Social Pricing and Rural Issues

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

Market liberalization and private sector participation have raised the question of service quality differentiation¹. On the one hand, governments have tended to focus on the main utility provider while overlooking alternative providers, and therefore set standards that are usually above what would be acceptable to the poor and socially optimal. They do not take into account affordability or the costs and benefits of different quality standards. On the other hand, competition has driven operators to offer de facto different quality and price bundles, even though they do not all respect the regulations that are in place. In economic terms, the preferred level of quality should reflect the value customers place on quality and the operator’s cost of providing service quality²: differentiating quality thus appear rational in both economic and social terms.

OFWAT, the water regulation agency in the UK, was the first to develop an approach where allowed prices are linked to service levels: the operators providing the best service are rewarded with an increase in price limits within a price-cap regulation, while the “bad ones” would see their price limit reduced.

The rationale for differentiating quality is essentially two-fold:

• To save costs for operators: poor areas are more expensive to serve because of remoteness, low consumption that does not cover the high cost of connection and higher risks of non-payment. Allowing for greater flexibility and cost-saving measures include finding alternatives that would reflect the entire cost of service on poor consumers, for instance by offering lower quality at reduced costs. By doing so, the operator would market new services aligned with the poor customers’ preferences and their willingness to pay.
• To make the service more affordable to the poor. Quality standards should be reviewed to see whether a lower minimum requirement would be acceptable to the poor and would allow fulfilment of social objectives. Providers should be free to compete on quality above the minimum standards.

However, differentiating quality of service also presents some constraints:

• While both operators and poor consumers could gain from choosing the level of service quality offered, regulated firms³ could be constrained by existing regulations⁴.
• There may be high costs or technical difficulties associated to service quality differentiation, which would offset potential gains. For integrated network services such as electricity provision, there may be no point in seeking to differentiate quality parameters such as voltage consistency. For water supply, beside the obvious public health concerns, it may not be possible to treat water to different levels, as it would require building separate distribution networks. However, specific parameters, such as reliable hours of service could be differentiated.
• In addition, cost differences driven by quality differences may be difficult to reflect in tariffs: if quality variations lead to differences in marginal production costs, they will not reflect by varying the volumetric charge.

There are a few ways to circumvent those constraints:

• By adapting regulation: both poor consumers and operators would gain benefit of a regulatory framework that would allow large and small providers to compete to supply a range of services at prices that better reflect consumer willingness to pay.
• By allowing alternative providers⁵ to take action. Regulation should acknowledge the role of alternative providers and leave them leeway to meet the needs of the poor more appropriately, while giving them incentives to enter the formal sector and upgrade their services in the long-run.
• By allowing the main provider to deliver different quality levels to different customer groups: this possibility should be allowed in the quality specification imposed on the operator. In the case of concession contract, quality agreements and minimum standards can be monitored and enforced by the contracting parties and the regulator⁶.

In allowing for quality differentiation, regulators should nevertheless be aware of two potential pitfalls:

• All operators should meet minimum quality standards requirements. The regulator would have to determine what minimum quality level to impose, and which aspects of quality are important. It includes nature of the product (impurities in water for instance), delays in obtaining the service, service reliability, and safety aspects. The next stage is to determine what trade-offs consumers are prepared to put on different aspects of quality and price, and to make sure that they have all relevant information to make informed choice (especially when it comes to public health issues).
• Operators offering lower quality service should have an incentive to improve their offer. Exposing the “worst in class” has proven successful in pressuring utilities to provide better service to consumers.

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. Offering different quality of product and service to different group of consumers. Lower quality may reflect actual cost of service to low-income consumers and lead to varying prices that would save costs for operators and make the service more affordable to the poor (Ed.) Back to Content
2. See Chapter 6 Section 2. Back to Content
3. See “regulated utility” in the glossary. Back to Content
4. For instance, a price-cap regulation would stop the operator of charging more when it delivers higher quality, therefore giving the operator an incentive to undersupply quality. On the contrary, a rate of return regulation would give an incentive to oversupply quality, since the firm will pass on the costs of higher quality to consumers. Back to Content
5. See “alternative electric supplier” in the glossary. Back to Content
6. See Chapter 6 Section 2. Back to Content