3. CONTENTS
INRTODUCTION.................................................................................................... 4
CHAPTER 1.
THEORETICAL APPROACHES TO EFFICIENCY ESTIMATION OF
NATURAL MONOPOLIES' ACTIVITIES AND CONTROL............................ 5
1.1. The development of theoretical approaches to examining and estimating the
efficiency of natural monopolies......................................................................... 5
1.2. The concept of estimating the efficiency of natural monopolies: methodology
and optimality criteria.......................................................................................... 17
1.3. Government regulation as a method to enhance NM efficiency. Efficiency
criteria for government regulation....................................................................... 25
CHAPTER 2.
WORLD AND RUSSIAN EXPERIENCE IN REFORMING THE ELECTRIC
POWER INDUSTRY............................................................................................... 37
2.1. Methods of controlling and estimating the electric power industry............. 37
2.2. The global experience of reforming the electric power industry.................. 52
REFERENCES......................................................................................................... 64
APPENDIXES........................................................................................................... 66
3
4. INTRODUCTION
The processes of reorganization as a mechanism of adaptation to changed
environmental conditions to a greater or lesser degree cover all large-scale enterprises
in Russia, which are the core of national economy in the literal sense. Reform
processes in 'natural monopolies', including the energy sector – the base branch of
national economy, are of great social and economic importance.
The reform in the electric power industry has already led to its division into two
components: infrastructural (networks) and competitive (generation and distribution)
ones. At the same time there is a number of unsolved problems aggravated after
liquidation of RAO Unified Energy System of Russia resulted from imperfect
legislation, lack of a single reform methodology, noticeable gap between developed
countries in terms of the material and technical basis and labor productivity, and lack
of a comprehensive approach to efficiency evaluation of structural transformations.
The global financial crisis, which significantly affected the social and economic
situation in the country, has also aggravated problems associated with non-market
tariff regulation and low labor productivity in the industry. It puts into questions the
achievement by power industry enterprises the stated reform objectives: to raise
investment attractiveness of the sector and to replace worn-out equipment. The
Sayano–Shushenskaya power station accident drew additional attention to the
estimation necessity of conducted and conducting structural transformations in terms
of reliability preservation of the energy system.
All these factors bring high relevance to the theoretical and economic explanation of
the background, objectives, effective toolkit for efficiency estimation of the
management system for enterprises in competitive and non-competitive power
industry sectors.
The research provides a mathematical model to the available theory of natural
monopolies on the basis of GDP optimization conditions. Calculation parameters and
interaction between the model factors are identified. The model is considered in the
context of the electric power industry. A methodology for government regulation
enabling to maximize national benefits from NM operation is proposed.
4
5. CHAPTER 1
THEORETICAL APPROACHES TO EFFICIENCY ESTIMATION OF
NATURAL MONOPOLIES' ACTIVITIES AND CONTROL
1.1. The development of theoretical approaches to examining and estimating the
efficiency of natural monopolies
Natural monopolies (NM) play a special role in the system of economic relations. As
an important element of national and world economies starting from the end of the
XIXth
century the phenomenon of natural monopolies as a special type of monopolies,
which has been maintaining a privileged market position due to specificity of certain
enterprises in the context of industry markets causes contentious debates in the circle
of representatives of various schools of economic thought. Theoretical studying the
NM problem began in the western world in the middle of the XIXth
century, then the
development of capitalism and increase in industrial production scale only
strengthened this interest. Q. A. Marshall, E. Chamberlin, F. Hayek, J. Schumpeter, F.
Scherer, W. Baumol, H. Demsetz, J. Panzar, R. Willig, A. Harberger, H. Leibenstein,
R. Posner, R. Braeutigam, M. Rothbard, T. DiLorenzo, R. Pittman, etc. were among
scientists, who developed the theory of natural monopolies and specialized in
question concerning estimation of NM efficiency from the standpoint of society.
According to the western economic tradition, a natural monopoly is an extreme form
of imperfect competition at which there are markets where competition is undesirable
or even impossible [11]. In general, public utility enterprises as well as those kinds of
activities, resulting commodities of which are used by society, such as railroad, air
and some other types of transport, specific fuel and energy enterprises, for example,
gas, oil and electricity supply, telecommunications services [7], belong to this
category. At the same time in practice a list of industries, which are considered to be
natural monopolies at the state level may vary widely depending on a country.
In order to estimate the efficiency of natural monopolies theoretically the optimality
criterion, proposed in 1976 by R. Willig [20] in 1976, is used, namely: “The result
providing the highest total surplus, i.e. the largest sum of consumers' surplus and
profit, is socially optimal”.
By the beginning of the 70s a single approach to define natural monopolies
dominated in the theory. The presence of economies of scale was the key point. The
classic definition is contained in Scherer's [19] works, according to which “an
industry is a natural monopoly if economies of scope are so significant, that a single
firm can serve the market with lower costs per commodity unit than two or three
5
6. firms”. Constant costs, which in NM industries are significant and are paid once
without taking into account subsequent quantity of output (for this reason the
'infrastructuality' of these industries is so important to define natural monopolies) are
the source of economies. A modern approach to the definition of natural monopolies
is based not on economies of scale concept, but on the concept of cost subadditivity.
Baumol, Panzar, and Willig [13] gave the following definition: “An industry is a
natural monopoly if at all output levels the function of firm's costs is subadditive”.
The concept of subadditivity is a precise mathematical representation of neoclassical
natural monopoly concept and it allows the situation when there are no economies of
scale at some output levels even in a single product monopoly. If all potential active
firms in the industry have access to the same technology, represented by a cost
function c, and an aggregate output is x, the industry is a natural monopoly and a cost
function c(x) is subadditive if: for any constant set of outputs of x1, ..., xt
such that.
Thus, the concept of subadditivity, including the standpoint of Willig's optimality
criterion, economically justifies the existence of natural monopolies for the purpose
to minimize total costs for production of the same output quantity. In case of a multi-
product monopoly the economies of scale factor loses its relevance, since economies
of scale in this situation do not imply subadditivity, taking into account the arising as
a result of multi-commodity production effects of total and complementary costs,
economies of joint production, etc.
Natural monopolies have the following additional well-known identifying features:
• Significant entry barriers for new firms. The 'height' of the mentioned barriers is
determined by investment volumes required for creation of an infrastructure network.
At the same time infrastructure investments are always less attractive for investors,
than other spheres of economy. This fact can be explained by long payback periods,
high risk level and long periods of fixed assets amortization, and a significant number
of regulating authorities in the field.
• Absence of close substitutes of its products. Impossibility to replace some
commodities of natural monopolies with equivalent ones causes inelastic prices for
this products. Precisely such inelasticity enables making monopolistic profits
explained not by increase in efficiency, but by voluntary setting of greater prices and
tariffs.
• Public importance, economic benefits for the whole country and population, as well
as for national security. Some enterprises can be protected from competition by
political reasons to guarantee stable profitability of services, which are important
from the standpoint of public interests. It is particularly relevant in case of local
natural monopolies.
6
7. The market conduct model of natural monopolies in the neoclassical theory is
graphically illustrated in Figure 1 [11]:
E2 is a point of natural monopoly's stability (quantity of output, at which a
monopolistic firm covers all costs, but any increase in quantity made by this firm or
its competitor leads to losses). It is 'the second best solution' according to Ramsey; E
is a point of profit maximization by a monopolist. In this position the price (Рм) is
higher than average costs, a natural monopolist receives significant profit and price
exceeds marginal costs; E3 is a point of meeting an optimal consumer demand (long-
term marginal costs (MC) coincide with the value of an additional output unit for
consumers). It is Ramsey's 'first best solution'.
Figure 1. The market conduct model of natural monopolies in the neoclassical
theory
The establishment of output quantity at a Qм level, which is lower than an optimal
consumer level Q3, and the price at this quantity is higher than an optimal consumer
price P3, is a natural model of a monopolist's conduct. In this case there is a so-called
'allocative inefficiency' of a natural monopoly (the term is introduced by Harberger)
[17], or losses caused by unfair use of resources from society's point of view, to
eliminate which government intervention is required. Thus, the E3 point could be a
point of long-period equilibrium, since the corresponding price is lower than average
costs (AC curve), but the firm can not exist too long without normal profits. To meed
consumer demand with output quantity Q3 at a cost of P3 government has to
subsidize a natural monopolist to cover production costs of the output quantity, which
is optimal for society.
Therefore, according to Willig's optimality criterion, the achievement of optimal
result for society will mean direct losses for a natural monopolist's firm. At the same
time if there is no regulation from society (as a rule government is a regulator) a
7
8. monopolist tends to maximize profits by setting a high price with a much smaller
output quantity than optimal one.
Thus, the following statements are recognized by the neoclassical NM theory:
1. The necessity of natural monopolies taking into account potential benefits for
society by means of costs reduction resulting from subadditivity of production
function; social importance of an industry resulting from low demand elasticity
for the products of natural monopolies; high entry barriers associated with
infrastructural characteristic features of an industry;
2. The need for government regulation of natural monopolies due to the interest
of a monopolist to maximize profits and set output quantity and price at an
optimal level; high social importance of a naturally monopolistic industry.
Government regulation in the neoclassical theory is supposed in the form of
intervention in the price formation process of a natural monopoly: either subsidizing
a monopolist's losses to guarantee an optimal level of output quantity (Ramsey's 'first
best solution') or creation of mechanisms stimulating production in the break-even
point, when product price is equal to average costs (Ramsey's 'second best solution').
In 1970 Baumol and Bradford proved the value of Ramsey's price regulation rules,
developed by a French professor in 1927 for the purposes of optimal taxation with the
same optimality criterion — maximization of consumer surplus for the model of
multi-product natural monopoly price regulation. In the described model the
regulation according to Ramsey's prices provides a maximum average surplus, firm,
the only monopolist, suffers no losses and its profit is equal to zero.
Critics of natural monopolies have another point of view, appealing to the traditions
of neoaustrian school and such names as Hayek and Schumpeter [1]. The key feature
of the neoaustrian approach is competition interpretation not as a characteristic
feature of a stable mature market (that is typical for the neoclassical approach), but as
a process with a dynamic nature. Formation of a monopoly in a market is not a
'market failure', but a result of market mechanisms operation, which are a priori more
efficient than compensation mechanisms of government regulation. A modern work
by Thomas DiLorenzo “The Myth of Natural Monopoly” [16] is widely known.
According to his opinion, “the theory of natural monopoly is an economic fiction. No
such thing as a 'natural monopoly' has ever existed". The history of the so-called
public utility concept is that the late XIXth
and early XXth
century 'utilities' competed
vigorously and, like all other industries, they did not like competition. They first
secured government-sanctioned monopolies, and then, with the help of a few
influential economists, constructed an ex post rationalization for their monopoly
power”. In support of his conclusions DiLorenzo refers to the facts proving that there
is no connection between economies of scale and formation of natural monopolies.
Recognizing natural monopolies at a governmental level and conducting a protection
policy break natural laws of market competition and lead to abnormalities of natural
market mechanisms and market 'failures'. Government regulation for the purpose to
8
9. enhance the efficiency of natural monopolies also can not help to achieve the set goal.
The concept of 'X-inefficiency' or production inefficiency of natural monopolies [9]
was introduced by Leibenstein in the 1970s. And it is considered to be a confirmation
of critics' of neoclassical NM theory statements. A monopolist has less incentives to
diminish costs than a competitive seller, and even more, tends to raise costs in order
to set a greater price in future due to acquired rights to be a monopolist and the fact,
that government can set a price ceiling, as a rule, on the basis of the information
about production costs for all previous periods. At the same time if allocative
inefficiency losses, which were empirically estimated by Harberger, were very low,
namely, 0,1% of the USA GDP annually, so calculation losses from X-inefficiency of
monopolies could reach 20% of GDP of some countries [1].
Thus, defenders of the neoclassical theory of natural monopoly assume the existence
of objective economic factors, such as production cost savings, which are the major
reason leading to formation of a natural monopoly. Today it seems absolutely clear,
that the factor of economies of scale is an integral part of any capital-intensive
industry and only social importance or national security could be a justification of a
special privileged position of natural monopolies in the legislation in relation to other
enterprises with a monopolistic model of conduct. Market monopolization makes
government to control natural monopolies intervening into their activities.
Critics of the neoclassical theory of natural monopolies on the contrary consider
government intervention to be a reason for emergence of natural monopolies. It has
been argued that the mentioned factors (economies of scale and economies of scope)
do not lead in any case to market monopolization and “only government intervention
can generate monopolistic prices” [16]. Such a position, in spite of its logicality and
mathematical certainty of conclusions, according to the author,
does not take into consideration the impact of competitive forces on national model
of economic growth, as well as political and social factors of interaction between
modern society and government. The idea to cancel antimonopoly regulation assumes
an ideal competition and absence of imperfect market (including absence of
information asymmetry, chance of a secret deal, etc.), and such conditions are
impossible to be achieved in practice.
Influenced by debates about economic efficiency of natural monopolies and questions
concerning frameworks of government intervention into naturally monopolistic
market sector, concepts focused on indirect government control (a price-setting
mechanism), in other words, implementation of competitive mechanisms, such as
franchising contract (Demsetz), the concept of 'contestable' markets (Baumol, Panzar,
Willig), theory of monopolistic competition (Chamberlin), began to gain popularity.
One of possible 'decision charts' concerning regulation of natural monopoly [6] can
be found in a work by Braeutigam. First, it is necessary to identify, how great social
welfare losses between Ramsey's 'first and second best solutions' (Figure 1) are, when
9
10. they are not significant and society could 'accept' them, it is proposed to introduce
elements of alternative competition in order to raise efficiency of natural
monopolistic firms and to achieve 'the second best solution' without direct
government control.
Demsetz in his article “Why Regulate Utilities?” (1968) [15] formulated the concept
of competition not 'within the field', but 'for the field' of a naturally monopoly sector,
stating that if competition within the field is inefficient or impossible (the idea of
neoclassical theory of natural monopoly), competition for possibility to act in this
market can play its role. Demsetz's competition' is a bidding system, in which
potential producers submit a bid to serve the market, and the government as a
society's agent considers these bids and makes a decision. In order to implement
Demsetz's model the following conditions are needed:
1. Resources should be available to all potential rivals of an open market and at
competitive prices.
2. Submitting bids for the contract must be exclusively competitive, bidders must
have no chance to make a secret deal.
The winning bidder is determined by the best price. It is assumed, that if these
conditions are satisfied, price can be reduce to the zero-profit one ('second best
solution') and minimization of losses. In addition, bidding periodicity must stimulate
the monopolist to use all opportunities to raise production efficiency in order to
become the next winner as well. Thus, the presence of monopolistic producer does
not lead to setting monopolistic prices. Among disadvantages of Demsetz's model
concerning efficiency of natural monopoly critics found a time factor, which at a
fixed price and changed external conditions can lead either to monopolist's
bankruptcy or to unreasonable high monopolistic profits. Also there is a significant
investment problem, since an active monopolist, stimulated to reduce costs in order to
be the next bidding winner, is not motivated for long-term investing, that will raise
production costs. These losses for society are called 'dynamic inefficiency' [1], which
occurs due to the fact that an active monopolist has less incentives to become
technologically progressive and to expand the assortment in comparison with a
competitive market (it is associated with Х-inefficiency), in other words, an active
monopolist does not need innovations.
The problem of product quality against the background of constant attempts to
minimize production costs is also actual. In practice a model of contract monopolistic
activities on the basis of bids is applied in Great Britain in the course of privatization
of railroads and in water supply sector in France.
Another concept of 'contestable' markets (Baumol, Panzar, Willig) [13] assumes
potential competition in naturally monopolistic fields if there is no actual
competition. Accessible market is defined as a market without entry barriers and exit
losses, i.e. a condition concerning absence of sunk costs is met. If these conditions
10
11. are satisfied, 'second best solution' can be achieved without Demsetz's bidding. The
optimality criterion of monopolist's activities must be met, since “a potential rival
will not loose even the slightest chance to make a profit, because a rival firm can
enter before price drop, get the profit and exit the market without losses” (Baumol)
[13]. Such a possibility stimulates an active monopolist to produce goods or services
efficiently and with zero-profit, once again, without government intervention, role of
which is only to control the fulfillment of conditions for the accessible market model.
This concept also has weaknesses, which are similar to disadvantages of Demsetz's
model. First, sunk costs are a part of many enterprises, not only of naturally
monopolistic ones, for example, staff reduction costs, cost to sell productive assets,
etc. Second, the idea of easy entry into a 'complex' market of a natural monopoly for
rivals, even if there is a free access to infrastructure provided by government, is
impractical. During the period of 'sign-making' by a potential competitor (personnel
recruitment, advertising, purchase of equipment, etc.), an active monopolist can
reduce prices and thereby cause material losses to a potential rival. Problems of
investing and product quality are also actual, if a rival follows the 'market skimming'
strategy.
The third alternative concept of monopolistic competition by Chamberlin [14] is
based on developing technological progress and occurrence of so-called 'intermodal'
competition. The emergence of other transport types (air, automobile, water) as an
alternative to railroads due to expansion of infrastructure and reduction of costs can
be provided as an example. At the same time a naturally monopolistic firm needs
productivity enhancement to keep the same output rate. In this case market expansion
is important, where one sector is regulated by government as a natural monopoly, and
the others are controlled by other regulation principles.
The ideas of alternative competition instead of tariff regulation were developed in the
institutional theory of natural monopolies, which clearly defines the institution of
natural monopoly as a component of a market infrastructure aggregated institution.
Infrastructure is a special public market institution represented in the form of
networks, which are needed for supply of products or services between remote (either
in space or in time) economic agents as well as economic fields using these networks,
at the same time infrastructure in conceptual meaning includes natural monopolies
defined by government, but not restricted only by them. Thus, for example, a number
of researchers include systems of education and health care, Internet and other
institutions of national economy in infrastructure objects, which are not natural
monopolies, but are also social important components, and for this reason must be
regulated by government [5].
So, all natural monopolies are organized in the form of infrastructure or network
enterprises, in other words, production is a network, which is used for supply of
products and services, and duplication of which is uneconomic.
The notions of 'field of natural monopoly' and 'enterprise of natural monopoly' exist
11
12. separately in the institutional theory. At the same time industry structure includes not
only enterprises functioning under economic conditions of a natural monopoly, but
also enterprises working in accordance with market conditions. From an economic
point of view some industry enterprises are not considered to be natural monopolies
taking into account functioning conditions. However, these enterprises significantly
depend on activities of natural monopolies, since they are either commodity
suppliers, or consumers of commodities produced by a natural monopoly.
Traditionally enterprises of naturally monopolistic fields are classified by one of four
stages associated with chain of price setting for a final product: production, network
(infrastructure), sale and service. At the same time the most 'natural' monopoly is an
enterprise of a network stage. Taking into account that in the institutional theory any
firm is considered to be a set of contracts, the efficiency optimality criterion of
natural monopoly is minimization of transaction costs (the statement in general is
associated with Willig's definition of optimality criterion). It can be reached by
comparing of configuration variants of naturally monopolistic enterprises, as well as
terms and conditions of contracts with government and society. Possible variants of
NM functioning vary in the range from totally unregulated (private) to totally
government one [8]. At the same time institutional alternatives are distinguished from
the standpoint of the contract theory, to be more exact, contracts between public and
private sectors concerning regulation roles and ownership rights.
In order to examine the set of possible institutional models of natural monopolies'
operation a matrix table of NM institutional alternatives is proposed in this paper
(Table 1).
Table 1
Matrix table of NM institutional alternatives (MTIA)
Government regulation of
NM
Competitive market in an
NM sector
Private ownership of NM
property
Private regulated natural
monopoly
Private non-regulated
natural monopoly
Government ownership of
NM property
Government regulated
natural monopoly
Government non-regulated
natural monopoly
Thus, four institutional alternatives can be identified.
1. Private owned non-regulated natural monopoly. Its model is described in the
neoclassical theory of natural monopolies.
2. Government owned non-regulated natural monopoly. It is a state-owned
monopoly regulated by representatives of private sector. Concession
mechanisms are widely used here, i.e. transfer of not rights, but management
12
13. functions of government-owned property within public-private partnerships.
3. Private owned regulated natural monopoly. Government intervention is
implemented mainly by directive regulation of price level and efficiency of
capital assets.
4. Government owned natural monopoly with government regulation.
Great importance in the institutional theory of natural monopolies is given to
dynamics and estimation of transformation results in a correspondent sector of
economy [4]. In the modern world the achievements of technical progress (for
example, the invention of small power production facilities, which are not less
efficient than huge power plants and are more cost-efficient) gradually reduce returns
to scale. It means that some production stages of traditionally naturally monopolistic
industries are less economically feasible now. In order to raise their efficiency some
elements of regulated competition relations are proposed to use. The major economic
and regulation problem of disintegration of natural monopolies is risk to lose a
system effect, which results in growth of economic, time and other costs. At the same
time companies became more investment attractive. It can solve some serious
problems relating to investments in infrastructure sector (dynamic inefficiency).
Anyway, the division into production, infrastructure, sale stages (and a service one in
some cases) is the basis of all variants for reforming natural monopolies. Positive
effects after introduction of competition elements are expected as a result of
overcoming the so-called price discrimination.
In general, all the mentioned methods aimed at increase in efficiency of natural
monopolies from the standpoint of government are divided into two groups. The first
one is associated with improvement of tariff regulation and introduction of
stimulating contracts within its frameworks. The second one implies refusal from
tariff regulation of natural monopolies. The development analysis of NM theory is
generalized in Table 2.
Summary of Section 1.1.
Thus, the definition of natural monopoly in categories of imperfect competition has
been undergoing changes, becoming more structurally complex. The notion of natural
monopoly first considered to be a special form of a monopolistic firm, for which
average costs are a decay function of output rate at any their levels up to full demand
saturation. Then the notion of natural monopoly started to be associated more with a
multivariant contract between society, government and business. It is reflected in
changed theoretical approaches to the explanation of this phenomenon, efficiency
estimation of activities and model of natural monopolies. This change in theoretical
foundation has lead to started in many countries liberalization processes of naturally
monopolistic industries and replacement of tariff regulation with some elements of
competitive relations.
Today there is no single method to estimate a comprehensive efficiency of naturally
13
14. monopolistic industries, which could be proved by empirical formulas. Due to this
fact it is impossible to actualize the notion of naturally monopolistic industry under
modern conditions. Also there is no single method of government regulation in order
to reach an optimal efficiency of natural monopolies from the standpoint of society.
In addition, the existent theoretical base does not take into account modern
globalization processes of large-scale enterprises, including such processes in
naturally monopolistic industries. This global economy course stimulates further
development of the NM theory.
14
15. Table 2
The connection between the notion of natural monopolies and development of theoretical approaches to examine the
phenomenon from the standpoint of NM efficiency
№ Stage Name Special Features Examples Theoretical Justification Basis for Transition to
a New Level
1 Primitive capital accumulation Establishment of private
enterprises on the basis of
available natural or
infrastructural resources
Standard Oil Co. Inc.
established in 1870 by John
D. Rockefeller
Classical competition
theory and non-
intervention in market
mechanisms
Need for significant
investments in order to
increase economies of
scale
2 Concentration of Production Cooperation between
enterprises and financial
structures, capture of a
regional or industrial
market by one of producers
1898 – Morgan and
Rockefeller's group owns
56% of the American share
capital (22 bln dollars)
Neoclassical theory of
natural monopolies
Increase in public
welfare losses due to
monopolistic conduct of
major enterprises
(allocative inefficiency)
3 Government regulation Adoption of anti-monopoly
legislation, setting marginal
prices for NM products,
transferring the block of
shares to government
ownership
The 1890 Sherman Antitrust
Act in the European
countries by the 1970s
Direct government
regulation of natural
monopolies (price
regulation according to
Ramsey, government
control)
X-inefficiency as a
result of non-market
regulation, dynamics
inefficiency: drop of
investment volume,
technological gap
3* Nationalization Transferring enterprises to
government ownership,
regulation of enterprises
and price-setting in
accordance with the
national plans of economy
development
1917-1992 – Russia
1940-1970 – England
Marx's theory Loosing
competitiveness due to
absence of market
functioning
mechanisms, lack of
investments,
technological gap
15
16. (allocative + production
+ dynamics
inefficiency)
4 Deregulation. Liberalization
of competitive sector
Determining a potentially
competitive sector of
natural monopolies,
purchasing blocks of shares
by private owners in order
to attract investments
1970 – current time
reforming the electric power
industry
2003 – current time
the processes in Russia
Alternatives for the NM
theory introducing
competitive mechanism
and minimizing
government intervention
Need for reduction of
costs in a long-term
period. Introduction of
new technologies.
Global market threat
5** Narrowing of naturally
monopolistic sector to
infrastructure. Globalization
of natural monopolies
International deals
concerning the question of
using natural resources and
network infrastructure,
establishment of
correspondent transnational
corporations
Formation of transnational
corporations in the fields of
natural monopolies
The development of a NM regulation theory taking
into account opportunities for economic growth of
all sectors of economy and increase in competitive
efficiency of national commodities, but not
preventing at the same time foreign investments for
development of national infrastructures, is required.
* The stage is typical not for all countries, it accompanied the periods of communism and socialism.
** A forecast stage determined by the author on the basis of global tendencies of economic development.
16
17. 1.2. The concept of estimating the efficiency of natural monopolies: methodology
and optimality criteria
As there is no single methodology to estimate the efficiency of these enterprises
(industries) confirmed by empirical data, it leads to impossibility to actualize the
notion of naturally monopolistic industry under modern conditions. Antimonopoly
legislation in a number of developed countries is based on traditional neoclassical
notion formulated in the 1970s by W. Baumol. For example, Russian legislation
defines natural monopoly as “a state of product market, under which it is more
efficient to have no competition to satisfy the demand due to technological
peculiarities of production (due to significant decrease in production costs and
simultaneous increase in output rate). Products of natural monopolies can not be
replaced by substitute products. As a result the demand for products of natural
monopolies depends on prices much less, than demand for other types of products”.
The provided definition contains an allusion to economies of scale, although this
concept was replaced in the 1980s by a more relevant concept of subadditivity. An
allusion to efficiency of natural monopolies with respect to competitive production in
this industry is also very non-specific, since it does not contain criteria of efficiency
besides the mentioned above economies of scale. Such a lack of clear and specific
criteria of efficiency leads to misunderstandings in ways and methods of government
regulation in order to reach an optimal efficiency of natural monopolies from the
standpoint of society.
The importance of solving the problem of estimating the efficiency of natural
monopolies is associated with reforms in naturally monopolistic sectors carried out
worldwide, including Russia. A clear understanding of final objectives of
transformations and possible consequences for national economy and public welfare
is required.
The purpose of this section is to determine the methodology of comprehensive
estimating the efficiency of natural monopolies. In order to fulfill this task, it is
required to do sequentially the following subtasks:
1. To choose optimality criterion (or criteria) of natural monopolies from the
standpoint of economy and society.
2. To determine efficiency indicators of natural monopolies, which have either
direct or indirect impact on optimality criteria, nature and extent of this impact.
3. To array efficiency indicators of natural monopolies in accordance with their
impact on final optimality criterion.
4. To identify possible interaction between the determined efficiency indicators of
natural monopoly.
5. To develop a final model of impact of natural monopoly on the optimality
17
18. criterion.
6. To check (approve or reject) a resulting theoretical model by empirical data.
As a rule in order to estimate the efficiency of natural monopolies theoretically the
optimality criterion introduces in 1976 by R. Willig [20] is used, namely: “a socially
optimal result of NM activities is the result providing the greatest aggregate
consumers' surplus, i.e. the greatest sum of consumers' surplus and profits”.
Interpretating this criterion in a wider context than the frameworks of a naturally
monopolistic market, namely, within the national market (local one in case of
regional devision of naturally monopolistic field) and going beyond the economic
notions of 'consumer's surplus' and 'profit', this optimality criterion is relevant even
now.
A simplified diagram of impact of natural monopolies on general model of economy
(within national or regional limits) is presented in Figure 2.
Figure 2. The impact of natural monopolies on national (regional) model of
economy
In this diagram total economic impact effect of natural monopolies is being formed
gradually (see Figure 3).
Incomes and losses of households, as well as those of enterprises in other fields,
represent such an aggregate performance indicator of national economy as a gross
domestic product (GDP). The maximization of GDP is proposed to be taken as an
18
19. economic optimality criterion of natural monopolies.
The author's model of NM impact on national (regional) economy is graphically
presented in Figure 4 as a system of internal commodity markets.
Figure 3. Formation of total (aggregate) effect of natural monopolies
19
20. Figure 4. General economic effect of changing prices for NM products
Dем stands for aggregate demand for production of a natural monopoly. The slope of
demand curve is characterized by a low elasticity coefficient of production of a
natural monopoly; Sем is a supply function of a natural monopolist. As a rule, price
change as a result of tariff regulation is discrete and depends on change in tariff
(S2ем = S1ем + ΔP). The supply curve slope is characterized by presence of
economies of scale in the natural monopoly production function; Pввп/Pем is a
dependence function of an aggregate price of other GDP industries and product prices
of natural monopoly. The curve slope is a result of cost share per NM unit in
aggregate costs of other industries (for example, GDP energy intensity in the case of
electric power industry); Dввп is aggregate demand for products of other industries.
The slope of a demand curve is characterized by a relatively high elasticity
coefficient, which is associated with presence of imported substitutes; Sввп is a
function of aggregate supply of other industries. Changes in tariff of natural
monopoly lead to changes in production function of other industries.
This model represents:
20
21. 3. The impact of tariff changes of NM products on changes in price (∂Pем =
(Р2ем/Р1ем) – 1) and quantity of output (∂Qем = (Q2ем/Q1ем) – 1). Even a
significant price increase leads to an insignificant output quantity reduction due
to a low elasticity of demand for products of natural monopolies.
4. The impact of price change for products of natural monopoly (∂Pем) on change
in aggregate price of GDP products (∂Pввп = (Р2ввп/Р1ввп) – 1). The more
production costs of natural monopolies are contained in production cost of
GDP products, the more significant change in aggregate price of GDP products
is.
5. The impact on change in aggregate price of GDP products (dPввп) on
aggregate output rate of GDP (∂Qввп = (Q2ввп/Q1ввп) – 1). The change
depends on coefficient for price elasticity of supply of GDP goods. Having
import substitutes and relatively high coefficient for demand elasticity of GDP
supply in comparison with coefficient for supply elasticity of natural
monopoly, ∂Qввп can exceed dQем even in relative terms. The change will be
even more significant in absolute terms.
6. The model does not reflect the impact of change in price of products of natural
monopolies on purchasing capacity of households (the function of Dввп in a
short-term period is changed) as it could be qualified as null.
The impact of natural monopolies on national economy:
1. The impact of ∂Pем on ∂Qввп. A quantitative estimation of this indicator
characterizes the exogenous coefficient of NM efficiency:
ЭкКэфем = dQввп/dPеm, 0 < |ЭкКэфем| < 1. (1)
The higher the coefficient is, the more positive impact on national economy as a
result of price reduction of natural monopolies it produces, and vice versa.
Table 3
Calculating formulas to the model of NM exogenous efficiency
Known Parameters:
∂Pем = а
Кэл.ем = b (без
модуля)
Kэл.ввп = c
(without a module)
доля Peм/Рввп
Calculating
Unknown
Parameters:
∂Qем = ab
∂Pввп = ad
∂Qввп = acd
ЭкКэфем
= cd
Parameter value
limits at Pем
increasing:
if a > 0; b ε [–1;
0], b → 0;
c ε [–1; 0], c → –1;
so:
∂Qем ε [–1; 0];
Parameter value
limits at Pем
decreasing:
ifx a < 0;
b ε [–1; 0], b → 0;
c ε [–1; 0], c → –1;
so:
∂Qем ε [0; 1];
21
22. = d (const)
Linear Dем and
Dввп functions
∂Qем → 0;
0 < ∂Рввп < a;
∂Qввп ε [–∞; 0];
∂Qввп → (–ad),
|∂Qввп| > |∂Qем|;
0 < ЭкКэфем < d
∂Qем → 0;
a < ∂Рввп < 0;
∂Qввп ε [0; ∞];
∂Qввп → (–ad), |
∂Qввп|
> |∂Qем|;
0 < ЭкКэфем < d
As can be seen from the formulas, the exogenous efficiency coefficient of natural
monopolies is equal to price multiplied by products of natural monopoly in aggregate
GDP price and coefficient of price elasticity of domestic demand for GDP products.
In the case of high price elasticity the value of ЭкКэфем approaches the value of NM
product price share in the aggregate GPD price.
2. If price is increased, total economic loss is equal to losses of society resulting
from decrease in GDP plus 'dead' consumer losses resulting from increase in
tariff of natural monopoly. The profits of natural monopolist can be
compensated by losses of society resulting from increase in price of NM
products.
3. In a short- and long-term period the decline in output rate of GDP products to
Q2ввп level leads to a proportional decline in demand for products of natural
monopolies. At the same time natural monopolist's profits decrease due to fixed
production costs.
Besides an economic optimality criterion of natural monopoly there are some non-
economic aspects of optimality criterion, resulting from sector-specific issues.
The amount of economic and non-economic aspects characterizes an integral
optimality criterion of natural monopolies, which could be defined as maintaining
a necessary output quantity at minimum affordable price with required quality
according to ecological and technological safety as well as extended reproduction
of MN infrastructure.
At the same time non-economic optimality aspects are 'conditions' of natural
monopolies, i.e. they must be fulfilled regardless of economic ones. On the other
hand, costs of a natural monopolist required to fulfill these conditions directly
influence the economic aspect, or total production costs of NM products (see Figure
5).
Thus, the obligation to fulfill non-economic aspects of optimality criterion (NAOC)
is another economic indicator of NM efficiency besides the considered above total
costs, which also influences GDP growth. In other words, the key indicator of NM
activity is total production costs, and the costs calculation model must take NAOC
22
23. fulfillment into account.
Figure 5. Model of NM price-setting taking NAOC into consideration
It is evident, that a socially optimal price for NM products can not be lower than P1
level price (it is defined as efficient price of natural monopoly), and production costs
at this level are efficient due to fulfillment of NAOC. At the same time monopolist's
profit is equal to zero. It means that the monopoly can not attract outside investments.
Other results of this model include the impact of inefficient costs from allocative X-
inefficiency (which includes corruption inefficiency costs), government regulation
costs (taxes, fines, etc.) for setting final price of NM products P5 and absence of
monopolist's motivation to reduce inefficient costs under tariff regulation according
to a basic for the majority of economics cost plus pricing method.
The endogenous coefficient of NM efficiency is determined as a share of efficient
costs in the final NM price structure:
ЭнКэфем = Pэф.ем/Pем, 0 < ЭнКэфем < 1, (2)
absolute endogenous efficiency is characterized by ЭнКэфем = 1.
Solving the equations (1) and (2) simultaneously, a potential exogenous impact on
national economy from increase in endogenous efficiency of natural monopolies
(the other parameters are const) can be received:
relative effect: ∂Qввп = ЭкКэфем · ∂Pем= ЭкКэфем · ∂ЭнКэфем,
or absolute effect: ΔQввп = Q1ввп · ∂Qввп. (3)
23
24. The lower exogenous efficiency of natural monopoly is, the greater potential
exogenous impact on national economy can be received in case of its increase.
Maximum potential exogenous impact on national economy as a result of
endogenous efficiency of natural monopoly to the maximum level, which is equal
to 1, is
∂Qввп max = ЭкКэфем · ∂ЭнКэфем = ЭкКэфем/ЭнКэфем. (4)
ЭнКэфем is a kind of a 'multiplier' of ЭкКэфем impact on dQввп, as at a low initial
level of this indicator the final value of GDP may significantly vary from ЭкКэфем.
In the proposed model of interaction between two factors of NM efficiency
(exogenous and endogenous ones) determination of exogenous coefficient of NM
efficiency is the simplest part. It is the product of demand elasticity coefficient by
GDP products and NM production cost share in the total amount of production costs
of GDP. Determination issue of endogenous efficiency coefficient of natural
monopoly, to be more exact, the level of efficient costs of a naturally monopolistic
enterprise poses a significant problem. In order to fulfill this task it is necessary to
analyze an actual (post factum) production cost of NM products to calculate
'inefficient' costs, such as: advertising, employees' salary increase above average
region level, employee base grows, growth in payroll, construction of non-production
objects, etc.
Regulating authorities in Russia provide such analysis setting tariffs for next
regulatory periods, but due to the problem of information asymmetry and time lags
(as a rule, last year returns in relation to current year are analyzed for the next year
tariff formation), as well as some specific features of national mentality and labor
legislation, it is impossible to improve cost efficiency in comparison with previous
years. All these facts lead to the following situation: even though naturally
monopolistic enterprises in Russia are relatively investment-unattractive and there is
a great equipment wear and tear problem, so-called 'inefficient costs' still exist. They
are contained in unreasonable high salaries of key management personnel and those
paid in naturally monopolistic enterprises in general, high costs resulting from
construction of non-production objects, high level of social costs, etc. At the same
time in most cases labor efficiency per one employee of NM industries does not grow
proportionally to the increase in payment.
It is recommended to determine the endogenous NM efficiency coefficient in every
industry, region and naturally monopolistic enterprise independently on the basis of
data on costs for previous periods.
24
25. Summary of Section 1.2.
Thus, this section determines the parameters for comprehensive estimation of NM
efficiency, namely:
• An economic criterion of NM efficiency is determined, it is GDP growth.
• The concept of integral NM optimality criterion as a sum of economic and
non-economic aspects is introduced.
• The key NM efficiency indicators are determined (production costs). The NM
costs calculation model reflecting the fulfillment of integral efficiency
optimality criterion is developed.
• A scheme of NM impact on general economy model and its graphic model are
developed. The provided scheme proves the impact of NM products price
change on total GDP. Indicators for impact degree are determined. They
include price elasticity of domestic demand for GDP products and NM cost
fraction in total GDP costs.
• A concept of exogenous NM efficiency coefficient (ЭкКэфем) reflecting the
impact of price change of NM products on total GDP is introduced. A formula
for its calculation is proposed.
• A concept of endogenous NM efficiency coefficient (ЭнКэфем) reflecting
efficiency or inefficiency of NM production costs is introduced.
• A formula for calculating the potential effect on national economy taking
exogenous and endogenous NM efficiency increase into account is introduced.
Maximum potential effect is determined as well.
• A problem zone of author's method to calculate the coefficient of exogenous
and endogenous NM efficiency is found.
• The task of government as a society's representative guaranteeing social
efficiency and GDP growth is to develop that kind of NM regulatory policy,
which can ensure maxim efficiency under current conditions, and the
fulfillment of tasks and objectives of national economic growth. At the same
time this policy must be based on a 'methods case' solving specific problems of
NM industries in a particular country. The following section deals with detailed
consideration of this topic.
1.3. Government regulation as a method to enhance NM efficiency.
Efficiency criteria for government regulation
The task of government NM regulation setting rules for naturally monopolistic
markets to provide maximum total efficiency of national economy, in other words, to
25
26. ensure maximum GDP growth:
dQввп = ЭкКэфем · dЭнКэфем
dQввп → max, 5)
where ЭкКэфем is an exogenous NM efficiency coefficient and ЭнКэфем is an
endogenous NM efficiency coefficient.
Accordingly, an algorithm of steps to increase the efficiency impact of naturally
monopolistic sector on growth of national economy in the sphere of government
regulation is illustrated in Figure 6.
Four alternative combinations of exogenous and endogenous NM efficiency
coefficient levels enable to determine the most perspective direction (basic strategy)
for government regulation in every particular case:
1. High NM exogenous efficiency combined with a high endogenous efficiency
coefficient. In this case the task of government regulation is to prevent increase
in price for NM products (to limit NM profits and to prevent growth of
inefficient costs), taking into account that total price increase reduces GDP due
to high ЭкКэфем. Further increase in endogenous efficiency poses a problem
due to its high initial level. An additional direction of government regulation is
control of NM exogenous and endogenous efficiency in order to reduce
possible impact of NM price increase on national economy.
26
27. Figure 6. The algorithm of choosing a direction taking into account NM
exogenous and endogenous efficiency
2. High NM exogenous efficiency combined with a low endogenous efficiency
coefficient. In this case stimulating the increase in NM endogenous efficiency
with further tariff reduction is an efficient direction of government regulation.
At high value of ЭкКэфем price reduction has a significant positive impact on
GDP growth.
3. Low NM exogenous efficiency combined with a high endogenous efficiency
coefficient. In this case minimum government intervention into activity of
natural monopoly is the best strategy due to already achieved high efficiency of
NM activity. Maintenance of high efficiency level is a key task.
4. Low NM exogenous efficiency combined with a low endogenous efficiency
coefficient. In this case the major task of government regulation is to stimulate
increase in NM endogenous efficiency, but reducing NM product price is not
obligatory. If there are some problems in industry concerning lack of
monopolist's profits or investments, intervention aimed at replacing NM
'inefficient costs' by enhancing 'efficient ones' by means of new investments,
raising profitability of the industry in order to attract external investors, etc., is
efficient. Even if the final price of NM products is increased, negative impact
27
28. on national economy is insignificant due to a low ЭкКэфем.
Four basic long-term strategies for government regulation (Figure 7) could be
identified, which are characterized by gradual transitions between the described
above alternative combinations of NM efficiency exogenous and endogenous factors
(successful implementation of a strategy results in transition to the next stage in the
direction of green arrows, regulation failures lead to results in the direction of red
arrows).
Figure 7. Strategies for moving between the alternative combinations of NM
exogenous and endogenous efficiency
Thus, after calculating NM exogenous and endogenous efficiency coefficients, their
classification and choosing a strategy of government regulation it is necessary to
understand which methods from international experience can help in achieving the set
objectives.
It is required to analyze theoretical and practical methods and means of government
regulation in the context of their impact on NM exogenous and endogenous
efficiency, to consider current problems and restrictions of each method from the
standpoint of their costs and resulting efficiency. Determination of methods for
government regulation for each basic strategy considered in Figure 7 should become
a result of this work.
28
29. It is necessary to address the author's model of NM impact on economic growth in
order to determine potential influence spheres of government as a regulating authority
(Figure 8).
Thus, all methods of NM efficiency enhancement belong to two key spheres of
government regulation: control of NM exogenous and endogenous efficiency. As it
follows from the diagram (Figure 8), only one of three possible directions of
government regulation aimed at NM efficiency increase relates to NM endogenous
efficiency regulation, the direction No 1 (ΔPем). Such a way of regulation is typical
for basic strategies of government regulation No 1 and No 4 (Figure 7) and it can
bring positive results if the endogenous efficiency coefficient is initially low. The
objective of impact is to change NM supply curve slope downwards to reduce costs
to an efficient level (in order to ЭнКэфем => 1).
Figure 8. Scheme of possible directions in government regulation in order to
enhance the effect of NM activity on national economy
29
30. Potential methods for government regulation of NM endogenous efficiency, that are
theoretically described and widely used in practice, are considered in the first section,
their brief overview is presented in Table 4.
Thus, the main objective of NM endogenous efficiency regulation is minimization of
costs in short- and long-term period if NM optimality non-economic aspects are
fulfilled. The considered in Table 4 methods for government regulation are not
perfect, but the situation in each industry is also not the same. It is evident, that
particular methods should be chosen taking into consideration the situation,
advantages and disadvantages of each particular method. Deregulation, that also has
possible alternatives within naturally monopolistic industries and in some situations
can be more or less efficient, is the most widely used direction of NM government
regulation in most developed countries.
30
31. Table 4
Methods of government regulation for the purpose to enhance exogenous and endogenous efficiency of natural
monopolies
Method Name Regulation Means used
in the Method
Method Advantages Method Disadvantages Introduction in
practice
(country,
industry)
Government ownership Transfer of NM assets
into government
ownership, government
regulation of natural
monopolies
Access to funds
available for investment
(in case a fully funded
budget), cooperation in
development of a
naturally monopolistic
sector and national
economy
Lack of incentives to enhance
efficiency of natural monopoly,
increase in costs, small
investment incentives, limited
budget for NM development
The United States
Postal Service,
OAO Unified
Energy System of
Russia
Price regulation
Direct price regulation
according to Ramsey
Pем = МС (the first
best solution)
Subsidies
Price discrimination
Special tariffs
Pем = АС (the second
best solution)
Price limits
Maximum aggregate
social surplus can be
achieved (in theory),
natural monopolies do
not suffer losses, profit
is equal to zero
Complexity of implementation
in connection with high
information requirements,
information asymmetry as well
as authority asymmetry. Lack
of incentives to reduce costs in
a long-term period
The electric
power industry in
Russia
31
32. Regulating norms of
capital return rate
Stimulating price
regulation
Industry average costs,
participation in profits
Incentives to reduce
costs and introduce
innovations. No
incentives to raise
profits without reasons
Possible bankruptcy of
enterprises with a more
complex cost structure than an
average one in industry. The
total economic effect is less
significant, than as a result of
direct price regulation
Water supply and
energy sector in
Great Britain.
The USA energy
sector
1 2 3 4 5
Introduction of alternative competition
Demsetz's competition
(bidding system)
Franchise bidding. The
criteria: high quality,
minimum price
During bidding period
Pем decreases to the
level of effective
expenses. There is no
necessity to carry out
permanent regulation of
NM, since a monopolist
is interested in reduction
of costs. Economies of
the country make up to
20% [6]
Contract with fixed prices for a
long period. If external
situation changes, it may lead
to bankruptcy of NM or cause
unreasonable from the
standpoint of society profits.
Lack of investment incentives
due to a potential increase in
costs and uncertainty
concerning extension of the
contract.
Problems with quality of NM
commodity are possible
Railroad transport
in Great Britain.
Water supply in
France.
32
33. Accessible market
(Baumol, Panzar and
Willig's theory of
contestable markets)
Providing in NM
industry the following
conditions:
Free entry of potential
competitors into the
market
Absence of exit sunk
costs
Pем → Рэф (high
allocative and
production efficiency at
zero profit) are achieved
without direct
government regulation
and the organization of
auction due to a constant
potential competition
threat
In practice the idea of sunk
costs is hardly probable.
Market entry is always
associated with at least
temporary losses. This time is
enough for a natural monopoly
to reduce price, i.e. the
potential competitor will not
enter the market.
Possible decline in quality
during the entry period of a
competitor
Deregulation of natural
monopolies (vertically
integrated companies)
Division of a naturally
monopolistic sector
(vertically integrated
companies) into
competitive and non-
competitive sector,
transition in the
competitive sector to
market price-setting
mechanisms
Enhancing investment
attractiveness of the
competitive sector,
reduction of tariffs for
consumers up to 30%
[4]
Loss of systemacity effect.
Growth of costs for control.
Possible growth of total price
Pем, not always is associated
with increase in Pэф
Most NM
industries of
developed
countries
33
34. If high NM endogenous efficiency is achieved, the control of NM exogenous
efficiency for minimization of possible claims resulting from NM product price
increase becomes a new task of government. In other words, it is a basic strategy for
government regulation No 2 (Figure 8). Regulation is possible in two directions:
The direction No 2 (Δd) means changing curve slope of NM price in aggregate GDP
price (as a rule downwards in order to minimize possible NM price rise losses).
Possible methods for government regulation in this direction include the following:
• to change the GDP structure (to support industries using products of natural
monopolies in a lesser degree),
• to carry out resource-saving policy for natural monopolies (for example,
energy efficiency policy in the electric power sector).
The direction No 3 (Δc) means changing curve slope of domestic demand for
commodities of national producers in order to change the price elasticity coefficient
of domestic demand for GDP products (mainly to reduce elasticity), including:
• carrying out a policy to protect domestic enterprises in relation to imported
substitutes (customs and fiscal policy),
• stimulating domestic demand (monetary policy), etc. Thus, by controlling three
parameters (NM price, NM production costs in total GDP, and price elasticity
of domestic demand for GDP) government can efficiently maximize positive
impacts of natural monopolies on national economy in general. It is evident,
that regulation direction should be chosen taking into account current situation
in naturally monopolistic sector and national economy.
Thus, regulating three parameters: price of natural monopoly, share of production
costs of NM commodities in GDP, and price elasticity of domestic demand for GDP,
government can carry out an effective policy aimed at maximization of positive
effects resulting from activities of NM on national economy. Choosing an optimal
direction of government regulation must be based on current situation in the naturally
monopolistic sector and national economy (Table 5).
Table 5
Choosing an optimal direction of government regulation depending on the
chosen basic strategy
Basic strategies for NM government Optimal direction of government
34
35. regulation (Figure 8) regulation
Strategy 1
Strategy 4
Regulation of endogenous efficiency
(reduction of Рем to Рэф)
Strategy 2 Regulation of exogenous efficiency
(elasticity reduction of demand for
commodities of GDP products or
reduction of NM share in GDP)
Strategy 3 Maintenance of NM exogenous and
endogenous efficiency at the existent
level
Efficiency estimation of natural monopolies, i.e. the ration of activity costs to
expected (and real) economic and social impact, is an important moment of NM
government regulation.
КэфГР = effect of ГР/ГР costs = ΔQввп /ГР costs. (6)
In order to estimate the efficiency of ongoing reforms in naturally monopolistic
sectors of Russia and abroad it is rational to use the following criteria:
1. Fulfillment of non-economic aspects of NM optimality criterion before and
after reforming.
2. Dynamics of tariffs on NM commodities for consumers ΔPем.
3. Dynamics of NM endogenous efficiency during reforming processes
ΔэнКэфем.
4. Dynamics of NM exogenous efficiency during reform processes ΔэкКэфем.
5. Total economic impact of reforming natural monopolies Δqввп.
6. Total costs (which are not included in NM tariffs) incurred by government to
carry out NM reforms, for example, protection policy costs, etc.
Summary of Section 1.3.
This section considers the task to determine a comprehensive methodology for
government regulation of natural monopolies, namely:
• Three parameters of government regulation are formulated: NM price, NM
production costs in total GDP, and price elasticity of domestic demand for
GDP, controlling which government can efficiently maximize positive impacts
of natural monopolies on national economy in general.
• Four basic strategies for government regulation of natural monopolies and
corresponding optimal directions of government regulation are described.
35
36. • An algorithm of choosing basic strategies for government regulation of natural
monopolies taking into account factors of endogenous and exogenous
efficiency enabling to maximize positive economic impact of intervention is
developed.
• A scheme of a long-term strategy to transit successfully between four
alternative combinations of NM exogenous and endogenous efficiency is
developed.
• Methods of NM government regulation are summarized.
• Criteria for estimation of reforms aimed at NM efficiency enhancement are
determined.
36
37. CHAPTER 2
WORLD AND RUSSIAN EXPERIENCE IN REFORMING THE ELECTRIC
POWER INDUSTRY
2.1. Methods of controlling and estimating the electric power industry
The available theoretical base in the area of study, efficiency estimation and
government regulation of natural monopolies is summarized in the previous chapter.
An author's methodology for comprehensive efficiency estimation taking into account
the NM exogenous and endogenous factors (the notions are introduced by the author)
is proposed. Growth of national economy as GDP growth is considered to be the
main optimality criterion of NM activity from the standpoint of society. The
fulfillment of non-economic optimality criteria is an essential condition. On the basis
of the developed methods four basic strategies for government regulation of natural
monopolies are determined. A choosing algorithm depending on factors of
endogenous and exogenous efficiency in the field of natural monopolies enabling to
maximize positive economic impact of intervention is developed. A long-term model
of moving between the basic staged is proposed. The criteria for estimation of NM
reform process in Russia and abroad are determined.
On the basis of the research presented in Chapter 1 Section 2.1. we have considered
special features of one of the most important naturally monopolistic industries, i.e.
electric power industry, in the context of economy, identify regulation peculiarities of
this naturally monopolistic industry and specific regulation problems within
frameworks of the efficiency concept developed by the author. In Section 2.2. we
have analyzed the world experience of reforming the electric power industry. Section
2.3. presents the analysis of conditions, tasks and objectives of reforming the electric
power industry in Russia made on the basis of world experience. Problems of
competitive and non-competitive market formation within the industry are identified.
The electric power industry is a basic one of national economy and includes a system
of economic relations resulting from generation, transmission, sale and consumption
of electric power as well as operating-and-dispatch control. Its special features are
determined on the basis of production peculiarities of electric power industry, namely
by coincidence in generation and consumption time, impossibility to create
commodity stocks, economic inefficiency to transfer the commodity over long
distances (due to technological transfer losses) and use of this commodity during
production of most GDP products of a country. Due to these factors the electric power
industry is recognized as a naturally monopolistic one in most countries.
37
38. The proposed by us in Chapter 1 concept of efficiency estimation of natural
monopolies requires the determination of three basic parameters: NM endogenous
and exogenous efficiency, non-economic aspects of optimality criterion (NAOC). We
have explained these parameters in the context of the electric power industry for
further analysis and development of the model of its operation in national (regional)
market.
Endogenous efficiency of the electric power industry is characterized by an
efficient cost share in total production costs. The following efficient costs required for
fulfillment of the main task of electric power industry operation in national economy,
which are non-economic criteria of optimality at the same time, include:
• satisfying the demand for electricity;
• supplying uninterrupted power distribution and energy security;
• enhancing growth of national economy (the possibility to satisfy increasing
demand for electrical energy in order to develop national economy);
• securing the environmental safety;
• the compliance of activity nature of the industry with the requirements of
national policy (protectionism, closed economy, etc.).
We have considered the parameters of endogenous efficiency of electric power
industry and the production cycle parameters of the industry affecting total
commodity price simultaneously. These are:
Costs for production (generation) of 1 kWh of electricity Сг. They depend on:
• Structure of generation facilities. Major power generation technologies
include: hydropower industry (water energy), nuclear power industry, thermal
power industry (converting energy of such resources such coal, gas, mazut),
and alternative power industry (energy of the sun and other non-traditional
renewable sources of energy). Ki stands for the amount of produced energy
within national (regional) economy according to each production type for a
certain period, and Di stands for a share of produced energy in total energy
balance with Di = Ki/∑Ki; ∑Di = 1;
• energy production costs of each generation type, which depends on
technological peculiarities, fuel cost and wear and tear of equipment. Ci stands
for energy production cost (1 kWh) of each production type for a certain
period. In this case average production cost of 1 kWh can be calculated using
the following formula: Cg = ∑CgiDi.
• capacity factor of a power plant affecting the share of conditionally-constant
costs in production cost structure. Thus, ki stands for the capacity factor of
each production type.
38
39. It is evident, that not the whole energy production cost can be classified as efficient
costs due to possible production or allocative inefficiency. Key factors of possible
inefficiency include: irrational structure, worn-out equipment, outdated expensive
production technologies, fuel cost. It is possible to determine the share of inefficient
costs according to these parameters only after deep analysis of the costs structure in
production costs or comparing values of production costs needed to produce 1 kWh
of similar power plants situated in other countries (regions). In general case, there are
four directions to enhance efficiency of production costs, arranged by cost-intensity:
1.1. Elimination of inefficient production costs Potential effect of production
cost reduction is equal to inefficient costs in its structure.
1.2. Control of capacity factor of power plants in order to replace a part of
more cost-intensive production by a cheaper one. We have derived
formulas to calculate absolute and relative potential effects of maximal
using the cheapest production and maximal avoiding more expensive
stages.
absolute effect: ΔСg = Da · (Ca – Cb) · ((1 – ka)/ka), (7)
relative effect: ∂Сg = (Da · (Ca – Cb) · ((1 – ka)/ka))/Собщ, (8)
where Са is production cost of the cheapest production, Сb is production cost of the
most expensive one, Da is initial share of the cheapest production in the energy
balance, ka is initial capacity factor of the cheapest production.
1.3. Production modernization (the replacement of more expensive
technology with a cheaper one).
The formulas to calculate absolute and relative potential effect due to introduction of
new production technology:
absolute effect: ΔСобщ = Da · (Ca1 – Ca), (9)
relative effect: ∂Собщ = Da · (Ca1 – Ca)/Собщ, (10)
where Са is initial production cost according to production type, Сa1 is production
cost according to production type after modernization, Da is a share according to type
of production (which needs modernization) in the energy balance. It is necessary to
compare potential modernization effect with costs needed for its realization in order
to estimate the efficiency of this method for production cost reduction.
1.4 . The rationalization of productive facility structure in order to increase
the share of cheaper production (introduction of new and refusal from old
39
40. more cost-intensive methods). The effect formulas are identical with the
formulas (9) and (10).
Resulting increase in potential cost efficiency of energy production is equal to the
sum of received potential effects of all four directions to enhance efficiency ∑Δсобщ.
Costs incurred to transmit 1 kWh of electricity (operation and maintenance costs) Ct
depend on:
• structure of electricity transmission networks (high, medium and low voltage
of system), operation and maintenance costs for networks of each voltage
class;
• energy losses occurring during transmission (mainly in low- and medium-
voltage networks in the event of transmission over long distances) associated
with wear and tear problems. Упт stands for technological losses level, it is
equal to amount of electrical energy, not transmitted due to technological
reasons/Kобщ;
• commercial losses of electrical energy incurred during transmission (associated
with a weak accounting system of energy consumption). Упк stands for
consumption losses level, it is equal to amount of electrical energy not
accounted due to technological reasons/Kобщ.
Like in production, not all costs of energy company for electric power transmission
are efficient due to possible production or allocative inefficiency. Key factors of
possible inefficiency include: wear and tear of network infrastructure, outdated
transmission technologies requiring investments in network maintenance, material
costs. It is possible to determine the share of inefficient costs according to these
parameters only after deep analysis of the costs structure in production costs or
comparing values of production costs needed to produce 1 kWh of similar energy
companies situated in other countries (regions). In general case, there are two
directions to enhance efficiency of energy transmission costs, arranged by cost-
intensity:
• To exclude inefficient costs from transmission costs. Potential effect of
production cost reduction is equal to inefficient costs in its structure.
• To reduce transmission costs to the level of commercial and partially
technological ones by means of introduction of new transmission technologies,
account of electrical energy and prevention of counterparties' misconduct. A
potential effect of transmission costs reduction has to be calculated in order to
replace a part of more expensive production by a cheaper one.
Formulas to calculate absolute and relative effects of technological and
commercial energy transmission costs are the following:
40
41. absolute effect: ΔСобщ = Упк + (Упт – Уптнорм) · Сээ (11)
relative effect: ∂Собщ = Упк + (Упт – Уптнорм), (12)
where Сээ stands for energy transmission costs (%), Упк means commercial
transmission costs level (potentially it can be reduced to 0), Уптнорм means
minimum possible technological costs level (%).
It is necessary to compare the potential effect with costs needed for transmission
technology improvement in order to estimate the efficiency of this variant to reduce
production costs. Due to the fact, that losses of electrical energy lead not only to
network component of costs, but also to partial losses of total electrical energy
production cost in general, potential endogenous efficiency of transmission costs is
one of the most important factors to increase efficiency of the whole electric power
industry.
Costs for sale of 1 kWh of electricity (printing and delivering electricity bills, billing
operation costs, taking readings) Ссб depend on structure of electricity consumers.
Key factors of possible inefficiency include: non-optimal organization of sale system;
separation of potentially compatible functions of commercial and technical audit of
consumers (operating separately from network organization). It is possible to
determine the share of inefficient costs according to these parameters by comparing
the values of production and sale costs for 1 kWh with those of energy companies
situated in other countries (regions). In general case, there are four directions to
enhance efficiency of production costs, arranged by cost-intensity:
3.1. To exclude inefficient costs from production ones. Potential impact of
production cost reduction is equal to inefficient costs in its structure.
3.2. To exclude duplication of functions with a network company.
Formulas to calculate absolute and relative potential effect of duplication
functions exclusion:
absolute effect: ΔСобщ = Сдубл, (13)
relative effect: ∂Собщ = Сдубл/Ссб (14)
where Сдубл stands for duplicating of functions per 1 kWh (can potentially be
reduced to 0).
4. Costs of a system operator for dispatching production and transmission of 1
41
42. kWh of electricity (Сд) depends on parameters of energy network's operation.
5. Costs for energy company's executive personnel per 1 kWh (Су) depend on
number of market participants. As a rule, costs raise if a vertically integrated
organization is divided according to activity categories. Potential efficiency
increase in this direction is possible in the event of introduction of more
modern management technologies including computerized systems of
accounting according to administrative functions. Other conditions include
integration of companies and executive personnel reduction.
The dynamics of statistical data on costs of energy companies shows that increase in
number of market participants per 1 unit leads to increase in administrative costs by
5–10%. Let f = Суn/Суn – 1 denote a growth coefficient of Су. In this case potential
endogenous effect of reduction of market participants (companies) per n units as
a result of administrative costs reduction is:
ΔСобщ = Су(fn – 1).(15)
Other factors affecting final price of the commodity (electricity) include:
6. Investing in production and network infrastructure made from tariffs.
Investments needed for the fulfillment of non-economic aspects of optimality
criterion (NAOC) are considered to be effective costs, excessive ones are
considered to be ineffective costs Си per 1 kWh of electricity produced for a
period.
7. Costs for government regulation of the industry belong to inefficient costs (Ср)
per 1 kWh of electricity produced for a period;
8. Absence or presence of subsidies for energy companies form the state budget
are considered to be inefficient costs (Сд).
9. Total profits of the market participants (energy companies) is an inefficient
price (tariff) component (Пр) per 1 kWh from the standpoint of society.
Aggregate commodity price:
Сээ = (Сг + Сп + Ссб + Сд) + (Су + Си + Ср + Сд + Пр.
Costs in the first brackets can be partially regulated by the market participants, and
cost in the second brackets are regulated by government.
A share of inefficient costs in the structure of aggregate electricity price calculated
according to the cost-plus method is equal to the ratio of inefficient costs of each cost
item to profit of a natural monopoly, and the coefficient of endogenous efficiency
(ЭнКэфем) is equal to 1 – share of inefficient costs.
Comparison of total costs (Сээ) with data on costs of companies situated in other
42
43. regions (countries), whose resources costs, production structure, territorial coverage
and overall production of electricity are similar, is an indirect criterion of
endogenous efficiency.
In practice the following situation is possible: when current level of efficient costs in
the structure of aggregate price does not ensure NAOC fulfillment, as a rule, in the
investment component. In this case price restricting (direct of stimulating tariff
regulation) motivates a monopolist to replace inefficient costs by efficient ones if
absolute fulfillment of NAOC is stimulated. If there are no such stimuli,
underfunding of efficient costs is possible. In medium- and long-term perspective it
may lead to non-fulfillment of NAOC and, consequently, a company fails to satisfy
the demand of society.
As a rule, low endogenous efficiency combined with non-fulfillment (or potential
non-fulfillment) of NAOC is a key reason of reforming the electric power
industry of different countries. The analysis of world experience in the field of
electric power industry reforming will help us to answer the question: what reforming
methods may enhance endogenous efficiency?
We have attributed two major criterion proposed in the previous chapter, namely,
GRP or GDP power intensity (a share of costs for electricity in the integrated price)
and elasticity of demand for GRP/GDP, to exogenous efficiency parameters of the
electric power industry. As a rule, the first criterion is historically predetermined
and can be changed as a result of replacement of production technologies in other
industries by less electricity intensive ones, as well as a result of changing the
structure of GDP. The second criterion correlates with level of living in the country
(region), as due to rising prices for GDP (GRP) commodities electricity usage may be
reduced to a greater or lesser degree depending on savings of households. Also this
criterion can be regulated by government as a result, for example, of a carrying out a
protection policy in order to support local producers, but such methods require
significant government costs.
After determining the necessary parameters we can develop a model of interaction
between electric power industry and other industries of economy. The parameters of
endogenous efficiency determine the type of production function Сээ, which is the
sum of efficient and inefficient costs of energy companies. Its fixation in a short-term
period is associated with the peculiarities of technological process, namely:
coincidence in production and consumption time, impossibility to create commodity
stocks, high quality requirements (frequency, voltage), production hazards and
complexity (the necessity to comply with job safety rules, etc.).
The function of supply in electricity market (Sээ for end-consumers) may
theoretically coincide with production function (costs + profit) without government
43
44. regulation of natural monopoly. But as a rule due to government regulation and cross
subsidization in a certain period there are several electricity supply functions for
different categories of consumers in the electricity market (the price of integral
supply function is determined by the structure of electric energy consumption). At the
same time electricity supply is restricted by the capacity of electric power system and
cross-system flows of electric energy. In case of peak loads in electrical networks,
when most part of generators operate closely to their limits, producers providing
residual capacity have a chance to set extremely high monopolistic prices for their
commodity due to inelastic demand.
There are several variants of different configurations of production function and
supply one in the context of electricity market. When supply function is set on a
lower level than required costs (lower than production function), energy companies
have to reduce costs in order to avoid bankruptcy. The best way is to reduce
inefficient costs and the worst one is to reduce costs required to fulfill NAOC. In
addition to the above, sometimes it becomes impossible to satisfy non-economic
optimality criteria in a short- or more commonly long-term period as a result of
neglecting investments for modernization. Average age of production means (or wear
coefficient) is a 'marker' of such a situation.
In case when supply function is set on a higher level than necessary costs, an energy
company has a choice which costs (efficient of inefficient) to increase.
The situation when a supply curve coincides with a cost curve is a rather happy
coincidence due to information asymmetry, 'regulator-regulated' relations, and time
lags in providing essential for regulation information about energy company's costs.
It should be noted, that even in an unregulated market (for example, the wholesale
electricity market) a supply curve may not coincide with a cost one, if the market is
classified as a 'seller's market'. In a 'buyer's market' the chance of such coincidence is
higher. The features of a market are determined, first, by deficit/surplus of generating
facilities and, second, by a number of market participants on supply and demand
sides and their authority.
Market boundaries require a special attention. In connection with technological
peculiarities (dependence of end-customers on middle and low voltage) and
economic inefficiency to transmit electricity over long distances (without taking into
account cross-system flows in extra-high voltage grids including the necessity of
detailed dispatching and at least hourly electricity load forecasting, electricity
markets in major countries with high-voltage electrical grids (the USA, Russia,
China, Japan) as well as those in some countries, characterized by differentiation of
electricity supply and demand (Kazakhstan, Scandinavia), as a rule, are regulated
individually for each region.
44
45. The shape of an electricity supply curve is determined by the elasticity coefficient of
supply at that price, which in a short-term period approaches 0. First, today structure
of almost all production enterprises and households includes electricity consumption.
It results in a significant social and economic effect of change in functional
parameters of the whole industry. Second, there is no opportunities for cost-efficient
intermodal competition from other industries. Quantitative significance of electricity
demand within a regional market is directly related to the GRP electricity intensity
and electricity consumption by households.
A graphic model of interaction between electrical energy industry and other industries
within a region market in the context of parameters of endogenous, exogenous and
non-economic efficiency of the industry is presented in Figure 9. The shape of cost
function (Cээ), supply function (S1ээ, S2ээ) and electricity demand one (Dээ) is
determined by the considered above special features of the industry. If tariff is set at
P1 level, the costs of an energy company will not be fully covered and in order to
cover them a company may fail to fulfill the non-economic optimality criteria. If the
regulator decides to raise tariffs to the Pуст level (a break-even point for energy
companies) it is necessary to compare risks from possible reduction in reliability and
power supply balance in a middle- and long-term period with social losses from tariff
raising (the shaded rectangle) or to make a decision to subsidize the sum of losses of
the industry. This decision can lead to increase in taxes if state budget resources are
insufficient and as a result to social losses. In addition it can solve the problem only
in a short-term period.
45
46. Figure 9. Model of interaction between the electric power industry and other
industries of regional markets
Q3ээ is a critical volume of generated electricity in a region (peak loads). If
generation of electricity exceeds Q3 volume a sharp increase in unit price is possible.
It may lead to a sharp reduction in competitive ability of regional products, as an
electricity share of costs for their production is high, and to a possible situation when
a supply curve do not meet a demand one in a GRP market. In practice such a
situation has a minimum chance to have place, as available generating facilities are
not used at 100% and an uneven increase in demand for electricity in a long-term
period can be forecasted. If some electricity generating facilities break (as it was in
the case of the 2009 Sayano-Shushenskaya hydroelectric power station accident)
remaining facilities are loaded close to their limits and electrical shortage is covered
by flows from neighboring regions. Although in case of unregulated monopoly the
situation when electricity price of neighboring regions rapidly increases due to an
inelastic demand for electricity in undeserved regions is possible. The consequences
can be similar to those described in the model. In fact, such a situation occurred
during the California energy crisis in the USA.
We have considered possible strategies for government reforming the electrical
energy industry in case of low endogenous efficiency of the industry (the
determining criterion is comparison of cost dynamics with similar indicators of
46
47. energy systems of the same kind) and non-fulfillment of NAOC (the criterion is high
wear and tear of generating and major distribution equipment, and increase in number
of technological violations in the electricity sector).
1. In case of low exogenous efficiency the tariff for end-customers may include
the costs for NAOC fulfillment in a short-term period with a simultaneous
development of a middle- or long-term program aimed at increasing the
endogenous efficiency of the industry (basic strategy No 4, Section 1.3 of this
paper).
2. In case of high exogenous efficiency of the industry (basic strategy No 1,
Section 1.3.) the inclusion of costs for NAOC fulfillment in tariffs will lead to
a significant negative economic impact on national economy. If demand for
electric power is satisfied in a short-term period by means of neighboring
(regional or national) power systems and the state budget lacks funds, it is
possible to carry out a government policy aimed at maintaining electricity
tariffs at current level and opening market boundaries wider than regional
(national) ones. Such a variant is typical for countries of the EU. If provision of
energy security and a closed type of market boundaries is a priority (Asian
countries), a variant of government subsidizing needed costs of energy
companies in order to fix electricity price at least on a current level
simultaneously developing a middle- or long-term program to increase
endogenous efficiency of the industry is more optimal.
Need for government regulation of the electricity sector is also relevant in a situation
of high endogenous efficiency, i.e. in a situation of forecasted NAOC non-fulfillment
due to an expected increase in electricity price. In this case a strategy of government
regulating exogenous efficiency (reduction in energy intensity of GDP to compensate
the increase in demand for electricity) is optimal (basic strategy No 2).
Implementing a chosen strategy of government regulation in practice is possible in
the form of determining a destination model of the electricity market, which is a set
of alternatives of its components (Table 6).
Table 6
Matrix table of electricity market alternatives (MTEMA)
Market Component Possible Component Alternatives Index
Ai. Structure of
enterprises in the
industry
1. Vertically integrated companies A1
2. Division according activity types with
integration possibility
A2
3. Division according activity types without A3
47
48. integration possibility
Bj. Ownership right to
active assets of energy
companies
1. Government B1
2. Mixed B2
3. Private B3
Ck. Market access
rules for new
participants
1. Monopolistic market C1
2. Franchise bidding C2
3. Licensing C3
4. Other entry barriers C4
5. Free market C5
Dl. System and
institutions of
regulation, legal
position of the market
regulator
1. Government as the regulator D1
2. Third party regulator D2
Em. Price-setting rules 1. Direct tariff regulation with cross-
subsidizing
E1
2. Direct tariff regulation without cross-
subsidizing
E2
3. Indirect tariff regulation (setting and
controlling the methods of price calculation)
E3
4. Intermediate (combined) variants for
various types of consumers
E4
5. Free prices E5
Fn. Market boundaries 1. Regional F1
2. National F2
3. Transnational F3
Alternatives, which are typical for the industry in base period (before regulation),
determine a basic organization model with essential entry parameters of endogenous
and non-economic efficiency. Choosing one of the basic strategies for regulation
determines it target model as a set of selected alternatives enabling to achieve
required change in efficiency parameters of the industry.
Whether introduction of competition into the market helps to enhance endogenous
efficiency and to reduce prices for electricity, is a rather controversial question. In
order to analyze the connection between market competition and efficiency increase
we have introduced a notion of competition degree in the industry. The alternatives
48
49. presented in MTEMA are arranged in the following way: as i, ... n in limits of [1 →
max] increases, the competition degree in the industry growths. Maximum
competition degree is characterized by the sum of parameters which is equal to 18.
Minimum competition degree equals 6. A chosen competition degree of the target
organization model in the electric power industry is the sum of chosen i’... n’, the
value of which may vary, accordingly, from 6 to 18.
We have identified an algorithm to chose a target reform model taking into account
initially different historical peculiarities (entry markers) of the industry and
established priorities for reforms (Table 7).
Table 7
Algorithm of choosing the target model of reforming depending on entry
parameters (markers) of electric power industry activities
Basic organization of the industry – AiBjCkDlEmFn.
Target organization of the industry – Ai’Bj’Ck’Dl’Em’Fn’.
Priorities for
reforming the
industry
Entry parameter
(marker) of
industry
activities is
determined by
expertise in
comparison with
other countries
(regions)
Marker Index Possible Marker
Values
Correspondence
of the MTEMA
alternatives of
target
organization with
possible marker
values
Minimization of
costs for
reforming the
industry
Basic organization
of the industry
before reforms in
the context of the
MTEMA
alternatives
X X = (i; j; k; l;
m; n)
∑((i’ – i);
... (n’ – n)) → min
Efficiency of
market institutions
in economy
Y Y [0; 1]∈
high = 1
low = 0
if Y → 0,
so i’ ... n’ → min
Balance of NAOC
fulfillment and
NM price
reduction
Established
capacity of energy
system
Z Z [0; 1]∈
high = 1
low = 0
if Z → 1,
so (i’, k’, l’, m’,
n’) →
min, if
Z → 0, so (k’, l’,
n’) →max
Excess or shortage
of energy system
T T [0; 1]∈
shortage = 1
if T → 1, so (l’,
m’) → min, (k’,
49
50. excess = 0 n’) → max,
if
T → 0, so (l’, m’,
k’, n’)
→ max
Minimization of
possible losses
resulting from
introduction of
competition
The degree of
territorial entropy
of supply and
demand for
electricity
W W [0; 1]∈
high = 1
low = 0
if W → 1, so (i’,
j’, k’ m’, n’) →
min, if
W → 0, so (i’, J’,
k’ l’, m’, n’) →
max
Wear degree of
major facilities
U U [0; 1]∈
high = 1
low = 0
if U → 1, so
(j’, m’) → max
Social standard of
living
Q Q [0; 1]∈
high = 0
low = 1
if U → 1, so
(j’, m’) → min
Energy intensity
of GDP
R Z [0; 1]∈
high = 1
low = 0
if R → 1, so
(i’, j’, k’, l’, m’)
→ min
Let us explain the algorithm logic. We have determined the following criteria for
effectiveness of reforms: the fulfillment of NAOC in a balance with NM price
reduction (i.e. the relation between these two factors are inverse), maximization of
the resulting economic effect dQввп and minimization of reform costs. Values of
established activity markers determining special regional (national) features of the
industry identify the efficiency of a certain chosen alternative of MTEMA to a
significant degree.
Minimization of reform costs in the industry will be achieved in case of a minimal
deviation from the basic model. Such an indicator as efficiency of market institutions
in economy determines the efficiency of their introduction in the electric power
industry: if it is low initially, 'forced' introduction of competition hardly will enhance
the efficiency of industry.
High installed capacity of electric power system, capacity shortage, high level of
demand/supply territorial entropy as well as wear and tear of equipment determine
the degree of 'problematicity' of the industry in a certain region from the standpoint of
opportunity to introduce market relations due to possible reliability problems and
require maximum integration of energy companies as well as tough government
regulation in this sector. And vice versa, low installed capacity, its redundancy,
territorial coincidence of demand and supply and insignificant wear and tear of
equipment enable enter of new market participants. The introduction of competition
may result in an expected positive effect.
50
