Last month French economist Jean Tirole won the 2014 Nobel Prize in economic sciences. According to the Royal Swedish Academy of Sciences, he deserved the award because he has “clarified how to understand and regulate industries with a few powerful firms.”
With the increasing penetration of renewable energy driving conversations about appropriate utility rate and regulatory structures for the 21st century, in this post we explore three takeaways from Tirole’s work as they apply to electric utility regulation.
Jean Tirole: Three Key Takeaways for Regulation of Electric Utilities
1. Offer regulatory choices that provide incentives while avoiding the ratchet effect
Suppose regulators do not know the true potential of firms they regulate to reduce cost. If they offer cost-based, rate-of-return structures firms will have little incentive to reduce cost even when it is possible. On the other hand, if they offer fixed-price structures firms will have a strong incentives to reduce costs, yet depending on the price level allowed it may be the firms—not ratepayers—that capture the benefits.
Tirole showed that regulators can resolve this dilemma by offering firms a carefully designed menu of regulatory schemes and letting the firms choose between the options. Offered the two polar choices above, firms without good cost reduction opportunities would take the rate-of-return option, while firms with them would take the fixed-price option. A regulator can use a more sophisticated menu to ensure some of the benefits of cost reduction are shared with ratepayers.
Tirole also showed that regulators must be able to offer long-term contracts for high-powered incentives (such as fixed prices) to be optimal. If regulators can ratchet prices down after firms have made investments, firms will avoid making investments that require longer payback periods. To avoid this ratchet effect, such regulators should offer only modest incentives in the short run.
2. Incentives for firms offering network access should depend on competitors’ output
Regulated firms often control access to an intermediate good that other companies can use to compete in end markets. If the regulated firm’s profit is dependent only on its own level of output (or assets) it has an incentive to overstate the cost of providing access to such companies to foreclose that competition. Therefore, Tirole says “the regulated firm’s incentive scheme should depend not only on the firm’s cost and outputs but also on the output produced by its competitors”!
3. platform markets require network externalities and are sensitive to price allocation
Tirole has been a leader in the study of platform markets, such as those for video game systems, operating systems, payment systems, and newspapers. He defines such markets as those in which:
(a) the amount users benefit from the platform depends on the number of other users of the platform (i.e., video game developers prefer platforms with many gamer customers), and
(b) the volume of transactions depends not only on the total price level, but on the distribution of prices between parties that use the platform (i.e., advertisers and subscribers to a newspaper are charged different prices).
As we will see below, New York would like to set up a platform market for distributed energy resources.
Several states, including Arizona, California, Hawaii, Massachusetts, Minnesota, and New York are considering changes to their regulatory frameworks for electric utilities to manage or encourage the use of distributed energy resources, fairly allocate costs, and improve efficiency.
Let’s look at how some of the takeaways from Tirole’s work could be applied in two of these states: New York and Hawaii.