Incentive Regulation and Competition in Public Utility Markets: A 20-Year PerspectiveBy: Ingo VogelsangPresented 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:▫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

economy-wide 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 pre-specified 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 Population density▫Climate Local wage rates▫Taxes

•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

▫ 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