The National Science Foundation's (NSF) Tokyo Office periodically receives and disseminates reports on research developments in Japan that are related to the Foundation's mission. NSF-sponsored researchers currently working in Japan prepare many of these reports. These reports present information for use by NSF program managers and policy makers; they are not statements of NSF policy. .
Ms. Alexia Brunet, a Ph.D. student in Department of Agricultural Economics at Purdue University, prepared the following report. Ms. Brunet is a participant in the 1999 Summer Institute sponsored by NSF/NIH/USDA in the U.S. and the Science and Technology Agency and the Japan Science and Technology Corporation in Japan. Dr. Takashi Morikiyo of Socio-Economic Research Center at the Central Research Institute of Electric Power Industry hosted Ms. Brunet. Ms. Brunet can be reached via email at: brunet@agecon.purdue.edu
I. Introduction
In the year 2000, Japan will introduce further reforms to deregulate the electricity supply industry (ESI) inviting competition in the retail sale of electric power to eligible customers. The pressure is on for incumbent utilities to lower their costs in order to compete with independent power producers (IPPs) for contracts. Utility companies that are best able to lower their service costs will be the best prepared for the competition that lies ahead. Lowering costs, however, is not a simple task. A history of regulation has distorted capital as well as cost incentives in the Japanese electric utilities. As the year 2000 approaches, it is crucial for deregulators to understand how each firm will perform in a competitive environment. The starting point for such analysis is an understanding of cost asymmetries among Japan's nine electric utilities.
II. Objective
The aims of this article will be twofold. First, this article will expose cost inefficiencies among the nine electric utility companies in Japan. The target rate of return will be analyzed against the realized rate of return to assess the extent to which the nine utilities are cost efficient or cost inefficient in the short term. If the realized rate is higher than the target rate, then the firm is minimizing its costs and acting efficiently. Conversely, if the realized rate is lower than the target rate, the firm is not minimizing costs and is deemed inefficient.
Secondly, based on the results, this paper seeks to analyze preparedness of the nine utility companies for future market competition. Preparedness is judged by the firm's ability to match or exceed the target rate of return. The firms that receive a higher rate of return than the regulated target face decreasing costs, while those that receive a lower rate of return face rising costs. The firms that face the lower rates of return are more efficient than the ones facing the higher rates. Beginning in 2000, when retail competition is to be introduced, the firms that have been more cost efficient in this analysis will be better prepared to meet cost pressures. Future deregulation measures to correct for distorted cost incentives will be suggested.
The following section places this piece in the framework of existing literature on inefficiency and cost analysis in Japan's electricity supply industry. Section four presents the theoretical background necessary for an evaluation of this piece; section five introduces the data and outlines the empirical model. An appendix is included in this piece to describe the formation of the nine electric utilities and the history of regulation/deregulation in Japan.
III. Motivation
Inefficiency in regulated industries, and specifically in the supply of electricity in Japan, is not a new topic of investigation. Studies in this area fall into two categories: (1) studies which analyze the sources of inefficiency in Japanese electric utilities -- Nemoto et al (1993) and Goto and Tsutsui (1998)--and (2), studies which explicitly review the effectiveness of policy measures aimed to correct inefficiencies--Yajima and Riechman (1996) and Hattori (Forthcoming, 1999). This investigation has elements of both categories. A brief discussion of the ways in which this piece will diverge from those listed above follows.
Two recent studies showed that overcapitalization exists among the Japanese electric utilities, Nemoto et al (1993) and Goto and Tsutsui (1998). The results from the Nemoto et al (1993) study illustrate that eight of the nine firms experience scale economies in the short run but diseconomies in the long run, and that seven firms significantly over-capitalize (confirming the Averch-Johnson effect). The Nemoto et al piece is relevant to this article in so much as it, too, uses panel data of nine Japanese electric utility firms during a much shorter, but similar time period. More importantly, however, are the results of the Nemoto et al (1993) piece. A comparison between the Japanese utility companies that Nemoto et al (1993) have proven to be overcapitalized and the results from this study--the companies that exhibit distorted cost incentives -- will be undertaken.
Another study performed on cost efficiency in the Japanese electricity supply industry was performed by Goto and Tsutsui (1998). In their comparison of overall efficiency between U.S. and Japanese electric utilities, the authors showed that the high electricity rates are highly due to excessive amount of capital investment, a source of allocative efficiency present in Japanese electric utilities. This is consistent with the Averch-Johnson effect and the results found by Nemoto et al (1993). While the authors pointed to the allocative inefficiencies in the Japanese electric utility industry, and the overall cost efficiency of Japanese electric utilities versus that of U.S. electric utilities from 1984-1993, the results of this study are comparative in nature and do not yield firm specific conclusions. The aim of this piece is to extend cost inefficiency to a comparison among the utilities themselves.
Two studies look specifically at policy measures aimed to correct inefficiencies. First, a CRIEPI (Central Research Institute of Electric Power Industry) report submitted by Yajima and Riechman (1996) briefly exposes various cost, capital and investment distortions caused by rate of return regulation and then turns to an extensive review of incentive regulations as a means of correcting for the ill effects of regulation. The cases of the U.S. and the U.K. are cited and advantages/disadvantages of incentive regulations are discussed at length. This piece is instrumental in disclosing the negative effects of rate of return regulation and suggesting corrective policy mechanisms. Next, Hattori (Forthcoming, 1999) aims to test whether or not incentive mechanisms brought about by the 1995 reform of the Electricity Utility Industry Law (EUIL) had an affect on cost efficiency. His results show that efficiency gains are ambiguous. Both of these pieces are examples of studies, which aim to show that incentive mechanisms may have an effect on inefficiencies. By using data that ranges from 1980-1998, including the 1995 reform period, this investigation hopes to show the effect of incentive mechanisms on the actual versus the realized rate of return. If the firms are realizing a higher rate of return, incentive mechanisms aimed to lower costs of utilities may be shown to be effective.
IV. Theory
In Japan, electric utility prices have been regulated to cover utility costs plus a fair rate of return on investment. While rate of return price regulation (cost-plus regulation) has been used in the U.S. and in Europe, it has been criticized for distorting capital and cost incentives. Averch-Johnson (1962) showed that firms in regulated markets generate profits by increasing their asset base (rate base), or by expanding into markets that are marginal. Cost incentives may also be distorted when a firm increases its operating costs in one period, and the regulator responds by adjusting the price to meet the increase in average cost. In both cases, the firm bypasses cost minimization in order to receive a higher rate of return than the regulator intended.
Some have argued that this is checked by the regulatory lag, the time period before the regulator steps in to raise/lower the market price corresponding to the new cost structure. For, during the lag, the firm either makes profits or incurs a loss. An increase in operating costs will lead to a decrease in the rate of return leading to extra costs/losses, while a decrease in costs will lead to an increase in the rate of return, or profits. Yet, even the market oriented features of regulatory lag do not correct the existing cost inefficiencies.
V. Empirical Model
The model will utilize the concepts of regulatory lag rate of return differentials outlined above. The motivation for this section is to assess how individual companies fair relative to the target rate of return. In order to accomplish this, this study will calculate the realized rate of return (RROR) for nine electric utility companies from accounting records for the period 1980-1998. A comparison of the RROR with the target rate of return (TROR) will yield a panel of excess (or deficient) returns due to the regulatory lag.
Utilizing the panel of excess returns for the nine firms over the eighteen year period (1980-1998), a fixed effects model will be run to determine which firms show a significantly divergent excess return either above or below the mean excess return. Also, the effect of individual years will be included in the model to account for drastic, unpredicted changes in cost parameters such as factor prices. The data have been compiled using yearly company financial statements and statistical yearbook of electric power industry.
Finally, this model will assess the impact of the deregulatory reforms of 1995, namely the effect of the yardstick regulations aimed to promote economic efficiency. The effect of the yardstick years will be estimated in the model to remove structural changes on the excess return results, and to determine the ability of this reform to make firms more cost efficient.