is the gas supply market a natural monopoly? econometric evidence from the british gas regions

Ž .Energy Economics 20 1998 223]232

Is the gas supply market a natural monopoly?Econometric evidence from the British Gas regions

Philip Burnsa,U , Thomas G. Weyman-Jonesb

aLondon Economics, 66 Chiltern Street, London W1M 1PR, UKbProfessor of Economics, Department of Economics, Loughborough Uni®ersity,

Leics LE11 3TU, UK

Abstract

We have estimated a multi-output model of marketing and customer accounting costs in theBG regions. The cost function is well-behaved, separable, exhibits unitary elasticities ofsubstitution between factor inputs and there are constant returns to scale when both outputsrise by the same proportion. When one output is held fixed, economies of scale can beexploited by expanding the other output. If our model is representative of the global costfunction, this suggests that suppliers who already have a large market share in thenon-domestic market will have a competitive advantage when the domestic market isliberalised in 1998. Q 1998 Elsevier Science B.V.

JEL classification: L9

Keywords: Energy liberalisation; Cost functions

1. Introduction

Although BG was privatised in 1986 with a statutory monopoly over consumersof less than 25 000 therm, this position has been eroded by government policy tosuch an extent that in 1998 all gas customers will be able to choose their own

U Corresponding author. Tel: q44 0171 4468400; fax: q44 0171 4468484.

0140-9883r98r$19.00 Q 1998 Elsevier Science B.V. All rights reservedŽ .P I I S 0 1 4 0 - 9 8 8 3 9 7 0 0 0 0 6 -6

( )P. Burns and T.G. Weyman-Jones r Energy Economics 20 1998 223]232224

supplier } a process already underway for customers in the south-west of Englandsince 29 April 1996.

This shift in policy has been accompanied by dramatic changes in the structureof BG. Privatised as a vertically integrated monopoly, the 1993 MMC Inquiryrecommended the structural separation of BG’s transportation and supply busi-

Žness. This was rejected by the Secretary of State preferring to continue with the.policy of accounting separation BG agreed with the OFT in 1991 , reflecting a

growing emphasis on keeping together major businesses as ‘national champions’.BG therefore re-structured their company from the twelve regions in which

transportation, storage and trading were closely integrated, to four separate natio-Ž .nal businesses } Transportation and Storage TransCo ; British Gas Supply

Ž .BGS ; Retail; and Service. OFGAS took an active role in ensuring that thebusinesses were operated at arms length from each other for the purposes ofensuring a level playing field for the competing gas suppliers and imposed anumber of stringent rules on BG to ensure that the ‘Chinese Walls’ betweenseparate businesses were not breached. These included comprehensive financialreporting of each business, the appointment of a Compliance Officer within BG toensure that its Code of Conduct was being upheld, and even placing restrictions onthe movement of staff between various businesses.

However, in response to regulatory and commercial pressures, BG decided itcould best champion the interests of its shareholders by breaking up the companyvoluntarily. On 6 February 1996, BG announced that it will be separating into two

Žcompanies: British Gas Energy, encompassing the supply business British Gas.Trading , the service and retail businesses, the Morecambe gas fields and Accord

Ž .an energy trading company ; TransCo International will include gas transportationŽ .and storage, exploration and production excluding Morecambe , power genera-

tion, global gas and other group businesses.The purpose of this article is to estimate a cost function for the gas supply

business on a panel of regional data for the 3 years between 1990r1991 and1992r1993, that is, before BG was restructured from its regional structure to fourcentralised businesses. We emphasise that we are not estimating a cost function forthe whole of the gas business, which would also include transmission, distributionand storage costs but we are simply modelling gas marketing and customeraccounting costs which account for approximately 15% of the average domesticbill.

The restructuring has an important implication for interpretation of the resultsand any predictions for the future. It would be a mistake to draw a conclusion forthe shape of the global cost function from the shape of one segment of that costfunction which we have observed hitherto in the regions. We find that on the basisof this data, BG has experienced constant returns to scale when all outputsincrease in the same proportions. However, for a given non-domestic customerbase, there are economies of scale to be enjoyed by supplying new domesticcustomers. If these cost characteristics carry over to the fully liberalised market,this would tend to suggest that when the domestic market is liberalised, firms

( )P. Burns and T.G. Weyman-Jones r Energy Economics 20 1998 223]232 225

which already have a significant presence in the non-domestic market will enjoy acompetitive advantage in supplying domestic customers.

The article is organised as follows: in Sec. 2 we describe the model and in Sec. 3our data sources; in Sec. 4 we report our results; and in Sec. 5 we comment on theexistence of scale economies and the shape of the cost curves; in Sec. 6 we drawtogether some conclusions.

2. The model

We specify a general cost function that identifies the outputs as the number ofcustomers served in the domestic and non-domestic markets. We undertook somepreliminary estimation which included therms supplied as outputs but these vari-ables did not emerge as significant cost drivers. The functional form must beflexible enough to test for the possibility that increases in the supply of customerservices to one market can affect the cost of supplying to another market. Brown et

Ž .al. 1979 specify a functional form for the multi-output translog cost functionwhich we employ here. After imposing symmetry of cross-price and cross-outputresponse, the function is of the form:

c s k q a y q a y q b p q b p1 1 2 2 1 1 2 2

q d y2r2 q d y y q d y2r211 1 12 1 2 22 2

q g p2r2 q g p p q g p2r211 1 12 1 2 22 2

q r p y q r p y q r p y q r p y11 1 1 12 1 2 21 2 1 22 2 2

Ž .q Ýf Z 1i i

where all variables are in log and:

c s gas marketing and customer service costs;y s domestic customers served;1y s non-domestic customers served;2p s user cost of labour;1p s user cost of capital;2Z s control variables; andik , a , b , d , g r , f are parameters.i i i i i j i j i

If the cost function is homogeneous of degree 1, non-decreasing and concave infactor prices, then it is the dual of the transformation function for a generalproduction function. We impose homogeneity of degree 1 in factor prices bymaking the following linear restrictions:

b q b s 1;1 2

g s yg s g11 12 22

r q r s 011 21

r q r s 012 22


Homogeneity of degree 1 is a necessary but not sufficient condition for a well-be-haved cost function that is the dual of the transformation function. The cost shares

Ž .derived from the cost function by Shephard’s Lemma Shephard, 1970 must bew 2 Ž .xnon-negative and the Hessian matrix r p p must be negative semi-defi-c i j

nite. We evaluate our estimated model at all points in the dataset to ensure thatŽ .these conditions are met. Following Brown et al. 1979 we can test the following

hypotheses about the structure of costs in the gas supply business:

2.1. Homogeneity in the structure of production

If the transformation function of the general production function is homoge-neous then a proportionate increase in all inputs result in a proportionate increasein output. This has an important implication for the dual cost function, specifically,if the transformation function is homogeneous of degree r then the cost function ishomogeneous of degree 1rr. For the cost function this implies the followingrestrictions:

d s yd s d11 12 22

r q r s 01 2

where

r s r y r1 11 21

and

r s r y r2 21 22

from the imposition of factor price homogeneity.

2.2. Separability

The translog cost function allows us to test the restriction that outputs andinputs are separable in the transformation functions. The implication of a non-sep-arable cost function is that the marginal costs of production are not independent of

w Ž . Ž . xfactor prices see Hall 1973 and Lau 1972 for proofs . We test the restriction:

r s 0 for all outputs and factor prices.i j

2.3. Constant returns to scale

The scale elasticity is given by the proportionate effect on costs of changes in theoutput variable and the control variables, since changing the scale of a gascompany would involve changing all of these characteristics of customers and


network:

2 n c cSCE s qÝ Ý

y Zi iis1 is1

If both homogeneity and separability are accepted by the data we can test theŽ .further restriction that the cost function and the transformation function is

homogeneous of degree 1, i.e. exhibits constant returns to scale:

2 n

a q f s 1Ý Ýi iis1 is1

If this is accepted then outputs and total costs move in the same proportions.

2.4. Unitary elasticities of substitution

Ž . Ž .Uzawa 1962 has shown that the Allen 1938 partial elasticities of substitutionbetween inputs can be computed from the cost function by the formula:

CCi js si j C Ci j

ŽWhere s is the elasticity of substitution between inputs i and j, C is total cost ini j.levels and the subscripts on C indicate partial differentiation of cost with respect

to factor prices, i.e.

C 2 CC s and C s .i i j p p pi i j

By Shephard’s Lemma

� 4g q S Si j i js s .i j S Si j

Where S is the input share of factor i. We can therefore test that the elasticity ofisubstitution between inputs i and j is equal to 1 by testing the parameterrestrictions:

g s 0 for all factor prices.i j

2.5. A Cobb]Douglas specification

To test the highly restrictive Cobb]Douglas model, we test the restrictions:

d s d s d s 011 12 22

g s g s g s 011 12 22

r s r s 01 2


Ž .Finally Eq. 1 can be used to obtain an estimate of the ex post marginal cost ofsupplying customer services to each group by differentiating the fitted cost functionwith respect to the output. The output elasticity for output i is:

cs a q d y q d y q r p q r pi i i i i j j i i i ji j yi

which can be transformed into a marginal cost estimate by simply multiplying byˆ ˆ Ž .CrY where C is the fitted cost function in levels, not logs and Y is the level ofi ioutput, i.

3. The data

The multi-output model requires data on gas marketing and customer supplyŽ .costs, two outputs number of domestic and non-domestic customers served , and

the factor prices of labour and capital. The data form a panel of the twelve BritishGas regions for the 3 years between 1990r1991 and 1992r1993.

ŽThe data for gas costs on customer accounting excluding those for meter work.since these are now part of TransCo’s operations and gas marketing for the British

Gas regions were obtained from British Gas. These data include only the costswhich are directly attributable to these activities and therefore exclude from thecost base any shared administration costs.

The customer numbers data were obtained from the British Gas accounts andfrom the Digest of UK Energy Statistics produced by the Department of Trade andIndustry.

The factor prices are assumed to be the same for all the regions in each period.The user cost of labour is the user cost of labour in manufacturing industry takenfrom the Bank of England macroeconomic model. The user cost of capital weemploy is the user cost of capital in manufacturing from the NIESR macroeconomic

w Ž . xmodel see Young 1992 for a description of its construction .

4. Results

Ž .We estimated Eq. 1 by ordinary least squares, least squares with dummyŽ .variables a fixed effects approach and a random effects approach. The two latter

techniques are employed in order to capture any unobservable region specificeffect, such as inefficiency, that are not explained by any of the control variables.We tested to see whether therms supplied, as well as customers served, is asignificant output variable but found it was not. We also tested for the inclusion ofcustomer density as a control variable but the co-efficient on this variable was not

Ž .significantly different from zero. We augmented 1 with a time trend as a proxy fortechnical progress, but this variable, too, is insignificant.


We report the results of the random effects models in Table 1 for the unre-stricted version of the model, and our preferred restricted version. It is clear fromthe diagnostics that an LM test between the classical OLS estimation and therandom effects model favours the latter, and the Hausman test favours the randomeffects model over the fixed effects model.

Homogeneity of degree 1 with respect to factor prices was imposed throughout.The unrestricted model is reported in the first two columns of Table 1. In testingthis function we could not reject the joint hypotheses that the cost function is

Žseparable and that the elasticity of substitution between factor inputs is unity an F.test of the restrictions is 0.99 ; F . We also could not reject the hypothesis that3,25

Ž .the structure of production is homogeneous F s 1.73 ; F . The two output1,28variables, domestic customers and non-domestic customers are correlated, and thedata preferred the exclusion of non-domestic customers as a first order variable.The last two columns of Table 1 reports the restricted model, which is a separable,homogeneous function with unitary elasticities of substitution between inputs. AnF test between the two models is 1.13 ; F .5,26

It is clear from the restricted model in Table 1 that the output co-efficient isclose to unity. This restriction was easily accepted on the basis of a Wald testŽ 2 .x s 0.4 and an F test between the restricted and unrestricted models. Table 21reports the final version of the model. The Cobb]Douglas restriction was rejected

Ž 2 . Ž .on the basis of a Wald test x s 16.2 , and an F test F s 7.8 ; F .1 1,34The final version is a well-behaved cost function. The input shares are all

positive } the implied cost share of labour is 74% and of capital 26% } and the

Table 1Regression results

Coefficient Unrestricted model Restricted model

Value t-Ratio Value t-Ratio

a y6.49 0.4 1.06 11.11a y3.26 0.52b y4.07 0.7 0.74 7.11d 0.28 0.2 y0.15 4.011d 0.30 0.2 0.15 4.012d y0.05 0.1 y0.15 4.022g s yg s g y10.33 1.911 12 22r 1.19 1.11r y0.98 1.02Constant 62.69 0.7 y8.45 6.3

2Adjusted R 0.943 0.930SSR 0.261 0.318Autocorrelation y0.09 y0.07LM test 11.1 22.4Hausman test 0.0 0.0

Dependent variable: c r p ; observations: 36.k


Table 2Preferred model

Coefficient Value t-Ratio

b 0.74 7.31d y0.15 4.011d 0.15 4.012d y0.15 4.022Constant y7.64 39.2

Ž .Dependent variable cr y ) p1 kObservations 36

2Adjusted R 0.324SSR 0.333Autocorrelation y0.07LM test 23.1Hausman test 0.0

wŽ 2 Ž .xHessian matrix r p p is negative semi-definite. The cost function isc i jseparable, exhibits unitary elasticities of input substitution and there are constantreturns to scale when both outputs increase by the same proportion. We now moveonto explore in more detail the curvature of the cost curve with respect to theoutputs.

5. Marginal costs and returns to scale

As we have already noted, if both outputs increase by the same proportion thencosts will also increase by the same proportion. It is also useful to consider thebehaviour of the model when one output is held constant. In a two-output model, itis easier to observe this behaviour if we consider marginal rather than averagecosts.

The marginal cost of supplying an additional domestic customer is given by:

ˆ C C� Ž .4MC s s 1 y 0.15 y y y1 1 2 y Y1 1

Ž .where Y is level of domestic customers served rather than the log . The marginal1cost of supplying an additional non-domestic customer is:

ˆ C CŽ .MC s s 0.15 y y y .2 1 2 y Y2 2

The economies of scope between supplying the two types of customer is quite


limited. Notice that the marginal cost of each activity rises with increases in theother output:

MC 0.15C MC 0.15C1 2s ; and s .

Y Y Y Y Y Y2 1 2 1 1 2

However, holding non-domestic customers constant, adding domestic customerslowers the marginal cost of supplying those customers by more then it raises themarginal cost of supplying non-domestic customers. In other words, marginal costsfall significantly with an increase in one output with the other held constant.Furthermore, in order to exploit economies of scope in supplying non-domesticcustomers, a gas supply business would wish to attract an equal number ofdomestic customers.

ŽIf these characteristics persist when the market is liberalised and they may not.for reasons given in the introduction , these results suggest that since most new

entrants into the domestic market are likely to have already established themselvesin the non-domestic market, there exists the possibility for those companies toenjoy declining marginal costs of supplying domestic customers. This tends to implythat those suppliers who already have a large market share in the non-domesticmarket are likely to be at a competitive advantage when the domestic market isliberalised.

6. Conclusions

We have estimated a parsimonious multi-output model of marketing and cus-tomer accounting costs in the BG regions. The main cost drivers are domestic andnon-domestic customers } we found no role for therms supplied as an outputvariable. The cost function is well-behaved, is separable, exhibits unitary elasticitiesof substitution between factor inputs and is homogeneous in the structure ofproduction. There are constant returns to scale when both outputs rise by the sameproportions.

However, when one output variable is held fixed then there are considerableeconomies of scale to be had by expanding the other output. We are reluctant todraw hard and fast conclusions from this model on the likely market structurewhen the domestic market is liberalised, because we have estimated only onesegment of the cost function which we have observed hitherto, based uponmonopoly provision and a regional structure. It is possible that the shape of thecost curve at very low output levels in a competitive market will be different to theone in a monopolistic, regionally separated market. However, if our model isrepresentative of the global cost function then our results suggest that competitiveadvantage in the domestic market will be gained by those suppliers who alreadyhave a large market share in the non-domestic market.

This may not necessarily mean that there will be widespread abuse of monopolypower. The domestic market may be contestable despite the presence of decreasing


Ž .marginal costs of serving domestic customers. Baumol and Bailey 1984 suggestfour yardsticks for determining the contestability of a deregulated market, but theactual market concentration after deregulation is not one of them, since theincumbents may be a poor predictor of the efficiency of a market when entry and

Ž .exit are unregulated. Their yardsticks are: i deregulation will be followed byŽ .productivity improvements in labour and delivery systems; ii there will be in-

Ž .creases in the innovation and diversity of price-service options; iii there will beŽ .adjustment of prices towards incremental cost and an end to cross-subsidy; iv

there will be measurable transitions in market structure and profitability. Theproper tests for contestability require that we direct research towards the evolutionof the relationship between tariffs for a range of gas supply output indicators andtheir incremental costs.

Acknowledgements

This article forms part of the ESRC research project on Tariff Rebalancing andPrice Structure in Privatised Utilities, grant number R000221474. Jon Kerr hasprovided excellent research assistance. We are grateful to British Gas for providingmuch of the data for this study, and to an anonymous referee for helpfulcomments.

References

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multiproduct firms. South. Econ. J. 46, 256]273.Hall, R.E., 1973. The specification of technologies with several kinds of outputs. J. Polit. Econ. 81,

878]892.Lau, L.J., 1972. Profit functions of technologies with multiple inputs and multiple outputs. Rev. Econ.

Stat. 54, 281]289.Shephard, R.W., 1970. Theory of Cost and Production Function. Princeton University Press.Uzawa, H., 1962. Production functions with constant elasticities of substitution. Rev. Econ. Stud. 29,

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is the gas supply market a natural monopoly? econometric evidence from the british gas regions

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