Transcript Incentive Regulation and Competition in Public Utility

Incentive Regulation and
Competition in Public Utility
Markets: A 20-Year Perspective
By: Ingo Vogelsang
Presented by: Sarah Noll
The Roots of Incentive Regulation
• By 1970s economists found that the regulation of
competitive industries was inappropriate and a
major failure
• Rate-of-Return Regulation was criticized after
the discovery of the Averch-Johnson effect
• With the need for an improvement in regulation,
incentive regulation became an attractive option
Incentive Regulation
• “The regulator delegates certain pricing
decisions to the firm and the firm can reap profit
increases from cost reductions”
• The regulator controls less behavior, but instead
rewards outcomes
Characteristics of Incentive Regulation
• Bayesian Regulatory Mechanisms
▫ Describes the regulators lack of information by
subjective probabilities that the regulator holds
about parameters of the regulatory optimization
problem
• Non-Bayesian Regulatory Mechanisms
▫ Attempts to only use observable and verifiable
data (bookkeeping) and to be independent of the
particular regulator
• The most popular incentive approach, price cap
regulation, is a blend between the two
Characteristics of Incentive Regulation
• The most important types of incentive
regulation:
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Price Caps
Rate Case Moratoria
Profit Sharing
Banded Rate-of-Return Regulation
Yardstick Regulation
Benchmarking Based on a Hypothetical Efficient
Firm
▫ Menus
Price Caps
• Price Caps are defined by an index of the
regulated services that is adjusted annually by:
▫ An inflation factor that takes care of the economywide price level (input prices)
▫ An X-factor that reflects efficiency improvements
of the firm
▫ A Y-factor that allows for pass-through of specific
cost items outside the firms control
Price Caps
• Price Caps have been so successful because they
combine:
▫ Incentives for cost reductions
 Cost-reducing incentives of price caps are fairly stable
and viable, which is important to have hold over a long
period of time.
▫ Freedom and incentives for price rebalancing
 The flexibility to change relative prices in the regulated
basket of services, combined with a weighting scheme
that promotes price rebalancing towards more efficient
price structures has contributed to the success of price
caps
Rate Moratoria
• A special case of price caps
▫ Y-factor of zero
▫ X-factor equaling the rate of inflation
• Has strong incentive properties and are very
popular with customers
• Burden the utility with the inflation risk
▫ Threatens financial viability
• Today Rate Moratoria is used for specific basic
services
Profit Sharing
• Also known as sliding scale regulation, dates back to
the 19th century England
• Allows customers to directly participate in excess
profits or profit shortfalls earned by the utility
▫ Ex post refunds or price reductions for future
purchases
▫ Strong fairness and good efficiency properties
• Practiced in the U.S. for electric utilities in the first
half of the 20th century, however abolished in the
1950s, when the utilities ran up losses
Banded Rate-of-Return Regulation
• Allows the regulated utility to keep its excess
profits and suffer profit shortfalls within a prespecified band
• Requires continuous monitoring of profits,
which is equally costly in administrative terms
as profit sharing
Yardstick Regulation
• The prices the utility can charge is dependent on
the performance of other firms
• Risky for a utility to the extent that its costs
differ from the yardstick by virtue of such
factors:
▫ Geology
▫ Climate
▫ Taxes
Population density
Local wage rates
• Can provide strong incentives
Benchmarking
• Benchmarking based on a hypothetical efficient firm
• Base prices on efficient long-run costs, derived from
engineering models of a utility
• Cost proxy models try to measure the total long-run
incremental cost of a service or of a network element
▫ They often miss firm specific peculiarities on input
prices, demands etc.
▫ Not entirely accurate
• Regulators around the world still use them
Menus or Options
• Allows the regulated utility a choice among
different incentive regulation plans
• Typically a combination between price caps and
profit sharing
• Tailor the mechanism more closely to the
specific circumstances of a utility without the
regulator knowing beforehand
• Raise serious commitment problems
• Abandoned by the FCC
Price Caps in Monopoly
• Price Caps are seen as a fairly straightforward
way to provide incentives for cost reduction
• Where rate-of-return regulation and public
enterprise pricing failed, price caps prevailed.
• Price Caps simulated a long-term fixed-price
contract of 3 years.
▫ Adjustments to changing circumstances are
allowed, but they must be independent of the
regulated firm’s behavior
Price Caps in Monopoly
• Price Caps finesse the fixed-price contract through the
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inflation adjustment
X-factor
Y-factor
Pre-specified renewal date
• This combination increases the commitment power, but also
decreases the cost-reducing incentives
▫ This tradeoff has lead to the following findings:
 Little if any operating costs reductions
 Increased productivity growth
 Accelerated network modernization  increased capital intensity
• Incentive regulation induced the firms to improve input
efficiency, while paying higher prices for inputs and investing
in future cost reductions
Price Caps and Service Quality
• Lapses in repair and installation times became
widespread about two years after the
introduction of price caps in the U.K.
• Quality deterioration not only lowers costs but
also reduces demand
▫ The utility faces a tradeoff between cost savings
and a potential loss of sales
Price Caps and the Incentive for
Allocative Efficiency
• Idealized price-cap weights would lead to Ramsey
prices right away
▫ No lags or strategic behavior
▫ Weights= correctly forecasted optimal quantities
• Such forecasts require the same information as
Ramsey prices, better options?
▫ Average between a Laspeyres and Paasche index
▫ The Fisher ideal price index
▫ Could immediately improve the regulatory outcome
 Downsides: potential for strategic manipulation and the
impossibility to calculate them ex ante
Price Caps and Horizontal Competition
• A main goal of price caps has been to
accommodate competition
• Price Caps are compatible with competition
because competition requires flexibility and
because it constrains rents and therefore makes
profit control less important
• Competition and price-cap regulation have the
potential for conflict, when flexibility is used to
chasten competitors, or when price caps are so
tight, competitors are kept out
Price Caps and Horizontal Competition
Price Caps are too Tight
Price Caps are too Loose
• The tighter the cap, the lower
the utility’s prices will be
• Attracts less entry
• Negative correlation between
tightness of the cap and the
amount of competition
• Excessive entry occurs
• Unlikely in strong natural
monopoly situation
• Possible under weak natural
monopoly and natural
oligopoly
• Tighter price caps would solve
the problem of excessive entry
Regulation of Vertical Relationships
• Monopoly regulation today almost always concerns
firms that are vertically integrated so they hold a
monopoly over all stages or compete with firms that
use the same monopoly outputs as their inputs.
• Vertical integration vs. Vertical separation
▫ Vertically integrated utility competes with the buyers
of its intermediate inputs, while the separated utility
only sells at one level.
▫ Vertically integrated utility may enjoy economies of
scope so that vertical integration reduces total costs of
the industry
Conclusions
• Its important to find the best strategy for
substituting competition for regulation.
• Deregulation is warranted if actual competition in
the market is sufficiently strong
• Deregulation can occur in three broad stages:
▫ Regulation could be applied to all services of dominant
incumbent carriers but price structures could be
deregulated
▫ There can be partial deregulation, leaving specific
market segments to continuing regulation. Price caps
can accommodate gradual deregulation
▫ There can be total deregulation
Conclusions
• Total deregulation appears to be unrealistic at
this time for the main regulated industries:
▫ Telecommunications and electricity
▫ Due to the laws in place and the continuing
dominance of incumbent carriers
• The current choice is between partial and global
price caps