A considerable part of the yet to be privatised sector of the Russian economy is made up of what are usually regarded as natural monopolies.
Natural monopolies exist in Russia for much the same reasons as they do in developed market economies. Natural monopolies arise when the optimal scale of production of a single firm is comparable with the size of a national or regional market. In other words, within the bounds of domestic demand, the average production cost decreases as output increases. Theoretically, natural monopolies can appear spontaneously in a market economy, as a result of competition. However, this level of concentration of market power is most likely to emerge in infrastructure industries such as electricity supply, transport (including pipelines) and communication. Historically these industries have been created and/or controlled by governments. This is the case not only in Russia and other former communist countries, but also in industrially developed market economies such as Australia. Over time it becomes clear that something needs to be done to increase their efficiency and competitiveness, to reduce costs and prices. Economic decision-makers are then faced with a dilemma: either to improve regulation mechanisms, or to undertake comprehensive microeconomic reform with a view to deregulation, disaggregation and privatisation.
Having privatised most other industrial enterprises, Russian authorities are now facing a problem similar to that already experienced by developed market economies: how best to deal with natural monopolies in a predominantly market economic environment. The Russian version of this familiar problem, however, is far more severe than that experienced by countries such as the UK and Australia. Russian economists often describe this problem as "the dictatorship of natural monopolies".
A more precise description of the behaviour of natural monopolies is provided by another phrase used by Russian commentators: "the dictatorship of prices". During the first two years of post-communist reforms in Russia (1992-1993) prices for electricity and gas were kept relatively low in the context of an environment of comprehensive price liberalisation for almost all other products and services. Consequently, during the initial stages of gas and electricity price liberalisation, prices paid by domestic consumers were about 32% of the world average.
However, less than two years later, by October 1995, prices had soared as high as 75% of the world average for gas and about 102% of the world average for electricity (Izvestiya, 13 January 1996). This provided natural monopolists with an opportunity to decrease the effects of the Russian economic crisis on their own industries at the expense of other sectors. Thus, for example, wages in the gas and electricity supply industries were as high as 246% and 396% respectively of the national average in January-August 1995 (ibid.).
Given the Russian economy's substantial dependence upon these two major energy suppliers as well as upon another natural monopolist, railway transport, the most likely consequences are major periodical financial disruptions caused by the "domino effect" of subsequent inter-enterprise failure to pay bills.
So far, all attempts to resolve the Russian natural monopoly problem have been undertaken within a framework of "better regulation" philosophy. In October 1995 the industrialist lobby instigated a decision to freeze energy prices, as opposed to forced price liberalisation. According to Ministry for the Economy forecasts, subsequent liberalisation of energy prices would cause an immediate increase of at least 12-23% (ibid.)
Meanwhile the various industrial lobbies in the Russian federal government have come into conflict over the implementation of the Law on Natural Monopolies adopted by the Duma in late 1995. The Law provides for the establishment of a Federal Commission for Energy in charge of energy and gas price control and distribution. Representatives of the energy supply and gas industries regard the idea of such a commission as representing a return to the Soviet epoch "Gosplan" (State Planning Committee) system, when the regulator had total control and zero responsibility. A compromise has yet to be found.
Recently, however, there has bene talk of an alternative solution, proposed by gas industry representatives: disaggregation of the non-monopolistic part of their industry. Under this proposal, as of July 1996 the already corporatised industry would be divided into several legal entities with independent balance sheets. This means that a kind of restructuring of natural monopolies would be undertaken. This process is familiar to certain sectors of developed market economies, notably the electricity supply industry in the UK and Victoria and railway transport in the UK.
Even though the Russian authorities are still only considering such a solution, a comparison of the Australian experience with the current Russian economic situation may be helpful in predicting possible outcomes of similar reforms in Russia.
Historically, the electricity supply industries in countries such as the UK and Australia were established and developed as state monopolies from the very beginning. The same applies to the Soviet electricity supply industry, as well as all the other Soviet natural monopolies. In the former USSR, the UK and Australia alike, the electricity supply industry functioned not as a government-owned commercial entity, but as a statutory authority, directly funded from the state budget, with prices strictly controlled by the government. The goal of natural monopoly reform has usually been spelled out as increased competition, increased productivity through changed work practices and significant reduction of the embedded cost structure of the business, together with reduction of the work force.
The key aim of natural monopoly restructuring is to localise and extract the "natural monopoly component" of an industry. In the electricity supply industry this component is the high power transmission network, or "the grid"; in the natural gas and oil industries it is the network of pipelines, and in railway transport it is the network of railways. Restructuring aims at a situation whereby only the extracted indivisible component remains under government control. All remaining parts of the former natural monopoly are then commercialised, disaggregated (the measure currently under consideration for the Russian gas industry) and, eventually, privatised.
The first stage of the reform involves transforming the natural monopoly from a public property with statutory functions into an official commercial company.
The nature of the electricity generation industry (as well as of other natural monopolies) does not permit flexible changes in the physical amount of capital employed by the industry, either in terms of time or continuity of changes. Thus, in the short run, rationalisation of the industry does not affect the amount of physical capital. At the same time, a considerable rationalisation of job structure and reduction of employment is undertaken. The quantity of production appears to be relatively stable and not affected by the reform. On the other hand, it can be concluded from the theory that any attempt to deregulate prices at this early stage would inevitably lead to price increases. Hence the government leaves price controls in place until later stages of the reform.
The only likely results of the reform at this stage, therefore, is increased internal efficiency caused by the decrease in employment. Eventually, this enables the Government at least to remove subsidies from the sector, which was previously running at a loss, and possibly to make some profit. Even at this early stage the concept and sequence of the reforms in UK and Australia diverge greatly from measures taken to date in Russia, where prices were liberalised before making any attempt to destroy the monopolistic structures and improve internal efficiency.
At the second stage, the single monopoly is vertically disintegrated into three new state-owned companies. The first of these is in charge of all power plants. It is responsible for power generation and supply to the high voltage transmission network ("the grid"). The second is in charge of high voltage transmission. It is responsible for receiving the energy from the generators and supplying it to the distributor. The third is responsible for the retail distribution of energy.
During the third stage of the reform, the generation and distribution enterprises are disintegrated into commercially operating but still state-owned businesses, including several competing power generation plants and a number of regional distribution and retail monopolies. It is required that the balance sheet, cost and revenue structures for each of these new enterprises be appropriate to the commercial sector. Meanwhile, the high voltage transmission remains a regulated natural monopoly. The idea is that the generation units compete with one another for shares in the total amount of electricity suppled to the grid and to large consumers. At the same time, large consumers have the choice of either buying energy directly from a generation unit or relying upon the grid price, which is more stable.
Reduction of the workforce in the given industry continues throughout the second and third stages of the reform. This causes numerous additional socio-economic problems. In the UK and Australia these reforms are undertaken in a predominantly market economic environment with well-established job search and adult training programmes and social security systems. Moreover, in these countries the given sectors do not represent a considerable part of the labour market. Therefore, the re-absorption of the retrenched workers into the workforce is difficult, but ultimately achievable. In Russia this problem would occur in a completely different economic environment.
The Russian retrenched workers would be specialists in their field, and no comparable employment would be available for them elsewhere in the economy. The practice used in developed market economies of re-training those people with a view to their employment in other sectors would be a much more complicated in Russia. Not just one natural monopoly, but the whole Russian economy is currently undergoing costs rationalisation and job-cutting. Therefore, employment opportunities are limited across the board, yet Russia still lacks an operational system of institutions and/or arrangements established for the provision of re-training.
Another aspect of the unemployment problem is the degree of inter-regional mobility of the population. In Russia, as in Australia, power supply generation units are often located in the areas where they are major employers. The situation is similar in the Russian gas and oil industries, which are concentrated around the major deposits. Therefore, microeconomic reforms of natural monopolies mean that unemployment increases dramatically in these particular regions. A partial solution to this problem would be organised inter-regional resettlement of the retrenched labour force and their families to areas with relatively better employment opportunities.
The Australian population is relatively mobile. Nevertheless, during periods of mass retrenchment, the propensity to migrate from one such region affected by microeconomic reform, namely the La Trobe region in Victoria, appears to be lower than would be expected, given unemployment disparities. The costs of migration are barely affordable, especially for low income workers. The depressed real estate market in the La Trobe Valley has created a situation whereby family home owners are unable to sell property, and/or thus unable to obtain sufficient finance to buy a home elsewhere. The age of retrenchees is a factor here too: the less working period left, the less likely they are to migrate. Social and cultural factors also play a role: people are attached to their community and have extended family links in the region; they are concerned with children changing schools, with their spouses' employment opportunities elsewhere, etc.
One would expect even more serious problems in Russia regarding possibilities for moving retrenched labour forces. The Russian population is traditionally less likely to move for employment reasons, and have stronger ties to extended families than most Australians do. The costs of migration would be enormous, given the lack of a removal services infrastructure and recent dramatic increases in passenger and freight fares. However, the major problem would be housing availability. Before the liberalisation of the economy there was a shortage of housing in Russia. Now housing is subject to the embyronic level of market relations and considerable criminal involvement, and housing prices are astronomic in terms of the average household income. Therefore, for the majority of Russian working families a shift to another region is simply not feasible.
During the last stage of reform the generation plants are transformed into private corporations by offering them for sale through tenders to domestic or foreign investors. Distribution and the retail sector are further deregulated. The existing state-owned regional companies are transformed into private corporations, so that competing private providers then enter markets in each of the local geographic areas.
Only at this stage, when a level of competition has been achieved, does some liberalisation of prices become possible. This is achieved through bidding for market shares and prices periodically organised by the grid for generation units, and through the liberalisation of retail prices following the successful implementation of other reform measures.
The latest stages of the reform, horizontal disintegration, and especially privatisation, have been the subject of ongoing debate among politicians, academics and the broader Australian community. These discussions are very similar to current discussions around economic reforms in Russia. The main point of contention is who gains and who loses as a result of privatisation. Those opposing privatisation appeal to the public, who are accustomed to more or less stable prices and concessions provided by the government to pensioners and the unemployed. Defenders of reform, on the other hand, argue that state monopoly causes excess costs and that privatisation and the resulting competition would lead to increased efficiency and decreased costs and prices.
Looking at this problem from the public interest perspective, in terms of public utility maximisation, even though horizontal disintegration and privatisation do not cause a further major decrease in the number of jobs, only a decrease in costs and in the price for electricity would make the reforms acceptable to the broader community. The question is whether there are grounds for expectation of lower prices, considering the scheme of reforms being implemented.
On the one hand, deregulation really should lead to higher efficiency and lower costs. However, when such a reform is being implemented in a developed market economy, the cost minimisation goal is already largely achieved during the earlier stages of the reform, when the number of jobs provided by the state authority is reduced considerably, whilst the production of electricity sales remains stable.
In the case of Russia, where the factors of production have not been optimised during the early stages of the reform, the commercialisation and privatisation stage may cause enormous reduction of employment. This is evident in those sectors of the Russian economy that have already being privatised.
On the other hand, one can assume that even though the generation facilities are being privatised, the generation costs cannot decrease below a certain "technologically predetermined" level. The "technological" level of costs is structurally predetermined by the very expensive constructions and equipment installed in each of the generation plants. Basic technologies and levels of efficiency vary from plant to plant, mainly because of their different vintage. Each of them was built in a different period of time and embodied corresponding engineering solutions of the time. During the pre-reform period, the government, as a single owner of the monopoly, was able to protect less efficient units financially by means of cross subsidisation. An independent commercialised natural monopoly can use cross subsidisation as well, whilst the price is still regulated by the government. The question is how the price will be formed and the costs will be covered as a result of the disaggregation and privatisation of generation units.
The fact that the wholesale energy market is still subject to governmental control means that only two options are available. Either the high power transmission authority could differentiate wholesale prices through individual contracts with each of the suppliers, or prices could be established, as a result of bidding, at a (Pareto-optimal) level satisfying all suppliers.
The first option would dramatically restrict the degree of freedom for competition, whereas the second would establish one of the well-known forms of oligopolistic competition. Considering the "official past" of the newly established oligopolistic market, it would be realistic to assume collusion as the most likely kind of market conduct. According to this familiar concept of a collusive market, participants avoid rivalry and tend to maximise the total industry profit, which means that they continue to deliberately behave as a single monopoly, implicitly cross-subsidising each other. As a result, depending upon different factors, the price would emerge at a level either higher or lower than before deregulation, assuming that the "technological" level of efficiency had been achieved during the earlier stages of the reform.
Therefore, even if the reform is ultimately successful, in the short run, as long as the pre-reform structure of technologically predetermined costs remains unchanged, one cannot expect a decrease in price and increase in welfare. A definitely positive outcome can only be expected in the long run. Only if, as a result of disaggregation and privatisation, newly established commercial companies are controlled by truly independent proprietors, can competition cause, sooner or later, investment in basic equipment and a subsequent increase in efficiency. This would be the only possible condition for a positive welfare implication.
Meanwhile, it appears that even in Australia it is difficult to convince people that such a reform is justified. The 1995 and the present election campaigns in Russia have shown that anti-liberalisation and anti-privatisation views have a very broad social base. This is why a solution to the natural monopolies problem cannot be found until after the coming presidential elections in June.
School of Business and Electronic Commerce
Faculty of Business and Economics
Monash University
Churchill, Victoria 3842, Australia
e-mail: Gennadik@Gbus.cc.monash.edu.au
or