Use and abuse of regulated prices in electricity markets: “How to regulate regulated prices?”

• Author: David Martimort,Carine Staropoli,Jérôme Pouyet
• Date: 01 July 2020
• DOI: http://doi.org/10.1111/jems.12383
• Published date: 01 July 2020

J Econ Manage Strat. 2020;29:605–634. wileyonlinelibrary.com/journal/jems © 2020 Wiley Periodicals LLC

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605

Received: 6 June 2019

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Revised: 12 February 2020

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Accepted: 1 May 2020

DOI: 10.1111/jems.12383

ORIGINAL ARTICLE

Use and abuse of regulated prices in electricity markets:

How to regulate regulated prices

David Martimort

1

|Jérôme Pouyet

2

|Carine Staropoli

3

1

Paris School of Economics (EHESS),

Paris, France

2

CNRS, THEMA and ESSEC Business

School, ESSEC Business School, CY Cergy

Paris Université, Cergy, France

3

Paris School of Economics‐Université

Paris 1, Paris, France

Correspondence

Jérôme Pouyet, CY Cergy Paris Université,

CNRS, THEMA and ESSEC Business

School, ESSEC Business School, Avenue

Bernard Hirsch, B.P. 50105, 95021 Cergy,

France.

Email: pouyet@essec.edu

Abstract

We consider the regulation of the tariffs charged by a public utility in the

electricity sector. Consumers differ in terms of their privately known demands.

When regulating a firm's tariffs, the government is concerned by the redis-

tribution across consumer classes. A conflict between redistribution and

screening induces pricing distortions when the firm is a monopoly. Introdu-

cing competition with an unregulated fringe improves efficiency but jeo-

pardizes redistribution. In response to this problem, the government may now

want to manipulate information about the incumbent's cost to restrict entry

and better promote its own redistributive objective. To prevent such obstacle to

entry, the government's discretion in fixing the incumbent's regulated tariffs

should be restricted by imposing floors or caps on those tariffs and/or by

controlling the market share left to the competitive fringe. We highlight the

determinants of such limits on discretion and unveil to what extent they

depend on the government's redistributive concerns.

1|INTRODUCTION

In their reference book Market for Power (1983), Paul Joskow and Richard Schmalensee presented various proposals to

reform the electric power industry. Back then, the traditional model of monopolistic provision of electricity by publicly

owned or heavily regulated utilities had already raised enough skepticism to suggest that competition would be the best

vehicle to improve industry performance and foster innovation. Joskow and Schmalensee modestly acknowledged that

no reform would represent a panacea to solve the genuine market failures of electricity markets. Echoing this pre-

diction, paths toward liberalization have greatly differed throughout the world even though they have also featured

common elements. For instance, while generation, transmission, distribution, and retail activities had always been

bundled together within large vertically integrated public utilities, most countries chose to unbundle those segments.

Transmission and local distribution were generally viewed as being natural monopolies and have been separated from

more competitive segments such as generation and retail activities. At the same time, the standard “cost‐of‐service

regulation,”that was designed to ensure that the price for electricity would cover the average production cost was

replaced by some forms of “market‐based pricing,”at least on the more competitive segments of the supply chain. A

rationale for introducing competition in generation was that economies of scale on this segment were modest and the

potential benefits of mixing different sources of generation for the security of supply were supposedly substantial.

Despite its theoretical advantages, competition in retail markets remains rather marginal, in contrast to what

happened at the generation level. For instance, in the European Union (EU), the yearly switching rate of household

customers from incumbent suppliers to new entrants remains quite small (median household switching rate in 2018

was 9.8%) and retailer concentration is still significant, even a few years after liberalization.

1

Several facts may explain

such phenomenon. First, competition has sometimes been slowly introduced.

2

Second, some countries still maintain

some sort of price regulation that customers find attractive. Indeed, regulated and nonregulated retail tariffs (the so‐

called “market offer”) coexist in most cases. In other words, while the debate on the benefits of competition has focused

on the technological features of the market, the repeated failures of competition to emerge suggest that scholars and

practitioners should give more attention to the political and regulatory landscape that surrounds reforms in the

electricity sector.

For decades, governments have indeed always expressed some redistributive concerns in the way they regulated

electricity tariffs. Advocates for such regulation would argue that high prices disproportionately impact poor house-

holds since energy expenditures represent a large fraction of their income. Governments have therefore used different

approaches to protect low‐income households and reduce inequalities across different classes of customers.

3

However,

most governments also have on their agenda other objectives that might conflict with redistributive concerns, such as

recent concerns toward climate change issues.

The complex combination of economic and political landscapes behind electricity markets raises a number of

important questions. What are the economic and political rationales underlying the coexistence of regulated and

nonregulated tariffs on those markets? How can we explain that only a small fraction of the overall demand ends up

being served through “market offers”when efficiency considerations would call for a more open field? Is it possible that

regulated tariffs might actually hinder the development of retail competition and somewhat erect inefficiency barriers

to entry on this segment of the supply chain? If regulated tariffs do harm competition, to what extent might those tariffs

be actually manipulated to unduly favor the incumbent on the fallacious political grounds that regulated tariffs would

shelter vulnerable customers from high prices?

1.1 |Model and results

To address these questions, we develop a model of retail price regulation for the electricity sector that intertwines

economic and political considerations. The first key element is that customers belong to distinct groups that differ

according to their specific demands. The supplier should therefore rely on a nonlinear price to screen those different

types of customers in a context where they remain nonobservable. In a nutshell, to model regulation we assume that the

government can perfectly control the firm and decides de facto its nonlinear price.

4

This assumption is meant to capture

the long‐lasting and close‐knit relationship between incumbent operators and public officials and the corresponding

congruence of their interests.

5

The second key element is that the government has redistributive concerns and maximizes a weighted sum of the

utilities of the various types of customers. The distribution of the social weights associated to the different classes of

customers captures the nature of redistributive concerns. This assumption may also be viewed as a shortcut for the fact

that the government supports the sector by increasing production and consumption beyond efficiency. In any case, this

assumption will also justify the existence of regulated tariffs and a wedge between prices and marginal costs, even in a

market environment where the incumbent faces competitive pressures. We will be a priori quite agnostic on the nature

of the redistributive bias. The government may either favor low‐or high‐demand customers depending on the dis-

tribution of social weights that prevails.

Much in the spirit of the more traditional “cost‐of‐service regulation,”regulated tariffs must ensure that the firm's

revenues cover its fixed cost.

6

When the retail segment has been opened to competition, these tariffs must also be

designed with an eye on the customers' incentives to switch to potential entrants. We characterize the optimal regulated

tariffs, the corresponding consumption profile, and the market segmentation between the incumbent and its compe-

titors in those circumstances. We emphasize the distortions induced by the government's political biases and how those

distortions are modified by the threat of entry once competition is possible.

To understand the basic mechanisms at play, consider first the case without competition. This simplifying scenario

is meant to depict the old institutional setting where the incumbent enjoyed an unchallenged monopoly position. To

illustrate, suppose there are two types of customers: low‐valuation customers who can only afford a low price for

electricity, and high‐valuation customers who are willing to pay a higher price for electricity.

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If the government favors

low‐valuation customers, most of the fixed cost of production should be covered by the tariff charged to high‐valuation

customers. In response to this extra charge, high‐valuation customers are willing to shade their demands to reduce their

bill. When the customers' valuations are private information, incentive compatibility can be restored by reducing the

consumption of low‐valuation customers and making their allocation less attractive to high‐valuation types. Hence, a

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