Reform and Regulation of Infrastructure By Shantha Jayasinghe (Research Officer- Institute of Policy Studies)

Reform and Regulation of Infrastructure

By Shantha Jayasinghe

(Research Officer- Institute of Policy Studies)

Issues in Infrastructure Importance of Infrastructure networks

Lack has effects on: Share of National Product and influence economic

growth Competitiveness of the economy Living conditions of the people

High ratio of sunk cost that deter entry Government Provision

Reasons: Government usually does not go bankrupt Public Goods

In Sri Lanka: poor quality and coverage

Infrastructure in Sri Lanka Electricity: Access- 74% of households Relatively high cost of electricity in Asia

Increased reliance on expensive energy

Telephone: Land or Cellular – 24% Firewood for cooking – 83% Well or Pipe-borne water - 62%(Source: Development policy review, WB and CBSL)

Comparison of Electricity Tariffs of ASEAN Countries (source: World Bank)

Sri Lanka Malaysia Singapore Thailand IndonesiaPhilippines Laos

Residential- low

Residential - high

Commercial - low

Commercial - high

Industrial - low

Industrial - high

Government Failure

Principal – Agent Problem“how to get the employee or contractor (Agent) to act in the best interests of the employer (principal) when the employee or contractor has an informational advantage over the principal and has interest different from those of principal”

Government

Principal – Agent Problem

People People’s Representatives

People’s Representatives

Board of Directors

Board of Directors

Employees

Private Sector

Principal- Agent Problem

Board of Directors Employees

Shareholders Board of Directors

Why are Markets better?

Decentralized decision making Maximize the benefits of resource

allocation Provide incentive for innovation Markets relatively better than

centralized decision making

Infrastructure Reforms

Key characteristics: Subject to elements of Natural

Monopoly

“Natural Monopoly” Vs. “potentially Competitive” segments in the market

Natural Monopoly “Natural Monopoly exists in a

particular market if a single firm can serve that market at lower cost than any combination of two or more firms”

Natural Monopoly exists because Economics of Scale: Producing more

units results in lower unit cost. Economics of Scope: Producing multiple

products together results in lower cost

Design of Market Structure

Separating out the natural monopoly

ElectricityGen 1 Gen 2 Gen 3

Transmission

Dist 1 Dist 2 Dist 3

Creating Competition

Competition in the Market : If it is cheaper and technically

feasible to have more than one provider:

Ex-post (After the event) regulation: Independent Competition Authority regulate anti- competitive behaviour

Creating Competition

Competition for the Market : Auction to force the potential

monopolists to compete with each other for the right to be the single supplier of a network:

Regulation is necessary Ex-ante (Before the event) regulation:

Sectoral Regulation by Independent Body

Creating Competition

Sector Non-competitive Component

Competitive Activity

Electricity Transmission & local distribution

Generation & supply

Telecom Residential telephony

Long distance, mobile, value added services

Water Water main and waste water

Collection & treatment

Air Services Airport Facilities Aircraft operation, maintenace facilities

Railways Track and signalling Train operation,

maintenance

What is Regulation (Ex-ante)?

Broadly defined as imposition of rules by government, backed by the use of penalties that are intended specifically to modify the economic behaviour of individuals and firms towards maximizing welfare

Why do we need to regulate?

Market Power Imperfect information Externalities Joint Provision and consumption

Externalities

A situation where the effect of production or consumption of goods and services imposes costs or benefits on others which are not reflected in the prices charged for the goods and services being provided.

Eg: Pollution

Regulatory Strategies

Command and control Where legal authority and the

command of law is used to pursue policy objective

Strength: Fixed standards set minimum acceptable

level of behaviour Force of law Seen as highly protective of public

Proposed customer protection performance standards in Electricity - PUCSL

Restoring Supplies after a fault: …..Minimum percentage of supplies to be connected within 2 hours.

All supplies to be reconnected within 24 hours

Regulatory Strategies

Weaknesses: Prone to capture Inflexible Expensive to administer Incentive is to meet standards, not go

better Complex rules tend to multiple

inflexibles

Regulatory Strategies

Regulatory Capture; The pursuit of the regulated enterprises’

interests rather than those of the public at large

Information AsymmetryRegulators require a good deal of information in order to carry out their functions Eg: Fix appropriate standards, price increases etc.“the operator knows more about its abilities and effort and about the utility market than does the regulator”

Regulatory Strategies Self Regulation

Self-regulation usually involves an organization or association developing a system of rules that it monitors and enforces against its own members

High commitment to own rules Low cost govern Rules may be self serving May not represent the interest of consumers

Regulatory Strategies Incentive Regulation “Provide incentive to behave the way that the

government wants” To deal with information asymmetries regulator can

design and implement incentive schemes that reward the operator for using its private information to achieve the government’s objectives.

How could it be done? Provide the operator with additional units of

something it wants – Eg. ProfitBut in turn, operator should give something to the government Eg. lower prices

Regulatory Strategies

Overall Price Level Regulation: Rate of Return Regulation Price Cap Regulation Benchmark or yardstick regulation

Rate of Return Regulation

Tariff = Cost of Production including Cost of Capital

No incentive to operate efficiently Operator may over-invest in

capital equipment

Price Cap Regulation

Permits a utility to increase its overall level of prices by the previous year’s rate of inflation (RPI) moderated by a percentage (X) that reflects the real cost reduction that the regulator expects.

RPI - X

Price Cap Regulation

Selling Price Rs 100 100Profit Cost of pro.

20

80

30

70

Regulatory Impact Assessment

RIA - explained

RIA is used: to assess the likely consequences of

proposed regulation, and the actual consequences of existing regulations

to assist those engaged in planning, approving and implementing improvements to regulatory systems

It is a technique for improving the empirical basis for regulatory decisions

It systematically and consistently examines potential impacts (benefits and costs) arising from government action

It conveys this information to decision-makers allowing them to consider the full range of impacts associated with a regulatory proposal

RIA - explained Continued…

RIA meets the following criteria for good policy-making

Minimizes regulatory capture Improves understanding of the

benefits and costs of government action

Improves transparency and consultation

Improves government accountability

Origin and Evolution of RIA

Formalized arrangements for RIA originated in the USA in 1975

In 1980, two additional countries were using RIA, Canada & Finland

In 1996, 20 out of 28 OECD countries were using RIA

Mexico and Korea provide two illustrations from middle income countries

Countries like Chile, China, Indonesia, Korea, Malaysia, Peru, Philippines, Thailand and Vietnam are also considering the implementation of RIA

RIA - the methodology It is a continuous process, which can

be seen to consist of three phases: Initial RIA – prepared immediately after

the policy idea is generated. Includes pros and cons of alternatives

Partial RIA – Initial RIA + Greater depth of consultation with stakeholders

Full RIA – Builds upon the information and analysis of the partial RIA, and the complete consultation process

RIA Process Identify the policy objective the issue that

intend to address Identify regulatory and non-regulatory

alternative options, including do nothing/base case

Consider the pros and cons of each option Identify who is affected, including business

sectors affected Equity and fairness Benefits and Cost analysis Flag up any potential unintended consequences Consider how to secure compliance

Discussion