economics of regulation

Page 1

Question 1

A firm responsible for a country’s electricity transmission network is typically charged

with transferring the

electrical energy from power plants where it is generated to substations where it can be

then be distributed to

end users: domestic and commercial consumers. As a typical network industry, electricity

transmission is

associated with very high fixed costs. However, once this initial infrastructure is in place,

the marginal cost of

actually transmitting this electricity is (relatively) low. It is therefore considered to be a

good example of a

natural monopoly. In the case ofWelfareland, this natural monopoly argument would

explain the government’s

rationale for having decided to have a single electricity transmission company. In the UK,

the (natural)

monopoly responsible for electricity transmission (and distribution to suppliers) is the

National Grid. We

therefore assume that the industry is indeed a natural monopoly, (and equally that the

government’s objective

is to maximise welfare).

The government of Welfareland (and indeed of any country where electricity transmission

is considered a

natural monopoly) can take two possible approaches to solve the issue of a lack of

competition: it can either

allow the incumbent firm to be the legal (and regulated) monopoly firm for a set period of

time (here for 25

years), or it could franchise this right to the winner of an auction process. Franchising

would involve designing

an appropriate auction (and contract for its winner), setting out the responsibilities of the

would-be monopoly

provider, including detailing output, quality or social requirements. The latter case,

however, does not

inherently preclude the need for regulation, and indeed a regulator could still impose

controls on a monopoly

provider, with or without franchising.

Both alternatives available to Welfareland have their advantages and disadvantages and

both have already

been used, pertinently for electricity transmission, in the past. In the UK, the National Grid

was made a legal

monopoly by the British government under the Electricity Act 1989. It has since had the

“duty” to operate the

transmission network across England and Wales. In contrast, in the Philippines the

government franchised the

right to provide the service, with a 50-year license eventually being granted to the National

Grid Corporation of

the Philippines in 2008, following the largest government auction conducted in the

country.

As is often the case for regulation, the benefits and costs of franchising would have to be

assessed on a case-bycase

basis by evaluating, for example, the cost of conducting a tendering process and designing

an efficient

contract. Although franchising could be a useful tool for regulators, this will hinge on

whether or not the

benefits outweigh the costs. In any case, as will be discussed, franchising would likely