How can a regulator promote investment while keeping service prices affordable?

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

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

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

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

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

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

Resources

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Cambridge Surveys of Economic Literature Series, Cambridge University Press, 1988.
Berg, Sanford V., and John Tschirhart

The Economics of Regulation: Principles and Institutions
Cambridge, MA: MIT Press, 1988, Reissue Edition, Chapters 2-7.
Kahn, Alfred

Infrastructure Concessions, Information Flows, and Regulatory Risk.
Note no. 203 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, December 1999.
Burns, P., and A. Estache

Electricity Transmission Pricing: An International Comparison
Utilities Policy 6(3): 1997, pp. 177-184.
Green, R.

Accounting for Infrastructure Regulation: An Introduction
Washington, D.C.: The World Bank, 2008, Chapters 3 and 5.
Rodriguez Pardina, Martin, Richard Schlirf Rapti, and Eric Groom

Managing the Regulatory Process: Design, Concepts, Issues, and the Latin America and Caribbean Story
Washington, D.C.: The World Bank Group, 1999, Chapter 4, Chapter 5.
Guasch, J. Luis, and Pablo Spiller

Risk, Volatility and Smoothing: Regulatory Options for Controlling Prices
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Alexander, Ian and Chris Shugart

A Primer on Efficiency Measurement for Utilities and Transport Regulators
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Coelli, Tim, Antonio Estache, Sergio Perelman, and Lourdes Trujillo

Utility Benchmarking
Viewpoint, Note No. 229. Washington, D.C.: World Bank Group, March 2001.
Kingdom, Bill, Vijay Jagannathan

Profit Sharing Regulation: An Economic Appraisal
Fiscal Studies, 17(2): 83-101, 1996.
Mayer, Colin and John Vickers

Regulatory Requirements Under Different Forms of Utility Service Delivery
Macroconsulting, 2007.
Rodriguez Pardina, Martin, and Richard Schlirf Rapti

ICT Regulation Toolkit
Washington, D.C.: infoDev and the International Telecommunications Union, 2007, Module 2.

The Political Economy of Water Pricing Reforms
Oxford, U.K.: Oxford University Press for the World Bank, 2000.
Dinar, A., ed.

Impact of Market Structure on Service Options for the Poor
Presented at Infrastructure for Development: Private Solutions and the Poor, 31 May – 2 June 2000, London, UK.
Ehrhardt, David

Designing Direct Subsidies for the Poor – A Water and Sanitation Case Study
Note no. 211 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, June 2000.
Vivien Foster, Andres Gómez-Lobo, and Jonathan Halpern

Regulating Quality
Note no. 221 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, October 2000.
Baker, Bill and Sophie Trémolet

Public-Private Partnerships for Urban Water Utilities: A Review of Experiences in Developing Countries
Trends and Policy Options, No.8. The World Bank, PPIAF, 2009.
Philippe Marin

Footnotes

1. Government and Operator Objective explains this mechanism.
2. See Information in the Regulatory Process
3. See Regulation of Financial Statements
4. See Comparative Analyses
5. Regulators may create groups of service that are subject to similar degrees of competition. Operators may then be allowed certain price flexibility within these service baskets (Deviations from Marginal Cost Pricing: Ramsey Pricing).
6. See incentive-based regulation in the glossary.
7. See Incentive Features and Other Properties, Features of Price Cap and Revenue Cap Regulation and Earnings Sharing.
8. These issues are addressed in more details respectively in question What do regulators need to do differently to tackle the needs of poor consumers?, To what extent does service quality need to be the same for high and low cost areas?, What procedures should the regulator adopt in order to balance economic and social objectives (like efficiency vs. fairness)? and What are the strength and limitations of lifeline rates?.
9. See What do regulators need to do differently to tackle the needs of poor consumers? and the “willingness-to-pay” surveys, as a way to adapt service to customers’ preferences.
10. See Do higher income customers benefit more from subsidies than do poorer customers? on the limits of targeting subsidies.
11. See Are successful programs for peri-urban areas appropriate for rural areas? on the specificity of rural areas, where customers are often not monetized.