Is Irish Utility Regulaton Failing Consumers?

Is Irish Utility Regulation Failing Consumers? Patrick Massey1 November 2004. 1 The author is a director of Compecon Limited. I am grateful to Sean Barrett, Isolde Goggin, Robin Mason, Colm McCarthy and Tony Shortall for their comments on an earlier draft. The usual disclaimer applies. 1 Is Irish Utility Regulation Failing Consumers? Abstract: Over the past decade the energy and communications markets in Ireland, which were traditionally the preserve of State owned monopolies, have been opened up to competition to some extent, largely as a result of EU legislation. This has resulted in changes in the regulatory environment and the establishment of independent regulatory agencies for these industries. The present paper analyses the impact of these changes. It argues that competition, wherever it is possible, is superior to regulation. The paper suggests that policy to date has paid too little attention to measures necessary to promote greater competition and that regulation has failed to protect consumers. The paper concludes that active measures are necessary to promote greater competition in gas, electricity and postal services and that these need to be combined with reforms of the existing regulatory regime. 2 Introduction. Europe’s energy and telecommunications industries have undergone major changes over the past decade. EU Directives required Member States to open up their national markets to competitors from other Member States.2 Introducing competition in monopolised industries should increase productive efficiency, leading to lower prices, and lead to a greater alignment between prices and costs, thereby enhancing allocative efficiency. The present paper argues that the reforms implemented to date have been inadequate and that regulation of such industries in Ireland is deficient in a number of important respects. The paper considers some possible solutions to these problems. Electricity and gas prices have risen by 40% and 22% respectively since December 2001.3 (See fig.1) Fig.1: Irish Gas and Electricity Prices (Dec 2001 = 100) 85 95 105 115 125 135 145 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004e 2005f Electricity Gas Notes: The 2004 estimates are based on CSO data up to August 2004 and incorporate price increases for gas and electricity which took effect on 1st October 2004. The 2005 forecast includes a further 3.5% increase in electricity prices scheduled to take effect on 1st January 2005 and assumes no further price rises. Source: CSO and Compecon estimates. Rising oil prices only partly explain the sharp rise in electricity prices. The National Competitiveness Council (2004) reported that Irish industrial electricity prices were 2 Telecommunications was fully liberalised in 1998, full liberalisation of gas and electricity markets for smaller customers is scheduled to take place early in 2005, while liberalisation of the postal service is at a much earlier stage. 3 This takes into account a 3.5% increase in electricity prices due to take effect on 1st January 2005. 3 among the most expensive in the EU even before a 9% price increase in October 2004.4 UK electricity prices were 40% lower than in Ireland for firms consuming 10 GWh. Fixed line telephone charges declined by over 30% between 1997 and 2001 but have risen by 9% over the past three years. (See Fig.2) Eircom’s line rental charges are double the European average.5 Postal charges have increased by almost 25% in three years and An Post had sought a further 7 cent (14.6%) increase, although subsequent newspaper reports indicate that this is unlikely to be granted by ComReg.6 Senior (2004) reports that the standard price of a postage stamp in New Zealand, which has fully liberalised the postal sector, was unchanged on its 1989 level of nz45c. Fig.2: Irish Fixed Line Telephone and Postal Charges (Dec 2001 = 100) 90 100 110 120 130 140 150 1997 1998 1999 2000 2001 2002 2003 2004e Telephone (Fixed) Postal Charges Notes: The 2004 estimates for are based on CSO data up to June projected forward, i.e. assuming no further price increases this year. Source: CSO and Compecon estimates. ESB profits before interest and tax in 2003 amounted to €354m, with 61% of this attributed to the transmission and distribution network. Pay levels in the electricity industry have risen sharply relative to those in other industries since mid 2001. (See 4 Ireland was second most expensive out of ten countries for firms purchasing 10GWh; 3rd most expensive (out of nine countries) for firms purchasing 25GWh and 3rd most expensive (out of eight countries) for 70 GWh. 5 Sunday Business Post, 12.9.2004. 6 Sunday Business Post, 14.11.2004. 4 Fig.3). Average weekly industrial earnings in the electricity, gas, steam and hot water supply sector in June 2004 were €1,157.47, more than twice average weekly industrial earnings which stood at €560.60. According to newspaper reports, more than one ESB board member “is understood to have commented at a board meeting that the company was doing very well out of the regulation process”.7 Fig. 3: Average Weekly Earnings of Industrial Workers (1995q3 = 100) 100 120 140 160 180 200 220 240 260 1995Q3 1997Q1 1998Q3 2000Q1 2001Q3 2003Q1 Source: CSO All Industries Electricity, Gas, Steam & Hot Water Supply Not surprisingly such price increases have led to growing resentment among consumers and business. IBEC claimed that the energy market was not working and that a new approach was needed to ensure security of supply at a reasonable cost.8 The NCC (2004, p.ii) stated bluntly that: “Better regulation is needed in sectors such as energy, telecoms and professional services to ensure more vigorous competition and drive down the cost of doing business in Ireland.” Regulation – What Have we Learned? 7 Irish Independent, 2.10.2003, Why Regulation is Good for ESB. 8 Irish Times, 9.2.2004. 5 Traditionally gas, electricity and telecommunications were regarded as natural monopolies which had to be regulated to prevent the abuse of monopoly power. In Ireland, as in many European countries, State ownership was viewed as a way of ensuring these industries were operated in the public interest.9 (Hotelling, 1938). In the US such industries were generally privately owned with the scope for abuse of market power regulated by profit or rate of return regulation. During the 1970s and early 1980s, there was a growing realisation that traditional forms of regulation were ineffective. The economic literature highlighted regulators’ inability to achieve first-best outcomes due to information asymmetries, which enable the regulated firm to set price above cost and gain a socially-costly rent from its activities. (See Laffont and Tirole, 1993 and Laffont, 1994). Nationalising such industries creates highly centralised organisations in which information is asymmetrically distributed in favour of management, making it difficult to exercise effective public control. (Schick, 1993)10 Regulatory agencies are also prone to bureaucratic capture resulting in an inherent bias toward increasing their activities. Such considerations resulted in a major reappraisal of public policy towards the energy and communications industries, beginning in the United States and Britain in the early 1980s and subsequently spreading to other countries. It was recognised that, while the transmission and distribution networks in gas and electricity are natural monopolies, other activities are potentially competitive. The reform programmes introduced in most countries generally had two broad characteristics. 1. Measures to permit competition in potentially competitive segments of utility industries, reflecting a view that competition was superior to regulation; and 2. In natural monopoly areas, where regulation remains necessary, attempts were made to devise more effective regulatory tools designed to reduce the risk of regulatory capture. 9 Electricity and telecommunications were historically state monopolies, while the gas industry consisted of a small number of local urban monopolies, which were largely privately owned. With the replacement of town gas by natural gas in the 1980s, the old town gas companies were acquired by the State owned BGE. 10 Lawson (1992) describes how, in the UK, the CEGB misled successive Governments about the true cost of nuclear plants, something which only emerged on the eve of the UK electricity privatisation. 6 Regulation has frequently been seen as a necessary temporary measure “to hold the fort” until competition develops. (Littlechild, 1999) Promoting Competitive Markets. New entrants in gas and electricity must be able to access the natural monopoly network if they are to compete with the incumbent provider. A vertically integrated incumbent has obvious incentives to deny access to the network or to grant it on unfavourable terms. It is extremely difficult for a regulator to establish the true costs of providing access and vertically integrated incumbents have an incentive to overstate them. “The pricing of access to essential facilities can be complex even when their ownership is separate from competitive activities, but it is especially controversial when there is vertical integration.” (Vickers, 1998, p.34) In contrast, the unintegrated owner of a transmission network would never have an incentive to refuse to deal unilaterally. Vertical separation of the natural monopoly elements from the potentially competitive segments of the gas and electricity industries greatly simplifies the task of regulating access charges and is thus more effective at fostering competition.11 (See, for example, Armstrong et. al., 1994; Littlechild, 2003; Newbery, 2001; OECD, 2001; and United States Federal Trade Commission, 2000). Accounting separation is not enough, as it is very difficult for a regulator to ensure that costs are correctly apportioned between different business activities. The issues in telecommunications are somewhat different to those in gas and electricity. Rapid technological change and the growth in rival mobile networks mean that the natural monopoly problem may no longer arise. (Ricketts, 2004). Littlechild (2004) nevertheless argued for the vertical split up of BT, pointing out that, whereas price regulation had been removed in UK gas and electricity markets it remained in place for telecommunications. 11 International experience indicates that the potential gains from competition outweigh the loss of economies of scope that result from vertical integration. 7 The incumbent will typically have inherited a dominant position as a result of its former protected monopoly status and this may also stymie new entry. In the case of electricity Bergman et. al. (1999, p.229) concluded that “competitive outcomes cannot be reached without sufficient dispersion of the ownership of generation assets.” Nuttall (2000), Newberry (2001) and Littlechild (2003) all stress the importance of horizontal restructuring in electricity. Dealing with Information Asymmetries. Price cap regulation attempts to overcome the information asymmetry problem by encouraging the regulated firm to reveal accurate information about the potential for cost reductions. The price cap is supposed to provide a strong incentive for the regulated firm to achieve greater cost savings than those set by the regulator, since this will increase its profits. This in turn provides more accurate information to the regulator about potential efficiency gains when the price cap is due for review.12 Regulation is a repeated game which provides scope for strategic behaviour by the regulated firm. It will recognise that, while it can retain additional efficiency gains in the short-run, such gains will lead to tighter price caps in the future. (See Laffont and Tirole, 2003). Giulieti and Waddams-Price (2000), in a study of the effects of price caps in UK utilities, along with airports and telecoms in the US, found “little evidence that firms had moved towards more efficient pricing structures” under price cap constraints. They reported evidence of considerable gaming around the time of price reviews in an attempt to get price caps raised as much as possible. In contrast they report a move toward cost reflective pricing where competition had been introduced. Noll (1995) pointed out that high profits in public utilities were considered unacceptable politically and regulators in both the US and UK were forced to take action to reduce them, thereby reducing the incentive effects of price caps. 12 Setting price caps for a basket of products simplifies the task of the regulator and allows the firm flexibility to adjust prices in response to changes in costs and increase profits. Provided the price cap ensures that consumers, as a whole, are not worse off as a result of such price increases, the result is increased social welfare. Flexibility also enables the firm to unwind any cross-subsidies which may exist. 8 It was originally claimed that price cap regulation would be simpler to operate, and less vulnerable to producer capture than traditional rate of return regulation. Littlechild (1986) subsequently conceded that “rate of return considerations are necessarily implicit in setting and resetting x”. Price capping is therefore a highly complex process involving considerable information requirements and assumptions about cost and demand, as well as predictions as to future changes in cost and demand. Pollitt (1999) notes that poorly constructed incentive regulation may negate many of the positive benefits from reform. Laffont and Tirole (2003) and Laffont (2004) also question the efficacy of price-cap regulation. Massey and O’Hare (1996) pointed out that price capping assumes that firms are profit maximisers and relies on the incentive to increase profits to induce firms to reveal information to the regulator. It is designed to apply to private sector firms. Dodgson (2003) argued that price capping was unsuitable for regulating the UK Post Office for similar reasons. Why Regulation isn’t Working. The EU Directives on opening up energy and communications markets only set out certain general principles and left Member States considerable scope to decide how such measures should be implemented. As Waverman and Sirrel (1997, p.115) noted: “Experience in many countries shows that the devil is in the detail and that competition does not arrive overnight.” Cave and Prosperetti (2001, p.111) describe “the appalling record of some Member States in implementing [telecommunications] directives.” Littlechild (2003) has criticised France and Germany for failing to introduce competition in their respective electricity markets. The then EU Commissioner for the Internal Market described liberalisation of the energy market as “still incomplete because two big players, Germany and France, lag behind.” (Bolkenstein, 2004, p.126) 9 The existence of information asymmetries, combined with the fact that both incumbents and new entrants have an incentive to mislead the regulator, also has important cost implications. Incorrect regulatory decisions are likely to impose significant costs on the economy as investment decisions and competitive strategies of firms will be misdirected. Regulatory Accountability Regulators are themselves monopolies, which suggests that there is a need to ensure that they are subject to an adequate level of accountability. Levine (1998), however, claimed that “…the welter of information that the public receives about political issues from the media and the difficulties of organising to achieve political ends insulate regulators from monitoring and general interest pressures…” Westrup (2002) found that Oireachtas Committees had failed to properly oversee the activities of regulatory bodies because of a combination of inability; ignorance or partiality; and lack of interest. He observed that “the Oireachtas has shown little enthusiasm for carrying out its scrutiny role” (p.55) and described “the apparent unwillingness of different Oireachtas committees to meet with the different regulators on even an annual basis is an indication of a reluctance to take seriously a scrutiny role”. It appears that committees only take an interest in the activities of regulators when such issues become hot topics politically and present an opportunity for political points scoring. This of course does not permit for the sort of detailed and indepth performance reviews that are necessary. Getting the Market Structure Right The lesson from other countries is that, where competition is possible, it is far superior to regulation at increasing efficiency and ensuring the lowest possible prices to consumers. (Kahn, 1988) Policies which seek to limit competition, and rely instead on regulation to safeguard the interests of public utility customers are therefore misguided. As Stelzer (2001, p.7) observed with regard to UK regulatory agencies: “…it was somewhere between foolishness and wild optimism for the government to imagine that regulation is a process that can be performed by a few folks applying uncontroversial techniques to determine prices that will be fair to consumers and at 16 the same time yield returns adequate, but no more than adequate, to attract capital in sufficient quantities to maintain service at acceptable levels.” Borenstein et. al. (1999) point out market power problems may persist in electricity even when there are a number of competing generators, but nevertheless argue that competition is superior to regulation. Equally it must be recognised that simply permitting entry will not lead to the emergence of competitive markets in gas and electricity. The objective of policy should be to ensure that, in five years time, regulation will only remain necessary in the case of the natural monopoly transmission and distribution networks. Achieving this aim is likely to require some restructuring in gas and electricity. The ownership and control of the transmission and distribution networks needs to be transferred to companies that are independent of ESB and BGE. In the case of gas, approximately 80% of the market in volume terms is currently open to competition. While BGE still has 100% of the household and small business market, horizontal restructuring of its supply business would appear unnecessary. Electricity is more complex. The ESB (2003) has committed itself to reducing its market share of electricity generation to 60% “to facilitate the entry of new competitors.” This is unlikely to result in an adequate level of competition, particularly as ESB would still have 100% of the peak plants which effectively set the price for generation.18 It has been suggested that the Republic of Ireland electricity market is too small to permit competition; although Littlechild (2003) reports that competition is being considered in countries with a total generation requirement of 1,000MW or less. There are proposals for the creation of a single all island electricity market and for the construction of inter-connectors to Britain.19 IPA (2001) concluded, however, that action would be required to tackle ESB’s dominance in generation even in the context of an all 18 Borenstein (1999) has shown that firms with much smaller market shares may be able to wield market power in generation. 17 Ireland market.20 Borenstein et. al. (1999) reported that in parts of the US generators reduced the geographic size of the market by reducing output and causing congestion on the grid. Such experience suggests that increasing inter-connection capacity on its own might not suffice. Commenting on Swedish experience, Bergman et. al.(1999, p.229) concluded, that “it is better to rely on the redistribution of generation assets” whenever possible, because the benefits from market expansion “are likely to be more uncertain and less immediate.” Consideration should also be given to faster liberalisation of postal services. There is some evidence that final delivery may constitute a natural monopoly. In the UK rival operators handle the collection, transport and sorting and pay the Royal Mail for final delivery at a rate of 13p per item. Such mail can be sorted down to the level of individual delivery routes. (Senior, 2004) Reforming Ireland’s Regulatory Regime. Structural changes in gas and electricity need to be accompanied by significant reforms of the existing regulatory regime. Sharp price increases for gas, electricity and postal services in recent years has contributed to a growing public disenchantment with the regulatory process in Ireland and created a mistaken impression that competition in these industries has not worked. In many instances regulatory decisions simply summarise submissions of various parties and set out conclusions. (See, for example, CER, 2004). Stelzer (2001, p.105) has criticised such an approach in the UK. “This decision to establish a decision-making process that, to all intents and purposes, excluded consumers from participation relied on the very English notion that responsible chaps know what is best for the public.” There is a need for a properly resourced consumer body that is capable of undertaking the necessary research to present a counter case to the regulated firm. Greater transparency is 19 Bergman, et. al. (1999) describe how Sweden, Norway and Finland expanded their national electricity markets by integrating them in this way. Interconnection capacity between Scotland and England is being increased in response to a lack of competition in Scotland. See Ofgem (2001). 18 required to restore credibility to price regulation. Future price reviews should be conducted by means of a public hearing. This would allow the arguments put forward by regulated firms to be challenged directly. It would also require those opposing price increases to present more rigorous arguments. The CER (2004) reported that submissions from trade and business associations opposing the October 2004 price increase argued:  Prices should not be increased because of a cumulative increase of 28% over the previous three years;  Price increases should be less than inflation because they are a significant cost to industry; and  Company’s operating budgets had been set for 2004 and included no provision for higher electricity charges. The existing regulatory agencies for energy, telecommunications and airports should be combined into a single regulatory agency. There would appear to be obvious economies of scale and scope suggesting that a merger would be beneficial, while such an agency might also be less prone to regulatory capture. Massey and Daly (2003) describe the current ad-hoc arrangements regarding appeals against regulatory decisions, with wide variations in the type of decisions by the different regulators that can be appealed and with appeals by customers against pricing decisions excluded except in the case of the aviation regulator. Customers and customer groups should have a right to appeal decisions on prices and price caps with a single appeals panel responsible for considering appeals against regulatory decisions. An appeal by the major airlines, who are the customers, led to the CAR reducing price caps for airports. There is a concern that the appeals body would become the de facto regulator and that parties would not engage in the initial regulatory decision making process but preserve their ammunition for an appeal. Firms generally tend to want such issues decided speedily and it is not in their interests to act in such a fashion. In order to discourage vexatious appeals, appellants could be required to bear the cost of unsuccessful appeals. 20 This need not involve privatisation of existing ESB plants. New Zealand, for example, privatised 40% of its generating capacity but the remaining 60% was split into three competing state companies. 19 Waverman (2003, p.144) argues that regulatory creep is endemic by its nature as the regulator’s job is to regulate. “Hence blaming them for regulating is like blaming fish for swimming. There are only ways to restrain regulatory creep…” This is exacerbated by the fact that rivals have obvious incentives to complain to regulators about incumbent firms as they may benefit if the regulator restricts the ability of the incumbent to compete with them. He suggests that regulators should themselves be subject to a price cap while unsuccessful complainants should be required to bear the cost of investigations by the regulator. In Ireland’s case a price cap of CPI - 10% for the regulator(s) for five years would encourage moves towards developing effective competition and reducing the scope of regulation. The base point for the regulator’s price cap should reflect ComReg’s actual regulatory outlays rather than its revenue. Conclusion Little progress has been made to date in introducing competition in gas, electricity and postal services in Ireland. Arguably this is because too little consideration has been given to the introduction of measures necessary to bring about such competition. Policy has instead tended to favour regulation over competition. Such an approach is clearly misguided and will inevitably result in higher prices and a loss in allocative efficiency with consequent implications for industrial competitiveness. Technological developments have fostered increased competition in telecommunications in spite of such policy inadequacies. 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