Reform and Regulation of Infrastructure

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

2. 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

3. 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)

4. Comparison of Electricity Tariffs of ASEAN Countries (source: World Bank) Laos Thailand Philippines Indonesia Malaysia Sri Lanka Singapore Residential - low Residential - high Commercial - low Industrial - low Commercial - high Industrial - high

5. 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”

6. Government • Principal – Agent Problem People’s Representatives People People’s Representatives Board of Directors Board of Directors Employees

7. Private Sector Principal- Agent Problem Board of Directors Shareholders Board of Directors Employees

8. Why are Markets better? • Decentralized decision making • Maximize the benefits of resource allocation • Provide incentive for innovation • Markets relatively better than centralized decision making

9. Infrastructure Reforms • Key characteristics: • Subject to elements of Natural Monopoly • “Natural Monopoly” Vs. “potentially Competitive” segments in the market

10. 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

11. Design of Market Structure • Separating out the natural monopoly • Electricity Gen 1 Gen 2 Gen 3 Transmission Dist 2 Dist 3 Dist 1

12. 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

13. 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

14. Creating Competition

15. 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

16. Why do we need to regulate? • Market Power • Imperfect information • Externalities • Joint Provision and consumption

17. 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

18. 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

19. 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

20. Regulatory Strategies • Weaknesses: • Prone to capture • Inflexible • Expensive to administer • Incentive is to meet standards, not go better • Complex rules tend to multiple inflexibles

21. Regulatory Strategies • Regulatory Capture; The pursuit of the regulated enterprises’ interests rather than those of the public at large • Information Asymmetry Regulators 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”

22. 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

23. 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. Profit But in turn, operator should give something to the government Eg. lower prices

24. Regulatory Strategies Overall Price Level Regulation: • Rate of Return Regulation • Price Cap Regulation • Benchmark or yardstick regulation

25. Rate of Return Regulation • Tariff = Cost of Production including Cost of Capital • No incentive to operate efficiently • Operator may over-invest in capital equipment

26. 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

27. Price Cap Regulation Selling Price Rs 100 100 Profit Cost of pro. 20 30 80 70

28. Regulatory Impact Assessment

29. 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

30. 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…

31. 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

32. 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

33. 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

34. 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

35. Discussion