Foundations of Regulation

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[Response by Sophie Trémolet and Diane Binder, August 2009]

It has been estimated that close to 200 new infrastructure regulators have been created around the world since the late 1990s,¹largely as part of broader infrastructure reforms.

For much of the 20^th century, network utilities were vertically and horizontally integrated state monopolies under ministerial control. Recognizing infrastructure’s importance for generating economic growth, alleviating poverty, increasing international competitiveness and encouraging foreign direct investments, many countries have implemented far-reaching infrastructure reforms² in the past two decades. These reforms have been aimed at improving sector performance, via breaking up existing monopolies and unbundling³, opening markets to competition, introducing private sector participation and establishing regulatory frameworks.

Where they have been conducted, the main reasons behind those reforms were usually as follows:

• State-owned monopolies often exhibited poor performance, with low labor productivity, deteriorating facilities, poor service quality, chronic revenue shortage, inadequate investments, and recurrent problems of non-payment. In addition, large portion of the population lacked service coverage, and prices varied considerably across population segments, often leaving the poorest consumers to pay the highest prices. Reform was therefore viewed as a necessity to improve sector performance.⁴
• State-owned monopolies often suffered from undue political interference. As a result, they were frequently required to adopt inefficient tariffs, which were set much below cost and poorly targeted subsidies. They were also used to generate revenue for government, support excessive employment and provide services primarily to politically powerful groups, while delaying investment and modernization.
• Service deterioration was mainly caused by underinvestment, which was largely due to the failure of governments to prescribe cost-reflective tariffs. Prices were set artificially low for political purposes, at levels insufficient to cover investment needed to meet the growing demand for services. The problem was deferred as long as the government could provide subsidies and international financial institutions were willing to bail them out.
• Governments were fiscally stressed. Reforms were aimed to release state financial resources away from direct provision of utility services to other pressing needs.

During the 1980s and 1990s, policy makers began to conclude that regulated, privately-owned service providers might be more effective than state-owned operators because private operators might be less subject to political opportunism and might operate more efficiently than state-owned enterprises, especially if subjected to competitive pressures.

As part of this trend, countries began to introduce competition wherever possible and to establish utility regulatory agencies that would enforce concession or licensing agreements and regulate prices (this is what is referred to as the regulation by agency⁵" model). Other countries chose not to establish regulatory agencies but rather to regulate the newly privatized utilities based on the contract, possibly with the establishment of contract monitoring units with powers to monitor the contract but limited ability to adapt the existing arrangements to changing circumstances (this is what is referred to as the regulation by contract" model).

Some countries combine regulation by contract" and regulation by agency" in what has become commonly referred to as "hybrid regulatory models". These models can take different forms, depending on the local context. For example, an independent regulatory agency may be supplemented and strengthened by contracting out or outsourcing of certain regulatory functions, if the external capacity is there and if it is cost effective. A regulatory contract may also be supported by outsourced functions and expertise provided by third parties (consultants or an expert panel). The various models imply varying degrees of regulatory discretion; and the degree of discretion should be commensurate with local political, legal, institutional, and human resource capacities that support or constrain credible and legitimate regulatory decision making (Eberhard, 2007).

The establishment of regulatory agencies was often deemed preferable to provide a credible safeguard to consumers and to clarify the rules of the game for potential investors. This enabled attracting long-term private capital, including clarifying property rights and assuring private investors that their sunk capital will not be subject to regulatory opportunism. The basic motivation was to establish institutions that would encourage and support clear and sustainable long-term economic and legal commitments by both governments and investors, while giving protection to consumers.

However, because there is no universal reform model but rather programs taking into account the countries’ economic, institutional, social and political characteristics, the shape of market reforms has varied across sectors and countries, spanning from liberalization to restructuring and privatization. Therefore, the historical context has largely impacted the scope of authority and responsibilities of regulatory agencies, and the type of regulatory instruments they apply⁶.

Related Questions

• What are the foundations for regulatory activities in infrastructure?
  • Historic Rationale – What are the historical reasons leading to the creation of regulatory agencies around the world?
  • How can policy makers incorporate market failures in the design of infrastructure reforms?
  • Nature of the Benefits – Historically, what have been the main benefits of reforms?
  • Reformers – Who usually drives infrastructure reforms: governments, utility providers or sector regulators?
  • Beneficiaries – Who are the main beneficiaries of infrastructure reforms?
  • Opponents – Who may be hurt by infrastructure reforms and their unanticipated consequences?
  • Instability – How can regulators ensure stable (and predictable) regulatory regime under changing market and technological conditions?
  • Lack of political continuity – How can legislation be used as a tool for promoting stability and continuity in the reform and regulatory processes?
  • Risks – How can the regulator avoid unintended negative consequences when it adopts regulatory decisions?
  • Federal systems – What reform strategies and regulatory structures are best suited for large countries with federal system (multiple layers of regulation)?
  • Failed states – What reform strategies and regulatory structures are best suited in failed / post-conflict states?

Footnotes

1. See "The Handbook for Evaluating Infrastructure Regulators". Back to Content
2. Infrastructure reforms are defined as a set of policies aimed at improving sector performance, including the breaking up existing monopolies and unbundling, opening of markets to competition, increased participation of private utilities in service delivery, and the establishment of regulatory mechanisms (derived from "Infrastructure Reform", Kessides). Back to Content
3. Unbundling consists of disaggregating components of a previously vertically integrated network. For example, separating electricity service into its basic components (generation, transmission distribution, and retail) and offering each component for sale. With separate charges for each component, stages of production that are potentially competitive can attract entry-potentially leading to improved industry performance. (Adapted from the existing definition of "unbundled utility services" in the glossary). Back to Content
4. The meaning of "improve sector performance" can be subject to considerable debate. See Overview B for more details on discussion. Back to Content
5. See Section 1.B. Back to Content
6. See Section 1.C. Back to Content