1

Strategic choice of financing systems in regulated and interconnected industries

Anna Bassanini Jerome Pouyet

Rome & IDEI CREST-LEI & CERAS-ENPC

pouyet@ensae.fr

2

Liberalization and regulation

Liberalization of network industries

Infrastructures are essential facilities Large returns to scale Huge fixed costs Investments

Regulation of access railways, telecoms… to finance infrastructure

3

Liberalization and globalization

Volume of international transactions using many networks

Competition on the markets

Interaction between regulations

Strategic impact of national regulatory modes/financing systems on international services

4

Financing systems/regulatory modes

Railways in EuropePercentage of infrastructure deficit

covered by access revenue

Rmk: Only positive transfers Similar issues in other network industries

France Austria Germany

25% 40% 100%

5

The questions

Nature of the interaction between the access pricing decisions of national regulators that face international services

Interaction between access pricing decisions affects the choice of financing systems

Nature/specificities of the regulatory competition between network managers

6

Model - 1 Two countries, infrastructure manager IMi

International final services, q*(p*), requires the access to both infrastructures

First (budgetary) externality between countries

Net surplus S*(q*) is shared across countries: i+j=1 Second (direct) externality between countries

IMi decides: Access price a*i for the use of his infrastructure Transfer ti to finance the infrastructure

Downstream operators are competitive: p*=a*i+a*j+cd

7

Model – 2

IM1

Infrastructure 1s.t. break-even constraint

Transfer 1Access price 1

Final sector:Final price/quantity depends on both access prices

IM2

Infrastructure 2s.t. break-even constraint

Transfer 2Access price 2

8

Model – 3

IMi’s Budget Balance constraint

(BBi) : ti+(a*i-cu)q*(p*(a*1,a*2))≥ ki

IMi’s objective

SWi=i S*(q*)-(1+pf)ti+ti+(a*i-cu)q*-ki

Downstream Operatorsp*=a*i+a*j+cd

IMi : a*i and ti IMj : a*j and tj

9

Ramsey-Boiteux Access Pricing Principles

Perfect cooperation between IMs (a*=ai*+aj* , t)

Optimal access price

Trade-off between the two instruments

10

Simultaneous choices of modes of regulation-1

Transfers and access prices are decided simultaneously and non-cooperatively

11

Simultaneous choices of modes of regulation- 2

Given a*j,

Strategic interaction

Transfer in country i

12

Simultaneous choices of modes of regulation- 3

• Hyp:

• Stable & unique equilibrium

• Access prices excessive

13

Assumptions on infrastructure costs

14

Simultaneous choices of modes of regulation- Positive subsidy only-1

IMi chooses ti=0

15

Simultaneous choices of modes of regulation- Positive subsidy only-2 Consider that

• Multiple equilibria

• NS-equilibrium unstable• S-equilibrium is stable

• Access prices are lower in the NS-equilibrium

• Similar features when access prices are strategic substitutes under the subsidy-system

16

Strategic role of infrastructure costs in the NS-equilibrium Why are the access prices lower when both

infrastructure managers adopt the no-subsidy financing system? Infrastructure fixed costs act as a commitment device to

behave `aggressively’

• Therefore, IMs might have poor incentives for cost-minimization under the NS-equilibrium

• Scope for a strategic use of investment

17

Impact of supra-national policies aimed at developing international services

• International services are excessively charged

• Standard solution: subsidize the acess to infrastructures to soften the distortions

• But, the impact of such policy depends on the equilibrium!

• Subsidies to infrastructures must be contingent on the regulatory modes implemented in the countries

18

Sequential choices of financing systems-1

The mode of regulation has a commitment value It binds the infrastructure managers in the access

pricing decisions

Can countries use the mode of regulation in order to improve welfare? Two-stage game:

Choices of modes of regulation Choices of access prices

19

Sequential choices of financing systems-2

Resolution by backward induction

Given financing systems in both countries, determine the access prices Immediate

Analysis of choices of regulatory modes Given the financing system in country j, what is

the preferred financing system in country i? The choice of financing system has two effects:

Direct effect: on the access price set in country i Strategic effect: on the access price set in country j

20

Best-response in financing systems- Remark

Infrastructure manager distorts access price (reduces consumers’ surplus) to ensure the financing of infrastructure (increase the infrastructure profit)

To satisfy a strict budget constraint in a non-cooperative setting: Either reduce the access price to increase demand Or increase the access price to increase the margin Which strategy is chosen by an IM depends on the reaction of

the other IM

21

Best-responses in financing systems- 1

Country j chooses No-Subsidy

(S,NS)(NS,NS)

• If one country chooses No-Subsidy, the other country chooses No-Subsidy

• The commitment to a strict-budget balance creates a strong strategic complemen-tarity, which provides an IM with an incentive to adopt the NS-system in order to reduce access prices

• This holds whatever

• (NS,NS) always an equilibrium

22

Best-responses in financing systems- 3

Country j chooses Subsidy and

• If one country chooses Subsidy, the other country chooses Subsidy

• Multiple equilibria in the strategic game

• Infrastructure managers are `conservative’

• An IM is willing to reduce the access price onlt if he anticipates a sufficiently strong decrease of the access price set in the other country

23

Best-responses in financing systems- 4

Country j chooses Subsidy and

• If IMi chooses NS, then a*i increases

• Then, IMj reacts by decreasing a*j, but to a smaller extent

• Total access price increases

• IMi saves on the subsidy given to the infrastructure under S but reduces consumers’ surplus

24

Best-responses in financing systems-4bis

Country j chooses Subsidy and If the strategic reaction in country j is strong:

Country i chooses NS and total welfare decreases But then country j will also choose NS

NS in both countries is the unique equilibrium of the strategic game!

If the strategic reaction in country j is weak: The choice of financing systems depends on the

infrastructure fixed cost: ki small: Incentive to free-ride and choose NS

Unique equilibrium ki large: No incentive to free-ride and choose S

Multiple equilibria

25

Strategic choices of financing systems- Summary

Financing systems might be used as a coordination device and enable the infrastructure managers to reach the Pareto-superior equilibrium However, infrastructure managers might have free-

riding incentives

Issues Renegotiation-proofness Incentives in presence of domestic and international

services

26

Strategic choices of financing systems- Renegotiation-proofness

• Ex post, an infrastructure managers might be tempted to deviate from his equilibrium access price

• Financing systems must credibly commit the infrastructure managers

• Separation of access pricing and choice of regulatory mode

NS-equilibrium

27

Extensions- 1Domestic and international services

Consider that services are purely domestic No externality between infrastructure managers No distortion wrt 1st-best perfect cooperation case

If international services > domestic services: Whatever the `initial’ choices of regulatory modes,

infrastructure should to be less subsidized Role of a supra-national authority to coordinate

the transition

If international services < domestic services: No mandatory adoption of no-subsidy

28

`Pass-through’ country- 1

Consider j=0 Budget constraint never binding in this country Since taxation is distortionary, tj=0 Then:

Analysis similar to the choice of regulatory mode in one country when the other country chooses subsidy… except that…

29

`Pass-through’ country- 2

Whether the budget-constraint is binding might be endogenous

When a*j is sufficiently low, the budget constraint might not be binding in country i

This creates the possibility of another equilibrium in which the budget constraint is not binding and access prices are low

30

Conclusions Interaction between infrastructure managers with

direct and budgetary externalities Commitment to strict budget balance binds

infrastructure managers to behave aggressively

Potential coordination problems No-subsidy is Pareto-superior but unstable Subsidy is Pareto-inferior but stable

Supra-national policies to promote international services through infrastructure subsidies might have perverse effects

Financing systems might be used strategically to free-ride

31

Further research

Strategic role of investment

Interconnection

International competition and the incentives for cost-minimization (agency problem)