Privatisation (Vickers & Yarrow, Privatisation: An Economic Analysis) Before 1984 the firms that were privatised were

mostly operated in reasonably competitive industries. Firms like British Aerospace, Cable & Wireless are important and sizeable companies, but do not enjoy such market power as to pose major regulatory problems. The privatisation of British telecom, the first in a series of utility companies with great market power, represented a radical shift in policy. Regulated private enterprise was now regarded as superior to nationalisation, even in natural monopolies where competition was impractical. Principle aims of Privatisation 1) Improve efficiency Privatisation enhances economic efficiency if it sharpens corporate incentives to cut costs and set prices in line with costs. But achievement of this depends crucially upon the framework of competition and regulation in which the firm is to operate. 2) Reduce the public sector borrowing requirement Borrowings of a formerly nationalised firm are no longer part of the PSBR once it has entered the private sector, also the proceeds from the sale of state assets directly reduces the PSBR as they are treated as negative public expenditure 3) Reduce government involvement in enterprise decision making Resources tend to be used to produce the quantity and variety that consumers dictate, rather than according to the wishes of the government, which must necessarily reflect short-term political pressures and problems of managing the public sectors overall demands for capital. Companies which succeed in discovering and meeting consumer needs make profits, grow and survive. The capital market adds to this process, as access to additional resources for growth depends on previously demonstrated ability. The privatised firm will also be less willing to provide uneconomic services. The resources released will be used more productively but particular sets of consumers will lose out. How should these losses, often regarded as social obligations, be handled? 4) Easing problems of public sector pay determination Eliminating inefficient production and restrictive labour practices means the release of resources. This will benefit taxpayers and consumers outside the industry, but some employees and suppliers will suffer. Privatisation may do little by itself to reduce union power however, and it can be argued that private companies have less power to resist pressure. 5) Widening share ownership Encouragement of wider share ownership, especially by company employees is not furthered itself by privatisation. Instead, privatisation provides a good vehicle for rapidly expanding share ownership. 6) Gaining political advantage (implicit, but has shaped decisions) Many new shareholders held portfolios that consisted entirely of privatisation stocks, such as BT and British Gas. Share price movements before and during the 1987 election campaign showed that the stocks were highly sensitive to assessments of Mrs. Thatchers likely electoral fortunes. Therefore a visible financial interest in a Conservative victory. The starting structure for the successor private company or companies is important. In some cases, parts of the industry could compete if formed into horizontally separate companies. Resources or assets could be transferred to potential entrants. Vertically separating the industry into different companies would also generate rivalry. But splitting up an organisation might involve sacrificing economies of scope. Either way, when there are very few existing outside competitors or none at all, the starting structure should be designed to create effective competition. Even the introduction of competition as is feasible may still leave the incumbent with significant market power in some industries. This is where regulation comes in.

Conclusions: Privatisation schemes should be designed to maximise net consumer benefits, measured primarily by lower prices and improved quality of services, rather than stock market proceeds The promotion of competition- by removing artificial restrictions on entry, making resources equally available to potential entrants, and restructuring the existing industries is the most effective means of maximising consumer benefits and curbing monopoly power. Stricter competition policy is preferable to rate-of-return regulation, efficiency audits and related forms of government nannying. Clear ground rules should be laid down concerning the criteria for providing uneconomic services and the sources of finance for these. Compensation should be paid for serious transitional unemployment, though in the LR employees prospects will be enhanced by privatisation. Priority should be given to those industries where consumer benefits are likely to be the greatest. Potential benefits will depend on the size of the industry, whether it has already received attention, and whether a monopoly or competition is likely to ensue. Public Enterprise in the UK: Public ownership is most frequently criticized on the ground that it typically fails to establish efficient incentive structures. (Robson 1960) The public corporation is based on the theory that a full measure of accountability can be imposed on a public authority without requiring it to be subject to ministerial control in respect of its managerial decisions and routine activities. In the post war period a principal objective was to create an arms length relationship between government and management. In this way it was hoped that the minister, and ultimately Parliament, would be able to control the board strategic decision making of the corporations, while leaving managements in full control of operational matters. In practice this didnt function as hoped ministers were left free to adopt their own definition of the public interest, which came to resemble the interest of the political party in power. On average between 1970-85, the ratio of gross trading profit to net capital stock for privately owned companies has been about three times higher than the nearest equivalent measure for public corporations. One view of the matter is that the figures simply reflect the pursuit of allocatively efficient pricing and investment policies. This argument is believed to have some merit, however public sector rates of return have been substantially below the private sector counterparts, and to justify the discrepancy it would ne necessary to show that efficient pricing and investment policies had a very large financial implications. Empirical data doesnt support this very well. Molyneux and Thompson (1987) conclude that inefficient pricing structures have arisen from policies of offering uniform prices and/or quality in markets where costs differ substantially, and that in some cases, these inefficiencies derive from a failure of public corporations to respond the changing technologies or patterns of demand. In particular, four developments in public policy could have contributed to enhanced performance: The introduction of greater competitive pressures on those public corporations that have enjoyed protected market positions The creation of specialised regulatory agencies entrusted by Government with duties in respect of price controls and the promotion of competition similar to, but stronger than, those afforded to the regulatory bodies that were later established as part of the privatisation programme. The creation of a specialised agency (audit office) for the sole purpose of conducting efficiency audits on the nationalised industries, and responsible directly to parliament. The more widespread use of performance-related incentive schemes for the managements of public corporations.

Information revelation and incentives: Four particular issues have arisen in practice: 1) Risk aversion 2) Yardstick Competition 3) Quality of service 4) Dynamics and commitment We assumed that the firm was risk-neutral, but if it risk averse it will require additional compensation in the form of insurance to participate in the game. The power of the regulatory contract must be reduced to accommodate a higher coefficient of risk aversion. Yardstick competition Regulation is characterized by informational asymmetry between the regulator and the firm. The regulator has to make a judgment about the firms capabilities on efficiency, quality, and so forth. A regulatory judgment, which is based on partial information only, will inevitably be imperfect. An ex-ante approach to setting regulatory targets either for productivity or quality has the disadvantage that it has to rely on regulatory estimates, which in the absence of perfect information remain subjective and open to critique. An ex-post approach bases targets on actual performance of companies. However, when there is lack of competitive pressure as for example with rate of return regulation the outcomes are not likely to be efficient. By making profits dependent on the performance relative to others, the stimulus to operate efficient is significantly increased. Yardstick competition combines the best of both worlds. Regulatory outcomes are objective i.e., based on actual outcomes rather than regulatory guess, while the virtual competition that is introduced creates strong incentives for efficient behaviour. A yardstick scheme first assumes that the regulator is committed to the regulatory contract he offers to the company. Shleifer (1985), in his seminal paper on yardstick competition, argued that for a yardstick system to be successful, possible bankruptcy of one or more regulated companies should be a viable option. In practice it is not likely that distribution companies would be allowed to go bankrupt due to the public character of the product they serve. On the other extreme, some companies may earn large profits if they are able to perform significantly better than the yardstick. Political pressure may result in reclaiming these profits, again hampering the incentives and future regulatory credibility: the regulated companies will not engage in cost reduction activities if they are not allowed to rake in the associated benefits. The second problem is collusion. If the number of observed companies is too small, companies may manipulate their observed mean performance to benefit the group as a whole. Thus, a yardstick competition scheme can only be applied with a large enough number of companies. The third problem - comparability. It may not be possible to simply calculate mean costs, since the individual company costs may be driven by a series of company-specific factors. Clearly, the ability to generate a valid yardstick - is a necessary precondition for yardstick competition to be successful. Quality of Service: Quality of service regulation raises a number of issues. Armstrong and Sappington (2004) note that price cap regulation is not well designed for this purpose since it prevents the firm from capturing the full value that some consumers may place on high quality supply. It will usually have to be supplemented by additional regulatory incentives, possibly involving intermediate power contracts such as sliding scale mechanisms. (Where the price that the firm can charge is partially responsive to or contingent on changes in realized costs and partially fixed ex ante) Laffont and Tirole (1993) draw a distinction between search goods, where quality can be determined before consumption or at least legally verified after consumption, and experience goods where quality is not observable until after consumption, and may not then be legally verifiable. Quality aspects of search goods can be regulated as if dealing with a multi-product monopoly where quality is verifiable, additional regulatory instruments such as user panels or consumer watchdogs can be used to allow more reliance on high powered contracts.

On the other hand, with experience goods or where quality is not verifiable, a crowding-out effect may occur, with firms substituting between care for quality and cost reduction, so that the firm must be given a lower powered contract. Laffont and Tirole argue that where the firm is forward looking and sensitive to its reputation in repeated supply of service, then more high powered schemes may be used. The Ratchet Effect Regulators and firms in practice are engaged in repeated interactions, with possibly fixed periods. Imagine a two period repeated game in which the regulator and the firm share a common discount factor. With imperfect commitment, the regulator will wish to use the information gained in the first period to reduce the firms second period profit to zero. The firms profits are only positive in the first period and zero in the second. This may lead to large savings, for example in the first year or a 5 year contract and then the firm drives up costs in the later years, in order to try and secure a higher price for the next period.

RIIO C Jenkins (2011), RIIO Economics In October 2010, Ofgem published its decision to introduce a new regulatory framework for GB energy network companies. This marked the conclusion of RPI-X@20, the RPI-X price control regime that was first implemented at privatization in 1990. RIIO is an incentive-based framework that sets a constraint on the revenues that network companies can raise from customers during the price control period. The revenue that can be earned is linked to performance in playing a full role in delivery of a sustainable energy sector, and delivering long-term value for money network services. Those that deliver outputs, innovation and associated lower costs have the potential to earn above normal returns and those that dont deliver earn below normal returns. Three principles influenced the design of the new incentive framework. These are that: Effective incentive regulation will strive to mimic the benefits of dynamic competition; To be effective incentive mechanisms need to be clear and credible; and Appropriately designed incentive regulation can be used to deliver environmental objectives. GB energy network companies have regional licensed monopoly rights over distribution and transmission assets and the provision of network services using these assets. The companies were privatised in 1990 and have a range of different ownership structures. Since privatisation energy network companies have been subject to an incentive-based regulatory regime, RPI-X regulation. The rate of change in average revenue was subject to an annual cap linked to the retail price index (RPI) and an additional X-factor. The X-factor reflected amongst other things expected efficiency improvements, capital investment requirements and rewards or penalties for service performance. In March 2008 Ofgem announced a fundamental review of how energy network companies were regulated (the RPI-X@20 review). There were two primary drivers of the review: The changing nature of energy network services since privatisation, particularly the role the companies could play in delivery of a sustainable energy sector; and The need to tidy-up identified concerns with the RPI-X framework The scale, shape, location and flexibility of the networks could be one of the most important factors that affects whether new low carbon generation can be transported to customers in required timescales. Because of their role in delivery of a sustainable energy sector, it is expected that network companies will need to make new and different decisions about their pipes and wires businesses. There is real uncertainty about what needs to be done and when. This changes the nature of network decision making which in turn has implications for incentive-based regulation. It is generally accepted that for the core monopoly network industries a regulatory framework will remain in place indefinitely. In this context, the interactions between the regulator and the regulated companies represent a stylised example of mechanism design in a repeated principal-agent game with asymmetric information and uncertainty. A number of concerns have arisen with the RPI-X framework over time: Whilst the incentive to encourage companies to deliver cost savings was in the main successful it had an unintended consequence of shifting the focus away from output delivery. Additional incentive mechanisms were needed, for example relating to quality of service. At times this resulted in RPI-X being complicated and burdensome and there were difficulties striking a balance between cost saving incentives and output delivery incentives. Until recently, neither the regulator nor the companies collected consistent information on what the needs of customers were and hence did not know whether the RPI-X framework was meeting them. Absent any encouragement to focus on consumers, companies focused their attention on the regulator and had limited, at best intermittent, interaction with customers of network services Regulators have tended to focus on static benefits of competition, particularly allocative and technical efficiency, when setting five-year price controls. The dynamic benefits of competitive processes were

arguably neglected. The risk averse nature of most monopoly networks and the static focus of the regulatory framework resulted in low rates of innovation and companies that are not seen to be open to new ideas. This became increasingly apparent and concerning as the network companies and the regulatory framework struggled to respond to a sector-wide need for a step-change in technology driven by the push for a low carbon energy sector. The strength of the incentive to make cost savings has varied between capital and operating costs. This may have affected the choices that companies made arguably with a bias in favour of capital investment solutions, potentially with higher long-term cost. With five-year regulatory cycles, and increased data collection and monitoring, regulators have the opportunity to set future price controls at a level that is considered to be more reflective of actual costs. This is beneficial for allocative efficiency but has knock-on implications for technical and dynamic efficiency through the ratchet effect. Companies may adjust production choices, and the information they reveal, to influence future price controls. The strength of the cost saving incentive has also varied depending on when savings were made. Originally with RPI-X the closer the price control review the less benefit a company got from a saving. Regulators have attempted to deal with the problem through redesign of the incentives but there is continued discussion about the impact of the timing of the price control review on company decisionmaking. The process of reviewing price controls every five years has potentially encouraged companies to become overly focused on five-year regulatory cycles rather than the length of time consistent with asset and service delivery planning8. The absence of any focus on the long-term in the regulatory framework has implications for decisions relating to innovation, asset stewardship and trade-offs between long-term quality of service and cost savings. Related to this there are potential concerns with the ability of the regulatory framework, and the network companies, to respond and adapt in a timely way to stepchanges in technology. The five-year cycles may have also resulted in relatively high regulatory burden, with only a brief interlude when one review is completed and implemented before the next starts. Regulators have developed and adapted the price control frameworks over time, adding on new mechanisms and requirements. This has led to complaints about increased regulatory burden and complexity of the regulatory regime RIIO mimicking the benefits of dynamic competition: The focus on output delivery, with associated incentives, is intended to be consistent with a market where companies compete on the basis of quality of service and where companies consider the implications of their decisions for customer satisfaction. Enhanced engagement is expected to play an important role in providing parties with the information needed for determining outputs and the scale of rewards and penalties. The model aims to encourage companies to seek out long-term least-cost delivery solutions and to innovate. The most relevant aspects of the model are the fixed efficiency incentive rate, longer-term price controls, allowance for innovation projects in the price control, recognition of the need to limit expost discretionary adjustments when outputs have been delivered and recognition that customers benefit from the learning associated with failed innovation projects as well as from successful ones Ofgem has emphasised that network companies need to work with their customers and wider organisations in some cases (for example, local government) on an ongoing basis to identify what needs to be delivered and how best to deliver. During a price control period network companies may need to make changes to what was envisaged at the price control review and included in a business plan at the time. The intention is that RIIO provides them with the incentive to adapt in a timely way what they are delivering or how they are delivering. Where changes provide them with cost savings, they will get the benefit through the incentive rate. Where the changes result in new or adapted outputs being delivered provisions will be in place to adjust the regulatory contract where this is considered necessary and appropriate. In essence, a company that responds to changing demands for network services will be rewarded for making changes where the evidence is there of the need for change and the change does not jeopardise other outputs (e.g. safety). The model includes incentives which are intended to encourage companies to strive to be better than others in the sector. The relevant aspects of the model include benchmarking of forecast and actual costs and the potential to be treated more leniently at future price controls.

The intention is that the actual returns that a company earns will be linked to performance in delivering outputs and cost reductions and that companies that dont deliver will earn returns well below the allowed level. The allowed return will be linked to expected cash flow risk. There is an expectation that competitive pressures from incentives in the regulatory contract will be reinforced by the threat of Ofgem giving third parties a greater role in delivery. Buyer power pressures may also become more evident through enhanced engagement and the recognition that stakeholders could ask the Gas and Electricity Markets Authority (GEMA) to consider making a price control reference to the Competition Commission RIIO and Effective Incentive Mechanisms: Clear and transparent deliverables: Ofgem has introduced a framework and new price review processes to enable price controls to be underpinned by a shared understanding of what energy network companies need to deliver. The hope is that the focus on six streamlined output categories will increase the likelihood of a common understanding, even if there is debate about how best to develop specific metrics The option of a mid-period review of outputs may also prove helpful as it provides a clear time in which any new outputs, or concern about the relevance of existing outputs, can be discussed in a transparent way. Clear, credible and appropriately calibrated rewards and penalties: Ofgem has set out principles to be considered when designing rewards and penalties for long-term cost efficiency and output delivery. The principles are intended to be consistent with the criterion of ensuring the mechanisms are transparent and strong enough to affect behaviour. RIIO incorporating environmental objectives: Given the difficulties of calibrating environmental output incentives the encouragement to innovate and to focus on the sustainable energy sector is reinforced by a number of other aspects of the RIIO model: Ofgem have signalled that they would encourage network companies to include innovative ideas in their business plans and that they would not penalise companies for innovations that fail even where the costs associated with the innovation are included in the price control. Companies are incentivised to make decisions about how best to delivery outputs using the best available information. Specific technologies are unlikely to be incentivised, reducing the risk of Ofgem getting it wrong. Similarly, there is recognition that companies are not expected to stick to the original plan where they identify a better way of delivering or identify that something different needs to be delivered. The onus is on companies and wider stakeholders to respond to learning during the price control period. There is explicit recognition of the need to offer potential rewards, in addition to cost efficiency incentives, for companies that develop new charging regimes or other service offerings related to delivery of a sustainable energy sector at long-term value for money. The innovation stimulus package is specifically designed to encourage innovation linked to delivery of a sustainable energy sector and recognises that there are innovations that companies will not consider, at least at the required scale or in required timescales, without upfront funding support.

Ofgems IQI Frontier Economics August 2008 paper on Ofgem's IQI Ofgem set cost allowance for next period. Each regional distribution company submitted cost forecast to Ofgem. Ogfem asked consultant (PB Power) to scrutinise draft business plans. PB Power view of expected cost was often different to company forecasts. Ofgem set the allowed cost to be between the company and PB Power forecast, with the allowed cost being closer to the company forecast if PB Powers view was not too different from the companys. To reflect uncertainty about forecasting future costs, Ofgem allowances were never lower than the PB forecast. Ofgem set proportion of profit that firm could retain (the sharing factor), with the proportion varying with the scale of the difference between company forecast and consultant view. Ofgem allowed the company an additional revenue allowance to ensure incentive compatibility. The firms actual profits depended on what they had in their business plans and how they performed.

The IQI represents progress over the arrangements that were in place for investment forecasting before DPCR4. Shortcomings remain, which reflect Ofgems observation that DNOs may still have an incentive to over-forecast, even though the IQI was intended to encourage more realistic forecasting. The investment expenditure performance of DNOs during 2005-07, relative to allowance, is summarised on the horizontal axis of Figure 1 below. A ratio of less than one indicates that a DNO has under-spent its cumulative capex allowance for the first two years of the present price control period. The vertical axis in the figure shows how the DNOs final investment forecasts at DPCR4 compared with those developed by PB Power on behalf of Ofgem. A ratio in excess of one indicates that the DNO submitted a higher forecast than PB Power believed was necessary. Many DNOs lie well into the bottom left hand quadrant of the chart, meaning that they forecast a high requirement, and yet have spent less than the allowance set by Ofgem, which was typically lower than the DNOs own forecasts. The overall picture would look considerably worse had each DNOs original forecasts been used, rather than their final forecasts

In aggregate, the industry has under-spent its allowance by 18% for the first two years of the control. While this gap may close over the remainder of the price control period, the scale of the under-spend to date is substantial. Moreover, much of it has been achieved by the DNOs that produced the highest forecasts relative to PB Power. These outcomes suggest that the IQI has not completely solved the problems it was intended to. It is difficult for Ofgem to identify whether investment underspend is due to a DNO making genuine efficiency improvements, or simply not delivering some volume of investment activity. The continuation of the problem of over-forecasting is due to two features: At DPCR4, DNOs were given complete freedom to adjust their capex forecasts at late stages in the process. At worst they faced no penalty from unrealistic forecasting in the early stages, and at best they could have benefited from such a strategy. The calibration of the rewards offered by the IQI at DPCR4 did not take account of risk aversion in the industry. Managers of some DNOs could have used high forecasts to insure themselves against cost overruns, to the detriment of customers. Rebidding freedom: The central premise behind the IQI is that it encourages realistic forecasting by reducing a DNOs profits if it submits an unrealistically high forecast. This cost comes through a lower additional revenue allowance and a lower marginal incentive rate on any under-spend. Ofgems analysis claimed to show that a DNOs most profitable forecasting strategy would always be to submit a forecast in line with its genuine expectation of outturn expenditure.

However, DNOs could avoid the cost of unrealistic forecasting by resubmitting a lower forecast at a later stage in the process. This made it possible for them to benefit from submitting a high forecast in the early stages. DNOs could submit high forecasts at an early stage in an attempt to influence the regulators benchmark. Even if this was partially successful, it would result in unambiguously higher profits. Solution: The appropriate solution to the problems caused by complete re-bidding freedom would not to be allow only one opportunity to present forecasts. To do so would remove a valuable source of interaction and challenge from the price control review. Instead we propose two measures that can be expected to weaken incentives to over-forecast. 1) Undertake an ex post assessment of the conduct of DNOs who have simultaneously submitted the highest forecasts (relative to PB Power) and underspent their allowance by most. The purpose would be to assess whether the behaviour of the DNOs is so extreme as to be unreasonable. Given that ex post changes to allowed revenue that have not been signalled clearly in advance would represent poor regulation, Ofgem will need to review carefully its pronouncements during DPCR4 on ex post assessment of performance under the IQI4. Should Ofgem move in this direction it would establish an important principle, which is that excess profits arising from the manipulation of regulatory arrangements will not be retained. This would discourage DNOs from following a strategy of forecast inflation at DPCR5, since they would anticipate that any gains could and would be unwound at DPCR6. Furthermore, it would also encourage DNOs that did forecast honestly at DPCR4 to continue to do so in the knowledge that there is no easier route to earning additional profits. 2) Develop a set of procedures for administering the IQI that follow those put in place by Ofwat. Ofwats approach has two desirable features. Firstly, it encourages a constructive dialogue between the regulator, its expert advisors and the DNOs. Secondly, it makes clear that all submissions made to Ofwat must be consistent, and that wholesale changes to forecasts at the final stage will not be allowed. This combination of features should reduce the incentive to inflate capex forecasts whilst still allowing a full dialogue between regulator and DNO over an appropriate baseline forecast. Risk Aversion: In calibrating the IQI, Ofgem effectively assumed that DNOs would only seek to maximise their profits (in other words that they are risk-neutral). Under this assumption, the calibration would result in DNOs forecasting in line with their expectation of investment needs. However, the assumption of risk-neutrality is unlikely to be realistic. The greater the uncertainty, and the more risk averse the DNO, the more likely it is that it will be rational to submit a forecast that is in excess of genuine expectations. Solution: Forecasting future investment needs is not straightforward. Uncertainty is unnecessarily increased by DNOs remaining exposed to risks that are beyond their control. A good example of such a realised risk during the present price control period is the (only partially anticipated) increase in commodity prices. This has resulted in substantially higher component costs for all the DNOs (which makes the emerging pattern of substantial under spending by some DNOs more surprising than it first appears) Removing the impact of this uncertainty from the forecasting and incentive arrangements could be achieved by, for example, indexing the baseline investment allowance to a commodity price index, so that the allowance awarded to each DNO flexes in a proportionate and timely manner with component prices. By removing DNO exposure to this risk, there would be less need for them to use the IQI to obtain insurance against these effects.

The second measure Ofgem should adopt is to recalibrate the IQI matrix in order to make the submission of lower forecasts relatively more rewarding. Risk averse DNOs require a greater reward than Ofgem provided at DPCR4 in order to submit a forecast that will result in them facing a higher powered incentive regime, where over-spend relative to allowances is more possible. If this recalibration was introduced alongside the recommendations outlined above the overall effect would be to provide a strong incentive for forecasting in line with expectation, rather than submitting forecasts biased upwards as a result of risk aversion. Traffic Light Indicators: As well as implementing the above measures, there is another more general issue with capex regulation to address. That is, Ofgem treats underspend against allowance synonymously with genuine efficieny in terms of the rewards it offers. There are three main factors that could lead to a signifncant underspend: - Genuine efficiency - An acceptable of higher operational risk; and/or - Excessive allowances due to forecast inflation or risk aversion (Covered) Suggested traffic light indicators, against which Ofgem can ensure that the savings have not simply come at the price of higher operational risk. If lights were flashing red over a number of metrics, this would provide the trigger for further investigation of performance.

Franchise bidding In 1968, Harold Demsetz questioned the accepted belief that a natural monopoly must be regulated in order to achieve the social welfare optimum. In place of regulation, he proposed that there be franchise bidding. Specifically, the government would award a franchise to one firm for the provision of this service. The franchise would be awarded via competitive bidding, where a bid would take the form of the proposed price that would be charged for the service. The prospective firm that offered the lowest bid would be awarded the franchise. If there is sufficient competition at the bidding stage, then price should be bid down to average cost, and the winner would earn normal profits. The role for government would be to act as an auctioneer rather than as a regulator. Modified English Auction: What is the optimal bidding strategy for a firm? Firm i will choose to remain an active bidder when the bid B is greater than its average cost. If B exceeds average cost and firm i wins, then it earns above normal profits as it ends up being able to charge a price greater than average cost. If B is less than average cost, the firm leaves the bidding as if it were to win, it would incur losses. Thus the optimal bidding strategy is to remain active as long as price is above average cost. Suppose the bidding isnt very competitive and the lowest cost firm is, for example, producing at a cost 2 units lower than the next most efficient firm. There is good and bad news from the auction the good news is that the firm with the lowest average cost curve is the franchise owner, but the bad news is that the price is equal to the second most efficient firms average cost, and this will exceed the franchise owners average cost therefore giving the franchise owner above-normal profits, and consumer surplus is lowered. The reason that price is too high is due to insufficient competition. Firm 1 does not face other firms that are as efficient as it is. Suppose there are two firms with the same average cost, then when the bid falls below the mark of the second most efficient firm before, then 2 firms will continue to bid to the point where they are both indifferent to winning the franchise. To decide on the winner, the auctioneer would choose randomly, and the lowest cost structure and socially optimum price would be chosen. Thus the ability of bidding to result in a desirable outcome is very much dependent on there being sufficient competition. Although regulation in principle could achieve this outcome, the advantage to franchise bidding is that it imposes no informational requirements on a government agency. Thus franchise bidding can achieve the same outcome as regulation, but at lower cost, since a regulatory agency need not be established. A second advantage is that the inefficiency of rate-of-return regulation is avoided. With franchise bidding, there is no incentive to overcapitalise (Averch-Johnson effect_. The franchise owner has every incentive to utilise resources efficiency because it retains all profits. One criticism is that it does not result in MC pricing average cost is certainly preferable to monopoly pricing, but we know that a two part tariff with per unit price equal to marginal cost generally yields higher social welfare than average cost pricing. Franchise bidding can be adapted. We now assume that the government knows the market-demand function, though it still does not need cost information. Knowledge of demand gives the government a measure of how much consumers value a two part tariff. Instead of awarding the franchise to the bidder who offers the lowest price, the government awards it to the one with the two part tariff that maximises social welfare. Competition results in the franchises being awarded to the firm that offers the two part tariff that maximises consumer surplus, subject to profits being normal. First let us assume the demand curve is perfectly income inelastic. I.e. the demand curve will not shift as we change the fixed fee. Increasing the fixed fee is equivalent to reducing consumer income, and if the demand curve was not perfectly income inelastic, it would shift in as we increase the fixed fee under the assumption that the good is normal.

If a firm bids a price equal to AC and is awarded the franchise, then consumer surplus is abc. Now consider a second firm that offers a price equal to MC and a fixed fee of F. Because MC pricing increases CS by the area bcde, consumers are better off with the two part tariff as long as bcde exceeds NF, where N is the number of customers. That is, in order to have price lowered from AC to MC, consumers are willing to pay up to bcde. Thus if it costs them less than bcde, they are better off with the two-part tariff. In order for a firm to earn at least normal profit, it must set F such that NF exceeds defg, where defg represents the losses from pricing below AC. Because bcde exceeds defg, there exists a two part tariff that yields higher welfare for consumers than average cost pricing, and allows the firm to earn above normal profit; that is, bcde>NF>defg. As long as there is sufficient competition, the fixed fee will be bid down to (defg/N) so that the franchise winner earns normal profit. We conclude that if the government has demand information, franchise bidding will result in a two-part tariff with marginal-cost pricing.

It is essential that the franchise be auctioned off to the firm that proposes the tariff with the highest social welfare. IN contrast, suppose the franchise was awarded to the firm that was willing to pay the highest fee to the government and it was allowed to price freely. The franchise owner would set the price at the monopoly level Pm, and firms are willing to pay a fee up to the value of monopoly profits for this franchise. Hence the competition results in the franchise being awarded to the firm that offers this. The winners effective average cost is then [(Fee/Q) + AC(Q)], and at the monopoly price the franchise owner earns normal profit. Although normal profit was also earned when the franchise was auctioned off to the firm offering the lowest price for service, a major difference is the market price. For franchise bidding to lead to a socially desirable solution, the franchise must be auctioned off to the firm offering the lowest price for service and not the highest franchise fee. To this point, we havent mentioned much disadvantage to franchise bidding. Its best to regard the discussion so far as representing the potential of the method.

Quality of service: If the service is homogeneous then competition over pricing at the bidding stage leads to the social welfare optimum. Typically however, a firm chooses the characteristics of the service it offers in terms of such variables as durability and reliability.

Suppose that product quality is a choice variable and per-unit cost is increasing in the level of quality. If bidding takes place over the price of a service, competition will drive down not only price, but quality. The winning bidder will be the one that offers the lowest quality product at a price equal to average cost. But consumers may not desire the low quality, low price alternative. Consumers may be willing to pay a higher price for higher quality service. There are several methods for adapting the bidding to cases in which products can be differentiated. One is for the relevant government agency to specify the quality of service that is to be provided by the franchise owner bidding can then take place over price without driving down quality. A second approach is to have multidimensional bidding, in which firm proposed not only a price but also the attributes of the service it will offer. There are difficulties inherent in both of these methods first, they require the franchising agency to have information on consumers valuation of quality. A second difficulty is enforcing the agreement made with the winner regarding quality it is more difficult to monitor than price. Therefore, introducing the quality dimension complicates matters and requires a bigger role for government. The main attraction of franchise bidding is the minimal role for the government, and so when more realistic elements are introduced, the advantage of bidding over regulation is reduced. Contractual arrangements for the postbidding stage: Weve assumed that bidding is performed once and for all. This is suitable fi the environment never changes, but it does. Input prices and technology change over time, causing the average cost curve to shift. The demand changes as income and preferences change. In order to allow prices to adjust in the future, franchise bidding will have to be supplements with a contract that specifies how changes in cost and demand conditions are to be handled. Recurrent, short-term contracts: This approach avoids having to specify too much in the contract. Periodically, the franchise is put up for auction, and so cost and demand changes are handled through re-contracting. This procedure provides the current franchise owner to honour its current contract, especially concerning quality. If it doesnt, it may be penalised in the next round of bidding. The key element to the success of these contracts is bidding parity at renewal time. If there is a lack of parity among bidders, in particular if the incumbent has an advantage, it may be able to renew the contract at non-competitive terms. One advantage the incumbent does have is that it has already invested in plant and equipment. A new firm would have to make this major investment, and while the incumbent would be willing to bid down to average variable cost, the new firm would not bid below average total cost. The result is that the new firm could be more efficient that the current owner, but would be outbid. This problem can be rectified by the transfer of capital from the previous owner to the new one the government could mandate a compulsory transfer of assets in a fair and efficient manner. Thus a new firm need not invest from scratch, but could instead purchase the existing plant from the previous owner. This is by no means trivial requiring the incumbent to sell at original cost less depreciation provides room for it to inflate the true value of its assets. Also, what about human capital? Workers learn over time and build up knowledge as to how best run the company. Nevertheless, if a franchise was won by a new firm, it would be in both firms interest to transfer those assets. This is then just a bargaining problem, and one would expect it to be resolved because its in the best interests of both firms to come to an agreement. Another source of advantage may imposed by the government agency monitoring the industry. It is often believed that bureaucrats try to maintain the status quo. Change brings additional work, and if the change turns out for the worse, bureaucrats are likely to be blamed in contrast, theres little lost from doing nothing.

So the current franchise owner has advantages, including having already invested, better knowledge about the technology, better information on market demand, and greater familiarity with the process these advantages may provide the current owner with the ability to engage in opportunistic holdup by forcing it to make favourable changes in future contracts. Incomplete, long-term contracts This is the main alternative to recurrent short term contracts. They are incomplete in the sense that not all contingencies are provided for but will instead be handled through negotiation and implicit understandings. An advantage to the long term contract is that it gives the owner the proper incentives to invest in long-lived assets, inasmuch as it is assured of being around to receive the returns from this investment. The disadvantage is that these contracts are difficult to write, and must allow for price to be changed in the future in response to changes in conditions. The contract will need to provide penalties with regards to quality, and monitoring this would be essential. What really matters in Auction Design (Paul Klemperer, 2002) Collusion: Consider a multiunit ascending auction. The price starts low and competing bidders raise the price until no one is prepared to bid any higher, and the final bidder wins the prize at the final bid. However, in this case, several objects are sold at the same time, with the price rising on each of them independently, and none of the objects is finally sold until no one wishes to bid again on any of the objects In such an auction, bidders can use the early stages, when prices are still low, to signal who should win objects and then tacitly agree to stop pushing up prices. For example, in 1999 Germany sold ten blocks of spectrum by a simultaneous ascending auction with the rule that any new bid on a block had to exceed the previous high bid by at least 10 percent. Mannesmans first bids were 18.18 million deutschmarks per megahertz on blocks 1-5 and 20 million DM per MHz on blocks 6-10; the only other credible bidderTMobil bid even less in the first round. One of T-Mobils managers then said. There were no agreements with Mannesman. But T-Mobil interpreted Mannesmans first bid as an offer. The point is that 18.18 plus a 10 percent raise equals approximately 20. It seems T-Mobil understood that if it bid 20 million DM per MHz on blocks 1-5, but did not bid again on blocks 6-10, the two companies would then live and let live with neither company challenging the other on the others half. Exactly that happened. So the auction closed after just two rounds with each of the bidders acquiring half the blocks for the same low price Ascending auctions can also facilitate collusion by offering a mechanism for punishing rivals. The threat of punishment may be implicit; for example, it was clear to T-Mobil that Mannesman would retaliate with high bids on blocks 1-5 if T-Mobil continued bidding on blocks 6-10. But an ascending auction can also allow more explicit options for punishment. In a multi-license U.S. spectrum auction in 1996-97, U.S. West was competing vigorously with McLeod for a license in Rochester. U.S. West bid for two licenses in Iowa in which it had earlier shown no interest, overbidding McLeod who had seemed to be the uncontested high-bidder for these licenses. McLeod got the point that it was being punished for competing in Rochester, and dropped out of that market. Since McLeod made subsequent higher bids on the Iowa licenses, the punishment bids cost U.S. West nothing. Entry deterrence/Predation: The second major area of concern is to attract bidders, as an auction with too few bidders risks being unprofitable for the auctioneer. In an ascending auction, it is presumed the firm that values the winning the most will be the eventual winner, and as a result, other firms have little incentive to even enter bidding and may not do so if there are costs of bidding.

Franchising National Audit Office (2012), Offshore electricity transmission Ofgem (2009), Offshore Electricity Transmission: Final Statement on the Competitive Tender Process Electricity generated from offshore renewable sources is expected to make an important contribution to achieving the UKs share of the EUs 2020 renewable targets. It is important that fit for purpose offshore electricity transmission networks are built to transmit the electricity generated from these sources to the onshore network and ultimately to consumers. It is also important that this infrastructure is developed in a timely and cost effective manner, achieving best value for current and future consumers. Offshore wind farms are built and operated by electricity generators (generators). In addition to wind turbines, offshore wind farms require offshore platforms with transformer plant and switchgear, undersea cables and onshore substations (transmission assets). These transmission assets carry electricity to the onshore transmission network, which in turn takes power to where it is needed. Based on Government forecasts to 2020, investment in transmission assets of about 8 billion will be needed to connect the offshore sites to the onshore grid. The Department and the Gas and Electricity Markets Authority designed a licensing regime with the following features: The tender process is structured to make it more accessible for new entrants to compete for OFTO licences, The tender process allows for interested parties to bid for multiple projects, Ofgem's costs for running the tender process are recoverable from participants (both developers and bidders), and Nobody may perform offshore transmission activities without a licence from the Authority. The Authority grants offshore transmission licences on the basis of competitions, with bidders tendering the annual amount they wish to receive in order to provide and operate the transmission assets. The Authority imposes price control by incorporating the amount tendered by the winning bidder into the licence. National Grid, as National Electricity Transmission System Operator, pays the licence holder the amount specified in the licence. National Grid recovers its costs through transmission charges to all electricity suppliers and all onshore and offshore generators according to a methodology agreed by the Authority. Suppliers and generators seek to pass on their transmission charges to consumers when they sell electricity in the competitive market.

The Authority secured good competition for licences in challenging circumstances but transaction costs have been high. The Authority launched its first competitions in March 2009, at a time of financial market volatility. Despite these adverse conditions, it attracted 29 expressions of interest for the initial competitions and had awarded four licences for assets worth, in total, 254 million by January 2012. Combined costs for winning bidders, generators and the Authority were 7 million to 8 million per deal. These transaction costs represented 7.5 to 21.1 per cent of the value of assets transferred