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Regulation and Cost Allocation

Regulation and Cost Allocation

Regulation of Monopolies

Network activities, such as distribution of electricity or water, are examples of natural monopolies or market failures. Here traditional competition on the market cannot serve to discipline the participants since there typically exists only a single supplier of the service for each customer or each network segment. To ensure reasonable outcomes in such settings, the society may empower a regulator to act as a proxy purchaser of the service, imposing constraints on the prices and the modalities of the production. Also, the regulator will typically impose some restrictions on the tariffs the network operator can charge for different usages of the network, and hereby regulate somewhat the allocation of costs and benefits of the network.

In modern economic theory, the overall price regulation problem is expressed as a game between a principal (the regulator) and a number of agents (the regulated firms). The objective of the regulator is to maximize social welfare.

Yardstick Competition

The availability and access to information is a key issue in this regulatory game. With perfect access to information, the regulator could impose socially optimal price and service quality. However, the information is asymmetrically distributed between the regulator and the agents. One regulatory regime with attractive theoretical properties is yardstick competition. The idea behind yardstick regimes is to mimic the market by using real observations to estimate the production function. Yardstick regimes have drawbacks as well, including the treatment of collusion and the fact that agents may not be willing to share information with regulator and other agents. In practice, the impact of different operating conditions is not known and has to be estimated using statistical and operational research based benchmarking methods.

CFEM Explores New Ways to Regulate Utility Networks

In collaboration with our partners DONG Energy, and DCA, we intend to explore new ways to regulate utility networks, while the Alexandra Institute and Partisia will provide expertise in implementing the required systems.

  • One aspect of this is to introduce more information (e.g. confidential upstream prices, international companies) and to ensure truthful revelation e.g. by using cryptography (secure multiparty computation) to guarantee that this information remains confidential.
  • Another aspect is to limit the collusion possibilities in traditional models by carefully controlling the information that effectively is shared via the regulation and that may be used to coordinate behavior.
  • A third aspect is to examine the use of ideal network models (reference models) calibrated on proprietary information about the specific load and consumption in different network nodes. The latter would combine economics with operations research and algorithm design since the computational demands might be massive.
  • A fourth aspect is to look into the possibilities to use more market based regulation models taking into account that parts of the regulated companies’ costs may be exposed to competition through tenders. These issues are of interest to all parties but each of the sub-projects may have to involve only one or two partners depending on the business relationships between them.

The cost and benefit allocation problem in networks has also been extensively studied in economics. Some of the main research questions have been: What types of allocation rules sustain a socially optimal structure of the network, what is a fair allocation of network externalities, how do pricing rules take network externalities into account and how are they influenced by the governance structure? Networks have been studied also in the Operations Research literature which focuses on algorithm design and computational complexity. A substantial amount of work in algorithmic game theory combines the two points of view. Existing models from the cost sharing literature will form our methodological basis and the project aims at extending these models in various directions; in particular to encompass different versions of network externalities as well as analyzing strategic behavior of agents in the presence of network externalities.

In collaboration with DONG Energy, we will also explore the possibilities of marginally affecting production and consumption to ensure optimal usage of the network. One aspect of this is how to allocate total charges on connection and usage tariffs, and whether to use total costs or marginal cost signals. Another aspect is that consumers and producers may not adjust to small cost differences and that more high powered tariff structures therefor may be required. The latter can be examined using experimental economics, cf. below, and a major challenge would be to design the experiments to optimize the tariff structure.

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