PERSPECTIVES

From the Editor

Our managing editor, Darcy Olsen, has been kicked upstairs so to speak. She has taken the position of Entitlements Policy Analyst here at Cato. Congratulations and thanks for your work on Regulation.

Taking over as managing editor is Ricardo Reyes. Ricardo has a B.A. from Rice University. He has worked as an election observer for the International Republican Institute, assigned to Nicaragua, his homeland, writing reports in both English and Spanish on democracy, development, and the like. He also did a stint at the Jefferson Group and the Leadership Institute. Welcome aboard!

 

Edward L. Hudgins

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Who Do You Trust?

Antitrust laws purport to prevent monopolies and encourage competition. Yet since their advent in 1890, they have done little more than provide undue government support for politically powerful sectors and enterprises and give government operatives a kind of monopoly power that they exercise according to whatever arbitrary standard suits them at the moment. In 1962, Alan Greenspan wrote that antitrust was:

  • a world in which competition is lauded as the basic axiom and guiding principle, yet "too much" competition is condemned as "cutthroat." It is a world in which actions designed to limit competition are branded as criminal when taken by businessmen, yet praised as "enlightened" when taken by the government. It is a world in which the law is so vague that businessmen have no way of knowing whether specific actions will be declared illegal until they hear the judge’s verdict–after the fact.
  • The Clinton administration not only stuck with that tradition, it has also refined it to help further intrench government in business practices.

     

    Delegating Power

    The vague and sweeping nature of antitrust laws exemplifies the delegation problem. Contrary to the letter and intent of the Constitution, today the executive branch, not Congress, makes many of the laws in this country. Congress simply delegates open-ended authority to the executive which acts as it wills. When administrations change, policies can change dramatically. During her tenure, the Clinton administration’s recently departed Deputy Attorney General for Antitrust, Anne Bingaman, pursued many cases that Reagan administration officials would not have touched.

     

    Arbitrary Standards

    Antitrust laws are, by nature, arbitrary. The actions of Clinton’s Federal Trade Commission to block the merger of two office supply retailers, Office Depot and Staples, are a case in point. Those two enterprises account for only 4 percent of office supply sales. But using calculations akin to alchemy, the FTC argued that the two account for almost all of the sales by enterprises of their size. In other words, depending on how bureaucrats define a particular sector, they can declare anything a monopoly. Never mind that customers can get the same products in other stores. The stores are not as large.

    The administration’s vendetta against Microsoft also points out the arbitrary nature of antitrust. Bingaman threatened to stop release of the Windows 95 software because the company planned to create the Microsoft Network (MSN), an Internet service provider to compete with America Online, Compuserve, and other providers. Before the release of Windows 95, it was known that the software would automatically place an icon on the personal computer user’s desktop each time the machine was turned on. The icon would allow access to MSN with a single click of the mouse. Critics suggested the icon would offer personal computer users an unfair incentive to subscribe to MSN.

    But Windows 95 allows a user to put the icon for any competing system permanently on the machine’s desktop, with three or four clicks of the mouse. Whenever the PC is switched on, the icon for the competing Internet service provider will appear and can be accessed with a single mouse click. Perhaps neither Bingaman nor her staff had ever been on-line. Fortunately they didn’t act against Microsoft in that case. But the fact that they could make such threats indicates the problem with the current system.

     

    Extraterritorial Regulations

    A small but very dangerous trend that started under George Bush’s re-regulation binge continued under Clinton; the practice of exporting America’s bad policies, colluding with other governments to internationalize bad regulations. A case in point was the Antitrust Division’s action against several Japanese fax paper manufacturers. Those firms were engaging in pricing practices in Japan that are perfectly legal in that country. They also sold paper to unaffiliated distributors who marketed the products in the United States. The administration went to court to stop the practice of those Japanese firms operating in Japan.

    But consider the implications of that principle. Ford Motors operates plants in Germany that are subject to German labor laws. It also operates American facilities that are subject to American labor laws. Germany could consider the situation "unfair." Since America’s labor laws are not as restrictive as Germany’s, that country is at a competitive disadvantage. (That explains in part why German auto companies are building factories in Alabama and South Carolina rather than in the Rhineland or Schleswig-Holstein.) Thus Germany, operating on America’s extraterritoriality principle, might sue Ford in Germany because Ford plants in America do not offer forty days of paid vacation and other benefits that are driving down Germany’s economy.

     

    Trusting Markets

    If ever there was a time to question the need for antitrust laws, it is now. Global markets are much more integrated today than ever before. Average tariffs have dropped from around 40 percent after World War II to around 3 percent today. Transpor-tation costs over the past two decades have dropped significantly. Asian, Latin American, and formerly communist countries compete in the global market. The production process it-self is a global affair. Few products are made completely in one country. In short, there is no lack of competition.

    Further, technological change is swifter than ever. Com-munications is becoming more integrated. Broadcasting competes with microwaves, cable, and satellites. New technologies, such as digital compression, allow for better use of resources.

    Those facts are prima facia arguments against the need for Justice Department and FTC antitrust activities. It is not time to reform antitrust, or for governments to "manage" deregulation of telecommunications, electricity distribution, or any other sectors. It is time to trust markets, not governments.

     

    Edward Hudgins

    Editor of Regulation and director of regulatory studies at the Cato Institute

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    The EPA’s Clean Air Mischief

    Under Executive Order No. 12866, all federal agencies must submit proposed regulations to the Office of Management and Budget for review ninety days prior to their publication in the Federal Register. Among other things, the OMB is required to analyze the economic impact of new regulations and determine whether they comply with federal guidelines. Supposedly the review is independent and objective, much like a non-binding audit. The OMB acts as a traffic cop, ensuring that regulatory agencies do not publish rules before they have been properly analyzed. However, should a regulatory agency exercise undue influence over the OMB, the review would be little more than a rubber stamp for agency proposals.

    The Environmental Protection Agency’s efforts to squelch intra-administration criticism of its recent air quality proposals suggests manipulation of executive oversight is underway.

    Oppressive Air Standards

    The Clean Air Act of 1970 requires the EPA to set federal air quality standards for every city in the nation. States must ensure that all cities meet the standards or possibly lose federal highway funds and face other federal sanctions. Last November, the EPA proposed tightening the air quality standards for ozone and particulates, arguably the most controversial proposal in the EPA’s history. Even environmental stalwarts such as Senator John Chafee (R-R.I.) have openly questioned the proposed standards.

    The EPA’s proposal is controversial in part because it will more than double the number of cities out of compliance with federal air quality standards, triggering costly regulations on consumers, automobile owners, and small companies. For example, cities failing to meet the new standard could be required to impose new automobile emission inspection programs; promote the use of alternative fuels; and encourage "transportation control measures" (a euphemism for car pooling). Were that not bad enough, the EPA has failed to prove that tightening air quality standards will improve the protection of public health at all.

     

    Congressional Concern

    Congressional leaders from both parties have expressed concern about the proposed standards. Last December, House Commerce Committee Chairman Thomas Bliley (R-Va.) wrote to OMB officials asking their opinion of the EPA’s rules. He wanted to know whether the EPA had complied with federal guidelines in drafting the regulations. The OMB’s response was vague and scarcely informative. It almost read as if the EPA had drafted the letter itself.

    Recently released documents suggest the EPA may effectively have done just that. In January of this year, Bliley asked EPA officials about their involvement in the OMB’s response to his December request. Assistant EPA Administrator for Air and Radiation Mary Nichols replied that the OMB had asked her agency for its response to Bliley’s inquiries and that the agency had sent one along.

    But internal memoranda between the two agencies, leaked just after Nichol’s initial response, revealed that EPA officials censored OMB criticism of the air quality rules in an effort to mute public criticism of the standards. The EPA even proposed to revise the OMB’s response "line by line." According to a memo from Deputy EPA Administrator John Beale, the OMB’s first draft of the Bliley letter needed editing because, "As written, the OMB’s response could be very damaging." Beale was concerned that the OMB would tell Congress that the EPA did not examine the impact of its own proposed rules adequately.

    After the leaking of the internal memoranda, the OMB’s original draft letter for Bliley surfaced. It stated that the EPA’s economic analyses, "did not fully conform" with current federal guidelines. In particular, the EPA did not fully examine the costs of its proposal and had been unable to identify how many regions of the country would ever comply with existing air quality standards, let alone tighter ones.

    Curiously, despite Bliley’s specific request that the EPA identify all officials that reviewed the OMB’s response, Nichols made no mention of the Beale memo in her response concerning the preparation of the original response to his December inquiries. According to Nichols, the draft of the OMB letter, which had been faxed directly to Beale, had been "inadvertently overlooked."

     

    Ignoring Health Risks

    The Clean Air Act explicitly requires that the EPA set standards based upon "all identifiable effects on public health or welfare." However, the Agency ignored its own findings that reductions in tropospheric ozone (the goal of its proposed new clean air standards) could lead to an increase in ultraviolet-B (UV-B) radiation. According to prior EPA findings, even marginal increases in UV-B exposure are cause for concern, hence the Agency’s zealous efforts to phase out all substances suspected of damaging the stratospheric ozone layer. Translation: The proposed new legislation could actually endanger public health. Whether the EPA’s concerns about UV-B are overstated or not, it is troubling that the Agency cavalierly discarded its own scientific claims when regulating something else.

    OMB analysts Randall Lutter and Christopher Wolz, in an article published recently in Environmental Science & Technology, maintained that increased UV-B exposure caused by the EPA’s proposed rules could result in as much as $1.1 billion in health costs from the regulation itself. Yet when the OMB raised those concerns, the EPA would hear nothing of it.

     

    EPA Strong-arm Tactics

    Shortly after Bliley received the EPA-OMB correspondence, other agencies expressed unanimity with OMB concerns. Officials from several departments and executive agencies expressed concerns about the aggressiveness of the EPA’s proposal, its exorbitant costs and the lack of sufficient interagency review. Yet the EPA neglected to include those concerns in the regulatory docket for the proposed rule.

    A week before the regulations were released, White House Science Adviser John Gibbons wrote in a memo, "I find it hard to believe that we would suffer more than we would gain by taking more time–even sixty days–for further inter-agency review, consensus building, and additional analysis." Gibbons noted that "questions remain about the appropriate level and the significance of the health effects that might be avoided" by tightening federal air quality standards.

    Shortly after the rules were issued, Alicia Munnell of the President’s Council on Economic Advisers commented internally that the EPA’s analysis "understates the true costs of the stricter standards by orders of magnitude."

    A significant portion of the new air quality standards burden will fall on small businesses. Most large industrial emission sources are already subject to strict regulatory controls. Thus Small Business Administration counsel Jere Glover wrote in a memo to EPA administrator Carol Browner, "This regulation is certainly one of the most expensive regulations, if not the most expensive regulation, faced by small businesses in ten or more years." Regardless, the EPA asserted in the Federal Register that the new standards "will not have a significant economic impact on a substantial number of small entities . . ." The agency claimed that it was unable to perform the analyses required under the Regulatory Flexibility Act to certify that proposed regulations achieve their goals placing as little burden on small enterprises as possible. Centralized executive review is designed to catch that type of regulatory indiscretion.

     

    Reviewing Review Integrity

    Recent regulatory reform efforts have focused on establishing new review requirements for federal agencies. Legislative proposals have sought to establish guidelines for risk assessments and cost-benefit analyses that would apply to all federal rule-making. Such reforms will only be effective if the OMB maintains its independence. Emasculate the OMB’s ability to rein in regulators, and no set of analytical review requirements will restrain the bureaucratic urge to regulate.

    If the review (rather, lack thereof) of the EPA’s latest air quality proposal is any indication of current trends, executive oversight is an increasingly ineffective means of curbing regulatory excess. For regulatory reforms to be successful, they will have to directly challenge the prerogative of regulatory agencies to set their own agendas. Ending the delegation of rulemaking authority and requiring Congress to explicitly authorize substantive regulatory enactments is the surest way to achieve that end. Most other types of regulatory "reform" will fail.

     

    JONATHAN H. ADLER (jadler@cei.org).

    Director of Environmental Studies
    Competitive Enterprise Institute

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    End the Scientific Witch Hunt

    A few years ago, politicians alleged that they had discovered fraud and cheating in biomedical science. They marshaled the forces of the United States Government to expose the chicanery and, as a byproduct, intentional or accidental, dragged science and scientists down into the muck of politics. Those bureaucratic efforts have tarnished reputations and cost millions of dollars. Worse, they perpetuate the idea that science tolerates cheating and fraud that only a government-funded "fraud squad" can root out. To use a Mencken-favored word, it’s hooey.

    One episode began in 1986 when Thereza Imanishi Kari, an immunologist at MIT, David Baltimore, a Nobel Laureate also at MIT, and four other scientists published a paper in the prestigious journal Cell. Subsequently, a researcher in Imanishi Kari’s laboratory challenged the validity of her data. Review panels at MIT and Tufts, where Imanishi Kari moved after MIT, investigated the charges. Both panels dismissed them. In 1989, The National Institute of Health (NIH) also investigated the charges. The NIH found no evidence of fraud but required Imanishi Kari, Baltimore, and the others to publish corrections of some disputed data. A year later, NIH cut off Imanishi Kari’s research funding. The private American Cancer Society continued funding her research.

    To that point, the science community had dealt with the dilemma internally. That ended in 1989, when Representative John Dingell (D-Mich.), then the powerful chairman of the House Committee on Energy and Commerce, jumped into the "Baltimore affair." In a hearing that year, he attacked Imanishi Kari’s honesty and intentions. Dingell, notorious for his bullying tactics, may have been surprised at what happened next. Baltimore had the temerity to defend his colleague and to criticize Dingell’s meddling. Perhaps angered or annoyed, Dingell initiated a Secret Service forensic investigation of Imanishi Kari’s lab books. Then the second major player, the NIH’s Office of Research Integrity (ORI) got into the act. Based on the Secret Service investigation, ORI concluded that Imanishi Kari had fabricated her data. In 1994, ORI recommended that she be barred from receiving federal research funding for ten years.

    Imanishi Kari appealed the decision. The Department of Health and Human Services (HHS) appointed an adjudication panel that held six weeks of hearings in the summer of 1995. After questioning Imanishi Kari and ORI, the panel concluded that ORI had presented irrelevant information "based on unwarranted assumptions." The panel dismissed all the charges against Imanishi Kari.

    The Imanishi Kari case is not the only example of zealous investigations and attacks that have come to naught. HHS investigators combed through the lab notebooks of Dr. Robert Gallo, the co-discoverer of the AIDS virus. After much damaging publicity to Gallo, the HHS concluded Gallo had been guilty of "minor misconduct." An appeals panel rejected the decision.

    In 1994, Dingell attacked Dr. Bernard Fisher, a cancer researcher at the University of Pittsburgh. Subsequently, the National Cancer Institute removed Fisher from the directorship of an extensive breast cancer treatment study and labeled papers he’d written fraudulent. To its credit, the ORI exonerated Fisher in March of this year, saying that there was no evidence of misconduct.

    Earlier this year, Science magazine summarized the track record of the thirty-nine person, $3.8 million-per-year ORI. Since 1992, it has received more than fifteen hundred allegations of misconduct, finding seventy-four scientists guilty.

    Students and technicians are the targets of about one third of ORI’s investigations, but they comprise more than half of ORI’s "victories." And we can expect ORI to focus more and more on those with small budgets. After the appeals panel reversal of ORI’s decision in the Imanishi Kari case last summer, ORI dropped misconduct charges against three other scientists who were represented by her lawyer.

    ORI should be closed. It does little to no good but much harm. It has a miserable track record. But those are not the reasons for closing it. The reason is that ORI is unnecessary.

    Science functions at the frontier of human knowledge. Nobel Laureate Albert Szent Gyorgyi, discoverer of the structure of Vitamin C and arguably the most personable Hungarian biochemist who ever lived, said, "Discovery is to see what everyone else has seen and think what nobody has thought." Peter Medavar, another Nobel Laureate, likened the formulation of a new scientific theory to the creativity that goes into composing a symphony, writing a novel, or painting a portrait. But science doesn’t end with ideas or theories. Progress comes from experimentation.

    Does the theory predict, describe, and encompass the way some part of the physical world behaves? And fundamentally, is it possible to test the theory?

    The physicist Paul Davies said, "A theory that is too vague or general, or makes predictions concerning only circumstances beyond our ability to test, is of little value." Scientists make mistakes. Their theories can be wrong, their tests can be inappropriate or poorly done, their interpretations of test results can be off the mark. Such mistakes are so much a part of science that a section of a new book about the origins of molecular biology is titled "Misinterpretations."

    Mistakes, painful as they are to those who make them, are honest. The same testing that reveals mistakes will catch cheating and fraud. Cheaters pay the price. They are ostracized, their ideas discounted, their results doubted, their publications taken with a grain of salt. Fraudulent science provides no foundation for work by other scientists, it is properly tossed aside along with the scientists responsible for it.

    Chris Pascal, the lawyer who directs ORI, argues that ORI preserves the confidence of scientists, Congress, and the public. Yet its record of overturned rulings and its targeting of those least able to defend themselves does not reassure. Scientists themselves have the most to gain from preserving the public’s confidence in science. They can accomplish that by being skeptical, testing each other’s ideas, and validating or falsifying each other’s results. A fraud squad, even one with the Orwellian title "Office of Research Integrity," is unnecessary. Congress should close it down.

     

    Michael Gough

    Director of science and risk studies
    at the Cato Institute

     

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    Inadequate Superfund Reform

    The Superfund program was established in 1980 to clean up hazardous waste dumps. Since its inception, the program has spent some $40 billion from general federal revenues as well as from a special tax on the chemical and petroleum industries. Senator Bob Smith (R-N.H.), Chairman of the Superfund Subcommittee of the Committee on the Environment and Public Works, recently endorsed the comment of an unnamed former EPA administrator who said that Superfund is, "the worst program ever enacted by the U.S. Congress." He announced an intent to "restructure the program from top to bottom." To that end, he introduced the Superfund Cleanup Acceleration Act of 1997 (S. 8). Unfortunately, while the bill will provide some relief from some of the law’s worst provisions, Superfund is fundamentally defective. Even a far more radical "restructuring" than S.8 would be of only minor use. The program needs to be uprooted.

     

    Fundamental Flaws

    For the entire seventeen years of its operation, the Superfund program’s basic flaws have been evident. First, the program imposes liability for cleaning up hazardous substances on everyone connected with the pollution, including the generators of the alleged pollutants, the transporters, and the landowners. It even extends liability to parties who lent money and became active in the affairs of the borrower. Further, Superfund makes liability retroactive for events that occurred before the law establishing the program was passed.

    A second major problem with Superfund is that liability is strict. It does not distinguish according to amount of waste. The rule of joint and several liability applies. A party that discards one pound of waste in a dump the size of Manhattan could be billed for the cost of cleaning up the entire dump. The liability extends to individuals who have their waste picked up by municipal trash haulers, who in turn dispose it as directed by local public officials.

    Third, cleanup standards are absurdly stringent. Congress’s preference for "permanent" solutions has been interpreted as requiring cleanup rather than containment, regardless of cost or benefit. Future use of the land and the economic value of the property are not taken into account in the decision. Thus it might cost $30 million (the average price of cleaning up a major site) to clean up a piece of property in an old industrial park to residential standards even though the property will simply be used as another industrial park in the future. To compound the problem, "worst first" decrees require restoration of the most polluted sites before restoration of sites that might be made usable again with minimal expenditures.

    High transaction costs is a fourth costly effect of Superfund. At least 30 percent of Superfund expenditures from government and businesses are spent on the legal process, not on clean-up. Because of the high stakes, companies have strong incentives to challenge Superfund efforts. The fees of lawyers and consultants mount. For most sites, cleanup costs are divided according to complicated multi-factor equitable tests that invite wrangling.

    Since everyone who ever used the site is liable, the number of parties brought into the game expands. The EPA sued eleven companies who in turn brought in 180 more, and those added another 590. Swept up in the last tier was the owner of a diner who swore her contribution consisted solely of mashed potatoes and similar restaurant waste. Her story is distressingly typical.

    The EPA blames the corporations for such abuses. That defense misses a fundamental point. It is the statute, written by Congress with help from the EPA, that makes the restaurant-owner liable. The Agency’s desire to keep everyone legally responsible and then exercise complete discretion to decide who actually pays makes the whole situation worse, not better.

    Lastly, the scope of Superfund’s coverage is unmanageable. EPA has designated about 1,250 sites on its National Priorities List (NPL). Those are the only sites in which EPA is directly involved. Yet another thirty-thousand sites, rejected for inclusion in the NPL, are still covered by the basic Superfund liability laws. They can be the subject of private law suits. States have created their own programs that address tens of thousands more sites. In fact, every site where any amount of chemicals has been leaked, spilled, or dumped is covered by Superfund. The total must run into the hundreds of thousands, maybe the millions. Most could be cleaned up with minimal effort. But the program pressures new industries to head for the suburbs, for the "greenfields," rather than to redevelop old urban industrial plots, usually referred to as "brownfields."

     

    Reform Efforts

    S. 8 attempts to alleviate Superfund’s most obvious defects. First, it would exempt some future innocent purchasers of property from Superfund liability. Further, for NPL sites, it would eliminate the liability of minor parties, small businesses, and municipalities.

    Second, S. 8 reforms the cleanup standards, potentially allowing containment rather than complete clean-up at some sites. Specifically, EPA risk assessments would be required to consider the future uses of the land when deciding between clean-up or containment. Skeptics might question the extent of sound judgement EPA will exercise in making those evaluations. But at least the reform would prevent EPA from claiming that the statutes preclude more economically responsible options.

    Third, S. 8 replaces the judicial process of allocating costs among the parties with an administrative one. But the standards remain amorphous, and it is not clear whether bureaucrats would do a fairer job than judges in making such decisions.

    S. 8 further makes a bow towards federalism, giving the states some decision-making authority over NPL sites. But that devolution is really a Potemkin Village. States must ask for EPA’s approval of their decisions every step of the way.

    S. 8 deals with the brownfields problem in a manner all too common for government. Rather than eliminating economically destructive regulations, the bill creates a $40 million slush fund to be doled out to states and cities for cleanup. Further, the funds will be doled out only after a detailed process of planning and review, wasting significant amounts of money along the way.

    Finally, S. 8 offers special breaks, such as liabilities exemptions, for certain interest groups. The groups include clean-up contractors; recyclers; railroads; and educational, scientific, charitable, and religious organizations.

     

    Not Good Enough

    But the same question EPA asks concerning Superfund sites, (Should they be contained or eliminated completely?) should be asked of the Superfund program itself. S. 8 merely tries to contain a bad program. But its toxic effects on the economy necessitate its elimination.

    First, disposal of hazardous waste is simply not a federal problem. Sites are in particular states and should be the responsibility of those states. A federal response capability for certain kinds of emergencies might be defended on the grounds of the economies of scale involved. Or, if waste is dumped in a river, then some form of interstate and thus, perhaps, federal action might be needed. Even in such cases caution is necessary. Interstate groundwater contamination is often used as the excuse for federal intrusion, but the documentation of serious problems in that area is exceedingly thin. Most waste goes into the ground, where it just sits. Its effects are not interstate and offer no grounds for federal involvement.

    A second major shortcoming of S. 8 is that it applies principally to NPL sites in which the EPA is directly involved, not to other sites that are still covered by Superfund regulations. Private suits are still permissible under the program’s complex rules and other costly actions could still be required.

    A third problem with the legislation is that it leaves a huge loophole that could negate reform attempts. S. 8 requires EPA risk assessment studies to consider future uses of land. Agreed, future use of land must be taken into account, but the cost of cleanup should drive the land-use decisions, not vice versa. Herein lies the problem: the EPA can predict any pollyannaish uses for the land they choose. A site to be used as waste dump needs not meet the same standards that might be appropriate for a kindergarten.

    Though well-meaning, S. 8 merely takes a few shovelfulls of sludge from a toxic program that cannot be reclaimed. The debate should be not over how to reform Superfund but, rather, over how to eliminate it.

     

    James V. DeLong

    Environmental Attorney

     

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    ALEC’s Charge Down Regulatory Road

    The American Legislative Exchange Council (ALEC) has issued model legislation for injecting competition into the $208 billion American electricity monopoly. Today’s regulated system is responsible for wide price disparities across regions. In the U.S., the average cost of electricity is 6.89 cents/kilowatt-hour. Regional prices range from an average of 10.27 in New England to 5.07 in the some Southern states.

    ALEC, a non-profit organization, promotes market principles through dialogues between state legislators and members of the private sector. Regrettably, it endorses the dominant approach to deregulating electricity, an overly regulatory contrivance known as "mandatory open access." Under that approach, utilities would be required to wheel competitors’ power to homes and businesses over their own lines, at regulated rates. ALEC continues to operate within the bounds of today’s short-sighted debate, missing a grand opportunity to lend considerable clout to a principled case for total electricity deregulation.

     

    Regulating Competition

    The crux of ALEC’s reform bill, like other market proposals, states that electricity generation "should become fully competitive, while the provision of transmission and distribution should accomplish the triple objectives of open access, comparability of service for all users, and nondiscriminatory pricing." Under their plan, state utility commissions would heavily manage future competition, to the detriment of market innovations that would otherwise emerge. ALEC insists that the commissions will set regulations that "enhance reliability, compensate transmission owners fairly, allow for widest possible markets, and relieve transmission congestion." Unfortunately, those goals necessitate the same kind of price regulation that has failed in the field of generation and would threaten electricity markets with irreparable harm.

    The open access approach requires transmission owners to forfeit rights over their transmission hardware and perform power-flow management services for all those who inject uninvited power into the grid. The market conditions that ALEC believes can be established through regulations will be at least unstable, if not impossible. In embracing this regulatory paradigm, ALEC overlooks the route to permanent, successful reform. Historically, exclusive transmission and delivery franchises established by governments and based on "certificates of convenience and necessity," have stood between suppliers and customers. To establish free markets, these barriers simply should be Removed. The fact that open access leaves delivery franchise intact will distort markets for years to come and make full deregulation harder to accomplish later.

     

    Missed Market Opportunities

    True deregulation of electricity at all levels will lead to innovation in electricity generation and transmission, greater reliability and falling prices. For example, multiple rights-of-way into consumer’s homes already exist. Those could be exploited by competitors simply by removing utilities’ monopoly status. Cable, telephone, and Internet companies currently seeking ways to expand into homes could form competitive alliances with electricity providers and real estate developers if regulatory barriers protecting utilities were removed.

    By establishing Independent System Operators to micromanage the grid, open access regulations may delay competitive pressures that would promote full exploitation of new transmission technologies. Silicon power-switching technology now exists, permitting control of heretofore uncontrollably high voltage power flows by allowing a given transmission wire to handle more current. That technology would be optimally exploited in the face of true competition that would allow, indeed require, utilities and newcomers to control megawatts on the grid the same way Intel manipulates microwatts in a Pentium.

    Also, companies such as Allison Engine and Capstone Turbine are developing microgeneration technologies that, in the extreme, would eliminate the need for transmission altogether. Business establishments and even homes could have their own generators. The generators run on natural gas, a network with infrastructure already in place that can compete with existing transmission grids. But under the current regime or the one proposed by ALEC there is little incentive for newcomers to adopt such advances. They can simply dump power into the grid.

     

    Imposed Obligations

    A number of provisions of the model bill secure "cooperation" through mandates rather than markets.

    Obligation to Connect: In the early days, utilities themselves sought to maintain their legal monopoly status. Thus, they could not object too loudly to the traditional "obligation to serve" mandate. Moreover, in a regulated regime with monopolies using cost-plus-profit pricing, extending electricity distribution to distant environs was an easy way to overcapitalize the system and pass the costs on to consumers, thereby maintaining hefty profits. Now, however, the pressure group pendulum has swung to the low-cost utilities and industrial users seeking open access. ALEC obliges them by replacing "obligation to serve" with "obligation to connect." In a genuine, non-monopoly market, if a user seeks cheaper power, he has every right and opportunity to cut deals. But obtaining power is a customer’s problem. An "obligation to connect" simply gives the customer a special right and necessitates government bureaucracies to enforce that right.

    Mandatory Unbundling of Services: ALEC would require utilities to "operationally and/or financially separate electric generation, transmission, and distributions assets." But bundling one’s services and offering them at special prices is a perfectly legitimate business practice; failing to unbundle violates no one’s rights. In fact, every product with multiple features is bundled. Treating electricity differently is arbitrary.

    Mandatory Filing of Plans: Under the ALEC proposal, utilities are required to file their plans for open access implementation with regulators. If there were no options for utilities other than to remain insulated monopolies, perhaps oversight would be appropriate. But with deregulation, businesses should not need to report to commissions. Businesses should be allowed to answer only to customers.

     

    Programmed Competition

    ALEC’s model bill uses a number of statist devices that are unlikely to lead to truly free markets.

    Price Controls: The ALEC proposal dictates that transmitting utilities must charge "just and reasonable" non-discriminatory rates. Yet innovation on the grid is at least as important as innovation in generation. Fostering innovation sometimes requires pricing discrimination for access, for example, to relieve bottlenecks. Under the ALEC plan, state and federal regulators would share jurisdiction over monopoly transmission pricing, leaving no leeway for market pricing of services.

    Regulating "Market Power": ALEC notes that "The determination of corporate structure, excluding market power issues, should be left to the marketplace and not dictated by the government." However, state commissions will "mitigate concentrations of undue market power." But if competition is allowed, for example, from out-of-state suppliers, there need not be a concern over market power in transmission.

    Regulating "Safety and Reliability:" The ALEC model bill gives state and federal regulators authority to guarantee "safety and reliability" of the electrical system. But the present system has proven itself unreliable. A single line failure can cascade down the system, causing blackouts for thousands or millions of customers. Silicon chip-switching technology could reduce such failures but the open access mandates remove many incentives for implementation of that technology. Further, without profits tied directly to service as they would be in a more competitive market, providers have less incentive to take greater care about reliability. Reliability must be a competitive feature.

    Subsidizing Stranded Costs: The ALEC proposal grants utilities the right to recover "prudently incurred, net, verifiable stranded costs." Among the questions raised by that approach is what to do with the stranded asset. Can the utility collect stranded cost dollars and still sell the electricity? Should the utility be allowed to use recovery funds to launch unrelated ventures? Or should it be required to transfer the funds directly to the shareholders it is purportedly trying to protect? To its credit, ALEC leaves most of those decisions up to the states and limits the time for recovery.

     

    Saving Graces

    Happily, some recommendations in the ALEC bill are sound.

    Ending Public Power: ALEC correctly notes that public and investor-owned utilities should face the same legal, regulatory, and tax treatments and that preferential subsidies must end. In principle at least, that embraces the demise of public power and of administrations that market federal power, thereby obstructing competitive markets.

    Delegitimizing Franchises: ALEC also observes that the law of eminent domain was not intended to protect the utility but to protect the public interest when it declared, "the right of eminent domain shall not be used to restrict the construction of new transmission or distribution facilities by any qualified party . . . or otherwise limit competition." Unfortunately, the bill would not end the current franchise system, a necessary step in making such construction commonplace.

    Ending Hidden Support of Renewable Energies: ALEC wisely argues that the energy market ought not be exploited as a vehicle to meet other, often questionable, social and environmental goals. The costs for such programs should not be hidden in electricity rates and borne by unwitting electricity users.

    Partial Protection of New Markets and Innovations: Despite the unwarranted concession to stranded costs, the bill rightly disallows recovery of stranded costs for the increased usage of self-generation or co-generation. Though the model bill artificially bolsters central generation through open access, at least it prevents existing utilities from directly punishing others’ use of new technologies with the stranded cost mallet.

    Sunsets Transmission Deregulation: The bill sunsets all regulation of the electric power grid after ten years. While there is no more worthy goal, it is flatly contradicted by ALEC’s embrace of open access, which cannot operate without regulation.

    Limited Liability for Unchosen Obligations: ALEC rightly assures that distribution utilities forced to wheel power are not held liable for errors of the generation supplier or other parties not within their control.

    Acknowledgment of Federal Role: Despite its emphasis on state reforms, ALEC also wisely notes that federal reforms are necessary for full competition. Repealing the Public Utility Holding Company Act and the Public Utilities Regulatory Policies Act are specifically noted, but a federal role in ensuring that states not impede interstate commerce to protect local utilities will also exist under a complete proposal.

    No Independent System Operator Mandate: The inherently political, inherently monopolistic "independent system operators" proposed by most reformers to manage open access on a national scale will face political rather than profit motives. They will also serve as a ready scapegoat for service failures. ALEC does not explicitly recommend the creation of ISOs.

     

    Amending ALEC

    The proper deregulatory mechanics will flow naturally from the proper deregulation philosophy. Transmission is not a natural monopoly; treating it as such impairs future competition in the industry. State government’s forbiddance of full competition, not the utilities’ control of generation, transmission, and distribution, is the source of monopoly power. Exclusive territorial franchises awarded by state public utility commissions are much guiltier than any presumed natural monopoly status of transmission and distribution.

    ALEC should reject the model bill’s regulatory core and set an example by turning it into a model that will lead the national restructuring effort down the right path.

     

    Clyde Wayne Crews Jr.

    Senior Fellow in Regulatory Studies
    at the Competitive Enterprise Institute

     

    ..............................................................

     

    Financial Services Modernization

    The House Banking Committee reported on 20 June, by a narrow 28-26 vote, legislation that would effectively repeal the 1933 Glass-Steagall Act that separates commercial banking from investment banking. The legislation also would force thrift institutions to obtain a commercial bank charter; permit the integration of banking, insurance, and securities activities; and even allow some mixing of bank and commerce. A major impetus for reform came last year when the Comptroller of the Currency approved a procedural regulation under which banks could seek permission to offer non-bank financial services. But interest-group politics and turf battles between regulators could bog down this legislation, continuing to saddle the American economy with a less-than-modern financial system.

     

    Changing Structures

    Government regulation of banking and financial services is notoriously complex. Under the Bank Holding Company Act, any corporation wishing to own a commercial bank that takes deposits and makes loans must register with the Federal Reserve Board as a bank holding company (BHC). BHCs in turn can own one or more banks but corporate ownership of BHCs is highly restricted. For about a decade, BHCs have been allowed to establish so-called Section 20 subsidiaries that are allowed to underwrite and distribute securities. Thus the Glass-Steagall separation of investment from commercial banking has already eroded significantly. The Comptroller charters and regulates national banks; the states also charter banks.

    Federally chartered savings and loans are regulated by the Treasury Department’s Office of Thrift Supervision. An S&L can be owned by any other enterprise. The Securities and Exchange Commission regulates many activities of securities firms. And insurance companies are regulated by the states.

     

    Interest Group Battles

    While many banks, securities firms, and insurance companies agree that Congress should permit a full integration of financial services, they do not agree on how to do it. One proposed regulatory reform would allow commercial banks to offer insurance services. But independent insurance agents fear such competition. They want state insurance regulators to regulate all insurance sales activities, believing that state regulators will create a "level playing field." Specifically, the independent agents want all insurance agents, whether independent or working for banks, to be subject to state regulation. Further, they want states to limit the degree to which banks can tie or bundle their insurance offerings with other financial services. By contrast, banks want the Comptroller to regulate the insurance sales activities of banks to ensure that state insurance regulators do not discriminate against banks.

    Securities brokers oppose commercial banks underwriting or trading securities directly. They argue that banks that take deposits insured by the federal government would have an unfair advantage. Commercial banks, argue the brokers, should be restricted to offering securities through separate, Section 20 affiliates.

     

    Regulatory Turf Fights

    While interest group differences will have to be worked out if financial services modernization is to garner the political support necessary to proceed, the bigger battle is between the regulators themselves. The Fed contends that if securities firms and insurance companies want to own banks that are "large enough to induce systemic problems should [they] fail," they should be required to register as BHCs and be subject to Fed regulation. Not only do insurers and securities firms object to "umbrella supervision" by the Fed, but the Securities and Exchange Commission also strongly objects to the Fed taking on the role of top dog among the financial regulators.

    The finalization last fall of the Comptroller’s so-called "op-sub" regulation further complicates the situation. It opened the door for commercial banks or their subsidiaries to engage in activities that today can only be engaged in by non-bank sub-sidiaries of BHCs. In effect, the new regulation fosters the eventual emergence of universal banks which could then shed their holding company structure and Fed regulation while engaging in a broad range of financial activities, presumably including securities and insurance underwriting. Although banks are moving cautiously in applying for new powers under the op-sub regulation, it potentially gives banks a one-way street into the rest of the financial services industry. Further, most bank CEOs believe that the universal bank structure offers greater management flexibility and efficiency than the holding company structure.

    Understandably, non-bank financial firms object to the possibility that banks may be able to escape the Fed regulation to which a non-bank firm would be subject if it owned more than a small bank. The Fed is fighting hard to keep banks within its regulatory domain. It argues, incorrectly, that deposit insurance constitutes a subsidy to commercial banks. Further, it asserts that the holding company structure will minimize leakage of the subsidy to non-bank activities which would place securities and insurance firms at a competitive disadvantage.

    The Fed also claims that because it is uniquely empowered to provide practically unlimited funds to resolve any financial crisis that might erupt, it must have continuous oversight over any financial firm to which it might lend in a crisis. Contrary to nearly universal belief, though, the Fed is highly constrained in how much it can lend in a crisis.

    Another issue that provokes interest group and regulatory infighting is the proposed reform to allow greater mixing of banking and commerce, that is, allowing commercial banks to own substantial interests in other corporations and allowing non-financial firms to own commercial banks. Companies not linked to banks believe they would be at a competitive disadvantage. But commerce has long mixed with banking. Several score of thrift institutions are owned by non-bank firms. Further, many individuals that control commercial banks also have substantial non-banking business interests.

    Even the supposedly easy task of melding the commercial bank and thrift charters is running into problems. First, that issue has been subsumed in the wider debate over the mixing of banking and commerce. Second, thrifts increasingly see advantages to keeping a separate charter. And third, many commercial banks fear that modernization legislation could actually curtail some of the freedom they recently gained under the Controller’s new op-sub regulation.

     

    Overtaken by Technology

    These modernization efforts are proceeding against the backdrop of technological changes that make the current regulatory regime unworkable. Technology is making it increasingly difficult to neatly compartmentalize banking, insurance, and securities products. Despite Congressional sluggishness, though, universal banking, one-stop financial services for consumers, and a more efficient financial system are starting to develop.

    What should emerge from the modernization debate is not an industry sliced vertically, with a regulator for each of the traditional financial services industries. Rather, financial institutions should be free to offer whatever financial services they wish. There will be issues to resolve concerning protection for depositors, insurers, and the payments system from insolvent institutions or systemic crises. No doubt there will not soon be the kind of complete overhaul of the deposit insurance system that some reformers might wish. But Congress will truly harm America if it does not enact reforms that allow this country to have an integrated and efficient financial services sector for the 21st century.

     

    Bert Ely

    President, Ely & Company Inc.


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