Unfortunately, the answer to that question often has little or nothing to do with society’s long-term needs or the cost of meeting them. Rather, it boils down to politics, and results can be disastrous for the country in the long term.

It takes billions of dollars to build and operate safe and efficient energy, communications and water service networks. The more effectively maintenance and growth issues are planned in advance, the lower the cost and the more reliable service.

In the 1950s and ‘60s, Americans left cities and farms and moved to the suburbs in record numbers. The result was rapid growth in demand for power, communications and water services, and just as robust growth in utility networks.

One of the cornerstones of that era--which made such immense investment possible--was the so-called “regulatory compact” between utilities and those who set their rates. In short, as long as companies made the needed outlays, regulators more or less guaranteed a competitive rate of return. Companies’ earnings, consequently, were able to grow right along with the systems they built, and communities got the service they needed.

By the ‘70s, however, the regulatory compact was starting to unravel. Rising oil and natural gas prices were pushing up the cost of producing electricity, for example, which in turn started pushing up rates, something that hadn’t happened to any great extent in the ‘50s and ‘60s. The rate situation was further exacerbated by the decision of many utilities to build nuclear power plants to lessen dependence on oil for generation. And the cost of building the nukes was far greater than anyone had expected.

With stagflation taking hold in the US, consumers suddenly began to notice substantial increases in their utility bills, and they let the politicians know about it. At the same time, large industrial concerns were under growing pressure from overseas competition and were anxious to put a lid on costs to maintain margins.

The result: Regulators began to take a more skeptical eye of utilities’ investment in new power plants and other infrastructure.

Rising energy costs were no longer routinely pushed through in many areas of the country. Then, as nuclear plants came on line, officials subjected costs to intensive “prudency” reviews, sometimes disallowing billions in costs.

Since the utilities had already booked these as equity in anticipation of recovery in rates--typically as “allowance for funds used during construction”--the result was huge writeoffs, dividend cuts and credit rate reductions. A few, like PUBLIC SERVICE OF NEW HAMPSHIRE and EL PASO ELECTRIC (NYSE: EE) were actually driven into bankruptcy by disallowances.

By the early ‘90s, the breakdown of the regulatory compact was complete. Utilities minimized capital expenses for fear of huge disallowances. Meanwhile, every proceeding was treated by officials in some states as an excuse to cut utility rates, prompting companies to attempt to avoid filing for rate increases for as long as possible. The very process of rate hearings became a bargaining session, as companies would initially request a figure they knew they couldn’t get just so officials would grant half as much.

Industry deregulation urge was largely embraced by politicians of both parties because of its promise of cutting utility rates further. Story after story in the financial and popular press charged utilities had been gouging the public for years with high rates, and that the efficiencies of the “market” would force them to cut rates and become more competitive.

Shoved aside in the rush to open markets were concerns of the engineers who ran the system. So were worries that more than two dozen utilities could wind up filing Chapter 11, if they weren’t compensated for their stranded costs--i.e., investments made in large nuclear and coal plants under a monopoly regime that would supposedly be uneconomic in a deregulated market place.

The worst example of the broken compact was easily in California, where Governor Pete Wilson, a Republican, signed off on a plan pushed by ENRON and others to “open” the state’s power market to “competitive” pricing. Utilities were forced to sell most of their power plants and were forbidden from entering long-term purchase contracts, for fear they would game the market.

Instead, an independent system operator (ISO) was set up to buy all the power sold to it at the lowest bid. Utilities were forced to pay the price set by the ISO under this system. And in return for recovering their stranded costs, they were forced to adhere to a strict rate freeze, with no compensation for ups and downs in energy prices.

In my view, the absolute low point was reached in late 2000, when Governor Gray Davis stood by and watched SOUTHERN CALIFORNIA EDISON, a subsidiary of EDISON INTERNATIONAL (NYSE: EIX), and PACIFIC G&E, a unit of PG&E (NYSE: PCG), slowly go bust--as Enron and other providers gamed the system and pushed up wholesale prices which the utilities were forced to eat by borrowing. Despite the pleas of Edison and PG&E that bankruptcy was imminent, he did nothing until the crisis boiled over for fear of igniting a political protest over raising rates. His political demise in a recall election a year later was a fitting epitaph for a broken system.

By late 2002, it was clear to all but the most dense of politicians and regulators that the system was in dire need of a new regulatory compact that focused on encouraging utility investment rather than always pandering to the public’s perpetual desire for lower rates.

That point was hammered home by the Great Northern Power Outage of 2003, when a fault in the FIRST ENERGY (NYSE: FE) system knocked out the power to almost the entire Northeast US and part of Canada and underscored the weakness of the country’s transmission system.

The result has been an almost total change of heart on the part of regulators, and the best utility/regulator relations since the early ‘60s. In California, Governor Arnold Schwarzenegger and the Public Utilities Commission haven’t completely turned their back on deregulation. But they have fostered a far more cooperative relationship with the state’s utilities, which has speeded the recovery of Southern California Edison and Pacific G&E.

Even historically harsh states like Kansas, Michigan, Missouri and Nevada have begun allowing utilities to pass through costs in rates, rather than forcing them to bear the full brunt. As a result, even the weakest utilities are recovering their financial strength and borrowing costs are down to generation lows.

Positive regulatory relations are one of the three primary forces that have powered utility fundamentals and share prices of many companies well past the late 2000 highs. And as long as they’re in full force, fundamentals will only get stronger.

The key question is how long will they be in force. With President Bush in office until 2009, it’s a fairly safe bet the federal government will continue to promote utility-friendly regulatory policies. Further, President Clinton and his wing of the Democratic Party were generally favorable to utilities during the ‘90s.

Consequently, there’s a fair chance that whoever succeeds Mr. Bush--Republican or Democrat--will also be generally benign to the industry. And with the executive branch controlling all the significant regulatory matters regarding power, gas, communications and water, that means regulation should remain benign as well.

The states are more problematic. Despite 1994-like poll numbers for the president and Republican leadership of Congress, political handicappers still don’t rate the odds of a Democratic capture of one or both houses of Congress as very likely. One reason is that both parties have gerrymandered so many safe seats it would take a real political tsunami to shake things up.

The chances of major turnover on the state level, however, are considerably greater, and a number of key governorships and state houses could easily see a change in control. That’s not necessarily bad for the utilities operating there, but it does mean greater uncertainty.

The stakes are particularly high in states where consumer power rates are about to be unfrozen and re-set to reflect new market realities. Like the California utilities, utes in many deregulated states agreed to freeze their rates in the last decade, in exchange for recovering their stranded costs from consumers. As a result, they’ve been unable to pass along system upkeep or fuel costs for several years.

Removing the freeze and resetting to market rates, consequently, means massive increases. CONSTELLATION ENERGY (NYSE: CEG), for example, recently stated it would be raising rates 72 percent for its BALTIMORE G&E unit in Maryland. Regulated Illinois utility units of AMEREN (NYSE: AEE) and EXELON (NYSE: EXC) also expect to pass along massive increases to their customers next year.

Those numbers seem huge, until you consider the rates haven’t changed for a decade in these states while costs have skyrocketed.

Utilities have eaten the additional expense, but largely at the cost of investment in their systems. As a result, regulators in Illinois, Maryland and other states have reviewed these increases and found them justified.

That’s not sitting well, however, with politicians, particularly those who face tight re-election races. And big utility rate increases are the best possible fuel to fire up campaigns of challengers, such as that of Connecticut Attorney General Richard Blumenthal, who’s running for governor. Blumenthal has proposed some particularly draconian measures for what he calls Connecticut’s “broken” system, including a windfall profits tax of 25 to 50 percent on generators’ profits, over an allowed return of 20 percent on equity.

In Maryland, Governor Robert Erhlich is a Republican in a strongly Democratic state facing a major quandary over Constellation’s rate increase. The state legislature is threatening to dissolve the Maryland Public Service Commission as an emergency measure to prevent the rate increase. Erhlich is now faced with the choice of trying to fight the measure--which appears to have the support of a veto-proof majority--or attempting to reshape it in some less harmful way.

For its part, Constellation has warned it will fight any attempts by the legislature to either abridge the rate increase or to hold its prospective merger with FPL GROUP (NYSE: FPL) hostage to it. Its trump card is (under Maryland’s deregulation law) that all of its power plants are now held by an unregulated subsidiary. In fact, only 28 percent of its 2005 and 2004 profits are from the regulated Baltimore G&E unit and therefore under the control of Maryland regulators.

Throwing that unit into bankruptcy in retaliation for inadequate rate increases would probably be more damaging for Constellation than a similar move in Illinois would be for Exelon. But just looking at the strength of the company’s raw numbers, it appears to have a lot of room to play hardball, if that’s how the state decides to play it.

The best hope for avoiding a train wreck here is the company’s attempt to forge a settlement agreement with Erhlich, which apparently involves easing immediate rate hikes in exchange for ultimately putting them through. Even then, however, there’s no assurance the legislature won’t push through a bill to embarrass and weaken the governor, even as the Democrats continue their primary campaign.

The good news is these situations aren’t yet being repeated elsewhere around the country. And some companies with particularly volatile fuel cost bills, like SIERRA PACIFIC RESOURCES (NYSE: SRP), have actually been able to lower the energy cost component of their rates. That’s sure to earn it the goodwill of the regulators who have steadfastly supported the company’s recovery from near bankruptcy over the past few years.

Utilities in areas that never deregulated, like SOUTHERN COMPANY (NYSE: SO), also don’t face these pressures. In fact, Southern’s regulatory compact is alive and well throughout the Southeast.

California also continues to be very supportive for its utilities, as is Texas.

These rate cases, however, will continue to have critical importance for many companies. And if we start to see a pattern around the country, it could have troubling implications for much of the power industry.

We’re still a long way from there. But just to be on the safe side, I recommend steering clear of most utilities operating in states where regulatory uncertainty is growing. Happily, this has always been a major criterion of mine for picking utilities, so if you’ve been following my advice in Utility Forecaster over the years, you have little to fear.

As for Constellation Energy, its relatively low exposure to Maryland regulation is a distinct plus. In addition, the share price has come down a bit on the uncertainty. If there is a relatively favorable resolution to this dispute, it should shoot back up in short order.

And while some I respect disagree, I think the FPL merger would be a plus as well, combining FPL’s unregulated nuclear, wind and gas power plant base with Constellation’s demonstrated marketing prowess.

IF YOU OWN CONSTELLATION, HANG IN THERE WITH IT. IF YOU DON’T, THE SHARES STILL LOOK LIKE A VALUE ALL THE WAY UP TO THE LOW 60S. Just recognize that when politics are concerned, there’s a lot of uncertainty and things could get volatile for this well-run company before they get better.

INTEREST RATE IMPLICATIONS

Finally, turning to the subject of interest rates, the benchmark 10-year Treasury note is now closing in on the 5 percent mark, a level not seen in several years. That’s starting to have an impact on many high-yield investments, and the utility averages have become noticeably more volatile than usual.

As long as we don’t see serious erosion in utility fundamentals, the sector will avoid a major crackup like 2001-02. And, notwithstanding some of the turbulence in regulation, the odds of a real deterioration seem very low, particularly with management cutting debt and operating risk and underlying markets tightening in energy, water and even communications. Even if the regulatory environment does worsen a bit, it shouldn’t affect more than a handful of companies.

That said, however, utility corrections triggered by rising interest rates have typically shaved 15 to 20 percent from the highs reached in the previous cycle. If that holds, we could still see more downside. As a result, I continue to advise sticking to only the strongest companies--those with the ability to grow reliably over the long haul--and to buy only when value-based price targets are reached.

As for other types of income plays, Canadian royalty and income trusts appear to be holding up well, particularly those that are reliably growing dividends. We’re still seeing enough volatility on certain days to spook some investors. But as long as you’re sure about the ones you own, and in particular their dividends, the best course is going to be to ride out the storm.

Also realize that the over-the-counter market pricing system is flawed and prone to posting bad prices. Always check the US price of a trust you own against the action in the Toronto Stock Exchange listing to determine if the action is real or bogus.

Note I’m sticking to short- to intermediate-term maturity bonds, preferably in companies with improving credit ratings. I favor apartment and residential real estate investment trusts over other types of REITs. And, despite recent volatility and fears about oil prices, stick with the super oils stocks like CHEVRON (NYSE: CVX).