Safavi, Leila “Can Vertically Integrated Firms Evade Pricing Regulation? Evidence from Energy Utilities” (November 2023) | WP-344 | Blog Post


Vertical mergers can be used by a natural monopoly subject to cost-based price regulation to evade regulation: when regulators allow increases in input costs to be passed onto customers, a monopolist that is vertically integrated with an input supplier can earn profits by inflating input costs. I test for evidence of evasion by US electric and natural gas utilities through their purchase of interstate natural gas pipeline capacity. Building a novel data set of the vertical relationships of natural gas pipelines, I find incentives for evasion are widespread in this industry: 53% of US households with gas heating purchase gas from a utility that is affiliated with a natural gas pipeline. I leverage variation in buyers’ vertical relationships with pipelines and exposure to regulation to test whether evasion incentives cause buyers to inflate input costs. Results show that evasion incentives lead buyers to inflate costs by overbuilding pipeline capacity: capacity under contract with vertically-integrated utilities is underutilized by 28-33 percentage points on average, even during days where congestion rents are high. However, there is no evidence that utility affiliates pay differentially higher markups relative to other regulated or affiliated buyers. I develop a model of regulatory oversight that shows how asymmetric information can rationalize the limited impact of evasion incentives on prices. In total, regulatory evasion by utilities has shifted $2.4 billion in excessive input costs onto ratepayers between 2010 and 2021.