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E-MailAneil Kovvali is an Associate Professor of Law at the Indiana University Maurer School of Law, Bloomington. Joshua C. Macey is an Assistant Professor of Law at the University of Chicago Law School. This post is based on their recent paper, forthcoming in the Yale Journal on Regulation.
Rate regulated public utilities supply one-third of the electricity in the United States and own nearly all of the transmission and distribution lines that transport electricity to meet customer needs. Recently, they have also been at the center of high-profile corporate scandals. FirstEnergy and ComEd, for example, have been accused of bribing regulators to receive favorable treatment for coal-fired generators and nuclear reactors. PG&E pled guilty to eighty-four counts of manslaughter for its role in California wildfires. Utilities across the country have emerged as powerful opponents of state and federal climate action.
While none of these scandals can be attributed to a single cause, they are all, at least in part, failures of corporate governance. Corporate governance mechanisms are generally designed to encourage directors and officers to focus on generating financial returns for shareholders. That is because shareholders are normally considered the “residual claimants” on the corporation: shareholders have a claim on what is left over after the corporation has collected revenue from its customers and met its legal obligations to regulators, creditors, and workers. Because shareholders are entitled to the firm’s residual value, they normally internalize the consequences of corporate decisions. If a corporation delivers better products or invests in a more efficient technology, the shareholders profit. If the corporation loses market share to competitors that offer better or cheaper service, or if it experiences increased costs due to its failure to meet regulatory obligations or invest in efficient technologies, the shareholders are the first to take a financial loss. Creditors, by contrast, cannot collect more than they are contractually owed, and they lose the value of their investment only if the firm experiences financial distress. For these reasons, corporate governance mechanisms focus managers and directors on shareholder concerns. Shareholders elect the board of directors, which hires managers that—like the directors—owe fiduciary duties to the shareholders. The market for corporate control focuses on shareholder interests.
In The Corporate Governance of Public Utilities, forthcoming in the Yale Journal on Regulation, we argue that this justification for shareholder power does not apply to rate regulated public utilities. Public utilities typically possess exclusive franchises to sell and transport electricity. They operate monopoly franchises in their service territories and are limited—and often entitled—to a set rate of return on their investments. These two features mean that ratepayers, not shareholders, receive whatever value utilities generate beyond what regulators allow the utility to deliver to its shareholders. When this value manifests in the form of reduced costs, whatever residual value exists beyond what shareholders are owed goes to ratepayers in the form of lower bills. When value manifests in the form of innovative products that reduce carbon emissions or increase grid reliability, it is again ratepayers who benefit in the form of cleaner air and a more reliable supply of electric energy.
For these reasons, ratepayers are the residual claimants of public utility companies. Utility shareholders, by contrast, are properly understood as creditors by another name. Like creditors, their losses are limited to the value of their investment while their recoveries are capped by regulatory price controls. While corporate governance mechanisms ensure that public utility companies are managed for the benefit of shareholders, ratepayers internalize the consequences of utilities’ decisions.
Because creditor returns are capped at the value of the debt, creditors do not have an incentive to engage in risky or speculative ventures that might generate significant value. Price caps in utility industries have a similar effect, since they prevent shareholders from receiving any value above what the regulator will allow. In fact, utility shareholders arguably have even less incentive than creditors of non-utility firms to take risks, since their legal right to a monopoly means they do not need to innovate to avoid losing market share. The two characteristics of rate regulated public utilities thus explain, at least partially, utilities’ risk aversion, their reluctance to decarbonize, and their unusual incentives to curry favor with (or bribe) their regulators.
To address these misaligned incentives, we suggest a variety of governance reforms to induce managers to pursue the interests of ratepayers. These reforms include ratepayer representation on the board of directors, modifications to fiduciary duties and the business judgment rule, and regulations that quarantine utilities from other business enterprises to prevent firms from using utility franchises to subsidize their activities in non-rate regulated industries.
We recognize that such reforms would be extremely difficult to implement, and that they do not resolve many of the administrative and governance challenges posed by public utilities. As a result, our analysis highlights the need to tighten external regulations that narrow the scope of managerial discretion regardless of whether managers represent shareholders or ratepayers. It may also support restructuring these industries to introduce additional competition. But governance changes should be a useful complement to such efforts, and may be a useful stopgap measure if regulators are unable or unwilling to undertake deeper changes.
Our analysis has practical significance given the crucial role utilities play in providing electricity and addressing climate change. But the insights we develop also have broader theoretical and practical implications. Policymakers have tolerated and even promoted monopoly power in other areas of the economy, and legal scholars are increasingly optimistic that utility regulation can solve many of the ills associated with these large concentrations of economic power. Our analysis shows that these arrangements raise difficult regulatory and governance challenges. How, for example, should merger review be conducted in utility industries, where the market for corporate control cannot be expected to discipline? Or should the business judgment rule apply when returns are set by regulators? More fundamentally, our analysis raises questions about how and for whose benefit economic activity should be coordinated, at least in domains where uncoordinated market transactions are inadequate.
The complete paper is available for download here.
