Municipalization and Subsidized Utility Competition
The Taxpayers' Perspective

Municipal utilities in California have been part of the landscape since the 19th century, and they are here to stay. What's new on the scene is competition to provide utility services that heretofore have been provided by monopolies in the private sector, such as the major investor-owned utilities overseen by the California Public Utilities Commission, or by monopolies in the public sector, cities and municipal utility districts overseen by elected boards. Both Congress and the California Legislature have enacted laws that encourage, even mandate, competition between service providers. The questions raised in this bulletin highlight taxpayer concerns about government's involvement in that competition.
- Editor

Findings: Subsidies for municipal utilities, in the form of tax exemptions, preferential power purchasing, low-interest government loans, loan guarantees, and tax-exempt bond financing, nationally cost taxpayers more than $11 billion annually. In California, subsidies to municipal electric utilities are estimated at about $1 billion a year. Government-owned utilities are often less-efficient and higher-cost providers, but their tax advantages allow them to offer lower-priced services than private counterparts. As energy and telecommunications services become competitive, municipalities that operate their own utilities face a serious conflict of interest, because they can and do regulate their competitors. Many California local agencies are positioning to take over provision of electric and telecommunications services from private utilities or to use their subsidies, preferences and regulatory powers to compete against private utility companies.

In the wake of recent actions by Congress deregulating the electric power, telecommunications and cable industries, government-owned utilities are using taxpayer subsidies and special preferences to preempt marketplace competition. Municipalization is the inelegant term describing attempts by cities and local utility districts to seize markets from private, investor-owned systems, such as when a local agency condemns private utility property and uses that property to form its own utility. Competition by taxpayer-subsidized municipal utilities is also threatening private utilities. These attempts threaten competitive restructuring of these industries.

Successful deregulation and restructuring ultimately will allow customers to choose their local and long distance telephone, cable and electric power providers and allow businesses in these industries to do what businesses in other sectors have always done: Compete on the basis of established market criteria - price, quality, service, and innovation. It will not happen overnight. The details are still being worked out. Indeed, some of these "details" represent issues so major that their resolution is as important to the success of restructuring as the original congressional actions.

As policymakers work to implement the transition to utility competition, it is instructive to examine the taxpayer-funded subsidies currently enjoyed by government-owned and cooperative utilities, which allow them to offer significantly lower rates than their private competitors. These subsidies and preferences have been examined at length for the electric industry. The findings of those studies are also applicable to other utilities, such as telecommunications, which are beginning to face similar public-sector competition.

Elaine Davis and Richard Davis are principals in The Simeon Partnership, an economic and public policy consulting firm in Bainbridge Island, WA. Authors of "Competing for a Change, Market Approaches to State Government," and numerous other publications on the importance of competition to government efficiency, the Davises have practiced and researched public policy for more than 20 years.

Cal-Tax Director of Research Stephen Kroes contributed to this report.

As government agencies expand their presence in these newly competitive markets, the inefficient nature of government preferences and subsidies will be accentuated.

This report specifically examines the electric and telecommunications industries. Deregulation of the natural gas industry, however, has also prompted many of the same taxpayer concerns, particularly regarding the threat of municipalization and subsidized government competition with investor-owned utilities.

Electricity

These subsidies are substantial. In a 1994 study done for the Edison Electric Institute, Putnam, Hayes & Bartlett, Inc. (PH&B) estimated that these subsidies cost nationwide more than $11 billion in 1992. The major burden was carried by the federal government, whose various subsidies totaled $8.4 billion that year - $4.8 billion in taxes and $3.6 billion in foregone federal utility revenue. Local governments lost another $2.7 billion in taxes. Based on its share of public power nationally - estimated to be about 12 percent - California represents nearly $770 million of these revenue losses to the federal government and more than $247 million in state and local government revenues that were not collected.

An examination of the subsidies provided to government utilities is instructive. According to PH&B, they include:

• Exemption from federal and state income taxes;
• Exemption from other taxes (including property, gross receipts, and excise taxes);
• The ability to issue tax-exempt debt securities;
• Access to low-interest government loans and loan guarantees; and,
• Preferential access to low-price federal power.

" ... government subsidies to public utilities and coops have long outlived their usefulness and, in fact, distort the power market in ways that directly harm the vast majority of electricity customers and work to reduce economic efficiency."

The 1996 Annual Report of President Clinton's Council of Economic Advisers (CEA) anticipated the subsidy problem. Referring specifically to energy deregulation, CEA said,

"... competition will be distorted if producers are given selective privileges, or subjected to selective obligations imposed to further even legitimate social goals. ... As competition grows, increasing distortions may result from some entities having access to special privileges such as federally tax-exempt bonds or other preferential treatment."

"...subsidies provided to government-owned electric utilities... contradict federal policies designed to further competition in electricity supply. Clearly, in order to maximize the benefits of a competitive electricity market, federal policies which grant subsidies to electricity suppliers must be reformed."

Better yet, don't 'show me' A Missouri state statute in 1994 was revised to preempt public takeovers of private, investor-owned utilities. In Section 71.525 of state statute affecting cities, towns and villages the revised language states, "...no city, town or village may condemn the property of a public utility. ... if such property is used or useful in providing utility services and the city, town or village seeking to condemn such property, directly or indirectly, will use or proposes to use the property for the same purposes, or a purpose substantially similar to the purpose that the property is being used by the public utility or rural electric cooperative." This measure was intended to assure that government was not competing unfairly.

Government utility advocates admit that their lower rates are partially due to subsidies. They assert, however, that about 60 percent of the difference exists because government utilities operate more efficiently. The American Public Power Association (APPA) points to a study conducted for them that reviewed the PH&B methodology. Based simply on the study's conclusion that subsidies only represent a portion of the rate difference between government and private utilities, APPA concluded that the rest of the difference must be due to better operational performance by government utilities.

If their assertions were true, government power providers would constitute a novel exception to the general rule of monopolies. Even pro-government advocates, David Osborne and Ted Gaebler, authors of Reinventing Government and founders of "entrepreneurial government," do not promote government-owned business monopolies. At best, their work suggests, such monopolies may equal the performance of their private sector counterparts.

The best way to demonstrate efficiency is fair market competition. If APPA is right, municipal utilities should be able to successfully compete without their subsidies.

Palm Springs offers nothing for something In a now failed attempt, Palm Springs, California proposed to install meters at each home and business in its jurisdiction, basically intercepting the electric power provided by Southern California Edison (SCE). Called "muni-lite," city officials said that new federal laws allowed this unorthodox arrangement. They claimed unsuccessfully that federal laws gave the city the authority to purchase wholesale electricity from other suppliers and to transmit it across SCE lines through the city meters to the city's new retail customers. The Federal Energy Regulatory Commission ruled against the city, calling the proposal a "sham wholesale transaction." Since that determination, the city has embarked on another approach, establishing what it calls a "virtual utility," which will involve a partnership with Portland General to provide power which the city wants to transmit over SCE lines to compete against SCE for local customers.

The competitive edge that government subsidies allow municipal utility providers is substantial and is increasingly attractive to major power users. The potential for some of the nation's largest industrial power users, enticed by lower rates, to switch to government-owned utilities, or to threaten to do so, exacerbates the problem. Following the expansion of wholesale competition among electric utilities, the CEA said:

"Pressure is growing to allow retail competition as well. ... This pressure comes mainly from large customers, who, among other things, can credibly threaten to bypass their local utility by generating their own electricity using small natural gas plants, or through municipalization." (emphasis added).

A bias toward municipalized services is evident in California and around the country, and several examples are highlighted in this paper. Moves like those by Palm Springs, Modesto Irrigation District and others jeopardize private utilities, their investors, and taxpayers.

Taxpayers are harmed when a taxable economic activity is taken over by government and taken out of the tax base, leaving a revenue loss that increases pressure for tax increases. Such actions, especially when municipal utilities selectively target large customers, can leave behind a larger bill to be paid by the private utility's remaining customers - small businesses and residential customers. With retail competition following closely on the heels of wholesale competition, these remaining customers would eventually figure out how to take their business to government utilities in order to receive subsidized rates.

Left unabated and carried to its extreme, these subsidies could eventually spell the end of privately delivered electricity. Competition solely between government utilities is not the kind of competition envisioned by Congress. Congress anticipated that competition would result in lower costs and eventually in lower consumer prices. Government inefficiencies can be masked by taxpayer subsidies, however, so that they can charge low rates, even though they have higher operating costs.

A 1996 audit of the Los Angeles Department of Water and Power (DWP) illustrates the point. The audit concluded that "DWP's electric costs exceed the average costs of each of three comparison panels - California utilities, urban investor-owned utilities (IOUs), and publicly owned utilities."

The audit concludes, "The inconsistency between having low rates and high costs is largely explained by DWP's favorable tax status and its low cost [subsidized] generation mix."

The difference between costs and prices is a substantial tab that is being picked up by taxpayers.

Telecommunications

In telecommunications, as in energy deregulation, there is considerable disagreement about how the various details will be finalized. Opening of these markets has telephone companies evaluating cable TV service, cable TV providers eyeing telecommunications, and wireless telecommunications services with designs on both.

Increasingly, local governments are working to enter the telecommunications business. An article in the March 1997 issue of Government Technology describes Colorado-based International Communications Services (ICS) "promoting the concept of municipal ownership of telecommunications infrastructure." According to the article, ICS promotes municipalization as a way to provide leading-edge services to residents at a low cost, while controlling the right-of-way and generating non-tax revenue.

If municipalities compete in this market (and there is nothing currently preventing them from doing so), the same tax exemptions and financing preferences, historically available to government electric utilities, would apply, with similar competitiveness problems.

Many cities already provide one or more utility services, like electricity, water, sewer, or garbage; it would be easy to add one more service. For example, the city of Los Angeles has noted that its existing billing and customer information systems for power service could allow the city to enter the telecommunications business more easily.

In the case of older cities, many of the more traditional public services are already being fully utilized as revenue producers. Cities, public utility districts, even rural utility cooperatives, originally established to electrify rural farms throughout America, see in telecommunications a springboard of opportunity, with potential for additional revenue growth well into the foreseeable future.

The issue of who provides advanced telecommunications services is important. Several municipalities are evaluating whether to build, own, and operate their own full-service telecommunications utilities, either by themselves or in partnership with private sector firms.

Media Connections Group (MCG), a private consulting firm, was engaged by the city of Milpitas, California, to analyze the financial viability of such an idea. The city was particularly interested in the possibility of being a full service telecommunications provider and competing aggressively against the private sector. MCG recommended against the idea. Based on assumptions that "...were aggressively chosen to drive the model toward financial viability," MCG's evaluation concluded that "...such a network could not be operated successfully in a competitive environment by a commercial partner (of the city's) unless very aggressive penetration levels are assumed for core telephone and/or cable services. Before it accepts a proposal to partner in such a venture, the city should investigate the operating assumptions carefully."

Located in the northern part of the Silicon Valley, Milpitas prides itself on its quality of life, its highly educated population, and the forward-looking character of its general economy and business climate. In 1994, Pacific Telesis, the regional Bell operating company serving most of California, had proposed to lay new fiber optic/coaxial cable throughout the city, making it a model city for cutting-edge telecommunications technology. "We believed we were offering the community a tremendous opportunity to be a world leader," says Don Lehman of Pacific Telesis.

When city permit approvals were not forthcoming, Pacific Bell abandoned that plan and moved on to make a similar offer to invest in a more receptive community where it is now building the system.

"From the perspective of a community's economic competitiveness, we are concerned that there will be islands of technology," says Norm Smith of AT&T. With the speed at which technology is changing, communities that purchase their own systems are likely to have obsolete equipment the day they turn their systems on. Firms like AT&T and Pacific Bell, whose primary business is providing telecommunications services, are more likely to stay current with state-of-the-art technology, he says. Many businesses and state governments that tried owning and operating their own systems in the late 1970s and 1980s have since abandoned them. One example can be found in California state government:

• "Owning and operating telecommunications networks are neither core competencies nor core responsibilities of the state,"
• "State-owned network infrastructures have proven costly and cannot keep pace with the rapid developments in telecommunications technology," and
• "The inability of CALNET to meet, at competitive cost, the service requirements of... state agencies."

Taxpayers and Other Government Agencies at Risk

The state loses revenues when activity that formerly was subject to income taxes becomes a tax-exempt government activity, either through municipalization or the extension of government utility services to customers previously served by a private utility.

Finally, taxpayers lose because subsidies and tax exemptions cost money. Reductions in tax collections by state and local agencies cause increased pressure for tax increases.

Although a few customers may benefit by purchasing services from an expanding government utility, that benefit is paid for by many other individuals and agencies.

Distorted Competition

Multiple city utility services are not unusual: As a page one story in The Wall Street Journal described, however, mischief can ensue when government expands its range of utility services. The Journal's June 3, 1996 edition carried the headline: "Power Play, Little Town Becomes First Municipality Sued by U.S. for Antitrust." The article cited the case of a real estate developer told by the city of Stilwell, Oklahoma, that "if he didn't buy the town's electricity, they would deny him water and sewer service, which he couldn't buy elsewhere." The city, which relies on utility revenues to fund its general services, was exercising its monopoly clout to prevent the developer from purchasing his electricity from another local electric co-op. In doing so, it fell afoul of federal antitrust law barring sellers from using monopoly power over one product to force purchase of another.

Closer to home, the city of Anaheim is requiring any utility wishing to lay new fiber optic cable not only to obtain permit approval and pay permit fees, but to lay several lines of fiber optic cable intended for the city's future use and probable future competition.

Conclusion

"With so much uncertainty about the shape of the communications networks of the future and with significant potential for competition, the best course is to leave their evolution to be determined by the private sector."

"In economic terms, electric and gas utility services do not possess the characteristics that require provision by the public sector. ... The subjective judgment of taxpayers in a state or a local region may be that public provision of electricity is justified. This does not, however, necessarily imply that it makes sense for the federal government to tax its taxpayers [through federal loan programs and tax exemptions] to help pay for this state or local decision."

As the rest of the world moves more and more to privatization and divestiture of state-owned means of production, it is difficult to understand why policymakers would permit California's local governments to municipalize private assets and take business away from the private sector.