Beyond regulation

1. Beyond regulation Stephen Littlechild ESNIE Cargese, Corsica 16 May 2006

2. Outline • The regulation literature – some elements • Other possible arrangements – what are they and how do they work in practice? • Transmission regulation in Australia • And in Argentina • Settlements in Florida • And in Canada • Conclusions and further research

3. Regulation literature

4. The early regulation literature • Early discussions C18, C19 • Smith, Mill, Pareto, Marshall, many others • Institutional economists C19 early C20 • Commons et al in US, others in Germany • Economic theory (welfare economics) • Pigou, Lerner UK 1930s, 1940s, Hotelling US 1938 • Engineering • Dupuit mid C19, Boiteux at EdF in France 1950s

5. Later regulation literature • The traditional regulatory process 1950s 1960s • Bonbright, Phillips, Trebing • The economics of regulation – marginal cost pricing – second-best 1950s, 1960s • Baumol, Graaff, Little, Lipsey & Lancaster • Kahn 1970: economic theory & regulatory practice • Mathematical optimisation models 1960s, 1970s • Peakload pricing: Steiner, Hirshleifer, Williamson, Littlechild • Optimal prices emerge as dual variables in optimisation models – extend to depreciation and uncertainty • Cooperative game theory models to share common costs • Aim to characterise optimal pricing and investment policies

6. Modern regulation literature 1 • Extension of optimisation models • Constrained optimisation • Alternative objective functions • Extensions to uncertainty • Non-cooperative game theory • Partial and general equilibrium models • Extensive theoretical literature • Generally from a normative perspective: • What ought the regulator to do?

7. Alternative paradigms • Economic sceptics re marginal cost pricing • Coase 1946, 1970: blackboard economics v institutions • Wiseman 1957: ‘empty box’ • How does regulation actually work? • Averch & Johnson 1962: distortions in practice • Stigler & Friedland 1962: what effect of regulation? • Public choice economics: regulatory objectives and political pressures, what kinds of regulation actually adopted • J of Law and Economics (ed. Coase) • Austrian economics • Imperfect knowledge, uncertainty, change, information, discovery, incentives, competitive market process • How should regulation reflect these ideas?

8. Modern regulatory literature 2 • Modern institutional economics • Coase on regulation (as above), theory of firm, social cost, transactions cost etc • Williamson on satisficing, transactions costs, governance of contractual relations, markets & hierarchies, vertical integration • Demsetz on property rights & economic organisation • Joskow on regulation in practice, vertical integration & contracts

9. Modern regulatory literature 3 • US & UK theory & practice re incentives • UK utility privatisations 1980s • Competition can replace some regulation • What kind of regulation until competition? • Littlechild report 1983: RPI-X incentive regulation instead of US rate of return • Widely adopted internationally • Emphasis from allocative to productive efficiency • Economic literature on incentive regulation • Laffont and Tirole combines with earlier theoretical work

10. Summary of regulation literature • A long history of economic analysis • One theme: formal optimisation models • Another theme: how regulation actually works • A third theme: incentive regulation • All these analyses assume that regulation is necessary where there is monopoly • Aim to replicate outcome if competition possible? • The regulator makes/influences the decisions • Perhaps considering views of other parties • But they do not have a central or decisive role

11. Regulatory decision-making Alternative arrangements?

12. Regulatory decision-making • If regulation replicates a competitive market, how to decide for market participants? • E.g. how much investment in security of supply would customers be willing to pay for? • How does the regulator know this? • Has to make judgements on their behalf • In practice, one size has to fit all • UK electricity sector: a dozen similar companies • All had to have same kind of price control • Too difficult to justify variations by company • Consequent lack of variety and experimentation • No learning process from different experiences • This is different from the competitive market process

13. Alternative regulatory models • Must the regulator take all the decisions? • Is there scope to allow market participants to make more decisions? • Deregulated markets now allow competition • But what if there is still monopoly? • How do such alternative systems work? • What difference do they make? • What are their pros and cons?

14. Some cases studied • Transmission expansion in Australia & Argentina • Australia: Merchant transmission companies are allowed to compete with incumbent transmission monopolies • Argentina: Transmission expansion decisions have to be proposed, approved and paid for by market participants, not by regulator or transco • Settlements in US especially Florida • Instead of traditional litigated process, settlements are often reached between utilities and Public Counsel and/or users, and are typically approved by regulator • To understand: how do these alternatives work?

15. Transmission expansion Alternative regulatory arrangements

16. Transmission expansion • Traditional regulated approach • TransCo decides what to build and when • Some regulatory input before or after • Remunerated via return on rate base • Merchant transmission now proposed • Independent investor decides what & when to build • No need for regulatory input? • Remunerated by charging users • Is merchant possible? Which is better?

17. Concerns about merchant • Alleged difficulties involved • Needs property rights on transmission lines • Needs nodal prices – these do not always exist • Externalities and economies of scale • Market power and incentive to undersize • Problems of integrating with existing network • Allegations • Merchant transmission may not be possible • Would be ‘too little too late’ • And likely to be other problems

18. Counterarguments • Arguments for merchant transmission • Quicker to respond to market signals • Better incentive to more efficient capex and opex • Potential problems with regulated transmission • Regulation does not ensure ‘optimality’ • Utilities have incentive to gold plate • Regulators concerned to avoid capacity shortages • So regulation could mean ‘too much too soon’ • Hence need to establish how the two systems operate in practice

19. Evidence? • Any evidence of how regulated and merchant investment works in practice? • Yes - interconnectors in Australia • Both regulated and merchant lines exist • Special case of transmission: 2 nodes • fewer problems: market prices already available • little problem to integrate with rest of network • How have they worked in practice?

20. Australia Evidence on alternative regulatory arrangements for transmission expansion

21. Australian background • Until 1990s, each Australian state government owned its electricity system • little interconnection between them • decision-making from political perspective • 1996 National Electricity Market NEM • Australian Competition and Consumer Commission ACCC now regulates transmission • Potential culture clash?

22. Two interconnectors • 1994 proposed interconnector between South Australia and NSW called SANI later SNI • 1997 “Independent study” found it economic • 1998 did not pass ‘customer benefits’ test • 1999 Murraylink merchant line announced • Similar capacity and route to regulated SNI • 2001 revised SNI passed regulatory test • Murraylink appealed to Appeals Tribunal • 2002 Aug Tribunal hearings, M-link onstream • 2002 Oct Tribunal decision

23. Is SNI economic? • SNI = interconnector + network reinforcement • TransGrid consultants IES quantified costs and benefits • NPV Benefits and costs (A$m NPV) of SNI projects • SNI Network Interconnector • (extra) • Benefits 264.5 351.4 -86.9 • Costs -98.4 -41.2 -57.2 • Net Benefit 166.1 310.2 -144.1 • My testimony: Network reinforcement is economic • But duplicate interconnector is not economic

24. Arguments at Tribunal • Transgrid • Murraylink would have market power • So could and would restrict output • Hence risk that network reinforcement underused • So cannot do network reinforcement alone • Murraylink • Murraylink would not have significant market power • Negligible restriction of network use (0.013%) • Tribunal majority decision Dec 2002 • Real risk of stranding so upheld regulatory decision • Murraylink took to Judicial review • Jul 2003: 0.013% not a real risk – appeal upheld

25. Conversion to regulated status • Meanwhile price differentials narrowed • Murraylink less profitable than expected? • Oct 2002 Murraylink applied for conversion to regulated status • ACCC allowed at half Murraylink’s proposed figure • Nov 2003 Murraylink accepted

26. Conclusions on Australia • Merchant investment may have flaws • Misjudged market – built too much too soon • But losses borne by investors not customers • And company learned from experience • Australian regulatory process flawed too • Delay, cost and political influence • poor economic analysis (including Tribunal) • legal errors (c.f. Court view of Tribunal) • unjustified stance by transmission company • regulated investment too much too soon – at customer expense, any learning from experience?

27. Argentina Evidence on alternative regulatory arrangements for transmission expansion

28. Argentina background • Argentina electricity reform 1992 • restructuring, privatisation, competition, incentive regulation of existing T and D networks • Mistrust of regulation • Decided that transco & regulator should not be responsible for transmission expansions • Public Contest method • Users to propose, vote & pay for major expansions • Construction O&M (COM) out to competitive tender

29. Received view of experience • Argentine electricity reform worked well • lower costs & prices, better service, more investment • But major caveat: method of regulating transmission expansion did not work well • Claimed externalities, free riders, transactions costs • But only one illustration of this: • Several years delay to much needed Fourth Line from Comahue (major generation source) to Buenos Aires (major demand centre)

30. ARGENTINA HIGH VOLTAGE TRANSMISSION GRID (500 kV) - 1992 BOLIVIA PARAGUAY El Bracho BRAZIL Resistencia Recreo Romang Malvinas Santo Tomé Río Salto Grande Grande Almafuerte URUGUAY Embalse Col.Elía San Javier Gran Mendoza Rosario To Palmar and Montevideo Campana Rodríguez Ezeiza Abasto Henderson CHILE Puelches Olavarría ¨ E N Planicie I L . Banderita h t 4 ¨ Bahía Blanca C.de la Costa Chocón Central Piedrabuena Choel Choel ¨ E N I L . P.del Águila h t 4 ¨ Alicura Viedma Futaleufú Existing line & substation Pto.Madryn Projected line & substation Cdoro.Rivadavia Pico Truncado

31. Fourth Line • Congestion increasing on this corridor • Sept 1994 3 generators proposed 4th Line • COM fee about $58m p.a. over 15 years • Public hearing Feb 1995 50% vote against • Surprise and concern, including by regulator • May 1996 revised proposal - accepted • Max fee $44m pa + $11m Salex = $55m • Nov 1997 winning bid $24.5m + $11m = $35.5m

32. Benefits & costs of 4th line • Ave congestion revenue = $30m p.a. • Capacity increase = 1/3 • Benefit = 1/3 x $30m = $10m p.a. • Cost • First proposal $58m p.a. • Second proposal: $24.5 + $11 = $35.5m p.a • Conclusion: 4th Line was not economic • Delay was socially beneficial, not costly • Cheaper to locate generation near demand instead • None of alleged problems materialised here • Public contest method worked well in other cases

33. Competition in construction • Bidding competitive: 2-3 bids in 5 cases • All these won by new independent cos • 4th Line: 4 bidders 13 bids (alternatives) • innovative technologies introduced • Cost reductions over time • pre-reform at least $230k/km • 1st & 2nd tenders (Govt) $267k/km, $170k/km • 4th Line $130k/km - so cost/km about halved • Bidding to construct was very successful

34. Assessment of Argentine policy • Public Contest method in fact worked well • Made better use of existing lines • Competitive tendering lowered costs • 4th line: delay not a failure of PC method • Regulation would have yielded to political pressures to build many uneconomic lines • PC method resisted political pressure • Led to more economic outcomes than regulation • Preferable if aim is efficient allocation of resources

35. Negotiated settlements US origins and early perceptions

36. Origin of negotiated settlements • Large backlog of rate cases at Federal Power Commission (FPC) in 1960s • 1960: over 2900 applications, 10 dealt with • 1960: 3200 requests, triple staff would take 82 yrs • FPC encouraged settlement • 1960-70: some or all of 56% cases • saved time and money, reduced uncertainty • some concerns about non-consenting parties (slow down process?) & non-participants (overlooked?) • Assumed settlement easier way to same end

37. Settlements at FERC • Successor FERC continued FPC policy • Federal Energy Regulatory Commission • 1980: 70% of gas pipeline rate cases settled • Wang (2004): 41 cases 1994-2000 • 34 settled in full, 5 settled in part, 2 litigated • savings in cost & reductions in uncertainty minimal • Settlement: different process & outcomes • looked at situation as whole, not item by item • more innovative outcomes not available to FERC • especially rate moratoria 21 of 39 settlements

38. Florida Evidence on nature of stipulations and settlements

39. Regulation in Florida • Public Service Commission FPSC 1897 • 386 staff, budget $27m • Office of Public Counsel OPC 1974 • single incumbent Public Counsel 25 years • duty “to represent the general public of Florida” • staff 15, budget $2.5m plus consultants • Scepticism about US consumer advocates • limited effect? tend to favour larger users?

40. FPSC rate cases

41. Stipulated settlements in Florida • Public Counsel represents customers • by challenging utility in regulatory hearings • also by negotiating stipulated settlements with utility, then inviting FPSC to approve • FPSC staff not now involved in talks • All stipulations were accepted in total, no cherry-picking (unlike California)

42. Types of case where OPC signed stipulations, 1976-2002

43. Florida PSC earnings review cases 1976-2002

44. FPSC rate cases and OPC stipulations

45. Who benefits? • Cost savings relatively small (<1% value) • Customers: bigger and earlier rate reductions • note staff/FPSC views + lack of reduction before • Confirm larger users benefit more in some ways • Utilities: less uncertainty & embarrassment? • Utilities get what FPSC could/would not give • e.g. Removal of objection by others to merger • Flexibility on accounting provisions (depreciation) • Revenue sharing (not profit caps or earnings sharing) • often despite objections of regulatory staff

46. Conclusions on Florida • OPC stipulations are significant in Florida • 77% of rate reductions since 1976 • They benefit customers • OPC got greater & earlier rate reductions • especially for industrial electricity customers • but residential customers still benefit overall • And lead to changes in regulatory policy • More flexibility on depreciation etc than staff/FPSC • More innovative forms of incentive regulation

47. Conclusions

48. Conclusions • Many economic analyses assume that monopoly necessitates regulation • And that regulator will replicate competitive market • But there are examples where market participants play a major role • Australia, Argentina, FERC, Florida (also Canada) • These systems actually work well • better than widely believed • The outcomes are different from regulation • And often more economic, better for most parties • Scope to encourage elsewhere – and research