1.1 Let’s Start with Some Intuition
Every time you turn on the light, take a shower or ride on a train, you are using a regulated service. Do you ever wonder how it gets funded? Are you paying for this service as a user or are you paying as a taxpayer? For sure, someone has to pay for it. Whether the service is funded by users or taxpayers, it has to raise enough revenue to ensure it is financially and/or fiscally sustainable. But revenue cannot be the only dimension against which these prices should be assessed. The price should also send the right signal to users. If the price you pay for water is too low, you are likely to stay longer than necessary under the shower. And if the price is lower than the costs involved then water companies may not have a strong incentive to invest. This might not hurt you in the short run, but it could eventually result in water rationing. Farmers may not be able to irrigate enough and as a result food prices might increase. Equivalently, if the price of public transportation is too high or there are no tolls on highways, you may prefer to use your car. Air pollution is likely to increase as a result. And if the price of water or electricity is set high in order to get people to consume less, that may exclude some poorer users, who need the service as much as the richer users (think of water).
Clearly, getting the price right is not simple (and it is even more complex when subsidies are an option to finance the service). Adding to these dimensions the strong role of monopolies (or quasi-monopolies) in the production and delivery of these services explains why, in most countries, electricity, water or transport prices tend to be subject to regulation by the government or a regulatory agency.Footnote 1 How theory argues this regulation should be done and how policy experience suggests it can be done is what this book is all about. In the rest of this chapter, we look in more detail into each of these dimensions before revisiting some of the intuitions more conceptually in the following chapters.
1.1.1 Every Time You Turn on the Light, Take a Shower or Ride on a Train, You Are Using a Regulated Service
Significant investments are needed to allow you to use these services. A firm, public or private, has to invest in the facilities needed to produce the electricity and then rely on transmission lines to bring it close to your location. A firm, maybe another one, has to maintain the local delivery lines to your home to allow you to plug in your phone or laptop safely when it suits you. The water you use to take your shower or to drink has to be pumped from ground sources or rivers. Before you use it, it has to go through expensive treatment facilities to make it safe for consumption. Then it is channelled to your home, often from quite far away, through large pipes which have to be maintained and repaired regularly. Similar investment and maintenance needs apply to the train stations and tracks. The point is that most of the regulated services you enjoy are heavy users of capital and labour and other basic inputs to ensure their operation. Many are also set in public space and rely on complex planning and coordination between the various users of shared public assets, which can include air, land and water assets.
1.1.2 Someone Has to Pay for the Regulated Services
The investment, maintenance and operating costs of regulated services are significant in most circumstances.Footnote 2 These cost levels, however, do not only depend on the cost of the physical inputs. Because these services involve long-lived assets amortized quite slowly, they are particularly sensitive to financial costs associated with long-term borrowing requirements. The expected return for public or private banks or investment funds providing or lending the capital is an important cost driver in these activities. These costs show up, somewhere, in the price paid by users or in the subsidies the government needs to allocate to the sector.
If, on average, the price paid by users fully recovers these costs, it is essentially a user fee. But in many of the sectors providing services of public interest, the price is often set below costs. In that case, subsidies are needed and these are financed by current taxes or public sector borrowing (i.e. future taxes).Footnote 3 For instance, in most countries, rich or poor, the investments made to ensure that we all have access to water are usually largely paid for by current and future taxpayers rather than users. The price we pay often only covers the costs of operating and maintaining the assets. It seldom recovers the amortization of the investments made. Even more rarely does it reflect the scarcity value of water, which, in an ideal world, should be accounted for in the price we pay for these services. Such formal or informal subsidies make these services more affordable. But, as will be discussed in various chapters, while they are well intended, and certainly necessary for the poorest populations, they also tend to lead to overconsumption by users who do not face the real cost of their consumption and this adds to the demand for underfunded investment.
1.1.3 The Price Paid Needs to Account Jointly for Financial/Fiscal Viability, Efficiency and Equity Concerns
Regulated prices have multiple purposes. Combined with subsidies, they are essential to ensure the long-term economic, social, financial and fiscal viability of the service. The discussions between regulators and regulated firms tend to focus on the role they have in the determination of the financial returns to public or private investors and the residual costs to taxpayers if subsidies are needed. Regulators, and increasingly many stakeholders in civil society, also spend (or at least should spend) time analysing the role of prices in signalling the effects of consumption decisions on the use of natural resources. Many stakeholders think as well about the impact of prices on the affordability of the service, to avoid penalizing the poorest users. Moreover, many analysts highlight that prices have to be fair to tomorrow’s stakeholders. It is indeed easy to forget – or to choose to forget! – that if investment is not made today services will not be available tomorrow. From a financial perspective, the prices need to ensure that the investors get a return consistent with the risks they are taking – accounting for subsidies. And from a fiscal perspective, they need to deliver on many policy responsibilities, including accounting for the distortions associated with the need to raise taxes to pay for subsidies, as will be discussed in some detail in subsequent chapters.
Ideally, prices should also account for the difference between the social return and the financial return from the regulatory decisions. For instance, the net costs of environmental externalities should be reflected in the price of the services you are consuming if they are not subject to a specific tax. This is seldom the case. This explains, for instance, why it is still much cheaper to travel short distances by plane than by train.Footnote 4 In a nutshell, getting the price right implies addressing the often conflicting concerns of many different stakeholders, including some that are yet unborn.
1.1.4 Pricing Is Influenced by the Strong Role of Monopolies in These Industries
Ensuring that the price of a service accounts for all these concerns would be challenging in any market, but it is particularly hard for industries in which the services are often best provided by local, regional or national monopolies, as is the case for many of the regulated public services. Monopolies are a source of concern if they enjoy enough discretionary margins on their production decisions to underprovide quantity and/or quality and to overcharge. Monopolies also enjoy an informational advantage over all other stakeholders that they can use to influence the setting of prices or quantities to their benefit. For instance, they know more about their actual costs, and their potential cost savings from changes in technologies or improved management efforts, than consumers do. They can use the informational advantage to inflate their costs report and hence secure higher compensation for their services than they deserve, as a way of increasing their profits.
Regulation needs to arbitrate between all these concerns, and it is not simple. It has to account for the fact that not all participants have access to the same information and that the abuse of market power is a serious threat in these sectors in most countries. This is why, historically, the price of basic services has usually been, directly or indirectly, controlled by the State in some form. In other words, this is why the prices charged by monopolies are typically being regulated. Regulation is needed to minimize the risks that the de facto power a firm has over a market is not abused to the disadvantage of users (domestic and industrial) or taxpayers.Footnote 5
1.1.5 What Does Regulation Deal With?
Ultimately, in very broad terms, regulation could be defined as a policy tool used to ensure efficient price, quantity and quality outcomes in utilities services that are fair to all stakeholders when markets on their own fail to do so. And this applies whether the tool is implemented by a national, regional or local public authority. In practice, regulation ends up being an essential policy tool. To make the concept as practical as possible, it may be useful to point to some of the most basic questions it is expected to address when competition is limited:
What is a fair price?
How can a price possibly be fair to all stakeholders?
Should it be based only on the level of costs claimed by the service providers?
Is the cost data reported by the firms the right one to compute the price?
How much margin is there in adjusting quality to influence cost levels and hence prices?
How are prices, subsidies and expected returns connected?
How well are social concerns and externalities accounted for in prices?
How is investment taken into account in short-term regulation?
How much does the nature of consumers and investors matter to the way prices are set?
Should regulation be implemented by the government or by an independent regulator?
Should regulation be local, national or international?
Does the prevalence of corruption in a country influence the answer to these questions?
More generally, is the answer to these questions the same for developed and developing or emerging economies?
By the end of the book, you should have an informed view on how to address each of these essential questions because the economic theory of regulation offers answers, or at least guidance, on how to deal with them. In many cases, there are various ways of answering any of the questions. In each chapter, we summarize the options available to regulators suggested by theory and practice, as well as the limits of our collective knowledge on these issues, and therefore the need for future research.
1.1.6 The Choice of the ‘Optimal’ Regulation Also Depends on the Institutional Context
The degree of adoption of technical guidelines and rules derived from theory varies significantly according to the specificities of the informational, institutional and political environments in which regulatory interventions have to be designed and implemented. The preferred approach to regulation depends on the extent to which countries trust markets and institutions involved in the design, financing, implementation and enforcement of regulation. When trust among consumers, taxpayers and firms is strong, rule-based regulation tends to prevail over politically driven regulatory decisions. When trust is weak, political solutions tend to prevail over technical rule-based decisions, often deepening the distrust of many stakeholders.
The option to be somewhat flexible with rules may be useful when significant economic shocks such as brutal devaluations, changes in interest rates or social crisis hit a country, making extreme policy reversal such as renationalization less likely. But it also makes the regulatory process much more subject to political interference and sensitive to electoral cycles. For instance, a change in government can lead to price freezes resulting in financing gaps despite commitments to cost recovery made by the previous political administration. This is what happened in 2001 in Argentina, for instance. It led to legal battles between the government and service providers that were sorted out by international arbitration courts, sidelining national regulators and overruling previous regulatory commitments.
The dual characterization of countries between rules versus discretion is clearly extreme. Many countries sit somewhere in the middle of the trust ladder and of the scope for discretionary leverage to change rules. Moreover, regulatory preferences can be a moving target as they tend to evolve over time with the political context. But as discussed throughout the book, the risk of abuses resulting from the difficulty of achieving full protection of regulators from undue political interference is serious in any country.Footnote 6 When regulators are not independent and free from political pressure, they can indeed be pushed to adjust to changes in political preferences.Footnote 7 This is true whether the country is a young, unstable democracy or an old, established one.
Some of the instability of regulation is the result of ideological fads. For instance, less than thirty years ago, when the privatization wave started with the British reforms, nobody focused on the fact that the privatization of a public electricity or railway company could actually mean the acquisition of a national public enterprise by the public enterprise of another country.Footnote 8 Hardly anyone really worried about this possibility in the 1990s when Prime Minister John Major cleared the transformation of the sector. In 2019, in a context in which the British population had voted to exit the European Union and the perceived German influence on the region, the fact that Deutsche Bahn (DB), the national German railway company, controls five British rail services (through its Arriva subsidiary acquired by DB in 2010) had become an issue in regulatory discussions.
In addition to the effects of ideological swings on preferences, there are also more technical reasons why countries may differ in their choice of design and practice of regulation. For instance, size matters. Mali’s regulatory challenges are quite different from those Brazil has to address. And those Portugal must deal with are quite different from those of the United States, Canada or Australia. In other words, the regulatory needs and constraints of a small market are not the same as those of a much more complex large market in which regions have a lot of autonomy to decide on how they regulate. Market size defines the distribution of regulatory responsibilities across government levels and sometimes across government agencies within the same government level. Market size defines the margin a country has to attract domestic and international private financing. It also often impacts the level and composition of demand. Differences in income levels may explain differences in the willingness to pay versus the ability to pay and demand different regulatory designs. Circumstances and context clearly matter too, as illustrated throughout the book. But before getting into the technical details of what can be learned from economic theory and policy practice, it is useful to set the stage in broad terms.Footnote 9 That is the main purpose of this first chapter.
To complement the intuitive discussion, we provide some basic statistical information on the relative and absolute economic importance of infrastructure industries to show how large the stakes are in terms of affordability, investment needs and associated costs across the world. Next, we summarize the main case for regulation made in the economic literature. This is followed by a first discussion of the continuous gap between the theory and practice of regulation and the need to reconcile the two more systematically to account for a more realistic sense of what regulation can and should deliver. The need for more pragmatism in the development of theories and a faster adjustment capacity is reinforced by a brief discussion of the evolution of the context in which regulation is expected to deliver, suggesting that theory continues to lag behind rather than lead real-world discussion on some key issues. The chapter concludes with an overall presentation of the content of the book and a discussion of how it can be used in different ways by the diversified audiences interested in regulation.
1.2 Some Basic Statistical Evidence on the Importance of Regulated Services
One of the main challenges for the design of regulatory policy is the need to work with partial or incomplete data on the various economic characteristics of the sector. It is, indeed, often only when frequency and duration of traffic jams explode, when a bridge collapses or when there is a significant power outage that additional audits are conducted to collect the data that would have helped identify the risks of technical failure well ahead of the incident. Despite these limitations, there is enough data collected by national governments and international organizations to demonstrate that the services provided by regulated industries are economically, socially and politically important. For instance, we know how much consumers spend on infrastructure services – that is, the sum of expenditures on electricity and gas, information and communications technologies (ICT), transport (including ownership of vehicles, their use and the use of public and private transportation) and water and sanitation (W&S) services. We also have a good sense of how much countries actually invest against how much they need to invest in these activities to sustain growth and meet demand. Any of these indicators illustrates the importance of these services and can be used to highlight the role of regulation in the effective delivery of public services. In what follows we focus on household infrastructure expenditures and investment in the sector.
1.2.1 How Much Do We Spend on Infrastructure as Consumers?
This is an important question, as how much we spend on a regulated service is one of the core indicators used to assess the extent to which regulation accounts for social concerns. It turns out that we all spend a lot on these regulated services and that some income classes end up spending a lot more than others in relative terms, as will be discussed in detail in Chapter 9.
In 2017, on average, depending on where we lived, between 16% and 26% of our total consumption expenditures went to pay for infrastructure.Footnote 10 For developed economies, the differences across countries varied from around 16% for Australians on average to around 25% for American and European households. Canadians were closer to Europeans at about 22%. For developing, emerging and transition economies, the range was somewhat narrower than for developed economies. The average household spend on all infrastructure services was between 16.3% in South Asia and 21.7% in Latin America.
For a vast majority of families, this is a significant share to allocate to services that are hard to compress, in particular for the middle- and lower-income classes. This is also a big part of the reason why these services are so politically sensitive at all stages of development. To make this relevance as concrete as possible, think of what it would mean if the costs of these services were cut by, say, 10–20% because regulation managed to make the service providers become more efficient. It would be equivalent to an increase in the total purchasing power of families of 1.5–5%. This is significant and can come from various sources, ranging from improvements in the management of regulated companies leading to cuts in operational costs to the adoption of cheaper technologies. Chapter 10 will show that the equity payoffs of these efficiency gains can make a difference to the political viability of regulatory reforms, but this requires a design of regulation which ensures that the gains are shared fairly. The basic data on expenditure shares allocated to regulated services suggests that the efficiency–equity trade-off should be a core focus of the design of regulation at all stages of development.
To get a more precise sense of the relative importance of these trade-offs across sectors, it is useful to take a look at the disaggregated expenditure data. Once again, the most obvious observation is the strong heterogeneity across countries and regions. Nevertheless, it is on transport (including all expenditures linked to vehicle ownership) that people spend the most. In developing, emerging and transition economies, on average, in 2017, households spent from 6.7% of their income in South Asia to 12% in Latin America on this sector. Energy absorbed from 4.5% of the household expenditure in Sub-Saharan Africa (SSA) to 6.9% in Eastern Europe. ICT expenditures vary from 3.2% in Sub-Saharan Africa to 4.4% in Eastern Europe. Finally, W&S absorbs from 0.4% of income in South Asia to 1.5% in the Middle East.
In developed economies, the patterns were somewhat different. As in the rest of the world, transport dominates with on average 10–11% of household expenditure but the share spent on energy is also quite significant. In Europe, for instance, it stands on average at 7.5%. And the share spent on W&S in this region is also much larger at about 4%. At 3–4%, Europeans’ expenditure on ICT is closer to the figures noted in poorer regions. Australia is somewhat of an outlier since its households spend on average only about 1.2% of their disposable income on W&S, 2% on energy and 2.2% on ICT (it is in the average range for transport at 10.2%).Footnote 11
Table 1.1 summarizes these figures to make the comparison across country groups and sectors easier. If the shares noted in developed economies serve as a leading indicator of what is the likely evolution of expenditures in developing and emerging economies, the demand for energy and water should be expected to grow the most. This is consistent with the evolution of demand resulting from the fast-emerging middle class in these regions. This is not a minor concern in practice since both are central to the debates on the environmental sustainability of growth.
Table 1.1 Order of magnitude of share of total household expenditures in infrastructure services
| Total infrastructure (%) | Electricity and gas (%) | ICT (%) | Water & sanitation (%) | Transport (%) | |
|---|---|---|---|---|---|
| Developed economies | 16.2–26.5 | 2–7.5 | 2.2–4 | 1.2–4 | 10–11 |
| Developing and emerging economies | 15–25 | 4.5–6.9 | 3.2–4.4 | 0.4–1.5 | 6.7–12 |
Regulation is not neutral to the evolution of these shares and what they imply for the environmental sustainability of household infrastructure consumption. The expected evolution means that the regulatory pressure is likely to have to adapt, and possibly increase, as demand management becomes a necessity, unless new resources and technology solve the problem. For now, the most likely scenario is that demand is going to be rationed unless regulators come up with politically sustainable ways of managing it. In Europe, the European Commission has been pushing for a national regulator to take on the challenge. In all cases, regulated prices (including subsidies) and the definition of harmonized standards will be central to the solution but there is evidence that not all countries will adapt at the same speed. In the USA, states differ in the pace at which they adapt, mainly based on local needs. For instance, California has a long tradition of being ahead of other states in testing and mainstreaming regulatory innovations to improve the sustainability of water and energy consumption, simply because these resources are scarce locally. States with more abundant resources are less keen on using regulation for conservation and optimal rationing.
Overall, while the data reviewed so far is useful to highlight the social and political relevance of regulation, it ignores some of the other concerns that regulators must address. One of these is the impact of regulatory decisions on investment levels. It is frequently the case that the apparently high costs stated by regulated firms hide higher profit margins allowed by creative cost accounting and corporate financing practices. This implies that getting a firm, public or private, to cut costs is equivalent to cutting its profits. If, in the process, the efficiency gains demanded by regulators cut too much into these profits, its incentive to invest or its ability to do so may also decrease. Unless this can be compensated by subsidies, service coverage and quality may drop. This is why it is also important to track the evolution of investment, subsidized or not.
1.2.2 How Much Do Countries Invest in Infrastructure and How Much Should They Spend?
Tracking investment is needed to assess the extent to which there is a fair regulatory treatment of current and future generations of consumers. Regulatory decisions designed to protect the weakest users in the short run may not always have the intended consequences in the long run. This can be avoided in the design of regulation. For now, however, the investment data available at the global level suggests that there is a regulatory failure. Investment in many regulated industries is lagging demand in most countries of the world. This lag tends to penalize the poor in the short run and all users in the longer run.
Consider the case of infrastructure investment.Footnote 12 Since the mid-2000s, a large number of estimations conducted by consulting firms and multilateral organizations such as the World Bank and the regional development banks suggests that investment levels have ranged from less than 1% of GDP in some of the most developed economies to 10% in some of the developing countries with the lowest initial infrastructure asset stocks or with the strongest commitment to develop their capacity (notably China). The levels for most developing countries are actually much lower: their infrastructure investments are estimated at about 4% of GDP on average. In most cases, these figures are well below what is needed to meet the demand for these services that is expected to come from economic growth. These needs are summarized in Table 1.2. The growing middle class in developing and emerging economies may not get what it wants even if it is willing to pay for it. This is why it is important to make sure that the incentives to invest to meet the growing willingness to pay are one of the mandates assigned to regulation.
Table 1.2 Annual investment needs per sector and country group between 2020 and 2035 (ranges as share of GDP)
| Total infrastructure (%) | Electricity (%) | ICT (%) | Water & sanitation (%) | Transport (%) | |
|---|---|---|---|---|---|
| Developed economies | 3–7.5 | 1–2.5 | 0.5–1 | 0.5–1.5 | 1–2.5 |
| Developing and emerging economies | 7–12 | 3–4 | 0.5–1.5 | 1–1.5 | 2.5–5 |
The regulatory challenge is not minor. According to the World Economic Forum, if investment trends follow the current paths, the world is expected to face a US$15 trillion gap in infrastructure investment by 2040.Footnote 13 That is close to 20% of the world’s GDP in 2018 to be spread over a twenty-year period, with much higher gaps in the figures for developing regions than for OECD countries. But this does not mean regulators in the OECD should not worry about investment. Many OECD countries are relying on outdated water pipelines, excessively polluting energy sources and transport networks biased against shared mobility. For now, they are also rationing investment and hence future consumption of these services. In most countries, governments tend to underestimate the importance of the costs of operating and maintaining the assets. Without maintenance, services will usually fail to match the level promised at the time the investment was made. And in some cases, the consequences can be quite dramatic, including killing people, as when trains derail, flood walls break or bridges collapse.Footnote 14 When prices are too low, maintenance falls, as discussed in Chapter 9. In many countries, the maintenance budget should be as high as the investment budget on an annual basis if service standards are to be met.
This insufficient investment and maintenance performance at the global level, and across country types, illustrates how decisions tend to be biased towards the short run rather than the long run. And this has an impact on regulatory preferences. Political preferences focus attention on the price level of public services and/or on the subsidies going to the sector, instead of focusing on the need to increase revenue to pay for investment. Such short-term preferences can translate into indiscriminate efforts to cut costs. This is also politically attractive since the consequences of poor maintenance tend to have to be addressed much later, possibly by other political administrations. From a technical viewpoint, the bias also reflects an underestimation by many regulators of the scope to rely on creative pricing, and subsidy design options, to deliver pricing strategies that are both politically and financially sustainable. These options are quite well established in the academic literature and some countries have been open to adopting them, as discussed in Chapters 7 and 8.
Without a regulatory mandate to push firms (whether public or private) to make the right investment decisions and regulatory decisions that ensure the proper financing of investments, neither public nor private firms are likely to make them. This is particularly damaging in countries where the poorest are excluded from service due to the lack of investment, as illustrated by the low access rates in low-income countries. For now, while high-income countries enjoy access rates close to 100% for electricity and for W&S, SSA stands at less than 40% for electricity, 68% for water and 30% for sanitation. And it is the wealthier households that have access to the public utilities services. On some dimensions, the poor regions of rich countries are just as bad as some of the poorer countries. For instance, access to safe sanitation is a problem for every one of the poorest regions of the world, including within Europe.
In developing countries, these gaps mean that when international organizations make the case for investment increases, they are pushing for regulatory fairness in the treatment of all citizens. But the call for change has not been having much impact in national political circles. Many governments are keen to promise change, but few are taking the investment and regulatory decisions that will make a sustained difference in a wide range of regulated industries. This is why the case for market-based financing solutions continues to be popular. While the evidence shows that hardly more than 10% of the needs are eventually financed by private sources, the promise and the partial efforts buy time and reduce the need to wait for fiscal support.
A similar conclusion could be reached from a diagnostic of the actual financing of the significant investment needed to implement the energy transition in most OECD countries. As of 2019, for instance, few countries had voted in climate change laws that would trigger adjustments in the regulation of the sector in a structured way, accounting for the needs of both future generations and today’s poor. The regulatory tools are there, as will be shown throughout the book. This lack of action often reflects strong political constraints. For instance, the attempt by the French government in 2018 to increase the price of petrol and diesel in order to reduce its use and fight global warming (and collect new taxes) was met by strong popular opposition, in the form of the ‘Gilets Jaunes’ (yellow jackets) movement. Trying to internalize the welfare of future generations is a tricky business if it means reducing the welfare of today voters.
1.2.3 What Does This Data Mean for Regulation?
The data on only two of the indicators of interest in the evaluation of regulatory policy effectiveness suffices to argue that there is a case for various improvements in the practice of regulation. First, markets need more and better regulatory incentives to invest, as will be analysed in Chapter 11. The massive sectoral restructuring implemented over the last three decades throughout the world, including deregulation and privatization reforms, has failed to deliver the right incentives to invest. The private sector is not going to fill the investment void, especially in poor countries. Public money will continue to be needed in most regulated sectors and in particular in the poorest countries. Second, social concerns need to be dealt with more cautiously. In most countries of the world, where these services are actually delivered they represent such a significant share of expenditures that there is a case for regulators to track the evolution of affordability more systematically. This should also be on the agenda of regulators, as discussed in more detail in Chapter 9. Yet as we shall see, these concerns have often failed to attract the attention they deserve, in theory as well as in policy circles. As discussed next, short-run (static) efficiency concerns tend to dominate research in regulated industries, even if the growing case for environmental concerns is producing a fast-growing volume of research on their investment implications.Footnote 15
1.3 Efficiency at the Core of the Main Academic Economic Case for Regulation
In the academic economic literature, the inefficiency risks associated with monopolies, and highly concentrated market structures, largely drive the case for regulation of public services. At the very broad level, this literature identifies two main policy concerns. The first is linked to the choice of technology to make the most of the size of the market to be catered to. The second is related to the need to mitigate the risks of abusive exercise of market power allowed by the differences in access to information by the various stakeholders. The producers of these services tend to have the upper hand in their interactions with consumers and regulators. This is because they have access to more and/or better information on the supply and demand characteristics of many of the markets that are delivering public services, as discussed at some length in the book.
The ‘size argument’ is the oldest one in the academic and policy literature. When there are significant scale and scope economies to be captured in the production and delivery of the service, it is efficient to allow a monopoly to take over the market rather than relying on competition. In other words, it makes sense to adopt an integrated production and service delivery structure as long as it is more efficient for one firm to produce the public service(s) than two or more firms.Footnote 16 And this is supported by the evidence available on the empirical assessments of scale and scope economies across the regulated sectors.
For the water sector, for instance, Saal et al. (Reference Saal, Arocena, Maziotis and Triebs2013) surveyed about twenty years of empirical studies measuring scale economies and validated the case for a significant degree of vertical or horizontal integration. They found solid evidence of vertical scope economies between upstream water production and distribution. They also found evidence of scale economies, although only up to certain output level. Abbott and Cohen (Reference Abbott and Cohen2017) reached equivalent conclusions from a survey of the railway industry. Cost efficiency gains from vertical integration tend to be more common than losses but depend on predictable factors, including the range of services provided (e.g. passengers versus freight) and the intensity of track use. And for the electricity sector, the survey by Meyer (Reference Meyer2012a) suggested that the switch from vertically integrated firms prevailing in the sector prior to the reforms of the 1980s–2000 to more complex market structures with unbundled services (in the hope of making the most of competitive options in the sector) did not improve efficiency enough to offset the losses of coordination gains from vertical integration. For the United States, for instance, Meyer (Reference Meyer2012b) estimated the cost increase from an unbundling of generation to be between 19% and 26%, 8% and 10% for separation of generation and transmission, and 4% for the separation of transmission alone. For Europe, Gugler et al. (Reference Gugler, Liebensteiner and Schmitt2017) estimated the added costs associated with vertical unbundling of the sector at around 14% for the medium-sized utilities and over 20% for large ones.
At first sight, this research shows that the initial case for reforms designed to unbundle large, vertically integrated monopolies underestimated the payoffs to intra-firm coordination and overestimated the gains from competition. One of the reasons why the empirical results are biased against unbundling is that reformers underestimated the importance of regulation. The level and quality of regulation both matter in practice and drive the optimal choice of an organizational form. Failure to assess the ability of a country to implement a specific form of regulation determines the quantity and quality of services, as discussed at length in Chapter 14.
To tease your curiosity, consider the evidence accumulated since the mid-1990s for a wide range of countries and sectors on how the efficiency gains achieved through reform were passed on to users. Despite the common focus of the narrative on reforms highlighting efficiency gains, there is significant evidence that, when the opportunities for competition were realistic and unbundling the historical monopolies was desirable but demanded residual regulation, the regulatory models adopted by most countries failed in various ways to ensure that firms delivered the potential efficiency gains or at least passed them on to consumers through lower prices. The residual market power achieved by the many monopolies serving local, regional and national markets often continues to be excessive and many of these firms still manage to capture most of the efficiency gains achieved by the reforms.Footnote 17 The point is that the case for regulation is as strong under a vertically integrated monopoly as it is in a structure in which residual local, regional and national monopolies continue to enjoy market power that can lead to efficiency losses. The scope for market power by a monopoly is thus still the main reason why regulation is needed and the evidence suggests that this necessity is hard to overestimate.
The second major justification of regulation by academic research emerged in the late 1980s. It also focuses on efficiency. It became ‘academically mainstream’ with the Laffont and Tirole (Reference Laffont and Tirole1993) textbook that synthesized research produced since the early 1980s on the risks of efficiency losses due to information asymmetries. As mentioned earlier, firms know their costs and clients better than anyone else (including the regulator). The only other agent that may know almost as much as an incumbent may be another firm operating in a comparable market. Unless regulators intervene, there is little reason for a monopoly to reveal enough information to check if there are abuses leading to inefficiencies in the production decisions. This is why many regulators spend significant resources trying to approximate the cost and consumption information they need to make fair assessments of the regulated market. In most cases, these efforts are insufficient to obtain detailed data, but they are usually good enough to allow regulators to develop processes to shift the burden of proof for relevant information onto the regulated firm.Footnote 18
The effectiveness of these regulatory processes drives the extent to which the market will fail and abuses take place. Most of these processes are associated with insights that can be credited to the continuous (economic) academic push for the need to recognize that access to information matters in many ways, none of them simple. Since the breakthrough started by Laffont and Tirole (Reference Laffont and Tirole1993), many other excellent surveys or textbooks have contributed to the dissemination of the theoretical insights as these were improving, including Train (Reference Train1991), Armstrong et al. (Reference Armstrong, Cowan and Vickers1994), Newbery (Reference Newbery2000), Crew and Kleindorfer (Reference Crew and Kleindorfer2012), Vogelsang (Reference Vogelsang2002), Crew and Parker (Reference Crew and Parker2006), Armstrong and Sappington (Reference Armstrong, Sappington, Armstrong and Porter2007), Joskow (Reference Joskow, Polinsky and Shavell2007), Robinson (Reference Robinson2007), Sherman (Reference Sherman2008), Baldwin et al. (Reference Baldwin, Cave and Lodge2012), Decker (Reference Decker2014), Rose (Reference Joskow and Rose2014), Tirole (Reference Tirole2015), and Viscusi et al. (Reference Viscusi, Harrington and Sappington2018 in its fifth edition).Footnote 19 Until Jean Tirole, of the Toulouse School of Economics in France, was awarded the 2014 Nobel Prize in Economics for his work on regulation, most of the insights summarized by these textbooks were largely reserved to technical specialists of regulation. The Nobel prize awarded to Tirole managed to increase the profile of research in the field and the transparency of some of the various perspectives on the topic.Footnote 20 These provide most of the material covered in Chapters 2–6.
This early research has focused on the many ways in which information asymmetries can distort the supply, pricing and investment decisions as well as demand in regulated markets. A quick look at the tables of contents of the various textbooks covering the topic shows that there has been less interest in financial viability or increased accountability generated by regulatory solutions to the initial information gaps. And there has been even less interest in the distributional effects and political viability of regulatory solutions. Yet, as the world is finding it hard to recover from the series of global crises that started in 2008, these concerns have risen to the top of the policy and political agenda in many countries. Politics needs economics to deliver more ideas to address some of the negative distributional effects of public services reforms that have been much more clearly exposed in the post-crisis years, as discussed in Chapter 9.
1.4 When Politics Meets Standard Regulatory Economics Equity Shows Up
While mainstream regulatory economics emphasizes efficiency, political speeches tend to focus more on equity. In many countries, the promise of freezing, or at least capping, the price of electricity has become a standard campaign promise (e.g. the promise was made by all left-leaning parties in the 2019 Belgian parliamentary election). A cynical interpretation is that this is because equity buys more votes than efficiency. A gentler, fairer perspective would argue that accounting for the social effects of regulation makes regulatory pricing decisions more politically and ethically acceptable. This makes them easier to implement and sustain. In practice, these dimensions are thus more important to consider than often recognized by economic academic and policy research.Footnote 21
Some are likely to argue that poverty and equity concerns are seldom accounted for in regulation because they are best addressed through well-targeted subsidies to be included in the fiscal policy agenda. Allowing price regulation to focus on efficiency would thus be reasonable: two tools for two goals. As we shall see in Chapter 9, this is not a realistic perspective in a world in which fiscal constraints are often too binding to address the social mandates. Yet these mandates are important for the viability of reforms aimed at improving both efficiency and equity.
Besides these differences in perspective in the proper use of policy instruments to achieve two goals, there is a second important reason why academic research may not have dealt well enough with poverty concerns. This is linked to the increasing role of ideology in the definition of regulatory preferences. It is not easy to deal with these concerns because ideology changes often turn policy goals into moving targets. Consider, for instance, the evolution of perceptions on the desirability of privatizing public enterprises or nationalizing private ones.
From the early 1980s to the mid-2000s, the main assumption was that private providers would be able to do anything better than public providers. And this included the assumption that they would do better at meeting the needs of the poor, for instance.Footnote 22 To allow private firms to make the most out of their potential, politicians, supported by many economists, started to argue that deregulation was essential.
This narrative was built on two main ideas. First, technology would make it easier to maximize the opportunities to increase competition and limit the role of residual monopolies to the activities for which competition is not a cost-effective option for users or taxpayers, or an efficient one from a technical perspective. Second, the long record of failures by public enterprises provided enough case studies to fuel a growing global mistrust in public authorities. Government failures were seen as riskier than market failures and this stimulated a global effort to try to limit the role of the public authorities to a supervisory role. This role would be split between independent regulatory and anti-trust agencies whenever possible. Self-regulation of large public utilities was no longer politically easy to sell (even if, as discussed in Chapter 14, politicians have been quite good at continuous interference with the independence of the agencies).
But there has also been an evolution since the late 1990s. Over time, the relative importance of anti-trust has increased and in many countries the role of regulators has become more focused on narrower residual monopolistic activities and the coordination of activities with other national regulators on well-targeted matters (e.g. the definition of access rules and prices for common facilities). In many of the poorer countries, the regulator’s role has been limited to the supervision of network industries while local alternative technologies have been left to local communities or to agencies concerned with rural needs.Footnote 23
During that period, regulation has also evolved because of the increased scope for trade-in-services, including traditionally regulated services. This increased the need to consider supranational regulation as an option to minimize the risks of national distortions of investment opportunities that can cut costs. The debate is not settled as many countries are fighting to maintain full sovereignty and secure access to basic services in a world of increasing political instability. This is one of the cases made by pro-Brexit advocates.
The tide may now be turning, as seen in recent reports and decisions in Europe since the late 2010s. Consider the United Kingdom. This is the country that launched the ideological preference for market-oriented solutions to any market failure in the late 1970s and served as a model around the world in the following thirty or so years. In 2018, its National Audit Office, an independent but official watchdog, released a report providing evidence of the lack of credibility of the assumption that market-based solutions will do better than public solutions (National Audit Office 2018). This was then followed within a few months by an equivalent assessment by the European Court of Auditors (2018). Since in many ways the dominating ideology tends to influence the research agenda, it is likely that research on how to make public enterprises more effective and how to tackle equity concerns will start benefiting from new research on a systematic basis.Footnote 24
A third, subtler, way in which political perspectives are now influencing economists is in communication strategy. Across political parties the communication of regulatory preferences benefits from careful narratives building on selected examples and anecdotes rather than robust empirical and technical assessments. In many ways, these communications strategies have fuelled ideological cycles regarding the way regulation has to be assessed, designed and implemented.
For many audiences, the political marketing is much more effective than the very technical approach adopted by many regulatory experts. Case studies and anecdotes are indeed useful and the literature disseminated by international organizations offers many of these to illustrate technical insights. The ‘best-practice’ approach helps ‘non-technical’ readers get a much more concrete and intuitive sense of the challenges than many econometric and other complex technical studies favoured by the economic academic literature. This is why, throughout this book, and despite a clear technical bias in the presentation of theoretical results, we rely on examples to set up the technical discussions. We try to leave the most complex technical insights to footnotes and boxes, which may only be useful to readers as interested in theoretical developments as in the policy-oriented arguments of the book. For the sake of completeness, we also provide many references to the academic literature to ensure that the intuition provided by case studies and anecdotes is complemented by more robust statistical evidence.Footnote 25
1.5 When Theory Meets Practice
As for most policy areas, the practice of regulation is typically more complex than its conceptualization. It involves a number of predictable challenges that need to be considered before jumping from theory to actual regulatory decisions. Some are technical and require the measurement of specific dimensions, including the efficiency levels and their changes since they need to be shared in theory between producers, users and taxpayers. Many other financial and social indicators are also needed to be able to decide on trade-offs between the social, financial and political goals imposed on regulators. This quantification seldom takes place at the required level of detail. According to the OECD (2019), in 2017 only three of the twenty-eight member countries of the European Union had the obligation to quantify the costs and benefits of new regulations.Footnote 26 As we shall see, the skills demonstrated by regulators to conduct these assessments vary a lot across countries and sectors, but this in itself is an essential insight.
This matters because a fair share of the regulatory failures can be traced back to the underestimation of the relevance of the differences in institutional capacity across countries and/or sectors.Footnote 27 These differences are too often ignored by mainstream approaches to regulation, resulting in sometimes misleading standardized policy recommendations. This is also something we try to address in the book, in Chapter 14. For instance, regulation in a corrupt country should not be modelled on regulation in a country in which all economic actors comply with laws and regulations. The British system is unlikely to work in Tanzania, Mongolia or Paraguay. Academic research is getting better in its ability to account for these institutional differences and is much better than it was twenty years ago. But we still have a long way to go in our understanding.
A third challenge is the need to actually account for processes and managing the time it takes to get things done much more seriously than is often the case in economic publications.Footnote 28 Processes have not really made it into mainstream economic regulation textbooks, yet they are one of the key reasons why things get done slowly in regulation. For instance, firms and regulators need to agree on the method to be used to estimate efficiency levels. They need to agree on the terms of the interactions of the firms with financial markets (e.g. should leverage be controlled, should dividends be controlled?). All these interactions need to follow due diligence and it may take from six months to two years depending on the complexity of the situation. During that period, many things can happen. This also needs to be accounted for in the design of processes.
Another reason why these processes can be slow and complex is that they often involve multiple government units. The degree of complexity of the interactions between these units makes a difference to the optimal choice of regulation. This choice needs to account for an extremely broad set of dimensions, such as the distribution of regulatory rights among these units, including at different levels of the government, the specific objectives assigned to each unit, the timing and sequencing of the various steps demanded by a regulatory intervention, the voting procedures used to pick managers, the duration and scope of control of different regulatory bodies, and the design of the communication channels within the regulatory hierarchy.Footnote 29 A failure to address these influences is bound to over- or underestimate the effective impact of incentive-based regulation on regulatory outcomes.
While we will not deal in detail with all the day-to-day constraints of regulation, we will remind you of their relevance. Unless these constraints are accounted for, the odds of regulatory failures increase. There are disagreements between the various research fields on their degree of importance but, in many cases, keeping processes as simple as possible is a good strategy. The more complex they are, the more likely it is that those with the most resources will grasp an unfair share of the efficiency gains. This might work to their benefit for a while, but not when it becomes an identified pattern. And this brings us back to the need to consider the political viability of regulatory decisions as much as their short-term and long-term efficiency impacts.
1.6 Is Academic Research Lagging or Leading Regulatory Practice?
Until the 1990s, it could be argued that regulatory practice was lagging theory. Most regulators were focusing on controlling the rate of return on assets. They largely took costs, including investment costs, stated by regulated firms for granted, which means that incentives for regulated firms to improve their efficiency levels were not really included in the design of regulation, even if efficiency losses were a central focus in academic research on regulated industries. Since then, efficiency has also risen to the top of the regulatory agenda in practice. The ideological switch pushing policymakers to trust markets more than governments explains the trend towards deregulatory policies that continues to prevail in many countries and among many international organizations. In many ways, this ideological commitment could be credited or blamed (depending on your personal ideological perspective) for the systematic efforts to limit the scope for regulation to infringe on individual freedoms and on business freedom.
But ideology has not only changed regulation; it has also changed the perception of what is needed in regulation. After the reign of overactive public enterprises since World War II, politicians with strong ideological convictions on the superiority of the private sector persuaded the OECD countries first, and some of the emerging countries next, to switch to the reign of the all-powerful private enterprise as a provider of public services. But ideology was not the only driver of the change. The demand for regulation and the nature of this demand also changed because of other factors that should not be underestimated. And some of these changes also influenced academic research.
The three main sources of change that have contributed to transform the theory and practice of regulation are:
(1) A technological revolution.
(2) A financial sector regulation revolution.
(3) The globalization revolution.
1.6.1 On the Technological Revolution
Technology matters to regulated industries as much as it matters to any industry. But the various public services are highly heterogeneous in their ability to benefit from technological innovation. The telecoms sector is a clear leading outlier (consider the growing number of things you can do with your smartphone that nobody could have imagined in the mid-1990s). Mobile technology has been disruptive. It allows providers to operate on a much smaller scale than with fixed lines. It has justified the deregulation of the sector and the move towards regulated competition, generally overseen by antitrust authorities. The deregulation ‘example’ of telecoms has sometimes been used to justify deregulation in other public utilities. Yet some of them did not experience significant innovations, not to mention disruptive ones. For example, at the other extreme of the innovation spectrum, the W&S sector is a clear laggard despite major improvements in desalination and data management techniques. It is not too surprising that the public utilities that did not benefit much from technological progress are still the responsibility of state-owned enterprises (SOEs) in many countries, especially in developing ones. For electricity distribution, the share of countries with a public enterprise in charge was 62% in 2017 (Küfeoğlu et al. Reference Küfeoglu, Politt and Anaya2018)). In the W&S sector in 2018, in a sample of 174 countries, 55% did not have any significant private participation in the ownership of their main utilities and only 22% had managed to get at least some private investment when they had agreed to some form of public–private partnership (Bertomeu-Sanchez and Estache Reference Bertomeu-Sanchez and Estache2019). In many of those with private participation, the contract was signed at a city level rather than at the national level, suggesting that the relative importance of large-scale public operators in a given country is actually much greater than 55%. For developing countries, the domination of SOEs is even clearer. In a panel covering 1990–2002 and collected by Gassner et al. (Reference Gassner, Popov and Pushak2009), it was found that only 15% of the 977 water utilities in their sample were not SOEs.
But focusing on ownership and market structures underestimates the many other, subtler, ways in which innovations have been making a direct difference in the operation and management of all public services.Footnote 30 For instance, the digitalization of these sectors is starting to make a big difference and matters just as much to the optimal design of the regulation of public services. The explosion of information (the big data phenomenon) is changing the way providers can optimize their supply as well as the way in which they can practise price discrimination. For instance, ICT improvements have allowed competition in wholesale electricity (electronic auctions), increased the control of flows in all networks and facilitated metering and billing (with smart meters). Many of these changes may result in the questioning of some of the regulatory decisions that were once considered to be best practice, as will be discussed in the last chapter of this book.
Innovation is, however, not the only engine of technological change in these industries. First, technology also changes because preferences change. The most obvious change in preferences, largely driven by consumers in the last 10–15 years, is linked to environmental concerns. The transport and energy transformation are part of that agenda and meeting this evolving demand implies many changes in the optimal design of regulation of the concerned sectors as well. Here also, progress has been slow.
1.6.2 On the Financial Sector Revolution
Changes in both the demand and supply side of the global financial markets have impacted on the way services traditionally operated and financed by the public sector are now being financed and regulated. The financial sector is ultimately where the ideological and technological changes translate into concrete opportunities and challenges for regulated industries and for regulators. This ability to influence the regulated industries keeps evolving and is part of the challenges regulators have not yet been able to internalize, as will be seen in Chapters 7 and 12. This essential role of the financial sector has become possible for at a least a couple of clear reasons.
The first is that the deregulation of the financial industry created an explosion of savings and liquidity in the 1990s. This explosion eased somewhat the rationing in financing of a sector in which the investment needs were growing while fiscal support was increasingly binding. And all this happened in an environment in which financial market integration also accelerated. Access to private funds to finance public services has progressively become a credible complement to traditional public financing options for many countries, although not for all countries and not for all types of investments, as will be seen in Chapters 7 and 12. For many, however, there was the hope that they would find a way to use this excess supply of savings and liquidity to help close the historical financing gap. At the same time, it gave the financial actors input into the design of regulation, more often informally than formally.Footnote 31
Second, the deregulation of the sector has also unleashed a significant creativity in the production of financing tools, which increased the leverage of the financial actors in negotiations. In the context of infrastructure, this became clear with the development of the use of project finance techniques as part of the financing strategy for investments in regulated industries. The new techniques have been welcomed by many governments, but it has also led to significant regulatory concerns over time. A common one is the increased incentive for cream skimming which reduces the scope for cross-subsidies within a sector.Footnote 32 Often the packaging of projects leaves the high-profit-margin operations to the private investors and maintains the high costs and low or negative margins in the hands of the public sector. The extensive use of the technique has also revealed the incompatibility between the short-term return concerns of private investors and the long-term perspective on payoffs from long-lived assets that governments and users tend to focus on. Any disagreement ends up increasing the average price expectations. This is usually reflected in a risk-sensitive cost of capital or in extensive public sector guarantees rebalancing sector costs from users and investors to the taxpayers. It is impossible not to address these issues in some details in this book. And we will do so in a chapter focusing on the interactions between finance and regulation (Chapter 7), but also in the discussion of the additional changes to come resulting from the evolution of the number and types of actors in the financial markets. The growing role of shadow banking is indeed already having an impact, as discussed in the last chapter of this book.
1.6.3 On the Impact of Globalization
Since the end of the cold war countries worldwide have engaged in a substantial restructuring of their economy. Former communist countries implemented massive privatization and deregulation programmes to make the transition from a planned to a market-based economy. To create a fully integrated economic zone, European member states opened all their markets, including their public utilities, to EU competitors, which generally implied deregulating, corporatizing and privatizing several national monopolies. In other OECD countries and in developing and emerging economies, the move towards deregulation and privatization was generally part of a broader agenda of reforms known as the ‘Washington Consensus’. As a result of these global structural reforms the role of the State in the sector is now weaker than it was thirty years ago. National governments in many cases lost direct control over essential infrastructures and public utilities. In contrast, firms, both national and multinational, and institutional investors such as pension funds, have become key players. It increased the case for a careful look at regulation. In many instances, the effectiveness with which it has been implemented did not meet the expectations of the reformers.
The internationalization of experience also increased the political dimensions of regulation since some of the big international players are also often part of an explicit or implicit industrial policy in their home country. This implies that when they operate outside of their borders they can also count on the political support of their government. One of the outcomes is that regulatory conflicts called for an institutional solution capable of reconciling differences in perspectives on the role of regulation (e.g. how much discretionary power should be granted to regulators implementing general principles against how much to specify in a regulatory contract to limit discretionary powers). International arbitration has been the solution adopted in general. But the solution was also often seen as increasingly politicized.
This has been one of the issues raised in the context of international trade agreement that covers trade-in-services, for instance. The ease with which large global firms could call upon an international court would turn national regulators into minor actors. Consider the debates on concerns for the protection of public services at the centre of some of the tensions between Europe and the United States in the negotiation of the Transatlantic Trade and Investment Partnership (TTIP). The resolution of regulatory conflicts impacting the profitability of regulated industries is one of the sources of divergence. The US and European regulatory traditions in public services are quite different. As of 2016, the official European Commission (EC) position is that, in case of conflict, national rules will prevail and US companies will not be allowed to sue for loss of profit. This is a bit less credible than it seems at first sight, because one of the mechanisms for arbitrating disputes is known as Investor–State Dispute Settlement (ISDS), which essentially, in practice, is a form of international private arbitration. This form of arbitration can overrule many national decisions made by a regulator. That is a political and social problem.Footnote 33
This implies that there is a layer of regulation above national regulation because the TTIP proposals de facto allow an appeal of national decisions to supranational arbitration. This could disempower national regulatory agencies. For anyone familiar with conflicts between governments and private operators and investors in infrastructure services in developing countries, this sounds familiar. In the last twenty-five years, regulators have frequently been overruled by arbitrators, sometimes fairly, sometimes not so fairly. This large number of conflicts illustrates the difficulty of getting regulation right in an environment in which technology and the number and the type of stakeholders keep evolving.
1.7 Conceptually, What Are the Sources of These Regulatory Failures?
The failures of any organizational mechanism must be assessed in reference to the objectives assigned to this mechanism. For instance, because market mechanisms are based on egoistic behaviours, they cannot reach the level of production of common goods expected by the members of a community. This market inability is well identified by the economists, for example when they consider environmental concerns. It can be corrected in different ways, all of them requiring the intervention of a public authority, a form of regulation. The regulatory options to solve an environmental crisis associated with a specific firm cover a wide range of actions. The most drastic solution is the nationalization of the faulty industry. A softer one is the allocation of tradable property rights or the introduction of use taxes. Equivalent crises can arise for non-environmental reasons, as will be shown in the book. These include mistargeting support to the poor, underinvesting to meet the needs of future generations or undersupplying a quality standard.
For many reasons that the book will help to identify, none of the regulatory patches suggested by theory or acquired in practice can fully fix the problem. It would thus be tautological to systematically refer to regulatory failures when the regulation cannot fully bridge the gap between the market and the optimal frictionless outcomes. By contrast, the performance of a given regulatory mechanism can be usefully measured relative to the results pledged by its designers. With this benchmark, any discrepancy can be tagged as a failure.
One can imagine testing the performance of a regulatory mechanism in comparison with alternative mechanisms. This definition is not perfect either, since, as we will show repeatedly in the book, regulation is multidimensional and, in most cases, when a mechanism outperforms a rival one in one dimension (say efficiency), it is at the cost of a lower performance in another (say equity). This is why, throughout the book, when we conclude that ‘regulation has failed’, it should be understood as the failure of a regulatory mechanism to close the gap between its designer’s specific public commitments and the measured outcomes. This is, in many ways, also how arbitration courts and auditors tend to assess regulatory failures by a State. They boil down to identifying non-compliance with contractual commitments.
1.8 How Will the Book Cover the Issues?
The big-picture story on the gap between practice and academic research discussed earlier is not representative of the full range of issues that need to be addressed across countries. The wide range of cross-national differences in regulatory and legal preferences explains why there are so many different ways of taking on a similar challenge. Moreover, the practice has also evolved in very different directions around the world. Anglo-Saxon countries (i.e. Australia, Canada, New Zealand and the United Kingdom) and the Nordic countries have adopted regulatory processes and tools signalling a steady commitment to accountability for economic and financial decisions. In most other countries, regulatory decisions often reveal, instead, a preference for ignoring possible trade-offs between short-term political concerns and long-term economic, social and environmental needs when they represent a short-term political risk. These differences are interesting per se, but we cannot deal with all of these in the context of this book.
To limit the coverage, while still doing justice to the diversity of issues revealed by these different experiences, we have decided to focus the book on the economic regulatory role of the State. This includes the usual discussion of the incentives to be built into regulation as well as the scope for fine-tuning price level and structure in any of the services. But it also covers subtler dimensions such as the relevance of the choice of market structure for the optimal design of regulation. In addition, the book addresses explicitly the relevance of the financial markets and institutional constraints on the optimal choice of market structure and hence of regulation through their effects on risk perceptions. This is an often underestimated, yet crucial dimension in the practice of regulation.
Although the legal implementation of many of the policy and regulatory choices made for each sector is important, they are not covered here in detail. They will, however, often be referred to through this text because they are central to the way the sector actually works. They also explain differences across countries, and sometimes across sectors within a country, in the degree of coherence between the economic intentions of the law and the outcomes.
1.9 The Structure of the Book: A Readers’ Roadmap
After this introductory chapter, the fourteen remaining chapters are organized in four main blocks. The first block, composed of Chapters 2–5, covers basic concepts of microeconomics required to understand the rest of the book, and the two canonical models of regulation. The second block, Chapters 6–9, deals with the crucial issue of price setting in regulation and what it implies for regulators in terms of finance tools. The third block, Chapters 10–12, enriches the analysis by studying multi-product monopolies, including quality and investment issues, as well as the regulation of oligopolies. The fourth block, Chapters 13–15, covers advanced topics, including the moving frontier between regulation and anti-trust, institutional quality, and finally the implications of the IT revolution and behavioural economics in regulation.
The book is constructed in such a way that it can be used to teach at different levels. The main intended audience is economists with at least a core training in microeconomics. To make the book as helpful as possible for academic use, the different topics are addressed in fifteen chapters, each equivalent to what is usually covered in a three-hour lecture. We have also tried to make the book useful for professional training for new regulators or for regulators wishing to develop additional conceptual skills. That is why the level of technical detail can be easily adjusted to match the needs of these different types of audience by simply skipping the more analytically demanding sections. This is possible because difficult concepts are always presented in two steps. We illustrate them first with the help of simple numerical examples. Then we develop the conceptual discussion of the issues at stake. In every chapter, the most demanding technical parts of the book are either in boxes or in an appendix, which can be dropped without losing much on the policy insights. We provide a road map so that both audiences can be addressed easily with the book.
Introduction. Chapter 1 is the introduction to the book and should be useful to all. It offers a brief review of the most ‘popular’ views on the role of economic regulation and of the distance between theory and practice. We show that this distance is partially due to the fact that theory is often trying to catch up with a fast-moving real world and that policymakers have a much broader agenda than recognized by the majority of academic economic research on regulation.
Core concepts and canonical models of regulation. Chapters 2 and 3 are a primer in industrial organization. They cover standard microeconomics concepts necessary to understand the rest of the book. These chapters should therefore be covered in detail for advanced bachelors students and professionals. For masters and PhD students, they can either be covered very quickly in class, read at home or simply skipped. Chapters 4 and 5 present the canonical models of regulation, first in a situation of complete information (Chapter 4) and then in a situation of asymmetric information (Chapter 5). These are the key concepts of the book. More specifically:
Chapter 2 summarizes the normative framework anchoring the theory of economic regulation at the most basic level. It serves as a reminder of some of the essential concepts used in economics and explains how concrete these are in analysis of regulation in practice. It should be helpful to practitioners in particular because it shows that many of the theoretical concepts can actually be measured, an essential dimension to be able to take informed and fair decisions.
Chapter 3 then explains how monopolists get their market power and manage to use it without regulatory supervision. To regulate well, it is necessary to understand all stakeholders. Since the regulated firms are central to many of the distortions likely to hurt efficiency and fair allocations of resources, it is essential to get a good ‘operational’ perspective on what drives the decisions by this central actor. This chapter presents the Lerner index, a key concept used throughout the book to understand intuitively how laissez-faire monopoly prices and regulated prices impact on the markets of public services.
Chapters 4 and 5 complement each other. Chapter 4 summarizes the theories of optimal regulation when the regulator has all the information needed to make efficient decisions. Chapter 5 shows what happens to the optimal regulation design when the regulator has less information than the regulated firm on costs and demand. The two chapters also remind the reader that the theories of the optimal design of regulation have initially been designed to consider the viewpoint of both public and private firms in their interactions with a regulator. Since dealing with asymmetric information can be challenging technically, Chapter 5 is in two parts. In a first part, intended for all readers, the cost imposed on regulation by asymmetric information is illustrated with the help of a simple example. This part delivers the main results and intuitions at the core of the regulation literature, in a simple way. The second part is more technical as it presents the general case. It is intended for a more advanced audience and can be skipped by policy-oriented readers and bachelors students.
Prices and finance. Chapters 6 and 7 also need to be thought of as complementary. Chapter 6 focuses conceptually on the relevance of regulation for efficiency outcomes and on average prices. Chapter 7 shows how these theoretical concepts are put into practice. More specifically, it explains how the financial management of the regulated firms internalizes the incentive issues identified by theory. Chapter 6 summarizes the main results covered by the theoretical research of interest to any academic audience, while Chapter 7 covers familiar ground for a professional audience, which is often ignored by theoretical research on regulation. Linking the two is useful to both types of audience, although one might insist more on the former or the latter, depending on the orientation of the class. Chapter 8 focuses on allocative efficiency and non-linear pricing; Chapter 9 on redistribution and equity concerns. These chapters are intended for all. The most technical discussions are in boxes. More specifically:
Chapter 6 explains the various models used to get to an average price that allows firms to break even and compares their incentive effects. It emphasizes the comparison between the ‘old’ rate-of-return approaches and the use of prices caps. But it also briefly summarizes the evolution of the practice towards a hybrid form of regulation combining these two approaches. It focuses on productive and cost efficiency.
Chapter 7 may be unusual in a book on economic regulation. It emphasizes the essential role of finance in the implementation of regulatory principles to foster productive efficiency. It shows the central and concrete role financial concepts play, or should play, in defining a reasonable expected rate of return for both public and private regulated firms. It summarizes how many of the insights of the traditional approaches to the optimal design of incentive regulation can be internalized in relatively simple financial models used by many regulators around the world.
Chapter 8 considers the heterogeneity of the demand side. It focuses on allocative efficiency and summarizes when and how to use non-linear pricing options, emphasizing the various forms of price discrimination and their effects. In particular, it shows that price discrimination, even though politically condemned and sometimes legally banned, can be an efficient way to cover the costs of the regulated operators. Price discrimination is useful to manage demand and to reach different goals, but it must be closely monitored because of the risk of market power abuse and regressive discriminating tariffs.
Chapter 9 is also somewhat unusual in a textbook on regulation as it discusses the pricing tools that the regulators have to comply with in their equity mandate. It goes through the different available options to address social concerns in the context of regulatory policy design and implementation. This chapter is accessible to all. It can be used independently, in a development class, for instance, or in a class on social policies, to illustrate the options available to ensure access and affordability in public services.
On the multidimensionality of production decisions and the scope for regulated oligopolies. The first part of the book focuses on single-product monopoly and deals with choices such as effort to reduce costs, information revelation and price structure. However, regulated firms are typically dealing with multidimensional products and services in deconcentrated economic environments. In this third block, we enrich the initial analysis to cover other types of decisions regulated firms make, including choosing quality (Chapter 10) and investment (Chapter 11). We then address the consequences for regulation of the fact that regulated firms are also often operating in complex oligopolistic structures and managing several products (Chapter 12). More specifically:
Chapter 10 discusses the various dimensions of quality and the margin available to regulators to ensure that the quality delivered meets its demand. For regulated firms, an easy way to comply with cost-reducing requirements is to lower the quality of the service they provide. Their performance should thus also take quality into account, as long as it can be verified.
Chapter 11 summarizes the theoretical and empirical literature on the effects of regulation on investment decisions. It highlights the gaps between the insights of theory and those produced by empirical research, emphasizing the relevance of contextual and institutional dimensions identified by econometric studies but sometimes omitted by theoretical research. It also emphasizes the role of access pricing in the sharing of capital costs. The most technical parts of the chapter are in boxes.
Chapter 12 considers the various situations in which the regulators need to monitor multi-product firms and discusses why the substitutability or complementarity of products makes a difference to the optimal regulatory choice. It also analyses the scope and limits of some form of deconcentration by comparing the relative merits of monopolistic to oligopolistic regulated market structures. It discusses mixed oligopolies, self-regulation and public–private partnerships.
Advanced topics. The last part of the book covers topics that are emerging in regulation or are key to its evolution. Chapter 13 focuses on the link between anti-trust and regulation and on the moving frontier between the two. Technicalities are relegated to boxes. Chapter 14 looks into the institutional dimensions of the regulatory process. It is accessible to all. Chapter 15 concludes. More specifically:
Chapter 13 discusses the ways in which traditional regulation needs to tackle new sources of possible abuses of market power. Increasingly complex ownership structures seem to characterize many firms as the role of hedge funds, pension funds and other institutional investors grows in regulated industries. Access pricing in formerly vertically integrated structure and competition in network industries are also analysed.
Chapter 14 reviews the various sources of institutional weaknesses and explains how these should influence the optimal regulatory instruments choice. This is the chapter most relevant to understanding why there are so many regulatory failures, which in turn explains why market failures can last. It is particularly relevant to anyone interested in designing regulatory policies in developing and emerging economies but also in OECD countries requiring significant governance and institutional reforms.
Chapter 15 concludes with a look at the future of regulation. It discusses the main emerging issues and changes in the way regulated markets operate, are financed and are supervised, thanks to the IT revolution and the insights of behavioural economics. It is non-technical and intended for all.
1.10 Summing Up
Regulated services are costly to operate and maintain. They demand heavy investments to deliver services for extensive periods of time. Both types of expenditures have to be funded for the sector to be able to deliver.
Investment needs in infrastructure average 1–2% of GDP (about 4–8% in developing or emerging economies).
For all income groups, in all economies, regulated services represent 14–26% of household expenditures.
The price of these services coupled with subsidies should be recovering the costs of meeting demand.
When setting the price of the various regulated services, the regulator usually needs to address multiple goals:
∘ Financial or fiscal viability
∘ Efficiency
∘ Equity
∘ Institutional viability
∘ Political viability.
Most of the common regulatory decisions have an impact on the extent to which each of these goals are achieved, e.g.:
∘ Should the financing of the services rely mostly on users or on taxpayers?
∘ Should the regulator favour more efficiency or equity?
∘ Should the regulator favour short-term or long-term goals?
The fact that the technological characteristics of some services justify their production and/or delivery by monopolies or quasi-monopolies and that the demand for these services can be quite difficult to adjust implies a risk of abuse of market power by these firms; this drives the original case for the regulation of the price of these services.
In view of the nature of the trade-offs and the social risks of abuse of market power, regulation is not only an economic decision but also a political one and it needs to account for the specific institutional context in which the decision is taken.
Since the institutional, political and social contexts evolve, regulation has to have some flexibility to adjust to the changes, while still providing enough protection guarantees to all stakeholders.
For many of the key decisions, economic theory provides useful guidelines, but in some dimensions, theory still has some way to go to become fully operational in the practice of regulation.
