HKDF newsletter - 17 - Monopoly and Public Utilities in Hong Kong

There are three major losses or inefficiencies due to monopoly power: they are allocative inefficiency, X-inefficiency and losses due to rent-seeking behaviour.

Despite the regulatory reforms in the telecommunications and transport industries, the Government is hesitant about introducing reforms to the energy and water industries. The electricity supply industry in Hong Kong is still controlled by two regional monopolies. These two electric utilities are controlled by the Scheme of Control proposed by the industry in 1964. The Scheme is essentially a formal long-term contract (15 years) made between a private firm and the Government. Under the Scheme of Control, a regulated utility is subject to both rate-of-return control and price control.

At present, the gas market is dominated by the Towngas company. The company is not subject to any government control on prices and returns since the Government believes that a choice of substitutes, such as electricity, bottled and piped liquefied petroleum gas, are available to consumers. In 1998, the Government stated its position to favour the introduction of a common carrier system of natural gas to Hong Kong, with the objective of increasing competition in the gas industry. In the oil market, the oil companies are often accused of collusive price-fixing and the Government has to rely on moral suasion to invite oil companies to lower prices, or not raise prices.

Unlike other utility industries, the water supply industry is still under government ownership and operation. In fact, the privatisation of water was considered, along with all other utilities, in Hong Kong’s early period during colonial rule. As the financial prospects of such a private venture were not promising, the idea was not adopted by the representatives of the business community in the Executive Council at that time. Consequently, the Hong Kong Government was forced to set up the Water Supplies Department (WSD) and borrow money from banks to build the territory's first water supply system in the 1850s. The water supply in Hong Kong has been in public hands for more than 140 years. In 1998, the Government commissioned a consultancy company to study the transfer of the water supply industry to the private sector.

Wastes due to monopoly
As we can see, private and government utilities in Hong Kong are still under monopoly or oligopoly. Over the last two decades, there has been a world trend of market liberalisation and privatisation of the utility sector. The energy and water industries of many countries have been privatised and competition has replaced monopoly in these industries. One of the objectives of these market reforms is to eliminate the wastes due to monopoly power.

In economics, there are three major losses or inefficiencies due to monopoly power: they are allocative inefficiency, X-inefficiency and losses due to rent-seeking behaviour. As compared with ccompetitive markets, the price is hhigher and output is lower under monopoly. Apart from causing allocative inefficiency by setting a price higher than marginal cost, a monopolist is under little pressure to keep its costs down and it will tend to be ‘X-inefficient’. That means the firm incurs higher costs than are strictly necessary.

Because of the lack of competitive pressure to minimise costs and because the profits cannot be above the permitted levels set by the regulator, a monopolist will tend to spend more on staff and on ‘perks’ or ‘fringe benefits’ for the management than is necessary. The degree of X-inefficiency will tend to be higher as the market structure in which the firm operates is less competitive. The existence of X-inefficiency suggests that profits and wages in monopolistic industries will be higher than those under competitive pressure. So when we talk about uneven distribution of income, monopoly should be a cause for concern. Removal of monopoly power will undoubtedly close the income gap between the rich and the poor.

Some economists have suggested that monopoly does not only result in losses arising from allocative and X-inefficiencies, but also losses of scarce resources in the attempt to acquire or protect their monopoly positions. Any artificial barriers to entry created by the government, will have redistributive effects on wealth and income. Firms and individuals will spend resources to obtain these political favours. They engage themselves in rent-seeking (or profit-seeking) activities to make or prevent wealth transfers. The monopoly rent (or profit) is dissipated in the competitive process for monopoly rights.

Policy Options available
To avoid the losses due to monopoly and to improve the performance of the utility sector, regulatory reforms are needed. Several policy options are available for the government to reform the utility sector, they are the introduction of price-cap regulation, introduction of competition law, privatisation and deregulation.

Price-cap regulation
Historically, public utilities in Hong Kong and the US are subject to rate-of-return regulation. The objectives of rate-of-return regulation are to protect the consumer to have adequate services at reasonable prices, and at the same time to provide the company with a ‘fair’ rate of return. As the major concern of rate-of-return regulation is on equity and fairness, it is not surprising that outcomes are inefficient. Rate-of-return regulation has failed to achieve four types of economic efficiency, they are allocative efficiency, productive efficiency, dynamic efficiency, and governance (or monitoring) cost efficiency.

Allocative efficiency is the traditional measure of static efficiency. Under rate-of-return regulation, prices are based on average cost pricing or second-best pricing, rather than true marginal cost pricing. The result is allocate inefficiency in the sense that price is higher than marginal cost.

Productive inefficiency (or X-inefficiency) refers to the losses or wastes that occur when firms fail to combine inputs efficiently, which results in higher production costs. Rate-of-return regulation is similar to a cost-plus contract which provides little incentive for regulated firms to minimise costs. This is because when regulated firms successfully reduce costs so that their returns exceed the allowed level, prices will be reduced in the next review. A firm under rate-of-return regulation may intentionally spend more on staff and management than necessary, as the firm can pass the cost on to consumers. Hence, it has been argued that rate-of-return regulation fails to achieve productive efficiency.

Dynamic efficiency refers to the ability of the regulatory system to accommodate growth and change over time. A system is dynamically efficient if it is able to encourage the regulated firms to adopt innovation and invention, and to accommodate changes in tastes and preferences. Rate-of-return regulation is also deficient in dynamic efficiency. As profits are fixed, regulated firms have little incentive to adopt cost-saving innovations or to introduce new products.

Governance cost efficiency of a regulatory structure means the transaction costs involved in operating the system. If a governance structure requires considerable inputs (e.g. lawyers, accountants and regulators) to function properly, then these transaction costs must be included when measuring the net benefits. Governance costs are substantial under the rate-of-return regulation in the US, as considerable resources are spent in the process of public hearings.

In the 1980s, the many shortcomings of rate-of-return regulation mentioned above induced a lot of studies in incentive regulation. One type of incentive regulation proposed is price-cap regulation. Price-cap regulation was first applied to the privatised industries in the UK and is now widely adopted by regulators in the US and other countries. The price-cap regulation works in this way: The regulator sets a ceiling for prices to be charged by the regulated firm according to a formula: the average price of a specified basket of services must not exceed RPI-X (rate of change in retail price index minus X), where X is an adjustment factor to share productivity gains between the company and the consumers. The adjustment factor X is specified by the government and will be reviewed and possibly changed at the end of the specified period. The regulator can adjust the factor X in any review.

There are several advantages of price-cap regulation over traditional rate-of-return regulation. First, price-cap is more efficient than rate-of-return regulation. It is less vulnerable to ‘cost-plus’ inefficiency and over-capitalisation. This is because the regulated firm can keep whatever profits it earns during the specified period, but it must also accept any losses, thus there is an incentive to produce as efficiently as possible. As efficiency increases, it is possible for both the company and the consumers to benefit. The company enjoys higher profits while the consumers buy at lower prices. Since regulated companies keep all profits, they have a greater incentive to innovate and to introduce new products, resulting in higher dynamic efficiency than under rate-of-return regulation.

Second, price-cap allows the company greater flexibility to adjust the structure of prices, as there is no price control on services outside the basket. As a result, the regulated firm can adopt pricing arrangements to achieve optimal second-best pricing.

Third, it is argued that price-cap is easier to operate and its governance costs are lower than the US rate-of-return regulation. Both regulators and company can devote fewer resources to operating the system. It is also more transparent as the system focuses on prices, which are of greater concern to customers. Customers are guaranteed that price increases are under some form of controls. Hence, the system also helps to curb inflation and, being less discretionary, price-cap also has less danger of regulatory capture.

Competition law
To prevent the dominant firms from abusing their monopoly power, another option available is to enact a competition law. As in many other areas of economic analysis, there is no consensus on the importance of the need for competition law to constrain monopoly power. Some economists argue that monopoly power is a major impediment to the efficient use of the economy’s resources, imposing substantial costs on the economy. Others take the view that the dangers have been exaggerated and that there is no need for intervention by enacting a competition law covering all industries.

Besides, the approach to competition policy varies among countries. A government can consider a sector-specific approach or a general competition authority approach to introducing competition policy. In many countries, comprehensive competition laws covering all sectors coexist with sector-specific regulations. For example, in the UK and the US, there are general competition authorities as well as specific-sector regulators.

Some countries or economies may opt for a sector-specific approach to competition policy without setting up any competition authorities. It has been argued that the needs, characteristics and requirements of individual industrial sectors are different, so as compared with a general competition authority approach, a sector-specific approach to safeguarding competition is more practicable. For example, in Singapore and Hong Kong, there is neither a general competition law applying across industries, nor an independent agency to enforce the law. The governments in these two economies adopt a sector-specific approach to competition policy.

For the sector-specific approach, if a government finds that effective competition does not prevail in certain industries, or dominant firms abuse their market powers, it will take actions to promote competition. The actions taken by the government include the establishment of sector-specific regulatory authorities and the enactment of sector-specific competition law, rather than the establishment of a competition authority and the enactment of a comprehensive competition law.

Privatisation and deregulation
Privatisation and deregulation have proved to be effective ways of improving the performance of the utility sector. The world trend towards privatisation and deregulation started in the early 1980s. A lot of economists have attributed the good performance of the US and UK economies in the 1990s mainly to privatisation and deregulation, not so much to technological development. When we talk about privatisation, it in fact covers a number of programmes adopted for reforming the public sector.

Privatisation was found to be a very useful policy to raise the productivity of the UK economy. In the US, as the utility sector has long been under the private sector, reform policy is mainly on deregulation and market liberalisation, which means the removal of government-granted monopoly rights and the removal of other artificial barriers which prevent other private firms from entering markets.

Policy directions ahead
When reforming the utility sector, Hong Kong can learn from the experiences of the UK and US. The recent successful flotation of the MTR stocks in the market indicates that privatisation of government assets is well received by the public. We believe that so long as choices and competition are available to consumers, the performance of a company is better monitored by the stock market rather than by the bureaucrats.

Based on the experience of the privatisation of MTR, the Government can work out a complete programme for privatising other assets. Other suitable candidates for privatisation are government tunnels and car parks, post offices, Airport Authority, and KCR. The Government can also consider divesting its shares on Cyberport and Disneyland. When the current water purchase agreement expires in 2010, the Government can consider privatising the Water Supplies Department.

If it is likely the privatised industry will remain under monopoly, the Government has to restructure the industry, or to put in place appropriate regulatory mechanisms before handing the public assets to the private sector. Industry restructuring includes the introduction of new players and adopting an open access system. If government regulation is really needed, we have to opt for a system that will not distort the incentives of the regulated firms. Evidence in Hong Kong and other countries has indicated that incentive regulation like price-cap will provide better industry performance as compared with traditional rate-of-return regulation.

A lot of economists have attributed the good performance of the US and UK economies in the 1990s mainly to privatisation and deregulation, not so much to technological development.

Concerning the energy industry in Hong Kong, it is likely that natural gas will gradually replace towngas as the major fuel for domestic use in Hong Kong after the completion of the liquefied natural gas (LNG) terminal in Shenzhen. To facilitate the entry of new players, the Government has to introduce policies and enact laws to allow other players to use the pipelines of the towngas company. In the electricity industry, better interconnection of different transmission systems is needed before the Scheme of Control expires in 2008. The electricity industry has to be restructured in order to facilitate new entrants to the market. An open access system that allows new generating companies and suppliers to use the transmission facilities of the incumbents should also be put in place. In the transitional period, the Government can consider replacing the Scheme of Control by price-cap regulation.

In the local oil market, the experience in the last two years has shown that moral suasion is not a useful way to contain oil price increases. The comments made by government officials on oil prices from time to time may affect the confidence of the investors in the long run. Instead of using moral suasion, some people suggest the introduction of competition safeguards when granting land to oil companies. But over the years, we have already seen two many sector-specific competition laws introduced by the Government, such as the Telecommunications Bill, the Broadcasting Bill, and the Securities and Futures Bill. If the sector-specific approach continues, we may need a Supermarket Bill, a Newspaper Bill, a Property Development Bill, etc. in the future.

Such a sector-specific approach is becoming more difficult to apply and enforce, as different economic sectors are integrated and inter-related. For example, it is very difficult to apply sector-specific regulations to conglomerates. Therefore, the Government has to reconsider whether a comprehensive competition law, which covers all business sectors, will better protect the interest of the consumers, as well as the investment of the investors. It is believed that the introduction and creation of competition authority can also provide better checks and balances on government’s regulatory power.