Paying the price for distorted incentives

The city is moving towards the dawning of a new electricity market in 2008 - or so the government tells us. But will this be an era in which the perverse incentives of the past - arising from an obsolete regulatory regime that has cost the public dearly - are reversed?

Any regulatory framework for public utilities creates operational incentives for the market players. Yet, when these incentives are not consistent with the prevailing social objectives, the purpose of regulation is lost. Such incentives invariably lead to an awkward situation, where the corporate behaviour of the utilities comes into conflict with the public interest.

Sadly, this is what has happened in Hong Kong 's electricity sector: despite major shifts in the economic structure and public expectations, the regulatory framework under the scheme of control arrangement has remained largely unchanged over the past four decades.

Under that agreement, the city's two power companies are allowed to earn a return on assets of 13.5 per cent plus an additional 1.5 per cent return on shareholder equity. In practice, this translates into an annual return on equity of over 25 per cent after debt financing. The two power companies responded to these powerful incentives and adjusted their corporate behaviour accordingly.

One may argue that their behaviour is entirely rational - though not exactly likeable - for sophisticated market players. Yet, such corporate behaviour produces odd distortions that are obvious on three fronts.

First, resources are allocated to areas where they generate negligible marginal gains. For instance, the reserve capacity for power generation of the two companies has fluctuated between 30 and 40 per cent in recent years - far above the international standard of 20 per cent.

Furthermore, although power-sharing links between the two companies have been in place for many years, they are used only in emergencies. This exposes the rationale behind building such overcapacity: more power-sharing would deprive both companies of the chance to expand their own generating capacities.

Second, neither company seems to have much concern for resource efficiency. Many cities adopt a sliding tariff to encourage customers to use less power during peak hours, shifting to low-demand periods of the day. The purpose is to get a more consistent level of power use during the day. This is, however, a non-issue in Hong Kong .

If Hongkongers could be persuaded to endure higher indoor temperatures - or simply dress more cooly during a few of those summer days when we hit peak demand levels - we would avoid annual increases in peak load.

That would delay, or even avoid, the need for new power plants.

Hongkongers find no joy in energy conservation. The more we conserve electricity, the less efficient the power supply system becomes: then power companies demand higher tariffs to maintain their permitted return on assets.

Third, the regulatory framework also encourages the failure to account for the external cost of environmental pollution. According to the department of community medicine at the University of Hong Kong , the direct medical costs attributable to air pollution amounted to $1.3 billion in 2002.

The preliminary government proposal for a new regulatory regime does not seem to recognise the huge costs that Hong Kong business and consumers have paid in the past.

The litmus test for the new regulatory regime is whether it can create for the power companies incentives that are aligned with our long-term social objectives - fair for all stakeholders, healthy for the environment and efficient for our economy.

Albert Lai Kwong-tak is vice-chairman of the Civic Party.

(Originally Published in South China Morning Post, 2006-4-24 , p. A15 )