Regulation of Utilities and Monopolies:

Frequently Asked Questions

By
Matthew Hensley
David Jankofsky
Mary Webster
Ali Memon
Produced in collaboration with:
The Asian Development Bank's
Working Group on Regulation

Introduction

During many of our assignments working around the world on issues of economic reform, privatization, and competition policy, the one area that continually appears as a topic of interest is regulation. Given that most countries have had little experience with regulation, this is not surprising, however, many of the questions regarding regulation often focus on more than the rationale and theory. They increasingly have to do with the "implementation" of regulatory approaches and the appropriate "tools" of regulatory practices. Regulation is an art and science, and there are no easy answers or blueprints. Every sector, country and market is different. Given the interest, IP3 President Matthew Hensley, and our Regulatory Practice Group Leaders David Jankofsky, Ali Memon, and Mary Webster, all former Commissioners or Staff Directors of Regulatory Agencies, decided to prepare a Frequently Asked Questions (FAQ) on regulation. This FAQ, while not comprehensive, is intended to serve as a primer for those seeking a fundamental understanding of regulatory theory, practices, tools, and policies. At IP3, we plan on using this FAQ as a start to a wide range of more detailed notes, glossaries, briefs, and toolkits to assist our clients and alumni master the techniques of regulation in their respective countries and environment. Divided into five main areas of regulation, the FAQ and answers can form the first entry of your library on regulation. We hope you find it useful!

Rationale and Definition of Regulation

1. What is regulation in the context of public services?

According to the dictionary, regulation means a law, rule or other order prescribed by a relevant authority. In practice, it is an instrument of government oversight that is often required in the context of public services where excessive market power exists. Whenever the provision of a certain service remains a monopoly and is considered an essential public good, it would continue to be regulated by the government or an independent commission, to prevent abuse of market position and power.

2. What is the relationship between privatization and regulation?

In many countries-both developing and developed, government owns infrastructure assets and enterprises. Privatization in this context means the partial or full divestiture of those assets to private investors. When privatization takes place, and there is limited scope for full competition in the market, regulation of prices and service becomes important. Where full competition in the market can be achieved, the need to regulate price and performance is lessened, as the market should effectively self-regulate. The responsibility of government, however, to provide continuous oversight for quality, access, and customer protection remains irrespective of regulatory institutional arrangements.

3. Why is the regulation of certain public infrastructure services desirable and necessary?

The main objectives of regulation are to (a) improve efficiency in the industry; (b) prevent market power abuse; (c) build investor confidence to attract investment; (d) build consumer confidence; and (e) achieve public policy goals.

Electric power, for example, is an essential input to all industries and has a significant influence on the size and growth of the entire economy. It constitutes a large part of the infrastructure uniquely required for economic development and the sectors outputs are essential to the well being of society, including households and businesses. Effective regulation is necessary to not only ensure that prices are reasonable and ideally reflect the costs of service, but also to ensure that the service continues to be provided reliably and that the sector is fundamentally sound.

4. If competition exists in the provision of public infrastructure services, is regulation still necessary?

If full and direct competition exists in the provision of infrastructure services, than price regulation may not be necessary. The definition of natural monopoly has changed dramatically in recent years, with technology advances making it possible to introduce competition in many heretofore-protected sectors. However, in cases where competition in the market is not possible or where market forces are difficult to introduce, regulation remains a useful substitute for competition. Policy-makers must remain mindful however, that competition should be promoted and nurtured wherever possible in order to increase the quality and availability of service to consumers.

5. Is there a scenario in which regulation is not necessary?

Yes, there are many examples of infrastructure where regulation is not necessary. In the telecommunications sector, for example, the regulation of basic telecommunications may be desirable to ensure access and affordability, however the regulation of tariffs for cellular services, where it is easy to promote direct competition, may not be required. While it may be necessary to regulate transportation services, where only one or two providers exists (rail for example), the regulation of urban transport, where firms compete against one another on price and quality may not be required. Where competition exists and where the barriers to entry and exit are eliminated, is where we see sectors that do not require anything more than the operation of market forces. Opportunity for "choice" is a key driving factor.

6. Are there different types of regulation?

There are various different types of regulation. Economic regulation and social regulation are but two examples. "Economic" regulation focuses on the keys issues of price, quality of service/products, and competition in a range of industries. In the case of infrastructure, price controls of telecommunication services, licensing of electric power generation plants, quality control of water supply are common. Social regulations include those statutes and rules that are intended to protect citizen health and safety, maintain minimum environmental standards, or promote human rights. Regulation of quality, service, access, performance, and pricing, are all part of the broad mandate of regulators in most countries. In different sectors such as financial market regulation, price regulation is irrelevant, but ensuring consumer protection against fraudulent behavior is primary. Thus, regulation forms are often dictated by the services that are regulated.

Competition Policy and Market Structure

1. Why is regulation called a proxy for competition and why is the introduction of competition the best form of regulation?

Economic regulation of infrastructure services is a proxy for competition when there is no competition. Many infrastructure services have historically been (and some continue to be) natural monopolies. Natural monopolies exist when it is inefficient to have more than one provider of a service in a geographic area. This is usually due to factors such as high fixed costs to enter a business and declining average costs of producing a product-such as a cubic meter of potable water-as production volume increases. In practical terms, it does not make sense to have five or six main lines buried under a street so that a customer can choose the provider from which it receives service.

In such cases there is no competitive market to ensure that pricing is fair. Therefore, a regulator is necessary to "stand in the shoes" of the market to ensure that the natural monopoly service provider delivers services at a level and price that a competitive market would have provided.

Since the regulator cannot accomplish this as effectively as a competitive market, it is always desirable to let a competitive market emerge if possible. In the past decade a competitive market has emerged in most aspects of telecommunications, the generation/procurement aspect of power and natural gas, and in many aspects of transport.

2. How does a regulatory body determine that it is appropriate for competition to be introduced in a particular sector?

A regulatory body has to stay abreast of changes in technology that might change all or a portion of an infrastructure sector such that it is no longer a natural monopoly. That is, if there are no barriers to entry (such as high fixed costs) combined with increasing returns to scale (i.e., the more product produced the lower the marginal and average cost of production), then one has to question whether there is a natural monopoly any longer. At that point, it is appropriate to consider the introduction of competition.

Practically speaking, potential entrants into the market (competitors) will bring these items to a regulator's attention as they seek to enter a market. They will point out the technological or market changes that have occurred or are occurring that make competition feasible. It was precisely the advent of new technology that made competition in certain aspects of the telecommunications industry possible and technological and market changes that allowed some competition in electricity generation.

3. What is the regulatory role as a sector transitions into competition?

As a particular sector begins the transition from a monopoly to a competitive state, the regulatory role changes from that of a "command and control" organism whose main focus is protecting the public from monopoly abuses to one in which its role is to ensure a "level playing field" between competitors.

All former monopoly fields have a dominant incumbent. To allow competition to flourish, the regulator must ensure that the incumbent does not use its market power to squeeze out potential competitors. Regulators therefore have to concern themselves with incumbents seeking to lure large existing customers into long-term contracts, and predatory pricing that puts competitors into a price squeeze. Additionally, often the new competitors must use part of the incumbent's network/grid to provide service to end-users. In these cases the regulator must ensure that the network is open on a non-discriminatory basis to all and that the incumbent "charges itself" (i.e., imputes costs) for its own use of its network at the same rates it charges others.

4. Is there a particular market design or structure that enhances competition?

There is no one particular market structure that enhances competition. The authorization of competition by the proper authorities, a consistent set of rules, and the ability of entrants to make a profit are all considerations that potential competitors will evaluate in deciding whether to enter the field.

To the extent possible, consistent with public interest considerations the regulator can help competition grow by lowering barriers to entry and by raising the body of knowledge about competition by providing/enhancing the dissemination of information to the public.

5. Why is non-discriminatory access to an incumbent's (monopoly) facilities often important in ensuring that competition flourishes?

Infrastructure facilities typically involve high fixed costs; a high investment to enter the market. In those cases where it is desirable to have competitors building their own facilities, it may take some time. However, competition need not wait until competitors construct facilities. Indeed, most competitors "rent" portions of an incumbent's network in providing its own service. Over time the competitor build its own facilities. (This has been the traditional route to "facilities-based" competition in the telecommunications industry.)

Therefore, allowing the competitor to have access to those facilities at a fair price is essential if competition is to flourish.

6. What role can a regulatory body perform in ensuring that the benefits of competition are enjoyed by all societal sectors?

In most cases the pressures for competition and choice in service providers come from large customers. These customers generally see that in a monopoly environment they are subsidizing the provision of service to smaller customers. They recognize that competition wrings subsidies out of the system and lowers their costs, thereby making their own products more competitive.

However, generally, it is politically impossible to move into a competitive environment without small customer/residential support. Hence mechanisms must be in place to ensure that the benefits of competition reach this customer class as well. Since competition drives price towards cost, it often results in lower prices for all consumers. That is the optimal result. Nevertheless, other benefits for small consumers include: the fact that they have a choice of providers; a choice in service offerings; and new products brought on by competitive forces.

In short, while competition generally brings the most benefits to the largest customers (that are, in turn, indirectly felt by smaller customers), the small customers do not want to be left at the gate.

Regulatory Institutions and Their Design

1. Why is a regulatory institution, separate from the government, desirable in infrastructure regulation?

In a competitive market, the regulatory institution provides independent oversight based on transparent rules arrived at through public participation. In a monopoly, the regulatory institution provides price controls that are designed to balance the right of the monopoly provider to earn a fair return on their investment with the interests of the consumers. Both competitive markets and monopoly markets are regulated best when there is minimal political interference from government. An independent regulatory institution is free to make economic decisions that are in the best long-run interest of the regulated sector without undue consideration to short-term political consequences. Short-term political interference tends to keep prices below long-term sustainable levels.

2. What factors determine whether a regulatory institution should be single sector or multisectoral in scope?

One of the most important factors affecting the suitability of a multisectoral regulatory institution is the size of the jurisdiction to be regulated. In small countries or small states within large countries, multisectoral institutions enable the concentration of talent into one body; the staff is often enriched by the opportunity to participate in cases relating to different regulated infrastructure industries. In larger countries, where the issues may be more complex, it is often necessary to create different regulatory institutions focused on specific industries.

3. How independent from the government should a regulatory institution be?

The enabling law creating a regulatory institution should clearly provide for an independent regulatory institution, with the ability to make decisions independent of the relevant Ministry and free from undue political influence over budget and personnel decisions. There should be a transparent selection process and the provision for clear and fair criteria for removal. The regulator should have access to independent funds that are not tied to political decisions. The regulator should have the ability to set rules, licenses and tariffs for regulated companies. As government institutions, all the same, regulators will need to abide by government laws, personnel practices and administrative procedures.

4. Is there a preferred organizational structure for a regulatory institution?

Experience shows that three or five commissioners works the best. Each of these commissioners is appointed for a fixed term of office, which are staggered in years. This enables continuity and stability on the commission. Some commissions then organize themselves according to profession, such as an economic, legal, engineering and administrative department. Others organize themselves along functional lines, such as tariffs, licenses and consumers affairs. Either works well as long as the job descriptions and responsibilities are clear, and the chairman of the regulatory institution can make appointments and remove staff for non-performance.

5. Should the decisions of regulatory institutions be subject to review or appeal?

Decisions of a regulatory institution should be subject to judicial review only. They should not be subject to review by a ministry, by heads of state-owned enterprises or by a legislative body. The judicial review should focus only on the legality of the decision, not on the merits of the decision. This is particularly important for new regulatory systems. Even if there is a relatively weak judicial system, judicial review is more appropriate than any other appeal.

6. How large should the Board of Directors be, what should be their term in office, and should there be professional qualifications for appointment to the Board?

Experience would suggest that a board of three or five people, who work full-time at regulatory issues, is best. If there is a Board of Directors that oversees one regulator, then a larger board may be appropriate. The smaller the board, the more engaged and responsible are the board members. An odd number of members is usually necessary to ensure the ability to reach a decision by a majority of votes. The single-most important qualification is the ability to reach fair decisions by consensus without undue influence by any one party.

Tools of Economic Regulation

1. What is economic regulation and how does it differ from other forms of regulation?

Economic regulation is price or profit regulation. It involves the setting of rates that providers of infrastructure services may charge users of those services. It differs from other types of regulation, such as safety regulation in that while regulating safety may ultimately have a cost to a service provider that is reflected in the price, safety regulation does not set the final price that is charged to consumers. The two types of regulation may exist in the same regulatory body.

2. What are the typical forms of economic regulation and the attributes of each?

The typical forms of economic regulation are the rate of return model and the price cap model. The rate of return model regulates profits. It seeks to establish a "fair" rate of return for a given company and then sets prices so that the company, if operating efficiently, attains that rate of return.

The price cap model regulates prices. It sets the maximum price that a company is able to charge. If the company is operating efficiently, the company makes a profit. If the company operates more or less efficiently the profit would be greater or less than anticipated, respectively

3. What are the main separating issues between each form of economic regulation?

In short, rate of return, allows a rate of return on the company's assets and gives the company a natural incentive to build (perhaps overbuild) its plant. Price cap, on the other hand, only regulates the end price, which gives a company wanting to increase its profits an incentive to lower costs. At times, this could cause a firm to "cut corners" and reduce its operations and maintenance expenditures to an extent that compromises good service delivery to the end user.

4. What is Incentive-Based or Performance-Based Regulation?

While, as noted above, different forms of regulation have incentives naturally built into them, incentive or performance-based regulation usually refers to a system in which prices (rates) are decoupled from profits so that a company is free to earn as much as it can by operating efficiently. To ensure that the company does not engage in excessive cost cutting that impairs service delivery, performance standards are often coupled with the incentive system. If utilities attain the performance standards, they are rewarded through the incentive mechanism. If they fall short, the incentive mechanism is established to penalize them.

There are many forms of incentive/performance-based regulation.

5. Are any of these forms of economic regulation used in a competitive environment?

Yes. Each of them can be used in a competitive environment. However, in a truly competitive environment, the market would set the price. These economic regulatory tools are, though, often used as an infrastructure sector transitions into a competitive mode.

6. Can these tools be used when a contract is the primary regulatory instrument?

Yes. These economic regulatory tools can be captured within the provisions of a contract such that, for example, a regulatory body could reset a price cap (first established in a bid proceeding) periodically throughout the term of the contract.

Regulation and Contract Compliance/Monitoring

1. What is the difference between regulating by institution and regulating by contract?

Regulation by institution generally involves price regulation, regulation of quality, and customer satisfaction. The regulatory mechanism is overseen by an independent regulatory body and the process for regulation is consistent applied sector wide. Regulation by contract generally involves all of the performance elements, including prices, in a contract between two parties, often a municipality and a service provider. All of the terms of contract compliance, standards, incentive, penalties, and performance requirements are incorporated in the contract and the enforcement measures are specifically assigned to a contract compliance unit or officer. Given the long-term nature of contracts, generally speaking, it is difficult to predict or capture all of the unforeseen events that can occur between two parties.

Thus, regulation by contract, while perhaps more efficient than regulation by institution, has its limitations while the regulatory ambit and authority of a national regulatory institution can be more far reaching and effective in tariff setting, dispute resolution and customer satisfaction. Another oft cited reason for regulation by institution is the statutory authority vested in a regulatory body. In many countries where the independence of the judiciary system is in question, the ability to resolve disputes in a contract through the courts is viewed with some skepticism, making the participation of the regulatory institution, vested in law, an important part of any contractual arrangements between the public and private sectors. In fact, what is likely needed in most countries are independent regulatory bodies using regulatory contracts as the legal mechanism to compel and govern performance.

2. Are there criteria that dictate when one form or the other of regulation should be used?

Generally speaking, regulation by contract works best in systems where the administration for contract oversight is embedded in laws, concessions, and regulations and the service commitments on the part of the investor in somewhat limited in scope, scale, and jurisdiction, i.e. a city or service area. Regulation by institution, works best where the regulator has substantial authority and discretion and where the ability to establish reasonable tariffs is in place. Rather than viewing both regulatory approaches as either or, many experts are advocating a merging of the two systems whereby independent regulatory bodies would be establish that sets prices under a clearly defined system, and a regulatory contract is in place during the tariff period that specify adjustments, terms, and conditions and can be easily and transparently enforced. In some countries, where decentralization is taking place, regulation by contract is entirely feasible, in many sectors, at the local level, whereas economies of scale in grid-related industries may warrant regulation by institution using contractual principles and licensing.

3. Does it make sense to have local offices of national regulators to oversee contract compliance and regulation?

In most forms of privatization involving the granting of a right to provide service under monopoly or quail-monopoly conditions, the service provider is providing a specified service at a pre-determined price. Often prices for service vary from region to region and town to town, based on the cost of service. That cost data is often provided by the service provider to the national regulator to justify tariff adjustments. In many cases, oversight of performance responsibilities can be carried out by contract monitoring experts on behalf of either the client (utility, municipality, etc.,) or the regulator. By outsourcing the responsibility for contract compliance at the local level, while ensuring that local price setting conforms to national norms and standards, the process of regulation can become more efficient and transparent.

4. Are different skill sets required of regulators as opposed to contract monitors?

Not necessarily. Regulatory experts must be equipped to handle the range of issues found in contracts. This would include financial analysis, economic analysis, legal issues, accounting, and customer service. Typically, contract monitoring activities may focus more on the construction and operation of a particular asset or service, thus skills for contract supervision and performance may include engineering, quality assurance, environmental, as well as the legal, financial, and economic skills to review costs of service and reasonable tariffs.

5. Can regulation by institution and regulating by contract be used simultaneously?

Absolutely, in many countries regulation by contract is in place between a city and a service provider but the tariff setting formula and dispute resolution clauses are overseen by the national, independent regulator. It is critical that the regulatory roles and responsibilities of both the regulator and the monitoring entity are spelled out in the bidding documents to enhance the transparency and certainty of the post-award arrangements.

For further information or comments, please contact Matthew Hensley at mhensley@ip3.org.

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