The Contamination Problem in Utility Regulation

Transcription

1 The Contamination Problem in tility egulation Fernando T. Camaho & Flavio M. Menenzes. Disussion Paer No. 35, November 007, Shool of Eonomis, The niversity of ueensland. Australia. Full text available as: PDF- equires Adobe Arobat eader or other PDF viewer Abstrat This aer formally examines the imliations of a utility s diversifiation into an unregulated industry. In our framework, the utility is the most effiient rovider in the unregulated industry (u to a artiular aaity and, as suh, there is no question about the desirability of allowing it to oerate in that market. Nevertheless, the risk faed by a diversified utility is greater than the risk faed by a utility that oerates only in a regulated market. This additional risk an otentially affet the diversified utility s redit rating and, therefore, inrease the ost of aital for the regulated business that will be reovered from rateayers. We show that by allowing a regulated firm to diversify into an unregulated market, the regulator faes a trade-off: a lower ost in the unregulated market versus a higher ost in the regulated market. If the regulator only ares about welfare in the regulated market, then a ringfening requirement is otimal subjet to imlementation osts not being substantial. Of ourse, the ring-fening requirement effetively revents the firm from ahieving a lower ost in the unregulated market. Therefore, if the regulator ares about welfare in both regulated and unregulated markets, ring-fening may no longer be otimal. EPrint Tye: Keywords: Subjets: ID Code: Deartmental Tehnial eort multi-utility regulation; utility diversifiation; ring-fening; risk rating Eonomis; JE Classifiation 5 Deosited By: Flavio M. Menezes Shool of Eonomis, niversity of ueensland, Brisbane, ueensland, Australia; Phone: Fax: f.menezes@eonomis.uq.edu.au

2 The Contamination Problem in tility egulation # Fernando T. Camaho and Flavio M. Menezes Shool of Eonomis, The niversity of ueensland Otober 007 Abstrat: This aer formally examines the imliations of a utility s diversifiation into an unregulated industry. In our framework, the utility is the most effiient rovider in the unregulated industry (u to a artiular aaity and, as suh, there is no question about the desirability of allowing it to oerate in that market. Nevertheless, the risk faed by a diversified utility is greater than the risk faed by a utility that oerates only in a regulated market. This additional risk an otentially affet the diversified utility s redit rating and, therefore, inrease the ost of aital for the regulated business that will be reovered from rateayers. We show that by allowing a regulated firm to diversify into an unregulated market, the regulator faes a trade-off: a lower ost in the unregulated market versus a higher ost in the regulated market. If the regulator only ares about welfare in the regulated market, then a ring-fening requirement is otimal subjet to imlementation osts not being substantial. Of ourse, the ring-fening requirement effetively revents the firm from ahieving a lower ost in the unregulated market. Therefore, if the regulator ares about welfare in both regulated and unregulated markets, ring-fening may no longer be otimal. JE Classifiation: 5 Key-words: multi-utility regulation; utility diversifiation; ring-fening; risk rating # This aer is art of Fernando Camaho s PhD rojet at The niversity of ueensland, whih investigates the relationshi between regulation and investment. Camaho aknowledges the finanial assistane from The niversity of ueensland and Menezes the suort from the Australian esearh Counil (AC Grants DP and

3 . Introdution The landsae in whih energy and teleommuniations utilities oerate has hanged dramatially over the ast two deades. Monolithi strutures whih were reviously ublily owned have been vertially searated, rivatized or given stritly ommerial, rofit-maximizing mandates. The ororations that have emerged are often diversified and exhibit sohistiated ororate strutures. In artiular, a struture that aears worldwide is that of a holding omany whih has ownershi interests aross a number of ativities where not all those ativities are regulated. Examles are lentiful: K-based Centria oerates in gas and eletriity transmission, in ometitive segments of energy setors as well as in teleommuniations and finanial servies; Frane s Suez-yonnaise des Eaux, Germany s WE and Italy s Enel oerate aross regulated and unregulated markets in energy and other utility setors. There are also a multitude of muniial enterrises in Euroe (e.g. in Italy and Sandinavian ountries whih are loally embedded but offer a wide array of servies both in regulated and unregulated setors. AG is one of Australia's leading integrated energy omanies with interests that inlude retail and merhant energy businesses, ower generation assets and an ustream gas ortfolio. In the nited States, one third of over two hundred existing eletriity retailers suh as Northern States Power and Potoma Eletri and Power Comany also offer teleommuniation servies. oal telehone servie oerators suh as egional Bell Oerating Comanies also rovide unregulated broadband Internet servies. Although in many of the examles above diversifiation resulted in ororate strutures with ownershi interests in more than one utility setor (and otentially subjet to rie regulation aross different setors, the fous of this aer is on diversifiation into unregulated (and otentially unrelated markets. Examles of this tye of diversifiation inlude the leasing by Potoma Eletri Power of Boeing 747s to KM and Singaore Airlines; the aquisition by FP Grou (formerly Florida Power & ight of the insurane omany Colonial Penn Grou; the urhase by Paifi ighting Cor of a hain of drug stores and the aquisition by Pinnale West (the arent omany of Arizona Publi Servie of Merabank, Arizona s largest savings and loan assoiation. For examle; Jandik and Makhija (005.

4 The existing eonomis literature on the diversifiation of regulated firms whih is reviewed in the next setion, fouses on the firm s inentive or ability to transfer osts from the unregulated to the regulated business. The standard onern within the literature highlights the need for inreased regulatory oversight ost diversifiation to revent the regulated business laiming higher regulated ries and ometing unfairly in the unregulated market. This aer, however, examines the roblem of ontamination, whih emerges in its simlest form when a utility that oerates only in a regulated market invests in an unregulated market affeting its own redit rating. In our framework and given that the utility is the most effiient rovider of the unregulated business (u to a artiular aaity, it is desirable that it be allowed to oerate in that market. owever, as the risk faed by a diversified utility is greater than the risk faed by a utility that does not diversify, it is likely that the utility s redit rating will be affeted. Consequently, eteris aribus, the ost of debt for a utility that oerates only in a regulated market is lower than for a diversified utility that oerates in an unregulated market as well. This inreases the ost of aital for the regulated business that will be reovered from rateayers. We show that by allowing a regulated firm to diversify into an unregulated market the regulator faes a trade-off: a lower ost in the unregulated market versus a higher ost in the regulated market. If the regulator only ares about welfare in the regulated market, then a ring-fening requirement is otimal, subjet to imlementation osts being insubstantial. As the ring-fening requirement revents the firm from ahieving a lower ost in the unregulated market, under ertain onditions ring-fening will not be otimal for a regulator that is onerned about welfare in both markets. A distintion from earlier literature is that it is the market that rovides the inentive for firm rosssubsidisation. Cross-subsidisation is not a strategi hoie for the regulated firm. This aer is organised as follows: Setion reviews the existing literature on diversifiation by utilities; Setion 3 disusses some of the institutional features of the interation between the existene of ring-fening, whih aims as isolating risk, and redit rating; Setion 4 introdues the model; Setion 5 investigates when it is soially otimal to ring-fene the regulated business in order to avoid the ontamination roblem, and Setion 6 onludes the aer.. The Existing iterature on Diversifiation There are many exlanations of why regulated firms have been allowed to exand and diversify into unregulated markets. ewis and Saington (989 develo a model in whih earnings in the unregulated market are ositively orrelated with osts in the regulated market. In this setting, the firm's inentive to exaggerate rodution osts in the regulated market is mitigated beause suh 3

5 an exaggeration imlies a laim that artiiation in the unregulated market is more rofitable than it atually is. The regulator's task of ontrolling ost exaggeration in the regulated market an atually be made less burdensome by allowing artiiation in unregulated markets. Given this, a regulator may be able to enhane the level of exeted onsumer surlus in a regulated market by allowing the regulated firm to enter unregulated markets. Palmer (99 investigates the imliations of a firm's deision to diversify into an unregulated market for both a firm's inentive to innovate and for the level of onsumer welfare. The tehnology is assumed to exhibit eonomies of sale in the rodution of the regulated rodut as well as eonomies of soe in the joint rodution of the two roduts when the ost funtion for the regulated rodut has both fixed and variable omonents. Investment in &D redues both omonents through an innovation fator. If the firm seeks to diversify into the rodution of the unregulated rodut, it must obtain the aroval of the regulator who may simultaneously lower the regulated revenue requirement and the regulated rie in this eriod. This is aomlished by shifting the alloation of a fration θ of the fixed ost of roduing the regulated rodut to the unregulated rodut. The regulator hooses a value of θ that reflets his attitudes towards how the benefits of eonomies of soe should be slit between the regulated and unregulated markets. nder this rule, the firm diversifies if θ is below the firm's breakeven level, θ*. The diversified firm hooses a higher level of &D investment and onsumers of the regulated rodut are better off if the regulated firm diversifies beause of the lower average revenue requirement. Over time, the oliy of sharing fixed osts will lead to higher onsumer welfare gains even if the diversified firm's &D investment is biased toward fixed-ost-reduing &D. Palmer s analysis assumes that the regulator is able to distinguish joint and attributable osts and aurately assess, ex ost, the effets of &D investment on the firm's ost funtion. If the regulator is unable to ategorize osts or to observe ost redutions, then the negative effets of ross subsidisation, distorted tehnology hoie (or both, may outweigh any long-run benefits to onsumers from redued osts. Another stream of literature investigates the otential negative onsequenes that result from the ability of the regulated firm to shift osts from the unregulated market to the regulated market. Braeutigam and Panzar (989, for examle, study the inentives for firms to shift osts from ometitive to monooly markets aross two tyes of regulatory oliies: rate-of-return and riea regulation. They onlude that rate-of-return regulation rovides the firm with inentive to misreort ost alloations and in some ases to hoose an ineffiient tehnology, undertake ost- 4

6 reduing innovation in an ineffiient way, under-rodue and rie below ost in the ometitive market. In ontrast, ure rie-a regulation an indue the firm to minimize osts, rodue effiiently in non-ore markets, undertake ost-reduing innovation as an unregulated firm would, and diversify into a non-ore market if and only if diversifiation is effiient. There is then no inentive to misreort ost alloations and hoose an ineffiient tehnology sine ost alloation is not required under this regulatory sheme. Brennan (990 analyses two ross-subsidization tatis osts misalloation and distorted tehnologial hoie under a setrum of regulatory ost alloation oliies. In his model, outut in the regulated market will be redued as higher ries are set by the regulator to fund the ross-subsidy. In the unregulated market, the rie may fall below true marginal rodution ost and effiient rodution by others may be dislaed. Moreover, if ometitors in the unregulated market are large and thus render game theoreti onsiderations as more imortant, the otential for ross-subsidization may enable a regulated firm to maintain a monooly rie in an unregulated market. owever, where there are eonomies of soe, inreasing the regulated firm's share in the unregulated market at the exense of its ometitors may inrease welfare. The marginal ineffiieny from overrodution of the ometitive good by a regulated firm or overutilization of the regulated good by a vertially related firm, may be outweighed by the marginal gain when suh rodution generates eonomies of soe that benefit rateayers. Brennan and Palmer (994 identify onditions under whih gains from eonomies of soe and inreased ometition in unregulated markets tend to outweigh the osts of ross-subsidization. They use a erfet ometition model of the unregulated market to examine trade-offs under eonomies of soe. Effets of inreased ometition are assessed using Cournot models with linear and onstant elastiity demands. They show that diversifiation trade-offs deend on variables that regulators should be able to estimate. For instane, the likelihood of a welfare loss rises as the elastiity of demand, level of ometition in the unregulated market, or the size of the ross-subsidy grows. Brennan and Palmer show that, with no fixed osts, diversifiation is benefiial when it leads to net entry. owever, diversifiation in the resene of fixed osts leads to welfare gains only if the unregulated market is highly onentrated and demand is weakly inelasti. When there are eonomies of soe, ross-subsidized diversifiation is more likely to enhane welfare the larger the eonomies of soe, the smaller the ross-subsidy, or the smaller the firm's elastiity of suly for the unregulated rodut. Diversifiation an redue welfare even without a loss in the regulated market if ross-subsidy indues ineffiient rodution and eonomies of soe are not 5

7 extensive. Eonomies of soe aear to lend more suort for diversifiation than does inreased ometition. More reent literature fouses on the otimal design of regulation to aount for the ossibility of diversifiation into unregulated markets. Saington (003 develos a model where effort an be alloated to regulated and unregulated ativities. In this framework, horizontal diversifiation an rovide imortant benefits for ustomers of the firm s ore regulated servie. In artiular, some of the rofit the firm earns in non-ore markets an be taxed (exliitly or imliitly and delivered to ore ustomers. owever, diversifiation may harm ore ustomers if the roset of signifiant rofit in non-ore markets indues the regulated firm to divert its reative energies from its ore market to non-ore markets. Saington investigates this trade off and onludes that diversifiation would be advantageous for ore ustomers if the effort diversion roblem were not resent and if the regulator were well informed about oerations in non-ore markets (and so able to distinguish between neessary and unneessary exenditures by the regulated firm in these markets. nder these onditions, a regulator who is aable of erfetly monitoring the firm s alloation of ost-reduing effort aross markets would always authorize diversifiation. In ontrast, a ombination of effort diversion and ost adding roblems may lead the regulator to rohibit diversifiation. Moreover, a regulator is more likely to rohibit diversifiation when its knowledge of non-ore markets is limited, when the inremental surlus that the regulated firm is ertain to seure in non-ore markets is small, or when the otential ost variation in the ore market is large (in this ase, the gains from reduing osts in the ore market are large. In addition, the regulator may authorize diversifiation into a given non-ore market when the imat of the firm s ost-reduing effort in the ore market (and thus the otential loss from effort diversion is substantial, but relude diversifiation when the imat is more limited. Whenever the regulator authorizes diversifiation, he admits rofit in the ore market that inreases as realized oerating osts deline. Doing so limits the inentive of the regulated firm to divert effort from its ore oerations to its non-ore oerations. Finally, Calzolari and Sara (007 study the regulation of a utility firm whih, when it jointly oerates in ometitive and unregulated setors, enjoys eonomies of soe. The size of soe eonomies is assumed to be rivate information. These authors show that if soe eonomies are signifiant, onsumers in the two markets may benefit from the effiieny gain of integrated rodution. The lak of information on the art of the regulator and the behaviour of the rival firms 6

8 in the ometitive setor distort the rie in the regulated market and may negatively imat on ometition in the unregulated market. Nevertheless, on balane, the authors show that allowing the utility to oerate in the ometitive market is desirable. While the above literature fouses by and large on the inentives for and onsequenes of ost misalloation between unregulated and regulated markets, this aer fouses instead on the ontamination roblem. In order to understand how ontamination might ome about, it is useful to review the urrent redit agenies raties when rating utilities. This is the subjet of the next Setion. 3. ing-fening and Credit ating ing-fening generally involves tehniques to insulate the redit risk of an issuer from the risks of affiliate issuers within a ororate struture. These tehniques inlude, among others: aital struture requirements; dividend restritions; unregulated investment restritions; rohibitions on utility asset sales; ollateralization requirements; working aital restritions; rohibitions on interomany loans; maintenane of stand-alone bonds and indeendene of board members. 3 The relationshi between ring-fening and redit rating is exliitly onsidered by redit rating agenies. For examle, Moody s rating methodology for regulated eletri utilities omrises assessment of five elements: (i the extent of a regulated omany s exosure to its unregulated businesses the strongest redit risk osition is enjoyed by a omany whose business is wholly regulated and where non-utility ativities are substantial, the main redit driver will be the assessment of these businesses; (ii the redit suort that is gained from oerating within a artiular regulatory framework, inluding ring-fening mehanisms; (iii the exat level of risk osed by the unregulated businesses to the overall redit; (iv six seifi finanial ratios whih are onsidered the most useful when assessing an eletri utility and the adjustments made to alulate these, and (v more generi risk fators that are not seifi to utility omanies, e.g. the adequay of liquidity arrangements and the aetite for aquisitions. 4 Moody s methodology inludes an assessment of the oerations of the unregulated division in order to determine the overall rating of a firm. In artiular, onsideration is given to the extent of regulatory imosed ring-fening restritions on dividends, aital exenditures (CAPEX and See, for examle, Bonelli et al ( See, for examle, egulatory esearh Assoiates (003 and Beah et al ( See Moody s (005. 7

9 investments, searate finanings, searate legal struture and limits on the ability of the regulated entity to suort its arent or affiliate omany. Standard & Poor s rating methodology exliitly states that the ageny would rarely view the default risk of a regulated subsidiary as being substantially different from the redit quality of the onsolidated eonomi entity, whih would fully take into aount the arent omany s obligations. egulated subsidiaries an only be treated as exetions to this rule if there are substantive ring-fening mehanisms. In this ase, the rating of the regulated subsidiary would be more refletive of its stand-alone redit rofile. As a orollary, the arent and affiliates rating is negatively affeted in the resene of ring-fening sine they are derived of full aess to the subsidiary s assets and ash flow. 5 Finally, Fith s rating methodology states that it will generally undertake searate analysis of the resetive robabilities of default when ash flows between a holding omany and its subsidiaries are formally restrited via ring-fening mehanisms. This will result in the assignment of different ratings when the two entities have different stand-alone redit rofiles. Suh ringfening mehanisms an take the form of restrited dividend ovenants or minimum finanial ratios before aying subordinated inter-omany loan obligations. 6 The methodologies of the redit rating agenies disussed above suggest that in the absene of ring-fening mehanisms, the rating of a firm is obtained by the aggregation of the risks faing both the regulated and unregulated divisions. This leads to a regulated division being enalized via a lower redit rating. The rationale for the imortane given to ring-fening mehanisms by the redit agenies methodologies relates to the ossible finanial losses that the regulated utility an suffer as a result of its linkage to the unregulated arent or affiliate omanies. Burns and Murhy (006 oint out that these losses might our when utility assets or revenue streams are used as ollateral for ustream or affiliate loans, or when utility dividends or working aital are moved elsewhere in the holding omany system and are not available to the utility when needed for utility investment to maintain safe, adequate, and reliable servie. In addition, the holding omany struture an lead to utility exenditures that suort tehnologial innovations of unregulated subsidiaries or affiliates within the ororate struture. owever, the ultimate onern is that the finanial viability of the utility business may be 5 See S & P, Standard and Poor ( See Fith (007. 8

10 threatened by losses inurred by the non-utility businesses. For examle, West Pinnale (arent of Arizona Publi Servie was brought lose to bankruty due to the disastrous erformane of its savings and loan subsidiary, Merabank. The FP Grou had to divest its insurane subsidiary, Colonial Penn, beause of the losses it generated. Indeed, based on this exeriene, FP Grou subsequently deided to abandon all diversified ativities. 7 The establishment of ring-fening requirements to avoid this ontamination roblem and assoiated inrease in the ost of aital of the regulated division is urrently an imortant oliy issue in the S with the reeal of the Publi tility olding Comany At of 935 (PCA 935. The entral goal of the suessor statute, the Publi tility olding Comany At of 005 (PCA 005, is to enourage the infusion of aital into the eletri and gas industries by failitating the effiient onsolidation of eletriity and gas omanies. 8 Although PCA 005 rovides the State s Publi tility Commissions (PC and the Federal Energy egulatory Commission (FEC with aess to reords of holding omanies and their affiliates, the reeal of PCA 935 means that the federal regulatory oversight over holding omanies and their affiliates has been redued. owever, some States have already established regulatory frameworks aimed at holding omanies. Burns and Murhy (006 give several examles of State ring-fening strutures. The Oregon Publi tility Commission, for instane, uses a aseby-ase ring-fening aroah whih is imlemented through its merger review roess. Conern about the relationshi among ring-fening, diversifiation and risk is also resent in the regulatory debate in the K. Although liene onditions in the K inlude exliit ring-fening requirements, there is onsiderable variation among setors. For instane, although nearly all water lienes require an investment grade issuer redit rating, only one water omany is revented from engaging in non-ore ativities. In ontrast, all the major network businesses in the energy setor have to retain an investment grade redit rating and are revented from engaging in non-ore ativities. In artiular, in 005, Ofgem inreased the restritions offered by finanial ring-fening by formally adding ash lok-u rovisions to liene onditions of all gas and eletriity distribution businesses and announed its intention to introdue similar onditions in all other gas and eletriity network lienes. This mehanism is triggered when a liensee has the lowest level of redit rating onsistent with investment grade (MIS Baa3, and for S&P and Fithatings BBB- and a redit rating ageny has revised the rating outlook to negative or laed the liensee s 7 See Jandik and Makhija ( See Burns and Murhy (006. 9

11 rating on review for ossible downgrade. With the exetion of highly geared omanies, suh rovisions are not formally inororated into lienes in the water setor. 9 In 00, the Indeendent Cometition and egulatory Commission (ICC reviewed ring-fening requirements for gas and eletriity network servie roviders in the Australian Caital Territory. ICC (00 states that in rinile any business that oerates in a ometitive market whih is assoiated with, or art of, another business that oerates in a related ustream or downstream regulated market should be subjet to ring-fening rules. The rules otentially aly to all businesses that oerate in the market where there is a risk that ometition in the market might be redued as a result of the business relationshis between the entities. The guidelines inlude ring-fening measures suh as legally searating the network and retail arts of their businesses; ensuring that their marketing staff and ertain other oerational staff are not also staff of related businesses; hysially searating the offies of network roviders and related businesses; searating the information systems of network roviders and related businesses; develoing roedures for ost alloation, shared boards of management and omlaints handling, and onduting any business with related (non-retail businesses at arm s length. This Setion strongly suggests that redit rating agenies methodologies reflet a onern with the ossibility of default ontamination between regulated and unregulated businesses. This in turn suggests that the ost of debt of the regulated business might inrease in the absene of ring-fening mehanisms. This onern has been reently iked u by regulatory agenies in the S and in the K. We label this onern the ontamination roblem; the idea that the revenue from the regulated business an be used, for instane, as ollateral for investing in more risky ometitive markets. In this ase, the trade-off is between allowing the firm to diversify and (effiiently invest in ometitive markets and allowing rate ayers to bear some of the risk of this effiient investment. Thus, this aer investigates the onditions under whih it is otimal for the regulator to establish ring-fening requirements in order to avoid the ontamination roblem. 9 See Ofwat and Ofgem (006. 0

12 4. The Model We now examine the simle, but ommon, senario where a holding firm has two subsidiaries. The first subsidiary oerates in a regulated market and will be referred to as the egulated Division. The seond subsidiary oerates in a ometitive market and will be referred to as the nregulated Division. An examle is that of a holding omany involved in an ativity where it faes no ometition (suh as the transmission of eletriity and in an ativity where it faes strong ometition (suh as in the rovision of internet servies. The underlying harateristis of the regulated and unregulated markets follow those seified in Saington (003. The egulated Division is required to satisfy the entire demand at a regulated rie. The demand in the regulated market is assumed to be erfetly inelasti at outut level u to a reserve rie. The unregulated market is haraterized by ometition among firms that rodue a homogenous rodut with onstant returns to sale. With no artiiation by the nregulated Division, ometition in the unregulated market drives the market rie to the marginal ost of the leastost sulier,. The nregulated Division is assumed to be the most effiient roduer in the unregulated market due to, for instane, new tehnology imlementation. Thus, the marginal ost of the nregulated Division is always lower or equal to. For simliity, onsumer demand in the unregulated market is erfetly inelasti (u to a reserve rie, at outut level. The maximum rodution aaity of the nregulated Division in the unregulated market is <. Thus, the rofit-maximizing rie for the nregulated Division is ost of the next most effiient roduer in that market., the marginal There is a rating ageny that is resonsible for setting redit ratings for both the egulated and nregulated Divisions. The ratings are influened by the existene of ring-fening mehanisms searating the oerations of the two divisions. In the resene of a ring-fening mehanism, the rating ageny treats the two divisions as indeendent businesses. The underlying assumtion is that the rating ageny ereives the

13 resene of a onsistent set of ring-fening mehanisms as a fully informative signal that the egulated Division will not be ontaminated (default risk by its affiliate (the nregulated Division or its arent (the olding. A erfetly insulated egulated Division is seen by the rating ageny as a low risk business, with low volatility of revenues. 0 In artiular, in the resene of ringfening mehanisms the ratings of the egulated and nregulated Divisions are given by, resetively, and, where stands for high and for low, with 0 <, where a high redit rating is, of ourse, better than a low rating. In the absene of ring-fening, the analysis that follows assumes that the rating ageny s subjetive evaluation onsiders the existene of a transfer of risk from the nregulated Division to the egulated Division. It is assumed that this transfer of risk is diretly roortional to the nregulated Division s hoie of outut q. In artiular, we ostulate a diret relationshi between q and the redit rating of the two divisions. First, the egulated Division s rating is q that ranges from its highest value when given by a ontinuous, dereasing funtion q 0 to its lowest value. Moreover, the nregulated Division s rating is given by the ontinuous, inreasing funtion ( q highest value (. ranging from its lowest value when q 0 to its The underlying rationale for ( q to derease is that q measures the size of the nregulated Division and, as a onsequene, the extent of the egulated Division s exosure to its unregulated affiliate. The larger q, in the absene of ring-fening, the greater the soe to leverage art of the egulated Division s assets to suort the nregulated Division. Conversely, the underlying rationale for ( q to inrease is due to the same fat that the larger q, in the absene of ring-fening, the greater the soe for the nregulated Division to be suorted by art of the egulated Division s assets. In this sense, in unfavourable senarios the 0 Standard rating methodology inludes the analysis of both quantitative and qualitative asets of the finanial osition of a firm. The former involves the analysis of seifi finanial ratios while the latter inludes the use by the ageny of its exertise on evaluating non-quantifiable fators that might influene the riskiness of firms oerating in artiular setors. The analysis that follows assumes that the quantitative measures that influene eah division s rating have little weight or are neutral (i.e., the urrent finanial and eonomi onditions faed by both divisions are onsidered equivalent and what really matters are the qualitative fators of the rating setting. That is, the subjetive eretion of the rating ageny regarding the overall risk faed by eah business is the only differentiating fator when determining the redit ratings for the two divisions.

14 nregulated Division s obligations ould be offset by using the assets from its regulated affiliate while keeing its own assets safe. It is further assumed that the redit rating funtion affets the marginal ost of eah of the divisions. The underlying rationale is disussed at the end of subsetion 4.. In artiular, we an write the egulated Division s marginal ost funtion as a ontinuous, inreasing funtion (, ( C q C that ranges from its lowest value highest value ( ( C C when q 0 to its C. The nregulated Division s marginal ost funtion is given by a ontinuous, dereasing funtion C (, ( q C ( C C when 0, whih range from its highest value q to its lowest value ( ( C. At a basi intuitive level, the imat of a hange in the redit rating on the marginal ost funtion will deend on the amount of debt that is rolled and/or issued. We now examine this relationshi in more detail. 4. The Cost Funtion The ostulated diret relationshi between q and the redit rating of the two divisions is reresented as follows in the absene of ring-fening:, where > > 0 ( q q q for so that > 0 q ( and ( q q, where > 0 and ( q > 0 for any q ( In the resene of ring-fening, ( q and ( q. It is further assumed that the redit rating funtion affets the marginal ost of eah of the divisions as follows: C ( ( q K r( ( q γd (3 3

15 and C ( ( q W r( ( q δd (4 where K, W > 0, and r is the ost of debt funtion, whih is the same funtion for both divisions and is given by: r (5 Moreover, we let D denote the debt issued or rolled over throughout the eriod by the egulated Division and γ the egulated Division s debt amortization rate during that eriod. denotes the debt issued or rolled over throughout the eriod by the nregulated Division and δ is the nregulated Division s debt amortization rate. D The underlying rationale for the marginal ost funtions above is that firms finane investments and oerating osts with both equity and debt. Moreover, short term debt is ommonly used to finane oerating osts and working aital requirements suh as to exand a urrent faility, inrease rodution and over oerating exenses. In this sense, at least a small art of the firm s debt deends uon urrent rodution and it is then a variable ost. This omonent of the marginal ost is assumed to vary with hanges in the ost of debt following a hange in the redit rating of a division. It is worth noting that the ost of debt funtion has an inverse relation with the rating value. In this sense, an inrease in the rating means that the division s overall risk has dereased and, as a onsequene, the market ost of debt dereases. 5. Soially Otimal ing-fening 4

16 This Setion investigates when it is soially otimal to ring-fene the regulated business in order to avoid the ontamination roblem. While subsetion 5. addresses the ase where the regulator only ares about welfare in the regulated market, subsetion 5. examines the ase where the regulator ares about welfare in both regulated and unregulated markets. 5.. Otimal ing-fening under imited egulator s Objetive Funtion In this subsetion, we onsider a regulator who only ares about the welfare of onsumers and the firm in the regulated market. First, we find the market outomes and the assoiated total welfare in the regulated market in the absene of ring-fening mehanism. In this ase, the regulator solves the following maximization roblem: Max λ ( λ {[ C ( ( ] } (6 subjet to [ C ( ( ] 0. where λ denotes the weight assigned by the regulator to onsumer surlus in the regulated market. Note that due to the unregulated market s struture, the nregulated Division will always rodue at its maximum aaity; that is, q. In addition, the egulated Division rofit onstraint is learly binding and, therefore, the regulated rie is set at marginal ost: ( ( K r( ( γd C. Consequently, the regulator s utility is λ C ( ( ( λ K r γd. 5

17 We now onsider the regulator s roblem in the resene of ring-fening mehanisms whih are ostless to establish. In this ase the regulator solves the following roblem: Max λ ( λ[ { C ] } (7 subjet to [ C ] 0. Again, it is lear that the egulated Division rofit onstraint is binding and that, therefore, the rie in the regulated market equals the egulated Division marginal ost: ( γd C K r, whih now avoids the ontamination roblem. Thus, in the absene of a ring-fening struture, rie in the regulated market inreases by an amount equal to [ C ( ( C ] r ( [ ] r γd. Consequently, the regulator s utility dereases by an amount equal to λ [ C ( ( C ] λ r ( [ ] r γd (8 and substituting equations (, ( and (5 we an rewrite (8 as follows: λ γd ( (9 By definition we know that 0 > so that exression (9 is greater than zero. We have just established the following result: 6

18 7 Proosition : When ring-fening is ostless and the regulator only onsiders the welfare in the regulated market, ring-fening is always desirable. Moreover, from (9 above it is lear that the negative effets of diversifiation on the regulated market welfare are diretly roortional to the initial onditions γ λ,,,, D and. In addition, if the establishment of a ring-fening struture reates an additional ost to the regulator or to the regulated firm ( μ, the regulator should establish a ring-fening mehanism only if D γ λ μ. Setion 6 reviews the existing sant evidene on the osts of establishing ring-fening mehanisms. 5.. Otimal ing-fening under General egulator s Objetive Funtion Now, suose that the regulator s utility funtion inludes the total surlus in the unregulated and regulated markets and assume that ring-fening mehanisms are absent. In this ase, the regulator solves the following roblem: [ ] C C Max λ λ (0 subjet to [ ] 0 C C In the same vein as in subsetion 5., the firm s rofit onstraint binds. Thus, the rie in the regulated market is equal to: C C and

19 8 D r W D r K δ γ and the resulting regulator s utility is equal to D r W D r K δ γ λ If the regulator deides to establish a ring-fening struture, there is no ontamination between the markets. In this ase the regulator has the following maximization roblem: [ ] C C Max λ λ ( subjet to [ ] 0 C C Thus, the rie in the regulated market is: D r W D r K C C δ γ and the resulting regulator s utility is D r W D r K δ γ λ The differene between the utility with and without ring-fening mehanisms is λ, whih an be written as:

20 [ ( ] [ ( ] λ r r γd r r δd λ ( Thus, the regulator would establish a ring-fening struture if and only if exression ( is nonnegative. Moreover, it is easy to see that the term r ( [ r( ] γd [ C ( ( C ] is always ositive and refers to the utility diversifiation imat on the egulated Division marginal ost in the absene of a ring-fening struture. It is the ost of diversifiation, that is, the imat on the regulated market s outome due to an inrease in the default risk (ontamination roess. Furthermore, the term r ( [ r( ] δd [ C ( ( C ] is always negative and refers to the utility s diversifiation imat on the nregulated Division marginal ost. It is the benefit of diversifiation, that is, the imat on the unregulated market s outome due to a redution in the default risk (ontamination roess. In other words, the differene between the ries deends basially on the indiret imat of on the marginal ost funtions and the relative size of the unregulated market diversifiation by the utility firm as measured by. The weight of eah variable is ditated by the initial market onditions. Furthermore, from ( we know that a ring-fening struture is referable for the regulator if ( ( r r ( ( r r σ (3 where δd σ. γd Inequality (3 indiates that ring-fening will be referable if the egulated Division s ost of debt ontamination is larger than the nregulated Division s ost of debt ontamination multilied by σ. Therefore, it is easy to see that for any ost of debt funtion, the higher the σ the less 9

21 desirable it will be for the regulator to romote a ring-fening struture. While an inrease in δ or or D redues the hanes of ring-fening mehanisms being desirable, an inrease in γ, inreases the hanes of a ring-fening struture. D eall that δ is the nregulated Division s debt amortization rate. An inrease in δ means that the nregulated Division will ay a larger roortion of its debt and the imat of diversifiation on the nregulated Division s marginal ost beomes more ronouned and the benefit of diversifiation inreases. Similar reasoning alies to the analysis of the effet of inreasing D, the debt issued or rolled over throughout the eriod by the nregulated Division. Moreover, an inrease in γ, the egulated Division s debt amortization rate, means that the imat of diversifiation on the egulated Division s marginal ost inreases beause the egulated Division will ay a larger roortion of its debt. Therefore, the ost of diversifiation inreases. Again a similar reasoning alies to D, the debt issued or rolled over throughout the eriod by the egulated Division. In addition and not surrisingly, an inrease in inreases the hanes of ring-fening mehanisms being desirable beause the larger the size of the regulated market the larger will be the ost of diversifiation in the ase of default ontamination. Inequality (3 also shows that beause the ost of debt is a funtion of the imat of this arameter on the regulator s deision will deend on the ost of debt funtion. Substituting (5 in (3 we have: ( ( ( ( σ (4 and substituting equations ( and ( in (4 we have: ( σ ( (5 To address the imat of, and to see that inequality (5 defines a region on the desirability of ring-fening mehanisms, it is easy in the lane (, where 0 < and In the Aendix we rovide a formal roof of this statement. 0

22 >. Thus, if inreases due to a hange in an initial ondition, it means that the hanes of ring-fening mehanisms being desirable have inreased. In the Aendix we show that if grows then grows and onsequently the desirability of ring-fening inreases. owever, if inreases then dereases and the desirability of ring-fening mehanisms also dereases. Finally, if initial onditions. inreases then an derease or inrease deending on the other An inrease in means that the derivative of with reset to inreases in module and, as a result, the imat of in the egulated Division s rating funtion beomes more signifiant. On the other hand, an inrease in also means that the imat of in the nregulated Division s rating funtion inreases but in the form of a benefit rather than a ost. This leads the regulator to avoid ring-fening mehanisms. Finally, erhas more surrisingly, we found that an inrease in an inrease or derease the hanes of ring-fening mehanisms being desirable. In fat, while generates benefits to the nregulated Division, it reates osts to the egulated Division. The analysis above is summarized by the following roosition. Proosition : When the regulator s utility funtion inludes the unregulated market as well as the regulated market the desirability of a ring-fening struture will deend on what initial market onditions satisfy inequality (5. The table below summarizes the effets of hanging artiular initial onditions, eteris aribus, on the desirability of ring-fening mehanisms. Inrease in the Initial Condition δ D γ D Effet on the Desirability of ing-fening Mehanisms edution edution Inrease Inrease Inrease edution Inrease edution, Inrease

23 6. DISCSSION This aer onsiders a situation where a firm that oerates in a regulated market diversifies into an unregulated market. This diversifiation is effiient in the sense that the firm is an effiient rovider in the unregulated market. Moreover, the ost of the nregulated Division an be redued; for examle, when the arent firm uses revenue from the regulated business as ollateral to raise funds to finane oeration osts in the unregulated market. We label this henomenon the ontamination roblem. Contamination unambiguously redues the ost of the nregulated Division, but it an affet adversely the ost of the egulated Division. The mehanism through whih ontamination generates adverse effets is the redit rating. ating agenies often examine both quantitative (finanial indiators and qualitative fators. Contamination an affet the redit rating of the egulated Division through an ageny s subjetive eretion of the risk faed by the egulated Division when its future revenues are ommitted in investments in the riskier unregulated market. ing-fening an be seen in this ontext as an effetive isolator of risk. owever, ring-fening also eliminates (or more realistially mitigates any ost redution in the unregulated markets. egulators often have requirements that regulated businesses an diversify into ometitive markets as long as their redit rating is not too adversely affeted (e.g., as long as the regulated division retains an investment grading. owever, regulators also often mandate ring-fening mehanisms of varying degrees of sohistiation. In this sense, the disussion on the introdution of ring-fening seems to fous only on its benefits and does not onsider its (indiret osts. The ontribution of this aer is to show that a regulator that has a wider welfare funtion whih inludes total welfare from both regulated and unregulated markets, will not neessarily imose ring-fening. In artiular, we show how the desirability of ring-fening hanges as the various ost arameters hange. The analysis undertaken in this aer has also abstrated from the otentially signifiant diret osts of imosing ring-fening mehanisms. These osts will vary with the stringeny of ringfening from aounting searation to division searation to strutural break u, whih in our ase amounts to reventing the firm from diversifying into ometitive markets. In this aer, the assumtion of inelasti demand in the ometitive market based on Saington (003 imlies that all ost savings in the ometitive market are atured by the firm. owever, if the demand in the ometitive market were erfetly elasti, then it is not diffiult to see that all the benefits would be atured by onsumers.

24 Although there are no established emirial evaluations of the diret osts imosed by ringfening, reent estimates from the teleommuniations setor suggest that these osts an be substantial. For examle, Crandall and Sidak (00 estimate at $40 million the diret osts of the roosed strutural searation of Verizon s Pennsylvania oerations. British Teleom reorts that it faed a ost of 70 million for setting u its aess servies division BT Oenreah under its voluntary division searation initiative. 3 Although these are estimates from more omlex searation requirements in the teleommuniations setor, they do suggest that imosing ringfening requirements is not ostless. eferenes Beah, A. et al Maryland Commission Staff Analysis of ing-fening Measures for Investor- Owned Eletri and Gas tilities. The NI Journal of Alied egulation 3:. Bonelli, S. et al Cororate Finane, ating inkage Within.S. tility Grous, tilities, olding Comanies and Affiliates. Fith atings: Global Power/North Ameria Seial eort. Braeutigam,.., and J. C. Panzar Diversifiation Inentives nder Prie-Based and Cost-Based egulation. AND Journal of Eonomis 0(3: Brennan, T. J Cross-Subsidization and Cost Misalloation by egulated Monoolists. Journal of egulatory Eonomis : Brennan, T. J., and K. Palmer "Comaring the Costs and Benefits of Diversifiation by egulated Firms." Journal of egulatory Eonomis 6(: Burns,. E., and M. Murhy eeal of the Publi tility olding Comany At of 935: Imliations and Otions for State Commissions The Eletriity Journal 9(8: 3-4. Calzolari, G. and C. Sara "egulating a Multi-tility Firm." CEP Disussion Paers See htt:// eba687ea9#df. 3

25 Crandall,. W., and G. J. Sidak. 00. "Is Strutural Searation of Inumbent oal Exhange Carriers Neessary for Cometition?" Yale Journal on egulation 9(: 335-4, at Fith Fith Criteria eort: Parent and Subsidiary ating inkage. Fith s Aroah to ating Entities Within a Cororate Grou Struture. Geradin, D. 00. "egulatory Issues aised by Network Convergene: The Case of Multi- tilities". Journal of Network Industries : 3-6. ICC - Indeendent Cometition and egulatory Commission. 00. ing Fening Guidelines for Gas and Eletriity Network Servie Oerators in the ACT. ewis, T.., and D. E. M. Saington "An Informational Effet When egulated Firms Enter nregulated Markets," Journal of egulatory Eonomis (: Moody`s Moody s ating Methodology: Global egulated Eletri tilities. NAC - National Assoiation of egulatory tility Commissioners - Staff Subommittee on Aounting and Finane ing Fening Mehanisms for Insulating a tility in a olding Comany System. Preared on behalf of the NAC Staff Subommittee on Aounting and Finane. Available at htt:// Palmer, K. 99. "Diversifiation by egulated Monoolies and Inentives for Cost-eduing &D." Amerian Eonomi eview 8(: egulatory esearh Assoiates ing-fening: A State-By-State Summary. egulatory Fous Seial eort. Ofwat and Ofgem - The Offie of Water Servies and the Offie of Gas and Eletriity Markets Finaning networks: A disussion aer. Jandik T. and A. K., Makhija "Can Diversifiation Create Value? Evidene from the Eletri tility Industry." Finanial Management 34(. Saington, D. E. M "egulating horizontal diversifiation." International Journal of Industrial Organization (3:

26 S&P - Standard & Poor s ating Methodology: Evaluating the Issuer. 5

27 6 Aendix In this Aendix we investigate the effet of hanges in, σ, and on the desirability of ring-fening strutures. From inequality (5 onsider the region in the lane, defined by: : 0 4 σ σ The boundary of is a hyerbola, labelled. : 0 4 σ σ Also, we label C the intersetion of with the first quadrant. Note that the region above C is ontained in. It is easy to verify that the oints of intersetion of C with the axis are (0,0 and,0. eall that < 0 and >. We define the region as > < 0. Clearly this region is bounded by the vertial segment between the oints,0 and,, by an interval of the diagonal and by a iee of the hyerbola C. The urve C an be onsidered as the grah of a funtion that an be differentiated at 0 and. Thus: 0 ' σ (6