The laissez-faire economic philosophy and the increasing dissatisfaction with the performance of public enterprises can lead to the explicit attempt to opt for a market solution which will abandon the main features of the current “energy policy”. Hence, there should be new objectives to create a market for energy.
In a competitive energy market, production is carried out by many separately owned firms. There are no statutory restrictions on market entry other than general environmental planning requirements and those related to health and safety. A competitive market in the production of fuel is thereby established. However, the infeasibility of competition in the distribution of some fuels (because natural monopoly exists, especially in electricity and gas) provides the opportunity for prices to be raised above efficient levels. Local distribution networks are separately owned, however, and a regulatory ceiling is fixed on the distribution charges for each area. This ceiling is set in a systematic relationship to existing charges in all other areas, thereby preventing significant exploitation of consumers, but also providing opportunities for distribution companies to increase profits by beating the average level of performance of all companies.
Distributional concerns relating to the energy sector are dealt with directly through the tax and benefit system. The development of natural resources is left to the market, but resource taxes are used to achieve the desired distribution of resource rents between producers, consumers and the government. External costs and benefits are dealt with through regulation (e.g. on emissions) or through specific taxes and subsidies.
Under this framework, prices perform a short-run allocative function. Consumers with a high preference for price stability can achieve this through purchasing of futures via long-term contracts. The path of output is determined by the investment decisions of the various market participants, which are based on their perceptions of the future path of costs and prices. The mix of fuels supplied is therefore essentially market determined. Since these decisions are formulated in private markets, this policy framework is assumed to provide incentives which ensure that efficiency is achieved rather than simply planned for.
Evidently such a market approach is very different, in appearance and probably in consequence, from the structure which has always prevailed. The major legislative components of any new policy, should include:
- An Oil and Gas (Enterprise) Act which will potentially prevent any statutory monopoly in gas supply and distribution, could force any national company to dispose of its oil interests (as Enterprise Oil) and provide for common-carrier provision and hence competitive entry. Most notably, it must provide for the compulsory publication of the prices that the local utility would pay for privately generated electricity (the private purchase tariffs) and tariffs for rent of the network;
- A Gas Act which can privatise the local market, transforming it for private sector and to be subject to regulation by new authorities.
The central policy dilemma in creating a competitive market was and is the selection of an appropriate liberalising strategy. Much of the energy sector remains characterised by natural and artificial monopoly. Whilst the former type of monopoly requires careful regulation, the latter demands attention to the enhancement of competitive pressure: markets need to be liberalised and the terms of entry for rivals set to prevent artificial obstruction from barriers to entry.
Thus, in order to appreciate the impact of the any new Oil and Gas Enterprise Legislation and the Energy Regulations, Guyana needs to look at the underlying entry-preventing strategies. Any liberalising strategy must be based on a prior view as to the degree of potential entry and the sorts of entry barriers which may inhibit it. The energy sector industries combine elements of both natural and artificial monopoly. Competition is possible only in the potentially competitive segments of the industry, and the natural monopoly elements should therefore be separated and subjected to regulation.
Non-natural monopoly elements are open to competitive entry. The dominant incumbent can, however, employ a number of strategies designed to create and sustain an artificial monopoly. In addition to the statutory barriers to entry, recent industrial theory has highlighted a number of strategic activities by which dominant firms may deter rivals. As applied to the electricity supply industry, these strategies may deter entrants and hence could undermine the liberalisation intentions (Hammond, Helm and Thompson 1986). The principal barriers identified are excess capacity, entry costs, the bankruptcy constraint, and the strategic choice of objectives.
Where an industry is characterised by excess capacity, the potential entrant alters its expectation about the response rivals will give to entry. It will decide to enter only if the rivals’ response is sufficiently muted to leave profitable opportunities for the entrant. If the incumbent has spare capacity, the cost to it of a loss of market share will be greater than if it were at full capacity. Thus, entry is more likely to produce retaliation, and hence make entry less attractive.
Entry costs are of two forms – fixed costs and sunk costs. Fixed costs are dealt with under natural monopoly. Sunk costs are ones which are irrecoverable to the entrant, should it subsequently decide to leave the market. As these increases, the incentive to enter declines because the size of the initial investment at risk, and hence the costs of failure, rise. In the energy sector, the principal sunk costs relate to planning the entry decision, acquisition of energy skills, and the imperfection of the second-hand market for pipes, generating capacity, and so on. Much investment in the energy sector is specific.
The bankruptcy constraint is of considerable importance in the energy sector, because of the considerable presence of the public sector, and thus the fact that debt is underwritten. The potential entrant perceives that in a price war, the public sector incumbent is better able to withstand the short-term loss of profitability and hence is more likely to win. The existence of financial resources and a weak bankruptcy constraint is therefore a credible threat to the entrant that the incumbent would find it worthwhile to challenge the entrant, and hence reduces the entrant’s expected return. This financial or bankruptcy barrier to entry is reinforced by another aspect of State ownership, namely the impact of managerial objectives on rivals’ entry decisions. The separation of ownership and control encourages the presence of managerial rather than profit objectives. An output-maximiser to lower prices and total profit to gain extra market share is expected (Rees 1984). This has a dual impact on potential entrants. The potential profit to the entrant is lowered because the nationalised firm lowers the general level of prices in the industry and is more likely to retaliate to loss of market share to the entrant, because market share more directly affects output than it does profits.
Any new legislation should ensure that the industry publishes the prices which would be paid to private sector producers (private purchase tariffs – PPTs) and the prices to be charged for the rental of the network (the common-carrier or network charge). However, three problems must be avoided; the setting of the tariff levels by the dominant incumbent, the absence of longer-term contracts, and the failure to set up an independent body to review the administration of tariffs. The fundamental impact of public ownership must be altered by new regulations: control of the tariffs should enable the excess capacity to remain, and its costs to be passed on to consumers as higher prices without encouraging entry, because entrants received only ‘avoidable’ variable costs. New entry is rarely promoted by letting the dominant incumbent set its rivals’ price.
The dominance that an incumbent exercised could be addressed through restructuring. Such an opportunity could be presented by the role of privatisation. Enhancing competition through liberalisation may achieve very little in electricity and gas industries, and government attention should be shifted towards improving the productive efficiency of the existing dominant firms. The changing of the ownership of nationalised industries would in itself improve efficiency, subject to an appropriate regulatory structure.
The regulation of private energy utilities in the United States, where private ownership of energy production is most common, has been subject to well-known difficulties. The most usual regulatory instrument – rate-of-return, or rate-base, regulation – involves the specification of price ceilings which are based on the enterprises’ actual costs and which provide for a pre-specified ‘fair’ return on the enterprises’ capital assets. This system provides no additional profit in improving efficiency and reducing costs. Conversely, any increases in costs can be passed directly on to consumers in higher prices. The efficiency incentives usually associated with private ownership are therefore almost completely eliminated. Furthermore, because the price ceiling is determined to provide a specified return on capital assets, there is an incentive for profit-maximising firms to adopt production techniques which are too capital-intensive. There may also be adverse incentives for the efficiency of pricing policy with incentives to under-price capital-intensive (for example peak) outputs (Sherman and Visscher 1982).
This regulatory failure is reflected in studies which have compared the costs and efficiency of regulated private utilities with those of similar publicly owned enterprises. Generally, the findings of these studies show either no systematic differences in performance between the public and private sector or a differential which marginally favours the publicly owned enterprises (Yarrow 1986).
The underlying cause of this regulatory failure lies in the asymmetry in information between the regulatory authority and the regulated enterprise. If the regulatory authority knew what level of costs constituted efficient performance by the enterprise, then it would be able to structure the regulated price ceiling accordingly. In the absence of this information, prices are regulated in relation to achieved costs, with the adverse consequences for efficiency which have been noted. It can be seen that the nature of this regulatory failure is the asymmetries of information in the achievement of efficiency between a monopoly enterprise and the relevant regulatory authority.
In theory, at least, the management of an enterprise which failed to achieve productive efficiency would find itself replaced (via take-over or at a shareholders’ meeting through the actions of shareholders seeking to maximise their return).
The proper test of this regulatory system will lie ultimately in the performance (in terms of costs and efficiency) of the newly privatised enterprises. It will clearly be some years before any, even preliminary, verdict can be reached on this.
These enterprises are not profit-maximising in any usual sense. The limits to the enforcement of profit maximisation are well known (Helm (1988), and in the case of the newly privatised utilities their size, market power, diffusion of shareholding and immunity from take-over make them very different from the textbook model of the profit-maximising firms.
Information necessary to assess efficiency appears, if anything, less readily available than before. If neither shareholders nor customers can monitor this, however, then the effectiveness of the system will turn on whether or not the regulatory authority can determine what constitutes an efficient level of performance and may design the regulatory price ceiling accordingly. In capital-intensive industries, however, if the price ceiling is set too ‘tightly’ then the consequence is likely to be underinvestment and, eventually, supply failure.
The regulator’s task is thus not straightforward. Yet it is clear that unless the regulatory authority can form a judgement on the enterprise’s efficiency which is largely independent of actual costs and performance, then the system starts to become very similar, in practice, to rate-of-return regulation, with all its associated weaknesses. This will be particularly likely if there is concerned to avoid supply failure in capital-intensive industries.
One method of generating such an independent judgement is to make comparisons of the performance of particular activities in different geographic areas. The regulatory price ceiling applied in each area can be established by reference to the costs and performance of the other areas. Similarly, shareholders will be provided with comparative information on their company’s performance. Effectively the system establishes ‘yardstick’ competition (Shleifer (1985) in which, although each distribution network is a natural monopoly, the regulatory framework requires each company to match the efficiency of other distribution companies if it is to maintain normal levels of profitability. Thus, the new market philosophy could fail in its ambitions. The energy sector may not see significantly enhanced competitive pressure, and the newly privatised industry could survive with its integrated monopoly intact, and subject to less control than when in the public sector.