Cato Institute
1000 Massachusetts Ave, NW
Washington, DC 20001-5403

Phone (202) 842 0200
Fax (202) 842 3490
Contact Us
Support Cato
Regulation Magazine

The Cato Review of Business & Government

Public Utilities' Private Rights
Paying for Failed Nuclear Power Projects

Michael W. McConnell

Michael W. McConnell is professor of constitutional law
at the University of Chicago Law School.

The energy crises of the 1970s and early 1980s caused a major restructuring of energy producing and consuming industries as unprecedented scarcity gave way to unanticipated surplus. During the same period, safety and environmental regulations dramatically increased the cost of electricity from coal, oil, gas, and especially nuclear sources. In the electric utility sector those years left a legacy of partly built but unneeded power plants, and one unanswered question: Who will pay for them?

Investors who has sunk billions into power generating facilities with no alternative uses were at the mercy of intensely political bodies. In good times, politics smiled so warmly on utilities that regulators were said to be "captured" by the utilities they were supposed to be regulating. As long as demand outstripped capacity and regular infusions of substantial capital were needed to satisfy it, regulators had little choice but to pay interest and dividends at least commensurate with the risk. In bad times, though, utilities became a popular target for public resentment. Woe to the politician who defends the greedy and wasteful electric company against righteous consumer ire.

The past 10 years have been bad times, and all over the country regulators have left utilities without the revenue to repay investors for the cost of mammoth power projects-Shoreham, WPPSS, Grand Gulf, Braidwood, Pilgrim, Hope Creek, and Tyrone, to name a few. The most notorious case is the Public Service CO. of New Hampshire, which has been driven into bankruptcy over the seabrook project. Increasingly, utility lawyers have sought refuge in the Fifth Amendment of the U.S. Constitution: "nor shall private property be taken for public use without just compensation."

It has not been easy for utilities together their cases heard in federal court. Congress repealed the jurisdiction of lower federal courts to hear constitutional challenges to state rate making proceedings, leaving only the Supreme Court as a forum to hear these cases on appeal form state supreme courts. This discourages appeals, since the Court is notoriously reluctant to address complex economic and technical issues. Indeed, it has been 50 years since the Supreme Court last entertained a constitutional challenge to a state utility rate order. Meanwhile, the Supreme Court has rubber-stamped each state court decision in this field, without so much as asking for a brief or listening to an argument.

The Supreme Court's era of indifference to state utility ratemaking apparently ended last year. In a case involving the Wolf Creek nuclear power plant in Kansas, the Justices agreed to hear their first state ratemaking appeal in half a century. No doubt startled by this development, the state agreed to an out-of-court settlement before briefing or argument. That staved off a Supreme Court decision, but not for long.

This spring, the Court again agreed to hear a utility rate case, this time filed by two Pennsylvania utilities, Duquesne Light Company and Pennsylvania Power Company. Duquesne Light Company v. Barasch will be argued this fall and presumably decided early next year. Interestingly, several years ago the Court summarily dismissed appeals involving the same issues filed by Ohio utilities that had participated with Duquesne and Penn Power in the same canceled nuclear power project.

The Duquesne case is relatively small potatoes; the dispute involves roughly $4.4 million per year. But waiting in the wings is an appeal by Public Service of New Hampshire in the Seabrook case-a $2 billion controversy. Behind it lurk multi-million-dollar disputes in perhaps a dozen other states. The Court's dramatic decision to revisit the issue of state utility rates has summoned forth a blizzard of amicus briefs, mostly from governmental, consumer, and environmental groups. When the justices consider the matter, they will discover that the issues are as complex as the stakes are high.

The Utility Compact

Electric utility rate regulation is based on the proposition (only recently disputed) that the generation, transmission, and distribution of electric power is a natural monopoly. Economists dating back to Adam Smith have claimed that social welfare can be advanced by regulating the rates charged by natural monopolies. This has given rise to what is called the "utility compact." The government, usually a state or municipal franchising authority, grants the utility a protected monopoly in the distribution of electricity. In return, the utility commits to supply the full quantity of electricity demanded in the community, at a price calculated to cover all operating costs plus a "reasonable" rate of return on the capital invested in the enterprise. The first half of the deal protects the utility from would-be competitors, and secures for the public the substantial economies of scale available in the large-scale production of electricity. The second half counteracts the injurious tendency of monopolists to cut production below, and raise prices above, the levels that would prevail in a competitive market.

For many decades, the system worked tolerably well. Demand surged, doubling about every 10 years; larger and more efficient plants were constructed; real prices fell steadily, Looking back from the contentious present, the early 1970s was a period of astonishing harmony: regulators, consumer groups, and utilities, each for their own reasons, favored a common policy of expansion through large base-load generating facilities. In 1973 the Pennsylvania Public Utility Commission told the Duquesne Light Company that "this commission and other regulatory bodies consider essential the continuing construction of electric generating capacity to meet the energy needs of the public.... To protect the public interest, this commission has insisted that construction be accelerated and all feasible methods adopted to meet the present emergency." And under cost-plus ratemaking, the utilities had no incentive to resist further commitments of capital. Indeed, if-as many economists suspected-utility rates of return exceeded levels necessary at that low level of risk, then utilities had an incentive to overinvest in new power plants.

The almost universally favored source of increased production was nuclear power. At the time it seemed extraordinarily cheap, especially after the run-up in fossil fuel prices following the Arab oil embargo. Like the looming power shortage, however, the low cost of nuclear power would prove a fleeting illusion.

Nuclear power plants take 10 to 14 years to build, and by the time they had been completed the participants' expectations looked wildly optimistic. Energy price increases and a flat economy had stimulated conservation and slowed demand. At the same time, tightening safety regulation, construction delays, and skyrocketing interest rates pushed construction costs far above projections. The recently abandoned Shoreham plant, for example, cost 10 times more than projected. Plants that seemed urgently needed and inexpensive in 1973 were costly white elephants by 1983.

With demand falling, consumers' utility bills rising, and a convenient villain at hand, it became politically costly for regulators to honor the utility compact. Even where they did, the state legislature, the state courts (themselves often political), and voter initiatives often reversed them.

Useless Plants

An investment in electrical power can go sour at any stage of power plant construction and operation. The Duquesne case involves only pre-construction costs-principally engineering and siting studies-preparatory to the building of four nuclear power plants. In 1980, even before obtaining a construction permit from the Nuclear Regulatory Commission, Duquesne Light Company canceled the project because of cost increases and declining demand. Its share of the pre-construction costs was $34,697,289. After an investigation, the Pennsylvania Utility Commission determined that the utility's decisions both to initiate and to cancel the project were "prudent" when made. The loss was due to change of circumstances-not to negligence, mismanagement, or lack of foresight.

Duquesne was relatively lucky. Other nuclear projects have advanced well beyond the preparatory stage before the decision to cancel. The Hope Creek 2 project in New Jersey was 19 percent complete, at a cost of $419 million, when it was abandoned. The decision to abandon Long Island's Shoreham plant was not made until after construction was complete and initial low-power testing had begun-when political pressures made it impossible for the utility to commence production. Shoreham's price tag was $5.3 billion, not counting decommissioning costs. Similarly, New Hampshire's Seabrook plant is ready to commence production. Lacking only the agreement of Governor flukakis and ten Massachusetts towns to cooperate with required emergency evacuation planning, a $6 billion investment- almost 200 times Duquesne's-lies idle. More than 40 nuclear projects have been canceled or abandoned after expenditures ranging from $50 million to $5 billion each.

Even after plants are complete and operating, the recovery of costs can be disputed. Putting aside claims that construction costs were inflated by mismanagement (a different, though important, issue), state utility commissions sometimes decline to recompense utility investors for the full cost of new power plants. In the Wolf Creek case, for example, which was settled last year after the Supreme Court agreed to review the decision, the Kansas regulatory authorities decided that $1.2 billion of the investment represented excess capacity and denied any return to investors on that sum.

Power plants may even be completed and brought into service but later shut down because of accidents or fear of accidents. At Three Mile Island one plant is permanently closed because of an accident; a second, undamaged plant was closed for many years because of fears of a recurrence. For similar reasons, moves are afoot to close down nuclear power plants operating in Massachusetts and Oregon.

At whatever stage power plants are canceled or abandoned, the regulatory commission has three options. First, it can allow the cost of any prudent investment to be included in the rate base. The investment is then amortized over a given schedule, and interest and dividends are paid on the unamortized amount, just as if the project were successfully producing power. In industry parlance, investors receive both a return of their investment and a return on their investment. Second, the commission can disallow the investment altogether, giving investors neither a return on nor a return of their investment. The third alternative is to return the investors' principal through amortization over a period of years, but without any interest or dividends. Depending on the length of the amortization period, this alternative can result in the loss being borne mainly by the investors or mainly by the consumers.

In the Duquesne case, the Pennsylvania utility commission, following its own precedents, took the middle ground, allowing the utility to recover its investment in the canceled plants over a period of 10 years but denying any return on the unamortized amounts. The Supreme Court of Pennsylvania reversed and disallowed any recovery, based on its interpretation of a new statute forbidding the commission to include power plant investments in the rate base until the plant actually enters service for the customers. The question now before the Supreme Court is whether that decision violates the takings clause of the United States Constitution.

Ratemaking and the Takings Clause

From the beginning of utility rate regulation, the Supreme Court has held that:

This power to regulate is not a power to destroy, and limitation is not the equivalent of confiscation. Under pretense of regulating fares and freights, the state cannot require a railroad corporation to carry persons or property without reward; neither can it do that which in law amounts to a taking of private property for public use without just compensation, or without due process of law. Railroad Rate Cases (1886).

The "public use" condition is met because, through the franchise agreement, the government requires utility shareholders to devote their private property to a public use, the provision of electricity. Thus shareholders are entitled to a "just and reasonable" return on their investment, not merely because the phrase appears in the typical state statute, but because the federal constitution requires just compensation.

The "taking" in these cases can be visualized in three ways. First, there is a diminution in value of the investors' property when utility earnings are reduced. Cutting rates, without justification, effectively takes a portion of the investment and gives it to the consumers. This is analogous to what the courts have called "regulatory takings," where zoning or land use controls substantially reduce the economic value of a property.

Second, the taking can be visualized as the extraction of mandatory but uncompensated services. Under the franchise agreement, the utility is legally obligated to provide adequate and reliable service to all who demand it. Unlike a firm in an unregulated industry, the utility has no right to curtail investment or withdraw from the business, even if returns are unprofitably low. The situation is analogous to eminent domain, where the government condemns an interest in land, and must pay the market value in compensation. The difference is that here the government requisitions a service-the production of electricity-rather than land.

Third, and most compellingly, failure to provide a just and reasonable return on utility investments is a breach of promise. Investors commit their capital to the public service only on the understanding that they will be paid a return commensurate to the risk. When regulators secure investments on the promise of a low-risk return, and then shift the risk of changed circumstances onto the shareholder, they violate the implied terms of the agreement. In the Supreme Court's language, this frustrates the property owner's "reasonable investment-backed expectations.' This is analogous to a violation of the constitutional prohibition of "laws impairing the obligation of contracts. The Supreme Court has held that a state may not borrow money for public works and later increase the investment risk. (See United States Trust Company v. New Jersey, 1977.) The same principle should hold when the investment is made in a utility whose earnings are set by the state.

What Are Just and Reasonable Rates?

Historically, there have been two competing interpretations of the requirement for a just and reasonable return on utility investments: "prudent investment and "fair present value." Under the prudent-investment rule, investors are entitled to a reasonable return on the money they have invested in the utility, without regard to the value of the assets purchased with it. Under this approach, the only items excluded from the rate base are those portions of the investment that were imprudently incurred-an unexacting standard that precludes the application of hindsight.

Under the fair present value approach, the investor is entitled to a reasonable return on the current value of the physical assets devoted to the public service. If a project is useless, its current value is zero, and shareholders are entitled to no return. This aspect of the fair-value methodology is called the used-and-useful test: assets that are not "used and useful in public service" may not be included in the rate base. Under the fair-value approach, investors bear the risk of an investment going sour, but they also keep the gain if an investment is more successful than expected.

On average the two approaches should result in about the same returns to investors and rates to consumers. Consider an example. Suppose the it costs $1,000 to drill an exploratory natural g well, and that it takes (on average) three exploratory wells to find one producing well in a give field. Disregarding all other costs, what should the rate base be for a typical firm with 6 exploratory wells, 20 of which are successful Under the prudent-investment approach, the fin has invested $60,000, and is entitled to include the entire investment in the rate base. Under the fair-value approach, however, only the 20 working wells in the firm's portfolio are considered; the 40 dry holes are worthless. The value of each producing well is about $3,000, the amount a firm would have to spend on average to locate one producing well. Once again the rate base is $60,000 ($3,000 times 20).

While the two methodologies appear equivalent in static terms, they generate quite different incentives-and therefore quite different results. To see this, assume that finding natural gas is not wholly random in the sense that a well-managed firm will tend to find gas in, say, one out of every two attempts, while a poorly managed firm will tend to find gas in only one out of four attempts. If both firms make prudent investments in 60 exploratory wells (a $60,000 investment), the well-managed firm will find about 30 producing wells and the other firm will find only about 15. Under the fair-value approach, the well-managed firm's assets will be worth $90,000 and its shareholders will receive a "supernormal" return on their $60,000 investment. The poorly managed firm's assets will be worth only $45,000, and its shareholders will receive a "subnormal" return. By contrast, under the prudent-investment rule, both firms would have a rate base of $60,000, and shareholders would receive the same return. The inherent tendency of the prudent-investment rule, like all cost-plus pricing, is to remove incentives for cost reduction and efficient management.

The fair-value test more nearly replicates the outcome that would be achieved by the competitive process if problems of natural monopoly were absent. In competitive businesses, firms are not guaranteed a return on their investments, however prudent. They are able to command a return only on the current value of their assets. If, by dint of intelligent planning, hard work, or tuck, they create an asset that is worth more than their investment, they reap the gain. If poor planning, bad management, or bad luck reduces the value of their asset below its cost, they bear the loss.

For about 40 years, the Supreme Court mandated the use of the fair-value method. By the late 1930s, however, the Court ceased to insist on any particular methodology, apparently for three reasons. First, calculation of the fair value of utility property was speculative and subject to manipulation. The income stream of the firm cannot be used as a basis for valuation since the size of the income stream is set by regulation, which in turn depends on valuation of the rate base-a perfect circle. Accordingly, fair value generally was taken to mean reproduction cost minus depreciation-a figure dependent on the opinions of experts about how much it would cost today to build the facility. This speculative measure was an invitation to inconsistency and abuse. Second, the inflation of the early twentieth century caused reproduction values to rise well above historical cost. Fair value was perceived as too generous to utilities. Third, the prevailing regulatory philosophy treated capital as just one factor of production, largely divorced from management. Just as laborers on an unsuccessful project still expect to be paid, so do investors.

Prudent-investment ratemaking then gained ascendancy, though it was never mandated as a constitutional rule. As long as demand growth continued and there was little risk in power plant construction, the administrative advantages of the system seemed to outweigh its inefficiencies. The lack of incentives for cost control were submerged in the growing economies of scale. Indeed, a stable and consistent application of the prudent-investment rule enabled utilities to obtain capital at relatively low rates of interest and dividends. So secure was the utility compact that utility stocks became the quintessential conservative investment, suitable for grandmother's retirement fund. The returns were not large, but they were reliable.

For reasons already mentioned, the risk-reward calculus changed in the 1970s and early 1 980s. Power plant investments, though prudent when initiated, proved to be mistakes in retrospect. The response of many states was to take a critical look at the prudent-investment rule. "Why should shareholders be given a return on investments that turned out to be useless?" they asked themselves. Why indeed? And so they excluded from the rate base investments in facilities that were not "used and useful in the public service." On the other assets in the rate base the states continued to give no more than a "normal" rate of return, measured by the cost of capital. The legality of this policy is at issue in Duquesne.

Why Make Rates a Constitutional Issue?

The state's position in Duquesne is deceptively simple. The Constitution does not confine utility ratemaking to any particular formula; the result is what matters. The fair-value used-and-useful test, which once was the constitutionally mandated methodology, is still a permissible basis for rate base valuation. The takings clause does not require that shareholders be paid for investments that produced nothing and are worth nothing.

Focusing solely on the state's treatment of the canceled plants in Duquesne, this analysis is hard to dispute. The flaw in the argument, however, is that it fails to take into consideration the state's treatment of Duquesne's other investments. To use the gas well analogy, Duquesne is an average firm with a portfolio of 60 wells, one third of which are producing and two thirds of which are dry. Applying the prudent-investment approach to the 20 producing wells, the state concludes that each of them cost $1,000. But the state applies a different methodology-the fair-value used-and-useful test-to the dry wells. They are worth nothing. Consistent application of either methodology, as shown above, would result in a rate base of $60,000; the state's mixed methodology results in a rate base of only $20,000.

Selective application of the fair-value approach imposes the burden of risk on Duquesne investors, with no corresponding reward. As the cost of building new power plants has increased, the value of existing plants has appreciated. Rather than build a new nuclear power plant for $6 billion, a firm in need of additional capacity would happily purchase older plants for a price well above historical cost. But the utility commission allows a return only on the historical cost of those plants, not on their higher current value.

Moreover, while the supply of electricity currently outstrips demand, depressing the value of generating facilities, these conditions are likely to reverse within the decade (or sooner, if hot weather patterns continue beyond 1988). When this happens, the value of generating facilities will rise again. If unsuccessful investments at times of depressed demand are to be valued according to their current market value, successful investments in times of shortage also must be valued on that basis. The "supernormal" profits in good times and on successful investments will counterbalance the "subnormal' profits in bad times and on failed plants. The taking in Duquesne is not the state's disallowance of the costs of the canceled plants; it is the state's imposition of a one-sided risk, without any compensation for it.

In addition to its constitutional problems, the state's approach in Duquesne makes terrible public policy. This is a game that can be played only once, and consumers will pay the price for many years. Since utilities bear the risk of capital investments, but consumers bear the risk of underinvestment, the regulatory policies of the past decade have created a strong disincentive for new construction. It is smarter, under the circumstances, for utilities to fulfill service obligations by purchasing excess power on the wholesale market. Under federal law, state regulators must allow utilities to pass the cost of wholesale power on to consumers, and consumers therefore bear a substantially increased risk that they will pay exorbitant spot market prices for electricity during the next shortage, with no new power plants to cushion the blow.

Underinvestment today may produce shortages as well as high prices in the future. The social costs can be enormous, as the Northeast's experiences with black-outs and brown-outs attest.

To avoid shortages and high spot prices, consumers will have to pay more in the future to attract capital. Past investors have been trapped, but future investors will not provide capital without full compensation for the risks they assume. Even if the regulators promise a restored utility compact, investors will perceive-and demand compensation for-the risk that future regulators will react to future cost increases by again expropriating the sunk investments of utility shareholders. The utility compact has been broken once; it can be broken again.

Only a promise that binds can restore confidence in the utility compact. That is why a constitutional decision is so important. No regulatory commission or state legislature has the power to bind its successor. The states therefore have no credible way to reduce regulatory risk. A constitutional rule forbidding a selective reallocation of risk would restore the compact. It would enable utilities to raise capital on more favorable terms, thereby making future investment more attractive and future electrical supplies more affordable and secure.

The De Minimis Argument

Hoping to avoid a Supreme Court ruling in favor of the utilities, the state and its amicus supporters offer a fallback position: that constitutional standards come into play only when the taking is a sizable percentage of the total investment. Duquesne's $3.4 million per year claim is "minimal," they say, when compared to its annual revenue of $802 million. A more extreme version of this argument holds that the utility must be driven virtually to the point of bankruptcy before the possibility of an unconstitutional taking can be considered.

It would be nice to be able to dismiss these arguments out of hand. They amount to the proposition that taking from a rich man is not really a taking, since he has so much left. They would justify seizing one acre of a 100-acre parcel to build a post office, and refusing to pay compensation on the ground that the landowner's other 99 acres were undisturbed.

Unfortunately, there is precedent-mostly in the field of zoning and land use-for the claim that government regulation is a taking only if it deprives the property of virtually all viable economic use, It is possible that the Supreme Court will extend these precedents to the field of utility ratemaking. But this would ignore the origin and rationale of the "no viable economic use" principle. The principle of zoning is that each landowner gains, on average, from enforcement of a coordinated plan for land use in the area. This 'average reciprocity of advantage" is a form of in-kind compensation for the zoning restriction. Since this reciprocity of advantage can be measured only in the roughest of terms, the courts generally presume the gain to each landowner instead of imposing the burden on zoning officials to prove it. An exception is created, however, for the extreme case, where the effect of the zoning ordinance is to deprive the landowner of all viable economic use of his property. At this extreme, it is clear that the landowner has received no reciprocal gain, and is therefore entitled to compensation. This theory, which is the source of considerable abuse even in the zoning area, is obviously inapplicable to utility ratemaking, where "average reciprocity of advantage" is not an issue.

The Utilities' Argument

Despite the powerful case that can be made against the selective reallocation of risk by state regulatory commissions, lawyers for Duquesne Light Company and Pennsylvania Power Company have made the strategic decision to lead with a less sweeping argument, based on process rather than substance. They contend that the statutory used-and-useful test is inconsistent with the free-wheeling "balancing" of consumer and investor interests they say is required by the Constitution: "A state ratemaking agency must possess under state law sufficient discretion within the boundaries of its ratemaking authority to balance investor and consumer interests and thereby produce a constitutional end result." In effect, they say the state legislature has kept the Public Utility Commission on too short a leash. Moreover, their prayer for relief is confined to the modest claim for a return of investment over a period of years, without interest or dividends.

Sometimes a cautious litigating strategy is best. But in this case, the utilities' less confrontational argument may play into the hands of their opponents, who wish to avoid a clear statement of constitutional principle. As a constitutional standard, "balance" would effectively preclude judicial review of regulatory results. Moreover, the argument that state legislatures must delegate unbridled discretion to an administrative agency to make rate determinations is not a persuasive reading of precedent or of constitutional purposes. Generally, the federal constitution does not impose any particular form of organization on the states; they are free to allocate state powers among their governing institutions as they see fit. It is difficult to see a contrary principle in the takings clause.

A more compelling analysis of the problem appears in an amicus brief submitted by the Pennsylvania Electric Association (the trade association of investor-owned utilities in the state), which was written by former Solicitor General Rex Lee. The association condemns the statutory scheme for its selective allocation of risk, noting that Pennsylvania has mandated the "principle of 'heads the utility loses, tails the ratepayer wins.'" It insists that Duquesne and Penn Power "have a federal constitutional right to a recovery of, and on, the over $50 million investment that they prudently made to discharge a statutory duty to the public."

Unfortunately, the association's proposed alternative constitutional standard would be a step backward for utility ratemaking. The association urges the Court to adopt, as a "constitutional benchmark," the prudent-investment rule. While it is true, as the association states, that this rule would "secure constitutional values" in a way that neither the state's nor the utilities' position would do, it is also true that the prudent-investment rule is bad policy.

It is understandable why an association of utilities would recommend restoring the prudent-investment rule. It is the safe, low-risk alternative. But the prudent-investment rule freezes into place all of the well-known inefficiencies of cost-based ratemaking. It makes no use of competitive pressures or financial incentives to hold utility costs to a minimum, to improve utility performance, or to force the utility to balance the risks of over-and underinvestment.

Consumers are justifiably indignant when they see electric utilities spend billions of dollars on uneconomic plants and excess capacity, and then find that they, the consumers, have to pay for it. In a free economy, investors bear the risk of their investments. Prudence is no excuse for failure. If the logic of the regulatory system demands that investors be shielded from investment risk, popular opinion will demand that the logic of the regulatory system be changed, to bring it more into line with free-market principles. From the point of view of the consumer, as well as of economic efficiency, it would be a great misfortune if the Supreme Court mandated a return to "prudent investment."

Fair Value: The Competitive Alternative

It is not the place of the Supreme Court to set regulatory policy for the 50 states. Each state should be free to choose among the various ratemaking methodologies, of which prudent investment and fair value are the most prominent, to determine which best promotes the public interest. But a state should not be free to apply different methodologies to different investments-unless it has announced its intentions clearly and in advance, so that investors are able to demand and obtain an appropriate risk premium. Nor should a state be free to flip back and forth from one method to the other, choosing the method that gives the lowest return. Consistent application of the prudent-investment rule, as proposed by the association, would satisfy this test. Far better, from the standpoint of regulatory policy, would be for state regulatory commissions to return to a version of the fair-value test.

There is every reason to believe that many, perhaps most, states would move toward the fair-value test if the option of selective reallocation of risk is declared unconstitutional. In the short term, the fair-value approach would usually produce lower electric rates than the prudent-investment rule, since the market for power is currently depressed. (Rates would rise over the next decade with increasing demand, since virtually no new capacity is under construction.) In the longer term, this approach would generate incentives for more efficient planning and operation. The prudent-investment rule offers no incentive to avoid overinvestment, while the used-and-useful test offers no incentive to avoid underinvestment. Only the fair-value approach guards against both risks.

While the fair-value test may have been impracticable when it first was tried, the emergent market for wholesale electric energy now provides an objective basis for determining value. There is no longer any need for speculative estimates of hypothetical construction costs. The value of an asset in any given year is equal to net expenditures that would be incurred if it were not for the existence of the asset. A power plant with a capacity of 1,000 kilowatts is worth the cost of purchasing a constant supply of 1,000 kilowatts from the cheapest alternative source, minus the operating cost of the plant.

One of the greatest advantages of moving back to a fair-value ratemaking methodology is that it will facilitate the transition to a competitive market in generation. So long as rates are based on prudent investment, certain groups-either utility investors or consumers, depending on the circumstances-will resist this transition, because the result of competition will be to take away their legal right to either a supernormal rate of return (on present value), or to subcompetitive electric rates. The ultimate solution to electricity pricing is to restructure the industry along competitive lines, separating generation from distribution. (See Vernon L. Smith, "Currents of Competition in Electricity Markets," Regulation, 1987 Number 2.) In the meantime, a fair-value ratemaking methodology will approximate the rates that would prevail under competitive conditions, while guarding against the ills of monopoly, so that when competition becomes viable there will be less entrenched resistance to deregulation.

The takings clause of the Fifth Amendment anticipates that government officials, from time to time, might find it expedient to infringe private property rights, and that the victims would not be able to protect themselves in the political process. Besides protecting individual rights, however, the takings clause also promotes the long-term public interest in a competitive economy. Properly applied, it enables states to make the credible, enforceable commitments upon which major investments depend.

For the first time in 50 years, the Supreme Court has the occasion to apply these principles to an industry at the core of our industrial economy. By reversing the action of the Pennsylvania regulators in Duquesne, it could restore the utility compact, secure future energy supplies at lower long-term costs, and ease the inevitable transition to a competitive electrical power industry.

Subscribe to Regulation