REGULATORY ECONOMICS LUISS – Economics and Management of Energy Business September 30, 2014

Costs and Supply Perfect Competition and Monopoly Welfare Economics Introduction to Regulation Focus: Market Power Regulation Focus: Market and Liberalizations Bad regulation examples

Some key terms Production – inputs used to make outputs Revenues • the amount a firm earns by selling goods and services in a given period Costs • the expenses incurred in producing goods and services during the period Profits • the excess of revenues over costs • Assume that firms aim to maximise profits

The production decision

For any output level, the firm attempts to minimise costs Assume the firm aims to maximize profits Profits depend on both COSTS & REVENUE each of which varies with the level of output Profit = Total Revenue – Total Cost Maximum Profit where MR=MC

The theory of supply Firms’ decisions about how much output to supply depend upon the costs of production and the revenue they receive from selling the output

Costs of Production Determine Supply Curve

Revenues From Demand Curve

Firm chooses input levels And level of output To maximise profit

Choosing output COSTS

REVENUES

Technology & costs of hiring factors of production

TC curves (short & long run)

Demand curve

AC (short & long run)

AR

CHECK: produce in SR? close down in LR? MC

Choose output level

MR

MC, MR

Maximising profits

MC

If MR < MC, a decrease in output will increase profits.

E MR 0

Q1

If MR > MC, an increase in output will increase profits.

Output

So profits are maximised when MR = MC at Q1

Costs and Supply Perfect Competition and Monopoly Welfare Economics Introduction to Regulation Focus: Market Power Regulation Focus: Market and Liberalizations Bad regulation examples

Perfect competition Characteristics of a perfectly competitive market •

many buyers and sellers –

no individual believes that its own action can affect market price

•

the product is homogeneous

•

perfect customer information

•

free entry and exit of firms

•

Result – Firms are PRICE TAKERS

•

so face a horizontal demand curve

Short run vs. long run

•

The short run is the period in which a firm can make only partial adjustment of inputs  e.g. the firm may be able to vary the amount of labour, but cannot change capital.

•

The long run is the period in which a firm can adjust all inputs to changed conditions.

•

The long-run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels.

The firm and the industry in the short run under perfect competition (1) Firm

INDUSTRY

SMC

€

€

SRSS

SAC

P

D=MR=AR

P D

q

Output

Q

Output

Market price is set at industry level at the intersection of demand and supply The industry supply curve is the sum of the individual firm’s supply curves

The firm and the industry in the short run under perfect competition (2) Firm

INDUSTRY

SMC

€

€

SRSS

SAC

P1 P

D=MR=AR

P D

q

Output

Q

D1 Output

The firm accepts price as given at P – and chooses output at q where SMC=MR to maximize profits

The firm and the industry – adjustment in the long run under perfect competition Firm

INDUSTRY

SMC

€

€

SRSS SRSS1

SAC

P

P

D=MR=AR

P1

D q

Output

Q

Output

At this price, profits are shown by the shaded area. These profits attract new entrants into the industry. As more firms join the market, the industry supply curve shifts to the right, and market price falls.

Long-run equilibrium

Firm €

INDUSTRY

SMC SAC

€

SRSS

LRSS

P*

P*

D=MR=AR

D q*

Output

Q

Output

The market settles in long-run equilibrium when the typical firm just makes normal profit by setting LMC=MR at the minimum point of LAC. Long-run industry supply is horizontal. If the expansion of the industry pushes up input prices (e.g. wages) then the long-run supply curve will not be horizontal, but upward-sloping.

Adjustment to an increase in market demand: the short run

€

D

D'

Suppose a perfectly competitive market starts in equilibrium at P0Q0.

SRSS

P1

If market demand shifts to D'D' ...

P0

in the short run the new equilibrium is P1Q1 ... D Q0

Q1

D'

Output

– adjustment is through expansion of individual firms along their SMCs.

Adjustment to an increase in market demand: the long run

€

D

D'

In the long run, new firms are attracted by the profits now being made here

SRSS

– and firms are able to adjust their input of fixed factors

P1 P2 P0

LRSS

D Q0

Q1 Q2

D'

Output

If wages are bid up by this expansion, the long-run supply schedule is upwardsloping And the market finally settles at P2Q2.

Monopoly A monopolist: – is the sole supplier of an industry’s product • and the only potential supplier? Is the market CONTESTABLE?

– is protected by some form of barrier to entry – like high fixed costs so the incumbent has different costs to potential entrants – faces the market demand curve directly – Unlike under perfect competition, MR is always below AR

Profit maximization by a monopolist

Profits are maximized where MC = MR at Q1P1

€

MC AC

P1

In this position, AR is greater than AC so the firm makes profits above the opportunity cost of capital

AC1

MR

MC=MR

Q1

D = AR

Output

shown by the shaded area

Entry barriers prevent new firms joining the industry

Comparing monopoly with perfect competition Cost Price

The monopolist faces a downward sloping demand curve. Must set MR=MC to max profits

Revenue

Pm

Profit

PC firms end produce a market output where Supply = Demand

DWL Supply = MC=AC

Ppc

MR

Monopoly

Demand = AR curve

PC

Output

Discriminating monopoly •

Is monopoly always inefficient?

•

Suppose a monopolist supplies two or more separate groups of customers – with differing elasticities of demand  e.g. business travellers may be less sensitive to air fare levels than tourists, and them less than students

•

The monopolist may increase profits by charging higher prices to the businessmen than to tourists

•

Discrimination is more likely to be possible for goods that cannot be resold  e.g. dental treatment, airline tickets

Example – air line prices

Price

PC = CONCORDE PF = FIRST CLASS

PC PF PB

PB = BUSINESS CLASS PA = APEX DEALS PS = STUDENTS & STANDBY

PA PS

AC=MC

AR= Demand Quantity

Another issue – introduction to natural monopoly Costs

The other issue is that P=MC is efficient – but this means making losses for a natural monopolist

Ps LRAC Pb

LRMC Qs

Qb

•

This firm enjoys substantial economies of scale relative to market demand

•

LAC declines right up to market demand

•

the largest firm always enjoys cost leadership

•

As Karl Marx put it, “the bigger capital will always beat the smaller”

•

and comes to dominate the industry

•

It is a NATURAL MONOPOLY

Output

Costs and Supply Perfect Competition and Monopoly Welfare Economics Introduction to Regulation Focus: Market Power Regulation Focus: Market and Liberalizations Bad regulation examples

First theorem of welfare economics – – –

If consumers and firms behave in a competitive way in all markets If markets exist for all exchanged goods and, finally, if operators get perfect information

then competitive equilibrium – if it exists – is Pareto-efficient, i.e. it allows to achieve at the same time efficiency in production, efficiency in the allocation of resources and in consumption

The first theorem requires many conditions to be met simultaneously: if not, a market failure shall occur and no efficient allocation would be guaranteed

Competitive equilibrium and Pareto-efficiency

•

D

SS •

P1*

•

D

Q1* Quantity of films

•

At any output such as Q1*, the last film must yield consumers P1* extra utility The supply curve for the competitive film industry (SS) is the marginal cost of films Away from P1*, Q1*, there is a divergence between the marginal cost and the marginal benefit derived by consumers so a move to that position makes society better off

Competition process and social welfare €

Consumer Surplus

Example of noncompetitive quilibrium Supply = marginal costs DeadWeight Loss (DWL)

Pnon conp > MC Pareto-efficient competitive equilibrium

P= Marginal cost (MC)

Producer Surplus

Demand Qnon comp

Qcomp

q

Perfect competition ensures production and allocative efficiency = Maximization of social welfare 26

Market equilibrium in a non-regulated monopoly Graphic solution - monopolistic problem

Solution to the monopolistic problem – an example Domanda:

a

ε1

ε2 > ε1

Curva di costo totale: 

 

Profitti:  Impresa è price‐fixer, quindi: 

a

D1

 

D2

MR1

 

MR2

   

Ramsey rule

 

P-MC P

=

Legend

1

a- reserve price

ε

D- Demand MR – marginal revenue

 

MC – marginal cost

ε–

 

elasticity of demand

Monopolist’s market power is inversely proportional to elasticity of demand 27

Costs and Supply Perfect Competition and Monopoly Welfare Economics Introduction to Regulation Focus: Market Power Regulation Focus: Market and Liberalizations Bad regulation examples

What is regulation? Regulation means State intervention over supply and/or demand conditions to services delivered to final users. Public health, safety and working conditions are generally excluded

ANTITRUST VS. REGULATION •

Antitrust intervention occurs ex-post, in case of anti-competitive behaviours where market conditions exist but their results are unsatisfying

•

Regulation, on the contrary, occurs ex-ante, where there is no market competition but where its positive effects are willing to be introduced (efficient pricing, quality of services) or where market mechanisms should be improved or developed (accounting equipment / access to basic infrastructures)

Why regulation?

Who benefits from regulation? Which firms are more likely to be regulated? Which features should regulation have?

First answer: regulation exists when competition is not achieving good results, that is to say it is not efficient from an allocative and productive point of view

3

Why regulating

In a world of perfect competition, there would be no need for government’s intervention. Regulation must be considered as strictly connected to market structures

•

If the efficient market structure is a monopoly, the problem is to match the interests of the monopolist with those of the system

•

If the efficient market structure is a combination of monopoly and competition , the problem is to “match” them together.

31

Market failure •

Presence of market power Price is not fixed equal to marginal cost

•

Externalities Difference between private costs (benefits) and public costs (benefits) :

•

Positive externalities (ex. spillover): private consumption is lower than the social optimal consumption (i.e. public)

•

Negative externalities (ex. pollution): private consumption is higher than the social optimal consumption (i.e. public)

•

Public goods These are characterized by a “non-excludability and non-rivalry consumption” (ex. public administration, health)

•

Lack of Markets Not all goods have their own market

•

Imperfect information Adverse selection and moral hazard

In case of market failures, State can deem it necessary to intervene in order to regulate the market 32

When Regulating Why

Objective

Example

Natural monopolies

To “Simulate” competition

Utilities – network services

Externalities

To internalise the social cost

Pollution

To give information to consumers in order

Medicines, food labelling

Information

Continuity of services

Public goods

to ensure good market functioning

To ensure socially desirable levels for

Territorial continuity for air

basic services

transportation

To share costs of those activities at risk

Health, R&D

of free rider Rationalization and coordination

Protection of Competition

To guarantee efficient production with

Product standards

high transaction prices Prevention of anti-competitive behaviours

Predatory prices

33

Forms of State intervention State can overcome market failures:

•

By direct intervention through the acquisition of the firms supplying the good/service (ex. Nationalization);

•

By indirect intervention through:

•

Ex Ante regulation of the firm :

•

Access regulation: concession of exclusive rights (legal monopolies), authorizations and licenses, liberalizations

• • • • •

Control over prices Economic incentives (public welfare payments and taxation) Standards definition Obligation to information disclosure

Ex-post regulation of the firm through anti-trust interventions in order to penalize anti-competitive behaviors (ex art. 81 TCE) and abuses of dominant positions (ex art. 82 TCE). 34

Forms and extent of State intervention vary depending on different historical periods, economic context and dominant political-cultural models

35

From post-war to the end of the 70s: the interventionist State •

Keynesian economics and Welfare State:

• •

State intervention in case of market failures

Predominance of the “interventionist State”

“In any industry, where there is reason to believe that the free play of self-interest will cause an amount of resources to be invested different from the amount that is required in the best interest of the national dividend, there is a prima facie case for public intervention.” A.C. Pigou (1924)

“Nor is it true that self-interest generally is enlightened; It is not a correct deduction from the principles of economics that enlightened selfinterest always operates in the public interest[…]. I think that capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system” J.M. Keynes (1924), The end of laissez-faire

Facts in short

•

Growth of public spending over GDP  Deficit spending  growth

• • •

of borrowing

Political ideas

Nationalization

Social-democracy, liberal-democrats,

Social security programs

Christian-socialism:

Market social economics and

Predominance of progressive ideas

planning 36

The academic debate: the limits of the interventionist State Interventionist State actions are criticized by two main academic streams : 1) POSITIVE THEORY OF REGULATION – economic analysis of institutions in charge of regulation

•

Regulatory capture models, Stigler (1971): state regulatory agencies, created to act in the public interest, instead advance commercial interest (votes, careers). Predictably, the agency will be “captured” by interests of regulated firms

•

failure of direct state management

2) AUSTRIAN SCHOOL AND NEO-INSTITUTIONALISM

•

Austrian School (Von Hayek): any single person holds a unique set of information, socially relevant and partially unknown to the State; only in a free market individuals can express and exploit these information

•

Neo-institutionalism: regulatory authorities are not a mere passive means of transmission of public interests nor of private lobbies  need of a suitable institutional framework to guarantee an efficient control over administration offices

Scientific debate foretells the end of the traditional model 37

The 80s: limiting State intervention The School of Chicago Baumol (1982) theory of contestable markets: even in a monopolistic market, potential competition exerted by possible new entrants entails an equilibrium effect, bringing prices equal to production average cost Friedman and monetarism: private operators are rational individuals maximizing their own interests by exploiting information they own; prices flexibility ensures a full regime to economics  State intervention causes distortions and inefficiencies

Facts in short

• • • •

Political ideas

Liberalization of industrial relations

Conservative ideas

Deregulation

Ronald Reagan 1981, first inaugural

Restrictive fiscal policies Privatizations

address : « In this present crisis, government is not the solution to our problem; government is the problem. » Margaret Thatcher 38

The last two decades: beyond traditional intervention and deregulation Critics to the school of Chicago Stiglitz, Sutton (1992-94): contestable markets theory has little realistic basis: (sunk cost absence; demand reactivity; slow incumbent reaction) The new approach According to Stiglitz (1992) the task of theory of regulation is to find out when and how the State takes a comparative advantage from intervening in case of market failures (benefits vs damages of regulating) How can Government manage its intervention? Well-timed public decisions and credibility of regulation  State “takes its hands off the wheel”  creation of Independent Regulatory Authorities in order to monitor the liberalization process from the market opening until effective competition is established

Facts in Short Independent Regulatory Authorities Antitrust legislation Central Independent Banks

“Regulation is essentially the means of preventing the worst excesses of monopoly; it is not a substitute for competition. It is a means of ‘holding the fort until competition comes.” Littlechild Report, 1983 39

Current trends and perspectives Re-regulation Many years after liberalization has been achieved, the intervention by Regulatory Authorities becomes wider, thus generating more comprehensive and detailed disciplines Regulation and policies New policy objectives set by governments require from Authorities a regulation able to guide investments and the development of regulated sectors

The energy case Geopolitical instability, commodities volatility, externalities “The market enthusiasts failed to the recognize how far the electricity market deviated from the normal commodity model… supply must instantaneously match demand … assets are sunk or long lived, the networks are natural monopolies. There are very great environmental externalities; and critically, electricity and gas are complementary to the rest of the economy, in that failure to supply has (extremely) large costs to all economic activity... If the issue of fuel poverty and the distributional implications of electricity and gas pricing and supply are also included, it is extraordinary that anyone could have regarded these as anything other than political industries” Dieter Helm 2007

The new paradigm: Security of supply, sustainability, competitiveness

Facts in short

• • •

Oil shock and financial crisis 2008 New UK electricity market reform 2010 Decarbonization policies and climate change combat (directive 2009/28/CE)

40

Costs and Supply Perfect Competition and Monopoly Welfare Economics Introduction to Regulation Focus: Market Power Regulation Focus: Market and Liberalizations Bad regulation examples

Market power regulation

Definition of natural monopoly •

An industry is defined as a natural monopoly when its cost function is subadditive at the relevant output level

•

The cost function is subadditive when one single firm can meet the market demand at the lowest price compared to any other group of firms:

C

T



i

 

qi 

i

C q i



EXAMPLE: production of a given quantity qA by a single firm with a cost function AC vs. production of qA distributed in equal parts between two identical firms with a cost function AC €

D

Graphically:

D’

ACA*qA<2*AC(1/2)qA*(1/2)qA

Average Cost =AC

AC(1/2)qA

G

B

B= non monopolistic market

ACB AC(1/2)qA

F

ACA

A= Monopolistic market

A

q O

(1/2)qA

qA

qB

More general: C

T

q a  

C

T

 1 q   2

a

   C 

T

 1 q   2

a

  

This formula is connected to that of subadditivity; If demand shifts from D to D’ and the production increases to qB it becomes more efficient to cover demand by splitting production between two identical firms 42

Market power regulation

Costs and benefits of regulation of a natural monopoly Policies: 1. No regulation (Qmonopoly ). Social welfare is equal to the area (A – Pfirst - G - B) – fixed costs (Psecond - Pfirst – H - D) 2. Regulation through a price equal to average costs (Psecond). Social welfare in area increases as in area (B – C- D) 3. Regulation through a price equal to marginal costs (Pfirst). Social welfare increases as in the area (D-H-F). In the first-best the monopolist must be refunded of his fixed costs equal to (Psecond Pfirst – H - D)

€ A Demand

B

Pmonoply

Psecond Pfirst = Pconc

Firm’s financial losses in the «first best» solution that must be refunded by cash transaction from consumers to producer

D

C G

H

AC F

MC

MR q Qmonoply

QSecond

Q

first

= Qconc

In a natural monopoly situation, tariff regulation can increase social welfare. Benefits must be compared with regulation costs: direct costs of the Regulator (ex AEEG about 60 ml €/year) 43

Market power regulation

tariff regulation: the traditional theoretic approach

• Choice of the optimum tariff definition of the return for the private firm that ensures maximization of social welfare • it is based on the crucial situation of a perfect information

• Discriminating tariff :

– Consumers might have different possibilities to pay for the good – 2 tariffs: P=AC for consumers with higher evaluation P=MC for consumers with lower evaluation

• 2-part tariff : – Fixed charge (to cover fixed costs) + variable part (depending on consumption) Ex. Electricity: capacity component per kW + price per kWh – Compared to discriminating tariffs, all consumers take part to fix charges coverage • Peak–load tariffs: – Some “non stockable” services have a very variable demand during the day (electricity, for example) – Massive installation generation capacity (increase of fixed costs) – Discriminating tariffs according to consumption period (higher tariffs when demand gets higher)

44

Market power regulation

regulation as a local agency problem Principal = Regulator

Agent = Regulated

Asymmetric information

Less information More information

Adverse selection (hidden information)

• The agent doesn’t disclose relevant

information (costs, demand function) in order to get some extra profit • it is an ex- ante asymmetric information, since it occurs before the regulatory framework definition (ex. Akerloff’s Market for lemons)

Moral Hazard (hidden action)

• The agent undertakes actions that cannot be

controlled nor foreseen by the regulator • The effectiveness and the costs of the control depend on the efficiency of the regulator and its ability/willingness to obtain suitable information to carry out its task with success. • It is an ex-post asymmetric information because it follows the definition of the regulatory mechanism

Need of a suitable incentive structure that leads the agent/regulated to behave according to the rules established by the Principal / regulator 45

Market power regulation

methodologies for ex-ante regulation • •

The regulated firm has an information advantage as to its production costs First-best solution (prices equal to marginal costs) is not easy to adopt since it requires some transfer of resources from consumers to producers

•

Second-best solution needs the coverage of the total costs of the firm (fixed and variable costs)

•

Second best solution can be reached through different regulation methodologies:

   

Rate of Return Regulation Price cap Yardstick competition Profit sharing

Different regulatory mechanisms must be designed in such a way that the producer has incentive to disclose its own costs and to produce at the minimum cost

46

Rate of Return Regulation •

The Rate Of Return Regulation requires the following condition : returns  maximun rate invested capital

• •

RoR was widely used until the ’80s This mechanism creates an incentive to increase the invested capital (Averch-Johnson effect). By increasing the invested capital, the regulated firm can increase its returns

•

Owing to the information advantage of multi-product firms, this RoR mechanism is hard to implement. In fact, it requires an accurate definition of the invested capital, the so called Regulatory Asset Base (RAB)

•

Vertically integrated firms need at least an accounting unbundling keeping separated regulated activities from the liberalized ones.

ROR is not an incentivizing method of regulation and it suffers from asymmetric information on costs 47

Price cap • •

It has become a widespread methodology since Littlechild’s Report (1983) Different specifications : multi-product firms mostly use the one based on the tariff basket mechanism

pq t

•

 RPI  x  p t 1 q t 1

where:

• • • •

t 1

t = current period of regulation t-1 = previous period of regulation x = efficiency gain

The firm for n products is free to fix prices pi, provided that the global return of the previous period (after all efficiency returns) is not lower than the hypothetical global return calculated as a product between sales of the previous period and current prices

•

In the regulatory practice there are some revenue drivers (in terms of minimum/maximum number of clients or sold quantities of a given product). These drivers discourage an opportunistic behavior by the firm which, in order to loosen the constraint, would tend increase the sales at low prices.

Price cap is an incentivizing mechanism not subject to asymmetric information 48

Yardstick competition • • •

In theory, firms operating in the same market conditions have the same cost efficient functions In practice, however, firms are not really perfectly efficient and operate in different market conditions Given these two conditions, the regulator can elaborate a regression model considering the main cost variables (for example population density) and calculate the efficient cost curve parameters; through this specification we can fix the price that any producer can apply

• • •

An incentive for producers to have production costs below the regression line For each new regulation period, new parameters of the regression line are calculated Without collusion among producers, it is possible to obtain the efficient cost level

Average costs

Losses during the second regulation period

Losses during the first regulation period

Regression line during the 1°regulation period Regression line during the 2°regulation period Extra-return during the first regulation period

Extra-return in the second regulation period

Population density 49

Profit Sharing • •

Profits sharing, beyond a «normal» level, between a regulated firm and consumers Consumers share returns through: prices reduction or refunds after the excessive profit has been calculated • •

• • •

Banded rate of return : profits are distributed on a level of return basis Dividend sharing: distribution of the extra-dividend. It can be applied in a wider regulatory framework but on of a price-cap basis: the constraint also includes the extra profit distribution and leads to a price reduction higher than the one foreseen for the price cap application period.

An immediate profit sharing discourages firms to cut down their costs The higher is the profit share given to consumers, the lower is the incentive to cost reduction (sharing parameter) Circularity problem: (profit connected with costs saving, which is connected to incentives system defined by the regulator)

50

Most widespread types of final prices regulation % of OECD countries falling in each category

Electricity: • 74% Rate-of-return regulation • 13% Regulation through price cap • 13% No regulation Telecomunicazioni fisse • 66% Regulation through price cap • 19% Others • 11% Rate-of-return regulation Railways passenger service • 50% Regulation through price cap • 28% Rate-of-return regulation • 22% No regulation

Source: OECD Int’al regulation database 2000

51

Distribution tariff The Italian scheme

Opex

Initial Tariff = allowed costs volume

Descending trend due to “price-cap” and CAPEX updating

OPEX

Tariff review based on 2010 actual costs and application of new WACC

 Updated at the beginning of each regulatory period, based on actual costs (year n-2), allowing for a 50% profit sharing of efficiency gains  Updated throughout regulatory period by means of price cap (CPI – X)

Depreciation  Updated yearly based on net investments in year n-2, allowing for revaluation

Depreciation Return on RAB Return on RAB

2008

2009

2010

 Updated yearly based on net investments in year n-2, allowing for revaluation

2011

2012

 WACC (real pre-tax) updated at the beginning of every regulatory period

Distribution tariffs are based on a price cap:  at the beginning of the year total allowed revenue is divided by expected number of clients  if actual volumes are higher (lower) than expected, DNOs actual revenues are higher (lower)

Price-cap and profit sharing The Italian scheme

Price cap I regulatory period:

Profit sharing1

 applied to the whole distribution tariff  X-factor set an exogeneous factor

Recognized Opex

Price cap II regulatory period:

Recognized Opex

Efficiency gain 2010



applied to depreciation and opex



X-factor set an exogeneous factor

Profit sharing Price cap III e IV regulatory periods: Actual Opex2010

2010

2012

…

2015

…

2019



applied only to opex



X factor set to claw back profit sharing in 8 years



doesn’t imply further efficiency gains beyond actual opex

 X-factor is set at the beginning of the regulatory period and it is set at the same level for all DNOs  Inflation is updated yearly according to last 12 months change of Consumer Price Index published by the Italian Statistics Office (so called “Indice dei prezzi al consumo per le Famiglie di Operai e Impiegati”)

1

The chart doesn’t show the overlap of 2° period and 3 period claw back

53

Invested capital remuneration The Italian scheme

(revaluation based on age of assets)

x 7.6% (net historic cost of assets)

RAB 2011

(net invested capital - 31/12/09 stock)

New investments 2010

Depreciation 2012

Revaluation

(invested capital / useful life)

(based on specific fixed asset inflation index)

RAB 2012

WACC

Allowed return on RAB

 Investments are recognized on an ex post basis with no screening by AEEG. Investments are recognized with a 2 years regulatory lag  Investments remunerated under different frameworks (energy efficiency, generation plants connection fees, etc.) are deducted from RAB

Costs and Supply Perfect Competition and Monopoly Welfare Economics Introduction to Regulation Focus: Market Power Regulation Focus: Market and Liberalizations Bad regulation examples

From monopoly to market: a new scenario Liberalization

Privatization

From public monopoly to private companies in a free market

Public monopoly

Public companies in a free market

• Company mission: electrification and development (a sort of Electricity Local Agency?)

• Company mission: value creation for customers and shareholders

• Company culture: stress on public service

• Company culture: change and innovation

• Main lobbies:

• Main Lobbies:

− Government

− European Commission

− Trade Unions

− Government − Authorities … − Financial Markets, investors… − Trade Unions

56

The value chain of the electricity sector before liberalization …

Production Transmission Distribution Metering Sale

Customer

Before liberalization, a vertically integrated monopoly used to control the whole chain 57

…and after liberalization

Production

Transmission

Activities in competition

Distribution

Metering

Sale

Regulated natural monopoly (tariffs fixed by the regulator)

58

The role of the “regulator” before liberalization…

User A

Government User B

Monopolist User C User D

Focus on long-term investments to support economic growth 59

… after liberalization

Customer A

Customer C

Customer B

Customer D

Firm A

Firm B

Firm C

Firm D

Ministry Antitrust Authority 60

Costs and Supply Perfect Competition and Monopoly Welfare Economics Introduction to Regulation Focus: Market Power Regulation Focus: Market and Liberalizations Bad regulation examples

Bad regulation: examples (1) Photovoltaic – PV Incentives «Conto Energia»

Qualitative scenario photovoltaic evolution

€

•

Fair incentive

Extraprofits

• Such an acceleration given by

Cost evolution

2006

2008

2010

2012

2014

2016

2018

The growth of Photovoltaic was higher than 2020 goals

incentives so far, might reduce chances to exploit all continuous and fast tecnology innovations

2020

Source : GSE data

62

Bad regulation: examples (2) Californian crisis (1) •

Huge increase of wholesale prices (from 26$/MWh in 1998 up to 110 $/MWh in 2000)

•

38 rolling black-outs between november 2000 and may 2001

•

Financial crisis of distribution firms

“Between November 1, 2000 and May 31, 2001, California’s electricity customers experienced power blackouts and service interruptions on 38 days. Blackouts and service interruptions during this energy crisis disrupted commerce and compromised public safety, affecting roughly one-third of all Californians." California Public Utilities Commission

Californian crisis was so much serious to undermine the whole liberalization process even outside California 63

Bad regulation: examples (2) Californian crisis (2) –increase of prices

•

Market power is the ability of one or more firms to alter competition. For example, they could rise and keep prices beyond the competition level

•

Incentives (typical for the electricity sector) to power market: supply concentration, lack of longterm contracts, inelasticity of demand

64

Bad regulation: examples (2)

Californian crisis

(3) – Rolling black outs

•

It was demonstrated that Californian crisis was characterized by severe capacity witholding strategies carried out by producers

•

Producers did not make all their generation capacity available, in order to increase wholesale prices, thus creating an artificial situation of lack of capacity

“If the state’s five largest independent electricity generators had operated all of their available capacity, California’s citizens could have avoided All 4 days of blackouts in Southern California; 65% of the blackout hours in Northern California; 81% of service interruption hours in the South, and 51% of service interruption hours in the North; …. On all but 2 of the 32 statewide blackout and service interruption days shown, the five biggest independent electricity generators did not supply well over 500 MW of power that they could have generated.” California Public Utilities Commission

65

Bad regulation: examples (2) Californian crisis (4) – financial crisis of distribution companies

•

Lack of long term contracts and Assenza di contratti a lungo termine e tariffe congelate •

Procuring by Distribution companies on California Power Exchange (Calpx)

•

Freezed supply tariffs (price initially set at a level higher than the wholesale price)

•

FERC interventions expected in case of wholesale price increase after exploitation of market power

Lack of incentives to avoid long term contracts 66

Bad regulation: examples (3) Disruptions in Italy – disruption on june 26, 2003 (1) Very hot weather, lack of rain and insufficient generation capacity, caused :

•

an exceptional increase of demand due to great use of air conditioning

•

Strong reduction of generation availability due to environmental reasons

•

Electricity prices increase in the most important European markets

67 67

Bad regulation: examples (3) Disruptions in Italy – Lack of price signals (2) 

The increase of electricity prices in European markets forced EDF to stop supplies towards Italy and to sell electricity to France: lack of price signals in Italy



The Italian Transmission System Operator, instead of buying energy abroad at market prices has organized planned disruptions. Lack of clear directives for the TSO



The issue of adequacy: did rules take it into account? (Enel Antitrust thresholds and incentives to investments for other operators…)

€/MWh

160 140 120

F1

100

F2 F3

80

F4

60

baselaod

40

peak

20 0 Italia

APX

68

Bibliography • •

Atkinson, Stiglitz (1980), Lectures in Public Economics, McGraw-Hill Baumol, Panzer, Willing (1982), Contestable Markets and the Theory of Industry Structure, Harcourt Brace Jovanovich

• • •

Cassese (2001), La Nuova Costituzione Economica, Editori Laterza Helm, D (2007), The New Energy Paradigm, Oxford University Press Hunt, Shuttleworth (1996), Competition and Choice in Electricity, John Wiley & Sons, Inc, Publication

• •

La Spina, Maione (2000), Lo Stato Regolatore, Il Mulino Littlechild (1983), Regulation of British Telecommunications’ Profitability, Secretary of State for Industry

• • •

Marzi, Prosperetti, Putzu (2001), La Regolazione dei Servizi Infrastrutturali, Il Mulino Motta (2004), Competition Policy: Theory and Practice, Cambridge University Press UK Governement(2010), Electricity Market Reform. Consultation Document, Secretary of State for Energy and Climate Change

• • • •

Stigler (1971), Theory of Regulation, Bell Journal of Economics Stiglitz (1992), Il Ruolo Economico dello Stato, Il Mulino Stiglitz (2003), Economia del settore pubblico, Hoepli Stoft (2002), Power System Economics, John Wiley & Sons, Inc, Publication 69

BACK-UP

Externalities

•

An externality arises whenever an individual’s production or consumption decision directly affects the production or consumption of others…

•

other than through market prices  e.g. a chemical firm discharges waste into a lake & ruins the fishing for anglers

Correcting a production externality How? Need a tax equal to the value of the externality at the social equilibrium

DD is the demand curve for wheat and is the Marginal Social Benefit

MSC=MPC+Ext

Externality Ps Consumer’s burden

Pp

Producer’s

Supply = MPC Tax burden

Demand

Qs

Qp Quantity

Deadweight loss due to producing beyond the socially optimal level Resources moved to other market

Slope of the Supply curve

Back up

Short run tends to slope upward (diminishing returns to the variable factor). Long run can be horizontal if all inputs are in perfectly elastic supply – but managerial ability is usually not. Price Can have declining long run costs due to economies of agglomeration

Also odd cases like beef – a fall in price can increase short run supply Quantity

Market Failure and Government Intervention in the Market

Back up

If the market works – laissez-vous faire Markets fail for two main reasons 1. Lack of markets – often caused by lack of property rights – or prohibitive transaction costs. Then third parties are positively or negatively affected by economic activities which the market misses – externalities 2. Not enough firms in the market – so they have MONOPOLY POWER and are price fixers instead of price takers

Market failure

Back up

•

… occurs when equilibrium in free unregulated markets will fail to achieve an efficient allocation.

•

Imperfect competition

•

Externalities

•

Social priorities (e.g. equity)

•

Other missing markets – future goods, risk, information

Institutional Innovation

Back up

•

Institutions – the rules by which the game is played

•

Organisations – the teams that play them

•

Marx was a technological determinist – North says it was institutional change -the Enclosure Movement – that made the Agrarian Revolution possible

•

What many LDCs need – but often policies are self defeating. Tanzania tried Pan-Territorial pricing and Pan-temporal pricing. Doomed to fail as they ignored transactions costs.

•

High transactions costs are a reason for lack of markets and hence externalities in areas like pollution

Correcting externalities •

1) Taxes and subsidies

•

2) Bargaining solutions

•

3) Internalising the externality

•

4) Technical correction devices

•

5) Regulation or prohibition

•

6) Separation of the parties

•

But who is guilty?

•

This is the interface between law and economics

Bargaining Solution: The Coase Theorem Marginal Benefit to UK 

Marginal Benefit to Sweden

MBUK =MBSW Total Benefit to UK  from electricity

Sweden  Level of SO2  only

Total Benefits  to Sweden  from less  damage

Bargaining solution

UK only

Public goods Excludable

Non-excludable

Rival in Consumption

Pure Private Goods e.g. Big Mac

Partly public Goods e.g. Oil pool

Non-rival In Consumption

Partly Public Goods e.g. Half full cinema

Pure Public Goods e.g. Malaria eradication, defence, technology