User:RegEconomist/Public utility regulation (Transactions costs approach)

Public utility regulation is a government-imposed mechanism for controlling the terms and conditions at which certain services of a public utility are provided to its customers. Most public utilities are natural monopolies, so that there are no alternative suppliers providing close substitute services. The transactions cost economics (TCE) approach to public utility regulation identifies, as the central issue, the need for customers to make a sunk or irreversible investment to extract the most value from the public utility service. However, both sides recognise that, in this context, there is a need to manage the threat of "hold up" - the risk that the service provider will raise its prices ex post to extract the buyer's surplus. This threat is managed through governance arrangements. In some cases - e.g., where there are few, easily-identified buyers or where the interests of buyers can be effectively represented in a single entity - this threat can be managed through long-term contracts or vertical integration. However, where buyers are numerous, small, and/or not all able to negotiate at the outset, some additional mechanism is required. This could take the form of government provision of the service (a form of vertical integration) or government contracting for the service, as in public-private partnerships for the provision of services.

According to this view, public utility regulation should be viewed as a government-imposed long-term contract designed to protect and promote sunk investment by both the buyers and the service provider. It has many similarities to its closest relative: long-term government contracts such as concessions, franchises, or public-private partnership agreements, and some similarities to a somewhat more distant cousin: private long-term arrangements. Public utility regulation differs from both in that it is imposed by decree rather than voluntarily entered into. However, that basic objective of all of these mechanisms is the same: the protection and promotion of sunk investment by the service provider and the buyers. According to this approach, public utility regulation should be designed and carried out in such a way as to replicate the long-term arrangement that the parties would have written if they could have costlessly negotiated before either made any sunk investment.

The Theory
Transactions cost economics (TCE) focuses, amongst other things, on the implications of sunk (or, more precisely, relationship-specific) investments and uncertainty for economic transactions. The issues arising from the need for sunk investments are somewhat different depending on the number of service providers.

Transactions cost economics
This section describes conventional results in transactions cost economics (or the "economics of governance") which typically deals with the case where there are multiple potential service providers. In this case, even if the buyer needs to make a sunk investment to extract the most value from the service, in many cases the sunk investment will typically not be specific to any one service provider. In this case there is no need for special governance arrangements and a spot market transaction will suffice.

On the other hand, if the sunk investment of the buyer is specific to a particular service provider, the investment becomes relationship-specific. These specific investments might take the form of specialized physical assets, specialized human assets, or location-specific assets (amongst others). This gives rise to the problem that Williamson has called the Fundamental Transformation - even if there any many potential transacting partners ex ante, once the relationship-specific investment has been made, the value of that investment is tied to the continuation of a particular relationship (also known as a situation of bilateral dependency). In this context there arises the threat of ex post opportunism or hold-up. For example, if the buyer incurs the cost of the investment, the service provider might threaten to raise its charges ex post, expropriating the value the buyer receives from the transaction. In such cases there is economic value in on-going mechanisms governing the relationship between the service provider and the customer. "Value-preserving governance structures - to infuse order, thereby to mitigate conflict and to realize mutual gain - are sought".

In the case where there are competing service providers and an on-going supply of new customers, relatively simple mechanisms might suffice. For example, the service provider may promise to not discriminate between new customers and existing customers or service providers may compete to subsidise the sunk investments of buyers. As long as there is on-going competition for new customers, these mechanisms may be sufficient to protect the value of the investment of existing customers. If the life of the sunk investment is short enough, the desire to create and maintain a reputation for not exploiting customers may also act to discipline the service provider.

Where such mechanisms are not feasible, transactions cost economics points to two alternative governance mechanisms which may overcome the hold-up problem. One such mechanism is vertical integration. This approach, where it is feasible, allows for efficient resolution of disputes between the two parties, and may result in some other economies of integration, but has its own limits (see Theories of the Firm). Specifically, carrying out certain transactions within a single firm changes both incentive incentive intensity and the need for administrative controls which limits the efficient scope of the firm.

Finally, the hold-up problem may be overcome through a long-term contract (a form of vertical agreement) which protects the interests of both parties. Long-term contracts, however, involve certain trade-offs. The longer the contract the greater the number of potential future contingencies the contract needs to take into account. As a result, all complex contracts are unavoidably incomplete. "Parties will be confronted with the need to adapt to unanticipated disturbances that arise by reason of gaps, errors and omissions in the original contract". The design of a long-term contract requires balancing the need for prescription, in order to protect the sunk investments made by both parties, with the need for flexibility to respond to disturbances ex post. In practice, long-term contracts involve both a framework of rules, combined with a degree of discretion to allow adjustment to developments ex post, mechanisms for information disclosure and verification, and a mechanism for resolving disputes. Long-term contracts should be thought of as a constitution governing a relationship. The greater the uncertainty in the future the greater the flexibility required in the long-term contract and therefore the greater the potential for ex post opportunism. Nevertheless, where there is material economic value in the relationship it may be preferable to enter into a flexible long-term arrangement which at least offers some protection for sunk investments, rather than to not enter into any relationship at all.

Relationship-specific investments and governance arrangements with a single service provider
The situation is somewhat more complicated when there is just a single potential service provider. This might arise, for example, where there are economies of scale so that the service provider is a natural monopoly. Economies of scale are particularly important in network industries such as telecommunications, electricity transmission and distribution, railways, roads, postal services and so on.

Again, the key issue is the need for relationship-specific investment. However, when there is just a single service provider relationship-specific investment problems are likely to be more significant. Unlike the case above where there were multiple service providers, where there is just a single service provider it is likely that any sunk investment made by the buyer will be specific to the relationship with that service provider. Where no relationship-specific investment is required, this approach to regulation argues that no particular governance arrangements (and no particular regulation) is required. A possible example is a major amusement park for which there are substantial economies of scale, but no particular need for regulation.

Let's focus on the case where the buyer must make a material sunk investment in order to extract the most value from the service. As just noted, this sunk investment is automatically a relationship-specific investment since there is only one potential supplier of the service. As before, where the service is expanding, with an on-going supply of potential new customers, it may be possible to partially protect and promote relationship-specific investment by buyers through relatively simple mechanisms, such as promises not to discriminate between existing and new customers. Alternatively, the service provider might offer to directly subsidise the relationship-specific investment of the buyer. (For example, many PC users must make a substantial sunk investment in learning to use the Windows operating system but this investment is, in part, protected by the fact that Microsoft has sought to expand and/or maintain its penetration of the PC market).

If the set of buyers is small, homogeneous, easily identifiable and if the transactions costs are low, the buyer or buyers may be able to protect their sunk investment through a long-term contract or vertical integration as discussed in the previous section. But this merely shifts the question of the identity of the buyer(s) further down the supply chain. If, at the next stage in the supply chain the customers do not need to make any relationship-specific investment, the contracting problem is eliminated. (For example, a coal-fired power station might need to sign a long-term contract with a local coal mine, but, provided there is competition between electricity generators, downstream customers need not enter into any particular long-term arrangements with the power station). Alternatively, if, at the next stage in the supply chain, the customers need to make a material sunk investment we can just repeat the argument above for the next stage in the supply chain.

Eventually we must reach a point where there are a large number of buyers or the set of buyers is not easily identifiable. In this case simple vertical integration and/or long-term contracting is not feasible. However, it may still be possible to achieve a degree of vertical integration with the buyers as a class, such as through the purchasing of the service provider by a collective representing all buyer interests ("club" ownership - in most economies a number of assets with a degree of local economies of scale are owned and operated by clubs) or by direct government provision of the monopoly service (government ownership).

Finally, where such mechanisms are not feasible, it is necessary to rely on some form of long-term contracting between the end-users and the service provider. Here we can make one further distinction. Where neither party has made any sunk investment it may be possible to enter into an explicit voluntary contractual arrangement such as a concession, franchise or a public-private partnership agreement. Such arrangements are common in the provision of many government services, including toll roads, bridges, rail services, cable television services, and so on.

Finally, where one or other party has already made a sunk investment, it is too late to enter into a voluntary arrangement (the negotiation process is subject to the risk of hold-up that we are seeking to avoid). Instead it is necessary to rely on a government-imposed contractual arrangement. This arrangement is normally referred to as public utility regulation.

The TCE approach to public utility regulation views public utility regulation as one form of governance arrangement that is designed to protect and promote sunk (relationship-specific) investment, particularly by the customers of a monopoly service. Public utility regulation is closely related to other forms of long-term government procurement contracts, particularly public-private partnership agreements and, to a lesser extent, other private long-term contract arrangements. Like other long-term contracts, public utility regulation involves a framework of rules, combined with an allowance for periodic exercise of ex post discretion, coupled with information disclosure and verification mechanisms, and mechanisms for resolving disputes.

Implications
This transactions cost perspective on public utility regulation has several implications:

The scope of public utility regulation
This approach to public utility regulation sheds some light on the appropriate scope for utility regulation. According to this approach, the choice whether or not to impose regulation is a choice between governance structures in situations where (a) there is a single service provider, (b) the buyers must make a relationship-specific investment, and (c) it is not feasible for the buyers to collectively resolve the governance problem with private arrangements such as vertical integration or long-term contracting.

In this context, the choice is between ownership mechanisms (such as club ownership or government ownership) and vertical contracting arrangements such as public-private partnership agreements or public utility regulation. As a general rule, it is preferable to focus these governance mechanisms on the natural monopoly component and allow competition in any related upstream or downstream sectors.

Moreover, as a general rule, it is preferable to rely on voluntary mechanisms, entered into before either party has made any sunk investment. This might involve, for example, forms of public-private partnership arrangements or concession contracts.

However, it is not possible to anticipate all future contingencies. It may be difficult to write even a flexible long-term arrangement to last more than, say 30-40 years, but sunk investments can last significantly longer than that. Even more importantly, it may not be possible to anticipate future market developments. A reduction in the number of competing providers over time changes the extent to which customers are exposed to the risk of hold-up. Mergers policy acts to prevent mergers which reduce the number of competing suppliers, but changes in technology may reduce the number of competitors in ways which mergers policy cannot control. There may come a point in time at which it is desirable to impose a contractual arrangement by fiat.

This is likely to be straightforward in the case where the imposed arrangements are merely an extension of existing governance arrangements (such as the conclusion of a public-private partnership, or the privatization of a government-owned firm) or where there is an explicit or implicit pre-existing understanding that regulatory controls will be imposed after a period of time (e.g., 20 years) or when certain conditions are satisfied. However, it is also possible that there will arise a time where it is desirable to impose a contractual arrangement by fiat. The key question to ask is the following: Suppose at the beginning of time, before either party have made any sunk investment, that the parties had rationally anticipated reaching the present point. Would the parties have foreseen the need to impose a regulatory arrangement to be in their mutual interest? Specifically, would the response of the customers (in failing to make a sunk investment) be sufficiently material as to make the initial investment of the service provider unviable?

The history of public utility regulation
The history of public policy towards natural monopolies both sheds light on and is illuminated by the theory outlined above.

In the early years following major new developments, such as the telegraph,the telephone, the railway, natural gas distribution, or electric power, there is often a degree of uncertainty as to the scope for competition and the degree of investment required by end-users. In many of these sectors - such as rail, telephone, telegraph, electric power, there were often many providers, often providing competing services. Over time however it was recognised that economies of scale and scope were important. Conventional competition in-the-market reduced over time. In its place there was some attempt to use competition for-the-market. Many cities, for example, offered geographic franchise monopolies for the provision of, say, electric power or natural gas. In the UK canals were granted concessions for a period of 21 years.

At the same time there was a recognition of the need for customers to make a material sunk investment. As long as the network was expanding, non-discrimination or MFN clauses were able to provide a degree of protection to existing customers.

However these protections were not adequate where the pentration of these networks limited the scope for further growth or where the nature of the network itself (such as a canal) limited scope for further expansion. In these cases state and local governments established mechanisms to allow prices to evolve over time.

In many countries (outside the US) dissatisfaction with monopoly and X led to government nationalisation of the sector.

The design of public utility regulation
The design of public utility regulation has much in common with the design of a long-term contract - particularly long-term contracts designed to protect and promote sunk investment by buyers That contract will involve the following elements: All long-term contracts will
 * The specification of a set of rules which must be followed during the life of the contract, combined with allowance for a degree of discretion to adapt to developments in the market in the future;
 * A set of rules governing the exercise of that discretion, such as conditions under which prices can be adjusted (at what time intervals, within what bounds, according to what principles);
 * Rules facilitating agreement on new terms and conditions (such as rules governing information disclosure and verification); and
 * Rules governing access to a mechanism for resolving disputes.

The role of customers in regulatory processes
=== The role of the regulator


 * To begin with, it suggests that public utility regulation is correctly viewed as a form of long-term contract - specifically, a long-term contract to protect and promote the sunk investment by buyers of the monopoly service. This approach emphasises the close connection between public utility regulation and other long-term contracts entered by governments, such as public-private partnerships, and, to a lesser extent, other long-term contracts entered into by private firms. At the same time, it emphasises the key difference between public utility regulation and other forms of long-term contracting.


 * This approach clarifies the primary objective of public utility regulation - the primary objective can be expressed as creating the long-term contractual arrangement that the parties would have agreed to if they could have negotiated costlessly ex ante, before either had made any sunk investment.


 * This approach provides a framework for understanding the structural reforms of the 1990s which emphasised vertical unbundling and the promotion of competition. This is discussed further below. This approach provides a framework for understanding the evolution of public policy toward natural monopoly over time. This is also discussed further below.


 * This approach has implications for the design of the regulatory process, the role of consumers in the regulatory process, and the role of the regulator that are discussed further below.

According to this view, public utility regulation should be viewed as a government-imposed long-term contract designed to protect and promote sunk investment by both the buyers and the service provider. It has many similarities to its closest relative: long-term government contracts such as concessions, franchises, or public-private partnership agreements, and some similarities to a somewhat more distant cousin: private long-term arrangements. Public utility regulation differs from both in that it is imposed by decree rather than voluntarily entered into. However, that basic objective of all of these mechanisms is the same: the protection and promotion of sunk investment by the service provider and the buyers. Public utility regulation should be designed and carried out in such a way as to replicate the long-term arrangement that the parties would have written if they could have costlessly negotiated before either made any sunk investment.

The reforms of the 1990s
Beginning in the 1980s...

Implications for the design of the regulatory framework
The TCE approach to public utility regulation views public utiliity regulation as a form of government-imposed long-term contract which seeks to protect and promote the sunk investment of the service provider and its customers. In designing this contract, policy makers should seek to reproduce the arrangements that the parties would have agreed if they could have negotiated costlessly before making any sunk investment. In this light, the theory and experience of long-term contracts (both with government and between private parties) is likely to be useful.

The theory of long-term contracts emphasises that long-term contracts are inevitably incomplete. That is, they do not specify every possible action that the parties will take in every possible future contingency. An incomplete contract increases the risk of hold-up ex post. To mitigate this risk, a long-term contract will usually specify both the limits of the discretion of the parties ex post and a mechanism for resolving disputes. A long-term contract can be thought of as a constitution governing a relationship.

This theory highlights that key elements in the design of any long-term contract (including a regulatory regime) are (a) the degree to which the framework prescribes the actions to be taken in the future versus the extent to which it allows discretion to the parties ex post; and (b) the nature and the rules governing the dispute resolution process.

In the context of long-term contracts to protect sunk investments, key issues are the price-service quality path into the future, incentives for service quality and efficiency, and decisions over augmentation to the monopoly facility.

Metion the role of the Building Block Model.

Implications for the role of the regulator
According to the TCE approach to public utility regulation, public utility regulation should be viewed as a long-term contract which seeks to protect and promote the sunk investment by the service provider and its customers. But why is public utility regulation so closely assocated with an institution known as the public utility regulator? The long-term contract perspective identifies two potential roles for an institution: as a specialised, long-lived, dispute resolution authority; and as a customer representation body.

The regulator as dispute resolution authority
As noted above, a long-term contract consists of a set of rules specifying the required actions and the extent of discretion of the parties, and a mechanism for resolving disputes when they occur. That mechanism for resolving disputes will inevitably involve assigning some decision-making responsibility to an independent third-party. That party could be a commercial arbitrator, an independent entity established for the purpose, a court or tribunal, or a public utility regulator.

Some of these institutions (such as a court, tribunal or a commercial arbitrator) are temporary, established on an as-needed basis for the resolution of a particular dispute. In contrast