Competition in Utility Markets

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Regulators and policy makers implement competition in the utility market1 by removing legal and technical barriers to entry, monitoring anticompetitive conduct, restructuring the sector, and providing access to essential facilities. Legal barriers to entry include licenses restrictions and high license fees that sometimes limit the number of firms that can serve a market.2 Technical barriers to entry include sunk costs and other barriers to entry noted above.

Restructuring the industry generally involves a) separating the potentially competitive portions of the sector from the non-competitive or natural monopoly3 portions and b) providing rivals with access to the non-competitive portions, which should be considered essential facilities. This separation of competitive from non-competitive may be accomplished through structural separation, functional separation, or unbundling. With structural separation, the competitive and non-competitive components of the sector are provided by separate entities, which may be under common ownership or separate ownership. For example, the government may not permit competitive electricity generation operators from providing monopoly electricity distribution services. In a least severe form, structural separations may simply mean that the components are owned by separate subsidiaries of the same corporation. With functional separation the competitive components and non-competitive components are provided by the same operator, but the personal and operations are separated.

Structural separation and functional separation are also called unbundling, but some forms of unbundling are less severe than separation. For example with unbundling, the regulator may allow the provider of the non-competitive component to provide a single service that combines the competitive and non-competitive portions of the service, but the regulator would also require the operator to provide rivals with equal access to the essential facilities under the same terms and conditions as the operator does its own competitive service. This is a common approach in telecommunications.

Regulators generally require accounting separation if the regulator allows common ownership of competitive and non-competitive components. The accounting separation requires this operator to separate its accounting records between the competitive portion (which is often deregulated) and the non-competitive portion (which is regulated).

To illustrate these restructuring options, consider the electricity industry. It is believed in many situations that electricity generation can be competitive and that electricity transmission and distribution should be provided by monopolies. Under a form of structural separation, electricity transmission and distribution are provided by separate monopolies and generation is provided by operators that provide neither transmission nor distribution. If the electricity operator is allowed to remain vertically integrated, which means that it continues to provide both the upstream competitive electricity generation and the downstream, non-competitive transmission and distribution, then the operator is required to unbundle transmission and distribution from generation and allow rival generators to have access to these unbundled essential facilities. The vertically integrated operator is also often required to perform accounting separation.4

Introducing competition raises issues of how to “buy out” the old regime by addressing issues of stranded costs and uneconomic subsidies.5 Stranded costs are costs that the operator has properly incurred and that the operator does not have a reasonable opportunity to recover given the introduction of competition. Stranded costs are calculated as the difference between sunk costs and operating earnings from sunk assets. Potential funders of stranded costs include shareholders, taxpayers, customers of this service provider, customers of competitors, and competitors. Another transition issue is how to convert monopoly price structures to competitive price structures. Traditional utility pricing contains a number of cross-subsidies that cannot be maintained when there is competition. Some of these subsidies are unproductive in the sense that they do not assist the poor or lead to network development. Such subsidies generally should be removed with an appropriate transition and productive subsidies funded by a competitively neutral means.6

Because existing customers already have access to the utility network, introducing competition for these customers raises issues of access to essential facilities and switching costs. Competition for new customers may have these same issues if network access is a natural monopoly. However, if there are no existing facilities for these new customers and if facilities can be competitive, then essential facilities and switching costs are not an issue.

The pricing of access to essential facilities is important for the success of competition in the market for existing customers. There are three basic forms of access. The first is exclusive use of unbundled facilities or capacity. The second is one-way access, which is the situation where the competitive operator pays the essential facility provider for transporting the competitive operator’s commodity (as in the case of gas or electricity) or service (as in the case of telecommunications). The third is two-way access, which is the situation where the rival operators both need access to each other’s network facilities for transporting their utility services. At present, two-way access occurs primarily in telecommunications where competing telecommunications operators interconnect their networks so that their customers can communicate with each other. If the essential facility provider offers only the non-competitive portion of the service, then regulators establish prices that cover the total cost of the operator. Otherwise, regulators typically price access at incremental cost.

The economics of access pricing depends in part on the nature of the relationship between the firms.7 Vertical relationships are those where a network provider sells access to its network to a downstream service provider, who is providing a retail service. The two operators involved in the transaction may (or may not) compete in the retail market. Horizontal relationships are those where there are two or more rival networks and the networks interconnect. This is most common in telecommunications. The appropriate pricing rules depend upon whether the relationships are vertical (one-way interconnection) or horizontal (two-way interconnection), the nature of competition, and the features of the regulatory system, to name a few. Common pricing options include no regulation, the Efficient Component Pricing Rule (ECPR), global price caps, and cost-based prices, such as fully distributed cost and long run incremental cost. The three models of short-term trading arrangements in electricity are the integrated, wheeling, and decentralized models. In telecommunications, most regulators use long run incremental cost for establishing interconnection charges.

Sometimes sector regulators share responsibility for ensuring competitiveness of markets with a competition authority, but in some instances a sector regulator may have responsibility for competition.8 In principle, competition policy tries to ensure that markets are competitive while regulation attempts to control conduct when markets are not competitive. This difference in roles leads to differences in primary functions. The competition regulator is generally concerned with all sectors and generally has three functions. The first function is to remedy anticompetitive conduct, such as collusion. This function is generally ex post, meaning that the competition authority responds to activities that have already occurred. In contrast, utility regulators generally address competitive issues ex ante, meaning that they act to prevent anticompetitive conduct. The second function is to ensure that industry mergers do not significantly decrease competition. The third function is consumer protection. In practice, regulation attempts to control the conduct of firms with market power so that they cannot take advantage of their market power to limit output, raise prices, or limit rivals’ abilities to compete. Regulation may conflict with the goals of competition policy to pursue particular government objectives.

Sector regulators and competition authorities often cooperate in their efforts. Sector regulators may adopt ex ante competition rules that complement the competition authority’s goals. Sector regulators may share sector expertise with the competition authority when the competition authority is investigating anticompetitive conduct or a proposed merger. The sector regulator may also investigate a proposed merger if the regulator has responsibility for managing the sector licenses. Lastly, the sector regulator generally also plays a significant role in consumer protection.

Footnotes

  1. The reference section for Competition in Infrastructure Markets covers this topic.
  2. Licenses are described in the Regulatory Instruments reference section.
  3. Natural monopoly is defined in the reference section for Monopoly and Market Power.
  4. The section titled Ring Fencing and Control of Cross-Subsidization covers accounting separations or ring fencing.
  5. See reference section for Competition in Infrastructure Markets. Tariff Design also covers issues of cost recovery and how competition affects pricing.
  6.  The section titled Pricing for the Poor and Social Aspects also examine pricing for universal access and universal service.
  7. See the reference section for Competition in Infrastructure Markets.
  8. See the reference section for Competition in Infrastructure Markets and the reference sections for  Institutional Design Issues and Stakeholder Relations for information on relationships with other agencies, such as competition authorities.