Federal systems – What reform strategies and regulatory structures are best suited for large countries with federal system (multiple layers of regulation)?

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

The question of the optimal level of government at which to set up regulatory institutions arises in all decentralized systems, and particularly in large countries with a Federal system (for simplicity, we refer to “State” as the largest political entity within the federal political structure).

Considerations for deciding on what reform strategies and regulatory structures are best suited to Federal systems include the following:

• The overall market structure and the level at which utility services are provided. This would vary depending on countries and sectors. Most federal countries would tend to have either State-level utilities (such as State Water utilities in Brazil) or utilities operating at a lower level of government (such as municipal providers). Utilities operating at the Federal level (such as the AT&T model in the US prior to reform) are very much something of the past nowadays. This type of market structure would tend to support a State-based approach to utility regulation, as it is done in the US or Brazil in virtually all utility sectors¹, in India (with the State Electricity Commissions) or in Mexico (for water). Setting up regulatory commissions at the State level means that regulation can be carried out at a level that is closer to customers and aligned with the level at which services are provided: for effective regulation, it may be preferable to set up regulatory agencies at a level which is closer to end-consumers. By contrast, carrying out all regulatory functions at the Federal level could be excessively costly and counter-productive.
• The degree of market integration and cross-boundary trading between utilities operating at State level. Even in decentralized contexts, the need to transport power or water across State boundaries and to avoid creating market distortions means that Federal supervision would also be required in order to foster cooperation and establish a level-playing ground for utilities. In addition, some networks, such as telecommunication networks, are national (and even international) in nature, which means that Federal supervision would definitely be required for those sectors.
• The overall institutional structure and political systems. Countries are more or less decentralized, which will have an impact on the powers that are allocated to each level of government. In federal systems, some countries leave a high degree of autonomy to each State (such as in the United States or India), whereas others have a more centralized tradition. However, even in traditionally centralized countries, regulation has been more and more delegated at provincial levels. For example in China, a traditional structural feature of the regulatory agencies had been the hierarchical structure between the central and the local regulatory bodies. The general trend in the reform of regulatory structures though is to delegate more and more power to the regional governments. For instance, in order to provide incentives for the regions to make investments in electric power, the central government has given the local governments the authority to approve entry and investments in electricity generation and to make price purchase arrangements. As a result of decentralization of regulatory power, China has in some sense solved the shortage of energy, which plagued the economy for a long time. Similar delegations have happened in the gas and transport sectors. The degree to which decentralization is reflected in financial flows is also an important factor, i.e. whether or not decentralized entities have the ability to raise their own tax revenues. In India, the description of reforms (delegating regulation to regulatory commissions at the state level, while the Electricity Act of 2003 would provide a regulatory framework for states to follow) envisaged by the National Electricity Policy required substantial autonomy, capabilities and stability in the regulatory process, and little progress has in fact been carried out towards restructuring and privatization. This is largely due to institutional weaknesses, such as limited financial autonomy and capabilities of regulatory commissions (who get funding from government’s budgetary support) and regulatory uncertainties.

All these factors would influence the allocation of regulatory functions between Federal and State level and the degree of autonomy that is left to the State for developing regulatory frameworks.

The double allocation of responsibility to both Federal and State governments, if not clearly set out, may lead to inefficiency in regulation and thus to serious impediments in essential service provision. For example, in the United States, where regulatory agencies were first created, regulatory agencies have been established at the State level as well as the Federal level. Substantial autonomy has been left to the State policy-makers regulators, which means that each State could adopt the infrastructure reforms that suited their circumstances at a pace of their choosing. This allocation of responsibilities between state and federal levels had at times negative effects. For example, the path of rapid market liberalization chosen by California led to what has been later referred to as the “California power crisis”, largely caused by regulatory failure. The deregulation process, started in 1998 with the partial divesture of electricity generation stations by the incumbent utilities brought in the forefront private energy suppliers. The State government expected the Federal Energy Regulatory Commission (FERC, created in 1935) to prevent manipulation from profit-oriented energy suppliers; however, the FERC hardly reacted at all and did not take serious action against Enron and the like, as its resources were in fact quite sparse in comparison to their entrusted task of policing the energy market. While the experimentation hit hard on the State of California, it has served as cautionary tale in other States and helped them adapt their approach to electricity reforms.

Even in contexts where a substantial degree of autonomy is left to the State regulatory commissions, Federal-level regulatory bodies would therefore usually still be needed to perform the following functions:

• To perform certain regulatory functions (particularly in institutional systems with limited autonomy);
• As an appeal body for disputes arising at State level;
• To provide guidance (and / or legislation) to state-level regulators on a number of common issues (such as on tariff-setting rules, etc.). For example, when the electricity sector has been privatized in Argentina, the concession contracts were negotiated with the provincial government according to principles set by the federal government.