Deregulation vs innovation?

Does electricity market deregulation encourage or hamper innovation in the energy sector, and why? Researchers at two French business schools believe they have an answer, writes Tildy Bayar

Everything the energy sector needs in order to meet today’s economic and climate goals – lower costs, greater flexibility, improved reliability, cleaner technologies, diversification, digitalization – depends on innovation. But how is innovation best supported and encouraged, and under what conditions will it be most likely to thrive? The answer, according to new research, may surprise you.

While encouraging competition through electricity market deregulation might seem on the surface to be governments’ best strategy, researchers at France’s EDHEC Business School and ICN Business School have found that deregulation’s effects on innovation in the power sector are far from obvious, and in many cases can actually be negative.

In a recent study, ICN economists Marianna Marino and Pierpaolo Parrotta and EDHEC economist Giacomo Valletta tracked the effects of major changes to 31 countries’ legal and regulatory frameworks on the number of patent applications filed in the electricity sector. The researchers aimed to examine a ‘wave’ of deregulation that has grown to include most OECD nations. They compared countries that have enacted major reforms to countries where the electricity market remains essentially regulated, hoping they would be able to distinguish the direct effects of market reforms from any pre-existing trends.

Two forces are at work, the researchers found. While market liberalization generally encourages innovation, as represented by the number of patent applications filed, major reforms followed by a further loosening of regulations has the opposite effect. In countries that have been through a major reform followed by a further decrease in regulation, the number of patent applications was found to drop, while the opposite was found in countries that lag behind in the reform process.

The conclusion? Deregulation fosters innovation in tightly regulated markets.Innovation reaches a peak at some intermediate level of regulation intensity, and then begins to slow. In other words, deregulation hampers innovation once the market liberalization process is fairly advanced.

In concrete terms, the researchers’ findings were consistent with the idea that if a restructured market is still tightly regulated, energy firms may have an incentive to innovate in order to pull ahead of their competitors. But if competition receives too great a boost, higher price volatility and tighter margins could shift firms’ R&D focus to the short term. Under such circumstances, imitation may become a more profitable way to keep up with the competition than innovation.

To discuss these results and their implications for the global power sector, PEi spoke with EDHEC researcher Valletta.

Q: How did you conduct the research?

A: We divided our sample of 31 countries into two categories. One included countries with an average or relatively low level of regulation; these countries have been through a relatively strong deregulation process. Then there were countries with a relatively high level of regulation, which have been through a weaker deregulation process.

As far as I recall, the countries which have deregulated the most are Japan, the UK, Norway and a few more. France, on other hand, at least when it comes to European countries, is among those that have deregulated the least.

We looked at the progression of relationships between the number of patents – taken as markers of innovation – and deregulation intensity, year by year. We started from a point where, on average, the OECD countries all had average high regulatory intensities. This has come down, of course, through time, and we observe an inverse U-shaped relationship which reaches a peak and then goes down.

Here we may observe, from an empirical point of view, two opposite effects. If we look at countries in the more intense deregulation sample, we observe that further progress in deregulation after a reform has rather negative impacts on the filing of patents, while in the other sub-sample we observe the opposite.

Let’s say there is an average level of regulatory intensity, and countries can be above or below it. When we look at our two subgroups separately, we can observe that pushing on regulation has opposite effects depending on whether you have already deregulated a lot. This is consistent with the descriptive evidence we find. We see two sides of the same coin: descriptive evidence that has then been confirmed by our more statistical analysis.

Q: What effects has deregulation had on innovation in the power sector?

A: In terms of final implications, we found that, consistent with economic theory, in markets that are tightly regulated a sudden decrease in regulation followed by a progressive decrease in regulation might boost innovation in terms of the number of patents, whereas if you push this too far, it might go the other way. Too much regulation might hamper innovation; the probability, though, is that first we have partial equilibrium. This is a rather technical expression meaning that our results need to be taken as a partial observation of reality. We look at the effects of certain variables on others, assuming that all else is kept constant. Our findings should be more of a caveat for governments since other factors, which we do not consider in our analysis, might ultimately also have an impact on innovation.

Our message is really relevant to the priorities of certain governments, especially for countries that lag behind in the regulatory process. Countries should beware that if they push deregulation too far, they might have this kind of consequence on innovation. It might also be the case that deregulating the market might affect other parameters we cannot observe, and the government might have other priorities – these are things we cannot forecast. A good solution might be to find a middle way.

Q: Does there seem to be a spike in patents after a major reform?

A: A spike in itself doesn’t tell you much. The only thing that can be informative is the trend. There’s a spike sometimes, and sometimes there isn’t, so there’s not really a regularity and it’s not statistically meaningful.

Q: Has deregulation meant a shift in focus towards shorter-term R&D, with imitation becoming a more profitable option than innovation?

A: Our findings are consistent with that. We cannot directly prove it, in the sense that of course we did not observe specific data about the profit margin. But from a descriptive point of view, some papers observe a changing focus when it comes to R&D and to the types of patents and types of innovation in the sector. Our story is indeed consistent with that.

Our observation of a shift in focus is consistent with the fact that, in certain countries after the rules have changed – say, a drastic change where the market has been opened – there was a prominent impact on innovation. The more reforms were aimed at opening the market or making it contestable to facilitate access for new operators, the more we observed a subsequent negative impact on innovation.

If a company is facing a lower profit flow because the market has been opened, and it fears competition, it might hence also possess tighter margins and might want to focus on innovation that keeps its profitability up in the short run, neglecting aspects of innovation that might bring it profit later in time. If margins are tight, you care about what happens today rather than in 20 years.

Q: What is the key takeaway here for policymakers?

A: We are facing a situation where the electricity market has certain long-term challenges that rely on innovation. Specifically, there is more and more of a shift towards electricity in terms of energy needs, and of course a growing need for clean electric power.

For example, if you look at the UK, there’s been a huge increase in the use of renewable energy, from 4 per cent in 2010 to 17 per cent in 2015. The problem in the UK now, like in many other markets, is that this has reached a sort of bottleneck. There is a profitability problem for renewable energy because it might generate electricity at times of the day when the price is relatively low, and this might indeed create problems for people who want to invest.

The two technologies that could eventually and concretely change the industry are energy storage and technologies that promote demand response, like smart grids etc. These are long-term investments – and this is our point: if the deregulation process is too tough, it might have long-term implications.

A further question which we are trying to address now is how the regulatory process has specifically affected green patents. Our first analysis was really more of a general view on the relationship between innovation and deregulation. A more specific look at the impact of deregulation on green patents would answer the question of whether, and to what extent, the issues we’re raising have a specific impact on certain aspects of electricity production.

Q: Would governments and regulators be better off opting for a middle ground rather than pushing the liberalization process too far, especially in the long term?

A: Again, this question is strictly related to the agendas of certain governments. It doesn’t necessarily mean, for example, that if you are a country like the UK or a region such as northern Europe where the market is already relatively open with regard to many other countries, you should go back. You should be aware that there might be an issue, though, and you might want to compensate for a potential decrease in innovation through other means – subsidies, for example. France, which is a relatively big and rich country that lags behind in this process, might want to know that instead of going too far, they might want to stop at some point because it could have negative effects on innovation – but they might also say “We have other priorities and don’t care about this”.

The policy implication is also related to the status quo in a certain country. This information can be used in different ways depending on how you have dealt with your electricity sector.

Q: Are countries such as the UK, which supports innovation through its Innovate UK funding body, moving in the right direction?

A: Our findings do not necessarily mean that a country should consider settling for a middle ground. That’s an option, of course, but a country that has liberalized a lot might then want to implement alternative policies aimed at obtaining a desirable amount of innovation.

In terms of implementation, it depends on how much the country has deregulated, which also depends on the wider political agenda.

Countries are giving up on subsidies because they are unpopular or seen as unaffordable. Probably this is more of a political problem, as in Germany where there is a huge debate about it. Also, from an economic point of view, subsidies might be dangerous in a way because they might give false signals to the market.

There are difficulties with finding the right balance of policies. On the one hand, if you deregulate too much you might lose incentives to innovate; on the other hand, if you push on incentives too much in terms of cost-effectiveness, you might create an imbalance in the energy mix.

It would be very difficult for any economist to determine the optimal amount of innovation. Too much may be inefficient. We’re not able to say if there is an optimal amount of innovation, but it’s interesting to know that an excess of liberalization might discourage further innovation.

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