Regulation and Regulatory Reforms in Developing Countries

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Regulation and Regulatory Reforms in Developing
Countries

• Antonio Estache
• European School on New Institutional Economics
• ESNIE 2009
• Cargèse
• May 2009

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Overview

• Focus on regulation in key infrastructure
  industries
• Some background data on the main reforms of the
  last 15 years
• A zoom on regulatory reforms
• A further zoom on the institutional dimensions of
  regulatory reform in developing countries

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The reforms of the 1990s

• Three main standard reforms
• Relying more on competition
• In the market when possible
• For the market otherwise
• End to old fashion self-regulation when
  regulation was still needed
• create independent regulatory agencies
• deal more explicitly with the incentives for
  efficiency in the design of regulation (i.e.
  replacing cost by price caps)
• Opening up to private sector to get access to
  private financing to fasten service coverage
  increases

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Mixed to poor success of the efforts to attract
the private sector of countries with Private
Participation in Infrastructure (2004)

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Investment commitments to infrastructure projects
with private participation in developing
countries in real and nominal terms, 19902007
Total US1,475 billion committed through /-
4,100 projects adds up to less than 20 of the
investment in the sector.
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Source World Bank and PPIAF, PPI Project
Database.
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Telecoms and energy dominate investments levels
2007 US billions
Source World Bank and PPIAF, PPI Project
Database.
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Energy and transport dominate the number of
projects
Projects
Source World Bank and PPIAF, PPI Project
Database.
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East Asia and Latin America are the favorite
destinations
2007 US billions
Source World Bank and PPIAF, PPI Project
Database.
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One slide on the crisis and infrastructure
investmentsnot good news
Private flows to LDCs forecast
PPI in infrastructure et PIB growth
2007 US billions
Percentage
US billions
Source World Bank and PPIAF, Impact of the
financial crisis on PPI database, PPI Projects
database, and Institute of International Finance.
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The regulation independence war also only enjoyed
only a mixed success( of countries with
Independent Regulatory Agency)

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In a nutshell.How did it work out?

• Fiscal cost ok in short term but not ok over the
  longer run
• Efficiency reasonably ok although increased
  shift from price caps to hybrids dominated by
  strong costs pass thru rules
• Equity key problem and essentially a regulatory
  design issue
• Accountability not good eitherand again a
  regulatory design issue

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The winners and losers in terms of Actors

• The actors in the payoff matrix
• The users (access ( but not as much as expected
  and distributional issues), affordability(-),
  quality ())
• The taxpayers (cash! in SR, -/ in LR)
• The workers (jobs cash - in SR, in LR)
• The operators (cash in the SR and IRRgt COC in the
  LR for a few! ( in SR, ? for LR)
• The local owners (cash! in SR and LR)
• The foreign owners (cash! in SR, /- in LR)
• The bankers (cash! in SR and LR)
• The politicians (cash! in SR and LR)
• The donors (???)

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Emerging Issues

• For users
• Residential users Distributional issues
• Non-residential users could do much better
• For operators
• Demand uncertainty
• Cost levels revisions to address overruns
• Projects design revisions
• Exchange rate risks and other economic shocks
• De facto expropriation risks
• For government
• Uncertainty about demand and costs!
• Uncertain net fiscal effects
• Fiscal space the illusion of private sector
  invest
• Weak regulatory capacity, commitment and strong
  capture
• But counterfactual may be worse!

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How can regulation theory help in the diagnostic
and how can it help fix things?
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First recognize a few basic principles emerging
from theory

• Information asymmetry matters and can matter a
  lot!
• When a regulated operator has privileged
  information it usually gets a rent from it
• Information asymmetry seems to be a much bigger
  issue in LDCs
• Rents existbut are not necessarily bad!
• Regulation can be designed to get operator to use
  the rent (within limits) in a Pareto improving
  way
• Limited commitment ability of a regulator is an
  essential driver of the effectiveness of
  regulation in terms of efficiency, equity and
  fiscal costs
• It may be a good idea to limit a regulators
  powers to avoid undue use of information through
  capture associated with a limited ability to
  commit

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How can these issues be modeled?

• Ideally, we need a general model to see how a
  monopolist will behave to maximize rent from weak
  institutional capacity
• But we need to make sure that the main
  institutional capacity issues generally
  recognized by experts on LDCs can be addressed
  explicitly within the model
• This also means we need to explicitly separate
  the regulator from the government to check for
  regulator specific problems
• In addition, we want try to reconcile the policy
  recommendations emerging from research focusing
  on narrow issues using issues specific models

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So what are the institutional weaknesses we need
to track down?

• A survey of policy and theoretical literature
  identifies
• Limited capacity/skills to regulate
• Limited accountability
• Limited ability to commit
• Limited enforcement capacity
• Limited fiscal efficiency
• Each of these dimensions needs to hit on a
  specific variable in the general model

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Some basic stylized facts on these institutional
weaknesses? (1)

• Limited capacity to regulate or to enforce
• Regulators are severely under-resourced
• which can lead to increased firm rents.
• Limited commitment
• Many contracts have been renegotiated
• tends to increase the cost of capital
• but could this effect have been decreased by
  independent regulation
• and better checks and balances???

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Some basic stylized facts on these institutional
weaknesses? (2)

• Limited accountability
• Regulators (and governments) are often not
  accountable
• which decreases efficiency and inequality
• Limited fiscal space
• High cost of public funds
• partly explains why SOEs have not expanded
  network enough
• but increasing access is not profitable for
  privatized firms
• partly because of conflicts between
  affordability and access
• independent regulation appears to help

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A Basic Model of Monopoly Regulation(1)The
Monopolist

• Monopolist produces a quantity q of a good with a
  fixed costs of F and a marginal cost of C(q)
• Monopolist cost-function is also driven by
• e firm effort (i.e. moral hazard variable)
• Exerting effort e causes firm disutility of ?(e)
  (?gt0 , ?gt0 , ? 0 )
• gt this is the controlable part of costs
• ß underlying cost outside of firms control
  (i.e. adverse selection variable such as
  technology or factor pricesgt this is the
  uncontrolable part of costs
• ß ß (low cost) with probability v, or high cost
  with probability 1-v.
• C(q) (ß-e)q F
• Monopoly utility is U qp - (ß-e)q F ? (e)
  t
• With pprice and ttransfer
• Participation constraint Ugt0 (once ß is revealed)

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A Basic Model of Monopoly Regulation(2)
Consumers

• Consumer welfare
• S(q) gross surplus
• P (q) inverse demand function
• ? gt0 is the opportunity cost of public funds
• Consumers maximize welfare ? pP(q)S(q)
• (3) Government
• Benevolent government welfare function
• Government always observes F c (ß - e)
• !!!but government does not observe not ß or e
  (i.e. composition of cost)
• In order to learn ß and e, the government
  employs a regulator

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A Basic Model of Monopoly Regulation (4) The
Regulator

• Intuitively, the idea is that the main focus of
  the regulator is the cost function and the
  variables it can control ß and e
• The firms cost ß is revealed to the regulator
  with probability ?
• If the regulator learns ß, it chooses whether or
  not to reveal it to the government
• Signal is hard information i.e. regulator
  cannot report a cost-level that it has not
  observed
• Government can incentivise regulator to reveal
  signal by paying s if ß is revealed
• Social cost is ?s due to cost of public funds
• Firm can incentivise regulator to hide signal by
  paying bribe
• Such side-transfers are illegal and hence
  costlygt regulator receives only a fraction 0 lt k
  lt 1 of bribe
• We assume the gvt decides on the set of contracts
  offered to the firm BEFORE the regulator makes
  its report on costs gt gvt can influence
  regulators choice on info revelation

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Complete Institutions BenchmarkSymmetric
information

• In this version, the country does not suffer from
  any of the 4 institutional weaknesses
• If regulator reveals ß, there is symmetric
  information
• ? Government maximizes welfare W, s.t. binding
  participation constraints (PC)
• ?dW/dq0 leads to usual markup price over mrgnal
  costs
• (? elasticity of demand)
• gtsince for a given ß, the only variable the
  regulator can focus on is effort (e) gt dW/de0
  to get the optimal effort the gvt aims which
  leads to
• - ?(e)q (i.e. efficient effort)
• - U0 (i.e. no rent)
• gt Price is set above MC to cover for cost of
  transfers which is itself set to avoid any rent
  and H or L firms efforts are both optimal

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Complete Institutions Benchmark NowAsymmetric
information (1)

• If regulator does not reveal ß
• Asymmetric information
• For a firm to be interested in any offer by the
  gvt, the offer has to satisfy the incentive
  compatibility constraints (ICC)
• Here and
• i.e. firm is incentivized to reveal ß truthfully
• Std result the binding PC is for high cost firm
  and ICC is for low cost firm
• ? Low cost firm is given positive rent
• an information rent which does not apply to high
  cost firm

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Complete Institutions BenchmarkAsymmetric
information (2)

• Nowif regulator reveals information, low cost
  firm gets no rent
• Low cost firm has incentive to bribe the
  regulator to keep ß hidden
• Willing to bribe regulator up to
• Government is willing to pay conditional
  transfer to regulator to prevent the regulator
  accepting bribe, i.e.
• Regulator only get k with 0ltklt1 due to
  transaction costs
• Paying the regulator allows the gvt to avoid a
  cost to society of ?k rent given
  to firm is costly to society since there is
  opportunity cost of public funds
• Now we can calculate the optimal gvt choice of q
  and e
• Do so by computing the expected welfare E(W)
  given ? and v
• dE(W)/dq0 and get usual markup formula for price
• AnddE(W)/de0 and get a complex formula
• (2)

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Complete Institutions BenchmarkAsymmetric
information (3)

• What does this equation mean????,
• Marginal disutility to effort of the firm (?)
  can be impacted by a set of variables of
  relevance to the government
• This includes the fact that the rent that the low
  cost firm receives is costly to society (comes
  from distortive taxation)
• The gvt wants to minimize it
• To reduce the rent, the gvt can make the high
  cost firm production (q) level less appealing to
  the low cost firm (work on e and hence Ø(e))

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Complete Institutions BenchmarkAsymmetric
information (4)

• We end up with an actual level of effort is lower
  than the efficient one
• The 2nd term is increasing in v since the more
  likely the firm is to be low cost, the less
  likely the distortion in effort will occur and
  hence the gvt can allow the distortion to be
  greater
• Note gvt can act directly on cost looking at
  effort BUT it can also introduce an incentive
  scheme to get the firm to do the right thing on
  its own
• Rather than setting p, cost or transfers, the gvt
  can set the price and come up with a
  reimbursement rule which makes the firm decide on
  the optimal effort level to max the rent (from
  low powered to high powered)
• Note in this particular model, the level of
  incentive is equivalent to the level of effort

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Now we have a modelso what?

• Lets use the model to review the impact of each
  institutional weakness and the optimal policy
  response to each weakness
• Lets see how consistent these various optimal
  policies
• Lets see how these optimal policies match the
  standard policies recommended and often adopted
  by regulators in developing countries

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What if limited regulatory capacity?

• Limited regulatory capacity implies
• (a) lower ? , the proba that the regulator
  observes the firms type or
• (b) no observation of C (ß - e)
• So what?
• (a) From equation (2), lower ? implies higher
  powered incentives needed since collusion btw
  firm and regulator occurs less often and hence
  anti-collusion payments less of a concern
• (b) Non-observation of c implies high-powered
  incentives by definition price caps are the
  only option
• gt less capacity makes a stronger case for high
  powered incentive regulatory regimes

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What if limited accountability? (1)

• Less accountability of the regulator can imply
  greater value of k (the cost to the government to
  cut the ease of making bribes)
• ? Less likely to be optimal to prevent capture
  because so expensive to do so
• ? Lower social welfare and greater frequency of
  capture
• Assume that with probability ? regulator is
  dishonest and will take bribes and with
  probability 1- ? is honest and will not but
  the gvt does not know the regulator type
• ? Strange resultwith less accountabilitymay no
  longer necessarily be optimal to prevent
  regulators capture through payments to this
  regulator!

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What if limited accountability (2)

• Now what if the problem of limited accountability
  is not about the regulator but about government
  non-benevolence?
• Less accountability of government can thus be
  modelled as greater value of ? gt can be
  modelled as misaligned objective function and
  favouring of firm over consumers WV?U
• Government favoring of firm implies cares less
  about rent, hence lower distortion of effort
• Now E(W) also includes ? and dE(W)/de0 leads to
  drivers of marginal disutility to effort of the
  firm (?) as follows
• ? greater ? results in higher powered incentives
  to cut costs gtbut associated with higher risks
  of regulatory capture

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What if limited accountability (3)

• So do we have any solutions???
• 1. recognize that limited accountability is
  mainly due to lack of information flows between
  actors!
• 2. this means that we need to reduce the
  importance of information that any agents holds
• 3. this can be achieved for instance by
• Lowering the power of incentives (cost plus looks
  good!)
• But also by the creation of new information
  sources (get multiple regulatory agencies to
  generate competition for the generation of
  information)
• but not easy if you have limited capacity

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What if limited commitment (1)

• 3 forms (i) too much renegotiation, (ii) non
  respect of promises to firm and (iii) limited
  enforcement willingness
• gt inefficiency ex-post and all firms will
  pretend to be high costs and hence gvt needs of
  give up more rent to get the right ones on board
• gt high risk when need to make long term
  investments
• If firm invests I to influence ß, it increases
  the probability that it will be a low cost firm
  i.e. ? ?(I) (?gt0, vlt0)
• If government can commit to rents at time of
  investment, will set firms payoffs to account
  for all surpluses as follows
• However, if no commitment, firm only considers
  private payoffs, hence
• gtLimited commitment therefore implies
  under-investment
• NOTE it will also lead to ratchet effect (if
  the firm reveals its type to be low cost, it
  knows the gvt will be more demanding gt added
  incentive NOT to reveal information gt gvt could
  increase welfare by promising not to use info!

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What if limited commitment? (2)

• Sosolutions?
• Note again gvt led renegotiations are common
  (unhappy with high firm profits) gt odds are
  driven by size of rent
• gt government can only commit to give a maximum
  expected rent (lets call it c)
• If not satisfied, gvt needs to reduce e
• gt To satisfy this ICC, the gvt may have to
  favor lower incentives!
• This is because the threat of renegotiation
  constrains its ability to offer the firm the
  possibility of making large profits!
• gtin practice, this means that limited commitment
  may require also a reduction in power of
  incentives since need to give more rent than it
  otherwise would have to get the firms to
  participate in the business
• NOTE empirical evidence suggests that price cap
  are more associated with renegotiation than
  cost-plus

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What if limited commitment? (3)

• More solutions?
• Nationalizationsince gvt end up happy with the
  rent they now controlgt tolerate higher profits!
• Increase debt financing since gvt has to tolerate
  more interest payment than it tends to tolerate
  dividends
• Increase independence of regulator
• The fact is that each form of lack of commitment
  tends to lead to its own solution!

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What if limited fiscal efficiency? (1)

• If no money for direct subsidiesa natural
  solution are cross subsidies (across people or
  across regions)
• Consider two regions rich (1) and poor (2)
• In region 2, only a share ? of the population
  are connected.
• Let Fi , ci , qi , pi be the fixed cost, marginal
  cost, quantity per capita and price in region i,
  and let F2 F2(?) (F2gt0, F2gt0) gt F2 a fct of
  share of people connected
• Write welfare function F
• WS(q1) ? q1 .p1 - (1?)(c1.q1 F1) ?S(q2)
  ?? q2 .p2 - (1?)(?c2.q2 F2 (?))
• dW/d?0 gt (3)
• Differentiate this to get
• This tells us that the optimal size of network
  shrinks as fiscal efficiency shrinks!

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What if limited fiscal efficiency? (2)

• Solutions??? Look at a typical problem
• Imagine rural area more costly, i.e. c2 gt c1 ,
  gtideally p2gtp1
• BUT uniform price restriction to help the poor
  rural area
• i.e. implies rather than p2 (1?)c2
• However, (from (3)) this reduces network size
• With no government-firm transfers, instead of (3)
  we have
• gt there is a trade-off between affordability and
  access
• Hence when 1? gtµ, need cross-subsidies targeted
  to network expansion to increase network
  expansion

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Summary of consequences of our institutional
problems
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What solutions does theory offer?
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CONCLUSIONS

• We know from experience that the real impacts of
  the various institutional limitations discussed
  can be large
• Main real problem is that the solutions available
  are imperfect and OFTEN contradictory
• Moreover, we still have huge gaps in our
  understanding of issues
• No real serious link between finance and
  regulation in this field
• Moreover, good solutions for LDCs often need to
  follow a different path from that taken in
  developed countries
• Thus insufficient and possibly damaging to
  advocate simply for a regulatory framework that
  is closer to some universal ideal.
• and a lot more work to do on this topic!

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