Market-Based Regulatory Mechanisms in Re-structured Network Industries Frank A. Wolak Department of Economics Stanford University Stanford, CA 94305-6072 wolak@zia.stanford.edu http://www.stanford.edu/~wolak Chairman, Market Surveillance Committee California ISO Outline of Talk • Market Design in Network Industries – Definition of Market Design Problem – Public versus Private Ownership – Regulation versus Competition – Costs versus benefits of both choices • For each segment of electricity industry evaluate this choice – Generation – Transmission – Distribution – Retailing 1
Market Design Problem • Maximize market designer’s payoff function (which depends on market outcomes) by setting – Number and size of market participants – Rules for determining revenues each firm receives • Subject to constraints that all market participants will choose their strategies to maximize profits given rules set by market designer • Competitive market may not always maximize market designer’s payoff function Adam Smith on Market Design • “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.” • The Wealth of Nations, Book I Chapter II 2
Principal-Agent Problem • Principal would like agent to behave in a way that maximizes principal’s payoff function but agent behaves to maximize its own payoff function given market rules set by principal – Example from vertically-integrated US electricity industry • Principal is regulator • Agent is vertically-integrated monopoly supplier – Regulator would like firm to produce at minimize cost so that it can set low regulated price that only recovers this cost • Unfortunately regulator cannot observe firm’s true minimum costs of production, only incurred costs of production – Must design incentive scheme for compensating firm that leads profit-maximizing firm to produce at minimum cost • Examples include, cost-of-service regulation, price-cap regulation Principal-Agent Problem • Optimal compensation scheme for regulator to set for firm depends on – Preference or payoff functions of regulator and firm – Informational asymmetries between the firm and regulator • Competitive market is one of many possible incentive schemes that can be used to solve this agency problem – Strong incentives for minimum-cost production by firm – Market may not pass on these minimum costs in prices • The conditions which guarantee a competitive market solves this agency problem may not hold for electricity – One condition is atomistic (very small relative to the size of the market) buyers and sellers 3
Optimal Market Design • Optimal market design unknown – Depends on market structure – Objective function of market designer • Proposed objective function for market designer – Lowest possible average annual delivered price consistent with financially viable industry – In economist’s language--maximize consumer surplus subject to marginal firm in industry earning zero economic profit • Minimum requirement for competitive market is lower average price than under vertically-integrated regime – Otherwise it is hard to rationalize industry restructuring Optimal Market Design--Electricity • Four segments of electricity supply industry – Generation – Transmission – Distribution – Supply • For each segment, market designer has option to design a regulatory mechanism, one of which could include a competitive market • Provide optimal market design rationale for this choice for each segment of industry 4
Necessity of Market Design • Most markets do not require explicit market design process – Markets evolve from locations where economic agents trade • New York Stock Exchange (NYSE) • Economic agents are free to trade at any market they like – Buyers search for markets offering lowest selling price – Sellers search for markets that offer highest buying price • Why do network industries, particularly electricity, require market design process? Necessity of Market Design • Network required to deliver electricity – Despite Nikola Tesla’s attempts, cannot beam electricity to final customers – Cost structure favors a single transmission network for a given geographic area • Network owner is privately-owned and regulated or government-owned in all markets – All generation owners have equal access to network – All electricity markets require single entity that manages transmission network • This requires designing a regulatory mechanism – To compensate entity that manages transmission network – To set prices charged for use of transmission network 5
Regulation versus Competition • Choice is not de-regulation versus regulation, but how much and what aspects to regulate • All markets are regulated – Anti-trust, Consumer safety, Environmental quality • Re-structuring is an alternative regulatory mechanism for attaining higher value for principal’s objective function than vertical integration – For market to be superior regulatory contract it must do a better job of solving market design problem Regulation versus Competition in Electricity Supply • In competitive generation regime, unregulated monopoly supplier of transmission and distribution services can set prices for use of network that results in monopoly price for delivered electricity – Price of transmission and distribution services must be set by independent regulator or government • In vertically-integrated monopoly regime, unregulated firm can set monopoly price for delivered electricity – Output price of vertically-integrated monopoly must be set by independent regulator or government • Both regimes require regulation of some services 6
Regulation versus Competition • “Competitive” regime restricts regulated portion of industry to smallest entity possible – Transmission and distribution are only services with their prices set through a regulatory process – Generation and electricity retailing are open to competition • Economies of scope difficult to capture under this regime • “Vertically integrated” regime imposes regulatory process on all aspects of industry – Final output price of vertically integrated monopoly is regulated--economies of scope possible • Choice between regulation and competition depends which regime achieves market designers objectives Re-structuring not De-regulation Construct alternative market structure (vertical separation) and industry-wide regulatory process to price or cost-of-service regulation Allow market as opposed explicit regulatory process to discipline prices consumers pay in some segments of industry Market still requires regulatory oversight, just a different form Agency relationship between firms and regulator remains Conflict between regulator's objectives and firm's objectives Firm still wants to maximize profits and it does this by increasing its price New form of "regulation" gives rise to a new set of problems Market Power—Ability of firms to increase the market price and profit from this price increase Explicit exercise of market power is not possible under traditional forms of regulation because regulator, not firm, sets market price--Wolak (1994) has examined this issue in context of traditional regulatory process 7
Dimensions of Market Design Problem • Government versus Private Ownership • Regulation versus Competition • Regulation of market necessary because – Transmission network is required to deliver electricity to final customers – Technology is such that duplicate networks for same geographic area is socially wasteful • Both of choices by market designer are continuous (a question of degree) rather than binary (yes or no). Private versus Public Ownership • Ownership – State ownership--firm’s assets owned by government – Private ownership--firm’s assets owned shareholders • Shareholders invest in company in exchange for current and future cash flows from firm’s operation • Control – State ownership--management of firm appointed by government – Private ownership--management of firm appointed by shareholders 8
Different Agency Relationships • Public Ownership – Principal--Government, politicians, ultimately voters – Agents--Firms • Private Ownership – Principal--Shareholders of firm – Agents--Firms • Objectives of two principals differ – Market outcomes differ because different principals set different compensation schemes for firm – Technology and structure of demand constant Private versus Public Ownership • Private ownership--Shareholder’s desire for net cash flows exerts pressure on firm’s management to maximize profits (return to capital invested) – Unregulated firms have incentive to set prices substantially above average cost to produce output • Public ownership--Management has incentive to pursue interests of government that owns it – Government may not wish to minimize production costs – Firm’s management has little incentive to set price substantially above average cost to produce output 9
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