How can policy makers incorporate market failures in the design of infrastructure reforms?

You're in the section: Frequently Asked Questions -> Foundations of Regulation -> How can policy makers incorporate market failures in the design of infrastructure reforms?

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

There are three different types of market failures that can potentially drive the design of infrastructure reforms: failure of competitive markets due to the existence of natural monopolies, information asymmetries and externalities. These are explained in more detail in turn below.

Competition failures. There are limits on the extent to which competition can be introduced in the provision of infrastructure services, as some segments of the value chain can be seen as a “natural monopoly”. For example, natural gas distribution or electricity distribution are seen as natural monopolies1, which means that a single firm can produce a given level of output at a lower total cost than can any combination of firms. This means that, for example, it is not efficient to build several parallel gas or electricity distribution networks. By contrast, suppliers of these products can get access (at an access charge) to the distribution element of the network and compete for serving the end-consumers. The design of infrastructure reforms would need to take account of what consists of a natural monopoly in the country and sector involved. Given the natural tendency of monopolists to exercise market power (which may result in excessively high prices and low quality), it would be important to establish a regulatory regime that constrains such market power for the natural monopoly elements whilst letting competition drive efficiency improvements in the other segments. This may require structural separation2 or unbundling, to separate those different segments and establish distinct regulatory regimes.

Information asymmetries. Information asymmetries materialize at different levels. Customers may not necessarily know the quality of the service they obtain before they consume it (this is typically the case with water supplies, which may look or taste the same even if they are contaminated) or the kind of hazard they are exposing themselves to (for example, with inadequate electricity supplies). Regulators would typically have access to less information than what utility management has at its disposal (this is typically referred to as a “principal-agent” problem). Information asymmetries need to be taken into account when designing infrastructure reforms, so as to introduce the optimal regulatory tools and instruments to address them. A first essential step of regulatory reform may consist simply of establishing mechanisms for collecting, comparing and disseminating information on utility performance3. The information required includes financial data on the operator, information on prices, sales, market shares, quality of service provided, etc. The most common approach is to require from the operator to provide the regulator with financial statements annually in accordance with a unified system of accounts4. Benchmarking, or yardstick regulation, may also be a useful tool to compare utility performance and identify areas of under-performance and potential for improvements. This can be conducted at sub-national, national or even international levels5. If the results are properly communicated to customers, this can also alleviate the information asymmetry at this level and stimulate service providers to improve their performance. Gathering information on historical trends, current baselines and realistic targets through benchmarking may also contribute to mitigate conflicts over reforms (Berg, 2007).

Externalities, or « external effects », materialize when the production or the consumption of utility services generate spillover effects for which no payment is made via a market. This may result in over or under production compared to the social optimal. For example, electricity generation leads to the release of CO2 (this is referred to as a “negative externality”), with different modes of electricity generation having different carbon footprints. By contrast, provision of adequate sanitation (either through on-site sanitation solutions with sustainable services to collect, treat and dispose of the sludge or via sewerage and treatment systems) can generate positive externalities, as it would reduce the impact of diseases in the community as a whole. Externalities can be taken into account in the design of infrastructure reforms in the following ways:

  • When there are positive externalities from consuming a given utility service, by giving incentives to utility service providers to extend service coverage beyond what they would do based on purely financial criteria. For example, rural services are rarely attractive from a risk/return point of view but can generate substantial spillover effects in terms of rural economic development. Governments can therefore choose to provide subsidies to encourage utility service providers to extend services in rural areas.
  • When there are negative externalities (from electricity generation for example), governments should introduce environmental safeguards and financial incentives to foster the selection of cleaner fuels for example6.

Resources

Fundamentals of Economic Regulation
Working Paper 03-17, Public Utility Research Center, University of Florida, 2003.
Berg, Sanford V

Regulating Infrastructure: Monopoly, Contracts, and Discretion
Cambridge, MA: Harvard University Press, 2003, Chapter 10 and 13.
Gómez-Ibáñez, José

Making Competition Work in Electricity
New York: Wiley & Sons, 2002, Chapter 4-6.
Hunt, Sally

Methods for Increasing Competition in Telecommunications Markets
University of Florida, Department of Economics, PURC Working Paper, 2008.
Jamison, Mark A.

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

Strategic Behavior under Regulation Benchmarking.
Working Paper WP 0312, 2003, Department of Applied Economics, University of Cambridge, U.K.
Jamasb, Tooraj. Paul Nillesen, and Michael Pollitt

Conflict Resolution: Benchmarking Water Utility Performance
Public Administration and Development, Vol. 27, No. 1, pp 1-11, University of Florida – Department of Economics, 2007.
Berg, Sanford

Environmental Externalities, Congestion and Quality under Regulation
in Infrastructure Regulation and Market Reform: Principles and Practice, edited by Margaret Arblaster and Mark Jamison. Canberra, Australia: ACCC and PURC, 1998, pp. 185-196.
Forsyth, P.

Footnotes

  1. See Competition in the Market.
  2. The meaning of structural separation here is different from the definition given in the glossary: ” Quantity supplies exceeds quantity demands because a minimum price has been set above the equilibrium”. Structural separation in the present context means the separation between the potentially competitive portions of the utility service from the non-competitive portions (see Competition in the Market). Structural separation is sometimes called unbundling, although the latter may be less severe: a regulator may allow a single operator to combine competitive and non-competitive elements to provide bundled service, while requiring the operator to allow rival access to the essential facility.
  3. See Second Approach.
  4. A unified system of accounts is a set of regulator-determined accounting rules that define the accounts and the accounting practices that operators must follow when reporting financial information to the regulator. Analysis of this information is aimed at regulating overall price levels (see Second Approach).
  5. Properties of benchmarking analysis and the metrics used are described in Properties of Benchmarking and Yardstick Analyses.
  6. See Environmental and Safety Issues.