HISTORY TELLS US THERE IS MORE TO THE STORY THAN ONE WAYWARD COMPANY
"History repeats itself, and that's one of the things that's wrong with history."
-- Clarence Darrow
True or false: the father of our electricity supply system is Thomas Alva Edison? On "Weakest Link" or "So You Want to Be a Millionaire" the answer would be true. But the real story is that the answer is FALSE. Very false. The history of "competition" in the electric markets is rife with myths, mistakes and missed lessons. What America is learning in 2002 is these missed lessons can be brutally expensive.
In 2001, United States witnessed a massive transfer of wealth to energy companies. This transfer was caused by poorly conceived regulatory reforms and is resulting in the creation of a new breed of megawatt moguls. A review of the history of regulation will show that such moguls roamed at the turn of the last century and their excessive greed led to their demise. It is likely that the excessive greed of some of the major energy companies in 2000-2001 will also lead to spectacular flame-outs. The Enron debacle was just the first. And what we'll find is that the cost of the greedmongering could be substantial for ratepayers and for the country.
We start with one very important missed lesson of history. Thomas Edison is properly credited for designing and developing the light bulb. Always looking toward the marketplace, Edison realized that his light bulb would mean nothing unless he developed an entire electric power system that generated and distributed electricity. So he built many of the early generating stations or "dynamos" that created electricity.
In 1882, he installed the world's first central generating plant in New York City's financial district. He built relatively small reciprocating steam engines that produced direct-current (DC) electricity to shop owners and other businesses that used electric lighting as a novelty to attract customers. He was unconvinced that the economies of scale would lend themselves to large, centralized power plants - in part because he relied upon direct current. Produced and distributed at relatively low voltages--around 110 volts--direct current electricity weakened substantially as it traversed the copper distribution lines. In practice, customers needed to be within one mile of a generating plant to receive power.
As a result, the emerging paradigm of electric power production consisted of cities being populated by numerous power plants, each selling to customers within a small radius. Typically, the large investment required for the plant prohibited one company from owning all of them.
So who was the real father of our centralized electricity system? What the game-show folks don't know is that it was the brainchild of a pariah, Samuel Insull. Insull's name is not well known, but in his day, he was to become an icon for greed and corruption, much like Ken Lay and his Enron executives have become today.
Insull migrated to the United States from England as a young man in 1881, linking up with Thomas Edison, serving as his secretary. He captured Edison's confidence and eventually co-founded the company that would become General Electric. In 1892 Insull was pegged by Edison to head a small Chicago Edison company, one of many Edison franchises around the country.
Insull had a different vision from his mentor. Actually, it wasn't really his vision but that of the banking industry. Whereas Edison wanted to own the manufacturing plant equipment and sell the product, electricity, Bankers such as J.P. Morgan who wanted to sell prime movers and generators to individual industrial and commercial companies. These same bankers held the patents Edison developed through the Edison Electric Light Company. The bankers refused to loan Edison more than a small portion of the money he needed to make his vision work. Instead, backed Insull who fought to make enormous profit by selling smaller generator sets to individual companies for their private generation of electricity.
Insull realized that his company could make more money by increasing what became known as the "load factor"--the ratio of average daily or annual power use to the maximum load sustained during the same period. Since Insull needed to purchase equipment to meet the peak load of use during a day--typically in the evening when customers used electric lights--he was stuck with power generating technology that sat idle most of the rest of the day. But Insull understood that if he could find customers who would use electricity during off-peak times, he could increase his company's income while avoiding new capital purchases (though he would still incur marginal expenses related to increased fuel use).
By enticing customers such as street railway companies, ice houses, and other businesses with low rates for off-peak power usage, Insull increased his load factor dramatically. He also found that lower-cost power stimulated demand, while still earning healthy profits for his company.
Insull also went for economies of scale. In other words, he found that larger generating units produced electricity at lower unit cost. Relying more upon steam turbines, he found that they could be scaled up to produce even more power with proportionally less investment. He fashioned a deal with the nascent General Electric corporation in 1903 that produced 5,000 kilowatts (kW) of power (5 megawatts [MW]). Within seven years, he was selling larger turbines that generated 12 MW. Power costs plummeted, allowing the company to sell more electricity at still lower rates.
Using steam turbines would not have been a successful strategy had it not been for Insull's use of an associated new technology --alternating current (AC) transformers. Developed in the 1880s, AC transformers overcame the technical limitation of transmitting low-voltage direct-current to distances beyond one mile. When power produced with already existing AC generators was transformed up to high voltages, current could flow for many miles without significant degradation. So when Westinghouse Electric promoted its AC motors, Insull turned his back on his mentor Thomas Edison and went with Westinghouse. AC quickly won the day, leading to the demise of Edison's direct current systems.
The last major innovation fashioned by Insull was the utility holding company. Insull quickly realized that competition in the fractured, regional electric power supply business would never allow him to exploit the large turbine-generators and AC transmission systems. After all, if many companies divided the market for electricity, none would have the demand for power that could be met by the bigger turbine-generators.
So Insull looked to consolidation. After buying-up competing firms, he often turned their generating stations into substations, relegating the generating equipment to back-up spares, and he used large, efficient steam-turbines to produce power for all customers. Successful in his efforts, Insull acquired 20 other utility companies by 1907 and renamed the firm "Commonwealth Edison." By that time, the company had already become known as one of the most notorious, but lowest cost utilities in the nation. As a result, Insull's strategies became emulated by utility entrepreneurs in other cities throughout the United States.
By 1912, Insull expanded outside of just energy utilities. He formed the Middle West Utilities Co., a holding company which eventually acquired several electric railways and utilities in Indiana. In 1924, the holding company became Midland Utilities Co., and in 1929 became Midland United Co. In addition, Insull continued to control Commonwealth Edison, and acquired three electric railways operating in Chicago and northern Illinois.
A natural outgrowth of electric utility companies was their ownership or acquisition of electric railroads such as interurbans and streetcar systems which were large electricity consumers. Insull acquired and rehabilitated during the 1910s and 1920s the major Chicago area interurbans (North Shore Line, South Shore Line, and the Chicago, Aurora, and Elgin) and the rapid transit lines which were merged into the Chicago Rapid Transit company.
The utility holding company phenomenon spread throughout the nation. Large banks saw what Insull had accomplished in Chicago and sought to emulate it. To help finance the great expansion of the early 1900s, the utility industry exploited Insull's "holding company" structure. It started by accepting the relatively unattractive stock and bond issues of utilities in exchange for generating and associated equipment. Thus, nascent utilities could therefore retain cash for their operations. After accepting the securities from several utilities (known as "operating companies"), the holding company issued stock and bonds using the subsidiaries' securities as collateral. Investors preferred the securities offered by the holding company, because they provided diversification and more secure returns than did offerings from individual companies.
Because the holding company now had a stake in the operating companies, they often consolidated the equipment and management of smaller companies into larger ones, thus helping them interconnect transmission facilities. The multi-state, multi-million dollar modern electric utility was born.
During the high-rolling Gatsby years of the 1920s, however the holding companies went wild. They assessed high fees for arranging financing for their operating companies, and they provided engineering services at levels way beyond their cost. Meanwhile, the companies pyramided one sub-holding company on top of another, none of which did anything but to hold securities of the companies below it. The scheme allowed stockholders of the top company to control the assets of operating companies with very little investment. Samuel Insull evolved to be one of the kings of these empires. In 1930, his capital investment of $27 million allowed him to control electric companies and assorted other businesses in 32 states having assets of at least $500 million. And in those days, $500 million was a lot of money.
So lucrative was the holding company structure that their number increased from 102 to 180 between 1922 and 1927, while the number of subsidiary operating companies actually declined from 6,355 to 4,409. By 1932, only eight holding companies controlled almost three-quarters of the investor-owned utility business.[1]
Perhaps best of all for the holding companies, their operations usually were exempt from the investigation of state regulatory commissions, since so much of their business crossed state boundaries. Yet another precursor of things to come.
As successful as Insull's company may have been, it soon became universally hated. A virtual monopoly in Chicago, the company reminded many public-spirited politicians and individuals of other monopolies that rubbed people the wrong way, with railroads being the most notorious.
When the stock market crashed in 1929, so too did Insull's empire. Newspaper accounts of abuses by holding companies invited a six-year investigation pursued by the Federal Trade Commission beginning in 1928. Public antagonism toward the companies intensified after the stock market crash of 1929 decimated the values of holding company securities. Campaigning for the presidency in 1932, Franklin Roosevelt lashed out against the "the Insulls, whose hand is against everyman's," and he vowed to reform the industry if he won election. Insull became the betrayed public's whipping-boy.
Pressure from creditors and the federal government, run by President Roosevelt, forced Insull to turn over Utility Investments Inc. to his creditors. Resigning from 60 corporations and facing an indictment, Insull left the country. Insull was tried and acquitted in each of three separate securities fraud trials in the mid-1930s. Insull became an example - and perhaps a scapegoat -- of the corruption and fraud which contributed to the Great Depression. The revelation of corporate duplicity brought to light during the Insull investigations led to a public outcry for reform.
Broken financially by the exhausting court trials and the Great Depression, he retired to France. Insull died on July 16, 1938, literally penniless, of a heart attack in a Paris subway station.
The current crop of megawatt moguls would do well to know the story of Sam Insull. Nowadays, his name is rarely mentioned in the industry, as he is associated with the condemnation of government and from the American people looking for explanation of the stock market manipulations and crashes of the 1930's. But if they did bother to read about this man, they could find that he was a pioneer whose greed led to his undoing.
RESPONSES TO THE REIGN OF HOLDING COMPANY TERROR
Creation of the"Natural Monopoly"
During the heyday of the electric utility holding company, another monopoly was unleashing its greed upon the public: the railroads. The greed of the railroad robber-barons, as they became known, spawned a period of reform that lasted from around 1896 through World War I. During this period, the Progressive movement created regulatory bodies to try to control the railroads. The philosophical core of the regulatory movement was the notion that some industries, such as the railroad business, constituted "natural monopolies."
According to academic economists of the day, such businesses exhibited tremendous economies of scale or the necessity of huge capital investment (and usually both) such that only one company would dominate a market. In the railroad business, it was argued that the large investment in equipment meant that duplication of facilities would incur great waste of financial and material resources, thus leading to overall higher costs for companies and higher prices to customers. Thus, monopoly appeared to be the "natural" outcome of such a situation, where one company could minimize the waste of resources to serve customers. In short, the railroad business was seen to be a "natural monopoly," one in which big technology and the high cost of investment led companies to move to a non-competitive environment.
The situation seemed similar to what was occurring in the electric utility business in the late 1800s. As electric power firms consolidated with others to exploit the benefits of large-scale turbine-generators and alternating current transmission, they increasingly looked like the epitome of natural monopolies. They were joined by other "public utilities," such as water and transportation industries that constituted, according to Richard T. Ely, an economist writing in 1903, "monopolies because, we know from experience, we cannot have in their case effective and permanent competition."
This rationalization of regulation set the stage for a series of reforms that began in the late 1890s and continued through the Roosevelt reform period.
Federal Action Against the Utilities
During the early years of his presidency, President Roosevelt had the opportunity to transform forever the utility industry. Having public and political support behind him after the holding company abuses became widely known, he could have urged that state and federal power agencies (such as the Tennessee Valley Authority and the Bonneville Power Authority in the Pacific Northwest) assume the assets and activities of privately owned utility companies. But Roosevelt was a capitalist at heart and a political moderate. He didn't go as far as the public likely would have let him.
Roosevelt and other policymakers realized the importance of electricity in achieving economic growth and social stability. They witnessed the vulnerability of this market to the manipulations of aggressive businessmen, like Insull. And they saw how the control of the energy markets could lead to the exercise of market power in related industries, such as transportation and manufacturing. When it came to electricity, the free market did not function smoothly.
Instead, Roosevelt sought to fill in gaps created by the private market and to impose safeguards, in the form of government oversight of holding companies and securities issuance, to prevent abuses in the future. As in other areas of his New Deal, the President preserved the private capitalist economy.
In order to fill in the gaps of the marketplace, Roosevelt and Congress used public funds to generate and distributed electricity to segments of the American public neglected by investor-owned utilities (IOUs). IOU executives had previously argued that electrifying rural areas would be too expensive and would not provide adequate returns on investment, but the Tennessee Valley Authority (created in 1933) and the Rural Electrification Administration (1935) proved otherwise. These and other institutions demonstrated that electrification of even the poorest households could raise standards of living of the inhabitants and produce good income to electricity suppliers. (In 1930, only 10% of American farms had electrical service; by 1945, almost 45% of them were wired up.) As a result of these actions, investor-owned utilities have been deprived, to this day, of a significant portion of the country's customers--customers who are served by municipal utilities or rural cooperatives.
Beyond embarrassing utility executives with rural electrification projects, the Federal Government also cracked down on the Insull-fueled industry consolations. Congress created the Federal Power Administration which imposed new rules on the investor-owned utility industry. By passing the Public Utility Holding Company Act of 1935, Congress outlawed the pyramid structure that had been at the core of financial abuses.
Holding companies could remain, but they could only have two levels--one holding company on top and one or more operating subsidiaries below. And the law also dissolved holding companies that did not contain contiguous operating utilities; earlier companies held operating companies that were scattered about the country and could not take advantage of consolidated or interconnected operation.
Moreover, all interstate holding companies and practically all businesses that produced a substantial amount of electricity would be forced to register with the newly created (in 1935) Securities and Exchange Commission. Furthermore, they were required to follow its strict rules about submitting financial reports, and they needed to obtain approval to issue stock and bond securities.
The number of utility holding companies declined, from 216 to 18 in the period between 1938 and 1958, while hundreds of operating companies became separated from holding companies altogether. The landscape of the utility industry remained fairly consistent since then: about 77% of generated kilowatt-hours were produced by investor-owned companies in 1970, while municipal and government utilities (and rural cooperatives) produced the remaining 23%.
State Regulation Enters the Scene
While the Federal Government cracked down on financial abuses, states followed-up with the creation of regulatory bodies to set the rates and rules for the utilities that were formed by the holding-company diaspora.
Many progressives looked to state regulation as a way of controlling the railroads. Though several states had created regulatory bodies to oversee the activities of railroad companies--with Massachusetts' railroad commission created in 1869 being one of the most notable--few had the power to enforce their recommendations nor could they establish rates and fares.
But the new type of regulation, promoted by progressive Republican governors in Wisconsin and New York in the first few years of the 20th century, was different. In 1905, for example, Wisconsin's Governor Robert La Follette pushed through creation of a railroad commission that had full jurisdiction over a railroad's rates, schedules, service, and operations of the state's transportation companies.
In 1907, New York governor Charles Evan Hughes, signed into law a similar measure to create a regulatory body for the Empire State.
Just a few years later, reform Governor Hiram Johnson was leading a similar revolt in California.[2]
All three states pioneered the "science" of state regulation of railroads and electric utilities. Gaining support from politicians and civic reform groups, state regulation of utilities became commonplace, such that by 1914, 43 more states had established government oversight of electric utilities.
The overall purpose of regulation, as viewed by its founders, was to serve as a body that would enforce the responsibilities and rights of electric power companies and their customers. For example, utility companies were required to serve all customers without discrimination who sought to buy power. To fulfil this "obligation to serve," they would need to raise capital and build plants to meet projected loads.
The regulators controlled what the utilities could charge customers - the rates had to be "just and reasonable" and based on the value of their investments in equipment plus a fair rate of return on the so-called "rate base".
But there was an unsavory trade-off. In exchange for not fighting regulation, utility companies earned valuable concessions. Perhaps most importantly, regulatory bodies legitimated the utilities' status as natural monopolies within their service territories and protected them from interlopers. Utilities also earned the right of eminent domain, formerly a power reserved by the state, so it could obtain property for their generating plants, transmission towers, and other equipment that was necessary for supplying an increasingly necessary commodity.
Utility customers, on the other hand, undertook the responsibility, overseen by regulators, to pay rates that helped maintain the financial integrity of utility companies. Often, regulators would insist (in theory) that rates be sufficiently high to keep utilities financially healthy. Sometimes, this obligation meant that customers had to pay higher rates than in previous periods.
Astute utility moguls, such as Samuel Insull, anticipated the benefits of regulation to power companies. As early as 1898, he pointed out that regulation would legitimate the monopoly status of utility companies and would keep at bay those who harbored distrust and antipathy for non-competitive industries. In other words, regulation gave the utility industry a special place in the American political economy and protected it from those who saw evil in the big oil and railroad trusts of the day. The genie was kept in a bottle, but it was a very profitable genie during a Depression-era when economic certainty was indeed a luxury. Throughout the difficult years of the 1930s and 1940s, no electric utility ever went bankrupt.
Municipal Ownership Rises and Falls
The big question for progressive reformers of the era was how to avoid the abuses common among the utility holding company moguls. Their answer actually took two forms--municipal ownership and state regulation of companies. Many pursued regulation - clearly the preferred choice of the existing utilities.
However, many cities chose to purchase the local utilities, thus they could ensure that the benefits of natural monopoly would flow directly to the people (or so it was hoped). In the electricity supply business, customers would enjoy lower rates as the city-owned utility exploited economies of scale and increased sales to greater numbers of people and businesses. Since cities pay no federal or state taxes and have no stockholders demanding dividend payments they could pass on savings directly to their citizens.
While municipalization of electric utilities enjoyed growing popularity, they did not win universal approval. Progressive reformers had not yet been successful in reforming the patronage-gilded city and state governments. At the same time they were dealing with railroads and electric utilities, they were also confronting corrupt city and state governments - many of which were controlled by the "trusts". The Progressives didn't trust that the Tammany Halls and other city rascals could be entrusted with an important service such as power. Moreover, several critics of municipal systems viewed them as attempts to socialize American industry at a time when private enterprise still carried much popularity in society--the existence of abusive monopolies notwithstanding.
Despite the move toward state regulation, the idea that city-owned utilities could better derive the benefits of natural monopolies for their citizens continued to hold some appeal. In fact, the number of municipal utilities peaked in 1922, with more than 2,500 "munis" in existence. Only accounting for about 5% of the nation's total generating capacity and less than 4% of the total electrical energy produced, municipal ownership never really blossomed.
LESSONS NOT LEARNED FROM HISTORY
Perhaps Clarence Darrow had it right. History's unfortunate penchant for repeating itself may be its greatest flaw. That flaw is certainly in evidence in today's deregulating electricity markets.
In this new century, the public is witnessing the recreation of megawatt moguls with great similarities to Sam Insull. Men whom the public have never heard of before have laid claim to unimaginable riches. Names like Kenneth Lay, Bill Dahlberg, Chuck Watson, Richard Priory or Steve Letbetter are beginning to be mentioned frequently in the press. Some were mentioned more frequently, as guests, in the White House. And as soon as the Bush administration is forced to reveal the people with whom Vice President Dick Cheney met with in 2001, the public will realize the profound impact that these men have on government policy.
The new "bilateral" contract era of the 21st century evokes images of the free-wheeling, unregulated years of the power industry in America in the 1880's and 1890's. Truths that the electric industry held as inalienable just a few years ago are now being challenged. Some legitimately, and some not.
A legitimate challenge is the move away from large centralized power plants. The principle of economies of scale that was so well established one hundred years ago may be obsolete in light of new distributed generation technologies. Today the small combustion turbine and combined cycle plant can be built by new players at less cost than even the depreciated value of the large units in the utilities older central stations. But isn't it interesting that these established truths were really just a phase of technology; a truth that technology could obliterate in a few generations?
Another truth on the verge of being obliterated is the concept of economic dispatch. But this one is more suspect. In today's electric trading markets there is a system that monitors remote units every five seconds and sends raise/lower signals to equalize incremental fuel costs. This system was put in place to ensure that electricity - a real-time commodity - was used as efficiently as possible. Yet, today's deregulation proponents advocate a system of power exchanges that don't need economic dispatch. For them, "economic dispatch" is an obliterated truth! They argue that the current exchanges must be obligated to take bids, and those bids involve not only fixed costs but also gaming strategies. Is this truly economically efficient or does it enable abuses by energy traders? The truth is not so clear.
Deregulatory proponents seek to obliterate yet another truth - diversity of energy resources. Only ten years ago, most regulatory bodies embraced, if not preached, the concept of Integrated Resource Planning and Least Cost Planning. These doctrines held that utilities were obligated to ensure that their energy production portfolios are as diverse as possible, so as to avoid over-reliance upon one fuel. This was a lesson painfully taught us by the OPEC sheiks in the 1970s. But in today's deregulatory fervor, this lesson is forgotten. As regulators have been phased out of the generation-building part of the industry, gone also are the reasoned Commission proceedings inquiring into the utility's use of the best load forecasts, expansion planning and economic costing models to arrive at the least cost, diversified energy portfolio. California - once the leader in reducing its dependence upon fossil-fuel generated electricity -- is now facing a future of having all of its new energy sources based upon natural gas.
And as we speak, Congress debates the removal of the most important provisions of the 1935 Holding Company Act. Utilities are poised to begin a new wave of consolidations with other utilities and with non-utility companies. The re-emergence of the vertically-integrated holding company octopus awaits the signature of a bill supported by the Bush administration that would dismantle the Roosevelt-era financial restrictions. This is a truth that is being sacrificed not for compelling efficiency reasons but because the Siren-call of dollars in the grasp of the financial markets.
The future of electricity markets in the United States is not clear. Certainly, the break-neck-speed approach to electricity deregulation has been slowed by the one-two combination of the California crisis and the Enron Meltdown. But the underlying technology drivers and the political influence enjoyed by the emerging megawatt moguls suggests that deregulation will continue. It may be more modest and unspectacular. But the dangers of market manipulation, inflated energy prices and diminished fuel diversity will continue to lurk.
AN APOCRYPHAL STORY FOR THE MEGAWATT MOGULS
There is an unconfirmed, perhaps apocryphal, story of a very important meeting held at the Edgewater Beach Hotel in Chicago in 1923. Attending this meeting were nine of the world's most successful financiers in America: Charles Schwab, president of the largest independent steel company; Samuel Insull, president of the largest utility company; Howard Hopson, president of the largest gas company; Arthur Cotton, the greatest wheat speculator; Richard Whitney, President of the New York Stock Exchange; Albert Fall, a member of the President's Cabinet; Leon Fraser, President of the Bank of International Settlements; Jesse Livermore, the greatest 'bear' on Wall Street; and Ivar Krueger, the infamous "match king" who assembled vast monopoly holding companies.
Twenty-five years later, Charles Schwab died in bankruptcy, having lived on borrowed money for five years before his death; Samuel Insull had died a fugitive from justice and penniless in a foreign land; Howard Hopson was insane; Arthur Cotton had died abroad, insolvent; Richard Whitney had spent time in Sing Sing. Albert Fall had been pardoned so that he could die at home; Jesse Livermore, Iver Krueger and Leon Fraser had all died by suicide. All of these men had dominated the free-wheeling capitalist orgy of the 1920s but their excess caught up to them in subsequent years.
If the remaining megawatt moguls like Bill Dahlberg, Chuck Watson, Richard Priory or Steve Letbetter ever assemble again, they would do well to consider this story.
[1] If this sounds familiar it should. Similar consolidation is now occurring in the deregulated electric industry of the 21st century.
[2] At his inaugural address in 1911, Johnson spoke with words that could well have been lifted by current-Governor Gray Davis when he said: "Much, doubtless, will be said of destructiveness, of abuse of power, of anarchistic tendencies and the like, and of the astounding and incomparable fitness of him who represents "big business" to represent us all. And in the end it may be that the very plan, simple, and direct, to which we have set ourselves in this administration will be wholly distorted and will be understood only by those who, with singleness of purpose, are working for a return of popular government in California. It matters not how powerful the individual may be who is in the service of the State, nor how much wealth and influence there may be behind him, nor how strenuously he may be supported by "big business" and by all that has been heretofore powerful and omnipotent in our political life, if he be the representative of Southern Pacific politics, or if he be one of that class who divides his allegiance to the State with a private interest and thus impairs his efficiency, I shall attack him the more readily because of his power and his influence and the wealth behind him, and I shall strive in respect to such a one in exactly the same way as with his weaker and less powerful accomplices. I prefer, as less dangerous to society, the political thug of the water front to the smugly respectable individual in broadcloth of pretended respectability who from ambush employs and uses that thug for his selfish political gain.