National

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National International EconomicsModule 2

• Regulation of Network Industries
• Simon J. Evenett
• www.evenett.com

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Contents of todays presentation

• Motivating questionsregulation and business
  strategy.
• The changing nature of competition in network
  industries.
• Changes in the regulation of network industries.
• Understanding regulators Three perspectives.
• Firm strategies in regulated sectors.
• Case studies on firm-regulator interactions in
  utility markets.
• Lessons learned.

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Objectives of this course

• To familiarise EMBAs with the types of regulation
  used in network industries, explicitly
  contrasting EU and US experience in this regard.
• To share insights derived from recent economic
  and political-economy analyses of regulation in
  network industries.
• To discuss the implications for corporate
  strategy of European regulation of these
  industries.
• Approach taken here blend of institutional
  material, economic analysis, and business
  strategy tools.
• Relationship to other EMBA courses.

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Readings for this course and evaluation

• Make sure youve read the following readings
  before the exam
• David Coen "Business-Regulatory Relations
  Learning to Play Regulatory Games in European
  Utility Markets." Governance An International
  Journal of Policy, Administration, and
  Institutions. Volume 18. No. 3. July 2005.
• David Coen. "Managing the Political Life Cycle of
  Regulation in the UK and German
  Telecommunications Sectors." Annals of Public
  and Cooperative Economics 761 2005.
• David P. Barron. Integrated Strategy Market and
  Non-Market Components, California Management
  Review, 1995, volume 37(2).
• Aidan Vining, Daniel Shapiro, and Bernhard
  Borges. Building the firm's (political) lobbying
  strategy, Journal of Public Affairs, 2005.
  Volume 5.
• The exam questions will refer to the readings and
  the material covered in class. The exam questions
  will focus on firm-regulator interactions, not on
  the regulations or the regulators themselves.

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Main messages for managers from this course

• Firm performance in network industries can change
  very quickly.
• Complex interaction between several identifiable
  factors are responsible.
• Managers should be prepared to alter the source
  of a firms competitive advantage.
• Firms need not be passive agents in regulated
  network industries.
• Strategic behaviour vis-à-vis the regulator and
  other firms is possible, and maybe even
  essential.
• Managers should devise integrated strategies to
  take account of regulatory and market-led
  dynamics.

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Regulation of Network Industries

• The Changing Nature of Competition in Network
  industries

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The changing meaning of network industry

• Public policies towards these industries have
  been strongly influenced by how competition in
  these industries was perceived.
• Until 15 years ago network industries were
  thought to have a small number of producersoften
  only onewith a large, possibly central,
  production facility as well as a distribution
  system from the producer to each (or many)
  customers.
• On this view network industries were associated
  with natural monopolies (economies of scale)
  and the market power that they might employ.
• Often there were multiple, inter-related market
  failures, e.g. market power and environmental
  concerns in power generation.

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The changing meaning of network industry (2)

• Old view overlooked the consumer-related benefits
  of network membership.
• e.g. fax machines.
• Essential point Consumers derive benefits from
  the total number of other consumers who are
  consume the same good or service.
• What does this mean? The willingness to pay for a
  good depends not only on its price but also on
  the number of other consumers who are willing to
  produce the good.
• Has implications for the structure of demand for
  a firms products.

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Network effects but still obeys law of demand
Willingness to pay
D (many network members)
D (few network members)
Premium due to more members in network
Own demand
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Characteristics of network industries relevant to
regulators

• Increasing returns to consumption.
• History and path dependence matter One standard
  may eventually dominate another even though
  initially they had the same market sharecritical
  role of customer expectations.
• Market power
• Large size is not necessarily associated with
  much market power.
• Control of access to the network and proprietary
  technology can be important sources of market
  power.
• Technological innovation implies that competition
  can be for the market as well as in the market.

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Regulation of Network Industries

• Changing nature of regulation in network
  industries

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Public policies affecting network industries

• Sectoral regulation
• Pricing access to networks.
• Prices to final consumers.
• Regulation of investment decisions and entry.
• Standard setting.
• Competition law.
• Abuse of dominance.
• Pricing (including predatory pricing).
• Use of standards.
• Barriers to entry.
• Merger review.
• Barriers to entry.

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Regulation in the 1980s and 1990s

• Shift from public ownership and public financing
  of network infrastructure to private hands.
• Many publicly owned firms were vertically
  integratedbreak up different functions. e.g.
  power generation, railways.
• Publicly owned firms had universal service
  mandates.
• Fears about security of supply gave way to
  optimism about incentives created by private
  enterprise, especially cost control.
• Government happy to see private sector bear
  burden of investment.
• Governments in Europe tended to choose
  privatisation over concessions.

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1980s and 1990s (2)

• Privatised firms were subject to strict
  regulation.
• Abandon rate-of-return regulation.
• What bad incentives were created by such
  regulations?
• Introduced fixed term price contracts, often with
  RPI-X formulas.
• Was an attempt to solve the long-standing natural
  monopoly problem.
• What incentives are created by this regulation?
• Many firms introduced competitive tendering for
  suppliers.
• Competition from rival technologies, especially
  relevant in telecommunications and entertainment.

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1980s and 1990s (3)

• Two widely-acknowledged failures affected
  regulation of network industries
• Californian energy crisisreminded critics of
  security of supply provisions.
• Issue separation of production from supply
  network.
• British railwaysHatfield railway crash in
  October 2000.
• Attention on who is responsible for maintaining
  the infrastructurewho invests and who pays for
  maintainence.
• Upgrades require slow train speeds for weeks.
• Both cases raise issues of coordination in
  vertically integrated network industries.

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1980s and 1990s (4)

• Many regulators were made independant during
  this period.
• Independence was said to have many advantages.
• However, need to recognise difference between de
  jure independence and de facto independence.
• There are many ways in which de jure independent
  agencies can be influenced by politicians. Can
  you think of any?
• Independence of regulators created the need for
  mechanisms by which regulators could cooperate or
  coordinate with other state bodies.
• Independence, then, does not mean detached.

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Contrasting telecoms regulation across the
Atlantic

• USA
• One federal body (FCC) created by 1934 Act.
• Act mandated a public interest test.
• Initially regulated telephone and broadcast media
  (TV, radio). Later cable TV added to regulatory
  powers.
• FCC asserted rights to regulate broadband and new
  technologies, but controversial.

• Europe
• Initially regulation was entirely national but EC
  has come to play a greater role.
• Creation of single market and promotion of
  intra-EU commerce motivated initial EC measures.
• Recognition of role of technology and entrenched
  national champions lead EC to develop a single
  regulatory framework.

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Regulating Telecoms in OECD nations

• Main findings of OECD June 2005 study (released
  on 11 January 2006).
• Responsibilites of regulators have tended to
  expand as ministries have transferred powers to
  them.
• Several telecoms regulators have been merged with
  broadcasting regulators.
• Shift towards joint responsibility for sector
  with competition agencies, sometimes with formal
  cooperation mechanisms established.
• Although seen by some as temporary institutions,
  whose job would be over when competition reigned
  in telecoms, sectoral regulators have survived.
• Why? Foreberance and new technologies.
• Next generation networks expected to create
  pressures for single regulatory regimes in
  telecoms-related sectors.

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Relationship between telecoms regulator and
competition agency

• Shift since end 1990s away from sole, full
  responsibility given to one agency to joint
  responsibility for competition-related matters by
  both agencies.
• Not for regulators authorisation and licensing
  functions.
• Competiton agency can have parrallel powers (e.g.
  UK).
• Sometimes agencies enter into cooperation
  agreeents to clarify areas of individual or joint
  jurisdiction (e.g. Canada.)
• Sectoral regulator reports cartel violations to
  competition agency (e.g. Austria).
• Sectoral regulator can issue opinions to
  competition agency (e.g. Italy).
• Sector regulator may seek opinion of competition
  agency (e.g. Turkey).
• Why does all of this matter for strategy
  formation?

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Areas of potential dispute between regulators and
competition agencies

• Pricing interconnection.
• Rules on price competition, especially rules
  against lower prices beyond a certain level.
• Mergers and acquisitions.
• Conditions imposed on new entrants.
• Forebearance of anti-competitive practices so as
  to meet a social regulation.
• e.g. unfunded universal service requirement.
• Even where the competition agency does not have
  formal powers it may engage in advocacy to
  those that do.
• Regulatory capture may not be enough!

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Business-oriented questions about regulation

• What factors trigger regulatory responses by
  government?
• In what ways does a regulation affect current
  firm behaviour and market outcomes?
• How do firms respond to regulation?
• How should firms respond to regulation?
• In what ways is future behaviour of firms
  affected by regulations?
• What is the impact on firm profitability of
  different types of regulation?
• In what ways, if at all, can firms influence a
  regulators decisionmaking processes?
• How do regulators learn?

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Regulation of Network Industries

• Understanding regulators
• Three perspectives

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What do these perspectives seek to explain?

• Why are regulations imposed?
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?
• I will explain how to make the best use of the
  three perspectives presented in the slides that
  follow.

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Three perspectives on regulation

• Public interest theories.
• Regulation is there to fix market failures.
• Capture theory.
• Regulation promotes the interests of incumbent
  firms and not social welfare.
• Economic theory of regulation.
• Politicians structure regulation so as to
  trade-off the interests of different societal
  groups in such a way that is most beneficial to
  them.
• Which theory is correct has considerable
  implications for firm strategy. Why?

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Public interest theories of regulation

• As much a theory of what the state should do
  rather than what it does do.
• On this perspective regulations are imposed when
  the normal operation of free marketstypically
  competitiondoes not deliver efficient market
  outcomes.
• Regulations are imposed when it is in societys
  interest to impose them.
• When do inefficient market outcomes happen?
• Natural Monopolies.
• Externalities.
• Information asymmetriesadverse selection and
  moral hazard.

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Public interest theories of regulation

• What does this perspective offer in answering the
  following questions
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?

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Critiques of the public interest theories of
regulation

• Failures in prediction
• It does not explain which sectors are regulated
  and which sectors are not.
• It cannot explain why some sectors are
  deregulated and others are not.
• Incomplete explanation
• Does not explain why the beneficiaries of the
  status quo cannot successfully oppose changes in
  regulation.
• Insufficient attention given to who influences
  regulatory choice.
• What are the implications for business strategy
  of this critique?

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Critiques of the public interest theories of
regulation (2)

• Does not consider the information needed by the
  state/regulator to set the optimal regulation.
• What information is needed?
• Who has that information (if anyone)?
• Does that agent have the incentive to share the
  information?
• What are the implications for business strategy
  of this critique?

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Capture theory of regulation

• Motivated by evidence that regulated sectors
  tended to have prices greater than costs and to
  have profits.
• One interpretation producers seek regulations to
  secure higher profits.
• Example taxi cabs.
• Regulations are supplied in response to industry
  demands for them.
• Major claim a regulatory agency can be
  effectively controlled by the industry it was set
  up to regulate!
• What are the mechanisms of control?
• Information
• Budgets

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Capture theory of regulation (2)

• What does this perspective offer in answering the
  following questions
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?

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Critique of capture theory of regulation

• Does not explain why one group (the incumbent
  firms) always triumph over other interested
  parties.
• Hard to reconcile with evidence on
• Discrimination in favour of small producers given
  in certain sectors.
• Cross-subsidisation imposed on some service
  providers e.g. universal service requirements for
  telecoms companies.
• Complaints about business people that regulations
  are lowering profits.

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Economic theory of regulation

• Predicated on the assumption that the state has
  the power to coerce and that politicians use that
  power to advance their own interests.
• Three key assumptions
• Regulation redistrbutes wealthbut is costly to
  society.
• Behaviour of legislators is driven by desire to
  remain in office.
• Interest groups compete by offering political
  support (votes, funds) in exchange for favourable
  regulation.
• Prediction groups that are more easily organised
  or have more to gain from legislation tend to
  receive the benefits of regulation.
• Prediction politicians will limit the amount of
  regulation given.

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Economic theory of regulation (2)

• What does this perspective offer in answering the
  following questions
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?

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Explaining cross-subsidisation

• Can you use the Economic Theory of Regulation to
  explain why cross-subsidisation of supply to
  rural and less-populated reasons happens in
  telecomunications and in other utility sectors?

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Critique of economic theory of regulation

• Voters tend to care about more than one
  mattermaking it easy for politicians to
  trade-off non-regulation-related benefits for
  pressures to intervene in markets.
• Politicians may care about things other than
  re-election.
• Assumptions being made about the vulnerability of
  politicians and the powers delegated to
  politicians.
• Various forms of representative democracy.
• Can this theory explain the creation of so-called
  independent regulatory agencies?
• Insufficient attention given to the role of the
  courts.
• Why does any of this matter for business
  strategy?

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Explaining the trend towards creating independent
regulators.

• What do we mean by independence?
• Ability of regulator to set own agenda?
• Financing?
• Need to explain why politicians would delegate
  their powers to a third party?
• Technocratic expertise.
• Investment of time and resources in acquiring
  expertise and information.
• Can each theory effectively explain this trend?
• Which sectors would tend to get independent
  regulators and which sectors not?

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Summary remarks on regulations

• There are many types of regulations and may
  reasons why they get imposed.
• The fact that regulations can affect business
  performance is the primary reason why a
  strategist needs to understand
• Why are regulations imposed?
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?

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Summary remarks on regulations (2)

• Dont worry about the fact that there is no one
  agreed explanation for regulationthe world is
  very varied and it would be surprising if one
  story could explain every regulation.
• Regard the theories of regulation as potential
  explanationsdecide which is more relevant to the
  suitation at hand.
• Important to undertand
• which actors are involved.
• their motives.
• the options available to a firm.
• the need to formulate a coherent strategy for the
  market place and in the regulatory arena.

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Regulation of Network Industries

• Firm strategies in regulated markets

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Firms in network industries need integrated
strategies.

• Such firms operate simultaneously in a market
  environment (think Porters 5 forces) and a
  non-market environment (made up of non-commercial
  actors.)
• The non-market environment can be just as much as
  a threat to firm profitability as any of the five
  forces.
• David Baron argues that firms need integrated
  (that is, coherent) strategies in the market and
  non-market environment so as to protect against
  threats to profitability.
• He adapted Porters five forces approach to
  include the non-market environment.
• Lets do that here in the context of regulation
  of network industries.

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Businesses operate in two environments
simultaneously.
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Examples of non-market strategies.

• Two main objectives creating and exploiting
  opportunities and countering threats.
• Create opportunities for selfopening foreign
  markets.
• Alter rivals current opportunitiesraising
  rivals costs through impact of differential
  regulation.
• Block rivals opportunities altogetheropposing
  rivals MA plans.
• Reducing threats from rivalsblocking entry by
  imports, patents.
• Reducing threats from the stateself regulation
  in financial services.
• Mitigating threatsstate bail outs and insurance.
• Creating threats and uncertaintythreatening
  legal action.

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Firms develop strategies for the market and
non-market sphere.

• Need not involve a change in the objectives of
  the firm.
• Effective strategy formation involves
• Identifying the relevant 4Is and 5 forces.
• Identifying a set of strategic options which may
  have market and non-market components.
• Anticipating strategies of actors in market and
  non-market environment.
• Given 1-4, evaluating strategic options decision
  and coherence in both spheres.
• Implementationconsideration of resources
  required.
• Mitigation of risks.
• Evaluation of prior decision. Start of feedback
  loop.

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Important characteristics of non-market
strategies.

• Appropriability Are the gains from pursuing
  non-market strategy only appropriated by those
  firms pursuing such strategies? If not, what are
  the implications for the desirability of a
  non-market strategy?
• Collective versus individual action Would
  collective action be preferable to individual
  approaches?
• Sustainability. What are the sources of
  distinctivethat is, hard to copy yet
  effectivenon-market strategy? Can non-market
  strategy be a source of long term competitive
  advantage?
• Reversibility Does precedent matter? Can a
  particular strategy be reversed? If not, does it
  matter?

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An alternative perspective to firm lobbying
strategy (Vining et. al.)

• Lobbying is defined as all attempts to
  communicate information to political actors
  (including regulators.)
• Before strategising need a good understanding of
  the many ways in which a regulator and its allies
  in the state can affect a firms business.
• Firms then devise a political strategy that has
  the five components shown.

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An alternative perspective government and
regulators as a sixth force (see Vining et al)
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Regulation of Network Industries

• Case studies on Firm-Regulator Interactions in
  Utility Markets

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Notes on Coens case study on European utility
markets
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Notes on Coens case study on the UK and German
telecommunications sectors
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Lessons learned (1)

• Corporate strategy tools must be adapted to the
  special circumstances of network industries.
• Those circumstances include
• Increasing returns to consumptionor how
  networks create value!
• Control over access to network.
• Choices concerning standards adopted
  (compatiability, and intellectual property.)
• In addition to competition in the market,
  sometimes there is competition for the market.
• Concentrated market outcomes is often the
  resultthis factor plus social goals and
  privatisation has led to plenty of government
  intervention.

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Lessons learned (2)

• Regulation calls for integrated strategies by
  firms to take account of the non-market
  environment as well as the other important
  market-based and technological developments
• Critical to understand which regulators matter,
  how they make decisions, on what basis, and who
  they talk to.
• Regulators are often deeply influenced by
  national bureaucratic traditionsso the best
  non-market strategies may vary a lot across
  countries.
• Dont make any assumptions about due process and
  procedural fairness.
• Effective non-market strategy typically requires
  distinct resources and capabilities to implement.