Regulator role – What is the appropriate role of regulators in the implementation of a new market structure and in evaluating / mitigating the impact of such changes?

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[Response by Sophie Trémolet and Diane Binder, October 2009]

Market structure decisions, such as vertical unbundling or grouping of several municipal companies, are by and large policy decisions, linked to broader infrastructure reforms. However, regulators also have a role to play in introducing effective competition1 in market segments that are not essential facilities (or natural monopolies), evaluating market structures both before and after a given change (merger, new entrant, etc.) and managing the effects of such a change.

Introducing competition2: Regulators can be involved in introducing competition in utility markets by being involved up-stream of the operators’ recruitment, restructuring the sector, and ensuring a smooth transition between a monopoly situation and a competitive one.

  • Regulators can be involved up-stream of the procurement process, by removing legal barriers to entry (which include license restrictions and access fees to the market in order to control the number of firms serving the market), technical barriers to entry (which include sunk costs) and by organizing auctions to decide which operator is best able to provide value for customers3. Regulators can provide sector expertise and ensure transparency in the procurement process.
  • Restructuring the industry generally involves separating the potentially competitive portions of the sector from the non-competitive ones through structural separation, functional separation4 or unbundling. Vertical unbundling is typically an activity where the regulator has a strong implementation role, in ensuring that the activities are effectively separated (first, through introducing separate accounts and then spinning it off into separate companies). The need for and potential benefits of market restructuring should be assessed on a case-by-case basis. For instance, full unbundling is generally preferred in medium to large power markets to facilitate the introduction of competition, whereas in small markets with little opportunities for cross-border trading, regulation of a vertically integrated monopoly may be the most cost-effective choice.
  • Transition issues include switching costs5, how to deal with stranded costs and uneconomic subsidies. Since stranded costs cannot be recovered by the monopoly operator once the market has been opened to competition, the regulator will have to identify funders and spread costs among shareholders, tax payers, customers and competitors. Besides, traditional utility pricing includes cross-subsidies that cannot be maintained in a competitive setting and that are often unproductive6. The regulator should remove such subsidies and establish new pricing mechanisms that take into account the nature of competition and the features of the regulatory systems.

Evaluating market structure and firm behavior. The regulator can be involved in two phases of the evaluation process before and after a given market structure change:

  • Ex-ante regulation is mainly concerned with market structure, that is the number of firms and level of market concentration, entry conditions and the degree of product differentiation. In the electricity sector, the variety of market structures emerging from reforms can be categorized according to increasing degree of competition, as follows: vertically integrated monopoly, purchasing agency7, competition in the wholesale power market and competition for retail consumers. Reform programs can also progress through these structures.
  • Ex-post regulation8 is mainly concerned with market conduct – the behavior of firms with respect to both its competitors and its customers. For instance, increasing energy retail prices in Great Britain since the beginning of 2008 have raised concerns about ineffective competition and possible anti-competitive behavior in energy supply markets. Subsequently, OFGEM (the Office of the Gas and Electricity Markets, the regulator of gas and electricity markets) launched a “market probe” to investigate the functioning of energy supply markets. Market investigations included a thorough analysis of the relevant market definition and their concentration (“structure”); the behavior of firms in the market (“conduct”) and an analysis of firms’ profitability (“performance”). Remedies may be applied, ranging from measures designed to increase transparency for consumers (e.g. clearer billing information) to reducing entry barriers and asset disposal.

Manage the effect of a new market structure. One of the primary goals of the regulatory process in newly competitive markets should be to prevent and mitigate market participants’ behavior that significantly degrades system reliability and market efficiency:

  • Regulators should make sure that conditions for vigorous competition exist, and therefore have access to all the information needed to analyze the behavior of participants.
  • Regulators need to run media and information campaigns to inform customers of their right to choose, perhaps to provide comparative information on all the providers so as to facilitate choice.
  • Consumer complaints mechanisms: if some customers perceive that they have been negatively affected, regulators should be able to hear their complaints and address them.

Resources

Power Market Structure: Revisiting Policy Options
The World Bank, 2013
Vagliasindi, Maria and Besant-Jones, John

Review of Electricity and Gas Licensing Regimes in NSW – Final Report
Independent Pricing and Regulatory Tribunal of New South Wales, January 2003.
IPART

Methods for Increasing Competition in Telecommunications Markets
University of Florida, Department of Economics, PURC Working Paper, 2008.
Jamison, Mark A.

Energy Supply Markets: are they competitive?
OXERA Agenda, March 2008.
Holt, D.

Reforming Power Markets in Developing Countries: What Have We Learned?
Energy and Mining Sector Board Discussion Paper No. 19. Washington, D.C.: World Bank, September 2006.
Besant-Jones, John E.

Transition Costs: Who Should Pay?
Electricity Journal 10 (5): 1997, pp. 68-77.
Baxter, Lester, Eric Hirst, and Stan Hadley.

Restructuring Public Utilities for Competition
Washington, D.C, 2001.
OECD

ICT Regulation Toolkit
Washington, D.C.: infoDev and the International Telecommunications Union, 2007, Module 2.

Footnotes

  1. Effective competition occurs in economic markets when four major market conditions are present: buyers have access to alternative sellers at prices they are willing to pay; sellers have access to buyers without undue hindrance or restraint from other firms; the market price of a product is determined by the interaction of consumers and firms; differences in prices charged by different firms reflect only differences in cost or product quality (Derived from ICT Regulation Toolkit, Chapter 2)
  2. For this section, refer to Competition in Utility Markets in the BoKIR for more details.
  3. See Competition for the Market, and more particularly the English auction system where the auctioneer starts with a high price to be charged to customers and lowers the price until there is one active firm left.
  4. Functional separation occurs when both components are provided by the same operator, but personal and operations are separate.
  5. “Switching costs are costs that a customer or an alternate supplier must incur for a customer to change suppliers, but that do not have to be incurred, either by the customer or the incumbent supplier, if the customer does not switch suppliers.” (Jamison, 2008).
  6. Refer to question: “Do higher income customers benefit more from subsidies than do poorer customers?” Pricing for the Poor and Social Aspects also examine pricing for universal access and universal service.
  7. A purchasing agency, also known as single buyer generally has, in power markets, monopoly for supplying distribution companies that serve customers under regulated terms. The functions of this agency are carried out by many types of entities in different countries (Besant-Jones, 2006)
  8. Ex-post regulation addresses specific allegations of anti-competitive behavior or market abuse and aims to redress proven misconduct through a range of enforcement options including fines, injunctions or bans (ICT Regulation Toolkit, Chapter 2).