Downstream Price-Cap Regulation and Upstream Market Power

In electricity and other industries, it is increasingly common for a utility's upstream affiliate (i.e., an electric generation supplier) to be unregulated while its downstream affiliate (i.e., the local distribution company offering retail service) is subject to regulation. In these industries, regulators are confronted with the potential exercise of market power by the upstream affiliate when choosing the optimal form of downstream regulation. This paper finds that downstream regulation in the form of price caps can eliminate the exercise of market power by the regulated firm's upstream affiliate. With the regulator establishing a price cap and an appropriate rate of profit sharing, the upstream affiliate engages in marginal-cost pricing even when it potentially possesses significant market power in the input market. However, full retention of downstream profits by the regulated entity will induce the upstream affiliate to engage in pricing below its marginal cost. The welfare-maximizing price cap and profit-sharing rate may be sustained even if the price cap is adjusted upward in proportion to past downstream losses, if the adjustment rate and discount factor are sufficiently small. Alternatively, as the discount factor approaches one, the upstream affiliate raises the input price sufficiently to induce price-cap levels that maximize downstream profits. The end result is higher downstream prices than would arise under pure cost-based downstream regulation, where the upstream affiliate acts merely to maximize upstream profits. However, these problems in implementing price caps with dynamic adjustment are eliminated if the cap adjustment can be downward as well as upward. In that case, the dynamically adjusting price cap dominates cost-based regulation from a consumer and social welfare standpoint. When competition involving supply functions is considered, it becomes more difficult and less desirable for the regulator to induce marginal-cost pricing by the upstream affiliate. However, a price cap with profit sharing still produces welfare improvement relative to cost-based regulation, when the downstream affiliate has an expected zero-profit "participation" constraint