Deregulation of Network Industries. What’s Next?

Citation

Stratling, R. (2001), "Deregulation of Network Industries. What’s Next?", International Journal of Public Sector Management, Vol. 14 No. 5, pp. 439-444. https://doi.org/10.1108/ijpsm.2001.14.5.439.1

For the majority of the twentieth century economic welfare considerations have lead to the assumption that network industries should either be directly owned by the government or should at least be tightly regulated. High sunk costs of infrastructure investments provide incumbent businesses, e.g. in the railway and electricity industry, with significant first mover advantages. In many cases this allows them effectively to prevent competitors entering the market, thereby safeguarding a monopoly position. Not only does this leave the customers at the mercy of the monopolistic pricing policy of the existing suppliers but it also reduces the incentive for innovation within the industries. Even if the profit prospects of the industry are such that market entries remain feasible, the duplication of certain infrastructure investments, e.g. of rail tracks or electricity lines by rival businesses is often perceived as economically wasteful.

However, especially since the 1980s the traditional ways of organising network industries have been increasingly criticised as uneconomical. The distortion of property rights incentives owing to government ownership of industries and tight regulatory regimes for private network industries have fostered the inefficient use of economic resources and failed to encourage product and process innovation as well as to shield customers from exploitation.

This dissatisfaction has lead to the privatisation and re‐ or deregulation of network industries in many countries around the world. However, as the recent electricity shortages in California have shown, the deregulation of network industries has frequently not yet yielded the expected benefits.

This is the starting point of the articles collected in Deregulation of Network Industries. What’s next?. The papers were originally presented in December 1999 at a conference organised by the American Enterprise Institute – Brookings Institution Joint Centre for Regulatory Studies. Focusing on the airline, railway, telecommunications and electricity industry in the US, the articles investigate the central political issues which have arisen out of the deregulation process. The objective is to analyse where deregulation has failed to achieve possible welfare gains through increased efficiency, innovation and improved services for customers (including price reductions). Although not explicitly stated the definition of “welfare” applied by the authors is that of “welfare economics” which aims for the distribution and use of resources that satisfies the conditions of pareto efficiency. Issues like accessibility of the services of network industries for socially disadvantaged groups are therefore largely omitted from the considerations.

Steven A. Morrison’s and Clifford Winston’s article on The Remaining Role for Government Policy in the Deregulated Airline Industry, (pp. 1‐40) investigates the need for re‐regulation in the Airline Industry. The airline industry is a network industry on account of the fact that planes need airports to land at and start from. The regulation of access to gates is therefore an important part of the competition policy for the airline industry. In the US the ownership of airlines and airports is separated. It is therefore puzzling that the majority of the regulation of the airline industry is directed at airlines and their competitive behaviour, not at the business policy of airports. A quantitative analysis of the influence of the competitive behaviour of airlines on customer services and airfares indicates that the threat of customer exploitation due to mergers and possible predatory behaviour is far smaller than customarily assumed. Morrison and Winston suggest that new or smaller competitors are more at risk of discrimination due to preferential treatment of large airlines by airports and the influence of large airlines on airport expenditure programmes through service contract clauses. They therefore recommend to deregulate the competitive behaviour of airlines and to focus on the setting of guidelines for access policies of airports.

An important difference between the network characteristics of the airline and the railway industry is that in the US railway companies usually own the network infrastructure they use. If competing railway companies want to service the same areas they therefore either need to build essentially parallel tracks or they need to arrive at a mutual agreement about the use of each other’s tracks. Because most railway companies hold regional monopolies for rail transport their price policies are subject to regulation. The regulation of prices is especially supposed to protect customers, who are considered captive to rail transport (e.g. coal, chemicals), from monopolistic exploitation. Unfortunately, before the 1980s price regulation also prevented the railway industry from entering into price competition with other modes of surface transport. In the 1970s this led to a number of bankruptcies in the railway industry. The aim of the deregulatory measures introduced through the Staggers Act (1980) was to enable the railways to improve their productivity and their financial performance. In their article on Competition in the Deregulated Railroad Industry: Sources, Effects, and Policy Issues (pp. 41‐71), Curtis Grimm and Clifford Winston investigate how deregulation has affected the balance between the economic welfare of customers of railway services (particularly captive ones) and the financial viability of railroad companies. Empirical surveys indicate that competition from alternative forms of surface transport causes shipping prices for railways to fall significantly. However, Grimm and Winston’s quantitative analysis suggests that captive rail customers pay about 20 per cent higher tariffs than non‐captive customers do. The price regulation by the Surface Transportation Board, which is supposed to safeguard captive rail customers from monopolistic exploitation, therefore does not appear to be working properly. Consequently Grimm and Winston suggest to withdraw from price regulation and to rely instead on the development of a contract equilibrium between rail customers and railways based on the development of competition between different railway lines. However, the question which the authors leave mainly unanswered is: why would railways voluntarily give up their regional monopoly position by allowing competitors to use their rail tracks? It remains unclear why Grimm and Winston conclude that the examples they provide for this type of behaviour does necessarily constitute a general and long‐term behaviour pattern for the whole of the railway industry. Would it be necessary to regulate the conditions under which railway companies need to offer rivals access to their networks?

The joint use of network infrastructure is also a problem investigated by Robert W. Crandall and Jerry A. Hausmann in their article on Competition in US Telecommunications: Effects of the 1996 Legislation (pp. 73‐112). The 1996 Telecommunications Act sought to open local telecommunications markets to competition and to further the earlier market‐opening process in long distance services. Crandall and Hausmann successfully achieve their task of shedding light on the rather tangled net of the multitude of regulatory measures which govern the line‐based (non‐mobile) telecommunications markets in the US. The main objectives of the telecommunications regulation are to avoid the need for parallel infrastructure investments by regulating access of new market entrants to existing networks of incumbent businesses and to cross‐subsidies prices of telephone calls for low‐income families and rural areas. Crandall and Hausmann criticise the present regulation on grounds of distortive effects of cross‐subsidies, strong disincentives to invest in modern technologies and the lack of competition in local telephone markets which subsequently leads to high prices, particularly for private households. The lack of competition in local telephone markets appears very surprising to the reader as Crandall and Hausmann frequently point out that the wholesale prices, under which incumbent telephone companies need to offer potential rivals access to their existing infrastructure, are supposed to be below cost. It is understandable how the authors deduct that this causes a disincentive to engage in large scale innovation and infrastructure investment by both incumbent telephone businesses and market entrants. However, as new market entrants would have a cost advantage over incumbent businesses when using already existing network infrastructures, market theory would suggest the development of a strong competition which would lead to falling consumer prices. Given the similarities between the 1984 equal‐access provisions for long‐distance telecommunications and the regulations governing access for local telecommunications in the 1996 Act (p. 100), it is surprising that while competition in long‐distance telecommunications has developed rapidly after 1984, competition in local telecommunications after 1996 has progressed only sluggishly. Unfortunately the article fails to deal sufficiently with these questions which would shed more light on the reasons why specific types of regulation are more or less effective in achieving an increase in economic welfare.

The electric power sector in the US is a network industry in which different parts of the network are owned by a multitude of independent businesses. Because of technical requirements power generation, distribution, transmission, procurement and retailing functions need to be co‐ordinated smoothly. In his article on Deregulation and Regulatory Reform in the US Electric Power Sector (pp. 113‐88), Paul L. Joskow explains how the electric power sector in the US operates and which effects deregulation and re‐regulation have on the industry. The electric power sector provides a good example of how past regulatory measures influence the ability to change a regulatory regime. In this context Joskow explores the concept of “stranded costs”, i.e. costs which arise out of past regulation which under a changed regulatory regime have to be borne by incumbent businesses but not by new market entrants. As the price elasticity of demand for electricity is rather low during periods of high demand, electricity companies are tempted to decrease their supply during periods of high demand in order to increase their profits. This has lead regulators to institute price caps for electricity charges in order to prevent electricity companies from abusing their market power. Although Joskow does not anticipate the current electricity shortages which are occurring in California, he does point out that such a direct intervention in prices can only be a short‐term measure. Joskow shows that since 1998 wholesale electricity prices have increased continuously. He rightly points out that the reason for this is not necessarily that the re‐regulation measures of the 1990s have led to a more inefficient organisation of the electric power sector. Given the fact that electric power generation is not an industry in which capacity can be cheaply or swiftly expanded, increased economic activity certainly plays a role in the increase of wholesale electricity prices. However, present regulatory regimes and the modus operandi of the electricity industry give little incentive for energy conservation or a more even spreading of energy consumption. For example, while wholesale prices are agreed on an hourly basis, customers are charged a flat rate, irrespectively of whether they consume energy during peak or off‐peak hours. As California is used as a case study for the influence of state regulation on the energy market, this article will be of great interest to anybody who would like a better understanding of the energy crisis in California. Interestingly Joskow raises concern not about future energy shortages due to a lack of investment in electric power plants but about investment in the transmission network and operating capabilities. He advocates strongly the development of effective institutions to govern the management of transition networks and to pay more attention to transition investment needs.

The tenor of the book’s Conclusion (pp. 189‐91), by Sam Peltzman and Clifford Winston is that policy makers should “leave deregulated industries alone and allow partially deregulated industries to proceed towards full deregulation” (p. 189). While regulation undoubtedly opens the door for all kinds of interest groups to enhance their welfare by exploiting customers, rivals or the government, particularly the articles on the electricity industry and the airways industry explicitly point out the need not only for de‐ but also for re‐regulation. The articles obviously suggest that direct, process oriented interventions in prices and quantities lead to distortions in both supply and consumption and thereby to an inefficient allocation and use of scarce resources. However, given the significant first‐mover advantages in network industries, it seems doubtful whether the trust in market forces is all it takes to further efficiency and innovation in these industries. Unless we want to risk exploitation due to the concentration of market power, certain rules of the game need to be established for market forces to operate in.