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

2. Aim To explain different approaches to setting regulated prices for natural monopoly Market Investigations2

3. Overview Some economics of natural monopoly Different approaches to regulation Rate of return regulation Price cap (RPI – X): the building blocks Political economy considerations 3Market Investigations Natural monopoly Approaches Rate of returnPrice capPolitical economy

4. Natural monopoly Market Investigations4 Output Price, cost average cost potential cost penalty from duplication One network is cheaper than two but... Natural monopoly Approaches Rate of returnPrice capPolitical economy

5. Natural monopoly Market Investigations5 Output Price, cost demand average cost potential cost penalty from duplication MC Unregulated price... much of the advantage may be lost if the firm is unregulated Natural monopoly Approaches Rate of returnPrice capPolitical economy

6. Examples of natural monopoly? Postal services Telephones Electricity Gas Market Investigations6 Natural monopoly Approaches Rate of returnPrice capPolitical economy What do they have in common?

7. 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 Investigations7 Natural monopoly Approaches Rate of returnPrice capPolitical economy

8. 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 Investigations8 Natural monopoly Approaches Rate of returnPrice capPolitical economy

9. If the average costs of delivering letters falls when more letters are delivered to each address this reflects... Market Investigations9 1.An economy of network scale 2.An economy of scope 3.An economy of density 4.None of the above

10. If average costs fall as the extent of the network increases this is an economy of Market Investigations10 1.Network scale 2.Scope 3.Density 4.None of the above

11. ALTERNATIVE APPROACHES Market Investigations11 Natural monopoly Approaches Rate of returnPrice capPolitical economy

12. Alternative approaches In summary, these are: public ownership use of competition policy rate of return regulation price caps concession/ management contracts Market Investigations12

13. 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 Investigations13 Natural monopoly Approaches Rate of returnPrice capPolitical economy

14. 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 Investigations14 Natural monopoly Approaches Rate of returnPrice capPolitical economy

15. RATE OF RETURN REGULATION Approach 3 Market Investigations15

16. 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 Investigations16 Natural monopoly Approaches Rate of returnPrice capPolitical economy

17. 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 Investigations17 Natural monopoly Approaches Rate of returnPrice capPolitical economy

18. 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 Investigations18 Natural monopoly Approaches Rate of returnPrice capPolitical economy

19. 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 Investigations19

20. 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 Investigations20

21. PRICE CAP: RPI-X Approach 4: Market Investigations21

22. 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 Investigations22 Natural monopoly Approaches Rate of returnPrice capPolitical economy

23. 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 Investigations23 Natural monopoly Approaches Rate of returnPrice capPolitical economy

24. Price cap: 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 Investigations24 Natural monopoly Approaches Rate of returnPrice capPolitical economy

25. 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 Investigations25 Natural monopoly Approaches Rate of returnPrice capPolitical economy

26. 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 may have A-J effects Market Investigations26 Natural monopoly Approaches Rate of returnPrice capPolitical economy

27. 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 Investigations27 Natural monopoly Approaches Rate of returnPrice capContractsPolitical economy

28. 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 regulator independent of government? =>issues of accountability, transparency, control, regulatory governance, legal appeals, etc. Market Investigations28 Natural monopoly Approaches Rate of returnPrice capPolitical economy

29. The difference between cost of service and price cap is... Market Investigations29 1.Price cap adjusts for inflation 2.Price cap has a longer regulatory lag 3.Cost of service uses accounting rated of return, but price cap uses DCF 4.All of the above 5.None of the above

30. The Competition Commission said that BAA... Market Investigations30 1.Has to sell Gatwick and Stansted airports 2.Needs to co-ordinate investment in new runway capacity in the SE of Great Britain 3.Had organised an airport cartel 4.All of the above 5.None of the above

31. The Averch-Johnson effect Market Investigations31 1.is designed to ensure that firms earn a fair and reasonable return 2.means that opex is above the optimal level 3.does not apply to one- shot price caps 4.all of the above 5.none of the above