Abstract
Regulatory agencies routinely seek to promote price stability. A rationale for this practise might be that regulators seek to protect customers’ relationship-specific sunk investments. We develop a simple model which confirms that commitments to future rigid prices may increase welfare when customers need to make such investments. We use data from the Swedish district heating sector during the 1998–2007 period to explore the impact of monopoly pricing decisions on the take-up rate of district heating.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
This can be seen as a complement to the more common claim, formulated by Gilbert and Newberry’s (1994), that there is a risk that governments appropriate monopolies’ investment.
The need to make sunk investments to extract the most value from a transaction commonly arises in competitive markets. However, in the case of monopoly markets, these sunk investments are also inevitably relationship-specific. The monopoly problem concerns protecting and thereby promoting these sunk investments.
Kerkvliet (1991) makes a related claim when he finds that transaction-specific investments changes the competitive relationship between a buyer and seller.
Obviously, monopoly regulation pursues additional objectives, such as promoting cost reduction incentives or limiting under-supply to locked-in customers. There might be tradeoffs with these objectives. For instance, protecting customer investments may reduce the firm’s incentives to invest in innovation. We do not claim that welfare maximization amounts to protecting customer investments.
As a result there have been calls for price controls by the Swedish Competition Authority and the Swedish Energy Markets Inspectorate (SCA 2009; EI 2007). The Energy Markets Inspectorate, in arguing the need for regulation, explicitly emphasises that district heating customers are in a “weak position” with respect to their suppliers and that regulation would “build long-term confidence in district heating as a product” (EI 2007, p. 66). This may have created a regulatory threat established during our study period and that partially disciplined district heating firms. We come back to this when interpreting the results in Sect. 6.
We use the words ‘firm’ and ‘municipality’ synonymously in this paper.
This section reports statistics from a number of sources. When not explicitly stated, data can be accessed from either ‘Nils Holgersson’s annual price comparisons’ (www.nilsholgersson.nu), Statistics Sweden (www.scb.se), the Energy Markets Inspectorate (www.ei.se), or the Swedish District Heating Association (www.svenskfjarrvarme.se).
E.g. Värnamo Energi, a mid-sized district heating firm in the centre of Sweden, states on its homepage that no customer has switched from its DH service since it was established in 1984 (www.varnamoenergi.se, visited on the 12th February 2016).
The Competition Authority can review DH prices, but in contrast to regulators who can determine the regulated price themselves, the Competition Authority has to prove that the price has been excessively high. The implication of this is that the Competition Authority has never intervened in the price setting processes of the DH market.
Electricity distribution tariffs are regulated by the Swedish Energy Markets Inspectorate, which is required to take into account customers’ interest in low and stable electricity prices (SOU 1995). See Jamasb and Söderberg (2010) for further details on the Swedish electricity market and how it is regulated.
Electricity distribution prices are based on firm-level data. Municipal-level electricity prices are not observed.
Both private and public district heating firms exists but previous studies have not found that ownership has an effect on pricing behaviour (Björnerstedt and Söderberg 2011).
Assuming a representative customer is sufficient to characterize the hold-up problem and its welfare consequences. However, in a more refined version of the model that is introduced in Sect. 3.2, we assume that customers are heterogeneous.
This assumption is realistic. As shown in Sect. 2, the short-run price elasticity for heating is close to 0.
In practice, district heating firms may not always maximise profit, but here we assume they behave as if they do since our primary objective is to highlight the hold-up problem generated by the pricing behaviour of profit-maximizing firms. This will not affect the econometric analysis since we will focus on the demand-side of the market.
In the worst case where the production cost is, the limit price leaving a firm with zero profit = yields higher customer surplus than switching to the alternative heating option.
Implicit enforcement could also come from the threat of regulation or loss of votes in a political economy setting.
Schedules with intermediate risk allocations are feasible, but the analysis of these two polar cases is sufficient to make our point.
These results would hold under the more general hypothesis that the firm is less averse to risk than the customer.
In addition, we ignore other potential market failures like environmental externalities or imperfectly regulated substitutes that could lead the adoption of district heating to reduce social welfare.
Using these two price terms together with year and firm fixed effects, the prediction error varies from 0.18% to 0.34%. Thus, the errors are very small and the two price terms closely approximate rational expectations.
The Energy Markets Inspectorate has developed principles to determine connection prices for physical energy networks and these principles are largely used by district heating utilities. Two primary cost components are: material/equipment and the distance between the network and the connecting property. The market for material/equipment is national (i.e. covered by year fixed effects) and the distance is strongly correlated to population density, which exhibits very little within-variation. The inclusion of density in the empirical evaluation shows that it is not even vaguely related to the number of connections. Hence, we assume that connection prices have been constant.
This baseline specification assumes that customers have the same preferences for falling and rising price trends. In the case of investments with long lifetimes, one cannot form strong expectations about the influential direction of past price decreases since a fall in the price may merely be interpreted by the customer as indicating that there is room to increase prices in the future (e.g. Adeyemi and Hunt (2007) find a negative effect on demand from cumulative price decreases in one of their models). We estimate models where the effects from negative and positive slopes are allowed to be different, see Table 2, but there is no indication that customers have different preferences for falling and rising price trends.
About 75% of Swedish households live in detached houses. Practically all of these own their properties since there is no tradition of renting detached houses in Sweden and no established marketplace for such properties. A proportion of the remaining 25% also occupy their own properties, but a non-negligible share of households nevertheless rent the dwelling they occupy.
However, a one-stage procedure where both and are included as explanatory variables in the same model gives the same qualitative results as the two-stage procedure.
Equation (5) assumes that customers have the same preferences for falling and rising price trends. In the case of investments with long lifetimes, we cannot form strong expectations about the influential direction of past price decreases, since a fall in price may merely be interpreted by the customer as the existence of room to increase prices in the future (e.g. Adeyemi and Hunt (2007) find a negative effect on demand from cumulative price decreases in one of their models). See Table 6 in Appendix 2 for details.
References
Adeyemi, O. I., & Hunt, L. C. (2007). Modelling of OECD industrial energy demand: Asymmetric price responses and energy-saving technical change. Energy Economics, 29, 693–709.
Berry, S. T. (1994). Estimating discrete-choice models of product differentiation. The Rand Journal of Economics, 25(2), 242–262.
Biggar, D. (2009). Is protecting sunk investment by customers a key rationale for natural monopoly regulation? Review of Network Economics, 8, 128–152.
Björnerstedt, J. & Söderberg, M. (2011). The market for district heating in Sweden: An empirical analysis of the relevant product market. Working Paper 2011-01, CRMA, University of South Australia.
Branch, W. A. (2004). The theory of rationally heterogeneous expectations: evidence from survey data on inflation expectations. The Economic Journal, 114, 592–621.
Brännlund, R., Ghalwash, T., & Nordström, J. (2007). Increased energy efficiency and the rebound effect: Effects on consumption and emissions. Energy Economics, 29, 1–17.
Chah, E. Y., Ramey, V. A., & Starr, M. (1995). Liquidity constraints and intertemporal customer optimization: Theory and evidence from durable goods. Journal of Money, Credit and Banking, 27, 272–287.
Chevalier, J., & Goolsbee, A. (2009). Are durable goods customers forward looking: Evidence from college textbooks. Quarterly Journal of Economics, 124, 1853–1884.
Chisari, O., & Kessides, I. N. (2009). Pricing dynamics of network utilities in developing countries. Review of Network Economics, 8, 212–232.
Crew, M., & Kleindorfer, P. (2006). Regulation, pricing and social welfare. In M. Crew & D. Parker (Eds.), International handbook on economic regulation (pp. 63–81). Cheltenham: Edward Elgar.
EI. (2007). Uppvärmning i Sverige 2007 ("Heating in Sweden 2007"). Energy markets inspectorate. (In Swedish). Available at www.ei.se. http://www.neova.se/sites/neova.se/files/page/uppvarmning_sverige_2007_utan_bilagor_0.pdf. Accessed on 9 July 2018.
Erdem, T., Keane, M., & Imai, S. (2003). Customer price and promotion expectations: Capturing customer brand and quantity choice dynamics under price uncertainty. Quantitative Marketing and Economics, 1, 5–64.
Evans, G. W., & Honkapohja, S. (2001). Learning and expectations in macroeconomics. Princeton: Princeton University Press.
Forsaeus Nilsson, S., Reidhav, C., Lygnerud, K., & Werner, S. (2008). Sparse district-heating in Sweden. Applied Energy, 85, 555–564.
Gilbert, R. J., & Newberry, D. M. (1994). The dynamic efficiency of regulatory constitutions. The Rand Journal of Economics, 25(4), 538–554.
Goldberg, V. P. (1976). Regulation and administered contracts. The Bell Journal of Economics, 7(2), 426–448.
Gowrisankaran, G., & Rysman, M. (2012). Dynamics of consumer demand for new durable goods. Journal of Political Economy, 120(6), 1173–1219.
Hendel, I., & Nevo, A. (2004). Intertemporal substitution and storable products. Journal of the European Economic Association, 2, 536–547.
Hendel, I., & Nevo, A. (2006a). Sales and customer inventory. RAND Journal of Economics, 37, 543–561.
Hendel, I., & Nevo, A. (2006b). Measuring the implications of sales and customer inventory behavior. Econometrica, 74, 1637–1673.
Henning, A. (2006). In bio-fuel we trust. In M. D. Brenes (Ed.), Biomass and bioenergy: New research (pp. 125–140). New York: Nova Science Publishers Inc.
Hepbasli, A., & Kalinci, Y. (2009). A review of heat pump water heating systems. Renewable and Sustainable Energy Reviews, 13(6–7), 1211–1229.
Isaksson, C. (2005). Lagom varmt och bekvämt. En kunskapsöversikt över hushållens relation till energi med fokus på hushållens val och användning av uppvärmningssystem i småhus, Tema, inst. för Teknik och social förändring, Linköpings universitet.
Jamasb, T., & Söderberg, M. (2010). The effects of average norm model regulation: The case of electricity distribution in Sweden. Review of Industrial Organization, 36, 249–269.
Jörgensen, E. (2009). Ökat förtroende för fjärrvärme, Fjärrsyn 2009:14
Kerkvliet, J. (1991). Efficiency and vertical integration: the case of mine-mouth electric generating plants. The Journal of Industrial Economics, 39(5), 467–482.
Leth-Petersen, S., & Togeby, M. (2001). Demand for space heating in apartment blocks: Measuring effects of policy measures aiming at reducing energy consumption. Energy Economics, 23, 387–403.
Mahapatra, K., & Gustavsson, L. (2007). An adopter-centric approach to analyze the diffusion patterns of innovative residential heating systems in Sweden. Energy Policy, 36(2007), 577–590.
McFadden, D. (1973). Conditional logit analysis of qualitative choice behavior. In P. Zarembka (Ed.), Frontiers in econometrics (pp. 105–142). New York: Academic Press.
Nair, H. (2007). Intertemporal price discrimination with forward-looking customers: Application to the US market for console video-games. Quantitative Marketing and Economics, 5, 239–292.
Nakamura, E., & Steinsson, J. (2011). Price setting in forward-looking customer markets (forthcoming). Journal of Monetary Economics, 58(3), 220–233.
Persson, U., & Werner, S. (2011). Heat distribution and future competitiveness of district heating. Applied Energy, 88(3), 568–576.
Reidhav, C., & Werner, S. (2008). Profitability of sparse district heating. Applied Energy, 85(9), 867–877.
Rydén, B., Sköldberg, H., Stridsman, D., Göransson, A., Sahlin, T., Sandoff, A., Williamsson, J., Hansson, N., Holmberg, U., & Gunnarsson, A. (2013). Fjärrvärmens affärsmodeller, Fjärrsyn rapport 2013:7.
SCA. (2009). Åtgärder för bättre konkurrens—konkurrensen i Sverige. Swedish Competition Authority Report No. 2009:4. (In Swedish). Available at www.kkv.se. http://www.konkurrensverket.se/globalassets/aktuellt/nyheter/atgarder-for-battre-konkurren---konkurrensen-i-sverige.pdf. Accessed 9 July 2018.
SCB (2001). Electricity supply, district heating and supply of natural and gasworks gas 1999, EN 11 SM 0101.
SCB (2009). Electricity supply, district heating and supply of natural and gasworks gas 2007, EN 11 SM 0901.
SEA (2010). Energy statistics for one- and two-dwelling buildings in 2010, ES 2011:10. (In Swedish with English summary).
Shah, V., Col Debella, D., & Ries, R. J. (2008). Life cycle assessment of residential heating and cooling systems in four regions in the United States. Energy and Buildings, 40, 503–513.
SOU. (1995). Ny elmarknad, underbilagor, 1995:14. Stockholm: Norstedts.
SOU. (2004). Skäligt pris på fjärrvärme. 2004:136, Stockholm, Fritzes Förlag. (In Swedish). Available at: http://www.regeringen.se/sb/d/108/a/37976. Accessed 9 July 2018.
Su, X., (2010). Intertemporal pricing and consumer stockpiling. Operations Research, 58(4), 1133–1147.
Sun, B., Neslin, S., & Srinivasan, K. (2003). Measuring the impact of promotions on brand switching under rational customer behavior. Journal of Marketing Research, 40, 389–405.
Westin, P., & Lagergren, F. (2002). Re-regulating district heating in Sweden. Energy Policy, 30(7), 583–596.
Wooldridge, J. M. (2002). Econometric analysis of cross section and panel data. Cambridge, MA: MIT Press.
Author information
Authors and Affiliations
Corresponding author
Additional information
The views expressed in this paper are the views of the authors and do not necessarily reflect the views of the ACCC or the AER.
Appendices
Appendix 1
See Table 5.
Appendix 2
The Appendix provides robustness checks of Eq. (5) when nest and prices are assumed to be exogenous (Table 6), when the nest is endogenous and prices exogenous (Table 7), and when both the nest and prices are endogenous (Table 8).
Rights and permissions
About this article
Cite this article
Biggar, D., Glachant, M. & Söderberg, M. Monopoly regulation when customers need to make sunk investments: evidence from the Swedish district heating sector. J Regul Econ 54, 14–40 (2018). https://doi.org/10.1007/s11149-018-9363-0
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11149-018-9363-0