Infrastructure Regulation and Investments g Peter Forsyth y - - PowerPoint PPT Presentation

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Infrastructure Regulation and Investments g Peter Forsyth y Department of Economics Monash University Monash University INFRADAY TU Berlin INFRADAY, TU Berlin October 10-11 2008 www.monash.edu.au Key Points: Key Points: Problems

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Infrastructure Regulation and Investments g Peter Forsyth y Department of Economics Monash University Monash University INFRADAY TU Berlin INFRADAY, TU Berlin October 10-11 2008

www.monash.edu.au

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Key Points: Key Points:

  • Problems exist in evaluating and handling wider

economic impacts of infrastructure investment in a regulated firm context in a regulated firm context

  • Price caps need not lead to under investment

and can work well but lead to profits and can work well, but lead to profits

  • Conditional trigger price caps can resolve the

“excess profit” problem excess profit problem

  • But give the regulator large discretion and can

lead to excessive investment

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Outline Outline

  • The problem of regulating investment
  • Regulators’ objectives

Regulators objectives

  • Price regulation and incentives for investment
  • The evaluation of investment
  • The evaluation of investment
  • Structural and institutional options
  • Conclusions
  • Conclusions

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The Problem of Regulating Investment The Problem of Regulating Investment

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Significance of the Problem Significance of the Problem

  • Infrastructure investment done extensively by

(regulated) monopolies ( g ) p

  • High cost of mistakes and bottlenecks
  • Few alternatives- other firms cannot invest

Few alternatives other firms cannot invest

  • Market power is present and can be used to

fund excessive investment

  • There may be wider economic benefits from

infrastructure

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Regulatory Theory Regulatory Theory

  • Relatively little attention given to investment

incentives until recently

  • Adequate capacity at time of

privatisation/corporatisation M f bli t i t l t d

  • Move from public enterprise to regulated

private enterprises

  • Incentive regulation: regulator imperfectly

Incentive regulation: regulator imperfectly informed about operating costs, cost of quality, and cost of increasing capacity

  • Price caps- a practical form of IR

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Investment Investment

  • To increase capacity or output; to

improve quality to reduce congestion improve quality, to reduce congestion (mix of the two) Objectives for efficiency: achieving the

  • Objectives for efficiency: achieving the

right quantity/ capacity, the right quality, minimising cost of investment minimising cost of investment

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Other Issues Other Issues

  • Regulatory gaming

Problem of long term commitment of

  • Problem of long term commitment of

regulator

  • Handling risks

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Regulators’ Objectives Regulators Objectives

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Welfare Maximisation Welfare Maximisation

  • Typical model: sum of consumers and

producers surpluses (plus tax) producers surpluses (plus tax)

  • Surpluses may have different weights
  • Regulator might only be concerned

about consumers surplus

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Actual Objectives Actual Objectives

  • Keep profits low- prices close to average

costs costs

  • Profits of monopolies likely to be

controversial controversial

  • Regulator may be set narrow objectives

by the government (look after consumer by t e go e e t ( oo a te co su e interests)

  • Making sure that investment happens

g pp may become an imperative

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Political Pressures on Regulators Political Pressures on Regulators

  • Keep prices and profits down- can lead

to under investment to under investment

  • Invest regardless of cost- resolve the

“infrastructure crisis” “infrastructure crisis”

  • Can flip between these quickly

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Information Asymmetry and Profits Information Asymmetry and Profits

  • Firms possess better information than

regulators g

  • IR models require rents for superior information
  • Regulators cannot keep P=LAC and still

Regulators cannot keep P LAC and still achieve efficiency

  • Profits could be large in some cases

g

  • This can lead to problems of inadequate

investment if regulators seek to keep prices and profits down

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Price regulation and Incentives for Investment

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Price Caps Price Caps

  • Concern that price caps lead to under

investment investment

  • Not necessarily the case- may or may

not be so not be so

  • Variants of price caps (conditional

i ) l d i triggers) can lead to excessive investment

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The Problem The Problem

  • Existing capacity at K1 is adequate now

Demand forecast to increase from D1 to

  • Demand forecast to increase from D1 to

D2

  • Price cap is in place
  • Various cost conditions will be

considered

  • Indivisible investment (K1 to K2), but

( ), LMC curve will be used

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Constant Costs Constant Costs

  • Price cap is sufficient to cover the cost
  • f investment
  • f investment
  • Firm makes small profit from investing
  • No problem

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Price, cost Output Output, capacity

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Opportunistic Regulation Opportunistic Regulation

  • Regulator wants to keep profits low

Perhaps regulator has poor information

  • Perhaps regulator has poor information

about replacement costs f

  • Firm earns “profits” even when

p<LAC=LMC

  • Price too low to encourage investment
  • Inadequate investment

q

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Price, cost Output, capacity

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Increasing Costs of Investment Increasing Costs of Investment

  • Extra tranche of investment will be more costly

(e.g. adding extra rail lines to existing track, ( g g g , extra port facilities in confined spaces)

  • Firm is currently profitable at p1
  • Will not expand capacity beyond K1
  • Can set an unconditional price cap at p2, and

p p p firm will invest

  • Will mean high profits for the firm even in the

LR

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Price, cost Output, capacity

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Conditional Trigger Price Caps

  • Same cost conditions as before

Regulator offers price cap of p IFF firm

  • Regulator offers price cap of p IFF firm

makes the investment

  • Extra revenue just covers the extra costs
  • Firm invests
  • Firm profit increases slightly

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Price, cost Output Output, capacity

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Unknown Investment Cost Unknown Investment Cost

  • Under unconditional price cap, regulator can
  • ffer p2 (high profit)

C t i ht b LMC1 LMC2

  • Cost might be LMC1 or LMC2
  • Conditional trigger- regulator offers p1- no

profits profits

  • If trigger depends on actual investment

expenditure then regulation is effectively cost based based

  • Weak incentive to minimise cost
  • Conditional triggers could be set without regard

gg g to actual expenditure to improve incentives

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Price, cost Output, capacity

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Excessive Investment Excessive Investment

  • Benefits of investment are less than costs-

investment not worthwhile

  • At cap of p1, extra investment is not worth

while R l t ff diti l hi h i f 2

  • Regulator offers conditional higher price of p2-

extra revenues cover extra costs

  • Using monopoly power to fund excess

Using monopoly power to fund excess investment

  • Could be done through cross subsidisation
  • “But this is happening under price caps!”

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Price, cost O t t Output, capacity

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Investments in Quality Investments in Quality

  • Higher quality shifts up costs
  • Users are willing to pay for higher quality

g p y g q y

  • Firm gains little from offering higher quality

under p1

  • Regulator can offer conditional cap of p2 if firm

supplies higher quality

  • In this case a conditional trigger is necessary
  • In this case, a conditional trigger is necessary
  • But the regulator may be poorly informed about

the cost of quality and users WTP the cost of quality and users WTP

  • Similar for the congestion case

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Price, cost Output

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Conditional Trigger Price Caps in Perspective

  • Can encourage investment while keeping prices

and profits low p

  • More demanding of information than

unconditional caps

  • If expenditure is used as the trigger, poor

incentives for keeping investment costs low

  • Consistent with excessive investment
  • More discretion to the regulator

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Investment and Regulation in Australia Investment and Regulation in Australia

Industry Adequacy Telecoms Inadequate Telecoms Inadequate Airports Slight Excess Rail Track Excess and Inadequate Rail Track Excess and Inadequate Water Excess Developing G Pi li Ad t Gas Pipelines Adequate Urban Transport Risk of Excess Electricity Adequate Coal Loaders Inadequate

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The Evaluation of Investment The Evaluation of Investment

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Wider Impacts and Investment Assessment Wider Impacts and Investment Assessment

  • Infrastructure investment typically involves more than

just producers and consumers surpluses E t liti ( h i i l ti

  • Externalities (greenhouse emissions, agglomeration

benefits), shadow pricing (labour under unemployment); impacts on substitutes (rail investments and road congestion) congestion)

  • Traditional response: do a cost benefit analysis
  • Government can do this- but will a regulator?
  • Government can set parameters (carbon price through an

ETS; noise charges)

  • This issue is not resolved well

This issue is not resolved well

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Structural and Institutional Options Structural and Institutional Options

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Options for Regulators Options for Regulators

  • Competition at some levels may be feasible

(changes regulatory options)- e.g. in electricity generation generation

  • Vertical structure of firms- can impact on

regulatory problem

  • Light handed regulation- can facilitate deals

between users and supplier, but also can lead to over investment to over investment

  • Overall institutional environment: how can

institutions be set up so that regulators pursue efficiency and recognise wider impacts? efficiency and recognise wider impacts?

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Conclusions Conclusions

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Conclusions Conclusions

  • It is difficult to handle the wider impacts in the regulated firm

model

  • In practice, regulators often have objectives inconsistent with

p , g j efficiency (such as keeping profits low)

  • Unconditional price caps can work well to encourage

investment for capacity, though not for quality improvement or congestion reductions congestion reductions

  • They will lead to high profits
  • Conditional trigger price caps can be used to encourage

efficient investment and keep profits down p p

  • But they can lessen incentives to reduce the costs of additions

to capacity, may depend on the regulator having good information, and can easily be used to encourage excessive investment investment

  • In an “infrastructure crisis” environment, the last point is a real

concern

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Vielen Dank! peter.forsyth@buseco.monash.edu.au pete

  • syt @buseco
  • as

edu au

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