A joint project between Norwegian School of Management (NSM)
and
Norwegian Water
Resources and Energy Directorate (NVE)
Co-financed by the Norwegian Research Council
(NFR)
June 13, 2002
1. Introduction
Due to the monopoly status of local utilities, the government regulates the prices of the network service. The main motivation behind this regulation is to avoid social welfare costs due to excessive pricing of the service. In Norway there has been a regulatory change from rate-of-return regulation, that guarantees a certain economic return on the invested network capital, to revenue-cap that gives the utilities a maximum revenue to be earned annually. Importantly, the revenue-cap is fixed for five-years periods, and, consequently, is supposed to be independent of costs and investment decisions by the utility.
The main objective of this research project is
(i) to investigate how current regulatory practices by the governments affect utilities’ incentives to innovate and develop new energy sources, and
(ii) to develop knowledge about good regulatory regimes for the future that stimulates innovation and investment in alternative energy networks an local production.
A traditional perspective on environmental policy is that taxes or subsidies could be used towards consumers of energy in order to provide them with the right incentives both with respect to the level energy consumption and to the choice of energy sources. However, in order to succeed with such energy consumption policies, utilities must have the right incentives to meet induced demand by developing new energy networks.
A good understanding of the energy utilities’ economic incentives to develop new and efficient energy sources for households and firms in the future, and how the government, by their regulatory practices, affects these incentives will be of crucial importance.
The project is organized as a co-operation between Norwegian School of Management (NSM) and NVE. The research team from NSM consists of Associate Professor Dag Morten Dalen, Professor Espen R. Moen, and Professor Christian Riis at the Department of Economics. NSM will also host the two Phd. students: Thor Erik Grammeltvedt senior adviser at NVE and Leonid Andreev a recent graduate from the University in Oslo.
The
project team from Norway will also include Professor
Nils-Henrik M. von der Fehr from the University of Oslo and the Frisch
Centre.
The project will also co-operate with two foreign research institutions. Professor Per J. Agrell at the School of Management, Université Catolique de Louvain in Belgium and
Professor Peter Bogetoft at Department of Economics and Natural Resources, Royal Veterinary and Agricultural University in Denmark.
2. Objectives
Energy consumption in Norway is dominated by electricity. This is mainly due to Norway’s access to rich supplies of relatively cheap hydropower. As a consequence, a large energy-intensive industry has developed, and electricity has become the main source for heating buildings and water in households. However, economic growth with a steady increase in energy demand will call forth developments of alternative energy sources for firms and households, as well as more efficient use of existing energy resources. Furthermore, both international and national commitments to sustainable development and reduced emissions of climate gases, increases the social benefits of developing clean energy sources such as district heating, bio-energy, wind-energy, heat pumps for firms and households. In Norway there is also a question of introducing natural gas for direct consumption by firms and households.
Energy choices made by firms and households, e.g. with respect to heating system, are restricted by available networks developed by energy utilities and the cost of local production. Most types of energy sources require large investments in capital-intensive, long-lived, and immobile networks. Electricity requires an extensive network of both high- and low voltage transmission and distribution cables, natural gas requires a network of pipelines, and so forth. Once such investments are undertaken, the network utility becomes a local monopoly. Competitive markets for network services are both hard to establish and undesirable from a social welfare point of view due to duplication of investments.
Due to the monopoly status of local utilities, the government regulates the prices of the network service. The main motivation behind this regulation is to avoid social welfare costs due to excessive pricing of the service. In Norway there has been a regulatory change from rate-of-return regulation, that guarantees a certain economic return on the invested network capital, to revenue-cap that gives the utilities a maximum revenue to be earned annually. Importantly, the revenue-cap is fixed for five-years periods, and, consequently, is supposed to be independent of costs and investment decisions by the utility.
The main objective of this research project is
(iii) to investigate how current regulatory practices by the governments affect utilities’ incentives to innovate and develop new energy sources, and
(iv) to develop knowledge about good regulatory regimes for the future that stimulates innovation and investment in alternative energy networks an local production.
A traditional perspective on environmental policy is that taxes or subsidies could be used towards consumers of energy in order to provide them with the right incentives both with respect to the level energy consumption and to the choice of energy sources. However, in order to succeed with such energy consumption policies, utilities must have the right incentives to meet induced demand by developing new energy networks.
A good understanding of the energy utilities’ economic incentives to develop new and efficient energy sources for households and firms in the future, and how the government, by their regulatory practices, affects these incentives will be of crucial importance.
3.
Frontiers of
knowledge and technology
There is a long tradition within economic science in studying the regulation of natural monopolies. This insight will form the knowledge base for the proposed project. The existing and relevant research frontier for network regulation is summarized by below:
i) The normative theory of regulation of natural monopoly largely consists of finding optimal prices that the monopolist should be allowed to charge. The earlier literature developed a good understanding of the optimal price structure for network services and optimal investment in network capacity taking into account issues such as the recovering of large fixed costs, time varying demand, and multi-product services.[1] These principles have much in common with principles of optimal taxation derived in the public finance literature.
ii) In competitive markets, competition will, without any regulation, generate the efficient prices that reflect the firms’ costs of expanding production. The prices charged by a network monopolist should also be linked to the cost of expanding production, but there is no market to inform us about these costs. Consequently, there is an informational problem faced by governments when designing regulatory contracts. If consumers are to benefit from low costs, prices must be kept close to the costs of the network operator. This gives the energy utility weak incentives to economize on costs, and the particular energy source becomes more expensive. Alternatively, prices could be fixed at a certain benchmark. However, since allowing new utilities to enter with new investments is not a desirable option (due to the immobile and long-lived capital of the incumbent), the price benchmark must be based on rather conservative guesses on efficient costs in order to avoid bankruptcy of less successful utilities.[2]
iii) An important aspect of regulatory policy is commitment. If utilities are to operate successfully, they will need a credible system of regulation. Once they have invested in network capacity, they become potentially very vulnerable to regulatory changes. The reason is that the utilities cannot exit with the invested capital since it is both long-lived and immobile. If the government cuts regulated prices, therefore, the utility will continue to operate as long as prices stay above variable operating costs (which can be very low compared to cost of capital in these industries). Anticipating a downward pressure on prices in the future, utilities may become reluctant to invest in the first place. A successful regulatory regime for network utilities, therefore, has to provide sufficient commitment devices in order to induce efficient investments.[3]
Our project will build on the insight from this research, and develop new insight into designing of integrated regulatory practices that gives the utilities the right incentives to innovate and invest in alternative energy network – that to some extent will compete with their existing networks. Existing research have focused on regulatory issues towards one type of network activities such as electricity networks, telecommunication network, gas distribution network, etc.
4.
Research tasks
The novel aspect of the proposed research project is the study of inter-linkages between the regulatory policies towards different, but related, energy networks. The regulatory policy towards the today dominating electricity utilities affects the incentives of developing new energy networks, as well as local production, that facilitates a desirable consumer switch to other energy sources in the future. Market design of new energy sources – both the downstream level (energy retailing) and regulation of new energy networks – should not be studied in isolation, but as an integrated part of policies towards energy markets in general.
3.1 Designing integrated regulatory polices towards energy networks
If current electricity utilities succeed in developing new energy networks, the economic return on their existing activity may fall due to reduced demand for electricity. Both the electricity network and their hydropower plant will become less profitable if other energy sources are successfully developed.[4] In order to have incentives to invest in the development of alternative energy sources, the expected economic return must exceed the economic return from further development of the electricity network.
The expected benefit from developing new energy sources for the existing energy companies depends on several factors:
i) The demand for alternative energy sources, if available.
ii) The future regulatory regime for the new energy networks if they are successfully developed by the utilities.
Demand for alternative energy sources depends on energy prices, investment costs within households and firms, and the quality of the network developed, such as environmental aspect, reliability, and safety. Energy prices are determined in energy markets (e.g. natural gas, and may be manipulated by the government with use of energy taxes and subsidies.
The second point raises the important issue of regulatory commitment. If the new energy networks are to be attractive investment options for energy utilities, the expected return on the invested network capital must be larger than the expected return from a continuing electricity strategy by the same utilities. However, due to uncertainty about energy demand and technological development (e.g. appearance of new, and currently unknown energy sources), there is always a probability of failure. This means that the economic return from the network, if they succeed by developing a new and sustainable alternative to electricity, must be relatively large in order to balance the probability of failure.
An important factor determining the economic return on new energy networks is the market design at the downstream level. Downstream energy companies that sell energy (e.g. natural gas) to firms and households need access to the gas distribution network. An open access policy at regulated, cost based prices, works to reduce economic return from investing in the first place. Giving instead the network owner an exclusive right to the downstream market, would increase the economic return and stimulate investment in new energy sources. These are just two examples of regulatory regimes, and illustrate the difficult trade-offs that have to be handled in the design of new regulatory regimes towards new energy networks. It also illustrates, the commitment problem of regulatory institutions: Once a new and energy sources is successfully developed, there will be both strong political pressure for relaxing the access policy in order to make new and cleaner energy sources less expensive.
A particularly challenge that arises when regulating networks with both transmission and distribution, and with different owners, is externalities. The development of alternative energy recourses within one distribution area also benefit other distribution utilities, as well as the transmission company, by reducing the need for increased capacity in the electrical network. Depending on the market design for capacity in different regions of the electricity network, this may establish wrong incentives for developing new energy resources.
In this part of the project we will develop new insight about the design of integrated regulatory regimes that covers several energy networks, both currently developed networks, and new network technologies developed in the future. The regulatory regime must define integrated policy rules both towards the innovation and investment phase for alternative energy sources and for the network operation phase.
The main target for the optimal policy is to confront utilities with the right incentives to invest in new energy network, and by this preparing the ground for efficient energy choices in firms and households.
When designing market rules and regulation in current (and future) energy markets and networks, the government may suffer from incomplete information. Incumbent energy utilities and downstream energy companies may be the best to know the potential demand in the future. In that case, the value of investment in energy network is private information to the industry. The regulatory regimes developed should take these informational problems in account.
One Phd. student will work on this part of the project.
4.2
Comparative studies
of energy network regulation practice in Europe
Energy sources for households and
firms vary through out Europe. In Norway the main electricity resource is
electricity, while in countries like Denmark and Holland there is also a large
degree of district heating and networks for distribution of natural gas.
In this part of the project we will collect information about current regulatory practices towards energy networks in different countries. This will be done partly by reviewing existing research on regulatory practice and partly by cooperating with regulatory authorities in a selection of countries. The motivation for these studies is twofold:
i) Gain a better understanding of regulatory challenges in mixed energy systems.
The difference in energy sources for households and firms trough Europe is for a large part a consequence of available natural resources and political decisions in the past. This has also led to differences in industrial organization and structure from country to country. A study of the different regulatory regimes that has been adopted under these circumstances in order to promote efficiency, may lead to some recommendations of best practice when it comes to the development of the regulation of mixed energy systems.
Regulation of mixed energy systems is particularly challenging since the combination of regulatory instruments, aiming at partial improvements of welfare, may lead to other types of distortions. The balancing of instruments is a delicate tradeoff because the effects and strategic behavior of several sectors, potentially interconnected, have to be considered. Examples of such phenomena are found in the cogeneration industry, environmentally friendly generation and horizontally integrated utilities (gas, electricity, water, etc). There are also important coordination problems and potential market malfunctioning in the case of regulatory competition across internationally active utilities.
ii) Gain a better understanding of energy utilities’ response to economic incentives.
The research proposed in 3.1 assumes that energy utilities respond to economic incentives. For instance, cost based pricing rules are assumed to increase network operation costs (profit becomes only weakly linked to costs), whereas more high-powered regulatory rules, such at revenue-caps and different types of price-caps, on the other hand, are assumed to improve cost efficiency.
Regulatory practice varies among European countries, and has undergone important changes during the 1990s. Variations in regulatory practices between countries and over time makes it possible to undertake empirical research to reveal the importance of economic incentive for the performance of energy utilities. Gaining a better understanding of the empirical importance of economic incentives and utility ownership, is important for the design of policy towards development of new energy sources.
The project cooperation with the regulatory authority (NVE) and their international network of regulators will be important for getting access to high-quality utility data that makes these types of studies possible.
One Phd. student will work on this part of the project.
5.
Research approach
The first part of the project will be based on the economic theory of regulation under asymmetric information. This theory has developed over the last couple of decades, and has clarified principles for designing regulatory regimes when taking into account the informational problem of the government (or the regulator). The regulated industry may have better information about cost of production, demand, and quality of services. The approach is normative in the sense that optimal, welfare maximizing, contracts that regulate the price structure, access to markets, and possibly cost sharing rules with the government are derived.
The second part of the project will be positive and seek to derive a better understanding of existing regulatory regimes and how utilities adjust to these regimes. An important element of these analyses will be the application of methods for measuring relative efficiency and productivity growth at firm level. This will include the Data Envelopment Analysis (DEA), which is based on linear programming techniques, and use used to derive relative performance measures. This method has already been used by NVE to set revenue targets for the regulated electricity utilities.
Data Envelopment Analysis (DEA) is particularly useful by its ability to cope with multiple input-multiple output technologies without imposing restrictive assumptions a priori. Moreover, the analysis of interaction between energy systems that are modeled using DEA is relatively easy by its foundation in production theory and activity modeling. The fact that several countries now rely heavily on DEA in their regulation adds to the relevance of using DEA and of exploring its pros and cons i regulation.
6.
Project
organization and management
The project is a co-operation between Norwegian School of Management (NSM) and NVE. The research team from NSM consists of Associate Professor Dag Morten Dalen, Professor Espen R. Moen, and Professor Christian Riis at the Department of Economics. The research team at NSM has a documented high competence in the study of regulation and market design, and will serve as core research group in the project. They have experiences with both theoretical and empirical analysis of regulated industries (among them the energy industry). NSM will also host the Phd. students.
The
project team from Norway will also include Professor
Nils-Henrik M. von der Fehr from the University of Oslo and the Frisch
Centre. He has a broad experience in the study of energy markets, and is
currently a member of the Norwegian Competition Authority Expert Group on
Electricity Markets and of the Dutch Electricity Market Surveillance Committee.
NVE will contribute with their experience in practical regulatory design and with their broad international network of regulatory authorities. The co-operation with NVE will both provide the project with crucial information and data regarding regulatory practices and energy utilities, and in return, increase the probability for deriving proposals for good regulatory regimes for energy networks that is possible to implement by authorities.
Thor Erik Grammeltvedt Senor Adviser at NVE will join the project as one of the two PhD. Students. The other PhD. student is Leonid Andreev.
The project will also establish a reference group that will regularly meet the researchers in order to discuss research results and research directions to be taken during the project period. The following institutions will be invited to the form this group:
1.
ENOVA (a new
agency for promoting energy savings, new renewable energy and environmentally
friendly natural gas solutions).
2.
NVE
3.
Regulators in
Denmark, Sweden, Netherlands and UK
4.
EBL (Norwegian
Electricity Industry Association)
5.
PIL (Federation
of Norwegian Process Industries )
7.
International
co-operation
The project will co-operate with two foreign research institutions. Professor Per J. Agrell at the School of Management, Université Catolique de Louvain in Belgium holds a position in operation management.
His research includes the modeling and analysis of productive efficiency, incentives and industrial organization. Aside from theoretical work on the foundations and methodology of frontier analysis, Agrell has contributed to regulatory practice in the electricity market in several countries.
Professor Peter Bogetoft holds a position in business and microeconomics at Department of Economics and Natural Resources, Royal Veterinary and Agricultural University in Denmark. His research interests includes incentive theory (contracting, regulation, mechanism design) and performance evaluation (in particular using DEA).
The research group has broad network of contacts aboard, and will use this to present and discuss research results.
8.
Progress plan –
milestones
Phase 1: Review of relevant research and hiring Phd. students on the project (2003)
Phase 2: Comparative studies of regulatory practices in Europe (2003-2004)
Phase 3: Theoretical studies of integrated energy network regulation (2004-2005)
Phase 4: Empirical studies of regulatory regimes and utility behavior (2004-2005)
Phase 5: Submission of two Phd-theses. (2006), organizing a conference and presentation of research (2006)
During the project period the group will hold seminars, participate at international conferences, publish articles in national and international journals.
[1] Natural Monopoly Regulation: Principles
and Practices by S. Berg and
J. Tschirhart (Cambridge University Press, 1988) summarized this research.
[2] A Theory of Incentives in
Procurement and Regulation by
J.J. Laffont and J. Tirole (MIT Press, 1993) presents this research strategy.
[3] Privatization, Restructuring, and
regulation of Network Utilities
by D.M. Newbery (MIT Press, 1999) review the problem of regulatory commitment.
[4] Many energy companies in Norway are both
network owners and electricity producers.