Background

		PUC-regulated industries were stable until the 1970s, when the energy crisis, stagflation and distrust of government forced the PUC to change its methods.
		The Energy Commission's charge to advance long-term policy goals such as efficiency and resource management has conflicted frequently with the PUC's short-term goal of keeping down utility rates.
		A number of technological advances, economic realities and political choices have allowed competitive pressures to erode away the monopolistic nature of public utilities and essential services.
		While public policies have sought to eliminate economic regulation of most utilites, private water services remain monopoly providers.

Background

As the 21st century approaches, energy and telecommunications are evolving from stable utilities into dynamic enterprises, redefining economies and lifestyles. Where corporate monoliths once controlled the field, a rush of entrepreneurs and investors are seeking to provide goods and services competitively. Where government regulators once stood sentry over the public interest, policy makers are re-examining the nature of that interest and the best way to protect it.

The definition and defense of the public interest has never been stagnant. The Public Utilities Commission has matured over the last century to balance the needs of corporate monopolies, captive customers and the larger public good. Over the last 20 years, the California Energy Resources Conservation and Development Commission has integrated environmental planning, energy efficiency and technology development to reduce air and water pollution, meet swelling energy needs economically and avoid the hardships of shortages.

This regulatory strategy has produced huge successes and notorious failures -- and it has prompted California to become a pioneer in the restructuring of essential service industries. By aggressively pursuing market trends and implementing federal policy reforms, California is trying to replace government regulation of energy with competition and consumer choice. Similar pressures require the State to rethink its role in three other industries regulated as public utilities and common carriers -- telecommunications, transportation and investor-owned water service.

This Background describes the present energy regulatory structure and important events that have challenged its effectiveness. It reviews the evolution of telecommunications and transportation regulation, and describes the challenges of the investor-owned water service industry.

The Regulators

While a score of government agencies have a hand in how energy is produced and consumed in the State, two agencies are the central authorities: the California Public Utilities Commission (PUC or CPUC) and the California Energy Resources Conservation and Development Commission, better known as the Energy Commission. In the case of telecommunications, the PUC is the State's primary agent. And in the case of transportation and privately owned water systems, the PUC is only one of several agencies with oversight responsibility.

The PUC is the product of a century-long evolution. In California, the railroads were the first among the nascent modern-day utilities to abuse their control of the market to exact unfair rates and discriminate against captive customers.

The Legislature responded by creating a State Board of Transportation Commissioners. By 1879, the agency had become an elected Railroad Commission, was embedded in the Constitution and charged with ending corruption and market abuses. The Commission, however, was impotent against the railroad robber barons. The problem, as described by one present day PUC Commissioner, was the lack of "a judicial capacity to maintain a sustained disciplinary presence" over an industry with multiple and changing public interests:

What was a reformer to do? How was one to gain the advantage of a sustained presence of a nonpolitical authority which could develop expertise in understanding the dynamics and economies of business affected with the public interest? The answer was to invent the regulatory commission.⁽¹⁾

As part of the Progressive Era reforms, the Railroad Commission in 1911 was established in the California Constitution as a five-member panel appointed by the Governor and confirmed by the Senate to staggered six-year terms. Commissioners were forbidden specific conflicts of interest and could only be removed for incompetence, corruption or neglect of duty as determined by a two-thirds vote of the Legislature.⁽²⁾

That same year, the Legislature adopted the Public Utilities Act, assigning the Commission regulatory authority over a range of private companies, many of them with overwhelming shares of the market and engaged in businesses so critical to the community welfare that the U.S. Supreme Court had found them to be "clothed with a public interest."⁽³⁾

In 1946 the Legislature changed the Commission's name to the Public Utilities Commission in recognition of the agency's broad reach over everything from power, heat and light to wharfages and telegraphs. The constitutional roots are often cited as the foundation for the Commission's independence. But its greatest legal powers have been granted by the Legislature, most notably in Section 701 of the Public Utilities Code: "The Commission may supervise and regulate every public utility in the State and may do all things, whether specifically designated in this part or in addition thereto, which are necessary and convenient in the exercise of such power and jurisdiction."

While some of the Commission's regulatory authority has been pre-empted by federal law, the PUC in 1995 established rates for $50 billion worth of commerce -- scrutinizing the bottom line of 655 privately owned natural gas, electric, telephone, water and sewer and pipeline companies, while overseeing 54,000 truck, bus, railroad, light rail, ferry and other transportation companies.⁽⁴⁾ Despite this breadth, the PUC and the industries it regulates were relatively stable for the middle decades of the century. In some respects, the job of Commissioners became routine with time -- as technological advances and the economies of scale resulting from the State's growth combined to keep utility rates steady, and often declining in real terms.

During this time, the relationship between consumers, the PUC and the utilities became represented by an unwritten "regulatory compact" in which the utilities agreed to price- and service-related regulation in exchange for the exclusive right to serve a specific area and a guaranteed rate of return on investment.

The stability ended with the energy, economic and environmental crises of the 1970s and early 1980s. In those years, Commissioners struggled to help the capital-intensive utilities ride out periods of high inflation and rising fuel costs. They simultaneously tried to respond to consumer advocates, who wanted to mute rapidly increasing rates, and environmentalists, who wanted to reduce the public costs of pollution and meet growing energy demands through efficiency.

An overall distrust of government increased the pressure for public input and open decision-making procedures. And as federal law gradually pushed for more competition in both energy and telecommunications, new market players gained a stake in PUC proceedings -- creating still more interests that needed to be balanced.⁽⁵⁾

The growing number of participants was accompanied by a growing number of statutory mandates: to administer conservation programs, monitor contracts between independent energy producers and utilities and enact subsidies for low-income consumers. Even some of the PUC's traditional duties became more complicated as utilities requested rate hikes to cover the costs of overdue and over-budget nuclear power plants.

The consequence of these developments was that the PUC abandoned its passive role of assessing utility proposals for fairness and efficiency, and began to scrutinize and manipulate utility decision-making. A former high-ranking PUC staff member, in a book analyzing these trends, concluded:

I argue that contemporary regulation is interventionist, meaning that there has come to be considerable regulatory involvement in decisions that were previously made entirely by utility managers or approved by regulators after minimal review. This recent regulatory strategy has generally had two related motivations: to minimize cost (and thus rate) increases and to minimize impacts of these increases on utility customers.⁽⁶⁾

The political and economic trends also made obvious two large deficiencies in the Commission's approach: First, by giving companies a guaranteed rate of return on expenses, the utilities were encouraged to build more plants, hire more people and focus on the short-term horizon between rate cases -- which contributed to reliability but put constant upward pressure on prices. Second, while the PUC controlled the investor-owned energy utilities, it had little sway over the broader policies that determined how energy was produced and consumed.⁽⁷⁾

The Energy Commission was formed in 1974 to counter those regulatory failures. Its duties went beyond the electricity and natural gas delivered by monopolies to understanding and influencing all of the State's energy uses. But while the PUC's control is nearly absolute over the monopolies, the Energy Commission's regulatory authority is limited: It sets building and appliance efficiency standards to reduce energy consumption, and it approves site applications for new large thermal power plants. The Energy Commission also was vested with a number of public purpose programs intended to promote development of cleaner, renewable and other alternative energy sources.⁽⁸⁾

At its inception, the Energy Commission's facility siting authority was its greatest. The RAND Corporation in the 1970s warned the Legislature that to meet the State's 7 percent annual increase in electricity demands, a series of nuclear plants would have to be built.⁽⁹⁾

The ensuing debate galvanized competing concerns -- that nuclear reactor domes would be riveted every 20 miles to the California coast and, alternatively, that public protests would prevent any new generators from being built.

The solution was to assign to the Energy Commission the duty of gatekeeper, letting through only those new electricity generating sources that mitigated environmental impacts and were needed after efforts were made to reduce electricity demands through efficiency improvements.

With some initial controversies and midcourse corrections, the Energy Commission is widely acknowledged for succeeding in that charge -- enabling the State to accommodate a rapidly growing population and economy with investments in demand-management tech-nologies.

Unlike the constitutionally based PUC, the Energy Commission is a creature of statute: Five commissioners are appointed by the Governor and confirmed by the Senate to five-year staggered terms. One commissioner is required to have a background in engineering or physical science, one in law, one in environmental protection, one in natural resources economics, and one represents the public at large.

Both commissions are characteristic of "fourth branch" agencies that have been created in this century to deal with complex public policy issues. They were granted policy making and adjudicatory authorities so they could efficiently regulate or promote public interests in the marketplace. The tradeoff for that efficiency has been a diminished accountability inherent in typical executive-branch departments and a muting of the checks and balances intended between the executive, legislative and judicial branches.

As the State rethinks its role in the market, it will need to reconsider whether the tradeoffs made in creating fourth-branch agencies are still appropriate or if they need to be redefined. But an even more important consideration will be to create a structure that avoids the notorious conflicts that developed between the Energy Commission and the PUC.

From the inception of the Energy Commission, the two agencies have at best displayed the behavior of rival siblings. The PUC was the only state agency that urged the Governor to veto the Warren-Alquist Act -- arguing that either it or another existing agency could perform all of the duties that were to be assigned the new commission.⁽¹⁰⁾ More important than any overlap, however, were the conflicts that developed between the PUC, and its short-term interests in keeping energy costs low over the three-year horizon of a rate decision, and the Energy Commission's long-term interest in efficiency and resource protection. The consequences were described by a public manager with experience in both agencies:

California has paid a high price for the conflict between the two agencies. The price has come in the form of arcane, interagency turf battles; forum shopping on the part of interest groups; and a resulting energy policy that is neither focused, implemented efficiently, nor friendly to the State's citizens or its business community.⁽¹¹⁾

The conflicts have severely tarnished the otherwise significant achievements the State has made in energy policy. And of greater importance today, despite assertions by both agencies that diplomacy guides their actions, both agencies see their duties expanding to include state oversight of competitive markets, raising the likelihood that the conflicts will resume.

Regulators: Pressures to Change

Over the last decades, the tensions and disputes between the Energy Commission and the Public Utilities Commission increased to a point that required recurring attention from lawmakers. But despite considerable efforts, wholesale reforms have been elusive.

The Legislature has created joint committees, formed working groups, established task forces and attempted political negotiations in its efforts to identify the key problems and legislate solutions. In one such effort, Senate Concurrent Resolution No. 7 of 1989, lawmakers declared at the outset that the existing system "has resulted in significant fragmentation, duplication, overlap and confusion in the formulation and execution of state energy related functions." Over the next two years, a special joint committee held hearings, hired consultants and issued recommendations for coordinating energy programs and merging many of the functions of the PUC and Energy Commission into a single agency. Few reforms were enacted into law.

The controversy escalated between 1992 and 1994, when the legislative leadership and the administration took divergent paths toward organizational reform. The administration looked at structural changes as a way of reducing government expenses, while the legislative leadership pursued reforms intended to reduce policy disputes. During 1992 budget debates, which were burdened by the recession-spawned revenue crisis, Assembly Republicans urged that the Energy Commission be eliminated to save money.

The proposal failed, but that winter a team of senior legislative staffers were assigned to examine the issue. The group identified overlaps between the two agencies in the areas of conservation, research and development and advocacy for cleaner and more efficient technologies. Increasingly, however, the group focused on criticisms aimed at the decision-making procedures employed by the Public Utilities Commission.

In January of 1993, the Governor's budget summary proposed eliminating the Energy Commission. And in the spring of 1993, SB 141 (Alquist) and SB 142 (Rosenthal) were introduced to address duplication identified by the legislative working group. The administration did not take a position on the bills.

That summer, language was added to the 1993-94 budget bill requiring the administration to develop a reorganization plan by December 1, 1993 -- otherwise the budgets of both Commissions would automatically be cut by 7.5 percent for the rest of that fiscal year. On December 1, 1993, the Governor proposed abolishing the Energy Commission "to reduce the size and scope of governmental activity in an arena which is increasingly dominated by competition and market forces."⁽¹²⁾

The plan also would have eliminated the State Lands Commission, transferred the functions of both agencies to the Department of Conservation and created a Facility Siting Board to provide consolidated reviews of all new energy facilities ⁽¹³⁾

In the spring of 1994, SB 2048 (Leonard) and AB 2468 (Conroy) were introduced embodying the administration's plan. The Senate and Assembly policy committees, however, became increasingly focused on reforming the PUC. Eventually negotiations between the legislative staff and the administration broke off. The administration's bills died after environmental groups and the utilities opposed them.

In January 1995, the administration proposed making those same changes under its authority to administratively reorganize executive agencies. The Little Hoover Commission reviewed the plan as required by statute and a majority of commissioners endorsed it with some recommended changes. The Senate, however, voted down the plan.

By 1996, the drive to reorganize the state energy-related agencies had acquired an added impetus. The dramatic restructuring of the energy industry itself would eliminate the vertical monopolies that are the foundation of PUC regulation and eliminate government planning for electrical generation that the Energy Commission was created to perform. In addition to its landmark work restructuring the energy industry, the PUC launched an internal review to rethink its mission in a competitive era. The project, called Vision 2000, invited utilities and interest groups that participate in commission proceedings, as well as the commission staff, to critique the PUC's internal workings and help to identify solutions.

The Vision 2000 document recognized that the industries were changing in different ways and at different paces, that old regulations did not work and there was a need for "new regulatory techniques which rely on well-structured incentives supplemented by strong enforcement programs to protect against market abuses." Based on that process, the PUC in the summer of 1996 adopted a plan that replaced an internal structure based on the role staff played -- advocacy, advisory and compliance, consumer protection, safety enforcement -- to one based on the industries the Public Utilities Commission regulates -- telecommunications, energy, rail safety, carriers and water. The plan was widely criticized by the PUC staff, the utilities, small businesses and special interest groups for dealing with structure before process, and especially for its attempt to blend the advocacy and advisory staff within the PUC.

The Commissioners saw Vision 2000 as a pivotal opportunity for the PUC to remake itself in the image of the new markets, and especially before the Legislature remade the agency. One Commissioner said the situation reminded him of a quote from a Harvard University president, which he paraphrased:

He declared to the senate of the university that the last phase of an organization in a death throe is that it shifts its focus from serving an external societal purpose to an overriding concern with conserving the state of its constituent members.⁽¹⁴⁾

The issues of restructuring the energy industry and reforming the PUC converged in the summer of 1996 with the passage of a bill on electrical restructuring and two bills that dealt with PUC procedures.

• Electrical restructuring. AB 1890 (Brulte) authorized the collection of transition costs to reimburse the utilities for investments that will be worth less in competitive markets, created an Independent System Operator to govern the transmission network and effect trades, continued funding for research and development, reaffirmed the State's commitment to commercialize renewable resources and staked out the PUC's responsibilities to protect consumers from overaggressive marketing.
• PUC procedural reform. SB 960 (Leonard) recreated a ratepayer advocacy unit in the PUC, required commissioners to be more involved in the fact-gathering processes, and created three classes of procedures -- quasi-judicial, quasi-legislative and rate-making.
• Judicial review. SB 1533 (Calderon) allowed for PUC decisions in adjudicatory cases to be appealed to the appellate court and for the court to determine if decisions are based on the evidence in the case.

The bills substantially dealt with some of the most pressing issues before the Legislature, particularly those associated with the PUC's plan to restructure electricity service. But other issues prompted by rapidly changing utilities were not resolved. Among the remaining issues are the government functions that will be needed in the future, the best structure for accomplishing those functions and the procedures and policy making paths those agencies should follow.

Energy

Three forms of energy -- electricity, natural gas and transportation fuels -- comprise 85 percent of the developed energy consumed in the State. These three forms also define the majority of energy-related policy issues -- debates that involve a combination of economic forces, technological developments and political preferences.

The United States spends nearly $500 million on energy each year, and Californians are responsible for about a dime out of every dollar spent. The typical California resident served by an investor-owned utility spends $65 a month on electricity and $32 a month on natural gas.⁽¹⁵⁾

Electricity. Electricity accounts for only 10 percent of the energy consumed in California, but that fact understates its value in the energy mix. Electricity accounts for nearly 50 cents out of every dollar spent on energy, and for most uses it is a commodity with no practical substitute. The State's network for providing electricity is elaborate: 19,000 power plants, 2,500 substations, 40,000 miles of transmission lines. In California, five investor-owned utilities, 26 municipal utilities, four irrigation districts and five rural electric cooperatives provide power.

But 75 percent of the electricity is provided by the three largest investor-owned suppliers. Pacific Gas and Electric Company, headquartered in San Francisco, with a service area roughly from the Oregon border to the Tehachapi Mountains, is the largest investor-owned power utility in the nation with electricity revenue in 1995 of $9.6 billion. Southern California Edison Company, headquartered in Rosemead, is the nation's second largest investor-owned electricity provider with 1995 revenues of $8.4 billion. And San Diego Gas and Electric Company had 1995 electricity revenues of $1.5 billion.

Equally important are the State's government-owned electricity suppliers. These government agencies vary greatly in size -- from the Los Angeles Department of Water and Power, which generates and sells electricity, to communities like Anaheim that distribute power purchased from federal authorities and private generators. The government-owned utilities were created as an alternative to private monopolies and generally operate under the rules established for government agencies: elected officials, open meetings and public referendum of decisions. They are not regulated by the PUC.

The large investor-owned and municipal electricity providers are vertical monopolies, owning and controlling the generation, transmission and local distribution of electricity.

For more than a decade, the generation aspects of the industry have become increasingly competitive. New technologies have emerged that can produce electricity cheaper than the technology of older and larger power stations. Federal laws have passed requiring utilities to purchase power from independent producers. And more recent federal reforms have effectively required the owners of transmission facilities to become common carriers, opening wider the market for wholesale electricity transactions.

Encouraging more competition among generators and allowing for retail trades will require placing the transmission system into the hands of an independent dispatch entity called the Independent System Operator. Most industry, academic and government experts see the distribution system remaining a monopoly for the near term.

Natural gas. Natural gas is provided by a network of pipelines that deliver the gas from producing regions, such as Canada and the southwestern United States, to areas where it is used. The largest distributors of natural gas in California are Pacific Gas and Electric Company, with annual gas revenues of $1.1 billion, Southern California Gas Company with annual revenues of $2.6 billion, and San Diego Gas and Electric Company with $310 million in annual gas revenues.

Federal regulation of interstate gas transactions has largely shaped industry trends. In the mid-1970s, strict regulation of the pricing of interstate gas discouraged exploration and production, resulting in winter-time shortages and higher prices than consumers would have paid under relaxed regulation. In 1978 Congress passed the Natural Gas Policy Act, which deregulated the price of newly discovered natural gas and eliminated the distinction between interstate and intrastate gas. While simple in concept, the process of turning pipelines into common carriers has been criticized for its complex and lengthy implementation.

The PUC's rate-making role has largely been to regulate the investments and pricing of the distribution facilities operated by the investor-owned monopolies. In California, the result has been competition among producers to serve the largest clients and an ongoing debate in regulatory arenas about how to prevent small consumers from picking up an inordinate share of the fixed costs.

While the utilities see a gradual trend of increasing competition, nearly all homeowners and small businesses still have one logical choice for gas service -- the historic monopoly provider. The result is a bifurcated market of "core" and "non-core" customers. Non-core customers are businesses that use so much gas that providers will compete for their business, while core customers are those relying on historic providers.

Transportation fuels. About half of the energy consumed in the State is used to move people and goods. Californians consume nearly 1 billion gallons of gasoline a month. On a global scale, California is the third largest consumer of gasoline, after only the United States as a whole and Russia.

Gasoline and diesel account for most of the transportation fuel. California's consumption allows both consumers and policy makers to exert significant influence on the market and national policies, such as the reformulation of transportation fuels to pollutants. The market for transportation fuel is for the most part competitive, but inventories and transactions are closely monitored to assess pricing and supply trends that could impact other sectors of the economy.

In the future, the market for electricity, natural gas and transportation fuels are expected to increasingly overlap -- as more natural gas is used to generate electricity and as more electricity is used for transportation. Currently about one-third of the State's electricity is generated from natural gas.

(Background continued in next section)