Infrastructure and Project

Finance
Regulated Prices
NATURAL MONOPOLY
 Network Industries

• Why may they be natural monopolies?

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 Monopoly
Pricing at marginal cost maximizes welfare (consumer plus producer
surplus)

Pricing at intersection of marginal cost and marginal revenue

maximizes monopoly profit (producer surplus) and creates
“deadweight loss” for society

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 Natural Monopoly
Marginal cost pricing optimizes consumer surplus, but monopolist makes
losses and will not produce
The profit-maximizing price will make the venture profitable, but
deadweight loss emerges
The regulated “fair-return” price would let monopolist break even and
maximizes welfare, if taxes or subsidies are not allowed

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 Regulated Prices
• Price needs to cover all costs (Long‐run
marginal cost or levelized cost)
– Operating costs
– Depreciation or maintenance
– Return to creditors and shareholders

• What is the NPV of a project when the price

covers all costs?
IMPLICATIONS OF (NOT) COVERING
COSTS
 A view from 1776
• “When the carriages which pass over a highway or a bridge, …pay
toll…, they pay for the maintenance of those public works. When
high roads, bridges, canals, etc., are in this manner made and
supported by the commerce which is carried on by means of them,
they can be made only where that commerce requires them, and
consequently where it is proper to make them.

• A magnificent high road cannot be made through a desert country

where there is little or no commerce, or merely because it happens
to lead to the country villa of the intendant of the province, or to
that of some great lord to whom the intendant finds it convenient
to make his court. … things which sometimes happen in countries
where works of this kind are carried on by any other revenue than
that which they themselves are capable of affording.”
 Marginal vs. average cost pricing
under conditions of natural monopoly
Marginal cost does not reveal whether it is
worth incurring the fixed cost (Adam Smith)

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 Choosing wisely
Don Quijote Airport:

“ the airport that

cost less than a car”
(when auctioned off
for 10,000 Euros)

Construction cost > 1 billion Euros

Capacity: 10 million passengers/yr

 Marginal vs. average cost pricing
under conditions of natural monopoly
• Marginal cost pricing requires taxes to be
raised and allocated
– Reliance on tax‐funded subsidies opens the door
to politics: for example, influence‐peddling,
uncertainty of future allocation
– Taxation shifts (“distorts”) optimal volumes – the
“deadweight loss from taxation”. Pricing above
marginal cost reduces need to raise revenue from
taxation.
 “Political ease of private finance”
• Are effective prices covering cost?
• Are retail customers being served?

• Water
• Electricity
• Natural gas
• Airports
• Ports
• Railways
• Telecommunications

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 Private Participation in Infrastructure
possible drivers
• Telecom prices dropping and competition
works

• Airports, ports, water treatment all do not sell

to retail customers directly, hence politics of
pricing are relatively benign

• But: sometimes pressure to lower prices to

subsidize industry
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Getting to investment: access

Price as percent of cost in emerging markets:

‐ Water: 30%
‐ Electricity: 80%
‐ Mobile phones: 100%+
SETTING PRICES
 Basics of deriving prices
• Assess costs
– Operating costs
– Capital costs (rate base)
• “Prudent”
• “Used and useful”
– Rate of return on capital
• “fair and reasonable”

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Accounting

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 Historic vs. current cost accounting
and rate of return
• Current cost accounting requires rate of return
in real terms

• Historic cost accounting requires rate of return

in nominal terms
THE COST OF CAPITAL
 Cost of debt

• Return on “riskless” assets

• Risk premium (spread)

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Cost of equity

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 Cost of Capital
• Weighted Average Cost of Capital (WACC)
• WACC = share of equity*cost of equity + share
of debt * cost of debt
• “Grab” numbers over long term:
– Real risk‐free rate (US) 0.5‐2%
– Equity premium (US) 2‐8%
– β (by company) – hard to estimate outside large
liquid markets; utility may be a large part of the
market in emerging markets
 Cross‐border Risk

• Should it be reflected in a the discount rate or

should revenue and income items be adjusted
for expected losses?
 Cross‐border risks
• Currency risk: Return on local currency bond – return on
local currency bond indexed to foreign currency

• Country risk: Return on local currency bond indexed to

foreign currency – return on foreign currency bond (=
convertibility and transfer risk)

• When adjusting for cross‐border risk: “beta” changes –

correlation with global markets is now relevant: assumption
– zero to “low”

• Empirically: integration into global financial markets

reduces country risk, but increases “beta”
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 The Modigliani‐Miller theorem
• Cost of capital depends on risks of assets not
on liability mix:
– “risk is risk; no clever financial engineering can
change that”
• In reality: adjust for tax deductibility of
interest and potential bankruptcy costs
• Adjusted MM theorem does not hold strictly,
but approximately, if creditors do not have
other recourse

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 The Cost of Capital
• Ostensibly the sovereign state’s cost of capital
is lower than that of private firms’
• This is not due to better quality management,
but due to recourse to taxpayers
• The implicit credit guarantee by the taxpayers
is not priced
• Properly priced, sovereign borrowing need
not be cheaper than that of firms
 Basic Financial Model
• A water company sells 100 cubic meter of water for 2$ per cubic
meter
• Operating costs: 0.5$ per cubic meter
• Profit tax: 30 %
• Investment in year 1: 1000$
• Depreciation: 5% straight‐line
• Equity: 500$
• Debt: 500$ to be repaid in equal amounts over 10 years
• Interest on debt: 5% (paid on outstanding debt at beginning of year)

• Construct all accounts (Income statement, balance sheet, flow of

funds)
• Calculate: EBITDA, DSCR, NPV, EIRR
 To read
• Background reading – financial modelling

• Read – 7 pages
• Study ratios
• Study Excel functions
BASIC INCENTIVE SCHEMES
 Low‐powered and high‐powered
incentive Schemes
• British prisoner transport to Australia
– Remuneration for cost per prisoner
– Remuneration for live prisoner landed

When the last shipment of convicts

disembarked in Western Australia in 1868,
more than 160,000 convicts had been
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transported to the continent.
 Incentive Schemes
Fiscal payment allowed Fiscal payment not
(public procurement) allowed (user pays)

Power of incentive

Very high Fixed price contract Price cap

Intermediate Incentive contract Incentive regulation

Very low Cost‐plus contract Cost‐of‐service regulation

(Rate‐of‐return regulation)

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 Rate‐of‐Return Regulation

• The rate of return limit

– US‐style: maximum rate
– Hong Kong (“Scheme of Control”): assured rate

• Variable review periods:

– when costs rise ask for review
 The Averch Johnson Effect
(perfect information)

• Rate of return exceeds cost of capital

• Firm chooses costs

• Result:
– Inflate asset base
– Resist anything that reduces capital costs (peak‐load
pricing, competition, lower standards for reliability or
interruptibility)
– N.b. commitment effect of pricing rule not considered

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 Price caps
• Prospective view on
prices
• Downward price
flexibility
• Fixed time between
regulatory reviews

• RPI‐x: price allowed to

rise with inflation
adjusted for expected
efficiency gains

• N.B.: budgets at year‐end

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 Ratchet effect with Price Cap

• High profit may lead regulator to reduce price

(including e.g. excess profit tax)

• Reaction of the firm? The firm may hold back

on effort, because effort today will lower
income tomorrow

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 We all know the problem well
• When the end of the budget year approaches,
do you try to spend what is left?
• If you were able to transfer funds to next
year‘s budget would you be happy to seek
efficiencies and underspend your budget?
• What happens to your budget, if you are
allowed to do this?
• Would it help, if the budget was reviewed not
annually, but only every fifth year?
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 Rate Reviews
• Rate of return
– Variable periods
– Regulatory lag

• Price cap
– Fixed periods
– Interim assessment (England) or “imprevision”
(France)
TRADE‐OFFS IN SETTING
INCENTIVES
 Basic Incentive Design Issues
• Power of incentives depends on
– Impact of effort on results
– Risk aversion
– Precision of measurement
– Responsiveness of agent to incentives
• Monitoring Intensity
– High powered incentives = more monitoring
• Unobservable dimensions of required effort
– Low powered incentives so as not to discourage
unobservable effort
 Incentive‐rent extraction trade‐off
Goal
Effort inducement Rent extraction

Contract

Fixed‐price 100% 0%

Cost‐plus 0% 100%

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High rent extraction and commitment

• Examples:

– Excess profit tax

– Nationalization
 Trade offs
• Incentive to invest and commitment
• Quality that is not measurable
• …

• Often low powered incentives may be better…

 The promise of competition

• High power of incentives

combined with

• Low rent extraction

MULTI‐PRODUCT PRICING
 Concepts of price discrimination
• First degree
– Individual consumer willingness to pay known
• Second degree
– Types of customers known – self‐selection
• Third degree
– Based on observable characteristic e.g. urban vs.
rural residence
 Price Discrimination
• Equivalent to pricing multiple services; a form of
Ramsey pricing

• Example: Natural gas, time‐of‐day pricing,

congestion pricing… (no resale)
 Pricing Schemes and Cap on Basket of Services

• 2 goods, MC=0, Fixed Cost=500

– Good A: Q=50 reservation price=10
– Good B: Q=150, RP=2
• Questions
– Common mark‐up over marginal cost?
– Feasible pricing schemes?
– Optimal pricing schemes
– Price cap? – outcomes and consumer surplus
Price Discrimination, Multi‐part tariffs
• Same good, 2 types of customers
– Customer A: Q=50, RP=10
– Customer B: Q=150, RP=2
• Pricing strategies?
– Not possible to distinguish customers
– Possible to distinguish customers
• Pricing strategy for following variant:
– 50 consumers of type B consume 3 units each
– 50 consumers of type A consume 1 unit each
 Substitute for one good
• Competition caps price of good A
– At 7
– At 3
– Implications?

– Real world example:

• Water to households
• Water to firms – competes with boreholes
 Subsidy
• No subsidy when price > marginal cost

• But how to allocate fixed costs?

– Fixed margin over marginal cost
– Some other rule
 Cross‐subsidy
• Faulhaber definition:

– Cross‐subsidy exists, if a stand‐alone entrant can

survive in a market segment at the prices used by
the incumbent

– Also definition of “sustainable Ramsey prices”

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 Ramsey pricing
• Balance budget w/o transfers from government
(why would regulator implement rule optimally if the rule is there only
because of fear of regulatory discretion?)

• Price/marginal cost ratio (Lerner Index) inversely

proportional to elasticity of demand of good

• Prices should reflect not only costs but also

demand

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 Ramsey pricing
• Basic idea: limit departure from welfare‐
maximizing quantities while covering average
cost

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 Ethical debates over Ramsey Pricing

• People who are dependent on a service are

charged more or people are charged more
when they most need something

• People with inflexible demands are the cause

of lumpy (often costly) capacity provision to
meet peak demands
 Peak‐load pricing
• The issue: Usage of
common underlying
capacity varies over
time
• How to price so as to
cover average cost,
while minimizing
departures from
optimal allocation

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 Examples of Multi‐part pricing
• Connection/capacity fee and consumption
charge

• Variable consumption charges

– Life‐line tariff
– Declining blocks
– Ascending blocks

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 Some pricing schemes
• Pricing complements: razor and blades,
printer and cartridges, connection fee and
usage fee (internet, phone, club entry and
drinks, food and wine)

• Two‐sided markets
– Disco, dating services
– Conferences for investors
– Credit cards
LONG‐RUN HISTORICAL
PERSPECTIVE
 Ownership of natural monopolies
• In the beginning natural monopoly industries
were mostly private, for example

– Japanese and Thai railways were public private

partnerships (“BOT” = build‐operate‐transfer”)

– US railroads and UK roads were private

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 In 1778, the Pérrier Brothers created the
“Compagnie des Eaux de Paris”.

Mirabeau in his "Pamphlet On The Shares

of Compagnie des Eaux de Paris",
dismissed as "a fantasy" a plan by the
Perrier brothers to issue shares to finance
a water supply system for the capital.

After the revolution of 1789 the piped water system of

the brothers Perrier was nationalized

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 Why did private ownership not last in many
cases: Historical reasons for nationalization

• Subsidization of industry
– Prussian railways
• Inflation control
– Brazilian railways
• Patronage
– The US Postal Service

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 Why did private ownership not last in many
cases: Historical reasons for nationalization
• System integration
– e.g. UK power grid
• National security
– French roads
– German railways
• Concerns for health and safety
– US and UK water
• Mistrust of Foreigners
– Latin American utilities
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The wheel of privatization and
nationalization 1
10
Entrepreneurial

Privatization 2
9 Dilemma of Consolidation
subsidy cuts,
fee increases
and service cuts
3
Regulation of fee
and franchises
Declining
8 efficiency
Decline in
profitability
Public 4
subsidies Withdrawal
of capital
7 and
Public
services
takeover
5
6

Source: Gomez-Ibanez and Meyer. 63

The origins of regulation of natural monopolies

• The Massachusetts railroad commission

(accidents)
• ATT embraces price regulation
• RWE embraces state co‐ownership
• China Light and Power (Hong Kong) embraces
price regulation

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 Stability of Regulatory Arrangements

• Regardless of ownership, policy regimes

remain unstable, if prices cannot be set at
levels that are both attractive for (private or
public) investors and legitimate politically
• Where price formation can be achieved in
competitive markets, it is easier to establish
lasting policy regimes than where prices are
set by administrative decision of a regulator

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Rate of return Price cap
Credibility
Regulation Regulation

Legitimacy Efficiency

Profit‐sharing