Competitiveness of the local energy market to maximise welfare

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Guyana’s energy sector includes the largest monopolies in the economy – in electricity and gas. The oil industry will be dominated by a few very large firms. The existence and apparent inevitability of monopoly have proved a motive for intervention.

A monopoly can be either natural or artificial. A natural monopoly arises where technical cost conditions are such that the industry can support only one firm in the industry. Artificial monopoly exists where, despite the technical possibility of entry, the single incumbent firm is protected from entry either by strategic barriers to entry or by statutory monopoly concessions.

Natural monopolies arise most frequently in networks – the electricity grid, the main telephone system, roads and public utilities. They can be either local (like Area Boards) or national (like the national electricity grids and transmission system). When these exist, it is wasteful to duplicate provision and hence, for cost reasons, one producer is better than two or more. The problem that arises is that, in the absence of competitive pressure, the monopoly can exploit its dominant position by marking up prices. Furthermore, there is little direct pressure to minimise costs.

Natural monopoly does not, however, necessarily coincide with the industry, and it tends to change over time. The national transmission system of the Guyana Power and Light Inc. is a natural monopoly, but the retailing of domestic appliances is not. The electricity grid is a natural monopoly, but household wiring and sales of appliances are not. Thus, the natural monopoly problem is typically confined to parts of the industry and not the whole. Consequently, the regulatory problem is not coextensive with the industry. This lack of coincidence gives rise to serious regulatory failure problems if a simple rule is applied to the industry as a whole (Hammond, Helm and Thompson 1985).

By contrast, artificial monopoly arises where dominant firms’ erect barriers to inhibit competition from rivals. Apart from the gas and electricity local and national networks, much of the energy industry has been characterised by this second type of monopoly, through a combination of statutory provisions and other entry barriers. Auxiliary services, such as servicing, billing and appliance sales, are similarly potentially competitive.

These two different types of monopoly require different regulatory solutions. Natural monopoly is addressed through direct regulatory control of prices, output or rate of return, whilst artificial monopoly is remedied by competition policy, directed at reducing barriers to entry.

Regulation Failure

The existence of market failure is common to all markets. For intervention to be justified, these failures must not only be large, but must also be greater than those which result from government intervention. Therefore, how do we consider the problems associated with government intervention to rectify these market failures in the energy sector?

The policies which can be followed by a government which wishes to intervene where private markets fail can effectively be divided into two broad groups. In the first, private markets are replaced by public enterprises which set the objective of directly following welfare-maximising policies. In the second, private firms are subject to regulatory constraints which aim to ensure that the pursuit of profit-maximising policies will yield efficient outcomes.

‘Regulatory failure’ arises where interventionist policies fail to remedy the market failures which they seek to correct or where intervention has unintended, adverse consequences for efficiency. In reality, the contrast between nationalisation and regulation can be drawn too strongly and the problems which arise are not very different in the two cases. The underlying causes of regulatory failure are related to objectives and to the availability of information (Kay and Thompson 1987). Should public enterprises or regulatory bodies choose not to follow welfare maximising objectives, then efficient outcomes will not be achieved.

However, the successful specification of regulatory constraints to ensure the achievement of efficiency depends critically upon the information available to the regulated enterprise (whether public or private) and to the regulator. The policy problem can be characterised in a ‘principal-agent’ framework in which the principal (the regulatory authority or government department) relies on an agent (the utility) to achieve its objectives in circumstances where the objectives of principal and agent diverge and in which the two partners’ access to information is asymmetrical (Crew and Kleindorfer 1979).

It can be seen that the problems of objectives and information interact. If the objectives of principal and agent coincide (that is, if the public enterprises and public regulatory bodies choose to follow welfare-maximising objectives) then the principal is likely to face good access to information, but to have little need for it. If, alternatively, objectives diverge, then information is required to set regulatory rules, but will not be (easily) available to the principal from the regulated enterprise. Where, as is the case for the Guyanese public energy utilities, the enterprise is a monopoly, with a corresponding dominance in information and technical expertise, the information asymmetry can be acute.

Therefore, use a framework to assess the development of energy policy in Guyana. Firstly, look at the performance of the nationalised energy utilities. Thereafter, consider liberalisation and attempts to introduce competition with the state monopolies. Finally, consider privatisation in the energy sector and the regulation of privatised energy utilities.

Policy and performance in the nationalised energy sector closely parallels those of the nationalised industries as a whole, not surprisingly given the importance of energy industries in the nationalised sector. This established corporations which were publicly owned, but which were separate from government and were intended to operate at arm’s length from day-to-day political intervention. These corporations are typically given a national monopoly in the supply of goods and services.

The solution proposed to the perceived failure of private markets was to replace them with public corporations which, it was assumed, would seek to implement welfare-maximising policies. The crucial determinant of the success or failure of policy was thus whether, in the absence of any explicit constraints or incentives, the public corporations would choose to follow the efficiency rules which provided the rationale for their existence. The development of nationalised industry policy to the present day can be caricatured, not altogether unfairly, as a progressive recognition of the inherent improbability of this outcome.

This recognition can be reflected in a sequence of attempts to prescribe regulatory rules which will constrain the industries to act efficiently. This type of allocative efficiency can give focus to the level and structure of prices which can be related to marginal costs. The benefits of proposed investments, discounted by the opportunity cost of capital, can be compared with the costs of the project. In contrast, the main focus of productive efficiency should be on establishing the primacy of financial controls and introducing performance targets. Therefore, the procedures for a welfare-maximising policy, can be characterised as follows:

  1. Prepare medium-term forecasts of the demand for energy and, within this, for component fuels;
  2. Identify the investment paths required to meet this demand in each fuel industry;
  3. Identify the efficient pricing policy for each fuel (using the marginal cost principles) and check the consistency of the planned investment path;
  4. Check the path of relative prices against the demand forecasts and iterate the process until the forecasts, prices and investment paths are consistent.

The function of prices, in this framework, is to provide a medium-term signal to consumers and a benchmark against which to evaluate investment plans. Unanticipated short-term mismatches between demand and supply are remedied not through adjustment to prices, but through the under-utilisation of capacity or through rationing. Under this framework a medium-term view is taken by government of the likely future path of comparative advantage of the different fuels, and it is assumed that an orderly substitution can be implemented.

If this is implemented, then the consequences should be that consumers face prices which are stable in the short term and which give appropriate medium-term signals to inform consumer investment. Energy supply is provided by the most efficient mix of fuels produced using the most efficient technology, and prices are set at efficient levels. This requires, however, that demand forecasting is effective, and the industries have incentives to implement the successive steps. In particular, they must produce the required level of output at efficient cost levels and set prices in relation to these costs.

Assess the success of energy planning by comparing forecasts prepared with the actual out-turn in that year. The differences between forecast and out-turn will be striking and should lead to the conclusion that policies built upon forecasts so prone to error are unlikely to be efficient. It is clear, however, that the technical standard of the Department of Energy’s forecasts must be high and that the forecasting models must be able to track closely the relationship between the demand for energy and the underlying determinants of demand, in particular economic growth. Any forecasting failure identified, will reflect both the sensitivity of energy demand to Gross Domestic Product (GDP) growth (and the difficulty in accurately forecasting growth over the medium term) and a failure to achieve planned substitutions between energy sources.

These problems are compounded by the probability that nationalised industry managers have concerns other than the maximisation of social welfare. There are many objectives which nationalised industry managers may choose to follow in preference to welfare maximisation, in particular output maximisation (Rees 1984), expense preference and managerial slack.

Compare the performance of the electricity industry with that predicted by a model in which the firm maximises output subject to constraints, set by governments, concerning the minimum level of profits and the maximum level of capital expenditure, and where the allocation of labour resources constrains labour bargaining power (Rees (1988). Key features of performance accord with the predictions of the theory: wages are above average (for relevant skill groups), reflecting the exercise of union bargaining power in a monopoly industry, and investment plans have been consistently, and substantially, over-optimistic.

More generally, a specification of the behavioural objectives of public enterprise managers in the framework of output maximisation or expense preference, subject to a government-imposed profit constraint, suggests that in periods when such constraints are weak, enterprises will fail to achieve both productive and allocative efficiency. In periods when the financial constraint is binding, however, this suggests that the achievement of technical efficiency will not be a serious problem and that the main failures will be allocative – both in relation to choose of production technique and in relation to pricing.

Most of these industries are, however, characterised by uniformities in the structure of prices (between different geographic regions or between time-periods) which fail to reflect variations in economic costs.

The main efficiency failures in the energy sector are now allocative. The reasons for this relate both to the absence of product market competition and to specific regulatory failures. Particularly important are the inefficiencies in pricing and output paths in the industry. Cross-subsidisation between energy industries will be accompanied by uneconomic cross-substitution within industries. Asymmetries in information between government regulators and monopoly industries have meant that requirements to relate the structure of prices to relative costs have been in some cases largely irrelevant. This summary thus suggests a fairly well-defined mix of successes and failures, and one which can be related directly back to the likely incidence of regulatory failure.