Economics of infrastructures 4

Liberalization of infrastructures
Since network related activities are considered natural monopolies, they could not be
exposed to competitive markets. Therefore it is necessary that transmission and distribution
networks are organized as separate economic entities that are subject to sector specific
regulation. On the other hand, production, trade, metering and sales are considered as
commercial activities that can be performed under market conditions. In this commercial
part of the electricity market, firms started to develop strategic positions by specifically
focusing on dedicated parts of the value chain. This resulted in a further process of
decoupling of the units in the electricity value chain.
There are 4 modes of infrastructure liberalization:

Without any regulatory intervention, network owners are expected to behave

opportunistically in an attempt to maximize their private profits. Competitors might be forced
to pay higher prices, or they might be even excluded from the use of networks. Hence,
allocative inefficiency is expected. Under these conditions the exertion of market power
becomes an important concern for the economic organization of infrastructures (Economides,
1996). In the ongoing discussion on the liberalization of various infrastructures, the
prevention of market power is a significant policy issue. It is a common belief that liberalized
infrastructure markets can only perform satisfactorily if there is a level playing field
without dominant market parties.
Liberalization thus requires an unbundling of firms into regulated network operations and
commercial activities. Certain commercial activities can be allocated through markets. Under
this paradigm, the infrastructure business is decomposed into regulated and commercial
components are forced to operate independently from each other. Under these conditions,
there is no economic or other incentive to optimize the systems complementarity.

Models of unbundling
Administrative unbundling
Administrative unbundling: different accounts for the network exploitation and for
sales/production, shared operational activities in one company. Still regulated by a regulatory
authority to ensure that competitors can enter the market and work under them same
conditions. Administrative unbundling still leads to illegal participation that pushed out
competition. Therefore Management unbundling is used:
Management unbundling: in addition to the administrative unbundling, the staff is
assigned to different business divisions/units that function independent from other
business activities, but still managed from a central holding

Legal unbundling
Legal unbundling: network activities are organized in separate legal entities, which might
however function in a holding company together with production and sales activities. Within
legal unbundling we can expect problems with the organization that had to deal with
business risk with respect to the network. The risk for the network is very low since it is
regulated and therefore guarantees a fixed rate of return (low profits). While the generation
aspect has to deal with high risk commercial activities. The problem is that the stable aspect
functions as a buffer for the risky sector which leads to a better position on the market. It
also leads to expenditure in high risk actives with money that has to be spend in the low risk
activities -> Cross subsidies.
Cross subsidization is the practice of charging higher prices to one group of
consumers in order to subsidize lower prices for another group.
Ownership unbundling
Ownership unbundling: the network is functioning under different ownership than production
and sales, thus there is no encompassing holding and no shared operational activities.
Ownership unbundling leads to a level playing field and equal access for competitors.
Ownership unbundling leads to more demand for technical regulation and more transactional
cost. Second, there are tradeoffs between investment in transmission or production. It is
much more difficult to get synergy effects within the complete value chain.

The textbook model for restructuring and competition in infrastructure

Privatization
Privatization of state-owned electricity monopolies to create hard budget constraints and
high-powered incentives for performance improvements and to make it more difficult for the
state to use these enterprises to pursue costly political agendas.
Vertical separation (Unbundling)
Vertical separation of potentially competitive segments (e.g. generation, marketing and retail
supply) from segments that will continue to be regulated (distribution, transmission, system
operations) either structurally (through divestiture) or functionally (with internal Chinese
walls or ring fencing separating affiliates within the same corporation). These changes are
thought to be necessary to guard against cross-subsidization of competitive businesses from
regulated businesses and discriminatory policies affecting access to distribution and
transmission networks upon which all competitive suppliers depend.
Horizontal restructuring
Horizontal restructuring of the generation segment, to create an adequate number of
competing generators to mitigate market power and to ensure that wholesale markets are
reasonably competitive.
Independent system operator
The creation of voluntary public wholesale spot energy and operating reserve market
institutions to support requirements for real time balancing of supply and demand for electric
energy, to allocate scarce network transmission capacity, to respond quickly and effectively
to unplanned outages of transmission or generating facilities consistent with the need to
maintain network voltage, frequency and stability parameters within narrow limits, and to
facilitate economical trading opportunities among suppliers and between buyers and sellers.
Various markets and trading arrangements
The development of active demand-side institutions that allow consumers to react to
variations in wholesale market prices and fully integrate demand side responses to energy
prices and reliability criteria into wholesale and retail markets.

Regulation of network access

The application of regulatory rules and supporting network institutions to promote efficient
access to the transmission network by wholesale buyers and sellers in order to facilitate
efficient competitive production and exchange. This includes mechanisms efficiently to
allocate scarce transmission capacity among competing network users, and to provide for
efficient siting and interconnection of new generating facilities.
Unbundling of retail tariffs
The unbundling of retail tariffs to separate prices for retail power supplies and associated
customer services to be supplied competitively from the regulated delivery charges for
using distribution and transmission networks that would continue (primarily) to be provided
by regulated monopolies
Mechanisms to guarantee efficient prices for final customers, if there is no retail
competition
Where policymakers have determined that retail competition will not be available (e.g. for
domestic and small commercial customers), distribution companies or alternative designated
suppliers would have the responsibility to supply these customers by purchasing power in
competitive wholesale markets or, if they choose, to build their own generating facilities to
provide power supplies. However, in the latter case the associated charges for power would
be subject to wholesale market-based regulatory benchmarks, primarily competitive
procurement processes.
Independent regulatory agencies
The creation of independent regulatory agencies with good information about the costs,
service quality and comparative performance of the firms supplying regulated network
services, the authority to enforce regulatory requirements, and an expert staff to use this
information and authority to regulate effectively the prices charged by distribution and
transmission companies and the terms and conditions of access to these networks by
wholesale and retail suppliers of power, are also an important but underappreciated
component of successful reforms.
Provision of transition mechanisms
Transition mechanisms must be put in place to move from the old system to the new system.
These mechanisms should be compatible with the development of well-functioning
competitive markets.

Economic features of networks

Market features
Reference: Assumptions of perfect competitive markets
Typically these assumptions are not meet in network industries:
Few players
Barriers to entry
Information asymmetry
Lumpy high risk investments
Market power
Interdependent activities and technologies
Consequences for the market design of infrastructure markets

Causes of tight oligopoly in infrastructures

Network economies create industry specific barriers to entry.
Common corporate control over multiple markets:

 Price discrimination.
Cross subsidies.
Control over monopoly focal points/ bottlenecks

Economic behavior in tight oligopoly

Protection of market position:

o Limit entry pricing.
o High access charges for new entrants.
Conscious parallelism in pricing.
Price leadership.
Collaboration/alliances.

Network Topology
Categorization of the technical hierarchy and interdependencies between nodes and links.
Serves as a basic condition for the market structure, and the opportunities for competition.
Example of the interrelation between technology and economics in infrastructures. Network
topology determines some important features of infrastructures

Star network
Star network: Bi-directional flows between nodes (N) through the Central
Resource (CR).
Central switch or facility
Local telecom network

Tree network
Tree network: One directional flow from CR to N
Centralized allocation
Electricity or water networks

Crystal structure
Crystal structure: combination of
backbone between the CRs
Long distance telecom networks

two

star

networks,

with

Web structure

Web structure: no network center

Distributed resources are located in the nodes
Functioning of the network does not depend on any CR
Example: internet

Spatial character

Spatial network: the existing lines determine geographically the service that can be
delivered (railroads, waterways)
Non-spatial network: free of geographical constraints (internet)

Network complementarity
Products and services have no individual value in itself, but only if they are combined in a
specific manner.
Examples: electricity system, telecom, water, transportation.
Compatibility through standardization
Different actors might supply different complementary services

Network compatibility
Interconnection of different specified networks
Gateways, Norm & Standards
Reciprocal vs. one-way gateways
Importance of compatibility:
Lock-in effects
gaining profits from interconnection
Examples: rail gauges, computer software, different voltage in electricity

Centralized and distributed energy systems

Traditionally electricity systems are centralized:
Economies of scale, natural monopolies
o Economies of interconnection
o Dominance of large scale technologies
Need for central coordination:
o Load balancing
o System management
o Interconnection

Why distributed systems?

Technological change:
o Production technology: gas turbines, renewables
o Information technology
Vulnerability of centralized systems:
o Terrorist attacks
o Natural disasters
o Geopolitics
o Climate change
o Regulatory and financial risk

Conclusion

Network characteristics have important implications on the economic organization of

infrastructure sectors
Changing network characteristics
Technical and economic changes can often not be designed, but they emerge.
Consequences for the regulation of infrastructures?