Strategic choice of financing systems in regulated and interconnected industries

1. Strategic choice of financing systems in regulated and interconnected industries

2. Liberalization and regulation • Liberalization of network industries • Infrastructures are essential facilities • Large returns to scale • Huge fixed costs • Investments • Regulation of access • railways, telecoms… • to finance infrastructure

3. Liberalization and globalization • Volume of international transactions using many networks  Competition on the markets Interaction between regulations • Strategic impact of national regulatory modes/financing systems on international services

4. Financing systems/regulatory modes • Railways in Europe Percentage of infrastructure deficit covered by access revenue • Rmk: Only positive transfers • Similar issues in other network industries

5. The questions • Nature of the interaction between the access pricing decisions of national regulators that face international services • Interaction between access pricing decisions affects the choice of financing systems • Nature/specificities of the regulatory competition between network managers

6. Model - 1 • Two countries, infrastructure manager IMi • International final services, q*(p*), requires the access to both infrastructures • First (budgetary) externality between countries • Net surplus S*(q*)is shared across countries:i+j=1 • Second (direct) externality between countries • IMi decides: • Access price a*i for the use of his infrastructure • Transfer tito finance the infrastructure • Downstream operators are competitive: p*=a*i+a*j+cd

7. Model – 2 IM2 IM1 Transfer 1 Access price 1 Transfer 2 Access price 2 Infrastructure 2 s.t. break-even constraint Infrastructure 1 s.t. break-even constraint Final sector: Final price/quantity depends on both access prices

8. Model – 3 • IMi’s Budget Balance constraint (BBi) : ti+(a*i-cu)q*(p*(a*1,a*2))≥ ki • IMi’s objective SWi=i S*(q*)-(1+pf)ti+ti+(a*i-cu)q*-ki IMi : a*i and ti IMj : a*j and tj Downstream Operators p*=a*i+a*j+cd

9. Ramsey-Boiteux Access Pricing Principles • Perfect cooperation between IMs(a*=ai*+aj* , t) • Optimal access price • Trade-off between the two instruments

10. Simultaneous choices of modes of regulation-1 • Transfers and access prices are decided simultaneously and non-cooperatively

11. Simultaneous choices of modes of regulation- 2 • Given a*j, • Strategic interaction • Transfer in country i

12. Simultaneous choices of modes of regulation- 3 • Hyp: • Stable & unique equilibrium • Access prices excessive

13. Assumptions on infrastructure costs

14. Simultaneous choices of modes of regulation- Positive subsidy only-1 • IMi chooses ti=0

15. Simultaneous choices of modes of regulation- Positive subsidy only-2 • Consider that • Multiple equilibria • NS-equilibrium unstable • S-equilibrium is stable • Access prices are lower in the NS-equilibrium • Similar features when access prices are strategic substitutes under the subsidy-system

16. Strategic role of infrastructure costs in the NS-equilibrium • Why are the access prices lower when both infrastructure managers adopt the no-subsidy financing system? • Infrastructure fixed costs act as a commitment device to behave `aggressively’ • Therefore, IMs might have poor incentives for cost-minimization under the NS-equilibrium • Scope for a strategic use of investment

17. Impact of supra-national policies aimed at developing international services • International services are excessively charged • Standard solution: subsidize the acess to infrastructures to soften the distortions • But, the impact of such policy depends on the equilibrium! • Subsidies to infrastructures must be contingent on the regulatory modes implemented in the countries

18. Sequential choices of financing systems-1 • The mode of regulation has a commitment value • It binds the infrastructure managers in the access pricing decisions • Can countries use the mode of regulation in order to improve welfare? • Two-stage game: • Choices of modes of regulation • Choices of access prices

19. Sequential choices of financing systems-2 • Resolution by backward induction • Given financing systems in both countries, determine the access prices • Immediate • Analysis of choices of regulatory modes • Given the financing system in country j, what is the preferred financing system in country i? • The choice of financing system has two effects: • Direct effect: on the access price set in country i • Strategic effect: on the access price set in country j

20. Best-response in financing systems- Remark • Infrastructure manager distorts access price (reduces consumers’ surplus) to ensure the financing of infrastructure (increase the infrastructure profit) • To satisfy a strict budget constraint in a non-cooperative setting: • Either reduce the access price to increase demand • Or increase the access price to increase the margin • Which strategy is chosen by an IM depends on the reaction of the other IM

21. Best-responses in financing systems- 1 • Country j chooses No-Subsidy • If one country chooses No-Subsidy, the other country chooses No-Subsidy • The commitment to a strict-budget balance creates a strong strategic complemen-tarity, which provides an IM with an incentive to adopt the NS-system in order to reduce access prices • This holds whatever • (NS,NS) always an equilibrium (NS,NS) (S,NS)

22. Best-responses in financing systems- 3 • Country j chooses Subsidy and • If one country chooses Subsidy, the other country chooses Subsidy • Multiple equilibria in the strategic game • Infrastructure managers are `conservative’ • An IM is willing to reduce the access price onlt if he anticipates a sufficiently strong decrease of the access price set in the other country

23. Best-responses in financing systems- 4 • Country j chooses Subsidy and • If IMi chooses NS, then a*i increases • Then, IMj reacts by decreasing a*j, but to a smaller extent • Total access price increases • IMi saves on the subsidy given to the infrastructure under S but reduces consumers’ surplus

24. Best-responses in financing systems-4bis • Country j chooses Subsidy and • If the strategic reaction in country j is strong: • Country i chooses NS and total welfare decreases • But then country j will also choose NS • NS in both countries is the unique equilibrium of the strategic game! • If the strategic reaction in country j is weak: • The choice of financing systems depends on the infrastructure fixed cost: • ki small: Incentive to free-ride and choose NS • Unique equilibrium • ki large: No incentive to free-ride and choose S • Multiple equilibria

25. Strategic choices of financing systems- Summary • Financing systems might be used as a coordination device and enable the infrastructure managers to reach the Pareto-superior equilibrium • However, infrastructure managers might have free-riding incentives • Issues • Renegotiation-proofness • Incentives in presence of domestic and international services

26. Strategic choices of financing systems- Renegotiation-proofness • Ex post, an infrastructure managers might be tempted to deviate from his equilibrium access price • Financing systems must credibly commit the infrastructure managers • Separation of access pricing and choice of regulatory mode NS-equilibrium

27. Extensions- 1Domestic and international services • Consider that services are purely domestic • No externality between infrastructure managers • No distortion wrt 1st-best perfect cooperation case • If international services > domestic services: • Whatever the `initial’ choices of regulatory modes, infrastructure should to be less subsidized • Role of a supra-national authority to coordinate the transition • If international services < domestic services: • No mandatory adoption of no-subsidy

28. `Pass-through’ country- 1 • Consider j=0 • Budget constraint never binding in this country • Since taxation is distortionary, tj=0 • Then: • Analysis similar to the choice of regulatory mode in one country when the other country chooses subsidy… except that…

29. `Pass-through’ country- 2 • Whether the budget-constraint is binding might be endogenous When a*j is sufficiently low, the budget constraint might not be binding in country i This creates the possibility of another equilibrium in which the budget constraint is not binding and access prices are low

30. Conclusions • Interaction between infrastructure managers with direct and budgetary externalities • Commitment to strict budget balance binds infrastructure managers to behave aggressively • Potential coordination problems • No-subsidy is Pareto-superior but unstable • Subsidy is Pareto-inferior but stable • Supra-national policies to promote international services through infrastructure subsidies might have perverse effects • Financing systems might be used strategically to free-ride

31. Further research • Strategic role of investment • Interconnection • International competition and the incentives for cost-minimization (agency problem)