Markets in everything - internalizing expenses due to misconduct as the cost of doing business

Since the disastrous oil spill from its Deepwater Horizon oil rig in April 2010, British Petroleum (BP) has apparently spent nearly $30 bn in clean up costs, civil damage claims, and restitution to businesses and residents along the Gulf of Mexico. The incident, which involved a spillage of 200 million gallons of oil, resulted in the death of 11 workers and a massive environmental disaster. However, despite the huge price tag of the oil spill, $30 bn and climbing, BP's commercials appear unaffected. It collected more than $375 billion in 2011, pocketing $26 billion in profits.

While criminal prosecution charges were framed against the executives of BP and its contractors, nobody has been prosecuted till date for these damages. This has important moral hazard implications. Though BP has been involved in similar safety failures earlier, when they paid huge fines, they have moved on without addressing the underlying safety related issues. In fact, as Times writes, "without personal accountability, the fines become just another cost of doing business".

Much the same story can be said about the several cases of financial market irregularities, bordering on criminal misconduct, that played a major role in blowing the sub-prime mortgage securitization bubble. Several financial institutions, including its leading lights, have been found guilty of practices that involved making money by betting against their own clients. These firms peddled unsuspecting clients securities that they themselves were betting against (say, shorting). They made money from fees as well as being the counterparty in the trade.

In most of these cases, the financial institutions have settled the malpractice suits and even the criminal prosecution by making huge compensation and fine payments. However, not one top executive has been convicted on criminal misconduct. Most of these institutions have weathered the worst of the sub-prime meltdown, paid their fines, and are back to making profits by indulging in the same practices. They have come to see the fines as another "cost of doing the business".

In his best selling book, Predictably Irrational, Dan Ariely has written about the changed behaviour of parents when a kindergarten moved from a regime of mandatory pick-up as soon as school closes to a regime that charged for additional hour spent beyond the school hours. They found that in the former regime parents generally came to pick-up their children within time, whereas parents preferred to pay and pick up their children at their convenience. He argued that in the first regime, social norms kept parents from tardiness in pick-ups. However, in the second regime, introduction of a penalty increased tardiness. A fine becomes the price (pdf here) of the violation or deviation. The same motivations lie beneath the moral hazard described in the first two examples.

Such trends are not confined to high-finance and business, but pervasive in modern-day lives. Old-fashioned virtues of equality (of people standing in a que to access a service) have given way to opportunity-cost driven conventions (rich people pay to access the service out of turn). The implications of this gradual shift have been far-reaching and is surely a major contributor to the widespread widening of inequality across societies. It is obvious that there is a slippery slope associated with these trends. Traditional mores slowly get replaced with market-based morality, with all its attendant consequences.

In this context, Michael Sandel's new book, What Money Can't Buy: The Moral Limits of Markets, provides an excellent perspective on how pricing human behaviour and responses runs the risk of crowding out other values. Jonathan Last has an excellent review of the book, where he writes,

Today you can purchase your way out of waiting in line for rides at many amusement parks. There are express lanes that allow us to buy our way out of traffic. Many schools now "incentivize" performance, paying students if they read books or do well in school; some schools now sell ads on children's report cards. Cities routinely sell advertising space on public property, ranging from parks and municipal buildings to police cars. In each of these cases, long-held ideas about inherent worth and common ownership have been displaced by the simple morality of the market. 

He quotes Sandel's assessment of market driven morality,

Markets don't only allocate goods, they also express and promote certain attitudes toward the goods being exchanged... When we decide that certain goods may be bought and sold, we decide, at least implicitly, that it is appropriate to treat them as commodities. 

Prof Sandel raises questions about the effect of such marketization on democracy itself,  

At a time of rising inequality, the marketization of everything means that people of affluence and people of modest means lead increasingly separate lives. We live and work and shop and play in different places. Our children go to different schools. You might call it the skyboxification of American life. It's not good for democracy, nor is it a satisfying way to live. Democracy does not require perfect equality, but it does require that citizens share in a common life. What matters is that people of different backgrounds and social positions encounter one another, and bump up against one another, in the course of everyday life. For this is how we learn to negotiate and abide our differences, and how we come to care for the common good.

The issues raised by Prof Sandel have enromous significance for our society today. If the creeping influence of markets and its touchstone of utility maximization crowds-out individual values and social norms, then we are not far from an age where man would move from being a "social" to a "monetary" animal. Its aggregate consequences would be far from benign.

Votes would be bought and sold, criminals would purchase their way out of jails, college seats would be auctioned off, policy decisions would be purchased based on donations made to parliamentarians and ministers, and so on. Further, it would be no longer anathema to let the poor suffer or even die for lack of access to medical care, or keep lowering taxes on the rich, or provide tax concessions to businesses while loathing welfare subsidies to the indigent, and so on. 

The parking problem in malls

How fair is it to charge shoppers a fee to merely enter the shop? If there is a premium experience attached to shopping there and a demand for that experience, it is appropriate to impose an entry fee. In its absence, it may not be economically viable for the shop to charge an entry fee as a commercial revenue stream. So how is it that large shopping malls in many Indian cities collect parking charges from their customers vehicles?

I can think of two possible reasons.

1. From the demand-side, the consumers/shoppers may value the mere experience of shopping in these malls and therefore may be willing to put up with having to pay the parking charge as an entry fee. The mall operators ride on this demand and capture it in the form of parking charges.

2. From the supply-side, the parking charges, which are often exorbitantantly high in cities like Hyderabad, have become a significant revenue stream for the Mall operators. In fact, the returns (by way of sales and profits thereon) from the premium outlets may be comparable to the parking charges collected from the visitors to the same outlets.

Does this "free-market determined pricing model" lead to economic efficiency all round? As could have been expected, the free-market price determination process inevitable results in the fragmentation of the different activities into separate revenue streams with their respective distortionary effects.

1. The shop-owners/franchises get away by socializing a major negative externality. They do not pay the price for the negative externality created by their customer's vehicle parking. Since this is not internalized into their costs, the shop-owner pays a smaller rent than would have been the case if all externalities were internalized. It distorts their incentives. They offer numerous promotional and other offers to attract more customers without having to bother about its social costs.

In fact, the shops make free money here. Since all these mall shops are outlets peddling branded products, their sale prices are fixed, irrespective of whether the parking charges are internalized or not. In the circumstances, by having palmed off the responsibility of arranging parking facility to the mall operator, the franchisee would see a mall space as being more profitable that having his own exclusive separate shop, where he would have to himself arrange for separate parking.

2. Instead of viewing parking as an accompaniment service to be bundled with shops, the mall operator sees the parking charges as another full-fledged commercial service from which they seek to make more money. Given the large volume of shoppers, they view it as a revenue stream with considerable commercial potential. In fact, many mall operators outsource this to another service vendor, with a contract aimed at maximizing their returns. This parking operator would naturally be left with no option but to increase the parking fees and maximize his revenues.

3. As both the aforementioned points convey, in the absence of its internalization, the price of the negative externality is now completely borne by the customer. Admittedly, the shopper has to pay the cost of the convenience of using a car for his shopping. But it is only fair that he shares it with the shop from where he makes the purchases.

This again raises the issue of whether free-markets always lead to the most efficient outcomes. A more efficient system would be one where it is regulated that parking in all malls should be free and the mall operator should collect the cost of maintaining the parking facility from the individual shops. There are several ways to apportion the parking costs on the shops. Even if some reasonable charge is collected, it could be reimbursed to the customer on production of the shopping bill. Interestingly, some shops do this, but not others. This will also help the operator gather data on which shop is the largest source of parking externality.

For sure, such regulations may create their own distortions. But I am inclined to believe that its distortions are likely to be far less inefficient than that created by the current free-market price determination model.

Cost of medical care - pricing failure

The Wonkblog has an excellent interactive graphic that captures the average cost of different types of surgical procedures. Two things stand out. One, United States is a consistent outlier in the high cost of treatment. Two, India stands at the other extreme, offering the cheapest procedures.



Conventional wisdom would have it that the higher cost of medical care in the US is because Americans use more health care services, see doctors more frequently and stay in hospitals longer. However, as Ezra Klein highlights by pointing to this 2003 paper by Uwe Reinhardt and Co, the reality opposite on all these counts. The real reason for the higher cost of medical care in the US, as the graphic makes amply clear, is due to higher prices.

The higher prices in the US health care market is yet another illustration of the failure of price signals in ensuring economic and allocative efficiency. In the United States, outside of the government run Medicaid and Medicare, prices are negotiated in a free-market between insurers and service providers. As Uwe Reinhardt has shown here and here, providers largely charge what they can get away with, often offering different prices to different insurers, and an even higher price to the uninsured.



Prof Reinhardt writes,

On average, the prices for health care goods and services negotiated by private health insurers in the United States tend to higher — about double or more — than prices for identical services and goods in other countries of the Organization of Economic Cooperation and Development. It is in good part so because insurers do not seem to have sufficient market power, especially vis à vis hospitals, to resist very rapid price increases.The varying degrees of market power among private insurers in the United States have led to pervasive price discrimination among payers, with prices for identical goods or services varying among payers by factors as high as 10.

In contrast, health care prices in the other countries is regulated, with the result that prices are considerably lower. Ezra Klein writes,

Other countries negotiate very aggressively with the providers and set rates that are much lower than we do... They do this in one of two ways. In countries such as Canada and Britain, prices are set by the government. In others, such as Germany and Japan, they’re set by providers and insurers sitting in a room and coming to an agreement, with the government stepping in to set prices if they fail.

I have blogged earlier highlighting the market failure problems associated with purchasing and pricing health insurance service.

The benefits of congestion pricing illustrated

Excellent videos from Streetsblog on congestion pricing...



... and its fairness.



Usage and vehicle-type based road tolling for trucks in Germany...



Would be great to have such videos for other social and civic issues!

Negative tariffs for electricity!

During howling winter weather two years ago, the thousands of windmills dotting Denmark and its coastline generated so much power that Danes had to pay other countries to take the surplus. The incident was the first of its kind, and lasted only a few hours... Since then, there have been just two more instances in which the price of wind power in Denmark turned negative for a significant period of time because of excess wind.

This draws attention to the problems posed by the intermittancy and volatility of wind power and the need to effectively manage it. Apart from required complementary physical infrastructure, it also requires technologies that can store electricity. With an ambitious off-shore wind power generation plan, Denmark hopes to generate half its power from wind within eight years, up from less than a quarter currently. In this context, it is estimated that the supply of electricity might exceed demand for about 1,000 hours each year by 2020 unless there are substantial changes in the way electricity is managed in Denmark.

Among the technologies and practices being tried out to store wind power include pumping water uphill to reservoirs and releasing them to generate hydro-power later; extracting hydrogen from water through electrolysis and then using it to run fuel cells or synthesize gas to provide power when wind was unavailable; different types of batteries; and storing them in the batteries of electric vehicles.

Hastening grid-parity or solar bubble?

A little late on this. The tariff quotes received in the second round of bids, concluded in first week of last December, for setting up solar projects under India's National Solar Mission (NSM) appears to indicate that solar energy prices will converge with conventional thermal power tariffs much sooner than expected. Or does it?

The lowest bid, in a reverse auction bid process, was for Rs 7.49 per unit, which is 50% lower than the benchmark tariff of Rs 15.39/unit fixed by the Central Electricity Regulatory Commission (CERC) and about 27% lower than winning bids in the first round of NSM auctions. The highest successful bid was only Rs 9.44/KWh and the average price for the winning bids for a total of 350 MW came to Rs 8.78/KWh (16.5 cents). Rajasthan was the preferred location for most bidders, with 295 MW out of the 350 MW located there. Germany, the world’s biggest solar-power user, pays about 17.94 euro cents (23 American cents) per KWh.

The projects are in the range of 5-20 MW capacity. The lower prices are attributed to the steep decline in prices of solar modules, which make up 50-65% of the total project cost. The successful bidders have to complete their projects in 13 months, failing which they face forefeit of large bank guarantees besides other steep fines.



In the first phase of the NSM, a total of 28 Solar PV developers aggregating upto 150 MW and 8 Solar Thermal Developers aggregating upto 500 MW were selected based on maximum discount offered on CERC determined tariffs. The feed-in-tariff determined by CERC was Rs 17.91 for PV and Rs 15.31 for solar thermal. The cut off discounts were 515 paise and 297 paise for Solar PV and Thermal projects respectively.

The NTPC Vidut Vyapar Nigam (NVVN) is the nodal purchaser of solar power under the Mission. It then sells to distribution utilities who have to meet their mandated renewables target. In order to incentivize indigenous production facilities, the NSM mandates the use of only indigenous crystalline silicon solar panels and solar cells. The NSM was launched in 2010 and has an ambitious 20,000 MW target by 2022.

Official estimates on grid cost parity for Solar is around 2020. However, at this rate, it may happen much faster. KPMG's excellent recent report on the prospects of solar power in India foresaw rapid declines in prices of solar PV panels and forecast grid-parity by 2017-19. However, if the recent solar bids are any indication, even its best case scenarios may be outstripped and the grid-parity could occur much earlier.



Some estimates point to a more aggressive convergence. The latest bid rates lend credence to this view.



Since industrial and commercial retail tariffs are already in the 700 paisa range for many consumer categories like commercial, solar roof-top is viable even today.

But amidst the euphoria, there may be a need for closer examination. Is there are winner's case associated with these extraordinarily low bids? It not only goes completely against conventional wisdom in the industry circles, even with the sharply declining panel prices, but there are also signs of irrational exuberance associated with bubbles. The quoted prices are far lower than anything anywhere in the world. There are stories that the bids from even the first round of auctions are commercially unviable.

Many generators have questioned the wisdom of these successful bidders and claim that the projects are commercially unviable at these rates. It cannot be a coincidence that most of the larger solar players remained away from these bids. Another concern is the fact that out of the 30 short-listed bidders, almost 20 have had nothing to do with solar photo voltaic (PV) power. These are normally prima facie indications of bubbles.

In this context, lessons from the first phase may be instructive. However, the project commissioning prospects for projects approved under the first phase of the Mission wherein 28 projects of 5 MW each were awarded late in 2010 and due for completion by January 9, 2012, appears not very encouraging. Atleast 12/28 projects are certain to miss the deadline and incur penalties.

In this context, India's solar industry and policy makers would do well to pay heed to the cautionary tale from Spain, once the unrivalled European solar market. In 2007 the government announced a solar policy that guaranteed fixed electricity rates of up to 44 euro cents per KWh to all new solar panel projects plugged into the electrical grid by September 2008. In 2008, backed by generous feed-in-tariff (FIT) subsidies, there was a flood of investments and Spain accounted for more than 40% of the world's total solar PV installations. In just 2008, the country committed itself to solar FIT payments estimated at $26.4 billion.

Against a modest target of 400 MW, some 3000 MW of solar capacity were installed in Spain within 18 months. Then the bubble burst on the face of over-capacity and fiscal strains. The entire industry was devastated. Its faulty regulations have become a watchword for how government renewable-energy programs, poorly conceived, can go awry.

On the positive side, there are two features of the solar policy that is laudable and stands in contrast to the governance failures that characterize such policies. One, instead of plunging big time into solar generation, the government is right in testing the waters with such small calibrated auctions. It will help the government learn about the market and help design effective policies when the implementation is done on scale.

Second, the transparency associated with auctions is in stark contrast to the opacity that has been the source of numerous corruption scandals that have rocked the country in recent years. In fact, this has ensured that the government does not face the problems created by the overly generous FIT subsidies of Spain and other European countries. But this is also a reminder to those advocates of mindless auctions that the most effective allocation process is market-specific and is not always open-ended auctions.

Update 1 (20/2/2012)

Government of India has encashed the bank guarantee worth nearly Rs 2 Cr each on 14 project developers for failing to meet the commissioning deadline (January 9,2012) under the first batch of phase I of the JNNSM. After this, the developers are given two months' time to finish the project, and if they still don't, this would entail further loss of bank guarantee — thereafter, three months time is provided with penalties to complete the project, failing which the project would stand removed from the Mission. The total extension in this manner is up to six months beyond the scheduled date.

Under the first batch, 35 new projects were expected to generate 610 MW of solar power (140 MW of photovoltaic and 470 MW thermal) and grid connectivity was expected by January 2012.

The pricing problem with subsidies

I have an op-ed in Mint today which examines the implications of tinkering with prices and how subsidies can be delivered without distorting price signals.

NREGS and mechanisation

Interference with price signals has been the bane of public policy in India. The latest example is the labour market distortions caused by wage guarantee schemes. Business Standard highlights the sharp increases in famr labour wages between January 2007 and April 2011. It is estimated that farm wages have risen by an average of 70% across the country in the past four years due to the success of the National Rural Employment Guarantee Scheme (NREGS) which has been in operation in all Indian districts since 2007.



One happy consequence of scarce and costly manual labour has been the pace of farm mechanisation, as manifested in increased use of tractors, combine harvesters, small tillers, de-weeders and small power-driven sprayers.



The BS article writes about the factors driving increasing mechanisation,

"Such high wages not only squeeze farmers’ margins, but also crimp availability of labour. Factors like MNREGA and the prevalent socio-economic conditions lead to a 30-40 per cent shortage in manpower, which, in turn, leads to escalating costs year after year... the overall harvesting cost of sugarcane in Tamil Nadu has risen from Rs 300 a tonne to Rs 500-600 over recent years. And, that it touches Rs 700 a tonne during peak harvest... a pair of bullocks cost Rs 50,000 and feeding these requires another Rs 5,000 per month. Though used only for a month, they need to be fed for the entire year... bullocks are a hugely expensive proposition in Indian farming."

Purchasing and pricing health insurance

As health insurance assumes centerstage in health policy debates in India, it is critical that we make informed decisions on the two critical factors in any health insurance model - purchase and pricing of medical care services.

In this debate there are two issues - how care is purchased and how much is paid for that service. There are two conventional approaches to purchasing medical services. Insurers can pay the service providers a specific amount for each discrete service (fee-per-service model) or make bundled payment for all of the care a patient needs over the course of a defined clinical episode.

The former is the prevailing purchase model across countries and has its set of inefficiencies. The biggest problem with this approach is that it becomes difficult to manage the incentive of doctors and hospitals to prescribe more diagnostics and treatments than is required. Insurers manage this problem by increasing the effectiveness of their pre-authorization and/or with conditions like prohibiting payments for certain basic tests. In contrast, the later approach effectively addresses this incentive problem. However, it fails with implementation problems.

Regarding the pricing of these services, different insurers can either individually negotiate with the service providers and arrive at their different price schedules or they could collectively bargain and fix standardized prices for all insurers. The US health insurance market is a classic example of such price differentiated market and its inefficiencies are well documented. Government-run health insurance systems undertake collective bargaining and fix standardized prices for each service.

Uwe Reinhardt summarizes the merits and demerits of both approaches and advocates the All-payer model,

"In developed nations that rely on multiple, competing health insurers — for example, Switzerland and Germany — the prices for health care services and products are subject to uniform price schedules that are either set by government or negotiated on a regional basis between associations of health insurers and associations of providers of health care. In the United States, some states — notably Maryland — have used such all-payer systems for hospitals only. Elsewhere in the United States, prices are negotiated between individual payers and providers. This situation has resulted in an opaque system in which payers with market power force weaker payers to cover disproportionate shares of providers’ fixed costs—a phenomenon sometimes termed cost shifting—or providers simply succeed in charging higher prices when they can. In this article I propose that this price-discriminatory system be replaced over time by an all-payer system as a means to better control costs and ensure equitable payment."

In particular, Prof Reinhardt points to the successful example of Maryland, which has historically deviated from other states in the US and has had an all-payer model of health services pricing. Maryland’s rate-setting system is widely believed to be one of the most enduring and successful cost containment programs in the United States. In his excellent paper, Prof Reinhardt finds evidence of price differentiation efficiencies at many levels. Private insurers pay much more for all services than public insurers, who use their larger bargaining power to lower prices.



For the same service, the variations in service fee are large in case of hospitals as against other treatment centers. There is an obvious high premium extracted by certain hospitals. The variations in payments across hospitals for the same service can be substantial.





The effectiveness of India's health insurance market will depend on it being able to get both the health service purchase and pricing model right. It is fortunate that being a nascent health insurance market, governments are not constrained by any legacy models. Since governments will be able to provide adequate health insurance to only a small proportion of the population, it is important that private health insurers too are able to keep their costs low and sell policies at affordable prices. Public policy should play a catalytic role in facilitating this.

The purchase model is more complex and not easily amenable to policy fixes. However, governments should encourage private insurers to adopt a purchase model that bundles services and makes payment for treatment of the medical condition. It is possible for governments to get health service providers as far away from the fee-per-service model of charging insurers. While it may be easier for large specialty hospitals to accept this, this model may end up excluding smaller diagnostic centers and clinics. Encouragingly, India's nascent health insurance model is, for various reasons, moving more towards the bundled purchase model than the fee-per-service model.

In case of pricing though, there is a more direct role for governments in assisting insurers arrive at standardized prices for services in all hospitals within a particular area. The model of all-payer price fixing, as is done in many continental European countries, would reduce the administrative and other transaction costs, and help keep insurance premiums at affordable levels.

In some ways, there is a free lunch here. Governments, both state and center, have an increasing leverage over private health service providers due to various newly announced state and central health insurance schemes. This strength should be used to bargain out standardized rates for services by participating hospitals within a geographical area. The private insurers could differentiate by offering variants of the basic service with top up prices.

Unfortunately, failure in this front is already evident in public health insurance. As I have blogged earlier, one of the critical failings with the Aarogyasri program was its inefficient price-fixing model. Other state governments, eager to embrace the wild populism inherent in Aarogyasri, may end up making the same mistakes.

Update 1 (3/3/2012)

Two excellent posts by Uwe Reinhardt on payment and pricing health insurance. The first dwells on the relative merits of the three purchasing models - fee for service, medical condition-based bundled payments, and capitation fee model. The second examines the three price determination models between the insurers and the insured and insurers and health care providers (doctors, clinics, hospitals etc) - free market negotiations, price-setting in quasi-markets (all payer system where the associations of health insurers within a region would negotiate with corresponding associations of hospitals, doctors etc uniform fee schedules that then would apply to all payers and providers in that region), and administrative price fixing by the government.

See also this paper by Prof Reinhardt on pricing in US hospital services.

Price controls are back?

The Andhra Pradesh government has announced its decision to set up a price monitoring committee to control inflationary pressures.

Taking serious note of the rise in the prices of essential commodities, Mr. Kiran Kumar Reddy announced plans to form a price monitoring committee to tackle the situation. The new mechanism will not only deal with people involved in hoarding and black-marketing of produce with an iron hand, but also play a key role in fixing prices.

"Fixing prices"? Hmm!!

Power sector reforms - farm power and tariff revision

The Business Standard reports that the Union Power Ministry have advised State Governments to transfer the massive losses, estimated at Rs 1.06 lakh Cr at end of 2009-10, off the balance sheets of state distribution utilities. It has also advised that states take action to ensure no further cash losses.



If the bailouts or restructurings happen, it will be the second time in almost a decade that state distribution utilities have received such help. At the turn of the century, as part of the first flush of reforms in electricity sector across the country, many state electricity boards were bailed with a Rs 41,400 Cr package. State governments assumed the debts and issued long-term bonds.

Like with the earlier bailout, the present need for bailout appears to have been triggered by similar reasons - the near inevitability of widespread defaults to central generating utilities by state and private sector distribution utilities. This is a clear sign that very little appears to have changed with the sector except in processes and formalities.

In fact, for all the structural reforms that have been enacted in the sector over the past decade, central and state governments have refrained from addressing the twin-elephants in the room - limiting free power for agriculture and regular increases in power tariffs. Unbundling, private sector participation in generation, liberalization of regulatory restrictions in transmission and distribution, and operational improvements like loss reduction, can only get you to the starting line.

Any earnest and meaningful effort to reform the sector has to place farm sector reforms and periodic tariff revision at its center. There is nothing secret nor mysterious about this. Any trading enterprise can survive only if its cost of purchase and service delivery matches its price of delivery. In simple terms, the power procurement cost plus the transmission and distribution cost have to match the aggregate tariffs.

In fact, its importance for the long term health of the sector itself cannot be over-emphasized. The problems faced by privatized distribution utilities in Delhi, who too have massive pending dues with generators, is a reflection of the magnitude of the problems. If the present trends are allowed to continue, it will adversely affect the prospects of private sector generation too. Unlike state generation utilities, private generators will not be able to manage their operations without regular payments on their power sales.

In many respects, the current sorry state of affairs is a serious indictment of the state and central power sector regulators. It is also a classic case of how easily important reforms can be subverted and given lip-service in implementation. It also drives attention to the important issue of tariff revision and the need for public conditioning to accept such revisions.

1. The Electricity Act 2003 and the various state regulatory acts clearly mandates that utilities should not bear state subsidies and state governments should transfer upfront (and not reimburse) the subsidy amounts to utilities for all subsidies being implemented by them. The regulators are supposed to safeguard the interests of the regulated utilities through the annual tariff revision filings. They are mandated to fix tariffs in a manner that reflects utilities' cost of power procurement, a reasonable level of operational efficiency improvements (read loss reduction), and required capital and operational expenditures.

But regulators across states have made a mockery of this, accommodating the interests of their paymasters, the state governments, at the expense of the utilities they were statutorily mandated to protect. Tariff filings in most states have been reduced to a charade, an academic exercise, and most often unprofessional at that, that has no relevance to realities in the field. Regulators, barring a few occasions, have failed to exercise their due powers and force states to bite the bullet on tariff and farm power related issues.

2. The policies of state governments since the reforms were initiated is a classic example of how easy it is to subvert well-intentioned and critical reforms. States have not raised tariffs on domestic consumers for many years now. Assuming inflation and the general increase in cost of procurement, the real subsidy has increased massively. Free power to farmers has remained a holy cow. Even the issue of mere metering of agriculture services raises unbelievable amount of passions.

Even with the latest crisis facing utilities, and despite being fiscally constrained, state governments are unlikely to take any meaningful steps to address this issue on a sustainable basis. It will require commitment at the highest levels to stand even a reasonable chance with pushing through such reforms.

3. Despite nearly two decades of liberalization, the one area where public debate, both in the political realm and in popular media, has remained entrapped in the mindset of the bygone era is that relating to cost-recovery and tariff revision. We cannot shy away for too long from the inevitable fact that consumers have to pay the full cost of any service consumed by them.

Public and political opinion needs to be conditioned into accepting the reality that there are no free lunches. Apparent free lunches are unsustainable and cause serious indigestion down the line. Reforms are not just cheap talk. For any meaningful reforms in sectors like utility and municipal services, important structural reforms have to complement with cost-recovery in service delivery. In simple terms, the culture of free or subsidized delivery has to end. At best, cost-recovery can be ensured in the aggregate through some form of cross-subsidization.

There can be a silver-lining to the crisis. If utilities are to be bailed out, it is a great opportunity for all stakeholders - regulators, state and central governments - come together and agree on some minimum steps with reforming farm power and tariff revision. This blog has always talked about scalable and practical steps in public policy reforms. However, the time may have come to stretch the definition of practicability given the serious magnitude of crisis facing power sector in India. I can think of three such minimal set of steps

1. All agriculture services should be metered. Leave alone bringing in efficiency and accountability in farm power consumption, this is an absolute essential requirement for many upstream reforms. For example, current estimates of distribution losses are badly flawed in the absence of any reliable estimate of agriculture consumption. It is common practice for utilities and regulators to use this as a sinkhole to doctor various operational efficiency and tariff figures that suit their respective agendas.

2. There is scope of considerable reforms with the terms of free farm power supply. To start with, free power supply should be restricted to only certain types of farmers, with the restriction being confined to easily enforceable or detectable parameters or proxy parameters. As I have blogged earlier, governments should move over to a system of fixed monthly units for agriculture consumption, to be reimbursed into the farmers accounts when they pay their monthly farm and domestic supply bills. Its benefits are manifold and the availability of Aadhaar, atleast in certain areas, makes the logistics simpler.

3. Periodic tariff revision, for all categories of consumers, must be made mandatory. In fact, even a simple, rule of thumb increase based on inflation or some other fixed parameter, will be one of the biggest boost for the sector. Just as was done to encourage unbundling of state utilities in the first generation of reforms, state governments should be directed to enter into MoUs or agreements with their utilities or mandate rules that define the terms for periodic tariff revisions. A mandatory and automatic requirement to periodically revise tariffs, agreed between all states and the centre can overcome, atleast partially, the political and collective action problems that accompany such hard reforms.

Efficiency trends in power trading market

I have blogged earlier about the anachronism in continuing the non-transparent OTC trade-based sytem of power sales when there were two functional power exchanges in the country.

The OTC trader-based system does not facilitate efficient price discovery, despite regulatory provisions on the profits that can be made, since the transactions takes place in private with little public disclosure of details. It is all the more unexceptionable given the with limited depth and breadth in the exchanges. Banning all OTC trades and bringing them into the fold of the exchanges would multiply its liquidity and optimize price discovery efficiency of the exchanges.

Currently, the two operational power exchanges in India, IEX and PXI, offer day-ahead and week-ahead contracts. The bilateral OTC trading term ahead contracts vary from hours to many years. Such traded power (less than an year contracts), including the unscheduled interchanges (UI), form about 10% of the power generated in the country.

A test of the logic behind this assumption is the trends in market share distribution between the OTC and exchange markets. If the exchanges were more transparent and efficient, it was natural to expect them to increase their market share at the expense of the traders. And, recent trends point to exactly this happening. The Businessline reports that cheap prices in the exchanges are driving consumers - industrial and distribution utilities - away from traders. It writes,

"In 2010-11, the value of deals on the PXs surged to Rs 5,389 crore, a 51 per cent growth (or Rs 1,826 crore in absolute terms) over the deal values clocked the previous fiscal. Volumes more than doubled on the bourses. Correspondingly, the bilateral trader market, or short-term deals executed through a power trader, was down by almost Rs 800 crore during the year even as volumes remained flat. One of the key reasons for the PXs gaining favour over the traders is the lower electricity prices discovered on the two operational bourses — IEX and PXIL.

At Rs 3.47/unit, the average price on the PXs was a good Rs 1.30 lower than the corresponding price of Rs 4.79/unit for deals involving traders in 2010-11. As a result, the gap between the volumes for deals involving traders and those transacted on the PXs has narrowed sharply last fiscal... Thanks to the surge in business on the bourses, cumulative deal value surged to Rs 18,657 crore in 2010-11."

One way to compare the relative efficiencies of the two markets is to compare their prices. The graphic below of prices in June 2011 reveals that even in case of contracts with duration less than a week, which are also offered in the exchanges, the prices were lower in the exchanges (even with the daily average) than with traders.



The differential in prices (between the exchanges and OTC traders) with contracts that are greater than a week too are disproportionately higher. The case for banning OTC trades could not have been more convincing.

Update 1 (11/9/2011)

In the corruption filled environment, it was only natural before skeletons came out from the cupboard of OTC trades executed by state utilities. Businessline reports that the Uttar Pradesh Power Corporation (UPPCL) signed a one-year deal with a private power generator in Gujarat, routed through a private power trader in the western State, to buy some 600 MW at around Rs 4.70 a unit. The price is well above the average of less than Rs 3 a unit on the power exchanges over the last two months.

In fact, the average electricity price discovered on the two operational bourses — IEX and PXIL – was Rs 3.47 a unit, well below the corresponding price of Rs 4.79 a unit for deals involving traders in 2010-11.

Parking charges across cities

Urban Demographics, via MR, points to an international survey on car parking rates by Colliers International. The results of monthly parking rates presented in the chart below, shows how cheap parking rates are in Indian cities.



(Please click on the figure to enlarge)

This blog has argued repeatedly about the importance of parking charges in addressing urban traffic challenges. Also see an earlier post on parking charges here.

The solar power convergence

One of the most talked about points in power sector is when the cost of solar power converges with conventional carbon power. At current pricing levels, solar photo-voltaic generators still cannot compete with thermal and other traditional generators. However, the dramatic reduction in solar panel prices in recent years has ensured that the convergence is not far away.

The graphic below shows that PV panel manufacturing costs have come down, from $60 a watt in the mid-1970's to $1.50 today, declining about 18% for every doubling of production. People often point to a "Moore's Law" in solar - meaning that for every cumulative doubling of manufacturing capacity, costs fall 20%.



A staggering ramp-up in installations around the world have driven an even greater increase in solar manufacturing. Underlining the speed with which solar panels can be manufactured and installed, in 2010, 17 GW of capacity was manufactured, shipped and installed, the equivalent of 17 nuclear plants in one year! GTM Research predicts we'll have 50 gigawatts of module global production capacity by end-2011.



The commercial convergence is more likely to happen earlier with distributed solar generation in rural and remote areas for lighting, agriculture pump sets etc. Even in cities, technologies other than flat-panel PVs, like concentrating parabolic troughs and multiple reflecting mirrors offer great potential to both generate electricity and heat for boiling water in large single-point installations like hotels, hospitals, airports etc.

Stephen Lacey has excellent pricing curves of solar with respect to peaking natural gas, nuclear, and thermal. He shows that solar PV panels will become competitive against even new coal plants in the next 6-8 years.

Winner's curse and market failures in resource allotments

One of the most controversial areas of public policy in recent years has been that involving allotment of public resources to private interests. As the role of the private participation in the economy expands, many hitherto public assets - land, mines, telecom spectrum, municipal infrastructure, etc - are increasingly being operated by private participants.

In light of the numerous resource allocation scandals in recent months, a debate has been generated about what is the most effective strategy to allot public resources. Though competitive allocation of resources appear to be the best strategy for such allotments, there are very valid enough reasons to be sceptical. Critics point to the need for governments to be flexible and retain discretion in such allotments in the larger public interest. Let us examine both sides and see how the balance sheet squares up.

Conventional wisdom would have it that competitive markets always result in efficient allocation of scarce resources. However, real world experience reveals that competition also has the potential to generate market failures that create inefficient outcomes. In particular, all sides in the bargain are vulnerable to the winner's curse - over-paying for your purchases. This happens irrespective of whether the allotments are done in a transparent and competitive manner or by discretionary allotments. So what is the most efficient method to allot public resources to private interests?

The most famous recent example of winner's curse is the 3G spectrum auctions in Europe at the turn of the century. Telecom operators who bid fantastic sums to claim 3G licenses soon realized the folly of their excessive commitments. It had a devastating impact on their balance sheets and adversely affected the sector itself. Subsequently, the subject has generated considerable research and analysis and many prescriptions have been offered on efficient auction designs (see Paul Klemperer here).

However, nothing seems to have been learnt from the European debacle by both policy makers and the industry itself. Though it is a little early to tell, there is enough evidence to suggest that most of the telecom operators in India over-bid during last year's 3G spectrum auctions. The poor latest quarterly results of these operators are an indicator of the strains imposed by their excessive bids.

All these represent classic market failures. It is astonishing that professionally competent managers who run these telecom operators could not have learnt the bitter lessons from the European auctions. Equally baffling is the failure of financial institutions that supported the respective bidders to exercise the required due diligence that would have exposed the risks inherent in such irrationally exuberant bidding. Policy makers too should take the blame for failing to take into account the inevitability of winner's curse in such auctions and their inability to design the auction so as to mitigate these risks.

However, one of the critical, albeit less-discussed, reasons for such exuberance in bidding could be attributed to the moral hazard arising from the increasing trend of contract re-negotiations. The number of recent precedents of governments permitting such re-negotiations on very specious and flimsy grounds, after the completion of a competitive price discovery process, has considerably eroded the sanctity of contracts. Bidders realize this and rationalize that they could bid on the higher side and mitigate any risk of winner's curse by lobbying to re-negotiate away the unpalatable terms and conditions. And when all bidders play the game on the same assumptions, then winner's curse becomes superfluous.

There is another side to the debate. Economies in transition, especially in a closely integrated world, face an interesting dilemma. On the one hand, they have to compete with others to attract investments and engender business confidence. This competition exists among nations and within them between regions. Governments therefore have to accommodate the requirements of this competitive environment and tailor policies that encourage investors. This often demands discretion-based decisions that appear to favor or provide preferential treatment to certain private groups or firms.

Consider this. A state government faces stiff competition from other states to provide additional incentives to lure say, an IT company, to prefer the state over competitors to set up its new development center. Apart from standard infrastructure sops (like assured quality of power, good connectivity etc), such incentives typically include fiscal concessions, exclusive infrastructure, and additional land. Over the past few years, states have wooed such investors with huge land allotments, far in excess of the specific investment requirements.

Arriving at the right type and degree of incentives is at best of times a very difficult exercise. There is a fundamental information asymmetry in this process. The private firm has clear information of what are the respective offers of individual states and can make its decision based on them. However, the state governments work in an environment of information asymmetry. Unaware of the promises and intentions of their competitors, a state government is forced into marking up its offer on the higher side so as to pre-empt its competitors. The private firm is fully aware of this game and contributes more than its fair share to exacerbating the information asymmetry and trying to bargain the best possible deal from its interlocutor states. The net result is that the successful government invariably ends up with a winner's curse by offering excessive concessions.

Since the environment in which these decisions have to be taken is bedevilled with information asymmetry, it is no surprise that preferential offers made to attract individual investments are mostly controversial and involve some form of corruption.

More worryingly, this challenge has to be managed by public institutions and a civil society that are rarely strong enough to exercise the vigilance required for ensuring fairness in such decisions. Most often, the public institutions are captured by the private firm and the terms of the bargain severely compromised against public interest.

The civil society and its opinion makers mistake the trees for the woods by falling prey to the attraction of a public media trial of a few scapegoats. The public debate gets circumscribed and rarely tries to address the problem with systemic solutions.

Given the prevalance of winner's curse with both strategies, how do we address the problem of public resource allotments? In an ideal world, the benevolent and wise ruler would negotiate with the best interests of his citizens at heart and commit just enough concessions to tip the investment in their favor. But as discussed, the real world is rife with information asymmetry, moral hazard, and winner's curse. Besides there are real-people (read officials and politicians) prone to colluding with unscrupulous investors and a public who are either powerless or distracted by media trials and the lure of instant justice.

Allotments of public resources by way of both competitive bidding and discretionary approaches face the problem of winner's curse. In the former, the private firms end up over-paying and ultimately ending up defaulting or atleast compromising on its commitments. In case of the latter, public resources get allotted on the cheap to private interests.

So the issue boils down to which approach is likely to work best, given these circumstances? Alternatively, which risk - winner's curse for bidders or governments - is less difficult to mitigate? Here, I am inclined to hold that ensuring transparency in the process of allotments of public resources on a discretionary mode, even through empowered committees of eminent people (who are the eminent people and how honest are they), is an almost impossible task in most developing countries, including India. Institutional mechanisms to minimize corruption is difficult to implement for a variety of reasons.

However, markets are versatile enough to mitigate the adverse consequences of winner's curse. After all, the fundamental ideological issue here is over whether the individual wisdom and knowledge of government (and a few of its officials) is superior to the collective wisdom of the market in both ensuring most efficient price discovery and in mitigating the effects of possible incentive distortions like winner's curse. This debate has been settled for some time now.

However, if markets are to determine the allotment process, it is important to structure its institutional design details by taking into account the specific issues related to the sector and lessons from failures across the world. Besides trying to resolve any winner's curse, the design should also address the other sector-specific problems that come in the way of success with such allotments. This not only ensures transparency and efficiency, it can also mitigate the consequences of the market failures that result from various incentive distortions.

The price volatility problem with cash transfers

I have blogged earlier that price volatility, especially with food grains, is the most difficult challenge with cash transfers. One of the strategies to overcome this is to provide a large enough subsidy, inclusive of a volatility buffer, so that even if price increases, the buffer will cover for the increase. The nutrient-based subsidy (NBS) for non-urea fertilizers under implementation since April 2010 uses this strategy to cover for price volatility.

It is therefore instructive to examine the experience with NBS in fertilizers. Under this model, fertilizers are sold to farmers at its decontrolled MRP (minus the subsidy) and the subsidy amount paid separately to the fertilizer companies. The nutrient-wise fertilizer subsidy is fixed once a year, based on its market and import prices, and with a reasonable buffer to cushion the producers against price fluctuations over the year.

What has been the progress report with this subsidy regime in operation for more than a year now? A recent report in Businessline highlights the sharp volatility in the prices of fertilizers, as reflected in the manner in which the subsidy fixed for 2011-12 (operational from April 1, 2011) was sharply revised between November 2010 (when it was originally fixed) and March 2011 (when the subsidy amount was frozen). It now appears that even this may have to be revised.

Recent imports of DAP have been for $612 per tonne (or Rs 27,540 per tonne), which with duties, freight and other charges will retail at about Rs 30,735 per tonne. Against this, the MRP of DAP is currently at Rs 10,750 a tonne and the NBS payable from April 1, 2011 is Rs 18,474 (fixed assuming a landed import price of $580 a tonne), thereby grossing the company Rs 29,224 for every tonne of DAP. This deficit of more than Rs 1500 a tonne or Rs 75 a bag will either have to be covered through an increase in subsidy or passed on to the farmer.

Given important state elections coming up, it is almost inevitable that despite the original decision to fix the subsidy once a year, the subsidy rates will be revised again. Similarly, even on MoP, where global suppliers are apparently pushing for a landed price of $420 a tonne (which is more than the current reference rate of $390 a tonne), a subsidy revision looks certain.

Further, there is also the problem of market expectations that get formed by the subsidy price announcements. Since India is one of the largest fertilizer importers, its procurement decisions and prices signals get embedded into the global market prices. Though the subsidy rates announced includes a volatility buffer, the market prices naturally get anchored at the upper end. As the Businessline report says,

"For 2010-11, the Centre had fixed the NBS rates on nitrogen (N), phosphorus (P), potash (K) and sulphur (S) with reference to corresponding import prices of $310 a tonne on urea, $ 500 on DAP, $370 on muriate of potash (MoP) and 190 a tonne on sulphur. For 2011-12, the Centre – in a bid to talk down world prices – initially, on November 19, pegged these reference prices lower at $280, $450, $350 and $125 a tonne. But with global prices showing no signs of easing, the Centre, on March 9, announced new NBS rates for 2011-12 based on higher landed prices of $350 for urea, $580 for DAP, $390 for MoP and $180 for sulphur."

The Businessline report also quotes industry sources who claim that the government's decision to tinker with the DAP reference price has contributed to the steep increase in its import price in recent months. Also, the NBS regime has had no effect on lowering the subsidy burden. In fact, subsidy burden is also projected to go up by Rs 30,000 Cr to Rs 82, 245 Cr, up from the budgeted provision of Rs 52,837 Cr for 2010-11.

The experience of fertilizer highlights the difficulty of managing price volatility and also ensuring access to fertilizers (or food grains) at affordable prices. The much greater price volatility and political sensitivity associated with food grains means that any buffer will have to be much larger. Far from lowering it, the food subsidy outgo will therefore increase.

Admittedly, with fertilizers, given the reasonably integrated national market, it may be possible to calibrate subsidy to a price index. However, this approach cannot work with food grains whose prices vary so widely across the country at any point in time, that it is impossible to capture it in one index with any reasonable degree of reliability. So what is the way forward? More food for thought!

Beating inflation by downsizing packages!

As input costs rise and inflationary pressures take hold, in order to keep sale prices unchanged, consumer products businesses have sought to subtly reduce quantities in their standard packages. The high unemployment rates and weak demand in the US means that businesses cannot afford to pass on price increases to consumers. A NYT article writes,

"As an expected increase in the cost of raw materials looms for late summer, consumers are beginning to encounter shrinking food packages... companies in recent months have tried to camouflage price increases by selling their products in tiny and tinier packages. So far, the changes are most visible at the grocery store, where shoppers are paying the same amount, but getting less...

In every economic downturn in the last few decades, companies have reduced the size of some products, disguising price increases and avoiding comparisons on same-size packages, before and after an increase. Each time, the marketing campaigns are coy; this time, the smaller versions are 'greener' (packages good for the environment) or more 'portable' (little carry bags for the takeout lifestyle) or 'healthier' (fewer calories)."

The size of the packages, atleast the width and height, are kept the same. Or marketers design a new shape and size altogether, complicating any effort to comparison shop. Businesses seek to capitalize on the fact that consumers are generally more sensitive to changes in prices than to changes in quantity. In any case, a very small number of shoppers take the trouble of reading quantity labels on packages while making their purchases.

See this fascinating advertisement (via Economix) by Blue Bell Ice Creams that it has not been trying to reduce the size of its packets!

Electricity prices and elections

Summer time which coincides with elections is a sure-shot recipe for spot power prices in our power exchanges going over the roof. Two upward demand pressures on electricity consumption are at work - the seasonal cycle associated with higher consumption in summers and the pressure on governments facing elections to cut back on load reliefs.

This trend is playing out now, with Assembly elections due in many states. Businessline reports of day-ahead spot prices in the southern region zooming to over Rs 12 a unit in the last couple of days, over four times the price quotes for the rest of the country on the IEX — the country's largest power exchange (handles 80% of transactions). It writes,

"A key reason for spot electricity prices shooting through the roof in South India is the mad scramble among utilities in the region to arrange power to ensure zero power cuts before the polls in States such as Tamil Nadu, Kerala and Puducherry. Lack of adequate grid interconnection between the southern region and the rest of the country has compounded the problem."

The concern here is about the regulators staying away even in the face of such price volatility. There has been ample evidence of spot market prices inching upwards in anticipation of polls from January.



Being a regulated industry, it is natural that regulators step in whenever required to protect the interests of all stakeholders. It is therefore unfortunate that, depsite clear indications of surging prices and resultant profiteering at the expense of consumers, the regulators have stayed away.

It is all the more surprising since the the Central Electricity Regulatory Commission (CERC) had intervened to regulate prices before the Maharashtra Assembly elections in September-October 2009. The CERC invoked the proviso to Section 62 (1) (a)read with Section 66 of the Electricity Act of 2003 and imposed price ceiling on the purchase of electricity through bi-lateral agreements and power exchanges. In order to curb profiteering opportunities in response to a sudden surge in demand, the CERC announced a price band of 10 paise per unit to Rs 8 per unit to cover all inter-state day-ahead trades for a period of 45 days.

The argument that better grid inter-connectivity of the eastern region with the northern and western regions is responsible for the absence of similar price spikes in the NEW grid is a straw man. Neither Assam nor West Bengal are in the market making purchases similar in magnitude to Tamil Nadu. West Bengal is amongst those with the lowest deficits. In any case, as the example with Maharashtra in 2009 shows, when the bigger states enter the market, the demand pressures show up and forces prices upwards.