A Brief Legal History of American Utility Regulation

The historical evolution of energy regulation in the United States is a familiar story in our schizophrenic nation's struggle between its two distinct identities: at once it is a constitutional democracy and a free market. Legal opinion has adopted three standards since the birth of the public utility for defining the regulatory function of government, each of which reflect a set of common assumptions about the goals of regulation, but take substantially different positions on how exactly to reach these goals. The question has never been if the Constitution justifies government regulation of commerce, but rather, who should oversee this regulation (the judiciary, legislatures, or bureaucratic commissions) and how (the ratemaking calculus).

Two foundational legal principles underscore about energy regulation. First, certain industries are natural monopolies must be regulated in order to secure supply of goods essential to the public interest. "From time immemorial, and in this country from its first colonization," the government has regulated various industries that involve the public interest, "and in doing so fix a maximum of charge to be made for services rendered." Munn v. Illinois, p. 2. However, of no secondary importance is the Constitution protection against confiscatory rates that are unjust and unreasonable so as to qualify as either a taking without just compensation in violation of the Fifth Amendment, or a deprivation of property without due process in violation of the Fourteenth Amendment. The rate value a utility is owed for its service remains the central issue of regulatory law and has been the crux of our national debate for more than a century.

Until the 20th century, legislatures were generally granted this power to set standards for what "constituted a confiscatory rate." Tomain and Cudahy, Energy Law, p. 132. In Munn v. Illinois, the Court held that an Illinois statute that regulated the price of the privately-owned grain elevators had not violated the Fourteenth Amendment. "If no state of circumstances could exist to justify such a statute, then we may declare this one void...but if it could, we must presume it did." Id., p. 6. The role of the judiciary was simply to determine what was "reasonable" and the Court deferred to lawmakers in setting rates.

Foreshadowing the battle that continues to this day, the dissent in Munn criticized the majority opinion as "subversive of the rights of private property." Id. Such a precedent, the dissent warned, allowed legislatures limitless scope in their regulatory authority, where "all property and all business in the State are held at the mercy of a majority of its legislature." Id., p. 9.

At the turn of the century, as railroad giants' power grew, and Insull's began to consolidate his electricity empire, the judiciary's fear of majoritarian control over the free market was dwarfed by the growing concern of corporate control over essential public goods and services. "Without assuming itself to prescribe rates," the courts began to do everything but write down the number. Smyth v. Ames established the "fair value" test, which the Court defined as the "fair value of the property being used...for the convenience of the public." Smyth v. Ames, p. 3. Judges were to examine a variety of factors in ascertaining the actual present value of the assets employed in the public service including, but not limited to: the original cost of construction, the capital invested in improvements, the market value of the corporation's bonds and stock, and company operating expenses, and "other matters," thus granting judges wide latitude in the ratemaking process.

The "fair value" test incentivized utilities to invest wisely, but did not insulate such investment from forces majeure like war or radical political change. Seemingly prudent infusions of capital, which, due to unanticipated market shifts, failed to yield returns, were not factored into the rate base. In 1923, at the height of America's feverish and ultimately unsustainable economic growth, the Court guaranteed, "no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures." Bluefield Waterworks v. PUC, p. 1. When the market crashed, and utilities' investment losses were ignored under the "fair value" test, the need for change in the regulatory framework became all too clear.

In the 1930s, a time of desperation, electrification became a symbol of hope and a practical means of economic progress. As President Roosevelt proclaimed in 1932, "Electricity is no longer a luxury. It is a definite necessity...It can relieve the drudgery of the housewife and lift the great burden off the shoulders of the hardworking farmer." FDR's Portland Speech (1932), No. 35. This progress required vigilant regulation of the "avarice and greed" so that electricity could be made cheap and available to a consumer-based economy still in its infancy. See id. But from an industry standpoint, the "fair value" test as a constitutional requirement stood in the way of restoring investor confidence in the stability and viability of the publicly regulated utility. See Duquesne, p. 5.

In 1943, this change arrived with the Supreme Court's landmark ruling in Federal Power Commission v. Hope Natural Gas. Adopting an "ends test" in lieu of the "fair value" standard, the Court extricated the judiciary from methodological meddling in ratemaking process. "It is not the theory but the impact of the rate order which counts. If the total effect of the rate order cannot be said to be unreasonable, judicial inquiry...is at an end." FPC v. Hope, p. 2. In deciding whether the interstate rate base the Public Utilities Commission of Ohio established for Hope Natural Gas Co. was "just and reasonable," (Hope contended the PUC was off by almost $30 million), the Court granted the Commission an unprecedented degree of deference, describing the rate base as "the product of expert judgment which carries a presumption of validity." Id. at 3. Thus the Court vested considerable authority in state public utility commissions to regulate the energy economy by shifting the burden of proof to those disputing rate orders as unreasonable or unjust. So long as the return based on the rate "should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and attract capital," the commission and its army of technocrats were given the reins in ratemaking. Id. Commissions were no longer required to adhere to one single standard of valuation: "the Constitution within broad limits leaves the States free to decide what ratesetting methodology best meets their needs in balancing the interests of the utility and the public." Duquesne v. Barasch, p. 2.

Hope's "ends test" has undergone its greatest challenges in cases where prudent investments prove disastrous or utility companies fail to generate revenue despite rate increases. The Court has limited the application of the due process clause to "prevent governmental destruction of existing economic values. It has not and cannot be applied to insure values or to restore values that have been lost by the operation of economic forces." Market St. v. Railroad Commission. at p. 5 (italics added). "[H]owever unfortunate the plight of a dying company" even rate reductions that forced a "substantial operating deficit upon the Company," were deemed constitutional so long as the Commission's decisional process was not shown to be unreasonable or unjust. Id. at pp. 1, 6.

Nowhere was the tension this legal stance engendered more apparent than in late 1970s, where political backlash against nuclear power that left certain utilities in a bind, facing hundreds of millions of dollars in lost investment due to abandoned nuclear energy projects and a regulatory structure that refused to pass these lost investments onto consumers. Regulatory statutes that limited the inclusion of any plant in the electric utility's rate base until it was "used and useful" were upheld. Duquesne, p. 1. Moreover, no profits were guaranteed: "Absent the sort of deep financial hardship described in Hope, there is no taking, and hence no obligation to compensate, just because a prudent investment has failed and produced no return." Jersey Central v. FERC, p. 9.

To this day, the delicate balance between public interest and commercial competitiveness encompassed by the ratemaking process remains a complex legal issue for the courts. In a prescient observation, acknowledging the inherent discomfort and difficult judges face in striking this balance the Court in Smyth v. Ames noted, "How such compensation may be ascertained, and what are the necessarily elements in such an inquiry, will always be an embarrassing question." Smyth at p. 2.



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