Sector Restructuring

In course of regulatory reform new organizational structures have been created.

Basically, the restructuring process can take place before or after liberalization (Eberlein 2001: 39). The post-reform structure of the sector has significant effects on both the costs and benefits of liberalization. Where infrastructures are already privately owned, liberalization might accelerate restructuring. Then, the fundamental question is whether privatization is a necessary condition for liberalization to unfold its full benefits, or whether the incumbent can as well remain state-owned (Newbery 1999: 176). Based on these alternatives, we can further ask the question if competition is compatible with public ownership at all. Obviously, governments can privatize without liberalizing as in the case of British Telecom. But they can also liberalize without privatizing as in the case of AT&T (Starr 1990: 29).

Nonetheless, public ownership emerged as the dominant form of regulation in network infrastructures after the Second World War Directly connected to public ownership was the organizational structure of a vertically integrated monopoly. Highly capital intensive infrastructure activities which justify monopolistic organization, i.e.

network operation, as well as potentially competitive activities, i.e. network control or service provision, were an integral part of the business portfolio of public infrastructure companies. One example for the diversity of these activities is the electricity sector whose supply chain consists of mainly five elements: generation (1), pooling and dispatch (2),

86 While electricity transmission and distribution are largely naturally monopolistic activities, competition can be introduced through the privatization of existing power generators, the removal of regional supply franchises and the admission of domestic and foreign competitors to the market.

high-voltage transmission (3), low-voltage distribution (4) and supply (5).⁸⁷ The naturally monopolistic activities of pooling and electricity transmission are joined by potentially competitive upstream and downstream activities, such as generation or supply, respectively (Figure 3.3).

Figure 3.3 Industry Structure Electricity Sector

In the process of regulatory reform this traditional structure was broken up. For example, supply refers to trading electricity, and there is no logical reason why the supplier should also be in charge of generation or distribution. If open access to the network is ensured the supplier can purchase electricity from any of the producers, rent capacities from the transmission and distribution companies, and finally sell the electricity to the consumer at the negotiated price. As a consequence of the diverse nature of these activities

87 ’Pooling’ and ’dispatch’ are considered natural monopolies. However, some experts believe that they are potentially competitive activities because of the possibility of decentralized contract trading. I am grateful to Roland Sturm who pointed to this fact.

Natural monopoly

Potentially competitive

Potentially competitive

Source: adapted from Klein (1998)

Generator 1 Generator 2 Generator 3 Generator 4

Pooling and Dispatch

Transmission and Distribution

Supply

Customer Customer Customer

most governments came to the conclusion that an integrated monopoly was hard to justify and that competition should be promoted instead.

As governments started to introduce competition in network infrastructures, it became obvious that potential new entrants were at a competitive disadvantage to the vertically integrated incumbent. The latter possesses the possibility to cross-subsidize his competitive businesses with profits from the naturally monopolistic activities. Another danger of maintaining vertical integration is the possibility that the incumbent favours his associated businesses which operate in competitive markets through prices or the service quality (Helm and Jenkinson 1998: 6). Hence, encouraging market entry of new providers is an important motive for the separation of monopolistic and potentially competitive activities.

Figure 3.4 Vertical Integration with Liberalization

In the case depicted in Figure 3.4, all operations of the ex-monopolist remain vertically integrated, but some of them are opened to competition. Generally, the liberalization of market entry while maintaining a vertically integrated structure, whether publicly or privately owned, is the least disruptive way of regulatory reform. However, as

Natural monopoly activities (i.e. network)

Potentially competitive activities (i.e.

distribution, service provision

Consumers

M

M

Market 1 Market 2

Price regulation

Compe-titor Access

price regulation

Source: Armstrong, Cowan and Vickers (1994)

there remains an asymmetry between the former monopolist and potential competitors also after liberalization, the prices set by the former need to be regulated. The efficiency and the effectiveness of competition in these newly liberalized businesses largely depend on the terms and conditions for the access of new entrants to the network.

A typical example for liberalization cum integration is the reform process in the telecommunications sector. The organizational structure of most PTOs was left intact while several product and service markets were liberalized in course of regulatory reform. In the electricity sector, in contrast, the common pattern is liberalization cum separation. In most cases, the organizational structure of the former monopolist was reorganized after the various business layers had been vertically separated. While the potentially competitive activities generation and supply, i.e. contracting, metering, and billing, were liberalized, the natural monopoly of the wire business, i.e. high-voltage transmission and low-voltage distribution, remained in the hands of the former monopolist. In most EU countries, the new regulatory model foresaw third-party access to the network for new private electricity generators and suppliers.

One problem with liberalization cum integration is that the incumbent is not exclusively concerned with satisfying customers at least cost. Instead, it desires to retain monopoly profits if privately owned or to enjoy monopoly profits in the form of excessive costs if state-owned. In addition, since vertically integrated incumbents do not only operate the network but also own upstream or downstream businesses they can cross-subsidize the latter and conceal the true costs of their contestable services. Proactive regulation by the state or a regulatory authority is therefore necessary in order to prevent anti-competitive behaviour of the incumbent.⁸⁸

88 If in a liberalized market the vertically integrated incumbent indeed continues to be owned by the state, another problem arises. Besides the potential discrimination of new entrants in the face of vertical integration, public and private companies face different capital costs. While the latter are exposed to the threat of going bankrupt, the incentives of public firms to avoid bankruptcy are relatively low. In addition, public companies are under less pressure to minimize investment costs. This might lead to overinvestment and an expansion of the incumbent on the expense of other firms in the sector. It therefore seems difficult to maintain state ownership in a competitive market for infrastructure services. The only exception is the core network in which competition is simply not feasible and which has to be regulated, most commonly through direct state ownership (Newbery 1999: 179-180).

Figure 3.5 shows the second case of vertical separation. The competitors are on an equal level since none of them is linked to the ex-monopolist, i.e. by ownership. Vertical separation demands access price regulation. This means that terms have to be set according to which new competitors can obtain access to the network which is controlled by the incumbent company. Access could, for instance, be priced at marginal cost or through a contribution to the fixed costs of network provision. Perhaps, it is advantageous to set the price below marginal cost due to imperfect competition or choose other forms because the former monopolist’s marginal cost is not relevant for the competitive activity (Armstrong, Cowan and Vickers 1994: 5).

Figure 3.5 Vertical Separation with Liberalization

Structural separation is a more encompassing reform step than allowing third-party access within a vertically integrated system. It separates ownership of the network from that of services. The goal is to ensure that all service providers have fair access conditions to the network. Vertical separation thus avoids certain regulatory problems that arise in the context of vertical integration. However, it creates other difficulties such as designing access pricing to retain coordination benefits (Newbery 1999: 188). Thus, when the natural

Natural monopoly activities (i.e. network)

Potentially competitive activities (i.e.

distribution, service provision

Consumers

M

Others

Market 1 Market 2

Price regulation

Access price regulation

Source: Armstrong, Cowan and Vickers (1994)

monopoly is separated from the competitive upstream and downstream activities, contracts are necessary to define the legal relationship between companies at different vertical positions in the chain. This raises transaction costs.⁸⁹