Promoting Competition – What are the different ways to promote competition in a utility sector and what can be the regulator’s role in doing so?

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

Facilitating competition is one instrument for overcoming market power and asymmetries in objectives or information. Competition generally promotes efficient allocation of resources and ultimately economic growth, by revealing actual customer demand and thus inducing the operator to provide service quality and price levels on par with customers’ demand, subject to the operator’s financial needs to cover its costs. Different types of competition exist, as listed below.

Competition in the market1 or direct competition occurs when operators are free to enter a market to provide goods and services to end consumers. It is the most common form of competition and requires the regulator to facilitate access to essential facilities (such as the transport component of a water network), ensure that barriers to entry do not interfere with competitive dynamics (such as unnecessarily high licensing requirements), monitor the effectiveness of competition and take measures to limit the incumbent operator’s market power (by requiring the organization of a competitive process to meet any new demand for example). In the telecommunications sector, most market segments have been opened to competition. By contrast, in the water sector, competition is often limited by granting exclusivity to the main service provider. The English market is one of the very few where the Government has pro-actively sought to introduce competition in the water market. A recent review of the sector, referred to as the Cave Review, has recommended introducing competition into the wholesale supply of water. Lessons drawn from electricity and gas competition suggest that it should lead to significant benefits for consumers in terms of price and quality, but also to improvements in water usage through bulk water trading. In many developing countries, competition is widespread at the low-income end of the retail water market, with a high number of small-scale entrepreneurs, who are often informal operators, covering the gap in coverage left opened by incumbent utilities.

Competition for the market is an approach used when it is inefficient to have more than one operator serving the market, i.e. when the utility system contains natural monopoly characteristics. Yet, customers can still gain benefits from competition as it eventually favors cost efficiency of the utility service. In the water sector, the most common option for introducing competition for the market is to organize a call for tender to attribute contracts such as concessions, management contracts2 or lease/affermage3 contracts to private operators. Another option to attribute these contracts is an auction. The goal of an auction is to reveal which operator is best able to provide value to customers and the value that this operator places on the opportunity to serve4. Several auction models exist such as the Vickrey auction, in which the firm with the best bid wins but receives the price of the second lowest bidder5, or the reverse auction used for example in the electricity sector in Chile, where the winner is the operator that has a positive social return but a negative private return, and needs the lowest level of subsidy. Successful auctioning requires careful design and a minimum number of bidders. Because of the uncertainty inevitably associated with long-term contracts, ongoing regulation of prices and contract renegotiation are common. Frequent rebidding of the concession may be an option for reducing the need for regulation and renegotiation. Indeed, ongoing regulation induces high transaction costs and requires strong capabilities that the regulator may lack.

Comparative competition6 or benchmarking competition is an approach that compares the performance of an operator in different jurisdictions that it serves, or the performance of utilities in different countries. It is the case for instance in the UK where regulators regularly assess regulated entities against utilities in other countries. It is also the case of Paris (France) and Manila (Philippines), two large metropolitan areas, where the water market is split into service areas covered by companies that do not compete directly but can be compared by the regulator. By making rewards dependent on the firm’s relative performance, yardstick competition7 strongly encourages information disclosure and efficiency gains: a firm will retain any surplus related to its cost-saving activities. While these comparisons may be useful for regulators, care must be taken to ensure that operating conditions in compared jurisdictions are similar.

Competition via financial markets occurs when operators can purchase their competitors by buying shares on financial markets or through direct mergers. The threat of being purchased maintains a competitive pressure on operators and gives them an incentive to improve their company’s financial health. The regulator can be tasked with allowing or disallowing such mergers depending on their forecast impact. For example, Ofwat, the regulator of water and sanitation services in England and Wales has disallowed some proposed mergers as it feared it would reduce the number of comparators used for its benchmarking analysis.

Resources

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

Promoting Private Investment in Rural Electrification—The Case of Chile
Note n° 214 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, 2000.
Jadresic, Alejandro

Competition in Water and Sanitation
Note no. 165 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, December 1998.
Solo, T. M.

Approaches to Private Participation in Water Services: A Toolkit
PPIAF, the World Bank Group, 2006.
PPIAF and The World Bank

Introducing Competition into England and Wales Water Industry: Lessons from UK and EU energy market liberalization
City University, Department of Economics, Discussion Paper Series, CCRP Working Paper n°13, undated (2009?).
Stern, J.

Independent Review of Competition and Innovation in Water Markets: Final Report
April 2009.
Cave, Martin

Reforming Infrastructure: Privatization, Regulation and Competition
A World Bank Policy Research Report, 2004.
I. Kessides

Using management and lease / affermage contracts for water supply: How effective are they in improving service delivery?
Gridlines, PPIAF, Note n°12, Sept. 2006.
K. Ringskog, M.E. Hammond, A. Locussol

Footnotes

  1. This topic is covered in Competition in the Utility Market of the BoKIR, as well as in previous question.
  2. “Management contracts last about five years and are limited to operations and maintenance. They are fee-based and do not entail any financial risk for the contractor or responsibility for investment”.
  3. Under lease/affermage contracts, assets are owned by the government, who is also responsible for investment. However, compared to management contracts, the private operators bear a substantial commercial risk because they have to generate an operating surplus sufficient to cover their remuneration. Lease and affermage contracts differ mostly in the way the commercial risk is shared between the operator and the owner of the contract. (Definition derived from PPIAF, 2006)
  4. See Competition for the Market of the BoKIR.
  5. Ibid.
  6. See Comparative Analyses in the BoKIR.
  7. See “yardstick regulation“, or “benchmarking” in the glossary.