Competition for the Market

When elements of the utility system exhibit natural monopoly characteristics,¹ customers can still gain some benefits of competition through effective use of competition for the market ². In these situations, the government often auctions off the right to be a monopoly. Doing so can improve the efficiency of the utility services because: (1) cost efficiency is achieved because the firm able to “pay” the most for the market would also be the firm that could serve the market at the lowest cost; and (2) monopoly rents can be distributed to customers. This latter feature occurs if firms bid their retail prices (with the lowest bid winning) or if the firms’ bid payments for the franchise and the franchise fees are returned to customers.

The goal of an auction is to provide the potential operators with an incentive to reveal their private information, which is in this case their ability to serve the market efficiently. Said another way, the goal of an auction is to learn which operator is best able to provide value to customersand the value that this operator places on the opportunity to serve. Several auction models exist, including the English auction and the Vickrey auction. In a modified English auction, the auctioneer begins with a high price (to be charged to the customers). All firms who are willing to provide service at this price signal that they are active. If there is more than one active firm, the auctioneer lowers the price one step and again the bidders signal whether they are active. This process continues until there is only one active firm. Another approach is the Vickrey auction, in which all firms submit their bids and the firm with the best bid wins, but receives the price of the second lowest bidder.

Regardless of the type, an auction must be both well run and well designed to be successful. Key design features include transparency and objective criteria for evaluating bids. Furthermore, to avoid significant renegotiation and to reduce risk, the concession contracts should clearly establish rights, obligations, risks and incentives for the operator. Renegotiation is especially problematic if regulators have incomplete information and weak monitoring capabilities. Firms with market power are able to exploit these weaknesses.

If there are a large number of bidders, open auctions and fixed price contracts are more desirable; otherwise, first-price sealed bid auctions may be preferable. Risk aversion on the part of bidders also increases the desirability of sealed bids.

Negotiations are generally unavoidable with franchises, even with auctions. This does not mean, however, that auctions have no value because using even some auction processes in concession letting can improve results. Auctions reveal information about operators and markets. Also, having a large number of bidders or diversity among bidders decreases the likelihood of collusion and lowers the danger of the winner’s curse.

Regulatory involvement in the operator procurement process has advantages and disadvantages. On the plus side, the regulator can provide sector expertise in pre-qualification and bid evaluation, ensure transparency, and ensure continuity between the procurement phase and the contract enforcement phase. On the negative side, the regulator may lose some objectivity in enforcement if the regulator becomes concerned about the appearance of success of the procurement phase.

Contract design is critical for the successful implementation of a competition-for-the-market policy. Concession contracts should clearly set rights, obligations, risks and incentives. However because of uncertainty, it is generally impossible to write a complete contract, which is a contract that covers all possible contingencies. As a result, some contracts provide for ongoing or periodic review of prices, service obligations, investments, and the like so that adjustments can be made for conditions that could not be anticipated at the outset of the concession. If such reviews are difficult for a country, it is sometimes possible to rebid the contract. Rebidding allows operators to adjust to changes in the economy or operating environment. With any rebidding, whether frequent or infrequent, if there are significant fixed costs then the transfer of assets to new franchisees may be necessary. The terms and conditions for these transfers should be set out in advance. Furthermore, because there can be significant costs in conducting an auction and in preparing bids for an auction, small systems may need to combine into a single auction to minimize such transaction costs.

The regulatory framework and the institutional capabilities the regulator affect the success of concession and franchising arrangements. Research has shown that renegotiation problems result from regulators having incomplete information and weak monitoring capabilities, allowing the operator to leverage its superior information to press for the renegotiation. Firms with market power are especially able to exploit these weaknesses because the information asymmetry is greater, all other things being equal, and they may be better able to influence the political process than firms with less market power. Frequent rebidding may help remedy these problems, but concession and franchising agreements need to have detailed provisions for renewal and asset transfer.

Footnotes

1. The reference section for Monopoly and Market Power contains definitions of natural monopoly.
2. The reference section for Competition for the Market covers this topic.