1 Strategic choice of financing systems in regulated and interconnected industries Anna BassaniniJerome Pouyet Rome & IDEICREST-LEI & CERAS-ENPC

2 Liberalization and regulation  Liberalization of network industries  Infrastructures are essential facilities Large returns to scale Huge fixed costs Investments  Regulation of access railways, telecoms… to finance infrastructure

3 Liberalization and globalization  Volume of international transactions using many networks  Competition on the markets Interaction between regulations  Strategic impact of national regulatory modes/financing systems on international services

4 Financing systems/regulatory modes  Railways in Europe Percentage of infrastructure deficit covered by access revenue Rmk: Only positive transfers  Similar issues in other network industries FranceAustriaGermany 25%40%100%

5 The questions  Nature of the interaction between the access pricing decisions of national regulators that face international services  Interaction between access pricing decisions affects the choice of financing systems  Nature/specificities of the regulatory competition between network managers

6 Model - 1  Two countries, infrastructure manager IM i  International final services, q * (p * ), requires the access to both infrastructures  First (budgetary) externality between countries  Net surplus S * (q * ) is shared across countries:  i + j =1  Second (direct) externality between countries  IM i decides: Access price a *i for the use of his infrastructure Transfer t i to finance the infrastructure  Downstream operators are competitive: p * =a *i +a *j +c d

7 Model – 2 IM 1 Infrastructure 1 s.t. break-even constraint Transfer 1 Access price 1 Final sector: Final price/quantity depends on both access prices IM 2 Infrastructure 2 s.t. break-even constraint Transfer 2 Access price 2

8 Model – 3  IM i ’s Budget Balance constraint (BB i ) : t i +(a *i -c u )q * ( p * (a *1,a *2 ) )≥ k i  IM i ’s objective SW i = i S * (q * )-(1+ pf )t i +t i +(a *i -c u )q * -k i Downstream Operators p * =a *i +a *j +c d IM i : a *i and t i IM j : a *j and t j

9 Ramsey-Boiteux Access Pricing Principles  Perfect cooperation between IMs (a * =a i* +a j*, t) Optimal access price Trade-off between the two instruments

10 Simultaneous choices of modes of regulation-1  Transfers and access prices are decided simultaneously and non-cooperatively

11 Simultaneous choices of modes of regulation- 2  Given a *j,  Strategic interaction  Transfer in country i

12 Simultaneous choices of modes of regulation- 3 Hyp: Stable & unique equilibrium Access prices excessive

13 Assumptions on infrastructure costs

14 Simultaneous choices of modes of regulation- Positive subsidy only-1  IM i chooses t i =0

15 Simultaneous choices of modes of regulation- Positive subsidy only-2  Consider that Multiple equilibria NS-equilibrium unstable S-equilibrium is stable Access prices are lower in the NS-equilibrium Similar features when access prices are strategic substitutes under the subsidy-system

16 Strategic role of infrastructure costs in the NS-equilibrium  Why are the access prices lower when both infrastructure managers adopt the no-subsidy financing system? Infrastructure fixed costs act as a commitment device to behave `aggressively’ Therefore, IMs might have poor incentives for cost-minimization under the NS-equilibrium Scope for a strategic use of investment

17 Impact of supra-national policies aimed at developing international services International services are excessively charged Standard solution: subsidize the acess to infrastructures to soften the distortions But, the impact of such policy depends on the equilibrium! Subsidies to infrastructures must be contingent on the regulatory modes implemented in the countries

18 Sequential choices of financing systems-1  The mode of regulation has a commitment value It binds the infrastructure managers in the access pricing decisions  Can countries use the mode of regulation in order to improve welfare? Two-stage game:  Choices of modes of regulation  Choices of access prices

19 Sequential choices of financing systems-2  Resolution by backward induction Given financing systems in both countries, determine the access prices  Immediate Analysis of choices of regulatory modes  Given the financing system in country j, what is the preferred financing system in country i?  The choice of financing system has two effects : Direct effect: on the access price set in country i Strategic effect: on the access price set in country j

20 Best-response in financing systems- Remark  Infrastructure manager distorts access price (reduces consumers’ surplus) to ensure the financing of infrastructure (increase the infrastructure profit)  To satisfy a strict budget constraint in a non- cooperative setting: Either reduce the access price to increase demand Or increase the access price to increase the margin Which strategy is chosen by an IM depends on the reaction of the other IM

21 Best-responses in financing systems- 1  Country j chooses No-Subsidy (S,NS) (NS,NS) If one country chooses No- Subsidy, the other country chooses No-Subsidy The commitment to a strict-budget balance creates a strong strategic complemen-tarity, which provides an IM with an incentive to adopt the NS- system in order to reduce access prices This holds whatever (NS,NS) always an equilibrium

22 Best-responses in financing systems- 3  Country j chooses Subsidy and If one country chooses Subsidy, the other country chooses Subsidy Multiple equilibria in the strategic game Infrastructure managers are `conservative’ An IM is willing to reduce the access price onlt if he anticipates a sufficiently strong decrease of the access price set in the other country

23 Best-responses in financing systems- 4  Country j chooses Subsidy and If IM i chooses NS, then a *i increases Then, IM j reacts by decreasing a *j, but to a smaller extent Total access price increases IM i saves on the subsidy given to the infrastructure under S but reduces consumers’ surplus

24 Best-responses in financing systems-4bis  Country j chooses Subsidy and If the strategic reaction in country j is strong:  Country i chooses NS and total welfare decreases But then country j will also choose NS  NS in both countries is the unique equilibrium of the strategic game! If the strategic reaction in country j is weak:  The choice of financing systems depends on the infrastructure fixed cost:  k i small: Incentive to free-ride and choose NS Unique equilibrium  k i large: No incentive to free-ride and choose S Multiple equilibria

25 Strategic choices of financing systems- Summary  Financing systems might be used as a coordination device and enable the infrastructure managers to reach the Pareto-superior equilibrium However, infrastructure managers might have free- riding incentives  Issues Renegotiation-proofness Incentives in presence of domestic and international services

26 Strategic choices of financing systems- Renegotiation-proofness Ex post, an infrastructure managers might be tempted to deviate from his equilibrium access price Financing systems must credibly commit the infrastructure managers Separation of access pricing and choice of regulatory mode NS-equilibrium

27 Extensions- 1 Domestic and international services  Consider that services are purely domestic No externality between infrastructure managers No distortion wrt 1st-best perfect cooperation case  If international services > domestic services: Whatever the `initial’ choices of regulatory modes, infrastructure should to be less subsidized  Role of a supra-national authority to coordinate the transition  If international services < domestic services: No mandatory adoption of no-subsidy

28 `Pass-through’ country- 1  Consider  j =0 Budget constraint never binding in this country Since taxation is distortionary, t j =0 Then: Analysis similar to the choice of regulatory mode in one country when the other country chooses subsidy… except that…

29 `Pass-through’ country- 2  Whether the budget-constraint is binding might be endogenous When a *j is sufficiently low, the budget constraint might not be binding in country i This creates the possibility of another equilibrium in which the budget constraint is not binding and access prices are low

30 Conclusions  Interaction between infrastructure managers with direct and budgetary externalities Commitment to strict budget balance binds infrastructure managers to behave aggressively  Potential coordination problems No-subsidy is Pareto-superior but unstable Subsidy is Pareto-inferior but stable  Supra-national policies to promote international services through infrastructure subsidies might have perverse effects  Financing systems might be used strategically to free- ride

31 Further research  Strategic role of investment  Interconnection  International competition and the incentives for cost-minimization (agency problem)