Regulation of energy markets

Summary: Regulation is the act of government intervention in a market intended to influence the behavior of firms and other market players toward a more socially desirable outcome.

Regulation is one of the main tools governments have to implement their energy policies, along with taxation. Regulation of energy markets is meant to address the failure of markets to deliver desired results, whether they are economic, social, or environmental. Firms participating in energy markets usually are subject to environmental, safety, inspection, and labor regulations, although the focus here is on the economic regulation of the electricity sector and the closely related gas sector. This includes the regulation of price tariffs, market access, investment levels, and service quality.

The level and form of regulation vary greatly by the energy industry’s structure, which can vary in terms of competition level, degree of integration, whether ownership is public or private, and whether the system is fully developed or if access is limited. Any of the four activities within the electricity industry—generation, transmission, distribution, and retail sales—can be undertaken by a private or a government-owned company, and the regulation to which those activities are subject can vary in terms of flexibility. Policymakers decide what form the regulation will take. Usually an independent, specialized regulator is responsible for the regulation of the energy industry, but other entities may be responsible for some regulatory elements, including departments in national governments, local authorities, competition regulators, and environmental agencies.

Role

Although regulatory models vary by energy market structure, the role of regulation is broadly the same in most areas. Regulation is intended primarily to address market failures and is considered necessary to protect consumers in industries with the characteristics of natural monopolies. Electricity and often gas are important inputs in a well-functioning economy, which lacks straightforward substitutes for these power sources in the short term, so demand for them does not drop significantly when prices increase. A firm that benefits from natural monopoly status could charge very high prices in the short run, because it competes with no one on its delivery. Mitigation of such market power is introduced either through competition, where possible, or through regulation.

Maintaining low prices is not the only aim of energy regulation. Because there is little market incentive for firms to reduce their level of environmental damage, policy makers create regulation aimed at reducing emissions, protecting water resources, minimizing land contamination, and reducing noise pollution. In many developing economies, where scarcity of supply is an issue, regulations are often designed to meet the goal of universal supply of electricity or heating fuels. Many policy makers are now introducing regulation aimed at incentivizing the use of alternative energy and enhancing security of energy supply.

Nonliberalized Versus Liberalized Markets

Some markets are characterized by a single vertically integrated supplier who generates, transmits, and delivers energy services to all users in an area. If this monopolistic firm is owned by the government, it often operates with a government mandate to supply consumers with the energy they demand for a set price. If the monopolistic firm is privately owned, it is often subject to command and control regulation—that is, legislation that articulates what an industry legally can and cannot do—to ensure that the firm does not abuse its market power and acts in the interests of the people or government. The level of regulation is usually a direct political decision. The regulator or government agency usually sets prices and outlines investment requirements, which often are written into legislation. If firms do not comply, legal action can be taken.

Since the 1980s, most developed economies have liberalized their energy markets, meaning that they have restructured and deregulated those markets and have introduced competition where possible. The vertically integrated energy supplier has been unbundled and its activities divided between different companies, often private. Generation of electricity and retail sales to end users have been regarded as particularly suitable to introduce competition as the main tool in maintaining low prices to consumers.

However, even the most liberalized energy market is subject to some regulation, largely because some activities within energy delivery systems are considered natural monopolies and are noncompetitive in nature, such as transmission and the operation of gas pipelines. For these activities, the economies of scale are so great that it is economically inefficient to have more than one firm operating in an area, and so these activities must be regulated. In liberalized markets, an independent regulator aims to set guidelines that create conditions under which prices are similar to what they would be under perfect competition.

Command and Control Versus Incentive-Based Regulation

There are some clear benefits to command and control (CAC) regulation. Clear targets and limits can be outlined, and standards can be imposed quickly. However, neoliberal economists can provide ample criticism of nonliberalized energy systems, and experience of CAC regulation has shown multiple problems. CAC is the least desirable form of regulation from the point of view of the private sector, as it does not allow firms any flexibility in their decision making. There is no inherent incentive to improve efficiency or innovation within the system, and cost increases are usually passed on to the consumer through tariffs or taxes. The involvement of politicians creates a risk that regulation is set with short-term political interests in mind as opposed to long-term economic or environmental interests. CAC regulation has not always been successful in setting standards, such as acceptable levels of pollution or realistic operational targets for electricity delivery systems, and has largely been abandoned in developed economies.

Incentive-based regulation is meant to incentivize firms to stop undesirable behavior through imposing taxes or granting subsidies. In economic terms, an incentive seeks to modify firms’ available choices by changing the marginal costs or marginal benefits associated with that choice. This type of regulation reduces the possibility for regulatory discretion and therefore regulatory capture. Companies often favor this type of regulation, since it allows the firm to choose whether to follow the rule or accept the consequence. It is the preferred type of regulation in liberalized energy markets, although CAC mechanisms may be imposed in crisis situations. Regardless of the regulatory structure applied to an electricity or natural gas market, regulation has its costs, including the cost of operating a regulatory agency, the social costs of ineffective regulation, and the costs imposed on firms by the regulator.

Regulation in Liberalized Energy Systems

Within the last several decades of energy system liberalization, government oversight was largely abandoned and independent regulatory agencies established. The regulatory agency, or regulator, acts to protect the interests of consumers by ensuring economic efficiency in a market.

The belief that effective competition is the best regulator and leads to the most economically efficient solution is commonly held among economists. Because the introduction of competition reduces the need for regulation in the competitive aspects of energy delivery, the role of the regulator is to provide guidelines that should be applied only where the benefits of regulation reduce costs to a greater extent than if the regulation were not in place. However, regulation is often designed to prevent market abuse or anticompetitive behavior, ensure effective competition is maintained, and prevent the growth of a dominant group.

The role of economic regulation of noncompetitive activities in liberalized electricity markets and their closely related natural gas markets is twofold: to ensure that enough investment is made in the long term to meet demand and to ensure that investors receive a reasonable rate of return on their investments. In natural monopoly industries, dominant firms can charge prices so low that competitors are forced out of the market. Once competition has been eliminated, the dominant firm can charge monopoly prices and reduce social welfare. Transmission and distribution have strong natural monopoly characteristics and are regulated in liberalized energy systems. However, generation and retail sales are generally considered competitive activities and are usually not subject to economic regulation.

There are several policy components for which a regulator can outline incentives or requirements in order to improve economic efficiency. Tariffs can be regulated, or the rate structure defined. Investment levels can be incentivized to ensure adequate investments that will protect long-term prices. Access rules can be outlined with regard to entry into the market, access to the transmission network for generators, and access to the distribution network for customers. Because private firms act to maximize their profit, there is, for example, strong incentive in place to focus on customers to whom it is cheaper to supply electricity than customers in rural areas. The regulator can also make requirements as to the quality of service with regard to reliability.

In the short run, the regulator aims to set a tariff structure that allows the firm to meet its costs and be recompensed for its investments. To do so, the regulator must determine the firm’s total revenues and its required revenues, or the amount needed by the firm to maintain the level of service customers require. In the long run, the regulator aims to encourage the electricity supplier to build enough infrastructure to meet long-term demand. This is usually done by ensuring a reasonable return on investment for shareholders. If the firm’s rate of return on investment is too high, the regulator may be creating incentive for the firm to build more capacity than is necessary. That is why there is usually a license requirement on new capacity for which firms must apply to the regulator. In the United States, the regulator is often involved in integrated resource planning (IRP), a process whereby the regulator determines if the system being proposed will ultimately lead to the lowest possible cost to customers.

A regulator can usually outline access rules, where competition has been introduced, that clarify the system’s entry and exit rules. Because new competitors reduce the market power of dominant firms, generally regulators want as many generators as possible to have access to the regulated transmission and distribution grids and therefore gain entry into the market. This may involve costs to the regulated industry that it would not assume unless expressly told to do so by the regulator. Exit rules usually apply to the regulated firm’s abandonment of high-cost customers, such as those living in rural areas. Although this does not usually occur, there is a tendency for regulated industries to better serve their low-cost customers. In such cases, the regulator must introduce some sort of incentive or rule to improve capacity in high-cost regions.

Usually regulators are charged with seeing that firms maintain a quality of service that guarantees reliability, minimizes disturbances, and ensures that customers are satisfied.

Price Regulation of Natural Monopolies

Because competition cannot be introduced to transmission and distribution, these activities need regulatory incentives to reduce costs and prices. In areas where competition has not been introduced to generation activities, they too are usually subject to price regulation. The regulator limits how much profit the regulated firm can make from efficiency improvements through price regulation. There are two commonly used methods for price regulation.

Rate-of-return regulation, also known as cost-of-service regulation, requires the regulator to determine a rate level based on allowed costs and investments and an appropriate rate of return. The goal for regulators is to determine levels so that economic profits are zero, although investors receive an approved rate of return on their investments. This type of price regulation is costly and time-consuming for regulators, although it can be highly precise. It usually involves a very close relationship between firms and their regulators, and it creates a risk for regulatory capture, whereby the regulator starts to become overly concerned with the interests of the firm and overlooks the interests of consumers. The most controversial issues in rate-of-return regulation are often determining required investment levels and determining an acceptable rate of return on equity investment.

Performance-based ratemaking (PBR) occurs when the regulator sets a particular rate and then allows the firm to keep any cost savings as profit. As a result, investors receive higher profits and a better return on their investment. Consumers benefit from lower prices and improved service levels. This method of regulation is less costly and time-consuming for the regulator. It is the method of choice in most US electricity markets and has several variations, including sliding scales, revenue caps, and price caps. All of the variations provide incentives for performance and cost reduction. Proponents of PBR say it helps improve efficiency, reduce operation and maintenance costs, and improve reliability. It gives firms flexibility on how to respond. PBR’s main regulatory risk is that it may cause firms to cut operational and maintenance costs too much, resulting in reduced service in the long run. Although PBR aims to provide economic benefit to both consumers and firms, if targets are wrong, unfair benefit can be provided to either firms or consumers.

Other Market-Based Mechanisms

To influence the activities of both competitive and monopolistic firms, policy makers may use any of the wide range of market-based mechanisms designed to provide cost-effective incentives with minimal involvement of the regulator. A few of these mechanisms are described below.

Competition laws, designed to prohibiting predatory pricing and other anticompetitive behavior by firms, can be a less expensive way to regulate, as disputes are settled by courts instead of a regulatory agency. Their application to the electricity and gas sectors is often criticized, however, because they generally outline broad rules and the judicial system often lacks the specialized knowledge to apply them to energy systems. They are, however, sometimes applied to fuel providers such as oil companies.

Cap-and-trade legislation has been introduced in the European Union and in other areas as a market-based mechanism for limiting greenhouse gas emissions from energy production. The government or regulator decides an appropriate level of emissions and then divides allowances among firms. Firms can then choose to reduce their emissions and sell off their surpluses or buy allowances from other firms so as to emit more than their allowances specified. From the firms’ perspective, this is preferable to CAC regulation and results in the most economically efficient solution. From an environmental perspective, the success of the scheme is dependent on the emissions levels a government is willing to set.

Disclosure regulation has been passed in some economies where competition has been introduced to retail sales. Such regulation requires suppliers to specify the source of their electricity or heat and allows consumers to switch providers based on the sources from which they supply. Experience in these markets, including the United Kingdom and the Netherlands, has shown that consumers sometimes choose to pay a higher rate for their electricity if they know it is generated from alternative sustainable sources of energy, therefore increasing demand for alternative energy production.

The Successful Regulator

In order to achieve economic efficiency, the regulator must have access to good information about the costs, quality of service, and performance of the firms providing the regulated services. The regulator must have the authority to enforce the requirements and an expert staff able to make sound decisions on effective regulatory requirements. The independence of the regulatory agency must be protected, and a judicial process must be available for regulatory disputes.

In the United States, state regulatory agencies oversee the price and delivery to end users, while the Federal Energy Regulatory Commission regulates the wholesale or generation market. In the European Union, the independent national regulatory agencies, which are all subject to the laws of the unified European energy market, coordinate their policies through an advisory council made up of individual independent regulators.

Although broad-issue stances should rightfully be determined by policy makers as opposed to regulators, the regulator is often left with the responsibility of making determinations when it comes to individual cases. Moreover, regulators often play an advisory role to policy makers, because of their experience in the practical implementation and monitoring of energy regulation. Consequently, they are often valued participants in the energy debate and can have major influence on the developments of policies.

Contradictions in Regulatory Aims

There are some regulatory aims that may not always be compatible. A nation’s energy policy goals may focus on energy supply, improving the performance of energy markets, reducing poverty, improving energy access, and promoting the use of alternative energy. These goals are often in contradiction to the traditional short-term goal of energy regulation: keeping prices low and improving economic efficiency.

Since the ratification of the Kyoto Protocol, regulation has often been introduced to promote the use of electricity from alternative energy or alternative fuel use. Alternative energy is most often more expensive to produce than traditional forms of energy, and promoting it through regulation seems to work against one of the main roles of the regulator: to keep prices to consumers as low as possible.

Alternative energy projects are often smaller and farther away from the grid than conventional generation facilities, making marginal costs higher for the monopolistic delivery firm. Ensuring access to transmission and distribution networks for alternative energy producers is the responsibility of the regulator in economies where policy makers have designed legislation to promote the use of alternative energy. Government-owned systems have a distinct advantage when it comes to the speed at which electricity and heat from alternative energy sources can be delivered to customers. In liberalized energy systems, economic regulation must be introduced to incentivize investment in alternative energy with its accompanying time lags.

The introduction of incentives, such as subsidies and tax credits meant to increase generation from alternative technologies or increase energy efficiency, may be more expensive to consumers in the short run, but policy makers must take into account the longer-term effects of such policies. In the long run, new technologies become cheaper, the learning effect increases, and depletable resources become more expensive.

Increasing access to electricity in developing areas usually indicates upward pressure on prices for consumers in the short run. In the long run, improved access is often accompanied by poverty reduction through the increased economic development that improved access brings. Energy systems that are still developing have an advantage in promoting the use of alternative energy. Their systems are not mature and are often in a better position to add small-scale alternative electricity generation to rural areas with limited access. These conditions also allow developing economies to leap-frog conventional polluting energy sources and use modern, clean technology.

One of the main goals of most countries’ energy policies is ensuring security of supply. There is increasing criticism that deregulated systems have underinvested in capacity and relied on the asset-sweating of capacity built before deregulation and privatization. This can be combated through increasing investment requirements in electricity capacity, implementing storage requirements for gas suppliers, and outlining regulation for interconnections with neighboring regions’ energy delivery systems. Increasing interconnections is costly but is often considered vital in minimizing any potential effects of delivery disruptions. Having unused capacity on the system is inefficient in the strictest economic terms but may be desirable where there is political uncertainty of supply or delivery disruptions have occurred.

Decreasing demand is often named as one of the most effective ways of both decreasing greenhouse gas emissions and ensuring security of supply. There is little incentive for energy suppliers to decrease demand, because they usually sell power or heat by a metered amount. One way of decreasing demand is making demand-side programs available, such as those provided by energy service companies. The energy service company offers to provide consumers with a certain level of heat or electricity services and often installs energy savings measures in a customer’s home or business in exchange.

There is no standard method of regulation that is successful in every situation; individual situations, with regard to access, price, and the environment, have to be considered and weighed carefully by policy makers in choosing the most successful regulatory regime for the desired energy policy outcomes. In most developed economies, the regulatory regime is under continual review and reform as situations and policy goals change.

Bibliography

"An Introductory Guide to Electricity Markets Regulated by the Federal Energy Regulatory Commission." Federal Energy Regulator Commission (FERC), 25 Apr. 2024, www.ferc.gov/introductory-guide-electricity-markets-regulated-federal-energy-regulatory-commission. Accessed 1 Aug. 2024.

Gowrisankaran, Gautam, Ashley Langer, and Mar Reguant. "Energy Transitions in Regulated Markets." National Bureau of Economic Research (NBER), Jan. 2024, DOI 10.3386/w32088. Accessed 1 Aug. 2024.

Pollitt, Michael G. “The Future of Electricity (and Gas) Regulation in a Low-carbon Policy World.” Energy Policy 29, no. 2 (2008).

Rothwell, G., and T. Gomez. Electricity Economics: Regulation and Deregulation. Hoboken, NJ: John Wiley, 2003.

Stigler, George J. “The Theory of Economic Regulation.” Bell Journal of Economics and Management Science 2, no. 1 (1971).

Ter-Martirosyan, Anna, and J. Kwoka. “Incentive Regulation, Service Quality, and Standards in U.S. Electricity Distribution.” Journal of Regulatory Economics 38, no. 3 (2010).