Foundations of Regulation

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

When infrastructure reforms have been introduced, they were expected to yield the following benefits:

• To improve performance, by generating higher investments (based on tariffs better aligned with underlying costs), productivity gains, increased service coverage and improved quality of service.
• To improve access to affordable basic services to poor households;
• To promote transparency and accountability of utilities’ operations;
• To improve the government’s fiscal position, by eliminating subsidized credit for the utilities and reducing direct subsidies, and generating proceeds from divesture from state shareholding in utilities.
• To generate better information on operators and markets, so that regulators have the right tools to make informed decision related to price levels (using ring fencing for instance), facilitating competition, etc.

In practice, however, these benefits have not always materialized. The impact on infrastructure reforms has varied depending on the type of reforms adopted, the local context and a variety of external factors (such as the impact of exchange rate devaluations or economic crisis).

Kessides¹ uses three criteria to assess the effects of reforms: the resulting level of investments and thus service expansion, the operating efficiency, and the allocative efficiency. To these economic effects, he adds the distributional consequences of reforms – especially their impact on poor households. Although experiences have varied considerably across countries and sectors, for the most part the reforms have improved infrastructure performance, albeit not sufficiently to ensure universal access and sustainability of service provision. Productivity and cost-effectiveness have usually risen, translating into better operational performance such as reductions in distribution losses. Service quality has improved. Prices have become more closely aligned with underlying costs, although in some sectors such as water, revenue streams have often remain insufficient to ensure the sustainability of private involvement unless there are explicit subsidy payments. On the negative side, evidence from a recent comprehensive study on private sector participation in water and electricity distribution points out to a lack of investment – public or private – in the maintenance and expansion of utility networks (Gassner, Popov et al., 2007). While poor households have by and large benefited from the reforms, the impact needs to be differentiated between low-income and middle-income countries: in Latin America for example, negative distributional effects of layoffs and price adjustments have been offset by improvement in quality and increased access for poor people (McKenzie and Mookherjee, 2003).

Despite an overall improvement, investors and consumers – the two groups that were supposed to have benefited from the reforms and regulatory systems – have often been disappointed by the reforms. Negative perceptions of privatization might also reflect that the process at times has been flawed. Kessides argues that privatization may have been oversold and misunderstood: infrastructure reforms are no magical remedy for the wrongdoings of state-owned network industries, but need to be pursued with due care to institutional and structural prerequisites.

• Effective regulation is the most critical enabling condition for infrastructure reform: protecting the interests of both investors and consumers is crucial to attracting long term private capital needed to secure adequate, reliable infrastructure services and to getting social support for reforms. However, if an effective regulation is not in place, or if its implementation is not sequenced properly (e.g., the legal and regulatory framework necessary for creating the new power market structure needs to be put in place before privatizing power supply entities and setting up new market trading arrangements), the benefits of reforms will be limited. In general, all parties have unrealistic expectations about what could be achieved and how quickly regulatory agencies could establish their capabilities and reputation. Moreover, these expectations often ignore the reality that even the best regulatory agency is likely to be ineffective in a country with high levels of corruption, a poorly functioning legal system, and repeated macroeconomic crises.
• Successful reforms will depend on the ability of the government to build a social consensus around the need for reforms. In Chile for example, this consensus allowed the government to triple the price of water, to base the regulatory approach on setting prices that convey appropriate signals to economic agents, to separate regulatory and supervisory functions from policy planning, investment, production, and sale of service, and proceed reforms in stages.
• Sustainability of reforms can be threatened by various political, economic and technical factors.

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. In "Reforming Infrastructure: Privatization, Regulation and Competition", 2004. Back to Content