CH8: Models of regulation

What is market monitoring?

Market monitoring is the lightest-touch regulatory model discussed in the lecture. Under this model, firms largely retain pricing freedom, and regulators monitor outcomes rather than directly setting prices.

How does market monitoring work?

Responsibility for pricing remains primarily with the regulated firm, but firms usually must consult users, follow pricing principles, and disclose information publicly or to regulators. Regulators may adopt proactive monitoring, meaning continuous monitoring of prices and service quality, or reactive monitoring, meaning intervention only if complaints arise. A key feature is the threat of stricter regulation if outcomes become unacceptable.

What are the advantages and limits of market monitoring?

Advantages of market monitoring include relatively low compliance costs and limited distortions. However, it is insufficient unless firms face some competitive constraints, for example customers possess bargaining power, and sanctions are credible. Without these conditions, firms may still exploit market power.

What was the Australian Airports case study?

Australia replaced ex ante airport price caps with monitoring in 2001/02. The Australian Competition and Consumer Commission, or ACCC, monitors business and financial information, publishes annual KPI reports, and may launch inquiries if concerns arise. Negotiations between airports and airlines occur under formal pricing principles, with arbitration available if parties disagree. The Productivity Commission concluded that this lighter-touch regime generated important benefits.

What was the New Zealand Telecommunications case study?

The New Zealand Commerce Commission, or NZCC, publishes annual monitoring reports and tracks prices, quality, connections, and investment. Telecommunications firms must disclose information regularly. Where problems arise, the NZCC may launch investigations and recommend remedies. This system combines monitoring with access obligations.

What are negotiated settlements?

Negotiated settlements involve direct negotiation between firms and customers regarding prices, quality, and investment. This model is more collaborative than traditional regulation.

What are bilateral and multilateral negotiated agreements?

Bilateral agreements are separate contracts with individual customers, for example where for each energy supplier the network negotiates one agreement. Multilateral agreements are one common agreement applying to all users, for example where the same agreement is negotiated for all suppliers.

What is the role of the regulator in negotiated settlements?

Even in negotiated systems, regulators remain important, more as a facilitator. They may establish negotiation rules, including principles and processes for consultation and negotiation, require information disclosure, set fall-back provisions if agreement cannot be reached, create sanctions if there is evidence of abuse of market power, monitor outcomes to ensure the process leads to outcomes in the interest of end-users, and approve agreements such as minimum service levels and maximum prices.

When do negotiated settlements work best?

Negotiated settlements function best when bargaining power is relatively balanced and users are informed, safeguards and dispute mechanisms exist, and service differentiation is valuable.

What are the advantages of negotiated settlements?

Advantages include that implicitly all parties should be happy, there is potential for tailored service, quality investments, and innovation incentives, and negotiated settlements can generate demand certainty.

What are the potential problems with negotiated settlements?

Potential problems include unequal bargaining power, especially if the leading company has an information asymmetry advantage, high transaction costs, and conflicts between downstream firms and final consumers. Large customers may negotiate better outcomes than smaller users, creating waterbed effects.

What was the UK Wholesale Electricity Market case study?

The UK electricity market uses bilateral contracts between generators and buyers. Features include negotiated bilateral contracts based on anticipated demand, prices negotiated bilaterally or determined through demand and supply matching, and parties communicating their anticipated behaviour to the system operator, which takes control of balancing supply and demand in real time. This replaced older centralised pooling systems and is more market-driven.

What was the US Gas Pipelines case study?

The US Federal Energy Regulatory Commission, or FERC, encourages negotiated settlements on transportation charges and service quality. The alternative is costly and intensive litigation, which creates strong incentives to reach agreement. Users have some buyer power because they can often choose a different form of energy or pipeline. Agreements typically last 3–5 years. FERC plays an active role in shaping and monitoring the negotiation process and outcomes.

What was the Gatwick Airport case study?

Gatwick uses legally binding minimum contractual commitments and bilateral agreements with individual airlines for modifications to elements. An example of an innovative agreement is easyJet consolidation into a single terminal.

What was the Copenhagen Airport case study?

Copenhagen uses multilateral negotiations only. Negotiations cover charges, investment, and service quality. If no agreement is reached, regulators may impose a fallback price cap.

What was the Scottish Water case study?

Scottish Water introduced a customer engagement process for the 2015–21 strategic review. It was based on working with other stakeholders so that the process correctly reflected everybody’s needs. The process involved ministers setting investment objectives while taking advice from stakeholders, customer forum engagement with the aim of agreeing a business plan, and WICS setting a final determination based on the agreement if reached. This reflects a more participatory regulatory model.

What is the relationship between market monitoring and negotiated settlements?

There is often not a big difference between market monitoring and negotiated settlements. In practice, regulatory models often involve a mix of both.

What is regulation by contract?

Regulation by contract allows the market to bid for temporary franchises or concessions. Contracts may specify pricing, service quality, investment obligations, and risk-sharing arrangements. Ownership lies in the hands of the government, but management lies in the hands of the company that won the bid.

What are examples of regulation by contract?

Examples include rail franchises, toll roads, and water concessions.

What are the advantages of regulation by contract?

Advantages include revealing market information through bidding, reducing the need for independent regulators, sharing risks with the private sector, and potentially preserving public ownership of assets.

What are the disadvantages of regulation by contract?

Problems include forecasting uncertainty, difficulty establishing incomplete contracts for complex arrangements, costly bidding processes, overbidding and financial instability, and incentives to invest declining later in the contract.

What was the Aéroports de Paris case study?

The Aéroports de Paris agreement combines CPI-X price controls, rewards and penalties for investment timelines, service quality indicators, and excellence indicators.

What are Quality of Service Indicators in the Aéroports de Paris case?

Quality of Service Indicators are minimum service standards applying to baggage systems, security waiting times, cleanliness, and airport infrastructure availability. These indicators have asymmetric incentives, meaning penalties exist for underperformance but no bonus exists for exceeding targets.

What are Excellence Indicators in the Aéroports de Paris case?

Excellence Indicators are not as fundamental to a passenger’s experience, but can improve it. They include passenger satisfaction with transit experience and overall airport experience. These indicators use symmetric incentives, meaning firms receive penalties for underperformance and bonuses for exceeding targets, such as an increase in airport charges. This structure attempts to align incentives with passenger welfare.

What are regulator-determined caps?

Regulator-determined caps are the most traditional regulatory approach, used where there are real concerns about market power abuse. Regulators directly determine prices, revenues, and profits based on a company’s business plan.

What is rate of return regulation?

Rate of return regulation is backward-looking. Prices are set based on historical costs and allowed rates of return, meaning the risk of operating in that market. It is also called cost-plus regulation. It is often used in the US and done on a regular basis.

What are the incentive problems with rate of return regulation?

If the rate of return is too low, large investors like BlackRock may not want to invest in the long term, which is difficult for the company. If rates are too high, there are incentives for overinvestment and limited innovation incentives. Because firms recover costs automatically, they may not minimise costs aggressively.

What is RPI-X or CPI-X regulation?

RPI-X or CPI-X regulation is forward-looking and incentive-based. The regulator forecasts inflation and expected efficiency gains. Prices then evolve according to inflation minus expected productivity improvements, called X. The regulator tries to correctly estimate the needed return, meaning the cost of capital that an investor would need to invest.

What is the logic of RPI-X regulation?

If firms outperform expectations, they temporarily keep additional profits. If firms underperform, they bear losses. This creates strong incentives for cost efficiency, innovation, and productivity improvements. During the regulatory period, underperformance or overperformance is borne by the company. At the next regulatory review, efficiency gains are passed on to consumers.

What is the building blocks model?

The building blocks model determines allowed revenues through several steps. 1. Determine outputs. 2. Forecast expenditure. 3. Determine allowed revenues using last year’s regulated asset base plus CAPEX minus depreciation plus indexation, plus return based on cost of capital, plus depreciation based on asset lives, plus OPEX. This determines total allowed revenues. 4. Divide by estimated service units to obtain per-unit tariffs. 5. Convert into customer bills. 6. Apply incentive mechanisms.

What is the incentive mechanism in the building blocks model?

The company has an incentive to lower its costs beyond the RPI-X building blocks target, because it gets to keep a certain part of that outperformance. This reveals the company’s true cost structure to the regulator for future price controls.

What are controllable risks in regulation?

Controllable risks are risks for which firms are rewarded or penalised, including managerial performance and efficiency outcomes.

What are uncontrollable risks in regulation?

Uncontrollable risks include inflation shocks, macroeconomic crises, and external disruptions. Regulators therefore often introduce risk-sharing mechanisms.