Price Level and Tariff Design ^{TEN new FAQs Nov 2010}

[Response by Sophie Trémolet and Diane Binder, November 2010]

Poor people often do not have access to the incumbent operator's network but rather rely on informal service providers. A major issue for extending the network is the difference between poor people's ability to pay and the cost of service, especially in remote areas. Operators have therefore no incentive for service expansion as the revenues earned for providing such services would likely be below costs. Various mechanisms set out in the contract or the regulatory regime can provide additional incentives for the operators to extend coverage, including well-designed subsidies. In the case of private sector operators, regulators may need to combine incentives with monitoring and enforcement measures, as the interests of profit-maximizing operators and those of governments aiming at maximizing welfare and providing service to the poor may diverge [1].

Regulatory incentives to expand service coverage may include the following examples (those refer mostly to the water sector, but can be applied to other infrastructure sectors):

• Setting realistic coverage targets[2] and verifying enforcement through appropriate institutional mechanisms (such as external consultants, surveys, dedicated monitoring units, etc.). In Gabon, coverage targets set out in the concession contract introduced in 1997 for the SEEG (providing both water and electricity services) have provided effective incentives for quickly increasing network density in newly served rural areas. The concession contract prescribed the use of external experts to monitor the service provider's performance.
• Allowing differentiated service levels : the regulation of infrastructure standards has many dimensions. While minimum requirements affecting public health and the environment can be relatively objectively defined, various quality and price bundles must be allowed reflecting customers' preferences (Baker and Trémolet). It means, for example, avoiding requesting that all connections be in-house connections and allowing that some customers may be reached through standpipes or connections with varying standards, such as condominial (in La Paz El Alto and Durban).
• Allowing for a more flexible regulatory framework in which the main operators have incentives to subcontract to small operators for example as a way to increase coverage (for example by selling water to independent entrepreneurs who would then sell the water through their own distribution networks). In many cases, a regulatory framework has been defined in the context of the privatization of the main utility, and would aim at regulating the incumbent operator, while paying little concern to smaller operators, thereby ignoring a large segment of the customer base. This is what happened in Maputo, with over 450 unregulated small-scale operators serving about 30% of the capital city population. The CRA (the incumbent operator's regulator) is now considering how such operators could be regulated without hampering the dynamism of the services they provide.
• Establishing a tariff level and structure that encourage higher access without jeopardizing financial stability . Sometimes, service can be made affordable simply by changing the price structure[3]. For example, customers may be able to afford cost-based usage fees, but not cost-based initial connection fees. In these situations, it may be optimal for operators to provide customers with optional tariffs[4] (the operator offers the customer a menu of pricing plans) or alternative payment mechanisms such as pre-paid service or monthly fees (Ehrhardt, 2000). When the price level is a hurdle because the overall costs of providing the service is too high compared to what customers can pay, it may be necessary to provide subsidies, preferably on an output basis[5].
• Using mechanisms such as Output-based aid (OBA)[6] to foster service expansion . The OBA approach, which consists of providing public subsidies for output actually delivered, can be a powerful incentive for operators to increase service coverage. In the water sector, OBA subsidies have usually been used to provide subsidies for new connections, as in Paraguay, Cambodia and Morocco amongst others. In Chile, as part of a massive electrification effort in the 1990s, the government decided to grant a one-time direct subsidy to private electricity distribution companies on a competitive basis, based on a number of criteria such as cost-benefit analysis and social impact.
• Modifying the service area , thereby allowing cross-subsidies between high and low-cost areas. This can be done through aggregation, i.e. the grouping of several municipalities into a single administrative structure. Aggregation reforms can be considered when service providers are too small to provide an efficient service or to share the cost of service over a larger demand base, thereby encouraging service expansion in remote areas. Alternatively, franchising would be another way to encourage service expansion, as the franchisor (a national or regional utility) could rely on local providers, who would benefit from its expertise to expand the service in rural areas at low cost and low risk (Binder, 2008).