AGENCY COSTS OF THIRD-PARTY FINANCING AND THE EFFECTS OF REGULATORY CHANGE ON UTILITY COSTS AND FACTOR CHOICES

ABSTRACT ** :  Beginning in 1999, the Canadian Province of Ontario undertook restructuring and tried to implement performance based regulation for local electricity distribution utilities. Regulatory parameters were based on productivity research covering 1988–1997 that found little productivity difference by size, but wide variations in costs, factor mix, financing, and returns to capital among utilities. While some utilities questioned their ability to improve efficiency, other observers maintained many utilities were over-capitalized, especially from third-party financing paid by customers for connection/development charges; these observers noted that rates, profits, and valuations would be inflated. Despite its pervasive use, we can find no literature dealing with the implications of third-party funding. We assess the effects and adjustment dynamics of regulatory and financing changes on costs, factor mix, and performance.     

VERTICAL AND HORIZONTAL ECONOMIES IN THE ELECTRIC UTILITY INDUSTRY: AN INTEGRATED APPROACH

ABSTRACT ** :  The empirical literature on the cost structure of the electric utility industry traditionally focused on the measurement of specific technological properties: 1) scale economies in generation or distribution; 2) multi-product (or horizontal) scope economies at one particular stage; 3) multi-stage (or vertical) scope economies. By adopting an integrated approach, which simultaneously considers both horizontal and vertical aspects of the technology, we find the presence, on a sample of Italian electric utilities, of both vertical integration gains and horizontal scope economies at the downstream stage. In the light of recent regulatory reforms aiming at restructuring European electricity markets, our findings have important policy implications as for the proper configuration of the industry. Moreover, this methodology can be usefully applied to the study of the production structure of other public network utilities involved in similar vertical and horizontal reorganization processes.     

Is big better? On scale and scope economies in the Portuguese water sector

The ‘big is better’ idea has recently been challenged in network industries. Scale economies are considered finite so that for the individual utility an optimal scale of operations arises. A similar observation yields for scope economies as joint production is not predicted univocally anymore. In the water sector, scale economies and joint production are preferred. Nevertheless, several countries are restructuring the sector in order to improve the scale and scope of operations. This article intends to provide some insights into this matter. We analyze the Portuguese water market structure using non-parametric techniques with data from the year 2005. After surveying the literature on scale and scope economies, we discuss the peculiarities of the Portuguese water sector. The paper confirms the natural monopoly features. Although scope economies are absent, it highlights scale economies. The optimal scale of the utilities is located between 160,000 and 180,000 inhabitants. As such, the Portuguese water sector optimally counts 60 water utilities.     

Efficiency analysis of German electricity distribution utilities – non-parametric and parametric tests

This study applies non-parametric and parametric tests to assess the efficiency of electricity distribution companies in Germany. Traditional issues in electricity sector benchmarking are addressed, such as the role of scale effects and optimal utility size, as well as new evidence specific to the situation in Germany. Labour, capital, and peak load capacity are used as inputs, and units sold and the number of customers as output. The data cover 307 (out of 553) German electricity distribution utilities. A data envelopment analysis (DEA) is applied with constant returns to scale (CRS) as the main productivity analysis technique, whereas stochastic frontier analysis (SFA) with distance function is the verification method. The results suggest that returns to scale play but a minor role; only very small utilities have a significant cost advantage. Low customer density is found to affect the efficiency score significantly, in particular in the lower third of all observations. Surprisingly, East German utilities feature a higher average efficiency than their West German counterparts. The correlation tests imply a high coherence of the results.     

Cost savings and deregulation: an analysis of fuel cost savings in deregulated electricity markets

Unregulated utilities face competitive pressures that lead to cost-minimizing activities, but regulated monopolies in the US electricity generation sector face pressures only from regulators who must balance a desire for lower prices against the need for the utility to generate a sufficient return to encourage investment. This paper analyses the cost-minimizing behaviours of regulated utilities by comparing their average input coal costs with those of deregulated utilities purchasing coal from the same mine during the same month of the same year. Results indicate that coal-fired electric plants operating in deregulated electricity markets negotiate prices that are 6.1 ¢/MMBtu (3.5%) less than their regulated counterparts. In percentage terms, this is a fairly small discount for deregulated plants, but it happens to be on par with the restructuring gains that others have estimated for labour and nonfuel costs.     

Economies of scope and scale in the Norwegian electricity industry

An important issue for multi-product firms to consider is economies of scope, i.e., whether there is any benefit from producing two or more products, or whether specializing in producing only one product would be less costly. We examined the economies of scope for Norwegian electricity companies because policy makers have decided to force companies that both generates and distributes electricity to split their operations into two companies, one engaged in generation only and the other in distribution only. We set out to test the validity of the policy makers decision on unbundling generation and distribution. Using data from Norwegian electricity companies for the period 2004–2014, we found evidence of economies of scope, meaning that policy makers’ insistence on separating generation and distribution companies will have increased costs. We also found evidence of economies of scale, meaning that there are cost savings in expanding outputs. Our findings provide important information to consider in future policy decisions in the Norwegian electricity industry, probably with implications for other countries.     

Are Municipal Electricity Distribution Utilities Natural Monopolies?

The purpose of this study is to analyse the cost structure of the Swiss electricity distribution utilities in order to assess economies of scale and density and the desirability of competition in the distribution of electric power. A translog cost function was estimated using panel data for a sample of 39 municipal utilities over the period 1988–1991. The results indicate the existence of economies of density for most output levels and the existence of economies of scale only for small and medium-sized electric utilities. The empirical evidence suggests that franchised monopolies, rather than side-by-side competition, is the most efficient form of production organization in the electric power distribution industry. Further, the majority of the utilities analysed do not operate at an optimal service territory size. Therefore, the consolidation of small utilities whose service territories are adjacent is likely to reduce costs.     

Service quality,scale economies and ownership: an econometric analysis of water supply costs

Issues related to service quality are crucial for water utility management and regulation. Omitting these aspects, especially when they are treated as exogenous, can lead to large biases in estimating cost functions as well as to misleading information concerning technology. In this article, we integrate the output multi-dimension in the cost function, considering delivered water volume and service quality as being endogenous. Network-related scale measures and private versus public ownership are investigated with the objective of evaluating how endogenous quality may affect their impact on costs. A translog cost model is estimated from a dataset of US water utilities. It is shown that including the quality level of the delivered services has a significant impact on scale economies and ownership effects. Significant economies of scope confirm the existence of trade-offs between water production and service quality.     

Channels of restructuring in privatized Czech companies1

The main contribution of this paper to the literature on restructuring in the transition economies of Central and Eastern Europe is the analysis of productivity‐growth effects for different channels of restructuring. It examines a panel of 737 voucher‐privatized Czech companies in the first years after the transfer of ownership (between 1993 and 1998). The results indicate that asset sales and employee incentives serve as restructuring channels through which productivity of the privatized companies increases. The analysis also indicates that capital expenditures, labour shedding and CEO replacements are not significantly correlated to productivity growth. Furthermore, the analysis suggests that the availability of bank loans is positively associated with productivity growth, but not for less profitable firms. This provides some evidence in support of soft budget constraints accommodated via bank lending.     

Electricity Prices as Signals for the Evaluation of Reforms: An Empirical Analysis of Four European Countries

This paper looks at price trends as signals for the evaluation of utility reforms. A specific example is considered: electricity prices in four countries, namely France, Germany, Italy and UK. These countries offer a natural experiment in different patterns of public/private ownership and liberalisation of electricity industry. Electricity prices are mainly influenced by the mix of energy inputs, their costs, and by consumption per capita. Under different institutional settings, prices for business users are often more cost‐reflective than prices for residential users. Beyond these common features, the evidence does not support the view that there is clear dominance of one industry pattern in terms of welfare change for the representative consumer. This conclusion tends to question the widely held idea that one specific ‘orthodox’ reform should be preferred: privatisation with liberalisation and vertical disintegration. Utility reforms should be flexible and country‐specific.     

Capacity,sustainability, and the community benefits of municipal utility ownership in the United States

ABSTRACT

Most literature on utility sustainability focuses on internal operations; this misses the role that utilities could play within a community. This study measures the impact of municipal ownership of water and electric utilities on the sustainability policymaking of local governments. I find that municipalities with government-owned water utilities adopt more sustainability measures than those with investor-owned service. Similarly, municipally-owned electric utilities have higher levels of energy sustainability in the community, but not in government operations. The utilities provide fiscal and technical capacity to municipalities. Interdepartmental coordination also strongly predicts sustainability policymaking. This study brings potential community benefits to the discussion of private investment in public service delivery.     

Efficiency and economies of scale of large Canadian banks

Abstract.  This paper measures the economies of scale of Canada's six largest banks and their cost-efficiency over time. Using a unique panel data set from 1983 to 2003, we estimate pooled cost functions and derive measures of relative efficiency and economies of scale. The disaggregation of the data allows us to include non-traditional outputs as well as time-varying, bank-specific effects. Our model leads us to reject constant returns to scale. These findings suggest there are potential scale benefits in the Canadian banking industry. We also find that technological and regulatory changes have had significant positive effects on the banks' cost structure.     

The Arrow-Debreu model: How math can hide a fatal conceptual error

I argue that math, like love, can cover a multitude of sins, and I use the neoclassical object of adoration, the Arrow-Debreu model, as the case in point. It is commonplace that the Arrow-Debreu (AD) model of general equilibrium does not describe the real world, but it is equally commonplace to accept it as representing the pure logic of the competitive capitalist economy in an idealized world free of transactions costs. I show that the AD model fails even as an idealized model; it actually mistakes the logic of pure capitalism. Unlike McKenzie’s model of idealized general equilibrium under constant returns to scale, Arrow and Debreu claim to have shown the existence of competitive equilibrium under decreasing returns to scale and positive pure profits. The AD model (again unlike the McKinzie model) needs to assign the profits to individuals and this is done using the notion of “ownership of the production set.” But this notion suffers from a fatal ambiguity. If Arrow and Debreu interpret it to mean “ownership of a corporation” then a simple argument in the form “labor can hire capital or capital can hire labor” defeats the alleged necessity of assigning residual claimancy to the corporation. A given corporation may or may not end up exploiting a set of production opportunities (represented by a production set) depending on whether it hires in labor and undertakes production or hires out its capital to others (all by assumption at the parametrically given prices). In the latter case, residual claimancy is elsewhere. There is no such property right as “ownership of a production set” in a private property market economy. The legal party which purchases or already owns all the inputs used up in production has the defensible legal claim on the outputs: there is no need to also “purchase the production set.” At any set of prices that allow positive pure profits, anyone in the idealized AD model could bid up the price of the inputs and thus try to reap a smaller but still positive profit. Therefore,pace Arrow and Debreu, there could be no equilibrium with positive pure profits. In the Appendix, the property rights fallacy that afflicts the AD model is shown to also afflict orthodox capital theory and corporate finance theory.     

Off-farm labour and the structure of US agriculture: the case of corn/soybean farms

While the growing importance of off-farm earnings suggests large benefits accrue to farmers from efforts to expand off-farm income opportunities, economic well being also depends on greater efficiency. To comprehensively gauge the economic health of farm operator households' off-farm income is interpreted as an output along with corn, soybeans, livestock and other crops. To accomplish this task two related methodologies were used. First, using 2000 data, a multi-activity cost function was set up to analyse labour allocation decisions within the farm operator household and also to estimate returns to scale and scope. Second, using 1996–2000 data, an input distance function approach was followed to estimate returns to scale, cost economies and technical efficiency – and the relative performance of farm operator households with and without off-farm wages and salaries compared. The cost function and input distance function results both suggest that off-farm outputs and inputs can be modelled in a multi-activity framework and involve significant economies of scope.     

ELECTRIC POWER DEREGULATION: BACKGROUND AND PROSPECTS

The incentive failures of rate-of-return regulation are well known and thus raise the question of whether to deregulate electric power. The development of long-distance transmission and of alternative power sources in networks has spawned several institutions that would or could allow markets to substitute for such regulation. These include long-term contract sales, spot power exchange, contract power pooling, shared facility ownership, and economic dispatch. Because of the current surplus of power, the existence of such institutions has caused increasing competition in the electric power market and has catalyzed the movement to deregulate generators from state authority and to restructure utility assets. By encouraging this movement, regulators can further the discipline that markets already exert on prices and costs. By making counterproposals to the utilities, regulators can influence asset restructuring so that some of the capital gains inherent in such restructuring can be shared with consumers in the form of rate relief. Finally, for the future, the cotenancy agreement—which is antitrust supervised and competitively ruled—has promising possibilities for deregulating transmission and distribution.     

PRIVATIZATION OF THE UK'S PUBLIC UTILITIES: THE BIRTH OF THE POLICY 1979–1984

The Conservative governments of the 1980s and 1990s privatized large numbers of state industries. Yet the privatization of the public utilities was not on the political agenda at the time of the May 1979 General Election or during the early months of the first Thatcher government. Privatization of the public utilities was considered both economically unattractive and beyond practical politics. This study details how and why the sale of the public utilities became government policy by the mid‐1980s. In explaining the change two particular developments are singled out. The first involved a commissioned study by the Central Policy Review Staff of the Cabinet Office on whether monopolies could be privatized and the public interest protected. The second was the financing needs of BT at a time of strict controls on public borrowing.     

THE ROLE OF MODEL SPECIFICATION IN FINDING THE INFLUENCE OF OWNERSHIP AND REGULATORY REGIME ON UTILITY COST: THE CASE OF SWEDISH ELECTRICITY DISTRIBUTION

The lack of consensus on how utility cost is affected by variation in ownership and regulatory regime has been attributed to sector‐specific conditions and interacting observed heterogeneous factors. This study investigates a further source of ambiguous outcomes as it evaluates different econometric specifications related to variations in utility objective/the design of regulatory regime and influences from unknown/uncertain heterogeneous factors. Consistent with theoretical predictions, 7 years of data from the Swedish electricity distribution sector reveal that private ownership and stronger financial incentives are associated with lower costs. It is also demonstrated that inappropriate model specifications can produce arbitrary conclusions. (JEL D24, K23, L51, L94)     

A role for preferred stock in the financing decision of a public utility

Summary We have shown that preferred stock has a unique role in the financing of public utility capital expenditures, particulary when returns allowed by regulatory commissions are perceived to be inadequate. From the firm's perspective there is no tax advantage for debt because the commission effectively passes the tax savings through the consumers. If allowed returns on common stock are inadequate and the firm has exhausted its perceived debt capacity, then preferred stock becomes the optimal financing instrument. The regulatory commissions compute the costs of debt and preferred stock so that companies can expect returns to cover payments on debt and preferred stock if the assets being financed are necessary and will be included in the rate base. During extremely bad years when revenues are much less than expected, the companies can delay or miss preferred stock dividends without running the risk of default. The data on new capital sources for the electric and gas utilities indicate that these companies made adjustments which are consistent with the implications of our model, but they did not follow the extreme policy of using only debt and preferred stock when market-to-book ratios for common stock were below one. Regulators have, on occasions, used capital structures for rate-making that differ from actual capital structures, and a utility might be penalized for using an extreme capital structure policy. The main emphasis of regulatory review of capital structure, however, has been on the debt component. One strategy would be to use a debt level that satisfies the regulatory commission and then adjust equity between preferred stock and common stock to maximize value for common stockholders.     

A THEORETICAL FRAMEWORK FOR THE MEASUREMENT OF WELL-BEING

The conceptual framework of the system specifies that societal resources are limited by two basic factors: the amount of available human time, and the stock of wealth inherited from the past. Wealth is defined very broadly to cover not only the conventional tangible capital assets familiar to economists, but also intangible human and other capital assets, stocks of organizational capital reflected by networks of social support systems (the family, the neighbourhood), stocks of environmental assets (the sun and air), and stocks of socio-political assets (security, freedom of choice). Human time covers market work, household production, leisure, and biological maintenance. Human time and capital stocks are used within households to produce a variety of tangible and intangible outputs, and these outputs in turn are used to produce a variety of satisfactions (utilities) or to augment stocks of capital, or both. The basic sources of well-being in the system are ultimately of two types: well-being is produced as a consequence of the intrinsic benefits from all activities engaged in by individuals, which is to say that people have preferences over the way they spend their time; secondly, people derive utilities from the existence of various stocks or states of society, and these satisfactions are independent of the way in which time is used. The satisfactions associated with flows of goods are subsumed by satisfactions derived from activities associated with those goods. The system contains a set of linkages among the various parts: inputs of goods and time are used to produce tangible household output, using the familiar notions of household production functions and constrained optimization; tangible household products, which are intermediate in the system, are used in conjunction with human time to produce direct satisfactions or to augment household capital stocks; both household (micro) and societal (macro) capital stocks are linked directly to psychological well-being; household activities are linked directly to flows of satisfactions, termed process benefits in the system; household preferences and values relating to policy variables are linked to public policies of various sorts, and policies modify the constraints and opportunities relevant for household decisions. The system also has dynamic linkages. Modifications of household or public stocks produce impacts on future flows of well-being; satisfactions from activities may adapt to the existence of constraints, hence changes in constraints can modify preferences and subsequently modify activities; and household behavior has a life-cycle dimension which is inherently dynamic.     

Restructuring of the Hungarian Electricity Industry

Restructuring the monopolistic, state-owned, obsolete and polluting utility industries of post-socialist economies poses a challenge for the utility deregulation wave travelling around the world. Utility restructuring in the Central and Eastern Europe (CEE) region is unique from several perspectives, including the domination of foreign capital vs. national resources as the only feasible vehicle for a drastic change in the industry and the ambitious goals of harmonisation with the EU liberalisation schedule to accelerate accession. It is also widely expected that deregulation will help bring down world-record high energy intensities in these economies. Hungary has been the pioneer among economies in transition in unbundling, deregulating and privatising the utility industries and taking the first steps towards EU-conforming market liberalisation within less than half a decade. The first stages of privatisation and restructuring have been declared a success story in the Western media. However, what is a success story from a foreign perspective may be seen differently from other viewpoints. The article describes the process of utility restructuring in Hungary and examines its impact from the economic, environmental and policy perspectives. The article also compares the pioneer Hungarian deregulation with other CEE countries' restructuring of their energy sectors. However, the lessons to be learned from the Hungarian electricity industry restructuring are not only vital for other economies in transition but are often universally applicable.