REGULATION AS A CONTRACT: THE ORIGINS OF THE ILLINOIS PUBLIC UTILITIES COMMISSION

Werner Troesken
George Mason University

State public utility regulation was never an historical necessity. Throughout the nineteenth century only one state, Massachusetts, regulated public utilities (excluding railroads) through a state commission. However, by the second decade of the twentieth century, this situation began to change. In the fifteen years between 1907 and 1922 more than forty states created public utility commissions.1 What was happening to cause such profound institutional change? This paper provides at least a partial answer. Interpreting state regulation as a contract, it explains the emergence of the Illinois Public Utilities Commission in 1913. The primary source of evidence for this study is the late nineteenth and early twentieth century Chicage (manufactured coal) gas industry.2

Asset Specificity and Credible Commitments

The nature of gas production and distribution made it necessary for producers and consumers to invest in specific assets. Gas production required a large investment in fixed plant and capital which was not easily resold, moved or adapted. Consumers also needed to purchase unique and immobile assets such as gas lighting or heating fixtures. Beyond this, imperfect housing and labor markets further restricted consumer mobility. This asset specificity made it necessary for consumers and producers to enter into long-term binding rate agreements. Before they would make the requisite investments, producers needed to be confident that they could set prices which would afford them sufficient rates of return. Likewise, consumers would not acquire the necessary fixtures before they were certain that producers were not going to charge monopolistic rates or provide inconsistent service. Public utility companies and consumers, in other words, must have been able to make credible commitments.3

Nineteenth Century Institutions

During the nineteenth century, gas producers and consumers in Chicago made credible commitments through municipal contract ordinances. In municipal contracting, gas companies bargained directly with the city council, which represented the interests of consumers.4It is important to stress that in these proceedings the city did not uniliaterally determine the terms of the contract; producers had to agree to the contract ordinance, in full, before it became binding. Through municipal contract ordinances the city granted gas companies certain operating rights. In return for these rights, producers agreed to a rate schedule setting consumer gas prices for the next five years. Typically, producers also agreed to pay the city a percentage of theirir earnings. Presumably this was done to compensate the city for the costs which resulted from gas companies digging-up the streets.5

For most of the nineteenth century three institutions- the market mechanism, Illinois law and transaction costs - promoted the efficacy of municipal contracting. Until 1897 competitive forces protected consumers against producers' attempts to monopolize the industry. Between 1880 and 1897 ten new companies entered the Chicago gas industry. Real gas prices fell by over 50 percent. In short, the market mechanism forced producers to agree to, and, in fact, credibly commit to, competitive rates. Simultaneously, Illinois' legal environment and high transaction costs constrained the behavior of consumers, forcing them to commit to gas prices which allowed producers reasonable rates of return. Transactions costs prevented consumers from organizing a monopsony and seizing the surplus of producers. Also, Illinois law severely restricted the regulatory powers of municipal authorities. The state and federal courts made it clear that without an enabling act from the Illinois legislature, the Chicago city council had no power to unilaterally dictate gas rates.6 In future years, when this constitutional constraint was removed, voting consumers mandated that the city council pass confiscatory rate ordinances. The effectiveness of these three institutions limited the demand for state regulation. As a consequence, all attempts to create a state public utility commission prior to 1900 failed.

Legal Change and the Demise of Municipal Contracting

At the turn of the twentieth century, three legal changes combined to destroy the institutions forestalling opportunistic behavior. First, around 1900, in Rogers Park v. Fergus, and several other decisions, state and federal courts began ruling that municipal contract ordinances were unenforceable.7 As a result of these rulings, Kneier explained that Illinois "cities had no power to make rate contracts for a long period of years."8 So even if producers and the city could agree on rates ex ante, enforcing such agreements through the courts would habe been difficult.

The second institutional change hasteneing the demise of municipal contracting was the passage of the Lowenthal street frontage act and the gas consolidation act in 1897. The consolidation act removed the common law obstacles preventing Chicago gas companies from merging into a single firm. The Lowenthal frontage act erected an impenetrable entry barrier.9 After 1897, not a single new firm successfully entered the industry. Gas prices rose substantially. By 1913, the Peoples' Gas Light and Coke Company was the sole supplier of gas to the city. In effect, the gas acts created and sanctioned monopoly, destroying the one institution - the market mechanism - which prevented producers from charging monopolistic rates.

Finally, in 1905, Illinois passed legislation empowering the Chicago city council to regulate gas rates. The law no longer provided gas companies clear protection against municipal rate regulation.10 After 1905 consumers possessed the political power to influence prices. With a mandate from vcters, the city council would pass coercive and confiscatory rate ordinances.

The gas acts of 1897 and the enabling act of 1905 greatly expanded the rate-setting powers of both consumers and producers. A Bilateral monopoly situation emerged, replacing one where neither party and enough economic or political power to substantially influence rates. As a result, it became far more difficult for producers and the city council to agree on rate schedules ex ante . Moreover, even if they could design such an agreement, court enforcement would have been problematic in light of Rogers Park v. Fergus and other similar decisions. By 1911, bargaining between gas producers and the Chicago city council collapsed.11 Untimely and costly litigation followed.12 State regulation quickly became a more compelling alternative.

The Origins and Efficacy of State Regulation

In an effort to replace the institutions which prevented opportunistic behavior for most of the nineteenth century, Illinois created the Illinois Public Utilities Commission (IPUC) in 1913.13 State regulation acted as a self-enforcing contract, enabling producers and consumers to credibly commit. In the absence of competitive forces, the IPUC protected consumers against attempts by gas companies to charge monopolistic rates. Similarly, as constitutional constraints had done prior to 1905, state regulation prevented consumers, acting through the city council, from taking the property of producers.

The legislative history of the Illinois Public Utilities Act, the act which created the IPUC, supports this contract interpretation. Support for state regulation among utilities, though no ubiquitous, was strong.14 Moreover, producers typically demanded state regulation because they believed it would protect them against the relatively hostile regulation of municipalities.15 Chicago consumers, in contrast, generally desired a reagulatory framework which vested the city council with supreme regulatory powers, not a state-wide commission. That is, consumers wanted "home-rule."16 Chicago utilities correctly feared such action and were "elated" when the legislature deleted the portion of the Public Utilities Act granting Chicago home-rule.17 The actual performance of the IPUC further suggests that state regulation was designed to protect both consumers and utilities. Gas prices in Chicago, and elsewhere in Illinois, were not materially altered, in either direction, after the creation of the IPUC in 1913. Moreover, both accounting data and market data suggest that Chicago gas producers did not reap large profits under state regulation.18

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1 See 4 Public Opinion and Public Utilities, Speakers' Bulletin 1 (1920), esp. pp. 14-5 and George J. Stigler and Claire Friedland, "What Can Regulators Regulate: The Case of Electricity," 5 J. Law & Econ. 1 (1962).

2This case study approach does not severely limit the generality of the argument. Chicago has over one- half of Illinois' population. It had an even greater proportion of the state's public utility customers. For example, 70 percent of the state's gas consumers resided in Chicago. Furthermore, the contracting problems which pervaded the gas industry were also present in other public utility industries. For information on the proportion of public utility consumers residing in Chicago at the turn of the century, see Majority and Minority Report of the Special Committee on Public Utilities of the Forty-Ninth General Assembly of the State of Illinois, January 20, 1917, p. 20. Hereafter this citation will be referred to as Majority and Minority Report.

3This argument was initially advanced by Goldberg. See Victor Goldberg, Regulation and Administered Contracts, 7 Bell J. of Econ. 426 (1976). See also, Oliver Williamson, The Economic Institutions of Capitalism (1985).

4Standard historical sources suggest that the late nineteenth century Chicago city council was corrupt. Nonetheless, the history of the Chicago gas industry indicates that the city council was generally more sympathetic to the interests of consumers than to the interests of public utilities. The full-length version of the paper examines this issue in more detail. I thank Louis Cain for his comments and for directing me to several helpful sources on Chicago history.

5For descriptions of these contracts see Comm. & Fin. Chron., June 20, 1891, p.939 and Comm. & Fin. Chron., May 25 1895, p. 928.

6For example, in 1900 the Chicago city council passed a coercive rate ordinance, not a contract ordinance, requiring gas companies to reduce their rates from $1.00 per 1,000 cubic feet to $0.80. Darius Mills, a stockholder of one of the larger Chicago gas companies, sued for injunctive relief. In Mills v. Chicago, a federal court ruled: "the regulation of prices to charge consumers by gas companies is not one of the powers essential to municipal government, and is not included in general powers conferred on cities...". The court continued:" and such power cannot be exercised by a city unless it has been delegated by the state in express words..." The ordinance was not enforced. See Mills v. City of Chicago et. al. 127 Fed. 731 (1904), p. 731.

7In Rogers Park v. Fergus , the Illinois Supreme Court ruled: "An ordinance granting a corporation the right to use public streets for that period is merely a declaration...and is not a contract which binds the city to recognize such rates...for the full period." See Rogers Park Water Co. v. Fergus, 178 Ill. 571 (1899), p.571;. Affd. Rogers Park Water Co. v. Fergus, 48 L. Ed. 702 (1901). See also Herbert Pope, Municipal Contracts and the Regulation of Rates, 16 Harv. L. Rev. 1 (1902) for a comprehensive survey.

8Charles M. Kneier, State Regulation of Public Utilities in Illinois, 14 University of Illinois Studies in the Social Sciences 9 (1926), p. 68

9 The Lowenthal street frontage act, which was originally introduced by a state senator from Cook County (Chicago is located in Cook), provided that no city or town in Illinois could grant a franchise "for laying of gas pipes...without the consent of the owners of more than one-half of the property fronting the street or alley along which it [was] ...proposed to lay the pipes..." Amer. Gas Lght. J., March 25, 1895, p.413. The frontage act also "made it possible for a person with the smallest interest in a piece of property facing a street or alley to go to court and block the laying of pipes..." Report of the Gas Bureau of the City of Chicage (1914), p. 22.

10 Even after the passage of the enabling act in 1905, substantive due process provided public utilities some, albeit imperfect, protection against confiscatory rate regulation by either state or municipal authorities. See Herbert Hovenkamp, The Political Economy of Substantive Due Process, 40 Stan. L. Rev. 379 (1988) and N. Matthews, Jr. and W. G. Thompson, Public Service Company Rates and the Fourteenth Amendment, 15 Harv. L. Rev. 249 (1901). Undoubtedly, though, public utilities would have preferred regulatory environments which minimized their need to appeal to the courts for such protection.

11 In the spring of 1906, gas companies and the city council managed to agree on one last contract ordinance. They agreed to set rates at $0.85 per 1,000 cubic feet (MCF) until 1911. In the spring of 1911, when the 1906 contract ordinance was set to expire, negotiations between the city and producers collapsed. For the first time the city council attempted to assert the regulatory power it received under the enabling act of 1905. The council passed a coercive ordinance requiring gas companies to charge $0.75 (MCF). Producers stonewalled, refusing to lower their rates from $0.85 (MCF). A complex tangle of battles wove through the state and federal courts. The dispute between the city and Chicago gas companies would not be fully resolved until 1927. See Mills v. Peoples Gas Light and Coke Co., 327 Ill. 508 (1927).

12 The Special Joint Committee, a committee created by the Illinois Legislature to study public utilities in Illinois prior to 1913, explained: "The effort of the city of Chicago as well as many other cities of the State is to regulate rates and services of utility companies by law suit. The purpose of litigation is merely to redress wrongs and not to afford a system of regulation. The method of thus supervising utilities is unscientific, expensive, vexatious and cumbersome... The termination of such litigation between municipalities and utility companies merely affords temporary relief... In Chicago there has been almost constant litigation between the city and utilities, resulting in heavy burdens of taxation being placed upon its citizens and an extraordinary expense being incurred by utility companies... The economic waste thus occasioned has been staggering. The present method of regulation as applied to the city of Chicago and the State of Illinois is disastrous alike to the public, to the utility companies and their patrons." Quoted from Report of the Special Joint Committee to Investigate Public Utilities, Journal of the Senate of the State of Illinois, April 17, 1913, p.860-1. Hereafter this citation will be referred to as simply Special Committee Report.

13 In 1913 the Illinois legislature wrote: "If municipalities are incapable of protecting their citizens for any reason from unjust exactions of public service corporations, it is the duty of the State to protect them...Conversely, if the citizens of any municipality, through their representatives, take such action as will destroy or confiscate public utility investments, it is likewise the duty of the State to assert its paramount authority to the end that justice may be accorded to citizens interested in such concerns..." Special Committee Report, p. 861.

14 See Forrest MacDonald, Samuel Insull and the Movement for State Utility Regulatory Commissions, 32 Bus. Hist. Rev. 241 (1968); Lloyd Wendt and Herman Kogan, Lords of the Levee (1943), pp. 172-3; Special Committee Report, p. 855; and Mansel Friffiths Blackford, Businessmen and the Regulation of Railroads and Public Utilities in California During the Progressive Era, 44 Bus. Hist. Rev. 307 )1970). See also the following issues of the Amer. Gas Lght. J.: Sept. 28, 1908, p. 537; March 25, 1912, pp. 207-8; March 27, 1911, P. 595; Oct. 12, 1908 pp. 620-1; and April 12, 1909, pp. 634-5.

15 In general, utilities were able to exercise more influence over state regulatorys than municipal regulators, because, city alderman represent smaller constituencies and act on a smaller range of issues then do state representatives. Voting consumers, in other words, held more power over municipal authorities than state representatives. Chicago alderman, and University of Chicago Professor, Charles Merriam explained: "The real reason why many corporations prefer state to local control is...that the indirect pressure of the state electorate is preferred to the direct pressure of the local electorate." Quoted from Majority and Minority Report, p. 27. Kogan and Wendt concurred when they wrote of late nineteenth and early twentieth century Chicago politics; "It has always been...strange...that a [state] legislator can be bought cheaper than an alderman." Kogan and Wendt (1943), p.172.

16 See Kneier (1926), p. 158.

17 During the final debates over the Illinois Public Utilities Act, the Springfield Illinois State Register reported that "it was quite significant during the fight that the corporation lobby vigorously opposed the 'home-rule' feature, and was elated when that principle was finally eliminated." Springfield Ill. State Reg., June 23 1913, p. 14.

18 See the full length version of the paper for a detailed presentation of this evidence.