Competition and Policy and Regulatory Reform in Public Utility Industries.

Patrick Massey

CompEcon Limited

Conference on Regulatory Governance and Network Industries.

Holiday Inn

Sarajevo

April 19 2002

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‘Regulation and competition are rhetorical friends and deadly enemies: over the doorway of every regulatory agency.....should be carved: Competition Not Admitted.’

G.J. Stigler, "First Lecture", in M.F. Cohen and G.J. Stigler, (1971), Can Regulatory Agencies Protect Consumers?, Washington DC, American Enterprise Institute.

Introduction.

The essential characteristic of public utility industries is that one or more segments of the industry constitute a natural monopoly. In the case of gas and electricity, for example, transmission and distribution constitute natural monopolies.[1] In telecommunications the local loop was traditionally considered a natural monopoly. This may no longer be true in urban areas at least. However, an owner of a telecom network must be able to interconnect with rival networks in order to provide the comprehensive service required to compete in the market so that new entrants require access to the existing network. Some form of regulation was considered essential to protect consumers from the exercise of market power arising from the natural monopoly segment of the industry.

In many European countries such regulation took the form of State ownership with the natural monopoly extended into the upstream production and downstream supply markets thereby establishing vertically integrated monopoly public utility firms. The belief was that state ownership would ensure that the monopoly operated in the public interest. In the United States private ownership of such industries was the norm with the potential for abuse of market power, due to natural monopoly, being dealt with by regulation which traditionally involved fixing a maximum rate of return on capital for the industry.

Regulatory Shortcomings.

Over the past thirty there has been a growing recognition of the potential for ‘regulatory failure’. Regulatory failure arises as a result of what economists refer to as information asymmetries. In simple terms a regulator simply does not and cannot know as much about the business as the regulated firm. Regulators are therefore heavily reliant on regulated firms for information. This allows regulated firms to manipulate regulatory decisions in their favour. Thus over time regulators tend to identify with the regulated industry and end up defending it rather than policing it. This process is known as regulatory capture. The creation of vertically integrated monopolies further centralizes information in the hands of the regulated firm thus exacerbating the problem. A second source of regulatory capture arises because regulatory bodies, once established, tend to perpetuate and enlarge their activities.

Based on this experience countries throughout the world have radically altered their approach to regulating public utilities over the past two decades. This process is frequently referred to as de-regulation but is more accurately described as regulatory reform. Essentially there are two key features common to the regulatory reform process in most countries. First the scope of regulatory controls in public utilities was reduced with competition being permitted in those activities where it was possible. The second element involved developing better forms of regulatory control that were specifically designed to overcome the information asymmetry problem facing regulators. Experience in many countries, however, indicates that simply permitting competition in such areas is insufficient to produce actual competition for a number of reasons.

Problems with Liberalising Public Utility Industries.

Reforming public utility industries and introducing competition must address the potential for abuse of dominance due to:

• The network natural monopoly.
• The dominant position of the incumbent.
• In the case of a vertically integrated incumbent, these problems are compounded.

Reformed regulatory structures are often considered to have an important role in addressing the potential for incumbent firms in public utility industries to abuse their dominant position. Structural reforms can help to ensure a more competitive outcome and reduce the need for hands-on regulatory interventions. International experience over a long period of time shows that regulation is not a substitute for, and will not deliver the benefits which can accrue from competition. In fact, certain forms of regulation may even hinder the development of competition.

A vertically integrated incumbent firm has obvious incentives to deny its rivals access to the natural monopoly network or to provide it on less favourable terms than those it applies to itself, thereby frustrating attempts to introduce competition. It can do this in a variety of ways.

• Outright Refusal
• Excessive Pricing
• Quality of Access

An independent network operator on the other hand has no incentive to discriminate against new entrants.

Consequently vertical separation of the natural monopoly elements from the potentially competitive segments can greatly simplify the task of regulating the natural monopoly network operators and is more effective than regulation at fostering competition.

Similarly where the incumbent has historically enjoyed a monopoly over a prolonged period of time, regulatory controls may be justified on the grounds that there is inadequate competition in the market. However, the level of competition in the market is not necessarily a given. Rather it can be affected by policy choices. Simply permitting entry will be insufficient to promote competition. Policy measures designed to increase competition through restructuring of the incumbent may eliminate or at least greatly reduce the need for sector specific regulation. Such measures are likely to produce greater benefits to customers than regulation. Such reforms may include the horizontal restructuring of incumbent firms or possibly restrictions on their installing new productive capacity until competition is sufficiently well developed in the market.

The Role of the Competition Authority.

Competition authorities have a potentially important role to play in the liberalisation process. There are two aspects to this. First they need to stress the need for proper restructuring that is necessary for the development of effective competition in public utility industries. Advocacy of pro competition options is necessary because of the potential for incumbents and other government agencies to oppose such changes. Second competition authorities need to address the fact that industry regulators are prone to producer capture and often tend to have an inherent bias in favour of regulatory interventions rather than allowing market forces to work.

Incumbent monopolies have an obvious incentive to oppose the vertical and horizontal restructuring that is necessary to allow competition to develop. Finance ministries are also likely to oppose such reforms on the grounds that the revenue from privatisation is likely to be greater if the incumbent is privatised as a monopoly. Of course the higher price merely reflects the fact that buyers expect to earn monopoly profits. While there may be some short-term benefit to the exchequer the cost of retaining a monopoly is borne by consumers. To quote the famous neo-classical liberal economist John Stuart Mill:

‘To confer a monopoly upon a producer is to give them the power of levying any amount of taxation on the public for their individual benefit, which will not make the public forego the use of the commodity.’[2]

There are numerous examples which illustrate that failing to undertake structural reforms prior to privatisation mean that the potential benefits from competition are deferred. Structural reforms have ultimately proved necessary. This is seen most clearly in the case of the UK which was one of the first countries to liberalise public utility industries.

In telecoms at the time BT was privatised only one other firm was permitted to enter the market, effectively creating a duopoly which lasted for a decade at the end of which BT still had a dominant position and consumer benefits were limited. The abolition of the duopoly led to a marked increase in competition and produced significant gains to consumers.

Senior management of British Gas effectively resisted the vertical restructuring of the company at the time of separation. The company was subsequently subject to repeated reviews by both the regulator and the competition authorities and ultimately decided to split itself into two separate companies - a transmission system operator and a gas supplier. This has resulted in the effective development of a competitive gas market.

In the case of electricity the industry was restructured at the time of privatisation. The transmission system was established as a stand alone company while the generating assets were split between two competing private sector generators with the nuclear power plants retained in public ownership. Green and Newberry suggest that significantly greater cost reductions in generation could have been achieved by dividing generating capacity at privatisation equally among five companies rather than two, an option which they conclude was feasible.[3] In fact the ability of the two private sector generators to effectively determine electricity prices ultimately forced the regulator to intervene and require them to dispose of generating assets in order to produce a more competitive market. (See Table 1). Competition has now developed to the stage where the industry regulator has decided that price controls are no longer necessary to protect consumers.

In Ireland the newly established transmission system operator in the electricity industry has instituted court proceedings challenging a decision by the regulator on the grounds that it would be unable to carry out its functions properly. The real problem is arguably the unsatisfactory nature of the restructuring which has allowed the incumbent former monopoly to retain ownership of the transmission system and given it exclusive responsibility for construction and maintenance work. The Competition Authority has expressed serious concerns about the unsatisfactory nature of the structures that have been put in place.

New Zealand originally opened its electricity market to competition in 1988. However, simply opening the market to competition proved ineffective. In 1994, the transmission functions of the former state monopoly, ECNZ, became a separate State-Owned Enterprise, TransPower. A report by a Government review group found that ECNZ's dominant position had prevented the development of effective competition and concluded that without the development of an effective wholesale market and measures to reduce ECNZ’s dominance in generation independent power producers (IPPs) would find it difficult to enter the market.[4]

In 1996 about one third of ECNZ’s generation assets were transferred to a new State-Owned Enterprise, Contact Energy which competed directly with ECNZ. In addition ten smaller plants representing just over nine per cent of capacity were sold to third parties and limits were placed on the amount of new plant which could be built by ECNZ for a period of ten years as proposed by the WEMDG report. In 1999, Contact Energy was privatized while ECNZ was further split into three competing State-Owned Enterprises. Thus ultimately four competing generators were formed from the initial ECNZ, a decade after the market was first opened to competition. (See Table 2).

In contrast in Australia the electricity industry was subject to significant restructuring at the beginning of the liberalisation process. This involved the vertical separation of the various electricity utilities into separate generation, transmission, distribution and retailing businesses. The generation assets in New South Wales, Victoria, South Australia and Queensland were further divided into a number of competing businesses. In Victoria the generation business was separated into five competing firms. This appears to have resulted in significant price falls compared to the excessive price-cost margins which resulted in further restructuring in England and Wales[5] The International Energy Agency found that real electricity prices had decreased by 10% on average in the decade up to 2001 and estimated that the benefit to the economy of liberalisation in the year 2000 amounted to at least A$1.5bn.[6] Estimates suggest that Australia’s GDP will be A$2.4bn higher in 2010 (in 2001 prices) that it would have been in the absence of reform.[7]

In many countries regulatory agencies have been required to take steps to actively promote competition. The problem is that regulatory agencies frequently tend not to understand or trust markets. They have a tendency to promote hands-on interventionist solutions rather than rely on markets. As with all bureaucratic agencies they also find it hard to relinquish control and let market forces work.

In the US telecommunications had been regulated for around half a century before the Justice Department forced the break-up of AT&T for breaches of competition law. A number of authors have criticised the FCC for its continued failure to pursue a pro-competition approach since 1984.

‘And staying on the path toward competition, without quite getting there, the FCC did not need to accept any diminution of its powers that might have come with deregulation.’[8]

In the UK the MMC has, on occasion, criticised Oftel for decisions that have adverse implications for competition. In Ireland as noted the Competition Authority has criticised actions of the electricity regulator.

While sector specific regulation may be necessary to deal with certain issues such as the natural monopoly element of public utility industries, such regulation should be seen as a complement to, rather than a substitute for competition law. The competition authority should be the agency that has the necessary expertise in competition law. It is more likely to be able to identify and address possible abuses of dominance since it will have experience of investigating such issues in a wide range of industries. Allowing it to apply the competition rules to public utility industries reduces the potential for regulatory capture and can thereby protect against the emergence of regulator sanctioned anti-competitive practices. What is equally important, however, is that it provides a safeguard against inappropriate regulatory interventions where aggressive competitive behaviour is mistakenly regarded as anti-competitive. Such errors are likely to have a chilling effect on competition.

A final consideration in a small country, such as Ireland, for example, is that there may be a relatively limited pool of individuals with expertise in competition matters making it difficult and costly to try and replicate expertise in this area in a number of different agencies.

Conclusions.

I believe that the competition authority has an important role to play in the liberalisation of public utility industries. Liberalisation requires significant industry restructuring, something that is likely to be opposed by potentially powerful incumbent firms and other government departments. Similarly the potential for regulatory capture makes it necessary for a competition authority to prevent the development of an inappropriate coalition between the regulator and the regulated firm. The development of competition is essential to ensure that public utility reforms deliver benefits to citizens and consumers. This reinforces the need, underlined in some of the other contributions that have been made today, for a strong independent competition authority that is prepared to take on strong vested interests and other government agencies.

Table 1: % Distribution of Generation Output in England & Wales

Source: S. Littlechild, (2000), A Review of UK Electricity Regulation 1999-2000, in Centre for Regulated Industries Regulatory Review - Millenium Edition 2000/2001, Bath, CRI.

Table 2: Structure of Electricity Generation in New Zealand (1999)

* State Owned Enterprises.

Source: Ministerial Inquiry into the Electricity Industry: Issues Paper, February 2000, p.12.

© CompEcon Limited 2002.

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[1] In electricity transmission refers to the high voltage nation-wide network of lines which carry power from the generating stations. Distribution involves taking power from the high voltage transmission network, reducing voltage by means of transformers to levels suitable for industrial and domestic usage and then supplying power to individual homes and business premises by means of the lower voltage local line network. Similarly gas is transported over the national high-pressure transmission network, and then through regional distribution pipelines, where pressure is reduced, for supply to individual customers.

[2] J.S. Mill, (1848), Principles of Political Economy.

[3] D. Newberry and R. Green, (1995), Regulatory Policies and Reform in the Electricity Supply Industry, in C.R. Frischtak, ed., Regulatory Policies and Reform: A Comparative Perspective, World Bank.

[4] Wholesale Electricity Market Development Group (1994), New Zealand Wholesale Electricity Market, Wellington, Government Printer.

[5] D. Newberry, (2001), Regulating Unbundled Network Utilities, EARIE Conference, Trinity College Dublin, mimeo.

[6] IEA, (2001), Energy Policies of IEA Countries - Australia 2001, IEA, Paris.IEA, (2001).

[7] C. Short, A. Swan, B. Graham and W. Mackay-Smith, Electricity Reform: The Benefits and Costs to Australia, ABARE paper presented to the Outlook 2001 Conference, Canberra, 27 February - 1 March 2001.

[8] P.W.MacAvoy (1996), The Failure of Antitrust and Regulation to Establish Competition in Long-Distance Telephone Services, Cambridge Ma., MIT Press.

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