Economics of energy corporations
Regulation and governance
V. Hajko
2015
V. Hajko (FSS MU) Introduction to Economics 1 / 26
1 Basic terms, definitions
Definition
Reasoning for regulation
Reasoning against regulation
2 Types of regulation
Traditional regulation
“Newer” forms of regulation
V. Hajko (FSS MU) Introduction to Economics 2 / 26
Basic terms, definitions Definition
Outline
1 Basic terms, definitions
Definition
Reasoning for regulation
Reasoning against regulation
2 Types of regulation
Traditional regulation
“Newer” forms of regulation
V. Hajko (FSS MU) Introduction to Economics 3 / 26
Basic terms, definitions Definition
Regulation I
Regulation: enforcement of rules by government, typically threatining
with penalties
to change the economic behavior in the private sector.
targeted at price(s), output, rate of return, ownership structure or
setting up standards
Energy sector typically rather highly regulated
both technical regulation (safety standards, technical norms,
compatibility requirements, distribution network operation
(subordination of production to transmission operator) - not as typical
in the effort to influence the economic behavior of market actors
and economic regulation (regulation in "common understanding")
V. Hajko (FSS MU) Introduction to Economics 4 / 26
Basic terms, definitions Definition
Regulation II
Energy corporations often encounter situations when they might
experience an incentive to exploit their advantage
information asymmetry
market power
energy (electricity?) as a necessity (?) - universal access (energy as
social right?)
Most typical types of economic regulation:
cost of service regulation, incenctive regulation, conduct regulation,
regulation by contract etc.
V. Hajko (FSS MU) Introduction to Economics 5 / 26
Basic terms, definitions Definition
Historical influence
Energy sector exhibits rather high degree of regulation
Arguably high capital intensity, long-term investments
Uncertainty regarding the profitability often motivated the
intervention of public sector (remote / rural areas)
Involvement of large number of stakeholders
Distribution networks typically require certain safety standards and
simultaneously incur limitations on the available space (difficult and
inefficient to build multiple distribution networks in the same place
(e.g. a city-wide area))
Public ownership
V. Hajko (FSS MU) Introduction to Economics 6 / 26
Basic terms, definitions Definition
Goal
Increase efficiency (compared to the situation of no intervention)
assumes inefficient market outcome (market failure)
Other (non-economic) goals
lobbyist groups, strategic games, politics, personal interests
V. Hajko (FSS MU) Introduction to Economics 7 / 26
Basic terms, definitions Reasoning for regulation
Outline
1 Basic terms, definitions
Definition
Reasoning for regulation
Reasoning against regulation
2 Types of regulation
Traditional regulation
“Newer” forms of regulation
V. Hajko (FSS MU) Introduction to Economics 8 / 26
Basic terms, definitions Reasoning for regulation
Reasoning for regulation
To ensure competition (and minimize the appropriation of consumer
surplus by producers)
To avoid unnecessary expenses (e.g. natural monopoly (decreasing
marginal costs: efficient operation implies one supplier))
To prevent "excessive competition" - leading to less uncertainity for
suppliers (regarding the potentially unstable quantity and price
conditions - especially if large sunk costs are necessary)
To "protect" consumers and ensure quality of the product or delivery
environmental or health and safety standards and requirements
To maintain the level of control over "vital"/"strategic" field (?)
Utilities, prices of energy or fuels, use of nuclear/renewable energy as
electoral topics
Security of supply - might be vital, but with a nature public good
(non-excludable and non-rivalrous)
To keep prices low (even inefficiently low) (“social justice”)
To prevent growth of “too strong players”
V. Hajko (FSS MU) Introduction to Economics 9 / 26
Basic terms, definitions Reasoning against regulation
Outline
1 Basic terms, definitions
Definition
Reasoning for regulation
Reasoning against regulation
2 Types of regulation
Traditional regulation
“Newer” forms of regulation
V. Hajko (FSS MU) Introduction to Economics 10 / 26
Basic terms, definitions Reasoning against regulation
Free market efficiency
Pareto efficiency: such allocation of resources when it is impossible to
make any single individual better off without making at least one
individual worse off
Pareto improving action: a change in resource allocation that makes at
least one individual better off without making any other individual
worse off
The so-called First Welfare Theorem: a system of free markets will
lead to a Pareto efficient outcome
On the unhampered free market with well defined property right, the
choices of the individuals lead to optimal situation
"Laissez faire" ("let them do as they will")
Historical evidence of "monopoly" or market power abuse controversial
Hard to maintain, even harder to enforce (regulation as market entry
barrier?)
Baumol’s Theory of contestable markets: markets served by a small
number of firms, showing competitive equilibria (as if perfect
competition): because of the "threat of entry" (potential short-termV. Hajko (FSS MU) Introduction to Economics 11 / 26
Basic terms, definitions Reasoning against regulation
Pragmatic reasons against regulation
(Even if market deficiencies plausible): problematic market outcome
vs. regulatory practice
"Two wrongs don’t make a right" and "Quis custodiet ipsos custodes?"
Legislation: laws, regulations etc. complicated and costly (resource
consuming)
Oversight + prosecution: costly, might not be impartial, may be
abused
Costs of regulation: US, 2009-2013: est. 494 billion USD in final
rulesURL
Office of Management and Budget (OMB): est. 128.7 billion USD in
2013
Competitive Enterprise Institute: est. $1.9 trillion USD annually (US
GDP ∼ $16.8 trillion USD)
Regulatory lag: how flexible is the regulation?
"Red tape"
Regulation can limit or inhibit innovation and growth (less innovation
∼ lower efficiency)V. Hajko (FSS MU) Introduction to Economics 12 / 26
Types of regulation Traditional regulation
Outline
1 Basic terms, definitions
Definition
Reasoning for regulation
Reasoning against regulation
2 Types of regulation
Traditional regulation
“Newer” forms of regulation
V. Hajko (FSS MU) Introduction to Economics 13 / 26
Types of regulation Traditional regulation
Self-regulation
Firms/Organisations/(Private) Associations set up rules,
Rules are created "in-house"
Monitoring and enforcement by its own members
Relatively uncommon in energy industry
Can be cheap and efficient
Can be designed ostensibly, as self-serving (instead of "public interest")
Relatively weak powers of enforcement (association and its members)
Oversight of the "regulator" difficult
V. Hajko (FSS MU) Introduction to Economics 14 / 26
Types of regulation Traditional regulation
"Command and control" regulation
Setting of rules and standards, along with criminal sanctions for
disobeying
Rules set up by law
might be too complex or too "legalistic" (adherence to the letter, not
spirit of the law)
might be unnecessary (over-inclusive regulation)
typically not flexible and hard to adjust
costs of enforcement relatively high
Regulatory capture
close relationship between regulators and business under command and
control
strong incentive for the regulated to procure their own interest (facing
relatively low incentive of regulators to procure public interest)
V. Hajko (FSS MU) Introduction to Economics 15 / 26
Types of regulation Traditional regulation
Rate of return regulation
Total revenue should match total costs (+ “reasonable profit”)
(sometimes called "cost plus" regulation)
No (economic) profit generation (typically publicly owned utilities) or
fixed economic profit
Regulator defines total permissible expenditure
Targeting the rate of return! (profit defined as s.RB, with preset s)
(RB - rate base (total investment), s - preset rate of return)
Renewable support in CZ: feed-in tariffs calculated to “generate” 7%
rate of return on investment to RES (in practice led to profitability
above 15%)
If strictly enforced: No need for innovation or efficiency: “profit stays
the same no matter what”
Necessity of detailed information regarding the costs
possibility of cost misreporting
difficulty of adjusting depreciation rate allowance (capital intensive
industry!)
imprudent expenditures (“overinvesting” into unnecessary/unprofitable
ventures)V. Hajko (FSS MU) Introduction to Economics 16 / 26
Types of regulation Traditional regulation
Incentive regulation
Regulation should not inhibit incentives based on profit maximization
"competition better than regulation" or "competition under regulation"
(information assymetry between regulator and regulated company:
since regulator lacks information over the level of efficient costs for the
company (as required under RoR regulation)
Commonly based on price or revenue capping
Performance based regulation (cmparative efficiency and productivity
analysis, “benchmarking”)
Menu of contracts regulation, Market-based regulation
V. Hajko (FSS MU) Introduction to Economics 17 / 26
Types of regulation Traditional regulation
Price cap
The regulated firm can set individual rates, but has to match certain
average price (for instance overally match the previous year’s level +
inflation) - the firm may rise certain prices, provided it lowers prices
elsewhere
Typically price cap based on pre-defined formula (price growth path
adjusted for inflation (incr.) and productivity improvement (decr.)
and other factors)
(sometimes called "CPI - X regulation" or "CPI - X + Z")
"inflation factor" (CPI)
"X factor" (productivity offset),
"Z factor" (optional)
exogenous factors, e.g. policy options (energy efficiency), "structural
breaks" (changes in laws or administrative procedures), political events
(wars, price shocks) etc.
Rate of return regulation sets the prices according to costs,
price cap can lead to prices well in excess of costs (so-called "excessive
overprofit")V. Hajko (FSS MU) Introduction to Economics 18 / 26
Types of regulation Traditional regulation
Revenue cap
TR = RB ∗ WACC + Coperating + d + T
RB - rate base, WACC - "profit rate" (Weighted Average Cost of
Capital: the average interest rate to pay to all its security holders to
finance its assets), Coperating - all operating expenses (material, labor,
other items for resale in short run etc.), d - annual depreciation
expenses , T - taxes
Might be in a form of setting a maximum profit (total or (more often)
per a customer)
V. Hajko (FSS MU) Introduction to Economics 19 / 26
Types of regulation Traditional regulation
Sliding scale regulation
A compromise between rate of return regulation and a price cap
Sometimes called "Earnings sharing", "revenue sharing", "hybrid price
caps"
regulator defines a band in which the firm is free to keep all earnings
(to motivate efficiency in production)
if profits are higher than the permitted ceiling, the regulated firm must
share these gains with customers
if profits are below the band, the regulated firm is allowed to increase
prices
Incentive for efficiency (cost reduction), + no "abnormally high"
regulated profits
If prices are reduced, consumer demand will rise (incentive for capital
adjustment)
V. Hajko (FSS MU) Introduction to Economics 20 / 26
Types of regulation Traditional regulation
Menu of contracts
Regulator offers the firm a menu of incentive plans (usually designed
to provide constant consumer welfare)
Regulated company can choose among the variants - they can choose
the strategy that will satisfy the regulator and simultaneously try to
maximize the profit
The selected contract suits the regulated company the best
This approach reduces the information asymmetry between the
regulator and the regulated company
Difficult implementation, regulator needs to set up a variety of complex
strategies, simultaneously they have to allow the firm to cover its costs
Proposed menu might be unsuitable
V. Hajko (FSS MU) Introduction to Economics 21 / 26
Types of regulation Traditional regulation
Performance based regulation
Benchmark competition, yard stick competition (performance of other
similar firms as a benchmark in order to set the regulated prices)
Measurable outcomes defined ex ante that the regulated firm should
achieve, BUT not defining how these results should be achieved
Regulated prices (or revenues) of a company depend on the
performance of other companies
Typically some form of frontier analysis (typically econometric
assesment or Data Envelopment Analysis, DEA) - distance of the
company to the efficiency frontier
Customers should benefit from lower prices and improved quality
BUT this framework is set beforehand (benchmarks and/or targets
might be set incorrectly)
Less reliance on costs, less interest in earnings, more emphasis on
prices
but with emphasis on reducing costs, it might cause underinvestment
in operations and management (in effort to generate profit by reducing
costs)
V. Hajko (FSS MU) Introduction to Economics 22 / 26
Types of regulation Traditional regulation
Market-based regulation
Competition laws
Tradeable permits (cap and trade)
Advantages: flexible, low enforcement costs, relatively high efficiency
once the system is set
Uncertainity + "unnecessary" transaction costs
Might create market entry barrier
V. Hajko (FSS MU) Introduction to Economics 23 / 26
Types of regulation Traditional regulation
General challenges of regulation practices
Inappropriate pricing and/or pricing rules
Poor financial performance of publicly-owned utilities
inefficiency of capital investment
Managerial and/or technical deficiencies
Sustainability of subsidies (recall the RES support in CZ)
Private sector participation
Low motives for innovation and investments
Low quality or low availability of service
V. Hajko (FSS MU) Introduction to Economics 24 / 26
Types of regulation “Newer” forms of regulation
Outline
1 Basic terms, definitions
Definition
Reasoning for regulation
Reasoning against regulation
2 Types of regulation
Traditional regulation
“Newer” forms of regulation
V. Hajko (FSS MU) Introduction to Economics 25 / 26
Types of regulation “Newer” forms of regulation
New roles of regulatory bodies
Development of competitive markets
Typically participation on liberalization, unbundling, building of
customer awareness, customer switching rules and terms
Monitoring market performance
Disclosure of energy generation, ownership structure etc.
Decrease information assymetry
Ensure safety, reliability and security of operation and/or
infrastructure
Inclusion of environmental factors into utility planning and operation
Coordinate policies and procedures with EU laws and international
agreements
V. Hajko (FSS MU) Introduction to Economics 26 / 26