OBSERVATIONS ON AFFILIATE RULES

Kenneth W. Costello
Associate Director for Electric and Gas Research
THE NATIONAL REGULATORY RESEARCH INSTITUTE

for

Federal Trade Commission Workshop on
Market Power and Consumer Protection Issues
Involved with Encouraging Competition in
the U.S. Electric Industry

Washington, D.C.

September 14, 1999


OBSERVATIONS

Affiliate rules are being debated in a belligerent environment where different interest groups are exploiting the political or regulatory process to gain favorable treatment. The debate over affiliate rules is being motivated by rent-seeking objectives. Of course, affiliate rules are not new, PUHCA and regulatory constraints on utility diversification activities have been around for some time. Regulators, as it often happens, are placed in a position where they have to form decisions in view of conflicting information. The challenge regulators face is, "Who do I believe?" Rivals of a utility's affiliate, of course, want to handicap the affiliate and be given special treatment; the utility on the other hand, would prefer its affiliate to confront less competition from other entities.

Major policy questions that should be asked

  • Why have affiliate rules?
  • What should they prevent?
  • Should efficiency gains be considered as an offset to possible anti-competitive effects? If so, how should they be treated?
  • Does less competition necessarily translates into lower consumer welfare?
  • Are there more effective mechanisms to mitigate anti-competition?
  • How can affiliate rules be enforced?
  • What are their limitations and drawbacks?

Challenge for state regulators is to protect retail consumers against the possible exercise of market power by a utility and its affiliate without giving up significant efficiency gains that could otherwise benefit consumers.

According to some regulatory participants, a utility can subsidize its affiliate by way of
  • customer data
  • shared logos or trademarks
  • cost-shifting
  • free advertising for the affiliate
  • preferential referrals
  • discriminatory access to and pricing of essential services
  • intra-company information benefitting the affiliate (e.g., 'inside information")

Are all of these activities anti-competitive or can some be regarded as pro-competitive?

Perhaps the most important benefit of affiliate rules lies with their up-front character (uncertainty-reducing) that attempts to mitigate market abuses that would otherwise require an after-the-fact investigation and possible litigation. Affiliate rules have the advantage of providing clear and coherent signals to utilities about what they can and cannot do. Affiliate rules can be viewed as "safe harbor" rules or before-the-fact regulatory safeguards against potential market abuses.

The major costs of affiliate rules include oversight and enforcement costs, and the possibility of "going too far" in terms of trying to prevent market abuses. Excessive restrictions on an incumbent utility or its affiliate may prevent (a) the realization of certain efficiencies that could otherwise be beneficial to retail electricity consumers, society as a whole, and (b) the strengthening of competitive forces. "Going too far" may also be interpreted as pushing beyond antitrust principles and mandates, thereby raising legal questions

Areas of disagreement

  • benefits and costs of different types of rules (rules that permit type I errors [disallowing integration and other practices when economies would follow] versus rules that permit type II errors [allowing integration and other practices when anti-competitive behavior would follow])
    • party with burden of proof
  • effectiveness relative to other alternatives (mitigation options are not equally effective and some require high administrative costs)
  • definitions (more on this later)
From a political economy perspective, state PUCs would prefer avoiding a type II error: regulators seem more concerned about the exercise of market power by an incumbent utility or its affiliate than about the loss of integration or scope efficiencies resulting from restricted rules. Specifically, state PUC regulators are bent toward preventing market abuses even when forgoing integration efficiencies. Many apparently believe that sacrificing some unknown economic efficiencies is a small price to pay to avoid the potential for market abuses. This uneven concern, if in fact true (which seems consistent with actual PUC policies and practices), is not surprising for risk averse regulators: market abuses or anti-competitive actions could be embarrassing and damaging to regulators, while forgoing as yet unseen, unrealized integration economies would have little or no political consequences. As an additional factor, economies may be perversely regarded as anti-social because smaller firms are disadvantaged by them. This could result in a "regulatory failure" where regulators' preferences may conflict with the advancement of consumer welfare.

This stance by state PUCs places a great deal of emphasis on fairness and much less on efficiency. A possible outcome is excessive entry of firms and harm to retail consumers. As I heard one commissioner say, "the floor of the arena is level but the lions always win." This view asserts that big firms always dominate small firms, with the implication that attention should be given to assisting small firms.

Regulators need to understand certain basic but important terms - namely, market power versus abusive market power, cross-subsidies, cost-shifting, fair or efficient competition (e.g., rules falling equally on entrants and incumbents, or avoidance of both undue entry barriers and incumbent burdens), anti-competitive versus pro-competitive, barriers to entry. Much disagreement exists over these terms, fueling the current debate over affiliate rules. As an example, a distinction should be made between cost-shifting (which arguably can be a legitimate barrier to market entry) and economies achieved through integration (which is never a legitimate barrier).

Key issues in identifying the appropriate policy for addressing market power abuses include

  • utility incentives
  • utility ability
  • monitoring of regulatory effectiveness
  • countervailing efficiencies - for example, scope or integration economies versus more entrants
Theoretical problems with affiliate rules (recognized by the FTC and DOJ)
  • as with all rules, they can be evaded
  • do not modify the incentive and ability of a utility to engage in abuses
  • detection of abuses can be difficult
  • require long-term monitoring
  • correct rules may vary over time and are difficult to identify at any point in time
In antitrust parlance, a pertinent question is, "Should affiliate rules apply a rule of reason (i.e., flexible, case-by-case) or per se test?" Rule of reason entails balancing a practice's anti-competitive effects against the pro-competitive benefits; the per se test presumes that a particular practice is inherently bad and should always be prohibited.

A point to keep in mind: assisting the competitors of a utility and its affiliate does not necessarily benefit consumers; an assessment of affiliate rules should place primary importance on the short-term and long-term price effects on consumers - not the effect on the utility's competitors; i.e., it is not the role of the regulator to pick winners and losers; instead it is to protect consumers

What constitutes anti-competitive behavior by a firm is disputable (it is assumed that such behavior makes firms better off at the expense of consumers). Some actions assumed to be anti-competitive may actually be pro-competitive, with associated efficiency gains benefitting consumers .

Even if utilities have the opportunity to demonstrate efficiency gains under a rule of reason test, quantifying the gains would be difficult. Because of this, the opportunity would arguably have little effect on a regulator's decision. Rigorous demonstration of economies or other efficiencies is not apt to be feasible, but just a mere showing that some economies and other sources of efficiencies would be plausibly realized would probably fall short of convincing regulators. A reality is that claims of efficiency are easy to assert but real efficiencies are hard to prove and specious efficiencies to disprove.

As a matter of both economics and law, it can be argued that the entity with access to relevant information should shoulder the burden of proof on an issue dependent upon that information. This would apply to the case of asymmetric information, where the utility would have more and better information than the state regulator and other parties.

Five general options for state PUCs

1. Prohibit all activities that could potentially lead to market abuses (no matter what the efficiency gains may be ) - per se illegality standard that seems to be embodied in many affiliate rules and reflects a position of "throwing out the baby in the bath water"
 
2. Allow all activities with the potential for efficiency gains (no matter how anti-competitive) - per se legality standard that is unobservable and politically unpalatable for regulators
 
3. Consider the benefits and costs of an act, weigh them, and form a decision - represents a rule of reason standard that contains no preconceived views on the merits of a practice and places equal burden on all parties to provide evidence; difficult to do precisely because of non-quantification of some of the C-B parameters. Full-blown C-B analysis would produce much litigation and unpredictable decisions.
 
4. Regard as desirable any potential efficiency gains, with burden of proof on those who claim anti-competitive effects - "truncated rule of reason" standard that is not observable as it places, from the regulator's perspective, the burden on the wrong parties.
 
5. Regard as undesirable any practice that has the potential to be anti-competitive, with burden placed on those to show efficiency gains are more than offsetting - "truncated rule of reason" standard, that many state PUCs probably believe they actually apply. The emphasis should be on maximizing consumer welfare, which requires a showing that consumers would benefit from efficiency gains. There is also the issue of the policy implications of the phase "potential to be anti-competitive;" some state rules prohibit or at least discourage any practice which has the potential to be anti-competitive -e.g., sharing logo, employee and other resource sharing; one can argue without much difficulty that such a position is excessively risk averse and potentially damaging to consumers

(Note: a rule that permits only practices that can be proven to increase consumer welfare will permit no such practice, while a rule that prohibits only those practices that can be proven to decrease welfare will stop no such practice.)