Jean Tirole: imperfect competition and regulation in the electric power industry by Claude Crampes and Thomas-Olivier Léautier

Jean Tirole has recently received the Nobel prize in economics from the hands of the King of Sweden in recognition of his outstanding research, in particular on imperfect competition and the regulation of monopolies. A large portion of Jean’s work examines the electric power industry. This article, originally published in the TSE Debate and for the first time also in the Florence School of Regulation’s blog, summarizes its main contributions.

Thomas-Olivier Léautier is professor of management at the University of Toulouse where he is responsible for the Master in Risk Management, and Research Director at TSE. His research interests include restructuring of the electric power industry, and risk management strategy.
Claude Crampes is professor emeritus at TSE and senior researcher at Institut D’Economie Industrielle (IDEI). He currently acts as an advisor for EDF, the main electricity producer and supplier in France.
Both Claude and Thomas teach TSE-M2 students The Economics of Energy Markets.

1. Asymmetric information and monopoly regulation

In the early 1990s, research conducted by Jean-Jacques Laffont and Jean Tirole ushered a permanent and far-reaching shift in the theory and practice of regulating monopolies. In some instances, a company is a “natural monopoly”. An electricity distribution company is an often-used example: it would be economically inefficient to build two electricity distribution networks in the same city; hence the network owner is naturally a monopoly. In the absence of competition, public authorities, in this case regulatory agencies, must determine how to regulate access to the distribution grid and how much the monopoly can charge for its services. All agree that the price should be equal to the cost of providing a connection.

A higher price would generate undue profits and a lower price would ultimately lead the company into financial difficulties because no company can operate for any length of time without covering its costs. The challenge for the regulator is to determine this cost. A first possibility is to use accounting costs reported in the company’s financial statements. However, if the company is allowed to pass on its costs to consumers, it has no incentive to reduce them. As John Hicks pointed out in 1935 [1]: “The best of all monopoly profits is a quiet life.” Can the regulator estimate a firm’s cost reduction potential? No, because the company has and will always have more information about its costs and performance potential. Given this information disadvantage, what can the regulator do? Jean- Jacques Laffont and Jean Tirole have solved the problem [2]. They show that the regulator has to explicitly take into account the asymmetry of information and give the regulated firm a menu of contracts, which propose a variety of cost-sharing options. The company then chooses the contract that best fits its performance potential. The contract includes incentives for the company to achieve this potential. In return, the company gets an informational rent. Good contracts minimize this rent, i.e., they deliver the service at minimum cost, given the necessary information rent. This first example illustrates the main features of Jean Tirole’s work. First, he applies the tools of economic theory to solve real-life problems faced by societies. When the authors of this blog contributed to set up regulatory agencies in Argentina in 1995, they were able to directly implement the recommendations developed by Jean-Jacques Laffont and Jean Tirole and summarized above. Second, his research depicts the world as it is, and not as we would like it to be. Jean Tirole considers actual imperfections, especially the asymmetry of information between regulators and companies, and offers solutions that acknowledge these imperfections. While it is sometimes necessary to leave information rents to certain agents, the mechanisms are designed to minimize them. Third, the models Jean Tirole develops to portray our reality are simple and elegant. Thus, they have served as a starting point for countless other researchers.

2. Electricity transmission networks

When the electric power industry was restructured in the 1990s, policy makers and academics spent a great deal of time focusing on the transmission grid. Since the grid is the physical location of the wholesale market, everyone agreed that its access must be fair and non-discriminatory. Countries that restructured the industry adopted different structures to guarantee fair access. European countries, with the exception of France and Germany, carved out the transmission grid from integrated incumbent utilities to create independent transmission companies. In the United States, the grid remains owned by the utilities, but is operated by Independent System Operators (ISOs).

Two other issues had to be solved. First, under which economic conditions should access to the transmission grid be sold? This was a new problem: the question had never arisen because electric utilities had been vertically integrated. The most natural solution was to define and trade physical access rights. For example, if a French producer wanted to make an intra- community trade and export to the United Kingdom, he had to purchase physical capacity on the interconnection for the duration of the trade.

William Hogan, professor at Harvard, proposed another solution that appears less natural but is more in line with the physical complexity of meshed grids. In a seminal paper [3], he demonstrated that financial transmission rights – which compensate rights holders for the difference in prices at the extremities of the right – are more effective than physical rights (under perfect competition). If financial rights are used, the producer no longer needs to obtain physical capacity on the line. He buys a financial instrument that offsets the price difference between the United Kingdom and France. Then, he produces electric power and sells it on the French wholesale market, and delivers electricity to its customers purchased on the British wholesale market. Financial rights protect him against any difference between the British and French wholesale
prices, caused by congestion on the interconnection.

As mentioned earlier, financial rights are efficient if markets are perfect. Along with Paul Joskow, professor at Massachusetts Institute of Technology, Jean Tirole examines the situation when markets are imperfect [4]. They demonstrate that if a monopoly producer (or a monopoly buyer) exerts his market power, he can increase this market power by using transmission rights. They also show that financial rights are usually preferable to physical transmission ones: a producer holding physical rights could increase his profits by withholding from the market a portion of the capacity acquired. This would not be possible with financial rights.

The second issue to solve involved opening up development of transmission lines to competition. To a great extent, the restructuring of the electric power industry resulted from the acknowledgment that electricity production had become a competitive business. This is turn was spurred by recent technical advances, in particular (i) the exponential growth of data processing capability enabled a independent market to coordinate the production of dozens of power stations, and (ii) the development of combined-cycle gas turbines that were smaller and less capital intensive than the nuclear or coal-burning power plants of the 1980s lowered the cost of entry into power generation.

In the early 1990s a new kind of production plant called merchant units arrived on the scene. These plants sold their production on wholesale markets or through long-term contracts and were no longer part of an integrated electric utility. Numerous analysts suggested that the same approach could be used to build interconnections. Why not authorize “merchant” interconnections, which would rely on wholesale markets to cover their investment cost? A natural solution would be to grant interconnection investors the new financial rights that the interconnection creates. Paul Joskow and Jean Tirole examine this problem, observing that investments in the transmission network are “discrete” and not continuous, and sequential [5]. Let us use again the example of an interconnection between France and the United Kingdom. Under reasonable assumptions, one can show that as the interconnection capacity increases, the price difference between the extremities decreases. The socially optimal capacity is such that the price difference precisely equals the marginal capacity cost. Under imperfect competition, the first investor strategically selects its line’s capacity. It can maximize its profits, for instance by building a line with capacity lower than optimal to capture a larger price difference. It can also attempt to block another investor’s entry by building a line such that the post-construction price difference would be too low
to allow competitors in.

How did these papers influence public policies? Most of the North American and European electricity markets have gradually chosen financial rights over physical ones, and regulators subject merchant interconnections to specific scrutiny, e.g. in Europe they are considered as essential facilities. Thus, recommendations from these papers have been followed. It is never easy to attribute public policy to papers published in academic journals. Nevertheless, these works main intuitions are well anchored in policy makers’ minds and have probably influenced them: financial rights are harder to manipulate than physical ones, and developers of merchant transmission lines can exert market power.

 3. Electricity retail competition

In the 1990s most analysts thought that competition in electricity retailing was sufficiently high that only light oversight – if any – would be required. Consequently, electricity supply activities (and natural gas ones) did not attract much academic research. Yet, Paul Joskow and Jean Tirole observe a significant imperfection in electricity retailing. Since most consumers do not have real-time meters, suppliers are selling to them based on an estimated load profile, which does not necessarily reflect their actual consumption. Since electricity prices on the wholesale market fluctuate greatly, flawed estimates can have considerable financial implications. In this case, the imperfection comes from the metering technology. Joskow and Tirole rigorously examine competition on the supply side when including this imperfection, and show that lack of real-time metering reduces the efficiency of this downstream market [6].

Competition in the retail market has become a critical issue for the electric power industry. For example, policy makers and regulators in the United Kingdom have opened in 2014 a retail market investigation, suspecting collusion. In addition, the emergence of demand response operators in the United States and many European countries has revived attention for the structure and economics of the retail industry. The article by Joskow and Tirole ofers a clear conceptual framework to examine these issues.

4. Generation investment and capacity markets

Starting in the mid-2000’s, policy makers and academics began turning their attention to investment in electric generation capacity. Are we sure that the market’s invisible hand will lead to sufficient investment to guarantee security of supply?
In other words, will competition not cause too many outages? Here again, if the markets are perfect, the invisible hand works and investment is optimal.
However, California’s crisis – where market power exerted by some electricity producers and traders caused blackouts in one of the world’s most advanced economies – shook the faith of analysts in the efficiency of electricity markets. One solution proposed by some academics and implemented in most North American markets is to create capacity markets: four or five years before a given date, the Transmission System Operator purchases capacity from producers. At expiry, the latter receive a capacity payment, which remunerates their contribution to security of supply, whether or not they produce any power.
Paul Joskow and Jean Tirole examine the issue by relaxing several assumptions about perfect markets [7]. Their paper develops a rigorous economic representation of the coexistence between (industrial) consumers who adjust to wholesale prices and others facing a fixed price over time (primarily residential consumers), which enables an accurate definition of security of supply. Joskow and Tirole then lay out the conditions under which capacity markets lead to optimal investment and those under which other instruments are required.

This paper is as relevant today as it was then. The United Kingdom has just concluded its first capacity auction, while France is reining the rules for its own capacity mechanism.

* * *

For the authors of this blog, this work is a cause for optimism. Contrary to many naïve assumptions, neither markets nor regulations are perfect. Some actors are endowed with advantages, for example an informational edge. However, Jean Tirole’s research shows that not everything is lost. Regulatory contracts aimed at obtaining the best results possible can be implemented, even under these imperfections. In order to apply these articles’ recommendations, competent and independent regulatory agencies are required. For instance, regulators should be prepared to leave a visible rent to regulated companies, to provide them with cost-reduction incentives. When the public and politicians criticize them for visible laxity, they should be prepared to stand their ground,
and argue that incentives are needed when regulated firms have better information than regulators about their costs and demand.

Unfortunately, human nature is imperfect. Regulatory agencies are run by professionals, who are also thinking about their careers. In certain cases, these professionals are subject to explicit political pressure. In other cases, the exerted pressure is less obvious. Sometimes, regulated companies themselves put pressure on regulators and even corrupt them. Since regulators themselves are also imperfect, they need oversight.
Should politicians exert this oversight? Their time-horizon is notoriously short, that extends only to the next election.

Should ordinary citizens exert this oversight? They are also victims of a significant information asymmetry and often lack the required technical knowledge. Who should then exercise this oversight? This question is not new. It appeared more two thousand years ago in Plato’s Republic [8] and in Juvenal Satires [9] under the form “Quis custodiet ipsos custodes?” and more recently in the great comics Watchmen [10] under the form “Who watches the watchmen?” The answer from Jean Tirole – the same that Plato attributes to Socrates – is resolutely optimistic: every generation produces men and women who, like Jean-Jacques Laffont and Jean Tirole, put the collective interest and the pursuit of a common goal above their own interests, and tirelessly conduct their work with diligence and honesty. This cheerful thought is a wonderful Christmas present.

References:

[1] John R. Hicks, Annual Survey of Economic Theory: The Theory of Monopoly, Econometrica, January 1935, page 8.
[]2 Jean-Jacques Laffont and Jean Tirole, A theory of incentives in procurement and regulation, MIT Press, 1993.
[3] William W. Hogan, Contracts networks for electric power transmission, Journal of Regulatory Economics, 4, 211-242, 1992.
[4] Paul Joskow and Jean Tirole, Transmission rights and market power on electric power networks, RAND Journal of Economics, 31(2), 450-487, 2000.
[5]Paul Joskow and Jean Tirole, Merchant Transmission Investment, Journal of Industrial Economics, 53(2), 233-264, 2005.
[6] Paul Joskow and Jean Tirole, Retail electricity competition, RAND Journal of Economics, 37(4), 799-815, 2006.
[7] Paul Joskow and Jean Tirole, Reliability and competitive electricity markets, RAND Journal of Economics, 38(1), 60-84, 2007.
[8] The Republic, book III, chapter XIII.
[9] Satire 6, lines 347-348.
[10] Alan Moore, Dave Gibbons, and John Higgins, Watchmen, DC Comics, 1986.
Cover picture: School of Athens, Rafaello Sanzio, 1509-1511. (In the middle, Plato allegorically pointing to the heavens, and Aristotle down to earth.)

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