71019 The Challenge of Designing and Implementing Effective Regulation: A Normative Approach and an Empirical Evaluation by J. Luis Guasch and Pablo Spiller The World Bank Washington, D.C . . " . " .. . Contents Foreword xi Preface xiii Acknowledgments X\· Acronyms and Abbreviations xvii 1. The Costs and Benefits of Regulation: The Call for Regulatory Reform 1 Regulation: Definition. Rationale, and Problems 2 The Costs and Benefits of Regulation 5 Assessing the Gams trom Regulatory Reform 9 Regulation as an Instrument Delaying the Introduction of New Products Ii Developing Countries 21 Summary 26 The Regulation of Utilities 31 The Case for the Regulation of Utilities 31 Regulation and Commitment: Contractual Problems Between Firms and the Government "" Regulation and Marke~ Power: Contractual Problems Between Firms and Customers Regulation and Cross-Subsidies: Contractual Problems Between Interest Groups and the Government 35 3. Creating the Basic Engineering of Regulation 41 The Choice of Basic Regulatory Instruments 41 Institutional Structures and Judicial Control Over the Executive 48 A Model of Effecnve Autonomous Regulatory Institutions 50 The Structure of a Reg'..llatory Institution 52 Appendix 3 5i .4, Basic Engineering Experiences in Latin America 59 The use of Contracts in Jamaica, Bolivia, Chile, Peru, and Mexico 60 The Use of Specific Legislation in Chile, Argentina, and Bolivia 62 The Use of Presidential Decrees in Argentina, Ecuador, and Venezuela 6-t The Use of Admmistratwe Procedures in Jamaica 65 Creating the Detail Engineering of Regulation: Price-Setting Policies 69 The Relation between Detail and Basic Engineering 69 Price-Setting Policies i1 The United Kingdom Price-Cap System 79 The Setting of Price Caps and Efficiency Factor in the United Kingdom "0 / - Analysis of Rate-oi-Retum and Price-Cap Regulation B4 Alternative Designs 88 Other Regulatory Issues Affecting the Design of Detail Engineering 90 Appendix 5 95 Contt'nts 6. Creating t.he Detail Enginee~.u'1g of RegulatlOn: Access Terms and Pricing in Network Industries 99 Creating Competition Through Interconnection: Pricing of Access 102 Time tabling: Establishing Optimal Delivery Schedules 109 7. Detail Engineering Experiences in Latin America and the Caribbean 113 Rate of Return in Jamaica 113 Reform of Chile's Telecommunications Sector 11"* Regulatory Pitfalls: Interconnection, Access, Verticallntegration, and CompetItIon 126 Privatization and Regulatory Refonn in the MeXIcan TelecommunicatIons Sector 130 Benchmark Regulation in Chile 15-* Price Caps in Venezuela 15-* Price Caps in Argentina 156 Price-Setting Regulation in Argentina's Electricity Sector 15i Appendix 7 Characteristics of Telecommunications Sector, Selected Countries 164 8. Concessions and Franchises as Modes of Private Sector Participation and Alternatlves to Regulation 171 . The Structure and Design of Concessions 1i'2 Guidelines for Salient Issues in Concession Design 175 Most Common Mistakes Made in Concession and Pnvatlzation Design 19,,* Case Studies and Examples of the Use of Concessions 197 9. The Design of Concession-Type Arrangements: Competitive Provision of Goods and Services to Government by the Private Sector in Developing Countries 219 Procurement: Sole Source and Competitive 221 Solutions to the Procurement Problem 225 Nonstandard Procurements 228 The Issue of Collusion 229 Conclusions 231 10. Privatization Restructuring and Regulation: Actions and Sector Restructuring Prior to Privatization 233 Conceptual Issues of Optimal Restructuring Prior to Privatiza tion 134 Methodology 235 Horizontal Versus Vertical Restructuring 237 Limits to Integration 239 Transfer Pricing 2"*1 Incentives 242 Private Sector Access 243 Sequencing 244 Minimum Investment Policies 244 11. Reform and Regulation in the Power Sector 251 Reforms and Private Participation 252 Regulation and Pricing 257 Pools 257 Some Lessons from Power Sector Reform in Chile, England and Wales, Norwav, Scotland, and the United States 260 . A Case Study: Argentina's Power Sector Reforms 262 Reform of Chile's Electricity Sector 266 Redefined Role oi Government 275 Pending Issues 275 1:. ~ew Frontiers in Regu!"t:or, m TeleComrnunic3tioru: \lJ11agLlb and Regulating the Spectrum ~77 Administrative Spectrum Allocation: Keeping the Political Rents Flowing . .....,. _II The ~\ielfare Cost ot Administrative Assignment of Spectrum 280 The Basic Building Blocks for a Property Rights Approach to Spectrum Aliocarior. 280 The International Experience with the Introduction of Spectrum Property Rights 284 C.:mciu::;ion 2S7 13. Privatizing and Regulating the Transportation Sector: Ports. Railroads, Toll Roads, and Airports 289 Ports 289 Railways 295 Roads 307 Potholes on the Path to Privatizing Roads: Mexico's Private Toll Road Program 309 A Case Study of Transport Privatization and Regulation: Argentina 312 Airports: Issues, Options. and Case Studies 313 Private Sector Optlons m Airports 320 l~, Creating the Detail Engmeering of Regulation: Competition Policies Competition Poilcies as Complements to RegulatlOn 3::- Structural Interventlons 333 Competition BOWldaries 334 13. Competition Policy as a Complement to Regulatory Policy: Competition Expe!1ence in Latin .America ..):);) Competition Law 335 Institutional Eniorcement (Operational Structure) 336 Jurisprudence 338 Utility Regulation and Antitrust Reform Complementanties: The Case of C:-we Institutional Design: Peru's Institute for the Defense ot Competition and Intellectual Property 344 16. Conclusion: The Challenge of Regulation 3"*9 Salient Lessons for Regulatory Design 350 Institutional Components 351 Discretion and Renegotiation Issues 333 Structural Issues 354- Detail Regulation 355 Admmistrative Procedures 358 References 361 Boxes 1.1 The U.s. Peanut Market "* 1.2 Regula tory Reform in Mexico 11 1.3 Montevideo Taxicab Market 26 1.4 Municipal Regulation in Peru 27 2.1 Economic Features of the Electricitv Sector 32 ':. 2.2 The Case of Montevideo Gas Company 33 2.3 California's Energy Bill 35 2.4 Twenty-Two Basic Regulatory Design Questions 40 3.1 Public Utility Regulatory Commissions in Colombia: Autonomous Experts or Politicians? 53 VI CorrUrrlS 3.2 Responsibilities of the tv1.in.ister and the Regulator 53 3.3 The National Regulatory Commission in Bolivia 3.4 Funding Colorado's Public Utilities Commission 3.5 Appointing Regulators :')0 4.1 Main Components of the 1988 Legislation Granting a License to Telecommunic.:i::or.s of Jamaica 60 .... "!t._ Re.-:-rulatorv Void Slow~ ~lex1Can Development 62 o . 4.3 Procedures for Setting Prices in Chile's Telecommunications Law 0..) 4.4: Evolution of Argentina's Telecommunications Pnvatization and Regulatory Sche!l1e 4.5 The Problem of Commitment 6i 5.1 How to Compute the Cost of Capital .. ..., 1- - ..., ::J .... Beta Values 72 5.3 AI. =:xample of a Price Adjustment Formula 76 5.4 Revenue Cap Formula 76 5.5 Hvbrid Price Cap/Revenue Cap Formula 79 5.6 R~negotiation of the United Kingdom's Elecmcity DlStribution Tariff 85 5.7 Chile's Open Telecommunicatlons Market 9:2 6.1 Interconnection in Independent Networks 101 6.2 Full ... Distributed Cost Pricing 104 6.3 Use.:Based Pricing (the Oftel Method) 105 6.4 The Efficient Component Pricing Rule 105 6.5 An Example of the Efficient Component Pricing Rule 106 6.6 Is the Efficient Component Pncing Rule Optunal? 108 6.i A Partial Price Cap 109 i.1 Price-Setting Procedures in Chile's Telecommunications Law 115 -..., 1- The X Factor in the United Kingdom 132 7.3 Expansion Targets Proposed for Privatized Telmex 132 8.1 A Sample of GovemmenfResponsibilities for Concessions 173 8.2 Measures for Determining Compensation at the Termination of a Concession 186 8.3 How Municipal Concessions are Often Awarded 191 8.4 Concession Design is the Strongest Determinant of Performance and ConUicts 195 8.5 Regulatory Agencies in Argentina's Water and Sanitation Sector 2(4 8.6 Receiving, Qualifying, and Adjudicating Commission Report, 18 August 1995 :10 10.1 The Breakup of Telebras Prior to Privatization 236 10.:! Competitive Bidding for the Provision of Universal Service i.rI. Telecomwucations: The Case of Peru 24:6 11.1 Long-Term Contracts 159 11.2 Dealing with Losses in Argentina's Energy Sector 26i 11.3 Privatizing an Electricity Monopoly: Chile's Endesa 2il 11.4 Electricity Generation in the United Kingdom 273 13.1 The Case of Colombia Ports 293 13.2 DeSigning an Effective Competitive System: Buses in Santiago, Chile 318 15.1 Milestones in Chile's Utility Sector Reform 343 Figures 1.1 Output Growth and Market Regulation 11 1.2 Distribution of Net Benefits of 54 United States Regulations, 1990 to Mid-1995 I: 1.3 Railroads: Total Employees and Revenue Ton-Miles per Employee (Class I Railroads), 1981-93 14 . ,4 Railroads: Revenue per Ton-Mile of Freight, 1970-93 14 ;:Onunts :"11 1.3 l\,;atural Gas Transmission: Industrial Service Price. 1980-93 15 1.6 i\:atural Gas TransmissIon: Total Employees and Total Natural Gas Deliveries ?er Employee, 1981-90 15 1.:- Airlines: First Class and Economv Fares. 1973-93 16 1.8 Total Employees and Revenue P~ssenger Miles per Employee in the Airline L-.':ustry, 1973-93 16 1.9 Long Distance Telecommunication: Total Employees and Interstate Switchec :-\ccess Minutes per Employees. 1984-93 17 1.10 Long Distance Telecommunication: Interstate Toll Charges. 1980-9: 18 1.11 Cost-Benefit Analvsis Framework for Regulation 28 3.1 Specific Legislatidn and Political Changes in Decentralized Systems 3.3 Implications of False Bicameraiism for Regulatory Credibility.;:; 3.2 Specific Legislation and the Size of the Bargaining Set 43 3.4 Implications of Parliamentary Systems tor Regulatory Credibility 45 35 Implications of Licensing for Regulatory Credibility 46 3.7 Judicial DIScretion in Two-Party Parliamentary Systems 48 3.6 Judicial Discretion m Bicameral Presidential Systems 49 5.1 Pnce Control Review Process 75 - ., :::l._ X Facto~ 1984-98 80 7.1 Return on Equity of CTC and Ef\.TIL. 1990-96 1:U -., I • .:. increase of Public Telephony by Type, Mexico, 1990-99 141 -., I.,,) Teledensity and Per Capita GDP. Selected Latin American Countries. 1999 7.-1 Connection Charges for Residential Users, 1997 160 7.6 Cost oi an international Call, 1997 162 ...,- I .,:1 Monthly Fees for Local Services, 1997 163 11.1 The United Kingdom Pool (England and Wales) 258 1:.2 United Kingdom Pool Prices, 1/23/96 258 11.3 Historical Evolution of the Price or Electricity, Chile, 1982-97 269 13.1 Segmentation of a National Railway Company 304 Tables 1.1 Annual Costs of Economic Regulation, United States. 1988 .3 l.~ Annual Costs and Benefits of Social Regulation, United States. 1988 6 1.3 Annual Costs of Federal Regulation, United States, Selected Years 6 1.'; Costs of Regulation and Gains from Deregulation 7 1.3 Economywide Effects of Regulatory Reform, Selected Countries 8 1.6 Labor Regulations. Selected Countries 10 1.7 Welfare Gains from Deregulation, United States, 1990 13 1.8 Fare Comparison of Similar U.s. and European Routes 19 1.9 Costs of Energy LT.S. and European Community, 1995 19 1.10 Price Reductions After Elimination of Economic Regulation 21 1.11 Examples of the Costs of Regulation, Argentina, Selected Years, 1965-88 1.12 Impact of Effective Regulation, Argentina 23 1.13 Changes in Performance, 1993 to 1995 23 1.14 Gains from Private Operation of Public Utilities 24 1.15 Sector-Specific Macroeconomic Effects of Private Management of the Sector 25 1.16 Impact of Airline Deregulation, Mexico, 1992-94 26 3A.1 Regulatory Agencies, Selected OECD Countries 57 .. 3A2 Regulutory Agencies, Selected Latin American Countries 58 Vlll Con If'n ts ~.1 Examples of Basic Engmeenng in Latin America and the Carribean: Instruments Embodyin::- Regulatory !\iorms 59 5.1 Formulas for i':;l~e-Basket. Revenue, and Rate-of-Retum Caps 76 5.2 Kev Features of Price-Basket, Revenue, and Rate-ot-Retum Caps 77 5.3 Av~rage infrastructure Firm Betas, by Country, Sector, and Type of Regulatio:1, 1990-94 75 7.1 Pnce Regulation in Telecommunications, Sample CountrIes 113 7.2 Lines U1 Service, Density, and Waiting I...l.:)t, Chile, 1907-95 .L.l1 7.3 Monthlv Local Residential Rates, Chile 1989-96 119 7.4 Evoluti~n of Domestic Local and Long Distance Tariffs, Chile, 1970-92 120 7.5 Return on Net Worth, Selected Years, 1960-91 121 7.6 Market Share RestrictIons in the Long Distance Markets, Chile, 1995-98 123 1.1 Telecommunicahon Comparues and Sen'ices Offered 12';; 7.8 Average Monthly Advertised Rates of Long Distance Telephone Calls, Chile, 1994-95 125 7.9 The Impact of Competition on Long Distance Service, Chile, 1997 125 7.10 Rates of Return on EqUity for Chilean Firms, 1995 125 7.11 User Prices, Chile, Selected Years, 1985-96 130 7.12 Teimex's Performance with Respect to Quality of Service, Mexico, 1990-93 133 7.13 Teimex' 5 Tariffs by Service, .\1exico, 1989-93 134 7.1ot Results of PCS license (at 1800s-1900s MHz) auction, Mexico, 1998 137 7.15 Results of Fixed Wireless License (at 3A to 3.7 GHz) Auction, Mexico, 1998 137 7.16 Indicators of Network Expansion and Modernization in the Telecommunications Sector, Mexico, Selected Years 140 7.17 Indicators of Telecommunications Traffic, Sector Revenues, and Labor Producti\ity, Mexico, Selected Years lotI i.18 Telecommunications Tariff, Mexico, 1988-98 143 7.19 ~etwork Investment and Lrsage Indicators, Selected Latin American Countries, 1998 lot6 7.20 Indicators of Tariffs, Revenues, and Productivity of the Telecommunications Secter. Selected Latin Amencan Countries. 1998 148 7.21 Firtancial Periormance of Selected Telecommunications Firms, 1998 149 7.2~ Telecommunications Sector: Tariff Regulation in Organization for Economic Co-operation and Development Countries 158 7.:'3 Comparative Perfonnance Indicators 163 7A.l Private Ownership. Regulation, and Performance of Telecommunications Utilities, Selected Countries 163 7.-\.2 Restraints on Regulatory Arbitrariness in the Telecommunications Sector, Selected Countries 167 7A.3 Current Regulation of Telecommunications Competition, Selected Countries 168 7A.ot Regulatory and Competitive Environment in Telecommunications, Selected CountI'.les 168 8.1 Examples of Prequalification Criteria in Private Infrastructure Concession Transactions 178 8.: Identilication and Allocation of Risks 180 8.3 Cost of Capital for Road Concession Projects 187 8A Cost of Capital for Seaport Concession Projects 188 8.5 Cost of Capital for Airport Concession Projects 188 8.6 Adjusted Results for Electricity Distribution Businesses, Year Ending March!. 99: 193 8.7 Adjusted Results for British Gas Companies, Year Ending March 1991 193 8.8 Adjusted Results for Water Services Companies, year ending March 1992 194 8.9 Contract Structure and Regulation of Aguas Argentinas, Greater Buenos Aires Area 202 8.10 Contract Structure and Regulation of Electricity Distribution for the Greater Bue:- ·:5 Aires Area 203 ':0!1t~!1t5 ;x S.11 Structure of Water Concessio[15, Argentina's Pro\'inces :::03 8.12 Regulation of Water and SanitatlOn, Argentina 206 8.13 Comparison of Award of Freight and Metropolitan Concessions, Argentina 205 .. 8.1"* Points Granted to Each of the Bidding Consortia 210 10.1 Structure of the Power Sector Industry, Argentina 237 10.::: Examples of Market Structure Reform 237 1Q.3 Comparison of Public 5ervlce Subsidy Schemes, Chile ana COlombia .;..".J lOA Investment Levels of Telef6mc an.:; :i.bbr-rouztlons ENRE Ente Nacional Regulatorio de Energia (Argentina) Entel Empresa Nacional de Telecomunicaciones (Chile) EPA Environmental Protection Agency ESMR Enhanced specialized mobile rad io ESVAL Empresa de Obras Sanitarias de Valparaiso ETOSS Ente Tripartito de Obras y Servicios Sanitanos (Argentina) FBO Fixed-base operator FCC Federal Commurucations Commission FIRE Finance, insurance. and retail trades FNM Mexican National Railways GATI General Agreement on Tariff and Trade GDP Gross domestic product GHz Gigahertz GNP Gross national product GUATEL National telecommunications company of Guatemala lAC Individual airport concessions IBM International Business Machines ICP instItution for CommunicatIOns in Portugal INDECOPI Institute for the Defense of Competition and Intellectual Property IPP Independent power producers ISDN Integrated services digital network ITS Interconnected Transmission System m International Telephone and Telegraph JPUC Jamaican Public Utility Commission rrc Jamaican Telephone Company Kb/S Kilobit per second KCS/TMM Kansas City Southern/Transportes Maritirnas Mex:icanas LAC Latln America and the Caribbean LAN Local area network LATC Lockheed Air Terminal of Canada. Inc. LEC Local exchange carrier LPRV Leas t present value of revenues LRlvIC Long-run marginal cost MB megabytes MDS MultipOint distribution service MEBOCo. Management and employee buyout team MEM Mercado Electrico Mayorista Argentina MGC Montevideo Gas Company MHz Megahertz MHz/POP Megahertz per population MMC Monopolies and Mergers Commission (United Kingdom) MW Megawatts NAFrA North America Free Trade Agreement NEC National Energy Commission NIAL Northern Ireland Airports Limited NrC National Telecommunication Commission (Canada) OECD Organisation for Economic Co-operation and Development Oftel Office of Telecommunications (United Kingdom) OSHA Occupational Safety and Health Administration PAC Procurement assistance commission A:ror::m-.J ::"'!i AbtJrC'lJIDJ!OnS XIX pes Personal communications services Pemex Petroleos Mexicanos PPI Producer pnce index PSTN Public switched telephone network R.A1v1 Random access memory REC Regional electricity companies RlA Regulatory Impact Analysis ROE Rate of return on equity ROR Rate of return RPI Retail price index SA Sociedad A..nonirna SCT Secretana de Comunicaciones y Transportes (:VleXlCO) SEGBA Servocios Electricos Gran Buenos AIres SERTEL Servicios de Telecomunicaciones SLA Sangster International Airport SMR Specialized mobile radio SNR Signal-to-noi.se ratio Subtel Subsecretaria de TelecomunicaclOnes (Chiie, TELCOY Comparua de Telefonos de Coyhaique TeU Twenty-foot equivalent units T01 Telecommurucations of Jamaica TRASELEC The Endesa transmission subsidiary (Chile) ITLP Terminal Three Limited Partnership TUFs Titulos de Uso de Frecuencias UF Unidad de tomento urr Unidad Imposition Total L"TRl' Union Telefonica del Rio de la Plata WACC Weighted average cost of capital WCS Wireless communication services WPI Wholesale price index \-VTO World Trade Organization .. 1 The Costs and Benefits of Regulation: The Call for Regulatory Reform In industrial countries, the past two decades have witnessed an unparalleled rise in new regulations related to the environment health, and safety. During this period, several industries in some countnes, such as New Zealand, Norway, the United Kingdom, and the United States, have also W1dergone sub- stantial economic deregulatio;, induding airlines, trucking, railroads, financial markets, energy, and tele- communications. At the same time, developing countries, complementing their far-readung privatization programs, are engaged in deregulating various sectors of their economies and in devising new regula- tory frameworks tor others, particularly the utilities (Guasch and Hahn 1999). This trend toward economic regulatory reform is likely to continue as a result of the increased de- mands and questions about the need for regulation, the globalization of markets, and the ongoing privatization of the utilities. P.,istorically, regulatory interventions were often motivated by economic conditions no longer applicable, by political considerations, and by interest group pressures to secure transfer of rents. Many sectors were viewed as either natural monopolies or as being oi vital social or strategic interest, requiring Significant regulation, if not direct public ovvnership. These rationales in many sectors are no longer considered valid. Changes in technology and experience and the :nore orgaruzed voice of consumer groups have called into question those arguments. Regulatory reform is also driven by the recognition that many existing regulations have become obsolete and even harmiuJ to economic growth. In addition, government failures may be as capable of creating inefficiencies as market failures. As such, the consequences of that type of regulation were an increase in the cost or goods and services and an overall significant welfare loss as reported below. As economies become more open, pressures on countries to become more competitive drive the call for regulatory reform to reduce costs and to foster increased productivity, competitiveness, and growth. In addition, regulators are becoming more constrained by the increased mobility oi ;:apital and labor (Lee and McKenzie 1991). If regulators choose to keep prices substantially above the costs of production, firms will consider moving to a more hospitable economic environment or will find a way to bypass the system. One example is the state-sanctioned telephone monopoly in some countries. lnceasingly, con- sumers and busmesses are finding ways around these monopolies by making use of Internet services and services that provide cheaper long distance calls. This natural tendency to control ror monopoly prices leads to increased pressure for deregulation and privatization. As the political costs of regulating specific sectors of the economy increase, politicians will see de- regulation as a cost-effective strategy for promoting growth. Other things being equal, those countries where the economic and political gains are likely to be greatest can be expected to proceed with deregu- lation most rapidly. Those industries with a more complicated economic or politically linked structure can be expected to be deregulated more slowly. Not all regulation is on the decline, however. Citizens in many countries express a desire for more regulation in several areas, such as utilities, environmental protection, and public health and safety stan- dards. The increased interest in regulating these areas can be partly explained by the privatization trend and by increases in income. The privatization trend in both developing and industrial economies, par- ticularly in utilities, has brought a call for a companion and effective regulatory framework for the sector. In addition, as consumers become wealthier, they demand more amenities, such as cleaner au and water ana oetter sanitation. As these demands increase, politicians will supply more of these goods and services, but they will also explore ways of supplying them more efficiently. 2 J. LUI5 CIUl5ch and Pablo Splila Current political concerns about luniting tax increases in many countries are creating even more Ul- centives to use certain kinds of regulation. '-"''hen legislators constrain themselves in teI'IT'..s of spending and taxes, regulation can be a useful tool for achieving political objectives, such as transferring wealth to particular interest groups in exchange for political support. In this kind of political environment, legisla- tors substitute regulatory requirements or mandates whose costs are not directly paid for by taxpayers with less visible, but nonetheless real, costs. For example, in 1993 U.s. cities incurred a cost of more than USS3.6 billion to comply with the unfunded mandates of the Clean Water Act. From the government's perspective, the regulation effort appears to be relatively low cost. The federal budget 1$ barely affected when a major change is mandated by regulation. Most of the costs of regulation show up in budgets outside that of the federal government. Regulated firms incur direct costs as they try to brmg their opera- tions into compliance. Moreover, they may contract the work out, move elsewhere, or cease to operate, destroying jobs and reducing the local tax base. The altered service or product may be less appealing to consumers than the old one. Productivity may decline in the short run as unit costs rise and may decline in the long run as regulation-driven projects absorb funds that could otherwise be used to improve or expand the plant. The bill for all these costs is paid partly by the firms that are regulated and partly by the rest of society, depending on the ability of firms to raise prices in their product markets. The impact of regulatory activity on country economies continues to be hotly debated. While few would deny that regulation can increase consumer welfare, the increase depends on how regulation is designed and implemented and the specific problem the regulation is attempting to solve. More- over, regulation can add substantially to the costs of doing business, and those costs frequently are passed along to consumers in the form of higher prices, reducing welfare and decreasing the com- petitiveness of the economy. This chapter has four objectives: to provide an overview of the costs and benefits of regulation through- out the world, to highlight the potential gains from the reform of regulation and deregulation in. indus- trial and developing countries, to glean some fundarnentallessons from the experience wit."'t government regulation, and to make suggestions for improving regulation in developing countries. Given the scarcity of data on these subjects in developing countries, most of the data presented comes from the United States and other industrial countries. This chapter defines regulation, explains its justification and the root causes of its inefficiencies, and reviews the literature on the aggregate costs and benefits of regulation, with all estimates expressed in. the year dollars of the Original study. This chapter also provides some general estimates ot the potential gains or realized gains from rerorm, provides a more detailed analysIS of the potential for structural reform of speciiic industries in industrial and developing countries, presents the key findings of regula- tory reform around the world, and offers some policy recommendations. Regulation: Definition, Rationale, and Problems Many types of regulation exist. While some overlap between the types is inescapable, a common classifi- cation scheme consists of three parts: economic, social, and process regulation. Economic regulation re- iers to restrictions on prices, quantity, and entrance and exit conditions ior specific inciustries. Social regulation refers to regulations that affect a wide array of industries. Typically, environmental, public health, and safety regulations are defined as social regulation. Finally, process regulation refers to gov- ernment management of the operation of the public and private sectors, such as paperwork requirements and administrative costs incurred by both producers and consumers. These categories are not as simple as they might first appear. Paperwork requirements, for example, might be a significant component of some social regulation, such as environmental protection or worker safety. Moreover, some regulations, such as those affecting education and social services, do not fit neatly into any particular category. De- spite these defiCiencies, this framework is a useful starting point for measuring many of the most impor- tant costs and benefits of regulation. This book is mainly concerned with economic regulation, particu- larly the regulation of utilities. The' Costs and Bmejits of &guilltron: Tht!' Call for Rlgul.:z:o'':I Refonn Several economic arguments support regulatIOn (MacAvoy 1992). The most COIl1L1on arguments are based on correcting for market failures, economies of scale, or equity considerations. In the case of social regulation, a primary rationale is that individual companies may not take into account the full social cost of their actions without government interventIon. For example, a firm will tend to pollute excessi\'eiy unless it incurs some implicit or explicit cost for polluting. In the case of workplace saiety, workers may not have adequate information on hazards to make fully infonned choices. Direct regulanon represents one approach to the problem of obtaining such infonnation. In the case of economic regt!lation, the pri- marv economic rationale has to do with the potential for improving production effiaency. If economies of s~ale or scope do exist. a single firm may, in theory, be able to produce more effiCiently than se\'eral competing firms, but then its monopolistic power may need to be restrained through regulation. In addi- tion, consumers may gain additional value as more consumers use a netvl/ork. such as telephones. E-mail is another example: It is more helpful to a user if more people have e-mail addresses. (On the subject of the economics of networks, see Klein 1996; Katz and Shapiro 1991; LIebowitz and Margolis 199-i; and White 1997.) While it is possible to provide some economic rationales for regulation for a wide range of economic activity, such rationales are often not persuasive in practice. Just as the potential exists for man\" kinds of market failure, the potential also exists for government failure. ~efficlent regulation has two causes. One cause is economic, and the other cause is political. Tne economic reason is that it is difficult for a government authority to regulate companies because the au- thoritv lacks the necessarv information. For example, a busmess might have a good Idea of its cost and dem~d structure, but a ~gulator typically does not have access to such information. The firm is usually better informed than the regulator; moreover, it rarely has an incenttve to tell the regulator all it knows. Such information asymmetries imply that economic regulation will rarely achieve a first-best or efficient outcome. In addition, uncertainty or the lack of accurate estimates oi the byproduct, external effects of agents' actions, or new products can induce inefficient regulation. This is common when considering social regulation. The regulator imposing social regulation must frequently base decisIOns on lirruted iniormation (Lewis 1996). For example, in setting the overall emission limitation for acid rain. the LS. government had some crude estimates of the costs and benefits. After the program was implemented. however, the costs of achieving the emission standard were lower than expected. The lower costs re- sulted, in part, because of the flexibility inherent in the market-based regulatory approach that was adopted. At the same time, unforeseen changes in energy and transportation markets also played an important role. These problems associated with regulation do not mean that regulatioh is not a useful approach for increasing economic efficiency when an industry is subject to increasing returns to scale or when exter- nalities or Significant coordination costs are involved. It does mean, however, that L.1.e effectiveness oi regulation is limited and that it has some serious structural defects. These deiects need to be kept in mind when comparing this approach with viable alternatives. Political considerations concerning regulation also lead to inefficient economic results. Since regu- lation redistributes resources and rents, politicians often use it to secure political gains rather than to correct market failures. An array of regulatory instruments, such as quotas, licenses, and subsidies, are used to transfer significant amounts of wealth from consumers to small groups of producers. The result is often that regulation is inefficient. Some classic examples arise in the area of agriculture. including peanuts (see box 1.1), sugar, wheat, and dairy products. ~loreover, the wealth transfers also arise in social regulation. Environmental and energy regulations that involve mandates frequently carry a heavy price tag. For example, Anderson and others (1995) estimated the sa\'ings from the use of market incentives in environmental regulation at US$8 billion (1986 dollars) in 1992 and projected that potential savings in 2000 could be as high as US538 billion, or 26 percent of estimated compliance costs. When transfers are that large, beneficiaries will be willing to expend considerable resources on lobbying and other activities that enhance their earnings and protect these transfers, even when there are huge efficiency costs to the economy as a whole. Since often the cost of regulation to each indi- vidual in the economy is relatively small, incentive exists for individuals to expend more effort to voice opposition to the regulation. oJ: j. LUIS Guasch and Pablo Splllt'?" Box 1.1. The U.S. Peanut Market An example of a small group benefltmg from regulation at the cost of a large group is with t...'e use of the peanut-quota system. Smce 19"*9 the federal government has run a program that hlTuts the ~u.mbe::, of farmers who can sell peanuts in the United States. Imports are also severely restncted. On top or these resmctlons. pnce supports are used to guarantee that tarmers with ~eanut quota~ can cover theIr producnon costs each year. This generally results m the mimmum selhng pnce oemg about ,,0 percent higher than the world pnce. Dunng 1982-87, it'was estImated that the average annual ~or:sumer~to.producer transfer was L'~Slli million (m 1987 dollars), with an assoaated deadweIght loss of LSS34 rrulllOn (Rucker and Thurman 1.90). In 1982. peanut farmers numbered 23,Q.;6, which means that on average eac~ rece:ved a net transfer of t:SSll.~: In contrast, the cost of this program to the average consumer was onJy USS1.23. Few consumers would be Willing to spend theIr own nme and money to dIsmantle the peanut pro~m when they would gam onJ~ USSl.23. However. the program is wor'...h USSll.OOO to the average peanut tanner and that would certallily make 1t worth one's while to see that the program contlnues. SOllru: VlScusi, Vernon, and Harrington (1995). Regulation can potentially have large intended or unintended welfare consequences. Because regula- tion, by deSign, interieres with firm-level pricing and investment decisions and often constrains entry, it restricts competition in one form or another. This is panicularly true for economic regulation. When properly deSigned, economic regulation can add to welfare; otherwise, it will induce welfare losses. The hypothesis is that excessive or improper regulation can increase transaction costs and reduce competi- non, adverseiy affecting productivity growth, efficiency, capital formation, and technological innovation, and can otten lead to higher user prices. Because firms in regulated sectors are able to pass higher costs and inefficiencies on to the final user in the iorm of higher prices, firms have little incentive to lower costs or to achieve productive efficiency. This can translate into ovennvestment of capital, employment of excess labor, or inefficient organization of production. Lack of regulation-induced competition can result in excess rents going to producers, labor, or both, and thus prices, profits, and wages are higher than they would be under competitive conditions. In addition, lack of competition tends to provide little incentive for firms to engage in technological innovation in production or in creating new products or services, pius it makes firms less eager to adapt the quality mix of goods and services delivered to address chang- mg conswner needs. Regulations can impose high compliance costs on government. firms, and consum- ers. When the social gains from regulation are large, the costs are worth bearing. If the gains are small, the costs are punitive and perverse. For this reason, positive gains, such as the delivery of better products or the use of lower-cost technologies, are often associated with deregulation. Ample evidence exists of the costs associated with excessive or misguided regulation, as reported in the next section. Unlike the situation with social regulation, with some dear exceptions, it is, arguably, difficult to find substantial benefits for economic regulation. Generally, whatever benefits accrue from the .regulations are so swamped by their costs that economists typically focus on' the efficiency costs or deadweight losses. These are simply wasted resources, losses imposed on one part of society that are not offset by equal gains to another. For example, by 1984, voluntary restrictions that the United States md Japan had negotiated on automobile imports were creating annual efficiency losses of USSS billion to the United States. These losses were reflected by the USS14 billion in higher prices that consumers paid for cars and were only partially offset by USS9 billion in higher U.s. auto profits. Of course, if regulation becomes inefficient and visible, pressure for change may occur. Firms with new technologies may lobby for reduced regulation. In addition, conswners and businesses may find ways to buy products and services at lower prices by opting out of the regulated markets. For regulation in tradable goods markets, the pressures to deregulate will come from declining market shares'of domes- tic - -~ducers who are vulnerable to less regulated imports. In addition, tradable goods producers that re]:, on heavily regulated nontradable goods sectors will have an interest in facilitating deregulation of these sectors to lower their overall productions costs. ThL' 01StS and Bmt'fits of Rrgularron: Tilt' Clil for ·:z..'rulAr,'-y Rtiform .5 Another source of pressure for regulatory refonn comes trom scholarship that documents the costs of regulation. As noted above, as technology evolves, the authors find that fewer industries exist in which classic economic regulation can be justified on effiCIency grounds. In addition, economists have also docu- mented a wide array of cases in which more flexible regulation, such as perfonnance star.=ards and market- based approaches, ~an achieve better results at a lower cost (Anderson and others 199::; Harm 1996). The Costs and Benefits of Regulation Most systematic economic studies of regulation have focused on federal regulation 111 the U~ted States (Weidenbaum and DeFina 1978; Litan and Nordhaus 1983; Hahn and Hird 1991; Hopkms 1992; Winston 1993). The first study to synthesize data on the costs and benefits or regulation was done by Hahn and Hird (1991). Tables 1.1 and 1.2 provide estimates for the costs of economic regulation and the costs and benefits of social regulation. Hahn and Hird demonstrate four key ideas. First, it is possible to systemati- cally explore the costs and benefits of regulatory activity using standard economic analysis. Second, the effiCiency costs of economic regulation appear to be much smaller than the costs associated with transfers (for example, between producers and consumers). Third, such inionnation can be u.setul in gaining a better understanding of the economic impacts of regulation. Fourth, a great deal of uncertamty eXISts in the data, and these uncertainties should be conveyed as clearly as possible to policy:r,akers. FOCUSing on the cost side of regulation, Hopkins (1992) has extended the work or Hahn and Hird. Hopkins' principle insight 15 that the costs of process regulation are substantial. Tabie 1.3 provides esti- mates of the cost of social, economic. and process regulatlOn as of 1991 and for selected :;ears from 1977 to 2000. The total cost of regulation in 1991 is estimated at USS542 billion (1991 dollars), or about 9.3 percent Table 1.1. Annual Costs a/Economic Regulation, United States. 1988 (billions of 1988 U5S) Regulated sector Efficient'}! costs Transf!''r,' St..':lrces" International trade 17.3 85.6-110.0 Hufbauer, Beri.tner, and Elliot (1986) TeleconununicatlOns <14.1 <42.3" Wenders (1987) Agricultural price supports 6.7 18.4 Gardner 0987\ Airline 3.8 7.i Morrison &: Wi.."'.Ston (1986, 1989) Rail 23 6.S· Winston (1985) Postal rates n.a. 4-1~ President's Corr..'":Usslon on Privanzation (1988) Milk marketing orders I 0.4-Q.9 0.9-3.5 Ippolito &: Masson; Buxton &: price supports Hammond (re':'arred m MacAvo:-' [19i7]) Natural gas' 0.2-0.4 5.0 Loury (1983) Barge 0.2-0.3 O.6-0.cr Litan &: Nordhaus (1983) DaVIs-Bacon Act 0.2" 0.5 Thieblot (l9i5i (updated) Credit 0.05-0.5 0.15-1.(;" Utan &: Nordhaus (1983) Ocean 0.05-0.08 0.15-0.:2" Jantscher (19i3'j Truc:king ()CI a n.a. Oil price controls 0 a n.a. Cable TV 0 0 n.a. Total 45.3-46.6 172.1-209.5 n.a. n.a. Not applicable. a. Figures estimated using 3:1 ratio of transfers to efficiency costs. b.lndicates primary source or estimate. c. Cost of natural gas regulation expected to approach zero as all price controls are liited. d.li estimate is zero, federal regulation is assumed to be negligible. Source; .Hahn and .Hird (1991). 6 J. LulS Guascn and Pablo Splllt!'" Table 1..2. Annual Costs and Bmefits of Socinl Regulation. United States, 1988 (billions of 1988 USS) Rt!gulated :;ector Costs Bmefits Environment 33.';'-77.6 16.5-135.8(58.4)' Hazilla & Kop? 11990}; Freeman (1990); Portney (:. 990) Hlghway safety 6..r9.0 25.4-lS.7 Crandall (1988a: OSHA 8.3-9.0 negligi0le Crandall (1988b;; Denison (19i9); Viscusi (1983) t-.;udear power 3.3-7.6 DOE policy stud:; (1979) (reported In Litan & Nordh.aus [1983]) Drugs < 1.5-3.0 Peltzman (1973) EEO 0.9 Weldenbaum 6.: Derma (1978); Litan & Nordhat.:.S fl983) Consumer product safety > 0.034 U.s. Federal Budget. (FY 1990) (administrative costs only) Total is.C-I07.1 41.9-181.3 - :-..lot available. a. Point esti.m.ate 15 in parentheses b. Indicates pru:n.u;.' source or est::u:nates Sourc~; Hahn and Hird (1991). Table 1.3. Annual Costs of Federal Regulation, United States, Selected Years (billions of 1991 U5S) Regulations q 1988 1991 20De l I-- ~ I Environmental regulation 42 87 115 178 Other socIal regulatIon 29 30 36 61 Economic regulation efficiency 120 73 i3 i3 Process regulation 122 153 189 221 Subtotal of costs 313 343 413 533 Economic regulation transfers 228 130 130 130 Total costs 541 473 543 663 ... Source: Hopkins (1992). oi the gross domestic product (GOP). Hopkins' estimate for the total cost oi regulation includes transfer costs. Total costs without transfer costs are USS412 billion. The largest component oi those regulatory costs was process regulation, or USS189 billion in annual expenditures related to government paperwork requirements, primarily for tax compliance. The tax compliance costs do not necessarily rep-resent effi- ciency costs, however, since one must consider all aspects of a tax system in evaluating its impact on efficiency. Nonetheless, the shear magnitude of the process costs suggests that paperwork could be re- duced dramatically while improving efficiency. To place the numbers in context, each American household would be billed US$5,6S3 (1991 dollars) annually in addition to its current taxes if this regulatory compliance cost was shaTed equally, collected directly, and not imposed on business instead. Those regulatory costs amount to 9.6 percent of the GOP and constitute USS189 billion in annual expenditures related to government papeI"\vork alone. From another perspective, total federal spending in 1991 was about US$1,200 billion, or apprOximately twice the total cost of regulation. This 2 to 1 ratio between government spending and regulatory costs cer- tainly does not correspond to the relative emphasis each receives in either the government's statistics or its decisionmaking. The' C::lsts and B~Mf:fir5 of ~gulation: The utI Jr;r .0. :;1.111::.:. Reicrrr; ~o JggregJte estimates exist of the benefits an": costs IJf .eg:..dation outside of the ~."nlteJ S,a.~e5. In Australia, the total cost or regulation was estimated to be between 9 to 19 percent of the GDP in 1986 (OECD 1997a). Mihlar (1996) provides a preliminary estimate of 12 percent of the CDP for the costs of regulation in Canada. Based on an assumed ratio between private complia:-.ce costs and regulatory program spending. he extrapolated natIonal regulatory costs from fede:al a:-.d pro\':""1cial administrative budgets. While the calculation IS crude. it provides a rough estimate of L~e size of the regulatory burden. Three points are worth nonng about these regulatory cost estimates, since they are otten ::1 tee wi:I'wut careful analysis. First, the figures are highly uncertain and often incomplete. Yet, esnrnates as reported in the press and even scholarly papers somenmes fail to reflect this uncertainty. Second, the figures devel- oped using this approach to cost estimation are likely to understate the total impac~ of reg-.llatory costs because thev do not include the adverse impact that regulation typically has on ir.nova:ion. Tnird, as shown in tables 1.4 and 1.5, the cost at regulation as a fraction of the CDP is fairly sigrtihcan: ior countries where such estimates are readily available, ranging from 7 to 19 percent. The impact of deregulation on a number of economic indJcato~, such as labor, capital, factor productivity, and price level as shown in table 1.5. is also quite Signi.flcant. The OECD (1997a) also estimated that regulatory reio:m programs could increase the GDP m the long run by as much as 3.5 percent In the Uruted Kingdom and by as much as 6 percent in France. Gennany. and Japan. Further evidence of the significant benents to c.eregulanon is described In the remainder or the secnon, including the tables. Table 1.4. Costs of Regulation and Gains from Deregulation (as a percentage of the GOP) ProJected ben~fits of Countnl Cost of regulation' economic deregulatron" Australia 1;-;.9 5.5 GEC:> (l?97a)d Canada :~.S ~!.ihlar :: 9g6)< European limon --, OEe:) (1c;.9/b\~ Gennan}" 0.3 DECD (1 99/b)h Japan '::.?-lS.i DEeD (l997b), :'\ietherlands 0.5-1.1 '. (CEeD 199/b)' Cnlted States :-'::-9.5 0.3 Hopkins 1l':?92)b: \Vinston f!9931' GOP Gross domestic product. a. These numbers are underestimates of the effects of deregulation since the studIes do not include all sectors where dere!!Ula· oon can be benefioal. ::> b The cost estimates. as of 1991, indude process costs. The range reflects the induslon of econoauc transfers. c. WInSton (1993) estimated the gam.s or deregulation in the Uruted States at 0.7 to O.B percent of GOP iT: 1990 The 0.3 percent estl.mate represents the potential gatns 1i the tndUStl"les could "clueve optimality. . d. The projected benefits from deregulation are based on both the Hilmer and related reforms (lndusm' CorrunisslOn 1995). These reforms essenoally cover leglSlative and reg1J.latory changes to provlde a national competition poll~y framework and to broaden the coverage of competition policy instruments. They also cover moves to foster competition U\ national infrastructure areas. such as electncity, gas, water. and road transport. e. The cost estl.mates were calculated in 1993-94. 1. ProJections of savings from deregulabon are based on reducing the pnce and productiVity gap Wlth the L'ruted States. See Shimpo and Nishizake (1991) for an oVervlew of the studies. g. Projections of savings from de.regulatlon are based on dismantling technical trade barriers and customs formalities. en.h.anced economies of scale. and lower pront margms rrom en.h.anced competition: h. Citing Lipschitz and others (1959). ProJections of savings from deregulation are based on more m.arket~rie:nted pnang in agnculture and mining, the dismantling of tariI:f and nontariff bamers in selected. i.n.dUStl"les, and reforms in product and labor markets. i. Citing Van Bergeijk and Haffner (1995), Projections of savings from deregulation are based on the reduction ot product market rigidities in 20 malor sectors of the Dutch economy Source: Author I.:ompilation from OECO studies cited.. 1;1"'1.' 1.5. ffonomywide fhi'cls til Rr8"""ory UlfOlm, St',.'dl''/ Co""t,it'S (unit Ilu.'ilsure) fffi'd -- ..... _----_._ .. ,- fralin' .~;'·"IU"'.II 11'/'at' Nd/ll',lall,l..; Sl'aill Su"',k,, Kjllsdoll/ SIll II'S 1',,,Ii,II CffrdS' I.abllt pmductivity 2.3 35 26 13 3.1 1.7 20 0.5 c.'p".;! productivity 3.3 1.3 4.1 2.9 3.1 1.1 O.C; 1" FaciOI' productivity 2.7 2.8 3.0 IS 31 15 IR os Business sector employment -0.4 -() 4 -1.0 06 -Q.7 06 -0.5 00 W.lges 0.0 -0.1 CHI -0.2 --(J.I 00 lUI on CDI' plicl:! level -1.4 -1.3 -21 -12 -03 [nmllmYlllidl'rffi',;ts· GIJIl 4.8 49 S6 15 5.6 3.1 .15 n.9 Unemployment 00 00 00 no no 0.0 Ot) 00 Employment 00 no Oil 00 Oil 0.0 no 0.1 Real 3.9 4. , :H 28 -1.2 2.1 21} O.R - N(lI.1Vallilbl~. a. 1 h(,Sl! effl."Cls art' h.1Sl·J 1111 all ,lggrl'r,.ltillu III l':-.Iilll;tkd Sf't lor :-,p""ili,' dl"lls IllI'y t'lIVl'1 IIII' IoIiSillt'!-o.., "'l'llllr ollly IJ. Th~ effects indudl' IlIng·term allli dynalilk illh'radilllls ill lilt' "ClIIUIIII)' .1"; ,1 \'IIblll" ilml MI' h,I~('d till Sillllll.llilJ/lS wil" a simplified 1II.1l'IIII·cOIlIImit' IIhlllt'l (SI't' '1,1101., 14). "ht' simulations for lilt' Nelherlands, Sp.lin, ami SWl'.Ien art' prelilllill .... y, hili IIIl' ,'Slilllol"'S 111''''('1 11II:' It·..:; illcllllll' ~lIl11l' dyn.lIl1k t'lft·rls. fur Spain. till' l'slilllollt'S oUl' h.lsf'd on )I}IJO "".~I strlll'- IIlFl'S, an,1 subseqlll·"t wfurm!'l may hmll' "fferll'" thl'Sl' ells I slrlldllrt'S 10 SOIlIl' It"~n'l' Sourrt. OECD (I'l97a) .. The Costs and Bt:ntifits of R~gulatzo": Thr CAli jar FL:;ulAtu:!' Rqarm 9 ~tan\" studies have atter:1pted to estimate the adverse impact of regulation usir.g =neasures o:::er than ec~nomic cost. For example, Christiansen and Haveman (l981) examined the effect of regulanon on labor productivity in the U.s. economy during the 19605 and 19705. Using three measures of aggre- gate regulation, the cumulatwe number of major pieces of regulatory legislation in errect, the amount of federal expenditures on regulatory activIties, and the number of full-time iederal personnei en- gaged in regulatory activity, productivity growth (output per person hour) in this period declined considerably, and government regulations accelerated. The authors estimated that oei:>veen ::: ane :: percent of the slowdown in the growth of labor productiVity in U.S. manufacturing during 1973-77, as compared with 1958-65, was due to the expansion of federal regulation. MacAvoy (1992) examined the long-term growth effects of regulation on eight industries from 1973 to 1987. He found economywide losses of 1.5 to 2.0 percent ot the U.s. gross national product (GNP). Studies examining environmental, health, and satety regulation have yielded qualitatively similar impacts. For example, Jorgenson and Wilcoxen (1990) found the cost of pollution control was associated with a reduction oi over 2.5 percent of U.S. GNP between 1974 and 1985. In an examination of the impact of environmental and occupa- tional health and safety regulation on manufacturing, Robinson (1995) concluded that the cumulative effect was to reduce multifactor productivity by more than 10 percent over a 12-year period. The incre- mental impact of regulation grew iTom a 1.1 percent annual reduction in multifactor productivity in 197"*-75 to a .2.5 percent annual reduction in 1985-86. Other studies describe the relationship between regulation and output gTowth. For example, Friedman (1995) argues that the growth in regulation is at least. in part, responsible tor the slo.....·o'own in U.s. eco- nomic growth in 1964-74. The number of pages in the Federal Reglster more than doubled during the Nixon administration, rising from roughly 20,000 in 1969 to 45,000 in 1974, when he resigned, and to 60,000 the year after. The all-time peak, reached in 1980, was 87,000. The number of pages declined sharply during the Reagan administration and then rose again under Presidents Bush and Clinton. Many federal programs were initiated during the Nixon administration. In addition, affi..'"IIlative action and wage and price cont::ois were introd uced. During the high-growth period between 1946 and 1969, the number or pages in the Fed~(lf Register was low; during the low-growth period after 1969, the number of pages was high. Clearly, ma.'1Y other factors affected the rates 6f growth during the postwar period. yet as Friedman pOlnts out. disman- tling the regulatory state would allow the United States to grow at roughly 4 percent a year. In a study of 11 Organisation for Economic Ccroperation and Development (OEeD) cou..,tries, Koedijk and Kremers (1996) tested the relationship between market regulation and output growth. shown in figure 1.1. They constructed an index of regulatory intensity in the countries and showed a shaI? negative corre- lation between regulatory intensity and output growth. The countries with the least regulation enjoyed the highest growth in output per person. The measures that the authors construct are admittedly crude, but they probably serve as a proxy for the degree to which markets are regulated in different countries. The economic impact of different labor regulations on empioyment growth can be seen in table 1.6. Tne table suggests that countries with less onerous labor market restrictions (at the top oi the table) enjoyed robust employment growth, while countries with more severe restrictions (at the bottom of.the table) sui· fered declining employment growth. While many other factors can affect employment growth, strong rea- sons exist to believe that flexible labor market polities are likely to increase employment (Guasch 1997). Tables 1.1 through 1.5 present the overall trends in regulatory costs and impacts, but they fall short of providing a basis for ultimate judgments about specific regulations. Such judgments require information on the benefits of regulation as well as costs. More important still, judgments require an~ysis of incre- mental rather than total effects. Only then is it possible to assess whether the economic benefits of a partlcular proposal outweigh its costs. l Assessing the Gains from Regulatory Reform While information on the economic impact of regulation is limited, the United States and other countries. such as Australia, Canada, New Zealand, and the United Kingdom, have a fairly comprehensIve 10 J. LULS Gwasch and Pablo 5;1!11~ Figure 1.1. Output Growth and :vIarket Rt!gulation 12 10 .J! ~ ~ 8 Belgium. eGermany :; 6 .E :.c e Italy c: 4 ~ Netherlands e !':; c::: France e 2 0 0 6 8 10 12 R.ank.tng 1I'l overall market regulation Not~: Real output growth in the mark.et sector. per capita 15 to 64. annual average growth 1981-:-93. Ranking by increasing; = growth rate (1 lowest growth). The Imear regression is aho shown. Soun::~: Koedijk..rul. Kremers (1996). Tllble 1.6. Labor Regulations, Selected Countries Unemploymm~ Empioymm: .Payroll taxeS" Severance Collective rate growth Country (percmt) paymentsi' bargaining (1996) (1992-95)( Australia 27.8 Low Centralized 9.0 1.0 Chile 20.9 Low Firm Level 6.3 .., _ •.:> ~ Japan 22.9 None Finn Level .., - ....:;, 0.6 MalaySia 24.3 Low Firm Level 2.8 3.3 New Zealand 11.5 None Finn Level 8.0 1.4 Umted States 20.1 None Finn Level 5~5 1.8 Argentina SO.Qd High Centralized .... .., !, .- -0.7 France 54- .1 High Centralized 11.6 -0.4 Italy 52.8 High Centrahzed 10.2 -1.7 Spain 38.2 High Centralized 2:.4 -1.6 a. Payroll taxes .are finn donations plus obligatory personal contributions. The values for France, Italy, Ja?an. and. Spam corre- spond to 1994, those for Ma.laysia to 1993. a.nd. those for A.rgentina and Chile to 1996. b. Severance payments based. on OECD iitdexes. c. Employment growth is measured as annUAl average percentage growth. d. Argentina amended its labor laws in 1996, and payroll taxes now average 4l.0 percent. 50un::t: Gu.asch (1997). database that provides a good indication of the scope for regulatory reform. Moreover, several countries. such as Argentina, Australia, Canada, Mexico, New Zealand, and the United Kingdom, are in the process of developing useful information about the costs and benefits of regulation that would help streamline the regulatory process (see box 1.2). This section first examines the potential for impro\'ing social regula- tion and then examines the potential gains from reforming economic regulation. The- Casts and Brn(:fits of Re-guiatlOn: The- CAli for R"''5,.!larc, "y ReJOrm I1 Bor 1.1. Regulatory R~form In .\tleXICO The goverrunent of MexIco is r.ow unplementing a far-reachmg pro~ram to carefully exa:r,.l:,e the country's regulatory structure at the federaL state, and iocallevels. The auns or the Agreement fo: me De~egulatlOn 0: Business Actlvitv include strea:nlimn£ iederal regulation, reducmg corruption by COdlf}'tng regulation, anc helping to promote more efficient and effective regulatIOn. The program, while new, has e:1joyed some early successes. Recent legislat:on st.'T_?liiles admmistrative procedures, reqUlres a qUlc~er adrrt:..'1.l.5:::am'e ~~sponsc tlme, and reduces paperwork for iorelgn investors. In additIOn, a senes of legal reforms auns to slmpiity cour. proceedmgs and to reduce the costs of commt:!rclallendmg. As a result of thes: reforms~ ~teXl~~ City's Supe- nor Court reports that the number oi Civil suits filed decreased by 24 percent trom 199, to 19'10. Agency-by· agency rule simplification and elumnatIOn is also proceedmg SWiftly. For example, the app~val tune for a busmess requiring health, saiety. and environmental controls to begm.operanon has been recuced 0 m an :r. average of over 200 worktng days to a maximum of 21 w~rklng days. FmaIly, a compl~te tn,ventory or tederaJ rules m effect 1.5 available on the Internet. Makmg such mtonnatlon more easily accessible snould help reduce corruption and compliance costs. Sourer: ~etana de Comeroo y Fomento Industrial (1996). Social Regulation In the area of social regulatlOn, :t 15 essential to examine the likely impact of individual regulations. Hah.'1 (1996) has compiled the most comprehensive analysis of the benefits and costs of recent regulation based on studies by government agencies. He surveyed over 90 Regulatory Impact Analyses (RlAs) for enVl- ronmental, health, and safery rules from 1990 to mid-1995 and found that considerable variation exists in the type and quality of analysis agencies perform for individual rules. Benefit analyses '''ere often incom- plete, and only in less than 20 percent of the rules did agencies show that quantified monetary beneiits would exceed quantified costs. To make the analysis consistent across different programs and regulations, Hahn converted dollar estimates to 1994 dollars and introduced a common discount rate and a consistent set or values for reduc- ing health risks. The results are swnmarized in figure 1,2, which provides an overview of the distribution of net benefits of 54 final regulations. The left side of the figure shows the number of rules with net costs that fall in various categories. The right side of the figure shows the number of rules with net benefits that fall in various categories. The figure illustrates that the average benefit for a rule with net benefits ex- ceeds the average cost for a rule with net costs. Several conclusions emerge from this analysis. First, usmg government agency data, it would appear that the present value is about USS280 billion (1994 dollars) in positive net benefits to goverrunent regu- lation in those areas since 1990. Yet, over half the final rules would not pass a cost-benefit test, even when using government agencies' numbers. Aggregate net benefits are positive because many of the rules that do pass have substantial benefits. Eliminating final rules that would not pass a cost-benefit test could increase the present value of net benefits by more than USS115 billion. There are reasons, however, not to take the agency numbers at face value. Both theory and empirical evidence suggest that agencies are likely to overstate substantially the aggregate numbers for positive net benefits. Agencies with a single objective (for example, protecting the environment or improving safety in the workplace) have an incentive to overstate the benefits of their program relative to the costS so that they can better meet the demands of interest groups. Another measure of the impact of regulations is how many lives a regulation is likely to save.Interest- ingly, a review of several final and proposed regulations reveals the amount spent for each premature death that would be avoided because of the existence of the regulation varies over eight orders of magni- tude, from roughly USS100,OOO to over USSS trillion (1990 dollars) (Morrall 1986). This suggests that regulatiOns could be developed that would prevent many more premature deaths while still saving 12 J. LuIS Gwzsch and Pablo SPllJt"r Figure 1.2. Distribution of Net Bene.Ats of 54 Unit~d Stact!s Regulations, 1990 to iv1.id-1995 (billions of 199~ L'SS) 16 - o -100 to < -10 -10 to < -1 -1 to < 0 a to < 1 1 to < 10 10 to < 100 Negative net be.'"lefits PosltlVe net benefits Present value of net benefIts Sourr:~: Hahn (1996). consumers money. Recent studies have attempted to quantify potential gains in both the United States and abroad. Reallocating the current U 5. investment in 185liie-saving interventions could avert an addi- tional60,OOO deaths, or twIce those at the present time (Tengs and Graham 1996). In addition. reallocating recent domestic regulatory expenditures of about USS8 billion (1994 dollars) could save more than 100 million additionalliie-years in developing countries (Hahn 1996). Economic Regulation Much economic deregulation occurred in industrial countries in the late 1970s and early 1980s, particu- larly in transportation and energy. Since the early 1980s, however, economic regulation has not advanced rapidly, even though ample room exists for further deregulation in areas such as telecommunications, electricity, and financial services (Noll 1997). Developing countries have been late entrants in the move toward deregulation, but are quickly catching up. Indeed, some countries, such as Chile, have progressed even further than most industrial countries, and some countries in the Latin America and Caribbean (LAC) region, such ·as Argentina. EI Salvador, Mexico, and Peru, are undertaking major ecpnomic de- regulation initiatives. This section reviews additional evidence on the potential benefits of economic deregulation. It first considers the industrial countries with a foc.Js on the U.5. experience and on the expe:ience of other OECD countries and then examines the record of the developing countries. The overall welfare gains from deregulation across sectors in the United States have been substan- tial. The focus was eliminating entry and exit restrictions and freeing prices to their market levels. Table 1.7, taken from Winston (1993), shows more recent estimates of the benefits of deregulation and the potential gains from further reform. Aggregate welfare gains amounted to USS35 to USS46 billion (1990 dollars) per year. Consumers had annual gains of US$32 to USS43 billion per year from lower prices and better services. Producers gained about USS3 billion per year from increased efficiency and lower costs. Winston estimates that additional gains from remaining distortions could be in excess of USS20-plus billion per year. Tht7 Costs and Ben¢t; of RegulatIon: Tne ew:i for R".5-'!aI~:J R¢mn 13 Table 1.7. Welfare Gains from Deregulation, Uniud States, 1990 (billions of 1990 tJSS) Further Industrv Consumers, Producers Total tJotential gains Airhnes 8.8-1,*.8 4.9 13.7-19.7 ·1.9 Railwavs 7.'2-9.7 .. ., .).- 10.4-12.9 0,'; Road freight 15.,* -4.8 10.6 0 Telecommunications 0.7-1.6 n.a. 0.7-1.6 11.8 Cable television 0.';'-1.3 n.a. 0.4-1.3 0.4-0.8 Brokerage 0.1 -0.1 0 0 Narural gas n.a. n.a. n.a. 4.1 Total 32.6-42.9 3.2 35.&-46.1 21.6-:::.0 n.a. Not applicable. Source: Wl.l\Ston (l993). However, evidence shows that the gains from deregulation that economists have est!mated are likely to be Significantly understated. In a 1996 paper, Winston argues that the time it takes for industry to adjust to the newly deregulated environment is substantial. Winston notes that although industry may adjust prices to reflect marginal costs quickly after deregulation, it takes time to optimize producuor.. He argues that policymakers and the public tend to notice only the short-term effects and. therefore, under- value the benefits of deregulation. Frequently, the positive impact that deregulation has on innovation is overlooked. Innovations in technologies and operations sparked by deregulation increased prociucovity and reduced operating costs by 24 percent to over 50 percent in different industries. Sectoral studies examining the effect of regulation yield similar results on the adverse conseque..'lces or economic regulation. Caves, Christensen, and Swanson (1981a; 1981b) undertook a cross-count:y study to compare total produco\tity growth for US. railroads from 1956 to 1974 to growth achieved by Cana- dian railroads over the same period. Both industries had access to the same technology, but Canadian railroads were subject to less regulation than US. railroads. The authors argue that regulation substan- tially reduced productivity growth. Average total productivity growth was 3.3 percent a year for Cana- dian railroads and only 0.5 percent for US. railroads, and the authors estimate that, if the United States had experienced the same productivity growth as Canada. the cost of providing rail services in 1974 would have been USS13.S billion (1985 dollars) lower. Alter railroad deregulation in the United States, Willig and Baumol (1987) esomated that between 1980 and 1985 annual operating expenses dropped 26 percent while traffic volume remained virtually unchanged. Deregulation of the railroads also led to increases in mvestment (the capital formation effect). Following little investment dunng the 1970s. the United States, during 1981-85, invested USS27 billion in railroad structures, roadways, and maintenance and invested USS30 billion in rail cars, locomotives, and other equipment (Willig and Bal.\IDol1987). In their assessment of the effects of regulations governing the transport of surface freight. Willig and Baumol (1987, p. 31) state "Various studies estimated, for example. that between 1950 and 1980 more than J. billion dollars a year was \\'asted in transporting freight by truck rather than by rail. Another billion dollars a year was wasted in transporting freight on rail routes that were too long or were utilized with too little traffic density. Another USS1.5 billion a year or more (in 1977 dollars) was wasted on unneces- sary mileage traversed by empty cars, unnecessary demurrage time between car unloadings and load- ings, and circuitous loaded routings." Deregulation of trucking led to major improvements in efficiency. Average unit costs dropped dra- matically after deregulation. from US$O.343 in 1977 (before deregulation) to USSO.100 in 1983 (aiter de- -. regulation). A large number of firms had the lowest unit costs while facing more competition after de- regulation, anel many of the inefficient firms were forced to leave the industry, leaving behind those firms with low unit costs (McMullen and Stanley 1988). The annual welfare loss due to allocative ineffiCiency 14 J. LULS CUQsdl lind Pablo SpIllrr resulting from regulation of rail and motor carrier rates has been estimated to be US51 bi.l!..:on to USs.; billion (1977 dollars) (Braeutigam and Noll 1984; Winston and others 1990). Similarly, deregulation of the gas industry led to significant improvements in productivity and cost reduction, as illustrated in figures 1.3 through 1.6. A comparison of the pre- and postderegulated U.s. airline industry also provides stri..king e';idence of regulation's impact on productivity and production costs. Cost per unit of service was reduced byap- proximately:5 percent within a year oi deregulation anJ wa;:; accompanied by sharp \.. . ;or~ ;orce reduc- tions, with little effect on output in the first few years following deregulation (Caves and others 1987). Figure 1.3. Rnilroads: Total Employees and Rer.!ertue Ton-Miles pa Employee (Class I Railroads), 2?81-93 400 r 6 - -i---_ .; 350 I .. ... ............ .... ···············t • ~ c: !"; ~ 300 I5 3 ..":I .. :::J 100 ~ ~ , z ~ SO o 1 I r Z G 1981 1982 1983 1984 1935 1986 1987 1988 1989 1990 1991 !992 1993 --Employee •••• - R..'vfT /empioyee RTM Revenue Ton-Miles. Sourc~: Edison Electric Institute (1995). Figure 1.4. Railroads: R.e-oenue p~ Ton-Mile of Freight, 1970-93 (constant 1980 USS) 3.5 3.0 .st 2.5 .~ 2.0 ... Q.I c:.. 1.5 ~ = :.. U 1.0 0.5 0.0 1910 1975 1980 1985 1990 Not,: Figures above n!pn!SeRt Cass I R.iilroad.:i. ool)', which ACCOunt for over 90 percent of freight revenue. ~JW';:':-Edison Electric Institute (1995). Tne Costs and Bmrltts of Regularlon: The c..rll fa'" Regu;atc;,' Rtjorm ,- .::1 Figure 1.5. ;\;~ltllral Ga5 TransmisSIOn. I/lI.iH5tri~: 5t!r.;i•.:r: Pri~::, 19Sa-;G3 (constant 1980 U5S) 5 -i C 3 ~ ... CIi c.. 4A j ::; 2 (j, J I 0 1980 1982 1984 1986 1988 1990 199:: MCF r-tillJon cubic teet. Edison Eiectnc instltute (1993). SOU'f'CI:: Figure 1.6. Natural Gas Transmission: Total Employees and Total Natural Gas DeIivmes per Empioyee, 1981-90 :.200 ~ I~-------------------- I I I 40 J * .... ~ :.~OC ; I " :.... SOC ..; .. i '!- 30 -J _ ~ r··....... ••••••••••••••••••••••• ....... ••••• ..' -: I I . ••••••• •••••••• r 600 ..... ~ 20 I r5 i L- I .wO 10 1I I i I - ::00 L z I I o o 1981 1982 1983 1984 1985 1986 198i 1988 1989 1990 -Employee -•••• MCF I employee MCF Million cubic fet?t. Note: Total natural gas delivenes do not include unaccounted natural gas (losseS). Sou'f'Ce: Edison Electric instltute (1995). For example, work force reductions at American Airlines and United Airlines were 17 and 24 percent, respectively. Under regulation, the 3.0 percent annual decline in unit costs tor U.S. airlines was tar below the 4.5 percent decline of non-U.S. airlines from 1970 to 1975. Following deregulation, costs ot U.s. air- lines from 1978 to 1983 fell by 3.3 percent, compared to 2.8 percent for non-U.s. airlines. In addition, excess capacity decreased, and productivity increased. Morrison and Winston (1995) estimate the net annual gains t\) travelers from airline deregulation at USS18,4 billion (1993 dollars). The authors estimate that consumers are gaining USS12.4 billion annually from lower fares under deregulation and USS10.3 16 f. LUlS Gwz.scn ana Pabb 5ptl/~ Figure 1.7. Airlint!s: First Class .. nd Cl.'OllOmy Fllrt!.5. 1973-93 (constant 1960 l'SS) 0.20 0.16 t e:::: 0.12 ....... ". ,. ... c:... c:... . ... _-...... ............ .., .......... . ... _._ ....... ....................... ~ 0.08 '. ' .. :J o.~ 0.00 1973 19'78 1983 1988 1993 - - FU'St class •••• , Economv class RPM Revenue Passenger Miles. SOl.lrc~: Edison Electnc instltute (1995). Figure 1.B, Total Employees and Re'i.'e7Zue Passenger Miles per Employee in the Azrline Industr".J. 1973-93 - ' J' ""g .. -., ............... ",_ .......rt- 0.8 1.0 I'C ~ .......... : .. .' ~ 1:. 0.6 t ..; , 19S0-~2 (constant 1980 U5S) ., -~.~.~~.~.~.:.::::."!",,,----,,,-,,,--,,.~.;.:-:.~-,:.;;;.,,,,,,,,,,,,, o ~--------~------~---------r--~----~------~ 1980 1982 1984 1986 1990 1992 --AT&T .---- Mel --_.. US Sprint Sourc(: Edison Electric lnsbtute (1995) the U.S. economy more than t!SS25 billion per year (1983 dollars) (Rohlfs. Jackson, and Kelly 1991). In addition, the expenditures to obtain those licenses cost society between USS500 million and CS51 billion. Those losses, when cellular service began in 1983, were about 2 percent of the GOP. Similarly, the delay in introducing voice messagiI'ig services cost more than USS1.3 billion (1994 dollars) per year (Hausman and Tardiff 1996). Even if those two services had been offered at monopoly pnces, the consumer welfare loss remains significantly high.. The delay in provision of cellular telephones was caused by regulatory indecision and the subsequent licensing procedure used by the FCC, which was in charge of the cellular spectrum. The FCC could not decide whether to allow AT&::T to provide cellular service alone, to allow non-AT&T companies to prcr vide cellular services alone, or to allow competition between the two groups. AT&T had invented cellular and argued, not surprisingly, that because of Significant economies of scale in spectrum usage only one cellular provider should be present in each service area. Potential entrants into cellular argued, not sur- pnsingly, that cellular could provide competition to AT&T's landline local monopoly at some time in the future so that AT&T should be barred from cellular. The FCC made decisions and subsequently reversed itseli. Finally, in the early 1980s, the FCC decided to allow two cellular providers in each service area. Cellular service began in Chicago and Los Angeles in 1983-84 and reached most other major U5. cities by 1985 (Hausman and Tardiff 1996). More broadly, deregulation facilitates new entry and decreases costs Significantly. As a result, products or services that previously were not financially or legally feasible to produce can now be provided either by existing firms or by new entrants. For example, as transport costs and delivery times fall as a result of deregulation of the sector, time- and transport--sensitive products, such as cut flowers and other agricultural products, can be produced and/or exported. The welfare impact as described can be quite significant. This is particularly relevant for developing countries. Delays in privatization of state utility compa- nies induced de facto delays in the introduction of new products and in penetration of existing products, inducing in tum significant welfare losses. Among the best welfare estimates of privatization of utilities are Galal and others (1994). Current legislation and regulation in many developing countries hampers the development and competition of new products, particularly in telecommunications. While the database outside the United States is less extensive, there is reason to believe that the gams from deregulation of many industries elsewhere could be substantial (see table 1.5). For example, lifting The Costs and Berufits of ~gulatl.On: The Cull for i\erz,Ja:.:;'Y Reform 19 price and entry restrictions on air travel in Europe could lead to substantial gains for consumers. Table 1.8 provides some price infor..nation for trips of similar length and demand characteristics. The table 5ug· gests that fares for trips are roughly tv:ice as expensive in Europe as in the United States. Despite the higher fares, the profitabiiit)-1 or many of the European companies is far below tha~ of t.~e C.s. car.iers. Indeed, the European high-cost carriers, such as Iberia and Air France (both state owne:'j, have sun:ived until now only with government aid. Good, Roller, and Sickles (1993) argue that libe~al.ization would lead to competition among international carriers and a convergence of cost struct1..;.res. They estiInate that, if in 1986 the Europea.'1 airline industry were as efficient as the U.s. airline industry, the European airline industry would have achieved cost savings of approximately USS4 billion (1986 doUars). Significant opportunities also exist for gai1l.s in deregulating electricity markets. Tabie 1.9 shows elec- tricity prices in Europe and the United States. To the extent these prices reflect incremental costs, signifi- cant gaInS are likely to occur from reducing entry barriers into different markets. For example. stnct regulations in Germany require domestic companies to purchase electricity from regional producers, even though lower-cost power is often available nearby. The extent of the potential gains for consumers is difficult to estimate, but in the United Kingdom, energy deregulation resulted in a iO percent increase in producovlty, an 18 to :1 percent reduction in tranchlse contract prices, and a 33 perce!'1t reduction in Table 1.5. Fare Comparison of Similar U.S. and European Routes Route Miles Fare (USS) Boston to New York 187 153 London to Pans 211 263 Washington to ~ew York 216 153 Houston to ;\jew Orleans 302 89 Copenhagen to Oslo 311 315 Dallas to Minneapolis 853 435 Frankfurt to Madrid 887 720 Soura: Airfare Management tinit (1995, 1996); Consuiong Services Grouo (1995,1996). • Table 1.9. Costs of Energy U.S. and European Community, 1995 (cents pe: kilowatt-hour) CountrJ Cost German v 11.88 Italy 10.00 Portugal 9.65 Belgium 9.12 Spain 8.50 Uruted Kingdom 8.09 Luxembourg 7.62 Ireland 7.40 France 7.39 Netheriands -.,"';' ,.." United States 7.01 Greece 6.8i Denmark 5.89 Finland 5.72 . - Norwav Sweden 4.72 4.21 Sollru: Electricity A.ssoc:iallon Serllces Ltd. (1995). 1.0 f. LUIS GWlS.:h and Pablo 5pllI(1" generation costs (implying annual savings of £::,300 million). Users have benefited by seeing their aver- age domestic bills fall nearly 10 percent. The savings for domestic customers in England and Wales is worth £580 million per year and in excess of £650 million tor industrial and commercial Cllstomers (OECD 1997b). Franchise contract prices from generators to distributing companies have fallen by 11 percent in real terms, and those to direct industrial and commercial consumers have fallen by IS percent in real terms. The absence of similar deregulation in other European Union countries has led to iinns paying over 50 percent more for their eie(tricity than do their American counterparts, lvIoreover, me impact or higher energy prices on the overall economy can be quite Significant (Navarro 1996). For example, a 30 percent increase in electricity prices tends to raise the price of goods, such as paper and pulp, metals, chemicals, and glass by roughly 2.5 percent. Overregulation has clearly had negative effects in the United States and in other industrial countries, particularly Germany and Japan. As an example, the largest retail chain in Japan, Mr Max Corp., spent 2 years persuading more than 20 farmers to sell their land in the city oi Saga on the island of Kyushu and petitioning the government to rezone it for commercial use. nus was followed by at least 18 more months of haggling with local merchants who were demanding concessions when the new stores opened nearby. Mr Max expected to open its new outlets by early 1998, but the stores were probably at least 20 percent smaller than planned and had to pay tnflated membership fees to a local trade assodation. To further placate smaller local retailers, .Mr Max has to close stores n-vice a month by taking 2.; days of holiday a year. In Japan, laws deSigned to protect consumers from confusion prohibit dlScount coupons, and fire laws are designed for cramped, multistory buildings. As a result, Mr Max must install fire shutters that lower automatically to prevent rires from spreading to other floors, even though the company builds only large, single-story buildings. In all, Mr Max calculates that the requirements add 30 percent to con- struction cost (Wall Street JoumaI1995a). Germany also has a daunting list of regulations, some dating to the Kaiser's era. Laws that limit store hours and competition give store clerks regular hours and help smaller stores, but do a grear disservice to customers. Allkaui stores (a large retail chain) can be open only 68.5 hours a week and mus: dose at 0:30 p.m. on weekdays and 2 p.m. on Saturdays. Sunday shopping is forbidden. Meanwhiie, under a Hitler- era rebate law, German stores can hold full-scale sales only twice a year, usually in January and late July. Even then, they cannot discount food. Germany's regulatory system is designed to keep peace between labor and management, but at high cost to consumers. German companies must buy electricity from regional providers, whose rates are inflated, rather than from international providers, whose rates are cheaper. This problem is not unique to Germany. Energy prices all over Europe are substantially higher than in the United States, primarily because European states exercise a monopoly over the power sector. Supporters of deregulation would like to open the market to competition from all countries. This move would provide an opportunity for companies in the United States and elsewhere to develop a natural gas market in Europe, but, more importantly, it would support local businesses, boosting profits by reducing costs and creating jobs. The United Kingdom de- regulated its energy market in 1990, realizing a 4 percent decrease in real prices for residential consum- ers-a benefit that the rest of Europe would like to copy. In the current environment, electricity-intensive mdustries are unlikely to open new plants in countries with unusually high rates (see table 1.9). A variety of process regulations also creates costly burdens. In 1990, paperwork requirements alone consumed more than 5 billion hours of the private sector's time, mostly to comply with tax laws. This deprives the private sector of an important productive resource: time. Available research on valuing time translates this burden into USSll0 billion annually. Furthermore, many federal spending programs have reportIng and paperwork requirements that tall on state and local governments and on the private sector. One example is reimbursement for the cost of health care. These paperwork requirements cost about S25 billion annually. Of course, unquantUied benefits are associated with these requirements, such as a lower incidence of tax fraud, but whether these benefits could be achieved at a lower cost is an open question. Although regulations exist in theory to address market failure, they sometimes enable a weak sector to maintain stable and adequate levels or profitability or to allow influential interest gt'oups to capture Thl' Costs and Bl'nl'ftts of R.r:guiatlon: Thl' Glil for Rrgul..Ho,y Rl'TOrrr! 11 rents. The regulation of trucking occurred in response to the competitive pressures felt by the railroads, and the Interstate Commerce Commission played the role of a cartel setter. Obviously, this was not an appropriate reason for regulation, and the positive effects of deregulation seen in the airline, gas, freight and brokerage sectors prove false the concerns raised in support of regulation. Reg-.llated sectors are often correlated with enonnous sectoral inertia and low productivity growth, ane! regulatory actIvIty also leads to enonnous inertia. The United States provides a striking example. As of 1994, U.s. regula- tions totaled 202 volumes with ~3L803 pages. Of these volumes, 16 contained environmental regulations, 19 contained agricultural regulations, and 2 contained employment regulations. In 199~. the total \...·as 14 times greater than it was in 1950 and nearly 4 times greater than in 1965. The impact of economic deregulation on price level is also considerable, and table 1.10 provides esti- mates of significant price reductions secured after deregulation of road transport. airlines, electricIty, financial services, profeSSional services, and telecorrununications for a number of OEeD countries. As shown, the percentage of price reductions ranges from .5 to 66 percent. Developing Countries The evidence of the adverse impact of economic regulation on productivity and effiCIency can serve as a lesson for developing countries. Lower productiVIty in regulated industries translates mto lugher costs Table 1.10. Price Reductions Aft~r Elimination of Economic Regulation Pnce reductIons Sector Country in reaite'TmS (percent) Road transport Germany 30 Mexico France 20 United States 19 Airlines United Kingdom United States Spain Australia Electricity !'Jorway (spot market) United Kingdom Japan 3 Financlal services United Kingdom United States 30-62 cl Professional services Uruted Kingdom 33 Telec:ommurucatlOns Finland 66' United Kingdom 63' Japan 41' Mexico 21' Korea lo-3~ Nate: Pnce reduCtlon maY' be in part attributable to tactors other than regulatory reform. a. Refers to discount fares on the hishest-density route. L,uger drops have been reg:lStered on other routes b. The first figure refers to reductions for industrial customers who renegotiated contracts with the1%' traditional suppliers. The second hgure reters to industnal customers shittlng to new suppliers. c. The first figure refers to electricity rates for households. The second figure is for industrial customers. d. Refers to stock exchange commissions. In the US. case. the first figure refers to rates for small transaCtlons. The second figure refers to rates for large transactions. e. Prices of long distance aUs. f. Average prices of telephone services. g. The first figure reiers to domestlc long distance c::all.s. The second figures refers to intem.ational caUs. SOllru: OECO (1997a). 22 J. LUG Guasch .md Pablo Solill!7 for products and inputs produced domestically, thus reducing a country's ability to pursue a 5uccessiii export-led growth strategy. The ~ '~cise impact of regulation on developing country economies is diffi- cult to estimate in many cases. Yf :ata from the industrial world and a few studies in developing coun- tries suggest that the potential weuare gains from regulatory reform could be quite significant. For countries that have deregulated, the efficiency gains have been quite significant. For example, deregulation of entry into the long distance telephone market m Chile has cut rates by over 50 percent, making them close [0 L:.5. rates {Guasch and Spiller 1997;. Allowmg iorprivate sector parncipation in telecommunications has cut waiting time for installation of new lines from a minimum of two years to a matter of weeks in those Latin ,-\merican countries that have privatized the sector. Privatization and deregulation of the Argentine railroads have produced real gains in performance, a turnaround in traffic trends, a quadrupling of labor productivity, improvements in service quality, reductions in price, and a reduction in the public deficit of about USS600 million a year (equal to 0.5 percent of the GOP) (Thomp- son and Budin 1997). Similarly, in the port sector, the operung of the port terminals in Buenos Aires to competition has led to an 80 percent reduction of the fees and to productivity increases of 300 percent-In addition, the opening of stevedore operations to multiple parties in the port of Montevideo has increased productivity by 300 percent. 'Comparable measures in the port of Guayaquil, Ecuador, have decreased costs by 60 percent and have increased productivity by 55 percent. All these results were achieved withili a year of deregulation (Guasch 1996). A study of Argentina, summarized in table 1.11, assesses the welfare cost of regulations and other gov- ernment interventions in the 19805 (Fundacion de Investigaciones Economicas Latinoamencanas 1991). The total costs of regulation and state intervention amount to over US$4 billion per year (1990 dollars), and this is only for the selective listed interventions. While the measure of costs for different activities differs somewhat (for example, efficiency costs, additional cost to consumers, and subsidy cost), the overall total Table 1.11. Examples of the Costs of Regulation, Argentina, Selected Years, 1965-88 (millions of 1991 USS) Average Regulation Period annual cost Financial system High reserve requirements and SUbSIdized credit by the cenrral bank 1987 1,000 lnilatlon taxes on checkmg accounts 1983-87 670 Fuel price controls 1977-87 350 Health seI"Vlces Extra costs from double affiliation 1986 150 Idle capaCIty m public hospItals 1987 172 Fishmg export subsidies 1986-87 12 EffiCIency costs from domestic consumption restnctions in cattle markets 1984 104 Efficiency costs ot the speaal iund for tobacco 1987 30 Air transport regulatIOns 1988 75 Restnctions on rail transport of cement. wine, and grain 1987 95 Truck transport Costs of road detenoration 1987 100 Costs of provincial regulatiOns in the tranSport of grains 1987 30 Port restrictions on price and entry 1987 90 "! Regulatlons imposed on business 1965-87 1,200 RegulatiOns on employment in the public sector 1987 120 Not~: The costs of regulation presented 1l\ this table measure different concepts, such as effia.ency losses in the economy, COSt preauwns to consumers, tax redudlons, and subsidies. Thus. it might not be technically corT'Kt to total them. Sourr:~; FW'l.ciaaon de Investigaciones EconoaliC1.5 Latinoamencanas (1991). The Costs and Benefits of Rrglllatzon: TIre Cail for Rt!rui.D.t:;.-J R~nn 13 suggests that the cost of government intervention is signilicant. The values given are likely to underesti- mate the total costs, since they usually do not account for the additional impact on economic activlty. It would be useful to assemble data on regulatory costs in other developing countries L~t are comparable to that assembled for Argentina. Yet, there is no shortage of specific cases where economic regulation has had adverse consequences. For example, Uruguayan firms and consumers are paying an implicit tax of at least 30 percent for water, phone, and electricity. 'This implicit tax exceeds that of other countries in Mercosur (a tree- trade area comprised of Argenb.n.a, Brazil. Paraguay, and Cruguay and with Bolivia and enile as assOG.are members), thus hIndering the competitiveness of Uruguayan products reLated to those of other Mercosur countnes. In Brazil, inappropnate econorruc regulation has also reduced efficiency. For example, although trucking costs are almost three times as high as rail costs, rail transport has only a 12 percent share of rela- tively short tnps and a negligible 3 percent share in the longer-haul interregional market. The absence oi an inverse relationship between cost and market share is to a large extent attributable to meifident regulation. One of the few well-done studies of the impact on economic activity due to privatization and deregu- lation of utilities in Argentina is that of Crusari, Estache, and Romero (1999). Using a computable general equilibnum model, they estimate the efficiency gains of the privatization and deregulation of the energy, gas, telecommunications, and water sectors and these effiCiency gains' impact on lac or productinty, investment, and average tariffs (tables 1.1:Z and 1.13). By all accounts, the gains were significant. Even more interesting and novel is their estimation of the impact of good, effective regulation, as ShO\\ol1 in Table 1.12. impact of Effective Regulation, Argentma Annual gains for pnvate operation of utilities U5S GOP impitcit tax to users Regulation type (billion) (percent) (percent) Effective regulatio~ 3.3 .,- 1-:;! Ineffective regulation :'.3 0.90 16 - Not availabie. GDP Gross Domestic Product. 50uru: Ch.isa.ri.. Estillche, and Romero (1997). Table 1.13. Changes in Performance, 1993 to 1995 lpercentage) Performance ElectrICIty Eiectriclt'.,J Gas Water measure generation distributIon distribution distribution Telecoms First year of pnvate operation 1992 1992 1992 1993 1990 Efficiency gains" 19.51 6.26 8.84 4.S6 11.:28 Labor productivity gainsb 23.10 17.59 4.79 -27.58 ... 2' .,- ..:.:;) Increases In Investment" 8.65 n.a. 4.56 75.9i 28.10 lmprovemenLS in quality4 n.a. 10.00 27.80 6.1:! ~.56 Changes in real average tariffs' n.a. -9.50 ...{J.50 5.30 -1.90 n.a. Not applicable. Note: The table reflects the changes achieved under private management of the services. Indeed, 1993 dab reflects the first year in which all sector.; had benefited from some initial adjustment by the pnvate operator. The last vear tor which data was available at the time oi this writing was 1995. . a. Measured as reduction in intermediate inputs purchases as a share of total sales value. b. Measured as gigawatt hours per staff for electricity, thousands of cubic meter.; per staff for gas, population served per staif ror water, lines in servIce per staff for phones. c. As in concession contracts for gas and actual investments for the other sector.;. d. Measured as reductl.ons in losses (net of consumption by transmission)! production for electricity and gas. water unaccounted for /production for water. lines in repair/lines in service for phones. £. Defined as total sales value by a physical indicator of production. Sourrc Ousari, Estache and Romero (1997a). j 14 f. LuI.;; GIJ.IJS.-h and Pablo SpIll!''!' tables 1.1-1: and 1.15. Effective regulation is modeled as with endogenous tariffs to dissipate 5upranonnal a:::. rents to operators, while ineffective regulation is modeled as fixed tariffs. ChisarL Estache. and Romero (1999) find that when the regulations are effective. the annual gains from the private operation of utilities are about USS3.3 billion, or 1.:!5 percent of the GDP, and equally important, all income classes benefit. Ineffective regulation cuts the gains from the reform by USS1 billion, or 0.35 percent of the GDP. This cut in gains represents an implicit tax of 16 percent on the average consumers paid directly to the owner of the utility rather than to the government. For the poorest income class, this implicit tax is about 20 per- cent, meaning that good regulation is in the interest of the poor. The implications are that good regulation matters significantly and that aD income groups benefit. Similarly, Mexico has secured significant efficiency gains through its extensive deregulation program m most transport sectors, aviation, ports. railroads. and trucking. Tandon (1994) analyzes the impact of airline deregulation in Mexico. YVhile the two state-owned Mexican airline companies were sold in 1988 and 1989, full sector deregulation as a practical matter did not take place until 1991. The reform was far reaching. When a new airline enters the market, it is free from regulation. Airlines can freely add new routes and new flights on existing routes, and fares are practically free from regulation. On routes served by more than one airline or on regional routes where intermodal competition is strong, fares are totally free from regulation. On ttunk routes served by only one airline, tares continue to be regulated; however, earners must simply notify the Secretary of Transport of their intention to raise prices. The Secretary must then decide whether to object otherwise, the fare increases go through. Table 1.16 shows some of the cumulative impact after three years of deregulation. It led to a rapid expansion of capaory, new entry, increased produco\-ity, lower prices. and increased demand. However. as of 1995, the two privatized Mexican airlines, Aereomexico and Mexicana. experienced serious financial difficulties, and the govern- ment took them over. As a result the sector performance appears to have deteriorated, "vith claims of cross subsidies and other anticompetitive behavior by those two airlines. The extensive deregula.~on or port operations in Mexico and institutional changes in 1993 has had significant effects. Relaove to 1993 and as of 1997, productivity increased by over 100 percent in most ports, capaCity usage increased from 41 to 57 percent, tariff fees and levies declined by over 60 percent. ship waitlng time was cut in half. and total tonnage moved increased by over 20 percent. al.! at an annual rate twice as high as that of the years prior to deregulation. The 1991 deregulation of federal trucking also Table 1.14. Gains from Prwate Operation of Public Utilities (m.ill.ions of 1993 VS51 (A) (B) SaT7ing from Saving from Income class operational gains effective regulation 1 (poorest) 197 138 2 259 142 3 373 121 4 403 214 5 (nchest) 1,047 302 Total ~.179 917 Not,: These figures n!"pre5ent annu.a1 gams. (A) 15 the eqwvalent vanatlon com- puted in terms of the dollar revenue of each income class. It is ca.1culated by apply- mg the total giUl'\S IJ'l tne nxed-pnee sunuiation to the ineome in the base year. (8) 15 computed by applying the differences in gains between the &xed price and the flexible pnce simulations. In net pnese.nt value and over a period of b!:n years. the CA) gains represent a totIJ varying berwftn USSB.2 billion and USS14.4 billion. with discount rates varying between 12 and 18 percent and amortization rates varying berween 0 and 10 pen:ent The gains from efficient regulation under simiLa.r as- swnptlons vary berween USS3.3 billion and US$5.! billion. Source: Chisari. Estache, and Romero (1997). li,"'r J, 15, Seclur-S,'r'cijk Mtlfrol'cOIwmir f.j(c'ds of Prif/ille Mallllgl''''t'llt of 1111' Sedor (measured in changt'S OVt'r hase year ''JIIJ) f:lf'clril'ity Eleclricity ge"emtioll distribulion Gas Wall'r 1;.'/1'1'0'" S 1i"I,I .-------- --------- E.lJi'd I' fi:ud I' flt'x I' Ji:ml I' flex I' fiu" I' JlI'X rjill'j-,--'; flex l'fi,,'.1 I'pn 1'.Ii \'I'" I' J11'X cor 0.05 0.10 0.17 0.21 0.36 0.31 002 0.00 0.07 0.19 067 0.81 Industrial prnduclion -tWI 009 0.21 0.29 -{l.07 0.20 -um 0.00 0.(}1 0.10 U16 0.68 D: -2.47 -1.08 Uncmpillyment 000 I 17 -1.93 -6.76 -1.22 -2.36 6.75 3.21 052 -7.21 rrlce uf tradable/price of nunlradaLJle -{).12 0.18 o.n 0.78 -n.33 0.64 -0.05 -0.02 0.22 0.H8 0.49 246 Exports/imports 0.09 0.67 -0.25 0.67 -2.95 0.42 -0.31 002 0.75 0.77 -267 2.55 Industri.ll exports 041 141 0.36 215 -684 -2.11 050 0.07 1.40 159 -U7 3.11 GOP / employment OJt9 ··0. t:l 0.09 U.19 0.19 -0..12 ··0.29 -0.22 U.88 OW Of)(, ·.{).22 ., rha..'tl ? p (lex? SIII/TI't': C"lsarl. Esladlt'. alilt RomertJ (191)7) Tllble 1.16. Imp •• .;: of Airlillt? Dt?rt:?gulation, A,kxil.:o, 1992-9'; 1992-94 Impact Pt.'T'centage change Real yields (pnces) -29 Available seat/kilometer iO Traffic reve!"ue 'kl!omete; Souru: Tandon (1994), led to significant improvements. Effective fees dropped by 50 percent delivery time was cut by over 30 percent volume increased by a rate twice as high as before, and the fleet of trucks was almost fully renewed. Yet, the gains have not been as great as they could have been because Mexican states, which have jurisdiction over interstate trucking, have not followed with similar deregulation efforts. Prelimi- nary evidence of the 1997 railroad privatization and deregulation already indicates significant gains. These include a 30 percent reduction in delivery time, a 60 percent decrease in thefts, and an over 10 percent increase in volume. The costs of various kinds of process regulations can also be substantial in developing countries due to inefficient bureaucracies and high levels of corruption. For example, customs adm.inistration in many countries tends to be plagued by inefficiency and corruption, imposing a high cost to traded goods. According to the Nigeria Manufacturers Association, permission to clear goods in that country has to go through 27 stages, and the process takes 5 to 8 weeks (Nigeria Manuiacturers Association 1996). These numbers are not uncommon in other developing countries. Surveys in a number of developing countries indicate that managers spend between 10 and 30 percent of their time managing process regulation and that imputed costs on produced goods or services due to process regulation are in the 3 to 15 percent range (World Bank 1997a). The available evidence underscores the significant gains developing countries can secure by further deregulating their economies and by reducing the costs of process regulation. Estimates of those gains vary from country to country, but are at least a few percentage points of the GDP (Chisan, Estache, and Romero 1999; Guasch and Spiller 1997). Additional anecdotal evidence of regulation and its impact in developing countries is ample, as shown in boxes 1.3 and 1.4. Summary The lesson here is not that regulation is bad, but that it is often grossly abused for political rather than for economic, or welfare, objectives and that it transfers surplus from consumers to producers. Even when Box 1.3. .""'lonrevideo Tuicab .\1arktt Entry restrictions in the taxicab market Il\ Montevideo mduced a market price of a taxlc~b license III 1990 of some USS60.000 (in 1990 dollars), While lower than the USSllS,OOO price in New York. lower Uruguayan per capita income means that the market value of the license as a proportion of per capita income 15 more than four times higher in Montevideo than in New York City. The regulation of the taxicab market has led to a scarcity of taxicabs, reflected in difficulty III hailing taxicabs in the downtown area, III long waits when requested by telephone, in high costs borne by consumers, and in capture and wasteful rent-seeking activity by the taxi- owners association. Source: Gu.asch and Spiller (1997), 26 Tht Costs and Bmtfits of R...-gultltlo,,: Tht' Call far R.t~U:ztQ:-:· Rlfarm 27 Box 1.4. MUniCIpal Regulation in Peru In one munlClpality in Pe!"'.J. campa rues are reqUired by law to fumigate theIr factones onc~ :ve:.; ye~r. T.'1e municiDalitv has licensed oniv one firm as the official fumigator. While Its prIces are douD!e rna: or othe:- fumiga'tlOn ~omparues and Its ~en"ICe 15 very poor, the nrm IS tne only rumlgator that can ISSue a cer.J.ficate or compliance with the regulatIons. Source: Guasch and Spiller (l~7). political considerations are not a factor, regulation is a second-best solution, and one loaded with informational problems. The tradeoffs of regulation should be evaluated before regulation is set in place, and caution is needed about the possible consequences of partial deregulation, a policy that is often considered. Partial deregulation tends to encourage firms to enter orJy the more profitable markets and to leave the less profitable ones to regulated firms. The reVIeW of the literature on the costs and benefits of regulation demonstrates that it is possible to systematically explore the costs and benefits of regulatory activity using standard economic analysis. For a description of the analytical framework for cost-benefit analysis, see figure 1.11. Moreover, tlu.s analysis can serve as a useful aid to policymakers (Arrow and others 1996). It also shows that regulation can have a Significant adverse impact on economic growth and welfare. Specifically, regtilation aimed at control- ling prices and entry into markets that would otherwise be workably competitive is likely to reduce the average standard of living. In addition, process regulation that is unnecessary can impose a SIgnificant cost on the economy. Nonetheless, social regulations may have SIgnificant net benefits ior the average consumer. At the same time, these regulations may not meet goals in an effective manner and in some cases may result in a net decline in living standards. This underscores the importance oi dOIng economic analysis that will enhance the quality of regulations. While this chapter has focused on the economic impact of regulations on the average individual and the entire economy, it is important to recognize that regulations may be needed in some cases to achieve other social goals. Indeed, some regulations may be desirable from a social point of ';ew, even if they have an adverse impact on economic growth. For example, providing medical assistance and food for society's poor may not increase economic growth, but may be the correct policy for sodal and moral reasons. Similarly, helping to reduce discrimination mayor may not increase economic growth, but it is a correct policy in principle. Even when such policies are justified for other reasons, their economic impact should be assessed so they can be implemented in the most effective manner. Compared with budgets, regulations receive relatively little scrutiny. This is partly because politicians wish to hide the cost of regulation from citizens and partly because it is more difficult to estimate the costs and benefits of regulation.lniormation on the economic impact of different approaches to regula- tion needs to be improved to enhance public decisionmaking. Fortunately, several countries are begin- ning to place more emphasis on developing a better information base on the costs and benefits of regulation (OECD 1995). Analyses, such as those contained in OECD (1995), can be helpful in assessing the strengths and weaknesses of different administrative approaches to regulation. Developing countnes might consider adopting at least one of several policies to improve their general approach to regulation. The recommendations here are purposely general. In that spirit, the first important POInt to recognize is that effective poliCies will differ across countries. The appropriate regulatory tool and framework will depend on several factors, induding bureaucratic expertise, availability of resources, political constraints, and economic impact. However, the ability to enhance the capability to evaluate regulation at the local and national levels is a general need. This need is illustrated by the absence of even rudimentary data in several industrial and developing countries on the impact of regulation. Even rough calculations of regulatory costs, such as the 18 , LuIS Guasrn and Pablo 5111111'1" Figure l.ll. Cost-Benefit Analysis Framework for Regulation Activity, product. or ser.'lce: I Can it produce harm? Yes ~ Yes I Can public aVOid harm? l I I l\jo I • • No regulation I r Extent of potential harm , l Probability of harm I I I • No r Is government intervention justified? I Yes 1 Yes 1 Are alternatives to regulacon feasible? I No 1 ~ I Appropriate Will regulation regulating duplicate other agency? mecharusms? I IOutcome-based I regula non I What·15 least int NSlve I possible? app roach? I , • ! I Best possible regulation Should there be a sunset provislOn? No Do benefits of regulation Yes law exceed costs? Sourc:t: Authors compilation. Thr Costs and BI!I'If:jits 0/ RegulatIOn: The utI for R<'3l'U:::')'lI ReJOrm '-':I one completed for Canada, can be quite beneficial in developing a reform strategy. COL.:.n:nes shoulc at- tempt to develop a regulatory budget that would show the economic impact of regulations. This budget could be published along with the government's fiscal budget. Such a capability will take time to develop. Several jurisdictions, including some in developing countries, are putting procedures in place that would require a cost-benefit analysis for Significant regulations. The authors believe this will have a constructive impact on public policy by providing better information and by holding government offi- cials and political leaders more accountable. In the shurt term, il is important for agenCies charged with administering regulations to begin assembling crude cost and benefit data. For example, an agency could specify the rationale for a proposed regulation, the likely direct and indirect costs, a qualitative descrip- tion of benefits, an assessment of other alternatives, including the status quo, and an explanation of why other alternatives were not selected if they are likely to be better for the average citizen. Such analvses should not be overly burdensome. For small regulations, no analysis may be necessary. For regulatio~ having potentially large economic iIripact, more resources should be devoted to evalua- tion.Ideally, such analyses should be both prospective and retrospective so that analysts can learn how to improve their impact assessments. To get the process started, however, the emphasis should be on devel- oping an information management system that is low cost and implementable. It is extremely important to get front-line agencies involved in the process so that they become more sensitive to the economywide im pact of their proposals. As adminisrrative capabilities evolve, large regulatiOns and regulatory reforms should be subjected to more thorough cost-benefit analyses. These analyses should be an important factor in decisiorunaking.ln the case of economic regulation, the burden of proof should be on those who wish to maintain it, because the case for most economic regulation is weak in terms of economic efficiency. In the case oi social regu- lanon, flexibility should be encouraged so that consumers and producers are able to innovate in response to regulations. Thus, for example, perionnance standards for meeting a pollution goal are generally pre- ierred to standards that dictate the use of a particular technology. Of course, the amount or r1exibility In a regulatory policy should be based, in part, on the ability of the administrative agency to effectively imple- ment the policy (Hartman and Wheeler 1995). VVhile economic analysis can be helpfuL its limitations need to be reCOgnized. As noted earlier, the costs and beneiits of regulator:' policies are often quite uncertain. Trus uncertainty stems, In part, from a lack of analysis of specific policies. An important part, however, stems from a fundamental inability to predict how regulations will actually affect behavior. Regulations often have unexpected and perverse consequences (Ackerman and Hassler 1981). Thus, when regulating, one should 'proceed with extreme care and err on the side of less regulation, particularly when considering economic regulation. Where clear economic rationale for a regulatory policy is not present, these policies should be removed. Many policies do exist that involve licensing and price or quota intervention in industrial and developing countries that do not serve the public interest (Huber and Thome 1997; Guasch and Spiller 1997). Examples include applications for licenses and license renewals where the government's primary function is to trans- fer political favors to their preferred constituencies. Removal of such barriers may not be si,mple in many cases and may involve making resource transfers to politically powerful constituencies, A great deal more thought needs to be given to the design of regulatory frameworks. In some in- stances, even where deregulation is justified, partial deregulation may not lead to an improvement over the status quo. For example, removing price restrictions but retaining entry barriers could lead to ineffi- cient pricing. Full deregulation can lead to problems with monopoly, unless great care is successfully taken in managing the transItion to a deregulated environment. The point here is that the strategy for regulqtory reform is critical to the effectiveness of the refonn. Another serious design issue relates to the bureaucratic problem of tunnel vision, or the tendency of a single mission agency, such as health, education, or the environment, to consider only its mandate. If an agency considers only its mandate,. it will naturally tend to overstate the benefits of its program and to understate the costs. As noted above, one way to address this problem is to require the agency to develop 30 J. LutS Guasch and Pablo 5pl/J~ more data on the costs of specific regulatory proposals. A second way is to limit the agency's mandate. Other ways include having sunset requirements that would limit an agency's authority to a fixed time period, unless renewed by a legislature, and having a central agency review and approve or disapprove proposed regulations. Such an agency should be designed so that it has some independe!1ce and so that it is primarily concerned with the economywide impacts of regulations. Finally, regulators have a natural tendency to write regulations that are unduly complicated. This complexity allows bureaucrats and lawyers to have more power. It also makes it difficult for average people to understand the implications of regulations. It is important to make regulations more transpar- ent because greater transparency is likely to reduce corruption. Moreover, careful scrutiny of regulation, content, and constant benefits would diminish the likelihood of political capture by interest groups. Greater transparency is likely to increase the perceived legitimacy of th~ system. The move toward greater trans- parency will occur only as people begin to appreciate some of the hidden costs of regulation. A few developing countries have begun to realize the benefits of reforming economic regulation, and clearly, great potential for reform is present in many other industrial and developing countries. Still, much remains to be done in the areas of utilities and social regulation. However, regulation is beginning to appear on policy agendas of developing countries due to both domestic pressure and. pressure from interest groups. Thus, as developing countries, given their resource constraints, begin to address these issues, they need to think carefully about designing effective and efficient regulatory approaches. The overall lesson is not that regulation is generally undesirable, but that it often has undesirable eco- nomic consequences. When desirable, regulation's design, structure, and enforcement significantly matter. Moreover, these impacts result partly from political forces that lead to certain kinds of wealth redistribution (Stigler 1971a). While not denying such forces, the authors believe they can be mitigated by more sharply evaluating the consequences and tradeoffs involved in regulating before a regulatory policy is set in stone and by carefully crafting the policy's design, using economic principles and experience. 2 The Regulation of Utilities Since the late 1980s, developing countries have been extensively privatizing or concessioning the provi- sion of public services (utilities) for two reasons. The first reason is fiscal. The urgent need for extensIve investment in public services is in order to bring the services up to modem standards of service and coverage, and tlus need cannot be fulfilled by the public sector. Macroeconomic stabilization objecnves and the need to invest in the social sector restrict government ability to provide the needed funds in public services. The second reason is economic, induced by a better understanding of the role of the public and private sectors in utilities. It is now well Wlderstood that the private sector can and is more than willing to effectively operate and invest in utilitIes at higher efficiency levels than is the public sector. In addition, governments have come to terms with what the new role of the public sector should be, one oibroad policy formulation and regulatory oversight. not or ownership. It IS also now well under- stood that not only does regulation matter, but that there can be good regulation and bad regulation. Tnat is, regulation's design is critical to inducing efficient second-best sector performance. Designing effective regulatory frameworks and enforcing them is not easy. The i.ssue is highly com- plex and requires strong political commitment, highly trained workers, and a well-deSIgned incentive structure. Most of this book is concerned with the design and entorcement of regulatory frameworks for the utilities and transport sectors. This is complemented with an empirical evaluanon of how eXlSnng regulation has fared, mostly in the Latin American and Caribbean region. That regIon has been in many senses a pioneer and has 'taken the lead in privatization and regulation efforts. The Case for the Regulation of Utilities Utilities generally have three distinctive features. First, they require technologies that are commonly considered to be specific, sunk investments; second, they display aspects of-natural monopoly (econo- mies of scale and scope in the physical provision of basic services, economies of scale in planning and managing the network, and network externalities, and advantages in raising capital, which are being gradually eroded by technological innovations); and third, their products are massively consumed, usu- ally by captive customers with a fairly inelastic demand. For example, an electricity company's assets have little value in an alternative use, its network externalities and economies of density mean that mul- tiple wires cannot be deployed economically on the same street, and its customers (a large proportion of the urban population) have an inelastic demand for electricity. Other industries might exhibit some, but not all, of these characteristics: The steel industry, for ex- ample, has large sunk. investments and little value in alternative uses, but the economies of scale and scope are tnvlal compared with the size of the market,1bis may not be so in developing cOWltries, where the production of steel is protected because only a few steel mills are producing for a relatively small local market. Furthermore, although everyone indirectly consumes steel products, few individuals pay attention to the price of steel. Consider, too, the newspaper industry, for which large economies of scale and scope clearly exist in urban areas. Increases in the speed of communication and the use of computer design have drastically amplified the newspaper industry's economies of scale, resulting in fewer news- papers per city but relatively stable readership. Although readers usually constitute a large portion of the population (at least of the voting population), newspapers are not utilities. Despite the substantial amoWlt ~ of sector-specific human capital (for example, reporters whose principal contacts are with local politi- cians), the technology is increasingly generic, and investments are transferable. Shutting down a 31 32 ,. LuIS Guasch and Pablo Spllll.7 newspaper and moving the pnnnng presses, desks, computers, and so iorth elsewhe:e ::..ave become more and more common. These features distinguish the newspaper from the electrici;:.· se::ror, whose features more closelv resemble the features of most utility subsectors (see box 2.1). The three featur~s of utilities also distinguish the utilities from the rest of the econor;"',y a."1d are at the core of the contractual problems that have traditionally raised the need for governmental :eg. . Ilation of utilities (Goldberg 1976; Williamson 1988; Barze11989; North 1990; Baysan and Guasch lSo'13; Levy and Spiller 1993; Guasch and Marshall 1993). In utilities, three types of contractual problems are particularly important: (a) problems between firms and the government, which distort the investment :ncentives of utility companies; (b) problems between firms and their customers, which result In the utiJity's exerCISe of market power; and (c) problems between governments and interest groups, which prcmpt govern- ments to distort utility pricing for purposes of income distribution (cross-subsidization). ~oreover, along with the standard distortionary and distributive effects of monopoly pricing, contractual problems affect the competitiveness of the overall economy. In today's global econonues, competition and competitive prices are essential, particularly for the success of the export-led strategies pursued by most developing countries. The production of goods and services relies heavily on utility products as inputs. If the utility prOducts' pricing is high or inefficient, the country is unnecessarily vulnerable to offshore competition, which adversely affects overall growth and welfare. In an attempt to correct these problems. appropriate regulation provides the incenoves for firms to invest at efficient levels, induces finns to pnce their ser- Vices at second-best levels, and creates the framework for productive effiCiency. Appropnate regulation also minimizes opportunities for cross-subsidization or tor interest groups to lobb~' for inefficient policies and significantly reduces the nation's vulnerability to offshore competition. A constraint that Bo% .2.1. EconomIc Features of the ElectnCtty Sector The following c:haractenstics are relevant to the design of a new institutional environment for &.e eiectncitv supply industry: . • Electricity is essential to most productive processes and is an element in final demand. • Elec:ttic:itv cannot be stored. • The electricity network has strong externalities. • Investment in electncity cannot be divided and is specific. • Close coordination is needed because supply and demand need to be balanced contmually ~Iuoughout the system, • Economies of scale and scope are present. • The network takes a long time to build. • Both demand and supply fluctuate randomly. (Demand fluctuates by day and season and v.i:.' variations in the weather. and power outages cannot be predicted.) • User electriCity demand is highly inelastic to changes in price. • Electricity, to a large extent, is a captive market. Because electricity is essential and cannot be stored, power outages are costly, which encourages ovennvestment in order to secure ample reserves. To ensure these reserves, high-voltage networKs are con- structed that provide the sel"\':ce economically and in fixed quality. Interconnection is possible only if the network is closely coordinated among the different generatmg plants, because actions by anyone actor strongly affect the whole system. The traditional response to these technological characteristics has been vertical and hOrIZontal integration under state control (through ownersrup and regulation). Technological changes that took place during the 19805 allowed the introduction of a market approach to power supply. For instance, reduction in the optimal size of generation plants, together with the inc:rease in the size of the market, have undenruned the natural monopoly characteristic of this industry and have allowed the introduction of competition and the unbun- dling of the secttr. SOilret': Authors. prevents the attainment of at least one optimal condition also makes other optimal conditions ull-:e5ir- able; a second-best solution then becomes the preferred choice. Finally, regulation is an issue not of decision theory but rather of game theory. Game theory can be described as interactive de~.sion theory. In game theory, the behavior of each decisionmake: affects the choices of others. In decision theory, decisionmakers make choices in isolation. The regulator;; out- come is obtained by the regulated company's strategic response to the regulatory structure. The regu- lations set the incentive structure and elicit a strategic response and behavior from the regulated com- pany. The strategic component, or the interaction between the regulator and the regulated company (and other affected third parties), is what makes the regulatory process a game theory issue rathe: than a decision theory problem. In summary, the main objectives of a regulatory framework are to induce the regulated firm to oper- ate at the lowest and most efficient possible costs and to closely align prices (tariffs) with costs allowing the firm to earn only normal profits. Usually, subordinate objectives, such as inducing increased cover- age and access, improving quality of service, and addressing issues of universal service obligations, comple- ment the main objectives. Regulation and Commitment: Contractual Problems Between Firms and the Government Because a utility's assets are largely sunk and its customers comprise a large proportion of the population and are mostly captive and vocal, governments might have an incentive to expropriate the utility's quasi- rents, which are the portion of operating returns that exceed what a company could obtain if it devoted its capital to alternative uses. Because the assets of utilities are largely sunk, quasi-rents may equal the return on capital. This does not mean that the government takes over the operation of the company, but rather that it sets maximum prices for a utility's products that just compensate for its operating costs and the return on its nonspecific assets. These prices provide sufficient ex post incentives for the firm to operate, but not to invest at efficient levels. The company will be willing :0 continue operating because its return from operating ....ill exceed its return from shutting down and deploying its assets elsewhere. However, the firm will have little incentive to invest in new capital because it will not be able to obtain a return. Although it is feasible to conceive qf loan financing for new investments, failure to repay would bring the company to bankruptcy and eventual liquidation. Bankruptcy does not mean that the company shuts down. Bankruptcy, because the assets are specific, implies a change of ownership from stockholders to creditors. Creditors would have the same incentives to operate as does the firm, and they would be willing to operate even if quasi-rents were expropriated. Loan financing would not be feasible here either. Indeed, the expropriation of quasi·rents is more prevalent in Latin America than the direct takeover or expropriation of utilities without compensation. The expropriation of quasi-rents may be profitable for a government if the direct costs (loss of reputa- tion compared to other utilities and lack of future investments by utilities) are lower than the shorHerm Bor 2.2. The Use of Mon.tevideo Gas Compan.y Throughout the 1950s and 19605, Montevideo Gas Company (MGC), which was owned and operated b;' a British company, was not allowed to raise prices. Ouring a period of rapid inflation in the 19605, it went bankrupt and was taken over by the government. Compare this example with the Peron administratlon's takeover of International Telephone and Telegraph's (lTI"'s) majonty holdings in the Union TelefOnica del Rio de la Plata (UTRP). (L'TRP was the main provider of telephones in the Buenos Aires region.) In 1946, the Argentine goverrunent paid USS95 million for m's holdings (US$623 million in 1992 pnces). Given UTRP's 457,BOO tines, this translates into USS1,360 per tine (in 1992 prices, capital eqUipment producer pnces deflator). Because the marginal cost of a tine in a large city today is approximately USS65O, the price paid by the Peron administration does not seem unusually low. Sauru: Hill and Abdalla (1993). 34 J. LU15 GWlsch and Pablo Splll~r benefits (such as achieving reelection by reducing the price of utilities or by attacking the utility as a monopoly) and if the indirect institutional costs (such as disregarding the judiciary or bypassing traditional administrative procedures) are not too large. Thus, incen -;'.'es for the expropriation of quasi- rents are expected to be largest in countries where indirect institutioL- .:osts are low. These countries are where formal or infonnal governmental procedures or checks and balances are not required to make regulatory decisions, where regulatory policy is centralized in the administration, or where the judiciary does not have a tradition of reviewing or the power to review administrative decisions. The incentives for the expropriation of quasi·rents are also expected to be largest in countries where direct costs are also small and, perhaps more important. where the government's horizon is relatively short. For example, kev constituencies must be satisfied before an election. When pnvate utilities anticipate expropriation, th~y will not undertake investment in the first place, and government direct intervention may then be- come the default mode of operation. If the government wants to motivate private investment, it has to design an institutional arrangement that limits its own ability to behave opportunistically once a private utility has embarked on an invest- ment program. Such an arrangement is a regulatory framework that stipulates price-setting procedures, impartial conflict resolution (arbitration or judicial review), investment policies, and so forth. Unless such a regulatory framework is credible, however, investments will not be undertaken or, if undertaken, will not be efficient. In this sense, it is not surprising that private telecommunications operators have rushed to develop cellular rather than fixed·link networks in Eastern European countnes. Although cel- lular networks have higher long-run costs than do fixed-link networks and are sometimes of inferior quality, the magnitude of investment in specific assets is much smaller than it is in fixed·link networks. Furthermore, the customers themselves (who purchase the handset) undertake many of the specific in- vestments in cellular telephony. Credible regulation solves a key contractual problem between the government and the utilities be- cause it restrains the government's opportunistic expropriation of a utility's quasi-rents. As such, cred- ible regulation is needed for in\'estment to be undertaken. Even publicly owned companies will not invest if their quasi-rents can be taken over by the government. (See Goldberg 1976 for one of the first treatments of this problem; see also Williamson 1976.) This does not mean that the utility will necessarily receive assurances of some speciiic rate of return or that it will receive exclusive licenses. Indeed, Colom- bian regulation of value-added networks specifically stipulates that the government cannot set prices; neither does it allow exclusivity provisions. Regulation here means total lack of government discretion. In some countries, however, such guarantees may be the only way to limit the government's discretion- ary power and to reassure private investors. Regulation and Market Power: Contractual Problems Between Firms and Customers Contractual problems between fin:ns and their customers, or the asymmetric bargaining power between the sole firm supplying the servi.ce and its customers, provide what is usually called the ma.rket failure rationale for regulation. For example, if an electricity distribution company is unable to enter efficient long-term contracts with residential customers, social losses (of either real or deadweight resources) oc- cur as a result of the exercise of :narket power or inefficient investment policies (whic..'1 encourage dupli- cate investment or discourage investment). Regulations could at least partially alleviate these problems. Contracting between finns and customers may fail either because the sector is not contestable, which results in the exercise of market power, or because the sector is contestable but not sustainable, which implies inefficient investment policies (see Baumol, Panzar, and Willig 1982 in general and chapter 16 in particular for an insider view of the policy implications of this literature). A contestable market is one in which potential entTants, as well as actual rivals, compete with existing firms. The primary requirement for contestability is free entry to and exit from the market. The irretrievable sunk costs common in utility companies frequently impede entry. Because solving this contractual problem would benefit both con- sumers and the finn, a demand tor regulation arises. Tile &t;... liJ::-..or. :;. UtllctltS 35 Regulation and Cross-Subsidies: Contractual Problems Between Interest Groups and the Government Contractual problems between interest groups and the government are behind the regulations that gov- ern the creation or extraction of rents. Consider a politically powerful interest group ..~ar is demanding a cash transfer from the government. The contractual problem can be solved if the government is able to ensure that cash transfers are restricted to members of that interest group. In most circumstances, how- ever, efficient cash transfers are politically difficult to implement, and the government introduces distortive regulations in order to transfer rents to a particular interest grOLJP (Stigler 1971a). . An interest group that can convince the state to use the power of coercion to the group's benefit can improve its own well-being. The state can benefit, as well. because the policy can increase the political support of the well-organized group that benefits. Individual producers, who are typically few and well organized, stand to gain a great deal from regulation, whereas consumers, who number in the millions and are poorly organized, stand to lose. However, individual consumers stand to lose only a small amount, which explains the relatively weak incentive for them to voice complaints and organize. Regulation can create hann that, although large in the aggregate, is smail for individual consumers. Regulation can be an effective tool for redistributing wealth among population groups. For example, textile import restrictions limit C.s. conswner access to inexpensive clothing while allowing domestic producers to charge higher prices. Without these import quotas, consumers would pay at least US51 billion less for the same apparel. When transfers are that large, beneficianes will be willing to expend considerable resources on lobbymg and other activities that enhance their earnings and protect these transfers. This was extensively illustrated in the previous chapter. Other examples are the California energy bill described in box 2.3 and the licensing of taxicabs. The restrictions on entry raised the value of Box 1.3. California'S Energy Bill In April 1994, California decided to let large companies pick their own electncity suppliers, breaking up an 82- year monopoly, All other customers, even individual households, were to be allowed the same chcice by 2002. About two dozen states in the United States started down the same path. Just 13 months later. though, Califor- nia regulators disavowed their decision, bowmg to a torrent of criticism that their procompetitive ruling could wreck the state's 3 largest utilities, shift costs to small power users, and hann the environment. The much- heralded revolution in the Caliiomia power business died. Meanwhile, Caliiornia is still paymg electricity rates that are twice as rugh as Oregon's and 50 percent higher than the national average. At lSsue are the stranded costs incurred by the utilities m the late 1960s and early 1970s when CalifOrnia'S utilities built big nuclear plants that, at the time, appeared to be econorrucal. In the 19805, a federal law aimed at creating an alternanv~nergy industry forced many utilitIes into long-term power supply contracts with nonutihty generating companies. Both initiatives turned into financial disasters. Industrywide, the cost of these commitmenlS over and above market prices for power, the utilities' stranded costs, may total USS135 billion. In this round. the utilities shareholders won at the expense of the ratepayers, who will have to continue paying for those stranded costs. Soon afte~ the initial dec'.sion. the utility companies launched a massive lobbying campaip to attack the free market plan and alternative-energy contracts, and some pushed for a power pool scheme. One company alone spent USS440,QOO in three months to lobby regulators and lawmakers. As expected. the alternatIve being consid- ered, the English model, is not necessarily a panacea for the ratepayers. It requires the comparues to pool the!! electricity and then dispatch it under a coordinated. highly regulated system. However, the efficiency and wel- fare effects of that system are questionable, as the Bntish experience indicates. The pool system raised British electricity bills. The price of power coming from the pool shot up 46 percent between March 1990, when the pool was launched, and January 1994. The reason was that with few large suppliers in England and Wales, market prices are highly subject to marupulatlon and collusion. The same would appear to be true in Califonua. Sourc~: Willi Strrtt /ollrnJll (l995b). 36 J. LuIS CUIlSch and Pablo Sl'Jrll~ a taxicab license in the secondary market to more than USS200,OOO in New York City as of 1993 and to USS32,OOO in Boston as of the mid.-1980s. In cities that have relaxed the restrictions on entry, the price of a license is considerably lower. In Portland, San Diego, and Seattle, a license costs between USSl,OOO and USS5,OOO (Frankema and Pautler 1984; Viscusi, Vernon, and Harrington 1993). Although the extraction of rents is sometimes the only reason for regulating a partiC'J.ia.r sector, gov- ernments are sometimes motivated by more than efficiency. Thus, some regulatory instirutions arise in response to conflicts over distribution among private mterest groups, while others arise in response to contractual problems between private enterprises and government agenCies. In either case, a regulatory institution created to respond to one kind of problem can, over time, serve an entirely different purpose. Regulations that solve contractual failures may take many forms, depending on the nature of the sector and the country's legal, political, and institutional history. To be credible, however, the regulatory mechanism must take into account the potential for regulatory shortcomings. The nature of the demand for regulation and the institutional characteristics of a country naturall~.' affect the type of regulatory framework that is implemented. Mismatches between the two will produce unintended effects, such as regulatory failure, inefficiencies, and reduced productivity growth. The ef- fects are unintended because or the uncertainty as to whether the persons who set up a regulatory frame- work were naive in not foreseeing the potential effects or whether the unintended effects were at the core of the demand for regulation. Regulatory Failure RegulatiOns are implemented not by omniscient machines but by government entities subject to in- ionnationaL political, and institutional constraints. The same information and eniorcement prob- lems that cause private contractual failures may also hamper the implementation of regulatory poli- cies, causing regulatory failure. Modem regulation theory suggests that regulatory bodies have less infonnation about technology, costs, and, to some extent, demand, than the firms they regulate (see Baron 1988 for a survey of the modem agency theory approach to regulation). Efficient regulatory systems (that is, second-best effi- ciency given the regulatory objectives) must design policies that overcome these informatlonal disadvan- tages. Such poli~es require substantial regulatory discretion and substantial administrative capabilities and sophistication, but regulatory discretion can exacerbate the contractual problems, such as a government's opportunistic behavior, that were at the core of the initial demand for regulation. Thus, if a country's institutions do not limit administrative discretion. designing a regulatory system that grants substantial discretion to the regulator as a means of overcoming informational disadvantages may be self-defeating because this same discretion may be used opportunistically to extract a company's quasi- rents. (This seems to have been the case with Jamaica's Public Utility Commission from 1967 to 1975 [Spiller and Sampson 19941.) If an industry is characterized by substantial price and cost volatility, a second-best regula.tory frame- work will also require sophisticated administrative capabilities. If the country lacks such capabilities. implementing a sophisticated regulatory framework may fail either because the utility manipulates the process or because regulators do not follow the specified process and methods. The regulatory processes for Chile's electricity and telecommunications sectors are some of the most sophisticated in the develop- ing countries. Every five years regulators must develop a price scheme that provides a standardized company with a fair return and that sets maximum regulated prices close to long-run marginal costs. The implementation of such a regulatory process in a country with few administrators and lawyers versed in economics could result in wildly different outcomes, depending on the nature of the country's institu- tions. On the one hand, regulators could decide not to follow the regulatory procedures and instead design their own. On the other hand, regulators could follow the regulatory process, which is being completely manipulated by the utility. Regulatory failure reflects a mismatch betv-Jeen regulatory institutions and a COU1"ltry'S institunonal characteristics. Avoiding regulatory failure, then, may require introducing substantial rigidities in decisionmaking. If the regulatory framework engenders regulatory failure, public ownership may then .... become the default institutional arrangement because private firms will be unlikely to invest. The result- ing inefficiencies can be Significant. (For discussions of how the U.s. Administrative P:ocedures Act pro- duces rigidities and delays in the process that seeks to control the regulatory agency, see McCubbins. Noll, and Weingast 198i, 1990; for analyses of the role of judicial review in controlling agency discretion, see Spiller 1990a). lltterest Group Politics A second unintended re~torv effect results from the prevalence ot interest group politics. Consider a o . countrY where traditional checks on an admirustration's decisionmaking are weak, either because the ex- ecutiv~ is responsible for interpreting legislation (as in Argentina, Bolivia, and Uruguay) or because elec- torallaws and legislative institutions grant a single party control over both the executive and the legislature (as in Jamaica, which has a parliamentary system with Single-party voting districts, or Mexico). In such cases, granting the administration substantive dis.:retion over regulatory outcomes could allow interest group politics to overtake the regulatory process. Interest groups seek not only to obtain cross-subsidization but also to block the entrance ot new producers or products, adversely affecting overall welfare. The capture hypothesis argues that a vote-maximizing government has an interest in allowing regula- tory programs to reflect the will of powerful interest groups. A particular concern is that groups in a regulated industry will influence the regulatory environment, hence capturing the process. One way to test whether a regulatory package has been captured is to compare the stock market returns (or earnings if the company is not listed on the stock exchange) for a regulated company with the returns ror a compa- rable sample of firms not affected by the regulation. Abnormally high returns could indicate regulatory capture if they can be statistically associated with changes in the regulatory environment. For example, data are available for British Telecom (BT) for the period 1984-94. Alter privatization, BT's average daily returns were not significantly higher than the market index. This does not mean that BT did not attempt to capture the regulatory process, but simply that it did not do so. The regulat- ing body (Oftel) set low interconnection charges for BT's competitor, and this ruling showed up as a robust negative. Furthermore, investors appear to have gained some eonfidence from negotiations between Oftel and BT in which Oitel agreed not to ask the Monopolies and Mergers Commission to investigate BT. Overall, BT appears to have had normal market returns, indicating that it did not cap- ture the regulatory process. A detailed review of events revealed no clear pattern favoring or opposing commercial interests. Moreover, because BT was not pushed below a normal return, evidence does not exist that consumer interests captured the regulatory process. Oftel seems to have carried out its regu- latory function effectively. Similar conclusions cannot be drawn from many Latm American utilities. After these utilities' participation, their rates of return appear, at first glance, to be abn.ormally high. Finally, the unintended effect of regulation on productivity growth has already been extensively dis- cussed in the previous chapter. Institutions and Regulatory Discretion In trying to understand the ability of different countries to commit themselves to particular regulatory processes and institutions, it is useful to look at regulation as an engineering problem. Regulatory design has two levels: basiC engineering and detail engineering. Basic engineering comprises the mecha- nisms through which societies place substantive or procedural constraints on regulatory discretion and that resolve conflicts that arise in relation to these constraints. (Such constraints on regulatory decisionmaking have been called contractual governance institutions. See Williamson 1985; Levy and 38 J. Lu:s Gl.W.Sch and Pablo SpillEr Spiller 1993.) Detail engineering comprises the rules governing utility pricing, direct or cross-subsI- dies, entry, interconnection, and so forth. While basic and detail engineering are endogenous policy variables, the sets of choices are constrained. Basic engmeering choices are constrained by the nature of the contractual problems discussed above and by the institutional characteristics of a particular coun- try. Similarly, detail-engineering choices are constrained both by a country's institutIonal c..~aracter..s­ tics and by its basic engineering choices. Although most policy work on regulation has focused on detail rather than on basic engineering, regulatory impact, whether positive or negative, comes to the forefront only when basic engineering has been designed properly. Commenting on the interaction between technology (institutions), governance (basic engineering), and price (detail engineering), Williamson (1985, p. 87) says, "In as much as price and governance are linked, parties to a contract should not expect to have their cake (low price) and eat it too (no saieguard)." lnstitutiomai and Administratit1e Endowment and Basic Regulatory Engineering Following North and Thomas (1973), the institutional endowment of a nation is comprised of at least five elements: • The country's legislative and executive institutions, which include the formal mechanisms for appointing legislators and decisiorunakers, for creating laws and regulations (apart from judicial decisionmaking), for implementing these laws, and for determining the rela?ons between the leg- islature and the executive • The country's judicial institutions, which are the formal mechanisms for appointing judges, deter- mining the internal structure of the judiciary, and impartially resolving disputes among private parties or between private parties and the state • Informal but broadly accepted norms that tacitly constrain the action of individuals or government • The administrative capabilities of the nation • The character of society's contending social interests and the balance between them, including the role of ideology (Levy and Spiller 1993; North 1990). The extent and characteristics of a country's institutional and administrative endowments limit the choice of regulatory instruments and institutions. To be effective, regulation has to match the sector's and the country's endowments and institutional characteristics. Although economists have devoted much effort to sector-specific issues (as witnessed by the features described in box 2.1), country-spedfic issues traditionally have received much less attention. Two features of many developing countries are the discretionary power of the executive and centralized deosiorunaking. Indeed, Weingast (1995) claims that such discretionary powers and centralized decisionmaking lie behind the lack of economic development of many countries. He states, "lhriving markets require not only the appropriate system of property rights and a law of contracts, but a secure political foundation that places strong limits on the ability of the state to confiscate wealth." (Weingast 1995, p. 209) Thus, to promote private s~tor partlci- pation in utilities, for example, developing country governments may have to design regulatory pro-- cesses that restrain their discretionary power so investors can be confident that the rules of the game will remain stable and not subject to arbitrary or opportunistic changes by the government. The main challenge is to design regulatory processes that, while limiting discretion, are compatible with the country's institutional structure of government and with the legal and administrative tradi- tions of the country. For example, the antitrust laws in Colombia, Mexico, and Peru use independent courts (in Colombia), standard courts (in Mexko), and specialized courts (in Peru) to enforce innova- tive checks and balances of a nature not observed before. (See Baysan and Guasch 1993 for a discussion of antitrust enforcement in Colombia and Peru, respectively; see Guasch 1994 for an overview of Latin American enforcement policies). Similarly, Chile's approach to regulating telecommunications and elec- tricity and to enforcing antitrust legislation is based on checks and balances (the result of specific leg- islation) that require sophisticated use of the court system, including multiple decisionma.kers. (For a discussion of electricity regulation, see Spiller 1993; for a discussion of telecommunications regulation and antitrust, see GalaI199~.) in JamaicJ., the telecommunications regulatory framework limits discre- tion through contract law rather than administratIve law, using the courts to protect contracts and property (Spiller and Sampson 1994). These innovations were all designed with the nature of each country's political institutions b mind. They are intended to restrain the government rather than to grant it wide regulatory powers. When making regula- tory decislons, governments ;!1o~.:i cunsider and extract le550ru from ~~e experience gaL.'1t:.i in .:iverse COWl- tnes with the ways in which distinct iorms of regulation, and regulation in general, affect productivity. In most scenarios, regulatory mstruments may have to be relatively inflexible to provide regulatory cred- il:1ilitv. Moreover, the menu of commitment mstruments is larger in countries where the decsionmaking pre- is cess highly decentralized than U1 countnes where it is highly centralized. The following discussion high- lights the relatlon between a country's institutions and the development of a credible regulatory system. Credible regulatory structures are easier to implement in countries where decISionmaking is natu- rallv decentralized. In countries where decisionmaking is heavily centralized, achieving regulatory cred- ibility is possible only if structures are relatively rigid. To show the difficulties in building commitment, consider the case of the UnHed States. in the United States, decisionmakll1g is naturally decentralized in a presidentlal system with a legislature composed of two chambers elected under dilierent rules and at different times. The Unitec States also has electoral rules that tie legislators to their local constituencies and limit, but do not eliminate, the power of political parties. Finally, the U.s. judiciary is reasonablv well respected by the population, and its decisions are widely accepted and even implemented. In ;uch a system, regulatory corrurutment can be introduced in different forms. It can be achievec.. for example, by writing a specific piece of legislation and delegating its implementatlon to a regulatory agency, whose decisions, on both substance and process, can be reviewed by the judiciary. Alternatively, regulatorY credibility can be achievec by hardwiring the decisionmaking process to safeguard the interests of th~ regulated companies against administrative expropriation (see McCubbins, Noll, and Weingast 195i on hard wiring; see also Hamilton and Schroeder 1994; Macey 1992). Here again, the cou.'"tS may review the agency's decisions, both on substance and on procedure. Finally, regulatory credibility can be achieved by granting the utility a license specifying the regulatory process through which its prices will be deter- mined. Deviations from the license can be challenged relatively easily through the courts. These three regulatory instruments have different implications for both regulatory credibility and for flexibility, and they are the subjects of chapters 3 and 4. . The design and effective operation of a regulatory framework and enforcing agency are rather com- plex, and although some aspects are clear cut, others involve tradeoffs. Box 2.4 provides a checklist of the main ISsues to be considered in that design, and discussion is provided in the ensuing chapters. 40 J LUIs Gll.:ts(h .:md Pablo SpIll" Box 2.4. Twtnty-Two BasIc Regulatory Design QuestIons Prior to developing and unplementmg a sector regulatory framework, the foHoWIng questions s::ouid ~e ad- dressed. The correct answers to these questions and their consideration In the regulatory frame\~'o:-~ are ke\' to achieving effective regulation. ' 1. What is the true extent of narural monopoly elements in the sector' 2. Is vemcal or geographical unouncijmg a deslrabie poilcy ior me sector~ 3. Should there be limIts on market share at each horizontal level? 4. What is the best way to signal a credible commitment to a regulator)" regune? 5. Should there be a smgle regulator or a cOmm.lSSlon? 6. Should the regulatory entlty be mdependent of government? 7. How much discretion should be granted to the regulator? 8. How should regulators be chosen and how should their service period be staggered? 9. How should responsibility be divided among the regulatory entity and other government au:honties? 10. What should be the interplay between the regulatory and antitrust agency to oversee the runCtlons and operations of the sector? 11. Should exclusivity rights be granted, and if so, for how long? 12. Which kind of guarantees should be offered, if any? 13. What activities or parameters should be regulated? 14. What are the control mecharusms tor pnce and quality? 15. How should the initial vaiues be chosen for the pnces or parameters to be regulated. and wnat should be the critena for access (to the nerwork) prices? 16. How are regulatory rules created and eniorced? 1i. How should concessions and the transfer process be designed? 18. What is the best way to dissuade frivolous renegotIation, and what should be the conditlons for renegotiation? 19. How should conflicts be resolved? 20. How can transparency be built into the regulatory process? 21. What inionnabon is needed to best assist the regulator and how should it be acquired and ,,"ruch regula- tory accountmg practIces should be demanded? 22. Who regulates the regulator? Source: Authors. ',. 3 Creating the Basic Engineering ~f Regulation For basic engineenng to provide regulatory stability and credibility, three complementary mechanisms must be in place. First, substantive restraints on regulatory discretion must be embedded in the regu- laton' framework; second, formal or informal constraints must limit the ability of the executive branch to change the regulatory framework itself; and third, institutions must enforce those substantive or procedural constraints. Assume, for example, that the regulation is institutionalized through passage of a general piece of legis- lation, like Jamaica's Public Utilities Act of 1966, which set up a public utility commission similar to that of the United States. The legislation does not specify procedures that the regulator has to follow or the critena that the regulation must satisfy to be legal. In this case, the basic engineering fails to satisfy the first criterion of stability because it is not embedded in the regulatory framework. Another instance might be a country whose legislative institutions and iragmented political parties make it difficult to pass new legislation, as is the case in Bolivia, Chile, Colombia, or Uruguay. Basic engineering under such circumstances would satlSfy the second criterion of regulatory stability because the executive branch has limited ability to change the regulatory framework. In yet another situation, the country's judiciary is an independent entity, able to enforce limits on administrative discretion and able to detennine that presidential decrees violate the law or the constitution and are therefore illegal, as in Colombia. Basic engineering in this case would satisfy the third test of regulatory stability as well. However, the choice of basic engineering could still be flawed if the administration exercises almost total discretion over regulatory policy. Further, the presence of institutions that make new legislation difficult to enact (such as a multiplicity of parties, none of which has a dear majority in congress) also implies that regulatory policy could be altered concurrent with changes in gov- ernment. Under such circumstances, basic regulatory engineenng would fail to provide regulatory stability and would prOVide poor investment incentives to utilities. The Choice of Basic Regulatory Instruments The four types of basic regulatory instruments are specific legislation, presidential decrees, contracts, and admirustrative procedures. Clearly, a fifth choice, a composite or mixture of some of the four types. 15 also available, and indeed some countries have chosen the composite. The choice and level of commit- ment depend on the country's institutional endowments. Each instrument represents a dilierent level of credibility and signals a different level of commitment to the regulatory structure. Specific Legislation Consider, first, the use of specific legislation as a way to restrain regulatory discretion. Several countries have enacted specific pieces of legislation to provide basic engineering. Compare two pieces of U.S. leg- islation: the 1935 Federal Communications Act and the 1990 amendments to the Clean Air Act. The 1935 Federal Communications Act, which is still in effect. was developed to regulate monopolies, although the Federal Communicanons Commission (FCC) currently regulates competitive industries. The act did not guide the FCC's regulatory actions, but rather it mandated that the FCC should undertake actions to improve the welfare of U.S. citizens. It granted the FCC total discretion in this mandate, imposed only the limits of administrative law, and provided for continual congreSSional supervision of the agency. The 1990 amendments to the Clean Air Act specified precise actions that the Environmental Protection Agency 41 ~2 f. LuIS Guascn and Pablo Spl/lO' (EPA) had to undertake. In particular, the amendments ordered the EPA to institutionalize a market for pollution pennits and determined how many pollution permits each electrical utility in the nation could have, based on a generic determination (with 1985 levels as the baseline) and a long list of exemptions. Further, failure of the EPA to implement the market for permits could be contested in court as failure to comply with the law. More specifically, coru;ider the conditions for achieving regulatory credibility through the different instruments. Start with a U5.-style presIdential system. To simplify the analysis, drastic assumptions need to be made about the organization of such a system. These assumptions imply tha~ the preferences of both chambers of Congress and of the president can be represented through multidimensIonal ideal points, as in figure 3.1. (Although this is a simplified version of the U.s. system, a more complex frame- work is not needed to understand the main issue.) Figure 3.1 assumes that three veto players exist: the House (H), the Senate (5), and the president (P). Very specific legislation is equivalent to Congress and the president agreeing on a particular policy, call it xO' and writing such policy into law. To be an equilibrium, this policy has to be inside the contract set of H, p, and S. Call this set W(H, 5, P). The agency's latitude in implementing the policy is minimal, but it may nevertheless deviate from xO' Such deviations may, or may not, be checked by the courts. Even if this model is abstained from the courts' preferences on outcomes, the courts may not uphold Xo under all circumstances. Assume, as in figure 3.1, that Xo is initially inside W(H, 5, P) but, because of electoral changes, becomes outside the new contract set depicted as W(H', 5', P'). Now Xo is no longer an equilib- rium. Indeed, if the agency implements Xl' a court knowing that Xl could come out or the legislative process may not reverse the agency. Furthermore, reversing the agency will trigger new legISlation be- cause, by being outside W(.), Xo is not an equilibrium anymore. Thus, spedfic legislation may provide commitment insofar as the electoral system is expected to re- turn to Congress and to the preSidency politidans who are so divided in their preferences that changes in membership should not drastically affect the probability that the initial legislation will remain inside the new W(.).In other words, specific legislation can provide regulatory committnent if the set W(.) is large. Consider, for example, figure 3.2, which depicts two W(.) sets, one linking ideal points:-!, S. and p, W(H. 5, P), and another, wider set, linking ideal points H.", Sur' and PuI W(H.", S;r' PI). The initial5tatus quo, xO' is in both sets. Assume, now, that a given change in public preferences tmplies a shift of a gIven magrutude in all three main veto players. Now the relevant W{.} sets are W(H', 5', P') and W(H'u-' S'r' P'~. Assume also that the change in political preference moves all politicians in the same general direction so that the change does not affect the size of each of the W(.) sets. With a larger W(.) set, a given' change in preference has a smaller probability that the initial status quo will be left outside the new W(.) set. Figure 3.1. Specific Legislation and Political Changes in Decentralized Systems H 5 P' Sourre: Authors analysis. Creatrng the BasIc Engmur:ng oJ o\t>guliltiOn 'I..) Figllre 3.1. 5pt?c~fic Legisla!Ion and tht' Si:e of the Bargaining Sd H." ~--~----------~ Source: Authors analysIS. This discussion implies that analytical emphasis should be placed on the set of conditions that, for a given preierence structure. magnifies the set W(.). Consider, first~ electoral rules for the different houses of the legislature. Often, as in the state assemblies in the United States, both chambers are elected with essentiallv the same electoral rules. In such cases,S and H will be close to one another in the policy space. .. This type' of electoral rule creates a legislature that can be described as false bicameral. Figure 3.3 shows "- that such closeness in policy space reduces the set W(.) and that an electoral change has a higher probabil~ ity of bringing Xo outside the new W(.) set, eliminating the credibility of the regulatory structure. (For an interesting public choice perspective on bicameralism, see Levmore 1992.) Consider, now, parliamentary systems, even those with two houses. Usually the government requires support only from a single chamber. (For an excellent comparative discussion of the \irtues of different presidential and parliamentary systems, see Shugart and Carey 1992.) It is reasonable to assume that the executive is located close to the lower house. In figure 3.4, E represents the executive and is assumed to reflect the preferences of the house. W(.) now resembles a contract curve between the executive and t"'-e senate. Ii, as is the case in most bicameral parliamentary systems, the upper house has restricted legxslative powers, then the outcome of a bargaining process between E and 5 will be close to E and H. As a co~ quence, even ~or changes in political preferences will imply that the initial status quo z: is untenable. This discussion has important implications for the use of specilic legislation to provide regulatory commitment. Indeed, specific legislation will not provide regulatory credibility in traditional parliamen- tary systems and should not be used in those instances. Instead, specific legislation can be used to pro- vide credibility only in systems with substantial division of powers. This raises a major question of implementability. Because legislative specificity is hard to implement in a legislature with substantial division of powers, after all the status quo may well be inside the set W( .), preventing legislative action, under what conditions can legislative specificity be implemented in a divided polity? One possibility involves transitory unified governments. Unified governments, sensing that future electipns will bring Figure 3J. Implications of False Bicameralism for Regulatory Credibility H P P' Sourct: Authors analysis. -I-J J. LUIs GI4iLScIJ .J1'Id Pablo Splll~r FiguTe 3.4. Implications of PaT!U2m!"r.~:lTj· Systems for Regulatory Credi!:ifit"'.:i 5 s· H E H' E' Source: Authors analysis. about a wider W(.), may legislate extremely specific policies that will, most probably, bind future govenunents.lndeed, this was the case in both Argentina and Chile. Specific legislation as a basic engineering choice satisfies the first requirement for regulatory stability (that substantive restraints on regulatory discretion be embedded in the regulatory framework). Whether it also satisfies the second and third requirements depends, however, on the nature of the country's institu· tional endowments. Ii the legislative institutions make it easy to pass new laws, then the second require- ment ior regulatory stability may fail (that fonnal orinfonnal constraints limit the executh'e'sability to alter an established regulatory framework) because the executive could always upset the regulatory understanding by passing new legislation. Such would be the case in parliamentary systems with electoral rules that pro- mote a two-party system or in a presidential system with electoral laws that foster a single-parry system, where that party almost always wins the elections for both the legislature and the executive. Thus, unless widely accepted norms prohibit opportunistic changes in the law, specific legislation does not satisfy the second requ.irement for regulatory stability. A second instance where specific legislation may not be a sound basic engineering choice is where the judiciary is not truly independent, and therefore is :lot capable or restraining the executive. In this case, the executive could deviate from the direct instructions of the law without triggering a legal challenge. Specific legislation in this case will not satisfy the third requirement tor regulatory stability (that institutions be capable of enforcing substantive constraints). To strengthen the power of specific legislation as a basic engineering choice, the important elements of regulation may be incorporated into the constitution, giving them greater stability even where it is otherwise easy to overturn legislation not covered in the constitution. 1bat perhaps is the greatest signal of committ:1ent. To summarize. specific legislation may serve as a basIC engineering choice in countnes where legisla- tive action is costly and where the judiciary is relatively independent from the executive. In such coun- tries, however, passing the initial legislation will require an unusual level of legislative consensus be- cause legislation with a high degree of specificity will be more difficult to pass than a gene.ral piece of legislation. See Schwartz. Spiller, and Urbizondo 1994 for a model of endogenous determination of legis· lative specificity that takes into account the costs of writing specific legislation. Their main result. that. for legislative specificity to be an equilibrium in a signaling model, congress must care a lot about the issue and must expect the costs of reversing the decisions of an agency or court to be low, is consistent with the result that legISlative consensus is needed to implement specific legislation. P~sidmtial De~es A particularly popular regulatory tool in Latin America is the presidential decree. Two basic types of pre5~":' :ntial decrees exist. The most common is Simply an administrative determination. Latin American countnes in general have yet to develop a tradition of a fourth administrative hranch, as in the United States. Thus, administrative determinations are usually ministerial decisions that take the form of a presidential decree. Such decrees are commonly modified or replaced by other decrees as time passes. For example, Bolivia's electricity code, which stipulates how tariffs are to be set for aU electric utilities, is based on a 1968 presidential decree (decreto supremo). This decree can be modified, in tum, by another decreto supremo (as was done in Argentina's telecommtmications regulatory framework). The second most common type of presidential decree exists in the regulation or i."'l.Strumentatior. of legislation. Most legislation in Latin American countries is relatively generaL and implementa~ is delegated to a regulatory presidential decree. In effect, the regulator:-' agency is left to interpret a parti~~ lar law. Courts seldom contest these decrees, except when the decree clearly violates a direct stipulatioh of the law. Regulatory decrees, however, cannot easily be replaced by another presidential decree, but they may be reinterpreted or further regulated (totally replacing them may require new legislation). we potential for further regulation opens the door for future administrations to distort or amend the initial understanding. Regulatory frameworks introduced through presidential decrees may, therefore, fail the second requirement for regulatory stability (that formal or iniormal constraints limit the ability of the executive branch to change the regulatory framework). Contracts Because the basic contractual problem in utilities is related to the inability of goveI7l.IDents to commit themselves to a regulatory framework once it has been put in place, several countries have embedded the regulatory tramework in formal contracts. These contracts take the form of operating licenses that specify the regulatory framework in which the firms operate. The license stipulates the regulatory process to be applied, and if the government deviates from that process, the courts step in. In parliamentaI)' systems, the use of contracts to regulate is innovative because courts uphold contracts but do not restrain regula- tors in administrative decisions. Consider the example of British utilities. British utilities are, in general, regulated by different sorts of price caps. These price caps are embedded in each company's license rather than in an agency decision or piece of legislation (indeed, the enabling laws in the United Kingdom are silent about pricing schemes). The advantage of regulatory frameworks instituted through licenses is that, because licenses usually have the power of contracts between governments and firms, any amendment to the license will usually require the agreement of the company. British law stipulates that if the company does not agree to a license amendment proposed by the regulator, the regulator may use a process involving the Monopolies and Mergers Commission to amend the license against the will of the company (see Spiller and Vogelsang 1993). This feature provides credibility at the cost of inflexibility. The disadvantage of licenses is that they give the operator substantial bargaining power if there is a need to amend the license, which limits the flexibility of the regulatory framework. For example, if a technolOgical breakthrough eliminates econo- mies of scale in a segment of the market. the regulator may have to bribe the company into relinquishing its exclusive legal rights over that segment. In a more flexible basic engineering choice, such a decision could be made administratively. For contracts to satisfy the first criterion for regulatory stability, then, they must be specific and clearly limit what the regulator can do. A license that does not specify the regulatory mechanism in detail. but rather leaves the administration free to make all regulatory decisions, will fail the first cnterion tor regula- tory stability. (Comparing the licenses issued in Jamaica under the Jamaican Public Utilities Act of 1966 to those issued prior to 1966 or after the privatization of 1988 shows the total failure of licenses to restram the regulators; see Spiller and Sampson 1994). Operating licenses in the United States, for example, do not serve as a basic engineering mecharusm because they deal mostly with issues related to eminent domain and -. franchises. Whether specific licenses will satisfy the second requirement for regulatory stability depends on whether the courts see licenses as binding contracts. In particular, courts must be willing to uphold con- tracts against the wish of the administration. If courts do not treat licenses as contracts or if they grant the -. administration substantial leeway in interpreting those contracts, license-based regulatory contracts will fail the second ar.d third critena for regulatory stability. Observe, then, that contracts can be implemented in 46 J LU15 Gwzsch artd Pablo Splilt'r nations with strong or weak executives and either parliamentary or presidential systems. Indeed, a baslC requirement is that the judiciary must be independent and see licenses as contracts. Contract-based regulations, however, are particularly appealing to systems whose set W(.) is narrow or small. In such cases, as in figure 3.4, changes in political preferences would bring about either the creation of a new piece of legislation, if the current regulatory regime is based on specific le~..slation, or a modification of the agency's interpretation of the statute, if the current regulatory regime is based on general administrative procedures. In contrast, if x(j was initi~l1~' hardwired through a license, then the fact that Xo no longer belongs to W(.) is irrele\'ant. Changes in x':.J.Tlire the acquiescence of the company. Thus, introducing the regulatory process in the license introduces an additional veto point namely the company itself. The relevant set of parties required to change the status quo Xo now includes the company as well, and, in figure 3.5, the set W(.) is now the contract set given by the ideal points (H, S. £, C), where C represents the company's ideal point. The figure shows how regulatory credibility is enhanced even in a situation where electoral changes move against the company. (For a model of regulatory decisionmaking in the United Kingdom, see Spiller and Vogelsang 1993). It is not surprising that countries like Jamaica, the United Kingdom, and many of the other Caribbean countries have adopted license-based regulatory systems. It would be interesting to see whether other parliamentary systems in Europe move toward such systems when and if they fully privatize their utility sectors. Finally, informal norms may also provide some regulatory stability even if licenses can be unilaterally amended by the government. For example, the United Kingdom has been granting operating licenses since at least 1609 (see Spiller and Vogelsang 1993). Although licenses initially were granted by the king, eventu- ally Parliament took over this role. Ucenses were granted in many different forms. Until 1919. prospective utilities commonly applied to Parliament for a particular license. A select committee heard the case and either recommended a license or rejected the application. The select committee's recommendation was then presented to Parliament for approval, a step referred to as private bills and considered a formality. A license could also be granted by an order in council, whereby the Privy Council would grant a license recom- mended by a minister and the cabinet. Licenses were also granted by general acts of Parliament. For ex- ample, the Public Health Act of 1875 granted municipalities the right to establish water and gas senices in districts where no one else had undertaken the task. Provisional orders were also common, granted by a minister following a request for a license. The minister's order would then be formalized bv an act of Parliament. Finally, the 1919 Electricity (Supply) Act created an electricity commission that issu'ed licenses through special orders, which had to be approved by the minister of transport bpt did not require formal parliamentary approval. Parliament, however, did retain the right to reconsider those licenses (see Spiller and Vogelsang 1993). Because licenses were granted by acts of Parliament, Parliament could, in principle, change the conditions under which future licenses were to be granted. Parliament could, furthermore, unilaterally change the operating rights of current license holders, but such parliamentary power made Figure 3.5. Implications of Licmsing for Regulatory Credibility H' c Sourrt: Authors analysis. licenses a fragile instrument. Over the years, however, Parliament ha.s developed an ll1formal (constitu- tional) nonn of not revoking licenses without compensation. Indeed, licenses have been revoked only dur- ing the massive restructuring of the electricity sector in 1926. In that case, however, license holders received favorable transitory rights that compensated them for whatever losses might arise from the compulsory -'" shutdo\\l'Il (see Spiller and Vogelsang 1993). To summarize, the use of licenses as a regulatory instrument requires the existence of a judiciary that finnly respects contract agreements or the existence of widely accepted norms that inhibit the opportu- nistic revocation of licenses. Countries that are only now starting to regulate utilities have not yet devel- oped these types of'norms, and thus the key ingredient is the existence of an independent judiciary that considers licenses to be contracts. Administrative Procedures Administrative procedures may serve as the choice of basic engineering. Administrative law controls the administrative operations of government. It sets forth the powers that may be exercised by administrative agencies. lays down the principles governing the exercise of those powers, and provides legal remedies to the parties aggrieved by administrative action. This definition divides administrative law into three parts: the powers vested in administrative agencies, the requirements imposed by law on the exercise of those powers, and the remedies against unlawful administrative action (Schwartz 1984). Many developing coun- tries are deficient in the first and second parts. The regulation of utilities in the United States is based on a well-Specified body of administrative procedures, at both the federal and state levels. These procedures determine how agencies make decisions and specify the independent appeals process. US. regulatory agen- cies are required to announce their intentions to hold hearings well ahead of time, to hold open hearings, to substantiate their decisions, and to make public all communications among interested parties (that is. ex parte commtmication rules do not allow commissioners to commwticate with their staff or with individuals from regulated companies on issues currently under consideration). Freedom of iniormation limits the ability of agencies to keep infonnation from the public. These rules evolved in the United States over a period of more than 50 years and are based on the constitutional provision of due process. Furthennore, each enabling legislation complements these general administrative procedures with specific stipulations regarding who is allowed to participate in hearings, what type of rule-making powers an agency has, and so forth. However, administrative procedures slow down the regulatory process, prOviding a way for inter- ested parties to bargain over the issues and providing procedural grounds on which to appeaL (Adminis- trative procedures have been used in the United States to keep regulatory outcomes trom deviating from the initial regulatory bargain. See McCubbins, Noll, and Weingast 198i.) The use of administrative procedures as a generic way to enforce regulatory bargains requires not only a prevlOusly developed body of law but also a judiciary that is accustomed to c.hallenging administrations on procedural grounds. Although it may be possible to pass legislation requiring regulators to follow par- ticular procedures in their decisionmaking, and even if such legislation is difficult to change (thus satisfying the first and second requirements for regulatory stability), this body of law will only provide regulatory stability if the courts can be expected to challenge the administration on procedural grounds. Indeed, in most Latin American countries, administrative law has not been developed extensively, except in relation to government procurement. (Bolivia's SAFCO law establishes substantial procedures in procurement but is totally silent on regulatory decisionmaking.) Thus, in most, but not all, Latin American countries, regula- tory frameworks based on general procedural requirements may fail to satisfy the third requirement for regulatory stability because institutions are not in place to enforce procedural conStraints. . .. The use of administrative procedures as a generic way to enforce regulatory bargains also requires a set of institutions that guarantees that the set W(.) is sufficiently wide. Indeed, if because of electoral rules the -set W(.) is narrow, as is the case in two-party parliamentary systems, agency decisions will have to move with the set W(.}, limiting the credibility of the initial bargain. If, however, the outcome of the regulatory process as specified in the law is outside the set W(.), then there will be incentives to adjust 49 r Luzs GLLilSch ami Pablo S"I/l~r procedures to reflect more closely the preferences of the legislators a.."1d of the executi·.-e. Thus, ~ ~\ legislative specificity, a necessary condition for administrative procedures to provide regulatory credIbil- itv is that the set W(.) be wide. Hardwired administrative procedures are easier to implement than spe- cific legislation. At the same time, because administrative procedures do not strictly limit how the agency, or the courts, may interpret the statute, they provide a measure of regulatory flexibility that limits the agency's own commitment. As with specific legislation, administrative procedures may not serve as a mechanism of commitment in traditional parliamentary systems. In summary, three institutional characteristics are key to understanding the constraints that limit a country's basic engineering options: the existence of an independent judiciary that eniorces regulatory constraints, the role of legislative and executive institutions, and the existence of widely accepted infor- mal norms that limit opportunistic behavior. First, a judiciary with a strongly held tradition of admirusrrative law facilitates the use of administra- tive procedures. Such a judiciary can provide assurances that the government will not deviate from spe- cific legislative or constitutional commitments that underpin the regulatory system. A judiciary that re- spects contracts and property rights also makes contracts (licenses) a feasible choice of basic engineering. Second, legislative and executive institutions that grant the executive substantial control over legislative agendas and outcomes do not favor the basic engineering option of specific legislation because turnover in the executive may have a more important implication for regulation than it does in other countries. If legislative powers alternate between political parties with substantially different interests, specific legis- lation does not provide a safeguard against administrative discretion, because a new administration could modify the laws. Third, informal norms may substitute for legislative flexibility. In particular, nations that have a strong set of norms that determine acceptable legislative behavior may consider specific legislation as a feasible basic engineering option. (For an analysis of informal norms as equilibrium be- havior, see Calvert 1992.) Institutional Structures and Judicial Control Over the Executive The previous sections assumed that the courts will review administrative or regulatory decisions accord- ing to the precepts stipulated in the law. First, it was assumed that the courts are sympathetic to regula- tory deviations from the specific stipulations in the law. Then, it was assumed that the courts are sympa- thetic to complaints about procedural deviations. Finally, it was assumed that the courts agree to hear complaints about contractual deviations. Courts, however, do not operate in a vacuum.. The norms that govern judicial decisions and procedures evolve over time. Judicial norms will develop differently under different legislative and executive organizations: In particular, in a decentralized decisionmaking envi- ronment, courts can more easily challenge administrative and regulatory decisions on both procedures and substance. Such interventions, in most cases, may not trigger a legislative response, which leaves the court's decision standing. (On congressional reversals of Supreme Court decisions, see Eskridge 1991.) In contrast, in very centralized systems, attempts by the courts to reverse an administrative decision mav trigger a legislative or executive response that overrides the court. . ' Consider, for example, figure 3.6 in which the court faces the three-veto structure characteristic of a bicameral presidential system with a fragmented legislature. Assume that the legislation is vague and that, as a consequence, the agency attempts to implement a particular point in the set W(H, 5, P), I,4' which differs from the status quo Io' The parties may challenge the agency's decision on procedural grounds. Assume, now, that the court has preferences with regard to policy outcome. Say that two types of courts, 5C H and 5Cl , exist. In the figure, SCH prefers the original status quo. while SCI. prefers the agency's choice. The court, then, mayor may not reverse the agency's decision. (For a rational choice model of Supreme Court statutory interpretation, see Spiller and Gely 1990.) In any case, the Court's decision will not he reversed, because either decision is in W(H, 5, P). In two-party parliamentary systems, though, where the number of veto points is substantially re- duced, the court cannot reverse administrative decisions without facing a challenge. In figure 3.7, for C~t/ng tlu: &51C Eng'l7r~~"g of Iv~gullmo" 49 Figure 3.6. Judicial Discre!;cr: in Bic.1ma.&l Presidt!71tial Systems p 50urr~: Authors analysIS. Figure 3.7. Judicial Discretion in Two-Party Parliamentary Systems 5 s· E:./ E' Source: Authors analysis. example, a political move has made the initial status quo untenable. An agency's decision has moved the policy to XII' Attempts by the court to reverse the agency's decision (SC prefers x~ to x) will directly trigger a cabinet response, reversing the court and bringing the policy back to x II. (For a fascinating dis- cussion of cabinet control of the judiciary in Japan, see Ramseyer 1994; for a stmilar analysis in the United Kingdom, see Salzberg 1991.) lhis, however, may not be the case in multiparty parliamentary systems, in wtuch governments are formed from multiparty coalitions and the potential for the coalition to break up is substantially greater. This discussion-suggests that the norms of judicial supervision over an agency's decis!ons may vary substantially across countries. In countries where decisionmaking is traditionally decentralized, regula- tory deviations may not be restrained if the court's preferences are aligned with those of the agency. Thus, purely administrative procedures may not provide as much regulatory credibility as they would if the courts behaved in a more mechanical fashion. Within a decentralized political structure, a judicial norm that pressures the executive to respect specific legislation can develop and thrive. because such judicial decisions, in general, can stand up under legislative scrutiny. An argument could be made thar such a norm is against the court's own interest because it prevents the court from aclueving its O'WTl desirable policy outcome. Although appropriate, this argument fails to take into account a basic differ- ence between implementing the court's more desirable policy when the legislation is vague and when it is very specific. When the legislation is specific, the court is trading off policy outcomes against legiti- macy. Such a tradeoff is nonexistent when the legislation is vague. Such norms may not develop in a political system similar to that presented in figure 3.7. In those cases, judicial activism will only trigger 50 ,. LIlIS Gl.UJSch and Ptlblo 5plll~ a legislative reversal and political recrimination. In centralized political systems of the type being dis- cussed here, contracts between companies and the govenunent m.::.: be the only instrument that provides regulatory credibility. Courts, in this case, must have developed a norm of treating co~rracts between govenunents and the private sector in the manner ruled by contract law. Furthermore, i: ;.s reasonable to expect that such a norm will develop over time because it will reduce the government's ;::osts of procure- ment and of capital. (For a discussion of the evolution of political institutions in the UnHed Kingdom as il Wily to limit the gO\'emme~~'s 0 ..·.7'.. cost of capitill, see ~orth me yVeingast 1989.) To summarize, because admmisttative procedures provide vague standards for judidal review, they may not provide substantial regulatory credibility in countries with multiple veto poin!S. Furthermore, in countries with unified governments, such procedures will provide no regulatory credibility because courts will, in any case, not be able to enforce the status quo in the event of electoral changes. Legislative specificity can provide regulatory credibility in the first type of political system, but riot in the latter. Regulatory contracts, then, seem to be the main conduit for providing regulatory credibility in political syste~ that boast a unified government. A Model of Effective Autonomous Regulatory Institutions Whatever the basic regulatory instrument chosen, the conduit and oversight of regulation are delegated to a regulatory institution. Regulation is an ongoing task of fine-tuning and adapting decisions as fore- seen and unforeseen events unfold. This argues, on efficiency grounds, that the regulatory agency be accorded a fair amount of flexibility and that the principles that will be followed in adju.snng decisions be clear and publicly known so that other parties (particularly the operator) can assess the economic impact on their operations and plan and act accordingly. In practice, two problems often arise with that frame- work. One is that the commitment to stick to these principles is not credible and is often \ioiated, with the changes affecting the economic returns of the operator. The other is that the high le\'ei of discretion embedded in that framework is vulnerable to influence and to capture by interest groups. To min.i.mize these problems, five conditions are essential for regulatory institutions to be effective: (a) managerial and financial freedom, (b) political autonomy (freedom from political and. interest group influence), (c) accountability (the duty of an agent or employee to respond to and fulfill his or her respon- sibilities to his or }ler principal or employer), (d) checks and balances (to limit the power of single indi- VIduals within the institution), and (e) incentives (to reward good performance and to punish arbitrary or inadequate performance). . Managerial and Financial Freedom The agency has to enjoy managerial and financial freedom in obtaining given objectives. This freedom, including the freedom to set the conditions of employment, is intended to create the incentive for admin- istrative efficiency and technical capability. This is essential to good performance. The regula~ory agency needs to retain a permanent cadre of technically proficient and highly motivated professionals. To do • this, it may need to create a professional career structure, such as that enjoyed by man~' central banks. This will require, among other things, paying higher salaries. In tum, higher salaries 'Nill require more reso·urces, and these resources or budgets should be defined in the regulatory legislation and should not be subject to manipulation by the executive branch. Political Autonomy The agency has to enjoy political autonomy. TIlat is, somewhat like the judiciary, the agency must be insu- ~. lated from the pre;sures exerted by other parts of government and by interest groups. Political autonomy, combined with the technical capability that results from managerial freedom, leads to well-informed and fair decisions. This means a good quality of output. In reality, political autonomy cannot simply be legis- lated. Autonomy grows as the public perceives the high tP.chnical quality of the agency"s work and the effectiveness of its results. The regulatory agency needs to establish its reputation, with successes in Large cases of market abuse or flagrant violations of regulatory or contract norms, so that the public can see how the agency's interventions tmprove the quality of their lives. The appearance of a conflict oi interest will, of course, compromise the agency's autonomy, and its management must keep this in mine. Accountability The agency has to be accountable, has to fulfill defined objectives, and has to submit substantive financial reports to the government (elected officials). The institution performs as a servant of the government (and thereby of the people who elected it) through the close oversight of the executive or legislative branches of government or, as in the more recent experiments of New Zealand and the United Kingdom, through the contract-like system of an ex ante agreement followed by ex post controls on implementation of that agreement. This is the incentive for an output that is not only good quality but also desired. Accountability is often the most difficult problem a regulatory agency faces. At present. most account- ability is informal and ill-defined. The regulatory agency is accountable to the executive, but in a way that ~ personalized, which means based on relations between the president or minister and the head of the agency and based on the character of the top people in the agency. In other words, the accountability is not institutionalized, which means incorporated in formal procedures. If accountability is not institu- tionalized in one way or another, the agency will be at risk. The experience of most countnes in Latin America and the Caribbean (LAC) suggests an iron law of bureaucracy. If bureaucracies are not con- trolled enough, they take on a life of their own, they seek extra resources, and they justify their holding of these resources by using their monopoly of specialized knowledge to invent new tasks. There are two broad paths to greater accountability, and governments and regulatory agencies must consider both: • First, government oversight can be strengthened. Better overSight could be achieved through a stronger executive. The executive could impose better reporting requirements and could even con- sider moving in the direction of New Zealand's contractual model. The legislature could also play a stronger role in over~ight. Perhaps a super-regulatory body could be created with a semi- independent constitubonal standing similar to that of the central bank, the national election board, or the judicial council. The choices are many. • Second, the agency can seek to improve its direct accountability to the public. Public accountabil- ity is particularly important when the branches of government are 'weak and when most or the services (conflict resolution between two parties and registration of individual nghts) are pro- vided directly and individually to the public. To adtieve legitimacy and credibility, the regulatory process has to be made as transparent as pos- sible. Transparency means openness, specifying the rules, opening up the process, and explaining the decisions, preferably in writing (so that they can be appealed). Thus, the agency should improve its transparency by publishing as many of its decisions, deliberations, and views as possible)t should also improve its listening techniques and public access to its services by, for instance, decentral..izing its opera- tion or strengthening its procedures for hearing complaints. Checks and Balances The agency has to have internal checks and balances that limit the power of single indlviduals. Checks and balances are often the easiest condition to design, although they are often ignored. They complement accountability and make arbitrary decisions, bribery, and corruption more difficult. They have to do with how regulators are appointed and with how and who makes the decisions. Examples include making decisions by committees (rather than by a single individual), staggering decisionmaking as a function of the impact of the decision, using consultative groups, and instituting quarantine periods in which various parties have the opportunity to object before a decision goes into effect. Both Qille and Peru have relatively well-built checks and balances. S2 J. LuIS Guascn Ilrld PllbJo Sr:JlJJ~ Incelltives The agency has to have the right set of incentives, financial and otherwise, to reward and punish perfor- mance (Sheperd 1995). Regulators ought to be financially rewarded according to priva te sector salary scales, and the conditions for career advancement should be clearly delineated. Promotion ladders can be the greatest tool for providing incentives and motivation, and they are needed to attract highly capable personnel and to minimize the possibility of influence. The most common obstacle in most developing countries is the prevalence of quasi-wliform pay scales for public servants. However, countries can make exceptions, as is often seen in the compensation paid to tax collectors. The same arguments should apply to regulators. Likewise, dismissal for improper behavior is also in order. Clearly, dismissal can only be effective if salaries are high enough and career promotions are available and genuine so that dismissals constitute a Signilicant loss to the public servant. In addition, bonus payments, linked to the performance of both the regulator and the sector, should enhance the likelihood of inducing a good output as should rewarding top-performing workers with external educational, management, and training programs. Compensation contracts should take four factors into account: (a) the regulator's aversion to risk, (b) the regulator's aversion to effort, (c) the marginal contribution of effort and (d) the precision of the measure of performance or behavior. The Structure of a Regulatory Institution Conventional wisdom and incentive theory suggest that, to be efficient, regulation requires an indepen- dent, self-financed regulatory agency. The primary focus ought to be on reducing the opportunities for undue influence, and independence and self-finance often are taken as proxies or as necessary conditions for an absence of opportunities toexerc:ise undue influence. The difficulties in designing a regulatory agency that can be trusted to deliver bona fide performance and is strong enough to withstand political or eco- nomic forces lead to the seC:ond-best (or third-best) solution to limiting its discretionary powe::s. Consider first the size and budget of a regulatory agency. A regulatory agency's size must be commensurate with its tasks. A large agency managing few regu.latory tasks is likely to deviate from the initial understanding by increasing bureaucratic barriers to justify its existence. Consider the idea that regulatory agenoes ought to be independent entities. Much debate has focused on whether agencies should form part or a ministry or have separate identities. The discussion above suggests that an independent .regulatory process is best achieved, tautologically, by limiting a regu.lator's discretion. Only when regulators are granted substantial discretion is the location of the agency of importance, because it would not be reasonable to allow a regula- tory authority to be totally independent. The separation of jurisdictions between the ministry and the regu- lator should be clear and not arbitrary. Box 3.1 illustrates the appropriate normative funcnons of the two entities, respectively, in telecommunications. Accountability is important, and checks and balances, such as budgetary reviews and political oversight, provide ways to control regulators. Discretion can only be granted when the right incentive and accountability structure is set in place, generating the like!.ihQOd that the regulatory agency will behave appropriately. The example of Colombia, shown in box 32, illustrates the difficulty that governments have in letting go of regulatory institutions and the political arguments often used to defend their continued. meddling in reguLatory matters. At issue in the process of designing regulatory institutions is whether there should be a single regulator or a commission. Each design has its strengths and weakness. Tradeoffs exist that need to be evaluated in individual contexts. Individual decisionmaker's designs are superior in terms of speed of decisionmaking, accountability of decisions, minimizing resource demands and costs, and predictabil- ity of results. Moreover, in fragmented multiparty political systems (often leading to government coa- litions), a tendency is to allocate commission slots to the different parties, increasing the chance that the appointments will be political rather than technical and professional. On the other hand, commis- sions are superior in terms of resistance to individual agendas, resistance to tmproper influences, po- tential to reflect multiple perspectives, and potential to stagger terms to enhance stability and to weaken Cr~Qnns tnt: BasiC Engmt:mng OJ r .•:guumon i Box 3.1. Public Utillt"!1 RegulatDry CommIssIons m ColombIa: Autonomous Experts or PolLtzcwns' I I As a response to the regulatory demands that arose as the private sector Increased its parr.clpatlOn in the utilities sector, the Colombian government abolished the National Tariff Board and created three modem reg'..l· -- latorv commissions: one for telecommunications, one tor water supply and sanitation, and one for electriC!!]' and gas. These COmmiSSIOns were created to foster competitlOn and to prevent monopolistic practices. More precisely, they were charged with setting rate formulas, fees, conditions for auctions, and technical and com- mercial conditions for developing a compenuve market. While promoting competition, the commissions were also charged with establishing general rules, investigattng complaints against unfair pracnces, and ordering the vertical disintegration and suspension oi, for example, output restramts and market segmentation (over- lapping with the Antitrust Commission). These commissions were compn.sed of government officials and independent experts. The government's initial proposal was to establish fully independent commissions-independent from both the government and private carners, somewhat akln to L'.5. regulatory commissions. Some mirusters and members of congress, though, insisted on, and eventually propelled, the creatlon ot more public and thus less autonomous entities. Some ministers argued, for example, that setting tariffs could have a strong political tmpact and that responsibility should not be left in the hands of technical experts because the government ultunately would be blamed ior poor decisions. Likewise, some members oi congress feared that regulatIOns crafted solely by experts would be excessively technocratlc and would suffer irom the absence of regional and consumer input. As a compromise, congress approved three semi-tndependent regulatory COmmisSIOns. Souru: Montenegro (1995). Bor 3.2. Responsibilities of the Minister and the Regulator The Minister of Telecommunkations has the following responsibilities: • Translates general government policy into sector policy • Translates sector policy into regulatory framework and unbundling cholces • Approves major capital expenditures (while state owned) • Determines subsidies to customers and regions • Oversees regulatory performance • Establishes controls in the presence of real national security concerns The telecommunications regulators have the following responsibilities: • Issue and enforce licenses and concessions • Set prices and access terms in the absence of competition and monitor compliance • Monitor financial viability of operators • Set quality of service standards and monitor compliance • Reset prices and access terms at the end of the review period • Arbitrate disputes between operators • Arbitrate disputes between operators and consumers • Collect infonnation on the costs and earnings of regulated sector companies • Provide information and advice to the ministry and iniormation to the general public. Source: Authors analysis. links with particular governments. The optimal choice will depend in large part on the tasks entrusted to the regulatory entity, the country or sector context, and the broader implementation environment. Perfonnance is ultimately determined by the quality of the persons appointed to the positions. Ex- amples can be found of individual decisionmakers performing well and commissions perfonning poorly and vice versa. As a balance, the choice of commission should be made on the basis of resistance to capture by improper influences, since that is the factor most affecting the regulatory outcome. That 54 ,. Luzs Gl.UJSch and Pablo 5plll~ would slightly favor commissions over individu.J.l decision...-nakers, but even that has ~:::::e ·,veighted i..., the local context. Another issue is the extent to which regulatory agencies should be sector specific. Conventional wisdom suggests that regulatory agencies would be more professional if they were specialized, but in many coun- tries administrative capabilities are weak, thus limiting the pool of available manpower. vVhen the concern with government capacity to regulate is deeply rooted in a long history of government failure, often due to political interference, the best organizational approach is likely to be simple and transparent. An effective yet simple way to improve a count::rys or a province's capacity to regulate is to create a single (covering all sectors) and independent regulatory agency staffed with competent professionals. If administrative capa- bilities are vulnerable, then the regulatory framework should be extremely simple and should limit regula- tory discretion. Regulatory agencies could then be relatively small, eliminating the need ior a large, well- qualified technocracy. In some cases, provinces or states have initially considered separate regulatory bodies for each subsector, but the expenence of large decentralized countries suggests that at some point the subnational authorities end up with at least two or three of their infrastIucture and utilities sectors con- trolled by a single agency. In environments with a shortage of qualified individuals and in small countries, it is desirable to integrate regulatory jurisdiction across sectors into a single agency. Conceptually, the argu- ments are strong for the integration. Most of the problems and issues to be addressed are similar, and the synergies are strong. Furthermore, economies of scale would lower the administrative costs of regulation. For instance, the legal departments would not need to hire specialized staff for each subsector because many of the legal issues are similar across subsectors. This does not preclude each subsector from having a small, technically specialized cluster of professionals with competencies only in that subsecror. A single agency has further advantages, including the ability to resist manipulation by a specilic industry (Estache 1995). It eases the cross-sectoral coordination and improves the likelihood that policy will be consistent across subsectors. Also by deSign, a multisector agency has a larger constituency than a sector-specific agency. Increasing and broadening the constituency reduces the influence that anyone industry can exert on regulators. The standard orga:nizational structure of an integrated regulatory agency should include an administrative department and a legal department common to all subsectors. It should also include specialized departments, one for each subsector. However, the technical departments for each subsector, such as engineering, price and access regulation, and industry research and analysis should be quasi-integrated, because many of the issues, concepts, and modes of analysis cut across subsectors. (For a detailed analysis of the structure of an integrated regulatory agency, see Estache 1995.) A partial example of a single agency is Bolivia's National Regulatory Commission (see box 3.2). The most appropriate option for funding the operation of the regulatory agency is to let the agency generate its own revenues rather than to have allocations from the general budget, which is the other obvi- ous alternative. First, it detaches the agency from political interference; second, the users who benefit from its existence finance the costs of its operations. Revenues could be obtained by means of an access fee levied on users of the service or an industry levy assessed on operators (see box 3.3 as an example). In any event. the cost is likely to be passed on to consumers. In the case of an industry levy (such as licens~ fees in the United Kingdom and regulatory assessments in the United States), the cost could be expressed as a percent- age of the industry output or as a fixed amount. (In many countries, these levies tend to be the agency's main source of revenue, often exceeding 70 percent of total financing.) A second potential source of financ- ing is a usage or service fee for a specific service requested. For example, a filing fee could be charged when the operator or a conswner files a complaint (with the fee for the operator being larger than the fee for the conswner). The fee could have two components, particularly for complaints or requests by the operator: a smaller, nonrefundable part and a larger part refundable in the event of merit or a positive ruling on the complaint. The latter feature is particularly attractive because it would deter frivolous complaints, which often tie up many of the resources of the regulatory agency. All the fees and bases for them should be set by law or a similar instrument, and they should not be easily amended or revoked by the government. The levies should be set to cover operating costs. If surpluses or deficits persist, the rates could be adjusted. A reassessment every three to five years might be appropriate, subject to legislative approval. (For other views Box 3.3. The NatlonJJi Regulatory CommIssIon m BolivIa The Boli\'ian government created the National Regulatory Commission to regulate the communications, elee- tncity, hydrocarbon. and transport industries. The cOmmission has three core functIOns: it asslSts. tn adminlSter- -- ing and enforcing concessionary arrangements. admuusters pnce regula non agreements. and eruorces antltrust nonns. The agency conta..ms four sector-specific national supenntendents overseen by a comrrusslOner. Tne superintendents are responslbie for day-to-day declSionmakmg. performing tasks such as regulat:m g pnces and supervismg compliance. They are appomted for staggered five-year terms and are protected trom arbitrary removal. The comnuSSloner oversees the supenntendents and hears appeals regarding their dea.slons. The cross-sectoral focus is intended to promote policy consistency and to protect the agency from improper govem- ment or industrY influence. The corrumssioner is named by decree and also serves a five-year term protected from arbitrary ~moval. The supreme court IS the ultimate appellate body tor declSions by the commissioner. on the funding of regulatory agencies, see Smith 1994). Appendix 3 presents the financing and iru;titutional structure of a number of regulatory institutions. The regulatory agency's terms of reference should include the gathering of information and the dis- semination of sector-specific performance indicators. Such information would allow the assessment of the evolution of the sector and the creation of incentives for transparency, compliance. self-monitoring. and efficient performance. Box 3.4 describes one method of appointing regulators. To summarize. the available evidence and theory suggest that the issue of the independence of regu- latory agencies, though correct in principle, is poorly focused. in the absence of the three pillars of regu- latory institutIonal design. and particularly of credible accountability. the goal of regulatory engineering is to design flexible and efficient rules and to incorporate them into a system that restrains arbitrary administrative action and therefore does not impede private investment. A smgle, integrated regulatory agency generating its own financing is preferable to a proliferation of sector-specific agencies with funds from the general budget. Finally, regulators should do what their legislated statute enables them to do, no more and no less. They should not be free to determine their own mandate. An initial period, say five years, of inflexible regulatory rules and limited discretion. while all interested parties are learning. is warranted for most developing countries without a tradition of regulatory practice. Subsequently, addi- tional flexibility can be considered. Box 3.4. Fundrng Colorado's PublIC Utilities CommISSIon Colorado's Public Utilities Commission (PUC) was established in 1913. It has responsibility for electridty. gas. telecommunications, water, intrastate aviatIon, and some motor carriers m a state with a populaoon or around 3.5 million. The PUC has three commissioners and a staff of around 95. Its expenditures in the fiscal year 'ending June 1993 totaled US$6.1 million, all of which was obtamed from leVies on regulated finns. The PUC's annual funding process mdudes the foUowmg features: • The PUC s total expenditures tor the present year are determmed by the state legic;lature. and are subrect to a maximum based on a levy of 0.2 percent of finns' gross operanng revenues from intrastate business in the prevlOus year. • Assessments are calculated by the Department of Revenue to meet the income approved by the legisla- ture. The percentage contribution is uniform across regulated sectors. • Firms pay the levy to the treasurer in quarterly installments. • Levies received by the treasurer are placed in a dedicated fund. Surplus income at the end ot the year is used to reduce levies In the next penod. 56 J. Luu Gl.UlSch and P"bID Stllllt'1' Box 3.5. Appomtmg Regulators Appointing regulatory commissions (with between three and five members) is more common than appointing a smgle regulator (and there is evidence that this is the right way to go). In this case, selecting the members is the first severe political challenge that provmcial authorities have to face. Experience shows that elections are not appropriate because they reiniorce short-term political perspectives when longer-term perspectives are required. Best practice includes the followmg steps: • Prescribe professional qualifications for appomtees. • Involve both the executive and the legislative branches in the appointment process. • Provide regulators with secure tenure, subJect to removal only in case of proven rrusbehavior. • Exempt agencies from civil ser'Vlce rules that limn salanes to levels below those needed to recruit quali- fied staff. • Provide agencies with funding from industry leVIes and user fees to reduce their relIance on politically directed budgetary allocacons. Measures that insulate regulators from the political process have to be reconciled with the need to ensure that regulators are accountable for theIr actions. Although the .means of striking the appropriate balance between autonomy and accountability wiJI vary from context to context, common measures include: • Permitting the removal of regulators in cases of proven misbehaVIor. • Prescribing partlcular duces and obligations as clearly as possible in law and providing an efiective ap- peals process, whether involving the courts or another forum. • Mandatmg tugh standards of transparency in regulatory proceedings. SOU1U: Estache (1995). Appendix 3 Table 3A.l. Regulatory Agencies, Selected DECO Countries Budget Agency Staff (millions of USS) Funding source Canada-Federal NEB (electricity and gas) 343 (1992) 37.1 (1992) General taxa non RTC (telecommunications, cable, radio, and broadcasting) 423 (1992) 35.6 (1992) Levies on regulated firms Canada- Provinces Alberta PUB (electricity, gas. 31 (1993) 3.1 (1993) 33% general taxation, 66% leVIes on and telecommunications) regulated firms Nova Scotia URB (electricity, 31 (1993) 1.3 (1992) 64% general taxation, 36% levies on teletommunications, and water) regulated firms Quebec TB (telecommunications) 30 (1991) 1.7 (1992) LeVies on regulated firms United Kingdom OFGASS (electricity) 223 (1993) 16.0 (1994) Levies on regulated firms OFGASS (gas) 31 (1993) 6.7 (1995) Levies on regulated rir:ms OFTEL (telecommunications) 151 (1993) 12.7 (1994) LeVies on regulated firms OFWAT (water) 138 (1993) 13.1 (1994) Levies on regulated firms United States-Federal FERC (electricity and gas) 1,472 (1993) 140 (1992) General taxa tion; some fees recovered to the budget FCC (telecommunications. cable, 1,783 (1993) 126.3 (1992) General taxation; some fees radio, satellite, and broadcasnng recovered to the budget United States-States Califom.i.a PUC (electricity, gas. 1.029 (1992) 83.9 (1992) 92% from levies on regulated firms, telecommunications. transport. 4<;~from general taxation, and 4% water, and wastewater) from specilic ttansact10n and investigation fees Colorado PUC (electricity, gas, 95 (1993) 6.1 (1993) 100% from levies of up to 0.2% of telecom, transport and water) industry gross revenues Florida PSC (electrlClty, gas, 391(1992) 20.5 (1992) 100% from leVIes on Uldustry gross telecommunicatiOns. water, revenues: Electncity: Lip to 0.5% and wastewater (0.375% aClUal), Gas: Up to 0.125% (0.0833% actual), Telecom: Up to 0.25% (0.15% actual). Water / Waste water: Up to -*:3% (4.5% aClUal) New York PSC (electricity, gas. telecommurucations. and water) 686 (1992) 55.9 (1992) 99% from levies on regulated firms Source: Smith (1994). 58 J. LuIS Gwuch and Pablo Splllt:r Table 3A.2. Regulatory Agmcies. St!lectt't1 L.?·;'1 A ""!"r:cn~ C:;l!!"!:":!'~ Budg'!t Agmcy Staff (millrons of USj) Fund:ns source Arg!11t11'l,1J ENRE (electricity) 85 15.6 LeVIes on regulated firms ... ., , ENERGAS (gas) 86 "';'_.0 :"e\i~s 0~ ::-~6.J.!.:!.tec :::--::-.5 Ct--.'TF (rail) 701 9.4 Portion of concession fees paid b~' regulated firms Q\,'T (telecommunications) 400 2:::.1 O.5~0 on mdustry reve.."'\ue..:.. plus radiospectrurn tee ETOSS (water in B.A.) ,- """"\ 15.7 1.000 const:rners wa:~~-se"':a3e bills ColombUl CREG (electricity and gas) 35 3.9 Cp to 1% of industry's functioning expenses. excludmg operatmg C!x;::-enses and enerb;' ?urcnases Peru OSIP'TEL (telecommunications) 65 6 O.5~0or mdustry gross revenues SNSS (water) 45 _- ., ..., Cp to 2~o ot mdustry gt'oss revenues Veru:ue[a CONATEL (telecommunications) 80 (1993) 2.9 (1992) O.5~o of regulated f:r:ns' revenues Note: All figures for 1995 unless otherwISe speclllt!"'!. SOl.lrr~; Smith (1994). 4 Basic Engineering Experiences in Latin America The choices of basic engineering design vary greatly across Latin America. They include the successful use of contracts in Brazil, Jamaica (prior to 1966 and after 1988)' Mexico, Peru, and Venezuela; the disas- trous use of presidential decrees to regulate telecommunications in Argentina; the uniorrunate choice of administrative procedures in Jamaica from 1966 to 19i5; the successful application of specific legislation in Chile to regulate electricity and telecommunications and in Argentina to regulate electricity; and the use of licenses in Bolivia to regulate the private electricity company. As a result of the issues and tradeoffs described in chapter 3, the salient choice for most Latin American countries in the 1990s appears to be contracts. A bnef summary or examples of the choices of basic engineering in Latin .~erica and the Caribbean (LAC) is presented in table 4.1. Table 4.1. Examples of Basic Engineering in Latin America and the Carribean: Instruments Embodying Regulatory Norms Engineering examrJles Desm.rJtlon Constitution The Constitution of Colombia provides for proper indemnificanon ror the expro- pnation of private property (Art. 58). It also speclfically gives tne state control or th~ electromagnetic spectn.un and the mandate or combating mono!=lollsCC pracnces m the use of the spectrum (Art. 75). Parliamentary laws In Chile, the 1982 Mining, Electric Power Se:'"vices Law (oFL-l) !=lro\'1oes the basis for the regulation of electricity generation, transmission, and olstnbunon and sets out the provisions tor rate setting. Decr~Laws In Peru, the 1992 Decree-Law of Electnc Concessions (Decree-La ....' 25.8+1:) was adopted by the government (preSident and cabinet members)' acc.ng under emergency powers, and replaced prevlOus electrlcity laws. Presldentlal decree In Argentina, the creation of the Corrusi6n NaclOnal de Telecommunicaci6nes, the telecommunications regulator, came in a preSidential decree (Dec-eto 1185/90). In addition to the structure of the agen.:!" it described procedures for the award of licenses, control of pnces, and interconnection rules. Ministerial decree In some cases, a decree may be issued by a sector ministry, such as Costa RIca's decree by the Ministry of Natural Resources, Energy, and Mines in 1989 (Decree No. 18.(47), which established parameters for prIvate investor partlcipatlon in some power projects. wcenses In Jamaica, the license for the national telecommunication. operator mciudes .. proVISIOns fixing the rate of return to be earned by the company. Contractual arrangements A concessIon contract for the operation and maintenance of the water and wastewater sYStems m Cancun, Mexico, sets out service einClency standards and the tariff regune. Decisions by In Colombia, the Comisi6n de Regulacion de Energia y Gas, a specia.lized regulatory regulatory agencies agency, plays an active role in implementing competition regulanon in the sector. The Comision imposed a system of free access to the electricity network and issued decisions requinng the state oil company to divest its gas transportation assets. Sourct: Author.. compilation. 59 60 1. LuIS Gu.asch and Pablo Srnlin- The Use of Contracts in Jamaica, Bolivia, Chile, Peru, and Mexico Jamaica has had successbl experience witl: regulation b~' contract. (For an in-depth discussion, see Spiller and Sampson 1994:.) Jamaica instituted re;l.liation by contract early in the twentieth century to regulate development of telecommunications and electricity. Indeed, contract regulation was the norm m Jamaica until the Jamaican Public Utility Commission arUC) was created in 1967. Until 1967, Jamaica's telecom- munications and electricity licenses stipulated the process by which prices were to be set (rate of return on assetsL the mirumum re'al rate of return (8 to 10 percent), the operahons of the regulatory body (through ad hoc rate review boards), and the process by which disputes between parties were to be resolved (ap- peal to the courts up to the Privy Council in London). These licenses provided the local telecommunica- tions company with substantial guarantees against opportunistic government behavior. In fact. in sev- eral instances the company went to court to request rate increases above those granted by the government and won. With the creation of Telecommunications of Jamaica (TOJ) in 1987, licenses again became the regulatory norm in Jamaica (see box 4.1 for the components of TOrs license). The licenses deSignate the price-setting process, specify the company's responsibilities and the regulator'S limits, and define the procedures for arbitration. Although TOJ allows the government to cancel a license, it also specifies how the government must pay for the assets. These licenses substantially limit the discretion granted to Jamaica's regulators. Although the present regulatory framework couid be improved, it offers the provider sufficient guarantees of stability. More- over, the level of investment and the quality and availability of service have risen dramatically, while real prices have fallen. The question here is not whether the Jamaican government could have de- signed a better regulatory framework, but rather what the rationale was for limiting discretion through the use of specific licenses. Spiller and Sampson (1994) claim that although the government could have designed a better regulatory framework (in particular, one where competition was allowed in value- added and other services), attempting to liberalize the international market would have reouired such a large increase in domestic utility rates that the reform program would have been block~d entirely. Bo% 4.1. Main Components of the 1988 Legtslatron Granhng a ucense to Telecommumcatrons oj Jamaica The following are the maID components of the Telecommunications of Jamaica's (TOrs) license: 1. The JamaIcan Telephone Company QTe) is granted a monopoly over all domestic (both local and toll) ut implicit or explicit juridically protected minimum rates of return or a defined conflict resolution process. Indeed, despite a doubling of prices and requests to increase rates, no increase was granted between 1960 and 1971. (In its August 1972 report, the JPUC stated that its policy was to make prices contingent on the quality of service provided). A series of conflicts erupted. One of the conflicts involved definition of the base rate (whether the investments undertaken were actually proper). The JPUC's main complaint was that the number of new lines was expanding more slowly than was the base rate. Essentially, the com- pany seemed to be replacing technically and phYSically obsolete eq~ipment without expanding its net- work at the same rate. The other conflicts involved accounting procedures (whether depreciation should be computed at the beginning of the period or at the beginning of each month), the company's cost of capital, and reasonable costs. The license was amended in early 1974 to specify both how depreciation was to be measured and the minimum allowed rate of return. These issues elicited substantial hostility. Basic Engmt't'nng £.rpt'TIt'nC!~ ;11 La:.,,: Ammca 07 The price of JTC's stock fell to J5O.28 by March 197:2, well below Spiller and Sampson's (199~) estunate of a book value of J51.3 for December 1971 and the J51.13 per share paid by Continental Telephone. Two other major changes occurred in the regulatory enVIronment. The first was t.~at third parties were allowed to participate:.... . the rate hearings. As a result, the Jamaican Tax and Rate?ayers AssocIation 0- and the Jamaican Hotel and Tourist Association presented evidence against lTC du..-ing rate hearings. (Th.e Tax and Ratepayers Association even asked the supreme court to review JPUC's dec15ion to grant TTC a rate increase.) A seeo:1': cnange was mal tnt' (ourtS had a smaller roie m tile regularory' process. Prior to creation of the JPUC, the supreme court reversed rate board decisions thac did not allow the company to recoup past profit deficiencles. Following passage of the JPUC Act the court refused to hear WUC cases. Two aspects of the new regulatory environment may have affected the court's implicit ap- proach to JPue decisions. First. the 1966 license was less forthcoming in providing minimum rates of return. Second, while the rate boards were ad hoc commissions, the JPue was a fully staffed. semijudicial. organization. More important because the JPUC was directed by political appointees. its decisions were thought to reflect the will ot parliament. Thus, unless the JPUC violated a procedural formality or a license stipulation, the court did not find it proper to intervene. Consequently, the wC'e Act provided no coherent process for resoh'ing conflicts between the JPue and JTC, essentially granting full discretion to the JPue and dooming JTC to continual finanCIal difficulties. The lTC's lack of incennves and poor performance dunng the first half of the 19;'Os are best under- stood in light or two factors: fust, the tnitlal conditions under which Continental Telepnone agreed to buy a maJority shareholder'S stake mlTc' and second, the passage and implementation or the JPUC Act. The former implied that lTC would have to undertake a substantial development progra=1, which to a large extent was supposed to be undenvritten by Continental Telephone itself. The JPUC's v"'orkings, however, dampened Continental Telephone's desire to increase its exposure in JTC, leaving rrc reliant on cash flow or international loans to finance its expansion. Both these options were restrainec: D:-' JPUC poliCies. By late 1975, the lTC's finanoal situation was so precarious that Continental Telephone agreed to sel.! the government its holdings in the JTC Another example of the problems of comminne:1t iliat is not credible 15 presented in box 4.5, concerning toll roads in Thailand. Bor 4..5. The Problmt o!Commrtment The Economrst (1993a, p. 32). pnnted the following description of problems WIth the development of road tnirastructure in Bangkok: . If proof were needed that Bangkok's traffic is the worst in the world, then it has am .... ed :':1 tile shape of tile "Comfort 100," a red plaSIJC bottle which is bemg sold as a portable unnaL .. Thai motonsts are not alone m finding the Comiort 100 symbolic of goverrunental inaction on traffic. ForeIgn construction comparues, which had been salivating at the thought of some 520 billion of promised mfrastructural spending, are now havmg second thoughts. Three mooted mass-transit systems have got no further than the drawmg board. And the one new highway that is almost complete-Bangkok's second-stage expressway-has now become the subJect of a bitter dispute. The road is a 20 kilometer (12 mile) six-lane tollway, built by a Japanese-led consortium and financed by a 5200 million loan, in which 31 foreIgn banks have an interest. The consortium has built the expressway on a "build, operate and transrer" basis. Its profits were supposed. to come from levying a 30 baht (51.20) toll. At the last moment. the government balked. unilaterally setting a new pnce of 20 baht. In theory, the trussmg 10 baht will come out of the state's share of the toll-money. The goverrunent now wants the consortium to open the expressway in the next few weeks. The road itself is still only partly completed. with four or U.s 18 ramps "ski- jumps" which end in midair. in the meantime, competItors to the Corniort 100 are already appeanng on the market. A Taiwanese device called "Basi Pee" is advertised as ideal for children. And from Japan comes a more unwieldy piece of eqUipment, the ommously titled "Thunderbolt." (box contmuts 07'1 followmg pag~) 68 f. UlLS GU.JlScn and Pablo 5plll~r Box 4.5 contmued Tite EconomIst (l993b, p. 29), ?rmted the follov,/ing continuation of the Bangkok road mirasr:-..lcnue saga: On August 31st th~ government took legal acnon to force an intematlonal consortium to open a new motorway in Bangkok .... Initially, the govem...-nent balked at levymg the 30 baht (S1.20) toll specified L"'t the contrac:, though it later agreed to it. But when the company said that other matters remained unsettled. the government lost patience and obtained a court order. Agreemg to open the road, the presidmg judge saic !!--3.! the gQve~­ ment had law on its side, but added. "The people's suffering is the highest law." ... On September 2nd. ChuanI'l Leekpai. the Thai pnme minister, gave the go-ahead ior a ribbon-cuttl1lb ceremony at the disputed expressway. His action angered intematlOnal bankers connected With the motorway consortium ... They argue that under the origmal contract they are already owed 2 billIon bah: in tolls from a stretch of motorway controlled by the government. Bankers dose to the Bangkok Expressway Company say that it is under threat of bankruptcy. The government responds that the priority is to get the road opened and that all investors will be paid, once negotiations resume. Sourct: TM E.c01fom1.St (1993a. p. 32; 1993b. p. 29). 5 Creating the Detail Engineering of Regulation: Price-Setting Policies The standard elements that are often subject to regulation vary from country to country and from sector to sector. The general principle of detail engineering is to regulate (economic reguianon) those segments of the market that display natural monopoly characteristics to curtail abuses of monopoly power. The three main instruments of regulation, or decision variables, are price(s}, quantity, and the number of firms. Other less common instruments include product quality, service timeliness, coverage and invest- ment, and universal service obligation. Of course, regulanon on safety and environment is also required in many contex.ts, but those contex.ts are not the subject of this book. Often, the failure to use a potentIally powerful instrument of regulation, such as quality, has to do with the eXlStence of severe informational problems and the high cost of monitoring and enforcement. More specifically, regulatIon commonly en- compasses the following ace VI ties: • Licensing carriers or operators • Setting opera tor prices or tariffs for services • Setting technical standards • Monitoring the quality of service provided by operators and initiating corrective ac:ion it necessary • Approving operators' programs for construction and capital investments • Setting the financial, administratIve, and technical terms for interconnecting the net'W'orks of dif- ferent operators, including access pricing • Controlling the type and approval of equipment on the customer's premises and the eqUipment's connection to the public network • Considering complaints from telecommunications users and taking corrective action if necessary • Collecting market or cost information and requiring operators to provide technical information on their opera tions • Acting as a binding arbitrator in the event of conflicts between service provide::s and network operators. Not all of these elements must be regulated. The regulatory functions and the regulated elements depend by and large on the country's regulatory philosophy, endowments, and characteristlcs; the sector's characteristics; and the extent of competition allowed. For example, New Zealand has \i.rt:ually no regu- latory control of the prices charged to end users; Hong Kong, China, has no control of equipment on the customer's premises; and t.~e Federal Communications Commission (FCC) in the United States often chooses not to impose technical standards. As mentioned, there are tradeoffs in regulatory deSign, and a country should evaluate them carefully when choosmg how much regulation to impose. The Relation between Detail and Basic Engineering Theories of regulation presume that the choice of detail engineering can be properly computed and un- dertaken in any political or institutional environment. These theories fail to recognize that, in the absence of a reasonable match between detail engineering and the basic engineering on which it rests, achieving the desired outcome will be difficult. Nonnative .theories of natural monopoly as applied to comparative regulation presume that second-best detail engineering is readily transferable across countries. For 69 iO , Lul.S G!w,:;.;h and Pablo 5pllkr example, if appropriate basic engineering translates into specific regulatory rules that li.I:I".H opportunism, then flexible pricing schemes requiring regulatory judgments are not feasible. Thus, second-best pricing is not attainable, and attempting to create a regulatory system with substantial flexibili~; is not credible. However, if the appropriate basic engineering allows for a flexible regulatory framework, t.~en discre- tionary regulatory schemes might be credible. Regulatory management is crucial to both the economic and the political success of privatization program.::;. PrIvatization has the potential to bring credibility to the government an": ~0 provide re\- enue that can alleviate short-term fiscal problems. Utilities are particularly sensitive because their op- erations affect voters directly. It is not uncommon for economically successful privatization programs. to arouse a fair amount of political opposition, which can damage not only the utility Ln question b~~ . also the entire privatization program. There are two basic approaches to regulating utilities: structural and conduct. In many countries, especially in Western Europe, policymakers have attempted to alter the structure of public utilities before privatizing in order to increase competition aftenvard. One ai- pect of the structural method is that it separates the activities in the industry, such as transportation from provision. The United States and the United Kingdom regulate the conduct of the utility. The United States favors the rate-of-return approach to regulation, while the United Kingd.om leans to- ward price caps and performance standards. In the United States, the public utilities commission of each state determines the pr.ces that the mo- nopoly franchise can charge. The criterion used to determine these prices is that the fum cannot earn more than a fair and reasonable rate of return on its capital stock. The U.S. approach keeps the utility from earning monopoly profits, but not from investing heavily in its capital stock. Howeve:-, attempts to tackle this problem have led to legal battles with firms over whether new investments can be justified because they are needed to meet demand. Litigation has made regulating the cost of capiral expensIve. Detail Engineering and Country Endowments A country's legal and administrative endowments can limit its potential for undertaking a complex reg. ..l- latory framework, thereby restricting its choice of basic and detail engineering. Consicie: implememm§; flexible price systems in a nation whose institutional characteristics call for inflexible derail engineering. Jamaica, with its two-party parliamentary system, substantial government turnover, and lack of informal norms limiting administrative discretion offers an example. Jamaica could not implement rate-of-retum regulation of public utilities because this approach would give the Public Utility Commission too much discretion in setting the rate base and the appropriate level of return on capital. If implemented, this type of regulation would have to restrict the extent to which the regulator could determine rates of return, capital levels, and costs. The implementation of a price cap would have similar implications, because price caps have to be reset every few years to avoid profit over or undershooting, and leaving such a decision to the regulator might grant too much discrec.on. Again, the system of revising the price cap would have to limit regulatory discretion and disc::)':.:.=age oppor=:..!- nistic behavior on the part of the regulator. The Tradeoff between Commitment lind Flexibility Countries differ in the extent to which efforts to limit opportunistic administrative behavior require that the regulatory framework be specified in great detail. Some countries can afford more flexibility in their regulatory design than others. In particular, countries with informal norms restraining arbit::y Ft!atures of Pnce-Basket. Rt!,/t:!nut;!, and Rate-of-Rt!t1ln1 CAps F~ature Pnce-vasicet cap Re::.1emlt' cap Revenues cannot exceed Tariff canno~ predict a -'" Constraint set by cap WeIghted average of limit (rel.lte~ to output r.lte of recu:::"l above prices cannot exceed Colp set by cap) regula tee level Coverage Speci,c:': pnc~:> nine Spcci:;e'; ~ypc;; oi .j.lles Rc::gu:ati::G :nJ:>U1c;;.:>·.:> rentals, domestic calls) (such .lS to captive small predicted revenues consumers) Implementation A list of prices Output measures Tanfis that grve revenue reqUIrement predlOaDS Weights on quantIties Set by regulator Actual quantities Predicted quantlties Price weights in cap None explicit Set by regulator From tariff Constraint on croSs- Subsidiary cap reqUlred Separate constramt Regulator could disallow subsldv reqUired tariff Opportunity for Very small Some (likely to be small Some ,likeiy to be small marupulahon m pracnce) tn pracnce) COSt pass-through terms Might be mcluded In cap Simple to Include tn cap Tariff rrught contam (difficult) escalanon clause Correction factor Not required Required Not requlIed Advantage Simple to define and Allows constramt to Investors face lower nsk. monitor respond to actual output reducmg COSt of capltai and pass-through costs Limitation Needs a full list of prices Needs homogeneous Needs oremctions oi output measures revenues and costs for (revenues must be each new set of tarilis < output x weight) Example British Telecom British Gas c.s. utilities Source: Green (199ia) • Income risk of investment. With rate-of-return regulation, the operator is guaranteed the rate of return on new investments; however, that is not necessarily the case with pnce-cap regulatIon. Consider the returns available from investing in a utility that are subject to a rate of return regulation. Because prices are adjusted each year to keep the rate of return roughly constant, investments in the firm are subject to little risk, particularly the market-related risk that investors worry about. If returns 1n tpe market as a whole rise, the regulated utility's returns won't rise much (though they can rise a little in the period before the regulator requires a price cut). However, if the market tums bad and returns fall. the utility's returns will not tall below the target set by the regulator for long. Thus, finns subject to rate-of-return regulation tend to have low betas and a lower-than-average cost of capital. Price-cap regulation does not have the same efiect. Because in the short run the regulator sets no target rate of rett;.rn, the regu- lated company's return can vary from period to period. and is free to vary with the returns on the market. Even under price-cap regulation, utility firms are orten fairly safe businesses, with returns that are affected less by economy-wide shocks than other firms are. As shown in table 53, their betas are still lower than one, but they are higher than the betas of firms subject to rate-of-retum regulation. There- fore, investors will demand a higher return for investment in a firm that is subject to price-cap regula- tion. This hints that for sectors requiring massive investments a preferable approach would be rate-of- return regulation over price-cap regulation but with proper monitoring of investments. lit'''e 5.1. AI'L'ra.~I·'lIfrtlslr"d""c fi,,,, Rl'las, "y ('u'lIJI,y, S"dor, mId '/~II'I' (1/~t'g"It'IiIl", 1990- 94 t 'wI/billed gas E/ectril'ily' Gas a,.,1 t'il'd r ic:i IY Willa ·1t·/('nml5 ------ COIIIIlry Reg II/tl lioIJ Bl'la Rt'g II/fl I ion Rettt R"g ,,'atimr nt'la Rl'g II/al ion fll'la NI'.~"/1I1ion nt'la Canada lum 0.25 ROR 0.11 Japan ROil 0.43 H(lIt () (12 Sweden PrietO Clip 050 ;;: O.RI Pril'e Cilp 067 p, ire ('ap Uniled Kingdom I'rin! Cilp () 87 lInited Slilll!s ROR 0.30 ROil 0.2(J nOR 0,25 r~(m 0.29 Price Cap n.n (AT&T) 052 HOR (ntllL'rs) - Nul availahle. ROI( Rale til relurn. 501"t't: n?? " ,., Crca:ms tht' D('ta:1 Enpnur:ng of R.:gul.ilt:or.: Pr..:.:-S(!:ms PO/ICI(S 79 The price-cap system has se\'eral \·ariations. mcluding hybrid forms with price caps as sho'A'Tl in box 5.5, The following description of the L".K. price-cap system across dilierent sectors. telecorn..rnurucations. water, aL.""P orts . gas. and electrici~; illustrates how pnce caps are determined in practice and presents some of the variations, This mode of reg'J..latlon 15 being extensively introduced in Latin :\.merica and the Caribbean (LAC), The United Kingdom Price-Cap System l.n 198.t the L'.K. government privatized BrItish Telecom (BT), thus converting it from a statutory mo- nopoly ot network services to a vinual monopoly with a sole fledgling competitor, Mercury Communica- tions Limited. Recognizing that BT would long remarn the virtually monopolistic, or at least a strongly domrnant supplier of nerwork services, the government set up a regulatory system to be admInistered b\' the Office of Telecommurucations (Of tel), whIch IS headed by a director general of telecommuruca- ti~ns. Oftel controls BT's prices in market segments where BT enjoys significant market power. As the fundamental inscrument for contTolling the large bulk of BT's prices, the government applies the price-cap formula, RPl- x, to a basket of services. The formula dictates that in each year berween regulatory reviews BT rna\' raise the average nominal price of services withm the basket by a percentage determined by the composl'te effect of the past year's percentage increase m the official (RPT) minus a temporarily fixed parameter (x). which is intendec! to estimate the average annual rate at whIch BT can improve its total factor produchnty. 1£, for instance. the retail price mdex mcreased by 10 percent in the past year and if x was set at 3 percent, then BT could increase the average basket price by no more than 3 percent. Ii in any year BT took less than tull advantage of the price ceiling, it could carry over the unused allowance for up to two years. Restated. the price for the basket of services must fall, in real tenns, by at least x percent each year. Although this rule sets a ceiling on BT's year-on-year pnce movements, it sets no floor. The Setting of Price Caps and Efficiency Factor in the United Kingdom The value of x is normally rese~ at. the time of regulatory reviews, which have taken tllace at intervals of four or five years, although a nt:.mber of mid-term adjustments were made m 1991. Origmally, in 198~, x tor the mam cap was set at 3 percent. Since then, it has been increased successively to 4.5 percent (1989-91), 6.25 percent (1991-93), and ';.3 percent (1993-97). See figure 52 for a comparison of the x-factor across industries. In considering the level at which x should be set for ~ither the main cap or any of the special caps, the director general has repeatedly relied on BT's rate of return on capital employed (both overall and on particular services). The director general has also relied on the relation between BT's price for a particular service or tor a bundle of ser;rices and the costs incurred by BT in supplying those serVIces. Figure 5.2 also provides iniormation on the annual real price increases for the United Kingdom's regulated industries: electricity distribution, electricity transmission, gas, telecommunications, and wa- ter from the time of privatization, which is when RPI - x was first instituted, to 1997. Bor 5.5. Hybrid Pric~ Crrp{Rn:tmu~ up Formuia R, $ [k(P,.p.> + (1 ~k) R,_,] [1.,. (\-:')] R,: Revenue at penod t I,: Measure of inflation between period t and t - 1 X: Measure of expected effiaency gam P,_I: Pnce at period t-1 Dr: Number of units distributed at period t Source: World Bank staff. 80 J. LU1S GWlSch and Pablo Spillt'T Figure 5.2. X Factor, 1984-98 Britlsh utilitles' maxunum annual real price increases 6 I Water and sewerage c::::==========; r ~ I Electricitv distribution _ _ _ _ _ _ _ _-=. Electricity transmlSSion ====::::::J" ra~ _----IIt--··--········I····-····---··-·-···-···1- 2 ~r I 0 I :% I":: ,... BntlSh Gas b -2 I -'-- BT rj.) ~ L:;:::::==:=::::li -4 -6 -8 1984 1986 1988 1990 1992 1994 1996 1998 Not~: Years begmning April 1st (BT. August 1st). a. One-off pnce cut of 14% in 199~. b. Excludes ga.s-p~se mus. c. Applies up to 2004-05. Sourrt: Bia-an and others (1999). The setting of the efficiency factor, x, in the U.K. experience, has been as follows: • Since privatization, water and sewage companies have been granted positive .r values. meaning that prices have risen each period. Even in these sectors, however, the amount by which prices can rise decreased from 4 percent to approximately 1 percent in 1995, where it is expected to remain until 2005. • Similarly, electricity distribution companies benefited from a negative .x value for the first five- year evaluation period, but that value dropped to 2 percent from 1995·onward, indicating real- price reductions. • Electricity transmission companies used an .:r. value of 0 from 1990 to 1993 and the.~ decreased prices by about 3 percent. Anew assessment was made in 1996. • Gas and telecommunications companies have never received positive.x values and, therefore, have reduced prices since privatization. British Gas was granted a slight reversal in prices in 1994 when the.x value was revised from 5 to 4 percent. Telecommunications companies were forced to adjust prices downward three times to the current level of 7.5 percent from the initial value of 3 percent. The contents of the so-called main basket in telecommunications, governed by the main cap of RPI - x, are also subject to change. The main basket (1984-89) originally included only exchange-line rentals and direct-dialed inland calls. In 1991, it was substantially extended to include international calls and direc- tory service (for which BT began to charge separately) and tariff packages (and other OptIonal charging arrangements for heavy-usage customers). From 1993 to 199i, the main basket was extended to cover connection charges, but tariff packages and other quantity discounts were excluded. The private-ci.rcuit basket, when first subjected to price controls in 1989, included only inland cir- cuits. For 1991-93, the basket was extended to cover international circuits as well. The single basket for 1993-97 was partitioned into three baskets covering inland analog circuits, inland digital circuits, and international circui~, each subject to a separate price cap. The standing charge basket (1984-89) originally included only residential exchange-line rentals, Which, though within the main basket, were controlled by a separate price cap. This special basket was extended Creating the Dt'tall Er.g1n~e':'1ng cf RegulatIon: P--:~·5e!:mg Pollcres c, in 1989-91 to cover exchange-line rentals of business and residentlal customers, boli'. oi .....·ruen were 1.."1- side the main basket and connection charges, which until 1993 remained outside the mam basket. In 1991, this basket was divided into three smaller baskets, each subject to a separate price cap: excha'1ge- line rentals, single-line residential use, and business use; exchange-line rentals, multiline use, and who ie- sale use; and c;nnection charges. For 1993-97, all exchange-line rentals were regrouped in a single bas- ket and connectlon charges were placed in another, although all figure in the main baske! as well. .!umual changes in the price of the main basket are calculated by a weighted average. Tne change :.n the price of each mdividual service within the basket is weighted by a fraction measunng the relanon between BT's turnover from that service and BT's total turnover from the entire basket of senices. Tnis weighted average is the figure that cannot rise annually by more than RPI- x. Similar weighted averages establish the price of baskets other than the main basket. A successful program for regulating privatIZed industries should embrace the following principles: • Seek to preven't the abuse of monopoly power. • Ensure that economic regulation does not distort business decisions. • Limit the costs of regulation to what is essential. • Have regulation of a monopoly replicate the behavior of a competitive market as far as possible. The RPI- x system of price control follows these basic principles. Expenence, primarily in the Cnited Kingdom, has shown the mecha.rusms to be broadly workable and coherent. Six governments have re- cently privatized their telecommunications systems (Alberta, Canada; Argennna; Australia; Japan; Pue:to Rico; and Singapore); only Alberta and Japan have chosen rate-oi-return systems rather than RPI - x. Moreover, the United States, the largest economy to embrace rate-oi-retum mechanisms, 15 in the process of switching from rate of return to RPI- x. Nevertheless, RPI- x can rail in two ways. Ir can become eithe: wmecessarily intrusive or too detailed. The former tendency goes against the second pnnclple listed, ensuring that economic regulation does not distort business decisions, and while the latter ignores the third, limiting the costs of regulation to what is essentiaL Practical £"Cperience with Price Caps in the United Kingdom Different price-Cap fonnulas have been used for the industries that have been priyatized in the United King- dom. This section presents those fonnulas and discusses their potential dangers and the overall success of this particular method of regulation. The full formulation of the pnce caps is presented in appendix 3A. BRITISH TELECOMMUN1CATIO:\S. Littlechild (1983) provides a framework for the pri . . . atization of BT and argues that direct price regulation should be used until sufficIent competition develops. (This section 15 adapted from Glynn 1992). Littlechild's proposal links prices to a general index of inflanon, which would allow BT a period without price changes (about five years) that is long enough to produce incentives tor improved efficiency. That is. price reductions would not instantly remove the profits f40m increased profitability-. A second feature of Littlechild's proposal is that the controls should apply to a basket of tariffs in which management is free, with some constraints, to alter relative prices. This means that BT could incorporate new infonnation about costs or markets without involving the regulator. In tlus case, the regulator would be Oftel. which has the responsibility to prevent undue discrimination in tariffs. A pure tariff basket control limits the prices charged, not the revenue per customer or per call in BT'S formula: ". (5.1) W, = RPI'_l-x + 2, where W is the weighted average increase in charges for a basket of services, RPI is the percentage change in the retail price index, x is 4.5, and 2 is unused allowance from the previous year. The left-hand side of the inequality is the weighted average increase in charges in year t for the basket of regulated services. This calculation is straightforward. Weights are given by each tariff item in the previous year, and the 82 /. LuIS Guasch lind Pablo SpIll" price increase proposed for each tariff item is multiplied by that welght. On the right-hand side. RPI1 _; refers to the increase in the retail price index during the previous year. in this, x was origrnally set at 3 and was increased to 4.5 for the following four years. A 1991 review further increased x to 6.25 percent and included international telephone calls in the basket. The final item, 2 1, is unrecovered entitlement (if any) from the previous year. BRITlSH GAS. The British Gas formula differs from that of BT: (5.2) M, = RPI,.t - x + GPI, - 21 + EI T Kt where M is the maximum revenue per therm, RPI is the percentage change in the retail price mdex, x is 5, GPI is the gas price index, 2 is the efficienc}, factor, E is the cost incurred in promoting energy efficiency, and K is the correction factor. The left-hand side is the maximum average revenue or price per therm in the relevant year. The price constraint is set in relation to the gas price index, which reflects escalation arrangements in the purchase contracts of British Gas. The formula includes two efficiency factors to allow customers to share directly in this benefit. One variable, Zr' relates directly to the purchase con- tracts, while the other, Et• represents costs incurred by British Gas in promoting efficiency. A major differ- ence in the formulas for gas and telecommunicatlons is that in the formula for telecommunications the controlled prices are guaranteed to be reduced in real terms, whereas tn the formula for gas, prices de- pend on changes in the cast of gas to British Gas. BRIllSH AIRPoRT AUTHORln'. The controls applied to British Airport Authority introduce further features into the formula: (5.3) MG, = RPI, -:c + SG, - KG, where MGt is the increase in maximum revenue per passenger, RPI is the percentage change in the retail pnce index,:C is 1, SG is the allowable security cost per passenger, and KG is the correction ractor. As is the case with British Gas, the control applies to the forecast revenue yield. To protect the airport authonty from excessive losses if it becomes necessary to substantially increase security expenditures. the formula allows 75 percent of these costs to be recovered. British Airport Authority is subject to an additional RPI - x control on total revenue earned. This price control covers airport charges, such as landing fees for planes and parking fees for passengers. Attempts to rebalance charges within the overall limit led to complaints from airlines, and the authority eventually agreed to restrict the extent of rebalanCIng if it had greater effect on a particular airline. This is an example of the creeping extensions of reguiation. WATER COMPANIES. The price cap formula for water companies is similar but not icienncal to the previous ones: (5.4) Wt =RPI'_l + K, + 2, where W is the weighted average increase in charges for a basket of services, RPI is the percentage change in the retail price index, K is a variable correction factor, and 2 is the unused allowance from the previous two years. The water ind us try needs price increases to finance steeply increasing investment. This invest- ment, in general, does not increase supplies for which a charge can be made. but it does improve the environmental effects and raise the quality standards of existing supplies. The peculiar importance of quality in this industry. the long lives of the assets involved, and the difficulty in knowing the condition of assets have led asset management plans to become part of the regulatory contract. Companies car, recover the costs of changed standards through price increases. Another novel feature of the water price .- cap is that it is a hybrid of revenue yield and tariff basket methods. This is because the weighted average increase in charges (W) is a combination of the increased charges for metered supplies, which are calcu- lated on tariff basket principles (that is. as the increase in pure price), and for unmeasured supplies, which are calculated as the increase in the average bill per chargeable supply. This hybrid protects the company's revenues from losses if customers switch from an unmetered to a metered supply. Crtatmg the Dt.'tali Engtru't.'nng of Rtguumon: Pnct-5mrng Pollclt.'s 83 ELECTRlcm- COMPA."IES. In all of the cases considered here, a tradeoff is made between competition and regulation. This tradeoff means that countries privatizing a monopoly power industry must decide wheL~er to restructure or to break up an integrated business to create the conditions for competition. The restruc- turing of the electrical sector in England and Wales has made it possible for the regulator not to set prices for companies that generate electricity, although their initial contracts will have to be approved by the government for at least the first three years following privatization. Even under this reiormed structure, however, many parts of the industry retain monopoly power and will be subject, accordlI1gly, to RP; -.\ price caps for the following situations: • Distribution minus use of the regional electricity company's lines: M = RPJ - X, where M is maxi- mum change in the average charge per kilowatt-hour, and x is between 0 and :!.,3, according to regional circumstances. • Regional electric company's supply minus the p~ice charged by the co~pany for ele~tricity: M =(RPI -x) ... p ... Y, where M is maximum change In average charge per kilowatt-hour, x 15 0, P 15 the price for servIces provided by companies other than Y, and Y is the cost of transmission, distri- bution, and the fossil fuel levy. • Charges for the regional electric company's small customers (less than 1 megawatt): M = RT'I, where M is the maximum change in average charge per kilowatt-hour. • Transmission minus use of the grid: M =RPJ - x, where M is the maximum change in the average charge per kilowatt-hour, and x is O. Each of the 1:! regional electricity companies is subject to 3 price caps. The first one sets a limit on the amount that companies can charge for use oi their distribution lines. The second one prevents them trom charging more than the average amount they paid (plus outside or separately regulated costs and increases in their profit margins). The final cap controls the pnce that regional comparues can charge to customers that consume less that 1 megawatt of electricity. As joint owners of the National Grid Company, regional electric companies also face limits on price increases for use of their high-transmission wires. As a wholly owned subSidiary of the regional electric companies, the grid company does not need to be too concerned with differences between income and investment, so x is set at 0 in this formula. These arrangements allow the owners, where a monopoly exists, to use the asset available at a non- discriminatory price, and with these arrangements, the caps on profit and minor expenses protect cus· tomers and give companies added incentives to increase effiCiency. Costs that are outsIde the control of the companies can be passed on in full, and smaller customers are guaranteed that prices will not in- crease more than the retail price index. Finally, a fully competitive retail market develops in which any buyer that consumes more than 1 megawatt of power each year can purchase power from any producer in England and Wales. In the United Kingdom, the privatization of electric utilities has enjoyed economic success. Output per employee has increased 70 percent noniue! costs per unit of output have decreased ~ percent, ar.c. investment in new technolOgies has been large and successful. In addition, contract prices have dropped, in real terms, 21 percent for distribution companies and 18 percent for direct industnal and commercial consumers. The United Kingdom is the only country in the European Union that has had real falling electricity prices. Competition has increased, with the market share of the largest fum projected to de- cline from 33 percent in 1989 to 22 percent in 1997. Despite this apparent success, political pressure has slowed the drive to privatize utilities in the United Kingdom. The electricity regulator backed out on a promise to maintain prices at a certain level because of the public outcry against abnormal profits. New electricity price caps were announced on schedule in Au- gust 1994 and were due to take effect in April 1995 and to last for five years. In early March. however. the electricity regulator expressed concern over evidence of previously WlSuspected financial strength on the part of the generating companies. Accordingly, the agreed prices were reviewed, which resulted in lower caps. (The electricity regulator's announcement was made the day after the government sold its remairung shares in the two major generating compar.ies at a high premium.) The significance of and potential 84 1. LuIS GUJlSch and Pablo SpIll" dJmage resulting from this incident should not be underestimated. The key feature of the British system, which distinguishes it from rate-of-retum capping, is the credibility of the interval betweerl reviews, which is crucial to companies undertaking long-tenn investments or other actions designed to cut costs. The political pressure arose for a number of reasons. First, more could have been done to increase competition by splitting up the capacity into a larger number of smaller units at the time of privatization. After privatization took place, the regulator asked the two major generating companies to divide them- selves into smaller enterprises, but they failed to do so. The regulator then threatened action from the Monopolies and Mergers Commission. Second, the shares of the generating companies were seriously underpriced at the time of privatization. Indeed, large profits were made in a short time from increases in the stock market value of these shares. Third, after the electricity regulator announced the new price caps in August 1994, one of the major generating companies successfully countered an attractive take- over offer from a major conglomerate. Fourth, a significant amount of political heat has been generated in the United Kingdom about the high salaries of chief executive officers and other senior managers of the privatIZed utilities. Countries should consider several approaches to privatizing utilities. First, competition is always preierable to regulabon. The extent to which competition can be introduced is growing all the time thanks to technological deveiopments. To put it another way, natural monopolies are becoming less natural with every year that passes. To ease the burden on regulators, the competitive framework should be put in place before privatization. In the United Kingdom, the task of regulation was made more onerous because inadequate restructuring took place before privatization, which iorced regula- tors to introduce competition ex post. Second, where the industry is not a candidate for perfect compe- tition, it is important to identify the causes of market failure in advance and to gear the powers of the regulator accordingly. Finally, the relationshIp between the regulator and the regulated industry is best thought of in contractual terms. Like all contracts, it should be clearly specified and should mmimize the ability of either party to resort to discretionary or arbitrary tactics. nus includes a cheap, rapid, and fair means of resolving disputes, whether they are between the regulator and the regulated firm or within a regulated industry. In the United Kingdom, the Monopolies and Mergers CommlSsion is the only arbiter of disagreements. Appeals to the Monopolies and Mergers Commission are tune consum- ing, and the commission's decisions are not universally regarded as impartial. If these conditions are not in place or are inadequate, the regulatory system is susceptible to political interference. When that happens, the regulator is more likely to succumb to outside pres- sures, and governments are more likely to interfere, to the detriment of both the regulator and the utility companies, as seems to be the case in the United Kingdom (see box 5.6). Many of these prob- lems could be avoided if the government ensured that the utilities had the right structure before privatization. In the United Kingdom, only in electricity were the parts liable to market failure sepa- rated from the rest of the industry. Short-term politics are to blame because the BrItish government wanted to make soon-to-be-privatized firms attractive to potential buyers, and the government knew that increasing competition would not have served this purpose. Despite these defects, B;-itish regu- lation is a big step forward. The process of setting price caps is transparent, debate is formalized, and regulated finns can appeal if they do not like a decision. Additionally, regulation is cheaper in the United Kingdom than in the United States, where regulatory disputes provide huge dividends to lawyers. Furthermore, British utility bosses have by and large been given the right incentives to keep prices and costs low. Anal ysis of Rate-of-Return and 'Price-Cap Regulation The rate of return used in the United States and the price caps applied in the United Kingdom are the two most commonly used regulation schemes. The U.s.-style rate-of-retum regulation, if strictly implemented, will eventually isolate the fum's profitability from its cost performance and hence imply highly ineffi- cient outcomes. However, as implemented in the United States, rate-of-retum regulation has orovided the finn with excess profits when costs are falling and with below-normal profits when costs are increasing. Creatmg the Detail Engmeer.ng of Regulauort: p.,a·5~::ln5 Poilcles 55 Box 5.6. Rmegotl.1tlOn of the Untted Kmgdom's Electr:cIty D,stributIOn ranff One of the most controversial eVe!1ts in the Linited Kingdom's utility regulation was the regulator's deciSIOn to revisit the pnce controls placed on eiectricity distributors rune months after the controls were I.I\ltially agreed on. Paradoxicallv, tillS decisIOn was made after the imposition of tough price controls that resulted in an IDltial drop in prices or'll to 1i per:::en t m one year, followed by an x factor of 2 percent thereaite::-, despIte there bemg a positlve.r factor (that IS, real pnce increases) In the initial five-year penod. Critics have seized on this renego- tIation as the end or pnce-cap regulatIon, and, indeed. the United Kingdom is engaged in a Vlgorous debate about movmg away trom p:1ce caps toward iorm.s of sharing rules, partly as a result or this debacle. The history or the reVISIon began with the privatization of electricity distributors on the bastS of a regulatory regime featunng positive x ?rice caps that allowed the distribution pnce to Increase m real terms, an actlOn taken by government to ertsure a successrul privattzatlOn and urged on it by the comparues, which cited the sector's substantlal investment needs. This regime allowed companies to increase divldends substantially in the first few vears and to buv back shares. As investors realized that the regulatory regime was much less rukv than envisio~ed, market vaiues mcreased substantially. In fact. beginning with an irutial share price of £240 ~ 1990, market values rose to an average of £710 by April 1994, a threefold increase in four years. The mountlng cash pile or the distribution companies, the result of a generous irutial settlement. exerted pres- sure on the regulator to get tough in the forthCOming pnce review, whlch was to set pnces irom 1993 to 2000. In April 1994, rrudway througn the pnce reVIeW process, a letter from the regulator to the comparues was leaked that suggested an initial price drop of between 20 and 30 percent in the first year, followed by an.r ractor of 4, percent in the rollowing four years. The market values of the companies fell sharply following this announcement, and shareholders became increa.smgl:' concerned about the severity of the potential settlement. Institutional share- holders wrote open letters demanding that the companies stand firm against the depredations or the regulator. The outcome of the review process was announced in 1994. Although tough relatIve to price reviews in other utilities, the 11 to 17 percent initial drop in prices and 2 percent .r factor were seen as lax relatIve to the proposals made in the April letter. The market value oi the comparues rose sharply and continued to rue in the next few months. One investment briefing carried the headline "Comparues 2-Regulators 0," which reflected what was seen as the lenient outcome in the price reviews of both the water and electricity mdusmes. As the market values or 6e comparues continued to rise throughout autumn 1994. the reguiator was pres- sured to re\;se the formula. In the winter of 1995, a complicating factor came to light: the imminent expiration of the government's golden share in the distribution companies, which was due to be retired m April 1993. The gOiden share had effectivei:' prevented hostile takeovers of the companies until that point. On December 19,1994, Traialgar House, a conglomerate, announced a bid for Northern Elec:nc, one of the reglOnal electricity comparues, valwng it at £1.2 billion or £10.77 a share. Subsequently, Northern's defense, which included a £5 per share one-off dividend twice the vaiue of the initial purchase of shares, triggered the mtervention of the regulator. In February 1995, the reg-..llator declared that he was going to review the dJstribution pnces again. Despite the poor precedent caused by this action, the regulator felt that action now would prevent worse pressures later on. He cited the new iniormanon contained. in the Northern Electric deiense document as one reason for the intervention. This decislOn created a huge pohncal controversy, not only because it reopened what was seen as a closed five-year deal, but also because the announcement was made on the day after flotation of the government's remaining 40 percent share.i:lOlding in the generation companies. Although these companies are in a separate part of the I:':arket :mc .lre :e~~3ted on a completely different basis, the market impact was :'::-.;nediate and dramatic. Pnces of the generation shares felL and a number of investors, partIcularly those that had planned to stag the issue--that is, sell them qUIckly for a profit-threatened to sue both the government and the regulator. In the end, the second reVIeW resulted in an additional one--<>ff reduction m prices of between 10 and 13 percent and an increase in the ongomg x charge to 3 percent. None of the companies, which had pronounced the origu1al price review tough but fair. dJsputed the details of the outcome. In any case, the concerns of the sector had moved on as a series of intended takeovers in the sector was announced. By April 1996, 8 of the on gina I 12 distributors were the subject of takeover bids. What are the lessons here? Some commentators have argued that this was the end of price caps in their con- ventional form and that the information requirements and political difficulties associated with setting a stable pnce for five years are too great. However, price caps have been used successfully in many other countries and sectors. Perhaps what this illustrates more vividly is the difficulty that any regulatory regime will have in chang- ing the status quo in one dtreetion or another and the intnnsically political nature of utility regulation. Source: Authors. 86 J. LuIS GUD.Sch Qrld PQblo SpIll" Strict implementation of rate of return would make rate reviews mandatory at short Intervals, for ex- ample, one year. in the United States, rate reviews are open to being called by either the firm or the state public utility commission. Tne fum will call a rate re\'iew when it expects to get a higher price" (for example, when its costs have gone up suffiCiently to make the expense, and the risk, of the rate review worth taking). The public utility commission will call a rate review when the observable profitability, or cash flow, of the firm is too high. (See Joskow 19i4.) U.K.-style price-cap regulation has a similar feature as long as the cap is held constant for a relatively long period of time. Price-cap regulation with profit sharing, as implemented in the United States in some states and at the federal level in the regulation of American Telephone and Telegraph (AT&n, would also limit the correlation between demand and a finn's profits. (For a discussion of state price-cap innovations, see Face 1988.) Both price-cap regulation and rate-oi-retum regulation are relatively flexible regulatory designs. Their flexibility arises from various sources. Consider rate-of-retum regulation as implemented by state public utility commissions. First, lags, arising from the endogeneity of rate reviews, provide some cost incen- tives to the firms. Second, regulators have strong incentives not to accept all costs and investments at face '''alue, which restrains, to some extent, incentives to invest excessively, if they ever existed. (For a discus- sion of investment disallowances, see Lyon 1992.) Finally, because an exogenously given required rate of return does not exist, regulators could penalize the firm for unusually high costs. indeed, the reluctance of public utility commissions to grant rate increases in the early 1970s could have been a response to surprising cost increases arising from the inflationary environment. Once it became dear that much of those cost increases were indeed inflationary, automatic adjustment clauses were introduced. (See Joskow 1974.) In the meantime, however, electric utilities experienced their lowest level of retums. Price-cap systems, whether similar to the system ot the United Kingdom or of the United States, provide cost incentives as long as price caps are adjusted every four or five years. Because the price cap may not be adjusted because of unusually high or low profitability, higher-than-expected cost reductions benefit the firm, while lower-than-expected cost reductions penalize the firm. However, US.-style price caps with profit sharing limit the extent of rents that companies can capture, increasing consumer or taxpayer sur- plus (Laffont and TIrOle 1993). Furthermore, under any price-cap system, the company's pnce flexibility allows it to adjust its price structure to new technologies and competition. Where comparison is possible, as it is between different states in the United States, the evidence indicates that price-cap regulation leads to lower prices than does rate-of-retum regulation. For example, Face (1988) has reviewed the experience of Michigan's Bell contract and estimated that the change from rate-of-return to price-cap regulation saved about USS40 million (1982 dollars) in costs over what would have been incurred if rate-of-retum regulation had continued. Similar results were obtained in an Of tel report (1988). Mathios and Rogers (1989) estimated that the rates of AT&T's Message TelecommWlica- tions Servlce are on average between i and 10 percent lower in states that have a price-cap approach than in states that use rate-oi-retum regulation. Moreover, cost-reduction investments are higher under an optimal price-cap regime. In addition, Braeutigam and panzar (1989) report that more than 20 states in the United States have moved from rate-of-retum regulation to a combination of sliding-sca1~ and price- cap regulation for telephone companies. For example, a telephone company is allowed to retain all earn- ings under price-cap rates as long as the rate of return is less than a specified amount, typically in the neighborhood of 13 percent. The limited U.5. evidence available seems to support the view that price-cap regulation is an effective means of controlling the prices of dominant firms when their profits are con- trolled by the competitive marketplace. Thus, as has been observed many times, price-cap regulation is probably most effective as a transitory step on the path toward. total deregulation and full competition. However. a caveat on the difference between these two modes of regulation is in order. Actions by U.K. regulators illustrate that, in practice, the two systems have a tendency to converge. Regulators an- nounced new electricity price caps, which were due to begin inApri11995, on schedule in August 1994. In early March. however, the regulator professed concern over evidence of previously unsuspected finan- cial strength on the part of the generating companies. Accordingly, the prices agreed to in August were reviewed, and lower caps were set. The timing of the regulator'S announcement was also significant. Just Cwwng the DetaIl Engrnemng oj Regulatlar:: Pnce-Sett:ng POilC!eS 5:" the day before, the government had sold its remaining shares in the two major generanng companies at a high premium. Share prices of these companies and of the 12 privatized distribution enterprises fell sharply. Legally, the regulators were acting within their powers. The new caps were not ye: rn place, and the period of consultation was still in force. This behavior has tended to reduce the incentives for utility companies to reduce costs and to improve efficiency because the gains from these impr:Jvements will be captured only throughout the remainder of the review penod. When the next review penod comes, com- panies will be penalized by berng assigned higher x values. Similar tendencles have begu.-~ to surface ::. Latin American countries, again as the result of the significant earnings that a number of regulated com- panies appear to be enjoying. This argues in favor of fairly long intervals between reviews. If the penod is too short, the regulated company has an incentive to influence the regulator'S use of its discretion rather than to operate efficiently within a clear framework. The shorter the period, the closer the system is to the rate-of-return regulation system. Consider, now, implementing a flexible price system in nations whose institutional characteristics call for int1exible detail engineering. In Jamaica, which has a two-party parliamentary system with a substantial amount of government turnover and no informal norms limiting administrativ.e discretion, a rate-of-return svstem could not be implemented, because the Public Utility Commission would have too much discretio~ in setting the rate base and in detemuning the appropriate level of return on capital and the nature of allowable costs. Consequently, rate-of-return regulation would have to restrict the extent to which the regulator could determine capital level, rates of return, and costs. (This is precisely the type of regulation that was designed for the newly privatized Telecomrnurucahons of Jamaica.) Another vana- tion is the implementation of either a U.K.- or US.-style price cap. Because price caps have to be reset every few years to avoid profit over- or undershooting, leaving such a decision to the regulator mIght grant the regulator too much discretion. Hence, if price-cap regulation were to be implemented, the pnce- cap revisions would have to be determined so as to limit regulatory discretIon. The United Kingdom designed such a system.by allowing price caps to be adjusted in two ways: (a) by obt:a.l.n.lng the agree- ment of the company and (b) by having the regulator request a decision from the Monopolies and Merg- ers Commission on whether such an adjustment is in the public interest. Given the nature of the Monopo- lies and Mergers Commission, such an arrangement limits opportunistic behavior by me regulator. A U.K.-style arrangement could in principle be implemented in political systems like Jamaica's that have a tradition of independent agencies. Otherwise, independent arbitra..tors would have to resolve disagreements between the company and the regulator. The following arrangeme~t could be the basis for a price-cap system in countries like Jamaica. First, the initial price cap would be set in the company's license. Second, the price cap would be set for an indefinite period of time. Third, the license would stipulate that, after a minimum number of years (such as four), the regulator might ask for an amend- ment to the price-cap provision of the license. If the company agrees, then the license would be amended. If the government and the company do not agree, an ad hoc board of arbitrators would be formed bv agreement between the parties, and the board's decision on a new provision would be binding. Th~ board of arbitrators would be required to bring forward a price cap t.'1at assures a mir.i=t~ rate of return to the company, with that minimum set in the license. To ensure its reliability and impartiality, the board of arbitrators might have to be formed by foreign academics. Unless a minimum rate of return is speci- fied, the arbitrators would have no way of anchoring their discussions, and a wide range of outcomes could arise from the arbitration. Although the design of this detail engineering would be compatible with the choice of basic engineer- ing, it might not fit Jamaica's legal and ad.m.in.istrative capabilities. For example, the regulator would .. have to develop a model shOwing how the company would perform-under alternative price-cap scenarios . If a model was not developed, then the board of arbitrators would use information provided by the company, which might lead to excess rents. If the development and maintenance of such models are beyond the administrative capabilities of Jamaica's bureaucracy, this choice of detail engineering would not be feasible. Although it would certainly be feasible to contract out the creation of the initial model, its continuous updating and maintenance would have to be done in-house. Given the complexity of sectors 88 f. LuIS Gwzsch and Pablo Splllt'l" like telecommunications and electricity, spendlI\g the resources necessary to maintain high-quality pro- fessionals in that job may not be politically feasible. In the United Kingdom, it takes three full-time econo- mists to maintain Oftel's model of BT. Similarly, it took two years for three full-time senior engineers from Chile's National Commission of Energy to develop a model of Chile's electricity sector. "- Finally, whichever price-setting policy is adopted, the rules of the game must be clear. Uncertainty about prices or the criteria used to determine them deters investment in the sector. For example, in Mexico, the Comisi6n Federal de Electricidad (the Mexican parastatal electricity company) has refused to set and commit itself to a purchase price for electricity from private, lI\dependent operators, and this refusal dissuades domestic and foreign firms from investing in the sector. Failure to establish transparent regu- latory procedures increases the risks for private sector participants and adversely affects the develop- ment and competitiveness of the sector. Despite the apparent differences in regulation across industries, several common themes appear in all RPI- x regulation. Predominant among these themes is the long interval between periodic reviews. If the interval is too short the regulated company will try to influence the regulator's decisions rather than to increase efficiencv because the framework is unclear. Although the detail and emphasis on quality will varv considerablv ~other common feature is that some control will always be necessary to avoid creat- ing'an incentive .t~ produce a cheaper basket of products. An additional unportant feature is that whe:l price controls are set. the\' reflect forecasts of the rate of return and other financial ratios rather than actual levels. This calculation should not cause difficulues ii the company keeps its costs under control. The inclusion of the rate of return in some of the formulas can lead one to believe that not much differ- ence exists between rate-of-return and price-cap systems. That is not the case. For example, when prices are reset fonowing a periodic reVIew, companies that have achieved exceptional profits should expect tighter.r factors so that, over a period, they are likely to return to normal rates of profit. Thus, the x factor preserves incentives and mimics the way in which a competitive market would work. Regulators, on certain occasions, should extend or curtail their control. Although the BT regulatory system was supposed to be reduced as competition increased, in practice the controls have become more detailed and intrusive. Overall, a Ganger exists of the RPI-.r system becoming excessively detailed and intrusive. How does the practical experience in the United Kingdom meet the objectives lisced at the beginning of this section? The price limits have always been effective, so that the system has clearly prevented the abuse of monopoly power (except to the extent that x factors may have been set too generousl y). There has been controversy over the limits on management's freedom to rebalance tariffs in telecommunications and to adjust prices of gas. However, no serious suggestion has been made that investment decisions are being distorted in major ways. More research is needed beiore it is possible to detennine whether the cost of administering this form of regulation is excessive. One obVIOUS fact is that as more regulators intervene, the system becomes more costly. Alternative Designs Several less common types of basic (price setting) regulatory design also exist. and they are dis~sed next. Incentive Regulations Incentive regulatiOns, which are variants of price-cap regulation. involve more complex rules or addi- tional incentive clauses. Incentive regulatory mechanisms include automatic rate adjustments, optional tariff menus, and profit sharing. In the United States, incentive schemes linked to performance standards are becoming more common for electric power plants. A specific standard of plant performance is estab- .: lished. If performance is above the standard, rewards are granted to the firm, but if performance is below the standard. penalties are levied against the finn. Joskow and Schmalensee (1986) report the case of the scheme imposed by the Arizona Public Se~ce Company on its Palo Verde 1 nuclear plant. The target is the plant's capacity factor, or the actual amount of electricity generated by the plant divided by the amount Cr~atzng tht Detazl Engmunng of RegulJwon: Pnce-Sct:mg PO/lOtS 8~ it could generate if it ran continuously throughout the year. Ideally, because of the low costs of running a nuclear plant. the capacity factor should be high. The incentive scheme is as follows. r\o penalty or reward is given if the capacity factor is between 60 and 75 percent. If the capacity factor is between 73 and 85 percent, the company is rewarded by 50 percent of the fuel cost saved by running the plant more. If the capacity factor is between 50 and 60 percent, however, the company is penalized by 50 percent of the fuel cost incurred by running more costly plants (Viscusi, Vernon, and Harrmgton 1995). Other incentive rcg-ul.ltions in the United States .lIlow telephone companies to ret.lir. .:l share of the ea.r7i..i:.g3 ::-. exec.:;.; c: a given rate of return. Yardstick or Benchmark Regulation Yardstick regulation seeks to introduce competition in single-firm market environments to induce effi- cient behavior. Market discipline is introduced by comparing the performance of similar firms in differ- ent markets to the performance of an efficient prototype and by basing the allowed profits on the regu- lated finn·s relative performance. The advantage of this type of regulation is that it introduces competition that fosters incentives for efficient behavior and eliminates the adverse effects of common risks (relatIve performance standards). For an analysis of relative performance mecharusms, see Bhattacharya and Guasch 1988. This type of regulation is being used in Chile and Spain. Similarly, in France, the performance of water companies across the country is compared in order to establish rewards and thus regulation, while in the state of Mississippi, the allowed rate of return for power companies depends on their performance relative to comparable utilities. Regulation by Threat An alternative form of regulation is the absence of any form of direct intervention in setting the param- eters that constrain the behavior of a firm, but with the proviso that the regulatory bod y reserves the nghr to intervene if it decides that the actions or prices chosen by the utility are creatmg Significant distortIons or welfare losses, according to specified criteria. The principle behind this form of regulation is that the threat of intervention will create incentives to comply with general efficiency principles. In the game theory lexicon, this is a tit-for-tat regulatory strategy between the commission and the finn. This type of regulation is being used extensively in New Zealand, with reasonable success to date. Another example is the telecommunications sector in the state of Nebraska, where utility firms are not allowed to raise the price of basic local service by more than 10 percent in any year, or the state of Kansas, where telephone companies are allowed to increase rates by 4 percent and to decrease them by 7 percent without the need for a rate case. Beyond this restriction, the state utility commission does not control the operation and performance of the firm unless 2 percent of the firm's customers complain to the commission about the firm's activities. This scheme grants substantial discretion to the agency in determining what sorts of actions or results would trigger its intervention. Decreed guidelines can reduce but not co~pletely e!irm- nate this discretion. No Explicit Regulation At the end of the spectrum. no explicit regulation is always an option. l:iistorically, this was the standard mode of regulation in Latin America when the utility services were provided by state or nationalized firms. .. A current example is French munidpalities, where no separate regulatory agency exists_ As in the case of nationalized or state firms, consumers can exercise their rights by complaining and by voting in mayoral or national elections. Perhaps the most interesting example of no explidt regulation is the New Zealand case, where none of the utilities, whether privately or state owned, is subject to direct regulation. Utilities are, though, subject to several basic constraints. First, there are no exclusive licenses, so that entry into all mar- kets is guaranteed by law. Second, utilities are subject to reporting requirements. 1b.ird, utilities are also 90 r Luis GUJl5ch and Pablo Splll~ subject to the Commerce Act, which limits anticompebtive behavior. Indeed, claims against utilities may be heard by the Commerce Corrurussion if they involve violations of New Zealand's Commerce Act. In that sense, the Commerce Commission may play the role of a super-regulator, albeit without specialized staff or knowledge. Fourth, customers can fHe suits against utilities for antitrust violations. Indeed, interconnection problems between Clear Communications and New Zealand Telecom have been litigated, and only par- tially resolved, through the court system. The fact that the conflict between Clear Communications and New Zealand Telecom was not resolved through the courts has triggered a reconslderation oi the idea of no direct regulation. (See New Zealand Mirustry of Commerce 1995.) Other Regulatory Issues Affecting. the Design of Detail Engineering Other issues need to be addressed to secure efficient price setting, such as rebalancing of tariffs, exclusiv- ity rights, costs of different schemes, resolution of conflicts, and so forth. These issues are discussed in the following sections. Rebalancing of Tilriffs The use of competition in non-natural monopoly segments obviously requires substantial price rebalanc- ing, particularly in telecommunications. Indeed, in telecommunications, the non-riatural monopoly seg- ment is the most used bv businesses and, consequently, has the most distorted pricing. Likewise, the prices of local calls are ~ually heavily subsidized at the expense of interurban and international calls. Similarly, before privatization, the pnces for water and electricity are highly subsidized. are often regres- sive. and do not reflect marginal costs. Introducing competition ought to align prices and costs, substan- tially rebalancing prices and. particularly in the telecommunications sector. increasing local exchange prices. Rebalancing yields Significant economic welfare benefits and removes a big impediment to the development of local competition. The issue is how fast rebalancing should occur. because it has impor- tant economic and political impacts. In the United States, such rebalancing was partially accomplished through a gradual reduction in access charges and a gradual increase in month! y subscriber access charges. In 1984, the FCC wanted to move quickly toward competitive pricing by setting subscribers' monthly charges much higher and access charges for interexchange carriers much lower. The FCC backed down and followed a more gradual process only because of congreSSional threats (Ferejohn and Sipan 1990). The transition toward competitive prices has become a key ingredient in the refonn of teleconununica- hons regulation. In the United Kingdom, free entry into long distance service was not allowed for seven years following privatization of BT, thus guaranteeing a cozy duopoly for BT and the other provider, Mer- cury. In Argentina, long distance competition was also prohibited for a ten-year penod. In Chile, long dis- tance and local service rebalancing was based on a formula that reduced cross-subsidization over a five- year period (from 1987 to 1992). Similar approaches have been used in Argentina, Peru, and Venezuela. In some countries, however, cross-subsidization prior to privatization may be so extensi~e that less- ening it sharply might not be politically feasible, at least in a relatively short period of time. Consider Jamaica, where prior to privatization in 1987, international revenues were 60 percent of total telecommu- nications revenues, while fixed assets fully dedicated to the international segment comprised less than 15 percent of local (and inland toll) fixed assets. Thus, liberalizing international operations would have reduced international prices substantially, affecting the viability of the local operating company. At that time, users on a monthly flat rate paid only USS9 for local calls, plus toll calls. Calls from Jamaica to the United States are priced more than double the ~ost of calls from the United States to Jamaica under or discount plans. Since international calls are based on accounting rates negotiated among the international providers, reducing those rates would be necessary to promote competition in international calls. To compensate for the loss in international rev~ues, real local prices would have had to increase substantially, a feat that few governments would attempt in a highly contested electoral environment. If the demand for international calls has no price elasticity, then liberalizing international calls should re- duce prices 50 percent. A 50 percent loss in international revenue would have to be compensated for by Crrarlng th~ D~tQil Engln~mng of R~gulatlon: PnCi'-S~t~r:g PollCI~s 91 an 80 percent increase in domestic rates. Yet Spiller and Sampson (1994) find that the dema.'1.d for interna- tional calls is relativelv elastic. suggesting that a reduction in international calls could well bring about an increase in total inte~ational revenues. Whether a 50 percent reduction in price would still increase total revenues, however, cannot be precisely predicted. In principle, however, access charges could be set to maintain international calls at their initial levels and then be reduced gradually so that at the end of, for example, a decade, they would approximate the long-run costs of access. On the one hand, if such a transition had been designed, competition in interna- tional calls could have been implemented. On the other hand, the need to restrain administrative discre- tion in Jamaica may have required specifying the evolution of the access charges ahead of time. Such a transition would have been difficult to design, and the process would have required substantial modifi- cation durmg the period, increasing the potential for opportunistic behavior. With the exception of Mexico, where prices were adjusted signilicantly pnor to privatization, most of the telecommurucatiol15 sale con- tracts in Latin America included a time schedule for rebalancing tariffs gradually. The window of oppor- tunity presented at the time of privatization ought to be used to make significant price adjustments. The faster full rebalancing is achieved, the faster competition will develop. As long as some prices differ from marginal costs, protection and exclusivity rights have to be provided at the expense of competition and the benefits it can produce. likeWISe, as competition develops, the operator ought to have the discretion to adjust prices (downward) to respond to competitive pressures. This is often an issue in the distribution segment of the electricity sector, where the trunk costs are distributed across the users. As major users are offered better prices fro~ independent generators, their exodus from the market of the main distributor (if not allowed to match prices) implies higher charges to small users, because the same fixed costs now have to be distributed among fewer users, producing an inefficient outcome. Granting of Exclusivity Rights Further to that point and in consequence, extreme care should be exercised when granting exclusivity nghts. They obviously dete:- competition, and their induced benefits are unlikely to enhance welfare or private sector participation. little conceptual support exists for granting exclusivity rights. If the activity does possess natural monopoly characteristics, it has de facto exclusive rights, and granting exclusivity rights de jure is not necessary. If the activity does not possess natural monopoly characteristics, no justification exists for granting a legal monopoly through exclusivity rights. Exclusivity rights should only be contemplated in situations with significant coordination problems or transaction costs (or signifi- cant risks), such as central dispatches or lOgistics. Exclusivity rights are sometimes justified because of (universal) service obligations, with implicit or explicit subsidies to certain groups or areas. Again, this is a weak argument. Institutionalizing cross-subsidies is better handled either with transfers specifically to the operating company or preferably with transfers directly to the targeted consumers through vouchers or income tax credits. This ought to eliminate the need for cross-subsidization. Although potential investors prefer exclusivity rights, the absence of exclusivity does not deter their partidpation. The examples are multiple. New Zealand Telecom was successfully priva~ed in a policy environment of open entry in all market segments. The same was true in Qille, as illustrated in box 5.7. In the Philippines, foreign investors such as Nynex, Cable & Wireless, and Telstra have entered the market as competitors or as partners of competitors. In Mexico, a large domestic cellular operator with support from Bell Atlantic has proposed installing a fixed wireless network to serve 1.5 million customers. In southern India. US. West has proposed a telecommunications build-own-operate scheme and has not asked for an exclusive franchise. Investors have accepted competition in telecommunications in Australia, Malaysia, Sweden, the United Kingdom, and the United States, and in the cellular market in almost every country. Complexity and Administrative Capabilities An additional criterion for distinguishing among alternative regulatory schemes is the intensity of the administrative demands they impose on regulators. Admin.istrative intensity is a slippery notion, with 92 J LULS GUiZSch and Pablo Spll/~r Box 5.7. Chile's Opm TelecommUrtlCatlons Market In 1989, while pnvatlzing EnteL the local monopoly, Chile immediately introduced compennon in long distance and mternational traffic from Telex, and in 1994 It opened the market completely. A scheme allowmg customers to select their carrier by sunply dialing a three- or four-digit company code and then the number required (made possible by an almost 100 percent digital network) every tune customers m.a..;..e a call has attracted two Babv Bells and five Chilean oDerating companies and has produced slgnificJn! price competi- tion, dnving dow~ internanonal tanns to th~ lowest lev:l in Latm Am~nca; ~ a result. in 1995 ~ th:ee-minute call to the United States durmg peak hours cost L!SS1.6.J, compared With L;SSJ m MexIco and LSSO I!l Argen- tina. By 1997, it had dropped to nearly LISSl. Source: Authors. two relevant dimensions: (a) how cumbersome, time-consuming, and controversial the tasks imposed are on a regulatory agency and (b) how difficult to understand, and thus to implement properly, is the regulatory scheme. A country's ability to handle both dimensions of administrative mtensity is likely to depend on the quality and technical skills of its human capital. Complex detail engineering soiutions may require a level of adrrurustranve capability not available in the country in question. For example. Chile's bureaucracy and judiciary have a level of sophisticated regulatory training that is unlikely to exist in many other developing countries. Such traming 15 crucial for understanding the nature of a regulatory system and for determining whether computed prices ap· proxunate those of an efficient firm. Further, because disputes will naturally arise, inilividuals involved in resolving them must understand and evaluate competing proposals. Although Chile and many Asian and Latin American countries have a large number of well-trained professionals who can perform those tasks appropriately, this may not be the case in all countries. Accordingly, sophisticated detail engineer- ing like Chile's may exacerbate contractual costs between the government and th~ fum, iurther reducing the incentives for private sector investment. By either dimension of administrative intensity, RPI- x emerges as a simple regulatory scheme. Its underlying logic is straightforward, and it imposes only limited tasks on the regulators. Viewed solely from an administrative perspective. it is the hands-down winner. By contrast both traditional and bench- mark rate-of-return regulatory schemes can be administratively cumbersome and technically demand· ing. Benchmark regulation requires regulators to simulate the costs of the best-practice finn; to adapt this sunulation periodically to changes in best-practice technology; to estimate the allowable, nsk·adjusted competitive rate of return; and to calculate a detailed set of prices. Chilean regulators have apparently struggled to implement this system adequately, relying on international consultants to prepare the neces- sary technical material. The complex technical work of benchmark regulation, though, needs to be un· dertaken only infrequently (every five years in Chile). By contrast, a traditional rate-of-return approach requires regulators to monitor the utility's revenues, costs, and capital stock annually to ens!JI'! that the utility remains within the imposed rate-of-retum ceiling. Inevitably, traditional rate-of-return regulation gets bogged down in controversies about what should be included in the capital base against which a utility's rate of return is computed. This problem is bypassed by benchmark regulation, which simulates the prices charged by a theoretically efficient finn. Benchmark regulation falls short, however, in the second dimension of administrative capability, because it requires sophisticated regulatory training to understand and judge whether the prices calculated according to its rules are indeed reasonable approximations of the behavior of an efficient : firm. In Chile, an explicit process is laid out for resolving price disputes between the regulator and the utility. The success of this process, however, depends on the ability of the major actors to evaluate com- peting proposals on their empirical merits. Chile and a number of other East Asian and Latin American countries are well endowed with professionals capable of performing such evaluations. Where that is not the case, the risk of wildly unstable regulatory outcomes is likely to be high. In those environments, price-cap regulation, RPI - x, is a reasonable choice of detail engineering, regarding Crtatmg the Detail Engmeenng of Rt'gui4tlon: Pr.,/!·5c:mg polICIes 93 the criteria of administrative requirements. Rate-of-return regulation is the least desiraole because of both incentive effects and administrative capacity (measurement and morutoring problemsj.ln any event, it should be applied only to the natural monopoly stages (that is, the local fixed-link ner..:ork), allowing competition in the remaining sectors. Clearly preferable overall would be a simplified form of bench- mark regulation that avoids the inefficiencies of traditional regulation but that coule: be evaluated m a relatively straightforward way. The Administrative Cost of Deta.il Regula.tion A consideration in designing detail regulation is that decisions are made in a quasi-judicial environment in which consumer groups. mdustry representatives, and other interested parnes are allowed to present arguments. Because the potential gains from a favorable actIon can be substantial. ranonal interest groups might devote substantial resources to lobbying activities. Crew and Kleindorfer (1985) describe one of the few attempts to measure actual adrni.-ustrative costs of regulation for New Jersey water companies. They found that administrative costs ave:-aged O.8i per- cent of total revenue for large water companies. 5.25 percent of revenue for small comparues. and 0.92 percent of revenue overall. Similarly, unpublished research suggests that regulatory costs t:"pICally amount to 1 to 2 percent of turnover for large regulated companies and even more for smaller on~. There appear to be substantial economies of scale due to the regulatory process itself. The mdirect costs oi regulatIon are much more difficult to quantify. Experience with telecommunications suggests that once market en- try becomes technically feasible, both the regulated firms and the potential entrants ::nay be prepared to expend considerable resources to intervene in the regulatory process. Resolution of Conflicts Concessions or operational contracts in the utilities often span ten years or more ane rouonely include clauses allowing the parties to renegotiate in the event of unforeseen circumstances. These clauses sim- ply state that under certain conditions either party may request a renegotiation of the r-r1ce or terms, with no criteria given as to how the new level or terms should bt;,.set. They foster rent-seeking behavior and exploitation of regulatory capture. Incentives to dissuade frivolous and rent-seeking renegonations should be built into the contract, so that the firm is financially penalized if the renegotiation attempt is deemed inappropriate. In addition, to reduce the concessionaire's leverage and thus its incenti\'e to renegotiate the contract for rent-seeking purposes. overlapping and split concessions should be favored whenever they are technologically feasible (Guasch and Marshall 1993). A further advantage or multiple conces- sions is that they enrich the information set, foster competition, and base rewards on periormance. Agreements on how to resolve conflicts or impasses during renegotiation should be established. In environments where the independence or expertise of the court system is quesnonable. mternational arbitration should signal the government's commitment and should increase the confiden~e of potential investors. Although arbitration should not be the first choice for resolving disputes. any contract that is a complex concessionary agreement must have a mechanism for settling disputes. Two essentlal elements of this mechanism are a forum selecnon clause and a choice of law provision. The forum selection clause governs where the dispute will be resolved. The choice of law provision specifies whlch law the forum will use. Care should be taken to secure proper legal counseling to preempt potential arguments. For example, some legal regimes might not permit a simple contract arbitration to achieve a conclusive and binding decision. The apparent legal basis for the argument is that infrastructure tariffs are a matter of fundamental interest rather than of the parties' rights under the contract and hence cannot be decided in a court of law. Arbitration is likely to be on its firmest legal footing when it is addressed in the statute that sets up the overall regulatory framework. Constitutional and other legal challenges are more apt to arise where the regulatory authority itself decides to submit disputes to commercial or other types of arbitra- tion regimes. It is also essential that there be confidence that tariffs will be paid and governments will support policies to induce compliance. Laws such as those in Mexico that prohibit cutting off service to 94 f. LuIS GU4Sch and Pablo :;pllkr delinquent accounts signal a questionable commi!::!nent to sustai.ning cost-li..'1.kec tariHs a..'1.G .:lre a bar:-ie: to private sector participation and to efficient levels of investment. A second source of conflict is the terms by which new entrants have access to networks and the quality of service provided by transmission-network operators. This is an issue because of economies of scale. Often no more than one network is sustainable, and the operator is often a competitor in the market served by the entrants. Access rules that are clearly entmciated in the contract with network operators can reduce the number of complalIlts, yet discrepancies in interpretatlOn are likely to arise. Transparency, accountability, and consistency must characterize the procedures and decisions of the regulatory agen- cies. In some'cases, the administraove procedures for handling consumer complaints and for resolving disputes between operators and new entrants will have to be modified to meet these criteria. In the event of technical rather than legal discrepancies, binding arbitration by a teclutical committee or a specialized court with consequences exceeding a significant income threshold should be preferred to a decision by the mainstream judiciary system. 'This would improve the speed and predictability of decisions and would deter frivolous complaints. A particularly interesting example is Mexico's 1995 telecommtmications law, which stipulates that interconnection is to be determined by negonation between the parties (similar laws were passed in EI Salvador and Guatemala). If the parties fail to reach an agreement in 60 days, any party may request that the regulator make a determination. The regulator has, in tum, 60 days to make a final determination. Although the law provides for expedient resolution of a key issue for competition, it may be difficult to apply. First, the law does not specify the terms under which the regulator will settle the dispute. Indeed, a practical way for the parties to challenge the regulator'S decision does not exist, unless it is grossly arbitrary. Second, the time constraint on the regulator is not binding. Indeed, Mexico's institutional weak- ness turns what seems to be a reasonably good law into an ineffective law. The law shoulC. have snpu- lated how the regulator is to arbitrate those disputes and the pricing schemes that would limit regulatory discretion. Although the 1995 telecommunications law requires incumbent operators to implement inter- connection tariffs by September 1, 1995, according to rules set by the Mexican regulator, by mid-November 1995, the regulator st;ill had not published the rules under which operators are to do so. The law could have taken the regulator out of the picture altogether by requiring conflicts to be solved by binding private arbitration. Instead, it granted the regulator undue discretionary powers in an enVlfon- ment where the exeCutive is subject to minimal checks and balances. Given the nature ot Mexico's politi- cal hegemony, a preferable approach would have been to insert these regulatory requirements in Telmex's initial license. The reform of telecommunications legisi.ltion would have been a useful tJme to limit regu- latory discretion and potential capture. A third source of conflict is the granting of exclusivity rights, particularly in sectors, such as telecommu- rucations, where technological innovation is difficult to predict. The conflict tends to arise when innova- tions used by third parties affect the activities and revenues of the providers (such as call-back services, bypass options, and so forth) and when exclusivity rights are interpreted. 1bis obviously is one more argu- ment, although not the essential one, for disposing of exclusivity rights in concessions and pn~atizations. Creatll1g the Detali Engineering of R(gu/atIOTl Pnct-Setnng Polrafs Appendix 5 Full Fonnulation of RPI- X Controls for the United Kingdom This appendix, which contains the full fonnulation of RPJ - x controls for the vanous utilities in the United Kingdom, is based on Glynn (1992). British Telecommunications (SA.I) W,::; RPJ'.l - X + Z/ The RPJ - x formula for British (BT) upon privatIzation IS detailed in condition 2.; of BT's license.11us condition sets a limit for price increases for its main inland services that was to apply for five years beginning August 1, 1984. Price increases for business and residential rentals, local calls, and trunk calls weighted according to their proportion of revenue, WI' had to be at least 3 percent (the x factor) less than the retail price index (RPI) (as calculated over the 12 months preceding the previous June 30).lf the actual increase was less than this figure, BT was allowed to carry this credit fonvard for two years, the correc- tion factor Z.. Rental charges for the first telephones connected to exchange lines were excluded begrn- nmg on Dec~mber 31, 198·t when BT's monopoly of such telephones ended. In 1989 the Office of Telecommunications (Oftel) amended BT's license, increasing x to 4.3 per- cent. The carry forward or pnce mcreases is allowed withIn the new control penod (1989-93), but not from the previous period. A 1991 review increased x to 6.25 percent and included international calls in the basket. In addition, BT and Oftel have agreed to an RPI ... 2 formula to limit exchange-line rentals and correction charges. This formula has never been incorporated into BT's license. BT has indicated that it would prefer to be released from this agreement, but both Of tel and the government believe It should be retained. British Gas The price limits of gas charges to tariff customers are set out in condition 3 of British Gas's authonza- tion. The tariff market for gas is for customers using less than 25,000 therms a year and does not apply to larger consumers (the contract market), which are now charged according to an unregulated price schedule set by British Gas. Average price per therm beginning on April 1, 1987, is detemuned accord- ing to the formula: where M: is maximum average price per therm in relevant year t, and RPI: is the percentage change in the retail pnce index with respect to the index published in October in relevant year t and the index deter- mined with respect to the preceding October. P,., is given by the followmg formula: (~. 3) -A PI· 1 = P1-2 [ 1 .... RPk 1 - 2 ] 100 but in reiatJon to the first relevant year, P, _I and P, -2 have a value equal to the average pnce per therm in the financial year beginning Aprill, 1986, minus the allowable gas cost per therm in that year. Y/ is the allowable gas cost per therm in relevant year t, and K, is the correction per therm derived from the formula: 96 J. LuIS Gu.as.:h and Pablo Spll/t!'r where T: -1 equals tariff revenue from tariff quantity i..~. year: - L Q,_; equals tariff qua:,rit;.; in relevant year t - 1; Q, equals tariff quanhty tn relevant year t; M/ -1 equals maximum average price per thenn tn relevant year t - 1; It equals the percentage interest rate in the relevant year t; which, where K, > 0, is equal to the average specified rate plus 3, or where K, < 0, is equal to the average specified rate. Cost pass-through in tenns of allowable gas cost, )'" is an aggregate of the amount paid by British Gas to gas suppliers, subject to certam undertaktngs triat to the best of its knowledge represent no more than the market value. In addition, condition 4 sets a price limit tor an increase of standing charges or the "imposition of charges having a similar effect on a tariff consumer to a standing charge" to not more than the retail price index m the 1:2 months preceding December of the relevant year. British Airport Authority Airport charges are subject to price limits in accordance with airport licenses. This sets limits for five years beginning April 1, 1987. In the case of, for example, Garwick Alrport, it limits the average revenue YIeld per passenger using Gatwick Airport from aIrport charges to an amount not exceeding the maxi- mum average revenue Yield per passenger calculated according to the formula: RPl,-XG] (5A.5) MG, = [ 1... 100 YG,_l- KG, where MG, equals the maximum average revenue yield per passenger using Gatwick Airport in relevant year t; RPI, equals the percentage change in the retail price index over the preceding 1:2 months from September ot the relevant year; XG is the efficiency factor and equals 1; and YG 1 equals the speci.hed t _ average revenue yield per passenger determined by the formula: RPI._1-XG] (5A.6) YG'.l =YG t-2 [1..;. 100 ... SG'.2 where SG ,.: is the allowable security cost per passenger to be applied. KG, is the correcnon per passenger determined by the formula: • _ [TG,_c-QG,_~MGf_2]( 1)= (:>A.I) KG,= QG,_2 l+l(lO where TG , -1 is total revenue from airport charges levied at Gatwick Airport; QG, _~ 15 the number of passengers using Gatwick Airport; 1 is the appropriate interest rate, which is calculat~c! the same as the rate applying to British Gas. Allowable security costs mean 75 percent of the annual equivalent of the increase or decrease 1Il security costs at the airport (or airports) in question in relevant year t - 2, which results from direc- tives certified by the Civil Aviation AuthOrity, divided by the total number of passenger? using the airport in that year. In addition, the total revenue from such charges at Gatwick Airport, when aggregated with total revenue trom such charges at Heathrow and Stanstead, divided by the total number or passengers, does not exceed the maximum revenue yield per passenger calculated in accordance with the formula: (5A.8) MI RP!,-X] = [1 + - - Y I - I - KI 100 ; where the variables have the same meaning as before but are applied to the three airports, as opposed to just Gatwick (and hence the letter "G" is omitted from the title of each variable). ; CrtatlnS the Detail En8'1rTecr'Tng of Regulation: P:-::r-5mmg POilClto 9:" Water The price limits set for the v,,'ater rndustry are contained in the instruments of appointme:1ts under ccndi- bon B. This limits increases in standard charges to the sum of movement in the retail pnce index and an adjustment factor, K, plus an allowance, 2, for the unused allowance from the prevIous tv.'o years. (5A.9) W: £ RPI, -l + K/ ~ 2: WI' the basket of items, is determined by (5A.lO) W, = r: (:'~~:)i) .nil) r: (:~~~). rlj)) + -1 where i identifies unmeasured water and sewerage services, and j identifies measured water and sewerage services. Unmeasured supplies, Am, are calculated by reference to changes in average revenue pe: chargeable sup- pl~~ where the number of chargeable supplies is, in each case, as of December 1 in the year before the charges applied or will apply; whereas measured or metered supplies, B(j), are calculated by reierence to actual con- swnption in a single weighted year. Each is weighted in proportion to its share of total revenue (r). The adjustment factor, K, allows for prOjected real price increases and varies betwee:1 companies. K is set for ten years, although it can, subject to certam conditions, be reviewed at five-year !ntervals. Electricity in England and Wales Price caps for the regional electricity companies are set out in their respective public eiectriciry su?ply licenses. These are set out in condition 3. There are three basic charge restrictions, or which the basic formulas are: Initial restriction of distribution charges (condition 3A): (SA.ll) 1'\1 111 = [l . . RP:~~Xd] P,II_I'A/-Kill where Mdt is the maximum average charge per unit distributed in relevant year t; RP!. is the percentage change in the retail pnce index; X,; equals various charges, for each regional electricit;.' company, between oand 2.5; P J , -1 is the amount per unit distributed; At is a tactor in respect oi distributIon losses; and KJ! is a correction factor, Initial restriction of supply charges (condition 3B): (5A.12) M.,= [ 1~~ RP[,- x.] P,,_,+Y,-K., where Mil is the maximum average charge per unit supplied in year:; X, equals 0; RP!: is the percentage change in the retail price index; PSI -1 is the allowed amount of supply unit category; Y: is the allowed costs of electricity, which include the fossil fuel levy and transmission and distributIon costs; and K is a correction factor.' ;r In addition, condition 3 places supplementary restrictions on supply charges to regulated customers (those receiving 1 megawatt [MW] or less). This states that for the first three years the licensee must ensure that the average charge per regulated unit shall not exceed the maximum average charge, M, in accordance with the formula: 98 {. LuIS G~ch and Pablo SpllIt'T' where RPI, is the percentage change in the retail pnce index, p~, _I is the amoW1t per unit supplied to regulated customers in the previous year, and Frn is the fossil fuel levy per unit supplied to regulated cu..stomers Initial rest:-i.:t:i.o1Z OJ! transmission charges (conditiou 4.4.): The regional energy companies are joint owners at the National Grid Company, which also faces price caps in its transmission license. The charge restrlctions are set out in condition "* of the license and are determined according to the basic formula: _ (~A.14) M, RPI~-XJ] = [1 + - - ' Pr-l . G-Kr 100 I where M, is the maximum average charge per kilowatt, P, _i is the price in the previous period, G( is a weighting factor of system maximum ACS demand, K, is an adjustment factor, and Xg equals O. G, is calculated in accordance with AQ. (5A.l5) G, =Q where AQ, is the average system maximum ACS demand over the five-year period, : - "* 15 equal to t. and Q r is equal to the system maximum ACS demand in the relevant year. 6 Creating the Detail Engineering of Regulation: Access Terms and Pricing in Network Industries Setting and implementing tenns for and the pricing of access to networks, such as elecmcity rransrrus- sion, local telephone exchanges, and railroad rolling beds, has proven to be the. key em.erging regulatory issues in Latin America and the Caribbean region and elsewhere. Technologtcal mnovatlOns have brought into question the economies of scale associated with some components of the production of utility ser- vices. Significant economIes of scale are related to the transmission, but not the generation, of electncity. In communications, economies of scale exist in local exchange servIce, but not U1 long distance servIce. This understanding has fostered the push toward facilitating competItion in the non-natural monopoly segments of the production of utilities services. Because the network component of the production line has (for the time being) natural monopoly characteristics, it needs oversight and regulation. OthenvlSe, incumbents or network operators might deny new entrants access at iair terms and conclloons, resulnng in market foreclosures, bottlenecks, and rents in key monopoly essentials facilities. The natural monopoly argument does not imply that complete systems of infrastructure need to be owned and managed by a single firm. Complete systems, for example, a telephone system, may be com· posed of several small interconnected systems that are each the sale provider in a parocular geograprucal area. Examples are telephone franchises in Finland and Hungary (56 small systems), gas transmissions in Germany, railways in the United States, and road systems managed by different regional government entities. Issues such as interconnection and terms for access to networks and vertical integration options are critical to fostering competition and to reducing market dominance. Network operaong comparues are dominant players in the local loop, which is an input into the provision of their own interexchange services and those of their competitors. Similar structure exists in the transmisSIon segment of the elee· tricity sector. Regulation should ensure that access charges promote an efficient structure of production, use, and consumption; allow network operators to make a sufficient return; provide incentives ror needed expansion of the network; and promote efficiency on the part of the network operators, while avoiding unnecessary construction of duplicate networks. The impact of these terms on the final cost to users, and thus on social welfare, can be quite Significant. In telecommunications, 45 percent of a long distance company's operating cost in the Uruted States is for access to telephone lines, access to the network, that is paid to the local phone companies that control the network. Similarly, in the United Kingdom, 51 percent of Mercury'S total costs are interc,?nnection fees and settlement rates that are paid to other operators and networks. Aside from prOViding the quality of connecting calls (which is an issue in itself because the network provider and external users or the net- work often compete in the same market), interconnection fees are often contentious, because the regula- tory framework is frequently vague on the subject of interconnection fees, which companies typically justify on the basis of reasonable costs. Those costs can be calculated in several ways and disputes often take months, if not years, to resolve. Should they include marginal cost, full cost, replacement cost, or opportunity cost? Indeed, complexities exist in apportioning costs into line-sensitive and traffic-sensitive areas; peak and off-peak hours; central business district, metropolitan, provincial, and rural areas; and different areas of the network hierarchy. Yet, methods are available for approaching the problems and securing second-best solutions. One of the key issues of interconnection or access policy is the set of rules under which interconnec- tion is negotiated. For example, when interconnection involves a collocation agreement, what power 99 100 J. LULS Guascn and Pablo Spllit'1" does the government have to impose conditions on a regulated firm? VVhat is the proper roie of antitrust legislation in providing a framework for negobating interconnections? The court fight between New Zealand Telecom and Clear Communications illustrates a fundamental problem with interconnection that is not mandated bv the rerulator. Likewise, the introduction in Chile of a mulhcarrier long distance .. • 0 telecommunications service, offering a range of services second only to those in the United States, has not proceeded without problems. The country has experienced total shutdown of the network, occasional blockJge of c=m?e:itors' dia1..i.nt; codes by the r...l!r. ;;.lsic c.lrrier, ane lent; delays ir. cor.. -.ecti.."1g diillec calls. In Mexico, as the Telmex monopoly in the provision of long distance service withers (it expired in 1996), the terms for interconnection to the local exchange are being hotly contested. Regulators from the Communications and Transportation Ministry rejected, quite appropriately, the Telmex plan for estab- lishing ten interconnection points. Instead, the regulators approved a plan for establishing 200 such points to be a\'ailable bv the year 2000. The key issue is to define the terms under which the privatized Telmex will face compehtion:.A..s of 1997, two new finns, Alestr-American Telephone &. Telegraph (AT&T) and AvantreI-MCI, both joint Mexican-U. S. consortiums, have entered the long distance sen'ice market, and prices for border calls are beginning to fall from their current US$O.30 a minute. The reluctance of incum- bent operators to open the network to external users is not surpnsing because significantly lower rev- enues are expected to accompany such a move. For example, in telecommunications, the estimated loss of revenue induced by an equal access poliCY, an incremental loss of 5 percent of traffic due to the ease in SWitching providers, is around 20 percent. A low interconnection rate that causes a 15 to 25 percent loss in international traffic can decrease revenues more than 50 percent (Beardsley and Patsalos-Fox 1995). Setting standards for interconnection is essential to fostering parity and effective competition. Chile's telecommunications market is an example. Chile's multicarrier system in the long distance and interna- tional telecommunication market allows users to access any carrier at any time by simply dialing a code before the desired number. This framework enabled one of the new service providers to claim 16 percent or the Chilean international service mark.et after only seven months of operation~ The absence of direct or indirect costs associated with switching operators makes the price of service the major factor guiding customer choice of operator and ~ances competitive behavior. With free entry and an almost 100 per- cent digital network that allows for clear standards, seven new firms have entered the long distance market, bringing the price of long distance calls to by far the lowest levels in Latin America. Otherwise, the carrier operating the network has incentives to engage in unfair competition by urmecessarily delay- ing connections and by interfering with the quality of those connections. Imposing standards, such as minimum average differentials in connecting time and quality between the connections or the main car- rier and those of other carriers, is critical. Ukewise, issues such as collocation, divestiture strategies (for example, proposals made by companies such as Rochester Telephone and Ameritech to trade greater access for greater regulatory freedom) ought to be considered as well. At the other end of the spectrum, the access charges that were imposed by the Federal Communications Commission (FCC) when the Bell System was divested in the United States illustrate the problems with solutions that are unilaterally mandated by the regulator without proper attention to market conditions and alternative delivery technolOgies. Pricing interconnection as an intennediate service or bottleneck facil- ity should ensure that neither the incumbent nor the entrant is disadvantaged by the pricing structure. Moreover, in the context of alternative delivery systems, such as the alliance between AT&T and McCaw Communications or the bypass of the exchange carriers by companies, such as the subsidiari~s of TeleCommunications Inc., the correctaccess prices become vital to ensure efficiency of the total system. The worldwide trend toward privatization and deregulation of public carriers raises these issues in a broader context. An example is communications in the United States since the breakup of AT&.T. While in 1984 only 3 percent of US. telephones had the ability to access, under equal access conditions, more than one long distance carrier, by 1991, 90 percent of telephone lines had such ability (Mitchell and Vogelsang 1991). Interstate access rates have been falling in the United States from an average of US$O.173 per minute in 1984 to usSO.on in 1991 (Mitchell and Vogelsang 1991). The state public utility commissions regulate access rates fer intrastate calls, and today these calls average USSO.105 per minute. At the same Crt!11tlng th~ D~taJi EnglT'l~mng of R~gulatlo": Access Tt'nTIs and Pncmg Ir: NU·.JJori< 17tdU5rn~s 101 hme, telephone users pay rno~t..l-Uy flat access fees that irlcreased from L SS1.00:""". 19~ to t:SS3.5C i.."". :99i T (Mitchell and Vogelsang 1991). These access charges constitute a large percentage of the retail price of long distance telephone calls and are vital to the financial viability of local operators. Approximately 27 ·. percent of local loop costs are recovered from monthly and interexchange access charges. Because this access charge compensates the local exchange carrier for what essentially is a fixed cost, the access charge creates a distortion by reducing long distance volume and by promoting bypassing of the local loop. (Mitchell md Vogelsang 1991.) For example, since AT&T's price fo: an SOO-rr..il~ o=-:e-r..i..-.;.;.:e ;:.111 is CSSC.S::::3, the access charge of USSO.Oi2 is approximately one-third of the total cost. Appropriate pricing and terms of access are key to the development of a competitive market (see box 6.1). Similar issues appear in other network industries such as power, gas, and railroad. Issues, such as pricing and tolls, timeliness in connectlons, service quality, and the rights of independent users, ought to be clearly spelled out for both network operators and independent producers in the concessionary con- tract, as should a process in the event of disagreements. For example, one of those rights in the United States is equal access. Telephone users who are served by a dominant local network operator can access any long distance carrier (interexchange carrier) by dialing the same number or digits, through the same technical arrangements, and with the same quality of service. In the United Kingdom, a carrier other than British Telecom (BT), say a cellular operator, may be unable to agree with BT on technical or finanCIal Bor 6.1. Intmonnectron in Independent N~tworks Network access for independent producers is key to fostering competition. Users oi infrastructure systems, such as telephone or electricity transmission lines. gas pipelines, or time slots on rail tracks, are interdepen- dent in the sense that they 1n.t1uence each other's marginal costs of access. This create:; a campi ex problem or pricing user access to a system. Such pricing is particularly important where infrastructure systems are be:.ng unbundled to allow users more options. Interconnectlon in networks 15 important for the follOWing reasons: • Increases supply of network services by extending the geographic area of coverage and increasing re- sources (capital, expemse) in the network sector • Improves the performance of the sector by introducing and intensifying competition, resulting in lower- cost services. a broader range of services better matched to market tastes, and innovation in sennce supply • Increases the value and productivity of the network infrastructure, resulting in a positive consumptlon externality and increasing network traffic (utilization). Key analytical concepts in the interconnection of networks are • interconnection is an essential input to production that is ohen a bottleneck input that the competing finn cannot easily produce itself, such as access to telephone subs..--ribers or electncity users in diiierent geo- graphical areas. • interconnectIon requires a degree of continuing operation between the two operators that 15 unusual m ordinary purchaser-supplier relationships. • The network suppliers are often unequal in the size and value of their markets and in the extent to which they integrate network components and services. Policy optIons in the interconnectlon of networks are • Do nothing: laissez-faire. • Establish a right to tnterconnect, with terms left to negotiations; pass ann trust (competltlonllaws to limit abusive behaVior. • Publish the terms or negotiated agreements; impose terms by regulatory action if parties fail to agree. • Have the regulator or legislature establish terms and conditions by tariff and set the quality of service delivered by the network operator to other carriers comparable to its own. • Establish public service obligations for interconnecting firms. Sourrt: Adapted from World Bank (1994). 102 I LuIS Gu.Jsch and Pablo Splll~r ar!"J.ngements for interconne::::o:1 to BT's net'l.\'ork. If so. they may apply to the regulator. Office of Tele- communications (Of tel). for a binding decision fixing the terms for interconnection. The failure of contracts to provide clear rules for the tenns and pricing pertaining to access has been and will be one of the most common and critical problems affecting Latin American regulatory regimes. At best. policies prohibiting vertical integration across monopolistic and competitive segments of the production cycle have been established to facilitate competitive access tenns and to eliminate conflicts of interest. The threat of market foreclosure to upstream competitors has led to a policy of unbundling, or separating, the stages of utility production in some countries. For example, US. local telephone service providers are not allowed to enter the long distance market unless they have opened their local markets to competition. This is not the case in Latin America or in the United Kingdom. Most Latin American countries allow exclusive provision of a full range of services for a limited number of years. Granting long distance service monopoly rents was, arguably, essential to the privatizatIon of telephone companies and has been used to secure investment commitments and subsidization (which will eventually be phased out) of local exchange service. In Argentina, Bolivia, Peru. and the United Kingdom, electricity transmission compa- rues cannot enter and compete in the electricity-generation market, but they can in Chile. Yet, prohibiting vertical integration, without providing clear tenns for access, is not sufficient even in the most advanced and capable environments. . Creating Competition Through Interconnection: Pricing of Access Technological improvements have led to a new set of issues in the area of public utility regulation. Some utilities no longer qualify under the natural monopoly rubric and, as such, should face differ- ent constraints from in the past. In telecommunications, for example, interconnection charges will clearly playa greater role as competition develops in local segments and networks proliferate. Policymakers have taken one of two approaches in responding to these developments. The radical approach has been to break up the vertically integrated dominant firm and to prohibit the essential facility spin-off from reentering the competitive market. This is the salient approach in the power sector, where both generating and distributing companies are forbidden to participate in the trans- mission segment of the cycle, precisely to prevent market foreclosure to competitors or inferior qual- ity of service. The divestiture approach. while helpful and often quite approp.,riate, is often criticized as ignoring economies of scope or as being cumbersome. A more common policy consists of preserv- ing the vertically integrated firm as a monopoly, while regulating either final prices to consumers or access prices to competitors (or both) to promote competition. The best conceptual analySIS is pro- vided by Laffont and Tirole (1994), who give a simple account of the theoretical recommendations. draw policy implications, and analyze current practice and policy proposals in this light. The follow- ing analysis is adapted from their work. In recent years, a broad array of recommendations and practices has been suggested to increase com- petition. Entrants typically argue for a cost-based access charge, such as a long-run incremental cost of access. Although this approach was adopted in Australia for telecommunications, it is wideiy accepted that marginal cost pricing of access keeps the dominant telephone operator from recovering the fixed costs of the nel:\Vork or the deficit stemming from the universa1 price constraints. Many regulators and economists have suggested using, instead, long-run incremental cost plus a markup to allow recovery of the access defici t. Two main questions really exist. What is the theoretically correct benchmark, and how can theory be translated into a workable policy? Although cost-based rules are advocated as more practical, most economists consider use-based arguments more theoretically legitimate. For example, Baumol and Willig (1981) advocate the efficient component pricing rule (ECPR) as the logical implication of their theory of contestable markets. Laffont and TIrole (1994) support the idea that use-based rules are the proper theoretical benchmark and discuss the practical difficulties in implementing such rules. They develop a theoretical framework in which to assess cost- and use-based rules and offer a Cr~armg tk~ D~tali £ngmrmng cf Rtgl.llatrOM: I'kC~S5 Trrms and Prtong in N~:-../.·C"k industnes 103 new and simple policy for interconnection. This policy's main attraction is that it follows the theo- retical precepts. And, a'lthough it imposes some informational demands, it requires no more information than existing schemes. The policy consists of regulatmg the owner of the essential facility according to a global price cap, which includes both access charges and final goods prices. By decentralizing price decisions, including those relative to access, a global price cap implements the optimal Ramsey price structure conditional on the firm's knowledge of its demand and cost struc- tures. it does not require the regulator to measure margmal costs or to estimate demand elasticitIes. The key msight provided by Laffont and Tirole (1994) is th~t the mclusion of access prices in the price cap, making it a global price cap, reestablishes the symmetry between access goods and final goods and partly reconciles the hrm with the existence of competition. There are tw.o versions of the global price cap: the plain version and an enriched version, in which the ECPR derines a ceiling on access pnces. The structure of the global price cap for a telecommunications finn is shown below and is based on Laffont and Tirole (1994). Set Up Assume that a monopolistic telephone operator fully controls the local network and faces competition from at least one competitor iIi the long distance market. Let qr and qc represent the qua.'i.tity of local calls requued for the long distance calls of the monopolist and the competitor, respectively; qo represents the quantity of purely local calls: and Q represents the sum or these three quantitleS or the total amount of local call units required for all calls. If all long distance activities exhibit constant returns to scale, then the total costs will be the margmal cost times the quantity. Using a hxed cost, k(" in the local network, the cost equations would be as follows: (6.1) Co =coQ + ko for the local network of the monopolist C) =crqr for the long distance network of the monopolist C: =c q: for the long distance network of the competitor l Prices to consumers are PiJ ror local calis, PI for long distance calls carried by the monopolist, and p. for long distance calls carried by the competitor. To use the local network, the competitor must pay' the monopolist an access charge oi a. Because the competitors have no market power, they will charge their marginal price oi P: =Q + c:. Three Common Pricing Rules The most common approach is the fully distributed costs method under which costs are allocated accord- ing to some mechanical accounting rule. For example, one might divide the fixed cost by the total usage and add that quantity to the access fee and to the price that the monopolist can charge for local and long distance calis. In this modeL the benefits earned by the monopolist from proViding loca~ service. long distance service, and the access charge to the competitor exactly equal the fixed costs for the monopolist of maintaining the local network. One can also use price (or marginal cost) proportional markups instead of the quantity proportional ones used above. This method is known as the Allais rule. Fully distributed cost pricing has met with its share of opposition from economists. It does not encourage cost m.in.imiza- tion because it is cost based and, therefore, subsidizes less elastic demands at the expense of more elastic demands. It also does grant sufficient flexibility so that firms can make efficient allocations regarding -.. . large customers. Finally, it encourages inefficient entry in the competitive sector. Box 6.2 provides a more technical description. To avoid these problems, some regulators have opted for a use-based rule, which forces entrants to internalize the opportunity cost of the monopolist, that is the forgone profit from allowing others access to a particular segment of the network. Oftel in the United Kingdom designed one of these use-based schemes. Under this rule, competitors pay a tax or access deficit contribution to the monopolist in UN J. Ll.llS GLIi1.Sch and Pablo Spill" Bo% 6.2. Fully Distnbuted Cost Pricrng The variables are defined in the sectlon, Se~ Up. Prices are computed as follows: Po = co'" kofQ PI =(co'" kofQ) ... 'I p. =/J'" c. a· ::,o .,. k IQ 0 Benefits or variable profits are computed as follows: Bo =(Po - (0) qo LocaJ calls . B\ :: (PI - Co - cl) ql MonopoHst's long dIstance B: :: (a - co) 'i1 Competitor's long distance In this case, the total benefit equals total cost so that the monopolist's budget is balanced: Bo'" B1 .,. B: = (k/Q) • (qo ... q: .,. q1) :: ko The Allais Rule is Po:: co'" 0 Co Pl :: (co'" 'I) ... o_(co '" 'I) a :: co'" dc o For this rule, the coefficient of proportionality, 0, is chosen to satlSfy the following budget constraInt: = (1 ... 6) ['0('10'" '11'" 'I:)'" ',"1,] kg ... 'o(qo'" "1 1 '" "1 2)'" c,ql Note that under this marginal cost-proportional markup. meffiaent finns can enter because :..'ey wlll make profits even if c: > cl ' as long as: a .,. ': :: 'il ... 6) ... c: :: PI - [(1 ... 5) 'I - ': <: PI proportion to the profit that the monopolist (Bn would have earned. The deteI'lltination of the access deficit contribution can only be based on historical data or on forecasts, not on actual usage at the tlme. Of course, this applies to all the rules, whether they are cost or use based. 1bis rule also allows the regulator to define different access charges depending on the product supplied. For example. Oftel setS different prices for national and international calls, with the latter being more costly (see box 6.3). This is not a price-setting system for final consumption, but simply for access (to allow and yet to regulate competition). Consumer prices are set using a partial price-capping system that will be dis- cussed in the section on global caps. The system is a partial cap because the basket of goods that it regu- lates includes only the final goods, while the price of the intermediate access good is determined by the formulas in box 6.3. As a final note. when the monopolist's budget is balanced, the access p~ces exactly equal the opportunity cost, so the external and internal costs are the same. This means that, under a balanced budget, the Oftel rule is the same as the ECPR (see box 6.4). The ECPR sets the access price equal to the net benefit earned by society when that service is provided competitively. Baumol and Willig (1981), among others, have repeatedly stressed that the proper yardstick for defining access prices is that of the perfectly contestable market and that the supplier must be permitted to charge enough for the good to receive compensation for the sacrifice caused by supplying another fum. The ECPR defines in effect an upper limit for access prices because it still allows the incumbent vertically integrated operator to make excessive profits. A lower bound is set by the marginal cost of granting access to the network. The marginal cost may, however, fail to compensate the network operator for the fixed costs of maintaining the network. Such costs should also be incorporated in the access price as possible in the form of a two-part tariff, with a fixed charge covering network set-up costs, includin~ ~ne cost of capital, and a variable cost covering the short-run cost of access. Then. such an access price wOt.. ...: be equivalent to Crt!atmg the DetaIl Engmunng of Rt!gulatlon: Acct!ss Terms and Pncmg ITt f\:'~.J.Iorl: Jl1dustnes 105 Box 6.3. Use-Based Pricmg (the Oftel Method) The access charge under the Ofte! rule is: a =Co + ADC (access deficit contribution), where ADC =(kclqt) [B/(B o " B\ .. B2 )] This formula can be generahzed ror multiple competitive segments with different access pr.ces io., each segment. Of tel. for example, currently requires the competItor. :v1ercury, to pay separate access :-ates ror na- tional and intemational calls: at =Co + (kolq) [B/(B o " Bt .. B~ ... B) - B.)ja = Co" (kolq) [8/(Bo - B; .. B: .. B) ... B.)] Q) B =(p -c -c )/q is British Telecom's (BT's) profit on itsownlJ1temational calls,B 4 is profit on the competitor's margmal d . calls, P is 0the 1markup charge on the calis, L, IS the nonloca I ' cost, an qJ IS th e lJ1temanoN j output. ) 1 3 The inclusion of BT's profitability means that access for intemanonal calls is higher than access for national ones (a >a ) because the benefits from Mercury's access charges become B: =(a t - Co )/q2 for domesnccalls and 3 1 BJ =(a l - Co )1 q4 for intematioNI calli, where q. is Mercury's internatIOnal output. . , Assuming that the monopolist's budget is balanced: Bo .. B; ... B: ... B) + B 4 =ko and the rarmulas tor the access charges simplify to: at =(co+B\)/qt=pj-c l a) =(co +B)IQ3=P,-C) Box 6.4. The Ejficirnt Compcmrnt Pricing Rule The efficient component pricing rule (ECPR) equates the access pnce to the difference betwee:t ~,he !:',anopolist' 5 pnce and the marginal cost on the competitive segment. or the difference between the net benefit and margmal cost of providing access: a = PI - ci =cO'" [PI - (co'" cl)J The more general form would be: Q =c'o + [PI -(co'" cj)} =pj-c i + (c'a-col where the cost of providing access to the competitor, ,'0' is not the same as the cost for the monopolist ;:;(j' the ECPR without compensating the incumbent for loss of excessive profit. One of the expected social benefits of charging the opportunity cost is that the rule sends the right signal to entrants. Unlike U1 a cost-based system, companies can only enter the market profitably if they are more efficient than the cur- rent telephone (or other utility) operator at providing the service in question. Another benefit is that entry will be revenue neutral to the monopolist and, therefore, will not interfere with the cross-subsidization of the monopoly and the competitive segment. In other words, it will not be possible for firms to enter the profitable segment and siphon off profits from other segments so that the monopolist can no longer afford to provide less profitable services. This protection, in tum, screens the regulator from the political pressure of politicians who are trying to protect their local subsidies. Revenue neutrality also reduces the monopolist's incentive to skimp on the quality of access in order to destroy the level playing field. An example of how to compute the access price under the ECPR is presented in box 65. . Unfortunately, not all is perfectly settled in the world of the ECPR. The ECPR assumes that all firms face identical cost structures (that they are equally efficient) and that they provide perfectly substi- tutable goods. It also abstracts from incentives so that there is no reason to have more than one firm in the competitive segment. Therefore, entrants must be more efficient than the monopolist, or they would never choose to enter the market. In that case, however, the monopolist would cease providing 106 , LUlS Gwzsch and Pablo Spill" Box 6.5. An Example of the EfficIent Component Prrcmg Rule Town A Route AB Town C price marginal cost mnrginal cost Town B Route BC (average cost (AB) (BC) joint cost access price over AC) Incumbent .3 5 10 20 Efficient 4: 15 19 Entrant inefficient 6 15 21 Entrant This is a simple example of the efficient component pricing rule (ECPR) developed by Baumol (1982) as a principle for setting access prices. In this example, provided by Baumol, a vertically integrated incumbent offersa rail service between towns A, B, and e. An entrant wants to develop a rival rail service between towns A and C but has to pay for access to the vertically integrated incumbent for its bottleneck service between towns A and B (route AB) and will provide the service itself between towns B and C (route Be). The costs of the service are as follows: the margmal cost (assumed constant) of service is 5 for each leg of the route AB and BC in addition. the Jomt cost or servIce 15 10 (an average fixed cost incurred by the incumoent for operation of the entire rail network) so that the average cost of the service AC is the sum of the marginal costs and the joint cost, that is, 20. The incumbent charges the average cost of the service (20), and the entrant charges a price equal to its marginal cost over Be and the access price to AB. As illustrated in the table above, the ECPR states that the correct access price to charge the entrant for the bottleneck service (route AB) is the sum of the marginal cost of access to the bottleneck AB, which equals 5. and the jomt costs or servIce 10 (the opportunity cost of entry to the incumbent). The effiCIent access pnce is therefore 15. This example is illustrated by two entrants. The first. the efficient entrant, has margin31 costs or -t over the route Be. It, therefore, can profitably enter at the ECPR access price of 15 and undercut the incumDent with an average cost of 19, which is less than the incumbent's average cost of 20. If an mefficient entrant has marginal costs of 6 for the route BC, then it will have an average cost of 21, that is, more than the incumbent. and hence will not enter. In other words, the correct access pnce mduces effiCIent entry. An access pnce less than the ECPR (in tius Simple example) will mduce inefficient entry. Access price (under ECPR) = MC(BC) + Ie Average cost (to incumbent) = MC(AB) + MCCBa -+- Ie Average cost (to entrant) = MCeBe) + AP. Sourc~: Klein (1996). long distance service at all because it would earn higher profits by selling those rights without incur- ring any costs. This rule is stark in its predictions. Its main advantage is that, when it works, it avoids inefficient entry. It does so, though. at the expense of maintaining the incumbent's monopoly power over the final good. Economides and White (1995) show that, with reasonable assumptionS about de- mand elasticities and cost disadvantages. the loss in consumer welfare from maintaining the monopoly would overcome the loss from productive ineffidencies arising from inefficient entry. Furthennore, maintaining the monopoly limits the development of dynamic efficiendes arising from competition. (For a discussion of the advantages and disadvantages of the ECPR, see Armstrong and Doyle 1995; Economides and White 1995; Kahn and Taylor 1994; and Baumol and Sidak 1994.) One could, however, build on its insights and on those of its critics and develop a model with actual competition in the competitive segment. To do so, one must allow for cost and demand asymmetries between the mo- nopolist and the competitors and must introduce product differentiation to allow for several competi- tors. This normative framework will help answer the two key questions about the ECPR: (a) What is the proper price reference, P" for computing the access price, and (b) is the ECPR optimal? CreDtrng the Detail £l'TgmeC'rII'TS of Rt'guiatlorr: Access Terms and Pncmg II': l',;~ttt.'ork Industnes 10;" The Optimal Price in Theory In a first-best world, one without constraints, a necessary condition for optimality would be tha: the competitors internalize the margmal cost of operating the local net\-vork, or bottleneck. In that situa- tion, the regulator would set the access price equal to the marginal cost of operating, crY and the rates for final goods would also obey marginal cost pricing. Assuming, on the one hand, that the monopolist also must have a balanced budget, one can calculate the optimal prices for Po' P1, and a. If the monopo- list and its rivals are equally efficient on the competitive segment and the demand is the same for both firms' long distance service (no product differentiation), then the access price will be the same as the ECPR, so a = p -- c . Consider, on the other hand, either of the following two scenarios in which prices differ for the ~o ~roviders. If there 1S some kind of product differentiation (brand loyalty, name recog- nition, or switching costs), then the monopolist will have a certain number of captive customers who will always choose its service if the price difference is small. This advantage will allow the monopolist to charge- PI > P: because not all customers will switch when faced with a higher price. At the same time, the access price charged to the competitor will be lower than under the ECPR because PI rerlects the opportunity cost of a relatively more inelastic demand. Another cause of unequal prices would be if the demand functions are the same but the monopolist has lower costs. In this situation, the monopo- list should be able to charge the public less on the competitive segment than its competitor due to a cost advantage. However. the access charge will be less than that of the ECPR due to the absorption of costs. See box 6.5 for a more complete analysis. The conclusion that access prices should be based on use has been challenged by both regulators and economists who have argued correctly that these rules are difficult to implement. This is true for two rea- sons. First, it can be difficult to calculate the correct prices. Box 6.6 demonstrates some or the calculanons that would be necessary to set optimal rates. TIti..s argument is most accurate if one is discussmg a rapidly changing industry, such as telecommunications, rather than a more stead y industry, such as electricity·, in which the calculations would not have to be redone after each technological improvement. At least as important a point however, is t:hat any complication in setting prices increases the probability of regulatory capture. The more discretion the regulator has, the more eHort (and money) the industry will devote to influencing the outcome. The result may be an inefficient rate structure and a waste of resources in the lobbying effort. For an industry like telecommunications, the only promising way to base a rate structure on demand considerations while avoiding these problems is to allow the monopolist to set prices under a price cap. One can obtain the same results as in the ECPR by impOSlllg a global price on the monopolist provided that (a) the intermediate good (access to the local network) is treated as a final good and included when computing the cap (this is, in fact, the difference between a partial and a global price cap) and (b) the weights used to determine the cap are proportional to the predicted quantities of the relaove goods. In other words. a price cap will induce the firm to use the proper Ramsey prices as long as all the goods are included in the determination of the cap and the weights are fixed exogenously at the level of output expected. This result holds for any structure and allows for substitution between access goods and final goods without requiring the regulator to estimate any demand functions. The gl~bal price cap, despite its apparent advantages. is at odds with standard practIce. For example, BTs cap does not in~ elude intennediate products. in fact, the very debate over access pricing rules results from the general opinion that intermediate and final goods should be treated differently. It is important, therefore, to con- firm the lOgiC of a global price cap. The adoption of a partial cap and the ECPR would bear much resem- blance to the policy of the United Kingdom. The monopolist would maximize profit subject to this cap and would use approximations for anticipated output. Ii the expectations are accurate, the price of local calls will be lower than the Ramsey price, while the price of long distance calls and access charges will be higher. Because the access charge is not included in the cap, the bottleneck segment is subsidized at the expense of the competitive segment. A global price cap, in contrast, will result in Ramsey prices, pro- vided that the weights used to determine the individual prices are proportional to actual output. 108 f. LuIS Gu:aScil and Pablo 5pll/t'T Bor 6.6. Is tile Effic!ent Componf."Tlt Prlcmg Rule OptImal? Assuming no government subsidies (a balanced budget constraint for the monopolist), the optimal prices can be represented by standard Ramsey-Boiteaux ratios (for further details. see Laffont and Thole 1994): (6.1) (Po - col/Po:: [A/n ... 1.)]0/110 ) (6.2) (PI - cl - 'o)/PI = [A/(1 ... i.)J(1/11 I) (6.3) = (p~ - ':2- ,o)/P2 [1./(1 or i.)](1/11~) where Ais the shadow price of the budget constraint and the 11,5 are superelasticities. That is, if the demand for the calls is independent, then the cross-elastlcities will be the same as n~~al elastlCltles. More specifically, if E, is regular elasticities and E.. is cross-price elasticities, then: 11: = E=r(E1E~ - E1:( 21 )/(£:E; - E:E:,)] < E: From the above formulas, one can calculate the access charge as: a:: '0'" rA/(l ... A)l(P/l1:) The question remams whether the efficlent component pncmg rule (ECPR) will obtain these opnmal prices as soiutlOns. Consider the followmg: Case 1. Assume the demand and cost functions of the monopolist are identical to those of the competitor. Then, 1'\1 :: 1'\: and (PI - 'I - ,o)/P1 =[AI (1 + A)](1 l'l) :: (P= - ': - 'o)/P: or a :: PI - 'I :: P: - '2' whJc.h comes from equations 6.2 and 6.3. Under these assumptions, ECPR is the optimal price. Case 2. Assume the monopolist has a1 -a; > 0 captive customers. In this case, the quantities d.emanded will be: q, = Q1- Up1 ... dP: for the monopolist, q: :: Q: - Up: + dp1ior the compehtor. and b > d to reflect the captive customer effect, whJch leads to P: > P: and a < PI - ' I ' In this case, the ECPR pnces are not optimal, and the eificlent access price.1.S lower than that predicted by ECPR. Case 3. Assume that demand is agam symmetric but that the monopolist has lower costs on the competitive 'I segment so that < ':' This inequality implies that PI < P: and that the access price a < PI - ',.In this case, the ECPR access price again overestimates the efficient level. If the mequalities reversed, the relatively meffiaent monopolist would undercharge using ECPR. Globtzl Price Cap with the ECPR Adding the ECPR to a global price cap would yield a partial price cap, but the weights on the prices would be different from those under a general partial cap. Box 6.7 provides a full deScription. Under a pure ECPR, an increase in the final price PI also raises the access price. From the point or view of profit. the price increase affects the total demand on the competitive segment. Under a price cap, the increase only changes the demand for the monopolist's product on the competitive segment. A pa.rti~l price cap, therefore, tends to cause higher prices on the competitive segment, while the global cap results in proper pricing incentives. There are two reasons to combine the ECPR and a global price cap: to facilitate weight setting and to avoid predation. Weights must be proportional to forecast outputs, but a precise forecast may require inionnation that regulators do not have. In practice, weights are frequently based on recent outputs or revenues. BT's weights, for example, are the previous year's revenue shares. To limit the pricing distortions inciuced by endogenous weights and to accelerate the convergence toward. Ramsey prices, regulators operating under a partial price cap must come up with a reasonable forecast of the total demand on the competitive segment and of the market share of the monopolist. Regulators and policy advisers are generally concerned about the possibility that incum.bents will prey on entrants. It is easy for an incumbent to do so under a Simple global price cap by raising the access charge while lowering p /' This practice allows the monopolist to undercut the price of its competitors without losing undue profits. The increased access charge raises the rivals' costs, making it that much Creatmg the DetaIl Engrnet:rrng of RegulatIon: At"ct'Ss Terms and PrICing 1M Ner,•.:ork Ir:.:ustnes 109 Box 6.7. A PartIal Pn,e Cap Using a partial price cap for external prices, combmed with the ECPR price setting for intemal rates. a monopo- list would face the following problem: Max ??? =(po - co)qo - (a - 'o)q: ... (PI - Co - ..)ql - ko =(Po - ';,)qo - (PI - Co - cl ) (ql ... q:) - k~ subject to iJ..·oPo + WI PI s: p, where P 1.S the pnce cap and the ws are weights to determine the :-elarive importance of local and long distance calis m determmmg the cap. Even if one chooses weIghts equal to the .expected outputs so that the constramt becomes qoPo • ql P; :S p, the pnces will not be efficient because the vatue of the access charge is not included. ... " To achieve R.amsey prices, t.~e monopolist's constramt should read qopo .. ql PI .... q:a s: P wn:re theq,s are actual quantities of outputs for the different types or services. nus partIcular setup represents a global pnce cap because both intermediate and final goods are Included. A global price cap with an ECPR-derived access charge a =PI - '1 looks very much like a partial cap, but the weights will differ from the standard ones: qopo .... (ql ... q: )P l :S P'''. more difficult to meet the monopolist's lower price. Without substantial financlal resources, rival finns are forced to exit the market. A more relevant question LS how much the incumbent would actually ben- efit from this sort of predatory behavior under a global price cap. If the potential entral'1ts are financially weak, the predation should prove to be relatively successfuL Competitors will be iorced out, and the incumbent will earn long-run monopoly rents. One way to protect entrants is to make predation less profitable. The ECPR can accomplish that to a certam degree by making it unpossil:He to se?arate access prices from final goods prices. In that situation, the only option available to the monopolist is to increase both the access charge an.d the final goods price. By charging a high pnce for long aLStance while requir- ing the competition to do the same by raising costs, the monopolist may succeed in lowering demand to a point where no firms will enter the competitive market. The difficulty with this strategy LS that it will likely prove too expensive for the monopolist to maintain, The final assessment of an ECPR policy under a global price cap would have to be mixed. A disadvan- tage of the ECPR is that it mav introduce some distortions in the case of asvrnmetric demand or cost functions. From a policy point ~f view, it can be quite costly to implement, bec'~use regulators must verify compliance. Furthermore. the ECPR requires measuring the incumbent's margmal cost on the competi- tive segment which regulators may not be able to do. However, the ECPR can provide a certain amount of protection against anticompetitive behavior and allows for a more efficient choice ot the weights used in the price cap. From a purely practical perspective, the ECPR can be used as an upper bound when real threats of predation exist due to asymmetric industrial structure. If this danger is not present and compe- tition exists between at least two or three strong networks, the additional constraints created by the ECPR may result in substantial distortions, costing the industry and the consumer more than it benefits them. The simplicity of the global price cap may be more illusory than real. Introducing a globai price cap has substantial informational requirements. Regulators have to set prices, or at least price caps and weights, on all prod ucts produced by the incumbent. This provides for continuous regulatory effort and facilitates manipulation of the regulatory process. Finally, in sectors where the setting of global price caps is not feasible as a result of vertical integration restrictions, the best solution would be to implement the ECPR. -. Timetabling: Establishing Optimal Delivery Schedules In the case of power or natural gas, it does not matter whether a customer receives electrons or molecules produced by the supplier with whom he or she has contracted for delivery because the product shipped is sufficiently homogeneous. A different issue arises in transport ventures like airlines, railways, or tele- communications, where freight, passengers, or callers need to reach a particular customer or point in the 110 f. LUIs Guascn and Pablo ~pllln' network. This :"'i1poses a more cC::1plex set of constr:lir,ts on the network optim!z41tion p:-::;iem t.~a..., the requirement that total inflows match total outflows (including storage). For example, if one were to define rIghts to use the rail tracks and allocated them to multiple parties, secondary trading should yield the optimal set of paths given the valuations by producers and consum- ers for the service in question, or, person or good x delivered to point y at time:. The optimal set of paths forms the optimal delivery schedule or timetable. The problem is whether an ophmal t:i.=1etable can be generated th::::::ugh decenr:alized barg:lin:"l'1g :::::r whether J r.,:lrket :..s needed that si.::'::.:lt:..-.eous!y ge:1er- ates the optimal set of paths through the network and the prices for all the paths cor.tained therein. Because the value of each right to use a piece of track at a particular time is dependent on what happens with all adjacent pieces of track, one may need a single optimizing market. A further issue is whether short-run adjustments to the optimal schedule due, for example, to mechanical breakdowns or other emergencies can be made in a timely manner by the dispatch center, or whether the loss or vertical inte- gration translates simply into higher transaction costs. Timetables need not be preannounced. Ideally, transport and congestion prices could be determined through segments of the transport network competing to provide the service. Through demand and supply conditions, prices on individual segments could be set independently and compe:itively. How might this work in practice? Optimal use would be obtained if users of the system faced pr.ces that forced them to use the system optimally. For pricing in a phone system, one might imagine the following sys- tem. The caller would dial. The system would then determine the optimal path at the desired time and quote a price that would appear on the phone, The customer could then conclude the contract by press- ing a yes button or aborting the call attempt. nus would yield a system of spot prices on the basis of which longer-term contracts could be established, enabling callers to have assured call tights at given prices at certam times. Similar access issues exist in the power sector, (and in the railway and gas sectors), '.,'hich also dis- plays network characteristics through the transmission grid. The issues will become eve.. more pressing ..... in the years ahead because between 50 gigawatts and 85 gigawatts of new capacity will be added in Latin America in the coming decade. Most of these additions will be generated from the private sector, which will require access to the transmission network. Several Latin American countnes have legislated power sector reforms to improve operating performance, reduce sector financial dependence on pu.olic resources, and enable private participation. The structure of the sector and the policy envitonment for various Latin American countnes are shown in chapter 11, where power sector reforms are discussed. Approaches to reform differ depending on the structure of each country's industry and regulatory framework. Some countries, including Argentina, Colombia, Norway, Peru, and the United Kingdom, have opted for a sector with mostly separate generation, transmission, and distribution, allowing private ownership of these functions. They seek to establish a highly competitive power-generating subsector by using con- tracts between generators and consumers or distributors to establish market prices for electricity at the bulk level. Price regulation is reserved for open access transmission and distribution grids and for retail tariffs for captive consumers. Other countries, like Costa Rica, Jamaica, and the United States, have so far opted for limited competition in power generation. Independent power producers supply buik power to a monopoly grid owner through a competitive bidding or contract process. In Mexico, legislators passed a new energy law in 1992 providing for third-party ownership and op- eration of power projects, with electricity sales to the Comision Federal de Electricidad (eFE), the na- tional electricity company. Under Mexican law, independent power generation is to be allowed using three vehicles: self-generation, in which facilities are owned by industrial users; third-party cogenera- tion; and stand-alone independent power producers. Electricity is to be sold to CFE at negotiated rates, subject to CFE 's competitive-bidding obligations. Access issues and terms are still to be stipulated. Simi- larly, in telecommunications, the regulatory framework remains quite vague with respect to implementa- tion of essential facilities. The mandatory rules, which were released in 1997 when the monopoly of Telmex in the long distance market expired, remain biased in favor of the incumbent and subject to quality-of-service :nanipulacion. Such unwarranted delays do not inspire confidence or allow for long- CreatTng the Detail Engtneumg of RegulatIon: Access Terms and Pncmg In .\'e:".J:ork lndustnes 111 term planning by potenti.:d investors a.'1ci entrants, or even Telmex, due to the ur,':e:~a:"'1t:; of the f~'1JI terms. In Latin America and the Caribbean (LAC), perhaps with the exception of Dille, the terms for interconnection to the grid have been left iai.rl~' .... ague, and this is and will be a permanent source of conflict and loss of welfare. In Argentina, Chile, Nonvay, Peru, and the United Ki..'1gdom, the power- generating subsector is or will be self-regulating, with basic concessions and operatIng standards the main requirements for generators. Regulation in these countries focuses on transmission and distribu- tion ope!"Jtions, which are commonly consicie!"e:: to be rut1.!:.ll monopolies. Re~"':'!.ltc:-. :"-. :..L...ese subse:~ors aims at providing substitures for market-based competition through the use of efficie!1cy models, pricing and access policies for power transport, and competition for the larger consumer market. In Norway and the United Kingdom, commercialization activities require a license, but pricing for the end consumer relies on market forces. In other countnes, retail distribution tarilis are still regulated. An optlOn is to forego regulation if society were willing to accept monopoly rents, which would always be limited to some degree by competition from substitute products. This is often politically unacceptable. However, a number of sectors exist that are not or are only partially subject to economic regulation. Such is the case when substitute product markets exist and society accepts possible remaining monopoiy rents, as in the examples of railways versus trucks (Argentina and the United States) or natural gas versus petroleum (Finland; Germany; and Hong Kong, China). At present, interconnection contracts in most Latin Amencan countries, which allo\',: private sector par- tlcipation m some stages of the production process, are negotiated between the network provider and the value-added service providers and generating companies. Conilicts have already begun to appear among the involved parties. In general, the current regulatory agencles in Latin America are poorly prepared to handle disputes between network providers and new entrants, particularly on issues such as whether net- work costs are allocated properly in establishing access prices and the quality of ser.1ce provided to net- work users. These disputes will certainly increase as the economies expand and new entrants seek access to the network's bottleneckiacilities, illustrating the unportance of clear access and seI"\ice rules. In the electricity sector in Guatemala, pnces are to be negotiated freely fo;- output generated by the independent power producers (IPPs) and sold to the transmission network operator. In the event of an impasse in those negotiations, the regulators can dictate the final price. No clear guicielines exist on how to set that price. While in principle such a system has some attractive features, it is highly vulnerable to capture on two fronts. First, since the transmission firm remains a state ftrn;,., its incentives are questIon- able, and in principle, its managers can be swayed to offer a sweet deal to the IPPs in exchange for pecuniary 0: nonpecuniary benefit (a recent contract paid US$O.lO per kilowatt to IPPs for output). That fum can always pass the costs to the final users or pass the losses to the state. In addition, the broad discretion of the regulators in dictating the final price makes them vulnerable to influence by either party. 7 Detail Engineering Experiences in Latin America and the Caribbean This chapter examines ho\\' several Latin American and Caribbean countries are undertaking regula- tory reforms in their utility sectors, taking into consideration the requirements across sectors. Some countries, such as Argentina, Bolivia, Chile, EI Salvador, and Peru are well advanced in their reform process, while others, such as Brazil, Colombia, Jamaica, and Mexico, have made and continue to make important inroads. Most of tlu.s chapter provides examples of detail engineering choices, mostly in telecommunications, such as Jamaica's rate of return, Chile's benchmark competition, Mexico's and Venezuela's price caps, and Argentina's price indexation. Table 7.1 illustrates the basic components of price regulation in telecommunications. Rate of Return in Jamaica Jamaica's rate-of-return regulation is a transparent system that provides regulated companies with a 17.5 to 20 percent rate of return on equity, which is not unusually high for international telecommunications operators (British Telecom [BT'S] rate of return is in that range). The regulator may neither disallow investments nor attempt to change the rate of return, and any disagreement between the company and the regulator goes to binding arbitration (as would be the case if the government disallowed some costs). Finally, firms have exclusive licenses to operate in the domestic and international markets for a relatively long period of time. Table 7.1. Price RegulatiDn in Telecommunications, Sample Countries ProductJvzty Pricing Frequency Inflation parameterl Countrv formula of tariff revif!W ad,;ustment rate of return ArgentIna PC Semiannual Indexed to U.S. CPI Partial Chile BM Every five years Indexed to CPI Full Jamaica ROR Company request Indexed to CPI None Malaysia PC Company request Indexed to CPI None Mexico PC Every four years Indexed to CPI Partial after 1998 Philippines ROR Company request None Partial Venezuela PC Quarterly Fully indexed to Partial WPI until 1996. Partial indexation for 1997-2000 PC price caps. 8M benclunark. ROR rate of return. CPI consumer pnce index. WPl wholesale price index. Sourrr: Authors compilation. 113 114 f. Lu/.S GUIlSch and Pablo SpIiJ~' The choice of detail engineering seems, in principle, to fit Jamaica's institutional characte!1sncs. Little regulatory discretion exists, the extent of administrative complexity is limited, and the mamtenance of the cross-subsid\' toward local operations is assured, which facilitates privatization. Tne system, how- ever, could be i~proved by limiting rate-oi-retum regulation to the local network and instituting a more competitive framework for long distance regulation. Although inefficiencies are associated with Jamaica's approach to rate-of-return regulation, the system does accommodate an environment characterized by lack of administrative capabilities and :.nstituhonal characteristics. This situation requires very specific procedures to provide regulatory stability. In such cir- cumstances, the choice of rate-of-retum detail engmeering may be close to the only option available. Refonn of Chile's Telecommunications Sector The perfonnance of Chile's telecommunications sector has been quite extraordinary. Since 1987, the year before the government privatized the main local phone company, the number of telephone lines has risen dramatically, from 581,000 in 1987 to almost 3,700,000 ll1 1997, reflecting a penetration rate of about 30 percent the highest in Latin America. OutgOll1g international traffic amounted to approxunateiy 21 mil- lion minutes in 1987 and exceeded 175 million minutes in 1996, while the mobile telephone system, which started operations in 1988, could claim more than 340,000 subscribers by the end of 1996. The local phone network, which was 37 percent digital in 1987, has been fully digital since 1993. The pnvatlZation of telecommunication firms also led to substantial improvements in their internal effiCiency. as exemplified by the number of phone lines per worker, which rose from 74 to 235 between 1987 and 1995.In addition, the cost of long distance calls is by far the lowest in the Latin American and Caribbean region, due mostly to the competitive opening of the segment. More generally, it is quite impressive that pnvate operators have made over 70 percent of the required investments in electriCity and telecommurucarions. Keys to Success The commitment by privately owned utilities to make significant investments can be explained by many of the macroeconomic reforms, including the relaxation of the financial constraints faced by public enter- prises; the isolation of publiC services from political pressures; and rapid economic. growth, averaging abou t 7 percent between 1986 and 1997, to which privatization itself has contributed. A key factor. though, in explaining the static and dynamic efficiency gains observed was probably the introduction of an ex- pliCit regulatory framework embedded in a law that encourages such efficiencies. The embodiment of the regulatory framework in a law provides for the credible commitment and stability or the regime, an essential ingredient to secure investor confidence and, thus, optimal levels of investment. Chile's new regulatory system includes detailed regulations, with explicit mechanisms for settling disputes between the regulators and utilities, with the judiciary as final arbiter. These regulations were innovative in their use of specific legal provisions restraining administrative discretion. See Spiller and Viana !l992) for a discussion of Chile's electricity regulatory reforms and Galal (1994) for a discussion of Chile's telecom- mWl.ications regulation. The level of detail in the law is such that, in the case of telecommunications, it even stipulates the type of regression to be used in estimating a fair rate of return to the emclent ri.rm (see box i.l). This experience also shows how difficult it IS to write a comprehensive law in a sector character- ized by technological change. Indeed, the telecommunications law was changed several times prior to privatization and prior to the advent of democracy. At the beginning of the 1970s, Chile's telecommunications were dominated by three publicly owned companies: Compaftia de TeltHonos de Chile (CfC), providing local telephony throughout most of the country; Empresa Nacional de Telecomunicaciones (Entel), prOViding some domestic and all interna- tional long distance services; and Correos and Telegraios, providing domestic a: telegram services, sharing the international market with International Telephone & Telegraph (fIT ,;~' . Transradio. All of these companies lacked the resources needed to expand and adopt new technolOgIes. Cross-subsidies Detail E.ngtn~mng E.rpencnces In LAtm Ammca and the Canbbtan 115 Box 7.1. PrIce·Setting Procedures m Chile's Telecommmucatrons MW 1. Demand is first estImated for each service/zone/firm bundle. .''' 2. The efficient firm IS defined as one that starts from scratch and uses only the assets necessary to provide that service. 3. For each service. the !:"!C'!"ementJI cost of develooment is calculated. which IS the long-mY" :-rarginai coc;t (LRMC), provided no lIlvestrnent plans are considered. The law stipulates that regulated companies must have investment plans or a mm1I1ium of five years. These plans are prepared by the comparues and pre- sented to Subtel on the basIS of a detailed outline de.fined In Law No. 18, 168 (Article 301) under the heading Technical and Economic BaSIS. . . 4. Revenue for each service is estimaled such that the net present value of provldmg the service IS equal to zero. This revenue IS the lIlcremental cost or development. 5. Movmg from the mcremental cost of development tathe long-run average cost, full coverage of cost is attained by increasing efficient tariffs in a least distortmg fashi~n.. . - 6. The fair rate of retum (ROR) is defined as the sum of the rate or return on the nsk-free assets and the nsk premium of the actiVity, weighted by ~e systematic risk of the industry. That is. R =. R, .... b(R~ - R,), where R is the ROR on revaiued capital for firm I, R, IS the ROR on rISk-free assets, b. IS the firm t s systematic ~k. and R. is the ROR on a diversified portfolio.. .. 7. Since tariffs are calculated every five years, the law allows firms to adjust tariffs every two months, USlIlg the inflation index of each service and the Divlsia index. 8. Disputes between comparues and regulators are settled by a committee of three experts, one nominated by each party and the thlrci by mutual agreement. SOllrre: G.aJ.iJ (1994). between local and long distance services were the norm within price controls often adjusted below inflation. Regulation, operation, and, to some extent, policyrnaking were all in the hands of these public compa- nies. These were the conditions at the time the government decided to deregulate and reregulate Chilean telecommunications once more before the actual privatization of the sector through a regulatory law introduced in 1982. The law was amended again in 1987 and in 1993 to allow for competition in long distance telephone services. • The reform of Chile's telecommunications was undertaken at the same time as that of the electric- ity sector. Indeed, the philosophical foundations of the regulation of both sectors are the same: free- dom of entry into all areas of the sector, licenses reqUired only for the taking of public or private property (and in the case of telecommunications, for the use of the spectrum), minimal obligation to serve, and minimal government intervention in the sector. There were, however, two main differ- ences in the implementation. First, the belief that telecommunications was an inherently competitive sector led the drafters of the 1982 law to not introduce any stipulation concerning the regulatIon ot prices. Although interconnection was required, the legislation left the terms of interc0X;_"i.ection to b~ decided by the parties. Second. unlike in the electricity sector, the government did not attempt to change the initial market structure and hence did not restructure the two main telephone companies. Thus, competItIon started WIth two monopoly companies, one a local service (eTC) and the other a domestic and international Long distance provider (Entel). A third government company was Telex Chile, which was formed in 1982 and which took over the telex activities of the post office. Several other private companies were formed during the late 1970s and early 1980s, but they held less than 5 percent of the Q1,;erall revenue. The Long and Winding Road to Sector Restructuring In 1982, Chile was the first country to introduce open competition in all sectors of telecommunications, with minimal governmental regulation and with no restructuring of the sector, which is the same policy 116 J bls GII.iJ..S~'iI and Pablo 5pllir implemented by New Zealand, Such path-breal'\.:.n; ::t3a:s. howe'.'er, ..lid not last len;. :::..::'....:se L";. : ~E-;- - major revision of the telecom.rn~icanon5 I.JW introduced a tariff-settmg process vnt:-, -:::: .. '-.2.:- :::!':C ct."":':?:" servIces specifically exempted from pnce regulatlor.. Foi:o\ll,i.n; ;3 dcte:mll1atlor, ~:" ::':'_-:i::-US~ C;:::- mission that neither local servlce nor long distanct' ser::(e 11\.·olS competiri\'e, Subte: : :~:-.~::: :~2. ~<,:,~­ settmg process that culminated a year bter, 1:-'. 5ep~::::nce: ; ?89. \\,lL~ the first reg....:bt~: :~.-::::;-:"l:::l~!:.?­ t!0!'S t2;iffs, ~e te!ecolT'mlJnir::!~~C'~~ I.::!'" :-':'~'fi"'>~ ~~.,. ;; : 3~':'~::: ;.=: :e~~;::-::::,'':::-: -:. '-.:: -:,.!~ Commission to be noncomoetitive, Subtel can reguiJte its 7;lces accordir.g to ~ ?Jrt~c: . .:· ~ :'~.:::-=: .:~:~~. mined in the law. Thus, pu~ely from a free-market the 1957 rerorms seer.. :: :~ a Dack,va:-:: movement toward price regulanon. A closer examination, however, suggests othe!'\\'lse. 'Gntil the privatization of C:''': .:i:-.C E:1te~, ~:::: main telecommunications operators, the two ::ompanies ,;~ares wert' ndJ by Co:-;.:.:.: :.': .. ':e :0:":"\2:-.:_' (CORFO), the goverrunent development corporatlOn of :hiie. CORFO impiemenLe..: <.I ;'v~!cy :: ,;e~· mentation of the two companies' activities, mo':in~ C-:-C r:1cstly to local .sernC2 an..: ~:"'.:~; :0 iong ':.5- tance services. Although, CTC and Entel were allowed to set prices freely since 19~: '':..:'''e\· iT: ~ac~ =e~ their prices following infonnal consultations with Subtel and the Ministry of ECOI"',C::',::3 'C;alal19~~. Furthermore, competition in both loc~l and iong .iistolnCe servIce die: not deveioF ::;: . .:::;. A;:hoL.:;:- five local companies were created since the openmg ot the teiecommunlcations marl'o.e:! :""'.6e '::)I:',;:-J- nies tended to locate in areas ..... here CTC did not h3\·e.3 license (Compania de Teieic:-. .:: ::~ Co\'~a:~:':-2 [TELCOY] and Telef6nica del Sur S.A. [C0..1] ope:ate:.n a:-eas ..... here eTC does nor ::-~'e an o?era::..-.; license.) or whe:e CTC provided relanvely bad ser:ICI.:, sucn as CampieJo ;vi.:::i'.t..:;:..::-...:::;:-: ':12 :::~:.::;: Telei6nicos (CMET), which operates In parts of the metropoiltan reglOn anc:i. m other re~C'r'..s: Cornpafua Telef6nica Manquehue (CT~1), wruc..1-t operates only i.~ parts of the mer:opolitan :e~:::- ':"-.: 3-:::-:::::~ de Telecomunicaciones (SERTEL). (TM, CMET, CTC, TELEuUCTOS anc:i. others aisc ;-:: .. :t:' :i~e::J;:::: se:vices around the metropolitaI"l region. SERTEL, C'I1v1, and CMET, however, faced growing diificulties and had gained or":' : ?;:!:.:er;, or :';-.e market by 1994. Some of these difficulties could be related to normal market condi:-:c:..5. :''':: ct.'1e~5 we;~ reiated to the fact that interconnection agreements were not easy to develop. The law ?r'':·.. ,:c:': :0: :me::::-.- nection agreements to be negotiated by the parties. Inc:i.eed, .all three companies obtainec. :.... e:: ~'[erc:Jr.ne::­ tion agreements only after the Antitrust Commisslon orderec:i. the agreements to be made, ::l~:". ume. ~;...ou::;:..~, the Antitrust Commission castigated CTC for undertaking "acnvities that have tended ~c "':"-:-";';:;Tee corr.?e- tition in the telecommunications market and tended to tinut entry ... " (~Resoluhon I=~ '::'33.? 3:.; Thus, by 1987, it was clear that competition had not come to telecommunications. r:.:.r:.-.e:more, hem passage of the 1982 Act until 19S7, the network was growing only slightly faster {6.S ?-::;:~::-.: U1 tenr.:: ;;;,i numbers of lines) than prior to passage of the Act (3 percent}. From 1987 on, though, :.--: ':~::2::- has t~e::1 growmg fast (at more than 20 percent per year). Indeed, by 1991, only three years arte:!tS ?L:vanzauon. CTC doubled its number of lines. More specifically, since pnvatization, the number or i..:.."'.-:5 ;r, SeIT1Ce has increased from less than 600,000 in 1987 to over 2 million in 1996, and phone c:i.ensity r..lS !...",\cre3sed £rorr. 4.~5 Fe!' 100 p'?op!'? in 1987 to l·t~ ~ 199'S ~see t3b!e 7.:2). . The free-market approach to telecommunications regulation, then, did not help deve!c~ ~;,e sector pnor to 1987. The difference could not be explained by the different spread or privatization. T.r.e:nam generanng comparues (Chilgener and Endesa) were pnvanzed at roughly the same tune as eTC ar...: :::':lte!. Z\.evertne· less, there was competition in and network growth of wholesale electricity from the beg"_""..!".:ng. Macroeco· nomic circumstances also do not seem to be behind the differential performance because eiecmcity genera- tion capacity grew rapidly even during the early 19805, a period characterized by slow ~onom.ic growtJ1. where, in 1982-83, Chile suffered one of its worst recessions. Electricity projects require large invesnnents :. and have a relatively long amortization period. On t.~e other hand, the deregulation of ;:e:=icity genera .. tion has drastically reduced the gestation life of new projects. Although other reasons couid be offered to explain the lack of dynamism of telecommurucations. one feature seems important. The reg-..llatory frame- work based on pricing freedom was not credible, particularly when the government also .:"I.'lned the two Detail Englf1url1'lg Expmerlces l1'I LAtm Ammca arid t~ Carib~an IIi Table 7.2. Lines in Service, Denslty, and Waiting List, Chile, 1987-95 Lines in SeriJICe Dt:nsity Waitzng lzs; Year (thousands) (lines/lOO people) (tho usands) 1987 581 4.65 232 1988 631 4.93 236 1989 689 5.40 2S4 1990 864 6.56 308 1991 1.956 8.02 2·U 1992 1279 9.56 31~ 1993 1.516 11.10 198 1994 1.657 11.97 117 1995 1.894 13.42 52 1996 2.0 ... 14.30 30 Note: ere figures. Source: Bitran and others (1999). main telecommunications entities. The 1987 reforms, by formalizing the price-setting process. reduced gov- ernment discretion in the detemunation of telecommunications prices, providing a more credible frame- work in which to invest. erc aggressively responded to those incentives. A particularly compelling alternative explanation is that, at the time, the government reqUired a 100 percent dividend payout from all public companies, including CTC. This, however, cannot be a full ex- planation for the slow periormance of the sector. First, by 1987, CTC's debt equity rano was a mere 63 percent. It could have, even under public ownership, doubled its debt by increasing !ts debt-equity ratio to 125 percent, a ratio that it had in the past without much problem. Such an increase in debt would have allowed the company a rapid increase in assets (Galal1994). Second, even if CTC could not invest and if the pre-1987 regulatory framewprk provided was so credible, then, such investment could have been undertaken by the private sector. The fact that the private sector did not invest mucr, prior to 1987 sug- gests that the pre-1987 regulatory framework did not provide adequate investment incentive. This rea- soning is as follows: CTC doubled its size from 1988 to 1991. Essentially, it created another crc. Assum- ing that the 100 percent dividend payout was the main limit to CTC's investments and that the free pricing regime provided strong ex-ante investment incentives, why is it that the private sector did not create a separate CTC prior to 1987? Instead, the private sector built just 5 percent of the total number of lines. If the free pricing regime gave strong incentives and macroeconomic conditions were not blocking development, then it has to be that CTC's presence preempted the competing companies trom investing. In other words, was it the fear of predatory investment by CTC that preempted the pnvately owned companies from expanding prIor to 1987? Since erc could not expand rapidly because of the 100 percent dividend payout policy, how could CTC be predatory? Indeed, the 100 percent dividend payout should have facilitated private sector entry by limiting CTC's response. Thus, the private sector had to face other constraints on its expansion ..~ already discussed, the vagueness of the regulatory framework as it relates to interconnection was one important factor, but another factor, the uncertainty about the future evolution of prices, may have provided a strong disincentive for private sector development. Although the 1987 reforms had an important impact on both CTCs and Entel's incentives to invest, the reforms do not seem to have drastically affected the companies' ex post performance. The profitabil- ity of both companies improved following passage of the 1982 law, although it seems that the main beneficiary was Entel, because its retum on net worth reached almost 40 percent by 1986. The 1987 re- forms also benefited Entel; its profitability exceeded 40 percent in 1988 and 1989. CTC's profitability also increased a bit, but remained below 20 percent. In fact, the companies' ex post performance started to improve, not in 1987, but in 1982 (Gala11994). 11 B f. LuIS Gwzscn and Pablo Spd/~ The RegulatonJ Institutions Since 1977, the telecommunications regulatory body in Chile has been the Subsecretaria de TelecomunicaclOnes (Subtel) at the Ministry of Transportation and Telecommunications. Subtel shares responsibilities for rate setting with the Ministry of Economics. Its other main duties are to present proposals for national policies in the area, develop and update technical standards, ertSure compliance ''''ith regulatior. a~d !e£,isla:io~, a::!::-.i... iste:- and cc~t::-ol t!1.e use of t.!;e :-adior.1ag-:;etic 5?ec::-..:~, process .... franchise applications, and administer the rate-setting procedures. Its decisions are also subject to the rulings of the Antitrust Commission. Subtel is a publiC sector agency subject to public sector salary scales. These scales are not competitive, and many of Subtel's most able staff members end up working for the regulated firms. The 1982 telecommunications law established total separation between the regulatory function and the operation of services. The Resolutive Commission detennines the services that are subject to price setting according to a broad legal criterion regarding services provided under insuffidently competitive conditions. This regulation has two clear goals: (a) providing the incentive for firms to m.ini.mize long- term marginal costs, as identified through hypothetical efficient firms and (b) ensuring that the efficiency gains are passed on as benefits to consumers. All telecommunications services are, however, subject to Some degree of regulation either through the granting of licenses used to regulate entry or through the technical standards, including those covering the obliganon to establish and accept interconnections or through the rate-setting mec.hanisms to which the monopoly services are subject. Price Regulation The price-setting process designed for telecommunications is almost identical to that of the electricity sector. There are, however, two important exceptions: (a) the use of the capital asset pridng model to compute the cost of capital of the effident telecommunications firm and (b) disputes among the compa- nies and the regulator are settled through binding arbitration rather than through a fixed formula, as in the electricity sector. Thus, again in 1987, the reformers chose to limit regulation at the expe:1Se of regula- tory flexibility. Prices are based on long-run marginal costs of putatively efficient finns. Currently, only the local telephone service and access to long distance service are subject to price regulation. Price re- views are supposed to take place every five years, with indexation in the interim years. The resulting prices are supposed to ensure that the £inns earn a fair rate of return on revalued assets. The procedure involves estimating demand for each service, zone, and firm bundle, the incremental cost based on a benchmark efficient firm, and a fair return for the firm. Rules are spelled out quite specifically, and dis- putes are resolved through a three-member arbitration commission. The specific pricing rules for local telephony are.discussed next to illustrate some of the outstanding regulatory problems. Local Telephony Rate Setting Local phone ra tes are set so that the net present, value of expansion projects equals zero, when discounted at a rate reflecting sectoral risk. The local service is metered, and the billing has two components, a fixed monthly charge for connection and a variable charge per minute. There are two per-minute rates, corresponding to peak and off-peak hours. Rates are adjusted every five years on the basis of cost studies prepared by the phone companies in accordance with government guidelines. Regulators have UO days to.object and to draw up counterproposals once a study is completed, and differences are brought before a panel of experts. Although' the final decision rests with the regulators, they will usually follow the panel's advice since the companies can take them to court. Despite big efficiency gains in the sector, local phone charges have not fallen since privatization; on the contrary, they have increased. According to OWe's National Institute of Statistics. in April 1989, a family's average bill was ChS2,825 (USSll.21), increasing to Ch$3,814 (USS15.13) by May 1996 at constant prices De-tazi £rlgme-l!'Mrlg £rpe'rtmce; IrI Latm AmI!'Mca arid ~fl! Cartbbtar. 119 (see table 7.3 and table 7.4 for the evolution of all tariffs). The exchange rate was then 252 pesos per C.S. dollar. Some of the increase is explained by the partial abolition of the subsidy paid by long dlStance carriers to local phone firms and by the abolition of the surcharge on phone line installahon. However, the ." main explanation is that CTC has not passed efficiency gains on to its clients. Indeed, CTC's rate of re~m on equity, which was 14.8 percent in 1990, climbed to 22.5 percent by 1993. In 1995 the rate of return on equity dropped back to 16.9 percent, due to strong competition in the long distance market, ane rebour.ded to lSA ?e:cent m 1996. The last rate-setting process made explicit the problem of information asymmetry in telecommunica- tions. The existence of one dominant provider prevented benchmarking, and, moreover, regulators had serious difficulties gathering precise traffic data and other information from the companies. Even regula- tion of efficient finns requires actual data from the firms because costs depend on, among other tlungs, customer density and traffic per line. It is therefore difficult for regulators to build a credible counterpro- posal when they do not have full access to the regulated finn's data (a specific sanction does not exist for withholding information). However, a single regulatory change could be made that could reduce this problem: the regulatory agency prepares the rate study. In that case, the regulated firm would have to provide verifiable information if it WIShed to challenge the ruling. This proposal would shift the burden oi proof from those who have little information to those who have full information. Access Rules ConcessiorlS are required for operaoon and use of local public phones, national and international long distance services, and radio broadcasting. These concessions are granted by Subte!. are free (except for rights to use the radio electrical spectrum); are granted for an indefinite term on a first-come, first-s~rved basis (although more than one concession can be granted tor each area); and have spelled out serVIce obli- gations. What these concessions imply for long distance c.ills and mobile telephony are discussed next. Long distance Calls Following privatization of the long distance monopoly, regulatory ambiguities generated legal entrY b~riers to the industry, which combined with inappropriate rate-setting schemes to keep prices sig- ruflcantly above marginal costs for several years. In practice, the long distance company achieved av- erage rates of return on capital above 30 percent. Legislation passed m 1993 eliminated legal barriers to Table i.3. Monthly Local Residential Rates, Chile 1989-96 (fixed c:ha.rge plus variable rate with tax., U'I ehS as of April 1989) Date Tariff April 1989 2.825 July 1991 3.278 December 1991 3,19i June 1992 3.349 December 1992 3.341 June 1993 3,718 December 1993 3.623 June 1994 3,921 December 1994 3.885 June 1995 3,m December 1995 3,834 May 1996 3,814 Note: The exc:hange nile was 252 pesos/USS. 501lra: Bitran and others (1999). Ti.ble 7.4. [00/,,';011 of' )0 lilt' S t it' '.t,nr/llud l,flt/X "i.-;tlll.n' lirriff:;. ('1,;/1'. 1970 -92 DOlllfstir/m'8 tlistalla (witlwlI' tali's. ;" lillie 198R. Clt$) tocfli St'rll;ct' JIll 1 mte 8U kilo",eters 40(} kilolllelers 3,250 kilolllt'las (1985 ( 'Ir$ "t'r lind I )omest if Domeslic I )o",es' ic Rl'sidelltial Com m,.,da I Ol'erator dired dial ( Jpl'ra'or tlired dial O/('rlltor direc' dilll }'t'M 3 //I ;11 II It's 1 mi,,,,,,, I mi,,,,,/! I ",i" III,. I mi""'t' I ,,,i,lllll' I ",i"",,, 1970 1.243(J ),342.2 17S III 557.0·' 1,799.71 1971 971.7 2,610.8 17S 01 557 ().I 1,799.71 1972 778.7 2.092.5 17501 557.0-1 1,799.71 1973 360.9 1.575.6 174.41 555.25 971.77 1974 906.4 3.061.3 19\.32 620.89 984.20 1975 842.6 2.848.0 161J7 510.82 841.67 1976 576.0 1.942.7 131.76 429.41 679.1·1 1977 694.1 2,346.1 144.94 445.79 691.31 ..... 1978 S~86 2,868.0 SU.IS 2-16.44 N 0 182.20 1979 78S.0 2.65.12 86.21 2(IS09 411.2\ 1980 830.3 2.806.3 8n 11 IHO!Jn 243hh 1981 78RO 2.66'-3 R\)4 177.12 2()'JOO 1982 870.9 2,94'il 8:114 177.J2 209.(ltJ 1983 1.014.5 2.41."9 8.1 '·1 IRI01 2Hi8 1, 19M 983.1 1,991.7 56.W 12'129 147.(1/l 1985 1,3l)0.7 2,387.1 49.65 IO I}lJ2 12lJ51, 1986 1,384.2 2.0..Ui.2 41117 A5.17 93.20 1987 1,4981 2.41 \,7 ]'1.97 7h 49 79,,1" 1988 1.486.1 2,511.3 3200 6R.27 707"7 1989 1,653.5 2.576.7 24 12' 44.72' 84.52' 1990 I,Sj5.0 2.700.6 1974 3265 6751 1991 2.0790 2,AI1l.6 IR r, .. 2!J.20 627(, 1992 2.3()5.B 3,U71).7 16 (,9 2:'89 ,~- ---- .~ --- .-. --- !lS2U a. In 1989, dl.angt'S W£,fl! 1I1"d" In IlIl' dis,allt.:1! tMlhls SOllfCt: Cal.,1 (1991) .. , . DetaIl El1gmen'Tl1g Expenel1ces 111 Latin Ammca and !t:e Ca"bbear: 121 competition in long distance ser\'ices, PJvine; the way for a multicarrie:- syster., lall...c.L..ed i;-, October 1994, in which long distance callers choose their carrier for each phone call by dialing hVo digits. The new legislation also facilitates competition by allowing long distance carriers to have access to end- users directly through private circuits. Until the beginning of the 1990s, telecommunications services were dominated by hVo firms in Chile: CTC and EnteL CTC had a virtual monopoly on fixed telephony throughollt tJ-e country, \,.. hile Entel monopolized long distance services. The antitrust agency's decision in 1992 direcnng Telefonica, which owned Entel, to divest its 20 percent share in EnteL was essential for the emergence of competi- tion, because competition would have been impossible if both CTC and Entel had been controlled by Telef6nica. Currently, eight firms are competing in the long distance market. The operung of the sector to competition eliminated the need to fix. rates, which are now market determined. On the other hand, given that a carrier needs access to and from local networks in order to provide long dlStance servlces, regulation of this aspect has become crucial. The law obliges a1110cal telephone franchise holders to give access to carriers on a nondiscriminatory basis, and the cost of interconnection behVeen the public network and long distance carriers is set by the regulator. This access toll approximately reflects costs (two-thirds of a local call for each origin-destination end point). However, the access toll for incoming international calls clearly exceeds the cost of providing this service. (It is 14 times the iocal peak rate.) The 198i reforms and the subsequent privatization had all the predicted effects. The network ex- panded, and prices for long distance services fell more rapidly, while those for local service increased more rapidly, which tended to eliminate the extent of cross-subsidIZation from long distance to local service. Furthermore, the profitability of the long distance market provided a strong SIgnal for poten- tial competitors, and in 1989, CTC and other local exchange providers attempted to enter the long distance market by requesting licenses from Sub tel to build and operate long distance tacilitles (see table 7.5 and figure 7.1). This is where Otile's institutional framework starts to have an impact on the sector's de\"elopment in an unexpected way. Opposing the entry of the local-exchange companies into the long distance market, Subte! requested in 1989 that the Central Preemptive Commission consider whether entry of local-exchange TAble 7.5. Return. on Net Worth, Selected Years, 1960-91 (percent) Year eTC El\7EL 1960 7.90 1965 14.10 1970 10.70 1975 -8.60 1979 1.68 1~.31 1980 4.45 12.14 1981 2.61 11.13 1982 -15.14 11.53 1983 11.89 13.05 1984 9.17 16.79 1985 -15.29 19.97 1986 21.02 35.37 1987 10.91 38.98 1988 12.31 45.54 1989 17.22 45.63 1990 13.46 38.76 1991 15.17 38.93 - Not available. Soura: Ga.Ia.l (1994). 1"" J. LIlIS Gua5ch and Pablo 5pll/~ Figure 7.1. Rdurn on Equity of eTC and ENTEL 1990-96 :jj. . . . . . . . . . . . . . . . . . . . . . .. 40 C :" ~ 30 :: ~---- 20 ' .. ". " ......... . 10 o ~--------~--------;-------~--------~--------~ 1990 1991 1992 1993 1994 1993 -Cfe .---- EN'TEL 50urct: Bitran and others (1999). companies into long distance was in the public interest. Subtel's opposition to the integration of local ex- change companies into long distance was based on the potential anticompetitive impact that erc could have on the long distance market. (See Resolutive Commission's Resolution No. 389 of April 16, 1993.) Although the Central Preemptive Commission sided with the government, it was rapidly reversed on ap- peal by the Resolutive Commission, which ordered that there be no segmentation of local and long distance services and which requested the int;roduction of a multicamer system whereby customers can choose their long distance provider. Thus, by 1989, Chile could have moved directly to long distance competition. Entel, however, appealed to the supreme court. which. in 1990. requested from the Resolutive Com- mission a more in-depth study of the technical conditions that would allow for fair playing conditions, including the supervision of interconnection quality. The Resolutive Commission took three years to study this issue anew. During this time, the composition of the Resolutive Commission had changed. In 1993 it upheld its prior decision and ordered the government to implement the multicarrier system in less than 18 months. The system was introduced in late August 1994 outside Santiago and a month later in Santiago. Prior to its introduction, and to some extent reflecting the strong pressure exercised by Entel (see, for example, El Mercurio 1994), congress amended the General Telecommunications Act limiting each operator's market share in the domestic and intemaoonallong distance market for the next five years. Those carriers affiliated with local exchange companies (mostly erC) were subjec~ .to stronger restrictions. Table 7.6 shows the nature of the bargain. erc was initially limited to 35 percent of the long distance market. while Entel was required to initially relinquish at least 30 percent or the market. The market share restrictions. though, also provided erc with some protection from competition from Entel. If Entel decided to enter into local service during 1995, it had to relinquish 80 percent of its current long distance market share, or 50 percent more than if it stayed out of the local-service market. Thus, table 7.6 reflects a particular bugain struck in Law 3-A among the companies that allowed implementation of the Resolutive Commission's ruling. Although Entellost in the Resolutive Commission. litigation provided 2 delay of five years. i~elationship between Regulation and Sector P~ormance The combination of this regulatory ~lh U"onment and state-owned-enterprise privatization has led to a remarkable expansion in the quality and diversity of services prOVided. Currently,. multiple Detail El1gmurtl1g £rpt:'rtf'l1ceS In LatIn Ammc.::l an';:; the Cartbbtar. L::3 Table 7.6. Markt?t Shnre Restrictions in the Long distance Markets, Chilt? 1995-98 (percent) DomestIc long dzstance Internat!cm..:z; Ion,'Z distance Year Affihated Nonaffiliated Affiiiated ;\ionafjiiiated 1995 35 80 .,'" ... 1.: 70 43 70 30 ~~ 1996 1997 55 60 40 60 1998 60 60 - Not available. Source: Bitran and others (1999). telecommunications services are provided by many finns, of which the most important are CTC, Entel. VTR, Telex Chile, and Bell South. The largest of these, CTc' owns about 95 percent of all telephone lines, controls the largest cellular phone company, has a long distance subsidiary with the second-largest mar- ket share, and controls the company providing cable TV to almost half or all subscribers, Foreign inves- tors participate in the o\'VTIership of most telecommunications companies. Telef6ruca de Espana controls CTC; the Italian company, STET and Sarnsung, respecnvely, own 19.5 percent and :::'.5 percent of Entel; and Southwestern Bell owns 49 percent of VTR. Despite good progress in telephone density, universality of service is for the moment a distant goal, although it is realistic to consider universal access. For this reason, a decLSion has been made to subsidize public and community telephone servlce solutions in remote areas, and it was financed out of the Tele- communications Development Fund. Subtel prepares a needs list and draws up the corresponding proJects, which are put out to tender among interested finns and awarded to those seeking the iowest subsidy. So far, deregulation, and thus the ensuing competition for long distance. ha.s had the expected results. First, 12 firms requested long distance licenses, and by 1997,8 firms had entered the market, and 3 more ·have been approved by Subtel to provide the service (see table i.7). Apart from CTC and Entel, Chilesat (the owner of Chile Telex) and VTR (the owner of CNT and of TELCOY) were already providing long distance telecommunications services. New entrants include Bell South and lusatel while cm also started providing long distance services. Following a hectic advertising campalgrt by all the long distance pro- viders, prices of long distance services fell by more than half of Entel's prices prior to September 1994 (see table 7.8). Take, for example, the prices carriers charge on calls to the United States. At the beginning of 1997, the normal rate was about USSO.90 per minute, with one carrier charging less than USSOAO (carriers charge their large customers even lower rates). By the latter part of 1997, that charge had dropped to USSO.34. By way of comparison, American Telephone & Telegraph (AT&T) in the Uruted States charges USSO.1S per minute under its One-Rate Plan (see table 7.9). These prices can be contrasted with the premulticarrier regulated rates. If the rate-sett;ing scheme in force from 1988 onward had been maintained, a call to the United States today would cost USS2.40 per minute. The drop in prices led to a substantial increase in traffic. International calls per month rose from about 6 million minutes before the multicarrier system in September 1994 to around 19 million minutes by March 1997. Entel's market share more than halved overnight. Even without including public tele- phones, its market share had not reached 50 percent by December 1994. EI Mercuno (1995) estimates that without counting public phones (where CTC has the majority of the outgoing calls) and private lines, Entel has 46.2 percent of the market, Chilesat 30.6 percent, erC-Mundo 11 percent, VTR i.4 percent, Bell South 2.4 percent, and CNT-Carrier 2.4 percent. The rates of return in the regulated segment (crC) fixed- link contrast sharply with those in the non-regulated segment (En tel), the long distance market, and pre- and postcompetition (see table 7.10 and figure 7.1). So far, the fear that CTC would capture a large percentage of the market has not materialized. CTC is still the third-largest long distance carrier, with less than 30 percent of the market. The introduction of the multicarrier system, then, completed the first round of reforms that started in 1987 with the "iJble 7.7. 'Ieleco",,,,,,";nltio" COIII/'lwit's nll,J Snl'icc's OjfcTl'd ._--------- I'" --~. Sl'Illil'I':' ClJJ~" Assochltl'd Iollg dis'''"fe nllsilless I:1/"iI'IIIell' fore;gll (n,,';ollnl nlld nlld vIIIIIC- nil'" firm 0l'eratiolls toeal sen1ice iut","ntionnl) nddf'd sen,;ces Mobile seroices 'ermi/lIlls Cn"'c' .,-V III knrct 11((1'55 LTC TciefOnica x x x x x x x Enlel STET-Italia x x x x )( n.1. x .... N Telex-Chile x x x n.a. x n ..1. x VTR SOC-EE.UU. x x x x x x n ..1. '" flellSmllh Bell Soulh na, x n.a. x na. n.a. x CIA. Telef. Manquehue x n.a. n.a. n.il. n.a. n .1. n ..1. CMET x n.a. n.a. n.il. n.a. n.1. x IUSilld Illsacell-Mexico na. x n.il. n.a. n.a. n .1. x Transilm na. x n.il. n.il. n.a. n.1. n.il. It.a. Nol applicable. SOllrt't: Bilran and ntlll'rs (1999). J, Deta:l Engtnemng E.rpenmcC's m Latm Ammca ana ;;'.e C:mbbt-an 125 Table i.B. Average Monthly Advertised Rtltes of Long distance Telephone Calis, Chile, 1994-S:S (USS per minute) September October November Decem::?'7' January 00- Rtlte 1994" 1994 1994 199'; 1.J::J Nahonal long distance, daytime 0.047 0.028 0.040 0.053 National long distance. mghttune O.Oli 0.026 0.016 0.039 International long distance, United States 1.602 0.407 0.390 0.328 0.·U8 lnternationallong distance. other countries 2.676 0.497 0.607 0.'*61 1.285 - Not available. a. Entel tari..fu>. prior to introdUC':lon of the multicarner system. SOIln;:e: El Mercuno (1995). Table 7.9. The Impact of Competition on Long distance ServIce, Chiie, 1997 (USS} Type of call Price per minute CTClEnte! Domestic 0.17 To United States O.3-t From United States 0.51 Nott:'Th~ prices represent the baSIC rate for a typical domestic long distance call and an international call to the United States. expressed Ul USS at the 1997 exchange rate. Souru: Spiller and Cardilli (1997). Table 7.10. Rates of RetIlm on Equity for Chilean Firms, 19~5 lperceIlt) SmJice Type Rate of return Electtiaty distribution Regulated 30.0 Elecmaty generation Competitive 15.0 Basic telephony Regulated 16.9 Long distance Competitive 8.4 Nott: The data in this table are the latest comparable data availab~e. Bltran and others (1999). 501lrct: Resolutive Commission determination that both local and long distance services were not competitive. While the multicarrier system improves upon the degree of competition in the long distance market. it does not affect the extent of competition in local services. That is the next battlefront in the Chilean telecommunications war. As with the introduction of long distance competition, competition at the local exchange will require further refinements in the regulatory framework, Which, given the constraints involved in the regulatory scheme, will have to await the results of litigation now before the antitrust authorities and the courts. Yet, competitors are currently positioning to compete in that market through the construction of facilities, since Chile does not require unbundling or resale. Six local exchange providers are already in the Greater Santiago area, including erc and Entel; two original competitive local exchange earners in Santiago, 126 f. LuIS GUJl5ch and Pablo SpilltT CMET .:md Manquehue; VTR, a large cable TV provider (whiG~ subsequently me:-gec wit..' CTC); a.."c Telef6nica Andina, a new entrant. As a result, consumers already have a choice of local providers in a number of areas in Santiago. This strategy to integrate is a consequence of the level of competition in- duced in the sector. The counterpart of the consumers' gain is a reduction in the industry's profits. In 1993 Entel made profits of about USS80 million, whereas the total profits of all carriers in the new system in 1995 amounted to CSS31 millior.. These meage: :esu!ts J.:e explainec b:; t..~ee factors: (J.) the dissip T('k"l.·omllllmkaliolls S4,·rvin.'S ('hnllllllogical Timl' Scril·s. Also ilvailil"l~ at htlp:! /wwwcll goh.mx/ " , . DeUzII E"grne~"g Expenmc~ in Latl1'l Am~ca and the CilrilJ~a" 141 Table 7.17. Indicators of Telecommunications Traffic, Sector &venue:;, and lAbor Productivity, Mexico, Selected Years Indicator 1988 1990 1992 1994 1996 1998 . 1f Domestic long distance (million mmutes) n.a. 951 1221 1,630 2,002 2,881 Intemationallong dlstance (mulior. minutes) 126 212 351 451 593 737 Sectoral revenues (USS million) 1,499 3,801 6,175 8,653 6.93i 8,8i:. Revenue per person 19 46 72 97 75 90 Revenue per line 342 710 914 1019 786 894 Lmes per staff 88 109 144 185 201 153 n.a. Not applicable. . . ' Source: rn.;, Yearbook or StatlStlcs Teiecommunications Services ChronolOgical Tune Senes 1998-9i IIi 1999, Telmex launched n-vo initiatives that conceivably could tum the stagnation in residential wire-line access around. One is shared service, or multiparty lines, which are offered at a lower price than single lines. By mid-2000, Telmex had 1.2 million telephones using shared service. The other initiative was prepaid wire-line service, enabling customers to commit to a firm budget for tele- phone service. WIRELESS ACCESS. Wire-line penetration is not a completely accurate measure of telephone penetra- tion, for wireless telecommunications also offers local telephone service. Mexico relies primarily on two technologies: cellular telephones and pes, which is similar to cellular but can accommodate a broader range of telecommurucations services, including text and video. In Mexico, paging (a text service) and cellular telephony were introduced first, then pes and fixed wireless service. As of mid- 2000, almost all wireless service consists of mobile telephony, which has enjoyed spectacular growth since 1995 (see figure 7.2). The ratio of fixed to mobile lines fell from more than ten to one in 1995 to about three to two in 1999.Some analysts predict that by 2001, the number of wireless customers will exceed the number of wire-line connections. Figure 7.2. 12.000 ~ 10,000 j Increase of Public Telephony by Type. Mexico, 1990-99 :; 8.000 I 0.000 ..., -1,000 2000 . j J ................. .- . . .. ..........•..•... -...........•..•. o ~~·~~··Ti~··~·--~----~i----~i----~I----~----r---~----~ 1990 1991 1992 1993 1994 1995 1996 1997 - - Fixed lines •••• - Mobile lines a. PreJi.tninary. SOUTa: CoieteL 142 j. LI.lLS Gw:zsch and Pablo Splllt'r Although the nature of mobile telephony makes allocating this service between business and residen- tial difficult and even arbitrary, much of the growth in mobile service is probably for pe:sonal use. As in many countries, mobile wireless telephony so far has been the main vehicle for introducing limited ac~ cess 'competition for both business and residential service in Mexico in the sense that customers who have access to both telephones can choose between them for placing calls, depending on their relative prices. In addition, some customers may decide to have only a mobile telephone. This pos3ibiliry encour- ages wire-line carriers to make service more attractive to retain these customers. A rece~t study reports that entry by competing wireless carriers causes the incumbent to expand wire-line sen'ice significantly more rapidly than if the incumbent wire-line company is given a wireless monopoly. Telmex's introduction of prepaid wire-line service in 1999 reflects the competitive influence of wire- less on wire-line sen'ice. These effects arise because wireless service offerings can be comparable In cost with wire-line service costs. In some remote areas, wireless service is less costly than wIre-line sen'ice, which has led Telmex to encourage the entry of wireless resellers in rural areas .. The growth in wire-line service between 1990 and 1995, followed by the growth in wireless service, has meant that the waiting list for fixed access service, the best measure of excess demand, has essentially disappeared. However, the problem of many households not wanting service at curren~ prices remains. in some cases because their incomes are insufficient to make telephone service affordable. In the 11 Mexi~ can states where per capita GDP fell below 53,500 in 1999, penetration averaged 5.3 lines per 100 house~ holds. In four states where per capIta GDP exceeded $7,000, telephone penetration was roughly ty.'ice as high at 105 lines per 100 households. L'\J'TER.'\lET. Use of the Internet in Mexico has been low, with only 2.6 percent of the population con- nected in 1999. That year, Telmex introduced a new program to expand Internet usage. Ir. this program customers receive a low-end personal computer and access to the Internet as a bundlec sen·ice. Te!mex reports that during the first half of 2000 about 1,200 new customers per day acquired t.1is service. An- other element of the program is to increase Internet usage at schools by using funds from an affiliated foundation to pay part of the initial cost and monthly fee for a computer and Internet access for schools and teachers (at home) if the government agrees..to pay the rest. PRJCES. Telephone prices are much higher in purchasing power parity than at the offidal exchange rate. Thus the ability of Mexican households to afford service, as measured by per capita Income, appears to be far greater than it really is. This is because purchasing power parity rates imply a much higher poverty rate and much lower per capita income among Mexican citizens. Given these caveats, the price data (summarized in table 7.18) reveal the following basic facts. THE BASIC INSTALLATION FEE. The fee for residential users has fallen dramatically from nearly USS300 to around US$100 during the period of state-owned enterprise. Business installation charges are far higher, in the range of USS350 per line, but these, too, are declining. Telmex has announced plans to cut installa- tIon charges to USS30 for households and USS100 for businesses by 2005. . RECL'R.R.ING SERVICE PRJC£S. Recurring service prices are high in Mexico, especially for usage. At the be- ginning of the year 2000, the basiC monthly tariff was about USS15 for residences and USS20 for busi- nesses, and the local calling charge was about 14 cents for each call. Businesses must pay this rate for all calls, but residences pay only for calls in excess of 100 calls per month. Telmex reports that approximately half of residential customers make fewer than 100 calls per month. These charges are much higher than ; during the period of state-owned enterprise. h..."TERNET ACCESS. The price for access to an ISP is simply the US$O.14local calling charge. Alternativelv, a customer can buy Telmex's bundled service of a computer, a modem, and its affiliated ISP tor a hook-up 'fee Table 7.18. TclecI1nr""mit'al;mfs lnriff, Mt'x;m, 1988-98 1991 1992 1993 1994 1995 1996 1997 1998 Com'fclioll charge Business line 509 471 731 661 S.1O 917 921 480 4Orvkes finland Operaturs can freely set Tariffs without approval n.a. France· Direction General des (Justes et Munopoly services Individual approval ~ Telecommunications Othl!r S('I-vices Price-cap regulation by contral de plan (from 1995-98, ('PI -5.25%) Germany" Ministry uf Pusts and Telecommunications Telecommunication services Approval based nn it baskd al1pro,Kh using Digilal ('ellular Mobile Radin presnibed benrhm,ub Price-cit!' rt'gulation From 1993. CPI -4% Greece· National Tell'communication Commission hriff uf new st'fvice enlers inlo force afler Price-cap regu blion (NTC) months from announcemenl if th{Ort! is no 1995: CPI 0% opposition fmOl NTC. 19%: CPI .. 2% ld~cummunicali(}n serviCf"s are included in 1997: CPI .. 1% the basket fur the pike-cap regulation. Ilungary" Ministry "f Transport, Tl·lecomnlllllicalioll.~, l"-Iccommunication s('fvin's with thn'e Price-cap rq~tllatilln and Water management subtariff classt~s Iceland Ireland Italy Ministry of (Iosb antl'lclt-ClIIIIIIHmk"tiolls MOllop"Iy sl'rvin's Sct by Milli-;Irr Japiln Ministry IIf !'ush and Tclt-·l'WIIIIIIIIIil'.lliIlIlS ~'rvin's 111.11 ".IVl' SlIbst,lIIli.II illll'It'II'-c 1I11 Ratc-lIf-ll~tllrll It'glll.llillll (.IJll'lov.lI) Ihe eVt'r yday life of citizens anJ natillilal economy luxembourg (la/Jl(- COllti,,,",:; 011 /OllCII4 1;II8 11,'gd I, .. .. ~ ... li,,,,t' 7.22 ro"ti""ed CcJ/llltry Rl'glllillll/y "oily Cowrnge .. Adioll/lIIl'lllOd Mexin.· Secreti\! ia de COlllullicadllnt's y Tranpurlt's St.·rvices with monopolv or domin.ml scr mllst approvl' tiHiHs lIsing a h,lSI rcc For AT&T st.'rvices~ Price-cclp rrom 1989 FCC Uilskel I: Hl'sidplllial Price·cilp rwm 1991 Public Utility ('lIl1lmi:>siIlIlS B.ls!.;l'I 2: BOO nask ... 1: Cnmnlt'rrial rill I.H·s - Not available. na Nut applicable. a. Indicates countrics wilh priccl-ap rcgUI.llioll b. All common carriers are requiwd lulill' lariffs .u-rordillg 10 Ihe (I'~III.l~I'~y guidl,lilll's I'SI,lhlislll'" by Ihl' FCC. NOIIIIII lIIiII ,1IlI carril'rs gl'lIl'rally s('l tlwir (lWI1 rall·s. TIlt' r,lll's fllr 111(' nt'll opl'ratillg companies alld GTE aresllhj('d 10 pril"l:~-(-.lp !t'g II 1,1 I illll I he I·el. I'fIIl'oSI'.lloIISl· ils aulhorily \llltl"r IIIl' 1l)<)(...... h·Cllllll1lllllil·aliolls Ad I" fOlhl'M from n''1"iring IUI/Hlolllill,llll carr iNS It) fil~ lariffs for JOO1cslic Iwrvin's, Sour,t!: UECO CUll 1111 IInkal ion.... Oulluuk ( 1':I1J7d· 160 J. LuIS GWlScn and Pablo SpllltT In pricing electricity generation, the price pm of the distribution companies' supplier is unique, set by the market, and computed at local prices. It is equal to the system's marginal cost of generation, which is determined by the marginal cost of the most expensive thermal power plant running to meet demand at any given hour. It is established by Compaflia Administradora del Mercado Mayorista Electrico Sociedad An6nima (CAMMESAfor each generator on the basis of its fuel cost and thermal efficiency. This method ensures that the price of the last megawatt bought is equal to the cost of supplying it. It also signals to the powe: users the proper \'alue of the~: ele:tridty use Jl"'.c! 3110ws distr!'bunon :::ompa.'1.ies to :::ake informe:: decisions on this component of their costs. Although not a serious problem, this signal is somewhat biased. There are indeed other components to short-run margmal cost that deserve some attention in view of the vast differences in technologies across generators. In practice, a price p" is set at each node to remunerate the generator supplying electricity to node n and is paid by users located at the exit node. It is determined by p'" and a. nod~l factor. This nodal factor is a measure of the established transmission losses between the entry or eXIt pomt and the load center of the Ministry of Energy and Mines. It varies according to the season and time of day and depends on whether the nodal point is importing or exporting power. CAMMESA dispatches power from generating plants bv order of merit which means bv order of increasing short-run marginal costs of production. The market- ciearing price is ~enerally set b): the most expensive generator needed to meet demand. Any generator with a lower cost makes a profit. The existence of this profit pushes generators to cut their costs as much as possible to improve their standing. . Transmission pricing uses an RPI- r rule, with x initially set at O. The real key to the transmission regulation, however, is open access to the network. Because the main carrier, Transener, enjoys ex- clusive rights ior the provision of high-voltage transmission (500 kilovolts) on the existing: network, it has to be regulated. Its regulation is based on prices and quality standards. A penalty for failing to comply with obligations and a prohibition on buying and selling electricity protect distributors and generators from abuses. The objectives of Transener's price regulation are to transmit accurate sig- nals of costs from producers and carriers to distributors and large users and to give the operator strong incentives to develop transmission infrastructure. The short-run marginal costs of the trans- mission of electricity are mainly the physical losses of the line and the congestion costs when the line cannot absorb all the power injected by generators. To relate positively the transmission company's profits to the power losses on the lines is clearly not a good incentive for the company to improve the quality of its equipment. Therefore, Argentina's regulations impose quality objectives on the trans- mission company. Ente Nacional Regulatorio de Energia (ENRE) regulates three types of fixed trans- mission charges: connection, capacity, and energy. Connection charges cover the cost of maintaining the equipment needed to connect the user and are levied by CAMMESA. Capacity charges distribute among all users the total costs of operating and maintaining the existing transmission equipment. Energy charges reflect the difference between the value of the energy received at a receiving node and the value of energy at a sending node. The connection and. capacity charges are fixed for the first five years, after which ENRE can reduce them yearly to improve efficiency. nus decrease cannot be larger than 1 percent a year, with maximum a cumulative effect of 5 percent in each ten-year management period. To reduce the volatility of revenue from the energy charge due to its dependence on the market value of electncity, this energy c:h.arge is always fixed for a five-year period. When justified, transmission companies can apply to ENRE for tariff adjustments. Similarly, users can complain to ENRE if the tariffs are too high. In that case, public hearings are organized, which means that many of the provincial private operators are likely to have regular interaction with ENRE. ENRE calculates the tariffs used in distribution pricin.g. The tariffs include a complete pass-through of the Ministry of Energy and Mine's seasonal prices allowing for technical losses (11 percent) plus a distribution cost defined in the concessionary contract. The prices that were fixed before the monopoly positions were conceded are used in price caps. This means that the price regulation system is of the DetaIl Engmunng E.rrx!Tlences In LAtin Amenca arui tlu umbbean 161 RPI- x + y type. In other words, prices are allowed to increase at a rate equal to the retail price index, less some productivity gain x, plus the increase y in the price of inputs over whic.'-l the firm has no control (essentially the costs of energy in the wholesale market). The prices are automatically adjusted everv six months on the basis of the current price index and the producer price index of the United Stat~s for set x and y values. This pricing mechanism is a good incentive to promote cost-reducing activities, but it can result in a decline in quality. The other problem with this type of regulation is ~"at it promotes a strategic behavior of less-than-expected effort when the managers know that the present cost will be used to determine next period's x value. Prices applied by distribution concessionaires are based on five specific elements: • Energy charges that are based on seasonal electricity costs of the Ministry of Energy and Mines and on electricity bought under long-term contract with Central Puerto and Central Costa-nera • Loss charges corresponding to technical and nontechnical losses that are equivalent to about 11 percent of the distributor's losses • Connection and transmission costs . • Costs of capacity of the Ministry of Energy and Mines • Distribution charges that are fixed for small users or are based on a charge per unit of maximum demand for medium and large users. The loss charge corresponds to a recognized allowance for tec:hn.icallosses:The 11 percent allowed may not cover actual losses but is a reasonable benchmark. It is intended to give an incentive to distnbu- tors to achieve a level of losses acceptable to consumers and regulators. Obligating distributors to grant access to the network to all interested parties is a key ingredient of the system, but it has a cost. That is why distributors can charge a toll for that use. The toll essentially corresponds to the connection and transmission component of the standard tariff and also includes a loss charge. Finally, figures 7.4, 7.5, and 7.6 present comparative prices in the telecommunications sector for a selected group of Latin American and Caribbean countries, and table 7.23 presents the comparative sec- tor performance and best practices for selected Latin American and Caribbean countries. FiguTI! 7.4. Connection Charges for Residential Users, 1997 600 500 200 100 1 1 o ' Argel'uira Chile (CTC) Mexico Spain VenezueJ.a Peru ColOmbia E.C'IW1or Uruted Kingdom Country Not~: Taxes included. Sourr~: Oslptel (1998). 162 f. LuIS GllILSch and Pablo 5"il/l!'1' Figure 7.5. Monthly Fees for Local SmJZces, 1997 18 7.000 16 6,000 14 5,000 12 4,000 C CJ") ~ 3.000 2,000 1,000 0 Argentina Bruil Colombia Qu.le E.cI.w:1or MelUCO Peru Country G Monthly subscription - - GDP per capita Not,: Taxes included. Scurr,: Osiptel (1998). Figure 7.6. Cost of Qn International Call, 1997 (one minute to United States during business hours) 2.0 1.5 0.5 o ColombLil Venezuela PeN Eawdar t:niled KIngdom Country Not': Taxes included. Souru: Osiptel (1998). ,. , . lid",- 7.2.1. COIIIl'flmtil't' Pa!onl/fll/t'1' l"diUllo,s (hl'slpf.lc1iu.' illl'arh munlry) 111'51 (mId rcnsntlflMt' St"-lIke Bmzil ,.,1ft ;(0 Cllilt' I,elle/wltlt k) Ot'K(('(' of (OIIt'mgt.' Telecoms (Tdedellsily in large cilies in 1994 = number of lines per IOU inhilbitilnls) 32.6 21.2 IIR 11.6 IS.4 (,t;I(LJS., Eleclricily(percenlage of populalion connecled in 1992) 92 9'1 87 1)2 95 100 Waler (percenlagl' of population served) 83 M 92 B3 87 B9 (uppt'r- middk· illllHlll') Tariff lelecoms (monlhly fce fur busim'ss in 1994 in U5$) 19.3 29.3 6.2 18 21.8 ... e Electricily (residential in cis/kwh in 1995 exrepl U.s. and nECD) 1453 11.85 9.'10 309 13 (i() Waler and sanitation (residenti.,1 cls/ cubic meter) ISO 28 71 1)1J2 114.2 Rl'li"bllily Telecoms (fmlils/ 100 main lillt's/yt'iHS in 1994) 12 29.1 41.2 8 1.7 (Spain) Ell'ctricity (percl'nlage of 105<;c5 in 1992) 19 20 15 15 14 8(US) Waler (percenlagt' of unaccounted for waler) 468 40 39 SO 41 9 (Sin~aJ101l') •"'itH l,rodllcliv;Iy l'ilj ldl!cnms (m.lin lines per t·mpIIlYl!l·) 8t1 12t 17·' t'i.1 '}I) 1 (Klllt-.I) EIl'clricity (clistUlncf per l-ml'luYl'l') 102 (ill IIJ')S) 2m) 177 lOH :?Wi 2Wi (t 'Idle) W"ler and sanitation (employt'!!s/ 8 :1 5.2 4 21 LB NIII.wailabl<, CIs?????? Sour.-,,: World B.lIIk (1997.,) 164 J. LuIS GWlSch and Pablo Splill!r Appendix i Characteristics of Telecommunications Sector, Selected Countries II- lIrblc 7A.1. Prir'ate OWllt'rsl!i", l~t'R"/at;()Il, alld I't"j(ll'll/tlllt'l' oj 1Het'''",''1II II it'at;o"s Utilities, S,'/t'fkd COllI/tries Country Ownersl';I' Pril'ate rC8"/tltory I,istory Private perjonll(wre Argenlina Nnlionalized in 1946; privtllized ill 1990 Repeated ,changes in regulation, 1989-92 llighly prohtaule, but too soon 10 delemlille Ihe impaci on service qualit y and natiunill welfare Chile 1930-58, controlled lJy rnu/linnlionnl, nnd l1T Reglllilioty law qllile open-elided; no Initially rapid expansion or Ihe m'Iwork, lndepende'nt reJ;\llalor followl'd by a slowdown 1958 lu lat~ 19603, controlled 11'1' • parlinl )(egulatory sulJagreements ill 11)58 and 1967 Accderalhm of nelwOl k expansion III g()v~rnrnenllakt'()ver in 1967, government tlt;'lt eliminaled some vagucness; super levels exisling hefore Ihe slowdown, intervention in 1971. and natiollaliziltion scded by natiunillizillion prior to inlerv('ntion and nalionalizalion in 1974 Privatized during 1988-90 llighly detailed benchmark regulillion Unprecedented high rales of invl'sl ment supervised lJy regul;ttory agency with and nl'twork t'xpallsion slI!Jsequent 10 explicit arbitration process privatization; suustantial increase in .... Ch national wdr;'lre I.JI Jamaka 1925-66. privalety owned, wilh separate Hille of retmn sliplllilted in liccns(' Sustailll'd network f'xp,lIlsion in 1950-62, domeostic and international companies agrel'ment; ad hoc Il'mporary r;lIe boards folluwed hy slilgllalillll; sll'ady mod('rale responsible ror rate reviews rate of rt.'lurn 1966-75, privalely owned \lntil Rt'gulillion lJy permanent, indepl·ndent Inilialnl!lwork expansion, then slllwdown; natinnaliz"tioll ur intern"tional cornp;lIlY in commission; license spt'dfying only low profitability afler 1970 IlJ71 and of domestic company in 11)75 milximllm fate of rettlrn Merger uf dumeostic and international Rail' of return spl'cified in license .1gfl'emenl; Major invl'slnll'nl in domestic network alld companies in 1985 and sulJseqtlent IlO incil'pentlent fegulator increased nlltional wdbre, high profit.lhilily privatization Mexico Privatizcd in 1990 I'rklLcap rl'glll"tioll correch.'d hy incn';1sed Major invl'stml'nt in domestic nl'lwOlk, )lmdllclivily \11\ till' w(.ighlt-d ,IV\",lge l·xn·l·dillg C(lnn's"iCl ... lI y CllflllllilllH'llls; I'lin'; illili,ll J.lIgl' )llin· ('IIIII'dill"; all st'lvin' illl)lIIlVL'IlH'lItl.lIgt'lS Illd y body wilhin Ihe lIIilli:;lI (/11/111' I OIIIi" 114':' 011 J("'(llpil/.~ 11Ilgl'l TaMe 7.A I ("0111;""1,11 Country (Jullft'rsl,i" P"ll"tt' "I'~,,'atonj I,istory Prir1tJtl'III"I0rl/IIHln' I'~ru Privatiud in 1994 1'1 kc-cap rcglll.llinn, with 'llliHledy TOil SlIlIn 10 evalu.lll' ,u'juslm~nl; rciJillanring of tarif(<; IIVN a fiv~- y~ar pcriod; (ormulas contained in Ihe license ar;rcenwnt; i'HItonomnllS regulah lfy ag('ncy estahlished 10 regulate tariUs according to the coulmet and In monitor compliancl' .... United Kingdom Publicly owned from 1912 until Price-cap regulation and complex TakeoU of inveslment in 1983, with large 3: privatization in 1984 mechanisms o( conmet rcstllulion spl'cified gilins in n;llional wclfare hy Ikenst' Venezuela Privalized in 1991 Price-cap nnd regulation and rebal.lncing o( Major investment in dllmestic nt'lwml<, by tcUiHs ov~r a nin~-y('ar period; tiny tariff far exc('('ding cllnn'ssillllary commit chal·'gt' rt''l"ires approvaliJy till' menls; all service Improvl'nwnlt.lrgl'ls mel regulatory agenl'y and Ihe Ministry of Communications; cinc l: written into license contr;lct company allowl'd 10 ilppe<1110 Ihe execulive 10 secure chilngl'S Peru Explicit priet·-cap reguliltilln with price Liel'USC illtered Ollly hy mulual agn'l'llwnt Ml,diulll judiciMj' ildjllstments illld rcb<1bncing of the lariff fonnula in the concessionary conlmet United Kingdom, 1984 -presenl Main regulatory issues, including RPI - x, l.in'nsl' changed (lilly wil h consl'lIl of Sirong Jlldici;uy, pIllS clIslmn wilh a specific x written into license compillly IIr Ihrough a precis!' Ilion'ss requiring the ilppmvill of Ihrel' sl'pilrale hudil's; infurmal re!->Irilinls Oil "buse of powt'r hy S(lVl' I t'ign • Vl.'nl.'z Ul.' I " l:xl'lidll'rir(' adjusllll!.!nl alltlll'h.d.llltillg l.in'II~I· .1111'11·.111111), hy 11111111.11 ,lglI'I'III1'III; t>.h·dilllll jlldil i.1I Y of the l;niH formul.1 in IIw CUIlCt·s'iillll.1ry any rOllllirl tlr disagrl'PlIlI'lll IwI wel'lI p;1I1 il'S ("unlral'! resolved by .1d,il .. llioll; <1l'lwallo l'xeClilive fur - -~~---------- Sourer: Alilhors LOlllpil.llion Ti,ble 7A.J. CII"t'llt Rc'gllllll;tm oj '/Ht'rom"",,,h',,I;olls ('mul/clilion, SI'/,'e"''' Co,,"I,;I'S COUlftry R,'st,ktil1l' lin'/lsing I""dirt's 1~lI/f's gOl'l'rll;IJg int('f((IIlllrt'fiOlI Argentina Twu companies given exclusive lic('nses tu supply hasic Operalors are reqlliwtito provide; regulalory agency has right 10 intl'rvl'ru', services in separate regions rur up tu ten years, plus line cxclusive license rur Intemillion.,1 and long distance scrvices fur a limited periud, as of 2IK.U. free entry. Chile No exclusive lifenses; price regulation in nuncumpelilive Ohligatory inlercontwrtion is according In presperifil'd ll'r/lls; enfnrccnll'llt is sectors adjudicated by H'gulalor, antitrust commissions, and courts. Jamaica Single, exclusive monopoly nver alltclecurnmunicatluns Ncme servict's for 25 )'ears Single. exclusive monopoly over ba.sic telecommunications Oprralors are required In plOvide extensive service and an l'SS; regulalory .... 0- Mexico Co services for six vears, as of 1997, frl'e entry. ar,ency has right In inlt'rvelll', P£'ru Singlt". exclush'c monopoly over all lelccommunications After monopoly periud expiws, opefillors Me fl'fJuired 10 \.rovidl' exh'l\sive services fur five years, as (If 19YR, free entry- St.'rvice and ilcn'ss 10 I'0lenliillelllrilnls; lerms will be I'rtlvi,fl'd ill a tIler d.ltl'; and wgulalory agency has righl 10 intervene, Uniled Kingdom fntry inlo fixed-link services restricled to duopoly, Ohligatnry interconnt'ction is slIbjecttu paymt'nl 10 rixed lillk provided this is 1983-90; subsequently opened, but all licenses provided at negotiated by parties wilh regulator as arhiter, discretion uf regul"tor and dcpiuhncnt (If trade and industry (on parliamentary authority) Venezuela Single, e)(clusivt' monopoly liver alltt.'lecommuniralions After mOllupoly period expires, operilturs are required to provide extellsivl' services for nine years service and acn'ss 10 polt'nlial ('nlranls; tt'rms \IIill Lt.' providl'd .11 a !.Her dale; and regul,ltory agcllcy hilS righttn inlervene. Sourct: Authors cuml'ilation . .. .. , . ... .,.' I/o I. Table 7AA. Rt'glllatory n,,11 ',lU""'''';"" EII11;rmlllll,,,t ;11 '1i'iI'co"Wl/lllinJt;mls, Sdt'l'il'd COIlI/tril'S ('()IIII'd/I 'all Coun'ry Rt'g II III tio n Iv(nt Umgtlistlmft' 1,"rrnllllOllat data MD/·II Prml/e I1rlwork lInih'tl Stall'S 11,,1('1"'11111'111. RI1\ll'rnm""I,rt'gul,lll'll (llll' IIK.11 mon"l'oly in ;\11 nnec major r.1rril'ls allli sl'ver;\1 M.my rllllll'l'lilOlS Two ('lrri(,15 In l'.11 h (1l'en ClHlllwlilion monupuly prior 10 1984, I'll"" III< '1Iil'"'>; SUI Ill' (llllll'elilion hun." ... llnillllr ('a"iers an.! III1' II0l'uUlan.,Il·;) (lml'dilion for long .Ji<;I,11ue in IIIb.lI1 area~ in .1.1/.1 servicC'S rl"St·lll·IS 5t'rVilC'S ... inn· Iq~; regional monol'oliC'S'm lucal s('rvj«(, Argcnllna I'rivalilt'll ill Iq?O, gl)\ll!rnlll('nl Mllllol'"ly wilh Iwo !".lIlh'IS (.III! lillllwilh ,'"lusII'" I i.:hls ()I'I'11 tOIllI't'lin"", ""llinly S ill IltH'II"~ I\yo ( ,II' il" ()I"'lIl1l1l l l"'liliPII regol.'lury ('nlily is CNT. monul''''y Tl'Il'''~lIif.l .II! Argl:'nlinil Illllill'/'18 (JIll' "I "'I,lll1r (o",nl'i,t.ling tI' was 1I.'lI"ilc.1 hiJden ,'II I he iillle IIf minimum c'I'e'II .. nct' .1n.1 IIWIWIShip ill £IIn'l'"ni,,,,,; I',"v.'n ill, ,,"',os.c .. , '" I.."" III pfl"llialiljcOlUun consullium !,l'rHTllln .''is'" v.,tlle in IlIn'!! ),",lI5I'rilll 10hitl,ling n.lIspO" Meklco Concrsslonlng til rail Ireighl lines Regislrallnn Ihfllll@h wrillen slaleml'nl 01 l)(>monsltalN legal. "'(hnleal. ~ntl Ill'mllnslralnllinancL,1 cilp"rily mll'rE'Sl; illlihorilalilln of regislcn'l.t jI.lrlil"S aolmlnlslralive (al'.1Cily ... 0' by Ihe Minlslry Communicallons and nansporlalilln based on uniform rrilcria c;;: Ilungary DOT for loll roaiJ m~ilalions for rrl",lIalifiralilln h.lSt'l.f tin (·,'p.lfily of l,ioMt'rs to 11("5 ig-rl , huil.l, \ill','Cily of hl,Mers In finance fll,lllwilhoul .1(11'1011 .... 1prciiminary design plans tn.linl,"", alltl o(1(,I.,le loll m.ltl 51,111" ai,l Cllilluall'l.f l,y ('-I'CII assl'SSnll'nl cUlllmilln' IVnl..r Arlltenllna ftu('nos A irE'S c()l\ .. es~i(ln USSlO.IUl ••'e fm I'reolu;llifi.-.,lh,n Minimum 1'"1'"I,llion of "'rgl'sl rily anJ Minimum r("luilemt'nl~ fOf Inl.I1311nllOlI dlll,lIml'lIls aggl"lpll'l'''l'ul.llillll ~l'r~l.J I>y I>itltll" Lilling anol nci shall' shOlfe (ill'ilal; consortium sh.veholtlillK .1i~lri""Ii.,n rt'gim~ fIolillla 1..1 I'u concE'Sslon QII.lllli,aliun 1'llXess In l"h'I,I.l! e 011 S.Wll' ('onsnrli,l muslim IIhle wale" opcrator with Minimum nt'l worlh and llIa_lmllm dd'Ho lime as t"(tlIHlnU( l,i,1s I'n~'III('o.1 minimum e'l'c,it'ncc antlrl knillf servl(e II' l"'tuily ralio ol'eralor Nn'lIf11'glfi Me_ko Concessionlng of ,1151, illlliiOIl Rq~islr'llllIll 0/ hlh'l~h',1 hhld"ls .1Ihl Ilo.lll1l11o'III"Ii"l\lIlkdmi!al.llltl I 'It"I"".. nl.lli,," IIf lill.lnt 1;.1 ("I'Mil), nu .. ·th'l-\sl'l'IWI't'l1 Il'gul.lhlt "nlll'I"·'I'.'oli~... aol,"inislr.llivC' (,110.11 ily l,i>I,h'lslo d.llify ill'''I",''lilllll'liOl It) Il'dllih .III,itls; ~m.11I hoc Sourct: Kt'rf alld nlllt'rs (1(11)8) . .. " Co"crsslorrs a"d FranchIses Q$ Modes of PrIVate 5t!ctor PartlCl'oatro" and AJtt"matlut'S to Rl!'gulatlorr 179 • Two stages should be used: one to prequalify interested parties on the basis of experiences and the technical proposal, if applicable, and a second one to solicit bids from the prequalilied bidders using a single criteria for selection. • Prequalification should use established procedures with strong technical and financial critena (see table 8.2 for examples). • The winning bid should be selected solely on the basis of the financial proposals (single criteria highest canon or fee) submitted b:: bidders who have met the technical qualifications, which may include a requrrement to submit a technical proposal for meetmg the requirements of the contract. • The financial proposals or second stage bidding should normally be specified in terms of the high- est annual canon-as a percentage of gross invoices-to be paid by the concessionaire (perhaps after a suitable grace period) on the basIS or a defined combination of tariffs, initlal payment, and assumption of debt. Alternatively, for some special settings, the financial proposals should be speci- fied in terms of the least present value of revenues, The Implementation of an Optimal Concession Award Criteria The awarding of a concession should be established using the t\No stages desc:ibed earlier. At the second stage, the salient choices for concession award eiteria, based on effiCiency, incentives, and effectlveness agam.st renegotiation, should be two, an annuity canon and LPVR. The following describes these two in greater detail. CA.,\:ON-BA.S£D CONCESSIO:-': AWARDING CRITERlA SCHE.'v{E. During the second stage, the awarding criteria should be based on the maximum amount for the rights to operate the concession, having established a duration commensurate with the life of the assets (20-30 years) and haYing set maximum tariffs and regulatory regime price caps or rate of return. The operator submitting the highest amount obtams t..r,.e conceS51On. That amount or money is placed into an interest accumulating trust, which could be Invested In rISk free assets, to be disbursed to the government in annual amounts throughout the liie of the concession. While the first payment could be larger than the rest, it should not exceed 15 percent of the total amount. Any government could borrow against these payments, but only tor the disbursements matciung its elected period. This scheme has three attractive features. First, it uses a nonsoft criterion to award the concession, which is more difficult to renegotiate and is consistent with the transfer for the use of the existing assets and the right to operate the concession. Second, by forcing the operator to pay a single amount up front it generates a lock-in effect increases the commitment of the operator, and grants increased leverage to the government in the event of the operator's performance noncompliance. Third, it provides for in- creased ownership (of the concession decision) for future governments, because they will also benefit from annual payments. This component ~s a drawback, compared with a scheme where an operator makes annual pay- ments, in the sense that it is financially more expensive, because the amounts of funds needed at the start are clearly greater than in a scheme with a simple canon, paid annually by the operator. However, argu- ably, the benefits of increased commitment are bound to be greater than these increased financial costs MINIMUM PRESENT VALliE OF REVENUES. An interesting alternative developed by EngeL Fischer, and Galetovic (1998,2000) for certain types of concessions is the use of the nunimum present value of total revenue as the criteria to allocate concessions. Interested operators bid on the present value of total revenue to be received and the one submitting the lowest value gains the concession. Once that present value of total revenues is received the concession ends. The government sets up maximum tariffs and a rate of discount that can be fixed or variable. This scheme has multiple advantages. Perhaps the most important is that it preempts renegotiation and rent seeking by opportunistic operators. This is most important because renegotiation of concession contracts is pervasive. Almost 50 percent of all conces- sion contracts are renegotiated within three years of the award of the concession, and at least half of the TillIte B.2. idl'rrtijit'lIlicm alltl AI/oIl/till" of RisAs What ;s tl,e risk? /low dol'S it nrise? 1I0ll' sllOlIld it lIe nl/vclIlt'll? I Jros;S,,'Jt'lIf'IOPlIIl'lIt ,iii Ul'Sit;n dell,," Ill'sign '.11111 in I.. ncler sl'c'tilkalions "IIIolie ~I' 10' lu he." ri ... 1e Conlradur cll'Sign 1.\1111 Jj'lul.t,.Ir.1 ,I'llll,'gt><; 10 1>"l'ilid loy (Onlr.lel",. onet:' li'l'li,lilk.1 tt..m.'g.,~ illl' l'.h.lt" .... l. t'fo~illn 01 rroj(', I elllol',ll1Y'S returns ('Ol.st1ll,,';Oll ,ijl Cuslu'IIt'rrun Wilhin {on'ilnillion ((1nslI,IIIIIII'S (ullirol (indlidrnl {onslnltliclfI pm(licc"5. {'onl,.IIIOI In h.·ar lis" ItHollgh fi.l·d·rrice (onslru{!;lIn ("(lI\lr.l(( I'III~ waslagl'S, ,ll1tl 'ill 'millt li'llIhl.,h .. llt"m,lgl'S; on((' 1i'I"i,IOIh.,j ,1,1",,1/-:1"5 aft' l'\h.,"s"'.I. ('Io·.itlll 01 I'rt;l't I (IIml'any's rei urns Oulsitll' cUlIslrllcli"n CIIn~o'lillm'5 conllol; {h~l1gc'S in Ih"ll'llI'I,ll1ll'g,ll IIl·HII.·. ri~k il in~lIr.U\ee is ayaiI.JhlC'; IIn((' in~III,lI1(t' 1'11 •.-..,£,\1 ...HI' l'\h.llhl.~I. fr.lmework (rh.lngl':> u11Ol1'V5. IlIeft''''i,'\II.lxc><;, iUlll slIl",tI., ~ .. >silln "'1',,;,·,1 (IIml'.111)··5 H'lulnS Olllsl.ll· cfllISlrllcli"n ellno;nrlillln'S I4II111nl; ",liolls ~1l\·l'.nn"'nllhOlI (1' ,'uhli( ';1... lnr \"h",l1 rhk sl'ecilirally ;:III ... llh!..' 1"lIjl·II(" ....1)'5 in ,,"Iainlng a!'p,oy.lls III l'l·lmiI5. and 5(1 IUrlJI, 1Jd.lr in flllllpll'litlil Wilhi"I·O"~llIlllh,nl"ns... lillm·l' 1'11111 ...1 (I ... L: .., t· ...... lill.llillll ,,' , ill"i.I,h''' ".lIn.II:I'~ 10 I,.· I ',Ii, I I'Y 'nih'"'' !'" ...... ,. li'I',i.l.III. t ,1.11 ... 11:'· .lI,' 511114.· .. 1111.1(101 ~ .Ulllloll!.' l',h.," ""I. "Il~i.JII oll'''~'' ICII.nl, .• ny· .. 11'1"",, Uuls;.I" ,.'_1 . . I it I.' [' \ tl,II.~.lt'I' t'rn~ipJl lit I fr"i~'t It t IU\p.t1\)'·t.\ • t h.IIl') .... fall II It.- u'I'roj('{llo Rlecll· .. .,.. ml.lucl' clilt',i.) ~ al {IIOIpldi"n CJII.)lil), SI"'III'III .• Id,'d, in • ""~In .. linn .•10.1 ~" ,,,,lit I hl',id .ltd ,1.1Il,,'r,I'·' III""1',li.1 I,,, '"11,1""11,,. "Ii"'liqllid"',,,, .1.III"f,I·' .11,' 1'.h.I"· .... 1.1"11"'"" IIII',"j,·.1 tll'\lI,.III~··S .dlllib P,Ie-Flllillg cost ,i ..l ("',·r.,ling fIlSl o'lll.'rmns (h.tn~I' io I'r.l, lill' ,,' "1'1"1 11011 ,111"'1'" I fI'ml',lII), '.; 11"111 •• ,1 1"01"1' "'ml""'}' Iii ",",., ri·'\'; (,.,~,.111l1 "'iluli' I i'l"ill.oI,'" ,1.1I1I.,~"s 1,,1,,· 1,·.i,II,\ "I',·L1!·', II. 1III'I·".i'~ I htluht..ted l"l.H.tJ~\"'" fHt.' (',h.HI"",-", ('f\ l"'iipu pi I'h1J\'\ I tun, •• In\'' ~ ,,'11111'--. f .. ilull'tlr clday In ohlaillillK I't-,lIIisslll •. ,. (011 sell Is, anJ .1I'I"0'I/,l1" Ilublil,;c.'I:lurllb"..,i"o ,'ul,lit" .Iulhllrili,'~ 10 I',·.IT. i,l. n"m~l'"S In I'rifl"S ttl sUI'1 ,Iil" Inut'.I,<,.II'lin's ,\lI"I,IIIIInllllh\.. 101111' I' III) 1.... 1.'1,1,· 10' ,.,,11 ..1 II I. If I. " : " . III 1"'.1. ,! \S1I1'1";,·I.I"O;'·,! ,,11II1'.In). II', ,,;1 ii' Nlllllldi'lll'ry of 5ul'l'lil"S 11111111.' I,.HI "'I'III,lit iI"IIHlIilil'S I'uhlit' "',1.,, I.,illlll' l'ol.li. 11I1I1I"ili,,,," ",',11 I i,~ It"",,,,"- ,is' (l!.Iogl.'s in I.uilf~ 111,"'01,1,11'1" \\'ill •• I,,· 11'''11';''' 11"'1,.1\'1.11' (1111 ,· •. 11111,1,·. 1",1,·,.,1;,","1 ""'it I' I ~ ""p.IU)" k' 11,:~u li·.l I.uill~ 1",IIb III fI'.lufi·' I ,II 111.,11,1) (;"'111""1111'11110,,',11 h ,,/11 .. ·1,'1111511' II .. ,. ,,"11,111 l'III·Ii. ·•·.. 01 1t0l .... 11 Ii,\.. ('hM'8''S In llcm.lntl I )c(l!..',lsl ... lcll'lII.III.1 l'ltli'", '"1111',111)' 10 1"'OIr II>\.. ---- ..- - - - ----_ ... _-- (/,,'1', ,,,,,111/11,'''; PII I'".,''' ., .. '. Table 8.1 L'O",i"Ilrd WIlt'll ;s lilt' risk? flow dol's it III ist'? HoUl sllould it I", ll11ot'tJfc'd? Shortfall In qU.lrltlly. or ~horllaliin qllollily 0l'cralof'S f.lllil I i'llIi.I.'lnl.I.III"'g~"'II". \I" I"'icl \')' Ih" "",·r ..... ,. ,,,,,-,·Ii'I,,i,I.!I,... I.I,IIII.1I;'''' leading 10 re..luce..l dernarul illl! ".h.IIISku. erosion 0' PlUjC( 1(01111'.111)"" rclllll\s rroje.... company's faull l.i'luid.llrtl ,bmaRC'S 10 be l'aiJ hy lhc pmj('<:1 compallY 10 ruhlie authority rill/llle;,,1 Ri:J: Euhange ralt!'5; inl('fest rales r~v.ilualion 0'10<.11 (lI"rncy; nllCI",lllons rwje.,... one mSllres the protedion 0' the lngger mle ror changes hil.!"N bitlolll !3 Ind,,,I" delAiled If'\ hnical oUe,s (such as lesal .lSJlects environmenl on an agu'l'lt (051 struclure TIming rl'lmml, SO'''l't: Authors. I I ,t I j " lirble B.l0. COlltmd Siructllre nlld Ut''lu/irlillll of lIt'rtricity ,1I,rrlllllflllll tilt' (;,mll'f Buenos A irl's A rl'll Bidtlitl8 proCl,dllre 1erm Coulmcl requirelllcnt Rnlt' rt'8u1nl;m, Qunlity rt'quin'''lt'llts '''llI'stmt'lit Two cnv~I0l'es: envelope (lne C('I1Cl'ssion is fur 95 years fnr Ili~llihlltt" as a I'uhlic Sl'llIifl' in RI" X t Y Minimllm 'l"alily slan.I.lnls No (onlml of inveslml'llll>y specifies the lecMlcal exdusillity in a "rt"Cilic lOne Ihe wnn'ssion lone (Ill/rring' (a) rrodud (1I'nsion). thc I'uhlk 5('(lor ahl1l)\!~h tf'f:)ull1!menls and delermines aflt'r which new bid, ling will M".imum !,rice Is USI:'tI willt (hlll'(hnical servicf' (duration ir"'('''lm('nls oll('r US S2 the plt'tlualifie..1 biJJe~ II hall!.' 10 be made PmCl'CIls 01 (ommil 10 Spt'l'lIic qll.llily levels 101011 rass·lhrough ollhe (o~ls "nd frr'lu,'ncy of (llll.lg~). and mill)lIn n('("llh(' fl·glll.llllry conlalns the share of a,llons bill are 10 gu 10 Ihl! Incuml>l'nl, III ellrrg)' In the whol~ale leI commercial service enlity's "1'PHlII,ll and al'\lblir 10 be subscribed by each whu is also allowed 10 hhl Ihw;I'l.. llhe righls of users as mal ~I'I I y) "noJ In.leulion lu (complain Is hy cli('uI5. lime 10 hl·.llillg cohlJJer, show, a single specified In Ihe reglamenlo US price Inti ex (RPI, g('1 cl1llO('(tion. bill estlmal~) unllle..llocal h."'Sldcnn" rroof 11l<' 1l"lm can be c.lcn,IL,,1 (n, a .11.' suhminlslro Hf h,'Sal cKisll'nce; IlSS 10 1"'1 iOllup III Il'II yean. 10 I,c 1111.' 111,11.''' liSt" I Is 67 !'t'rn'lll r"r n"',lSlIu"nenl. twu slq's nlilllonB,uaranlee for offer; Jl'lerminCtI by Ihe regula lory Salisly Ihe tnl.J1.tf'm.1WI IOf I'rOlhl(t'r I'rlce In,lel an.1 33 ,ldim,,1 witi. dilll'II'nl ~llals an,l prllposetl acUnn rliln lot enlily. whh h c.lll also RIotlify serllice. IncllhllnB, den.antllur I't'rccnl {lIfl1!nll'rice in,h-•. (.1' during the firsl1l> monlhs. conlractual olJligalions. or !'ul'l'ress the zonal new services m{'''~lIremenl of ml'llillm exclusillity 1lIlli.llly X was 100 It'n~ion, anoJ (N as of Ihl' thirly· F.nvt>ll'1,e two has Ihe ecnnnmic I'rovitle l'nergy for 1'1I1,lie s,·v('nlt. month ml'a~urt'mcnl offer with amuunl in ce lin tariff (as the current t;uHf) dishursed in rive )'ears; stage pl'rn'nt.lge of clIrrt'nt) alld tWII, aproposal Oil tariffs per I'riu' of ctlnression I.tbor cost cllhic meter, debt service commitl1lents 51 ('IIVl'I.lge of iltleast I, and dl'ht tll rl'Vl'lllll' rOltill or 15 Investment needed US$75 million US$320 million US$1UO million in first five Not aVilil.lbll' years Customer base 50t.),OOO inh"hitilnts in ten citit,!; 700,OOO,inh.lhitants in 120 Not avaif.1Lle of l 'ordllb.l tIIhiln for waler ami sewerilge communities for willt'r ,lIld 127,000 people ill tl'll comm- unities ror sewl'ragt' ResponsiLililies of Operatioll and mainlt'nalKe Operation ilild m.lillll'll'lIlCe as ()pl'r.ltillll ilntl maintenance ()pl'ralion and lll;'linlf'll.1nce private operator as well as investnwnls well as ilK. percpllt wilter l'OV- with minimum targl't and as wl'll as illvestllH'nt eragl' after sh.th yt'iH ;md 100 objedives Sl't in the contr;lcl percent S4..'Wl'ragl' ~;t'rvicl's after and .1 Illal!.illlllm time fralllt' eleventh Yl';U "IllS l'HlI'rgency fur l';\Ch glial (expansion. work ill first two yt';US 'lll'llily. IHl'SSlIrl' rehahilit;,tio", alld healnlt'llt) SO",Lt',' !:starlit' and ROllriglll'z-Paulina (1(J97). r"ble B,12. Rt's"'atioll of WII'O 1I11t! Sa"U,";"II, CI.araderisl it' 1I111"IOS Aires Con/olm Sallta 1'(' Brood st>dor nforms Reorganizatiun Allhe n.1lionallevel, no mil;nr ...('cloral rd()rm~ yel Several proposals still under discussion ror reform Main objective AI the mt'lropolitan • .Hpa h'vel (under ft·tler,,1 responsibility), 10 privted from Hughes 1999.) The metropolitan region of Piripama, Recife has been facing a rapidly growmg imbalance between water. demand and water supplies. The performance of the state water com- pany, COMPESA, is weak, and it is unable to finance the development of new water supply projects. As a result, in 1996 it started to explore the option of private finance to complete the development of a new reservoir, water treatment plant, and associated transmission system drawing upon the Piripama river to the south of the region. The company's water losses in 1995 were 54 percent. Its demand projections assume that these losses can be reduced to less than 30 percent within seven years although it is not clear how thIS IS to be achieved under the present system of incentives and management. Even so, the water supply available from the current system and one other project nearing completion will only cover 60 to 70 percent of projected demand at that time. Hence, the state invited proposals for a BOT-style contract to supply water from the Piripama reservoir to COMPESA over a period of 20 years. The investment required was about USS200 million for the reservoir, a treatment station with a capac- ity of 5.6 m 3 / s, and transmission pipes. Construction would require two to three years, but the projec- tIons assumed that water supplied by the project will only reach 80 percent of full capacity 3..tter nearly eight years of operation. The slow build-up of revenue from water supply meant that the net cash flow from the project was unlikely to cover the full costs of debt service for several years, even though the bulk water price was USSO.575 cents per cubic meter, which is high for such contracts. A preliminary project analysis indicated that the project might be viable on current projections with an average cost of capital of 20 percent. However, the risks were high. Cost overruns or delays in completing the reservoir would greatly reduce the return on capital. On the other hand, if COMPESA failed to meet its targets for reducing water losses, revenues in the early years would be higher than projected. and the return would be significantly higher. In effect. any firm that undertook the project was betting that it could control its development costs and that COtvlPESA would not be successful in reducing its losses. Many features of the project suggest that neither COMPESA nor the state government appreciated the ccnditions required to develop a successful Bar project. The marginal cost of water under this scheme Conct.Sslons and Franctll.ses as Modes of Prwate Sector Partl::lpatlon and AIte'Tl1.atlPeS to kgulatlon 213 was high, yet the project was not viable because less costly measures to meet some of the supply deficit had not been implemented. lndeed, this deficit will increase rapidly after the project reaches full capacity, and it will be no more than a temporary stopgap. Further, large changes are required in the financIal and operational management of water and sanitation services in the metropolitan area in order to achieve something close to 100 percent coverage of piped water and sewers. The attempt to award a BOT contract failed, which was almost certainly the best outcome. In the circum- stances, a muc.>t ~_. ~ .... _::.:. ~. ~ have bee!'1 to split the exist'_~g v·,rate: and sa."1it~t:ior. syste:n for t.>te metropolitan region of Reciie into two or three separate subsystems. The concessions could be awarded to private operators who would take complete responsibility for improving or expanding services. The Piripama project might then be completed after review and, perhaps, redesigned by the concessionaires acting jointly or bv one concessionaire that would have exclusive access to the water that it supplies. Finanang the project as o~e part of a much larger investment program covering both treatment and distribution would be much easier and more satisfactory than relying upon a stand-alone BOT contract. Contract Termination in the Province of Tucuman (Adapted from Artana, Navajos, Urbizondo 1998) Water and sewage were privatized in the province of Tucuman in 1995 (Artana, Navajas, and Urbizondo 1998). Only one group, Compafua de Aguas del Aconquija (CAA), a joint venture between a French company (Compagnie Generale des Eaux) and three Argentine companies (none of them from Tucuman), participated in the August 1994 auction. After the government of Tucuman accepted CAA's technical proposal, it negotiated the economic proposal, which was based on an initial increment of the average tariff. CAA reduced its original request of a 94.1 percent increase to the finally approved 67.9 percent increase. In December 1994, a 3D-year concession ror the provision of water and sewerage was granted to CAA, which started operations in July 1995. Two unexpected events occurred that affected the concession and that led to the cancellation of the concession in September 1997: • In October 1995 a new government took office in Tucuman, and in December 1995 the provincial Congress passed a resolution to limit the increase in the average tariff to 35 percent until a new tariff is negotiated. On January 15, 1996, the public agency that reviews the legal aspects of public decisions in Tucuman decided that the 67.9 percent increase in the average tariff already included provincial and local sales taxes, contrary to c.A.A's position that any indirect tax should be added to its tariff. • On January 25, 1996, manganese was found in the main water source for Tucuman. Although the finn had to comply with quality targets that included a maximum level of manganese and the affected water source was not the responsibility of C.A.A, public confidence in the company was shaken when the water changed to a dark brown color. (CAA argues that manganese level was not a priority because, according to the contract, it had to be measured only once a month.) In March 1996 the provincial government threatened to terminate CAA's contract. The fum's response was to apply for protection of investments under the Argentine-French treaty. A lengthy negotiation between CAA and the provincial government still continues. Political pressure existed to reduce tariffs, and campaigns were launched to not pay water bills. CAA did not suspend service for political reasons although the contract allowed it to do so, which was probably part of a negotiation strategy. As a conse- quence, water bills arrears increased from 38 percent at the beginning of the concession to 75 percent as of December 1997. In August 1996, CAA, the executive branch of the provincial government, and federal officials agreed. to a new contract, but the provincial Congress rejected it. In December 1996 CAA appealed to the Argentine- .. French treaty again, but suspended its request in March 1997 because the government decided to name a commission to negotiate a new contract. The vice governor, two legislators, and a labor union representa- tive fonned the conunission that negotiated a new contract with CAA, but the provincial legislature and the 21-1 ., LuIS Gwzscn and Pabio Spliirr executive introduced some changes. CAA did not accept these changes and again asked for protection under the Argentine-French treaty. The executive sent draft legislation to the legislature with the new con- tract agreed to between the commission and CAA, but Congress rejected it again in August 1997. After that. both CAA and the government of Tucuman asked for the termination of the concession. CM was iorced to continue operating the concession for 18 additional months until the government found a new supplier because the contract allowed the executive to extend the contract for such a period, if needec!. Ar-.:ALYSIS OF THE CASE. Under the terms of its concession, CAA was responsible for providing water and sewage treatment to the city of Tucuman, 9 other cities, and 70 small towns. A clear intention existed to subsidize the provision of the service in some areas, especially the small towns, with higher tariffs in the city of Tucuman. The average tariff was calculated based on several characteristics of the propert)" as in the Buenos Aires concession, with no formal targets on metenng. A new government took office in 1995 whose electoral campaign was based on several criticisms of the reforms initiated by the previous admin- istration. When manganese appeared in the water in Tucuman, the Ministry of Health announced that it was no longer drinkable. Throughout this episode, CAA's strategy was to negotiate with the government. This was clear even before it started operations because it accepted a lower increase in tariffs than the one included in its original proposaL Moreover, the contract provided for an annual 10 percent increase in the average tariff, calculated over the adjusted price. This strategy was evident on two occasions when CA.A. agreed to postpone its appeal to the Argentine-French treaty for the protection of investments. Furthermore, al- though it would have been within its contractual rights, CAA did not wlthhold the provision ot water to families who were in arrears. This case was clearly outside the initial contract because the eventual outcome was the cancellation of the concession. The cancellation decision was motivated by two events: the change tn government that led to a politicization of the c;ontract and the manganese episode, which was resolved tn two days but increased political pressures. . The contract explicitly mentioned that CAA was responsible tor providing water (point 4.3.1.) and not just for compliance with routine controls. More important, point 4.3.1 also said that CAA had to take, at its own cost, any measures necessary to avoid pollution of the treatment plants or the distribution sys- tem. The contract also included, though, specific penalties for an eventual deterioration in quality. Point .. .3.2 of the contract states that deterioration in quality must be considered a d~ger to the health of the population. No cases exist in which an isolated incident of noncompliance leads to the cancellation of the contract. Furthermore, unexpected events are not subject to sanction (point 142 of the contract). In fact point 14.10.5 of the contract imposes a penalty of USS10.000 for not adopting in due time the necessary measures to prevent polluted water from entering into the facilities for treatment or distribution, and POlnt 14.10.6 imposes a penalty of USS20,OOO for any noncompliance in the quality targets for water, whlch has serious consequences. The most severe sanction is mentioned in general in article 8 of the legislation (Law 6529) approving the privatization. This article allows the regulatory agency to intervene if there is a danger to the population even if the firm is found to be the major cause of the danger. Article 59 of the law states, though, that. in the case of severe noncompliance with the contract, the regulatory agency may demand that the concessionaires resolve the problem. Article 64 states that, if deficiencies exist in the quality of the service, the concessionaire should pay a penalty calculated as a percentage of the sales of the firm in the area affected by the problem. Government threats to cancel the concession without follOwing the steps prescribed by the contract in cases of serious deterioration in water quality can be understood to signal its intention to politicize the conflict. Congressmen and officials, as shown by their pronouncement that the increase in the average tariff already included the impact of indirect taxes, were also making politic.al demands. The contract is clear about this issue. Provincial and municipal taxes are not costs to the firm (point 9.2), and they are to be passec on to the consumer (point 12.10.5). Another example is a similar discussion about who has to COrtCt:SSIO'f'lS arta FranchlSt's as Moat's oj PrTtJatl! 5ec~::Jr Partlopatlon and AJum.t:r:'C't'S w Rt'gulatlo'f'l 215 pay the percentage of the tari.."i that finances the regulatory agency. It is interesting to note that the law establishing the privatization of water and sewerage in Tucuman required the winrung bidder to main- tain on the payroll at least 90 percent of the employees of DIPOS, the public finn. Given the traditional overstaffing of public enterprises, this requirement leads to a higher average tariff or a service that has shown major difficulties in collecting overdue payments. In addition to political conflict betvveen entering and departing governments, other factors mig.~t explain whv the CA.A. contract became the focus of disputes. First, the increase in tariffs was negotiated betvveen th~ firm (the onlv one that participated in the auctlOn) and the former government. No other bids were received. Alth;ugh the final outcome of that negotIation was an increase in tariffs that was lower than that requested by CAA, no benchmark occurred, leading casual observers to believe that the process was not transparent. Second, a higher tariff was needed to finance CAA's ambitious investment prog:-am. This in- creased the likelihood of customer noncompliance with bill payments. The canon was set to zero in order to offset this risk. In fact, Law 6445 stated that the tariff should not include any charges for the depreciation of the existing stock of capital. The intent of Law 6445 was clearly to penalize consum- ers who were in arrears, but the change in government in 1995, together with severe macroeconomic conditions in a province that had one of the highest unemployment rates in Argentina, eased the way for the politicization of the collection process. Law 64-45 established a restflction on the regional subsidy of 5 percent of the total revenue of the company, which would be compensated by the gov- ernment through the budget. CAA's renegotiation position with the new government was ambivalent. The company's request for protection Wlder the terms of the Argentine-French treaty was clearly issued as a threat. CAA could have first opted for requesting arbitration as per point 5..1..1. in the contract. Such an option would likely have been ignored by the press outside Tucuman and also by the federal government. It is also interesting to note that, although CAAemployees own 10 percent of the company's stock, this has had no effect on the politicization of the conflict. The rules that govern the regulatory agency have some positive aspects. For example. sanctions to the firm are included in the budget of the agency, providing an incentive for effective monitoring (and appli· cation of the penalties). The executive names the agency directors _with the approval of the provincial legislature for a period of six years, and the agency directors cannot have any contractual relationship with the conceSSionaire for two years after they leave the agency. This restriction has not been common in federal or provincial privatizations in Argentina. However, the municipal governments name tvvo of the five agency directors, introducing some room for politicization. The concentration of ownership in the French company was different from the alternative chosen in the case of Corrientes, another province of Argentina, where domestic participation in the ownership of the concession was stronger. Instead of raising the interest of local entrepreneurs, equity investment protection offered by an international treaty had the effect of further concentrating equity in the hands of foreigners. The treaty was not enough to avoid the cancellation of the contract. however, despite the fact that the finn might end up receiving compensation in the future. . The case is illustrative or the difficult balance between securing the financing of important sunk in· vestments ex ante and ensuring the ex post sustainability of high tarilis in the presence of a profound change in government and insufficient competition in the award process. In spite of the use of several standard instruments like reserving a fraction of the equity of the firm for employees, having a relatively good design of the regulatory agency, and placing a limit on regional cross-subsidies, the privatization tailed. Some pitfalls may have contributed to this failure. For example, the requirement that at least 90 percent of the existing staff remain employed in the new company implied a higher tariff. Moreover, CAA accepted the requirement that it negotiate on a bilateral pOSition with the government from the beginning. Finally, the fact that the regulatory agency was local may have eased the way for the politicization of the conflict. 216 J. LU1S GWlSch Qnd PQblo Splilr. Renegotiations of Railway Freight Concessions The kev elements of anv concession are the requirements to fulfill and the canon to pay by the operator, both of which have an impact on costs and on the level and structure of tarifis. (This section is based on Artana, NavaJas, and Urbizondo 1998.) Also important, although sometimes forgotten, is the consistency of incentives to carry out all the terms of the contract, either through auditing efforts and penalties or through the use of private incentives to maximize profits. An auctIon tries to match the seller with the best buyer. Therefore, design of the concession has to account for the interrelationship among these as- pects in a way that effectively induces competition and the selection of the best possible option. The five existing freight concessions were designed for a 30-year duration with an optional 10-year extension. Competinon from trucks sets a limit on tariffs to final users. Thus, the regulatory burden does not disappear, even though it is reasonable to require approval by the regulator or authority before changes in prices. The key issues, then, are the combination of the canon, required expansion, quality of service, unemployment of the preexisting labor force, and the access charge to alternative users of the network in an incentive-comparable way, that is, provinces that wish to provide passenger services. Naturally, dif- ferent feasible combinations of canon and requirements are available according to the objective followed. In this case, the goal of the concession was to find new sources of funds to expand capacity and to im- prove the efficiency of the network's operation because its underdevelopment and poor functioning ex- erted a heavv burden on the treasury. Another goal was to increase the use of a less pollunng means of transportati~n, which, paradoxically, suffers from the effect of public subsidies to autocamers for the use of roads. Privatization experiences before the Convertibility Plan and the Bradv Plan (in 1990 and 1991), on the other hand, stressed the financial aspects of privatization. Furthermore, objectives included not only the development of freight service but also passenger service, which would be promoted by lower charges for access to the railways network, because Ferrocarriles Argentinos was transferring passenger service to the provinces. Naturally, the way to combine these elements so as not to destroy incentives is not a simple matter. Generally speaking, the concessionaires must find it in their interest to respect the offers made. If this 15 sufficiently the case, offers will not be opportunistic, and the auction will attract serious InVestors while at the same time minimizing ex post renegotiation of contractual terms. The importance given to all these aspects does not mean that the criterion for selecting the best offer has to combine all of them. The weights given to each would make the selection process problematic and even arbitrary, increasing the chance of opportunistic offers made just to win the competition, but resting on the hope of ex post bilateral renego- tiation. Instead, it would be highly advisable to fix two of the three vanables, providing some degree of flexibility in the contract and organizing competition. For instance, the quality and expansion requlI'e- ments of the network could be predefined. Similarly, an access charge consistent with real competition by alternative providers of passenger transportation over the network can also be established. The best offer would then be the one fulfilling these conditions and offering the highest canon for the rental of the assets received. Naturally, if requirements are tighter, the highest canon will be lower. Thus, the establishment of quality requirements while competing for a canon is perfectly compatible with differen't objectives pursued in the privatization process. This choice would certainly be transparent and probably would also be more difficult to modify by having explicitly combined different conditions to be considered in the offers. The orgaruzer of the con- cession typically tries to provide consistency and credibility by analyzing the relationship between the three conditions and the projections made by the participants. This fadlitates contract modifications when these conditions do not hold because the weights attached to each dimension might induce high levels of investments. Announced projections must look optimistic even if they are not really optimistic and even if the benefits of the concession came from elsewhere. If, instead, the requirements of the concession are fixed, or linked in the contract to observed market conditions, no need exists to require explicit projec- tions of traffic and other market conditions, which then makes it more difficult for the firms to claim that unexpected events require a renegotiation. The relative ability to renegotiate multidimensional offers Conr:(SSIOnS and FranchlS(S as Modrs :J.{ PnvaU 5ec~or PartiCIpatIon and AJt~nves to RLguiatlor: 217 and one-dimensional offers is at this point a theoretical conjecture with no formal model to defend it (to the authors' knowledge). For instance, in the case of water in Buenos Aires, renegotiation occurred even with one-dimensional offers in 1994, and this also happened, to a certain extent, in the Port of Buenos Aires in 1995. In this case, it was not a renegotiation but rather the misuse of a clause of the contract. Even though the offers were ordered according only to the canon, the offers had to be expliCIt regarding the traffic assurances, which later was argued that this was what was expected. Still, the transparency in the selection of the best alternative with one-dimensional offers reduces the scope for opportunistic behavlOr and, other things being equal, should reduce the probability of renegotiation. Naturally, other tiungs must be equal to draw conclusions from different experiences, induding the warranty for the execution of the contract, the structure of final tariffs making incentive compatible the expansIon of the network, the respect of the investment plan, the autonomy and technical expertise of the regulatory body, the concentration and lobbying abilities of providers and users, and so forth. Unfortunately, the auctions for the concessions of freight services and for the operation of railways in Argentina dete~ed the selection of the winning bids according to a complex set of weights regarding canon, access charge, and investment plans, in addition to experience, size of the work force, and partlci- pation of domestic investors, which made matters even worse. Given tius, even though traffic has in- creased (6.2 percent between 199.2 and 1994 according to former Secretariat of Transportation and Public Works), competition from trucks has been strong, and demand projections have not been reached, which in tum has led to concessionaires lagging behind in their investment plans and in the payment of canon. According to the press, the concessionaires have only carried out 50 percent of the investment plans and owe US$20 million in canon, which for some concessionaires corresponds to being overdue on mOre than one year of monthly payments (see Clarin 1997; Ambito Financiero 1995). The contracts called for the application of penalties for these faults, including the termination of the concessions, but the contracts have proven difficult to enforce. The problem with enforcement also stems from the fact that carrying out the initial investment plans would be inefficient, and, therefore, the renegotiation can be Pareto improVlIlg. Naturally, the renegonatior. would be transparent if it were carried out in the market, that is, if the concessions are terminated and a new auction is organized in which the assets added by the private operators can be included in the package at the price requested by the owners, provided that the new participants have the option to reject these assets. If the option is technically impossible, the valuation of all the assets transferred has to be done by the authorities. New concession requirements should be modified to avoid the inconsistencies of the previous ones. In fact, the current operators could participate and could continue the operation of the freight services provided that they are the highest bidders. The fact that the government has not adopted this alternative leaves open three possible interpretations. First, that the government has problems 111 executing the con- tra.::t which would then trigger a lawsuit. Second, that the government believes the transactlon costs of this alternative are too high, including running the risk that the services may collapse at some point in time. Third, that there is slDlply an inadequate mechanism to defend the interests of taxpayers and users ot the service, either due to a lack of capacity on the part of public officials or the lobbying efforts of CUI1"eIit operators. The last two options seem to be the most relevant ones because the contract did not include the government's active participation in the provision of certain inputs or services to the concessionaires, but the distinction among these options is rather difficult and therefore not attempted here. The ex post inefficiency or the investment plans justifies some type of renegotiation. However, the fact remains that the method used to select the best offer was quite inefficient. This is, in part, also reflected in the difficulties faced during most auctions, which needed to be repeated to find interested investors because in some cases only one offer was presented. It also indicates that renegotiation does have its costs. Indeed, a lower access charge together with a lower investment plan would have meant a much better concession outcome and also probably a more attractive auction with more high-quality offers. In July 1997 the executive ordered the Secretary of Transportation and Public Works to modify the concession contracts (Presidential Decree 605/97), following the authorization to do so by the Comisi6n Bicameral de Reforma del Estado (a bicameral regulatory review commission) in April 1996. During 1995 218 J. LuIS GUtlSch and Pablo SpIll" the executive was trying to renegotiate the contracts without going through Congress. The commission opposed these attempLS. arguing that the discussion disregarded important issues such as the dispute over access charges inVVI','ing the provinClal operator (UEPFP) in Buenos Aires, which had demanded a renegotiation of the USS5 per train/kilometer access charge. This charge was, allegedly, 10 times higher than international standards (see Clarin 1996). The reasons for renegotiation alluded to in the decree include unforeseen changes in conditions, which made contract plans incompatible with the level and composition of the demand, partly due to a shortfall in actual demand relative to ex?e~~e::! demand. Renegotiation requirements in the decree correctly include four important constraints. First they do not affect the economic and financial equation of the concessions, that is, leaving profits constant as in a rebal- ancing of tariffs towards a Ramsey Structure. Presumably, the renegotiation will include lowering the ac- cess charge and the canon, whereas the investment plan will be adapted and the ownerslup of the assets used will be more flexible. Second, they preserve the pnnciple of entrepreneurial risk assumed at the time of competition for the market. TIUrd, they introduce flexibility to formal (or input) requirements without respecting substantial (or output) results. Lastly, the agreement is subject to both internal and external scrutiny by auditors, such as the Auditoria General de la Nacion (SIGEN), an ex post agency directed by a representative of the first political party in the opposition and the Bicameral Reform Commission. In this sense, given the decISion to start a bilateral renegotiation of the contract, the characteristics of the mandate are ex post appropriate, allowing improvements relative to the initial contract. This would mean investments, of which there is no efiecnve demand, and the current high access charge delay the actual development of competition and the expansion in the provision of long distance passenger trans- portation by alternative providers, such as the provinces. Nevertheless, the renegotiation will be carried out with asymmetries of information and a weakened bargaining position by the Secretary of Transpor- tation and Public Works, which makes it unlikely that the financial and economic equaoons of the con- tracts remain constant, as mandatf'd in the decree. Renegotiation is a costly process that should be avoided at the time of the design of the competition for the market. This requires consistency and flexibility in contract clauses, defining the exogenous changes that would lead to changes in the contract and the guiding principle to follow, and al:so avoiding causmg opportunistic misconduct by either party. The design of the concessions did not have these characteristics. Thus, even though the final details of the decision are not yet available, the previous considerations provide sufficient insights to deserve their inclusion in this studY. 9 The Design of Concession-Type Arrangements: Competitive Provision of Goods and Services to Government by the Private Sector in Developing Countries In addition to the transfer or sale to the private sector of productive activities previously undertaken by the government, every government in the world procures goods and services from the private sector and trans- fers rights to the private sector. (This chapter is adapted from Guasch and Marshall [1994].) This has become ever more relevant following the massive privatization programs being implemented in most developing countries. Whereas the state enterprise used to produce the goods or services, private firms are now pro- ducing them. The issue is how the government should transfer or sell productive activities to, and procure goods and services from, the private sector. The problem of transiers and procurement can, at first glance, seem elementary: determine what to sell or buy (or what service to procure or'what rights to transfer), solicit bids and ~ounce how they will be evaluated, rank the bids accordingly, specify a recipient, and take delivery of the commodity. Why are procurements often wrought with arbitrariness, corruption, and waste? Why do governments often end up with underpriced sales, arbitrary winners, poor-quality mer- chandise or suboptimal services for which they have paid too much, and future unwarranted financial liabilities? Why are the regulations of government procurement so voluminous in industrial countries? Oearly, special nontrivial problems exist regarding government procurement and concession desigr... Historically, government transfers of enterprises and procurements often have been characterized by waste, arbitranness, and ineffiqent allocations. These difficulties stem from an underlying principal and agent problem, nontransparency of deSign, and opportunities for discretion and corruption. The govern- ment officials running the transfer and procurement typically have different objectives from those of the government. It is difficult for an outsider to assess whether the discretionary actions of officials are con- sistent with the objectives of government. Discretion is often abused through the scoring of bids. At a single-price auction, bids are scored quite Simply. Monetary offers alone determine the winner and the pnce paid. In procurement bids are scored by more than just cost, because the commodities offered by different vendors are often distinct. The typical constraints of civil service compensation make it imprac- tical to implement high-powered incentive schemes for these officials. Given that renegotiation of complex and often long-term franchises frequently occurs, features that enhance the stability of basic contract provisions may enhance the meaningfulness of the initial award procedure. At the same time. trade-offs are involved in choosing relatively renegotiation-proof contrac- tual provisions, particularly implications for efficiency incentives. For example, the contract may include investment obligations that will be undesirable ex post when demand shifts. Clearly, solutions exist to these types of problems, such as pricing formulas that adjust to benchmark indexes or risk-sharing ar- rangements between consumers, taxpayers, and investors, but these solutions carry their own burden in terms of transaction costs and institutional knowledge if they are to be carried out correctly. Another problem area is designing the process that the government will use to assign the concession and then evaluating the bids. Many of the case studies presented in this book used a two-stage process where technical characteristics were scored first followed by a price bid, but another option is to simply weigh price against all other attributes. When there are several different factors being considered in choos- ing a winner, the committees frequently combine all the parameters into a single value. Although this does simplify one aspect, it also requires a weighting system. Additionally, even after the bids are evaluated, 219 220 f. LUIS GWlScn and Pablo 5pllln- it is possible that the initial bid will not be a good predIctor of eventual performance in a long-term franchise. In certain cases, it can be extremely difficult to evaluate the credibility of a franchisee. This is especially true if past performance does not provide adequate information about future behavior. The ideal auction design will assign rights and obligations to the party or parties best able to perform while minimizing the possibiliry for collusion and reducing the likelihood of ex post renegotiation. A bewildering array of mechanisms is available to aclueve this end. For example, public bids will reduce the incentive to renege, but sealed bids will limit the opportunity to collude. Risk-averse bidders may prefer bidding on a stream of payments rather than a lump sum, but is that-the preferred type or bidder? Descending (dutch) and ascending (english) auctions prOVIde different types of knowledge about valua- tions, and the optimal design depends greatly on the concession. Finally, if the cost of preparing the bid itself is high, the costs could be reunbursed to some extent to enhance the ferOCIty of competItlOn, but the savings from more competition may be lower than the expenditures. Even after the auction, the consigning entity may have to exercise a substantial amount of discretion to determine a winner. The issue is how to manage that discretion so that the process remains credible to investors and legitimate to the public. The government could use independent procurement bodies, staifed by people without conflicts of interest in the process, or the whole process could be contracted out to professional procurement agencies, which have their reputation on the line for future bUSIness. A diffi- culty with those options is that regulatory agencies will in any case be responsible for any recontracting issues arising under the franchise after the award, so perhaps they should be involved in the initJal choice. Ideally, the process should be transparent and the results of making the evaluations public can be seen in the GUATEL example in Guatemala. Against these advantages, one must weigh the fiml.'s need to safe- guard legitimately confidential information. If the government finds the competitive bidding process unwieldy, it can opt instead ior a negotiated agreement, but there is no guarantee that such an agreement will bring about a more efficient or more equitable result. Negotiated,deals require large amounts of institutional knowledge, technical experi- ence, and lots of available human capital. The institution must be equipped to check abuse through appropriate institutional arrangements and through use of benchmark information. Moreover, although it may not make sense to negotiate with a single bidder without another challenger, it may be even less efficient and sensible to carry on simultaneous negotiations with a series of bidders. Many countnes do not have these negotiating capabilities, and even if they do, simultaneous neggtiations may not differ enough from the competitive evaluation process, with minimum specifications in the request tor propos- als, to make the choice worthwhile. The questions that must be answered before deciding between com- petition and negotiation include: " Are the rules clear and credible? • How likely is it that discretion will be abused? • Will bid costs render competition infeasible? • Is the outcome of a competition meaningful given problems of scoring? • How will the credibility of a bidder be established? This chapter focuses primarily on standard procurements, which are procurements that are not re- petitive in nature. However, the chapter also discuss some of the issues associated with nonstandard procurements, such as procurements where development occurs prior to production or, alternatively, where the contract extends over several periods and where the initial commodity specification is likely to change through time. Along with all the problems of standard procurements, additional problems arise with nonstandard procurements because incumbents make procurement-specific investments and seek informational rents during the progression of the contract. The chapter provides a simple conceptual framework within which to analyze standard procurement issues and offers specific policy recommendations for procurement in developing countries, followed by a discussion of the special iss'ues related to nonstandard procurements. (Much of the procurement litera- ture has been surveyed and beautifully exposited in a book by Laiiont and Tuole [19931, on which ~e authors heavily rely. Specific references are contained at the end of chapters in their book.) Desl!n of ConcesSlon- Typt Arrangt'7'l"lmts: CompetitIve PrOVlSICm of Goods and ServIces I7y the PrtvaU Sector In D~laptng Countrtes 221 Procurement: Sale Source and Competitive Many procurements rely on the solicitation of competitive bids. Others involve negotiations with a single supplier. Sometimes a government is forced to conduct a sole-source procurement because the comrnod- . ity that the government wishes to obtain is produced by a monopolist. In the absence of a monopolistic supplier, sole sourcing might still be justifiable. For example, if the government has made a large invest- ment in customizing some procedure to the products of a particular firm, converting to the products of another vendor might be too costly. The process of procuring from a sole source is different from the process of competitive procurement. Sole sourcing involves bilateral negotiation although one might think that a sole source is just the limit- ing case of a competitive procurement. That would be true if the government made a take-it-or-leave-it offer that the sole source, in tum, accepted or rejected. In practice, though, sole sourcing involves much more negotiation than that. Very little negotiation occurs in a competitive procurement. Instead, competitive procurements are much like auctions. Offers bv vendors are considered simultaneously. Simple procedural rules identify the probability of winning f~r each bidder and the payments that the government will make to bidders. The Significant differences between procurements and auctions will be discussed later in this chapter. This analYSis focuses on competitive prOcurements, although sole sourcing is mentioned periodically. In general, sole~ource procurements should be avoided whenever possible. The main reason is that a govern- ment official is typically at a gross informational disadvantage relative to a vendor in the private sector regarding the perfonnance of a commodity. The vendor will, of course, attempt to ma.xim.ize the informa- tional rents earned in the sole-source procurement. Noncooperative competition between vendors greatly reduces informational rents. Simply put, with a competitive procurement, government offiaals can get away with being relatively uninformed. Noncooperative competition will tell them what they need to know. In addition. and probably more important, sole sourcing induces wasteful rent-seeking behavior and may encourage bribery. If the government official must keep the solicitation of bribes confidential. then not all the rents for the sole-source vendor will be transferred through bribes to the government official. In other words, both parties will gain from the bribery. However, such an activity is obviously inefficient and thus detrimental to social welfare (for additional information, see Klein 1998a, b). A Simple Framework for Thinking about Standard Procurement: The Got1ernment's Objectit1e What is the objective of a government that is conducting a competitive procurement? For this chapter, the authors make a simple but encompassing assumption. The government wants to ma.ximize its surplus from the acquisition. The assumption is for now that the government is not a player in the game. Specifi- cally, the government is not setting a strategic reserve policy, imposing an entry fee. or using any other device to take advantage of its monopsony power. Why is the concern with surplus maxiIIUzation rather than efficiency? If a fixed quantity is being purchased. surplus maximization generally produces efficient outcomes when the government is passive in the procurement. (This depends on the procurement mecha- nism used and the underlying characteristics of the bidders.) What is meant by surplus? In a competitive procurement, each firm submits a bid that consists of two distinct components. First each firm specifies exactly what it will produce for the government. The gross benefit that the government derives from the acquisition of firm i's commodity is expressed in monetary wtits as Q,. The function that maps the multi- dimensional commodity characteristics of firm i's bid into a single number, Q,., is called the scoring func- tion. Second, each firm specifies how much it must be paid to provide the government with the proposed commodity. The acquisition cost for the government is denoted as Xi' Then, the surplus offered to the government by finn i is Q, - Xi' The scoring function is critical to many of the issues associated with procurement. More generally. each firm submits an Xi and a vector of function or product characteristics: Z, Z, ... Z and then Q,"Q,{Z, Z... , Z). nus scoring function, Q.. maps the multidimensional characteristics of a procurement bid into R/ for each finn i. Then, surpluses can be calculated for each firm, the firms ranked, and a winner determined. 222 f. Lul.5 GllASdt and Pablo Splllt'~ Surplus maximization may seem to be an o\'erly simplistic goal. Aiter ill, many govemme..... ts make skewe::! procurement awards. For example, fledgling comparues that are viewed as vital to the national interest may receive awards as a form of govcmment subsidy. How does this fit in with surplus ma.xmtization? The key to answering this question and to understanding many of the central issues with procure- ment is to understand the scoring function, Q" and its origins. The cost component of a procurement bid has a transparent meaning. In trivial procurements, Q, is not problematic either. For example, if a govern- ment wants to buy high-density 3.5-inch diskettes that meet certain quality standards, then Q, is the same for all firms that can meet those specifications (presuming that no bidder receives credit for surpassmg the specifications). Surplus max.imization in this case is eqUIvalent to cost minimization. However, for most procurements, the commodities being offered by different firms are different. A computer network offered bv International Business Machines (ruM) is different from a computer network offered by Apple. Forklifts 'offered bv fum A have characteristics different from forklifts offered by firm B. Government officials, either explicitly or implicitly, will evaluate these different commodities in such a way as to be able to compare them. The forklifts offered by finn A, with its maintenance costs and functional abilities, are mapped into another number, Q" while the forklifts offered by firm B are mapped into a number, Q1' Finn A's forklift may have higher maintenance costs, a tighte:- turning radius, and lower lift capabilioes than finn B's forklift. Clearlv, different functional demands would produce different scores for the two forklifts. Then, the X from ~ach bid can be used to detennine surplus. Support of fledgling companies can be reflected in h~w they are scored (that is, in their Q). U.s. federal procurements are classified into two categories related to the scoring function. With an invitation for bid, the scoring function is remarkably Simple. All vendors that meet m.in.i.mum standards are scored identically. An example might be the procurement of the 3.5-inch high-density dlskettes men- tioned above. With an invitation for bid, all compliant bidders are ranked by their cost blds, and the low- cost bidder is the winner. Other procurements are called requests fo!' proposals. These are more compli- cated procurements in which bids specify heterogeneous commoduies, such as the computer network and forklift procurements mentioned above. Suppose a U.s. federal agency wants to install a computer network for electronic access to manuals or other documentation. IBM's proposal may be very different from Digital Equipment Corporation's proposal, which might be very different from any other vendor'S proposal. The scoring function provides a way to evaluate and rank these very different bids. A bid solicitation often will specify precise credits for upgraded equipment. For example, the bid solicitation might explicitly say that the personal computers on the network should not be technologically lower than 486/25, should have 8 megabytes (MB) of random access memory (RAM), and should have 120 MB disk drives with access speeds of not more than 28 milliseconds. The solicitation may continue to say that a 486/S0 will increase the score by USS150 per machine, each MB of memory above 8 per personal com- puter will increase the score by US$3S, each MB of disk space above 120 but less than 250 will increase the score per personal computer by USS2, and any unit increment above 250 will increase the score by USSl. Alternatively, the solicitation may specify a functional scoring system. For example, secretaries will be asked to use demonstration models and will be surveyed immediately thereafter. The survey results (indicating, for example, user friendliness and compatibility with existing software) will tJe translated directly into a dollar value for the score. The authors advocate scoring based on functional capabilities rather than on product characteristics. The fonner is better understood by the procurer, while the latter 15 often used as a device to restrict competition unjustly. But what is the origin of the Q,s? The basic motivation for a procurement by a government agency is an underlying demand for some good or service. This underlying demand is then mapped into a scormg function, which in tum accomplishes the mapping described above, The Procure:m.ent Mechanism What mechanism should a government use for procurement and concession transfers? lr! this setting, a mechanism is an allocation device whereby eligible bidders submit "?orts to the government agent D~lgn of Conc~sSlon· Typt ArTangm1m~s: Compttltlvr! proVISIon of Goods and Sr!"TJlCtS ", tht Pm:lQU S~tor In D~lcrpi"g CDunmts 223 running the procurement. Based on these reports, a winner is determined. The winning vendor then tenders the commodities bid in exchange for payments by the government. No attempt is made to establish a general allocation mechanism. The presumption is that the government solicits sealed bids simultaneously from bidders, ranks the bids by surplus, awards the contract to the bidder offering the highest surplus, and pays that bidder its bid price, X" to supply the commodity (or receives X, if it is a concession). No other bidders receive anything from the government. This is a first-surplus procurement mechanism. Although an infinity of alternative mechanisms are available. much recommends the use of this first-surplus procure- • ment. ~e primary recommendation is its robustness to collusion by the bidders (a not uncommon feature of procurement). If firms are bidding to supply a homogeneous product to the government, then the firm offering the lowest procurement cost wins and supplies the commodity for that price. First-swplus pm- curement is used throughout much of the world, and its procedural rules are quite simple. Hansen (1988) analyzes a competitive procurement in which multiple homogeneous objects are being prorured and the purchaser has a publicly known demand curve. The purchaser demonstrates that a first-swplus procure- ment provides the buyer with greater surplus than a second·surplus procurement and that the first-surplus procurement is preferred by buyers and is more efficient. This constitutes a strong explanation for the prevalence of first-surplus mechanisms in the arena of procurement. The Centra.l Problem of Government Procurement State employees run government procurements. To the best of the authors' knowledge, state employees are never compensated with high-powered incentive schemes that encourage them to maximize surplus. As a point of comparison, consider auctions in the private sector. Auctioneers typically receive com· missions from owners of the items being sold that are equal to, say, 10 percent of revenues generated. Consequently, auctioneers want to generate as much revenue as possible, a goal shared by owners of the items being sold. The auctioneer's and the owner's interests are not directly aligned, though. Auction- eers will not take certain actions when earning a 10 percent commission that they will take if they are the sole owner of the item for sale. However, in an auction setting, shirking by the auctioneer is, in many circumstances, easy to detect. For example, it is easy to determine how extensively the sale was adver- tised and whether the reserve price agreed with the consignor was enforced. In the vernacular of eco- nomics, even though the principal and agent problem could arise in an auction context. it typically does not because the actions of the auctioneer are verifiable (shirking can be established in court as a breach of contract between the auctioneer and the consignor). With government procurement, the authors are not aware of a single case where a procurement offi- cial has received compensation directly tied to the surplus generated from the procurement. In practice, two or more kinds of government officials often run a procurement (technical officers, contracting offic- ers. and others). For simpliCity, they are combined into a single individual referred to as the procurement official. Typically, the official is a government employee and is compensated according to civil service rules. Without dose monitoring. it is natural to expect that procurement officers would shirk their duty, at least relative to the desires of the citizenry of their country. One of the most extreme forIns of shirking is the acceptance of direct personal enrichment from a vendor (bribes or future employment) in exchange for determining the outcome of a procurement. It might seem strange that the agency of government buying the commodity does not closely monitor the behavior of the procurement officer so that surplus is maximized. The incentives of chief administrators, though, are often distorted as well. For example, it is not uncommon for the central government to reduce or revoke budgetary allocations for an agency in future years if current spending falls below expectations. Consequently, an wmecessary urgency to pro- cure arises. This pressure falls on the shoulders of the procurement officer. Measures that the officer will take to expedite a procurement are similar to what he would do as an unpressured shirker. An officer who sees the outcome of the procurement affecting his career path typically confronts the distorted mea- sunng sticks placed before him by his superiors, rather than looking to maximize government surplus.1n other words, a bad procurement may occur because the procurement officer is dishonest or a shameless 214 J. Lu:1.S Gw:zscn 11M Pablo 5priitT shirker, but it may also occur because the officer is honest and diligent but a victim of a hierarchical agency problem. A typical maniiestation of the principal and agent problem is finn-specific favoritism. A single fum, or some small subset of firms, is dearly favored. This avoids the disutility of effort associated with full and open competition. The favored fi~ may be those that the procurement officer feels confident can at least provide a commodity that satisfies the demands of the government agency (but t.his may be quite far from the outcome of a surplus-maxiImzmg procurement), or they may simply be a group oi firms that are offering the officer direct personal enrichment. Once the officer begins the procurement process, it 15 extremely difficult for an outside observer to discern whether the officer's discretionary judgment was exercised in a manner conslStent with taxpayers' objectives. The Decision to Include OT Exclude and Biased Scoring Which finns can participate in the procurement? It might seem obvious that if a finn wants to submit a bid, it should be allowed to do so. However. in many procurements, the bids that describe the capability and function of the product are several hundred pages long. These bids are difficult to score. Domg so takes a great deal of time and expertise. Consequently, from the vlewpomt of the social planner, who sees the costs or preparing such bids, it is reasonable to allow only a subset of bidders (presumably those with the highest ex ante probability of winni.ng) to partlClpate in the procurement. Who should be allowed to participate and who should not, though, is largely dependent on what the government wants to buy. The exact commodity or functional demands of the government are typically specified by the procurement officer in a bid solici- ta tion. Construction of the solicitation often requires a great deal of discretionary decisionmaking. Although the solicitation will not typically contain explicit declarations of who can and cannot bid at the auction, the specification of what the government agency wants to buy often makes it clear to vendors that only a few bidders have any possibility of winning. Rather than being exclusionary, sometimes the scoring iuncnon in the bid solicitation will simply reflect the procurement officers' bias in favor of a subset of firms. Because officers are not compensated for the disutility of effort involved, in evaluating numerous bids, they have an incentive to abuse their discretion, to restrict unjustlv the firms for inclusion, or to dissuade manv firms from bidding through the statement of their bias in th~ scoring function. In the extreme, procurem~t offic· ers will run a sole-source procurement. Their superiors might be quite pleased with this because the pro- curement is conducted quickly and within a specific budgetary period. Best and Final Offers With relatively complicated procurements, bidders are often given an opportunity to revise their bids in a way that provides the agency with greater surplus. This revision process often involves communi- cation between the procurement officer and vendors. At this juncture, room for abuse of discretion obviously exists. For example, the procurement officer can inform an unjustly favored firm of the con- tents of other bids, thereby providing the unjustly favored firm with the informational advantage needed to secure victory. Of course, if all firms know the contents of each other's bids, some ather firm could emerge victorious. Product Evaluations After submission of the best and final offers, the products of firms are typically evaluated to ascertain whether they indeed have the functional characteristics asserted by the firms in their bids. As one can imagine, if a procurement officer unjustly favors a particular firm, then that firm could easily outperform all others in the evaluation. Again, the officer is given the opportunity to exert massive discretionary judgment behind dosed doors. D~lgn of ConcesSIon-Type Al'Tt1ngmTmts: Competttn·e proVlSlon of Goods Qnd Snvrces l1y tite Pnvate Sector in DewLopl11g COllrftnes 225 Discretion of the Procurement Officer The exercise of discretionary judgment is at the crux of the procurement problem. Unlike an auctioneer, a procurement officer chooses a scoring function and then implements it. The scoring process, both the ex ante declaration of it in the bid solicitation and the implementation of it in the product testing, involves the procurement officer's discretionary judgment. Misuse of this discretion is difficult to detect. So, if the officer is stripped of any ability to exercise discretion in the procurement process, doe~ tltis solve the problem? This is the critical point in understanding the central problem of procurement. If officers are good agents of taxpayers, they should have maximum discretion with which to maximize surplus. How- ever, if they are bad agents of taxpayers, they should not have the ability to make discretionary decisions. Without knowing whether the procurement officer is a bad agent or a good agent and without having access to incentive schemes, wha t can be done? In what follows, potential solutions to this principal! agent problem are discussed. Keep in mind that the theoretical literature in economics provid~s little guidance on this issue because the compensation scheme of government employees is a given in any practical approach to this problem. Solutions to the Procurement Problem The following discussion assumes that competition is good. Of course, arguably, limiting competition can be beneficial at times. Allowing a vendor to secure extranonnal profits encourages asset-specific investments, and explicitly banning potential bidders that have little chance of winning avoids incumng the costs of formulating and evaluating their bids. Despite these exceptions, competition is good. More competition means more surplus for the government. More competition makes it easie: for the procure- ment officer to become informed about commodities in the private sector. As a corollary, the members of the community of finns are better informed about anticompetitive procurement abuses than any central enforcement agency would be. A vendor excluded from a procure- ment knows whether it can provide a commodity that satisfies the demands of the government agency. A finn knows better than anyone else if a product evaluation test was conducted with a bias toward a given finn. The result of such abuses is that excluded firms, disfavored firms, and procurement losers are for- going expected profits. The recommendations proposed here rely on the creation of an independent commission to work closely with developing-f state enterprises are subject to fairly rigid and unifonn salary scales. Principal-agent theory is one means of addressing this issue. The theory of agency is concerned with the incentive problem in enterprises where the deci.sionmakers do not bear a major share of the income effects of their decisions, which is the standard case in state-owned enterprises. Theory suggests that the agency costs resulting from that separation of ownership and man- agement can be limited by the existence of three markets: the capital market, the market for corporate control, and the managerial labor market. In the absence of those markets, agency costs inaease. That is generally the case for state-owned firms where the absence of a market for corporate control and the exist- ence of weak capital markets undercut the managerial incentive system. Therefore, setting Incentlve schemes that link perfonnance with compensation is crucial for the success of any restructuring. A good incentive system has to account for the objectives of the agent. For example, regulated films often avoid (efficient) peak-load pricing to justify higher investments in capacity, which presumably brings them higher rents. In addition, unifonn pricing reduces the stakes that consumer groups have in regulatory decisions and thus reduces the extent of their lobbying and the risk of regulatory capture. That knowledge ought to be used:.n setting and shaping the regulatory and compensation constraints. Others distortions can appear whenever there are multiple jurisdictions and conflicting objectives among principals. That is often the case when the enlerprise is under both state and federal jurisdictions. The process of restructuring, while not resolving that issue, can generate a richer set of information with which to implement better incentive schemes. It can also facilitate the undertaking of monitoring and finan- cial controls. A number of compensation schemes and contractual forms effectively address the issue of incentives in principal-agent relations (see, for example, Lazear and Rosen 1981; Nalebuff and Stiglitz 1983; Bhattacharya and Guasch 1988; TllOle 1986; and Holmstrom and TllOle 1987). First is absolute performance- based compensation. Although attractive in principle, such compensation tends to induce little (below optimal) risk taking. Second is relative performance-based compensation. If enough information is avail- able, relative performance-based compensation is likely to dominate absolute performance-based compen- sation because it automatically controls for risks that are common to all participants. 1hird is the contract plan system, which retains public ownership and mana~ment but institutes tighter financial controls. .... Assets are leased, giving residual claims of the proceeds to the individuals involved in the productive activity. However, this approach is subject to possible distortions regarding long-term investment. Finally, there is leasing part of the activities of the enterprise (such as secondary, marginal,.or service activities) through private management contracts to private agents. This form of compensation could be practical and operational as a start. By leasing productive units, residual claims on the performance of Pnt'atI;;Jzt/ol'l Restructunng and Regulation: Actrons and SC'ctor &structunng Pncr :0 Prroati:z.atlon 243 the enterprise are retained by the productive agents, thus generating the right set of incentives, although ownership is retained by the state. Then, if desirable at some later time, outright sale of the productive unit could be considered. In that case, favorable terms for the purchase should be provided to the lessee, to avoid decapitalization or to induce efficient levels of investment. Insofar as doubts exist regarding the length of the contractual relationship and ownership of the added capital stock, efficient levels of invest· ment are not attained in this scheme. Three connected issues need to be considered under this scheme: how to determine the value of the lease, how to distribute the residual profit, and how tc :-2..."'1dle clai.rns of unfairness when employees of highly profitable units benefit more than employees of marginally profitable ones. Generally, open bidding for the right to carry out those activities and for reSIdual rights can efficiently address these concerns. The resulting differences in lease contracts across activities would equilibrate the expected structural differences in profitability. Although the case for organizational restructuring is substantiaL limits exist to what it can achieve. The evidence on the performance of state-owned enterprises is quite clear. Although a small number perform rather well, the vast majority do not perform as well as most private enterprises, when the comparison is made using a number of efficiency measures. An issue in those comparisons is how to separate the effects of ownership from the effects of competition. In principle, breaking the enterprise iIi.to a number of units or profit centers, some similar and some different, will quite likely foster competi- tion within units of the govemment~monopolized sector. But even then, the efficiency gains relative to those to be secured through privatization are likely to be smaller. That structure is akin to management contracts, and their experience has often been quite disappointing (\Vorld Bank 1995). Moreover, if finan· cial discipline cannot be induced, if severe penalties cannot be credibly imposed or enforced, or if perfor- mance is not properly remunerated, the distribution of payoffs faCing the units is truncated at the lower level, but not at the upper leveL creating strong incentives for excessive risk-taking strategies that in- crease the upper end of the range of profits. Private Sector Access To the extent constitutionally feasible, partiCipation of the private sector should be favored in corporate governance and in the creation of incentives and competition. Private sector participation wholly or in segments of the operation can be affected through the direct competitive sale of assets, the provision of outright access, free entry, competitive concessions, or more involved contractual arrangements, accord- ing to the nature of the acthity. When the activity is such that the private operators have to depend on or compete with the state-owned enterprise for access to a service, inputs, or placement of output, activities incompatible with efficiency can arise, such as favoritism and opportunistic behavior by the state-owned er.terprise.1bis possibility can be reduced by horizontal restructuring (if more than one unit of the state- owned enterprise provides the service) or by regulation. Likewise, private sector firms that have exclu- sive rights to a segment of the operations ought to be subject to regulatory oversight. Private sector participation is attractive because most state-owned enterprises are undercapitalized. Often, the enter- prise does not have the financial resources to update capital equipment or to fund needed expansion, nor does the government have the resources to provide the finanang needed for such tasks. That is often the case in most developing countries in state sectors, such as railways. airlines, electricity, telecommunica- tions, roads, water, and hydrocarbons. The extent of private sector participation in both the number and segment of operations open to the private sector will affect the design of an effective horizontal and vertical restructuring of the state- ... owned enterprise. With private sector participation, an extensive and competitive interaction exists between any residual state firm and private firms, with the state firm having leverage or monopoly power in some transactions or rights. That conflict of interest might undermine efficiency. Thus, a regulatory agency should be established that is independent of the state-owned enterprise and that has jurisdiction over prices for noncompetitive segments and access fees, the granting of licenses, conces- sions, new investments, and the resolution of conflicts (prior to entering the court system). The issue is • I 244 J. LULS GWlScn and Pablo Spill" whether the quasi-monopolist should be free to negotiate transfer or access prices to be paid by cus- tomers and competitors, or whether the regulatory agency should prevent market foreclosures and, more generally, regulate a fair transfer and access price. The answer clearly depends on the degree of contestability of the operation. In the absence of contestability, a need for regulation exists. Sequencing Privatization shifts the government's role from being a direct operator and provider of infrastructure services to being a regulator of private utilities. However, few agencies in Latin America have completed this transition. Often, privatization has preceded the creation of regulatory agencies and the develop- ment of a regulatory agenda, and when regulatory agencies have been created, they have often been staffed with fonner employees of the state-owned companies or ministries who were ill-prepared to handle their new responsibilities and were oriented toward controL Many of the agencies have not clearly defined what their role should and should not be or have not developed the core expertise to handle the new issues. Chile's approach to privatization of electricity and telecommunications was to restructure the .industries first and to privatize later. The restructuring process included price adjustment and was more successful in the electricity sector than in telecommunications. Reform of the electricity sector started in 1978 and was implemented in a 1982 law. Privatization followed gradually throughout the 19805. While only 2 integrated companies existed in 1978, today 21 distribution companies and 11 generating companies exist in addition to the two integrated companies. By the time the system was finally priva- tized, the technical staffs of the operating companies were well acquainted with the regulatory system's workings, and the system had a financial history. Gradual privatization assured private investors that Chile's rather complex regulatory framework was indeed reliable. During privatization of the electricity sector in Argentina, everyth.ing was done simultaneously. The creation of Servicios Electricos Gran Buenos Aires (SEGBA) coincided with passage of an electricity law that restructured the sector's regulatory framework. In telecommunications, privatization was clearlY the first step, while design of a regulatory framework came afterward. Although prices were adjusted prior to privatization, this adjustment was done exclusively to satisfy investors' profitability require- ments rather than to bring prices closer to long-nm costs or to reduce cross-subsidization. In Jamaica, regulatory reform was introduced a year before the telecommunications sector was priva- tized. Regulatory reform started with the creation of Telecommunications of Jamaica (TOn, a joint ven- ture between Cable and WJl'eless (the minority shareholder, with 49 percent of Jamintel, the international operator) and the government (the majority shareholder of the Jamaican Telephone Company UTCl, the local operator). Each partner contributed its holdings in Jamintel and rrC to the venture. When the joint venture was created, the partners designed a shareholders' agreement specifying the nature of the future regulatory regime. This agreement was similar to the regulatory regime that was stipulated in the li- censes given to TOJ. While the regulatory regime was clearly negotiated ahead of time with the under- standing of the operating companies, the cross-subsidies in the tariff structure were left untouched. Minimum Investment Policies Because privatization creates a naturally adversarial relationship between the government and the firm. a utility cannot be counted on to blindly follow the government's wishes. Instead. incentives are needed to encourage investment and cost savings and to improve quality. In particular. when prices (including initial connection charges) are high and no competitive threats are introduced, the price can be close to the monopoly level. In such a case, the privatized finn may not have strong incentives to invest unless demand is growing rapidly. 1his is the rationale for the minimum investment levels observed in several privatization cases. Minimum inyestment levels have several implications. First, private investors take these minimum investment levels into account at bidding time and adjust their payments accordingly. Second. and more Pnvatl::Jltlon Resrructurmg and RegulatIon: Acttons and Sectcr Rtstructunng Pr.a r to Pnvatl::Jltlon 245 important, if minimum investment levels are too high, the incentives for administrative expropriation increase, requiring even further restraints on administrative discretion. In other words, binding minimum investment levels require further safeguards, which are naturally costly, particularly in terms of regulatory flexibility and price-setting options. Unless minimum investment levels have no effect on the incentives for administrative opportunism, a tradeoff will occur betvveen regulatory flexibility and minimum investments. Third, minimum investment levels can be considered an impliat subSidy ex post privatization and may violate antidumping provisions. Often, firms being pnvatized are assigned to competitive bidders under criteria based not only on the highest price, but also as a function of the InVestment program that the fum promises to carry out. Bidders will offer to buy the firm at prices that allow them to expect a competitive rate of return on equity. There is no reason to assume that they will earn excess profits ex ante. This is independent of the type of competitive sale used, whether stock flota- tion or a trade sale to a strategic investor. As a result, the buyer has no unfair advantage. However, whenever the investment commitment is enforceable and higher than the investment level that would otherwise have been chosen, the firm is expected to have a higher share of the relevant market than it otherwise would have. In that sense, unfair competition exists because other firms elsewhere cannot sell as much as they otherwise would have been able to sell. In that case, the purchase price paid to the government is lower than it would have been if there had been no investment commitment. Such a low purchase price is eqUivalent to a subSidy. The new antidumpi..'1g rules account for and can penalize such actions. Likewise, the new rules also target subsidies provided prior to privatization. The issue is whether a government subsidy paid prior to privatization, but not through the choice of criteria for the sale or afterward, leads to unfair competition. U the subsidy paid prior to pnvatlzatJ.on resulted in the construction of production capacity that would not have been economical in the absence ~f such a sub- Sidy, unfair competition would exist, as in the previous case. Again the buyer of the company would not have an excessive level of profit because such profit would be eliminated under a com'Detitive sale. It may be difficult to demonstrate that a previous subsidy resulted in excess capacity. For ~xample. if the ~ previously suffered from negative effective protection (excluding the subsidy), the subsidy would not have led to excessive investment, or if the firm was inefficient it might not have constructed excessively. If there was an unjustified subsidy, then given the new antidumping ruling, the buyers of the compan'y would expect the imposition of countervailing duties following privatization. In the sales price, the bid- ders would discaunt such expected duties and thus offset their impact. Only an order to close the excess capacity would undo the subsidy effects. Ideally, subsidies should be granted directly to users. That often requires significant administrative capacity; thus, a transfer to the provider is a second-best option. See. table 10.3 for structure in Chile and Colombia. . Table 10.3. Comparison of Public Service Subsidy Schemes, Chile and Colombia Category Chile (water) ColombUz (eiectricity) Type Direct subsidy to operator 85% cross-subsidies 15% direct subsidies Level Covers 40-85% of low consumption 50% on average to residential users Aim to keep bills below 5% of income (65% on average to low-income users) Total cost of scheme is US$12 million Total value of subsidies USS640 million Eligibility Multiple cnteria: Regional income, wealth, Zone of residence family size, and price (classified. by socioeconomic class) Trie.nnialreviews of eligibility Experience All eligible urban households covered Recent legislation aims to reduce levels Successtulreplacement of crosssubsidies (maximum 20% for high-income users) Problematic Source: Authors compilanon. 246 f. LuIS Gw.asch and Pablo SpiJl" Another effective option, which avoid: . he subsid y :,!'oblem stated above, that is beginning to be used extensively, particularly in telecommunications, is corr.::,etitively assigning expanded coverage to areas not financially viable through auctions by asking for minimum lump-sum transfers to potential operators and by not imposing any universal service obligations on the main operators. See box 10.2 for the case of Peru Telcom. Further, in private markets, troubled companies may receive new capital or obtain write-offs from lend- ers, sometimes as a result of bankruptcy protection. Would this also constitute an Wliair subsidy? If the assumption is that it does not, then one would need to show that the previous government subsidy was different from similar cash infusions into private companies. To argue this, one would presumably need to apply a prudence standard similar in spirit to that in utility rate reviews. To make the case for countervailing duties, one would have to argue that a prudent private o'w'ner would not have obtained a similar capital infusion or debt relief from the parent company or its lenders. The government may ultimately support private company bailouts if the government rescues the lenders involved in the company bailout. In that sense, many forms of explicit or implicit deposit insurance may be grounds for imposing countervailing duties. Equivalently, sales of companies that had benefited from debt write-offs or refinancing, such as those granted by Continentallllinois prior to its bailout, should be punished with countervailing dUlles. The ques- tion also arises of how far back one should go in arguing that subsidies were granted at some bme in history. Latin American countries have had mixed experience with minimum investment policies. Mini- mum investment requirements have either appeared nonbinding (in Mexico and Venezuela) or have been the source of extreme regulatory conflicts. Consider the case of telecommunications privatization Bo% 10.2. Com~titive Biddingjor tht Prurnsion ojUniPf'7'sai ServlCt 1M Ttltcomunicatu7nS: Tht Ca.Sf of PfTU In their search to provide universal service in telecommunications, countries are using a variety of schemes. One of the most effective is competitive bidding. Under thIS scheme. the government designs geograptucal packages of villages where it wants the type of service provided. The projects and packages are then submitted for competitive bids among interested private providers. and the bid requesting the mmimum subsidy to provide the service is awarded the project and the concession of the service for a given number of years. Most of these schemes are financed through a central competitive fund from which those direct subsidies are drawn. The corresponding resources may be provided by the treasury (Chile), by contribUtlons from operators (Peru), from the revenue of licenses (Bolivia), or from resources coming from spectrum bids (£1 Salvador and Guate- mala). Peru is one of the countries using tha t scheme. It is a part of the Program of Rural Projects. The telecom- murucations program was designed by tile regulatory agency (OSIPTEL) in coordination with the Ministry of Transportation, Telecommunications. Housing, and Construction with the objective of promoting pnvate en- terpnses to invest Ln the delivery of services of telecommunications in rurallocalitles that do not have any service. The scheme is funded through a small levy on the revenues of all telecom operators in Peru. called th~ Investment Fund in Telecommunicatlons, and is managed by OSIPTEL The objective of the program is to connect the 5,000 communities, without service to date. by the year 2003. The Program of Rural Projects started with the pilot project "Frontera Norte," competitively awaraed to the operator. Global Village Telecom. This operator has connected to the network and provided servu:e, by De- cember 1999. to the 213 villages included Ln the proJect. The second round of the program took place in late 1999. Three geographical packages were designed to provide for the mstallatlon of public telephones and access to the Internet in rural localities. The selected three geographical areas were South (Arequipa. Moquegua. Puno. and Tacu), Southern Center (Apunmac. Ayacucho. Cusco. Huancavelica. lea, and Madre de Dios), and Northern Jungle (Loreto and San Martin). The projects have a maximum tenn of execution of 18 months and will connect to the network 534; 1,Q29; and 374 localities in the respective geographical areas. An open and internationally based call for bids was widely disseminated. Interested operators were asked to submit bids for a minimum subsidy and were requested to provide service to those three areas, per individual areas and for packages of two and for a package of the three areas. The operator requesting the minimum subsidy would then be awarded the concession. The table shows the bids (box continutS on jollaunng pagt) Pnr:atl':.tltlon Restnlcrunng and RegulatIOn: ActIons and Sector Restructunng Pnor to PntlQMZanon 247 Box 10.2 continues for the different packages submitted by three interested operators. Based on those bids, the g?vemment of Peru awarded the concession for the three areas to Telerep. Tm5 operator requested a subsidy trom the gov- ernment for the execution of the three projects in the amount of USSlO,990,888, less than the figure requested by the other two operators, Global Village Telecom (CSS53,2i2,600) and Cifsa Internac~onal (USS16,900,OOO ). The winner obtains the concession through 20 years and guarantees the contlnUity of the services wIth stated standards of quality and rates and will be regulated and supervised by OSIPTEL. Results of the Competitive Auction ruSS) Centro 5ur- Sur-/ungla Centro Sur Sur /ungla Norte Centro Sur-Sur Norte Particrpant Gpl!Tators 1 :2 3 1 and 1 1, 1, and 3 Global Village Telecom 15 .519 .:200 21.306.600 ::;.440.000 38.762..100 53.273.600 Cifsa International SA 8,700.000 5,160.000 4.398,000 16.900.000 TELEREP 6,427,930 3,942.282 3.185.854 S.431292 10,990.888 Minimums 6.417,930 3,942.182 3.185.854 8.432292 10.99O.88S Nate: Evaluation of the mirumum subsidy for the three projects = 1) Minimum (Centro Sur) - Minimum (Sur)'" Minimum (Jungla Norte) U5S13.556,066 2) Minimum (Centro Sur-Sur)'" Minimum Oungla Norte) = U5S11,618,146 3) Minimum (Centro Sur-Sur-lungla Norte) = U5S10.990..888. Optimal assignment (minimum subsidy tor the three projects): opbon three for t;5510,990.888. Source Authors compiLabon. in Argentina. Table 10.4 shows ~t the two operating companies fell just short of minimum investment plans in 1991, while they exceeded investment requirements by 100 percent in 1992 and 1993. Telecom- munications enterprises in Chile, Mexico, and Venezuela also have significantly exceeded minimum investment requirements. In those cases, minimum investment levels had no implications for regula- tory design. That, however, was not the experience of the water sector in Buenos Aires, Argentina, or in Jamaica during the Jamaican Public Utility Commission (JPUC) period. In Argentina, the failure of the privatized water company in Buenos Aires to comply with the Jl1vestment commitments is inducing a major regulatory and contractual crisis. Similar problems appeared in the investment requirements of Bolivia's capitalization program. The minimum investment levels stipulated in Jamaica in the late 1960s and early 1970s were at the core of the conflict between the utility company and the JPUc. The JPUC determined that rrC was reneging on its investment plan and refused to grant a rate increase. The rrc meanwhile claimed that due to deterioration of the outside plant, its investment needs were much higher than expected at the time of ownership transfer. (See chapter 3.) . The JPUC began operations at the same time that rrC s new majority shareholder, the Continental Tele- phone Company, took over the company's management. As mentioned previously, the government im- posed several financial and developmental obligations on the transfer of shares from T> to Continental Telephone, among them (a) the refinancing of a IS-year, U5$115 million World Bank loan to a 25-year loan at rates not to exceed the New York prime rate by 05 percent; (b) a USS5 million government loan to]TC made under similar conditions (the loan was to be redeemed by selling]TC shares to the public); (c) reduction of Continental Telephone's ownership share in rrC to 20 percent by January 1971; and most important. (d) expeditious completion of rrCs J$13 million development plan within three to three-and-a- half years. The development plan had specific quantitative goals for the expansion of service. In 1968, under Continental Telephone's ownership,rrC began to change its forecasted investment and revenue needs. lnunediately after taking over ]TC, Continental Telephone revised its expansion plan 248 /. U.HS Guascn Imd Pablo S"iJlf"" Table 10.4. Investment /...et,'els ofTelefonica and Telecom, Argentina, 1991-93 Company and type of investment 1991 199:2 1993 Telejonica Network investment (millions of USS) 208.6 615.2 549.2' Lines in service added (fiscal year ending September 30, unaudited) 66.176 276.36-+ n.a. Lines in service to be added per calendar year Seven-year exclusiVity 70.000 105.000 154,000 Ten-year exdusi VitI' 91,000 137,000 200,000 Telecom Network investment (millions of USS) 132.0 609.0 771.4' Lines in service added (fiscal year ending September 30, unaudited) 50)309 n.a. 221,941 Lines in service to be added per calendar year Seven-year exclusivity 60,000 90.000 135,000 Ten-year exclUSivity 79,000 117.000 175,000 n.a. Not applicable. a. Company e5runates. Source: Hill and Abdalla (1993). upward to J$25 million. In 1969 the plan was increased further to J$42.2 million because of the poor quality of the outside plant. As table 10.5 shows, by 1970, JTC had already fulfilled its investment expen- diture obligations. The wue however, questioned the actual extent of JTC's investments. Although the number of main lines grew slowly, this growth was accompanied by increases in fixed assets GTC claimed that it was investing to replace obsolete and poorly maintained facilities, rather than to increase nominal capacity; see The Gleaner 1971). In the wake of its disagreements with the JPUC, JTC halted its investment program in July 1971. A series of conflicts with the JPUC over rate increases and capacity additions ended with the government takeover of the company in 1975. The Jamaican case illustrates how minimum investment mandates can increase contracting costs if the basic regulatory engineering is relatively weak. Compare the performance ot JTC under the !pUC with the performance after privatization in 1988. The 1988 privatization arrangement included no mini- mum investment requirements. Nevertheless, TOJ invested rapidly, doubling the value of its fixed assets in four years while increasing the number of main lines in service by 38 percent during the same period. Minimum investment requirements did not expand the network in the 1970s and were irrelevant to the improvements of the late 1980s. in summary, the restructuring and unbundling of a sector prior to privatization ought to be seen as a major part of having an impact on, and a golden opportunity to impact, the performance and efficiency of the sector through changes in market structure. This applies to most sectors, telecom..al.unications, electricity, rail, ports, and so forth. The potential gains often far outweigh the 'associated losses on transaction costs and on economies of scope and scale. increased competition, decreased opportunities and incentives for market foreclosures, and increased welfare are the payoffs of a well-designed restruc- turing program. Technological innovations are making the arguments for vertical and horizontal karate disintegration even more convincing as economies of scale collapse. Such opportunities to shape market structure rarely occur. While mechanisms exist to influence structure, after privatization they are often costlier and more time consuming and face stronger opposition as a result of the created property rights. The evidence to date from countries that have restructured and unbundled sectors prior to privatization confirms the strong desirability of doing so. '. -. 'li.ble 10.5. /mnnicn 'n'/t'pJwlle COlUl'llIry's Im1estme"ts, Selt'dl'l# Years 1ype of itwestmc,,' 1970 J971 1972 1973 1974 1975 1987 J988 J9H9 199(/ 1991 Investment (thousands of currenl Jamilican dollars) 21,191 3,2'15 5,889 1'1,678 12,118 11,21)·1 .... N <.0 Addilion~ tn main lines 5')8 37) 1,4% 88R 4,-1l)() ·1"IO'i :1574 5.0:12 3,.1(1) 4,779 16,22'\ Rcal fixed assets (millions nf 1991 Jamaican dollars) 777.5 7720 805,0 939·, I,{W.O UWi8 1,4R.10 1,6000 1512.0 2,0900 2,81)8.0 - Nol 3\1ailalJlc. Sour.-t: Spiller 3nti Sampson (1'194). 11 Reform and Regulation in the Power Sector Since the early 19905, most developing and industrial countries have restructured their energy sectors. The major motivation for restructuring has been to improve sector performance and to compensate for the lack of public sources of financing for much-needed physical investment. However, in the l~te 197?~ and 19805. the expansion programs of the power sector in many countnes began to lose steam. FlISt, tariff policies caused a reduction in funds available for investment in the sector. Second, both government and sector finances deteriorated as fuel prices escalated, economic growth fell dramatically or stagnated. inflation levels peaked, and local currency depreciation and rising interest rates increased the cost of e.xternal borrowing and imports. Sector financing relied increasingly on government contributions. The financial resources of govern- ments were strained, especially by heavy foreign debt burdens, high or hyperinflation, unstable curren- cies, and, ultimately, in many cases, by the loss of international creditworthiness and restrictions on addi- tional borrowing from external sources. Since the 1980s. growing economies have fueled dramatic increases in energy demand, and electric power sector expansion needs have become great. For example, new power supply requirements for six Asian countries, China, India, Indonesia, Malaysia, the Philippines, and Thailand, are estimated to be between 25 gigawatts and 30 gigawatts per year. For ten other Asian countries, estimateci new (generation- transmission-distributio~) capacity between 1994 and 2004 is estimated to be 290 gigawatts, requiring investments of about US$3S billion per year, and in Latin America, 40 gigawatts of new generating capac- ity will be needed during 1995-2000, requiring investments of about USSIS billion per year. The need to improve operations and finandal performance while making massive new investments in the power sector is the result of the accumulated effect of inadequate tariff levels and ineffective in- vestment strategies (which are now being corrected). Efforts to allocate resources to meet these needs, however, are handicapped by the pressures faced by the financially strapped governments to fund basic socioeconomic programs and to obtain financing for critical nonpower infrastructure projects. Thus, sig- nificant private capital investment will be required by power sectors in developing countries. Performance of the sector under the traditional, fully integrated state firm has been disappointing. In addition, the common fiscal austerity measures implemented to secure economic stability have reduced the state's ability to finance investment requirements and have increased the need to shift investment responsi- bilities for sector expansion and development away from the government to free resources for socioeco- nomic programs considered less attractive to private investors. Part of the blame for the disappointing per- formance (financial, quality, and coverage) of the sector has been the inherently weak and vulneIable incentive structure of state enterprises, lack of competitive forces. distorted pricing, and extensive subsidies. Recogni- tion that the structure was not sustainable, that it hampered the growth of economic acthity and impacted the competitiveness of domestically produced products, essential for success in the new export-led develop- ment strategy, has been the driving force behind the reforms in most developing countries. Reform has taken place at three levels: ownership, structure, and regulation. Ownership reform has taken place through privatization or concession to the private sector of former state enterprises (fully or in parts) in the areas of generation, transmission. and distribution and elimination of entry restrictions on private sector operators participating in the various segments of the energy sector, particularly generation. As a result, Significant new private sector entry has taken place, mostly in generation activities. Structure reform has focused on shaping the energy market, both horizontal and vertical. The principle has been that the traditional, integrated firm is not efficient and, most importantly, that full integration is no longer justi- fied by economic principles. Therefore, the reform drive has focused on isolating the components in the 251 252 J. UlLS Gu.a.sch and Pablo Sp1I1t!T productive process that embody Significant economies of scale, or natura! monopoly, and on opening the rest of them to entry and market competition. In the electricity sector, supply, billing, customer service, and bulk purchase of electricity are potentially competitive, as is generation. The wires businesses, high-voltage transmission and low-voltage distribution, are natural monopolies. Pooling (operation of the market) and dispatch are also considered natural monopolies, although some believe that these tvvo are potentially com- petitive through decentralized contract trading. That often involved (a) the breakup of the integrated finn not only along the three stages of production, but breaking (and pri'l;atizing) the generation CC::1ponent i..,to separate firms (the thinking has been that vertical integratIon does not compensate for the benefits arising from competition); (b) the transmission component should be kept in government hands or should be concessioned to private sector operators, since it displays significant economies of scale; (c) there should be competitive concessioning or privatizing of the (segmented) distribution to private sector operators; and (d) cross-ownership restrictions should be established horizontally across generator operators and verti- cally across the three components of the production cycle. For example, in Chile, the two main companies, Chilectra and Endesa were broken up. Oillectra was broken into a generation and two distribution companies, and Endesa was broken into a generation and a transmission company, several regional distribution companies, and several companies for the new generation of projects. In Argentina, the three main companies were broken up as follows: Servicios Electricos Gran Buenos Aires (SEGBA) into three distribution companies and several generation compa- nies, Hidronor into several hydro companies, and AyE into transmission companies and generation com- panies. In Bolivia, for generation companies, 35 percent of market share is the limit. For distribution • companies, generation cannot exceed 15 percent of peak demand of the distributlon company, and trans- mission companies cannot operate in generation and distribution. 1his appears to be the sector structure pattern in Latin American and Caribbean countries. That is, to avoid abuses of dominant positions, gen- . erating companies have a limit on their market share. and to avoid market foreclosure, generating com- panies are prevented from participating in transmission and distribution operations. This process is what has been labeled the 'deregulation of the energy sector. Regulatory reform has focused mostly on restrictions on prices, quality of servIce, and other actions by operators of the transmission and distribution segments of the cycle. The principle has been that in those segments where entry is not economically feasible as a result of Significant economies of scale, restrictions on pricing and quality of service have to be imposed to deter monopolistic behavior and market foreclosure. Those segments are transmission. distribution, and system operator. Segments that need neither regulation nor separation are generation, energy supply (direct or by means of wholesal- ers), invoicing, and metering. Consequently, by and large, the pricing in the generating segment, spot markets, and bulk power markets, where no significant economies of scale exist has been left to mar- ket forces and free entry, with perhaps some rules on the functioning of pools and bilateral contracts with large.end-users. The trend in pricing regulation in the other two segments appears to be competi- tion for the market through competitive concessioning bidding and average cost pricing for transmis- sion and price-cap regulation in the distribution segment, but with the principle, in the latter, of work- ing toward end-consumer deregulation. Finally, two segments of the sector where the need for regulation is arguable are spot market operator and forward or futures market operator. As a result of the ongoing transformation of institutional arrangements in the power sector, various new structures have appeared, with a notable number featuring unbundled or separated generation, transmission (central dispatch), and / or distribution activities. In some cases, and in a period of transition, vertically integrated utilities may continue to operate, often alongside independent generators and distribution-only companies, for example, but with separate accounts required for each area of business activity. Reforms and Private Participation Several Latin American countries have legislated power sector reforms to improve operating perfor- mance, to reduce the financial burden imposed on government resources by the need to expand the sector, and to enable private participation. Latin America's regional reform movement has gained R~mt and RLgulanon In the PfJtIJ!1' S~ctor 253 momentum because the Chilean and Argentine experiences with power sector reform have validated the expectation that operati~nal efficiency can improve, and adequate levels of operating and investment resources can be raised, if the appropriate legal framework and financing mechanisms are developed to ". permit private participation. As of 2000, 16 Latin American and Caribbean countries in addition to Argentina and Chile have made or initiated changes in the way in which business is done in the power sector. These countries are Belize, Bolivia, Brazil, Colombia, Costa Rica, the Dominican Republic, Ecuador, El Salvador, Guatemala, Jamaica, Mexico, Panama, Peru, Trinidad and Tobago, Uruguay, and Venezuela. Most of these countries have sought to implement or approve legislation that changes the power sector's structure, ownership, and regulatory and pricing bases. Honduras and Nicaragua are grappling with major reform issues as well, but the policy direction in these countries has not yet been articulated. Efforts there are too preliminary to be able to dearly identify possible outcomes. The remaining Latin American and Caribbean countries do not appear to be considering major sectoral changes, although severaL for example, Barbados, Dominica, St. Lucia, and other Caribbean countries, are reviewing measures that would improve their regulatory regime or modify their rate procedures. . Approaches to reform differ depending on each country's industry structure and regulatory frame- work. Some countries, including Argentina, Chile, Colombia, El Salvador, Norway, Peru, and the United Kingdom, have opted to separate and to allow private ownership or concessioning of generation, trans- mission, and distribution functions. They have sought to establish a highly competitive generating subsector by using contracts between generators and consumers or distributors to establish market prices for electricity at the bulk level. Price regulation is reserved for open access transmission and distribution grids and for retail tariffs for captive consumers. Some countries, such as the United Kingdom, still re- serve residual regulation in generation along the lines or a global price cap. Other countries, such as Costa Rica, Jamaica, and the United States, have opted so far for limited competition in generation. Inde- pendent power producers supply the operator of the monopoly grid Wlth bulk power by means of com- petitive bidding or contract or through a pool arrangement. Common Elements of the Restructuring Process in the Electricity Sector Several steps have commonly facilitated the restructuring process in Latin America and the Caribbean: 1. Cultivating the support of utility management, staff, and unions is a major consideration in implement- ing power sector reform policies. This support has been sought through inducements, such as employee stock options; improved career and salary tracks based on job performance; and train- ing, retirement, and compensation programs. 2. Corporatizing, or allowing management to run an enterprise on a profit-oriented basis rather than attempting to achieve socioeconomic policy objectives, can be an e£fecbve means (if privatization is not politically feasible) of removing the political agenda from decisionmaking in state-owned enterprises. While privatization should be the salient choice, corporatization prepare~ government- owned companies to compete in the marketplace and facilitates the transition to private owner- ship. Furthermore, corporatizing before privatization can demonstrate a company's competitive- ness and provide a better basis for evaluating its sales value. 3. Restructuring the power sector's existing utility monopoly by functionaUy and geographically break- ing down integrated power companies into separate generating, transmission, and distribution entities is a means to ensure competition in power generation, to allocate costs for each level of service pro- vided, and to make each function more responsive to its customers' requirements. 4. Countries that have undertaken utility restructuring have determined that a transparent, commer- cially oriented reguJ.atory regime Jor the sector must be codified in law to attract private investors. Elec- tricity reform laws generally indicate authorities or agencies responsible for policyrnaking, rulemaking, tariff setting, quality control, planning and data collection, issuance of concessions, and technical operating guidelines. 254 ,. LuIS Gwzsch Qnd PQblo Split" 5. Establishing a regulatory authority with junctional and budgetary indt!pendence is necessary in order to implement, oversee, and eniorce a reformed sector. Functional independence is achieved through the selection process for regulators, support by high-level professional staff, adequate compensa- tion, and autonomous budget authority, all of which insulate the regulatory body from political pressures exerted by the central government or regulated industries. : 6. New pricing systems should be introduced that aim to encourage efficiency in plant investment and operations by relying on competitive !!!arket forces for pricing electric:~: at !:.he generation level and on regulation for setting prices for the electricity transmission, for distribution of electricity, and for access to the grid terms. These pricing schemes vary depending on the degree of vertical and horizontal disintegration of the power sector structure and on the price-setting tradition in each country. 7. Although CoWl tries aspire to recover the costs of electricity through economic-based pricing, subsidi- ZJltWn of low-income consumers is still accepted as necessary for equity and income distribution goals. Rema.ining subsidies, however, must be transparent and directly measurable (cross-subsidies have, for the most part, been removed with the breakdown of vertically integrated utility structures). Post-Reform and Privati:ation Evaluation The outcome of power sector reform efforts to date can be evaluated using the following criteria: Competition. Most countries have increased or are expected to increase the number of entities par- • ticipating in the electricity sector. The exception is Norway, where mergers to achieve more com- petitive positions in the sector have reduced the overall number of participants. In Argentlna, Bolivia, Oille, Colombia, Peru, and the United Kingdom, considerable deconcentration of the sec- tor has occurred as the number of generators and distribution utilities has increased significantly. The trend is to induce competition in generation by allowing its pricing by market forces. Compe- tition in transmission and distribution is to be secured by competing for the market through com- petitive bidding for the concession. • Private Sector Ownership. Privatization of electricity generation capacity transmission and distribu- tion assets increased considerably in Argentina, Chile, Bolivia, Peru, and. Jhe United Kingdom. In Norway, a small portion of commercialization functions is privately owned. Colombia, El Salva- dor, Guatemala, and Jamaica are still in the initial planning and implementation stages so it is too soon to evaluate the degree of private sector ownership or involvement in the electricity sector. • Degree ofDeregulatian. In Argentina, Bolivia, Otile, the Dominican Republic. El Salvador, Guatemala, Norway, Peru, and the United Kingdom, the generating subsector is or will be self-regulating, with basic concessions and operating standards being the main requirements that generators must meet. Regulation in these countries focuses on transmission and distribution operations, which are COID- monly considered natural monopolies. Regulation of these subsectors aims at providing substitutes for market-based competition through the use of efficiency models, pricing, and access" policies for power transport, and competition for the larger consumer market. In Norway and the United King- dom, commercialization activities require a license, but market forces determine pricing for the end- consumer. In other countries, retail distribution tariffs remain regulated, but the overall tariff struc- ture varies substantially in some cases. The trend regarding the pricing of large users is to allow bilateral contracts to coexist with pool structures. In Argentina, contracts between individual genera- tors and distributors or la.rge users use a market-based pricing system, as does Peru in those areas ; where competition exists. Chile, Colombia, Norway, the United Kingdom, and the United States also allow large-sca1e customers to negotiate with utilities, while Costa Rica and Jamaica primarily use formulas. Table 11.1 provides detailed desaiptic- ,~f these systems. • Autonomy of Regulatory Entity. It remains to be s;:en how efforts to set up independent regulatory authorities will succeed. Although structurally separate, regulatory entities are frequently sup- ported through government budgets, rely on ministerial support for policy proposals, and lack Rt!fonn and Rt!gu.larlon In tru Pt::JUl!7' St!ctor 155 Table 11.1. Basic Elemmts of Power Pricing System Refonns Country Refonn elements Argentina Market-based pncmg is used for hrm power contracts between individual generators and distnbutors or large users. Wholesale system spot prices for distributors or large users are set bv CAMESSA. Transtnlssion tolls charged are based on the value of the service from entry to e~it node, including a system access charge and an energy charge for amount of power transferred. Retail rates are based on a federal formula based on node price for electnaty taken by retailer, plus the added value of distribution. Provincial utility tariffs are determined by provincial regulators. Chile Consumers reqwring 2 MVI/ or more can negotiate supply terms for bulk electIicity with individual generators. Transfers with generators are pnced accordmg to the short-term margmal cost of energy plus a capacity charge and the cost of transmission losses to the delivery point. Bulk power prices to distribution entities include the system's 48-month, long- run marginal cost of generation, a peaking capacity charge, and transmisslon costs. Transrrussion tolls and tariffs include an access charge and entry and exit tees for the transfer of power between specific nodes. Retail rates are based on the price of power and energy taken at the node plus the value-added of the distribution service. Colombia Existing decrees permit IPPs to sell bulk power to large consumers and vertically integrated power Utilities at negotIated pnces. Proposed legislation targets the introductIon of deregulated bulk power prices between all generators and power purchasmg dl5tribution, commercialization, and nonregulated (2 MW or more) consumers. As a proxy for competinon, the price to final consumers is the sum of the price paid for the electricity by the distribution company, including generation and distribution costs, plus the benciunark-based value added of distribution for an efficient enterprise model. The value added of distribution 15 calculated every four years. In the interim, distribution companies can automatically adjust tariffs Using approved formulas. Costa Rica ICE, the integrated power utility, proposes a purchase pnce to the IPPs (who then sell to the gnd) using formulas established by the regulatory entity. The purchase pnce uses a basic pnce for energy and a capacity payment reflecting various technical a.nd operating cost criteria for the entire system, The price for power sales considers the cost of providing power to the delivery point, plus a negotiated rate-of-retum on invest::inent costs and a risk factor. Jamalca Build~wn-operate-type generators negotiate prices with the monopoly utility company. If the sector is restructured as currently proposed, it will become a regulated tran5rrusslOn- distributIon company. jamaica intends to compose retail prices by adding the costs of transmission and distribution services, including investment costs and a rate-of·retum on capItal, to generation prices. Norwav Prices of firm bulk electricity delivered by the generators at a given point of the high voltage grid are freely negotiated between the generators and the distribution companies. The price ior the latter is the sum of the negouated purchase price plus the regulated tra.ri..smission toll to be pa.ld to the transm.ission company for wheeling the electricity nom the generator· delivery point to the distribution receiving point. Prices of bulk power transfers among and between generators and a power pool are driven by the marginal costs of power and energy on a spot-market basis. IPPs may sell to the grid or negotiate supply contracts with large consumers, commercialization entities, and retail customers. Retail prices for captwe consumers are set through formulas, but technically all consumers can purchase electricity from any generator or supplier at negotiated prices. The information and metering systems needed for small end-users to take advantage of the deregulated supply market, normally through electricity brokers or traders, are being provided through local electnaty suppliers. (table conhnues on following page) 256 f. LuIS Gwuch and Pablo SpIIln- Table 11.1 continued Country Refonn elements Peru MgC-based prices for sales to distribution companIes are set biannually for each busbar by erE and are basec! on 4S-month forecasted demanc., factormg in fuel costs, hydrology, and 50 forth. Retail rates are based on busbar electricIty price and the aggregate value of distribution. Transmission tolls include a tariff for ~ower transfers and a connection fee to cover total cost of transmission. United Kingdom The pnces of hnn bulk electncity dehvered by generators are negotiated as in Norway. Retail tariffs are subject to a cap regulation that pegs pnces to the RPX - X formula, where X is a factor Intended to capture efficiency gains in the distributIon side after considering demand growth and the supplier's capital investment requirements. Costs beyond the supplier's control (such as generating supply costs) are Ulcorporated into a Y ractor, which is simply passed on to ratepayers. Future U.K. reform will allow final consumers to obtain electricity and to negotiate prices directly with generators through electricity traders and brokers who also arrange the electncity delivery. United States IPPs negotiate bulk power supply prices contracts with vertically integrated utilities and or provide bulk powe: supplies to utilities through a competitive solicitatlOn process. IPPs or utilities also supply distant bulk power markets under negotIated pnces, wheellng the power through the transmission system of other utilities and paying negotiated tolls for the wheeling service. At the retail level. the United States employs rate-<>f-retum regulation for electnc power utilities, with.about 210 investor-owned utilities providing between 73 and 80% of the generating capacity and end-customer service. Source: Estache, Helou. md Rodriguez-Pardina (1995). sufficient in-house technical and staffing capability to fulfill their mandates. This threatens their political independence. • AntitTust Regimes and Arbitration Mecfuznisms. To safeguard the power sector's newfound ability to compete, countries that have already implemented sector reforms rely on their regulatory entity or a previously established antimonopoly commission to handle disputes between buyers and sellers over price and quality of service or charges of anticompetitive behavior. Antitrust enforcement is critical for behavior control to deter agreements, abuses of dominant position, and market foreclo- sures to potential competitors. Despite judicial reforms, doubts about the integrity of judicial sys- tems persist, and a modem antitrust regime is lacking in many countries. Although the industrial- ized countries generally have well-established antitrust laws and oversight authorities to deal with anticompetitive and monopoly issues, the legal basis related to power sector issues has often had to be modified or extended. • Impact on Electricity Rates and Service Quality. As private sector participation in the power sector grows, the impact on ratepayers will become measurable as trends in retail and whol~sale tariffs and in service quality (reliability of the power supply system, coverage, and so forth) become observable after an initlal adjustment period. Downward pressure on rates is expected m all the countries that have undertaken reform. Privatization is also expected to result in higher levels of electric service coverage (in Colombia, Jamaica, and Peru) and enhanced service quality for cus- tomers. In the United Kingdom, there has been a slight decline in prices and large profits for the private operators. A longer track record of qualitative variables is needed to assess performance and to establish trends. • Projected New In'Destmmt. Governments that are encouraging private participation in the power sector are concerned that investment will not be undertaken as needed to build new capacity to cover growing consumer demand. Some governments (Chile, Colombia, and Costa Rica) plan to ReJonn and R.t>gulauoM m t~ Potvr:r 5tcto r 257 remain involved in the planning and development of the sector due to concerns about the private sector's capaClty or market-based motivation to back capacity-building proJects. Other govern- ments have declared the\' will not finance new projects (Argentlna and Peru). Incentives to expand capacity through marke~ pricing policy mechanisms are expected to be suffici~nt to promote ex- pansion of the system. New entrants to the sector may compete for any proJect to expand the system through the bidding process so that capacity will be added at the lowest possible cost. Yet this remains an issue because so far, as the Argentina and TJ.K. cases show, !..."':::e:1ti'.'es to ex?a.'1.d capacity through pricing policy mecharusms have not been sufficient. Regulation and Pricing In the generation segment, the trend is to leave the pricing to market forces, with only general regulatory oversight of the working of the pool and of bilateral long-term contracts with major users. Free entry into that segment and coherent, well-enforced antitrust legislation then ought to suffice to guarantee competitive be- havior. Regulation of the transmissIon segment should focus on average cost pricing and access terms and pnong and on providing incentives to efficiently expand the network, if needed. In distribution, the trend is toward price-cap regulation, eventually providing customers with a choice of supplier and allowing for price flexibility by distributors. Price rigidities limit the potential for better service derived from greater competition and discourage distribution companies from actively seeking the cheapest and/or more reliable source of energy in the wholesale market. The competitive concessioning of both transmission and dist:ribution for the market should be the folUldation on which to build efficient operation of those segments. Pools The main task of the pool as an organization of all actors in the industry should be to make transparent rules for the pricing and allocation of generated power. In fact, an efficient pool creates the set of rules of engagement freely agreed to by all members. Conflict of interest among participants (generators pushing for higher prices and users pushing for lower prices, for example) is the mechanism by which fair rules are obtained. Yet, governance of pools remains an issue. Regulatory supervision, through formal partici- pation as a pool member or requiring the regulator's approval before a rule becomes effective, also has to be included to protect the public interest. Arrangements by which two or more utilities pool their re- sources to achieve savings date back to the 19605. These pools, which were also used to minimize genera- tion costs by utility trading among utilities, became the basis of the market in most restructuring pro- cesses. Going iTom a mechanism for cost savings through marginal trading (usually including a rule to allocate these savings) to a market in which all energy is traded among freely actJng participants is a major step in the organization of the sector. Pooling as a solution to competition over power transmission systems has by now been tried in sev- eral countries. Chile introduced a competitive power pool in 1978, when its system was still publicly owned. Least-cost dispatch contJnues to be on the basis of audited costs of power plants. not on continu- ous price bids by generators. Bidding thus takes place implicitly as costs are reset. The United Kingdom introduced a competitive bulk power market on the basis of half-hourly price bids in 1990. The price is determined by ranking the bids of each generator in the system (the price at which it will generate and the quantity it can generate at that price) and then by taking the highest bid needed to meet expected demand in every half-hour period (see figure 11.1). The U.K. pool is open to all participants in the market (very much as a club) in charge of making the rules (known as a pool and settlement agreement) by which the system is governed. Figure 11.2 illustrates the working of the pool in England and Wales. The regulator has the power to veto any rule that it deems to be against the public interest. Nonetheless, both Chile and the United Kingdom continue to suffer from high market concentration in the generation seg- ment and a lack of baniers against vertical integration. ::!S8 ,. LuIS GlI.lZSch and Pablo Spillt"!' Figure 21.1. The United Kingdom Pool (England and Wales) Expected demand Pool price GE"oJSET 1 QuantIty The price in the pool in England and Wales is detenni.ned on the day ahead of operation. The pnce 15 detenruned by ranking the bids (the price at which it will generate and the quantity it can generate at that price) of each generating turbine (GE\!SEll in the sYStem. The pnce 15 determined by t.akmg the highest pnce bid needed to meet eltpected demand U\ every half-hour penod in the day ahead. as shown I.l\ the dJ.agram above. The pool pnce is therefore detemuned for every half·hour penod on a gwen day. See Figure 11.1 for sample prices tor a tu.I.l day's cycle U\ the United Kingdom. Note that this is a very SLmplibed expJ.a.nation of the mechanism. In practice, there are other elements to the pnce. and. the bids are complex. nonlinear func:tlons. SOl.lrc~: Klem (1996). Figure 11.2. United Kingdom Pool Prices, 1123/96 200 .. ?! ::E 150 ........ =. Q./ ~t :::... 100 :oJ :n :; "'E 50 - o 0:30 2:30 4:30 6:30 8:30 10:30 12:30 14:30 16:30 18:30 20:30 22:.30 ." 1/2-Hour Period Ending £/MW Pound per megawatt. SOl.lrc~: Klein (1996). · Ri!fo'f7n and R~guJatlon 11'1 t~ Pt1IL'1!T 5ec:o r 159 The Argentine system introduced in 1992 places strict limits on horizontal and vertical integration, thus effectively creating the conditions for workable competition. However, bids so far are based on audited cost data rather than on price bids by generators. Compafua Administradora del Mercado Mayorista Electrico Sociedad Anomma (CAMMESA) is the private Argentine company in charge of ad- ministering this wholesale market. Representation on the board is limited to representatives of sectoral, government-created associations of generators, distributors, large users, and transmitters, each holding 20 percent of the shares. The re:r.aini...i.b ~c percent is in the ha.."1ds of t.~e federal government represented by the Secretary of Energy, who has veto powers over all decisions. CAMMESA is in charge of the phy~i­ cal dispatch and settlements. The rules, however, are made by the Secretary of Energy under the power given by article 35 of the Electricity Act. All the svstems dIscussed set transmission prices in an essentially administrative way by not allow- ing congestion prices to be established by a market. Nonvay, on the other hand, is trying to generate prices using the market. Its pool, which was originally limited to large generators, was open to all participants by the Electricity Law of 1991. Three markets (one weekly, one daily, and one spot) are operated by the pool, which 15 also U1 charge of coordinatmg the system. These markets have the func- tion of short-term optinuzanon because no central dispatc.l.;. exists (long-term contracts are for physical energy and therefore detemune dispatch). This structure allows generators to minimize costs through trade. These particular arrangements are the outcome of specific situations in each country. The design of the functions and responsibilities of the pool are a cornerstone of the restructuring process that deserves careful analysis. Results from the introduction of competition are encouraging. In the United Kingdom, productivity of generators has roughly doubled within four years, including for the remaining public nuclear power operator. Productivity in the distribution segment, which is not subject to competition, has also increased, but by only about 10 percent. In Argentina, the switch to a private competitive system qUlckly resolved all of the urgent problems of power shortages and created temporary excess capacity, essentially because the new generating firms efficiently rehabilitated and operated existing plants. While spot prices are esse~tial to decentralize investment decisions and to provide the correct signals for capacity expansion in generators, they can be subject to volatility, making payments and supply obli· gations unpredictable. To hedge price fluctuations in the spot market, generators and consumers can arrange long-tenn contracts for power delivery at agreed prices, enhancing efficiency and keeping the pool honest. The workings of long-term contracts are illustrated in box 11.1. . Box 11.1. Long- Tl'Tm Contracts In many corrunodity and financial markets, buyers and sellers face a variable spot pnce. A wide variety of contracts exist to allow players to hedge the risk of buying and selling at a variable price. This box explains the basic mechanism in the sunplest case. . In a long-term contract, a buyer and seller of a corrunodity agree to el.i.m.i.nate revenue risks caused by varia- tions in the spot price through fixing a price at which they will contract. There IS a vanable spot pnce (SP), and the buyer and the seller declae to fix the pnce at which they will trade (CP). In a Simple long-term contract. a constant quantity (q) is traded. (1) If SP > CPo then the seller pays q x (SP - CP) to the buyer. (2) If SP < Cp, then the buyer pays q .r (CP - SP) to the seller. (3) If SP =cr then no money changes hands. If both parties are buying and selling the amount q in the spot market, then the financial flows in the finan- cial contract will exactly offset the price variations in the spot market and essentially fix forward the pnce at which the trade is concluded. 260 J. LuIS Guasch and Pablo 5pill~r Some Lessons from Power Sector Refonn in Chilel England and Walesl Norway, Scotland, and the United States A study of power sector reforms in eight different power systems, Chile, three pools in the United States (FCG, N-EPOOL, and MAPP), Norway, England and Wales, and Scotland and Northern Ireland, identi- fies alternative approaches to power sector reform and draws lessons from the experience to date in reforming power sectors in developing countries,l in particular, the report considers alternative approaches to plant dispatch, least-cost expansion, allocation of nsk, and transmission pricing (Webb, Carstairs, and Adamson 1996). The main results are as follows. Dispatch Dispatch can be based on actual costs, on indexed charges under long-term contracts, or, for larger sys- tems, on competitive bids. ROLE OF SHORT-TERM MA.R.KEIS. Close attention is needed to industry structure to make competition in generation effective. The percentage of electricity traded through the spot market affects its short-term liquldity. A more liquid market increases short-run efficiency and transparency. In systems with vertical integration, such as Scotland and parts of the United States, typically only some limited trade exists at the margin, and in the absence of a spot market, a pricing mechanism needs to be est'ablished. In Chile and England and Wales, 100 percent of electricity is traded through a short-term market. CONnAO-BASED DlSPATOi. Northern Ireland provides the only case in which all dispatch is driven by long-term c~ntracts. The four generating plants hold contracts with a central purchasing agency. These are two-part contracts, with capacity payments related to part availability and energy payments related to the energy produced. The plant is dispatched on the basis of the energy charge. Evidence exists that the energy charge, which is based on a fuel index, has diverged from mar- ginal operating costs. For one plant in Northern Ireland, the plant owner has succeeded in purchas- ing fuel significantly below the index rate, with consequent supranormal profits. Generators have thus earned high profits, but this has not led to suboptimal dispatch. The Northern Ireland system is ' small, has a large divergence in marginal operating costs, and the purchaser-is obliged to buy only a small share of energy produced by the plant under a must-take provision in the contract. However, it is likely that the contract provision, which allows for expert reexamination of the fuel indexes used. will be called upon. COST-BASED DISPATCH. The N-EPOOL (United States) system is dispatched on the basis of actual mar- ginal cost. Procedures were set up to audit and check cost and to calculate the opporturuty cost of electric- ity generated by hydroelectricity. Many of the cost-based systems are explicitly geared at short-term optimization and require all pool members to have sufficient capacity to meet their own demand. In other cases, where a cost-based system also provides incentives for investment, some evidence existed that it could encourage gaming, by which generators seek to increase their overall revenue. BID-BASED DISPA1CH. In England, Norway, and Wales, generators bid to be dispatched from a pool. For England and Wales, the pool covers 100 percent of electricity traded, while for Norway the pool covers around 17 percent. In the England and Wales system, generators bid for each half-hour of the following day. The Norwegian system, which is hydro dominated, is more complex. Norwegian generators place bids in a day-ahead market for five periods of each weekday and for three periods on weekends. A spot 1. To obtain a copy of this study, including the system case studies, call (202) 473--3613. Rt!fonn aM': ReguiatloM Ir: tlu Pau'!'1' S~ctor 261 market (the regulating market) also exists where bids are made for the energy used to balance supply and demand. This, too, is run on a dav-ahead basis. In both pools, evidence exists that generators had enjoyed some success in raising prices above levels that would have been expected in a fully competitive market. In part, tlus appeared to be due to lack of competition in the generation market rather than inherent flaws in market design. In England and Wales, . for example, existing thermal generation is split between only hVo companies. Nonvay's state-o'NTIed generator, Statkraft. appears to have been able to riilSe pool prices, at least temporarily, from nonfinancially viable levels. Statkraft announced a policy of not supplyrng below a certain pnce per kilowatt hour and of ~$hing deviators by momentarily flooding the market and pushing the market price down to zero. Investment There are two approaches to investment, a planned approach and a market-based approach. PLANNED APPROACH. A planned approach provides an obligation to ensure sufficient capacity through familiar exercises in planning least-cost expansion. Different entities can be made responsible for ensur- ing sufficient capacity is commissioned. In some U.s. pools, this is the responsibility of distribution busi- nesses that have a regional monopoly on supply. In Chile. investment is left to the private sector, but a central body can comlnJ.SSlOn additional capacity, using public funds. if sufficient private investment is not forthCOming. MA.RJCET-BASED SYSTEM. Otile and England and Wales give incentives to invest through a capacity pay- ment, in addition to the marginal cost-based pool price. Payment of the marginal operatrng cost of the marginal plant creates a rent for other plants, the difference between their marginal operating cost and their payment, which allows the nonmarginal plant to recoup capacity investments. Bid-based approaches allow generators (irlcludirlg new entrants) flexibility in building new tec...'1- nologies, which may lower cqsts over the long term. In England and Wales, as discussed in the next section, generators reduce risks by enterirlg long-term contracts with the regional electricity compa- nies (RECs), which supply electricity to captive customers, and overinvestment may result. The Chil- ean approach places a cap on capacity payments, but relies on the accuracy of a central plannrng mechanism to determine new investment. In both approaches, underin~estment has not been the problem that critics feared. REsERVE MARGThIS. A similar distinction can be made on the approach to reserve margins. A planning margin can be adopted and incorporated into the capacity requirements. Alternatively, schemes can at- tempt to attribute a market value to capacity. Capacity has a high value if it 15 scarce in relation to de- mand, so a higher probability of load shedding exists. Both the Chile system and the England and Wales system have developed payment systems that give generators cost Signals on both the economic cost of load shedding and the probability of it being shed. . Risk Sharing INCREASE IN RISK. Investments in generation and transmission require major sunk costs in assets with long lifetimes and low resale values. After vertical separation, generators and distribution companies are ex- posed to risk on the bulk supply price. Market structures, and in particular a lack of retail competition, mean that the costs of risk reduction can be passed on to consumers. Given this, existing generators and independent power producers (IPPs) have invested against long-tenn contracts rather than pool-based revenues. Evidence is available that this is changing as a greater degree of competition is introduced into electricity retailing. However, significantly, in the United Kingdom, the majority of new investment in gen- eration has been by the RECs diversifying into generation in an attempt to reduce their market exposure. 262 f. LuIS GW1Sch and Pablo Spllit'1" ROLE OF CO:-"IRACTS. In all of the case studies, generators continued to make their investments on the basis of long-term contracts with distribution companies (which have captive consumers). Where 100 percent of electricity is traded through a pool, these contracts need to be reconciled with the pool pricing system. In England and Wales, this is done through the use of a financial hedging contract known as .a contract for differences. This is a purely financial contract by which one or both parties can reduce thelr exposure to pool price fluctuations. By hedging actual pool revenues with a contract for differences (efDs), generators assure themselves of a revenue stream to pay for the fixed costs of financi.'1g a... . ::i r:1a!..'1t3i.n.i.r;.g the plant. Distributors, who buy electricity from the pool, use efDs to minimize the nsks that the price paid for electricity from the pool does not exceed the resale price. IMPACT ON JNVESt'ME\".. No examples were round in the case studies where generators have made major investments on the basis of forecast spot payments from a pool. In part, this may be because none of the case studies have yet introduced full competition at the retail level. There was evidence emerging from England and Wales of investments on the basis of revenues from the pool rather than long-term contracts. However, no plants have yet been built in England and Wales by independent generators where long-term. contracts have not been signed with a REC. The two major thermal generators have built new plants, but they possess a portfolio of contracts and other plants that allows them to hedge risks effectively. Tra.nsmission PRICING PRINCIPLES. An efficient tariff for transmission needs to reflect marginal costs, includmg marginal losses, the costs of transmission constraints, (that is, the cost of running a generation plant out of merit), and the operating and maintenance costs of the transmission wires. PRICING PRACTICE. Transmission pricing is poorly structured in most of the case studies, and none have transmission tariffs that reflect all the costs. The main cost of poor transmission priang 15 poor locat:1onaJ signals for new generation, which would be particularly Significant in countnes where generation 15 expanding rapidly. In the United States, transmission charges have historically not been cost reflective. Existing charges have been made on a capadty basis, with lower charges for interruptible transactions. Often transmis- sion charges have been included in the costs of purchased power. In some pools, utilities agreed to share their transmission systems and have not charged each other for use of their transmisSion network. New regulation is currently leading to reform of transmission charges in the United States. In the England and Wales pool, congestion charges and losses (both energy related) are averaged into an uplift payment, which is added to the spot price. These costs are therefore averaged across all custom- ers, which is not cost reflective. Most fixed costs are recovered through a system of zonal charges, which vary by location. These too have been criticized on cost-reflectiveness grounds. Chile and Norway make greater use of Iocational signa..1s. Norwegian transmission charges include an energy fee based on esti- . mated marginal losses. These are calculated for six regions and three tariff periods. Interestingly, in Chile, the refonn has gone even further. There, the regulated price is set for each node of the network, taking into account the location of electricity generation and marginal losses. COVER,UI.lG FIXED COSTS. In all the countries studied, energy-related transmission charges yielded inad- equate revenue. The case studies describe a number of alternative approaches to recovenng fixed costs. All of the systems studied use some form of fixed charges (for example, fixed connection charges or capacity-based charges) to generate enough revenue to keep transmission operators financially viable. A Case Study: Argentina's Power Sector Reforms In 1992 Argentina reorganized its power sector following generally acceptable guidelines and in a way that has met with great success. Transmission and distribution were considered public services and were sold as Rdorm and RLgull1tlon In tiu P(1'IJ}t"r 5~c:top 263 concessions. The standard contract requires the utilities to provide quality service to all users, maintain equipment. protect the envirorunenL and ensure public safety. Tables 11.1 and 11.3 detail the bidding pro- cess, contract terms, and contract requirements for transmission and distribution utilities. Generation was restructured to create a market, so the pnmary requirement in that area is that generators accept the rules that govern the market. The quality and investment requirements for all three areas appear in table 11.4. As mentioned earlier, the major institution responsible for Argentina's power sector is CAMMESA. a private company. Its primary responsibilities are to (a) manage the interconnection system, including rpaximizing safety and quality while minimizing wholesale prices on the hourly or spot market; (b) optimize use of capacity; and (c) supervise the term market and manage the technical implementation of contracts signed on that market. The government has a majority share in CAMMESA. while the tour major organizations in the sector (generators, transporters, distributors, and large users) each have 20 percent of the residual. The regulatory institution is the Ente Nacional Regulatorio de Energia (ENRE). which is financed through fees, fines, and subsidies. ENRE is required to Table U.1. Transmzssion and Distribution Concession Contracts in Argentina Bidding Two envelopes are used where the rlrst envelope is the techrucal one that speahes the requue- ments to be met by bidders and deternunes who is allowed to present the second envelope. The first envelope also contaLnS the share of actions to be subscribed by each cobldder: the specification of a single, unified local residence; proof of existence as legal entlties; guarantee of US$lO million for the offer; and project of implementation plan for contractual obllgatlons. The second envelope contains the offer amount in cash and public bonds. Bidde!"S had to have assets of at least USS300 million and a proven net wealth of no less than L SS200 ITl.illion, T which had not declined by more than 5 to 10% over the previous year. All bids must identify at least one, but no more than two, experienced operators. The econOmlC offer had to be valid for at least 180 days as of the operung of t.~e envelope. and at least USS30 million would have to be paid in cash :3 days after selection or the wmner. For public bonds, the term is 90 davs. The winner must pay the fees for the lawyers (US$1.5 million each for transmission and distribution) and the financial consultants (who are paid 1% of the value of the deal onlv if there is a deal). . Terms of contract A 95-year concession for exclusivity in a zone was included. after which ne\'.' bids will have to be made. Proceeds of the bid go to the incumbent, who 15 also allowed to otd. The term can be extended for a period up to ten years, to be determined by the regulatory entity (Entre NaClonal Regulatono de Engergia). whIch can also modify or suppress zonal exclusivity. The term is divided into management periods of 10 years (except for the first. which lasts 15 years). At the end of each management penod, the Entre Nadonal Regulatorio de Engergia organLZes an international bidding to sell maJonty bundles of stock and sets the tariff regune for the following five years. The bidding conditions are similar to the original ones. The owner of the majonty package, if the price offered by the incumbent 15 the highest, keeps the property. If the owner is outbid, the highest bidder has to pay the pnce bid to the incumbent and becomes the new majority owner. An mdependent inspector nOminated by • Entre National Regulatono de Engergia will ensure the proper functioning of the company for one year before the end of the management period and for the first year of the new manage- ment period. Failure to deliver obligatiOns results in termination of the contract and fines of more than 20% of yearly income. Source: Estache. He.lOLl. and Rodriguez-Pardina (199S)' 264 J. LuLS Guasch and Pablo SptlJ/!7' Table 11.3. Transmission and Distributzon Contract Requirements in Argentina TransmissIon Provide servIce to dIrect and indirect users Respect quality norms spelled out in contract Allow access transport capacity to any agent of the \\'holesale Elecmc Market accordmg to access rules Invest in and maintain system and connections Allow free access to Installation, including other t:.J:-.5Forters l:1tercoru,ectec ProVlde all information and documents Entre NaClona! Regulatono de Engergia and CAMESSA as required Pay for the electnctty required for its own consumpnon Process on time and conform with request of mcreases m capacity Comply with CAMESSA requirements as long as they do not put their mstallations at risk Respect the enVlronment Promote rational use of energy Guarantee public safety in the way equipment is installed Ensure that their activities do not damage ecosystem5 Promote ratIonal use or energy Comply with Entre Nacional ReguJatono de Engergia norms Do not engage in di.scnminatory or anticompentive actiVIbes Distribution Respect obligation of public service of distribution in the concession zone Commit to specific quality levels Respect the rights of users as specified in the contract Satisfy the total demand for service, including demand for new serviCes Provide energy for public lighting Provide electricity at 3x.380/220V, 13kV, 2kV, 33kV, 132kV. 220kV, or any as agreed to with Entre Nadonal Regulatorio de Engergia . Make the investment and maintenance requIred to achieve established quality requlrements Adopt the measures necessary to ensure provlslor. and availability of elecmClty to meet demand Increase capacity when needed to provide public service as reqUired by Entre Naaonal ReguJatorio de Engergia Allow third parties undiscriminated access to transport capacity ii it does not impede capacity to deliver Allow large users to rely on their networks in the conditions agreed upon in contract Guarantee public safety V Volt k\' Kilovolt Sourc~: Estache. He1ou, and Rodriguez-Pardina (1995). • Enforce the regulatory framework • Issue rules and regulations on safety, technical procedures, and service access and quality • Prevent anticompetitive, monopolistic, and discriminatory behavior • Define the basis for the calculation of tariffs set in contracts • Publish the general principles to ensure free access to services • Detennine the basis and criteria for the assignment of concessions • Organize and implement the bidding, adjudication, and signing of contracts • Organize public hearings ". • Monitor respect of property rights, the environment, and public safety • T.', . relevant issues to court • 1Ir: ?ose sanctions • Publish information and advise generators " . Table 11.4. QUillity illlt/lllPI's'ml'II' Rt'ql/;relllt·"ts for Argt,tI,illn's Power Sedor Rt'quiremeuts Ct'llertlliOll Trillfsmissinll lJisi rillll' ;011 QUillily requirements Technically oriented Minimum quality standards on two aspects: Minimum quality stand:Hds covt'ring (a) prodlld rt·gulation related to the (a) tension and (b) tl'dmical !icn,ice (duration "od (Il:'n!';illn); (b) IL'chnical ~>l'rvicl' (duriltion illld functioning of the frequency of uutagl's) frequency of outagl's); and (c) cornmerdill s\'fvin' interconnected system I:ailures to meet quality stand.uds penalizcl' through (cOInpl.lints by cI iClltS, t il1ll' 10 gl'l Cli III wct ion, illld Nil pl'rformance a dctailed fine system; the proceeds of tlll"st" fines gn bill estimate~) standards to meet te the users who are vktims of the quality gaps rUf measurement, Iwo steps dt·fined wilh diHt'fl'nl guals: (a) during Ihe first 36 months, measurement of medium tension; (b) ClS Ilf 37th month, measurement of every tlser railures 10 meet qUilli1 y standards pl'nalin'd N 0- Ihruugh a detailed fine system; the proceeds ~~Il III VI Ihe users who are victims of the gilps No cOlltrll1 of investment by the pUblic sectur, No control uf investmenl hy Ihe public seclor, Investment requirements Nu controillf investment although investments over US$2 million need although investments over US$2 million need hy the public sector EN HE's approval and a public hearing ENHE's approval and a public hearing Purely competitive Concession implies only maintenance and operation Investments m.1Je by concessionaire regime wilh free entry of existing facilities plus minimum quality Only conslrilinl based on (a) obligation 10 meet all and exit standards and maximum tariffs dl'mc1llds, (b) minimum qUillily standards, and (c) Users required to pay for any expansion of the maximum tariffs transporl syslem Hl'qllired 10 cll'.1r ab,mdollmenl of facilities with Rl'quired to dear aha"donml~fll of facilith's with ENHE ENRE . SOl/ret Estacht:'. , Ielnu, and RII.h iguc.·, 1'.lhlilla (19')5) 266 J. LuIS Gwuch and Pablo Spzllt T • Issue an annual report and recommend actions when needed • Collect miormation from transporters. The tariff system, although somewhat complicated by the differing types of regulations that govern each area, holds true to basic regulatory principles. In the wholesale or spot market, generators use a uniform tariff at the point of delivery that is based on the economIC costs of the system. All generators charge a single market price determined by the cost of the last unit called upon to generate electricity. The process to determine this price starts with an estunate of the hydroelectric production for the first three years, then in decreasing penods going down to one week, and the resulting generation has to be at minimum costs. The probability of system failure is calculated, and the list of generators that will have to operate is established according to their marginal cost (specific consumption and fuel pnces). On the basis of these factors, the hourly spot price for the wholesale market is determined by the cost of the fuels of the last unit in operation, after having ranked generators in decreasing order of efficiency. Capacity payments do not enter the spot price; they are made separately at a rate of USSIO per megawatt per hour to all available generators. It is an adm.inistrated price set by the Secretary of Energy. . The transmission and distribution prices are more straightforward. They have to be deSIgned to pro- vide the opportumty to obtain sufficient revenue to cover reasonable operational costs to those transporters and distributors who are performing prudently and economically and to provide a rate oi return that is both related to the efficiency and effectIveness of the firm and is similar to an industry average of other risk-oriented activities, or at least comparable nationally and mternationally. This im- plies that the utility must account for reasonable differences in costs existing between the vanous types of services, considering the form of delivery, the location, and any other relevant characteristic according to the regulatory entity. Finally, with the above constraints in mind, the tariff must guarantee the minimum reasonable cOSt to userS compatible with the reliability of supply. For transporters, the price system is expected to send users economic signals allowing three determinants to drive prices: the energy trans- ported, the connection charge, and the transport capacity. This price system uses RPI- X where X is set to zero initially and with semiannual indexation to the U.s. price index, where the index used is 67 percent producer price index (PP!) and 33 percent consumer price index (CPI). Tariffs are set in U.s. dollars. The concessionaire then gets a stable tariff resulting from the expected average of the prices at the connection knots over the following five years. For the distributors, the price system must identify the costs of ac- quiring electricity from the Mercado Electrico Mayorista Argentina (MEM). This price system uses RPI - X ~ Y. This represents the maximum price with total pass-through of the costs ot energy in the wholesale market (Y) and indexation to the U.s. price index (X), where X is set to zero. initially. The index used is 6i percent PPI and 33 percent CPl, and the tariffs are set in U.s. dollars. When large users (those with demand over 100 kilovolts) go directly to the wholesale market. their fee is uniform but has to include the cost of transport. Also, as shown in box 112, effectIve ways are available to reduce energy losses, which obviously impact on the profitability and prices of the distribution companies. Reform of Chile's Electricity Sector The conditions preceding the refonns of Chile's electricity sector include price controls. service ration- ing, overstaffing, and large deficits in the public electricity utilities. (This section is adapted from Bitran. Estache, Guasch, and Serra [1999].) The overall design of the reforms was'fitted into a general attempt to deregulate, while maximizing fiscal revenue or minimizing revenue. losses characterized the first wave of privat:i.zation. Concentration of the control of former public companies was also considered an acceptable strategy at the time. Implementation of the reform took place in an environment in which .... competition was the main goal, but the philosophy of the first wave was still quite present, as will be shown. In fact, the restructuring of the sector was done in two stages. The first stage, between 1974 and 1979, was intend~d to adjust price:. allow the public utilities to achieve self financing and to prepare t.'le groundwork to allow private :- .. :or participation. The second stage, between 1979 and 1990, dealt with the main institutional changb discussed below and with the restructuring of sector generanon Reform and RLguli2tlon In tht POU't'T S(cto r 267 Box 11.1. Dealmg wIth Lasses in Argmtm.a's Energy Sector The problems of Edenor. Edesur, and Edelap, the threedistributlOn companies r~presennng 47 percent of ArgentIna's market, are poor conditIOn, low productiVity, and hlg!1 levels of thett (Esta~e 199)). Durmg the mid-1990s, for instance. customer losses in Edenor and Edesur amounted to 30 and 25 percent. respec- tively. Yet, the compames are only allowed to pass about 11 percent of the losses to the consumers. To cut these losses, Edesur reduced techmcal and other losses (due, tor example, to theft). emploYment and over· tIme. Edesur cut employment from 7,·n 7 in January 1992 to 4,617 in October 1994. Edenor cut employment from 6,368 to 3,759. The amount of overtime allowed was reduced from about 40 hours per employee per month to about 3 to 5 hours. Reducing theft was more complex because doing so mvolved shanty towns and low-mcome areas where cutting off power was not VIewed as acceptable by the local authontles. The solutIOn was to .negotIate a deal with the regional metropolitan area. Edenor and Edesur would place a medIum-tension distnbutIon network in those areas and connect onlv 10 or so consumers with low-voltage lines and related ttansiormers. The voltage in these med.ium-tensio~ lines is too high for an illegal cormection. Any illegal use of the low-voltage line will be easy to identify because the transformer cannot process more than ten users. This places the bur- den on the entl~ commurtitv to solve the "illegal" problem. The bills are paid to the co~cessionaJ.re by the municipality that collects pa yments from the users. The outcome is obvious. Payment levels 1l11ow-mcome areas have reached 90 percent for Edesur and 50 percent for Edenor. Source: Estache (1995). and transmission, which were separated from distribution. The two existing utilities, Endesa and Chilectra, were decentralized and regionalized. Endesa, the largest company, was divided into 14 com- panies: 6 generation comparues (Edeinor [with 240 MW of capacity], Endesa [1,832 MW], ColbUn [490 MW}, Pehuenche.[585 tvIW], Pilmaiquen [35 MW], and Pullinque [49 MWJ); 6 distribution companies (Emelari, Eliqsa, and Elecda combining 18,000 customers in the north, Esmelat [5,000 customers], Ernec [143,000), and Emel [122,000}); and 2 companies combining generation and distribution (Edelaysen [15,000 customers} and Edelmag f35,000J). Chllectra was divided into three firms: a generating com- pany, Chilgener~ with 756 MW capacity and two distribution companies, Chilectra with 1,064,000 cli- ents and Chilquinta with 32:,000 clients. Privatization per se started in 1986 after introduction in 1982 of the regulatory framework described below. Most divestitures took place between 1986 and 1990. Only two generation companies were left to be privatized by 1990, and both have since been privatized. This was done mainly through three mecha- rusms: sale of the smallest companies through public auctions, awarding the deal to the highest bidder; auction of share packages on the stock market for the largest companies; and sale of small packages of shares in the largest companies (popular capitalism). Privatization was also conducted through a specific approach that involved giving shares as a way of returning the financial deposits users had to make per kilowatt of connected power. A major footnote in the description of this restructuring is that Endesa was privatized jointly with its transmission system, which is the largest in the country. The main reason was that the transmission pricing rules had not yet been fully defined and, as shown below, this decision continues to haunt Chile's regulators. Since 1992, OUlean electricity companies have become major play- ers in other privatizations in the region, evidence of the success of this privatization strategy. Chilean electricity companies are present in Argentina, Bolivia, and Peru and have been actively diversifying their activities into other sectors as well, such as real estate, water, telecommunications, and cable TV. The Regulatory FrllmetlJork New electricity sector legislation was enacted in Chile in 1982. Its goal is to maximize social welfare by creating conditions in which the energy system can develop and operate efficiently. The law distin- guishes three separate segments in the electrical sector: generation, transmission, and distribution. It 268 /. LuIS Guasch arid Pablo 5p11It'1' spells out the main rules for the regulation of these three segments, but also for the allocation of li- censes, pricing, investment, quality, and safety. It makes clear the obligations and rights of all players involved, the service providers as well as the government institutions. THE ROLE OF GOVERNMTh'T PLAYERS. There are three key government institutions whose creation pre- ceded the actual privatization. The National Energy Commission (NEC) was established in 1978 to develop medium- and long-term guidelines for the sector independently of the potential influence of the large utilities in the sector. The NEC is managed by a board of directors composed of seven minis- ters and has an executive secretanat, technical staff, and resources to recruit special advisors as needed. The NEC proposes policies to be implemented through laws, decree, or ministerial resolutions; sets tariffs; and grants licenses to public service distributors for specific areas. The electricity law also resulted in the creation of an Economic Load Dispatch Center (ELDC) to coordinate the a~tivities of all generating companies; in other words, it is essentially a generators' pooL The ELDC's specific objectives are to achieve the minimum total operating cost for the system as a whole and to ensure equitable market access to all generating companies. Each member of an ELDC is entitled to make direct supply contracts with clients for amounts up to its available firm capacity. Any shortfall has to be purc..~ased from other members at the marginal cost of peak power, equal to the annual cost of increasing by 1 kilowatt installed capacity during peak demand periods. The firm capac- ity of each producer is the maxunum power that its generating units can contribute in the peak period of the system with a reliability exceeding 95 percent. The ELDC plans daily production and computes the instantaneous marginal energy cost by considering the vanable costs of generatIng units currently operating, independently of any existing direct supply contracts. The programming of electricity gen- eration, disregarding supply contracts, gives rise to energy transfers between generators, and these are priced at the systemic instantaneous marginal energy cost. The last key government actor of the sector is the Superintendency of Electricity and Fuels, created in 1985. It was set up as an administrative branch of the Ministry of Economics, and it supervises compli- ance with the law and regulations and monitors the quality of services. Finally, it deals with users' and suppliers' complaints and prepares the information for the price-setting process carried out by the NEe. The multiplicity of these institutional actors and their lack of independence may be the most salient feature of these institutional arrangements. The only apparent form of independence in the whole system stems from the role of the antitrust commission. The regional Preventive Commissions (Comisiones Preventivas) and the Resolutive Commission (Comision Resolutiva) seem to have the required independence, but as explained earlier, may lack the required technical skills to make the most of their independence. PRICE REGt.;"LATION. Competition is the norm in generation and in the supply to large users (those requir- mg more than 2 megawatts of power), which could be argued to be too large a number to be able to achieve effective competition. Distribution (to small users) and transmission are considered natural mo- nopolies. The price system consists, thus, of regulated charges for small customers and freely negotiated rates for large customers, whose maximum power demand exceeds 2 megawatts. The regulated rates must be within a 10 percent band of the average price of freely negotiated contracts. These contracts represent about 40 percent of total consumption. The regulated price to final customers has two components: a node price, at which distributors buy energy from generating companies; and a distribution charge. The node price is equal to the sum of the marginal cost of energy, the marginal cost of peak power, and the marginal cost of transmission. It is thus : designed to approximate long-run marginal costs. The Ministry of Economics, with technical support from the NEC, is responsible for calculating node prices. Marginal costs do not fully cover total transmission costs. The law states that the difference is charged to generating firms according to their :: area of influence. The law, however, is not explicit as to how to do this, and the charges end up being negotiated between the owner of the grid and the generators. This is a recurrent source of conflict be- cause the owner of the grid is also one of the generators. RLform and ~gu14tron in t~ p(1« Transportatlon Sector: ports, Rizilroads. Toll R:;.u1s, and AIrports ;Zg7 Table 13.1. Sum1TU1ry of Findings of Study on Financial Viability of Railway S~rvices, Argentina Status Services Commercially Viable All freight services were .... Iable. Buenos Aires-Mar del Plata intercity service: Concessions were granted. Commercially nonviable and not expendable All other intercIty servlces: Responsibility was returned to provinces. Some have been discont:lnued. Some have had concessions issued. Commercially nonVlable, but soclally essential Metropolitan commute!' rail and subway: Concessions issued were supported by government subsidies. SOIlTre: Authors. Finally, the restructuring process in railways should follow the same general analyhcal guidelines as described in chapter 10. (The separation of fixed facilities from operations has also been discussed in Moyer and Thompson [1992J as a techmque tor railway restructuring.) National Railway Company Most national railway companies are troubled state enterprises. Their obvious problems include financial distress, excess employment. lack of resources for needed investments, costs of wages and benefits, and technical and managerial inefficiencies in many divisions. This analysis of restructuring and privatization concentrates primarily on organizational issues involving horizontal and vertical groupmg within the en- terprise for private sector partiCIpation. A descnption of a prototype situation is presented below, followed by a potential organizational and operational restructuring along the lines described above. REsoURCES. The basic activities of a national railway company can be described as the loading and unloading of trams; assembling trains; operating of terminals; operating of stations and shops for the maintenance ot rolling beds and rolling stock; constructing new beds and acquiring rolling stock; coordi- nating and scheduling traffic, freight, and passenger transport; and marketing of those services. A descriphon of the stock of resources controlled by a mediwn-to-large national railway company (for example, the Mexican Railway Company) is presented in table 13.2. However, the numbers are often Ta.ble 13.2. Resources of a Medium-to-Large National Rililway Company Resources Qua nr: ty Rolling beds (kilometers) 26,000 Stations 700 Mam terminals and warehouses Maintenance shops 30 Rolling stock Engines 1,600 Freight wagons 47,000 Passenger and express wagons 1,400 Labor force 55,000 Sourc.t: Authors. 298 . J. LUlS Gwzscn and Pablo Spill" misleading. Fewer resources are in operational condition. For example, out of 1,400 passenger wagons, only 560 are in service (40 percent),242 are awaiting some type of service, 92 are waiting to be discarded, and the rest are being evaluated to see if they should be discarded. The average age of the wagons is 16 years. Out of 1.600 engines, only 995 are operational (55 percent), and 200 are irreparable. The average age of the engines is 15 years. In addition, out of an existing network of. say, 26,000 kilometers of rolling beds, 96 percent of the freight traffic takes place in a nenvork that is often less than half of the existing network. Usually the company is a freig.~t-orie!1ted ::illway camp.:my ',vith a significant :ole in the country's freight transport system. In contrast, its contribution to the passenger transport market is minimal. This is reflected not only in the stock of freight wagons relative to passenger wagons, but also in the following statistics. For example, the national railway company moves 51 million tons yearly, about 14 percent of the market or 36.500 million ton-kilometers, with an average trip of 717 kilometers. (In addition, the freight service tends to be heavilY concentrated; often less than 10 products account for more than nvo-thirds of the total tons transported~) In the passenger market the railway company moves about 18 million passengers a year, or about 2 percent of the market. and 5,600 million passenger-kilometers, with an average trip per passenger of 322 kilometers. While the potential to increase the share of the passenger market is questionable, the potential to increase the freight market is usually Significant under more effident operations. For example, in the United States, the railway system accounts for nearly one-th.ird of the volume of freIght moved. Last but not least. a highly valuable resource is the rights-of-way, which are essential to operation and which generate additional rents when marketed to outside parties (utility companies). Those rights prOVIde for contlnuous links between urban centers and are attractive to telecommunications, narural gas, and oil companies. For example, rents are derived from use of railways' rights-of-way for fiber-optic cables. COST STRt:CTUR.E. For a company with fully integrated operations. the aggregate distribution of costs 15 typically as follows: • Input allocation of costs Labor, 67 percent - Capital inputs, 21 percent Depreciation, 2 percent - Services and others, 10 percent • Activity allocation of costs Freight services, 78 percent Passenger services. 15 percent Others, 7 percent • Fixed- and variable-cost allocation Fixed costs (maintenance and depreciation, management, debt service, pension liabilities, and services), 75 percent Variable costs (labor for operations, operations en route, loading, and unloading; fuel and en· ergy; use of rolling stock, stations, and rolling beds; coordination of use and scheduling of service; sales and marketing; and maintenance), 25 percent. Costs and revenues are as follows. For freight operations, 36 products generate revenues larger than variable costs, 4 break even, and 14 generate deficits. That takes into account the recent 23 percent in- crease in railway freight tariffs. On average, variable costs exceed average revenue by 10 percent. That statistic, coupled with the breakdown of fixed and variable costs, best describes the financial situation of a typical national railway company. To some extent, the numbers are affected ~y the system of accounting and the labor contract, which is a fixed cost. Moreover, passenger service as of now represents 20 percent of operating costs and contributes 5 percent of total revenues. The high level of subsidies and inefficiency is reflected in the fact that revenue from passenger service accounts for only 17 percent of the company's total costs. In contrast, revenue from freight operations accounts for 88 percent of the total. Pnvatl:l'I1g and Rrgulatmg tne Transportanon Sector: Ports. RAIlroads. Toil RDa.d.s. and Alrport.s 299 PRODUcnvTrY. Productivity of the typical national railway company is 0.82 ton-kilometers per wagon per year, while the average productivity of railroad enterprises, particularly in industrialized cOW1tnes, is ~ore like 3.4 ton-kilometers per wagon per year. For example. in the United States, the average productlVlty among the top 16 railway enterprises is more than 2 million ton-kilometers per wagon per year (Ochoa and Asociados 1990). A large component of that differential is due to differences in speed. 'While the average speed for the national railway company is 22 kilometers per hour, the comparison railroads travel at an average speed of is kilometers per hour. National companies are slower because they use single-track beds, experience delays in loading and unloading (iO percent), have a high percentage of wagons retunung empty (42 percent), have smaller loads per wagon (85 percent), and have less operational equipment (18 percent). Only 60 percent of national railway company locomotives are available for use at anyone time, compared to 90 percent for the average U5. railway company. The average locomotive availability rano in Latin Amenca is roughly 60 percent, with the actual values ranging from 30 percent in Colombia to 83 percent in Brazil. The values are between 80 and 90 percent for European railways, with the exception of Greece; between iO and 80 percent for Asian railways; and between 40 and 50 percent for African railways. Likewise, a Significant freight-cost differential exists between the national railway company and the average U.s. railway company. Measured in tenns of dollars per ton-kilometer, that unit cost for a na- tional railway company is more than 20 percent of the average unit cost for a U.S. railway, despite rugh unit labor and fuel costs in the United States. Additionally, while labor costs as a percentage of input costs are 6i percent for the national railway company, they are 32 percent for the average U.s. railroad. National railway companies have low productivity and high inefficiency for two reasons: structural (external) and organizational (internal). Among the external factors are poor infrastructure and outdated technology. Among the internal factors are excess labor, inadequate organizational structure, and lack of an effective incentive system. The last two affect particularly the quality and markenng of servIces and hamper the potential growth of demand. By any standard, national railway comparues are overstaffed. Despite efforts to rationalize labor in recent years, through volWltary retirement and attrition programs, national railway companies are still significantly overstaffed. As of now, they have about 55,000 employ- ees, plus between 10,000 and 12,000 temporary workers who fill in during the occasional absence of permanent workers. Moreover, they have the financial liability of about 40,000 pensioners, which repre- sents 15 percent of labor costs and 11 percent of operating costs. Fuel consumption is 50 percent higher than the consumption of U.5. companies per unit of transport or freight. The recent deregulation of truck tariffs and the extensive privatization of former parastatals in coun- tries with national railway companies have adversely affected the demand for their services. More than 50 percent of the demand came from those enterprises that often were forced to use the national company' 5 services. Those clients, in the process of becoming private themselves, are becoming more sensitive to costs, which has encouraged them to seek alternative, apparently more reliable and cost-effective sources of transport. National railway companies lost about US$70 million, which does not include direct bud- geted transfers from the government. Recently, their revenues in real terms have declined by 1O.i per- cent, and their costs in real tenns have increased by 12 percent. ECONOMIES OF SCALE AND INTEGRATION. Most of the cost involved in maintaining a rolling bed unit is fixed. Because of the Significant economies of scale existing in the track and coordination units, no gams are derived from breaking that segment of the national railway company's operations into various units. At best, some geographical subdivision could be considered if size is perceived to be a problem. How- ever, no economies of scope or scale would be lost by separating the maintenance and repair of engines and wagons from the rest of the enterprise. They are very distinct and technical operations that have little in common with the rest of operations .. Rolling stock operations, passengers, and freight display some economies of scale, but those econc>- mies are not excessive and are likely to be exhausted at a relatively low level of operation. Most of them are embedded in the concept of the unit train, but technology and safety impose limits on the length of the train. Variable costs are roughly constant if the unit of measurement is taken to be the unit train. A constant returns to scale technology is a good approximation of those types of operations. Fixed costs are JOO f. LULS Gu.asch and Pablo Sprlln- essentially management costs plus the costs of capital, and they account for roughly 30 percent of the total costs of the operation. Breaking that segment of the enterprise into several similar units able to perform the same operations would not lower efficiency because of economies of scale, but it would provide a competitive environment. The benefits of competition would be lower costs of operations, higher productivity, better quality and reliability of service, and perhaps less need to regulate tariff struc- tures. To achieve these benefits, incentives would have to be linked to relative performance, allowing each unit to retain a share of the residual rights. Likewise, because labor is a major component of operat- ing costs, to achieve cost efficiency and improve the quality of the service, the units should have discre- tion to contract and sever labor, including determining bonuses and other appropriate compensations that are tied to performance. Marketing for both passengers and freight displays some economies of scale that are probably larger than those connected with running the trains, but are not terribly large. Establishing geographically dis- persed offices entails fixed costs that will need to be duplicated if passenger and freight services are divided into several units. Given the large volume of merchandise moved, particularly freight, it would be fair to apprOximate the technology as a constant returns to scale, particularly for the relevant range of operations. Freight is perhaps the least developed and most important segment of operations and is where the largest returns can be obtained. Particularly in industrialized countries, the railroad sector moves more than one- third of all goods, while national railway companies have only 14 percent of the transport market. Because of that, significant potential for growth exists. The aggressiveness of marketing agents seeking to increase market share, which is usually associated with competitive markets, could well be the vehicle to generate that growth. Nevertheless, growth in itself is not necessarily desirable, particularly if it occurs in products where variable costs exceed revenues. As of now, the average variable cost exceeds the average revenue by 10 percent. Given almost constant returns to scale technology, growth of that service would lead to a larger deficit. The emphasis should be on reducing costs and increasing productivity for those products where variable costs exceed reven~es. For products where revenues exceed variable costs, the combination oi growth, reduced costs, and increased productivity should be sought. Significant economies of scale are possible in scheduling, coordination of operations, and infrastruc- ture (tracks, terminals, and stations). Moreover, no advantages and numerous disad"'antages exist in breaking these segments into several similar units, and these segments should remain whole and central- ized. Whether they should remain in government hands is a different issue.llthough the government could retain the property rights or ownership, a concession to a private entity should be considered. The arguments just presented focus on the issue of economies of scale gained or lost if horizontal disin- tegration were to take place at the various stages of operations. However, another aspect needs to be consid- ered: whether economies of scale exist in the vertical integration of its operations and, if they do, to what extent. The three broad categories that determine the extent of vertical integration are technological econo- mies, transactional economies, and market imperfections. A preliminary examination of the operations of national railway companies indicates that no significant technological economies are gained across stages of production, nor do market imperfections justify the vertical integration of their operations. Transactional economies might be lost in a vertical disintegration, but even those losses are not likely to be sigNftcant and can be mitigated by the use of transfer prices. Some economies of scope might be lost because of manage- ment, but once again the losses are likely to be small and to be more than compensated for by the efficiency gains that potentially can be reaped by the vertical restructuring process. FRINCE AND INTERMOOAL COMPE'TT1l0N. In freight service, the relev~t competition is provided by the trucking sector, which has steadily been gairung transport market share. During the last two decades, freight transport has been growing at an average annual rate of 4 percent. During the same period, the market share of railways has decreased from 21 to 14 percent, while the share of trucking has increased from 73 to 79 percent. Rate structure and the quality and reliability of service are the major causes of this shift. Deregulation of the autotransport sector, as expected, has affected the demand for freight service provided by national railway companies. The ratios of freight to autotransport range from 123 percent to Pn;;:a:LZmg and ~gllilltlng the TransportatIon Sc;;::or: por:s. RaIlroads. Toll Roac.s. and AIrports 301 85 percent for the 12 most significant (in terms of volume) products (automobiles are an outlier with a ratio of 58.2 percent). Allowing companies the flexibility to negotiate tariffs would enable .ational rail- way companies to respond to the increased competition from the autotransport industry. In passenger services, tne relevant competition is prOVided by f'Jbilc bus sen'lces. Tne changes in this sector have been quite dramatic. During the last two decades, the average annual growth rate has been 7.5 percent. In that period, the demand for railway services fell b:' half, and as of now its market share is about 1 percent. (If sen'ices rrovided within urban settings Zlr€' excluded, the share :"'1c::e.:tses to 3 r er - cent.) In contrast, the demand for public bus service has gro ....'I1 fivetold, and its market share is 99 per- cent. That has been the trend. although fares for all railway servIces are substantially below bus fares for the corresponding service. The exception is sleeping wagons, where the pnce is significantly higher. For first- and second-class services. railwav fares are 51 and 25 percent, respectIvely. of bus iares. For special first-class service, the fare is identical t~ the bus fare (similar sen'ice). and for sleeping wagons, the fare is 67 percent more than the closest equivalent bus fare. The apparent reason for the dominance of bus over railway transport is, foremost. time, fol.lowed by scheduling and possibly service. Railway service time between two points tends to be on average twice as long as bus service time. The decrease in passengers and freight has produced a decrease, in real terms, in revenues of 28 and 35 percent, respectively, in the last two years of operation, relative to the highest revenues. L"JCE!\"TIVES. The incentive structure designed to induce and reward effective performance is usually set forth through a contract plan. \Vhile hlstorically incentives were determined largely by output targets and incompletely defined financial measures (targets), some improvements have been made 1Il the most recent plans. In these, targets have orten been replaced with a complex system of weighted periormance mea- sures. For example, 40 percent of the evaluation grade is based on deficit control, 20 percent on generaoon of freight traffic and total use of locomotives, 15 percent each on rehabilitation of rolling stock and fixed facilities, and 10 percent oJ;1 studies of human resources and structural change in the railway institution. Although the incentive structure set forth in recent contract plans represents an improvement over t..'ie previous incentive structure, it is still deficient. The performance objectives often contain irrelevant. con- flicting, and potentially perverse incentives. For example. tradeoffs eXISt in the weighted periormance in- dex between increasing ton-kilometer and deficit control. Increasmg freight traffic can increase the deficit. Likewise, tradeoffs exist between track maintenance and increased traffic ane! between rehabilitation and deficit reduction. The tradeoffs (to management) are based on the weights of the periormance measures, and those weights do not necessarily provide the correct Slgnals tor. or reflect, margmal social value. Some of the performance measures currently used are not relevant or are redundant, like those regarding the availability of locomotives, Which, in any case, will show up indirectly in the deficit measure. These are internal measures that are factored into the cost structure of the enterpnse, and the decision to use them or not for setting its own incentives (for the relevant units) should be left to management. As Galenson and Thompson (1991) have stated, the current performance measures guarantee continuing government inter- ference in matters that should be left entirely to the discretion of railway management. Finally, the incentive structure of the contract plan is valid for only one year, and a new one has to be reconvened for the year after. That is too short a tune span for anything other than inefficient myopIC actions. Performance measures should be based on clear and relatively simple financial variables (targets) and should cover an extended period to allow efficiency of investment and capital plaruting to take efiect. Compensation, based on those measures, should be designed for the enterprise as a whole. The setting of internal incentives and the decisions on how to divide the compensation across layers and units of the ,- enterprise should be left entirely to the discretion of management. GOVERNMENT ROLE. Given the characteristics of the railroad sector, the government has a key role to play in the restructuring process because national railway companies are owned by the state and be- cause a number of services deemed desirable are not financially viable. In almost all countries, the government subsidizes railway services. As of now, direct transfers from the government to the 302 J. LuIS GWLSch tmd PtlbJo SpllJtr national railway company range between 0.1 and 0.5 percent of gross national product. For eA lIe, the subsidies for the Italian, German, French, and U.K. railways are USS4.3 bi!:: :1n, USS3.5 1: .• on, USS3.25 billion, and USS605 million, respectively. The idea is to induce the railwa:-.> to operate as effi- ciently as possible given the financial constraints. Some are doing better than others_ Railways in the United Kingdom travel 49 percent more kilometers per employee than the West European average, with one-sixth of the public subsidy. A number of acceptable justifications for the subsidization of railway services exist, including their social desirability in sparseJy populated areas and the reduction of congestion on motorways. The subsidies ought to be transparent, though, and the operating com- pany should not be forced to bear the losses. Government involvement is also needed because some of the economically desirable restructuring might be politically damaging because the indebtedness and liabilities of the enterprise affect the quaSi-fiscal deficit. In particular, the issues to be negotiated are • Establishment of a politically feasible schedule to rationalize excess labor (perceived to be more than one-third of the current labor force) • Deregulation of tariffs and discretion to abandon services with negative net social costs and benefits • Assumption by the government of current pension obligations, prior to concession and privatization • Acquisition of contracts for (socially desirable) below-cost sen/ices • Investment for modernization of fixed facilities, equipment, and control systems • Determination of criteria and sources of financing and the private sector's role • Financial rescheduling of existing debt • Privatization or concession of most operations • Establishment of an independent regulatory agency with jurisdiction over the pricing of noncom- petitive aspects of railroad operations, access to network terms, and resolution of disputes be- tween pnvate agents and government agents and with jurisdiction over access rights and new capital investment rules. . OmONs FOR SEClOR REsnu:CTURINC. The main objectives to be sought through the restructuring process are increased efficiency (through the reduction of costs and better use of the existing resources), increased productivity, financially viable growth (particularly in the freight service category), and generation of private sector participation in selected areas. Broadly stated, the mechanisms and options through which these objectives can be accomplished are selective horizontal and vertical segmentation of the enterprise, implementation of unit-specific compensation or incentive schemes, and the opening to the private sec- tor of access (wholly or partially) to railway operations. These recommendations can be divided into two categories, one for short-term and the other for long-term restructuring. Obviously, the latter IS more encompassing and therefore requires a longer time span for implementation, while the former can be started right away with little disruption of ongoing activities. The short-term recommendations are as follows: • Labor. Labor should be rationalized at a rate politically and socially acceptable, with a target reduc- tion of at least one-third of the labor force by the end of the program, through attrition, voluntary (with incentives) retirement, and a freeze on new hiring. As of now, labor costs exceed two-thirds of operating costs, making financial viability of the enterprise nearly impossible. Pensions, which cover an average of 40,000 pensioners, and liabilities account for 15 percent of labor costs and 11 percent of operating costs and should be transferred to the federal budget. Labor redundancy has been and is a chronic ~- :oblem in railways. Successful restructuring has consistently entailed drastic reductions in the labor force. For example, since 1980, railway comparties in France, Jap~ New Zealand, Spain, the United Kingdom, and the United States have reduced their labor forces between 30 and 60 percent. Prwatl::.mg and &gulatrng the Transportation Sector: Ports. IVJl/nxu;J.s, Toll ROQris. and AIrports 303 • Operations. Financial and operational autonomy should be granted to maintenance units being concessioned or sold to private operators. EffiCiency would improve by reducing slack, and costs would be reduced bv decreasing the number of units, by automating the signalization of rolling beds, by modernizing accounting procedures, by computerizing operations and inventory, and by closing down ineffective services in the areas of passengers, express mail, stations, and mainte- nance units (shops). • Private sector participation. Facilitating the participation of the private sector can range from the subcontracting of concessionaire services (food, janitorial, medical, and so forth), maintenance services, or services, such as running sheds purchased or leased from the national railway com- pany, to full (segmented) privatization of railway operations. In addition, railway assets should be able to be used for nonrail business, allowing private sector entities access (at a price) to the infra- structure and services, both for their own use and for the provision of services to third parties. The private sector should be allowed to construct and operate new terminals, both specific or multiproduct, and to concession and divest repair shops. A number of existing cases of those types of private sector participation are presented in Galenson and Thompson (1991). • Organizatio7Uli structur~ and incentives. Reforms include identifying profit centers and decentraliz- ing decisionmaking, granting autonomy, and implementing incentive schemes or compensation (residual rights), preferably related to performance. Comparisons could be established across units or, if necessary and appropriate, across units outside the organization performing comparable activities. Measurable and objective performance criteria should be established for each type of unit. In particular, unit managers should be allowed to retain a fraction of the gains from improved productivity that is not directly linked with the acquisition of new technology, rather than have compensation determined as a percentage of current wages, as is now the case. Specilically, com- pensation to the operations units, in the form of commissions and similar modes, should be strongly linked to the volume of sales. The freight operations and the various modes of passenger services should be converted into distinct business units, as should the maintenance of rolling beds. • Investment prilJrities. Capital investment priorities should be directed toward communications, sig- naling, and management information systems, which will significantly improve the use of existing capacity. New extensions of tracks could be concessioned to the private sector through competi- tive bidding, based either on lowest costs or on lowest toll track per unit of service. The latter option clearly has fewer implications for the government budget. • Autonomous decisionmaJcing. The national railway company needs to be able to make dedsions autono- mously, relative to the government, or at least to improve the coordination of objectives and dedsions, particularly on the choice of standards and investment planning (construction of new routes). • Contracting. Given that most of the passenger services now provided (at subsidized prices) by national railway companies are not financially viable and are undertaken with a social obJective more than an economic one, it is imperative to increase transparency by implementing contracts between the affected parties, municipal, provincial, or federal entities, and the preferably private railway company, so the financial burden is explicit. Those entities should assess now much the service is worth to them (how much they are willing to pay for it). Ii that amount covers the costs of providing the service, then the company should provide it, if no alternative use of those re- sources generates higher value. Otherwise, the service should be discontinued. (Other activities might generate greater benefits both for the company and for society as a whole, if the same re- sources were to be used there.) The idea is that the national railway company should be run as an autonomous, financially viable service company that is open to any contractual relation with any party desiring its services. • Clear rules of the game. In the short run and perhaps in the long run as well, private and public operators or entities will coexist. 'That in itself is bound to create suspicions of unfair use of control or of favorable treatment of state-owned operators, which can reduce private sector interest. There- fore, to entice private sector participation, the rules guiding operations, rights, and transactions J04 j. LUl5 Guasch and Pablo Spillt"" should be as dear as possible. This is quite important because large stmk costs have to be borne by private participants. The rules and criteria for changing the sunk costs and the procedures for resolving disputes and for detennining private participation should be transparent. For example, the following questions need to be addressed: How will nonmarket prices or fees be detennined? How will scheduling conflicts be resolved? Will the company have priority? How will a level playing field be guaranteed for all participants? What restrictions will be placed on operations and on ~ntry and exit procedures? How will decisions regarding new routes and theIr financing be made? How will labor disputes affecting private operators be handled? Without clear rules, both efficiency and private sector participation will be hindered. • Creation of an autonomous regulatory agency. The often common structure of the national railway company rema..ining both the provider of services, some under exclusive controL and the regula· tor, is untenable. With private sector participation, an extensive and competitive interaction occurs between the national railway company and private finns, with the railway company having lever· age or monopoly power in ~ome transactions and further control through scheduling, the provi· sion of access equipment crews, and other complementary services. 1b.at conflict of interest might undermine efficiencY. Thus, a regulatory agency (within an integrated transport regulation agency) should be establish~d independent of the national railway company and should be given jUrisdic· tion over tariffs for noncompetitive segments, scheduling, logistics, connecting and access fees, the granting of licenses, concessions, new investments, operating fees for private sector unit trains, and resolution of conflicts (prior to the court system). They should also have jurisdiction over repair and maintenance shops. High setup costs, economies of scale, and geographical separations .confer some degree of monopoly power on the operators and concessionaires of those services. The issue is whether the quasi·monopol.ist should be free to negotiate with a customer or competi- tor the transfer prices for trackage rights (as in the United States) or repair maintenance fees, or whether the regulatory agency should prevent market foreclosures and should more generally regulate a fair transfer price and maintenance and repair services fees. The answer clearly depends on the degree of contestability of the operation. Moreover, the national railway company should be empowered to regulate safety standards, mechanical inspection, professional competence, and the working hours of drivers. A long·term perspective suggests that the national railway company should be' divided into three types of autonomous companies: one for scheduling, rolling beds, tenninals, and stations; one for rolling stock and maintenance; and one for operations, freight, and passengers. Moreover, several subcompa- nies of each type, except the first, should be formed, and concessions or sale and access should be granted to private operators so that a competitive culture can develop. Clearly, the extent of pnvate participation might render the existence of the equivalent state-owned subcompanies unnecessary. A deScription of the types of companies follows; the structure is depicted in figure 13.1. A single company should be in charge of scheduling (rights-of-way), rolling beds, terminals, and stations (this is the Peru and U.K. model). The extent of fixed and sunk costs of this activity provides for natural monopoly cost conditions, which warrant the existence of a single entity with control and re- sponsibility for those operations, albeit subject to regulation. However, this company should contain three units or profit centers: one for maintenance and new construction of rolling beds, another for the sched Wing and coordination of traffic, and a third for the operation of terminals and stations. User charges for scheduling, access to rolling beds, and use of terminals and stations should be levied on the operating units or private entities when applicable. In the event of congestion, differential pricing (related to time) should be used to determine both access and scheduling fees. This single company could be government· owned and operated or, preferably. the operations could be concessioned to the private sector. A number of rolling stock companies could split the property rights of traction and both passengers and freight wagons. With a stock of 1.600 engines; 47,000 freight wagons; and 1,400 passenger wagons, few economies of scale would be lost by partitioning the freight segment into at least two subcompanies, Prroatr:.mg and &-guUztrng tn( Transportatron Sector: Ports. &lzll"OOUis. Toll R.oatis. and AIrports 305 Figure 13.1. Segmentation of a National Railway Company Type A company: Rolling Beds Temunate :xheduling One company (51) Rolling Stock I (52) Mamtenance I Type 5 companies: Two companies & private access Private I II entItIes Freight Passengers Type C companies: At least two & private access P::-l\:ate I n X y Z operators I I Source: Authors. and much would be gained by having increased competition for the pricing and use or placement of equipment. The effect should be to provide better service and increase productivity by reducing idle time. increasing load factors, and lowering turnaround time. Private operators should be allowed access to provide both their own service and service to third parties. Maintenance should be privatized or subcontracted to private parties. In the event that it is not, it should be tied to the rolling stock companies. Because service operations are sufficiently distinct, a nwnber of subcompanies (or units by type of service) could be established and offered to the private sector. In particular, freight and passenger opera- tions should be separated, and passenger operations should be separated further into companies serving freight and passengers. At least two (private) subcompanies should carry freight and engage in similar operations, and several companies should carry passengers and be subdivided into proVincial, long dis- tance, and commuter (suburban) service. Given the relatively low volume of passengers per route, there should be little advantage to having more than one company provide passenger service. The lost economies of scale might easily outweIgh any gains from increased competition. On that basis, only different units or profit centers should be created for different types of passenger service. However. it would be appropriate to consider forming more than one unit for freight operations and to extend access to the private sector. The operations companies are of particular importance because it is in their area of jurisdiction where significant gains, cost reductions, increased. productivity, and growth are possible. In turn, they will pro- vide added incentives for improvements in the running of rolling stock and maintenance companies. Freight and some intercity services have the potential to be profitable, and a significant untapped market exists for 306 , Ul1.S Gw:zsch lind Pablo SpilitT both types of services. Establishing the right set of incentives is critical. Marketing the service ~ main activity, and compensation should be determined by volume of sales and by relative performa: Separating rights-of-way and scheduling from operations would give outside parties greater a~:ess to the network, which would enhance the likelihood of intramodal competition. Access to the railway infra- structure should be provided at a fair price to potential operators or individual customers wishing to provide their own service. British Railways provides a good example. Two private companies, Foster Yeoman (a quarrying company that runs its own freight trains) and the Royal Scotsman (which operates deluxe tourist trains) have proven that competitors can run on the same track as British Railways and provide real benefits (The Economist 1991). Other precedents exist. Japan already has a private railway and has broken its state network into regional companies (with the idea of ultimately pnvatizing them), Sweden has allowed new entrants access to its nationalized service to compete on local routes, and Hol- land is considenng privatization. Giving potential private operators access to railway infrastructure would deter cross-subsidization among types of service, which is generally an undesirable feature of a multiproduct pricing system. U cross-subsidization were to exist. profitable entry could occur in the ser- vice that is priced above costs. In addition, the suggested separation would improve finanaal account- ability and would clarifv the cost structure of the units separated. When separated, operations units would be charged variable costs for the use of rolling beds and the costs of scheduling. That would make comparisons between and within modes of perfonnance much easier and would enhance competition in the transport sector. An advantage of long-term restructuring is that it separates the (essential) monopoly part of national railway company operations irom the rest. TIlat separanon is desirable because it facilitates the future privatization of parts of the operation. The operations company could remain in government hands, and the rest of the network could be privatized. Moreover, separating rolling beds (rights-oi-way) from op- erations could create opportunities for competitive operations on common track. That competitive argu- ment is behind the railway restructuring in Peru, Sweden, and the United Kingdom and behind the European Community proposal to require all European railways to separate their railway operations from their rights-of-way functions .. The proposed vertical and horizontal disintegration and the granting of private sector access should be considered as ways to promote competition and capture effiCiency gains in the railway sector. In summary, horizontal and vertical separations could constitute a valid technique for enterprise re- structuring, and, as such, deserve careful consideration. However, if the costs of these separations prove to be excessive, other restructuring tools are at hand. Current RlJil FrlJnchising Agreements Although vigorous debate still occurs about whether contracting out has improved the quality of service, little doubt exists that it has significantly reduced the cost of providing services, primarily due to reduced labor costs. Franchising has generally been adopted as a means of introdUcing competition and private sector capital into subsidized rail services. The experience of rail franchising in Argentina (Buenos Aires freight and intercity), Bolivia, Brazil, Mexico, Peru, Sweden, the United Kingdom, and the United States (Boston and Los Angeles) gives some guidance on the franchising arrangements that are likely to be attractive to potential bidders and on pOSSible problems. Although not all of these cases have been fully implemented, the design process is well under way. Local transport authorities in Sweden opened the operation of local passenger services to bidding from both private sector firms and the state-owned com- pany. The first contract was awarded to a private sector finn, which has since won additional contracts in competition with the state-owned company. In the United States, suburban rail. services in Boston have been franchised since 1989, and Los Angeles will soon accept 'b.. ,~ for commuter service franchises. The Manchester franchise in the United Kingdom began operating 11. 1992. The Argentine government intends to issue franchise contracts for virtually the Pntlatl:mg and RLgulatmg thr: Transportauon Sr:ctor: Ports. RailroDds. Toll RoAds. tmd Airports 307 entire rail system, including suburban and metro services in Buenos Aires, intercity passenger services, and .an extensive nehVork of freight services. There is much to be gained from having a rolling program of franchise awards. It allows mistakes in the design and award of franchises to be rectified and gives time to build up a pool of potential bidders. The franchiser will need to survey bidders' views in advance and to promote the franchises, particularly if it hopes to attract bids from foreign companies. At least 12 months are needed to move from the request for bids to the award and signing of the final contract. Evidence on franchise performance is limited. Of the cases mentioned above, only the franchises in Boston, Manchester, and Sweden have been operating for some time. In those cases, franchisees negotiated significant changes in labor contracts, compared with previous or other industry arrangements, reducing the labor force, allowing greater flexibility in the use of labor, and, in Boston, lowering the rates of pay. In Sweden the process of franchising services previously operated by the state-owned railway has had benefi- cial effects on the rest of the organization. The threat of increased competition has caused the state-owned railway, as a whole, to become more efficient. A striking feature of these examples is the sheer diversity of franchise arrangements observed. The contracts have been written for anywhere from one year (in Sweden) to 30 years (in Argentina). Moreover. in Sweden the typical contract covers only the operation and mainte- nance of trains, while in Argentina contracts include infrastructure and all rolling stock of traction equip- ment. Argentina also requires franchise companies to undertake major investments. In conclusion, both analvsis and experience indicate that a key characteristic of franchises is the length of the contract. Short-term ~ontracts maximize the opportunity for competition for the market, which is a primary objective of any franchising process. Long-term franchises, however, make it easier for a wider range of responsibilities to be transferred to the company and offer stronger inducements than do short- term contracts for innovative reorganization. If franchising is to improve the railway industry, the agency in control must create conditions that encourage competition for franchises while giving companies both the motive and opportunity to invest in and improve the service. Roads Many developing countries are experimenting with private toll roads, mostly for fiscal reasons, although most developed nations with mature and broad network coverage, such as Australia, Canada, Northern Europe, and the .United States, continue to rely primarily on tax revenues to finance road maintenance and new construction. As a result of fiscal pressures to maintain macroeconomic stability and the clear priority to invest in the social sector, developing countries have opted for toll financing and private concessions in their dire need to expand the highway network. However, since many of these COWltIles started building expressways only in the late 1980s and 1990s, a large body of evidence is not available to examine. This section will consider the main issues on road financing, operation, and regulation, and the specifics of the Mexico program (Information on the Mexican program is from Gomez-Ibanez and Meyer [1993}.), which presents a relatively advanced. example and the more general challenges of constructing a successful private toll road system. The other country in Latin America that has been involved in private toll road development has been Argentina, although its involvement has been mostly restricted to new access roads and rings around the Greater Buenos Aires area. The objectives of those two cases contrast. While Mexico was seeking a significant expansion of its road network, Argentina's objective was the reconstruction and maintenance of existing roads. The experiences are reported in this chapter. The incentives and challenges related to privatizing road ways do not differ greatly from those for privatizing highly durable assets, but some of the issues are quite distinct and most extreme. First, the level of required investment is most significant; most of it qualifies as sunk costs and is long term. The assets are long lived, around 20 to 30 years, and given the standard cash flows (with competitive toll road fees), require a similar number of years to amortize the investment. Financial markets in most developing countries do not provide long-term capital. Efficient pricing, based on marginal costs, does not allow for coverage of the fixed costs; in a first·best context, efficient pricing should reflect ma~l congestion 308 ,. UllS Guasch and Pablo 5pllI~r costs. It could be as low as zero in times of excess capacity, and at whatever level is necessary to clear the market in times of excess demand congestion. Finally, significant externalities, which in principle are not captured by the road operator, exist in the construction and operation of a highway. Arguments in favor of private provision of highways include government relief of large investment requirements, increased efficiencv of the service, and increased (private) capital investment entering the economy. Opponents of privatiz~tion point to insufficient network coverage if cross-subsidies are not allowed, to inefficient pric- ing, and to potential abuses by the provider if given free rein in setting toll levels. Besides lowering expenditures of the central government, attracting investment (particularly foreign) clearly would have extremely beneficial effects for any developing economy. Private domesnc capital markets in developing countries offer few long-term investments, especially when a history 0; mflation or political instability exists. Access to mternational capital markets may be even more limited. Detrac- tors, however, argue' that the total pool of savings for the country cannot increase unless the laws allow international investors to participate. If that is the case, success in tapping new capital markets will be directly related to the government's willingness and ability to provide investors with reasonable security. Both domestic and foreign inves- tors will want guarantees about the rate of future toll increases and assurances that the government will not unilaterally alter the terms of the franchise agreement. Foreign investors are likely to seek greater assurances because of exchange rate risk and because their political risks are greater or, at least, more difficult to assess. The more lim.ited that the government assurances are means that the pool of investors is more limited. In Mexico, for example, the government agreed to a specific toll formula, but uncertainty about other related government policies and constraints on their participation limited those interested in the initial road privatizations to domestic entrepreneurs. Another area of concern is whether a private provider will maintain all aspects of the service as it was when controlled by the government. Transportation planners and economists have long debated the wisdom of financing roads with tolls rather than taxes. One concern is whether toll receipts can or should cover costs, since often the social returns considerably exceed private returns as a result of externalities or equity concerns. In countries or network areas with low traffic levels, franchisees will have to charge high tolls that may, in tum, lower the number of users. Obviously, the cnterion to guide the desirability of new highways is whether the social benefits exceed the social costs (and even then, opportunity cost of capital issues would dictate the course of action). If so, and given that low traffic volumes are a particular prob- lem in developing countries, some type of cross-subsidization may be necessary. With toll-financed roads, some areas will not be profitable. If the provider cannot price in such a way as to compensate for low- traffic roads, the quality of service will decrease, particularly toward the end of the concession period. Although this problem is not limited to the privatization question, it increases the opposition to privatization and further complicates the role of government in setting acceptable rates. Additionally, political pressures for a standardized level of service, such as uniform toll rates over a broad geographic area, can further complicate attempts to privatize highways. Governments may prefer a standardized network as a way of politically or socially integrating a nation. A standardized network can also be helpful in achieving a more uniform pattern of regional economic development, and it can be argued that disruptions are less likely to occur if different parts of a highway system use the same weight and dimension restrictions. However, standardization a.i.so reduces the ability of capital to adapt to dif- fering needs, thereby creating use inefficiencies. As a result, networks that require standardized tolls or other similar policies are difficult to privatize and will attract fewer interested bidders. The final objection to privatizing roads is the regulatory requirements on the government itseli. Al- though the government will have removed itself from day-to-day operations, it still must oversee the pric- ing and service provision choices. One unfortunate outcome is that public officials yield to popular pres- sures and set unrealistically low toll rates. This gap would lead to service inadequacies and shortages. The reverse unfortunate outcome is that public officials are captured by the very firms they regulate and set tolls wen above costs. Striking a balance between protecting the public and providing investors an opportunity to earn adequate rates of return may well be the most challenging aspect of the entire process. Pnvatl::mg and uguwtmg the Tral1Sportatron Sector: Ports. Railroads. Toll RDtld.s. Dnd Arrports 309 Potholes on the Path to Privatizing Roads: Mexico's Private Toll Road Program Mexico has shifted between toll and tax financing of highways several times as public sector resources have waxed and waned. The country began building its high-performance road system as publicly owned toll roads in the 1950s. Beginning in 1963, a govemment-o\VTled toll road company built almost 1,000· kilometers of toll roads. The federal toll road authority, Carninos y Puentes Federales de Ingresso y Servicios Conexos (CAPUFE), which is an agency of the Ministry of Communications and Transportation, mostly operates those roads. The public toll roads are concentrated around Mexico City, where traffic volume is generally highest. In the early 1970s, however, Mexico shifted to tax financing for new expressways, fueled by the pro public sector regimes of Presidents Luis Echeverria Alvarez (1970-76) and Jose Lopez Portillo (1976-82). By the mid-1980s, almost 3,000 kilometers of untolled four-lane divided highways had been opened to supplement CAPUFE's I,OOO-kilometer toll network. The rapid expansion of the public sector, combined with the collapse of oil prices in the early 1980s, adversely affected the Mexican economy, which led to another dramatic reversal of government polices. With the Mexican economy experiencing negative growth rates in 1982-83, government budget deficits ~ew to as much as 16 percent of the gross domestic product (GDP), and the financing of those deficits helped stimulate severe inflation. In response, President Miguel de la Madrid (1982-88) initiated a pro- gram to cut the size of the public sector, which his successor, President Carlos Salinas de Gortari (1988-94), expanded and accelerated. Privatization played a key role in the two presidents' strategies to reduce the government's budget deficit, largely through sale or liquidation of money-losing state enterprises. Highways did not become a focus of the privatization program until the late 19805. President de 1a Madrid raised tolls on the CAPUFE network beginning in 1982, but he hoped to use the proceeds to cover the government's budget deficit rather than to expand the system. The recession also cut traffic growth rates and made road investments a less pressing priority. The need for road improvements became more apparent as the economy began to show signs of recovery, and in 1986 the de la Madrid government asked the national development bank, BANOBRAS, to study the possibility that new toll roads could be built as private concessions. BANOBRAS was optimistic, but recommended an experimental program to test the feasibility. Accordingly, two road' concessions totaling 215 kilometers were granted at the end of the de 13 Madrid administration, with BANOBRAS serving as the concessionaire and finanong 50 percent of the project costs, contractors financing 25 percent, and state governments financing the remaining 25 percent. In February 1986, President Salinas announced a dramatic new program to build 4,000 kilometers of new toll roads and seven new international toll bridges as private concessions berore the end of his administration in 1994. The projected cost was almost USS5 billion, which trIpled the rate of new high- wa y investment over that of the preceding few years. Accelerated road construction was viewed as an important part of President Salinas' effort to revive the Mexican economy. Road building would stimu- late the economy by putting Mexico's construction industry back to work, and high-qUality infrastruc- ture was deemed critical to Mexico's long-term prospects. Private toll roads seemed the only choice, smce the government was trying to cut the public deficit and was in the midst of difficult renegotiations of the enormous foreign debt left over from the public expansions of the 1970s. . Under the new program, the Ministry of Communications and Transportation would select the roads to be offered for concessions and would specify the initial toll rates. Toll increases were to keep pace with the consumer price index. Bidders would be supplied with preliminary designs, cost estimates, and traffic projections prepared by the ministry. The concession would be awarded to the bidder that offered the shortest concession period, which could in no case exceed 20 years. The new program would rely primarily on private concessionaires and financing, unlike the pilot projects of the previous administration. The con- cessions were to be awarded to consortia of construction companies and banks. The construction compa- nies were expected to put up 25 to 30 percent of the cost in the form of sweat equity by discounting their construction bills by an agreed-on percentage. The banks would finance the remaining 70 to 75 percent. To guard against conflicts of interest, each concession would create a speci.a1 independent trust to review the contractor's bills, disbwse the bank financing, and distribute the toll proceeds to the investors. 310 f. LuIS Guasch a"d Pilblo Srnllrr The government would guarantee its traffic and cost estimates in part. If traffic were less than the ministrv forecast, the concessionaire could request an extension of the term of the concession. The con- cession~ire was responsible for the first 15 percent of any construction cost overruns. Overruns in excess of 15 percent and any overruns caused by govemment~imposed delays or design modifications were grounds for requests for concession extensions. Direct public assistance for the concessionaires was to be kept to a minimum, except that the ministry would assemble the required right-of-way and lease it to the concessionaire for a nominal charge. . The ill-advised emphasis on short concessions was driven largely by the need to attract private capi- tal. Financing long-term debt was nearly impossible in the Mexican domestlc capital market during the 19805, given the virulent inflation at the time. Even five-year instruments were rare and could be sold only by the largest and most secure comparues. The banks involved in the consortia preierred shorter concessions because thev were reluctant to tie up their own funds for long penods. The contractors were also anxious to recover 'their sweat equity quickly, especially since some of it would be in the form of deferred depreciation on their equipment. Mexican government officials wanted to ensure that the process of concession bidding was competi- tive and fair and thus favored making awards on only one criterion. such as the concession duration. Under the new program, competing proposals would differ only in the duration of the concession, since all bidders would be reqUired to accept the ministry's route and toll rates. Competition along one dimen- sion would make the process transparent to all and less subject to charges of manipulation or iraud. The private concessionaires included most of the major construction companies and banks in Mexico. Mexico's three largest construction companies were awarded 9 of the 29 new concessions signed by the Salinas administration from 1989-91, smaller construction companies were awarded 14 concessions, and state governments received 6 (which were not awarded competitively). Mexico's pace of new toll road construction was extraordinary. However, from an economic efficiency standpoint, the program was a disaster. The efficiency problems started with the choice of a minimum concession period as the criterion on which to assign concessions. The basic problem of this approach is that it induces the bidder to propose a fast amortization for an asset that has a much longer life. This criterion, coupled with the ample and predictable opportunities to renegotiate, led to highly inefficient allocations (allegedly one bid was tor 18 months for a new 6O-kilometer highway). Most oi the earlier winning bids were in the &ote-lO-year range, well below the normaillfe of a well-maintained road. It is inconceivable to expect that the investment in a new highway can be amortized in such a short penod. The fast amortization period, in tum, tends to justify charging the maximum tolls permitted. This, in tum, leads to toll road underutilization. a Significant welfare loss. A related problem was that the maxi- mum tolls set by the ministry were too high to induce the minimum amount of traffic the ministry guar- anteed. Due to minimum traffic guarantees and the nsk of concession cancellation (if traffic exceeded guaranteed traffic), total traffic over the concession period was fixed at the time the concession was awarded (equal to minimum daily traffic guaranteed times the number of days of the concession). Since total traffic is thus given, revenue maximization is achieved by setting the price at its maximum allowed level (accounting for the nonlinear increase over time of maintenance and financial costs). . In addition, a major problem was inaccurate cost and traffic projections by the Ministry of Communi- cations and Transportation. While government officials reported that the costs on most projects were within 15 percent of the estimate, a number of dramatic underestimates occurred. The combination of those inaccuracies and the government guarantees was lethal, leading to highly perverse operators' in- centives and opening the door to capture and highly favorable (to operators) renegotiation opportuni- ties. The Mexican government and the concessionaires blame the poor cost projections largely on the speed with which the concessions were awarded. The designs for the roads were often incomplete when the concessions were put out to bid. Sometimes the federal government or local communities pressed for modifications in the route after the concessions were awarded. Indeed, incomplete plans were somewhat advantageous in that they allowed the concessionaires more freedom to suggest changes in alignment or design when they encountered unexpected problems. Pnvattzzng tzrui Rrguillhng tnt Transportatton Stetor: Ports. Raltroads. Toll &ads. tl71d Airports 311 The errors in the traffic projections were blamed not just on the pace of the program but also on the high toll rates for the new concessions. In 1988, before the concession program started, CAPUFE tolls averaged only slightly over U5S0.02 per vehicle-kilometer. The toll rates on the new concessions aver- aged U55020 per vehicle-kilometer in 1991 and were much higher for trucks. Mexican highway planners had little experience with such high tolls and were sometimes surprised by the amount of traffic diverted to parallel un tolled roads. Occupancy rates, not surprisingly, were extremely low, in the 20 to 40 percent range on most toll roads. Inaccurate cost and traffic projections also encouraged the opportwlity to renegotiate concession tenns in the event of overruns. Concessionaires might have been more inclined to overlook forecast inaccura- cies when the concessions were being awarded because they understood that the concession terms might be renegotiated eventually to reflect more realistic cost and traffic figures. Moreover, some banks and other observers feared that the contractors had strong incentives to pad their construction bills to reduce the real equity they contributed. Obviously, bill padding and the opportwlity for renegotiation, common features in most concessions, could undennine the competitive procurement process, particularly the possibility of securing the lowest cost or most efficient contractor. . As a consequence of these problems, toll roads were underused. The ratio of observed traffic to guar- anteed traffic was nearly 50 percent, and the tolls were exceedingly high, around US50.20 per kilometer (between 5 and 10 times higher than comparable tolls in the United States). This arrangement was highly inefficient since traffic along the fastest and safest road (the toll road) was kept to a minimum, while traffic in the parallel toll-free road was excessive and congested. That implies, on average, higher conges- tion and faster deterioration of the toll-free road, maintenance of which is a responsibility oi the govern- ment. The problem of underuse has been particularly acute in the case of trucks. The projected propor- tion of truck traffic was on average four times higher than the actual truck traffic. In the end, most of the concessions were renegotiated, with more favorable terms granted to the operators. Ironically, among those terms was extension of the concession agreements, which had been the criterion used to grant the concession. Another factor that limited the effectiveness of the privatization program was that the government increased its financial contribution to the system. The government awarded the most profitable concessions first, in keeping with its desire to limit public assistance. As the network expanded, profitability declined, and Mexico was forced to gradually increase the direct government aid it offered for concessions. The primary source of the government aid has been surpluses generated by the existing CAPUFE toll roads. Thus, Mexico in effect began to subsidize the more recent private concessions using CAPUFE surpluses. In the spring of 1990, the Ministry of Communications and Transportation began to solicit bids for concessions that included government promises to pay a fixed share of the estimated construction costs. The government announced that its share of construction costs would never exceed 25 percent of total concessionary toll road investments, but that limit was soon reached. The concessions awarded through July 1990 were financed 29 percent by contractor equity, 61 percent by banks, 5 percent by the federal government, and 5 percent by state governments. By early 1992, however, the contractor and bank shares had declined to 28 percent and 49 percent, respectively, while government's share, most"of which was federal, had increased to 23 percent. The government announced its intention to alter the form of public support for new concessions in early 1992. Future government contributions toward construction costs would be treated as equity investments instead of grants. They would thus earn the same returns as the sweat-equity investments of the contractors, instead of no returns at all. The maximum government share would also increase to 40 percent as compared with 30 percent for the contractor and 30 percent debt. Perhaps one of the few positive aspects of Mexico's aggressive private road program is the way it forced the Mexican capital markets and the government to devise new financial instruments to tap addi- tional sources of funds, albeit not efficiently. The Mexican banks were collaborative, possibly because they were still nationalized when the concession program began, and may have been pressured by the government to participate. Initially, most banks financed their share of construction costs through nor- mal construction or commercial loans, drawing on the banks' existing pool of savers. Later, many banks began to refinance their contribution by issuing medium-term inirastructure bonds on the domestic bond market. Toll road revenues are not sufficient security to back most of these bonds, however, so the bank has guaranteed them. As roads have opened and developed a reliable traffic base, however, a few banks have begun to successfully sell certificates of participation that carry a fixed interest rate (over inflation), and are secured only by a claim against the toll road revenues and are not guaranteed by the bank. The right criterion to assign concession should have been the lowest toll (with the possibility of ad- justing it for inflation), with the length of the concession being fixed in the 20- to 3D-year range to match the life of the asset. Apart from specific penalties, the granting of an option of first refusal to the operating concessionaire at renewal time should be considered to provIde incentives for the proper level of road maintenance. Alternatively and ideally, consideration should be given to awarding what would be in effect a permanent concession, where the tools would be fixed for an initial penod of, sa y, 5 to 10 years (except for inflation), and after that revised for a subsequent period through a process similar to price-cap regulation. An alternative criterion is to select and fix efficient tolls and concession terms and adjudicate the toll road to the minimum lump-sum subsidy required to construct and operate the road. Interested bidders would submit as bids the subsidy they would need. With competitive behavior for the market, a second-best allocation would be obtained. The advantage of the latter option is that it allows for compen- satiitg the private operator for the externalities of the project and partially captures, if necessary, the differential between the social and private benefit while allowing for efficient pricing. The government should guarantee levels of traffic under either scheme. The Mexican government also wants to attract foreign capital because of concern that further toll- road investments might increase domestic interest rates and displace useful private domestic invest- ment. It has been difficult, though, to convince foreigners to invest in new toll roads, since under the revised Mexican concession system no assurance exists that the government will make investors whole in the event of a cost overrun or traffic shortfall. Mexican investors, who understand the system, appear more willing to assume these risks than are foreigners. Mexico's private concessionaires are trying to refinance some of their older concessions on foreign capital markets. Even though these roads have been opened for only a few years, not many have attracted sufficient traffic to satisfy foreign lllvestors. The main beneficiaries of the program have been the construction companies. The highway stock has certainly increased significantly, but it is not clear, from a social standpoint, that a number of those high- ways should have been built. One lesson the Mexican experience teaches clearly is the trade-off between the long-temt efficiency and short-term government benefits of privatization. The finanoal difficulties of the public sector forced the government to move quickly in its attempt to enlarge the road system. Although that aspect of the process was successful, the. lack of forethought damaged the long-term pros- pects of private toll roads in the country and cost the government a significant amount of money in unanticipated subsidies and compensations. As usual, the government must find a balance between the needs of the public, those of the company that will provide the service, and its 0'WTl ability to continue su pervision of the sector. A Case Study of Transport Privatization and Regulation: Argentina Argentina has taken steps to privatize railways, roads, and ports. Law 23696 (reform of the state) addressed privatization of railways and toll roads. Decree 2740 (memorandum of understanding for railway restructur- ing), Decree 1143/91 (regulatory framework), and Resolution 1456/91 from the :Ministry of Economy and Public Works also apply to railroads and subways. Law 24093 dealt exclusively with ports. The port law is the only one that explicitly states the objectives of the reforms, but the implicit goals are similar. They are to • Reduce costs (for ports this means sell-financing, while for railroads this means reducing subsidies) • Promote competition • Decentralize. Additionally, the port law reformed the role of the National Authority in an attempt to grant manage- ment greater autonomy. The reorganization of all three sectors reqUired honzontal disintegration PrroatlZJrtg and RLguumng th~ TransportatIon S~ctor: Ports. RJn/rot:Jds. Toll RDtlds. and AIrports 313 (separation in the case of roads), with ports and roads being divided more or less geographically and rail lines divided either by type of service or geographically. Unlike in the case of roadway concessions in Mexico, the privatization contracts are quite Ion,!;, ranging from 10 years (with the option for an equal extension) for metropolitan railways, to 30 years for freight lines. Port concessions vary from 18 to 25 years, and the road concession is also over 20 years. The contract will be terminated in all cases if the concessionaire so chooses or goes bankrupt, if the service is ended, or when the term ends. Moreover, port and road agreements cease if both parties agree, if the facilities are destroyed, or if the concessionaire fails to comply with the terms. Table 13.3 provides more specific information on the bidding process, the contracts, the regulating entities, and the postprivahzation rules for the three transport sectors in Argentina. Unlike the Mexi- can case, the bidding criterion for the Buenos Aires access roads was the basic toll indexed to the U.S. consumer price index. The government did not provide any guarantee, including a guarantee of a minimum traffic leveL The concessionaire derives revenue from tolls and from commercial exploita- tion of service areas as authorized by the regulator. The impact has been considerable. Under the inter- city highway concessions. road use more than quadrupled between 1991 and 1996, raising toU rev- enues from almost US$60 million in 1991 to USS2.58 in 1996. The maintenance of the intercity highway system, including the concessioned portions, has improved Significantly. The share of paved roads in bad condition declined from about 30 percent in 1989 to 25 percent in 1993 and was expected to fall to 10 percent by 1997. Maintenance of the concessioned network is no longer a-major drain on govern- ment budgets, though government subsidies increased from USS23 million in 1991 to more than USS65 million in 1996, in part because of the government's reluctance to allow toll increases. On the negative side. investment is behind schedule because renegotiations reduced the concessionaires' potential re- turns. Still unclear, however, is the efficiency of construction and maintenance. No information is avail- able yet on whether the private sector is maintaining the roads at lower cost than the public sector did. or whether it is doing better for the same cost. Three main lessons emerge from this experience. First, it is critical to have simple and transparent bidding criteria. Second, the rules for renegotiating contracts should be spelled out as earlv and clearlv as possible. The rules should recognize the importance to the concessionaire of ensuring ~t renegotiation does not alter its financial return when the problems that led to renegotiation are beyond its control and are government induced. Third, institution building must be taken seriously. Poor coordination among various agencies with jurisdiction over different components of the concession led to poor planning and inefficient decisions (Estache and Carbajo 1996). (See box 13.2 for Santiago's approach to deregulating bus transport.) Airports: Issues, Options, and Case Studies Aviation infrastructure is a combination of commercial and noncommercial operations. Increasingly, it is viewed as a center of commercial business activity, as opposed to a public commodity managed and operated by bureaucrats. (This section is adapted from Juan [1996J and Kapur [1997}.) Aviation infra- structure encompasses all aspects of air traffic control; a range of facilities and services for the airline industry in the transfer of passengers and goods; and disparate commercial activities including duty-free shopping, hotels, catering, restaurants, car parking, and rental activities. In spite of strong foundations in these areas in the LAC, the aviation infrastructure is faced with new challenges in addressing issues of aviation safety and environmental concerns, modernizing, and selectively expanding its facilities in re- sponse to growth in air-traffic volume. These challenges have arisen largely because (a) policymakers have not recognized the need to sup- port development of aviation infrastructure compared to other modes of transport; (b) there has been limited public investment, which has been allocated to other higher-priority sectors, especially during and following the debt crisis; (c) the liberalization of economies has increased demand for better aviation services; and (d) there is a lack of trained personnel to manage operations within a global and commer- cial framework. Closing the gaps will require more money, better management, and an integrated sector 'li.ble 13.3. Argf'n,illa's 1'rm'''I,or' Privntizalim, and Rt'8,,'ation ClUlrflcltrisl ic Railways (Iud subways Potls Road.; COIICNSIoIi 81,Min, I'm fl'dgh!. Iwo mvd. 'IlCS are lISal mlll'I"I'<' I)(I~' nllllloim,,1 lWo .."VI-l1'l'('5 .lU!' u~1 nnt' contains I~'(hnkallll ... lilic-ali"ns FOllr mVE'I"I'e's .lre' uSl'\1 om.' r"nl.lins thl' m.-lin ""I"irrmmls. tl'(hnlcal and finanl'ial '1".llifkallon; mVl'llll'l' Iwo oll1\.liul'd ani I 1 hll~lnt'ss ,ll.VI of bilhl4.'r5 (int luding I.nVe5tmentl,lan haiallCe slwd illfonn.ltion. MlJ SIIIE'nlClll of e'l~ri('flc('; weighll'll seiet-U(A1 crilli'ria (l'lIl'crience. slalf.l.usln<'SS MIll .mlUminl!" Ilrganil.atlilll, costs. an,1 financing ol'linn.-;,; l\Vo and Iwo conLl.ln'lll"alifkalJon alll'r {'""I"aUIiI'l.llinns are luvt5lmml plM!, fl'!."'; II) gllvl'f1lnlClll t'Sllllc lilln of f.ldlilles I >t'Sllllclion 01 'ildlitil'S ('1l1ll1,II.lnce f.lllure hy ("nn'Ssi"na"l' railure 01 cnnr('S~ion.lirl' 10 con'ply (laMI' rOll/i'lllt':; (II/ !ollow;II.'{ "I'S'" .~ .. ,. . ~ . . " Ti,ble lJ.J fOlltilllU'S Clulrai'ler isl ic 1\,IIIII:lI1~'S (I"d slIl,ways Purts Roads Conlracl I'uhlit' service of 1r.\Osporl hy rail of I'a~sengers is .Irliveled TI,e conc(!Ssion;lire has f'.dllsivily over allloa.ling anti lilt" ron(l"Ssion is a rulolir servict', implying Ih.llihe requlremenls ... ulusively on the lines fm which Ihe conct'Ssion.:tile h.tS IInl03Jillg servin'S in Ihe lemlinal Juring Ihe concession concessionaire catUlolinlenurl ttw service and (annol re'5ponsi\)illly lUI Ctlmmen:ial nperallon of IIains. "eriod inc/u,ling' recl"l'linn. rll'Nillon, ",,10il'ul"lion Mltl Ji~rirolnale amung users as long ,1S Ihl.'y coml,ly wilh The I,"hlie selvlce nallltl' Implies Ihal Ihe conu"'!Islonolire- Is slocUng, MId control iln.1 rec-ur.Jing of all merrhan,lisl' norms rf'quirl.'l.lln ddlvel the service wllhnutlnlernll'lion loodt.. 1 an.lunloadl'd TIlt.! n{'(essary steps rt'lluilN hI all .. w Ihe nlli.lily ot the throughout the cnnlracl perio.1 and musl gille lip any aclion Mooring MI.I unmooring ilre 11"luired Irallie now al any lime have II) be I.Ihn by Ihe Ihill would inlerfere wllh the sl'rlllce Use of ~lIlpmenlls I('e ellsur!'..! alld In slations an,j on equlpmenl for ,,jverll!'emenl • rt'SJ1l'(led • Nonlransfera\)Uily of contrilcl 1('1"'11';011 Thrifts Definillon of a basic lariff I, bJ.!e'lJ on a price Iable IInldn" lhe lariffs musl \)1.' public, jllst. and reasonahle anti musl be lhe origin."lilenns o. Ihe conlracls slaled Ihal Ihl:' the '0111." 10 Ihe distance for a single Iripln a single claS!l, 5e1 In such a wily Ihalthe revenlle of Ihe concl'S!>innilires concessionaire's revenue w01l1tJ come from a lolllcvi~1 on lhe concession aile is frl~ 10 sdlhe prices for mlliliple Irip', does nol e.ceeJ whalls trqllil,..1 for the nonnal, dlicil'nt uSl.'rs; Ihe 5101'1.' defined a unifonn t.lriff pl.'r Idlon1('11:'1 and ~ Theil:' Is a IClII.lll't·n.ling on the number of kilomeler! e~plollallon of Ihe lerrolna!. with a relum malthing 11ll' pl.'r type of vehicle for all com.lors TI,is larill i .. in,leH~1 to 1.11 coven-J. which mllsl be raid hy FA, rEMfSA, anJ lither inveslmt"nls ",a.ll' domeslic rrices t:tJ(lcf'";slonaires'or the u~ of rails on 1.1110..1 {Ofllt'Ssionl...J lhe larif'~ all' 0..1 l'Iin('< I In Ihe hi,I.ling docllmenls lhe recovl:'ly o. Ihe lariff sial Is as sIlun as Ihl:' u'hahilil.llion In case of gross mism"lhhl'S hl'lwl'en ne('<;el Ihe 10.1' iff as nft... " ..1 wllhln Ihe limils l>C'Cn condu",... 1 £If the rules ~1't'l11"\1 oul in Ihe mnlracl 'lht'Se (lI,mgl"'! (.lnllul lhere Is nil gUiH,In 1t"E' 01 lIulume nlllaUic or any olher lyre \)1' tlSt'\lllIl'l'nalize Ihe ,"nn-ssionai.e 'm 1,.lSll'rnfils III II) of I'ublic gllilfanl<'e compensate Ihl'llI lhe wnrl"'>sion.,I,1"'> r"y a It'!' 10 Ihl' gllV I'm IIlcnl (s('t In Ihe ltiJ.ling Jocunll'nl<;) IllIring Ihe l'nlill:' (onct'Ssilln period A .enegoli.1Iinn of Ihe (Onll.1(1 I('{I 11(('\ I IIII' /I.15ic brill from 115$2 J 10 USSI 'or evt'ry 100 killlnll'lers, SI'I'I"t"Ss.'\llhe 'ee Jill' 10 Ihe govem",enl, ,l'ltl inln,.l"c"..1 a sllhsi.ly In Ih(' cnnCl"'!lsitl'l.lin-s ul US$S7 lIIi11illn '"r Ihe wholt' nl'lwOlk 1)1'1' (I' n-gllldlhm ( '(}SII ,1115 Iln,I("h'I... 1 M.nimllm !,ril e tI' lIigg"r rult' 1o.1St,·.! till a SIIIl(\lIll' Ctl~1 ,1gll·I·,1 tll'"O '1IIl'!"1I1 ""1II1111,1r.11101\ " .. 11.0. ily ,,',!II .II,III,,;,·la,ill St'1 I" 0.',,1 kllllS The (1I,IllKt'S ill fI,,1 "VI'( lin,.. (Ollll'l'IlS"Il'J Ihltlllljh 3(cOltllng I" 1111.· ~I"'llt-d ,,111 ...... Vl· illf!t' ....<..J 1.llilfurlltloIlKI. oJ, III,' ':"""11111"'111 'I h.·It: is 'UI ~I "., ilir II i.:.:", II .... h.lt.i"1I ., •• ,h"ngt's III Ih,' ",t'll"S r"nlloll! or ,IllY .. llll'r Iyl''" "I 1111,' III' 1.11 ill, .... II,.; •..; Tariff lIarit'S wilh ,,".,Ii1y ilcwftllllg to I"l"'.... rult's an. I in.licalllrs (tnM., nmlillll,'S I'llg~' ) lirble U.J conU""t's Cllllrnc:ltrisl ic Railways aud sulnl'llys Pods RO(JI's Qllallty FI.,licil minimum Il'vels uf quality f('lI"lr(,l1It'nls No !lpt'C illc rt'(llIlreml'nIS Quality contrul on mainll'nance fl.'tlulrl·ml·lIls Imrrovl'ments In '1II,llily finkellto innt'aS('s In tariffs In,licalufS indt"le: Qualily InJlcalm!l indll.I~: • 1l.(lughm'5s o Number of trains St;'nt o RUlling • Service frtqllency • Clacking o Service Jelivt'rt'\1 o Raveling o nmdine-ss • Friction • (Jualily o' ~alaturs (for subways) • SholllJefS o I ighlinJ!: sysh'ms • Signaling • Patklng '.Kililit"'; ~ QUAlily cllnlrol'or Cll~""I\l'r s('I\'ll'e 0\ • I Imil on \V"iling lillie ;lllht' 1,,11 hoolh (2 lIIinlllt ... ) • Maximum nlllllhl" O. ('.Irs in lilli' (I'i) 1n\lf."Slmenl t:1.,lidllnvt"Slm('nl program Indu.ll'Sl'Stlm.lle o' r:.plidl invl'stmenl rI"luir~mt'nts In J SI.lg1'5 afl' d.lssifi ....1 lhrl"t' lyrt'S (If invC'Slrnl'nl fl'tl"il('mt'nts I"l'qulremenl! invt"Slmelil costs accorJing h' 11l'!1\fC'e of IIIgl'nry The lerms assod'llt'J aiel. • Stage 1 Inll~lml'nlll) h" mAd!' ......ore wllrClin!1\ any loll I Jt'nuIlJ fur changt's In the Invt"5tmml pwgram can lit! 2, an.1 Yl'.us rl~I'~"ltl\l!'ly ~ • Stage 2 hlllC'Sllnmlluloe m"dt~ ,"Il'l loll i~ «(1111'( It"Li initialed lIy bol11ll;lrtlt"S 11ll11e contracl The mlkl.1lilies anJ l('Inl~ ate sl't'fifi('l1 in Ihe conlr.lds • Sla!1\c)' IUlit'SllIImllrqllir('t1 AS a rt"'iul\ lI'Ir"lIic 1(,lIt'ls '"Veshlk'tll tt'tlllirl'menlS in trains for .1 lhe I'ml ""lhorlly fonllil,"h.''!; a Sl'l arnililiM e.e(ul~ sl'l'dlic I',ubkms in lhe syskm en Utles rights of thl' conCl'ssionairl' 10 Increa5l' thl'Sl' l.nilfs wh"n 0' their cmrunilmenls In lerms cunstruetion. rl'hahilil.uilln. Monilor I"rill an, 1 con(t"'NV) nn all n.allcrs tthling 1(1 con("';~i(jns Ihe conlrarl Suggesllo the e.('(ulive !'ower'genl'ral p"lidt'S on I'm Is anti Organire a tl"COItilng sy~tl'rn fm alllrilnsi'I(lions Deman,1 information and org.mlle inspection anll au,lillng walerway' 1'"..Juel' a monlhly rpporl on r~r("1 of (onlrads and 51'..11 Impost' Ihe reqlllrl'\1 pl'nahil'S through the Nallon,,1 Assign rt'Sl'"n5ibililit'S on "r('·.Ising Ihl' acet'Ss of each rorl oul aJjuslrot'nt nl'i.'lh Railways Rt'8l1laUlln Commission whl'n conflict over rl"S1'0nsihililies arises Conlrihull' 10 thl' ,,'SOlulion of controvl'C5ll'S helwCl'n stall' Fn'otce nalional "'('cislons nml concl'Sslonalre-; or b('lwt'l:n conct'Ssionairt'S (unJt'Ss Coordin.1le the variolls enlilil'S tnvolvr.1 ill SIl!,CI vision and spl'dfll'd olhl'rwise In lhl' conl.acl) conlml of rurts 10 avoh! overbl'l'lng Rl"Cl'lve and manilgl' complainl!! by Ihl' public Apply sanctions as nE'{'tle,1 Make the paymenls 10 the concessionaire as agrt"('J 10 in 5<'llhe lerm 'nr i'lmorli/alion u'l(lvt'SIIlH'1I1 fequirl'lll"nls thl' contrad defined In Ihe law Coiled Ihe 'l'l'5 dUI' by the concl'Ssionillre • Pelln\' I'w(l"lurl"l 1m Iml'lf'm(·nl.llion 0' agn't'ml'llls hclwC'{'n Do anything else 111.11 thl' en lily set'S 'i1ln l'n5ure Ihe varillll5l,.lrlS rel.11illg 10 I'orls __________'·,.'''"lIon "' lis rlOSI'tlnsihillllt·"______ SOIIrc'e: Fslachc, Iidoll, ililtl Hu(I,It;m·I.·I'.mlil101 (11)'}!j) 318 f. LuIS GUJ1sch arid Pablo Splii~r Box 13.2. DesIgnmg an Effective Competltwe 5yscem: Buses m 5anturgo, Ollie At the end of 1977, public road passenger transport in Santiago was provided by a public sector operator with 710 large buses (capacity of 90 seats) and a number of strictly regulated private assocatlOn5 operatmg 3,16i regular buses (capacity of 78 passengers) and 1,558 taxibuses (capacity of 40 passengers). Fares: routes, fre- quencies, and bus imports were stnctly controlled. In t-;ovember 1979, entry to the sector was effectIvel y de- regulated, although a formal power of regulatIon remained. Fares were progressively decontrolled and be- came completely unregulated J..r. June 1983. Entry into the taxi bus mess and taXI fares were also liberallZed over the same period. The effects of deregulation were dramatic. The public sector operator was driven out of the market. Total capacity more than doubled over the next decade, with benefical effects on the frequency of schedules and availab'ilitv of seats. Other effectS were not so benign. By 1985 the regular bus fares had increased l.n reaJ terms to nearly three tunes their 19/t level (partly due to collusion between operators), and the differennal between bus fares and taxibus fares had disappeared. Between 1980 and 1986, the average age of buses mc:rea.sed from 7.0 years to nearly 11.6 years, and the age of taxibuses increased from 5.0 years to 9.5 years. Congestion in the central citv and bus·generated air pollunon increased substanually. These problems have Since been addressed. In 1987 each weekday, on a rotatmg basis, 20 percent of the vehicle fleet were prohlbned from operanng. In March 1989, buses built m or before 1966' were barmed from the crv. Most recent!v, to maintain compention while restricnng the congesnon and env1fonmental effects of buses in the central ot"', licenses were put to competitJve tender, with the quality and cleanliness of the verucle and the price to be charged being among the decisive cntena. In ttus way, compentlVe pressure has been retained, while new environmental and quality Incentives have been introduced. Soura:: Thomson (1992). policy framework, plus suitable harmonization of local, national, and international regulatory fTame-- works. If that occurs, LAC's aviation infrastructure will be better able to contribute to economic develop- ment and become more fully integrated into the global marketplace. The air transport sector will require large capital investments over the next 15 years. By one estimate. it will need USS250 billion to USS350 billion (International Civil Aviation Organization 1992) to modern- ize aircraft fleets; improve airport infrastructure; introduce more sophisticated air navigation systems; and meet the demand of new markets in China, Eastern Europe, Latin America, Southeast Asia, and the countries of the former Soviet Union. These large invest:ments, together with a redefined role for the state, are transforming the air transport sector. Based on preliminary inionnation, investments in LAC are estimated to be in excess of US$6 billion to VSS7 billion (from public and private sources). Major investments are planned in Argentina. Brazil, Ecua· dor. Mexico, and Peru, with only Brazil and Mexico considering completely new (greenfield) infrastruc- tures. In contrast, the East Asia and Pacific region has invested or plans to invest over USS50 billion in greenfield aviation infrastructure facilities, while at the same time upgrading and maintaining its existing stock. In the East Asia region, aviation infrastructure is an integral part of the transport sector, gearing up to promote the export of goods and services; is managed as a profitable business venture with limited govern· ment intervention (though generally government owned); and is a growing and rapidly expanding market- place. Military involvement in many aspects of its operations has limited the full exploitation of commercial sources of revenues. While average income from airport concessions in Asia is about USS8 to USS10 per passenger, in LAC it is about US$2 to USSl per passenger. Significant opportunities exist to price airside and landside charges more aggressively. Aviation infrastructure in LAC generally has made a limited con- tribution to national and regional economic development compared to other industrialized and developing countries. The level of direct and indirect employment resulting from a:....-port activities is low, especially outside major metro~" .. ;m areas. In fact, a' ":.2.tlon activities are a drain on the national economy, and capital markets have not bee:. ;.Jeepened from a.i...-t=;;:t operations because of government restrictions. PnvatI;:mg and Rrgulatmg th~ TralUportatlon S~ctor: Ports. RAIlroads, Toll RDatLs, lind AIrports .319 Traditionally, the air transport sector, airlines, airports, and air navigation services, has been in state hands. Aviation infrastructure and services have been owned and operated by federai. governments (with strong military ties) serving jointly-and independently the needs of military, commercial, and individual private operators. For example, in Argentina, about 60 airports are owned and operated by the Air Force for military and! or commercial use, and in addition, about 600 general services airports (aerodromes) are owned and operated by the private sector. Argentina is not unique in this fonn of aviation structure. Brazil, Chile, Colombia, Ecuador, Mexico, and Peru also have extensive aviation networks, with varying degrees of military involvement. This network, though justifiable in many cases, has generally not made the same level of contribution to economic development compared to those in other industrialized and developing countries. Further- more, the national aviation inirastructure system in many of these countries is a financial drain on the national economy. Within this network, only a few large airports (those serving major capital cities) are marginally profitable, while almost all others receive fiscal transfers for capital and operating expendi- tures. Aviation infrastructure and services traditionally have been plagued by a series of problems that are responsible for poor performance and low productivity. The most important reason contributing to poor performance is the strong domination by the public sector. TItis structure has encouraged reliance on public financing, permitted monopoly practices in many aspects o~ airport operations and services, limited management practices in commercializing operations, and not provided appropriate incentives to promote safe and environmentally sound conditions. 1b..is structure, coupled with declining levels of public support, is placing aviation infrastructure in jeopardy. As a result, facilities and services are not well positioned to (a) serve the growing demand or users, airlines, passengers, cargo operators, exporters, and importers, which are confronted with the need to lower transport costs to remain internationally competitive; (b) meet future growth projections in passenger and cargo traffic; and (c) overcome issues of air safety and environmental concerns. Large geographical distances, limited dedicated cargo centers close to facilities that produce perishable goods, and major administrative bottlenecks have resulted in LAC's transport costs being higher than those of other export-oriented countries. Estimates are that air passenger and cargo traffic will grow between '* to 6 percent per year through 2003. Those growth projections do not take into consideration the effects of the North America Free Trade Agreement (NAFrA), the Uruguay Round of the General Agreement on Tariff and Trade (GAIT), and the World Trade Organization (WI'O), which will lead to increased regional trade. The region's air cargo infrastructure facilities are not capable of efficiently handling current levels of traffic, and the situation is expected to deteriorate further in light of growth proJections. A few of the large, specialized air cargo carriers are building Single-user, state-of-the-art cargo facilities, but they are insufficient to meet the more expansive air cargo requirements. Consistent with the global trend in other infrastructure sectors, in air transport, the state's role is shifting from owner to regulator and policyma.ker, and operational, investment, and management re- sponsibilities are moving to the private sector. The government's role as economic regulator is particu- larly important in light of the fact that some airport services are inherently natural monopolies. The airport business is becoming increasingly multifaceted, extending into real estate, commercial, and other ventures. These activities are of two main types: provision of airside, or aeronautical, services (runways, taxiways, aprons, and terminals), which by their nature are still considered monopolistic within each airport; and provision of lands ide services (passenger and aircraft services, food and beverage con- cessions, duty-tree shopping, parking, and hotels), where a wider variety of suppliers is possible. The current trend in airport economics is to rely on commercial operations to contribute an increasing share to airport revenues, resulting in less dependence on increases in airside charges. In industrial economies, airside charges are falling in real terms, leading to higher traffic levels and greater atrport revenues. The Economist (1995), in an article titled "Why Heathrow Is Hell," argued that, theoretically, it is perfectly possible for increasing commercial revenues to obviate the need for aeronautical charges, which, in tum, could saturate an airport's operating capacity. 320 . J. LuLS Gwzsch and Pablo SpIll" Private Sector Options in Airports The private sector became involved in the transport sector only recc :. beginning with airlines. By the end of 1995, 70 percent of airlines were privately owned, directly 0: .,iirectly. Private sector participa- tion in the airport subsector is just starting, with only two successful cases of complete privatization of airport infrastructure: the U.K. government's privatization of the British Airports Authority (BAA) in 1987 and of the Belfast International Airport (BLA) in 1994. By the beginning of 1995, however, some form of private sector participation was being implemented or was under consideration in 54 countries. Private sector participation in air navigation is at an early stage. Several countries, including Ger- many, New Zealand, and Switzerland, corporatized their air navigation services through the creation of corporations with independent financial and legal status as a step toward eventual privatization through public offerings Ouan 1996). In March 1996, the government of Canada announced its intention to sell the country's air navigation system for CanS15 billion to a not-for-profit-corporate entity whose board of directors will include private sector representatives appointed by the federal government and end users. Private sector participation in airports through ownership, management, or new investment programs can take many forms, including outright sale of shares or assets, concessions, and long-term leases (see table 13.4). Historically, the private sector has managed most of the landside concessions, but governments are now increasingly seeking to involve the private sector in the provision of airside services as well. The three most important objectives of increasing private sector participation (~ough not articulated explicitly by governments) have been to (a) improve efficiency, (b) increase fiscal revenue by selling profitable concessions and by improving infrastructure through privately financed investments, and (c) reduce the role of the military. Privatization schemes have started to flourish throughout lAC, with some countries being more aggreSSive than others, such as Argentina, Bolivia, and Chile. Although only a limited number of privatization transactions have occurred, two options seem to be the most suitable for transferring airport activities to the private sector: (a) build operate-transfer (BOT) schemes (a project finance mechanism generally used in developing countries, where the priority is new Table 13.4. Options for Private Sector Participation in Airports Structure Option 1 Option 2 Option 3 Allocation of responsibiiihes Ownership State State Private sector Investment State Private sector Private sector Management and operation Private sector Private sector Private sector Common strategies for Service concession Build-operate-transfer Wraparound additions private participation Contracting out schemes Trade sales Management contracts Long-tenn leases Build-own-operate Multiple concessions Master concessions schemes Strategic buyouts (management-employee buyouts) Capital markets Recent cases Aeroports du Cameroon Athens Intema tional British Airports AuthOrity Pittsburgh International Airport Sangster International Airport, United States Lester B. Pearson Airport. Airport. Jamaica Kai Tak Airport, Hong Canada Belfast International Kong La Chinita Airport, Airport Venezuela Palma de Mallorca. Spain • "at~: The options include Alternatives for selected airside activities. selected landsicie actiVities. and All &irpon activities. Sourer: Juan (1996). Pnvat:::mg and ReguJtztrng t~ TransportatIon Sector: Ports, RailrOQds, Toll Roads. and AIrports 311 investment to upgrade and expand facilities), and (b) corporatization followed by full or partial divesti- ture (generally used in industrial countries, where the priority is to obtain pnvatization revenues and improve efficiency) (see table 13.5). Developing countries trying to promote private sector participatIon in airports could choose a combination of the two options, beginning with a BOT scheme that gives way to corporatization with full or partial divestiture. The following are some examples of completed private sector participation in LAC. • Airport service concessions and other airport services (cleaning, building maintenance, and so forth) are operated by the private sector under specific and varied agreements among countries and airport loea tions. In 1989, Argentina concessioned its bonded warehouses, ground-handling services, duty-free shops, car parking, and catering to the private sector under a long-term con- cession agre~ment. Generally, governments have not negotiated favorable terms as compared to other countries for similar concession services. For example, national aviation fuel companies generally do not pay concession fees to the airport authority in LAC; in other regions, oil compa- nies pay from 3 to 6 percent of revenues. Duty-free concession shops in LAC generally have fixed-term concession rates compared with sliding scales used in other countTies. Limited knowledge of and expertise in the design of concession contTacts and varied approaches have resulted in lower revenues for many aviation authorities, thereby increasing subsidies. • Build-operate-transjer (BOT) allows governments to award a concession or franchise to a private firm or consortia to invest in and build specific segments of the airport infrastructure in return for obtaining a revenue stream from the airport operations for a designated period (generally ranging from 10 to 50 years). More than 17 countries worldwide have adopted this approach, although only 2 are in use in the LAC region. These BaTs have been used primarily to finance runways or terminal facilities rather than to fundamentally change the incentive structure of airport opera- tions. In 1994 Colombia completed the construction of a much-needed second runway at Bogota Airport using a BOT modality. nus is the only example in LAC of using a BOT mechanism for the expansion of a runway. The second example of the BOT mechanism is in airport terminal facilities. For example, in Mexico, the Mexico City international passenger terminal building is operated by a private firm that has invested about USS150 million in upgrading and maintaining the terminal building. The private firm will use its resources to build works on Aeropuertos y Servicios Auxiliares (ASA) land or installations in exchange for commercial use over a fixed number of years. At the end of the term, the assets and rights of use will revert to A.5A. This mecha..cism helps to achieve Table 13.5. Considerations Under Various Airport Privatization Options for Develaping Economies Ophon Considerations Build-operate-transier Facilitates relatively large new investments (or vanants, such as build own- MaintalnS goverrunent ownersrup {transier at a late!' ciate lunits operate and build-own-operate- political conflict) transfer) Requires relatively complex PI"Qcedures and an array of techrucal and financial specificanons Lack of ownership rights could make raising capital funds more difficult and costly for pnvate sector investors Full or partial divestiture through Generates fi.scal revenues a public offenng. capital markets, Full divestiture limits state intervention a trade sale, or a combination Public offering requires track record of profits and audited finan?a1 statements Public offering requires developed capital markets (rare in developing economies) Sourtt: Juan (19%). 322 J. LuIS GU/lSch and Pablo Spllir financial objectives (substitutes public resources with private funds), but is generally a more ex- pensive form of financing highly cumbersome and complex legal arrangements between the par- ties and does not provide appropriate incentives for changing the management culture. • Fixed-base operators (FBDs) traditionally have been used in smaller facilities geared primarily to corporate users and high-income customers. Luxurious facilities have been built by the private sector in Mexico's Toluca and San Jose del Cabo airports. These facilities normally include on-site customs and immigration services, dedicated hangers for guest aircraft, full-service restaurants and gourmet catering, on-site conference facilities, and passenger lounges. Even though these ser- vices are generally provided for the high-end users, the trend to convert terminal buildings to provide nontraditional airport services has made this mechanism more available. Other LAC air- ports have not fully exploited this mechanism, which offers opportunities to further increase com- mercial sources of revenue. • Individual airport concessions (lACs) are being used more actively among LAC countries. In 1996 Colombia transferred to the private sector, under long-term concession arrangements, the man- agement of Barranquilla and Cartagena airports with the rest to follow. In 1996, Bolivia concessloned three major airports (Cochabamba, La paz, and Santa Cruz) to the private sector, representing 85 percent of national air traffic. Argentina concessioned airports in 1997. Many countries are increas- ingly using LACs. However, issues of cross-subsidies among airports, and restructuring of nonvi- able airports, policy, and regulatory frameworks have not been systematically addressed as an integral part of the individual privatization process. Finally, as of 1999, Mexico and Peru are in the process of concessioning their airports. With a few exceptions, for example, Punta Cana Airport in the Dominican Republic and more recently the airport in Punta del Este, Uruguay (both examples of privately owned airports), private sector in- volvement in selected activities has been undertaken with the specific intent of not changing the O'Wl\er- ship structure and management culture. Furthermore, these privatizations (a) were not undertaken with the objective of achieving a broader set of reform initiatives (such as reducing fiscal deficits, increasing competition, improving services, and establishing regulatory standards for monopolistic practices); (b) were not executed within the context of the national aviation system; and (c) were not accompanied by policy and regulatQry reforms, systematically integrated with reforms in other intermodal transport strat- egies. Moreover, privatization modalities have actually limited governmental options in achieving fun- damental sector reforms. This is particularly noteworthy because many LAC countries have undertaken wide-ranging, complex, and innovative privatizations in utilities and other transport sectors. Generally. governments in many countries have not tully exploited the potential and contributions their air transport can make to economic development. It is doubtful that minor tinkering with o'Wl\ership changes will be able to systematically address the many challenges facing aviation infrastructure. The following case studies of Canada, Colombia, Jamaica, and Northern Ireland illustrate some of the issues and approaches in the sector. CanAda: Joint Ownership Structure Toronto's Lester B. Pearson Airport is a rare case both of joint public and private ownership of facilities on shared premises and of competitive provision of airport infrastructure services. Terminals one and two are o'Wl\ed and operated by Transport Canada, the government transport authority. and terminal three, operating since 1991, is oWned by the Terminal Three Limited Partnership (ITLP). Terminal three is operated under a management contract by Lockheed Air Terminal of Canada Inc. (LATC), and it was developed under a build-oWn-operate-transfer (BOOT) arrangement that includes a 6o-year renewable land lease contract. The development cost for the terminal, which has capacity for 10 million to 12 million passengers. was about CanS570 million. Transport Canada coordinates activities between Lester B. Pearson Airport's privately and publicly owned tenninals. It also provides air navigation services. owns all nmways and taxiways, and receives PrroQtu:mg Qrld RLgulatmg the TrQnsportatlon Sector: Ports, RaIIrtl4ds, Toll Roads, aNi AII"ports 323 all revenues from landing fees, passenger fees, airline fuel taxes, and ticket taxes. UTC controls the landside activities for terminal three, which begin when aircraft switch from general to terminal three tower control. While airside charges for temtinals one and two are purely on a cost-recovery bastS, termi- nal three generates revenues through airline rents and charges (aircraft taxiing and parking and terminal fees), concessions, and parking to cover not only higher operating costs and capital costs, but also profits. Because of the relative age of its terminals, Transport Canada does not include capital costs in the calcu- lation of airside charges. The market is segmented. The average per passenger airside charges at temtinal three are twice as high as those at terminals one and two, and the more prestigious international carriers tend to use terminal three, while lower-cost regional or local carriers use the others. Colombia: Innovative Financing At the end of 1993, the government of Colombia corporatized its Civil Aviation Authority ~CAA), sepa- rating airport operatioru from air navigation activities. At the same time, the government undertook the development of a second runway at EI Dorado lnternational Airport in Bogota, using a BOT scheme for construction and maintenance of the new runway and maintenance of the existing runway. In May 1995, the government awarded the BOT concession, stipulating investments of USS97 million to the coruor- tium of Ogden, Dragados, and Conconcreto. The concessionaire's investment and operating costs, fi- nancing expenses, and profits will be covered by the landing fee revenues, which the CA.A will cede during the 25-year concession. Once bidders fulfilled the technical requirements, bids were evaluated on the basis of the net present value of the minimum landing fee revenue the bidder would require through- out the concession period (landing fees multiplied by estimated traffic volume) and the weighted aver- age landing fee in U.s. dollars. The government has guaranteed a minimum level of revenues (floor pricing) in a rare case of a government's accepting commercial risk. If the landing fee structure, traffic volume, or both cannot support the required revenue stream, the government would compensate the concessionaire from a trust fund equivalent to 30 percent of the annual landing fee revenue. The El Dorado transaction demonstrates the flexibility of BOT schemes and is becoming a model for private sector par- ticipation in developing such airside airport infrastructure as runways, taxiways, and aprons. Jamaica: Wraparound Mechanism In an effort to expand airport facilities to accommodate tourist flow, the Jamaican government estab- lished three premises to govern airport privatization and expansion: (a) upgrades would be funded primarily by the pnvate sector, (b) airport operations would be transferred to the private sector, and (c) the government would not provide guarantees. Sangster lnternational Airport (SlA) in Montego Bay, the program's core case, will be expanded through the consttuction by SlA Ltd., a new company created by the government, of a new passenger ternunal under a build""Dwn""Dperate (BOO) scheme. Through a 49-year lease arrangement Airports Authority of Jamaica (AAJ) will transfer to SlA Ltd. the operation of the existing passenger terminals and the remain- ing landside facilities. The government will grant a management contract to SlA Ltd. for the operation of the airside services now provided by AAJ. Thus, the new expansion, the existing terminaL and the aJIslde facilities will all be placed under the management of SlA Ltd. The financial capital structure for SlA Ltd. calls for funds to be raised in domestic, regional, and international markets. At least 70 percent of the entity's shares will be held by the private sector, and up to 30 percent will be held by the government. The government plans to sell shares on a phased basis to maximize the gains on its investment. Northern Ireland: Public Security Concerns The privatization of Belfast International Airport (BlA), one of the two cases of full airport divestiture, illustrates the complexity of dealing with national security matters in a geopolitically sensitive context and 314 J. LUlS Gwzsch and Pablo Spillt!1' the government's creativity and determination in coming up with viable solutions. The winning bid came from a management and employee buyout team (MEBO Co.), which purchased the Northern Ireland Air- ports Limited (NlAL) public corporation, entrusted with operating BiA, for about US$72 million. The air- port contract was awarded to .MEBO Co. in July 1994, and all the share capital in NJAL was transferred to MEBO Co., except for a golden share of £1. The Department of the Environment for Northern Ireland (DOE) retains ownership of the golden share, which allows it to exercise power in instances related to matters of security and the public interest. In addition, under leasehold control over the 999-year lease agreement between NlAL and the DOE, the DOE and the Ministry of Defense are authorized to enter airport land if N1AL fails to honor its obligation to provide facilities and access to the Ministry of Defense. Since privatization, passenger traffic through the airport has increased by 17 percent, cargo freight by 17 percent, and turnover by 13 percent. no doubt helped by the cease-fire accord in Northern Ireland. 14 Creating the Detail Engineering of Regulation: Competition Policies In many utility sectors, technological changes have shattered the idea that a verocally integrated mo- nopoly 'is the efficient mode of organization. For example,. te~ological developments.in electnci~ ~ans­ mission have made economies of scale in generation tnvlal m almost any market SltuaOon. Similarly, while there rna\' be a need to coordinate dispatch, it is unclear to what extent the distribution transmis- sion network should also be owned by a single operator. Indeed, several countries are implementing regulatory systems that do not grant exclusive rights to distribution companies. For example, Chile's 21 distribution companies do not have exclusive territories. Telecommunications firms in Brazil and Chile have not been granted exclusive operating rights. New Zealand's regulation of utilities includes neither exclusive rights nor price regulation. Finally, although distribution companies in the United Kingdom have exclusive rights, those rights will be abolished by the end of the 1990s. Similarly, in the transport sector, with the possible exception of certain aspects of railroads, few arguments support de jure vertical integration and a minor presence of natural monopoly activities. The sector is highly contestable. Thus, the arguments for extensive regulation bear little credibility, while the arguments ior competioon poli- cies are increasingly more powerful. It is by now well accepted in the telecommunications industry that long distance service is not a natural monopoly. At least 50 companies provide long distance services in the United States, and close to 10 companies provide the service in Chile. Furthennore, even the idea that the local exchange is a natural monopoly has been challenged both by empirical work and by the entry of competitive access providers. While some blame the entry of competitive access providers on cream skimming, such providers have entered even in states where regulators have allowed the local operator total price flexibility in competi- tive markets (for example, illinois). Thus, i1 the local exchange company is a natural monopoly, such entry would naturally be deterred. (See Shin and Ying 1992.) The claim that technology allowed competi- tors to enter while the local network was a natural monopoly would not be credible ii the local operator had full price flexibility (Baumol, Panzar, and Willig 1982). Similarly, the claim that competitive access providers are successful because of high access charges is inadequate, because in states with price flex- ibility local exchange carriers can provide the same services without collecting access charges. However, at last count, five companies were prOViding competitive access in the Chicago area, even though Illinois Bell had total price flexibility in that market segment. The choice of technologies for the provision of local telephone service is now broader than ever. Several wireless options are available: analog and digital cellular radio, digital cordless telephony (for example, Digital European Cordless telecommunications), proprietary (noncellular) wireless local loop systems, such as lonica (being installed in Finland), and mobile satellite. There are also fiber-optic cable television options and hybrid solutions. Even in rela- tively small markets, such as Sri Lanka, local network competition can be beneficial. Sri Lanka has four cellular operators and some of the lowest prices for cellular telephone service in the world. In 1994 the number of telephone lines in the country increased by about 47,000. Of these, 30,000 were conventional lines provided by state-owned Sri Lanka Telecom, which was a record increase. The remaining 17,000 lines came from the provision of cellular service. The cellular operators demonstrated the transition of cellular service from a small, specialized, premium part of the market to a substitute for conventional service (Smith 1995). 325 326 I LuIS Gu.asch and Pablo SpIll" As a result, in Argentina, Bolivia, Brazil, Chile, EI Salvador, Guatemala, Mexico, Peru, and the United States, among others, local telephone markets are being opened to competition, while current local pro- viders in the United States, the Bell companies, are being allowed into the long distance market as long as their own market is open to competition. The central issue regarding deregulation i:~ the point at which local markets should be deemed competitive. Is it when the local companies have done what is required to allow competition to exist, or when each customer has a genuine choice of service provider? Not surprisingly, the Bell companies have argued for the first condition, while the long distance companies have argued for the second. The compromise appears to be requiring the Bell companies to face a local competitor that offers service through its own facilities, rather than simply buying and then reselling it. before entering the long distance market. This is known as fair facilities-based competition. As a result of this ever-increasing competition, antitrust agencies are playing a gro\Ali.ng role in oversee- ing the performance of the utilities. In New Zealand, the Antitrust Commerce Commission takes action in response to complaints by industry participants, competitors, and utility users. Under its minimalist ap- proach to regulation, the commission, together with the courts, comprises the sole government mechanism for regulating utilities. In Brazil, Canada, Mexico, Peru, the United Kingdom, and the United States, the institutions charged with applying general competition policy are not involved in utility regulation on a day-tO-dav basis, but thev do have extensive powers that are highly relevant to the regulation of utilities. In the United Kingdom, th~ head of the regulatory agency might refer matters to the Monopoly and Mergers COmmission, which has far-reaching powers to correct anticompetitive abuses. The pOSSibility of that reier- ral can convince companies to comply with the directives of the regulatory agency. (This clearly occurred during the 1992 negotiations on price regulation between British Telecom and Otter.) In the United States, the antitrust division of the Department of Justice provides input to district court decisIOns concerning competitive market behavior or requests to lift restrictions. TItat agency was also instrumental in breaking the American Telephone and Telegraph (AT&n-Bell monopoly in telecommunications. Thus, competition policy is becoming a potentially key instrument in the regulation of utilities (and also in the regulation of trade policies; see Guasch and Rajapatirana 1994). A number or Latin American countries (Brazil, Chile, Colombia, Jamaica, Mexico, Peru, and Venezuela) have enacted comprehensive antitrust legislation. Argentina's lower c:ha.mber of congress has approved a new competition law, but it has yet to be considered by the senate. Bolivia, Costa Rica, EI Salvador, Panama, Paraguay, and Trinidad and Tobago are in the process of drafting new laws governing competition policy. Enforcement, while still deficient, is gradually improving and complementing regulation. (See Guasch 1994 for a description and evaluation of competition policies in Latin America.) Competition policies should be seen as a comple- ment to, and in some cases or sectors, a substitute for regulation, and in a number of countnes, such as Brazil (telecommunications), Mexico, and Peru (electricity), the competition agency has been given direct junsdiction to oversee the utilities, to intervene in the event of anticompetitive behavior, and to rule on merger activities. However, although less and less so, some activities still remain in which competition is unlikely to arise. First, the high sunk investments in distribution (whether of telecommunications or electricity) will provide a credible advantage to the incumbent operator of the distribution network. Entry will therefore occur mostly on the fringes or in segments characterized by relatively small econo- mies of scale. Entry in telecommunications will usually occur in the long distance market, in private networks, or in cellular and other mobile telephony, rather than in the basic local loop. Yet, the existence of cable television provides an opportunity to create. almost overnight, an alternative local loop supplier with much smaller sunk investments than a totally new entrant. Consequently, access to the distribution network will have to be regulated. Second, in small economies, such as most Caribbean and Central American countries, single operators might not exhaust economies of scale and that will make competi- tion implausible and require comprehensive regulation. To summarize, although competition policy has become a potentially useful regulatory instrument in several utility sectors, not every COWltry will be able to use it to the same degree. and enforcement of competition policies still remains an issue in most Latin American countries. For example, in 1986 the C~atlng the Detarl Engmtm'l1g of Rtgulatwn: Compe'tltlon poliCIes Competition Policies Commission in Brazil (CADE) saw its authority signi.hcantl~· weakened by the minister of justice's acceptance of an appeal of a CADE final determmatlOn. Althougn the legahty of the decision is open to question, it reflects a backlash against the perceived aggressive enforcement of the existing law. Old-line industrialists have complained that the current law inhibits the potential for merg- .; ers that may be desirable in odeI' to provide Brazilian industry with necessary resources and help do- mestic markets compete internationally. Because mixing competition and regulahon U1 utility sectors may require substantial regulatory flexibility, countries needing specific rules to restrain administratIve discretion may find that promoting competition in some segments creates tmportant contractual prob- lems that deter private sector investment. (See chapter 12 for further discussion of competition policies and their presence and experience in Latin America and the Caribbean [LAC].) Competition Policies as Complements to Regulati~n The term competition policy encompasses the area commonly known as antitrust or antimonopoly law and practice and various microindustrial policies affecting markets. Competition laws strive to deter and prevent abuses of market power, dominance, exclusionary practices, and the reaching of agreements among competitors. The laws aim to promote and protect competition and economic efficiency, not to protect the competitors. In the context of preventing abuses of dominant agents and excluSionary prac- tices, properly enforced competition policy can be an appropriate complement to regulatory poliCies. Moreover, in sectors where deregulation rather than regulation should be the norm, such as transport, services, and othernontradables, and in network-based sectors, competition policies have a major role in fostering a competitive environment. Antitrust legislation should complement regulation and liberal trade and investment policies by ensuring competitive conduct by incumbents not only in domestic markets for nontraded goods and services, but also for traded products, where distribution services enter as inputs. Although, in most countries, recent comprehensive trade liberalization and domestic deregulation measures, financial sector reforms, and the removal of price controls and ot some public barriers to entry provide the foundations for a healthy competitive environment, they cannot be considered as a complete substi- tute for an effective antitrust policy. A large number of nontraded goods and services exist, either because they are inherently nontradables (domestic distribution services) or because they have high transportation costs (fresh vegetables and fruits, fresh dairy products, and some bulky items, such as metal ores and cement). The objective of antitrust legislation should be to deter anticompetitive practices. By focusing on this objective and by excluding other potentially conflicting and questionable populist objectives. such as preventing the development of large enterprises and ensuring fairness in the marketplace, an antitrust law could become an effective tool for promoting competition, efficiency, and good busi- ness practices and ethics. In many developing countries, where severe public resource constraints will continue to limit legal and administrative capabilities tor some time, it is particularly important to ensure that the antitrust law is transparent, defined dearly (leaving little room for interpretation or discretion by the implementing agency), and relatively easy to enforce. It should also create a level playing field for all participants, focus on actions that clearly and significantly harm competition and consumers, and strike a balance between overburdening (increasing transaction costs) and being too general and vague (having no impact; for further details and discussion, see Kovacic 1992). Competition policy is executed through the legal system and works through its proper and pre- dictable enforcement and deterrence effects. Competition laws essentially address two areas: the con- duct of business and the structure of economic markets. Issues of performance are embedded directly or indirectly in these two areas. In the event of transgressions, producers are subject to criminal and civil prosecution, fines, or injunctions. 328 J. LULS Gwz.sch a1fd Pablo 5pillt"l' Conduct Policies Competition policy prohibits conduct that unfairly diminishes trade, reduces competition, or abuses a market-dominant position. The laws are intended to counter • Horizontal restraints, which are unilateral or collective actions that weaken or restrain competition among finns in the same market. Examples are the fixing of prices or bids (competitors explicitly cooperate to set prices or to prearrange the outcome of auctions); conscious parallelism (tacit agree- ment on setting prices, which may occur in competitive markets and in oligopolistic ones so it is considered to be only a symptom of noncompetitive behavior); output restraints; market division (suppliers that self-allocate customers among themselves); exclusionary practices; exchange of commerciallv sensitive information; predation; and restraints on entry. • v'ertical restr~ints, which are provisions in contracts between suppliers and their distributors (and retailers). Vertical restraints may be used to support noncompetitive conduct by competing suppli- ers, the exercise of market power by distributors, or the segmentation of markets on a geographic basis to practice geographic price discrimination. Examples are exclusive dealing (suppliers that disallow the purchase of competitors' products); refusal to deal; resale price mechanism (suppliers that condition sale to distributors on establishing the distributors' price); territorial restraint (selling in a limited region to support price discrimination); price discrimination; premium offers; tie-ins; and tull-line forcing (suppliers that require distributors to carry all the supplier's products). • Enforcement standards, which are set by the legal system and the judiciary. Laws are necessary but not sufficient to achieve the objectives of competition policy. Enforcement depends on the attributes of the legal system and the judiciary and on how credibly and reliably the laws are upheld. Structurlll Policies Structural policies are the fastest growing means of pursuing antitrust a.iI:ns. Competition laws influence market structure by affecting transactions between firms (contractual or ownership relationships among suppliers or competitors), usually mergers, takeovers, jOint ventures, and asset transfers. Structural poli- cies aim to prevent. transactions that would reduce the independence of competing suppliers (vertical integration) and increase concentration in the market (horizontal integration). They include Merger control regulation; which selectively prohibits mergers that would substantially increase • concentration in the market or restrain trade among suppliers • Premerger notification, which allows authorities to review proposed mergers prior to execution. thereby making merger control administration more efficient • E"forcement and remedial measures under merger control, which promote competition by breaking up a supplier into smaller independent units, thus preventing the negative increased concentration effects of the merger. Remedial measures, such as divestiture and demonopolization. are neces- sary because transactions involving multiproduct firms lead to concerns about competition that affect only a few products. Remedies can effectively replace regulatory supervision of economic conduct with market discipline in some contexts. Performance Policies The state compensates for lack of competition by dictating prices or output Although available, administra- tive pricing by the antitrust authority is rarely used, because it counters the fundamental premise that markets are more efficient at determining prices and. outputs. While regulation is an ex ante and sector.-speci.fic govern- ment intervention, competition policies are an ex post and economy·wide government intervention. The stan- dard policy is to regulate various modes and, usually, to apply that regulation only to sectors that display Cr~atrng the Dl'tall Enginunng of Rl'guiatlon: Compdltlon PO"Cl~5 329 significant natural monopoly characteristics but are also subject to laws governing competition policies. This is the case for most utility sectors, which are subject to government regulation. While some busines~ practices, such as price fixing, are clearly anticompetitive, others, such as pn,ce discrimination, exclusive dealing, or resale price maintenance, oiten depend on the context. AccordlllglY, two distinct legal criteria should be and often are used to address those differences among practices, One is the per se criterion, where an action is disallowed and punished independent of the intent and conse- quences, Tne other is the rule of reason criterion, where an action in itself is not disallowed and is pun- ished only if the intent or the consequences are found to be damaging or anticompetitive, Various kinds of busine~s conduct might weaken or restrain competition, but could also enhance effidency. These types of conduct present difficult antitrust cases and are usually treated under the rule of reason critenon, which explicitly recognizes that certain types of conduct could have positive effects on efficiency, thus offsetting any harm to competition. While the rule of reason criterion appears to be fairer and more conceptually appealing, it has drawbacks. It significantly increases the cost of litigation and weakens the deterrence effect, which is the fundamental objective of legislation. Therefore, the tradeoffs should be considered. Indeed, when adm.inistrative and enforcement capabilities are severely limited, it is highly desirable initially to have a lean antitrust law that focuses mostly on anticompetitive practices that could be treated under the per se criterion, mainly the horizontal restraint cases and those vertical restramt cases that are dearlv anticompetitive. Business conduct that may weaken or restrain competition among firms in a given m~rket is generally classified as a horizontal restraint. Important horizontal restramts include price fixing, parallel pricing, output restraint, division of market, exclUSionary practices, exchange of iniormation, predatory pricing, and restraints on entry. Practices that may affect competition through arrangements and agreements in vertically linked relationships (such as between manufacturer and dis- tributor) are referred to as vertical restraints. Examples include exclusive dealings, refusal to deal, resale price maintenance, territorial restraint, price discrimination, premium offers, and tied sales. For further details, see Boner and Krueger (1991). Alter the implementing authorities gain expenence and resource constraints ease, 'the antitrust law could be amended to cover more complex cases of anticompetitive conduct that need to be treated under the rule of reason criterion. Price agreements, quota agreements, and conspiracies should be judged as illegal per se, notwith- standing the fact that situations or types of agreements can be found that can enhance efficiency. One of them was the subject of Arizona v. Maricopa County in the United States, whereby the setting of maximum prices for medical procedures by physician groups helped insurers reduce uncertainty about potential claims, thereby creating a productive efficiency, presumably of benefit to insurance purchasers. Tnat price agreements can yield efficiency is also shown in emerging conilicts over franchise-type operations. However, the rarity of those situations, coupled with the severe consequences of most agreements and the ease and deterrent effects of litigating per se cases, warrants the per se treatment of agreements. nus is not an insignificant point. Many incidences of all forms of agreements in most economies exist. Ex- amples have been common in sectors, such as cement, financial services and professional activities, fish- eries, poultry, and transport. Provisions in law specifically addressing tacit agreements and conscious parallelism are missing. Although these provisiOns are important because of their economic' consequences and because of their frequent presence in many environments, they are difficult to prove and thus to prosecute successfully. Therefore, these provisions should not be emphasized. Market power depends on the relative size and structure of the market (the number of competitors, ease of entry, extent of contestability, trade barriers, and availability of present or potential substitutes). Market power exists, in principle, in most utility firms, which often operate as monopolies. Domi.nance is based on the absolute size of the producing firm, its links to inputs and other output-!'roducing indus- tries, and its influence on and by the international market. Again, dominance is potentially present in utility firms. At issue is how to quantify a dominant position. The standard procedure is to associate it with market share. How to measure it and how to interpret it are the core questions in all cases concern- ing abuse of monopoly power or of dominant position. Alter all, it is not unusual in certain environments that a firm with a 20 percent market share can effectively dom.ina.te the market. Moreover, the definition JJO J. LuIS Gwzsch and Pablo SplJJtr and measurement of market share can be a blurry undertaking, depending on how the market is defined. It is of the utmost importance that guidelines be provIded for assessing market share and relevant range, particularly for issues related to dominant £inns and mergers. Geographic demarcations, sources and destinations of supply and deman:i, and closeness or substitutes are all factors to be considered when defining the relevant market. The legislation is often mute in that area, but it should not be. There are two steps to analysis of the relevant market. First, it is necessary to determine which prod- ucts or services are good substitutes for the goods of firms being investigated. Good substitutes need not be identical products; a Significant number of consumers may also consider them to be reasonable alter- natives. Second, it is important to consider how easily new firms might enter the market. If one or more of the firms producing in the market raises price, restricts output, or reduces quality, it might become profitable for new finns to enter. If important effective barriers do not exist and the lag-entry is not too long, customers cannot be hanned by such actions. Often in the legislation in many countries, the clause regarding what constitutes an abuse of domi- nant position outlaws pricing the same good higher in domestic than in international markets. The cl~use is inappropriate, particularly if there are no protections, barriers' to entering the sector, or natural mo- nopc;>ly conditions. and should be removed. One can envision a whole set of circumstances where that pricing policy is efficient. It is perfectly acceptable to have different profit margInS in different markets. The margins are triggered by different demand elasticities. However, if barriers to entry or protection exist, the policy should generally be to remove them. MERGERS. Market concentration ought to influence, but not dominate, antitrust decisions. Moreover, although the line can become blurred. a distinction should be made between concentration arrived at through internal growth and concentration arrived at through merger or protection. While mergers could be the desirable result of superior performance and know-how and a reward for competitive practices, protection need not be so. The critical issue is whether a merger is more like internal growth or more like a price agreement. The case for merger enforcement is Simple. It is largely futile to conduct an anti-price-fixing policy if companies that would conspire to' fix prices can readily evade the law by merging to form a quasi mo- nopoly. Similarly, it is generally far easier to avoid abuses of dominant pOSition through a merger policy that discourages the formation of dominant fums than through an ex post effort to regulate their behav- ior. The antitrust legislation should address merger issues. In particular, the commission should issue nonbinding guidelines about what types of mergers are likely to raise concerns and to be closely scruti- ruzed or denied. Such guidelines would reduce administrative and litigation costs and would deter clear- cut cases, reduce transaction costs, and thus enhance efficiency. In addition, care should be exercised to watch out for controlling interests. it is often the case that while two firms in the same or related market can be legally independent, a major shareholder(s) of one of them has a controlling interest in the other. In these cases, for the purpose of evaluating market power or dominant position, the two firms ought to be considered as one. Legislation in developing countries often does not address this situation, and it should. A merger law and a premerger notification procedure can be designed to accommodate the particular characteristics of the country (such as the existence of relatively small firms and potential economies of scale). For ex- ample, the premerger notification standards can be set so that only a relatively small number of large mergers must be reported and so that mergers are considered that enhance consumer welfare by creating finns of efficient size. Clearly, particular emphasis needs to be placed on the nontradable and quasi- nontradable sectors. such as perishable goods and goods with a low ratio of price to volume (paints and beverages), because the competition from foreign enterprises in those sectors will be limited. Although vertical mergers remain controversial, they should also be considered in the notification procedures. Vertical mergers can produce significant effiCiency benefits. reducing transaction and coor- dination costs and capturing economies of scope and % efficiency. However. they also can foreclose mar- . " kets, increase the cost of entry, shift market power to other markets, and increase the probability of collus'on. Cr~atms th~ Detail Engtn«11ng of Rt'guUJtton: Comprntlon PollClts 331 In particular, vertical mergers can be a significant barrier to entry for domestic and foreign producers, and they can delay the impact of opening the economy. . The most damaging situations tend to occur when producing firms control or are integrated WIth distribution firms. Some evidence of the adverse effect of that type of vertical integranon comes from Chile, where the difference between the retail price of consumption goods and the port price of goods, inclusive of tariffs, hovers in the 33-tcr139-percent range. That large price differential hints at failures or market foreclosure at the distribution leveL Similar price differences exist in Venezuela for products such as fish, cheese, sugar, refrigerators, and automobiles. The experience of Nabisco in the early 1990s in Colombia provides further evidence. Domestic producers, Nabisco's competitors, controlled the distri- butional channels and foreclosed the market to Nabisco, which then entered joint ventures with local producers and practiced parallel pricing, robbing the country of lower prices and the benefits of opening the economy in that sector. The standard structure of most Latin American and Caribbean countries is highly concentrated, with relatively large companies and small country markets. The sector level concentration indexes at the C4 level, the sum of the market shares of the four largest companies, it often exceeds 75 percent, and often those numbers are secured even at the C2level. For example, in Colombia, as of 1988, almost 70 percent of industrial output was produced under severely and increasingly concentrated oligopolistic structures. In 1968,49 percent of intermediate goods industries were highly concentrated, and in 1984, 78 percent were highly concentrated. In the capital goods industry. the share of highly concentrated industries rose from 24 to 85 percent. Of course, within the world market those companies are relatively small. Table 14.1 shows aggregate concentration levels for various Latin American countries. These high levels of concen- tration are not the result of superior efficiency, but rather of past government policies that emphasized quantitative restrictions, quotas, price controls, barriers to entry, vertical integration, high external tariffs, imperfect capital markets, and highly concentrated finanCIal resources. In many industrialized countries, mergers are discouraged if they raise the concentration index beyond a certain level. For example, that level is a Herfindhal Index between 1,000 and 1,800. In Germany, domi- nance is presumed if the C1 index is 33 percent, if the C3 is 50 percent, or if the C5 is 67 percent. In England, if the joint market share of the merged firms is higher than 25 percent, the merger is investigated. These standards appear too strict for developing countries, whose predicament and conditions are significantly different from those of industrialized countries and warrant a more flexible approach. Yet, the merger de- velopments need to be closely monitored, keeping the described competitive standards present. R..EsrRlCTTVE PRACI1as. Most legislation in LAC countries does not adequately cover restrictive practices; such practices are covered only insofar as they are part of agreements among producers or address the abuse of dominant position or price discrimination. However, restrictions, such as franduse arrangements, vertical restraints, and market foreclosure, are not explicitly covered. Some of them are anticompetitive and Table 14.1. Market Concentration Indexes in Latin America, Selected Years, 1972-91 (percentages ) Country Year C4 Argentina 1984 43 Brazil 1980 51 Colombia 1984 62 Chile 1980 50 Mexico 1972 73 Peru 1991 69 Venezuela 1991 64 S01lru: Vanous esrim.ations. 332 j. LuIS Gw%Sch and Pablo Sfllllf."l" of common usage and can be covered under the per se rule, and legislation should explicitly cover them. However, in some situations that type of arrangement would warrant exclusive dealing and tied sales (for example, to guarantee quality) as a result of the existence of economic externalities. Consequentl)~ restric- tions, particularly those emanating from franchise agreements, should be judged under the ruie of reason criterion, and their inclusion in the legislation could be deferred to a future date. Resale price maintenance, a restrictive practice, is rarely addressed in legislation. The practice of re- sale price maintenance can be defended based on efficiency gains, such as for products that need to establish an upscale and quality image and for products that require labor-intensive training of potential customers. In principle, the rule of reason criterion to judge that practice would be appropriate. But again, to facilitate litigation and because those favorable occasions are few and the unfavorable occasions can significantly lessen competition, the authors would advocate for a per se rule instead. The efficiency loss of that choice is small relative to the gains derived from a stronger deterrence efiect and from re- duced transaction costs. Predatory pricing practices are controversial and difficult to prove. The important and obvious cases can often be treated under the clause covering abuses of dominant positions (sII'l;ail firms rarely have the incentives and resources to engage in predatory pricing). The main reason is that it is difficult to distin- guish anticompetitive from competitive price cuts. Indeed, an important reason for relying on competi- tion is the inability to know what prices should be in its absence. UNEQUAL TREA'l"ME".'T OF AGD-'TS. Care should be exercised when drafting legislation addressing unequal treatment of seemingly identical agents. Often such legislaoon states that unequal treatment by suppliers of all their dealers or customers is unlawful. The rule should have exclusions or be subject to interpreta- tion because unequal treatment is often warranted from an efficiency standpOint. The exclusions are based on compensating conditions. That is, dealers and customers with dissimilar conditions face un- equal treatment by the supplier in a compensating manner. An economic interpretation is required that is broader than what is stated through the exclusions of compensation. Other differential situations, such as heterogeneity' of agents, risk factors, and different markets, also warrant unequal treatment. Consequently, action should be treated under the rule of reason criterion. The key element is the provision of equal terms to similar dealers in similar situations. In that case, heterogeneity would come from self-selection, which is not only acceptable but also desirable. BARRIERS TO E\."TRY M'D PROFESSIONAL ACTIVrnES. Agreements and practices in professional activities that restrict entry and coordinating practices should be disallowed. Current legislation is mute on th.ls subject. A case in point is the notary profession in Latin America. Because almost all documents need to be notarized, a question has been posed about the shortage of notaries in PerLl. Apparently, just 40 notaries are in Lima, which is clearly not sufficient by any standard and results in unwarranted delays of business transactions, high costs (monopoly rents), and wasteful rent-seeking activities. A professional association is apparently preventing the increase·in the number of notaries. That is unwarranted, and an effort should be made to free the entry of qualified individuals into the profession, or into any other profession, for that matter. CONSUMER PROTECTION ACT. Consumer protection laws should focus on fraud, standards, health, and safety, which are all areas related to deficiencies in consumer information and power. As such, these issues are not directly related to competition. However, poorly designed and vague consumer protection laws could run the risk of inhibiting competition and efficiency-enhancing initJ..atives and could become a vehicle for restricting import competition. SANCTIONS. The main objective of enacting competition law is to deter anticompetitive behavior, and for any cc -- ")etitior. .... w to have a deterrent effect, sanctions must be Significant. Often in Latin American and Carit:. ';:an countries, the level of sanctions is not sufficient to have that effect. Raising the sanctions to high levels poses the pOSSibility' of deterring legitimate activities. A more sensible approach is to make Crtatmg the Detail Engmttr1ng of Rtgulatlo~: Com"~ltIon POltClt5 333 the sanctions a multiple of the unlawful profits earned as a result of the unlawful activity (in the United States, the Criminal Fines improvement Act of 1987 provides that a court may impose a larger alterna- tive, the specified maximum fine, equal to twice the gain or loss caused by the crime). The extent of the losses to customers and related firms as a result of the unlawful behavior of a firm should be considered because those losses are often greater than the gains secured by the violating firm. CMl. REMEDIES. Antitrust legislation should provide for civil remedies and class actlon suits. Private parties should be able to file suits against parties for violatlOn5 of anntrust legislation and should be able to seek compensation for damages and" losses. OtherwlSe, because it generally has limited human re- sources, the agency in charge will not be able to investigate and litigate the usual flow of cases properly without undue delays and might be forced to prosecute only select cases. This could lead to wasteful rent-seeking activiti~s and could harm the deterrence effect of the act. In addition, if firms know the rights of competitors and customers in litigation and in poliCing behavior, this can also act as a deterrent. The threat of class action suits, which usually reward five times the amount of damages, increases the deterrence effect of the legislation. Although this policy can lead to abuses and exceSSlVe litigation, the tradeoffs are favorable enough to warrant provision of civil remedies. For that purpose, legislation should allow private parties to act as plaintiffs. Jt,'"OICIAL COMPETENCE. Enacting antitrust legislation is a step toward creating an environment that facili- tates competition. To be effective and deter unwarranted actions, the laws have to be credibly and pre- dictably eniorced. As pointed out earlier, the burden of eniorcement could be eased by limiting the focus of the law mainly to anticompetitive conduct that can be treated initially under the per se criterion. How- ever, as the law is amended to cover more complex cases of anticompetitive conduct, particularly cases to be evaluated under the rule of reason criterion, effective eniorcement will require further specialization and training. To that effect, it would be appropriate to select specialized COUIts, judges, or pseudo-judges (professionals trained in law and economics) to handle antitrust cases. On a related matter, it is also worth stressing that the antitrust law could serve its purpose better if it were to focus mainly on conduct related to nontraded goods and services markets. Most recent comprehensive trade liberalization measu..res will expose domestic producers of traded goods to effective import competitlon. Much still needs to be accomplished in Latin America with respect to competition policies. As of 2000, only eight countries in the LAC, Argentina, Brazil, Chile, Colombia, Jamaica. Mexico; Peru, and Venezuela, had enacted comprehensive antitrust legislation, and most of this legislation was enacted only within the last six years. The Dominican Republic, Ecuador, E1 Salvador, Guatemala, and Paraguay are in the midst of enacting legislation. Therefore, there is little record to evaluate. Yet, some positive results of competition policies in Latin America are already apparent. In Venezuela, competition policies have had a Significant impact in breaking and deterring existing price agreements among competitors. In Chile, a main focus has been the successful breaking of vertical restraints, while MeXlCO has focused on merger policy and on breaking collusive practices. Peru has successfully facilitated entry and exit in economic activity and deterred distri- butional restraints and misleading informational practices. Common issues in all these countries are scar- city of resources, little experience in enforcing the legtSlation, and questionable focus of their operations (Guasch 1994). A strong emphasis is on consumer protection cases that, while relevant, have much less impact on welfare than price fixing, abuses of dominant positions, and exclusionary practices. Structural Interventions Structural constraints are concerned primarily with preventing practices that could work against compe-- tition because antitrust legislation has (in the recent past) largely driven the process of telecommunica- tions deregulation. However, in theory at least, the problem of ensuring suitable quality of service in price-regulated activities could also require some form of structural constraint. Quality of service has been a serious issue in the past because of the uneasy cooperation among local carriers, other network .334 J. LuIS GiJJZSch aM Pablo Sp,lIn- operators, and regulatory authorities. Ii, for example, adequate quality of service in telecommunications is interpreted to include universal access to integrated services digital network (ISDN) services, largely deregulated firms might be reluctant to provide such expensive facilities. If regulated prices are low, profit maximization in the absence of regulatory pressures might provide incentives to not make such services universally available. However. the predisposition of telephone company management in favor of high tech.nolog): (witness the high levels of interest in ISDN and intelligent network features) might mitigate the tendencies of narrow profit-oriented calculation. Th.is might not apply to electricity trans- mission networks. Potentially anticompetitive behavior is more likely to be a problem than servlce quality, but that po- tential is no greater than in other industries. If price controls are focused predominantly on price rather than on profit. then there would be no incentives for partially regulated firms to attempt to cross- subsidize unregulated activities. Therefore, the problem of cross-subsidy is essentially one of establish- ing appropriate (relative) pricing rules. Residual issues of competitive policy are related to various kinds of potential discrimination by local carriers. In a completely deregulated environment, these could take the form of outright discnmination, charging different prices for the same services to different groups (for example, in private line charges for local versus interexchange access), or the form of indirect dis- crimination. such as product bundling of services or forward 1I1tegration into selected markets coupled with lower-than-normal service charges to downstream subsidiaries. One solution is to impose open network architecture requirements on local carners and network opera- tors following deregulation. This would require equal access to network information, specifications, and facilities by all potential network users including local carrier subsidiaries; equal pnces charged to all cus- tomers for the same services; and pricing of services on an unbundled basis. A major concern giving rise to open network architecture is the problem of possible price discrimination for enhanced services. Past regu- latory history indicates that administrative rules are problematic. For example, the ru.les must specify what services are to be encompassed. In the United States, although open network architecture is not yet fully developed, incentives could exist for carriers to create services with technical characteristics different from those defined as subject to open ne~ork architecture rules in order to offer discnminatory prices. Without any open network architecture rules, however. traditional antitrust penalties should make it attractive for competitors of the local exchange carriers to police price discrimination themselves. Competition Boundaries A similar problem arises with the determination of competition boundaries. Because of the potential to shift competition boundaries for opportunistic reasons, such as moving a previously competitive seg- me:1t into the regulation area or vice versa, some countries may have to be quite explicit about the prod· ucts that are subject to competition and those that are not. The United Kingdom has partially solved tiu.s problem by specifying in the company's license whether its products are subject to regulation and chang- ing this boundary requires an amendment to the license. Similarly, Colombia's deregulation of value- added services is based on a law, and attempts to regulate the prices of value-added serVices would require changing the law, which may not be a trivial undertaking (Colombia also deregulated private entry to networks, including international networks). The objective is to secure efficiency gains, prefer- ably through competition. The relationship between efficiency and competition is of course a two-way street, with greater competition spurring greater efficiency. In a study of producnvity changes in erst- while public corporations in the United Kingdom, Haskel and Szymanski (1993) have shown that each 1 percent loss of market share led, on average, across different industries, to a 0.5 percent increase in pro- ductivity. Further evidence of the impact of a lack of competitive pressures on prices and costs (and thus welfare) is given by Nippon Telegraph and Telephone Corp., the world's largest publicly owned com- pany, with a flJl monopoly in the domestic market. Telephone calls between different regions of Japan are often so expensive that it is cheaper to use an overseas telephone carrier and route calls through the West Coast of the United States. 15 Competition Policy as a Complement to Regulatory Policy: Competition Experience in Latin America Brazil, Chile, Colombia, Jamaica, Mexico, Peru, and Venezuela have enacted competition legislation in recent years as part of their economic reforms. An effort has been made to liberalize prices and interest rates, reduce tariff barriers, privatize state-owned companies, break monopolies, and deregulate eco- nomic activities. This chapter compares laws, institutional enforcement, and jurisprudence in Otile, Co- lombia, Mexico, Peru, and Venezuela. Brazil's experience with competition policy is too new to evaluate, and little is on record about Jamaica's experience. Other countries in the region, such as Argentina, Bo- liVia, Ecuador, El Salvador, Guatemala, Paraguay, and Trinidad and Tobago, are in the midst of consider- ing competition legislation. Competition Law In Chile, competition law was substantially modified in 1973 (D.L. 211 /1973 modifying law 13.305/1959). Reflecting the views of the new political regime, the legislation was drafted in a liberal economic spirit. There is a separate consumer protection law (enforced by the National Council for the Consumer) and an intellectual property law (enforced by a specialized department in the Ministry of Economy). The 1973 law is-not clear on what actions constitute illegal conduct per se (illegal regardless of conse- quences) or illegal conduct unde~ the rule of reason (illegal depending on the consequences). Under the law, all conduct appears to be dealt with under the rule of reason criterion. The law describes unlawful anti competitive conduct as any attempt to hinder free competition. The law defines the basic elements of anticompetitive c.onduct. With regards to production, anticompetitive conduct includes share of quotas and reduction or paralysis of production. With regards to commerce or distribution, it includes share of quotas and assignment of market zones and zones of exclusive distribution of the same product by differ- ent producers. With regards to the price of goods and services, it includes price agreements and other conduct not specifically mentioned in the law that may eliminate, restrict, or obstruct competition. The criteria tor determining such conduct are similar to those used for conduct explicitly classified as unfair under the law and as interpreted by the national economic prosecutor. In Chile, mergers are controlled only ex post if they restrict free competition. Under the law, anticompetitive cond uct is classified as follows, with no distinction made between the per se and rule of reason criteria: • Horizontal agreements (involving transactions between two or more agents at the same level of the productive process): horizontal price agreements, the creation of share territories or market zones, fixing of quotas, boycotts, unfair propaganda, and exchange of information • Vertical agreements (involving transactions between two or more agents at different levels of the productive process): exclusive distribution, fixing of resale prices, vertical integration, and dis- crimination • Abuse of dominant power: monopoly power, patents, price discrimination, barriers to entry, and dumping and predatory pricing • Coordination through the ownership of equity • Depredation through delays in the judicial process • Restriction on nonmembers undertaking a specific activity • Legal barriers such as ministerial resolutions. 335 336 r LUIS GUIlSch and Pablo Spillt!T In Venezuela, competihon law was enacted in 1992 in the context of adopting economic policies for a market economv. These economic policies have been backed by a series of laws: the consumer protection law enforced b; the Institute of Defense and Education of the Consumer (Law 4403 of March 24, 1992), the antidumping l~w (Law 4441 of June 18,1992), the intellectual property law (enforced by the courts), and the competition law (Law 34,880 of January 13, 1992). The competition law covers all unlawful practices that are intended, or are likely, to restrain or bias free competition. The law does not distinguish between the per se criterion and the rule of reason criterion. Horizontal agreements and vertical restraints are prohibited under the law wUess it can be proven that they generate major economic efficiency. (All practices seem to fall under the per se rule unless they are specifically exempted.) In Mexico, a new economic competition law was enacted in December 1992. The law confirms the ecc-- nomic policies of the past decade that support a market economy and establishes a framework for promot- ing the competitive process and economic efficiency. Reduction of monopoly power, and thus a positive redistributive effect is expected to result but is not an explicit objective of the law. A separate intellectual property law (and a newly established institute for its enforcement) and a separate consumer protection law (enforced bv the Consumer Protection Agency under the Ministry of Corrunerce) exist The law distin- gwshes betw~ two categories of anticompetitive conduct: (a) absolute conduct, such as ca...'1:els, price fixulg, client segmentation, establishment of exclusive spheres of influence, and manipulation of public bids and (b) relative conduct, also known as vertical agreements. The law treats absolute conduct under the per se rule and treats relative conduct under the rule of conduct. Moreover, merger guidelines a.ml to ensure the legality of a merger before it goes through. To define the rele\'ant market in which the acnvity takes place, the law considers the characteristics of the product and the geographic and temporal market. In Colombia, a decree was enacted in 1992 modifying a 1959 competition law. Under the competition law, anticompetitive acts and agreements constitute uniair conduct and are treated under the per se rule. Columbia has a separate consumer protection law and intellectual property law, eniorced by the Super- intendency of Industry and Corrunerce. In Peru, competition legislation was enacted in 1991-92 (Law 701/91 addresses monopolies, restnc- tive agreements, and practices; Law 716/91 addresses consumer protection issues; and Law 26122/9::' addresses uniair competition). The' laws are deemed to provide for a competihve private sector. Law 701/91 and Law 96 prohibit acts that constitute abuse of dOminant power In the market or that limit or distort free competition. The laws offer some examples of abuse of dominant power but do not associate that abuse with market share, and the provisions do not provide any guidelines on this issue (such as how to measure abuse of dominant power). The laws prohibit restrictive pracnces (such as price fixmg and price and quota agreements) under the per se rule, but do not address structural antitrust issues, such as mergers and interlocking directorships. Argentina was one of the first countries to enact antitrust legislation (1919), although that law has rarely been enforced, and no. agency was created to enforce it. The onginallaw was moaified in 1980 (Law 22.262) to define what constitutes anticompetitive and unlawful activity and to create the Comrnis· sion for the Defense of Competition under the Secretary of Domestic Commerce to supervise compliance with and enforcement of the law. In 1994 congress passed a new encompassing law that addresses the deficiencies of the 1980 law, which were (a) its enforcement authority (the Commission for the Defense of Competition) lacked the resources and political independence to enforce the law, (b) the penalties were not sufficient to deter unlawful activity, (c) no mechanism existed with which to control anticompetinve activity, and (d) no effective private remedies were available to consumers and businesses that were inJured by monopoly conduct. (See Economists Incorporated 1992, which makes specific recommenda- tions for the new competition law to be enacted. These recommendations are reflected in the draft law awaiting approval by the congress.) Institutional Enforcement (Operational Structure) In Chile, competition law is enforced through the Preventive Commission and the Resolutive Commis- sion (both administrative antitrust commisSions) and ultimately the supreme court Gudicial system). The Compt'trtron PolICY as a Complt'mmt to Rrgulatory PolICY: Comp!tltlOM E.rprrrmcl! 1M LAttM Ammca 337 Resolutive Commission is the appeals forum for the Preventive Conunission's decisions and is the first- instance forum for some cases. No guidelines exist as to when the Preventive Commission or the Resolu- tive Commission is the compe~ent first-instance forum. A claim may be filed with the national economic prosecutor by the national economic prosecutor ex officio, the Ministrv of Economv, affected companies (competitors), clients or agents vertically related to the accused party, 'and other individuals, such as managers or syndicates. The national economic pros- ecutor is responsible for investigating and prosecuting the case. In Venezuela, the competition law established the Superintendency for the Promotion and Protection of Competition. The superintendency is responsible for enforcing the competition law. It receives com- plaints (filed by the superintendency ex officio or by any affected or potentially affected individual), investigates the charges, and prosecutes the case. It may also render advisory opinions to the parties interested in undertaking a commercial activity (which runs the risk of being anticompetitive). Its deci- sions may be appealed to the administrative tribunal within 45 calendar days of their issuance. Any damaged third party may claim indemnities before the courts (the statute of limitations is six months). The superintendency may fine violators up to 10 percent of the annual revenues (turnover) of the infringing party. (The revenues are determined using the previous year's resolution). The fines can be increased up to 20 percent and, when violations are recurring, up to 40 percent. The amount of the fine takes into account the extent to which trade was actually resmcted, the size of the market the market share involved, the duration of the restriction, and recurring violations, if any. In case of refusal to com- ply, an additional fine of approximately US$12,000 is imposed, to be successively increased by 50 percent of the original amount in cases of persistent noncompliance. Any violation of the law, when not expressly provided for, is punished with a fine of up to US$375. The superintendency belongs administratively to the Ministry of Development and is functionally autonomous. Its budget comes from the executive, and it operates with a staff of about 20 people. Mexico created the Federal CommlSsion of Competition to induce compliance and enforce compe- tition law. The commission's Department of Investigations is responsible for investigating and pros- ecuting anticompetitive practices. The commission has four departments: legal, economic investiga- tion, investigations, and mergers and acquisitions. No critenon exists deriving from the law that would make it easier to decide which cases should be prosecuted; investigation and prosecution are based on what looks objectively suspiciOUS. This concern is common in all countries examined. The goal of their competition policy is to deter and prosecute the activity that deters competition. However, the choice of cases to be prosecuted is not easy. One has to take into account the risk of deterrmg behavior that is not hannful to consumers. The commissioners are responsible for resolving cases at the first instance. In addition, the commission may comment on the policies of the federal public administration when they stifle competition issues. The commission, which has 130 employees, belongs administratively to the Secretary of Commerce and Industrial Development, but enjoys functional autonomy. Its budget comes from the executive. There are five commissioners, appointed by the federal executive, with a ten-year mandate. A proceeding is initiated by the commission acting ex officio, or at the petition of an interested party. According to the law, in the case of absolute practices, any individual, whether an aggrieved party or not, may file a claim. In the case of relative practices, however, only the aggrieved party may file a claim. Similarly, in the case of mergers, the law allows only individuals directly related to the merger to sue. Mexicans argue that the monopoly problems deriving from mergers are eminently public; therefore, private litigation is not rel- evant and could only be harmful to the merging businesses' profitability. In all cases, the law mandates strict confidentiality of all information provided to the commission. The commission's decisions can be appealed to the same commission through the reconsideration proceeding. If the case is still contested, the parties have recourse to the judicial system. The following sanctions can be imposed: • For absolute conduct, sanctions can include criminal remedies, according to the provisions of the penal code, high fines corresponding to up to 375,000 times the minimum wage in the federal district, and, in serious cases, fines equal to 10 percent of the assets or sales of the company. 338 1. Lw.s GUilsch arid Pablo Spill" • For relative conduct, remedies are conceptually different. Punitive remedies are not so efficient because it is important to correct directly the relative conduct of the economic agents, The penal- ties include prohibition to operate in certain markets and to undertake certain activities, Fines are only part of the remedy, • For mergers, criminal penalties and fines are not imposed in an attempt to avoid concentration, According to the law, activities aiming at concentration are suspended or declared void. In addi- tion, monetarY sanctions can be imposed up to 225,000 times the amount of the minimwn wage in the federal d~trict. Monetan' sanctions are also imposed (up to 100,000 times the amount of the minimum salarY in the fede'ral district) when there is an intent to avoid the proceedings estab- lished under th~ law, Finallv, in order to enforce the provisions related to notifications prior to a merger, the operations c~ot be registered at the commercial registry until the commission has reached a decision. In Colombia, the operational structure resembles the one in Venezuela. The Superintendency of Com- petition, functioning under the Superintendency of Industry and Commerce, enforces the law. It files complaints (as can anv consumer), investigates, prosecutes, and serves as a first-instance administrative court. A case can be appealed from the superintendency to the administrative court. In Peru, Decree Law 25868 (issued on November 24, 1992) created the Institute for the Defense of Competition and Intellectual Property (INDECOPI) to oversee compliance with and eniorcement of the competition law. INDECOPI is responsible for implementing and enforcing the law intended to establish a competitive market environment and to protect consumer welfare. It combines a broad range of promarket regulatory refonns in an autonomous agency and serves as a registry for intellectual property nghts and an administrative court of first and second instance. Its creatlon represents a significant change in the institutional infrastructure because it shifts some enforcement and resolution of commercial dis- putes away from the judicial system. INDECOPI responds to the Ministry of Industry but operates as an autonomous body. Its several 'commissions enforce the provisions of their respective laws. They also act as administrative courts of first instance, with the power to enforce the law through ad.mJnistratlve sanc- tions, Seven commissions cover various aspects of the protection of competition and consumer rights: free competition, dumping and subsidies control, consumer protection, advertising, unfair competltion, technical standards and non tariff barriers, and entry and exit barriers. They each consist of four mem- bers, usually economists and lawyers. INDECOPI's Tribunal for Free Competition and Intellectual Prop- erry functions as an administrative court of second instance for all INDECOPI's commissions and offices. Further appeals go to the supreme court. The creation of INDECOPI established a watchdog for compe- tition and free markets and brought a number of previously dispersed offices that had little visibility under its umbrella. Jurisprudence In Chile, the commissions have concentrated on four areas of unfair conduct price discrim.iruition, fixing of resale prices, exclusive distribution agreements, and horizontal price agreements. According to the jurisprudence of the commissions. horizontal price agreements rarely have been declared unfair. To the contrary (and quite surprisingly), vertical restraints have been declared unfair far more often, despite criticism that Chilean regulators have not punished vertical agreements adequately or consistently. This, according to Chileans, is not because vertical restraints are more harmful to the consumer, but rather because horizontal agreements receive little treatment in general and because incriminating evidence is difficult to obtain. Unfair conduct largely concerns differentiating discount prices according to the buyer or distributor. A consistent pattern of sanctioning this practice has existed (at least up to 1988). Differentiating most sale conditions according to the client is treated as monopoly discrimination. The only legitimate conditions are considered to be discounts in the process of commercialization according to the payment and volume Compl!'tl!IOM Poltcy as a Complemmr to Rl!'gtllarory Policy: COmpl!'tltIOT! Erpn"ttmCl!' iT! !.Arm Aml!'nca 339 of sales. In that case, discounts have to be offered to all who wish to buy according to reasonable, objective, and generally applicable guidelines. The Preventive Commission dealt with 19 cases of price discrimina tion between 197,,* and 1993. Some of .' the cases involved companies seeking consultation prior to engaging U1 an activity. Four companies were found guilty of price discrimination, and one was awarded a fine (14~24 unida~ ~e fomento [UF1; 1 UF equals USS25). During 1976-9116 claims were submitted to the ResolutIve COmmlSslon. Among them, five were appealed to the supreme court (and onJy one defendant was acquitted). The other cases were decided bv the Resolutive Commission. In ali cases, fines between 8.03 UF and 873.77 UF were levied. J In Chile, consistent objection has been made to the use of resale price fixing as part of monopoly power. When adjudicating a case of resale price fixing, Chilean regulators have so far balanced the commercial relationship between the producer, which imposes the resale price, and the distributor, which implements the fixed price. If the distributor is an agent or a consigned seller ior the producer, then fixing the resale price is permitted. In that case, the distributor is linked directly to and acts on behalf of the producer (vertical integration). On the contrary, when the producer sells goods to the distributor (they are not in a master I agent relationship), resale price fixing is banned. Chilean regulators argue that the distributor cannot be lim- ited (by the producer) in its activity after the purchase-sale agreement. Arguments, such as the producer's imposition of quality requirements on the distributor, the existence of a notorious trademark, or the existence of special services provided by the distributor, have been rejected. Between 1974 and 1992, the Preventive Commission dealt with ten cases of resale price fixing. Out of ten companies, tw'o were found guilty of fixing prices for the concessionaires. Out of six companies seek- ing consultations, five obtained a negative judgment. These were companies seeking to suggest prices to their dealers in order to facilitate fiscal calculations. Between 1975 and 1992, the Resolutive Commission decided 18 cases. Ten companies were found guilty of imposing resale prices on distributors, and the companies were awarded fines ranging from 17.33 UF to 837.94 UF. Only one company was found to be fixmg resale prices legitimately in order to comply with copyright requirements. The Chilean commissions have looked suspiciously at exclusive distribution contracts as probable collusive price agreements. In that respect. they have banned distributors from being the exclusive dis- tributor ior potentially competing companies. To determine the legality of a contract of exclusive distri- bution, the commissions have focused on the relationship between the producer and the distributor. Ii the distributor acts on behalf of the producer (as an agent), the exclusivity is deemed iair and legal. The distributor does not risk concentrating a Significant part of the distribution of the same article. On the contrary, the commissions have sanctioned companies that do not have an agent relationship (a commer- cial mandate) with the distributor. In that case, the distributor acts on the company's behalf as a sale and exclusive buyer, eliminating the plurality of demand and acting contrary to competition prinCiples. Between 1974 and 1993. the Preventive Commission dealt with 40 cases of excluslve distribution. Thirteen companies were seeking consultation as to the legality of a contract. The majority of the consul- tations concluded that the contract was legal, provided that the distributor did not concentrate the total or a significant part of the production of the same good that is produced by other companies. One claim was filed by a competitor and one by a minority distributor, accusing the producer of assigning the rights of exclusive distribution to a company that was also producing the same good. In both cases, the defen- dants were acquitted because the commission did not find the exclusive distribution to constitute an abuse of dominant power. Between 1975 and 1992, the Resolutive Commission decided 12 cases on exclu- sive distribution, 2 of which were appealed to the supreme court. The supreme court found the defen- dant guilty of imposing conditions on its distributor, such as the right to sell only its products and terri- torial restrictions, and imposed a fine of 128.54 UF. In Chile, price agreements are usually banned as anticompetitive when the producers can form an authentic monopoly with prices higher than the competitive price. Given the lack of a per se prohibition in the law, Chilean regulators have been inclined to ban price agreements as unfair trade practices. Such cases are difficult to prosecute, and only a few cases have been presented. To determine the existence of a J40 J. Lws Guasch and Pablo Splllt'r' price agreement price surveys are conducted. If uniform prices are discc,'ered, a price agreement is presumed to exist. Between 1974 and 1992, the Preventive Commission dealt with three cases of price agreements. Two of the accused companies were found guilty of agreeing to raise their prices. During the same period, the Resolutive Commission dealt with 31 cases,S of which were appealed to the supreme court. The supreme court sanctioned the defendant in three instances, awarding fines ranging from 10.06 UF to 1,263,238 UF. In Venezuela, between 1992 and 1993, the Superintendency for the Promotion and Protection of Com- petition prosecuted nine claims (78 percent corresponding to the commercial sector and services, and 22 percent corresponding to the industrial sector) and initiated, ex officio, four proceedings, The cases in- volved price agreements between cement competitors (the superintendency found the companies liable for anticompetitive conduct and levied a fine of USS70,OOO) and between medical companies (the compa- nies were found liable and a fine was levied corresponding to 3 percent of their sales); pnce fixing (the accused municipality was found not liable for fixing public transportation prices); exclusive distribution contracts; and boycotts (inducing a refusal to deal). The superintendency is also consulted by interested parties, public organizations, and private enter- prises about technical aspects of the law. Between 1991 and 1993, the supenntendency' conducted 16 consultations and investigations. In an important consultation, the superintendency concluded that the fixing of telecommunications tariffs constituted a barrier to competition; only natural monopolies and public services could be subject to fixed prices. In the area of mergers and acquisitions, six companies sought authorization as to the proposed merger. Among them, three were authorized to go ahead, and only one was denied authorizaoon because it would result in undue economic concentration in the paint market. This case was appealed, and much debate occurred about whether the decision should fall under the superintendency"s junsdicnon and, thus, whether it would be binding. In Mexico, the commission has investigated several cases of absolute and relative conduct e'l:aluateci a considerable number of mergers, elaborated guidelines for the privatization of infrastructure, and con- ducted various studies in different economic.sectors. In its first year of operation, the comrrusslOn focused on three areas: mergers between two or more economic agents, investigations ex officio on possible mo- nopoly practices, and claims by individuals of possible monopoly practices. Among those areas, the fust was the most heavily investigated and prosecuted because of the law, which requires companies to notify the commission of most mergers and acquisitions before they go through (According to the law, mergers and acquisitions that exceed the limits established In the law must be reported to the commission before they go through.); because of the long time period requ..ired to complete an investigation ex officio; and because of the relative ignorance of the public as to their rights in respect of mergers and aCquisitions. The comrrussion also has jurisdiction over mergers and acquisitions that have an impact on the national terri- tory, although the definition of the relevant market may sometimes extend to a foreign territory. From June 1993 to 1996, the commission received 52 notifications of mergers and acquisitions. Among them, 45 have already, been processed: 37 in industry, 4 in telecommunications, and 11 in finance. Of these, 39 of the cases were found not to be monopolistic. In the remaining cases, the com..miSsion either disallowed the merger or demanded compliance with some conditions in order to eliminate the risks of unfair competition. The average time period for determining the legality of the notifications was 27 days (article 21 of the law gives the commission up to 45 days in which to examine a merger). On receipt of a merger notification, the commission reviews all information submitted, asks for more information as needed, and decides whether it is necessary to inform the parties not to finalize the agree- ment. The commission only renders preventive resolutions. That is, if a company has already completed a ;. merger found to be anticompetitive, the parties are responsible for the full cost of clivesbng the agreement. The commission then examines whether the activity constitutes a corporate restructuring, which means that it takes place for operative reasons. If the activity is not judged to be a corporate restructuring, then the commission will try to evaluate the effects of the merger. According to the law, the criteria for evaluating a merger or concentration are tailored according to the particularities of each case. However, in all cases, the Comprtrtlon PolICY as a Complmtrnt to Rl.'gl.datory Polley: Comprtltwn E..rptmmcr in Lann I\mmCD 341 relevant market has to be defined. TIti.s entails considering the characteristics (price and quality) of similar products and services, their geographic position, and the possibilities of access to them. In its first year or operation, the commission initiated 16 investigations in dilierent economic sectors. J\.mong them, 15 already have been concluded. In seven cases, no violation of the federal law of free competition was found. Where a ~olation was fOW1d, fines were awarded for a total of tviXNS2,453,OOO. Two of the commission's decisions were appealed before the comm.i.ssion (through the reconsideration proceeding). The commission received 22 claims of monopoly practices from indiVIduals. Of the 17 that have been processed, 16 were rejected for failing to meet minimum requirements. One of the commission's main objectives is to educate the public about their rights. In that respect, the commission has elaborated guide- lines for the public regarding the initiation of proceedings for unfair competition practices. In Colombia, 25 investigations were initiated in 1993-94. Among them, three cases were prosecuted. The investigation process takes an average period of six months. The fines are awarded in the form of injunc- tions and monetary fines rangL."1g from 300 up to 2,000 times the minimum monthly salary in Colombia. In Peru, INDECOPI has focused on disseminating the principles of free competition and its own role, on delegating its authorities to regional institutions, and on investigatlng and adjudicating cases. All of INDECOPI'S commissions have been active in receiving complaints, investigating ex officio, and decid- ing cases. Those commissions and some of their activities are • Commissions for tht? Simplification 0/ Entry and Exit from the Market. Under their supervision (Law 26116 of December 28, 1992, for business restructunng), the assembly of creditors of two compa- nies approved business restructunng plans, and one of them (a textile company) completed the restructuring process in only three months. • Commission for the Supervision a/Technical Stllnciards, Metrology, and Non ta rif! Barrie-rs. In July 1993, the commission established a new system of metrology control, based on the presumption of truth, freedom to contract, and ex post control. In January 1994, it authorized the establishment of agen- cies for qu.a.llty certification. • CommisSIon for the Restraint of Unfair Competition and Advertising. Since July 1993, the commission adjudicated various unfair competition cases and levied fines ranging from 5 Uniclad ImpOSition Total (UIT) (against a company for deceptive and misleading advertising, a first-instance decision) to 25 UlT. (Ibis was against a company for using similar trademarks that risk confusing the public, a first-instance decision. The urr is an index that accounts for inflation) In its first month of opera- tion Guly 1993), the commission initiated, ex officio, nine actions for deceptive advertising. So far, fines ranging from 05 urr to 2 urr have been levied, in addition to injunctions. • Commission for Free Competition. The commission concluded investigations on, among other things, price fixing by public transporters and price fixing in the wheat (bread) market. It found that the price fixing amounted to a restrictive practice and ruled for an injunction. In addition, the commis- sion brought a criminal action for abuse of economic power. • Commission for Dumping and Subsidies Control. Since July 1993, the commission has investigated more than 25 dumping claims. Among them, it investigated the import of dairy products from Canada, the European Union, and New Zealand and the import of baking bricks. In the latter case, the commission applied countervailing duties of 11.68 percent. • Commission for Consumer Protection. This commission has received, investigated, and adjudicated the most complaints. Its efforts have consumed a large share of INDECOPI's resources, with high opportunity costs and relatively low welfare impact. It has been active in helping consumers un- derstand and protect their rights. Finally, an issue of focus occurs in most of the agencies dealing with competition policies in LAC. These are obviously incipient institutions, which have little conceptual and practical experience and, as to be expected, have yet to detennine what competition policy should be and how best to execute it. Therefore, competition policy agencies in LAC in their early stages should focus on fairly clear cases of antkompetitive practices that have significant economic impact, ratherthan on ambiguous cases that are 342 J. LuIS Guasch and Pablo spm~ potentially controversial or have little welfare impact but consume many resources, such as consumer protection cases. This is necessary to avoid damagmg the agency's credibility and long·term effective- ness. The vagueness of some of the laws that the agencies enforce underscores the importance of developing that focus. In doing 50, the agencies could then become an effective complement to the en- forcement of competition and regulatory policies. Utility Regulation and Antitrust Reform Complementarities: The Case of Chile Refonn of the utility sector in Chile started early in the Pinochet period. It was undertaken in the shadow of the antimonopoly statutes that were passed in December 1973 as one of the first acts of the Pinochet regime (Decree Law 211, hereafter D.L. 211). Although antitrust statutes were on Chile's books prior to passage of D.L. 211, they were inoperative and ineffective, as in most of Latin America. D.L 211 made three important changes that became crucial detenninants of the evolution of the utility sector: (a) it deemed criminal all anticompetitive actions (articles 1 and 2), (b) it prohibited the granting of a mo- nopoly license to a nongovernmental entity m any area of the economy (article 4, which specifies that only through specific legISlation can a particular activity be reserved for government entities), and (c) it created a complex institutional framework for resolving antimonopoly claims of both the private sector and the government. The third feature was crucial to implementing the first two. Indeed, in the utility sector, companies both new and old used D.L. 211 to attempt to enter into de facto closed markets. As the telecommunications case will show, D.L. 211 provided a measure of regulatory flexibility that would not have existed otherwise. Its prohibition of exclusive monopoly rights implies that unless expressly stated by sectoral laws, no exclusive service territories exist, nor exclusive areas of operation. Thus, from 1973 on, there Was free entry into all areas of economic activity, including the utility sector. Furthennore, private investors were able to use the mechanisms stipulated in D.L 211 to force themselves in and to trigger regulatory changes that limit the power of the incumbent firms. In the utility sector, the reforms started with the creation of specialized regulatory agencies for the electricity and telecommunications sectors in 1977 and 1978. Box 15.1 provides the milestones in the utility reform process. The reforms involve both a change in the regulatory framework and the restruc· turing and eventual privatization of public companies. D.L. 211 created four entities: the Office of the National Economic Attorney General, the regional preventive commissions, the Central Preventive Commission, and the Resolutive Commission. These institutions were designed to limit the ability of the government and legislators to influence the outcome of antitrust cases. Three features of these entities are important: (a) the decentralized appointment pro- cess (including random appointees), (b) the rotation of membership in the commissions so that no easy qujd pro quo could develop between politicians and commissioners, and (c) the design of a complex declSionmaking process. The first feature is the appointment procedures. The national economic attorney general is appointed, as is the comptroller general, for an indefinite term by the preSident and cannot be removed except by a process instituted by the comptroller general. Each regional preventive commission is chaired by the regional economic secretary and is composed of three other members, one appointed by the governor or the region, one appointed by the regional development council, and one appointed by the presidents of the neighborhood committees. The CentTal Preventive Commission is composed of five members. The chair is a representative of the Ministry of Economics, and the other members are a representative of the finance minister, two university professors (a lawyer and an economist) appointed by the Council of University Rectors, and a representative of the neIghborhood committees of the metropolitan area. The Resolutive Commission is composed of five members. It is chaired by a supreme court justice (appointed by the court itself), and the other members are appointed in the following manner: the ministers of eco- nomics and finance each appoint one. and a law smool dean and an economics department chair are .: . ' .., . . ... :n law schools and economics departments. Membership in all antitrust Compmtlon Policy as a CDmpll:me'11t to Reguwtory PolICY: Compl'tltlOT1 ~e'11CI: IT! Lan" Ammca 343 Box 15.1. Milestones in ChIle's Utility Sector Reform Year Milestone r 1973 D.L. 211: Antimonopolies statute: Creation of antitrust authorities 190 Law 1.762: Creatio~ of Subsecretary of Telecommurucatlons (Subte!) 1978 Law 2.224: Creatlon of the National Energy CommisslOn 1979 Antitrust CornmisslOn: Operung of the telecommurucatlons equipment market to competition 1981 Begmning oi privatization oi electrioty distribution assets 1982 D.F.L. 1: Regulatory framework for the electricity sector Law 18.168: General telecommunications law 1985 Ministerial decree: Orgaruzation of Central Dispatch Center Beginning of pnvatizanon of electricity generation plants . 1987 D.F.L. 1: Reform or telecommunicanons law, mtroducmg pnce-settlng framework Privatization of ChilmetrO (largest distribunon company) Privatization of Chilquinta Privanzation of Chilgener (second·iargest electriCIty generator) 1988 D.F.L. 70: Pnce-setnng framework for water companies Privatization of Compaiiia de TeltHonos de Chile (erC) (the main local telephone company) 1989 Privanzanon of Empresa Nacional de Telecomurucaoones (Entel) (the malO long distance company) Privanzation of Endesa (the main generator) Request by crc and other local exchange companies for long distance licenses Anntrust Commission: Partiopation of telecommunications companies allowed in both local and long distance servICes, requiring the introductIon of a multlcamer system 1990 Supreme Court: The AntitrUSt Commission ordered to reconslder its 1989 declSion on iocal and long- distance servlce 1991 Ministerial decree: Regulatory framework for granting water company licenses 1992 Antitrust COIIUnlSSion: Prohibition of partial joint ownershIp of ere and Entel 1993 Antitrust COmrnlSsion: Pnor declSion upheld that allows telecommunicanons comparues to provide both local exchange and long distance services based on a mulhcarner system Supreme Court: Tne AntitrUSt CommisslOn's 1992 blockmg of partial Jomt ownership of erc and Entel upheld 1994 Law 3A: IntroduCtlon 6f the multicarrier system for long distance telecommunicatIons Source: Author compilation. The appontment process, then, limits the ability of the government to dictate antitrust policy. In particu· lar, although the government has two representatives in the Resolutive Commission, the other three are appOinted in an essentially random fashion. Similarly, the preventive comnussions have a heavily regional flavor, with the government controlling less than half the appointments. The process ior appointing mem- bers of the antitrust commissions is consistent with the intent of creating independent entities. Another important feature that strengthens the independence of the antitrust authorities from the central government is their formal interaction and the potential for subsequent appeals. First, the national economic attorney general is in charge of investigating violations of the antitrust statutes. 1b.is attorney general can investigate on his or her own or at the request of a preventive commission, and can request that the preventive and resolutive commissions take actions under the attorney general's respon- sibilities. The national economic attorney general can appear before the Resolutive Commission to argue for or against a decision by the regional preventive commissions and can appear before the supreme court to argue for or against a resolution by the Resolutive Commission. The regional preventive com- missions are in charge of resolving antitrust issues in their regions, while the central Preventive Commis- sion deals with issues that arise in the metropolitan area or that involve more than one region. Any person, including the government or the national economic attorney general, may file a com- plaint in front of a preventive commission, which then undertakes an investigation and issues an order. In the utility sector, followmg a detennination that no free competition exists, the commission may 344 ,. LUIs Guasch and Pablo Sprllt'T require the Ministry of the Economy to impose regulations on the supply of a particular good or service. All decisions of the Preventive Commissions can be appealed to the Resolutive Commission, the deci- sions of which cannot be appealed, except when they impose monetary penalties, require the modifica- tion of the statute of a corporation, or block a person from belonging to a particular assocIation. In those ." cases, the decision of the Resolutive Commission can be appealed to the supreme court. If D.L. 211 had stopped with article 4, it would not be that different from the previous antitrust stat-: utes, although article"* would have raised substantial problems for utility operators whose licenses would have lost their exclusivity. Articles 1 through 4 define anticompetitive behavior and determine that there can be exclusive monopolies or licenses. What makes these articles so important was the creation of a complex system of checks and balances concerning competition issues. This process has been used sev- eral times by both the government and the private sector and has had a significant influence on efforts to open the telecommunications sector to competition. Institutional Design: Peru's Institute for the Defense of Competition and Intellectual Property The institutional analvsis of Peru's INDECOPI has four parts. First. the four major components that can sigrtificantly determ~e the success of any institution are analyzed: autonomy, accountability, managerial freedom, and incentive structure. Second, the elements of institutional design that can facilitate achiev- ing high levels of those four major components are identified. TIUrd, the factors of function, transaction costs, and jurisdictional design that enhance the effectiveness of the institution are identified, provided that a high degree of autonomy, accountability, managerial freedom, and incentive structUre are present. Fourth, the reasons behind the shortcomings of INDECOPI's performance to date are analyzed, provid- ing recommendations for improvements. Components of Success INDECOPI seeks to enforce competition policy law; propose legislative revisions; play an advisory role in related government policies and actions; coordinate with relevant agencies; disseminate information about the law; and provide guidelines about standards for competitive behavior, particularly in areas where the law is vague or subject to misinterpretation or where firms appear to be misinformed. lNDECOPI's main efforts have been directed toward developing its institutio~l image and promoting a free-market economv. In principle, INDECOPI is supposed to be an autonomous institution; in fact, the funding structure and budget constraints are the major obstacles to bona fide autonomy. Any reasonable and desirable expansion of INDECOPI's operations would require additional government transfer of funds that are now discretionary. This discretion obviously limits INDECOPI's autonomy and makes political interfer- ence effective because a credible threat exists that the government will cut budget allocations. INDECOPl's capacity to generate adequate levels of resources is limited. The allocation of government funds should be set by law and should be determined as a percentage of the gross domestic product (GOP) or of the total government budget. This would create the potential for real autonomy. The internal strucrure and personnel contracts are, in prinCiple, designed to strengthen the account- ability of individuals to their supervisor. Professionals do not have job security, and people are account- able to their immediate supervisor. All are accountable to the president of INDECOPI, whose five-year term is renewable by Peru's president and who is directly accountable to the president and, indirectly, to the country. The media can exert political pressure on Peru's president to seek the resignation of INDECOPl's president or to not renew the appointment. Nevertheless, formal channels exist to evaluate the performance of INDECOPI. The Office of Institutions and Organizations of the State is the formal supervisory entity for the use of funds and functions. In addition, the office of IN"DECOPI's. president undertakes regular internal audits. Furthermore, informal channels, such as the media and private sec- tor, increase INDECOPI's accountability. INDECOPI's activities are highly visible, affecting the day-to- Comp/!!tItlon Policy as a Complmtl!'11t to RegulAtory Policy: Comp!tttlon E.:rpmI!'11C! In l.Atm Ammca 345 day activities of consumers. Evaluation and criticism of rNDECOPI by the media and the responses of consumers and their political impact also increase the degree of accountability. INDECOPI has more managerial freedom than the average state institution, but that freedom is still limited and incomplete. For example, although managers have discretion in filling vacancies, they can· not increase the number of vacancies and have to request written authorization from the minister to increase the salary for a given job classification. The incentive structure is above average by the standards of public institutions. First salaries are above the mean for the ci,til service (although below private sector salaries). Second, loss of employment is a possibility. Third, most jobs are perceived to be a step· ping stone (given a record of good performance) to better appointments, mainly in the private sector. INDECOPl's work provides employees with high exposure and invaluable experience. Most profession· als do not expect to develop their career path within rNDECOPl. Innovative and Desirable Institutional Design Features INDECOPI is a relatively new institution. It incorporated the old office of trademarks and copyrights, and no constituency existed to oppose the new mandate. This was because the appointed decisionmaking executives and professionals had no links with the old institution. The average age of its professionals is 34, which means the staff is not tainted by the old bureaucracy or political mode. Nearly. half of its profes· sionals come from the private sector and have no political record or political expenence. They are techno- crats, with no apparent political agenda. The decisions both on personnel matters and on the selection and resolution of cases are all made by committee and not by any specific individual. This reduces rent seeking and the opportunities to exercise undue influence. The institutional design of INDECOPI is quite innovative and appealing. It contains an appropriate amount of checks and balances to minimize patronage, arbitrariness, and rent-seeking opportunities. It has three main groups of decisionrnakers. The consultative board (consejo consulbvo) is composed of four private sector representatives and five public sector representatives, who are nominated by sectors and ministries. This consultative board is responsible for proposing short lists to the board of directors, the board of commissioners, office chiefs, and members of the tribunal. The board of directors is com- posed of the president of INDECOPI and two other directors, one nominated by the ministry of economy and one by the ministry of industry. The board of directors selects commissioners and office chiefs from a list submitted by the consultative board and recommends members of the tribunal to the president of the republic. The board determines budget allocations and main strategic policy design, provides a long- term vision and direction for the agency, and approves hiring a.ftdlabor reductions. The COmmisSIOns, which are responsible for selecting and deciding cases following the recommendations of the technical secretariat are composed of four to six members, mostly professionals in the private sector who partici- pate four to eight hours a week, with an expected regular turnover. The commissions also propose the hiring and firing of the technical secretaries. This decisionmaking structure is characterized by a fair amount of checks and balances'in the policies governing the selection and firing of personnel and in the policies governing the focus, activities, and performance of the institution. Factors of Function, Transaction Costs, and Jurisdictional Design A most attractive feature of INDECOP! is that a special appeals court (tribunal) is located within the institution that is staffed by specially appointed judges completely separate from and with no links to the judicial system proper. This court handles any first appeal of the conun.ission's decisions. Given the unreliability, delays, and tradition of the judicial system and the economic complexity of the cases pre- sented, this feature is essential to securing any degree of effectiveness. Any further appeal goes directly to the supreme court. 3-16 I Lu15 Guascn and Pablo 5pdl~ An issue that often diminishes the effectiveness of an institution is the existence of junsdictions that overlap or are fragmented among different institutions. Turf wars, coordination problems, and conflict- ing objectives and approaches among institutions are often the causes of failure. Those problems have been successfully addressed in Peru because INDECOP! integrates all jurisdictional and related respon- sibilities regard~g competition policy issues. INDECOP! handles not only antitrust and consumer pro- tection issues, but also all trade-related competition issues, such as antidumping and counte:vailing du- ties, and intell~ctual property rights. This level of integration is highly desirable and most innovative. No other country in the world has adopted such an integrated approach. Nevertheless, overlapping jurisdic- tions with various ministries, such as health and agriculture, and issues of public services and problems of coordination with regulatory institutions still exist and need to be worked out. INDECOPI's Perfonnance Shortcomings INDECOPI's perfonnance has been mixed. Although some advances have been made in deterring anticompetitive behavior, particularly in the area of consumer protection, performance has fallen short U1 more important areas, such as antitrust. The reasons are vaned and include • Lack of political support. The government does not appear to have given INDECOP! high priority. The government apparently thought INDECOP! could at least placate fears induced by the open- ing of its economy, yet it did not have a clear idea of how active it wanted INDECOPI to be. The result has been an apparent lack of political support, evidenced by budget shQrtcomings. • 11Uldequate staffing. INDECOPI's skill mix is not appropriate to its objectives. It has an excessive number of lawyers (55 percent) relative to economists (18 percent), although subsequent hinng has improved the mix. It needs to bring parity to those numbers. A large part of its work consists of conducting and presenting economic analysis of cases, which its staff is unable to do conVincingly. • Inadequate budget. INDECOPI's assigned resources are a major obstacle to securing the stated insti- tutional objectives. Its total 1995 budget was II .10.7 million (about USS4 million), with a staff of 118 and up to 126 approved positions. Its own revenues finance nearly 90 percent of its funding. The registration of brands, copyrights, trademarks, and patents accounts for 65 percent of its own revenues, and filing fees for cases and services account for another 10 percent. The government provides 11 percent of its total budget, and that amount cannot be used for wages or salaries. Given its mandate, the budget is woefully inadequate. In addition, it is not proper or efficient to cross-subsidize registration and other fees to antitrust operations. As a result, fees are the highest in the region. Moreover, an efficiency limit exists on how high those fees can be set. ... Mistaken priorities.lNDECOPI's major focus has been on consumer protection and related cases, to which it allocates more than 10 percent of its budget and human resources. In contrast, it allocates only 2.7 percent of its budget to mainstream antitrust cases. (The Tribunal of Free Competition has a staff of only three persons and only one computer with a hard drive.) INDECOPl's main priori- ties have been building its institutional image and preaching the benefits of a free-market economy. INDECOPI spends more on building its institutional image, 2.8 percent, tha..'1 on deciding antitrust cases, whlch should be the main focus of its activities. • Lack of skills. Aside from the scarcity of economists and excess of lawyers, the training and experi- ence of these professionals is limited, particularly in the technical secretariats. Most are barely out of law school and have little or no background in law and economics. not to mention industrial organization. The hiring of some senior experienced economists well versed in industrial organi- zation is critical for INDECOPI's future. This should be complemented with a program of intern- ships of no less than one month, such as those of the federal trade commissions or antitrust agen- cies in Canada, Chile, Spain, and the United States. • Inadequate salaries. To avoid excessive turnover of its young professionals and to attract senior professionals, lNDECOPI should have the flexibility to assign salaries, in a discri.min.atory fashion, Compttlhon PolICY as a Compkmt'n! to ReguLDtory PolICY: CompehtlOn Erpenrnet: In ult'ln Amt'naz 347 that are at least 80 percent of comparable private sector salaries. As of now, Ll\J'DECOPI salaries are on average 70 percent of comparable private sector salaries. . • Limited deterrence power. INDECOPI's limited budget and manpower, particularly in handling anti- trust cases (D.L. 701), lower the probabilities of detection and investigation; its limited capacity for sound economic analysis lowers the probability of successful litigation; and the relatively low maxi- mum fine of 1/.50 (about V5S40,OOO) renders INDECOPI's deterrence impact particularly for anti- trust violations, nearly nil, although the 1996 amendments substantially raised the maximum fine. • Lzmited internal flexibility. Two problems exist with the design of the competencies of the comnus- sions and technical secretariats and with their operational functioning related to each other. The first problem can be linked to the existing law, because the concept was to have one commission for each piece of legislation. Those several pieces of legislation show considerable overlap. Three commissions and technical secretariats, Ul1..fair competition, publiCity, and consumer protection should merge. The conceptual issues, misinformation, misrepresentation, or fraud, are the same ;n the three commissions and merging them would save resources and increase efficiency. The sec- ond issue concerns interactions across commissions and resource flexibility. The current design does not allow interacnon, communication, or discussion across commissions and technical secre- tariats, even when the issues and economic analysis have a lot in common. In addition, and just as important assigning a fixed budget to each commission does not allow resources to be adjusted in light of the number and relevance of cases during the fiscal year. • Other issues. First, issues of jurisdiction need to be resolved. For example, because other institutions have been given, within their by-laws, explict jurisdiction over food-related and public service cases, INDECOPI cannot address those cases even when a competition law may have been Violated. Sec- ond, INDECOPI operates essentially only in Lima. Cases that occur elsewhere m the countrv cannot be handled, independent of their welfare impact, because INDECOPI does not have the res~urces or infrastructure to do so. Third, the commisSlOns, except the one handling free competition, lack the power to issue cease and desist orders, an instrume!1 ~ essential to their mandates. 16 Conclusion: The Challenge of Regulation Ouring the 1990s, an extraordinary flurry of regulatory activity has occurred in most cOW1.tries, but par- ticularly in developing countries, and especially in the utilities sector. This flurry of activity h~ occurred mostly as a result of privatization in utilities, an increased awaren~ss of the need for and benefits of such regulation, and the recognition of the need both to address domesnc concerns about monopolistIc abuses by private (and mostly foreign) operators and to restrict government opportunistic behavior that would hamper foreign interest and investment in the sector. Specifically, the two main objectives of regulation are to align prices with costs so that only normal profits are generated and to induce firms to produce the service at the lowest possible costs. Two other complementary objectwes are to mcrease access as soon as possible and to ensure minimum quality and service standards to users and other operators, particillarly for network use. The challenge is considerable, not only because the establishment and operation of an effective regulatory system is a complex W1.dertaking and requires a learning process, but also because of the lack of a regulatory tradition and track record, scarcity of expertise, and weak formal and informal norms protecting private rights, which are all prevalent in developing COW1.tries. Moreover, the difficulty of establishing an effective regulatory regime is exacerbated by conflicting objectives, such as ensuring sector competition, high revenues from concession, privatization for fiscal reasons, ambitious investment demands, rapid expansion of basic services; distributional factors in the pricing of the services, and the reluctance of most governments to relinquish control of the sector. Governments tempted to use regula- tion to advance short-term political goals, with inappropriate regard for efficiency or implications for investors and information asyqtmetries in costs and performance that favor the operators, make the regulat0I!' system vulnerable to capture, thus diminishing credibility and overall welfare. Finally, the Significant asymmetry of information about costs between the operator and the regulator substantially complicates regulatory oversight. Information and commitment problems can undermine the efforts of even the most well-intentioned regulators. Consequently, it is not surprising that the development of the required and appropriate regulatory insti- tu tions and effective enforcement had been slower than desired and has generated criticism, as illustrated here. While the regulatory initiatives and activities have been many and varied, the results have been mixed, although improving. While much work still remains to be done in this area, both procedurally and substan- tively, the significant achievements on the regulatory front in most developing countries must be lauded, particularly given the complexities just described. Many developing countries have enacted adequate regu- latory laws, deregulated operations that should not have been regulated, established regulatory agencies, of and so on. It is most reassuring that the awareness of the need to establish, and the benefits establishing, an effective regulatory regime appears to be increasing, as is the commitment to the process. The consensus, supported by theory and practice, is that, while technological innovations are making feasible the use of competition in many segments of utilities, direct regulation of aspects of these indus- tries continues to be necessary. The general principle is to regulate those segments of the market that display natural monopoly characteristics in order to curtail abuses of monopoly power and especially to ;: protect consumers, given the lack of competitive alternatives of service, and to ensure access (fair price and quality of service) by would-be competitors to essential facilities often controlled by incumbent com- panies. At the same time, recognizing that technology and new entrants are eroding market power, gov- enunents should help this process along, fostering greater competition, passing antitrust legislation, pro- viding regulatory credibility, and implementing large-scale deregulation in order to facilitate entry by potential market players exploiting the technological opportunities. The trend toward liberalization and 349 350 J. Luis Guasch and Pablo 5rJlllt r increased competition, driven by technological innovation, is unquestionable, yet regulatory needs re- main, particularly in the network component of the sectors. For example, in telecommunications, the European Parliament endorsed a directive requiring its mem- bers to (a) open their telecommunications market to competition in the provision of public voice tele- phony services; (b) eliminate monopoly control of the telecommunications infrastructure; (c) place no limitations on the number of licenses issued; (d) allow alternative netw'orks already open to competition, owned by utilities such as rail, electricity, and water, to be used to carry telecommunications services, such as data transmissions, services for dosed user groups, and value-added network services; (e) intro- duce full competition in the mobile and personal communications sector (mobile operators cannot be subject to licensing restrictions in the provision of services, can construct then own infrastructure, use alternative networks, or interconnect with other networks); (f) make interconnectIon obligatory and re- quire safeguards to ensure cost-oriented interconnecting pricing; and (g) prohibit cross-subsidization of services to avoid barriers to market entry. Likewise, the 1996 US telecommunications law eliminates restrictions, preventing the longdistaflce and regional Bell telephone companies from entering each other's markets. However, before the local Bells can compete in the long distance market, they must demonstrate to the Federal Communications Commission (FCC) that they face competition from companies that use the BellIs own facilities, rather than from those that merely resell bulk-bought space on Bell lines. The FCC must also establish the rules under which new service will interact with the existing Bell infrastruc- ture. Many Latin American countries are applying similar directives and a number of them, such as Argentina, Brazil, Chile, EI Salvador, Guatemala, Mexico, Peru, and Venezuela, have fully liberalized the sector. Similarly, in the electricity sector, most countries have at the end of the year 2000 liberalized gen- eration and the wholesale market and are in the process of liberalizing commercialization and even the retail market. Also, in the transport sector, substantial and appropriate deregulation across modes has taken place, leaving only residual components to be regulated. Carefully designed regulatory policies and appropriate selection of regulatory instruments and re- gimes can increase a·country's limited powers of commitment and the effectiveness or regulation, pro- moting private investors' confidence about the stability of the regulatory framework and limiting the opportunities for regulatory capture from government, industry, or consumers, bringing about needed investment, efficient provision, and increased competitiveness of productive users, thus positively im- pacting growth. Fot:mal and binding rules need to be specified precisely if they are to provide a credible anchor for a regulatory system. The mechanisms for rulemaking (law or legally binding contracts) need to be reasonably resilient to pressures for change. Institutions also need to be in place to enforce credibly both the specific restraints and the restraints on system changes. The overall benefits, which can be sig- nificant, should be well understood. For example, aside from increased efficiency, the accompanying expansion of coverage has positive effects on productivity opportunities and on the quality of life of individuals with lower incomes who previously were excluded from service or were offered poor quality service. Consequently, the overall impact on welfare and income distribution is considerable. Many lessons are available both from theory and from the brief experience of regulation that should be most useful for the work ahead, either in fine tuning or creating new initiatives, or for countries still in the midst or only at the beginning of their regulatory experience. What follows is a summary of the salient lessons. Salient Lessons for Regulatory Design In the design of basic and detailed regulatory frameworks, institutions and country endowments matter, but so do other factors. In a broad sense, the requirements for successful regulation are • Proper concession design • Proper sector restructuring • Regulatory credibility • Clear rules for and limits to govenunent and regulator discretion • Minimal opportunities for frivolous and opportunistic renegotiations • Maximum use of competition wherever feasible • An incentive-based regulatory framework • Appropriate regulatory and antitrust legislation • Clear standards and procedures for regulatory accounting • Autonomous regulatory institutions, well-trained and well-compensated professionals, and effec- tive enforcement • A well developed set of benchmark indicators of performance • Clear rules for resolving conflicts At the regulatory design detail level (structure, pricing, service rules, and agency design), several prinCiples should be kept in mind. The standard elements that are often subject to regulation vary from countrY to countrv and from sector to sector. However, the five main elements are (a) price(s), (b) quan- tity or ~overage, (~) quality, (d) number of firms by subactivity-horizontal concentration restrictions, and (e) degree of vertical integration and access. Other instruments less frequently used include reliability, timeliness of service. and investment. Often the lack of use of some potential instruments of regulation, s~ch as quality. has to do with severe informational problems and the high cost of monitoring and en- forcement. The regulatory functions and the regulated elements depend by and large on the country's regulatory philosophy, endowments, country and sector characteristics, and the extent of competition allowed. For e~ple, New Zealand, El Salvador, and Guatemala (the latter two only in the telecommu- nications sector) have virtually no regulatory control of the prices charged to end users, and in the United States, the FCC often chooses not to impose technical standards. While tradeoffs, which a country should evaluate carefully when choosing what to regulate and how, exist in regulatory design, salient choices and principles are available for effective regulatory design and for reducing the opportunities for regulatory capture in the utilities. These salient issues and prinCiples are presented below and can be categOrized into five components: institutional, discretional and renego- tiation, structural, detail regulation, and administrative procedures. Institutional Components The institutional components of regulation are most important because they underpin the legal ground- ing and jurisdiction of regulation. These components signal how credible the framework is and how likely it is that will be respected and enforced. The main issues are: 1. Understand regulation is a game. It is a problem of conflict and interactive strategies. Regulation is not a decision theory problem. 2. Evaluate extent of regulation. Regulation may be less necessary than is believed. The tradeoffs be- tween regulation and its absence should be carefully assessed. Reliance on market-induced com- petition, narrow and broad, should always be favored over regulation, and when regulation is necessary and appropriate, its form and extent may matter greatly. 3. Establish credibility of regulatory framework. For regulation to be effectiv~, it has to be credible. Cred- ibility means belief that the rules and framework will not change arbitrarily, that opportunities for and success of renegotiations are minimal, and that enforcement will take place. Credibility is secured by embedding the regulatory framework in the most irreversible legal instrument a coun- try can produce. For some countries, it is a law. For others, it is a contract. Signals that enforcement will take place are the structure, staffing, and budget of the regulatory agency and its reputation through performance. 4. Fit regulation with country's institutioruzl endowments. The basic and detail engineering of a country's regulatory system have to be tailored to suit the country's institutional endowments. The main criterion is to take the institutional character of the country into account. If the regulatory 352 /. LULS Guasch and Pablo SVlJJ~r framework does not fit the institutional and administrative endowments of the country, it will never be credible, successfuL or sustainable. 5. Ensure independence of regulatory agency. The regulatory framework should be lean, detached from the government and from the provision of the service, have its own budget by law or through adequate industry and consumer levies, and should not be under the discretion of the executive branch of government. Five necessary conditions for regulatory institutions to be effective are (a) managerial freedom (exempting the agency from civil service salary rules that make it difficult to attract and retain well-qualified staff); (b) political and budgetary autonomy (freedom from politi- cal and interest-group influence and establishment of restrictions on arbitrary removal); (c) ac- countability (the duty of an agent or employee to respond, that is, to fulfill his or her responsibili- ties to a prrncipal or employer); (d) checks and balances (to limit the power of single individuals within the institution, establishing periodic external audits and scrutmy of an agency's budget and decisions); and (e) incentives (mechanisms to reward financially good performance and pun- ish arbitrary or inadequate performance). Regulatory agencies must operate within a statutory framework that stipulates a preference for competition and market-like regulatory practices, and they must be subject to a variety of substantive constraints and procedural requirements to ensure the integrity, independence, transparency, and accountability of the regulatory process. Among those requirements are affording all interested parties an opportunity to be heard on major policy issues, stipulating deadlines for reaching decisions and the obligation to supply reasoned justifica- tions for decisions, and establishing due process. 6. Ensure that regulators or the regulatory commission are essentially professionals with technlcal expertise and not political appointees. Avoid the appointment of politicians as regulators as well as the ap- pointment of sector and user representatives in the regulatory commission. Regulators should make technical decisions implementing the regulatory framework and overseeing concession con- tracts. They should not be agents lobbying for any specific constituency. 7. Favor single intersectoral regulatory agenCIes, particularly in small countries am! at provincial ierJeis, and integrate all transport regulatton into a single subagency. In small countries and at the provincial level, where administrative and human resource capabilities are often weak, a single intersectoral regu- latory agency should be favored over sector-specific regulatory agencies. Most of the issues cut across sectors, and pooling of resources enhances the learning process. It also reduces the risk of capture by government or industry and facilitates consistency of approaches across sectors. In the transport sector, integration of regulation across modes into a single agency should be the norm. 8. Complement regulation and define dear demarcation of jurisdzetion with antitrust laws and proper enforce- ment. Because a number of segments of the utilities are and should be open to competition and should function largely unregulated, it is imperative to capture the benefits of competition so that firms do not engage in anticompetitive practices. To deter such practices, it is essential to enact modem antitrust laws and to ensure their proper enforcement through proper jurisdiction over· the competitive segments of the utility sectors, or at least through an advisory role. Both the anti- trust and the regulatory agencies should establish a close collaboration, exploiting complementary expertise. For example. a member of the antitrust agency can be made a member of the utility agency (as in Australia), or the agencies can make formal submissions to proceedings conducted by the other, or the antitrust agency can determine whether the conditions for effective competi- tion are sufficiently absent to warrant price regulation (as in Mexico) or can act as an appeals body from the utility regulator (as in the United Kingdom). 9. Define the role of ministry versus agency. A common reason for inadequate performance of regulatory agencies is the lack of clear demarcation of responsibilities between the' agency and the ministry. Clear demarcations have to be clarified and harmonized at the outset. The ministry should retain responsibility for broad sector policy, such as public investment, privatization, sector restructur- ing, taxation, subsidies, intergovernmental relations, maintenance of the legislative framework, and, arguably, the granting of licenses. The regulatory agency should hav€ -::sponsibility for Cone/uslon: The ChallrngeofReguiiztion 353 elaborating detailed standards, administering tariff adjustment rules and reviews, morutoring com- pliance with norms and service quality standards and investments, gathering cost and perfor- mance indicators of both the regulated finn and of comparable finns elsewhere, and facilitating the settlement of disputes. in addition, the agency should playa major role in an advisory capacity to the ministry on policy and sector structure. Discretion and Renegotiation Issues Critical to the well funCtiOrUllg of any regulatory system are the limitations on the discretion of the regu- lator to avoid capture from either operators or government. These limitations need to be embedded in the strongest legal instrument. Likewise, the high incidence of renegotiation is beginning to raise ques- tions and concern about the validity of the concession model. Therefore, taking measures to credibly dissuade opportunities for frivolo~ renegotiation is imperative. These measures are the subject of this component. The main issues are: 10. Ensure limited rrgulatory discretion. Regulation is an ongoing task with decisions fine tuned and adapted as events unfold. On effidency groWlds, this argues for a fau amount of flexibility to be granted to the regulatory agency, with clear and publicly known principles to be followed in making decisions so that other parties, particularly providers, can assess the decisions' economic impact on their op- erations and plan and act accordingly. However, in practice, two problems often occur with that framework. One is that the implicit commitment to stick to those principles is not credible and is often violated. with the changes affecting the economic returns of the operator. The other is that the implicit high level of discretion embedded in that framework is vulnerable to iru1uence and capture by interest groups. In general, the regulatory framework should be predictable and have little discre- tion. COWltries should remember, however, that while the need for legal certainty is crucial to creat- ing a competitive environment (overcoming investor hesitancy), too much legal rigidity will impede adaptability. In prindple, with the rapid development of technology and managerial techniques, regulatory systems should be able to keep up with changes. However, risks do exist. and thus a significant trade-off is involved. The system needs to be adaptable but should not involve too much regulatory discretion. At the expense of some potential efficiency losses, rigidity provides investors with clear rules and reduces capture and rent-seeking opportunities. This is a balancing act that all countries will have to work out over time. It is advisable that for the initial period, when most of the learning by all parties involved takes place, a fairly rigid structure with little or no discretion by the regulator should be used. Subsequently, at the beginning of review periOds, some flexibility can be introduced. Periodic reviews, at five-year intervals, are advisable. 11. Spec~fy contingencIes that tngger regulatory lldjustments. The regulatory framework should specify the salient contingencies that would trigger adjustments in the regulatory pricing terms, and the conditions and terms for renegotiations and remedies should be clearly specified in the contrac- tual terms. The relationship between the regulator and the regulated industry is best thought of in contractual terms, and like all contracts, the relationship should be clearly specified and should minimize the ability of either party to resort to discretionary or arbitrary actions. 12. Limit and deter opportunities for renegotiations. Given the incentives to renegotiate and the inability to contractually cover all contingencies, financial incentives to penalize frivolous attempts to rene- gotiate should be built into the license. Whenever technically feasible, overlapping concessions and split concessions should be made to reduce the renegotiations leverage and hold-up threats. 13. Introduce compulsory arbitration mechanisms, preferably fitud offrr arbitration, when feasible, for dispute settlement. A compulsory arbitration mechanism and appellate body, preferably with technical ex- pertise and internationally based, should be established to handle disputes. When feasible, use final offer arbitration schemes. To preserve independence, the ministries should not be involved in the appeals process. The antitrust agency could act as an appellate body, such as in the United 35,J . ,. LULS Gu.asch and Pablo SpiUr Kingdom, as could an ad hoc tribunal led by the supreme court and comprised of reputable pro- fessionals, as in Chile. The appeals process should focu.5 -:-:''1 alleged errors of iact or law, including failure to follow a required process, and the appellate be'_.. or tribunal should not be permitted to reconsider the merits of the decision and substitute their own judgment. 14. Establish, whenever possible, specialized courts for appeals. First, appeals of a regulatory decision should never go to an executive, but should go to the appropriate judicial courts. Even more desirable is establishing specialized courts because the issues are ratr.e: complex and tech."'i:~l a. : :'~e tradi- .... tional standard judiciary body has little expertise on those matters. Structural Issues Issues related to the design of the concession, award criteria, principles to restructure the sector, and ownership and rights restrictions to a large extent shape the sector structure. These elements also contrib- ute to forming competitiveness and facilitating regulatory oversight. Thus parncular attention neec.~. to be provided to the following issues: 15. Understand tJuzt concession/privatization design is key to an efficient sector and regulatory performance. Most performance and regulatory problems can be traced to faulty concession or privatization design. The norm should be careful screening to determine the pool of qualified potential opera- tors, followed by transparent and single criterion competitive bidding for the rights to provide the concession or to purchase the firm. The length of the concession period should be no shorter than the productive life of the physical assets existing or to be acquired. When feasible, though, interim periodic competitive rebids for the rights to operate the conceSSIon, with rights or first refusal granted to the incumbent operator, should be considered. End-of-concessicn mcentlves should also be built into the concession contract. The granting of guarantees on regulatory (unilateral changes) risks force majeure events and currency convertibility, and repatnation of profits should be provided either through the market, international institutions, or the government. However. guarantees on commercial risks should be avoided. 16. Use proper criteria for awarding concessions. Avoid multicomponent criteria. The most salient option to use in awarding a concession is to set up a two-stage mechanism: one stage to prequalify inter- ested parties on the basis of experiences and the technical proposal, if applicable, and a second one to solicit bids from the prequalified bidders using a single criteria for selection. The single criteria should normally be based on the largest transfer price or canon due to the lease payment for the assets and operating rights. Also, an appropriate level and structure for tariffs is needed before a concession is awarded, and clear rules for tariff readjustment and revision should be established. The concession should then be awarded to the qualified bidder willing to pay the highest initial payment for a prespecilied concession fee or the highest concession fee for a fixed initial payment. In the event of a negative concession, which is one that is not financially viable, such as some toll roads, the concession should be awarded to the qualified bidder willing to accept the iowest sub- Sidy, given a prespecified toll fee. In settings where the concessionaire can do little to influence demand, and quality standards are easy to define and measure, as in the case of highways and airport landing strips, the lJ>RV should be the salient criteria. Qualiiication conditions should generally relate to the financial capacity of the bidder and to relevant indicators of experience and technical capability. These conditions should be unambiguous and capable of simple yes or no answers, so as to avoid disputes. -. 17. Facilitate eJfit:imcy gains by unlnmdling the sector. Unbundling the sector prior to privatization by breaking up the company geographically or by activity, horizontally and vertically as much as is economically feasible (long distance, local exchange, value-added services in telecommunications or generation, transmission, or distribution and supply in electricity), induces sector competitiveness much faster than otherwise and result: ;.:l higher efficiency gains. This is perhaps one of the most important actions that should be taken. The implicatlons and potentlal gains are enonnous. Unbundling in Argentina (geographical partition), Brazil, Chile (activity partition), and Mexico are examples. 18. Regulate by objectives, not means. The use of output indicators rather than input levels should be the norm. For example, rather than imposing targets on investment, set targets on coverage, access, quality, and so forth. It is more efficient, it dissuades creative accounting and transfer pnce issues, and it reduces litigation. 19. Do not grant exclusivity rights, in principle. Exclusivity rights might be considered only under limited situations where coordination costs are extremely high. Little conceptual support exists for granting exclusivity rights. Ii the activity does possess natural monopoly characteristics, it has de facto exclu- sive rights; then, the granting of exclusivity rights de jure is not necessary. Ii the activity does not possess natural monopoly characteristics, no Justification exists for granting a legal monopoly through exclusivity rights. Only in situations with significant coordination problems or transaction costs (or significant nonhedgeable risks), such as central dispatches or logistics, should granting exclusivity rights be considered. It is also often argued that exclusive rights are needed to successfully address the rebalancing-of-rates issue. This, again, is a misconception, as the case of El Salvador illustrates. Another argument often used to justify exclusivity rights is (uruversal) service obligations, with im- plidt or explidt subsidies to certain groups or areas. Again, this is a weak argument. This a relative price issue, and rather than institutionalizing cross-subsidies (as is often the case), It is better handled with either specific transfers to the operating company or, preferably, with·transfers directly to the targeted consumers through vouchers or income tax credits. This ought to eliminate the need for cross-subsidization and cream-skimming opportunities by potential entrants. While any potential investors prefer exclusivity rights, the absence of exclusivity rights does not deter their participation. The examples are multiple. In New Zealand, Telecom NZ was successfully privatized in a policy environment of open entry in all market segments, a case similar to Otile in the long distance market. In the Philippines, foreign investors, such as Cable & Wireless and Telstra, have entered the market as competitors or partners of competitors. In Mexico, a large domestic cellular operator with support from Bell Atlantic has proposed installing a fixed wireless network to serve 15 million customers. In southern India, US West has proposed a telecom build-own-operate (BOO) scheme and has not asked for an exclusive franchise. Other examples show that investors have accepted c;.ompetition in Austra- lia, Chile, El Salvador, Guatemala, Malaysia, Sweden, the United Kingdom, and the United States and in the cellular market of almost every country. 20. Qualify financial equilibrium principles. While the principle of pricirlg the services so as to secure the financial equilibrium of the operation is appropriate, it should be framed Wlder an expectation of efficient operations, appropriate investments, and performance comparable to selected benchmark indicators. The objective of the considerations on the principle is not to allow higher costs due to correctable inefficiencies to be passed to users through higher tariffs. 21. Allow for end of concession cIllU5es. Specific clauses and terms on both compensations and responsi- bilities for the operator in the event of early termination should be a norm on all concessions. In addition, terms and responsibilities for the operator at the end of the concession should also be clearly spelled out to eliminate perverse incentives towards the end of the concession. Detail Regulation This issue refers to the type and extent of regulation and is crucial to secure aligrunent of costs and tariffs and to induce the incentives for efficient operation. The main issues are: 22. Understand that incentive price-cap regulation tends to lead to higher efficiency reLative to rate-of-retum. Price-cap regulation tends to induce much better performance than rate-of-retum regulation, de- spite its potential ratchet effect. The rate-of-retum regulation approach resolves the problem of utili- ties earning monopoly profits, but results in the regulated finn overinvesting in its capital stock and I 358 f. Lul.S Gwzsch and Pablo 5plll~ in many developing countries is the lack of good benchmark indicators for long-term rates. It rmght then be necessary to rely upon secondary or proxy indicators. 30. Understand the nature and impact of regulatory risk. Reducing regulatory risk, the unpredictable or arbitrary interpretation or changes in the rules, should be a major objective. When unaccounted for or mishandled, regulatory risk can increase the cost of capital between two and six percentage points, which implies a 7 to 28 percent additional increase in tariffs. Understanding sources of regulatory risk and providing safeguards is thus essential. 31. Allow price discrimination. The provider should be granted flexibility to vary prices across users and times of services, all within the broad price-cap regime, to respond to competitive pressures and capadty constraints. This is particularly appropriate for distribution companies in the energy sectors when faced with competition from independent generators contracting directly with large users. In addition, price discrimination based on differential costs of services and demand elasticities should also be allowed. The latter is most relevant to assign all unattributable fixed and common costs of the utility among its services. Those fixed costs should be recovered by mark ups above marginal costs inverselv related to the elasticity ot demand tor that service (Ramsey pricing). 32. Accoun/ for the provision and structure of unzversal service obligations. Provisions and a strategy for increased. coverage or universal service needs to be considered, bu t it should be consistent with the stages of liberalization of the sector, so as not to distort or slow down the opening of the sector. The costs, transfers, or subsidies have to be accounted for in the most transparent manner and com- petitive auctions for that increased coverage considered whenever feasible. Administrative Procedures All regulation needs appropriate infonnation in the right format that is developed with agreed-upon accounting standards that clearly define the knowledge and administrative capacity of the overseers. The main issues are: 33. Develop standardized accounting and procedures for regulators. To facilitate regulatory oversight, a set of accounting standards for regulators has to be developed so that the operators provide informa- tion in the most useful format, conducive to proper costs, investment, and quality valuations. ).t. Build in informational requirements. Ensure that, in the regulatory framework legislation and con- tract, compulsory information requirements are introduced to oblige operators to provide the nec- essary information, particularly on costs, investment, quality and prices, conducive to effective regulatory overSight, and that commensurate fines are applied in the event of noncompliance. 35. REv,ew mformatlon on costs, trainmg, and networics oj n!g'.d.ators. Finally, a recommendation on informa- tion is provided. Many regulatory problems are a result of the limited information that is available to regulators and from their limited expertise on the subject. Firms have private information about technology, costs, and demand and can manipulate access to information by regulators to their ad- vantage. To limit the impact of that problem, it is imperative to develop procedures for gathering relevant information from the start, and it is imperative that a core of the agency staff receives exten- sive training in regulatory matters. To facilitate both information gathering and training, it is impor- tant to avidly pursue linkages and close collaboration among regulators sharing problems, initia- tives, and successful practices. That would also facilitate the process of benchmarking, a most effective means for regulatory oversight. A salient procedure to secure those linkages is the establishment of a network of regulators, both by electronic means and by periodic meetings. These lessons, when properly adapted to each country's own environment, can significantly increase the likelihood of effective regulation, improve sector performance, secure necessary increases in access, reap the benefits of concessioning or privatization programs, and improve country productivity and competitiveness. While the challenges are Significant, so are the efforts that developing countrieS are making to face them. This is a learning process, and while mistakes have been and will be made, the Conclusion: Tht Challmgt:J.f Rtg-uLatlon 359 trend is clear. Regulation is here to stay and is grad ually improving. As all parties involved increase their awareness and understanding of the issues, balancing constituencies are being formed. 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