Regulation, liberalisation and measuring innovation

Over the last 30 years, the electric industry has changed drastically. Most Western countries have started a reform process meant to break apart and privatise monopoly utilities (that were typically owned by the state, especially in Europe) and allow retail companies to sell electricity to consumers. Even if a full deregulation of the market has neither been feasible nor desirable, a “restructuring” process has opened the way for competition in certain segments, such as generation and retailing, which aren’t natural monopolies. Indeed, this separation has created the possibility of making “a unit of electricity into a tradable commodity with a price set by relations between supply and demand rather than by a regulator”[1]. Today, in many countries, households or firms can shop around for the best deals on electricity, sometimes in the same way they shop around for a phone provider.

The intensity of the reform process has been quite heterogeneous across countries. France, for example, has somehow liberalised its electricity sector (in accordance also with the requirements of the EU directives) eliminating the monopoly rights of the state company EDF. Moreover, the level of government involvement in energy companies has progressively decreased. On the top of this, the restructuring process has led to a substantial degree of separation between different stages of the production process and to the establishment of both a regulator, the Commission de Régulation de l’Énergie (CRE), and a mediator to protect electricity (and gas) consumers[2]. In spite of such changes, France is among the countries whose electricity sector is “less competition friendly” than the OECD average[3] because it is still subject to a relatively heavy regulatory burden.

In the light of such a heterogeneity, one may wonder to what extent this whole experiment has paid off so far. Is it time, for countries who have not fully embraced this path yet, to push on further with the restructuring agenda?

At an intuitive level, introducing market forces seems the best way to deliver reliable, cheaper and cleaner energy. Crucially, meeting all these objectives at once certainly needs new ideas: the International Energy Agency considers innovation as “central to meeting climate mitigation goals while also supporting economic and energy security objectives”. However, both from a theoretical and an empirical perspective, the effects of deregulation on innovation in the electricity sector are not as obvious as the effects on prices and cost efficiency. If deregulation increases competition, and the restructuring process involves a tightly regulated market, then companies may have an incentive to innovate in order to increase the gap between them and their rivals. However, if competition becomes “too strong”, the incentives to innovate may be hampered by higher price volatility and tighter margins (which may both, at the very least, shift the focus to shorter term R&D) and by the simple fact that imitation may become a more profitable option than innovation. Also, the empirical evidence about the relation between deregulation and innovation is rather mixed.

A recent study by Marianna Marino (ICN Business School), Pierpaolo Parrotta (ICN Business School) and Giacomo Valletta (EDHEC Business School)[4] tries to solve this puzzle by tracking the effects of major changes in the legal and regulatory framework (meant to drastically lower regulation intensity) on the number of patents, used as a measure of innovation, in the electricity sector. The idea is to progressively compare countries that have experienced major reform with countries whose electricity market remains essentially regulated in order to try to separate the direct effects of the reform on innovation from any sort of pre-existing trend.

It seems that two forces are at play. In general, liberalisation does foster innovation but a further decrease in regulation intensity, after a major reform, has the opposite effect on innovation. These two relationships however depend on the regulatory environment in which reforms take place. In countries that have already experienced an intense liberalisation process, a further lightening of the regulatory burden, after a major reform, decreases the number of patent applications. The opposite happens in countries which lag behind in the restructuring process.

These results nicely fit the descriptive evidence relating to the relationship between regulation intensity and innovation. This relationship is positive when regulation intensity is high (to put it differently, deregulation fosters innovation if the market is tightly regulated), it reaches its peak at some intermediate level of regulation intensity and starts decreasing afterwards (deregulation hampers innovation once the market liberalisation process is already fairly advanced).

This may have some interesting policy implications. Settling for some middle ground may be a better option than pushing the liberalisation of the electricity process too far, especially if one thinks in the long term. Even if in the short term a drastic liberalisation process may yield some positive effects, in terms of production efficiency and price reduction, the risk of a stagnation in innovation may have rather bleak implications considering the many challenges (meeting the growing energy demand using more efficient and sustainable technologies) that the industry is facing. As a matter of fact, the decision between market forces and regulation is not a dichotomous one. The complexity of this industry, that mixes pure market elements with public good/natural monopoly issues, probably calls for a combination of both in order to provide the actors involved with the right incentives to find innovative ways to produce and distribute electricity. Otherwise, another way to reach the “desirable” amount of innovation could be to push for further fiscal incentives but their design can be very complicated and yield further distortions in the market. 

References:

[1] G Bakke, The grid, Bloomsbury USA, 2016.

[2] OECD, Fossil fuel support - France, 2016.

[3] http://www.oecd.org/eco/growth/ indicatorsofproductmarketregulationhomepage.htm

[4] M Marino, P Parrotta, and G Valletta, Electricity deregulation and innovation, BETA Working Paper, 2017-33.