Foundations of Regulation

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

There are three different types of market failures that can potentially drive the design of infrastructure reforms: failure of competitive markets due to the existence of natural monopolies, information asymmetries and externalities. These are explained in more detail in turn below.

Competition failures. There are limits on the extent to which competition can be introduced in the provision of infrastructure services, as some segments of the value chain can be seen as a "natural monopoly". For example, natural gas distribution or electricity distribution are seen as natural monopolies¹, which means that a single firm can produce a given level of output at a lower total cost than can any combination of firms. This means that, for example, it is not efficient to build several parallel gas or electricity distribution networks. By contrast, suppliers of these products can get access (at an access charge) to the distribution element of the network and compete for serving the end-consumers. The design of infrastructure reforms would need to take account of what consists of a natural monopoly in the country and sector involved. Given the natural tendency of monopolists to exercise market power (which may result in excessively high prices and low quality), it would be important to establish a regulatory regime that constrains such market power for the natural monopoly elements whilst letting competition drive efficiency improvements in the other segments. This may require structural separation² or unbundling, to separate those different segments and establish distinct regulatory regimes.

Information asymmetries. Information asymmetries materialize at different levels. Customers may not necessarily know the quality of the service they obtain before they consume it (this is typically the case with water supplies, which may look or taste the same even if they are contaminated) or the kind of hazard they are exposing themselves to (for example, with inadequate electricity supplies). Regulators would typically have access to less information than what utility management has at its disposal (this is typically referred to as a "principal-agent" problem). Information asymmetries need to be taken into account when designing infrastructure reforms, so as to introduce the optimal regulatory tools and instruments to address them. A first essential step of regulatory reform may consist simply of establishing mechanisms for collecting, comparing and disseminating information on utility performance³. The information required includes financial data on the operator, information on prices, sales, market shares, quality of service provided, etc. The most common approach is to require from the operator to provide the regulator with financial statements annually in accordance with a unified system of accounts⁴. Benchmarking, or yardstick regulation, may also be a useful tool to compare utility performance and identify areas of under-performance and potential for improvements. This can be conducted at sub-national, national or even international levels⁵. If the results are properly communicated to customers, this can also alleviate the information asymmetry at this level and stimulate service providers to improve their performance. Gathering information on historical trends, current baselines and realistic targets through benchmarking may also contribute to mitigate conflicts over reforms (Berg, 2007).

Externalities, or « external effects », materialize when the production or the consumption of utility services generate spillover effects for which no payment is made via a market. This may result in over or under production compared to the social optimal. For example, electricity generation leads to the release of CO2 (this is referred to as a "negative externality"), with different modes of electricity generation having different carbon footprints. By contrast, provision of adequate sanitation (either through on-site sanitation solutions with sustainable services to collect, treat and dispose of the sludge or via sewerage and treatment systems) can generate positive externalities, as it would reduce the impact of diseases in the community as a whole. Externalities can be taken into account in the design of infrastructure reforms in the following ways:

• When there are positive externalities from consuming a given utility service, by giving incentives to utility service providers to extend service coverage beyond what they would do based on purely financial criteria. For example, rural services are rarely attractive from a risk/return point of view but can generate substantial spillover effects in terms of rural economic development. Governments can therefore choose to provide subsidies to encourage utility service providers to extend services in rural areas.
• When there are negative externalities (from electricity generation for example), governments should introduce environmental safeguards and financial incentives to foster the selection of cleaner fuels for example⁶.

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 Overview Section C. Back to Content
2. The meaning of structural separation here is different from the definition given in the glossary: " Quantity supplies exceeds quantity demands because a minimum price has been set above the equilibrium". Structural separation in the present context means the separation between the potentially competitive portions of the utility service from the non-competitive portions (see Overview Section C). Structural separation is sometimes called unbundling, although the latter may be less severe: a regulator may allow a single operator to combine competitive and non-competitive elements to provide bundled service, while requiring the operator to allow rival access to the essential facility. Back to Content
3. See Overview Section D. Back to Content
4. A unified system of accounts is a set of regulator-determined accounting rules that define the accounts and the accounting practices that operators must follow when reporting financial information to the regulator. Analysis of this information is aimed at regulating overall price levels (see Overview Section D). Back to Content
5. Properties of benchmarking analysis and the metrics used are described in Chapter 4 Section G. Back to Content
6. See Chapter 6 Section C. Back to Content