Wednesday, June 29, 2011

Let's blame the lawyers

Electricity price rises are much discussed in Australia, but the underlying causes aren't.

Tom Parry in the Oz today is prepared to lay part of the blame on lawyers.

In an informative article he takes us on a journey through the introduction of regulated pricing (rather than prices being set politically)in NSW. The regime started as light touch and incentive based, where firms could benefit by "outperforming" the regulatory allowance for efficiency improvements.

The system now is still "building block" based but is now about the regulator "second guessing" the business. The lawyers get the blame for increasing resort to appeal processes primarily to argue "arcane elements of the cost of capital (the angels on pinheads of regulation) that are increasingly accounting for large increases in network charges."

We should care about this because the ACCC has been moving to use energy style building block and Rate of Return regulation for telecommunications pricing.

Two particular features are worth noting. The first is Parry's observation that "businesses are being accused of gold-plating." The second is the relevance of cost of capital.

"Gold-plating" in a regulatory sense is really about building to a higher standard than is prudent. Regulated firms may have an incentive for doing so because all costs are recovered and so may indulge in inefficient design. There is, however, a more specific version of inefficiency called the Averch-Johnson effect. This effect, named after a 1962 paper, is that a firm under Rate of Return regulation can increase its profit by (inefficiently) changing the mix of capital and labour (or capital and expenses).

A particular example is the approach taken by energy firms to metering. The efficient way to use comms is to buy services from a dedicated comms supplier achieving economies of scale. But the profit can be maximised by investing capital in a bespoke communications network. As the cost of smart metering is one of the drivers of increasing energy prices the significance of the A-J effect is large and growing.

The cost of capital is the second area of dispute. Regulatory lawyers have an interest in arguing up the cost of capital - despite, as Parry notes, "that a business will drive all of its costs, including efficient financing costs, so that customers can share in those benefits." In fact, this is a paradox in the theory of managerial capitalism - an efficient firm drives down all costs including financing costs, yet we are to believe it exists to "create shareholder value" - that is to maximise funding costs.

The saving grace in telecommunications might be that the firm that used to be the industry's biggest access provider (Telstra) is about to be its biggest access seeker. If they can marshal their impressive intellectual power to the problem we might find a better outcome. Unfortunately they too have allowed regulatory processes to be captured by lawyers rather than economists.

A good strategy for them would be to split their regulatory teams into "old world" and "new world" teams. They can mount arguments that the old world treatment is to be grandfathered and new rules apply for the new world. The challenge is to have the "new world" team focussed on strategy, economics and markets rather than the law.

Note: modified to make clear that the AJ effect is not a case of gold-plating but an inefficient mix of capital and expenditure.

Novae Meridianae Demetae Dexter delenda est

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