Public Utility Economics, Regulation and Sectoral Reforms

“PUBLIC UTILITY ECONOMICS, REGULATION AND SECTORAL REFORMS”

1.0 INTRODUCTION

This course combines material from several graduate level courses in Economics and Public Policy and it was complemented with international consulting work. The purpose of the course is to introduce the participants to the key aspects of public utilities economics, regulation and sectoral reform planning. This course is designed in such a way to provide the theoretical tools as well as the fundamental practical approaches in order to understand the regulatory process, competition issues as well as competition policy, quality of service, prices and rate making, costs structures, monitoring issues and strategic regulation and planning of sectoral reforms (privatization) of public utilities.

This course was originally prepared by the author under the sponsorships of the Panamanian Antitrust and Consumer Affairs Commission (Comisión de Libre Competencia y Asuntos del Consumidor de Panamá – CLICAC ) and the Inter-American Development (IDB). This advance graduate course is taught in 36 hours.

2.0OBJETIVES

The objectives of the course can be summarized as follow

To familiarize the participants with the common and the specific characteristics of the many public utilities (electricity, telecommunications, transportation, water-wastewater and solid waste).
To familiarize the participants with the analytical tools that are most important for the effective regulation of public utilities.
To present and review some international experiences on public policy and regulation of public utilities.
To present the different types of costs, prices and tariff structures that is applied in regulating public utilities.
To work with participants in developing and calculating a rate model for the regulation of public utilities.
To provide a solid foundation for the use of analytical methods and quantitative techniques to properly regulate and reform public utilities.

3.0COURSE CONTENT

The course is made up of six sessions. The topics covered in each session are the following:

SESSION I : Introduction, Practical and Theoretical Concepts for Regulating Public Utilities

SESSION II : Natural Monopoly and Financial Aspects Applied to Public Utilities Regulation

SESSION III: Different Regulatory Models and Objectives of Rate Models

SESSION IV : Types of Cost, Prices, Rate Structure and Cross-Subsidies

SESSION V : Rate (tariff) Making in Practice

SESSION VI : Regulation, Private Sector Participation, and Sectoral Reforms

We sincerely hope that the participants will find these sessions very stimulating and informative, and that it will help participants to improve in their dealings with regulation of public utilities.

SESSION I: INTRODUCTION, PRACTICAL AND THEORETICAL CONCEPTS FOR REGULATING PUBLIC UTILITIES

1.0 Review of the Theoretical Concepts Applied on Regulation of Public Utilities

1.1 Agency Theory and Monopolies

1.2 Ratchet Effect

1.3 Averch-Johnson Effect and Rate of Return Model

1.4 Free riding, Rent-seeking, Contracts and Regulation

1.5 Regulatory Capture, Asymmetry of Information and Designing Institutional Framework

2.0 Theory of Political Economy and Regulation

2.1 Theory of Public Choice and Interest Groups

2.2 Commitment, Uncertainty, Incentives and Credibility of the Regulatory Policy

2.3 Equity-Justice and Efficiency Concepts

2.4 Property Rights and Effective Regulation

2.5 Transaction Costs, Asset Specificity, Contracts and Regulation

3.0 General Concepts of Regulation in Public Utilities: Practical application

3.1Natural Monopoly and the Need for Regulation

3.2Designing Regulatory Framework: Industry Characteristics, Institutional Environment and Performance

3.3General and Specific Regulatory Framework for Public Utilities Regulation

3.4Introduction to Regulation and Markets: competition for the market-services

3.5Regulation, Private Sector Participation (PSP), and Privatization

3.6Gains from PSP in Public Utilities and Distribution of Efficiency Gains

SESSION II: NATURAL MONOPOLY AND FINANCIAL ASPECTS APPLIED TO REGULATION OF PUBLIC UTILITIES

1.0 Natural Monopoly and Characteristics of Some Public Utilities

1.1Natural Monopoly Concept

1.2General Characteristic of Different Public Utilities (Telecommunications, Electricity, Water, Gas)

1.3Functional Categories and Potential Competition

1.4Industry Specific Aspects in some Public Utilities and the Institutional Environment

1.4.1Specific Aspects of the Electrical Sector

1.4.2Specific Aspects of the Water and Wastewater Sector

1.4.3Specific Aspects of the Telecommunications

1.4.4Specific Aspects of Solid Waste Management

1.5Firm, Industry Specific Aspects, Institutional-Regulatory Environment and Performance

1.6Designing Regulatory-Institutional Frameworks

2.0 Financial Aspects Applied to Regulation

2.1The Importance of Cost of Capital in Regulation

2.2The Concept of Cost of Capital

2.3The Different Techniques for Estimating Cost of Capital (CAPM, Bond Yield Premium, etc)

2.4Debt-Equity Ratio, Risk and Cost of Capital

2.5Asset Valuation

2.6Estimating Depreciation: Accounting Versus Real Depreciation

2.7Regulatory Capital and Estimating the Cost of Capital in Regulation Capital

Application: Depreciation and Discounting the Real Investment for Rate Setting: Implications for the effective regulation and the elimination of rent-seeking activities

Application: Review of Cost of Capital in Electricity, Telecommunications, Water and Solid Waste

3.0 Regulation of Natural Monopolies

3.1Optimum Regulation without Prices

3.1.1Auctions

3.1.2Competition for the Market

3.1.3Contestability and Competition for the Market

3.2 Introduction to the Different Regulatory Models

SESSION III: DIFFERENT REGULATORY MODELS AND OBJECTIVES OF RATE MODELS

1.0 Regulatory Models: different models and regulation in practice

1.1 Pure Rate of Return Regulation

1.2 Pure Price-Cap Regulation

1.3 Incentive Regulation

1.3 Hybrid Models

1.4 Yardstick Regulation

1.7Benchmarking Regulation

1.8Regulation through a Model Company (theoretical model regulation)

1.9Threat Regulation

2.0Regulatory Model with Cost Pass-Through. Cost Pass-Through and Effect on efficiency

2.1 Regulatory Models and Cost Pass-through

2.2The Use and Abuse of Cost Pass-through

2.3Price Cap Model and Cost Pass-through: implications for efficiency gains

Exercise: analyze the regulatory models applied to the telecommunications and electricity sector.

3.0 Objectives and Principles for a Rate Model (Tariff Structure)

3.1 Basic Objectives of Rate Model or Tariff Structure

3.2 Rate Model Objectives in a Context of a Private Sector Participation (sectoral reform)

3.3 Distributive Aspects in the Rate-Setting Process

Debate (pure economics vision versus the political economy vision): the objective of equity and justice. Problems for economists and regulators.

Debate: the objective of efficiency and the applicability of marginal costs.

SESSION IV: TYPES OF COST, PRICES, AND RATE STRUCTURE

AND CROSS-SUBSIDIES

1.0 Different Cost (prices) Normally Applied in Regulation and Cost Allocation Concept

1.1Marginal Cost

1.2Fixed and Variable Costs

1.3Different Types of Costs Normally Applied in Regulation

1.3.1Incremental Cost (IC)

1.3.2Average Incremental Cost (AIC)

1.3.3Long-run Incremental Cost (LRIC)

1.3.4Stand alone cost (SAC)

1.3.5Other costs (embedded cost, fully distributed costs, etc)

1.4Cost Allocation Techniques and Fully Distributed Cost

2.0 Prices and Regulation

2.1Marginal Prices

2.2Ramsey Prices and Inverse Elasticity

2.3Ramsey Prices and Distributional Concerns

2.4Volsengang-Filsinger Mechanism and Price Basket

3.0 Linear Rates and Non-Linear Rates (Rate Structures)

3.2 Linear Rates

3.3 Non-Linear Rates: increasing and decreasing block rates

a)Two-Part (Block) Rates

b)Multiple Block Rates

4.0 Price Structure and Cross Subsidies

4.1Different Definition of Cross-Subsidies

4.2Methodology for Detecting Cross-Subsidies

4.3Cross-Subsidies, Prices and Competition

4.4Cross-Subsidies, Equity and Efficiency

4.5Key factors in Designing Cross-Subsidies in a Price Structure

4.6Cost-Benefit Analysis of a Cross-Subsidy: application to the water sector of Panama

Application: Selecting the rate structure according to the objectives of the rate model and the relationship between efficiency and other objectives (cross subsidies, equity and justice)

Debate: objectives of rates models for electricity and telecom sector in different countries (USA, Chile, Panama)

SESSION V: BUILDING A RATE MODEL IN PRACTICE

1.0 Rate Making in Practice (developing a rate model)

1.1Workshop on Rate Making in Practice

1.2Characterization of the Systems and Brake-down

1.3Investment Plan and Long-Run Costs

1.4Application: building a water and wastewater rate model.

2.0 Other Elements of Regulation and Conceptual Framework

2.1 Periodic Reviews and Rate Rebalancing: the effect on efficiency

2.2 Periodic indexation of costs (polinomic adjustment versus unitary adjustment)

2.3 Quality of Service

2.4 Rules and Information Systems for Effective Regulation

2.5 Other Aspects of Regulation (forms and conflict resolution structures, etc)

Application: quality of service in the telecommunications industry in different countries (USA, Panama, etc.)

SESSION VI: REGULATION, SECTORAL REFORM AND PRIVATE SECTOR PARTICIPATION

1.0 Privatization and sectoral reform

1.1Why privatize?

1.2Privatization Theories in Practice

1.3Review of Privatization Experiences: what went wrong

1.4Reform without Privatization

1.5Privatization: Future Challenges for Policy Makers and Consulting Industry

1.6Conceptual Framework for a Sectoral Reform and/or Privatization

1.7Designing Privatization:

a)Market Segmentation and Integration Rules

b)Non-Price Regulation

c)Roles of Institutions, and Regulatory Agencies

d)Stakeholder Analysis and Regulation

1.8The Critical Path of Privatization: risk analysis

1.9The New Concept of Sustainable Privatization

2.0 Different Forms of PSP, Evaluating PSP and Strategic Regulation

2.1 Privatization Stages: pre-post privatization and risks

2.2Strategic Planning in Privatization: defining the key studies needed

2.3Analysis, Studies and Regulatory-Institutional Framework

2.2Existent Inefficiencies and Sectoral Reform (privatization)

2.3Implementing a Sectoral Reform (privatization)

Application:

Strategic planning for electric sector reform
Strategic planning for telecommunications
Strategic planning for water and wastewater sector

COURSE MATERIAL AND TECHNICAL REFERENCES

1.- BOOKS

As reference material the following books are required. These books are given as part of the present course

Amstrong, M., S. Cowan y John Vickers. Regulatory Reform: Economic Analysis and British Experience. Cambridge, Massachusetts: The MIT Press, 1994.

Basañes, Federico, E. Uribe y R. Willig, ‘Can Privatization Deliver: Infrastructure for Latin America?” InterAmerican Development Bank, Distributed by Johns Hopkins University Press, 1999.

Bishop, M., John Kay, y Colin Mayer. The Regulatory Challenge. Oxford University Press, 1995.

Ingo Vogelsang, y Bridger M. Mitchell Telecommunications Competition: the last ten miles. Cambridge: MIT Press, 1997
Sappington, David y Dennis Weisman. Designing Incentive Regulation for the Telecommunication Industry. Cambridge: MIT Press 1996.

Vickers, John, y George Yarrow. Privatization: An Economic Analysis. Cambridge: MA. MIT Press, 1996.

2. COURSE MATERIAL

As part of the course two binders are given as reference material for the course.

In the first binder you will find a series of technical summaries prepared by the author of this course. These summaries explain the topics covered in the course in a simple and descriptive manner.

In the second binder there are more than 20 key research papers that are considered as the classics in this field. These papers are key publications in every one of the topics that are covered in this course.

3.0 KEY REFERENCES FOR THE COURSE

The following list is an in-depth look at the required readings for each topic in the course. The readings with an asterisk next to it denote mandatory reading. The reading of the material is a minimal requisite for the understanding of the different topics covered. In addition, some additional reference material is included and given for a more thorough understanding of the topics covered in this course.

SECCION I: INTRODUCTION: theoretical and practical concepts for regulating public utilities.

*Madrid-Aris, Manuel. Technical notes prepared by the author.

Atwood, James R. “Antitrust, Joint Ventures, and Electric Utility Restructuring: RTGs and POOLCOs.” pp. 323-339, 1996.

Averch, Harvey, and Leland L. Johnson. “Behavior of the Firm Under Regulatory Constraints.” American Economic Review, Vol. 52, pp. 1052-1069, December 1962.

*Estache, Antonio, and David Martimort. “Transaction Costs, Politics, Regulatory Institutions, and Regulatory Institutions, and Regulatory Outcomes.” Regulatory Policy in Latin America: Post-Privatization Realities, pp. 49-82

Jones, Douglas, “Regulatory Concepts, Propositions, and Doctrines: Casualties and Survivors.” Journal of EconomicIssues, Vol XXII, No 4, December 1988.

Levy, Brian and Pablo Spiller. Regulations, Institutions and Commitment: Comparative Studies ofTelecommunications. New York: Cambridge University Press, 1996.

Levy, Brian and Pablo Spiller. “The Institutional Foundations of Regulatory Commitment: A Comparative Analysis of Telecommunications Regulation.” Journal of Law, Economics & Organization, Vol 10, No 2, pp. 201-246, 1994.

Manzetti, Luigi. Regulatory Policy in Latin America: Post-Privatization Realities, North-South Center: University of Miami, 2000.

Olsen, Trond E. and Gaute Torsvik. “The Ratchet Effect in Common agency: Implications for Regulation and Privatization,” Journal of Law, Economics &Organization, Vol 9, No 1, pp. 136-158.

Sappington, David, “Incentives in Principal-Agent Relationships.” Journal of Economics Perspectives, Vol 5, No 2, pp. 45-66, 1991.

Shirley Mary M. “Information, Incentives, and Commitment: An Empirical Analysis of Contracts Between Government and State Enterprises.” Journal of Law, Economics, & Organization, Vol 14, No 2, pp.358-378, 1998.

Stigler, George J. “Free Riders and Collective Action: An appendix to Theories of Economic Regulation.”

*Tenenbaum, Bernard. “Regulation: What the Prime Minister Needs to Know.” Electricity Journal, pp. 28-36,March 1996

SECTION II: Natural Monopolies and Financial Aspects of the Regulation.

*Madrid-Aris, Manuel. Public Utility Economics: theory, aspects and applications. Book draft, May 2000. Chapters 2,3 and 4

Hackl, Peter, and Anders H. Westland. “On Price Elasticities of International Telecommunication Demand.” Information Economics and Policy, Vol 7 pp. 27-36, 1995.

Myers, Stewart C. “ The Application of Finance Theory to Public Utility Rate Cases.” Bell Journal of Economics and Management Science, Vol 3, pp. 58-97, Spring 1972.

SECTION III: Different Regulatory Models

*Madrid-Aris, Manuel. Public Utility Economics: theory, aspects and applications. Book draft, May 2000. Chapters 5 and 8.

Liston, Catherine. “Price–Cap versus Rate of Return Regulation.” Journal of Regulatory Economics, Vol 5, pp. 25-48, 1993.

Isaac, R. Mark. “Price Cap Regulation: A Cases Study of Some Pitfalls of Implementation.” Journal of Regulatory Economics, Vol 3, pp. 193-210, 1991.

*Kwoka, John E. Jr. “Implementing Price Caps in Telecommunications.” Journal of Policy Analysis and Management, Vol 12, No 4, pp. 726-752, 1993.

*Berg, Sanford V. and Jinook Jeong. “An Evaluation of Incentive Regulation for Electric Utilities.” Journal of Regulatory Economics, Vol 3, pp. 45-55, 1991.

Howe Keith M. and William Beranek. “Issue Costs and Regulated Returns: A General Approach.” Journal of Regulatory Economics, Vol 4, pp. 365-378, 1992.

Kridel, Donald J., David E.M. Sappington, and Dennis L. Weisman. “The Effects if Incentive Regulation in the Telecommunications Industry: A Survey.” Journal of Regulatory Economics, Vol 9, pp. 269-306, 1996.

Rees, R. and J. Vickers, “RPI-X Price-Cap Regulation.” In The Regulatory Challenge, eds. M. Bishop, J. Kay and C. Mayer. London: Oxford University Press, 1995.

Shleifer, Andrei. “A Theory of Yardstick Competition.” Rand Journal of Economics, Vol 16, No 3, Autumn 1985.

Beesley, M. and S. Littlechild. “The Regulation of Privatized Monopolies in the United Kingdom.” Rand Journal of Economics, Vol 20, No 3, Autumn 1989.

SECTION IV: Types of costs, prices and cross-subsidies

*Madrid-Aris, Manuel. Public Utility Economics: theory, aspects and applications. Book draft, May 2000. Chapters 6 and 7.

Joskow, Paul L. “Contributions to the Theory of Marginal Cost Pricing.” Bell Journal of Economics pp. 197-206, 1976-1977.

Naughton, Michael C. “The Efficiency and Equity Consequences of Two-Part Tariffs in Electricity Pricing.” Review of Economics and Statistics, pp. 406-414, 1986.

Valla, Anna Della and Miles O. Bidwell, Jr. “Restructuring Rates Creates Value and Reduces Stranded Costs.” Electricity Journal, pp. 19-25, December 1995.

SECTION V: Selecting a Regulatory-Institutional Model in Practice

*Madrid-Aris, Manuel. Technical notes prepared by the author

*Lynch, John G. Jr., Thomas E. Buzas, and Sanford V. Berg. “Regulatory Measurement and Evaluation of Telephone Service Quality.” Management Science, Vol 40, No 2, February 1994.

*Berg, Sanford V. and john G. Lynch, Jr. “The Measurement and Encouragement of Telephone Service Quality.” Telecommunication Policy, Vol 16 No 3, pp. 210-224, April 1992.

SECTION VI: Sectoral Reforms y Private Sector Participation (PSP)

*Bitran, Eduardo, and Pablo Serra. “Regulation of Privatized Utilities: Lessons from the Chilean Experience.” Work presented for the OECD Advisory Group on Privatization, Paris, October, 30-31, 1995.

*Madrid-Aris, Manuel, and Juan Pablo Montero, “ Regulation of Water and Wastewater Systems: implications for the Chilean case” Paper published on Quinta Jornada de Hidraúlica Fco. Javier Dominguez Proceedings, Catholic University, Santiago, Chile, 1998.

Helm, Dieter, “British Utility Regulation: Theory, Practice, and Reform,” Oxford Review of Economic Policy, Vol 10, No 3, 1994.

Newbery, David M. and Michael G. Pollitt. “The Restructuring and Privatization of the U.K. Electricity Supply – Was It Worth It?” World Bank, No. 124, September 1997.

Advance Training Course: “Public Utility Economics, Regulation and Sectoral Reforms”