ACCC 2010 Regulatory Conference Transport Session Can private contracts replace conventional public utility regulation? Darryl Biggar ACCC/AER

Slide 2 11 August 2008 Points of agreement I agree with Prof Gómez-Ibáñez’s approach to the natural monopoly problem: The central natural monopoly problem is not the minimization of deadweight loss (as most textbooks would suggest) but the need for both sides to make sunk investments. –The provider of the monopoly service must often make an investment in a substantial sunk asset (such as a bridge, a rail network, an airport, a telecommunications network, an electricity network, etc.). –At the same time, the users of the monopoly service must also make their own sunk complementary investments in order to get the most value out of the monopoly service.

Slide 3 11 August 2008 Points of agreement As Prof Gómez-Ibáñez points out, when investors make sunk complementary investments they leave themselves exposed to the threat of “hold up” (“opportunistic behaviour by others”) –In other industries this problem is often solved through long-term private contracts. The central monopoly problem is not one of controlling deadweight loss but one of designing contracts (or similar arrangements) which maintain the incentives to make sunk complementary investments in the light of transactions costs. Prof Gómez-Ibáñez suggests that there are a continuum of possible arrangements for addressing the basic problem: –“private contracts”, “concession contracts”, “discretionary regulation” and “public enterprise”.

Slide 4 11 August 2008 A greater role for private contracts? The suggestion in Regulating Infrastructure is that there is scope for long-term private contracts between a natural monopoly and its customers to replace convention utility regulation, at least to a greater extent than we see now… –“The experience of the U.S. railroad and airline industries suggests that private contracts can be an effective, even superior, substitute for government regulation in certain circumstances. … The interesting question is whether private contracts could be applied more widely to substitute for regulation”. (p214). –“It is striking how often the market-oriented or contractual solutions can be applied”. Can we rely on private contracts in the place of conventional public utility regulation to a much greater extent than we do now?

Slide 5 11 August 2008 What about railroads and airlines? In Regulating Infrastructure Prof Gómez-Ibáñez suggests that two US industries illustrate the potential benefits of relying on long-term private contracts as a replacement for conventional regulation – the rail freight industry and the airline industry. But is this the case? –There has been a move to greater reliance on longer-term contracts in US rail, but prices are not entirely unregulated. Captive shippers have the right to seek a price determination from the STB. –Prof G-I recognises that this has not prevented captive shippers from being charged substantially higher rates (21%) than non-captive shippers. –Prof G-I notes that the only way that a captive shipper could be adequately protected is if it doesn’t have any sunk costs – but then the shipper is not captive!

Slide 6 11 August 2008 Absence of transaction costs At a purely theoretical level, in the absence of transactions costs private arrangements would solve the monopoly problem. –This is an example of the so-called Coase Theorem. But this is a theoretical abstraction from reality. In practice the best that we can say is that in some limited situations, long-term private contracts might be able to achieve a reasonably efficient outcome. –For example, where the users can negotiate with potential suppliers before one or other side has sunk any investment and when the industry is stable so that reasonably long-term contracts are possible. Possible examples include “foundation” contracts for a natural gas pipeline, or a large electricity consumer negotiating with the electricity transmission network, or large miners contracting for a coal network expansion.

Slide 7 11 August 2008 Reliance on private contracts? Should we go further to rely to a greater extent on private contracts as a replacement to regulation? There is one obvious immediate problem – most users/consumers of existing monopolies have already made a substantial sunk investment in reliance on on-going public utility regulation. –Eliminating existing public utility regulation would expose that existing sunk investment to the risk of hold-up. Deregulation and reliance on private contracts could only ever be applied to new customers (which have not yet made a sunk investment) or new pieces of network infrastructure.

Slide 8 11 August 2008 Reliance on private contracts? So, should we require long-term private arrangements for new customers of a network or for major new network infrastructure? Problems still remain: –The monopolist can still extract the value of any investment that happens to be sunk prior to negotiating the contract. –Contracts are inevitably incomplete and/or limited in term. If the contract has a limited term or is unenforceable under certain circumstances the need will arise in the future to renegotiate the contract – after even more sunk investment has been made. Very few private contracts in the economy are longer than ten years. Is this long enough to protect the sunk investment of, say, an aluminium smelter?

Slide 9 11 August 2008 Reliance on private contracts? Problems still remain (continued): –Negotiating a contract is itself costly, which could be an obstacle for small companies/users or companies/users who must negotiate with many monopoly suppliers. –The act of negotiating may itself reveal valuable information to the monopolist. In negotiating access arrangements the monopolist may wish to know the use to which the service will be put – but this may require the access seeker to reveal its business model. Suppose that the Internet were owned and operated by a single monopoly firm (such as Microsoft) which could charge firms for providing services over the Internet. Would we expect to see the same level of innovation which led to services such as, say, Google, Facebook or Twitter?

Slide August 2008 Reliance on private contracts? At the end of the day, which approach would you think would better protect the sunk investments of users: –An approach in which there is no external scrutiny of prices and each user is expected to enter into its own contract with the monopolist? –Or an approach in which the charges of the monopolist are set in a long- term stable manner by an independent regulatory authority? Unfortunately, the scope for reliance on private contracts as a substitute for conventional public utility regulation is strictly limited…

Slide August 2008 Summary Prof Gómez-Ibáñez is right to emphasise the role of sunk costs, the hold-up problem, and transactions costs, as at the core of the monopoly problem. –He is right in arguing that the underlying monopoly problem is best viewed as a contracting problem. It is true, in a theoretical sense, that in the absence of transactions costs we wouldn’t need to regulate – we could rely exclusively on long-term private contracts. –But the world is not perfect – contracting is costly, contracts are incomplete and information is asymmetric. There are circumstances (such as foundation contracts for natural gas pipelines) where we can rely on the parties entering long-term private contracts instead of regulation. –As a rule, we should be alert to the scope for allowing and encouraging private contracts as a substitute for conventional regulation. But in the big picture this scope is limited.

Slide August 2008 Summary (contd.) The examples Prof G-I uses in his book don’t seem to illustrate the central claim. –The US rail industry seems to better illustrate the use of private contracts as a supplement to regulation rather than as a replacement for regulation: For most public utility services and most users, conventional public utility regulation can better protect incentives to make necessary sunk investments over time at a lower overall cost to the economy. –Regulators cannot hang up their building block models just yet.