Regulatory Economics: Recent Trends in Theory and Practice ACCC 2004 Regulatory Conference July 29-30, 2004 Sea World Nara Resort Paul R. Kleindorfer University of Pennsylvania Kleindorfer@wharton.upenn.edu ACCC: PRK-July 04 1
The Past 20 Years or So** (A Mostly U.S. Perspective) • Theoretical Developments Over the Period • Developments in Practice • Implications for the Future **Based in part on the earlier survey by M. A. Crew and P. R. Kleindorfer, “Regulatory Economics: Twenty Years of Progress?” J. of Regulatory Economics , 21 (1), January, 2002. ACCC: PRK-July 04 2
Rationale for Regulation • Theory – Desire to avoid monopoly inefficiency, but allow for capturing economies of scale/scope – Protect the consumer from monopoly exploitation • Practice – Regulatory capture – Opaque Redistribution: taxation & subsidization – Rent-seeking Behavior set in motion with its consultants and advocates of all stripes • Result: – Piecemeal and selective implementation of changes and reforms—in tightly coupled systems, like electric power, this has led to real problems. ACCC: PRK-July 04 3
Regulation Since 1980 • Telecommunications – AT&T divests 7 RBOCs – Privatization of British Telecom – New technologies begin to enter (PCs, optical fibre, the Internet and wireless technologies) • Natural Gas and Electric Power – Natural Gas: long-term take-or-pay contracts to an industry driven by competitive forces, intermediaries, risk hedge instruments benchmarked on spots etc. – Electric Power: Many problems • Other Sectors: Move to the Market ACCC: PRK-July 04 4
Deregulation ??!!? • Deregulation is itself an ambiguous term – Consistent with any change in regulation – It means what it means! • Could be taken to mean reducing regulation, but that isn’t how it has worked out. • Generally: Unbundling & Competitive Entry ACCC: PRK-July 04 5
Theory: Pre-1980s • Advances of the 50’s-70’s provided the rich foundations for economic analysis (Samuelson, Arrow-Debreu, The Postwar French School, ...), Welfare Economics in the British School ... Collective Choice to Econometrics to Game Theory, ... Theory was alive and vibrant. • The Carnegie School on Behavioral Foundations (Simon, Williamson), leading to Tversky- Kahneman, Smith, Plott and the experimentalists • The Work of Averch-Johnson, Boiteux-Steiner, ... Integration of monopoly theory into General Equilibrium Theory. ACCC: PRK-July 04 6
Developments in Theory in U.S. • In many ways, the research of 70s & 80s was inspired in significant ways by the resources invested in microeconomics by AT&T. – Bell Journal (Panzar, Bailey, Sibley, besides established scholars) – The Baumol School, including Bailey, Panzar and Willig, and Contestability Theory, Weak Invisible Hand Theorems, Pricing under entry, Multi-product firms, joint costs, cross-subsidy tests ... • A. Kahn’s Books on Regulatory Economics, spawning a host of innovations in (Non-linear and Priority) Pricing and Regulation. ACCC: PRK-July 04 7
The New Regulatory Theory • Arguably these developments still had the traditional “regulated firm” and “regulated markets” in mind as the center-piece of attention. Indeed, most of these were rooted in practical problems, from Telecom pricing to Airline deregulation. • New Force appeared in early 1980s—Mechanism Design Literature; Information Economics ACCC: PRK-July 04 8
Enter P-A Type Models • Mechanism-design based Regulation, beginning with Baron and Myerson (1981) and strongly promoted by Laffont and Tirole (1993), was based on strong assumptions like common knowledge . [Loeb-Magat, Vogelsang-Finsinger, ...] • Information not available to (or at least not usable by) the regulator even with contested discovery process • Regulator concedes some information rents to the firm. • Commitment of the Regulator was claimed to be the chief barrier to achieving the efficiencies demonstrated in these theoretical models. ACCC: PRK-July 04 9
The Practice of PCR/PBR was Different Regulatory Judgment, Not Formulaic • Littlechild and PCR (Decouple Revenues from Costs): Basic Objectives: Incentives for efficiency while reducing transactions costs and micro management • On-going adjustments based on true-ups derived from assessment of past returns and likely future conditions. • The periodic tuning of PCR parameters was very much like the traditional Cost-of-Service rate hearing, with discovery, argument, etc. Little resemblance to the Mechanism-Design Paradigm. ACCC: PRK-July 04 10
Understanding Regulatory Commitment • Regulatory commitment is not the appropriate framing of the Achilles heel of PCR. The real problem is missing the essential attributes of the regulatory context. • Key Difference between Littlechild’s approach and the mechanism design approach: More realistic view of the constraints on regulatory commitment that are likely to be fundamental to the very nature of regulation. • Commitment as a two-sided process requiring commitment by both sides. This is understood in practice by regulators, companies and investors. Informed consent and reasonable returns, with transparent metrics: Wolak (2004) “smart sunshine regulation” ACCC: PRK-July 04 11
Major Advances in Regulatory Economics: 1984-2004 • Price Cap Regulation (PCR) and its cousin PBR • PBR: E.g. Yardstick Competition (Shleifer, 1985) leads to Balanced Scorecards/VAD and detailed Metrics • Cross-subsidy Analysis, and the analysis of the multi- product partially regulated firm • Depreciation Analysis and Capital Recovery • Empirical tools for productivity assessment • Experimental Economics and Institutional Analysis (including Market Monitoring) • Auctions and Bidding, Spectrum Auctions, and other approaches to Privatization • Access Pricing—ECPR, Global Price Caps ACCC: PRK-July 04 12
Developments in Practice • Some Adventuresome Experiments and Great Lessons! • Practical problems and a general conviction that change was required have driven the field of Regulatory Economics • Primary driver in practice has remained the redistribution of monopoly rents • Increased use of simulation and experimental models to support analysis of regulatory institutions before the fact; Good Development! • Increased recognition of the key role of independent market oversight and good data. ACCC: PRK-July 04 13
Developments: Electric Power GENERATION TRANSMISSION Plants produce the product - The Towers move the product Electricity DISTRIBUTION The wires carry electricity into • a house • a business 14 • an industry
Big Impacts on Typical Utilities Old Structure New Structure Wholesale Genco G Customers Trading ??? New Retail T Customers Ventures D Transmission Existing Retail Customer Distribution Base ACCC: PRK-July 04 15
Unbundled Electricity Value Chain Long- Wheeling into Term Out of & Across Generation The System Supply Fuel DSM Supply Contracts Risk Risk Local Risk Inside the Risk Economy Spinning Resvs Metering Management Management Delivery of Management Fence Management Energy and Frequency Services of of Service to End Generation of Fuel Supply Control Generation Transmission User Permits for Controls Env’ment & Onsite ( Air & Services Spinning System Control Water) & VAR Reserve On-Call Support Sales & ACCC: PRK-July 04 16 Fuel Supply Generation Transmission Distribution End Users Tariffs
Unbundling Pricing and Costing Example: Power Distribution Related Services • Distribution System Usage • Customer Assistance, Records, Billing and Collection • Meter Reading • Meter Operation and Maintenance • Meter Connection and Disconnection • Street Lighting and Signal System Support • Other Customer Related Services (Electric) ACCC: PRK-July 04 17
Changes in Distribution Company Strategy Learning to Spell “Marketing” Mapping Customers by Their End-Uses and Price Sensitivity End Uses Annual Market Size Lighting ($100 Million) Motive Power Relative Price Sensitivity Transportation = Insensitive = Sensitive Process/Domestic Use Climate Control Residential Commercial Industrial (Illustrative) ACCC: PRK-July 04 18 Source: EPRI
Regulatory Issues at the DISCO Level • Distinguishing competitive advantage from market power abuse (both in Retail and Wholesale Competition) • Removing barriers to entry to Distributed Generation (DG) • Establishing default/standard offer obligations & policies • Performance-based regulation ACCC: PRK-July 04 19
Transmission “Regional Tranmission Operators (RTO) Design” “Problems are often the unanticipated result of the solution of some previous problem!” ACCC: PRK-July 04 20
US Wholesale & Electricity Markets Western Interconnection Texas Interconnection Eastern Interconnection Load 118,494 MW Load 45,636 MW Load 497,644 MW Capacity 154,377 MW Capacity 55,230 MW Capacity 585,231 MW Margin 30% Margin 21% Margin 17% Control Areas 33 Control Areas 9 Control Areas 98
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