RIETI Report June 2011

Utilizing the Market Mechanism for Successful Post-Quake Reconstruction

Although a few months have passed since the devastating earthquake and tsunami hit the northern part of Japan, the hardships of the local people continue and daunting challenges must be overcome to reconstruct not only the affected regions but also the entire country as a more resilient society.

In this month's RIETI report, Ryuhei Wakasugi, Senior Research Advisor, Program Director, and Faculty Fellow, RIETI, and Professor, Institute of Economic Research, Kyoto University, notes that now is the time to shift gears from emergency response to long-term measures. Needless to mention the paramount importance of bringing the situation at the disaster-stricken nuclear power plant under control, he says that Japan must find ways of coping with anticipated power shortfalls and maintaining international confidence in the quality of Japanese goods and products and the resilience of Japanese industries. Professor Wakasugi demonstrates how employing the market mechanism and ensuring information transparency could be the way to achieve that end.

Also in this issue, we are happy to announce our newly launched database project. We invite readers to take a look at our new database on the daily nominal effective exchange rate (NEER), which reflects the value of the Japanese yen for each of the eight major manufacturing industries. Following the Lehman shock in September 2008, it has become increasingly important to monitor daily fluctuations of the Japanese yen, not only at the effective base but also by industry. Our daily NEER provides a better indicator to reflect differences in international competitiveness across industries compared with the conventional NEER. For further details, please scroll down to the Recommended Reading section .

This month's featured article

Utilizing the Market Mechanism for Successful Post-Quake Reconstruction

WAKASUGI Ryuhei(Faculty Fellow / Senior Research Adviser / Program Director, RIETI)

Long-term endeavor toward the construction of a new Japan

Two months have passed since the devastating earthquake and tsunami hit east Japan and we still have a long way to go before seeing the livelihood of the people in the disaster-affected areas get restored. The hardship inflicted upon them by the quake and tsunami is indeed very severe. Furthermore, the ongoing situation at the Fukushima nuclear power plant is causing additional suffering to those residing in nearby areas. With no prospects for seeing the troubled nuclear power reactors brought under control anytime soon, and amid persistent concerns over radioactive contamination, a number of local residents--often those of entire towns and villages--have been forced to evacuate and deprived of a peaceful life. With all of these people suffering, there is not a moment to spare. By mobilizing all resources and expertise, we must quickly bring the reactors under control, end the emission of radioactive material, and restore the local infrastructure for livelihood and industry. Each and every one of these challenges is daunting. We must be prepared for making this a long-term endeavor because overcoming all of these challenges will require an enormous amount of time and resources.

The first two months after the quake was a period of emergency, in which saving people's lives was of the utmost priority. Particularly, in the chaotic period immediately after the quake hit, there was just not enough time or information to allow careful planning for the optimum allocation of resources based on the whole picture of the damage. Inevitably, the situation had to be handled under direct orders and instructions on site. Rolling power blackouts in the Kanto region, the area served by Tokyo Electric Power Company (TEPCO), in the weeks following the quake were a typical example of such handling. It is understandable that in the face of a sharp drop in the power supply capacity of TEPCO, the allocation of power quota was about the only way to avoid the possible occurrence of a huge power outage. But today, two months after the earthquake, the situation is different. A significant amount of information has been collected and is being extensively made available. With efforts toward reconstruction going into full swing, it is now time to shift gears from emergency response to long-term measures.

Discussions on reconstruction plans are now beginning to gather momentum. What is important at this stage is for both the central and concerned local governments to provide a solid framework for reconstruction by clearly defining goals and measures. But the task of undertaking this endeavor rests on the private sector, i.e., each and every one of the Japanese people. Therefore, the reconstruction process must be the one in its framework. In other words, reconstruction plans should be designed in a way that provides incentives for businesses and individuals to act in accordance with the plans in the stage of their implementation, rather than the public sector giving instructions to those in the private sector. The market mechanism of allocation can be an effective tool to achieving this end.

Market mechanism to help supply and demand adjustments

As a result of the Fukushima nuclear power plant accident, TEPCO reportedly lost more than 10% of its power supply capacity. The power industry is a typical facilities-based industry, and each power company's supply capacity is constrained by the fixed capacity of its existing power plants. Indeed, building a new power plant is a task involving enormous time and resources. Also, the power industry is a monopoly industry with new entry into the power distribution business restricted by regulations, which is another factor constraining the overall power supply capacity. And while the accident at the Fukushima nuclear power plant will no doubt put on the brakes for the operation of other nuclear power plants, a shift to fossil fuel-fired thermal power generation is a difficult option to pursue given the mandate for Japan to reduce greenhouse gas emissions. At the moment, TEPCO has recovered its power supply capacity to some extent compared to the level immediately after the quake, which it has been able to do by securing power supply from other utilities including those in west Japan. In terms of long-term prospects, however, we must rethink and redesign our way of life and industrial activity with a view that there is a limit in the capacity of power supply.

It is estimated that electricity supply in the TEPCO service area may fall by about 10% this summer, assuming that peak load consumption will reach 60 million kWh. Thus, how to adjust supply and demand in light of such constraints on the supply side poses major challenges in promoting post-quake reconstruction. Particularly, given the fear that the power supply problem could surface as a power shortage at peak time, it is imperative for the government to take steps that ensure the thorough and effective implementation of a range of power-saving measures. The behavior of individuals and businesses engaged in reconstruction efforts will be greatly influenced by what means or mechanism to be put in place to adjust supply and demand.

Figure: Power Supply and Demand Adjustments Through Pricing Mechanism
Figure: Power Supply and Demand Adjustments Through Pricing Mechanism

The figure shows the supply and demand of electricity in two different situations, one during the period immediately after the quake and subject to rolling blackouts and the other during the summer peak time. Power supply capacity is rigid because of the difficulty of building additional power generation facilities (physical constraints) and the difficulty of entering the monopoly market of power supply (institutional constraints). Therefore, the demand curve becomes vertical at a certain level. The supply capacity decreased from A in the pre-quake period to B in the period immediately after the quake.

One way of controlling demand to a level within the supply capacity is to allocate quotas for the use of electricity, whereby power supply ("d-e" in the figure)--which falls short of demand ("c-e" in the figure)--would be allocated to users at the supplier's discretion. This is the scheme TEPCO used in implementing rolling blackouts in the weeks following the March 11 quake. The way the scheme was implemented, however, provoked a flurry of complaints. Because the 23 wards of central Tokyo were almost entirely excluded from the target areas, residents in areas outside the 23 wards felt that they were being forced to endure more than their fair share of inconvenience. Strong complaints were also voiced by those companies whose production operations were interrupted or otherwise seriously impacted as a result of an irregularity in the implementation of rolling blackouts. When allocated goods are tradable in the market, the negative effect of quota allocation can be mitigated to some extent. However, unlike ordinary goods, electricity is hardly tradable and therefore any quota, once allocated, is inevitably extremely rigid. Rolling blackouts might have been an acceptable scheme as an emergency measure. However, it has been pointed out that such a discretionary quota scheme would be highly problematic in terms of coping with the expected long-term power supply problem in the forthcoming process of reconstruction, and we must therefore explore other measures for achieving a supply and demand balance.

Demand is an aggregate of diverse users with different needs and values. It is difficult to set a priority order among different types of power demand, whether it is for lifeline, medical care, education, or industry needs. In order to be a sustainable system, a supply and demand adjustment scheme must provide users with freedom of choice as to when and how much electricity they use. At the same time, the scheme must be able to keep aggregate power demand to a level within the supply capacity. As a way to achieve the two goals of controlling total demand and ensuring freedom of choice for users, it is desirable to utilize a pricing mechanism, rather than having suppliers unilaterally allocate quotas to users. That way, the voluntary choice of those on the demand side can be reflected in the allocation of power.

Users make decisions on the use of power based on whether their benefits from the use of power are worth the costs. The current power supply capacity ("C" in the figure), though increased from the level immediately after the quake, has yet to reach a level sufficient to meet the expected peak demand ("a-e" in the figure). By raising the electricity rate from the normal rate (Pa) to a premium rate (Pb) during peak times, we can encourage users to cut back on overall power consumption, better balance the use of power across different time periods, and replace various goods with power-saving alternatives. As a result of such changes in the behavior of individuals and businesses, aggregate power demand would be kept to a level within the supply capacity ("a"→"b" in the figure) and would ensure the effectiveness of power saving measures.

For many years, the price of electricity has been determined by cost-plus pricing. This pricing method, however, cannot serve as a mechanism for balancing supply and demand. We should take this occasion as an opportunity to overhaul such price perception and use prices as a mechanism for adjusting supply and demand and coping with an expected long-term power supply problem in post-quake Japan. The perception of prices as a supply-demand adjustment mechanism has been partially adopted and materialized as special discount rates for night-time use of electricity. However, in order to ensure preparedness for long-term power constraints, we should consider introducing a completely new electricity fee structure. In doing so, we need to ensure that the minimum demand for power required in households and business establishments will be properly served and, indeed, it is quite possible to have a fee structure designed to that effect. With such a fee structure as given, allowing users to make their optimum choice in the use of electricity would prompt them to use their ingenuity to find new innovative ways of coping with power constraints. The utilization of the price mechanism is more efficient and democratic than the allocation of quotas.

Revenue gains from peak-time premiums should be returned to the public

A hike in electricity rates means an additional burden for users. This, coming on top of the mandate to save energy, is bound to be met with significant resistance from users. So long as the purpose of raising the peak-time electricity rate is to control demand, it must be ensured--and widely understood by the general public--that the increased burden on users is designed to give them incentive to use less electricity, definitely not intended to benefit power companies. Thus, revenue gains resulting from an increase in the peak-time rate (represented by the square part "bgef" in the figure) must not become windfall profits for power companies. Instead, they must be returned to the general public. To achieve this end, the central and/or local governments should siphon such incremental revenue gains in the form of peak-load power taxes.

If revenue from peak-load power taxes is appropriated to cover part of post-quake reconstruction costs, the increased burden on electricity users will be effectively returned to the general public. All of the issues of burden sharing are a matter of income distribution and should be considered and addressed in the light of the overall costs and burdens associated with post-quake reconstruction.

Sharing of quality information

Information sharing between suppliers and users--i.e., the supply and demand sides of the market--is an important element in facilitating progress and avoiding confusion in the implementation of reconstruction efforts. Radioactive contamination is posing a serious problem to the safety of Japanese agricultural and fishery products as well as industrial products. The biggest concern for producers in the affected region is how consumers and/or users would react to those food products or goods that are not subject to shipment or intake restrictions but may have been contaminated by radiation. This is because the effects of radioactive fallouts on the human body--which are cumulative in nature and increase in accordance with total radiation exposure--cannot be judged in black-or-white terms based on non-parametric independent data, and it is therefore difficult to conclusively determine absolute safety.

It is extremely regrettable that the high quality and safety reputation of Japanese agricultural and fishery products, which is the source of their competitive advantage in the international market, has been damaged by the ongoing incident of radioactive contamination. It will be difficult and inevitably take time to regain the lost reputation, particularly because the cause of such disrepute--radiation--is invisible. But the duration of the time required must be kept to a minimum. Unfavorable rumors are a form of self-defense on the part of consumers. Thus, simply denouncing them as unfounded would not lead to any solution. What is necessary instead is to work out measures by taking such consumer skepticism into account because, after all, individual consumers are to decide whether or not to buy certain goods or products based on their own judgment on safety. And this involves a thorough disclosure of information to the market.

We must keep in mind that the international community finds Japan's information disclosure to date regarding the nuclear power plant accident insufficient. We must avoid by all means the situation where consumers or users unnecessarily avoid purchasing Japanese agricultural, fishery, or industrial products as a result of our failure to provide sufficient information. Demonstrating safety from radioactive contamination is the most critical quality representation of Japanese products.

A situation where producers themselves must look for an inspection agency to have their products tested for radioactive contamination is inappropriate. Public inspection authorities should provide accurate testing and, based on the result of which, guarantee quality assurance for goods to be shipped to the market, and proactively disseminate information both in Japan and abroad. Once assured of the accuracy and sufficiency of information disclosed, large-scale, professional buyers would behave rationally in the market. The public sector is obliged to encourage and support such rational behavior.

Sharing of supply chain information

East Japan, a region severely damaged by the quake and tsunami, is home to material industries such as metals and chemicals, and embraces a number of parts manufactures including those producing electronic and automobile parts. The quake and tsunami destroyed virtually everything--factories and workshops, machinery and equipment, and electric facility--forcing a number of manufacturing plants in the region to suspend operations. Sudden disruptions in the supply of materials, parts, and finished products that were to be produced in the affected area led to the suspension of production operations in other areas, specifically, for those goods that require an item produced in the affected region as an input as well as those that are an input for an item produced in the affected region. The impact has been far-reaching, significantly affecting worldwide production activity.

Many companies that manufacture finished products, parts, or materials in the quake-affected Tohoku and northern Kanto regions for sales to overseas companies are outsourcing suppliers for those overseas companies. As it turned out, the March 11 disaster served as an opportunity to show just how much work is outsourced to companies in the Kanto and Tohoku regions.

As pointed out by RIETI President Masahisa Fujita ( RIETI Report No. 129, April 2011 ), companies around the world may switch to outsourcing suppliers in South Korea, Taiwan, or China, if they expect the supply of goods from the Tohoku and northern Kanto regions to remain suspended for a prolonged period of time. Furthermore, even if Japanese suppliers fully restore their capital facilities and their workforce returns, their customers--once lost to other suppliers--will not, and this spells the possibility that many Japanese suppliers may be forced to exit the market. Indeed, such a case is exactly what happened to the Port of Kobe in terms of its status as serving as an international hub port following the Great Hanshin-Awaji Earthquake of 1995. If the aforementioned switching of suppliers leads to inefficiency due to asymmetric information between suppliers and buyers, it would bring no benefit to the procuring companies, needless to say about the plight of quake-affected Japanese parts and materials manufacturers. In order to prevent this from happening, it is imperative to quickly restore plants and facilities in the affected area and secure the necessary workforce.

The devastating quake hit just as Japanese manufacturers were recovering from the doldrums brought on by the collapse of Lehman Brothers in 2008. As the end of fiscal 2010 (April 2010-March 2011) drew closer, Japanese companies were preparing to announce favorable business results for the second half of the year and many of them were planning to raise their dividends for the first time in years. The very fact that the disaster coincided with an upturn in the earnings performance of Japanese companies should be taken as a small mercy in the midst of the overwhelmingly tragic turn of events. Thanks to financial leeway provided by increased revenues, companies are better positioned to restore their damaged facilities and equipment. Even so, media reports circulated around the world are focusing so much on the tragedy of the disaster and the difficulty of brining the Fukushima nuclear plant accident under control, while little is known about Japanese companies' sufficient resources to restore their supply chains and the fact that restoration work is making progress. In order to avoid problems arising from such asymmetric information between Japan and the rest of the world, those companies concerned as well as the government and relevant public agencies must proactively disseminate information across the world to show just how manufacturers in east Japan are recovering and how they will proceed in the coming months. It is important for companies around the world to know this so that they can avoid sacrificing their long-term benefits for short-term gain.

Market mechanism and reconstruction

Post-quake reconstruction should go beyond restoring to the pre-quake state. Indeed, it is hoped that it will serve as an opportunity to create a new Japan. However, achieving such an ambitious reconstruction plan is not a task that can be carried out by the government alone. It is not warranted either that such a plan will be implemented smoothly by following the discretionary orders of the government. The ambition will be realized only when all participants--residents, companies, local authorities, producers, and consumers--join forces, demonstrating their wisdom and ingenuity in their respective capacities and yet working in concert.

For that, it is necessary to: explicitly specify conditions and constraints imposed on each economic entity; guarantee the freedom of choice to allow each entity to take optimal actions; and provide incentives to do so.

As made evident by the devastating disaster, the Japanese economy is deeply incorporated into the world economy. The reconstruction of Japan cannot be realized without worldwide cooperation. Referring to achieving a balance in the supply and demand of electricity, the protection of Japanese products against harmful rumors, and the restoration of supply chains as specific cases, I have pointed to the importance of implementing measures focusing on information tied to prices, quality, and tradability. If Japanese society is to be "built back better" as an integral part of the global market, sharing information between producers and users/consumers regardless of national boundaries is indispensable. We must remember that successful reconstruction can be achieved only with free and vigorous participation and actions by a diverse set of players. Bearing this in mind, it is hoped that reconstruction efforts will be implemented by fully utilizing the market mechanism.

>> The original columnwas published in Japanese on May 16, 2011.

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