(Reprinted from HKCER Letters, Vol.33, July 1995)

 

Competition in Hong Kong's 
Water Heating and Cooking Fuel Industry

W. David Walls

 

Introduction

The Consumer Council recently released a study assessing the degree of competition in the market for fuel used in cookers and water heaters.1 The study concludes with several policy recommendations designed to safeguard the consumer interest. The policy recommendations include making the gas pipeline system a common carrier, subjecting Hong Kong China Gas Co. Ltd. to regulatory control, and creating a regulatory commission to regulate the energy industry as a whole. These policy recommendations could initiate a dramatic restructuring of the water heating and cooking fuel industry. Therefore, the policy recommendations, and the premises on which they are based, should be subjected to a critical evaluation. In this essay, I present an analysis of the market for water heating and cooking fuel. To some degree, the discussion will focus on the arguments and the evidence presented in the Consumer Council's report, since the report makes some compelling arguments that are the basis for the Council's policy recommendations. However, the overall discussion will focus on the broader issue of market organization and economic efficiency.

There are essentially two questions that I will seek to answer in this essay. First: Is there evidence that the current market organization is economically inefficient? This is the question that much of the material in the Consumer Council's report seeks to answer by examining the industry structure as measured by market concentration, firm conduct as revealed in business practices, and firm performance as measured by profitability. If it is found that the market is characterized by a lack of competition, with a single firm exercising market power by restricting output and raising price, then there would be evidence that the current market organization is inefficient. Of course, an absence of evidence supporting the inefficiency of the current market organization does not imply that the current organization would necessarily lead to a competitive outcome. This leads to the second question: How could the market institutions be designed to result in an efficient or competitive outcome through decentralized market exchange? This is by far the more important question, although it is not the focus of the Council's report. In answering this question, I will briefly summarize recent changes in the U.S. gas pipeline industry that provide an example of how a so-called natural monopoly can be organized in a way that leads to a competitive outcome without the inefficiency of traditional regulation.

Current market organization

The Council's report presents much empirical evidence that is used to assess competition in the fuel market. Hong Kong China Gas Co. Ltd. (HKCG) is the main supplier of cooking and water heating fuel, commonly known as towngas. Because HKCG is the dominant supplier of gas and has not been subject to regulatory oversight, much of the analysis in the report focuses on whether or not HKCG has and exercises market power. Because the empirical evidence in the Council's report is likely to influence policy decisions, I will begin by examining and interpreting the most compelling evidence presented in the report. I will examine some qualitative aspects of the current market organization.

Is there evidence of monopoly pricing?

According to standard microeconomic theory, ''A profit-maximizing monopoly firm always chooses a price-quantity solution in the region of elastic demand along the market demand curve.''2 The estimates of the price elasticity of demand reported in the Council's study show that demand is relatively inelastic or unresponsive to a given percentage change in the market price of gas. Thus, the Council's estimates of price elasticity would logically lead to rejection of the hypothesis that HKCG has and exploits monopoly power for seven of the eight years for which the elasticity was calculated.3 This conclusion must be interpreted with some caution, however, since the estimates of price elasticity appear to be very sensitive to the method of estimation. For example, in the report, the elasticity is calculated using only household gas consumption as the measure of quantity. But since we are interested in estimating the elasticity of the market demand curve for towngas, the appropriate quantity measure is total market consumption, inclusive of commercial and industrial sales. Using the price and total market consumption data contained in Table A1 of the Council's report, I estimated the price elasticity and found it to be equal to -3.16.4 This estimate lies in the region of elastic demand and would be consistent with HKCG having monopoly power, as opposed to the Council's findings that would clearly reject the monopoly hypothesis. I must emphasize that while my estimate of the elasticity is consistent with HKCG having monopoly power, it does not prove this. In other words, my elasticity estimate would also be consistent with HKCG facing a high degree of competitive pressure.

As an alternative to the price elasticity test, one might examine the profitability of HKCG to determine how much competitive pressure it faces. It is intuitive, at first glance, to think that a firm with monopoly power would be highly profitable, with profit measured by, say, the return on sales or the return on assets. HKCG has been quite profitable by these metrics, and this led the Council to conclude that the high profitability resulted, at least partially, from a lack of competition: ''The lack of true competition provides impetus for HKCG's superior performance in growth and profitability'' (p.40). This would seem to be compelling evidence that HKCG has and exploits monopoly power; however, economic analysis is sometimes less transparent than it would appear at first glance. The fact is that, in general, high rates of profitability can imply neither monopoly nor monopoly profits, and the myth that they could was laid to rest a number of years ago in two well-known journal articles.5 The primary reason that the profitability measures can not be used to infer monopoly is that they are based on accounting concepts rather than on economic concepts. Thus, the profitability measures are of no use in the present analysis since inferences about the competitive pressure faced by a firm can not be made from them.

Another possible way to quantify the competitiveness of the market would be to look at how prices vary in response to changes in the marginal cost of selling an additional unit of gas. It is natural to think that reductions in production cost will be reflected in lower prices to a greater extent as the market becomes more competitive. In fact, a given reduction in marginal cost would reduce the market price twice as much under perfect competition as compared to the case of perfect monopoly. Conceptually, this comparative static result is quite clear. Unfortunately, this type of comparison can only be made in a thought experiment. In practice, we can typically only compare the reductions in price with the reductions in cost in the same market at different points in time, and this is the type of price/cost comparison made in the Council's report. In this context, the effect of a reduction in marginal cost on the market price depends on the elasticities of demand and supply. In general the price reduction will be less than the cost reduction, even in the textbook model of perfect competition.6 Thus, price/cost comparisons of the type made in the Council's report cannot be used to assess competitiveness within the water heating and cooking fuel market.

In summary, the empirical evidence does not provide serious support for the Consumer Council's maintained hypothesis that Hong Kong China Gas has and exploits monopoly power.

Consumer preferences and technology

To a large extent, consumers are captive customers of their gas supplier. This is the result of technical factors combined with the current market organization. For example, once a building is constructed, it is not practical to switch between suppliers for the central gas system. Thus, by design, consumers would have virtually no ability to substitute gas provided by alternative suppliers in place of their current gas supply, except to the extent that customers could withdraw from the central gas system completely and procure their own gas in portable cylinders from an independent source.

Electricity would appear to be a good alternative fuel for cooking and water heating. Electric instantaneous water heaters can be installed in flats equipped with three-phase electrical fixtures, or storage-type water heaters--the type commonly used in the U.S.--can be installed for use with a standard electricity supply. Electric cookers can also be used in existing flats without modification of the standard electricity supply. On purely technical grounds, competition between gas and electricity would be determined by the cost of obtaining the relevant appliances and retrofitting a flat with a three-phase electricity supply if an instantaneous water heater is demanded.

Although electricity is a feasible alternative to gas as a source of energy, consumers may not view alternative fuels in simple terms of dollars per unit of thermal energy. Instead, consumers may have a pure preference for one particular type of thermal energy in much the same way that some consumers may prefer vanilla ice cream over chocolate ice cream even though they contain the same energy content. The preference for gas is evidenced by the following statement in the Council's study: "'Flame cooking' is a critical ingredient in the preparation of the Chinese meal and is crucial to the daily life of Chinese consumers" (pp.13-4). An alternative way of stating this pure preference is in terms of willingness to pay: Consumers would be willing to pay more for a unit of gas than they would be willing to pay for a unit of electricity with the same amount of thermal energy. To the extent that consumers do have a pure preference for gas, any apparent lack of substitutability between gas and electricity is likely to represent the consumer's freedom of choice. After all, if consumers prefer gas and are willing to pay for it, why would anyone expect it not to be supplied in a free market?

Alternative market organization

Regulation of an indivisible production facility, such as a gas pipeline, often assumes that the entire capacity of the facility is under the control of a single owner. However, this is clearly not the only possible form of organization. In fact, it is often an inefficient way to organize an industry. It would be instructive to examine how an alternative organization of the gas industry could alter the market for water heating and cooking fuel. As an example, I will discuss the recent reorganization of the natural gas industry in the U.S.

Unbundling gas from transmission in the U.S.

In the United States, the interstate natural gas pipeline industry has evolved a new form over the last fifteen years. Gas pipelines were previously merchant carriers that owned the gas they transported and sold to downstream customers, much like the gas sellers in Hong Kong do today. However, the structure of the U.S. natural gas industry changed dramatically when the federal regulator permitted pipelines to become contract carriers (not common carriers).8 As a contract carrier, the pipeline was allowed to sell pure transportation to its customers. Natural gas became separated or unbundled from its transmission, and markets emerged in both gas and transportation. The formal separation of gas from transmission that was institutionalized in contract carriage evolved a new organizational form for the pipeline firm that would lead to an efficient allocation of gas. Before pipelines were allowed to become contract carriers, regulators had organized the industry as separate monopoly pipelines, and this regulatory policy had suppressed markets for more than forty years.

Under relaxed regulation, the industry participants created the institutions required to support market exchange in both gas and transportation. Gas markets began to function much like markets for any other commodity where the customer buys the good and arranges for its shipment. In the case of gas, there is no intrinsic reason that the pipeline should be constrained to own the gas it transports. There is little possibility for a moral hazard problem due to improper care while under shipment. Furthermore, units of natural gas are nearly homogeneous, so it does not matter that the molecules injected into the pipeline by the gas seller are not the same molecules withdrawn by the gas buyer.

The changes in the U.S. gas industry's organization were not designed by the regulators and imposed upon the industry. Quite to the contrary, the evolving market in natural gas and transmission created competition where regulation had previously institutionalized monopoly. Gas pipeline merchants voluntarily became contract carriers and began to supply an increasing proportion of their customers with pure transportation service. After a series of regulatory actions in the early 1980s, the regulators authorized markets and competition to be the forces that determine the price and allocation of natural gas. More recently, the federal regulators have required all interstate pipelines to stop selling natural gas completely and to become pure transporters.

Pipeline deregulation in the U.S. is still incomplete, but it does provide an example of how an alternative form of market organization, namely contract carriage, can unleash competitive forces. Under complete deregulation, transportation would become a property right. The pipeline would then become the supplier of transportation rights, and the holders of those rights would supply transportation. The holders of the rights would allocate supply through the market, as with any other property right. Under this form of organization, property rights in transport capacity would decentralize the control of a pipeline's output while centralizing its production.

One of the Consumer Council's recommendations aims to promote a related form of organization in Hong Kong's gas market by imposing common carrier status on gas pipeline firms. This would be a mistake. While contract carriage does formally distinguish gas from its transmission, it also obligates the carrier to observe special duties that other businesses do not, such as the duty to serve all at a reasonable rate. This form of pipeline organization creates monopoly by centralizing control of the pipeline's output in the hands of the common carrier. Worse yet is that the monopoly so created may be used to rationalize economic regulation as necessary to protect the public interest.

Monopoly and the role of regulation

The role of regulation should be to assure that an efficient economic outcome is achieved rather than using a particular problem created by a given set of circumstances as a rationale to expand governmental control. The danger with regulation is that, once allowed to start, those who regulate may expand their power in an effort to impose their own superior wisdom on others; this often results in the regulated firms facing perverse incentives that cause large inefficiencies. To prevent regulation from following this path, we should seek out organizational forms that lead to an efficient outcome without regulatory management of the industry.

Consider how a transportation right could be used to create an organizational form that avoids the natural monopoly problem altogether while still addressing the technological problem of concentrating the transportation of gas within a single pipeline. If transmission can be provided at less cost on one pipeline than on several, this does not imply that the entire transmission capacity must be controlled by a single firm. The pipeline is indivisible, but its capacity can be divided among several owners by creating a property right in transportation. Separate units of capacity can be individually owned, and the owners of transport capacity can hire a manager to coordinate the use of their individual rights. Under such an arrangement, the scale economies of a single pipeline are realized even though the control of output is decentralized. Regulation^___and the natural monopoly problem^__is predicated on the assumption that coordination and allocation are centralized under one authority, the pipeline. By decentralizing the ownership of capacity, the monopoly problem is eliminated because transport rights holders compete with one another to supply transportation to the market. Under a system of tradeable property rights, it is competition that regulates the price and allocation of output.

In contrast to a system that decentralizes supply while coordinating production, traditional regulation tends to create monopolies under the guise of serving the public interest. Furthermore, regulatory commissions often restrict entry, making customers captive to the regulated monopoly firm, and at the same time, they reward the firm when it operates inefficiently by granting an arbitrary return applied to the firm's asset base. The productive inefficiency induced by regulation causes the price of the firm's output to increase, relative to the case of no regulation, but customers are captive because the regulator has blocked the entry of competitors. There are various economic theories of regulation, but as applied to industry, they all tend to predict that deregulation enhances economic efficiency. This has been the major force behind the regulatory reform of the last fifteen years in the U.S. and in the U.K. The effects of relaxed regulation are even more telling: In the U.S., deregulation in the transportation, telecommunications, and energy industries is estimated to have resulted in a net gain to society of 36-46 billion U.S. dollars, which amounts to a 7-9 percent improvement in the part of national output accounted for by those industries.9 Furthermore, it is estimated that consumers were the primary beneficiaries of this economic deregulation.

Conclusions

The empirical evidence presented in the Consumer Council's report does not indicate inefficiency in the organization of the water heating and cooking fuel market. However, the existing market structure would not preclude an incumbent firm from exercising some degree of market power in the future due to the costs that must be incurred by a consumer in switching from one fuel to another. An alternative market organization, such as one in which pipeline transportation becomes a tradeable property right, would create competition by decentralizing supply while at the same time allowing coordination in production. Since such an organization leads to a competitive outcome by design, it obviates the need for traditional regulation.

The Consumer Council has made several policy recommendations, including the imposition of common carrier status on the existing gas distribution network, regulatory control of the gas industry, and the formation of a commission to regulate the energy sector. Establishing a market in pipeline transportation would dramatically alter the gas market, because it would allow alternative gas suppliers to access the customers who are currently captive. However, this transport market will only yield significant benefits if transportation is defined as a fully tradeable property right. Creating a property right in transportation, rather than saddling pipelines with the obligations of common carriage, would also obviate the need for the proposed regulatory controls. This would also ensure that Hong Kong's gas consumers would not become hostage to the potentially significant costs of regulation.

NOTES

1. Consumer Council, ''Assessing Competition in the Domestic Water Heating and Cooking Fuel Market,'' 1995.

2. Jack Hirshleifer and Amihai Glazer, Price Theory and Applications, (New Jersey: Prentice Hall, 1992): 213. Emphasis added.

3. In the report, the low price elasticity was erroneously interpreted as evidence supporting the monopoly power hypothesis.

4. My elasticity estimate is the estimated slope parameter in a log-linear regression of total towngas consumption on its real price.

5. Franklin Fisher, ''On the Misuse of the Profit-Sales Ratio to Infer Monopoly Power,'' Rand Journal of Economics, (Autumn 1987): 384-96; Franklin Fisher and John McGowan, ''On the Misuse of Accounting Rates of Return to Infer Monopoly Profits,'' American Economic Review, (March 1983): 82-97.

6. This would be true with any downward sloping demand curve and any upward sloping supply curve.

7. Much of this section is based on Arthur S. DeVany and W. David Walls, ''Natural Gas Industry Transformation, Competitive Institutions and the Role of Regulation: Lessons from Open Access in US Natural Gas Markets,'' Energy Policy, (September 1994): 755-763.

8. Contract carriers transport, under specific agreement, commodities that belong to their customers. Common carriers offer to serve the general public indiscriminately. See Stuart Daggett, Principles of Inland Transportation, (Berkeley: University of California Press, Berkeley, fifth edition, 1955).

9. See Clifford Winston, ''Economic Deregulation: Days of Reckoning for Microeconomists,'' Journal of Economic Literature, (September 1993): 1263-1289.

Dr. W. David Walls is a lecturer in Economics in the School of Economics and Finance at The University of Hong Kong. A reply by the Consumer Council appears in the HKCER Letters, No. 34, September 1995.

 

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