Dr' Chris Doyle Consultant Economist

1
LSE Short course on Regulation Utilities
regulation an introduction

• Dr. Chris Doyle
• Consultant Economist and
• Associate CMUR, Warwick Business School and
• Department of Economics, Warwick University
• 26 September 2008, London School of Economics
• chris.doyle_at_cdoyle.com

2
Overview

• Session 1 An Introduction
• Session 2 Price-caps, vertical industries and
  structural regulation
• Sessions 3 4 How price-caps are set and reset
• Session 5 Measuring efficiency
• Sessions 6 7 Regulation and competition law

3
Day 5, Session 1 An Introduction
4
Utilities characteristics

• Networks/Infrastructure capital intensive
• High set costs (irreversible or sunk costs)
• Economies of scale (horizontal integration)
• Economies of scope (vertical integration)
• Natural Monopoly elements
• Examples Telecoms, water, electricity, gas,
  post, rail, ports, bridges, sewerage

5
Utilities Telecoms and Water

• Telecoms
• Rapid technological change, declining costs
• Disruptive change in the form of IP?
• Convergence telephony, broadcasting, Internet
• Significant competition
• Bottlenecks local loop
• Increasing demand

• Water
• Incremental technological change, increasing
  costs due to environmental factors
• Sewerage quite competitive
• Water supply, limited competition
• Bottlenecks network
• Increasing demand

6
Cost concepts introduction

• Economic regulation aims to promote competition
  where feasible and the outcome of competitive
  markets where competition is not feasible
• What does competition lead to?
• Economists have shown that effective competition
  leads to retail prices that
• Reflect the underlying economic cost of supply
• Promote rivalry that generates the best
  investment and innovation
• If effective competition is absent, the regulator
  needs to identify costs to mimic competition

7
Cost concepts

• There are various costs we could measure and use
  for regulatory purposes
• Accounting costs
• Fixed costs
• Variable costs
• Opex
• Average and marginal costs
• Incremental costs
• Average incremental costs
• Forward looking long-run incremental costs

8
Cost concepts

• A regulator needs to make sure that the costs
  used to determine prices are correct
• Efficiently incurred costs versus inefficiently
  incurred costs
• Regulation should not reward poor management or
  encourage excessive investment e.g. gold-plating
• Historical versus current (replacement) costs

9
Cost concepts

• Economists advocate the setting of prices equal
  to marginal cost

Price Supply (Marginal cost)
Demand (Willingness to pay)
Q
Quantity
At Q, resource cost (at the margin) equals
consumer valuation (at the margin)
10
Cost concepts

• Utilities have often have declining average costs
  reflecting economies of scale
• Marginal cost pricing would entail a loss how
  can this be efficient?

Demand
Average cost
Marginal cost
Output
11
Achieving efficiency and scale economies

• Nationalisation (public ownership)
• Average cost pricing
• In multi-product firms may entail what is termed
  Ramsey pricing setting prices inversely to
  price elasticity of demand
• Cost of service regulation leaving firm to choose
  individual prices (also known as rate of return
  regulation)

12
The need for price control

• Market power arising from natural monopoly
  elements would, if left unrestrained, leave
  consumers worse off why?
• Sunk costs might expose investors to unreasonable
  risks, jeopardising worthwhile projects
• Solution We need to find a method of committing
  efficient cost recovery through a regulatory
  contract, structured to meet the interests of
  both consumers and investors

13
Day 5, Session 2 Price-caps, vertical industries
and structural regulation
14
Incentive regulation

• Good incentive regulation is about balancing the
  conflicting interests facing investors and
  consumers
• Investors want low risk and high returns
• Consumers want high quality and low prices
• One option would be to offer cost-plus contracts
  (assuring the supplier cost recovery and
  minimising risk for price determination)
• This would be a low-powered incentive scheme

15
Power of incentive regulation

• The power of a regulatory scheme measures the
  extent to which benefits accrue to the firm
  rather than consumers
• The higher the power of a regulatory contract,
  the lower will be production costs BUT prices may
  deviate significantly from cost
• The lower the power of a regulatory contract, the
  higher will be production costs BUT prices will
  be close to cost
• Trade off
• ALLOCATIVE EFFICIENCY versus PRODUCTIVE
  EFFICIENCY

16
Productive Dynamic Efficiency
Trade-off between productive and
allocative efficiency
Allocative Efficiency
Low
High
Regulatory Lag
17
Factors influencing power of price-cap regulation

• The duration of the price-cap
• Expectations about regulatory commitment or lack
  thereof
• Mechanism for resetting the cap
• Value of productivity offset factor

18
Role of information

• Regulators typically possess less insight about
  the regulated firm than the firm itself a
  position referred to as asymmetric information
• In this case a regulated firm might be able to
  game regulation to its advantage known as
  seeking to extract rents
• A regulator is aware of its informational
  disadvantage and will use methods to obtain
  better information ideally by incentivising the
  regulated firm to tell the truth (known as
  incentive compatibility)
• Extracting the truth will come at a cost
  notably higher prices (i.e. higher profits for
  the firm than would otherwise be the case)

19
How a price-cap works

• Typically a weighted average measure of prices of
  regulated products (note not all products are
  necessarily subject to a price-cap) is restricted
  so it does not exceed a value which is typically
  inflation (somehow measured) less a productivity
  offset factor (usually called X)
• Other factors may be included in the price-cap,
  such as a factor (usually denoted Y or K) to
  allow for what is termed cost pass-through

20
How a price-cap works

• For a multi-product firm where services are
  measured in different units (say minutes, access
  lines, bytes, etc), the formula is

21
How a price-cap works

• A firm selling a homogeneous product (say gas),
  would have the change in average revenue subject
  to a price-cap
• Individual sub-caps may also apply particularly
  if a regulator is concerned about the prices of
  certain products consumed by vulnerable
  customers

22
When are price-caps applied?

• Price controls should apply in cases where
  effective competition is not expected to occur
  and where customer protection matters
• Determining whether a market is or will be
  subject to effective competition involves
  assessment of recent history (the facts) and
  predicting the near future (informed speculation)
• Inevitably the process involves judgment and will
  be contentious where firms disagree with
  regulators about the future extent of competition

23
Implementing RPI-X regulation
RPI-7.5, previous years RPI2.5, permitted
weighted average Change in nominal prices
2.5-7.5-5
Weighted average price change (0.5 x -2)
(0.375 x -12) (0.125 x 4) (-1) (-4.5)
(0.5) -5 Price changes compliant with cap
24
Structural regulation Utilities are vertical
industries
Upstream 1
Upstream 2
Upstream 3
Downstream 1
Downstream 2
Downstream 3
25
Benefits and costs of vertical integration

• Benefits
• Economies of scope joint production
• Coordination of investment
• Avoids transactions costs associated with
  contracting
• Costs
• Concentration of market power
• Limits extent of competition

26
The extent of vertical integration

• Firms typically decide how much to make in-house
  and how much to outsource
• Factors influencing the decision will be
• Strength of scope economies
• Competency limitations
• Management capability
• Enforceability of contracts
• Regulation

27
Generation
Competitive
Transmission Distribution
Monopoly
Retail
Competitive
Electricity
28
Extraction
Competitive
Transport
Monopoly
Storage
Competitive?
Retail
Competitive
Gas
29
Content Applications
Competitive
Backbone
Competitive
Local Loop
Competitive? Monopoly?
Retail
Competitive
Fixed National Telecoms
30
Rolling Stock
Competitive
Track Stations
Monopoly
Services
Competitive
Railways
31
Collection
Competitive?
Sorting Trunking
Competitive
Delivery
Competitive? Monopoly?
Postal Services
32
Abstraction
Competitive?
Treatment
Competitive?
Storage
Monopoly
Distribution
Monopoly?
Retail
Competitive?
Water
33
Market power issue

• Vertical integration can lead to competition
  problems
• In a network industry certain elements may be
  monopolistic and absent regulation a firm might
  abuse its position
• Examples
• Set prices above cost for access to pipelines
• Exclude rivals from parts of the market
• Discriminate unfairly against rivals (via price
  or non-price discrimination)

34
Separation can accommodate competition

• Parts of the vertical value chain may facilitate
  competition
• To accommodate competition it might be necessary
  to separate or unbundle vertical elements
• Liberalisation can result in separation
• Subsequent regulation can also lead to unbundling
  and separation

35
Forms of separation
36
Day 5, Sessions 3 4 How price-caps are set and
reset
37
Price-cap regulation

• The setting of a price-cap involves trade-offs
• The trade-offs occur in relation to the two main
  decisions involved when formulating a price-cap
• The interval over which the price-cap extends
  (the period of regulatory lag)
• The appropriate value for X
• Once competition begins to take hold, a third
  area involving a trade-off arises
• The services to be included in a price-cap

38

• The history of retail price-caps in UK telecoms
• Started 1984, ended 2006

39
Price-cap in Irish telecommunications
40
An illustrative timetable for setting caps
41
Issues

• How much transparency?
• Degree of involvement of competitors
• External consultancy or in-house studies?

42
Productive Dynamic Efficiency
Trade-off between productive and
allocative efficiency
Allocative Efficiency
Low
High
Value of X
43
Designing RPI-X price-caps

• Need to decide which services
• Where competition is ineffective and expected to
  remain ineffective
• Duration of price cap
• Issue of incentives (regulatory lag) and customer
  benefits
• Too short, management incentives poor
• Too long, customers suffer
• Correctly designed, it is a high powered
  incentive scheme
• Is there a need for safeguard caps, sub-caps?
• How is X (or the K factor in some other utilities
  e.g. water in the UK) set?

44
Procedures for setting X

• Regulator constructs a financial model of the
  firms regulated activities
• Would exclude overseas activities
• Model embodies considerable judgment, about cost
  volume relationships, investment and demand
  elasticities (how demand responds to price
  changes)
• Model solves for X by equating revenue with costs
  in final period
• WACC (Weighted Average Cost of Capital) forms
  part of cost base

45
Choice of X equates Revenues and Costs Monopoly
case
Revenues
Costs
Own price
Initial asset base
Own output
Cost of capital
Revenue
Costs
Capex
GDP growth etc.
Opex
Cost volume relationship
46
Choice of X equates Revenues and Costs
Competition case
Revenues
Costs
Competitors prices
Own price
Initial asset base
Total output
Own output
Cost of capital
Revenue
Costs
Capex
GDP growth etc.
Opex
Cost volume relationship
47
Balancing costs and revenues
48
Sensitivity analysis X varies in key parameters
Estimates for variation in X for proposed price
control of Telkom in South Africa, 2005-08
49
Key assumptions

• Demand growth
• Cost volume elasticities (relationships)
• Efficiency gains (choice of comparators,
  measurement problems, problems of catch-up)
  (session five)
• Asset valuation (historical cost, current cost,
  privatised value, hybrid)
• Depreciation (accounting versus economic)
• Cost of capital
• Competitors positions (cross-price elasticities,
  market shares, rivals investments, etc.)

50
Cost of capital

• Firms are financed by a combination of equity (E)
  (shareholders) and debt (D) (bond holders)
• Each source of finance has a cost, let re be the
  cost of equity and rd be the cost of debt
• The overall cost can be expressed as a weighted
  average cost of capital (debt and equity)

51
WACC

• Expressed in terms of gearing (g), which is the
  amount of debt D relative to debt plus equity
  (DE)
• Alternatively

52
Cost of debt

• The price of debt is usually determined from
  assessing yields on government bonds and allowing
  for a debt premium of between 1-2
• The yields on certain government bonds are taken
  to be the risk free rate rf
• Ofcom (2008) looked at a broad range of
  maturities for UK equivalent assets (UK gilts),
  ranging from one to fifteen years and concluded
  that the nominal risk free rate was 5

53
Cost of equity

• Can be calculated in a number of ways
• Dividend growth model
• Capital asset pricing model (CAPM)
• The CAPM states
• Where rm is the expected market return and ß is
  the sensitivity of the asset returns to market
  returns which can also be expressed as

54
Cost of equity

• The market or equity risk premium is usually
  taken to be around 6
• The value of ß is assessed by looking at share
  price data

55
Illustration of WACC Cayman Islands 2008
56
Periodic review in water in UK 1994
57
Periodic review in water in the UK 1999
58
Periodic review 2004

• Review of price limits over the period 2005-10
  for water and sewerage companies
• Final determinations December, 2004

59
Periodic review 2004
60
Periodic review 2004
61
Periodic review 2004
62
Periodic review 2004
63
Periodic review 2004
64
Periodic review 2004 (based on Draft)
65
Periodic review 2004 (based on Draft)
66
Capex Assumptions versus Actuals
67
Ofwats challenges Periodic review 2004

• Capital maintenance
• Financeability
• Depreciation
• Incentives and efficiency
• Quality programme
• Supply demand balance

68
Key assumptions in the Periodic review 2004
69
Day 5, Session 5 Measuring efficiency
70
Setting efficiency targets

• Successful incentive regulation needs
• Prospects of reward for efficiency (some power in
  the incentive scheme)
• Accurate estimates of potential for efficiency
  gains (to generate targets which are attainable
  without generating excess profits this will lead
  to cost-related prices)

71
How can the regulator form estimates of efficient
levels of cost?

• Options include
• Comparisons over time project productivity
  growth on basis of firms past performance
  (weighted by history and subject to manipulation)
• Commission independent efficiency studies by
  experts
• Compare with engineering models
• Compare firms performance against the
  performance of other firms, benchmarking

72
An example of inter-firm comparison

• Two main methods can be deployed
• Regression analysis (RA)
• Data envelopment analysis (frontier analysis)
  (DEA)

73
RA and DEA OFGEM example
74
DEA illustration
75
RA versus DEA

• British regulators have used regression analysis
  (RA) and DEA to gain insights into the
  comparative efficiency of companies during the
  price-setting process
• RA and DEA are both potentially useful tools for
  comparative efficiency analysis
• RA has its own built-in checks to ensure
  objectivity and comparability of treatment
  between different companies (for example, the use
  of common weights on the variables), and addition
  or subtraction of doubtful variables will
  generally make little difference to scores
• Used carefully in large samples, DEA is good at
  identifying possible reasons for apparently poor
  performance which might be highlighted by crude
  indicators such as performance ratios, and
  providing a checklist of questions for management

76
Day 5, Sessions 6 7 Regulation and Competition
Law
77
Ex ante regulation versus Ex post competition law

• Regulation is prescriptive and sets out rules
  under which firms operate it is ex ante in
  nature and necessarily detailed
• Competition law sets out general rules under
  which firms operate and its application is said
  to occur after the event enforcement occurs
  after infringements (with one important exception
  mergers)

78
Telecoms example Overview

• European Framework
• Market definition, analysis and obligations
  (remedies)
• Ex ante regulation and competition policy
• Proposed test for functional separation

79
Legal framework
The 2003 regulatory framework is contained in
seven texts Directive 2002/21/EC of the European
Parliament and of the Council on a common
regulatory framework for electronic
communications networks and services, (Framework
Directive)  Directive 2002/20/EC of the
European Parliament and of the Council on the
authorisation of electronic communications
networks and services, (Authorisation
Directive)  Directive 2002/19/EC of the
European Parliament and of the Council on access
to, and interconnection of, electronic
communications networks and associated facilities
(Access Directive)  Directive 2002/22/EC of
the European Parliament and of the Council on
universal service and users rights relating to
electronic communications networks and services
(Universal Service Directive)  Directive
2002/58/EC of the European Parliament and of
the Council concerning the processing of personal
data and the protection of privacy in the
electronic communications sector (Data
Protection Directive) Decision 676/2002/EC of
the European Parliament and of the Council on a
regulatory framework for radio spectrum policy in
the European Community (the Radio Spectrum
Decision) and Commission Directive 2002/77/EC
of 16 September on competition in the markets for
electronic communications networks and services
(the competition directive)
80
Competition policy approach to regulation

• The 2003 framework seeks to harmonise sector
  specific regulation in Europe by adopting a
  competition policy perspective
• National Regulatory Authoritys (NRAs) need to
  demonstrate that dominance is present before
  obligations can be imposed in a market
• This is where the framework differs from
  conventional competition policy it is ex ante
  regulation rather than ex post competition policy
  
• The 2003 framework is also intended to be forward
  looking

81
The Framework Directive

• Harmonized framework for the regulation of
• electronic communications services
• electronic communications networks
• associated facilities and
• associated services
• Power of by EC veto limited to cases where NRA
  defines market different to Recommendation
  (Article 7)
• Can write serious doubts letter and request
  removal of a SMP designation
• National regulatory authorities take the utmost
  account of the desirability of making regulations
  technologically neutral

82
Principles

• The national regulatory authorities shall promote
  competition ensuring that
• Users derive maximum benefits
• There is no distortion or restriction of
  competition
• Encouraging efficient investment and promoting
  innovation
• Promote internal market objectives

83
NRAs and market reviews

• NRAs must decide whether to impose, maintain,
  amend or withdraw obligations on specific
  undertakings on the basis of a market analysis
• This process determines whether a relevant market
  is effectively competitive
• A market is effectively competitive where there
  are no undertakings with significant market power
  (SMP)
• The SMP concept is based on the competition law
  concept of dominance, i.e. whether or not an
  undertaking, either alone or jointly with others,
  is able to behave to an appreciable extent
  independently of competitors, and ultimately
  consumers (United Brands)

84
SMP

• NRAs must take account of the EC Guidelines on
  market analysis and SMP (Article 14 FD)
• Recommendation on markets (Article 15 FD)
• The overall approach has three main elements
• Market Definition
• Market Analysis and if SMP, then
• Remedies

85
Guidelines ex ante regulation

• Guidelines prescribe to NRAs an approach to
  market analysis and effective competition within
  the framework of ex ante regulation
• The purpose of imposing ex ante obligations on
  undertakings designated as having SMP is to
  ensure that undertakings cannot use their market
  power either to restrict or distort competition
  on the relevant market, or to leverage such
  market power onto adjacent markets
• Undertakings with market power are identified in
  the markets recommended by the Commission

86
Recommended markets

• 18 markets defined in total in 2003, 7 in 2008
• 7 retail markets (public telephony services
  access and calls minimum set of leased lines,
  i.e. below and up to 2Mbps)
• 11 wholesale markets
• Fixed Call origination and termination, transit
  services, unbundled access, broadband access,
  terminating segments of leased lines, trunk
  segments of leased lines
• Mobile Call origination and termination,
  international roaming
• 17 markets in telecommunications, 1 market for
  broadcasting transmission services

87
Principles for identifying markets

• Three hurdle cumulative criteria applied to
  assess market whether it is appropriate for ex
  ante regulation
• Barriers to entry and development of competition
• Dynamic characteristics
• Sufficiency of competition law
• The Guidelines propose application of the
  hypothetical monopolist test for market
  definition purposes looks at both demand-side
  and supply-side substitutability
• For example, in assessing whether fixed voice
  telephony services are constrained by mobile
• Entry regarded as market analysis

88
Market analysis

• Having identified market, analyse the market to
  see whether an undertaking(s) is dominant (i.e.
  has SMP)
• Market share (or size of an undertaking) may be
  important but is one of many variables that
  contribute to possible SMP
• Countervailing buyer power, technological
  advantages, economies of scale and scope,
  vertical integration, barriers to expansion, etc.
• Dominance is likely to involve a combination of
  factors rather than any one factor

89
NRAs and remedies

• Where competition is not effective in specific
  markets, NRAs must impose appropriate obligations
  on companies that are found to have significant
  market power on those markets
• Such obligations aim to enable competitors to
  obtain access to those markets and to ensure the
  interests and rights of consumers

90
Obligations

• Obligations can apply to both wholesale markets
  and retail markets
• Preference is given to regulating at the
  wholesale level first
• Wholesale remedies cover transparency,
  non-discrimination, accounting separation, access
  to and use of specific network facilities, price
  control, and cost accounting obligations (Access
  Directive)
• Possible regulatory controls on retail services
  include price controls or unreasonable bundling
  of services, requirement to offer leased lines,
  and carrier selection and pre-selection
  (Universal Service Directive)

91
EU policy on functional separation in telecoms

• EC proposed in November 2007 to include
  functional separation as an obligation within an
  amended Access Directive (article 13a)
• Currently under debate co-decision procedure
• Regarded as a measure of last resort
• EC seeking to retain veto national regulatory
  authorities need to seek approval
• What test might the EC apply when considering
  approval or veto?

92
Functional separation Exceptional measure

• Current obligations
• Transparency
• Non-discrimination
• Accounting separation
• Access
• Price controls and accounting methods
• Functional separation may be required in fixed
  to deal with enduring bottlenecks where there is
  little infrastructure competition and little
  prospect of such competition over a reasonable
  timeframe

93
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94
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95
Elements of the vertical merger test applied to
functional separation
96
Governance Test
97
Concluding remarks

• Functional separation test is likely to set a
  high hurdle
• National regulatory authorities will need to
  ensure that current obligations have been
  designed
• Optimally and
• Have had time to impact
• Unlikely to be proposed by a large number of NRAs