BSc Economics and related programmes Economics of Competition and Regulation EC 3015 Week 8: Price Cap Regulation

Market Investigations Aim To explain different approaches to setting regulated prices for natural monopoly Market Investigations

Market Investigations Natural monopoly Approaches Rate of return Price cap Political economy Overview Some economics of natural monopoly Different approaches to regulation Rate of return regulation  Price cap (RPI – X): the building blocks Political economy consideration Market Investigations

Market Investigations Natural monopoly Approaches Rate of return Price cap Political economy Natural monopoly One network is cheaper than two... Price, cost demand potential cost penalty from duplication average cost Output Market Investigations

Market Investigations Natural monopoly Approaches Rate of return Price cap Political economy Natural monopoly ...but much of the advantaqe may be lost if the firm is unregulated Price, cost demand Unregulated price potential cost penalty from duplication average cost MC Output Market Investigations

Examples of natural monopoly? Natural monopoly Approaches Rate of return Price cap Political economy Examples of natural monopoly? Postal services Telephones Electricity Gas Market Investigations

Network cost function characteristics Natural monopoly Approaches Rate of return Price cap Political economy Network cost function characteristics Cost per unit of output = f(density, scope, sometimes scale) Density: fixed investment (e.g. pipe laying) spread across larger throughput Scope: types of output Scale: Geographic extent Market Investigations

Network externalities Natural monopoly Approaches Rate of return Price cap Political economy Network externalities ...are about the benefit to existing users to adding another user. Clearest example: telephony – how many people can you call Less clear but related: how many places can you get to and from by e.g. rail Electricity network (e.g. grids) more extensive =>more efficient generation Market Investigations

Alternative approaches Natural monopoly Approaches Rate of return Price cap Political economy Alternative approaches Market Investigations

Alternative approaches In summary, these are: public ownership use of competition policy rate of return regulation price caps concession/ management contracts Market Investigations

Approach 1: public ownership Natural monopoly Approaches Rate of return Price cap Political economy Approach 1: public ownership Developed for posts, then telephones CEB 1920s (also BBC, as public corporation) 1946-9 Nationalisation Worldwide e.g.1930s-70s national flag airlines Different versions: direct ministerial control (govt dept.) via public corporation (Morrison), ministry regulator with independent regulator Market Investigations

Approach 2: use competition policy Natural monopoly Approaches Rate of return Price cap Political economy Approach 2: use competition policy i.e. ex post regulation problem: competition policy is not very good at tackling high price abuse New Zealand tried this but have moved to having regulators Market Investigations

Rate of return regulation Approach 3 Rate of return regulation Market Investigations

Approach 3: “cost-of-service” regulation Natural monopoly Approaches Rate of return Price cap Political economy Approach 3: “cost-of-service” regulation Was standard in USA and US “empire”/sphere of influence. Reconciles private property with controlling abuse Also known as “rate of return” regulation: key point is assuring “just and reasonable” return on investment Effective in generating investment, but incentive properties a problem (see below) Legalistic and cumbersome? Market Investigations

Approach 3: Key elements Natural monopoly Approaches Rate of return Price cap Political economy Approach 3: Key elements Required revenue = operating expenditure plus capital depreciation (= return of the money invested) plus allowed rate of return times net regulatory asset base. Essentially an accounting approach: Net regulatory asset base this year = net regulatory asset base last year less depreciation plus new investment. Market Investigations

Market Investigations Natural monopoly Approaches Rate of return Price cap Political economy Approach 3: incentives Investment: Since there is a guaranteed rate of return, all agreed investment tends to get done in time. US electricity system, for example was successful in largely avoiding black- and brown-outs for many decades. Operating cost: Regulatory commission (and consumer advocate groups) keep a watchful eye on costs, but limited by asymmetric information Market Investigations

Rate of return: efficiency Averch-Johnson effect: excessive capital intensity arises from guaranteed return = true cost of capital + “delta” delta = safety margin to ensure that return is earned Seen in form of “gold plating”, preference for capital not opex solutions A form of allocative inefficiency True extent of A-J effect is contested Market Investigations

Rate of return: process Companies apply for rate increases when they think justified (or can make a case) Contested by consumer groups Adjudicated by Regulatory commissions heavily legalistic rewarding to law firms process looks cumbersome to public Market Investigations

Market Investigations Approach 4: price cap: RPI-X Market Investigations

Approach 4: The price cap Natural monopoly Approaches Rate of return Price cap Political economy Approach 4: The price cap Introduced in Britain (1984) for BT as “local tariff reduction scheme” cost-of-service appeared cumbersome, poor incentive properties, not necessary for “temporary” monopoly “Prices” are set for a 4-5 year period, usually with price reduction in real terms (see below) Better incentive properties than cost-of service, at least in short run Market Investigations

Market Investigations Natural monopoly Approaches Rate of return Price cap Political economy The price cap: RPI-X RPI =retail price index X = relative efficiency improvement assumption, adjusted for quality/environmental improvements ensuring need for capital investment Market Investigations

Approach 4: revenue requirements Natural monopoly Approaches Rate of return Price cap Political economy Approach 4: revenue requirements Central equation NPV(revenues) =NPV( “Cash flow out”) Cash flows out: initial regulatory value (year 0) expected operating costs (each year) approved capital expenditure (each year) less final regulatory value All discounted using “cost of capital” Market Investigations

Market Investigations Natural monopoly Approaches Rate of return Price cap Political economy Approach 4 Comments on financial methodology: would be equivalent to cost-of service if accounting rate of return is economic rate fo profit Both systems require some assumptions about depreciation, but price cap only requires multi-year aggregates Market Investigations

Approach 4: key differences Natural monopoly Approaches Rate of return Price cap Political economy Approach 4: key differences Price cap is explicitly forward looking –requires cost modelling (next week) to drive real prices down automatic adjustment for inflation 4-5 year price control period gives incentive for firms to cut costs – benefit up to 5 years might be longer in some methods --but over time my have A-J effects Market Investigations

Market Investigations Natural monopoly Approaches Rate of returnPrice capContractsPolitical economy Approach 5: contracts Sometimes used especially in water, transport Management –only contracts: gov’t owns assets, operated by competitively tendered firms build, own, operate transfer e.g. bridges, toll roads where investment is key requirement Market Investigations

Political economy questions Natural monopoly Approaches Rate of return Price cap Political economy Political economy questions Why are some activities regulated, others not? When the industry seeks (tougher) regulation, why? Can the regulator be captured by the industry? Is the regulatory independent of government? =>issues of accountability, transparency, control, regulatory governance, legal appeals, etc. Market Investigations