Prospects for Caribbean utilities under a new regulatory regime

1. Prospects for Caribbean utilities under a new regulatory regime Presentation to CARILEC 2001 CEOs Symposium Grenada 20-22 June, 2001 Basil Sutherland – Executive Director, CARILEC

2. Outline of presentation • Description of current situation and a review of how we got here – a review of regulatory history in the Caribbean • What are the developments worldwide? • Which of these developments are relevant to our context and region? • Are there any issues of particular importance to us? • What new regulatory arrangements are likely to evolve and how will these affect our businesses? • How do we respond to the proposals? • What are the future prospects?

3. Current regulatory practice in the Caribbean region • The structure of the industry and the regulatory arrangements are generally characterised by: • The existence of vertical monopolies • The existence of 20-50 year exclusive licenses • Except in only a few cases, no formal regulatory process that is open to public scrutiny is in place nowadays • Very few tariffs are incentive based – • Most utilities have cost-plus tariffs

4. Current regulatory practice in the Caribbean region ... • Virtually all tariffs have fuel recovery clauses but only very few of these also have – • heat rate targets • targets for transmission losses • customer service standards targets • benchmarks are not in wide usage • Although some have voluntary customer service standards, very few have such standards imposed in their licenses

5. How did we get here? • Generally – as far as tariff adjustments are concerned at any rate – the arrangements were not always like those existing nowadays • Several jurisdictions at one time had PUC legislation or other judicial or quasi-judicial processes to approve requests for changes in electricity tariffs

6. Difficulties with the earlier arrangements • These arrangements were eventually dispensed with in favour of the simpler arrangements which we now have • There are valid reasons why this happened – • Firstly, regulators in those days were often untrained, had little or no background in the sector and probably misunderstood their mandate • Secondly, utility commissioners often saw themselves solely as “defenders of consumer interests” and paid little attention to reasonable requirements of investors.

7. Difficulties with the earlier arrangements ... • Thirdly, and perhaps because of the first two reasons, the process was often exceedingly time consuming resulting in considerable “regulatory lag” • The result was that tariffs were at levels significantly below the marginal cost of supply and there was significant under-investment in the power sector • private investors were unwilling to invest if returns could not be assured • even governments themselves were loathe to invest capital in enterprises which did not provide a positive returns

8. - And some fixes ... • And because subsidies were often required, utilities operated on a hand-to-mouth basis and supply became unreliable and efficiencies deteriorated • In effort to mobilise fresh private capital for the sector, governments moved to simplify regulatory arrangements: • Repealed or allowed public utility commission legislation to fall into disuse • Granted licences which provide guaranteed rates of return on capital employed

9. - Yielding largely positive results ...However ... • Increased investments resulted – usually accompanied by increased rates – and most jurisdictions with private involvement in sector no longer suffer from significant shortages of capital • Over time, forgetting earlier period, governments and customers have now become dissatisfied with arrangements: • Perception now is that there is insufficient transparency • Driven largely by developments outside the region, perception is also that competition will improve service and lower prices

10. Most recent developments • Already – decisive action in telecommunications sector whereby OECS governments claim to have effectively eliminated monopoly in telecommunications previously enjoyed by Cable and Wireless • Recently also public statements from from government officials in the OECS region talk about the need to eliminate as far as possible monopoly enjoyed by electric utilities by the introduction of various forms of competition.

11. Most recent developments ... • Governments of OECS sub-region have enlisted the support of the World Bank to assist them in evaluating the issues • Workshop convened during March 2001 and attended by two (2) OECS ministers and several officials and examined several issues related to regulation • The intention appeared to have been to examine possibility of approaching power and water sector regulation as a regional enterprise as OECS had managed to achieved with ECTEL in the telecom sector

12. Most recent developments ... • The workshop discussed concepts and issues such as: • The rationale for setting up regulation • The role of the regulators: economic, environmental, quality of service etc. • Different functions of regulation • Gains/benefits of regulation • Instruments for effective regulation • The role of benchmarking • Tariff structures • Universal service obligation • Concession design

13. Most recent developments ... • There appeared to be consensus among the officials that increased competition would assist in regulating prices • The conclusion of the meeting was that the participants wanted to work towards establishing revised regulatory arrangements for their various jurisdictions which would probably allow competition in certain areas, that a regional approach was possible and probably desirable, but that much more work needed to be done before a final position could be arrived at

14. Is competition feasible in the context of the Caribbean? • The type and level of competition which is foreseen by the officials, however, may not be feasible • Small-scale economies face the greatest obstacles in achieving true competition: • Power markets of the type in the U.K. and Chile are not feasible – even where technology might allow for competition, the market is often seen as too small by potential entrants • Increased transaction costs also likely to offset many of the gains which would derive from competition

15. Where and how could such competition take place? • However, some competition appears to be feasible on the larger systems by the introduction of Independent Power Producers (IPPs) and probably open access transmission • IPPs could compete for market entry – but again, high transaction costs could be a major disadvantage, and the requirements of their financiers – often government guarantees of one form or another – could present significant barriers to their entry into the market

16. Where and how could such competition take place? • Transaction costs are not insignificant: • It is estimated that the first IPP venture in Jamaica incurred costs amounting to well over US$2.0 million for legal fees alone • The conclusion appears to be that the scope for meaningful competition at the supply level is very limited – although in the operations of utilities, more competition in procurement and the competitive outsourcing of certain non-core functions such as metering and billing have the potential to lower costs

17. Conclusions on competition • Market liberalisation therefore appears to have only limited scope in Caribbean – and if this is so, introduction of supply level competition can not be used as a reliable method of minimising cost of service to the customer • where competition is not possible, regulation may be required to: • protect consumers by attempting to approximate market value of service • protect utilities by allowing them to anticipate a sustainable return on their investment

18. Sector regulation If the long-term viability of the sector is to be assured, the regulatory arrangements that evolve, apart from guaranteeing that consumers are protected, will at the same time need to ensure that returns to investors are in line with the financial risks encountered in fulfilling their “obligation to serve”

19. Regulatory issues and options • If utilities do not succeed, everyone loses – consumers, investors and government. Utilities are special companies in which are wrapped up more of the national good than probably any other enterprise apart from government itself • The utility will need to be regarded as a public/private partnership rather than a purely private enterprise – even if it is privately owned

20. Regulatory issues and options ... Principles and processes matter because potential investors are looking for signs of regulatory independence and signals that policies are based on a comprehensive analytical framework rather than on the whims of individuals

21. Regulatory issues and options ... The art of regulation involves establishing rules that allocate value to consumers and suppliers in such a way as to maintain incentives for the firm to create value, while promoting political legitimacy in the eyes of consumers and other stakeholders

22. Regulatory best practice 1. Communication (information to stakeholders on a timely and accessible basis) 2. Consultation (participation of stakeholders in meetings) 3. Consistency (across market participants and over time) 4. Predictability (a reputation that facilitates planning by suppliers and customers) 5. Flexibility (by using appropriate instruments in response to changing conditions) 6. Independence (autonomy—free from undue political influence) 7. Effectiveness and Efficiency (cost-effectiveness emphasized in data collection and policies) 8. Accountability (clearly defined processes and rationales for decisions, with appeals) 9. Transparency (openness of the process)

23. Regulatory best practice • Coming out of the best practice prescriptions, is also a requirement that whatever arrangements and structures are put in place, the system is able to respond quickly • Regulatory lag must be minimised in order to: • ensure the financial health of the utility – and in the long-term; • protect the security of supply and consumer interests by ensuring that expansion plans are not delayed because of financial uncertainty

24. The spectrum of regulatory independence HIGH Full autonomy with full decision-making authority – U.K., U.S., Mexico Full autonomy, but appeals to minister - Argentina Autonomy, but only advisory to minister - Hungary Semi-autonomous – ministers on regulatory body - Columbia Regulatory Independence Regulatory Risk HIGH Source: After World Bank

25. Government Regulator Utility Consumers Ideal regulatory independence Prevent unsustainable tariffs Prevent rent seeking Source: After World Bank

26. Regulatory governance, incentives and performance Source: Public Utility Research Centre University of Florida

27. Regulatory structures • What Type of regulatory arrangements would best be able to fulfill the requirements of “best Practice”? • Before regulatory structures can be decided on, government’s objectives will need to be clarified – they will first need to ask themselves whether their objectives include items such as: • expansion of service coverage • improvement of quality of service • lowering of prices to consumers • reduction of government’s fiscal burden

28. Regulatory structures ... • To avoid “regulatory lag” – necessary to have system which responds quickly • Popular types of incentive-based regulation which could respond quickly are price caps and modified ROR: • Price cap – (RPI-x) models • Rate of return with incentives for exceeding targets – and penalties for failing to meet them • Former requires much skill on part of regulator to set x-factor • Later requires good benchmarking data to set incentive targets

29. Regulatory structures ... • RPI-X form of price control has advantages over profit regulation • However, the RPI-X approach tends to place an undue emphasis on the periodic review process, perhaps to the detriment of incentives for continuous improvement • The periodicity can create distortions in the incentives over the duration of the price control. These occur if the reward a utility receives for making an efficiency improvement is perceived to vary depending on the timing of the efficiency improvement.

30. Regulatory structures ... • For example, the utility might have the opportunity to take an action to reduce operating costs in the last years of a price control. However, the company might then expect to receive the benefit of this cost reduction for only a short period of time because it assumes that in setting the next price control the regulator will reduce prices to share this efficiency benefit with customers • This might encourage the company to delay actions which could improve efficiency until the start of the next price control period

31. Regulatory structures ... • Another form of incentive based regulation which may be appropriate is a modification of the ROR arrangements which would provide incentives to the utility for better than expected performance – and penalties for poorer than expected performance • Targets could be set by benchmarking best practice and involve such areas as – • Line loss targets • Targets for heat rate performance • Customer service standards

32. Likely direction and scope of future regulatory efforts • Policy makers need to be reminded that competition is not an end in itself – it is the means to an end. Competition should not, therefore, be the goal of any electricity industry restructuring. The goal should be reliable, universal service to customers at the lowest rates which are sustainable – and we must all be careful not to lose sight of that • If we all keep this in mind, we will probably avoid making costly mistakes when devising the new structures and developing new regulatory arrangements for the power sector

33. Likely direction and scope of future regulatory efforts ... • Assisted by international organisations such as the World Bank, the tendency in the region will be for governments to appoint full time professional regulators who are well qualified and trained in regulatory principles. • Such regulators are likely to be guided by solid economic principles and relying on benchmarks, will probably demand: • Optimum system reliability • More efficient use of capital • Increased labour productivity

34. Likely direction and scope of future regulatory efforts ... • Regulators will probably begin requiring that expansion plans be submitted to them for prior approval – • they will justify this on the ground that, as the capital requirements for such expansion will form the basis for the utility’s compensation under ROR tariff arrangements, their duty to protect the consumer requires that they ensure that capital is being efficiently employed

35. Likely direction and scope of future regulatory efforts ... • Likely to see the introduction of customer service standards which will propose both voluntary standards and guaranteed standards whereby the utilities are required to compensate the consumer for failure to meet guaranteed standards

36. Likely direction of future regulatory efforts ... • Regulation will probably be carried out on a regional basis, commencing with the OECS countries – and in time, widened in scope and scale to include other utilities and, probably less likely, other countries • Governments/regulators likely to be less heavy-handed than in the earlier period, but still likely to insist that now well established cost-plus rate of return reward systems give way to incentive-based systems some of which discussed earlier

37. How do we respond to these developments? • We can stymie many of the worst aspects of regulation and prevent it from becoming too intrusive if we voluntarily set about: • Becoming more open in our dealings with the public – this will obtain more buy-in from the public and generate more trust with regulators • Publishing our expansion plans and be prepared to defend them in the public domain • Establishing more transparent procurement procedures – this will provide greater comfort to the public that they are not being asked to pay higher tariffs because of inefficient supply chain management • Establishing more proactive public information departments to provide information to the public before they ask for it

38. How do we respond to these developments? • Caribbean utilities will need, as a group, to keep a watching brief on the development of regulatory policy and mechanisms in the OECS sub-region and elsewhere in the region, as such developments are likely to influence policy formation everywhere • If regulation is to be region-wide, it will also probably be better for the utilities to exert influence in the development of policy and regulatory regimes acting as a group, because such group intervention is likely to be perceived as more objective and less self-serving than individual efforts mounted in each jurisdiction.

39. What are the prospects for the future? • We should begin by assuming that nothing that we can do will forestall the implementation of new regulatory regimes for an indefinite period – but what we can do is to influence the development • If we take a proactive stance and undertake some of the suggestions about increased openness discussed earlier, the future prospects will be very good – and we will avoid one of the worst pitfalls of regulation – that of the breakdown of trust between the utility, the public and the regulatory authority

40. What are the prospects for the future? • We have to act quickly to influence the proceedings and so avoid the regulatory pendulum swinging too far in the direction of control. Over-regulation will involve all of us – regulator and utility alike – in a lot of unnecessary work and in the end, it is our economies and customers who will be the losers. • We should, however, be confident in the knowledge that a trained regulator understands that his job is more about arbitrating the interests of consumers, investors and government than it is about protecting consumers.