A Look Upstream: Market Restructuring, Risk, Procurement Contracts and Efficiency
Corrado Di Maria (University of East Anglia), Ian Lange, and Emiliya Lazarova (University of East Anglia)
Attempts to liberalize previously regulated natural monopolies such as telecommunications, rail and air transportation, water provision, and energy generation and distribution have been commonplace in OECD countries since at least the late 1970s. Most analyses of these policies, however, have taken a rather narrow view of the issues and discussed the consequences of the policy exclusively from the point of view of firms operating directly in the deregulated market.
Such analyses, while informative, provide at best a partial picture of the overall consequences of deregulation, as they neglect its impacts on the supply chain upstream from the deregulated market. This omission is certainly relevant as the aim of the policy is to eliminate all types of inefficiencies and transfer the associated benefits to the final consumers. It is also likely to be significant in situations where input costs represent a significant share of the total costs of production, such as electricity production.
In this paper we take a first step into investigating the consequences of deregulation upwards along the supply chain. We analyze how deregulation impacts the fuel procurement contracts signed between electricity generators and coal mines. The interaction between the parties in terms of the type of price setting mechanism (fixed price, cost-plus, etc) and the duration of the contract, focusing on the changes in the degree of risk faced by generators following the shift from cost-of-service regulation to competition. The key insight is that one would expect to observe more rigid (e.g., fixed-price), shorter contracts in restructured markets as a consequence of risk-sharing attempts. Using data on actual contracts signed by U.S. coal-fired generators with coal mines, over the period 1990-2001, we find empirical support for this hypothesis.
This result has some large implications. On the one hand, contracts with more rigid pricing mechanism de facto provide the coal mine with strong incentives for efficiency gains as they would be able to keep the cost savings as profits (relative to a cost-plus contract which would see the sales price fall if the mine became more efficienct). We use data on coal mines' labor productivity, and conclude that more rigid pricing mechanisms in contracts are indeed associated with productivity gains. On the other hand, shorter and more rigid contracts are theoretically more prone to being renegotiated. Our final empirical effort confirms that the changes in contracting practices we identify imply more frequent renegotiations, which might lead to an increase in transaction costs.