Privatisation of the energy industry will only be effective in improving efficiency to the extent that it creates a market in the purchase and sale of energy; in other words, only if the present public sector monopoly can be converted into a competitive private industry.
However, a fully competitive solution is not available due to the existence of natural monopoly elements in the transmission and distribution network. It seems clear that this natural monopoly would not be contestable (in any significant sense) and some type of regulatory control is likely to be desirable.
The regionalisation option enhances efficiency incentives in both the product and the capital markets by creating a new market for the purchase and sale of energy. This option involves setting up separate companies to take over the functions of one utility company plus an additional company to operate the National Transmission System (NTS). Ownership of the existing energy supply contracts is also separated. This option would be based on utility company’s regional structure, and the present arrangements and transactions between regions (and with the NTS) would become explicit contractual agreements between separate companies.
Regionalisation retains the natural monopoly in each local distribution network, and in the NTS, and enables the associated scale economies to be exploited. Under this option the task of matching peak demand and supply, and the associated operation of storage facilities, could be co-ordinated centrally as part of the operation of the NTS.
Therefore, to the extent that there exist economies of scale or scope in peak matching, these would not be forgone in this option. The peak costs associated with the demand profile in each region would be passed on via the internal charging system (as happens, in principle, at present). It seems unlikely that separate ownership would increase transactions costs between regions and the NTS. The present internal charging system already provides a structure for financial transactions and a system of incentives for the provision of accurate information.
The advantages of this system are twofold. First, there would be a greater incentive towards profit maximisation because the capital market would exert pressure on each of the new entities. There would be a more plausible threat of take-over and the very remote possibility of bankruptcy. Thus, in addition to cost of capital effects, which this option shares, there are additional pressures from the capital market. The incentives for the achievement of productive efficiency are therefore strengthened. The regional companies would become explicit profit centres and hence provide information (both to their management and to shareholders and regulators) which enables their performance to be compared directly with other similar enterprises.
The second advantage of this option is that the structure of charges is more likely to be related to marginal costs. This option removes the basis for uneconomic cross-subsidisation between regions, and charges in each region are likely to reflect more closely the marginal costs of supply in the particular region. It is also more likely that charges made to regions for the use of system capacity and storage facilities during periods of peak demand will be passed on to customers.
Whilst the regionalisation option holds significant advantages it would require that the ownership of the existing energy supply contracts be separated. Where a private monopoly exists, the issues raised are essentially ones of monopoly rent. Nonetheless, when combined with the common-carrier NTS possibility, these may directly affect entry and the pricing structure. For if the private company operating the NTS also held the original contracts, at existing prices, competitors in supply (such as oil companies) would be at a disadvantage and little efficiency gain might be forthcoming. There are at least three possible methods by which ownership of the contracts can be separated:
- First, a wholesale agency could be set up to hold these contracts, with rents accruing to the State.
- Second, the contracts could be auctioned to the highest bidder and the returns remitted to the Government. Prices would then move toward marginal cost more immediately. The Treasury would gain its desired revenues and competition in the supply of energy would be facilitated.
- Third, all contracts could be cancelled, and renegotiation initiated. Oil companies would then reap the economic rents, and this gain may be offset by a modified the levy on oil and gas companies similar to a Petroleum Revenue Tax.
The regionalisation option would go a substantial way toward establishing a market for energy, but the individual organisations would still retain varying degrees of market power. In particular the organisation owning the NTS would be able to exploit its monopoly position and some type of regulation would be required. Similarly, each of the regional companies would continue to hold substantial market power in the supply of energy to domestic customers; supply to industrial customers may, however, become more competitive if the restructuring proposed enables any new legislation and their provisions to be implemented more effectively.
Vertical Separation of Energy Sale and Supply from Ownership of the Transmission and Distribution Network
In principle it might be considered that market power in the supply of energy to domestic customers could be reduced by the complete separation of the sale of energy from ownership of the distribution system (that is the NTS, and also the local distribution networks). Complete separation would involve individual households and firms in a particular area registering with different competing energy suppliers. Each household or firm would choose its supplier and be billed by that company. The owner of the distribution system would contract to provide a connection and the supplier of energy would lease ‘line-space’ from the owner of the distribution system.
Again, this option would preserve the natural monopoly in each local distribution network and the NTS. The central drawback, however, is that there is likely to be a significant increase in transactions costs. Additional costs are likely to arise in contractual arrangements between the separate companies owning the distribution network and supplying energy which would not arise if these functions were to remain vertically integrated. In particular a contract between infrastructure owner and energy supply company needs to be able to identify and pass on to each energy supply company the peak costs imposed on the transmission and storage facilities by its customers’ demands. In the absence of this capability there would be an incentive for each energy supply company to provide misleading information in its dealings with the owner(s) of the distribution network. To implement this option for supply to domestic customers requires more sophisticated metering equipment than at present in use. Furthermore, the risk of interruption and variation in supply is also likely to increase. Contractual arrangements would have to be three-way between supplier, infrastructure owner and customer and the assumption of legal liability would not be straightforward in the event of failure to supply.
Thus, although appealing in theoretical terms, the complete vertical separation of the sale of energy from ownership of the distribution system appears impractical at least as far as supply to domestic customers is concerned. However, as noted earlier, in the case of industrial consumers the scope for competitive entry under the provisions of the respective legislation should be enhanced under the proposed regionalisation option. Additional transaction costs are unlikely to be as significant because more sophisticated metering equipment will typically be in use and any additional costs will also be spread over a far larger volume of business.
Regulatory Framework for a Privatised Energy Industry
Regulation comes in many different forms, however, and there are three general criteria for how these might be implemented. The criteria are the desirability of promoting competing sources of information, the general preference for price rather than rate-of-return regulation, and the separation of natural monopoly from competitive elements within the industry.
A regulatory authority is typically given general guidelines and rules to follow as well as specific licences to monitor. The gap between these rules and licences on the one hand, and the complexity of production and pricing policies on the other, is considerable. For this purpose, the regulator needs information. The information is more likely to be accurate and reliable the more competitive is its method of production. In the absence of competing sources of information there is a greater danger of regulatory capture – that is, a situation where the regulatory authority forms a symbiotic relationship with the regulated industry in which the interests of the industry are promoted as well as, or instead of, the interests of the industry’s customers (Bailey 1973). The regionalisation option provides a range of competing sources of information for the regulatory authority (Vickers and Yarrow 1985). In particular, the regionalisation option would yield information on the costs of distribution, rates of return and the effects of alternative pricing strategies. If regionalisation is not adopted then different cost and profit centres, replicating what would have happened had the option been pursued, should be set up to generate that information.
The second regulatory principle – of price rather than rate-of-return regulation – is the preferred route for two rather different sets of reasons. A major limitation of rate-of-return regulation is the well-known overcapitalisation effect (Averch and Johnson 1962). Rate-of-return regulation may also distort the structure of prices set in markets with a different capital intensity in production (a material consideration for peak/off-peak price differentials (Sherman and Visscher 1982). Price regulation may also require less information than rate-of-return regulation and be more straightforward to monitor. Under price regulation a periodic assessment of the basis of the level of price control will be required, but between each review comparatively little information and analysis are required. To the extent that this reduces the degree of discretion open to the regulatory authority, the risks of regulatory capture are also reduced (Littlechild 1983). There may, however, be practical difficulties in specifying a price regulatory formula which is much different in effect from rate-of-return regulation.
The third regulatory principle is central. It is that natural monopoly elements should be isolated from competitive activities, so that regulatory rules applied to the control of the natural monopoly do not also interfere with the achievement of efficiency in activities where competition is feasible. This principle might be called the undesirability of ‘cross regulation’. The regionalisation option involves separation of the NTS and each of the local distribution networks from the purchase and sale of energy.
The problem of how to regulate residual natural monopoly elements effectively (given the problems identified above) remains. An old solution suggested in the literature is franchising – inducing competition, not directly in the production of the commodity, but for the right to exercise a monopoly. Thus, given the natural monopoly elements in the NTS and in local distribution, one possible option would be to auction the franchise rights regularly to competing managerial teams. In principle that team most able to distribute at lowest cost will put in the highest bid. Franchising does, however, raise problems of its own. identifies two of the most serious of these as how to organise an efficient franchise bidding system and how to ensure a transfer of assets on termination consistent with appropriate incentives to invest, but not to overinvest, in necessary equipment. Experience with franchising contracts (Domberger and Middleton 1985) indicates that incumbents may acquire advantages which deter competitive bids. The form of the tender might have to be quite complex since it would need to include provisions which relate to safety and security of supply. Franchising is thus an interesting theoretical option, but one where further exploration is required before its applicability to energy supply can be recommended.