The Regulatory Problem

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It seems fair to say that governments establish regulation of utilities to improve sector performance relative to no regulation. What might be meant by “improve sector performance,” however, can be subject to considerable debate. Often “improve sector performance” means that the government wants to control market power and/or facilitate competition. It may also mean that the government wants to address commitment issues; that is to say, the government may create a regulatory agency to protect operators and customers from politically-driven decisions that would sacrifice long run efficiency for short term political expediency.

“Improve sector performance” might also mean that the government has chosen to regulate in order to favor particular types of customers or to protect operators from competition. In some countries, for example, regulation has been used to subsidize electricity for farmers. In the 20th century many counties used regulation to protect monopoly telephone companies from competition.

Except where otherwise noted, this Overview addresses normative issues of regulation, with the perspective that regulation, and in particular regulation by a regulatory agency, is intended to improve welfare.1 In this context, welfare means the aggregate benefit that infrastructure services provide, including benefits to consumers,2 benefits to operators, and externalities.This Overview does not address the individual weight that the government may give to each element. These weights are important, but they are set aside here because each regulator can use her or her government’s own weighting system to determine which tools described herein to apply and how to apply them. Externalities are benefits or costs from a transaction that are received or born by third parties who are not part of the transaction. Air pollution produced by electricity generation or by transportation vehicles is an example of a negative externality.

At this point, it is important to note that some observers make convincing arguments that policymakers sometimes have more nefarious motives than maximizing welfare, for example, to gain short term political advantage or to benefit political supporters. Such motives raise the issue of how citizens can regulate their government and the regulator. Review of this issue is reserved to Section H of this Overview and to Chapter VII.

From a normative perspective, regulation of a service provider may be desirable if (1) the welfare objectives of the government are different from the objectives of the operator, (2) the operator has an information advantage over the government, and (3) the operator has market power.

To illustrate why regulation may be appropriate when the government and the operator have different objectives, consider a situation in which the government and the operator each has a single objective, namely, the government wants service expansion in rural areas and the operator wants to maximize profit. An unregulated operator with market power would restrict output to maximize profit and would invest in areas that give the highest profit. It is unlikely that either of these outcomes would be consistent with the government’s objective, so the government may want to take steps that would make it in the operator’s best interest to expand service in rural areas. In the case of a state owned operator, the management may have an objective of maximizing its political influence. This could lead the management to use its resources to employ a lot of people or to target investments to politically powerful areas. Neither would likely be consistent with the goal of expanding service in rural areas.

Now consider a situation where the government and operator have the same objective, say to offer service of a particular service quality throughout the country at the lowest possible cost. In this case, the government could simply give the operator whatever relevant information the government had and let the operator pursue this objective on its own. Regulation would not be needed in this situation because the government could not improve results by regulating the operator, that is to say, regulation, if designed to persuade the operator to do what the government wants the operator to do, would be redundant with the operator’s own strategic objectives.

Of course the world is not so simple. Many developing countries have not privatized their utilities, but have established regulatory agencies with varying degrees of independence. An important challenge for these regulators is that the state-owned utilities often do not operate on a commercial basis.3 The utilities sometimes are torn between the short-term social stability interest and the long-term viability of the utility enterprise. Therefore there are many opportunities for conflicts between the utility and the government even if the interests would appear to coincide.4

In practice a government’s objectives are typically different from an operator’s objectives. For example, the government may be primarily concerned with new investments, service expansion, and low prices. In contrast, a privately owned operator is likely to want to maximize profit, an objective that, left unchecked, is generally understood to be inconsistent with widely available services and low prices across the board if the operator has market power. State-owned operators may want to satisfy key political supporters, maintain high levels of employment for politically powerful unions, or secure large budgets, which would also be inconsistent with government’s objectives. Because of these differences in objectives, governments typically adopt instruments to induce operators to achieve the government’s objectives.

To illustrate the importance of the operator having an information advantage – a situation generically referred to as an information asymmetry5 – suppose that the government and the operator have different objectives and that the government knows just as much as the operator about customer demand and the operator’s ability to satisfy customer demand. In this case, the government could simply micro-manage the operator – i.e., tell the operator when to maintain lines, how many workers to employ, etc. – to achieve the government’s objectives. This approach is called command and control regulation, and is in effect complete government management of the operator.6

Furthermore, it is also generally the case that there is an information asymmetry between the government and the operator. Asymmetric information in this context means that the operator has what economists call private information about its ability to operate efficiently, about patterns of customer demand, or about the amount of effort that is required for the operator to be efficient.

There are three basic approaches to dealing with market power and with the asymmetries described above, namely, (a) subjecting the operator to competitive pressures, (b) gathering information on the operator and the market, and (c) controlling market power by applying incentive regulation.7 In the following sections, each of these approaches and how regulators put them into practice is reviewed. Regulators typically use some combination of these three approaches and the proper mix depends on the country’s needs and objectives, institutional capabilities and arrangements, cost or difficulty of obtaining information, and potential for competition.

Footnotes

  1. Focusing primarily on welfare is not meant to imply that distributional issues in regulation are unimportant. Distributional issues address how different stakeholder groups are affected differently by how infrastructure services are provided. Situations where governments use regulation to benefit some groups over other groups have been already mentioned. Portions of Tariff Design, Quality, Social and Environmental, and Regulatory Process are devoted to distributional issues, namely, assisting the poor. Welfare is the focus because it is the measure of benefit most often used in research and because policies that emphasize welfare do not preclude also adopting policies that address distributional issues.
  2. Benefits to consumers is generally measured as net consumer surplus, which is the difference between the gross value that the customer receives when consuming the service (called willingness to pay) and the amount the customer pays.
  3. This experience is not unique to developing countries. Studies have found that government-owned utilities in developed countries do not operate on a commercial basis.
  4. The authors are grateful to Jorry Mwenechanya for this insight.
  5. Information asymmetries are noted in the reference section dealing with Informational Asymmetry of General Concepts.
  6. This of course cannot happen in practice because information asymmetries exist even for government controlled enterprises.
  7. Information gathering is a critical tool in both of the other options, but it is listed separately because knowledge and information are valuable in all facets of regulation.