Abstract
Most energy is transported and distributed via networks to end-users, which holds in particular for electricity, gas and heat. These networks are often characterized by a natural monopoly. This chapter first discusses the economic definition of natural monopolies and what the consequences are if a firm operating a natural monopoly is not regulated (Sect. 6.2). Section 6.3 discusses the principles of tariff regulation and how to deal with the information asymmetry between regulator and regulated firm. Next, attention is paid to benchmarking methods (Sect. 6.4), the WACC (Sect. 6.5), the design of tariff structures (Sect. 6.6), relationship with investments (Sect. 6.7) and, finally, how regulators can evaluate the effectiveness of tariff regulation (Sect. 6.8).
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Notes
- 1.
The name ‘monopoly’ is derived from the Latin monopolium which means single seller.
- 2.
The profit that exceeds this normal profit level is called ‘supra-normal’ or ‘economic’ profit. See further on this issue Sect. 6.8.1.
- 3.
The ‘plus’ refers to the compensation for the costs of capital, which implies that cost-plus regulation realizes a compensation for all (operational and capital costs) of the firm. This compensation can be calculated on the basis of the accounting profit (i.e. the difference between revenues and operational costs) and then adding a margin (the ‘plus’) as a compensation for the required rate-of-return.
- 4.
Because of the information asymmetry between regulator and regulated firm, regulators usually require cost reports by independent accountants, which reduces the risk that a regulated firm will try to misinform the regulator by exaggerating its actual costs.
- 5.
At the end of a regulatory period, a regulator may reconsider the cap on tariffs, taking into account information on the actual costs of a regulated firm. In this resetting of the cap, the regulator may make use of benchmarking (see further Sect. 6.4).
- 6.
Hence, the incentive power of this type of tariff regulation is between 0 and 1, as all costs except costs of capital are fully compensated while the compensation for the costs of capital is exogenously set.
- 7.
Note that when tariff regulation is very loose, the cap may become ineffective. This is the case when the allowed tariffs would become higher than the profit maximizing tariffs, i.e. higher than the level of monopoly tariffs.
- 8.
After all, the incentive power refers to the marginal effect of changes in own costs on changes in own profits.
- 9.
Although TOTEX means ‘total expenditures’, this variable refers to ‘total costs’, as also costs which are not expenditures like depreciation are included, while expenditures that are not costs (e.g. investment expenditures) are not included. In the remaining of this book, we will not talk about TOTEX, but use the term ‘total costs’ indicated by C.
- 10.
The common formulation of this relationship is \(c_{e} = r_{f} + \beta \left( {r_{m} - r_{f} } \right)\).
- 11.
The Ramsey prices can be calculated by searching for these product prices which maximize the consumer surplus under the condition that the overall revenues are equal to the overall costs (i.e. the financeability constraint).
- 12.
Some regulators also require that each separate tariff is related to the costs of using a specific product. This is, however, a difficult objective to realize as most costs of network operation are so-called common costs, which means that they are shared by all users and cannot be attributed to specific products. In practice, several rules-of-thumb are used for this kind of cost allocation, such as the method of fully distributed costs, as discussed in Sect. 6.6.1.
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Exercises
Exercises
6.1 Why is subadditivity of costs a more general characteristic of a natural monopoly than the presence of economies of scale?
6.2 In which circumstances can antitrust be an effective policy measure to address market power?
6.3 A regulator does not know precisely what the cost structure of a TSO is. Does this information problem result in moral hazard or adverse selection?
6.4 What is the definition of incentive power in tariff regulation?
6.5 What is difference between tightness and incentive power?
6.6 What is meant by TOTEX regulation?
6.7 What is difference between productivity and efficiency?
6.8 Define the relationship between productivity change (p), catch-up (c) and frontier shift (fs).
6.9 What is the incentive power of the most efficient firm in case of best-practice regulation?
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Mulder, M. (2021). Natural Monopoly in Transport and Distribution. In: Regulation of Energy Markets. Lecture Notes in Energy, vol 80. Springer, Cham. https://doi.org/10.1007/978-3-030-58319-4_6
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