To what extent does service quality need to be the same for high and low cost areas?

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

Market liberalization and private sector participation have raised the question of service quality differentiation1. On the one hand, governments have tended to focus on the main utility provider while overlooking alternative providers, and therefore set standards that are usually above what would be acceptable to the poor and socially optimal. They do not take into account affordability or the costs and benefits of different quality standards. On the other hand, competition has driven operators to offer de facto different quality and price bundles, even though they do not all respect the regulations that are in place. In economic terms, the preferred level of quality should reflect the value customers place on quality and the operator’s cost of providing service quality2: differentiating quality thus appear rational in both economic and social terms.

OFWAT, the water regulation agency in the UK, was the first to develop an approach where allowed prices are linked to service levels: the operators providing the best service are rewarded with an increase in price limits within a price-cap regulation, while the “bad ones” would see their price limit reduced.

The rationale for differentiating quality is essentially two-fold:

 

  • To save costs for operators: poor areas are more expensive to serve because of remoteness, low consumption that does not cover the high cost of connection and higher risks of non-payment. Allowing for greater flexibility and cost-saving measures include finding alternatives that would reflect the entire cost of service on poor consumers, for instance by offering lower quality at reduced costs. By doing so, the operator would market new services aligned with the poor customers’ preferences and their willingness to pay.
  • To make the service more affordable to the poor. Quality standards should be reviewed to see whether a lower minimum requirement would be acceptable to the poor and would allow fulfilment of social objectives. Providers should be free to compete on quality above the minimum standards.

However, differentiating quality of service also presents some constraints:

  • While both operators and poor consumers could gain from choosing the level of service quality offered, regulated firms3 could be constrained by existing regulations4.
  • There may be high costs or technical difficulties associated to service quality differentiation, which would offset potential gains. For integrated network services such as electricity provision, there may be no point in seeking to differentiate quality parameters such as voltage consistency. For water supply, beside the obvious public health concerns, it may not be possible to treat water to different levels, as it would require building separate distribution networks. However, specific parameters, such as reliable hours of service could be differentiated.
  • In addition, cost differences driven by quality differences may be difficult to reflect in tariffs: if quality variations lead to differences in marginal production costs, they will not reflect by varying the volumetric charge.

There are a few ways to circumvent those constraints:

  • By adapting regulation: both poor consumers and operators would gain benefit of a regulatory framework that would allow large and small providers to compete to supply a range of services at prices that better reflect consumer willingness to pay.
  • By allowing alternative providers5 to take action. Regulation should acknowledge the role of alternative providers and leave them leeway to meet the needs of the poor more appropriately, while giving them incentives to enter the formal sector and upgrade their services in the long-run.
  • By allowing the main provider to deliver different quality levels to different customer groups: this possibility should be allowed in the quality specification imposed on the operator. In the case of concession contract, quality agreements and minimum standards can be monitored and enforced by the contracting parties and the regulator6.

In allowing for quality differentiation, regulators should nevertheless be aware of two potential pitfalls:

  • All operators should meet minimum quality standards requirements. The regulator would have to determine what minimum quality level to impose, and which aspects of quality are important. It includes nature of the product (impurities in water for instance), delays in obtaining the service, service reliability, and safety aspects. The next stage is to determine what trade-offs consumers are prepared to put on different aspects of quality and price, and to make sure that they have all relevant information to make informed choice (especially when it comes to public health issues).
  • Operators offering lower quality service should have an incentive to improve their offer. Exposing the “worst in class” has proven successful in pressuring utilities to provide better service to consumers.

 

Resources

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

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.

Resetting Price Controls for Privatized Utilities: A Manual for Regulators
 Washington, D.C.: World Bank, 1999, Chapter 8.
Green, Richard, and Martin Rodriguez Pardina

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

Utility Regulation: Regulating Quality Standards to Improve Access for the Poor Utility Reform
Note no. 219 in Public Policy for the Private Sector. Washington, D.C.: World Group, October 2000.
Baker, Bill and Sophie Trémolet

Electricity Service Quality Incentives Scoping Paper
Prepared for: Queensland Competition Authority, 4 July 2002.
Meyrick and Associates

Linking service levels to prices
 February 2002.
OFWAT

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

Access by the Poor in Latin America’s Utility Reform Subsidies and Service Obligations
 Discussion Paper No. 2001/75, World Institute for Development Economics Research, United Nations University, Helsinki, September 2001.
Chisari, Omar O., Antonio Estache, and Catherine Waddams Price

Footnotes

  1. Offering different quality of product and service to different group of consumers. Lower quality may reflect actual cost of service to low-income consumers and lead to varying prices that would save costs for operators and make the service more affordable to the poor (Ed.)
  2. See Quality of Service.
  3. See “regulated utility” in the glossary.
  4. For instance, a price-cap regulation would stop the operator of charging more when it delivers higher quality, therefore giving the operator an incentive to undersupply quality. On the contrary, a rate of return regulation would give an incentive to oversupply quality, since the firm will pass on the costs of higher quality to consumers.
  5. See “alternative electric supplier” in the glossary.
  6. See Quality of Service.