Alternative approaches to regulation: an economic analysis of light-handed regulation

1. Alternative approaches to regulation:an economic analysis of light-handed regulation Simon Cowan University of Oxford ACCC Regulatory Conference 26-27 July 2007

2. What is light-handed regulation? • Formalized in New Zealand for telecoms regulation • General competition law • Disclosure requirements • Threat of subsequent specific regulation • For Telecom New Zealand some additional constraints on pricing • In other versions there is the possibility of binding arbitration in the event of disagreement

3. Some theory • Three reasons for specific regulation • To avoid deadweight losses • To promote distributional objectives • To encourage relationship-specific investments • Asymmetric information and incentives • No regulation can be better than standard types of regulation • Other theoretical examples where regulation gives poor outcomes – input choices, relative prices • The threat of regulation

4. Why regulate? • Avoidance of deadweight loss (= unrealized gains from trade) • But regulation itself has costs • It requires specialists (who may be particularly costly in developing countries) • There are probably economies of scale in regulation, so it is more worthwhile in larger markets • There may also be economies of scope => multi-sector regulation

5. Bargaining instead? • The Chicago/Coase question • Why don’t the firm and its customers bargain to realize all the gains from trade, and thus eliminate the deadweight loss? • Standard counter-argument • Customers are typically too small, and too numerous, for bargaining to be effective • Maybe we can rely on bargaining when the customers are themselves large firms • Bargaining and distribution: regulation to allocate the gains from trade?

6. Bargaining and access • A network firm bargains with access seekers, but no-one bargains with final customers • The firms have an incentive to maximize joint profits, so bargaining is efficient for the firms but not for society • We want firm-to-firm bargaining to be less than fully efficient • The possibility of secret deals (private renegotiation) reduces the available profit • asymmetries of information on both sides reduce bargaining efficiency • King and Maddock (1999) – threat of binding regulation with lower profits, and constraints on the bargaining process, can dissipate actual profits in equilibrium • Overall the argument for bargaining is rather delicate: either we want it to be perfect for all players, or if it is firm-to-firm we want it to be less than fully efficient so that joint profits are not maximized

7. Regulation as a substitute for long-term contracts • There are relationship-specific assets, often on both sides, and long-term contracts cannot be used • A new electricity connection involves • (i) wiring in the customer’s premises • (ii) direct connection to the network • (iii) network reinforcement (possibly) • Typically these costs are shared, with the customer paying (i) and (ii) – which may be a uniform price – and the firm paying for (iii) • The legislation behind specific regulation, the agency tasked with implementing it and the judicial framework all provide some stability for both sides • Such features may be lacking in light-handed regimes

8. A model of incentives and efficiency • Demand is downward-sloping, so deadweight losses can occur • Marginal cost is subject to shocks, which are private information, and can be reduced by effort (which is costly and private) • Regulator chooses between three forms of regulation: rate-of-return, price-cap, light-handed

9. The set-up • Demand is linear in the price • Marginal cost (MC) = Cost shock – Effort • Social welfare = Consumer surplus + Profits • Full information benchmark has price equal average cost

10. Three types of regulation • Rate of return (ROR): constant margin • Price cap (PCR): constant price • Light-handed regulation (LHR): no regulation • The firm is free to choose its price and effort to maximize profits for each cost shock • Profit must be non-negative whatever the cost shock • The aim is to compare expected welfare under the three forms of regulation

11. Rate-of-return regulation • Price = Fixed margin + MC • Some effort is valuable for the firm if the margin is positive: it reduces MC, which reduces the price, which increases demand, and the firm then earns a fixed margin on the extra sales • Two offsetting effects of the margin on the price: • Direct effect: higher margin raises the price • Indirect effect: higher margin leads to more effort, which cust MC and thus the price • These two exactly offset each other: Price = Cost shock • Regulator can set the margin optimally to maximize expected profits

12. Light-handed regulation • The firm chooses price and effort to maximize profit in each state • Now more effort has an effect on the price • The firm exploits its market power • But effort cuts MC, which reduces the monopoly price • The overall effect is that The price with LHR is the same as with ROR • LHR dominates ROR in welfare terms, and not just on average • Why? The firm responds to the cost shock optimally under LHR, but will not change its effort level under ROR.

13. Price-cap regulation • Regulator fixes the price so that average cost in the worst state is just covered • PCR is fine if there is no asymmetry of information (the cost shock is known and constant) • As the cost shock becomes more variable it becomes more likely that rate-of-return regulation is better than price-cap, and thus that light-handed is better than the price cap

14. The lesson • In this model, with restricted regulatory options, light-handed regulation is better than rate-of-return, and can be better than price-cap • Light-handed regulation allows the firm to respond to cost shocks • With demand shocks such flexibility will usually be damaging • Well-intentioned regulation can unintended consequences • But we can always devise even better regulation • We could allow something in between full or zero passthrough • Better than either light-handed or price-cap regulation is a combination: price  price-cap

15. Specific regulation can be worse than nothing • Averch-Johnson (1962) effect • Rate-of-return regulation • Allowed rate exceeds the cost of capital • Costs are not minimized • Avoided if regulation fixes the price and reviews are stochastic • Price caps and relative prices (Cowan, 1997, 1998) • A tight cap on average revenue can induce the firm to set excessive prices in some markets to alter the weights in the index and allow prices in other markets to rise • This can also occur with a regulated price index with fixed weights: here the problem is excessively low prices in some markets • In both cases regulation is more likely to be worse than no regulation when the level of the price cap is low: regulation is “tough” • Avoided if price index is of Laspyeres-type (weights proportional to quantities and updated each period) – the “tariff basket”

16. The threat of regulation • Same as a firm choosing its price facing a possible fine for anti-trust abuse based on excess profits • If the probability of regulation (or of conviction) does not rise with the price the threat of regulation has no effect on pricing • The rate of increase of the probability as the price rises, as well as the level of the probability, matter for deterrence • The threat of regulation can achieve some of the outcome of direct regulation without the associated costs • But this doesn’t allow for investment decisions

17. New Zealand telecoms • Formalized light-handed regulation • Problems over access negotiations between Telecom and Clear • Recent move to specific regulation • Interconnection in other countries • Split of AT&T in 1984 partly because of anti-competitive behaviour by AT&T towards rivals • Pro-competitive determination of access prices for Mercury and British Telecom in 1985 in the UK, and subsequent direct regulation of access terms • Local-loop unbundling and broadband access – the modern version of an old story of interconnection controversy • Verdict: interconnection difficulties were predictable, maybe the possibility of binding arbitration should have been introduced

18. New Zealand electricity • Bertram and Twaddle (Journal of Regulatory Economics, 2005) do a careful accounting exercise to determine the excess profits earned by electricity distribution networks over 1995-2002 • Average variable costs fell from 1.85 to 1.25 cents/kWh in real terms • Output rose over this period by 18% • The physical asset stock was largely unchanged • Average cost pricing would have normally caused prices to fall • But average revenue rose from 3.49 to 3.88 cents/kWh • The asset base rose by $3.6 billion, of which $2.9 billion was due to unilaterally declared asset revaluations • The authors calculate that there was a $200 million over-charge each year, compared to what would have happened under a standard rate-of-return regime

19. Some problems • The study uses average revenue, but actual tariffs are multi-part, so the rent transfers identified need not imply allocative inefficiency • The study assumes (a) that the light-touch regime could have been replaced by perfect rate-of-return regulation that fully extracted rents and (b) that there would have been no resulting change in firm behaviour (no incentive effects)

20. Australian airports • Forsyth (2006) • Initial tough CPI – X price caps for the airports once corporatized and privatized (real price reductions of 20-25%) • Tariff-basket used • Losses incurred even before the shocks of September 2001 • Replaced by light-touch regulation in 2001/2 • After a review in 2007 the regime is to continue until 2012 • Deadweight losses probably unimportant, airport objectives not only profit-maximization • A success story for light-handed regulation?

21. UK gas • British Gas was privatized in 1986 • De facto light-handed regulation but with a specific regulator • CPI – 2 for transportation element of retail prices; full pass-through of gas purchase costs • No regulation of prices to larger customers • Weak regulation of access: regulator to determine price if no agreement • No competitive access for five years • Subsequent heavy intervention • Four investigations by the competition authorities (1988, 1991, 1993, 1997) leading to vertical separation • Tighter retail and access price regulation • Initial regulatory framework was unsustainable

22. Conclusions • Light-handed regulation has some attractions in theory • Saves on resource costs, the threat of regulation can keep prices low • In practice the record is mixed • New Zealand has moved away in telecoms and electricity • But the Australian airports example appears to be successful