Social Pricing and Rural Issues

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

Key regulatory duties include promoting investments and ensuring equity. Yet, economic efficiency and social policy are often at odds. In order to promote investments, tariffs must be set at a level that allows investors to recover costs and allow for sufficient return on their investments. The difficulty is to determine what is a “sufficient” or “reasonable” return, so that the level of tariff would not be prohibitive for poor consumers to access infrastructure services. This is the nature of the regulator’s role as arbitrator, between the operator’s objective to maximize profit and the government’s objective to maximize welfare and provide affordable service to the poor¹.

In order to play its role successfully, the regulator needs to undertake certain tasks:

• Gather appropriate information from the operator about its financial condition, the market demand and its ability to operate efficiently². Ways to do it include creating a Uniform System of Accounts, applying ring fencing and requiring pricing restrictions³.
• Be aware of the operator’s needs to pursue investments while remaining financially sustainable. When setting the overall price level, the regulator may use a rate of return regulation methodology, which adjusts overall price according to the operator’s accounting costs and cost of capital. It takes into account⁴: the cost of capital and operating expenses, that are “prudently incurred”, i.e. that are cost minimizing given the level of output and service quality required, and “used and useful” to be covered; an amount of unpaid bills within the limit of “normal business experience”, an allowed rate of return (except when capital is provided by the government or customers) and asset depreciation; and accurate forecasted investments.

However, price levels so determined do not guarantee that service is kept affordable for the poor. Regulators can reconcile the seemingly contradictory objectives in a number of ways:

• By shifting business risk away from consumers to shareholders through appropriate regulation. Complementary approaches to regulation include price cap, revenue cap and benchmarking with competitors. Those approaches encourage the operator towards more costs efficiency and leave him leeway to determine tariffs within determined service baskets⁵ as long as it does not exceed the price or revenue cap fixed by the regulator. The regulator can also use incentives⁶ for improved performance, which would bring the overall costs of service down: it does so by allowing additional profits, i.e allowing the operator to keep the difference between earnings and the cost of capital, or require that earnings are shared with customers through price reductions, refunds or increased investments⁷.
• By making special pricing and service arrangements for the poor. Key to these arrangements appear to be to balance quality, price levels and payment schemes so that the needs of the poor can be met⁸. The regulator should allow for differentiated service levels to serve different categories of customers⁹: providers serving the lower end of the market can adapt their service to the needs of customers and thereby lower their price to meet affordability constraints. When price levels are a hurdle to poor consumers’ access to infrastructure services, the regulator should provide targeted subsidies and design a tariff structure allowing those subsidies to be specifically targeted onto the poorest consumers¹⁰. Payment schemes should also be adjusted to the needs of the poor, especially in rural areas¹¹.

Related Questions

• What do regulators need to do differently to tackle the needs of poor consumers?
  • What should regulators do to meet social objectives set by policy-makers?
  • Should social objectives be met through funds obtained at the national level and allocated to meet the objectives in each sector and region?
  • What are the advantages and disadvantages of creating dedicated agencies or « funds » to support the development of infrastructure services in rural areas? How should the regulator relate to such funds?
  • Are successful programs for peri-urban areas appropriate for rural areas?
  • Do higher income customers benefit more from subsidies than do poorer customers?
  • How can a regulator promote investment while keeping service prices affordable?
  • What procedures should the regulator adopt in order to balance economic and social objectives (like efficiency vs. fairness)?
  • What are the strength and limitations of lifeline rates?
  • When and why would the regulator choose not to regulate the price structure, leaving the task to the operating company?
  • In an industry where an aging network and generation capacity constraints lead to poor service delivery, to what extent should consumers contribute towards capital expansion?
  • Since rates in the water sector seldom reflect full cost recovery, how can you convince citizens to accept higher prices (given their willingness to pay)?
  • To what extent does service quality need to be the same for high and low cost areas?

Footnotes

1. Chapter 5 Section 2-1 explains this mechanism. Back to Content
2. See Chapter 3 Section B Back to Content
3. See Chapter 3 Section C. Back to Content
4. See Chapter 3 Section E. Back to Content
5. Regulators may create groups of service that are subject to similar degrees of competition. Operators may then be allowed certain price flexibility within these service baskets (Chapter 5, Section B, 2). Back to Content
6. See incentive-based regulation in the glossary. Back to Content
7. See Chapter 4 Section C, D and E. Back to Content
8. These issues are addressed in more details respectively in question 1, 13, 8 and 9. Back to Content
9. See question 1 and the “willingness-to-pay” surveys, as a way to adapt service to customers’ preferences. Back to Content
10. See question 6 on the limits of targeting subsidies. Back to Content
11. See question 5 on the specificity of rural areas, where customers are often not «monetized». Back to Content