Applying economics in the so-called ‘real world’

Applying economics in the so-called ‘real world’

Equilibrium 2014
January 5, 2014

This article was featured as part of ESSA’s annual Equilibrium publication.

Had anyone told me when I set out on my career in economics that one day I would become an ‘economic regulator’, I would have been somewhat bemused by the apparent tautology. The description, however, is somewhat misleading. In reality, the Essential Services Commission is the State government’s leading applied economics unit. Every day we are applying economics to unravel problems and identify and implement solutions. We are motivated by the pursuit of outcomes that are not only effective but also promote economic efficiency (according to all its definitions).  Here are three ‘live’ examples of the economic problems we are seeking to resolve.

Water: Who should pay for the desalination plant?

The Victorian desalination plant was commissioned formally last December, meaning that Melburnians must begin paying for the plant. To be clear, this payment is not for the plant’s water. We will pay for that separately if water is ordered. Rather, the payment is in the form of an availability charge. Customers are paying the operator about $650 million per year just to have the plant sitting there ready to produce water at short notice.

But herein is an intriguing economic problem. The contract with the desalination plant runs for 27 years with the availability charge steadily increasing from $650 million to about $800 million per year. At the end of 27 years, the plant is handed to Melbourne Water and its operating life then continues for at least another 23 years. So who should pay for the plant and how much?  Should customers over the next 27 years fully pay-off the plant and then ‘gift’ the asset to future generations; or should all customers over the plant’s entire 50 year life contribute according to the benefit they receive?  And if so, what is that benefit?  After all, it is not water because we will pay for that separately.

Energy: Just how competitive is competition?

You may have heard various commentators observing that Victoria has an extremely competitive energy retail market because we have more providers offering more energy plans than anywhere else in Australia. You may have heard that we have the highest rates in the world of customers switching between retailers—suggesting that Victorians have real choice in their provider. But one thing has puzzled me for some time: Are these really the defining features of a competitive market?

We recently undertook some modelling to assess the state of electricity retail margins, that is, the extent to which retail prices exceed retailers’ input costs.  Of course, assumptions were made and caveats applied. Nonetheless, we found that retail margins appear to have increased steadily over the last few years. Will the market eventually self-correct and dissipate any excess margins? Or has the market settled into an equilibrium which enables economic rents to be extracted from customers? If so, how ought an economic regulator to respond?

Taxis: Fare reform. The next frontier

In June, the Victorian Parliament passed legislation promoting wide-ranging reform in the local taxi industry. This follows a public inquiry headed by Professor Allan Fels. During that inquiry, I presented a paper suggesting that ‘taxis are a service, not an industry’.  This somewhat innocuous looking statement has profound implications. It completely reverses the usual onus. It places the customer, not the industry, at the rightful centre of the policy challenge. (In contrast, think about this last statement in the context of the ongoing debate about car industry assistance.)  An industry will only prosper by virtue of satisfying customer preferences; by delivering ‘value’ to customers. The taxi reforms implemented in Victoria seek to create a more customer-focussed, innovative and dynamic industry.

Our task in the months ahead will be to determine a fare structure that supports these outcomes. This presents a most fascinating challenge, after all: What is the service being provided and what is its ‘value’ to customers? Are taxis a singular or multi-product market? Is demand undifferentiated or segmented? Is there a single market clearing price or should the fare structure be dynamic?