Sunday, November 25, 2012

What if Public School Districts were Treated Like Public Utilities

At the beginning of his first term, Governor Pawlenty wisely recognized that he could not fix the dysfunctional school finance system in Minnesota, unless he developed a consensus on the actual amount it should cost to deliver the educational programs and services required by the State.  And so, he convened a task force that was supposed to study the issue with great care, and report the results back.  But as the work of this task force moved forward, it began to develop that the bipartisan task force was likely to report that we were a couple billion dollars short of the actual cost.  That should have been unsurprising, because by then, the shortfall in special education alone was recognized to be about $650 million per year, and projected to rise still higher.   For whatever reason, the Governor cancelled the task force, and left the work of the task force unfinished.   Governor Dayton created a new task force, but he too refused to ask the task force to answer this question.   That has caused me to ask the following question:
What if the State of Minnesota set school district revenues as if they were public utilities?  That's the topic of my post today.   Or, I might rephrase that question:  suppose the State tried to set public utility rates by ignoring the cost of delivering services, as we do in the case of public schools?  

I think that I started down this road, because I've been working on a number of cases involving a Minnesota public utility, and that has caused me  think about the stark difference in the approach to rate setting between the two.   After all, a public school system has a lot in common with public utilities.  Both provide important necessary public services.  Both are required to provide those services to all comers.   And either one would surely fail if required to deliver services at below cost.    As with school districts, the government determines the reimbursement rate for public utilities.  However, think what would happen if the State tried to set utility rates in the same way that it set funding for public education---in other words, by ignoring the cost of providing mandated services? (Or, to rephrase the issue:  if the State can set public utility rates by determining the cost of electricity or natural gas, why shouldn't it be able to do the same with the cost of public education)

Suppose, for example,  the state decided to cut NSP's electric utility rates by 20% next year, just because Minnesota families are overburdened with medical costs, taxes and other expenses?  Suppose the state created a committee at the Public Utility Commission to examine rates, but the committee was ordered to ignore the true cost of producing electricity!  Would that be constitutional?  That's what Governor Pawlenty, and now Governor Dayton have both done! 

Clearly, our Courts would not allow the State to set utility rates at a level below the cost of providing service! Indeed, if the State attempted to force public utilities to deliver electricity in return for revenues below the cost of service, the state or federal courts would strike those rates down as unconstitutional, because it is just not possible to deliver a product for less than cost, and you can't rationally set rates, unless  you have a system that determines the rates based on real hard facts. 

Public utility rate setting actually begins by determining the public utility's necessary operating expenses.   The Public Utility Commission here in Minnesota approves rates based on a rigorous examination of the actual cost of delivering the required service, for example, natural gas or electricity.   As Wikipedia explains,the traditional rate formula is intended to produce a utility's revenue requirement:  R = O + (V - D)r   In this formula, R is the utility's total revenue requirement or rate level. The R is the total amount of money a regulator allows a utility to earn.   O is the utility's operating expenses.  Notice that where public utilities are concerned, the starting point for determining the revenues is the total operating costs required by the utility.   If the legislature proposed to set revenues for electric companies or natural gas companies without determining their total operating costs, why the legislature would be the laughing stock of the nation, and a lawsuit would result in an immediate injunction.   You can't run a power business or a natural gas distribution business if you're not allowed to cover your expenses.    V in the formula is the gross value of the utility's tangible and intangible property.   r is the rate of return a utility is allowed to earn on its capital investment or on its rate base.    The formula recognizes that it is impossible to maintain the physical plant necessary to run a public utility, unless the utility is provided with sufficient revenues not only to cover operating costs,  but also to provide enough money to pay for the equipment needed to deliver the service.    As Wikipedia explains:

"A [public utility's operating expenses, such as wages, salaries, supplies, maintenance, taxes, and research and development, must be recouped if the utility is to stay operational. Operating costs are most often the largest component of the revenue requirement, and the easiest to determine. Although both agencies and courts have the legal authority to supervise the utility's management, they will not substitute their judgment unless there is an abuse of managerial discretion.

In other words, when setting power or natural gas rates, the management of the public utility informs the state utility commission what the reasonable expenses of the utility are going to be, and the state basically accepts that judgment.  But actually public utility rate-setting requires the State to assure that the utility's expenses are completely covered  by revenues, with profit to spare.  Public utilities are protected by a process that assures that their right to full funding of their operations, plus a substantial rate of return sufficient to attract investment to build necessary infrastructure, is guaranteed.   The way it works is that the utility prepares a cost estimate which sets out the various component costs required to cover their costs plus a reasonable profit.    The State administrative agency that regulates utilities reviews those costs and reduces them where they are unreasonable through an administrative process that guarantees the utility due process.   The Minnesota Public Utility Commission is headed by an Executive Director with a PhD in economics.  The reason is that the public utilities expect that before their revenues are determined by the State, experts in evaluating the true costs of delivering electricity must make a fair and rational determination of the necessary revenues.   Under threat of constitutional litigation, the state has carefully crafted an administrative process, implemented by staff trained in the economics of costing public utility services, to determine the cost of service, and if the state ever attempts to make a public utility conduct its business at less than cost, the court will most certainly strike that attempt down.

Periodically, I've posted opinions that argue that Minnesota's school finance system is unconstitutional because it requires school districts to deliver mandated services, but fails to provide the funding necessary to deliver those services.   Links to some of those posts are listed below at the bottom of this post.   Suppose your spouse demanded that you purchase a lake home on Gull Lake on two acres of forested land with three fancy bedrooms, a family room and two modern bathrooms, but insisted that you "keep the price under $125,000."    That would be unreasonable, wouldn't it, because you can't budget $125,000 to buy a house with specifications for many times that price.   You'd have to figure out what a house like that costs, before you can set your budget.    The same is true with regard to public education.   You can specify how much a school district will have to spend per student.  Or, you can specify what the school district must accomplish:  what quality of education it must produce in its students.  But you can't specify revenue and results, unless you assure that the revenue is sufficient to get the job done. 

In Minnesota, however, the State makes absolutely no effort to determine the necessary operating expenses. As I pointed out in an October post, a 2004 Minnesota Education Finance Reform Task Force recommended that our public schools should be funded based upon a rationally determined, learning-linked, student-oriented and cost-based Instructional Services Allocation. (See Inve$ting in our Future, Seeking a fair, understandable and accountable, twenty-first century education finance system for Minnesota, Recommendation.  But the state terminated the task force designated to establish the reasonable cost of mandated services.  Recently, the Governor established a new task force, he told the committee not to try to determine the cost of providing state mandated services.   In other words, like Governor Pawlenty before him, the Governor decided that it would be inconvenient for the public to find out how much state revenues it would actually require to deliver the services that the State requires. 

If it is unconstitutional to order public utilities to deliver electricity at below cost, how can it be constitutional to order public school districts to deliver education at below cost, while providing them with no taxing power to meet state requirements?    I'm not suggesting that the same Constitutional law principles govern public utility rates and public education. I am suggesting that the same common sense principles make it impossible to contend that when a state mandates that districts deliver a specified service, that it need not provide sufficient funding, or a taxation source to provide sufficient funding, to provide that service.

If Minnesota is ever going to fix its school finance system, we need to stop avoiding hard economic facts.  You can't budget for public education unless you figure out the actual cost of providing that education.   What's true for electricity is true for education:  revenues must cover costs or the system is broke.   

Jvonkorff on Education McCleary v. State, Part I
Jvonkorff on Education McCleary v. State, Part II
Jvonkorff on Education McCleary v. State, Part III
Jvonkorff on Education McCleary v. State, Part IV
Summary of Decision Network for Excellence
Washington Supreme Court Blog  
JvonKorff on Education, The Rose Decision 
Minnesota's School Finance System is Unconstitutional, Part I
Minnesota's School Finance System is Unconstitutional, Part II
Minnesota's School Finance System is Unconstitutional, Part III
Minnesota's School Finance System is Unconstitutional, Part IV

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