies that may disadvantage some utilities over others.

A utility’s revenue requirements are comprised of approved budgetary obligations.  Revenues collected in excess of requirements are exploitive, even if promised to social causes or environmental remediation.  Monopoly pricing above cost extracts rents from price-inelastic consumers of essential services.  Abuse of monopoly power is as much a problem for publicly owned systems as for privately owned systems.  For publicly owned utilities, pricing above cost is essentially a hidden tax that would best be more transparent.  For privately owned utilities, excessive prices should trigger a regulatory investigation of excessive rates and earnings.

Environmental expenditures, like other expenditures related to service provision, are subject to regulatory review and potential disallowance in ratemaking if found to be excessive, unnecessary, or too lax with respect to cost control.   Expenditures that are disallowed by regulators flow “below the line” and are paid out of shareholder profits.  Even expenditures on activities generally perceived as social “goods” (such as environmental preservation or community charity) must comport with prevailing standards of regulatory review.  Seemingly innocuous contributions may be disallowed by regulators because it cannot be presumed that all customers of a monopoly would choose to support the same cause if they had a choice, as they would under competitive conditions.

Conclusion

In sum, utilities should ignore externalities for three principal reasons.  First, externalities associated with utility services are ubiquitous, complex, and largely incalculable for practical purposes.  Second, a meaningful response to true externalities requires collective over individual action.  Third, utilities are mostly monopolies that must be held accountable for spending the resources of captive customers.  Externalities are best addressed through broad democratic mandates where all market participants share in both burdens and benefits, and where distributional consequences are properly considered.

This is not to say that public utilities should neglect the natural or social environment.  Indeed, they should inform policy discourse and meet emerging standards with all due diligence.  In essence, however, externalities are not their problem, but ours.

 

References

Coase, Ronald, “The Problem of Social Cost.” Journal of Law and Economics 3: 1 (1960): 1-44.

Externalities.   http://www.econlib.org/library/Enc/Externalities.html.

Joskow, Paul L., “Weighing environmental externalities,” The Electricity Journal, 5: 4 (May 1992): 53-67.

Marshall, Alfred, Principles of Economics (London: Macmillan, 1890).

Pigou, Arthur C., The Economics of Welfare, 4th ed. (London: Macmillan. 1932).

Reich, Robert, Supercapitalism: The Transformation of Business, Democracy, and Everyday Life (NY: Alfred A. Knopf, 2007).

Rittel, Horst, and Melvin Webber, "Dilemmas in a General Theory of Planning," Policy Sciences 4 (1973): 155–169,

 

 

* Professor and Director, Institute of Public Utilities, Michigan State University, W157 Owen Hall, MSU, East Lansing, MI, 48825, (517) 355-1876, ipu.msu.edu, beecher@msu.edu.  Comments and suggestions from William Knudson, Kenneth Rose, and David Wagman are gratefully acknowledged.

 

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