Incentive Regulation: What are strategies for regulating state-owned enterprises with their unique information issues and strong links to government ministries?

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[Response by Sanford Berg and Carol Balkaran, May 2009]

Regulatory agencies establish incentives for performance, but they often have limited tools to deal with powerful (incumbent) SOEs. Information issues associated with SOE governance also apply to regulatory strategies. Information asymmetries characterize regulation, but when the firm reports to a powerful Ministry as well as to a new regulatory commission, the difficulties can increase. That is, in the case of a privately owned infrastructure firm, the license conditions may require that the firm provide information to the regulator. Unless such information requirements are made clear (for either ownership-type), the regulator is at a significant disadvantage. Benchmarking is one way to document relative performance, so that stakeholders are fully aware of historical trends, current patterns, and reasonable targets (based on quantitative analyses).

Responses to Incentives: Privately-owned and Publically-owned utilities respond differently to the same regulatory incentives. Berg, et. al. (2005) conducted a study of the Ukraine National Energy Regulatory Commission (NERC) Regulatory Scheme that involved two key elements:

The empirical results found that SOEs did not respond as effectively as private ones to incentives associated with reducing technical and commercial losses. Managers may not have been willing to confront the political pressures associated with dealing with non-payment and theft. It seemed that SOE were less motivated to increase cash flows due to lack of managerial motivation (low salary and minimal incentives). On the other hand, SOEs did not respond with in the same way as private firms to the incentives to inflate costs (arising from the cost of service—rate of return—regulation. Private distribution companies tended to inflate costs that could be passed through to consumers via (nearly annual) tariff increases.

Carol Balkaran (2008) identifies strategies for dealing with SOEs. The Abstract to her report states:

The primary incentive to reduce costs embodied in incentive regulation is the ability of service providers to increase their profit by so doing. Consequently, it may be argued that such a regime will be most successfully applied to utility service providers that are privately owned and operated. Utilities that are state-owned and controlled sometimes have very different objectives and it may be necessary to provide additional incentives and/or employ different mechanisms to ensure improved efficiency on the part of those utilities.

The paper explores some of the “tools” which can be used by a regulator in such circumstances. Including a heavier reliance on “sticks” within the regulatory framework, that is, setting tough targets, rather than “carrots”, that is, rewarding performance beyond the target level. Other possible “tools” include governance initiatives such as the establishment of a hard budget constraint and performance related pay. These “tools” have been used in several countries, both developed and developing with varying effectiveness.

Performance Targets (PTs) represent one of the most common tools used to incentivize performance. Some writers, including Mugisha et al (2006), believe benchmarking via PTs is the only tool that regulators have when regulating state-owned utilities. In the case of Trinidad & Tobago’s Regulated Industries Commission, in the review of rates for the electricity transmission and distribution utility special attention was paid to the establishment of specific targets in a variety of key operational areas. In the case of the water sector in Trinidad and Tobago, key areas of concern are likely to be the reduction of Non-Revenue or Unaccounted for Water, increasing the number of metered customers, and increasing the number of areas receiving a twenty-four hour supply.

There are other noteworthy examples of target setting. The Office of Utility Regulation (OUR) in its 2003 Determination for the National Water Commission (NWC) established a number of targets including the following:

  • Net receivables not to exceed 25% of revenues and bad debt provision to be 8%.
  • Employee costs not to exceed 35% of revenues (within two years of determination).
  • Unaccounted for water to be reduced to 55% by the end of fiscal year 2004/05 and thereafter by at least two (2) percentage points per year.
  • Collection rate to be 92% of billed revenues.
  • Water quality compliance to be 99% of the IJAM standards.

Targets are being utilized for Scottish Water and WICS (a UK equivalent for SOEs). The Water Services Regulation Authority (Ofwat) established the following targets for privatized companies in 2005:

  • Improvements at 227 water treatment works and replacement, relining or cleaning of 22,000 km of distribution mains to achieve compliance with drinking water standards.
  • Cleaner effluent from 1,043 sewage treatment works, and improvements to 2,005 intermittent discharges leading to less pollution of the environment.
  • A programme of nearly £1 billion to safeguard homes against the risk of sewer flooding was also approved. This was expected to resolve or mitigate every known high-risk problem of internal flooding from overloaded sewers by 2010. By then, the proportion of properties at risk is to be reduced to 0.01% of households.

The experience of the National Water and Sewerage Corporation (NWSC) of Uganda is instructive; lessons culled from that experience include:

  • Performance targets should be set in areas that enhance financial viability and operating efficiency. Targets should be easy to measure without creating conflict between the regulator/monitor and the operators.
  • Targets should be verifiable (to an extent) by customer perception surveys.
  • Reporting on process performance indicators can help firms identify trends that would lead to inadequate (and unacceptable) performance—leading to pro-active initiatives to correct the situation.
  • A balance should be struck between high effort-intensive targets and those requiring less effort. Thus, the monitoring framework should be structured so as to achieve knowledge synergies from different staff.
  • Performance incentives for staff should be formulated in conjunction with staff to determine what motivates them the most.

The role of Hard budget constraints were discussed earlier.

 

Resources

Incentivizing a State Owned and Run Utility to Improve Performance—Possible Tools for Use by a Regulator
Working Paper, Regulated Industries Commission (RIC), Trinidad and Tobago, 2008.
Balkaran, Carol

Regulating Government-Owned Water Utilities
Explanatory Note 6, Key Topics in the Regulation of Waster and Sanitation Services. World Bank, Washington D.C., 2006.
Castalia

Using Internal Incentive Contracts to Improve Water Utility Performance: The Case of Uganda’s NWSC
With Silver Mugisha and William T. Muhairwe, Water Policy, Vol. 9, No. 3, 2007, 271-84. PURC Working Paper.
Mugisha, et. al.

Regulation of State-Owned and Privatized Utilities: Ukraine Electricity Distribution Company Performance
with Chen Lin and Valeriy Tsaplin, Journal of Regulatory Economics, Vol. 28, No. 3, 2005, 259-287. PURC Working Paper.
Berg, et. al.