Regulation
The Cato Review of Business & Government

Decree Number 888

Paul Ballonoff

Paul Ballonoff is the President of Ballonoff Consulting Services

 

One of the graces of American economic regulation is that the regulators often give advance notice of intended actions. Thus in April 1996 when the Federal Energy Regulatory Commission (FERC) issued Order 888 to restructure the electric power transmission industry, the largest surprise in many ways was the date. (That the action would occur was advertised well in advance.) Many companies and interested individuals had offered comments on FERC's draft proposals-the commission took the occasion, and nearly one thousand pages, to respond.

Thus we deceive ourselves in thinking we have achieved a modern democratic means of government-FERC's actions may be little different from the arbitrary acts of a king, and the order itself not different at all.

The stated purpose of Order 888 is to remove impediments to competition in the wholesale bulk power market and to bring more efficient, lower-cost power to the nation's electricity consumers. The order claims to remedy the discrimination third parties face during attempts to gain access to the monopolized transmission system. To achieve this the commission required that all public utilities that own, control, or operate facilities used for transmitting electricity in interstate commerce file with FERC nondiscriminatory transmission tariffs containing minimum terms and conditions for access. Utilities also are required to take transmission service, including ancillary services, for their own wholesale electricity transactions under the open access tariffs. Order 888 also requires utilities to maintain certain information systems and to isolate their marketing and transmission departments from one another. Yet FERC assured utilities that they would be allowed to recover the "transition costs" or "stranded costs" incurred by moving from a regulated monopoly into a competitive market. The order then claims to "clarify" federal/state jurisdiction over transmission in interstate commerce by essentially claiming jurisdiction over all transmission activities. For the time being, however, the order leaves in place the existing "retail" or direct sale authority to the slates.

Before Order 888, FERC directly affected about 5 percent of all electricity transactions. Now FERC will affect perhaps 95 percent, if not all transactions. It is, however, a proper role of the federal government to open markets closed by state actions-this is the very purpose of the Commerce Clause. FERC has opened natural gas transmission markets in much the same way through Orders 436, 500, and 636-all three orders have been upheld by federal courts.

Why therefore should we fear Order 888? Because in Order 888 federal economic regulation far transcends its constitutional foundations. Of course this is a testable hypothesis: Does the Constitution contain provisions that deal with the circumstance in question, and if so, does the government have prescriptive authority to deal with it? Some argue that electricity generation and transmission, the laws of physics related to transmission, and the technologies resulting from these modern ideas are beyond the scope of the Constitution. The federal government, therefore, must improvise and use its authority to accommodate such new technology. The Commerce Clause provides the means for the federal government to structure electricity markets, prices, and related economic rights.

So let us test these claims. The Constitution is a historical document, so the test of course must be historical. Has there been historical consideration of the power of government to allocate economic rights, set prices, and control the applications and uses of new technology? If the actions related to these matters already are detailed in the Constitution, then we do not need new institutional mechanisms to accommodate the present situation.

First a brief history is in order. In the early seventeenth century Parliament was increasingly upset by the fact that Queen Elizabeth and her successor King James I were granting and selling patents for all manner of purpose. The grant of economic monopoly was of course good business for the Crown, which could gain from the sale of monopoly rights, as well as from revenues derived from controlling the sales of goods and services thus patented. The issue festered and finally in 1624 became the subject of what today we might call "antitrust law." Of course this law was directed specifically at the ability of the Crown to grant monopolies. The law was addressed to "your excellent Majesty" and stated:

The law, however, contained several exceptions- this one is familiar:

So in 1624 the English Parliament did two things: it forbade the Crown from granting monopolies, and allowed the Crown to grant limited-term monopolies to the first inventor of a new technology or "patent." (In 1624 the term "patent" was used interchangeably with the term "monopoly.")

Therefore it is significant that certain words do not appear in the Constitution. In particular the word "patent" does not appear in the Constitution. It does not even appear in the so-called Patent Clause. Instead the Patent Clause only gives Congress the ability to grant an exclusive right for a limited time to the actual inventor of a useful art. The Patent Clause of the Constitution very much mirrors the language of the 1624 parliamentary statute prohibiting monopolies. The Framers knew that the general power of granting patents-that is, monopolies, was very powerful. Indeed most of the original colonies were formed from exclusive patents granted by the Crown. One of the main objectives of the American Revolution was to eliminate the Crown's power over general patents on the commercial, public, and personal liberties of the colonists.

The granting of only a narrow power of patent to the federal government was no accident. James Madison's notes from the Constitutional Convention demonstrate that alternative and more extensive powers were considered and explicitly rejected. For example on April 18, 1787, the delegates to the Constitutional Convention tabled an amendment "to grant charters of incorporation in cases where the public good may require them, and the authority of a single state may be incompetent to act." The term "charter of incorporation" was simply another variation of the term "patent" or "letter patent," making open and public a right or charter issued by the king. Thus, two powers often exercised by Congress today were specifically considered and rejected: (1) the power to create institutions in the interest of "the public good"; and (2) the general power to act on matters that were, for whatever reason, beyond "the authority of a single state" to act.

While modern readers of the Constitution tend to read the Commerce Clause in isolation from the concurrent Patent Clause, both clauses must be read together in order to make sense of either one. Congress has the power to regulate commerce among the several states, but has no power to create or grant exclusive rights or any of the other general powers of the patent that were held by the Crown, except the specific power of patent to protect inventors' property. It was the states, not the federal government, that inherited the general powers of patent to create "monopolies, and all commissions, licenses, grants, charters, and letters patent."

So one asks: If Congress has the power to "regulate" interstate commerce but has no general power to create monopolies or patents, what rights or powers does it have? The answer is simple: If the federal government is specifically denied the power to create but granted the power to regulate, then it must regulate by destroying what others have created. Since the states can create monopolies, the power of the federal government lies in its ability to remove monopolies created by the states. Under the Articles of Confederation the states had issued laws that protected local commerce-this was a threat to the economic viability of each and all of the states. Thus the federal government was given the limited power to remove these obstructions.

This is also what the so-called Welfare Clause is all about. Structurally, the welfare language of the Constitution is not even in the list of powers granted to Congress; it is merely a preamble to the articles. We also know from contemporary writings that the welfare language is there-not as a grant of power-but as explanation for, and indeed as apology for the violation of 150 years of parliamentary struggles with the king. The struggles were so intense that the granting of even a limited version of the general patent power, as represented by the Commerce Clause, required explanation.

Now let us move ahead 209 years and look again at Order 888 and what FERC claims it might do next. Clearly the present situation, in all relevant respects, is addressed in the Constitution. It may be true that electric power transmission per se was not an issue at the time of the writing of the Constitution, but the notion that new technology could change the nature of commerce certainly was understood. Also understood was the ability of government to make mischief in the name of "public good," especially by creating monopolies for that purported purpose.

In at least one respect FERC's Order 888 to open markets is a power specifically addressed in the Constitution. Opening (transmission) markets closed by state action was the exact power granted to the federal government. But much of the order and indeed many of the commission's powers beyond its ability to open markets are not the prerogative of the federal government. This is because the explicitly limited form of patent powers granted the federal government does not include enumerated powers to fix rates or regulate by positive action. Under the Commerce Clause the federal government may prohibit what is wrong, and thereby may set standards for what is proper state action through defining what is improper. But due to the limited nature of the patent powers granted, the federal government has no positive power to prescribe rates or tariffs, nor to allocate markets. Thus while the basic purpose of Order 888 is certainly constitutional, many of the order's details, like many federal economic regulations, are not.

To see what can happen when governments exercise general patent powers, consider one of the conclusions reached in those one thousand pages of analysis of public good. The order is organized around a detailed discussion of specific issues, one of which is "flow-based contracting and pricing." At present, owners of transmission lines typically rent use of those lines to transmission customers using contracts that charge a specific rate for the use of the facility. This is "contract-based pricing." In contrast, "flow-based pricing" would not rely on such diverse contracts, but instead would price transmission based on the way in which electricity "actually flows." The commission concluded:

It is clear from the above example (and numerous others in the order) that the commission has in mind some new form of pricing for the transmission industry. "Well," says the believer in the ability of the federal government to do things for the public good after a fair announcement of intention, "this is certainly fair game." The commission uses good procedure-no doubt required by other federal laws such as the Administrative Procedures Act-takes public comment, and uses notices, hearings, and all other due process procedures. Indeed for our present purpose we can also assume the commission will assure the public that at the end of the process prices will permit utilities to recover their costs by accepted legal standards for compensation for takings.

The only real problem is that the federal government has no positive power to perform the contemplated actions. And if we look in more detail at just what the commission has in mind by "flow-based pricing," we can understand exactly what the colonists feared. The commission did not delve into much detail about what flow-based pricing might entail, but explicitly refers us to an author who does-one "Hogan." This is a reference to William W. Hogan, a professor at Harvard University. By what undoubtedly is not mere accident, only a month after the commission issued Order 888, Professor Hogan addressed the meetings of the Federal Energy Bar Association in Washington, D.C. with a detailed speech titled "Reshaping the Electric Industry: Markets, Rules, and Pricing."

Here is some of what he and, by inference, FERC intend:

And so in hinting of its intention to move from contract-based pricing to flow-based pricing, FERC appears determined to replace the present system of property rights with something else it prefers instead.

This is of course a very large leap. How does the federal government, which has only the tightly confined patent power to grant limited-term monopolies to inventors derive an ability to reallocate property rights? Surely not from any analysis of the "public good" since the ability to use the general patent power based on analysis of the public good was one of the powers specifically considered and denied to Congress. Under the Commerce Clause, the federal government can remove obstructions to commerce created by state actions. But the state action at issue is the granting of exclusive territories for transmission, coupled with perhaps other state exercising of general patent powers in retail services and electricity generation. The commission remedied these consequences of state actions by opening transmission markets.

But the technical problems upon which Hogan, and by adoption FERC, claim to base their proposed change to flow-based pricing derive not from state actions creating service territories, but from private property rights in some claimed relationship to the laws of physics. One must admit that state governments have great power, especially since they have inherited many of the general patent powers of the English Parliament; but, not even states can create private property rights or modify the laws of physics.

Thus FERC's contemplated move to mandate flow-based pricing is objectionable for at least four distinct constitutional reasons. First, Congress and hence the commission have insufficient power to create pricing regimes at all; this power is among the general patent powers not granted the federal Congress. Secondly, the premise for federal action under the Commerce Clause to open markets closed by state actions fails here because the premises for creating flow-based pricing-the existence of private property rights and laws of physics-do not entail prior state action at all. Third, the analysis relied upon is no more legitimate than some claims about the public good. Congress has no patent powers, including under the Commerce Clause, to act based merely on claims about public good, and indeed was specifically denied such power. The welfare language in the Constitution does not confer these or any other powers; it merely explains the presence of other specifically enumerated powers. Fourth, Congress has powers related to technology including the ability to grant limited-term exclusive rights to inventors; but, the proposed actions on flow-based pricing do not propose to create limited-term exclusive rights for a new invention. And in any event FERC has no statutory authority to grant either patents or copyrights.

Finally note in the text cited above how Hogan uses the words "essential facility" in reference to electric power transmission facilities. The naive reader might think this is an obviously true assertion-the transmission lines somehow seem to be "essential" to the carriage of electricity between generation and distribution facilities. Well, true enough-some such facility must be used when generators are not connected directly to distribution lines. But that is not the economic or legal meaning of the term "essential facility." Instead, the legally significant meaning derives from parts of the antitrust laws that essentially make it illegal to create a monopoly by "refusal to deal." Monopolization is illegal and if a monopolized facility is "essential" to the delivery of a service, then refusal to permit use of that facility also is prohibited. A facility must meet the following standards to be considered essential: the facility must be essential-that is, required for the transaction; the facility must be controlled by a monopolist; the competitor must be unable to duplicate the facility or do without it; the use of the facility must be required for the service and not merely convenient; and of course, the facility must have refused to deal.

Neither FERC nor Hogan has claimed or demonstrated that any of these conditions exist when it comes to the grid, and indeed most of them clearly do not. In the first place there has been no refusal to deal. The very presence of the contract-based flows being attacked in public discussion results specifically from a willingness of owners of transmission facilities to deal; to offer services of transmission lines at openly stated contract-based terms. It may be inconvenient but it is hardly impossible for competing providers to build their own transmission lines or to build plants closer to markets. Moreover, while there is a presumption that transmission is a monopoly, and perhaps a fact to the extent that states grant exclusive patents in the form of franchises, there is no evidence that electricity transmission is a natural monopoly. Indeed, there is good reason to believe otherwise (See Jerry Taylor's article in this issue). And thus, to the extent that there is a monopoly resulting from state action-that is, granting of exclusive franchises-there is also a ready remedy in the Commerce Clause for such an event: The federal government can void state franchises when they obstruct interstate commerce. Thus even if the technological premises of flow-based pricing were true, there is no need to invent a new remedy such as pricing power for the federal government.

Order 888 provides a very clear and current example of the dangers of general patent power. Clearly FERC is preparing the ground for reallocation of property rights in order to secure the purported "public good." If a federal commission can reallocate property rights on these grounds in energy transmission, then there is simply no limit remaining on federal power.

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