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The FCC & Regulatory Analysis

By 1 March 2011 5 Comments

A recent House Energy & Commerce hearing on Network Neutrality and Internet Regulation: Warranted or More Economic Harm Than Good took up the quality of the FCC’s “market analysis,” and the question whether the agency had performed any such analysis at all. The FCC Chairman insisted that the work had been done and that it is “contained in the Order.” Others, such as McDowell, contravened this, insisting that no analysis existed. Some committee members wanted to know whether the analysis performed met the standards set forth by the OMB Office of Information and Regulatory Affairs (OIRA).

Sorting out the confusion requires some history.

First, it should be noted that existing Executive Office of the President requirements that agencies engage in regulatory analysis do not govern independent regulatory agencies, such as the FCC, so any compliance by the agency is voluntary. However, the Administration certainly encourages regulatory analysis by independent agencies, as embodied in a recent OMB memo which said:

[Requirements of] Executive Order 13563 do[] not apply to independent agencies, but such agencies are encouraged to give consideration to all of its provisions, consistent with their legal authority. In particular, such agencies are encouraged to consider undertaking, on a voluntary basis, retrospective analysis of existing rules.

Politically, it is difficult for even an independent agency to assert that the independence shields it from any need to analyze the consequences of its regulations, so agencies usually take the stance that “we do it, but we do not have to run our analysis past OMB, and OMB cannot hold up our rules.”

For almost half a century now, the Executive Office of the President has been pushing Federal agencies to engage in cost-benefit analysis of their activities. (The first such presidential directive was in August 1965.)  In the 1970s, the focus turned to analysis of regulatory proposals, as Ford required economic impact statements (Executive Orders 11821 & 11949), and Carter, in conjunction with his drive for deregulation, issued Executive Order 12044, Improving Government Regulations (March 23, 1978), which required in general  terms a formal and public regulatory analysis for all rules having an impact of $100 million.

In 1980, the Office of Information & Regulatory Affairs (OIRA) was created as a part of OMB to provide a center for the analytic effort. The process was formalized in 1981 with EO 12291, Federal Regulation (Feb. 17, 1981), which added an explicit requirement that costs and benefits be calculated to the general framework of EO 12044.

EO 12291 governed until 1993, when Clinton issued EO 12866, Regulatory Planning and Review (Sept. 30, 1993), which was more prescriptive than the prior efforts, laying out requirements in more detail and using for the first time the concept that perhaps regulations were justified only in the event of “material failures of private markets to protect or improve the health and safety of the public, the environment, or the well-being of the American people.” The major innovation of EO 12866 was to establish a firm process of regulatory review by OIRA and to give OMB a purchase on the agencies’ regulatory processes.

EO 12866 remained in effect when Bush took over, but received a new implementation via OMB Circular A-4, Regulatory Analysis (2003), which made a serious attempt to ratchet up the quality of the required analyses. In particular, the OMB economists who captured the A-4 drafting process had strong views on the need for a showing of “market failure” as a pre-condition for regulation, and added a sermon on the subject to the Circular.

In 2007, the Bush Administration modified EO 12866 with EO 13422, Further Amendment to Executive Order 12866 on Regulatory Planning and Review (Jan. 23, 2007), which contained five major changes:

(1) a requirement that agencies identify in writing the specific market failure or problem that warrants a new regulation, (2) a requirement that each agency head designate a presidential appointee within the agency as a “regulatory policy officer” who can control upcoming rulemaking activity in that agency, (3) a requirement that agencies provide their best estimates of the cumulative regulatory costs and benefits of rules they expect to publish in the coming year, (4) an expansion of OIRA review to include significant guidance documents, and (5) a provision permitting agencies to consider whether to use more formal rulemaking procedures in certain cases.

These changes did not go well in pro-regulatory circles — the major objection was the control of the process given to the Regulatory Officer — and the Obama Administration, as soon as it took office, issued EO 13497 (Jan. 20, 2010) revoking EO 13422.

The Obama team spent two years debating other possible modifications to the system, then issued EO 13563, Improving Regulation and Regulatory Review (Jan. 18, 2011), which, per the explanatory memo issued by OIRA Director Cass Sunstein:

[I]s designed to affirm and to supplement Executive Order 12866; it adds to and amplifies the provisions of Executive Order 12866, rather than displacing or qualifying them. After the issuance of Executive Order 13563, agencies should continue to follow the principles and requirements contained in Executive Order 12866.

With respect to independent agencies, the Sunstein memo says (as quoted earlier):

Executive Order 13563 does not apply to independent agencies, but such agencies are encouraged to give consideration to all of its provisions, consistent with their legal authority. In particular, such agencies are encouraged to consider undertaking, on a voluntary basis, retrospective analysis of existing rules.

OMB Circular A-4 remains in effect, unchanged since Sept. 2003, and is linked on the OIRA website.

So if the FCC were to engage in a formal regulatory analysis, it would need to consult both EO 12866 and OMB Circular A-4. Some of the guidance it would receive is:

EO 12866:

Section 1. Statement of Regulatory Philosophy and Principles.

(a)    The Regulatory Philosophy. Federal agencies should promulgate only such regulations as are required by law, are necessary to interpret the law, or are made necessary by compelling public need, such as material failures of private markets to protect or improve the health and safety of the public, the environment, or the well-being of the American people. In deciding whether and how to regulate, agencies should assess all costs and benefits of available regulatory alternatives, including the alternative of not regulating. Costs and benefits shall be understood to include both quantifiable measures (to the fullest extent that these can be usefully estimated) and qualitative measures of costs and benefits that are difficult to quantify, but nevertheless essential to consider. Further, in choosing among alternative regulatory approaches, agencies should select those approaches that maximize net benefits (including potential economic, environmental, public health and safety, and other advantages; distributive impacts; and equity), unless a statute requires another regulatory approach.

(b)   The Principles of Regulation. To ensure that the agencies’ regulatory programs are consistent with the philosophy set forth above, agencies should adhere to the following principles, to the extent permitted by law and where applicable:

(1) Each agency shall identify the problem that it intends to address (including, where applicable, the failures of private markets or public institutions that warrant new agency action) as well as assess the significance of that problem.

(2) Each agency shall examine whether existing regulations (or other law) have created, or contributed to, the problem that a new regulation is intended to correct and whether those regulations (or other law) should be modified to achieve the intended goal of regulation more effectively.

(3) Each agency shall identify and assess available alternatives to direct regulation, including providing economic incentives to encourage the desired behavior, such as user fees or marketable permits, or providing information upon which choices can be made by the public.

(4) In setting regulatory priorities, each agency shall consider, to the extent reasonable, the degree and nature of the risks posed by various substances or activities within its jurisdiction.

(5) When an agency determines that a regulation is the best available method of achieving the regulatory objective, it shall design its regulations in the most cost-effective manner to achieve the regulatory objective. In doing so, each agency shall consider incentives for innovation, consistency, predictability, the costs of enforcement and compliance (to the government, regulated entities, and the public), flexibility, distributive impacts, and equity.

(6) Each agency shall assess both the costs and the benefits of the intended regulation and, recognizing that some costs and benefits are difficult to quantify, propose or adopt a regulation only upon a reasoned determination that the benefits of the intended regulation justify its costs.

(7) Each agency shall base its decisions on the best reasonably obtainable scientific, technical, economic, and other information concerning the need for, and consequences of, the intended regulation.

(8) Each agency shall identify and assess alternative forms of regulation and shall, to the extent feasible, specify performance objectives, rather than specifying the behavior or manner of compliance that regulated entities must adopt.

(9) Wherever feasible, agencies shall seek views of appropriate State, local, and tribal officials before imposing regulatory requirements that might significantly or uniquely affect those governmental entities. Each agency shall assess the effects of Federal regulations on State, local, and tribal governments, including specifically the availability of resources to carry out those mandates, and seek to minimize those burdens that uniquely or significantly affect such governmental entities, consistent with achieving regulatory objectives. In addition, as appropriate, agencies shall seek to harmonize Federal regulatory actions with related State, local, and tribal regulatory and other governmental functions.

(10) Each agency shall avoid regulations that are inconsistent, incompatible, or duplicative with its other regulations or those of other Federal agencies.

(11) Each agency shall tailor its regulations to impose the least burden on society, including individuals, businesses of differing sizes, and other entities (including small communities and governmental entities), consistent with obtaining the regulatory objectives, taking into account, among other things, and to the extent practicable, the costs of cumulative regulations.

(12) Each agency shall draft its regulations to be simple and easy to understand, with the goal of minimizing the potential for uncertainty and litigation arising from such uncertainty.

And from OMB Circular A-4, additional guidance, particularly on the concept of market failure:

The major types of market failure include: externality, market power, and inadequate or asymmetric information. Correcting market failures is a reason for regulation, but it is not the only reason. Other possible justifications include improving the functioning of government, removing distributional unfairness, or promoting privacy and personal freedom.

1. Externality, common property resource and public good

An externality occurs when one party’s actions impose uncompensated benefits or costs on another party. Environmental problems are a classic case of externality. For example, the smoke from a factory may adversely affect the health of local residents while soiling the property in nearby neighborhoods. If bargaining were costless and all property rights were well defined, people would eliminate externalities through bargaining without the need for government regulation.3 From this perspective, externalities arise from high transactions costs and/or poorly defined property rights that prevent people from reaching efficient outcomes through market transactions.

Resources that may become congested or overused, such as fisheries or the broadcast spectrum, represent common property resources. Public goods, such as defense or basic scientific research, are goods where provision of the good to some individuals cannot occur without providing the same level of benefits free of charge to other individuals.

2. Market Power

Firms exercise market power when they reduce output below what would be offered in a competitive industry in order to obtain higher prices. They may exercise market power collectively or unilaterally. Government action can be a source of market power, such as when regulatory actions exclude low-cost imports. Generally, regulations that increase market power for selected entities should be avoided. However, there are some circumstances in which government may choose to validate a monopoly. If a market can be served at lowest cost only when production is limited to a single producer B local gas and electricity distribution services, for example B a natural monopoly is said to exist. In such cases, the government may choose to approve the monopoly and to regulate its prices and/or production decisions. Nevertheless, you should keep in mind that technological advances often affect economies of scale. This can, in turn, transform what was once considered a natural monopoly into a market where competition can flourish.

3. Inadequate or Asymmetric Information

Market failures may also result from inadequate or asymmetric information. Because information, like other goods, is costly to produce and disseminate, your evaluation will need to do more than demonstrate the possible existence of incomplete or asymmetric information. Even though the market may supply less than the full amount of information, the amount it does supply may be reasonably adequate and therefore not require government regulation. Sellers have an incentive to provide information through advertising that can increase sales by highlighting distinctive characteristics of their products. Buyers may also obtain reasonably adequate information about product characteristics through other channels, such as a seller offering a warranty or a third party providing information.

Even when adequate information is available, people can make mistakes by processing it poorly. Poor information-processing often occurs in cases of low probability, high-consequence events, but it is not limited to such situations. For instance, people sometimes rely on mental rules-of-thumb that produce errors. If they have a clear mental image of an incident which makes it cognitively available, they might overstate the probability that it will occur. Individuals sometimes process information in a biased manner, by being too optimistic or pessimistic, without taking sufficient account of the fact that the outcome is exceedingly unlikely to occur. When mistakes in information processing occur, markets may overreact. When it is time-consuming or costly for consumers to evaluate complex information about products or services (e.g., medical therapies), they may expect government to ensure that minimum quality standards are met. However, the mere possibility of poor information processing is not enough to justify regulation. If you think there is a problem of information processing that needs to be addressed, it should be carefully documented.

4. Other Social Purposes

There are justifications for regulations in addition to correcting market failures. A regulation may be appropriate when you have a clearly identified measure that can make government operate more efficiently. In addition, Congress establishes some regulatory programs to redistribute resources to select groups. Such regulations should be examined to ensure that they are both effective and cost-effective. Congress also authorizes some regulations to prohibit discrimination that conflicts with generally accepted norms within our society. Rulemaking may also be appropriate to protect privacy, permit more personal freedom or promote other democratic aspirations.

5 Comments »

  • Larry Downes said:

    Thanks, Jim. That had been bugging me for the last two weeks. You’ve put all questions remaining to rest, and then some.

  • What we are reading: 3/3/11 | High Tech Forum said:

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  • Jonathan Lee said:

    This was a very well done article, Jim. As you note, the FCC–as an independent agency–was not required to perform this type of analysis, and after reading the Open Internet Order, it’s easy to understand why the Commission ignored the OMB’s encouragement to undertake a voluntary analysis. Even if you accepted the FCC’s casual empiricism, and anecdotes, as evidence of a “market failure”, the FCC never bothers to explain how any single rule would have prevented most of the instances that they cite as justification for their rules.

    Unfortunately–with a new Net Neutrality hearing set for March 9th, this issue continues to be a distraction from the very real issues of Universal Service Fund reform, intercarrier compensation reform, and making more wireless spectrum available to serve consumers. You provided a reasoned criticism–as opposed to some of us, who just express frustration! http://www.telecomsense.com/2011/02/the-nattering-nabobs-of-net-ne.php

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