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Book Summary

Florio, M. (2013). Network Industries and Social Welfare: The Experiment that Reshuffled European Utilities. Oxford University Press USA.

Florio (2013) challenges the dominant paradigm that liberalization of network industries in Europe in the last two decades has produced socially efficient outcomes by posing three research questions: (1) whether ownership matters for pricing and social welfare; (2) whether vertical disintegration is a condition for obtaining competitive prices; and (3) whether competition actually leads to lower prices to consumers. The author addresses these questions by assessing (a) the results of liberalization in telecommunication, electricity, and natural gas, and (b) consumers’ perception concerning quality and affordability of these services. Before answering to these questions, however, it is important to understand the European paradigm, particularly its three pillars.

I. The European Paradigm and its Three Pillars: privatization, unbundling and market entry

Network services are essential to the economic well being of any society, particularly for social cohesion, due to the capacity of these services to link users. It is noteworthy that in addition to have a decreasing average cost –as all natural monopolies– network industries also present the network effect, which means that a service becomes more valuable as a greater number of consumers use it. On the other hand, network industries also require heavy long-term investments, and the services are produced at the lowest cost when production is concentrated in the hands of a single firm. Given the importance of network effect for social cohesion, as well as the lack of competition in these sectors, natural monopolies were strictly regulated or were exclusively provided by state-owned enterprises.

Nonetheless, in the last two decades the European Union (EU) shifted to this new liberal paradigm, delegating network industries to market-player provision. According to Florio (2013), there were four main drivers. The first was related to the creation of a unique internal market, since those services were not included in the Treaty of Rome (1957) given that “they were highly sensitive to the political priorities of each Member State.” In other words, the network industries were the last frontier for full economic integration. The second driver was the UK example of privatization during Thatcher’s government and the US deregulation during Reagan administration. The last two were the collapse of the Soviet Union and the advent of global financial markets.

The liberalization reform in Europe had three main pillars, which consisted of privatization, partial unbundling or vertical separation of the net upstream and downstream, and liberalization of entry and regulation to encourage competition. Privatization was never officially endorsed by the EU. Instead, the EU adopted several measures to promote competition, and often these measures meant the reduction of government intervention. For instance, the EU prohibited state aid to firms and suggested privatization of network services to indebted countries in order to finance public investment.

The second cornerstone in the EU reform was unbundling, which consists of “the separation of non-competitive segments (typically the network core facilities), from those that are potentially competitive (such as production, supply, and maintenance)” (Florio, 2013, p. 12). Unbundling is usually justified on the grounds of promoting competition. For example, rather than having one vertically integrated provider of electricity, production, transmission and distribution are unbundled so different forms can provide these services. The third pillar is also concerned to foster competition, but in this case by encouraging new entrants in the market. Although network industries were considered natural monopolies at first, the technological development undermined the cost problem, allowing more firms to enter in the market. Additionally, the EU has pursued over the last two decades through directives more competition and the possibility of new entrants in the market of network industries.

II. Assessing the Paradigm: what does the liberalization experience in Telecommunication, Electricity and Natural gas tell us?

Florio (2013) analyzes the effects of privatization, unbundling and market opening across the EU in the sectors of telephone services, electricity, and natural gas. He uses regression analysis[1] in answering whether changes made in these sectors had effects on price levels. Through his regression analysis for telecom, for the fixed telephone sector, the decreases in market share of the incumbent was the only measure indicative of drops in prices, with ownership (i.e. from public to private) of the incumbent playing no significant role. In terms of mobile telephones substitution and unidentified country factors played the biggest role. While market entry is shown to be beneficial in mobile telecom, privatization shows little to no consumer benefit. Vertical disintegration has been limited except for the local loop.

In the case of electricity, the EU has changed the ownership, promoted vertical disintegration, and facilitated market entry. Florio (2013) explains in depth the differences in composition of energy sources across different EU countries, and its importance in looking at other characteristics of the energy sector. In looking at reforms within the EU, in terms of privatization and liberalization across the energy sector UK is seen as the prominent leader. On the other side of the spectrum, the Nordic countries are supplied with energy by mostly public sector firms. However, across the EU, in general, the three largest energy retailers by country usually control around 60 percent of the market.

The cross-country empirical studies up to this point on the energy sector have pointed to the following: privatization more often than not under previous empirical studies led to higher consumer prices, for unbundling the evidence appears to be limited and inconclusive, and for market opening it is the reverse where it actually resulted in lower consumer prices. In Florio’s own analysis it emerges that only public ownership as a variable has an effect on price, with the effect being it reduces price. For unbundling, reformers see it as helping separate potentially competitive stages with natural monopoly characteristics, and with entry regulation there will be more market forces in the industry to deliver both production and allocation efficiencies. When it came to the empirical analysis undertaken by Florio (2013), not one of these assumptions was proven to be accurate. However, under a higher significance level it is shown that entry regulation has a negative effect, meaning allowing consumers to choose their provider was negatively correlated, perhaps due to having advertising expenditures or mistaken switches in providers. The empirical results in this section very much defy the common arguments for reforms. Promoters of privatization mention that suppliers are more efficient than under public ownership.

In moving to natural gas, Florio (2013) discusses the EU’s heavy reliance on natural gas a primary energy source for final consumption, service activities, and production of electricity and other goods. He mentions the heavy reliance the EU has on imports predominately from Russia, then mainly from Norway and Algeria, and with domestic reserves declining this trend is only increasing. Similar to energy sector regulations, the natural gas sector is also required to separate transmission networks production and supply, as well as ownership bundling being invoked by directive. Natural gas usage is unevenly distributed across the 35 countries in the wider European area with just three countries (UK being the largest, followed by Germany and Italy) representing roughly 50 percent of demand. Florio (2013) through his analysis of the natural gas sector after controlling for relevant factors finds that privatization in itself does not lower prices, and there is perhaps some evidence to point that public ownership of utilities acts as a mechanism that caps prices. Florio (2013) mentions that through interpretation of his findings it is seen that only under the threat of entry is there perhaps the motivation of the incumbent to show price restraint, but in the long-term relationship of oil and gas prices the market is in itself oligopolistic. Efforts to privatize, unbundle, and vertically separate do not show any positive effects. There is also the issue of the EU’s upstream dependence on fossil fuels and ongoing debates within the EU over short-term contracts (used in U.S. and UK) versus long-term contracts (used in continental Europe).

In summary, the European Paradigm and its three pillars were not able to answer all the questions posed by the author. In the telecommunication sector, the ownership did not play an important role, while market entry mechanisms were considered beneficial in the reduction of prices. In electricity, public ownership was considered to have an impact on the reduction of prices, whereas unbundling results were inconclusive. Likewise, the overall evidence on the correlation of entry regulation with electricity prices was mixed. Finally, in natural gas Florio (2013) concluded that privatization has no impact on prices, showing some price restraint under the possibility of entry.

III. The Paradigm and Social Welfare: are they related?

The purpose of part three is to discuss consumers’ happiness related to the price they pay for electricity, gas or telephone services in countries where these services were privatized. It is through this consumers’ perception of satisfaction that the author measures the social welfare generated by the liberalized network industries. The consumer welfare was verified through the combination of a traditional price data assessment with a consumers’ perception survey. Despite the limitation of both methodologies, the author mentions that the application of the two methods could provide a reasonable result.

In order to obtain evidence of consumer satisfaction on the quality and affordability of the service provided by network industries, Florio (2013) used the Eurobarometer public opinion surveys from 2000, 2002, 2004 and 2006 in 15 EU member states. Given the risk of biased respondents, the author controlled the political views of the respondents by testing whether price satisfaction and average actual prices were correlated. He found that individual perceived price fairness is strongly negatively correlated to actual average price paid. Therefore, it was possible to conclude that a quite large sample of the respondents is driven by their perception of the difference between the price they actual pay and what they would consider a fair price.

The results showed no correlation with the reforms and the perception of service quality. Indeed, in the electricity sector the author identified a negative correlation between the reforms and quality of the service. With regard to affordability, Florio (2013) identified three main trends: (1) privatization may lead to higher average prices for households; (2) regulation may impose higher quality standards; and (3) tariff rebalancing may reduce cross-subsidies. By and large, there is no correlation between general consumer happiness and the network industries reform paradigm. In fact, there was some evidence of negative correlation, but Florio (2013) wisely preferred to conclude that objective (i.e. price data) and subjective evidence (i.e. satisfaction data) suggest that on average consumer’ welfare in the EU-15 did not improve as a results of the reforms for the years and sectors considered.

iV. Critiques

Although Florio (2013) refers to “social welfare,” the research presented focuses exclusively on consumer welfare instead. Indeed, the author acknowledges that perhaps the title of the book should have been “consumer welfare,” but he also argues that it is unlikely that a reform of network industries that increases consumer welfare could mean loss to a society as a whole. Given that network industries are responsible for the provision of essential services to virtually all households in a country, the assessment of consumer benefit from the liberalization reform could perfectly indicate the “social welfare.” Additionally, the author also considers in the last chapter of his book the accessibility of low-income households that cannot achieve a minimum standard of consumption. Such approach is similar to the Rawlsian social welfare function, which considers the utility of the individuals who are worse off, and it perfectly makes sense in a work that aims to study social cohesion –better than a utilitarian measure that considers only the total welfare of society.

However, he does not consider the impact of networks on other aspects, focusing exclusively on households’ difficulties in paying their bills. The liberalization paradigm may have produced other effects on society beyond the price of the services. For instance, in the case of telecommunication the author missed the opportunity to offer greater explanation to whether the European experience trying to grow competition and shift to private ownership have led to an increased or shrinking case for universality (i.e. expansion of the service), and whether investment objectives are leading to welfare losses or gains in more sparsely populated areas as compared to the urban context, particularly considering his findings of reduction in cross-subsidies. The empirical results lead the reader to hold an incomplete picture of the challenge of equity of access and welfare seen beyond a select country-by-county analysis that only goes briefly into rates of coverage, or through an EU level picture. In the case of electricity, Florio (2013) avoids discussing more in depth the advancement of green energy policies in coordination with the energy sector beyond the UK case. There also should be more in-depth of analysis of pricing levels by country and the changes that occurred before and after the reforms were implemented.

[1] Florio commonly uses Eurostat, International Telecommunications Union (ITU) data in a time-series regression analysis.