Beyond regulation

1
Beyond regulation

• Stephen Littlechild
• ESNIE Cargese, Corsica
• 16 May 2006

2
Outline

• The regulation literature some elements
• Other possible arrangements what are they and
  how do they work in practice?
• Transmission regulation in Australia
• And in Argentina
• Settlements in Florida
• And in Canada
• Conclusions and further research

3
Regulation literature
4
The early regulation literature

• Early discussions C18, C19
• Smith, Mill, Pareto, Marshall, many others
• Institutional economists C19 early C20
• Commons et al in US, others in Germany
• Economic theory (welfare economics)
• Pigou, Lerner UK 1930s, 1940s, Hotelling US 1938
• Engineering
• Dupuit mid C19, Boiteux at EdF in France 1950s

5
Later regulation literature

• The traditional regulatory process 1950s 1960s
• Bonbright, Phillips, Trebing
• The economics of regulation marginal cost
  pricing second-best 1950s, 1960s
• Baumol, Graaff, Little, Lipsey Lancaster
• Kahn 1970 economic theory regulatory practice
• Mathematical optimisation models 1960s, 1970s
• Peakload pricing Steiner, Hirshleifer,
  Williamson, Littlechild
• Optimal prices emerge as dual variables in
  optimisation models extend to depreciation and
  uncertainty
• Cooperative game theory models to share common
  costs
• Aim to characterise optimal pricing and
  investment policies

6
Modern regulation literature 1

• Extension of optimisation models
• Constrained optimisation
• Alternative objective functions
• Extensions to uncertainty
• Non-cooperative game theory
• Partial and general equilibrium models
• Extensive theoretical literature
• Generally from a normative perspective
• What ought the regulator to do?

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Alternative paradigms

• Economic sceptics re marginal cost pricing
• Coase 1946, 1970 blackboard economics v
  institutions
• Wiseman 1957 empty box
• How does regulation actually work?
• Averch Johnson 1962 distortions in practice
• Stigler Friedland 1962 what effect of
  regulation?
• Public choice economics regulatory objectives
  and political pressures, what kinds of regulation
  actually adopted
• J of Law and Economics (ed. Coase)
• Austrian economics
• Imperfect knowledge, uncertainty, change,
  information, discovery, incentives, competitive
  market process
• How should regulation reflect these ideas?

8
Modern regulatory literature 2

• Modern institutional economics
• Coase on regulation (as above), theory of firm,
  social cost, transactions cost etc
• Williamson on satisficing, transactions costs,
  governance of contractual relations, markets
  hierarchies, vertical integration
• Demsetz on property rights economic
  organisation
• Joskow on regulation in practice, vertical
  integration contracts

9
Modern regulatory literature 3

• US UK theory practice re incentives
• UK utility privatisations 1980s
• Competition can replace some regulation
• What kind of regulation until competition?
• Littlechild report 1983 RPI-X incentive
  regulation instead of US rate of return
• Widely adopted internationally
• Emphasis from allocative to productive efficiency
• Economic literature on incentive regulation
• Laffont and Tirole combines with earlier
  theoretical work

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Summary of regulation literature

• A long history of economic analysis
• One theme formal optimisation models
• Another theme how regulation actually works
• A third theme incentive regulation
• All these analyses assume that regulation is
  necessary where there is monopoly
• Aim to replicate outcome if competition possible?
• The regulator makes/influences the decisions
• Perhaps considering views of other parties
• But they do not have a central or decisive role

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Regulatory decision-making

• Alternative arrangements?

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Regulatory decision-making

• If regulation replicates a competitive market,
  how to decide for market participants?
• E.g. how much investment in security of supply
  would customers be willing to pay for?
• How does the regulator know this?
• Has to make judgements on their behalf
• In practice, one size has to fit all
• UK electricity sector a dozen similar companies
• All had to have same kind of price control
• Too difficult to justify variations by company
• Consequent lack of variety and experimentation
• No learning process from different experiences
• This is different from the competitive market
  process

13
Alternative regulatory models

• Must the regulator take all the decisions?
• Is there scope to allow market participants to
  make more decisions?
• Deregulated markets now allow competition
• But what if there is still monopoly?
• How do such alternative systems work?
• What difference do they make?
• What are their pros and cons?

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Some cases studied

• Transmission expansion in Australia Argentina
• Australia Merchant transmission companies are
  allowed to compete with incumbent transmission
  monopolies
• Argentina Transmission expansion decisions have
  to be proposed, approved and paid for by market
  participants, not by regulator or transco
• Settlements in US especially Florida
• Instead of traditional litigated process,
  settlements are often reached between utilities
  and Public Counsel and/or users, and are
  typically approved by regulator
• To understand how do these alternatives work?

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Transmission expansion

• Alternative regulatory arrangements

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Transmission expansion

• Traditional regulated approach
• TransCo decides what to build and when
• Some regulatory input before or after
• Remunerated via return on rate base
• Merchant transmission now proposed
• Independent investor decides what when to build
• No need for regulatory input?
• Remunerated by charging users
• Is merchant possible? Which is better?

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Concerns about merchant

• Alleged difficulties involved
• Needs property rights on transmission lines
• Needs nodal prices these do not always exist
• Externalities and economies of scale
• Market power and incentive to undersize
• Problems of integrating with existing network
• Allegations
• Merchant transmission may not be possible
• Would be too little too late
• And likely to be other problems

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Counterarguments

• Arguments for merchant transmission
• Quicker to respond to market signals
• Better incentive to more efficient capex and opex
• Potential problems with regulated transmission
• Regulation does not ensure optimality
• Utilities have incentive to gold plate
• Regulators concerned to avoid capacity shortages
• So regulation could mean too much too soon
• Hence need to establish how the two systems
  operate in practice

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Evidence?

• Any evidence of how regulated and merchant
  investment works in practice?
• Yes - interconnectors in Australia
• Both regulated and merchant lines exist
• Special case of transmission 2 nodes
• fewer problems market prices already available
• little problem to integrate with rest of network
• How have they worked in practice?

20
Australia

• Evidence on alternative regulatory arrangements
  for transmission expansion

21
Australian background

• Until 1990s, each Australian state government
  owned its electricity system
• little interconnection between them
• decision-making from political perspective
• 1996 National Electricity Market NEM
• Australian Competition and Consumer Commission
  ACCC now regulates transmission
• Potential culture clash?

22
Two interconnectors

• 1994 proposed interconnector between South
  Australia and NSW called SANI later SNI
• 1997 Independent study found it economic
• 1998 did not pass customer benefits test
• 1999 Murraylink merchant line announced
• Similar capacity and route to regulated SNI
• 2001 revised SNI passed regulatory test
• Murraylink appealed to Appeals Tribunal
• 2002 Aug Tribunal hearings, M-link onstream
• 2002 Oct Tribunal decision

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Is SNI economic?

• SNI interconnector network reinforcement
• TransGrid consultants IES quantified costs and
  benefits
• NPV Benefits and costs (Am NPV) of SNI projects
• SNI Network Interconnector
• 
  (extra)
• Benefits 264.5 351.4 -86.9
• Costs -98.4 -41.2 -57.2
• Net Benefit 166.1 310.2 -144.1
• My testimony Network reinforcement is economic
• But duplicate interconnector is not economic

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Arguments at Tribunal

• Transgrid
• Murraylink would have market power
• So could and would restrict output
• Hence risk that network reinforcement underused
• So cannot do network reinforcement alone
• Murraylink
• Murraylink would not have significant market
  power
• Negligible restriction of network use (0.013)
• Tribunal majority decision Dec 2002
• Real risk of stranding so upheld regulatory
  decision
• Murraylink took to Judicial review
• Jul 2003 0.013 not a real risk appeal upheld

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Conversion to regulated status

• Meanwhile price differentials narrowed
• Murraylink less profitable than expected?
• Oct 2002 Murraylink applied for conversion to
  regulated status
• ACCC allowed at half Murraylinks proposed figure
• Nov 2003 Murraylink accepted

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Conclusions on Australia

• Merchant investment may have flaws
• Misjudged market built too much too soon
• But losses borne by investors not customers
• And company learned from experience
• Australian regulatory process flawed too
• Delay, cost and political influence
• poor economic analysis (including Tribunal)
• legal errors (c.f. Court view of Tribunal)
• unjustified stance by transmission company
• regulated investment too much too soon at
  customer expense, any learning from experience?

27
Argentina

• Evidence on alternative regulatory arrangements
  for transmission expansion

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Argentina background

• Argentina electricity reform 1992
• restructuring, privatisation, competition,
  incentive regulation of existing T and D networks
• Mistrust of regulation
• Decided that transco regulator should not be
  responsible for transmission expansions
• Public Contest method
• Users to propose, vote pay for major expansions
• Construction OM (COM) out to competitive tender

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Received view of experience

• Argentine electricity reform worked well
• lower costs prices, better service, more
  investment
• But major caveat method of regulating
  transmission expansion did not work well
• Claimed externalities, free riders, transactions
  costs
• But only one illustration of this
• Several years delay to much needed Fourth Line
  from Comahue (major generation source) to Buenos
  Aires (major demand centre)

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(No Transcript)
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Fourth Line

• Congestion increasing on this corridor
• Sept 1994 3 generators proposed 4th Line
• COM fee about 58m p.a. over 15 years
• Public hearing Feb 1995 50 vote against
• Surprise and concern, including by regulator
• May 1996 revised proposal - accepted
• Max fee 44m pa 11m Salex 55m
• Nov 1997 winning bid 24.5m 11m 35.5m

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Benefits costs of 4th line

• Ave congestion revenue 30m p.a.
• Capacity increase 1/3
• Benefit 1/3 x 30m 10m p.a.
• Cost
• First proposal 58m p.a.
• Second proposal 24.5 11 35.5m p.a
• Conclusion 4th Line was not economic
• Delay was socially beneficial, not costly
• Cheaper to locate generation near demand instead
• None of alleged problems materialised here
• Public contest method worked well in other cases

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Competition in construction

• Bidding competitive 2-3 bids in 5 cases
• All these won by new independent cos
• 4th Line 4 bidders 13 bids (alternatives)
• innovative technologies introduced
• Cost reductions over time
• pre-reform at least 230k/km
• 1st 2nd tenders (Govt) 267k/km, 170k/km
• 4th Line 130k/km - so cost/km about halved
• Bidding to construct was very successful

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Assessment of Argentine policy

• Public Contest method in fact worked well
• Made better use of existing lines
• Competitive tendering lowered costs
• 4th line delay not a failure of PC method
• Regulation would have yielded to political
  pressures to build many uneconomic lines
• PC method resisted political pressure
• Led to more economic outcomes than regulation
• Preferable if aim is efficient allocation of
  resources

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Negotiated settlements

• US origins and early perceptions

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Origin of negotiated settlements

• Large backlog of rate cases at Federal Power
  Commission (FPC) in 1960s
• 1960 over 2900 applications, 10 dealt with
• 1960 3200 requests, triple staff would take 82
  yrs
• FPC encouraged settlement
• 1960-70 some or all of 56 cases
• saved time and money, reduced uncertainty
• some concerns about non-consenting parties (slow
  down process?) non-participants (overlooked?)
• Assumed settlement easier way to same end

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Settlements at FERC

• Successor FERC continued FPC policy
• Federal Energy Regulatory Commission
• 1980 70 of gas pipeline rate cases settled
• Wang (2004) 41 cases 1994-2000
• 34 settled in full, 5 settled in part, 2
  litigated
• savings in cost reductions in uncertainty
  minimal
• Settlement different process outcomes
• looked at situation as whole, not item by item
• more innovative outcomes not available to FERC
• especially rate moratoria 21 of 39 settlements

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Florida

• Evidence on nature of stipulations and settlements

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Regulation in Florida

• Public Service Commission FPSC 1897
• 386 staff, budget 27m
• Office of Public Counsel OPC 1974
• single incumbent Public Counsel 25 years
• duty to represent the general public of Florida
  
• staff 15, budget 2.5m plus consultants
• Scepticism about US consumer advocates
• limited effect? tend to favour larger users?

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FPSC rate cases
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Stipulated settlements in Florida

• Public Counsel represents customers
• by challenging utility in regulatory hearings
• also by negotiating stipulated settlements with
  utility, then inviting FPSC to approve
• FPSC staff not now involved in talks
• All stipulations were accepted in total, no
  cherry-picking (unlike California)

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Types of case where OPC signed stipulations,
1976-2002
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Florida PSC earnings review cases 1976-2002
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FPSC rate cases and OPC stipulations
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Who benefits?

• Cost savings relatively small (lt1 value)
• Customers bigger and earlier rate reductions
• note staff/FPSC views lack of reduction before
• Confirm larger users benefit more in some ways
• Utilities less uncertainty embarrassment?
• Utilities get what FPSC could/would not give
• e.g. Removal of objection by others to merger
• Flexibility on accounting provisions
  (depreciation)
• Revenue sharing (not profit caps or earnings
  sharing)
• often despite objections of regulatory staff

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Conclusions on Florida

• OPC stipulations are significant in Florida
• 77 of rate reductions since 1976
• They benefit customers
• OPC got greater earlier rate reductions
• especially for industrial electricity customers
• but residential customers still benefit overall
• And lead to changes in regulatory policy
• More flexibility on depreciation etc than
  staff/FPSC
• More innovative forms of incentive regulation

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Conclusions
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Conclusions

• Many economic analyses assume that monopoly
  necessitates regulation
• And that regulator will replicate competitive
  market
• But there are examples where market participants
  play a major role
• Australia, Argentina, FERC, Florida (also Canada)
• These systems actually work well
• better than widely believed
• The outcomes are different from regulation
• And often more economic, better for most parties
• Scope to encourage elsewhere and research