Timothy J. Brennan

Regulating by Capping Prices

The purpose of this article is to look at the theoretical underpinnings and properties of price caps, specifically, the rules governing how a multiproduct regulated firm may adjust its prices. To identify a standard for implementing price caps, we begin by identifying the constrained optimization to which “price caps” are the solution. Since price caps are at heart a policy in which a firm can do what it likes as long as prices do not rise, the relevant optimization is maximization of welfare or profit subject to a constraint that aggregate consumer welfare must not fall below a given level. Permitting prices to be flexible, subject to maintaining a constant weighted average where the weights are based only upon the quantities sold for each service, can approximate the behavior of a firm maximizing profit subject to an aggregate consumer surplus constraint. Flexibility to change prices is in this sense “optimal,” subject to the acceptability of the consumer welfare achieved under the original prices.

Cross-subsidization and cost misallocation by regulated monopolists

While cross-subsidization is understood theoretically as involving the sustainability of a cost allocation scheme, it is invoked in regulatory policy contexts, such as the divestiture of AT&T, where costs of serving unregulated markets may be borne by ratepayers of regulated monopolies. We analyze two cross-subsidization tactics—cost misallocation and distorted technological choice — under a spectrum of regulatory cost allocation policies. These tactics lead to higher prices in regulated markets and inefficient production in unregulated markets. Welfare effects are discussed; we conclude with observations on strategic behavior and regulatory policy.

A Methodological Assessment of Multiple Utility Frameworks

One of the fundamental components of the concept of economic rationality is that preference orderings are “complete,†i.e., that all alternative actions an economic agent can take are comparable (Arrow, 1951; De-breu, 1959). The idea that all actions can be ranked may be called the single utility assumption. The attractiveness of this assumption is considerable. It would be hard to fathom what choice among alternatives means if the available alternatives cannot be ranked by the chooser in some way. In addition, the efficiency criterion makes sense only if one can infer that an individuals choice reflects the best, in expected welfare terms, among all choices that individual could have made (Sen, 1982a). The possibility that a rearrangement of resources could make someone “better off†without making others “worse off†can be understood only if the post-rearrangement world is comparable with the pre-rearrange-ment world.

Consumer preference not to choose: Methodological and policy implications

Residential consumers remain reluctant to choose new electricity suppliers. Even the most successful jurisdictions, four U.S. states and other countries, have had to adopt extensive consumer education procedures that serve largely to confirm that choosing electricity suppliers is daunting. Electricity is not unique in this respect; numerous studies find that consumers are generally reluctant to switch brands, even when they are well-informed about product characteristics. If consumers prefer not to choose, opening regulated markets can reduce welfare, even for some consumers who do switch, as the incumbent can exploit this preference by raising price above the formerly regulated level. Policies to open markets might be successful even if limited to industrial and commercial customers, with residential prices based on those in nominally competitive wholesale markets.

Alternating currents : electricity markets and public policy

Many US states, as well as many countries, are opening their electric power markets to competition. Others, in response to the crisis in California, have ruled out competition. This book provides an overview of the major issues facing industry regulators, legislators and others as they consider whether, when, and how to open electricity markets. The authors begin with background on the electric power industry, including the technology for producing and delivering power, the history of regulatory policy and an analysis of recent experiences with restructuring. They then provide insights into the policy debates and economic issues, including industry structure, future regulation, system integrity and reliability, the mitigation of market power and environmental protection. The book describes the recent events leading to the demise of retail competition in California in order to extract lessons for future attempts at deregulation. It offers perspectives on what makes electricity a unique resource and what makes the potential conflict between competition and reliability the most pressing of the long-term concerns for the electricity industry.

Optimal Energy Efficiency Policies and Regulatory Demand-Side Management Tests: How Well Do They Match?

Under conventional models, subsidizing energy efficiency requires electricity to be priced below marginal cost. Its benefits increase when electricity prices increase to finance the subsidy. With high prices, subsidies are counterproductive unless consumers fail to make efficiency investments when private benefits exceed costs. If the gain from adopting efficiency is only reduced electricity spending, capping revenues from energy sales may induce a utility to substitute efficiency for generation when the former is less costly. This goes beyond standard “decoupling” of distribution revenues from sales, requiring complex energy price regulation. The models’ results are used to evaluate tests in the 2002 California Standard Practice Manual for assessing demand-side management programs. Its “Ratepayer Impact Measure” test best conforms to the condition that electricity price is too low. Its “Total Resource Cost” and “Societal Cost” tests resemble the condition for expanded decoupling. No test incorporates optimality conditions apart from consumer choice failure.

Comparing the costs and benefits of diversification by regulated firms

Previous work on the diversification of regulated firms has focused exclusively on either the costs of cross-subsidy or on the welfare gains resulting from economies of scope. Using theory and numerical simulations, we identify conditions under which gains from economies of scope and increased competition tend to outweigh the costs of cross-subsidization. We use a perfect competition model of the unregulated market to examine tradeoffs under economies of scope. Effects of increased competition are assessed using Cournot models with linear and constant elasticity demands. Diversification tradeoffs depend upon magnitudes of variables that regulators should be able to estimate or otherwise judge.

Industry parallel interconnection agreements

Abstract Prior analyses of interconnection in networks have emphasized vertical issues e.g. between local telephone companies and interexchange service providers. We consider here horizontal interconnection agreements. Such agreements among competitors to set a fee to use a standard can lead to monopoly pricing, through fees equal to the margin between the monopoly price and marginal cost. Industry parallel interconnection agreements among local telephone companies have similar effects. Profits from these fees could be competed away in attracting subscribers. With more general conjectural variations, incentives for anticompetitive interconnection fee agreements persist. Regulatory oversight could be valuable even absent monopoly or incumbency advantages.

Alleged Transmission Undersupply: Is Restructuring the Cure or the Cause?

Widespread concern over transmission capacity requires theoretical support to infer inadequacy from observed trends indicating reductions in the ratio of transmission to generation capacity over time. If integrated utilities had been regulated with allowed returns exceeding capital costs, transmission-generation ratios would have been excessive, and observed trends might be a correction. However, numerous commentators claim that post-restructuring transmission rates have been too low, with NIMBY also discouraging investment. We model the possibility that inadequate separation between generation and transmission may result in reduced investment, in order to preserve incumbent market power in generation. However, consideration of transmission price caps and coordinated generation investment support other analyses that conclude that vertical separation itself may be a culprit.

Implementing Electricity Restructuring

Electricity is one of the last U.S.industries in which competition is replacingregulation. We briefly review the technologyfor producing and delivering power, the historyof electricity policy, and recent state andinternational experience. We then outline themajor questions facing policymakers as theydecide whether, when, and how to implementrestructuring. We conclude with some thoughtson the California electricity crisis and otherpolitical controversies. Although theCalifornia experience has come to define whatit means for electricity markets to fail, mostof the problems it raised are among those weknow how to solve or prevent. The stillunresolved make-or-break issue remains whetherthe cooperation necessary to maintainreliability is compatible with the degree ofcompetition necessary to bring about greaterefficiency and lower prices.