The
contemporary literature offers two theoretical models
for the regulation of public sector utilities, the
Ramsey Model and the Contestable Market. The Ramsey
Model does not demand that the firms involved be small
and not benefit from economies of scale.
Further,
for such firms the prices for services do not tend
to the traditional economics of marginal prices, i.e.
the cost to produce the last element of production
or service. In this way the Ramsey Model is similar
to the Contestable Market. But Ramsey goes on to say
that the price for a product or service does not depend
only on the cost to produce it but includes how this
price itself affects the demand and there may also
be other substitutes for the product or service. Price
then becomes a mechanism to ensure the profitability
of the firm.
If
the price of electricity goes up certain consumers
may have the capacity to conserve, others may be able
to switch to other sources of energy for, say, cooking,
heating or air conditioning, by using natural gas,
and so demand for electricity falls. Still, others
may not be able to reduce their demand whatever the
price. Elasticity of demand is as important as costs
in setting prices. The problem however, is that elasticities
are difficult to come by. An associated comment by
Ramsey is that a firm that benefits from its size,
to avoid bankruptcy has to mark up its different services
above the marginal cost to produce. The amounts by
which the individual services are marked up depend
on their elasticity of demand. What this says is that
T&TEC will mark up most of the prices to its customers
who cannot reduce their demands for electricity.
Though
economists do not use the Ramsey Model for defining
final prices the above ideas are fundamental to modern
regulation techniques.
The
Contestable Market, on the other hand, like all competitive
markets, allows zero-economic-profits (i.e. dividends,
interest payments are expenses to the firm) but sets
instead price floors and ceilings based on costs alone.
Contestable Market methods set the price floor as
the marginal cost to produce the product or service
and the cost ceiling as the cost to a new entrant
to the market, using the latest technologies, in producing
a service/product or a basket of such.
These
costs are independent of the particular utility being
examined (though they depend on the market conditions)
and bear no relationship to historical costs, fully
distributed costs or present asset base of the particular
utility.
The
regulated firm like T&TEC sets prices for the
various services anywhere between these two constraints
(floor and ceiling) on the condition that it makes
zero-economic-profit. The Regulated Industries (RIC)
Act requires in the first place the RIC to set the
principles that govern the pricing of the utility
while T&TEC sets the prices according to these
principles. The modern regulator is not seen as being
primarily prescriptive.
The
drawback with this constrained market model is that
it does not encourage, say, T&TEC to improve productivity
via the technologies and equipment it is using. Thus,
the regulator normally imposes a "Price Cap-X''
system where T&TEC is allowed to raise its prices
annually by an amount at most equal to the rate of
inflation minus this X factor which is supposed to
drive T&TEC to increase its productivity in order
to maintain at least zero-economic-profit.
The
overriding idea here is that the regulator may be
very cognisant of the various costs in the industry
but has no experience or feel for the market with
regard to elasticities of demand. Normally the utility
managers have to somehow respond to these dynamic
demands if they are to be competitive. The role of
the RIC then evolves into the setting of the floor
and ceiling constraints, then the monitoring of T&TEC's
performance for its economic profit levels as far
as pricing goes.
What
is also a fallout of the Contestable Market approach
is that for a firm like T&TEC that offers different
services to the public, no cross-subsidisation is
normally allowed by the regulator or the market itself
if such competition existed; each sub-business in
providing its own service pays for itself.
Another
benefit of this non-prescriptive approach by the regulator
is that it does not get involved in the detailed direction
and management of the utility, which could send up
the costs of regulation. The regulatory process in
the Contestable Market becomes an interaction between
equals, allowing the utility, with its wealth of operating
expertise in the market, to optimise its performance
and even earn positive profit over the regulatory
period for this improvement.
Mary
King is
a columnist in the Trinidad Express ( maryking@tstt.net.tt
) . Trinidad Guardian's Weekly Business Review. Petroleumworld
not necessarily share these views.
