CONTESTABILITY IN NETWORK INDUSTRIES
May 2014
Introduction
Governments and economic regulators of transport, energy and other infrastructure services
have on various occasions considered how contestability can be used to support delivery of
network services in the past considered natural monopolies.
In Great Britain (GB) for example, Ofgem (the energy regulator in GB) is considering the option
of introducing contestability in the delivery of electricity transmission projects as part of its
Integrated Transmission Planning and Regulation (ITPR)1 project. Ofgem also already
administers a competition based regime for delivery of offshore transmission services in GB
and has introduced competition for connections in electricity distribution.
Ofwat (the water regulator in England and Wales) is considering how competition might be
introduced into wholesale elements of the water and sewage value chain and there is a long
track record of contestable processes being employed in the delivery of transport
infrastructure, including roads and services associated with railways.
This short note considers why and how contestability can be applied to the delivery of
network infrastructure services, the benefits from doing so and why the offshore electricity
transmission regime as designed by Ofgem in GB is in particular a good example of the
application of a contestable approach.
Why contestability?
Economic theory holds that perfect competition is Pareto efficient – that is, it delivers
technical efficiency in which least cost production is combined with an allocative efficiency in
which it is impossible to make any one individual better off without making at least one
individual worse off. Whilst few markets are perfectly competitive, in most sectors promoting
competition moves the markets involved towards greater allocative efficiency.
1
ITPR is Ofgem’s review of the current arrangements for system planning and delivery in GB electricity
transmission, covering onshore and offshore transmission networks and electricity interconnectors. Further
details on ITPR are available here:https://www.ofgem.gov.uk/electricity/transmission-networks/integratedtransmission-planning-and-regulation
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CEPA
Network industries have very high capital costs, which makes it difficult to create competing
networks. This results in what are traditionally termed ‘natural monopolies’ characterised by
economies of scale and scope in their operations, resulting in several key benefits such as:

network wide coordination and planning (both in terms of developing new
infrastructure, as well as on a day-to-day basis, for example, ensuring there is enough
electricity to meet demand); and

national connectedness – for instance, power can be transmitted over long distances
from large, optimal generation sites, rather than having to be produced locally by a
large number of small generators.
As such, trying to introduce network on network competition (for example, by the wholesale
splitting up of networks, or allowing for replication of assets) would significantly reduce the
benefits that the interconnectedness of networks bring2.
However, whilst such networks can exhibit technical economic efficiency, a lack of
competitive pressure can result in poorer allocative efficiency despite regulators seeking to
compensate for this through a range of regulatory approaches. As such, several regulators of
network infrastructure have over the last few decades been looking for a regulatory
framework that can combine the benefits of competition and of networks. This is promoted
not by creating competition ‘in the market’, but instead ‘for the market’ – market actors
compete for the right to be the monopoly network provider – or at least the monopoly
provider for an element of that network. This is often called making the activity or asset
contestable.
The literature suggests that introducing contestability to a networked industry can bring a
number of benefits. These include:

Lower costs: Contestability delivers lower costs as competitors seek to win contracts
by offering lower prices.

Innovation: It encourages innovation and new ideas, improving delivery and long-term
efficiency.

Reduces asymmetry of information: Contestability can reveal information on the
scope for efficiencies, through bidding processes and increased opportunities for
benchmarking.

Access to financing: Competitors may have access to alternative financing sources and
additional equity which supports the provision of services.
However, contestability does also bring some additional costs over traditional incumbent
delivery, which must be taken into account when deciding if contestability is a viable option:
2
Note that this is a separate issue to introducing competition in the use of networks through, for instance, third
party access.
2

Losses of network benefits. Some network benefits may be lost as a result of
contestability, for instance, where costs are duplicated.

Higher transaction costs. Bidding costs can be substantial in many large scale
procurements.
Various options for contestability of network services are available, and these can be seen as
ranging from contestability in service provision (for example, operations and maintenance
outsourcing) to contestability for asset provision (that is, the provision – financing and
operations – of pipes, wires, roads etc).
In practice however, the distinction between service and asset provision may not be
completely clear cut, involving a spectrum and / or mix of activities that are competed out.
Structuring optimal contestable opportunities
In choosing where and how to introduce contestability in network industries it is important
to ensure that the benefits of doing so outweigh any costs, especially as regards lost network
benefits and the transaction costs involved. When structuring competitive opportunities it is
therefore important to take into account; first, the potential for contestability and second,
trade-offs that may need to be considered in the design of different options. These will all
vary depending upon the specific opportunity in question.
Potential will turn on how easy it is to create an opportunity of interest to the market – and
therefore greater competitive pressures, which in turn will include considerations of:

Ease of definition of the parameters of an opportunity – how easy it is to ring fence
from the rest of the network, complexity of any interfaces and interdependencies etc.

Investment scale – at one extreme, is it likely to be large enough to interest investors
and at the other, is it too big?

Risk profile, in terms of the technical and other features of the opportunity and the
allocation of risks between the different parties involved, particularly service
providers and customers.
Trade-offs can include:

Benefits arising from competition versus transaction costs of the competitive process;
that is, the transaction costs need to be in proportion to the potential to derive
benefits from competition.

Losses of network benefits versus the benefits arising from competition.

The extent of the investment requirements involved in the opportunity and the length
of time that monopoly rights are conferred to investors.

Pros and cons of different risk allocations.
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Developing a viable contestable opportunity therefore requires considering a number of
trade-offs. However, when a project is well structured and these trade-offs are fairly
balanced, there is evidence that contestability can bring benefits to consumers.
Examples of where contestability has been applied
In order to provide a flavour of the reasons why and the favourable outcomes arising from
the application of competition for the market contestability approaches, we have reviewed a
number of examples. These lie across the range of contestable activities in service provision
and asset provision identified above and have taken place both in different regions and
sectors, as well as involving different types of network.
The table below summarises the examples we have considered, the rationale for the
introduction of the contestable approach, any observed favourable outcomes and any lessons
learnt. The case-studies we have considered are:

The operation and financing of offshore transmission assets in GB under the
Transitional regime for Offshore Transmission Owners (OFTOs).

The construction and operation of transmission lines in Argentina and in Texas, the
latter being specifically related to those for windfarms.

Competition for the market through bus franchising within GB (in which this has been
preferred as an approach to competition in the market).

Inset appointments in the England and Wales water sector in which there have been
opportunities to outsource certain water services, but typically not involving the
construction of new assets.

Design-Build-Finance-Operate (DBFO) roads in the UK, an asset intensive Private
Finance Initiative (PFI) model.

Rail franchising in GB which is an example of a contestable approach in the context of
infrastructure services, for capital intensive, but not for fixed networks.
The rationale for the introduction of such approaches varies with the context, but in addition
to obtaining lower prices through competition – a linking theme with all the examples – the
case studies show this can often be part of wider strategies of optimising investment
strategies, accessing new financial resources and improving customer services.
Overall, these case studies show that contestability can bring cost and other benefits when
compared to monopoly regulated markets.
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Table 1: Examples of contestability in infrastructure services and the lessons learnt from the contestable opportunity
Example
Rationale for introducing contestability
Lessons learnt
Offshore
transmission
in GB
A competitive tender process was introduced to
appoint new offshore electricity network operators
with responsibility for operating newly constructed
electricity transmission network assets.
The regime was created to facilitate the transfer of
ownership of transmission assets from offshore
generators to independent transmission owners. It
was also considered that a competitive regime would
deliver more efficient outcomes.
CEPA analysis (see below) of tenders completed under the Transitional OFTO
regime (initial projects which qualified for the tender process) suggests the
approach has resulted in cost savings when compared to plausible regime
counterfactuals. This was possible because the ‘market offer’ reflected a clear
set of risks that allowed efficient, competitive pricing.
However, in reading across to what might be implied for other parts of the
transmission network, it is important to recognise that OFTOs tendered to date
have been of a materially different scale and risk profile to the full electricity
transmission network in GB.
Transmission
in Argentina
Contestability was part of an approach in which
transmission assets were only built where users were
willing to pay for them, in order to drive out
unnecessary asset provision.
Competing out
construction and operations aimed to reduce costs
even further.
Contestability was used successfully to reduce costs as part of this model. In one
project, the competitive bids received were all significantly lower than the
envisaged price for the project, with the winning bid proposing a cost 44% below
this expected price.3
Transmission
in Texas
Competition has been used in the provision of new
transmission links for windfarms. The scheme was
developed to allow wind farms to be built where they
are most beneficial (not where they can most cheaply
connect to the grid).
Competition was used to tap new sources of finance for this very large scale
investment, and increase the pool of financially viable parties who could invest.
It also allowed for innovations in the development and construction of the
transmission links; for example, by simply using a different construction
material for transmission poles, one entrant was able to reduce the costs and
timelines significantly for its project. The transmission service providers were
selected to provide a good balance of these benefits, but ensuring that the pool
was not too large to reduce as much as possible any coordination problems.
Inset
Inset appointments allow non-incumbent suppliers to Martin Cave noted that: ‘A number of inset appointees… offer reductions off the
appointments provide water services in certain circumstances. This local incumbent’s tariff of between five and 13 per cent… if an inset appointee
in UK
can create competition for the market between reduced costs by five per cent through efficiency gains, then the average
3
Littlechild and Skerk, (2004) ‘Regulation of transmission expansion in Argentina Part I: State ownership, reform and the Fourth Line’
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Example
Rationale for introducing contestability
Lessons learnt
incumbent suppliers and new inset providers, as well household customer would save £15 a year.’4 However, the approach has only
as between new potential new suppliers.
been used very rarely and such competition is only mandatory in rare
circumstances.
DBFO in UK
The competitive DBFO model of PFI was seen as being
the best way of attracting private finance into road
construction and maintenance at a time of restricted
government capital expenditure.
By 1996 (only three years into the project) a review opined that DBFOs secured
modest but useful technical innovation, significant efficiencies which offset the
higher cost of private finance, successfully transferred risks, and enabled
projects to be brought forward earlier than would be possible using
conventional public financing.5 A year later, it was calculated that the first eight
projects had reduced costs by 15% compared to the public sector comparator.6
Later models of DBFO within the roads sector opted for an availability
‘performance’ metric rather than having operators exposed to significant traffic
risk, thus optimising the risk transfer to the private sector – this risk in much
more controllable than market risk.
Bus
Competition for the market can work better than Empirical studies suggest that franchising has reduced costs, with bids prices
franchising in competition in the market
minimised when the number of bidders increases over five. Experience in
the UK
London also shows that there may be some trade-off between competition and
economies of scale: large projects are likely to receive low costs bids, but it is
also likely that fewer companies will submit bids.7 This is because the larger the
project, the less likely it is that a company has the requisite capacity/ skills.
Rail
This approach to competition for the market was Rail franchising over the last twenty years has significantly increased passenger
franchising in introduced in the 1990s to reduce costs, improve numbers and reduced costs: rail operating costs in the UK were estimated in
the UK
service and increase use of railways.
2011 to be some of the most efficient in Europe.8
Source: CEPA analysis
4
Cave (2009) ‘Independent Review of Competition and Innovation in Water Markets’
Steve Nicholson (1996) ‘Working in Partnership: DBFO in the UK’
6
Local Government Chronicle (1997) ‘DBFO ROADS DELIVER BETTER VALUE FOR MONEY’ accessed at: http://www.lgcplus.com/dbfo-roads-deliver-better-value-formoney/1509903.article
7
Does Competition for the Field Improve Cost Efficiency? Evidence from the London Bus Tendering Model, M Amaral, S Saussier, A Yvrande-Billon, CEPR (2006)
8
Realising the Potential of GB Rail, Department for Transport (2011)
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Contestability within the context of OFTOs
Closer examination of the GB OFTO regime’s specific application in the context of Tender
Round 1 (TR1)9, illustrates a number of features that demonstrate why it has been a good
candidate for introducing a contestable approach.10
This has been realised through structuring contestable opportunities that are (i) well-defined
in terms of risk profile; (ii) exhibit a risk allocation between investors and customers that is
attractive to investors, without being overly onerous to customers; and (iii) which were
brought to market on a transparent and level playing field, thus maximising interest and
competitive pressures on pricing. We discuss each below:

Risk profile:
o Nature of the physical assets: OFTOs have to date been point to point
connection wires rather than a complex network (which means OFTOs can be
easily interfaced with the existing transmission network).
o To date, a post construction opportunity – divestment from wind-farm allows
interdependencies between windfarm and transmission assets to be better
managed through the construction process and which are much lower risk,
post construction, maximising investor interest.
o There may have been some trade-offs with a non-radial approach: arguably
some network economies of scale and scope may have been lost through radial
design (although there is debate over this), but as windfarms have been close
to shore, this is less clear than for say, windfarms less close to shore, where
there are likely to be greater economies of scale and scope.

Risk allocation:
o There are remote but high impact risks allocated to consumers in terms of
stranding risks.
o There is a widely understood availability-based, performance risk allocation to
the OFTO (which builds on learning from PFI experiences).
o There are regulatory protections through the licence regime.

Open competition
o Structured competition and marketing of opportunities has raised awareness
amongst investors.
9
The first round of projects (in total nine projects) tendered under the Transitional OFTO regime.
For a more extensive discussion of the contestable approach applied through the OFTO regime, and the
benefits it may have achieved, see CEPA and BDO’s recent report for Ofgem on the benefits from Tender
Round 1 (TR1). The report is available on CEPA’s website:
http://www.cepa.co.uk/news-details-oftotr1benefits?selYear=2014
10
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o The OFTO regime has been structured as a procurement programme with
tender rounds. This means that short-listed bidders are able to dedicate
resources to the process and the “OFTO opportunity” within specific time
windows.
o The licensing and tender regulations have also created a standardised
approach for the tender process which is likely to have improved the
attractiveness of the opportunity for investors.
Summary
Some of the examples provided above of the use of contestability in infrastructure service
provision support the theory that where it is possible to introduce, it can bring a range of
benefits, including costs reductions, innovation and access to a wider range of sources of
finance. Often contestability is also used as part of a wider strategy to improve allocation of
investment resources or to improve customer service.
However, as explored in this paper, when structuring competitive opportunities it is also
important to take into account; first, the potential for contestability and second, trade-offs
that may need to be considered in the design of different options. These will all vary
depending upon the specific opportunity in question. Developing a viable contestable
opportunity therefore requires governments and economic regulators of infrastructure
services to consider a number of trade-offs.
Contacts
CEPA regularly advises stakeholders in infrastructure sectors on issues such as contestability
in network services where economics, finance, and public policy overlap.
Please visit www.cepa.co.uk or contact the authors of this paper, either at +44 (0)20 7269
0210, or at the email addresses below for further details.
Mark Cockburn, CEPA Managing Director – [email protected]
Patrick Taylor, CEPA Managing Consultant – [email protected]
Fiona Kayes, CEPA Consultant – [email protected]
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