Innovation and the comparative efficiency of governance structures in the Dutch electricity industry: a TCE application.

Transcription

1 Innovation and the comparative efficiency of governance structures in the Dutch electricity industry: a TCE application. Eva Niesten and Albert Jolink Erasmus University Rotterdam & University of Amsterdam eniesten@rsm.nl, a.jolink@uva.nl Preliminary draft, for presentation at ENEF 2008 meeting. Do not quote without the author s permission Keywords: innovation, transaction cost economics, electricity industries

2 Innovation and the comparative efficiency of governance structures in the Dutch electricity industry: a TCE application. Eva Niesten and Albert Jolink Erasmus University Rotterdam and University of Amsterdam Introduction The electricity industry in the Netherlands is moving in the fast lane of organizational development, benefiting from the EU efforts to liberalize the sector. During the last decade the State owned firms have survived the market transition in the electricity industry and have discovered the merits of innovation and entrepreneurship. These firms have also learned, albeit by doing, that innovation comes with new organizational challenges. These innovation challenges involve product- and process innovation but also organizational innovation. In this paper we will analyze the influence of cost-saving innovations on the comparative efficiency of governance structures in the Dutch electricity industry. The analysis of the effects of innovation on governance structures offers a new set of questions compared to the standard transaction cost economics (TCE) approach. In particular, innovation complicates the assignment of transactions to markets or hierarchies based entirely on an examination of their asset specificity qualities. In the standard TCE model the comparative efficiencies of governance structures can be estimated on the basis of a confrontation of production and governance costs. As others have argued (Williamson, 1991; ) the comparative efficiency will largely depend on the asset specificity of the transaction. Williamson (1985) has introduced a heuristic model confronting the production costs with governance costs. In our paper we extend this heuristic model by introducing cost saving innovations. We argue that the effect of cost saving innovations will largely depend on the kind of innovation involved, the nature of the technology involved and the presence of hazards of knowledge leakage. Some of these factors will mainly affect the production costs difference, whereas other factors will mainly hook onto the governance costs.

3 In the paper we also explore the analytical options that one may come across and confront these with empirical findings of the Dutch electricity firms. We will conclude that innovations will affect the efficiency of governance structures. The degree and nature of the effect of innovation on the efficiency of governance structures will largely depend on the moderating effect of the nature of the technology and the threat of knowledge leakages. Innovation and TCE Transaction cost economics is concerned with analyzing the comparative efficiency of governance structures. The three generic forms of governance are the hierarchy, the hybrid and the market (Williamson, 1996). Within the TCE framework, the efficiency of these governance structures depends on their alignment to the attributes of the transactions. Hierarchies are said to economize on transaction costs when they govern transactions that are specific and subject to a great degree of uncertainty. Markets are more efficient for governing standardized transactions, and hybrids for governing transactions with intermediate values of asset-specificity and uncertainty. Transaction cost economics has been applied to a variety of subjects, such as public policy, regulation, labor markets, corporate governance and corporate finance. Some attempts have also been made to applying the TCE framework to innovations (e.g. Globerman, 1980). Williamson has also given some attention to incorporating innovations into transaction cost economics (Williamson, 1985, 1991) 1. He argues that the introduction of innovation into the TCE framework complicates the alignment of transactions to markets and hierarchies as predicted by transaction cost economics. For example, the hierarchy has an advantage over other forms of governance for innovation transactions, because within the hierarchy it is easier to cooperate on research and development. However, the integration of innovation transactions reduces the incentive intensity of the parties to these transactions, which means that the incentive to innovate is reduced. The hierarchy thus offers both an advantage and a disadvantage for 1 In 1965, Williamson also addressed the topic of innovation, but not yet within the transaction cost economics framework. In this article, in The Journal of Political Economy, he posed the following question: What factors influence the relative proportion of innovations that will be introduced by the four largest firms? He found that as monopoly power increases, measured by the concentration ratio, the relative share of innovations contributed by the largest firms in an industry decreases.

4 integrating innovation, which leaves the comparative efficiency of the alignment of innovation transactions to governance unclear. In addition to this difficulty of efficiently allocating a governance structure to innovation transactions, Williamson (1991) has focused on two other problems with innovation in the transaction cost economics framework. Firstly, innovation transactions are associated with a weak appropriability (Teece, 1986), which refers to an increased risk of leakage of knowledge and information to rival firms. An increased risk of leakage increases the costs of hybrids as compared to hierarchies. The familiar TCE alignment is altered in that the hierarchy is more efficient over a wider range of asset-specificity. A second problem with the analysis of innovation in transaction cost economics is timeliness. Innovation often requires fast responses of firms to rapidly changing conditions. These firms may prefer to engage in joint ventures for a short period of time to allow for these fast responses. Within the TCE framework, the joint ventures may not be the most efficient governance structures when looking at the attributes of the transactions. Transaction cost economics is a perspective that focuses on equilibrium contracting. It therefore has difficulty in dealing with the analysis of responsiveness in real time. Williamson introduces the concept of innovative potential to provide a provisional match of innovation transactions to governance structures. Innovative potential is the degree to which a good or service is susceptible to cost-saving improvements (Williamson, 1985: 143). When the innovative potential is small, the familiar alignment of transactions to governance structures is said to apply. If there exist any differences between the alignment of innovation transactions to governance on the one hand, and the familiar alignment on the other hand, these differences would have to occur when the innovative potential is great. The cost savings can be either generic or proprietary. When the cost savings are generic, they will be easily imitated by rival suppliers. Easy imitation is assumed to be associated with non-specific investments, and therefore a market is considered to be more efficient. Williamson argues that the difficulty of alignment arises when the cost savings are proprietary and the investments are specific. The buyer will want to appropriate the benefits of innovation and to encourage the supplier to invest in specific assets to innovate, but the supplier s incentive to innovate is reduced once the supply stage is integrated. The prediction is that new hybrid forms of governance may appear to resolve this tension.

5 Extending TCE with Innovation Williamson s heuristic model Despite this provisional match, with the concept of innovative potential, Williamson has argued that added apparatus is needed to deal with the full set of issues that arise in relation to innovation (Williamson, 1996: 118). The introduction of innovation in transaction cost economics offers a new set of questions compared to the standard TCE approach. In particular, innovation complicates the assignment of transactions to markets or hierarchies based entirely on an examination of their asset specificity qualities. Within the standard model the comparative efficiencies can be estimated on the basis of a confrontation of governance and production costs. Hence, if the comparative governance costs can be identified as the difference between the costs of internal governance and the governance costs of markets, this governance costs difference will fall with deepening asset specificity. Alternatively, Williamson estimates the production costs difference between internal production and market procurement. This production costs difference also falls with deepening asset specificity. This heuristic model is applied by Williamson, and others, to estimate the implications of disturbances on governance structures and can be illustrated by figure 1. Costs C G + C Figure 1 0 G k k* Asset specificity (k)

6 In figure 1, G represents the decreasing governance costs differential as asset specificity increases; the difference between the governance costs of hierarchies and markets decreases as asset specificity increases. The governance costs of hierarchies is, by definition, higher than the governance costs of markets when no asset specificity applies, reflecting the assumptions that markets operate more smoothly than hierarchies, and can aggregate demands to create economies of scale, at low asset specificity. As asset specificity increases markets lose some of these advantages and hierarchies have access to particular governance instruments, up to the point where the governance costs of hierarchies and markets are equal, and G equals zero. Up to this point the market has distinctive advantages above the hierarchy. Beyond this point (k ) of asset specificity, the governance costs of hierarchies are lower than the governance costs of markets, and the hierarchy has advantages over the market of dealing with these asset specific transactions. Beyond k, the market does not provide sufficient safeguards for the bilateral dependency between the contracting parties to the asset specific transactions. This contractual hazard, the bilateral dependency, leads to larger governance costs for the market. In figure 1, C represents the production cost differences between producing within the hierarchy, that is for one s own needs, and the production cost related to the same item but bought in the market. With low asset specificity the production cost difference is high as the costs for sustaining a hierarchy for relative standard transactions is high compared to the economies of scale and scope which can be obtained in the market. As asset specificity increases the production cost difference decreases, asymptotically approaching zero. The governance cost difference and the production cost difference can be summed, as in the line G+C. The vertically summed cost differences are positive with low asset specific transactions and negative with high asset specificity. The summed cost differences are zero at the point (k*) of asset specificity where the positive production cost differences equal the negative governance cost differences, or where the difference between the production costs and governance costs of hierarchies equals the difference between the production costs and governance costs of markets. If the cost difference equals, in which i=g,p and j=h,m, then C= and G=.

7 At point k* = and hence, =. At this point there is indifference between the market and the hierarchy. A graphic analysis and the introduction of innovation Williamson s heuristic model allows for a graphic analysis of governance structure decisions, on the basis of governance- and production costs, taking asset specificity as the leading factor. Taking the most efficient, economizing outcome, the minimization of governance and production costs will determine whether the market or the hierarchy is the most efficient governance structure. The introduction of innovation will, however, change these governance structure decisions. As Williamson raises the question How, if at all, is the assignment of transactions to markets and hierarchies altered by the introduction of process or product innovations? (Williamson, 1985: 141). As has been described above, the incorporation of innovation into TCE has been restricted to the study of innovation transactions. In the following we will extend the notion of innovation to a technological influence on the cost structure underlying the governance decisions. More specifically, we will consider innovation as a cost-saving influence. Although other influences may be envisaged, we will restrict the following graphic analysis to the effects of cost-saving innovation on governance costs and production costs. Following Williamson s question above, we will distinguish between product innovation and process innovation and their effects on the costs. In addition, we may discuss the effect of organizational innovation on the governance- and production costs. We will take the standard Schumpeterian definitions of product innovation, i.e. the introduction of a new good, of process innovation, i.e. the introduction of a new method of production, and of organizational innovation, i.e. the introduction of an organizational capacity for change and adaptation. In all varieties of innovations we presume that the main feature for the analysis is cost reduction. In terms of figure 1, innovation will directly affect the C- and G-curve. For the time being, we will restrict the graphical analysis to product innovation exclusively.

8 Next, we will presume that innovations will be of two kinds: either they affect an entire economy and are not geared towards a particular purpose, usually referred to as a general purpose technology; or they affect only a specific product or process, usually referred to as a special purpose technology. A typical example of a general purpose technology is electricity (Kander et al., 2007). In our analysis this dichotomy, general versus special, will allow for different effects on C and G in figure 1. Finally, following Teece and Williamson, we will presume that innovation and the process of knowledge creation will open up the hazard of leakage. This implies that innovation, in and by itself, is knowledge-intensive and contracting opens the risk that knowledge will leak out. For the present graphical analysis we will presume the binary situation of either a hazard of leakage or no hazard of leakage. Following De Figueiredo and Teece: When we use the term leakage, we do not mean to imply that intellectual property rights have necessarily been violated. We have in mind the quite legal imitation and emulation that takes place in the normal course of business. (De Figueiredo and Teece, 1996). When there is a hazard of leakage, firms have difficulty with capturing the profits of an innovation. But when there is no hazard leakage, firms can easily appropriate the profits that are generated by an innovation. Teece refers to a regime of appropriability as the environmental factors, excluding firm and market structure, that govern an innovator s ability to capture the profits generated by an innovation. (Teece, 1986: 287). He characterizes the two most important dimensions of such a regime as the nature of the technology and the efficacy of legal mechanisms of protection. In a weak regime of appropriability, there is thus a hazard of leakage. Tight regimes of appropriability, on the other hand, have no hazard of leakage and are characterized by innovations for which the innovator has an iron clad patent or copyright protection, the nature of the product is such that trade secrets effectively deny imitators access to the relevant knowledge, or the technology is simply difficult to copy (Teece, 1986: 290). These distinctions in innovation, in the purpose of the technology and in the presence of leakages creates 3x2x2 possible situations which can be studied separately. The outcomes of these 12 situations will illustrate the effects of innovation on the efficiency of governance structure. We will turn to four of these situations now.

9 I. Product innovation, general purpose technology and no hazard of leakage. The influence of product innovations in the graphic analysis of figure 1, above, is predominantly one of cost saving. In this first situation, the innovation is assumed to be widespread through the economy and available to any actor willing to adopt the new advantages. The innovation affects the costs of production. This implies that the C curve will shift. Given the definition of the C as the difference between the production costs within the hierarchy and the production costs within the market, the curve will shift either left or right depending on the impact of the innovation on these two types of production costs. As the innovation is, by definition, widespread the market will achieve economies of scope, and it will accumulate the economies of scale for each of the individual applications of the general purpose innovation. The market will therefore be able to accumulate the effects of innovation more effectively and efficiently than the hierarchy will. This implies that the cost of production within the hierarchy will decrease but not as much as the cost of production in the market, and consequently the difference between the two will increase. Hence, the C curve will shift right (See figure 2). The new point of indifference, k, has shifted to the right, as compared to the original situation without innovation at k*. What follows is that the market is preferred over an increased range of asset-specificity. Costs C G+C Figure 2 0 G k 1 k k 0 k* k ' Asset specificity (k)

10 As we presume that there is no hazard of leakage, due to the innovation, the G-curve will also shift to the right (from the indifference point k 0 to k 1 ). Since there is no contractual hazard that requires safeguards, the market will suffice as a governance structure. A governance by the hierarchy will create additional governance costs that could have been avoided. Because the governance costs of the hierarchy would increase as a result of this product innovation, the difference between the governance cost within the hierarchy and the governance cost within the market will increase, and the G-curve shifts to the right. The summed costs, as represented by the C+G-line, shifts to the right due to the increase of the production and governance cost difference. The new point of indifference, k", indicates that relative to the situation without innovation, market procurement has obtained more advantages. After point k", the hierarchy has the advantages. This implies that product innovation, of the general purpose technology type, without hazards of leakage, favors the market as an efficient mode of governance for a larger range of asset-specificity. II. Product innovation, general purpose technology and hazard of leakage. The introduction of innovation into the TCE scheme allows for the possibility that the related value of the knowledge and information may leak away from the original proprietor to other economic agents. This issue of property rights in information has been addressed earlier by Williamson (1991), Teece (1986) and Arrow (1962). In the previous case above, we presumed there would be no hazard of leakage. If the knowledge cannot be protected then innovation may not take place and/or safeguards need to be put in place in terms of protective governance structures. In the graphic analysis this implies that the G curve will shift as the governance cost difference between the hierarchy and the market is affected by the hazard of leakage. The hazard of leakage, or the appropriability of knowledge issue, will increase the governance costs of market contracting relative to the governance costs of the hierarchy. The governance costs of the market will increase, because the market is not able to provide sufficient safeguards for the opportunistic behavior of leaking knowledge. In figure 3 the G-curve shifts to the left representing the decrease of the governance cost difference.

11 The production cost difference in this second situation is affected in the same way as in the first situation, because the innovation is also a presumed to be a general purpose technology. The C curve will therefore also shift to the right. With a product innovation, of the general purpose technology kind, and with the hazard of leakage present, the summed effect is represented by the sum of two effects: the shift of the C+G line, through A and k"; and the shift of the C+G line, through B and k'. The summed effect will return to its original position, through X and k*. In this case the effect of the product innovation on the comparative production costs is entirely compensated for by the hazard of leakage and its effect on the comparative governance costs. Innovation, in this case, does not alter the advantages of the two modes of governance. Despite the effects of innovation, asset specificity up to k* is better served by market procurement, and the hierarchy is better equipped for asset specificity after k*. (G+C)* Costs C Figure G A B X k 1 k 0 k ' k* k Asset specificity (k)

12 An example of an innovation in the electricity industry of the general purpose kind with a hazard of leakage are the algorithms that have been designed for a more intelligent coordination of electricity supply and demand 2. In the Dutch electricity sector, electricity is increasingly being generated by very small, decentralized plants using renewable energy sources. There is an increase in the use of windmills, and the Dutch households use solar panels and micro combined heat and power systems for the generation of electricity. The electricity network needs to change in order to cope with this decentralized generation, and the fact that electricity is also put on the network at the local level instead of only taken out of the network through the consumption of electricity. The algorithms have been designed to allow the grid operators to more efficiently balance electricity supply and demand in this new environment of increasing decentralized generation. They thus allow for a larger proportion of durable energy in the total production of electricity, and thereby reduce the energy costs. Algorithms are innovations of a general purpose kind, because they can also be used for other optimization problems. Teece characterized algorithms as innovations with a weak appropriability (Teece, 1986: 287). They can thus easily leak to other economic actors. This innovation does not alter the comparative efficiency of the governance structures. The choice for a particular form of governance can thus be determined by the standard transaction cost economics approach in which the asset-specificity and the uncertainty of the transaction influence the efficiency of the governance structure. III. Product innovation, special purpose technology and no hazard of leakage. Product innovation in the first case favored the market, by allowing for economies of scale and scope through accumulation of orderings. This favorable position for the market is largely due to the general purpose technology type of innovation. When the type of innovation changes into a special purpose technology, this favorable position of the market is far from obvious, as the advantages for the hierarchy may be equally large. The decrease of the cost of production may take place in the hierarchy as well as in the market, as the type of technology is not relevant for all economic agents, and accumulation of innovation advantages is not possible in the market. 2 Information from the Energy research centre of the Netherlands (ECN) has been used for the examples of innovation in the Dutch electricity industry.

13 This implies that the difference between the cost of production in the hierarchy and the cost of market procurement will remain the same. In terms of figure 4, the C-curve does not shift. When the hazard of leakage is ruled out, as in case I, this implies that the G shifts to the right, from indifference point k 0 to k 1. The summed effect of the product innovation, of the special purpose technology kind, and no hazard of leakage, is the line C+G going through k. This implies that product innovation in this case, with special purpose technology and no hazard of leakage alters the efficiency of the governance structure; markets are preferred over a large range of asset specificity, due to their governance cost advantage when there is no hazard of leakage. Costs (G+C)* C Figure 4 0 G k 1 k 0 k* k Asset specificity (k) An example of an innovation in the electricity industry of the special purpose kind with no hazard of leakage is the innovation of connecting battery systems, that efficiently store electricity, to the electricity network. This innovation allows the grid operators to balance electricity supply and demand at lower costs. When there is a shortage of electricity, the price for balancing electricity supply and demand in real time can be extremely high. When grid operators

14 have access to stored electricity, they do not need to purchase electricity at these prices. This innovation is of a special purpose kind, because the technology is especially designed for the purpose of connecting battery systems to the electricity network. There cannot be any leakage within the Netherlands; the grid operators that use this innovation have a monopoly on distributing and transmitting electricity and the innovation is not relevant to other economic actors. The firm that has ownership of this innovation could therefore sell this innovation to the grid operators in a market, since there is no need for additional safeguards. IV. Product innovation, special purpose technology and hazard of leakage. In the presence of the hazard of leakage the governance cost difference will decrease, as we have seen above. In figure 5, the G curve will shift left. With unchanged production cost differences, the summed effect of the product innovation with the hazard of leakage, can be illustrated by the shifting G+C-line. As the appropriability of information becomes problematic, the hierarchy has more advantages in safeguarding the hazard of leakage than the market does. This is illustrated by the shift of the G+C line, as the market as the efficient governance structure shifts from k* to k'". This implies that product innovation, of the special purpose technology, in the presence of the hazard of leakage promotes the hierarchy at the expense of the market. An example from the Dutch electricity industry is the product innovation of the smart energy meter. This meter registers the electricity use of the consumer, and sends this information, either through the telephone line or GPRS, to the energy firms. The energy firms use this information to provide the consumers with better advice on how to reduce their electricity consumption, and specifically their consumption during peak hours. This allows the energy firms to reduce their costs of investing in peak production capacity. The energy firms are also able to send bills to the consumers that are based on the actual energy consumption, as compared to the monthly advance payments on the basis of energy consumption estimates. These monthly energy bills on the basis of actual energy consumption lead to a lower energy use by the consumers, and therefore lower energy costs (Darby, 2006). This smart meter can only be used for measuring the use of electricity, gas and water, and for transferring this information to the energy firms. It is therefore an innovation of the special purpose kind. The meter is not a technology that is difficult to copy;

15 by looking at a smart meter of a potential competitor, a firm will be able to copy the technology. The presence of a hazard of leakage and the special purpose technology will lead to the internalization of this innovation. The Dutch incumbent energy firms have internalized their smart metering services. Costs (G+C)* C (G+C)'" Figure G k 1 k '" k 0 k* Asset specificity (k) Conclusion In this paper we have graphically analyzed the effect of the introduction of innovation on the efficiency of governance structures. We have done so by extending Williamson s heuristic model to analyze this efficiency on the basis of relative production costs and governance costs. As we have argued the conceptual framework can be extended with the nature of the technology involved and the presence of the hazard of knowledge leakages. We have shown that a hazard of leakage will increase the efficiency of hierarchies. Alternatively, the absence of the hazard of leakages will decrease the efficiency of hierarchies.

16 The analytical results are largely in conformity with both theoretical explorations by others as well with practical findings for the Dutch electricity sectors. This supports the idea that transaction costs economics can deal with innovation issues within the existing TCE model and strengthens the efforts to study the effects of innovation on the efficiency of governance structures in more detail. Literature Kander, A., K. Enflo and L. Schön (2007) In Defense of Electricity as a General Purpose Technology. Center for Innovation, Research and Competence in the Learning Economy, Lund University. Darby, S. (2006) The effectiveness of feedback on energy consumption: a review for DEFRA of the literature on metering, billing and direct displays. Environmental Change Institute, University of Oxford. De Figueiredo, J. and D. Teece (1996) Mitigating Procurement Hazards in the Context of Innovation. Industrial and Corporate Change, 5(2), Globerman, S. (1980) Markets, Hierarchies and Innovation. Journal of Economic Issues, 14(4). Teece, D. (1986) Profiting from technological innovation: Implications for integration, collaboration, licensing and public policy. Research Policy, 15 (December), Williamson, O. (1965) Innovation and Market Structure. The Journal of Political Economy, 73 (1), Williamson, O. (1985) The Economic Institutions of Capitalism. New York: The Free Press. Williamson, O. (1991) Comparative Economic Organization: The Analysis of Discrete Structural Alternatives. Administrative Science Quarterly, 36 (2). Williamson, O. (1996) The Mechanisms of Governance. New York: Oxford University Press.