Country DOpL I Latin America and the Caribbean Region Economic Notes Regulating Infrastructure Funding Regulatory Agencies Warrick Smith Ben Shin September 1995 The World Bank Country Dept. I Latin America and the Caribbean Region Economic Notes Regulating Infrastructure Funding Regulatory Agencies Warrick Smith Ben Shin September 1995 The World Bank This series presents the findings of work in progress. They are prepared or sponsored by LA1 staff to address immediate policy concerns identified through the dialogue with governments and they reflect the views of the LA1 Department. This note was prepared by Warrick Smith and Ben Shin (PSD), under the general direction of Antonio Estache (LA11N). Questions and concerns should be addressed to Mr. Estache, telephone number (202) 458-1442, email address: aestache@worldbank.org. REGULATING INFRASTRUCTURE - FUNDING REGULATORY AGENCIES Warrick Smith and Ben Shin Governments around the world are retreating investments. Achieving this goal is not easy. It is from the role of owner and operator of difficult, if not impossible, to anticipate every infrastructure and placing greater emphasis contingency in long-term regulatory arrangements on their role as regulator of services provided for infiastructwe, thus placing a prenium on by private firms. This shift has heightened mechanisms to provide flexibility. Yet prices for interest in the questfor improved regulation of most infrastructure services tend to be "political", private infrastructure providers, including the placing govemments under strong political use of independent regulatory agencies pressure to misuse discretion to hold prices below intended to ensure that discretion is exercised the long run costs of supply. at arm's length from the political process. A critical question in establishing such agencies Potential investors in infrastructure activities are is how to balance autonomy with aware of this risk, and of the vulnerability of their accountability, including in relation to funding usualy large, long-term and specific investments arrangements. once they have been made. Govemments need to be able to commit credibly to regulatory policies This note dravs on recent international that provide investors with assurance of a fair experience to illzustrate some of the main eurn on their investment. This is necessary both issues and options associated with funding for attracting intial investment at reasonable cost independent infrastructure regulators. and for encouraging efficient operation of the Section 1 provides a background to the investment once it has been made. discussion by examining the role of Increasingly, the mai strategy goverments adopt independent regulators and their fundinig to commit to their regulatory undertakings is to arrangements in the broader context of establish a regulatory system which lmits infrastructure regulation. Section 2 discretion in pricing and other rules and places examines specifc implementation issues and responsibility for the exercise of residual options in more detaiL Section 3 presents a discretion in a regulatory agency with the requisite brief conclusion. The Annex provides expertise and independence. "Independence" in material on funding approaches in selected this context includes measures to protect the OECD and Latin American countries. regulatory decisionrmaking process from being "captured" by short-term political pressures, the 1. Why Worry About Agency Funding? regulated industry or other special interest groups. Infrastructure Regulation & Independent Safeguarding Agency Independence- Some of Agencies the safeguards commonly adopted to ibster The design and implementation of regulatory independence include: arrangements for infrastructure pose a number of . Providing regulators with a mandate that challenges for policymakers.' The general goal is excludes or limits polstical dirton. to restramin abuse of market power by firns em monopolistic activities while providing investors * Providing regulators with securty of tenure with assurance of a fair return on their during their fixed termts. See Smith & Klein (1994). 2 Regulating Infrastructure-Funding RegulatoryAgencies Box 1: Is An Independent Agency Really Required? One of the most contentious issues in many infrastructure reform debates is whether it really is necessary for Ministers to surrender regulatory control to an independent agency. Clearly, it is never "essential" to have such agencies. However, in the absence of effective safeguards against the misuse of regulatory discretion, the govermment will be required to: (a) rely on more specific and rigid rules, and hence reduce opportunities to promote efficiency goals and adapt to changing economic and technological conditions; and/or (b) accept higher infrastructure prices to reflect the risk premia demanded by investors. Independence wvill be particularly important if any of the following three conditions exist: * The regulatory rules involve a significant degree of discretion, particularly in relation to the control of prices or profits. * The private firm will be interacting with a public firm, whether as supplier, customer or competitor. In this setting, vesting decisionmaking authority in a Minister will involve a conflict of interest. * Civil service salary rules prevent Ministries from attracting or retaining highly-qualified professional staff, or exacerbate concems over corruption. * Prescribing professional or other context, common measures include: qualifications for appointment, and involving accountability will vary from context to the Executive and Legislative Branches in the appointment process. * Permitting removal of regulators in the case of * Where authority is vested in a commission, proven misbehavior. staggering the terms of appointees to reduce * Prescribing duties and obligations as clearly the connection with particular Governments. as possible in law, and providing an effective * Exempting agencies from civil service rules appeal process. that lunit salaries below those required to * Prescribing high standards of transparency in recruit and retain well-qualified staff. regulatory proceedings. * Prescribing high standards of transparency in * Prescribing rigorous public reporting regulatory proceedings. requirements, including requirements to * Providing agencies iwith an imdependent publish annual reports. source of funding to reduce reliance on Prescribing legislative scrutiny of agency budget politically-directed budgetary allocations. proposals. Balancg At. The Role of Funding Arrangements Bealsncin Autonpromyde WegulatorsithAcounability Traditionally, regulatory functions, like other Measures to provide regulators with a degree of fucin foenetwr uddfo insulation from the political process have to be g reconciled with the need to ensure regulators general tax revenues allocated through the budget process. The shift to alternative funding appropriate balance between autonomy Wld approaches is a relatively recent phenomenon. This has been driven by three main concerns, Regulating infrastructure-Funding RegulatoryAgencies 3 with the weight attached to any particular will still require their budgets to be reviewed. motive varying betveen countries. This in turn can re-introduce opportunities for political manipulation. This is a key issue and Safeguard Against Political Interference in is discussed in Section 2. Regulatory Decisionmaking. As noted above, funding arrangements are one of the measures Adequacy of Funding for Regulatory Tasks. often adopted to protect "independent" In some countries, past difficulties with regulators from improper political interference. infrastructure regulation have been attributed in While funding arrangements are only part of part to a failure of government to commit the total picture, the concern is that the adequate resources to the task through the Executive might use control over budget general budget process. This may be because allocations to undermine the exercise of the inmmediate beneficiaries of effective independent judgment. Examples might range regulation - consumers - are relatively diffuse from the use of control over agency budgets to and will usually be less well-organized than direct regulators' priorities to threats of other claimants on the budget. At the same reducing or eliminating funding if political time, regulated firms will often have an interest preferences are not accommodated. in the regulator receiving less rather than more funding, and Ministry officials may not be The significance of this concem will depend on strong advocates for agency funding in the the governance traditions of particular budget process if they feel the agency countries. In most OECD countries, this undermines their authority over policy matters. concern is rarely given as a rationale for use of In this environment, there may be a risk that the industry levies or user fees. In many task of regulation will be given insufficient developing and reforrning economies, on the priority in the budget process, with longer term other hand, this is often cited as the principal or negative consequences for the regulated even sole rationale for such measures. industry and the economy generally. Funding regulators through industry levies and the like While concerns of this kind may have some can assist in reducing this risk. The problem of validity, some weaknesses in the argument must defining "adequate" funding remains, however, be acknowledged. First, funding is only a small and is considered in Section 2. part of the overall institutional framework, and in many settings the Executive will have more Cost-recovery: Political, Efficiency & direct and less transparent means of attempting Distributional Goals. Pressures on to undermine the exercise of independent government budgets in most countries have led judgment. to increasing interest in recovering the costs of government services from users - the Second, it is interesting to note that other public immediate beneficiaries - rather than taxpayers institutions that are intended to operate free of in general. This strategy has political, political direction -- most notably the courts - efficiency and distributional dimensions. and are rarely given an independent source of has been the primary driving force behind funding as part of their protective mantle. independent funding arrangements for regulators in OECD countries. Finally, as noted above, measures to accord regulators a degree of insulation from political From a political perspective, shifting part of pressure necd to be reconciled with checks and the burden of public administration away from balances to ensure due accountability. Funding the budget reduces pressure on general taxation arrangements are usually a key part of the measures and public lending. Industry levies, accountability regime, and agencies funded by particularly when transmitted to end-users (ie, industry levies or other extra-budgetary sources 4 Regulating Infrastructure-Funding Regulatory Agencies consumers) through higher tariffs, are largely funding from the general budget, but recover hidden. some fees which are paid back into general revenue. In contrast, most state-level regulators From an efficiency perspective, there are two in the U.S. receive the majority of their fimding main arguments. First, charging user fees for from industry levies or user fees. In Canada, services rendered by government can improve telecommunications regulators are all at least the efficient allocation of resources if the partly funded from industry levies while other pricing strategy reflects any positive and regulators depend to differing degrees on negative effects associated with production and allocations from the general budget. In the consumption. Many agencies now charge for U.K., infrastructure regulators receive their specific services provided to particular users, funding from license fees levied on regulated ranging from copies of reports to discretionary finns. review and certification processes. Whether or not these fees constitute an efficient form of Latin America. The surge of activit) in user charge, or simply a source of de facto infrastructure privatization in Latin America taxation, depends on a judgment as to whether has seen many countries in the region establish the social costs and benefits of regulation are specialist industry regulators, many of which effectively captured by the particular pricing are intended to be independent. Countries with scheme. Second, even if user fees and the like provision for funding regulatory agencies from are treated as a form of taxation, they may industry levies or user fees include Argentina, nevertheless be a more efficient tax than some Colombia, Peru and Venezuela. alternatives. This argument rests on the high inelasticity of demand for most infrastructure Details of arrangements for regulators in services: taxing those services will lead to less selected OECD and Latin American countries distortion than taxes levied on goods or services are set out in the Annex. with more elastic demand. 2. Implementation Matters Depending on the detail of implementation arrangements, industry levies, user fees and The design of funding arrangements for general taxes can each have different infrastructure regulators raises a number of distributional consequences. For example, detailed implementation questions. under cost-recovery schemes citizens who do not have a telephone or access to electricity will How Much Funding Is Required? not be required to contribute to the cost of the Agency income needs to cover a number of relevant regulator through their taxes. specific cost items, including salaries, Moreover, it is possible to direct that certaim consultants, rent, computers, training, public users are exempt from user fees or that industry hearings and other operating expenses. levies be recovered primarily from a particular class of end-users, rather than users generally. There is no simple formula for detemining how much funding is required for a particular agency. Much will depend on the specific OECD Countries. Many OECD countries are functions assigned to the agency, the detailed only now beginning to privatize their tasks created by the regulatory rules, the infrastructure, and hence have not yet grappled managerial strategy adopted for executing those with issues associated with the design of tasks, as well as labor and other costs in each independent infrastructure regulators. country. Countries with independent agencies illustrate a range of approaches. In the U.S., Federal In most cases, salary costs will dominate regulatory agencies receive all or most of their agency budgets, which raises the question of Regulating infrastructure-Funding RegulatoryAgencies 5 how many staff an efficient agency should Levies on Firms or Consumers have. Again, there is no easy answer to this In principle, regulatory costs can be imposed on question, for there is no necessary correlation consumers directly, through a separately with the size of the country, number of identified fee on their utility bill, or indirectly, subscribers or turnover of the regulated firmis. where the levy is paid by regulated fims who For example, the U.K.'s electricity regulator then pass the costs on to consumers m the form has over double the staff of its Argentinean of higher pnices. counterpart, while the opposite relationship exists between those countries' gas and Levying consumers directly remains relatively telecommunications regulators. unusual, with examples including the regulator responsible for overseeing the private water As a general rule, quality of staff will be far cneso nBeo ie n h al concession in Buenos Aires and the cable more important than quantity, and it may often regulator in the District of Columbia in the be necessary to pay salaries above those U.S.2 This approach has the benefit of applicable in the civil service to recruit and retain top quality personnel. It should also be rong t ta y of the regulation, but may also increase the noted that having "too many" staff may be at ,, , complexity (and cost) of administering the least as problematic as having "too few scheme. Larger staffs increase the direct costs of regulation, which must be paid for by taxpayers Levying regulated firms tends to be the most or consumers. No less important, under- i employed staff* usually feel the need to be inp-ataleaiv tofdngrmth general budget. In the U.K. such levies are "doing something" to justify their existence. called "license fees"; in the U.S. they are This can lead to unnecessary (and costly) usually called "regulatory assessments. demands on the regulated firms or other forms of excessive regulatory intervention. Costs of fromeuer feesaby the ctnthatdtheregishno thiskin mut b boe inmin bygovnunnts from user fees by the fact that there IS no this kind must be borne in mind by governments ncsaycreainbtentelvlo that are tempted to swell the size of regulatory bnefitsa reeiv n btheipt. levels of w 2 ~benefits received and the impost. Levies on agencies n order to accommodate redundant regulated firms are used to fund most regulators staff from a Ministry or privatized utility. in the U.S. and Argentina, for telecommunications regulators in Canada and 'n each case, it will benecessarytoestfor the regulators i the U.K., Venezuela, Peru what skills are required and in wvhat quantity, and Colombia. having regard to the actual tasks to be performed by the agency. During the initial The manner in which an industry levy is passed phase of an agency's existence, it will often be - rX . 1 ~~on to consumers will depend mn part on the form preferable to err on the side of having "too few' of price regulation.3 Under traditional rte of staff and to rely more heavily on consultants. return regulation, this cost will often be treated as an element of operating costs and hence passed on to consumers automatically through Many agencies impose fees for particular the tariff schedule approved by the regulator. services -- such as reports or discretionary Under price cap regulation, accounting for review or certification processes. In some cases, fees are recovered directly bv the agency 2 In Buenos Aires, the water regulator and reported as income in the budget process; in other cases, fees are channeled through the applies a levy of 2.67% on consumers' bills. In the m other cases feesarechanneledthroughthe District of Columbia, a regulatory fee of $0.03 per budget. In most cases they are a relatively month is paid by residential cable subscribers small source of total agency funding. 3 For a discussion of alternative price regulation methodologies, see Schmalansee (1993). 6 Regulating Infrastructure--Funding Regulatory Agencies individual cost items is less important, and indicators, problems arise if such formulas are changes in a firm's cost structure do not applied rigidly over a sustained period. automatically flow on to tariff increases. As price cap schemes are nevertheless intended to There is no necessary correlation between the allow efficient firms to make a reasonable rate reasonable income needs of an efficient agency of return, the overall result may not be that and industry tumover, the number of different from under rate of return regulation. subscribers or any other objective standard. However, the risks implicit in price cap Rigid formulas are destined to lead to under- or regulation fall on the regulated firm, rather than over-shooting of requirements. For example, consumers, which may make a firm operating tying funding to industry tumover in an under price cap regulation more sensitive to the industry expected to grow rapidly after level of the industry levy. privatization will often lead to the levy generating excessive income, as costs of Where the levy is imposed directly on efficient regulation rarely grow in exact consumers, or is imposed on firms but tariff proportion to the size of the industry. As well regulation directs the incidence of the as the costs of excessive staffing noted above, regulatory fee component of the finns' costs, this approach will dull incentives for the agency questions arise as to the design of the most to perform efficiently. appropriate structure of levies. For example, if the regulatory fee is significant, distributional Some jurisdictions use such formnulas to objectives might be pursued by exempting some establish a maximum level of levy. In Peru, categories of users from the regulatory fee. laws provide that the maximum levy on More generally, efficiency objectives will teleconmnunications and water firns shall be generally be advanced by imposing the fee on 0.5% and 2.0% respectively of each industries' tariff components with least elastic demand, gross revenues. In Colombia, the electricity such as a connection fee, rather than a demand law provides that levies on regulated firms fee. The costs and benefits of adopting more cannot exceed 1.0% of components of the elaborate schemes of this kind need to be firms' costs. In the U.S., levies funding the weighed carefully in the context of particular Colorado PUC are subject to a maximum of environments. 0.2% of firmns' gross operating revenues from intra-state business. Levies As Safeguards Against Political Interference. Levies on consumers or firms Specifying maximum levies avoids some of the are often viewed as one of the safeguards problems associated with rigidly defined against political interference. While this is formulas, and provides a cap on the size of appealing in principle, several implementation agencies. However, it does not provide problems arise. agencies with protection from political interference in funding matters. Where (a) Total Funding: The Size of The Levy concerns over interference of this kind loom To provide real protection from political large, several approaches might be considered: interference, the size of the levy would need to be established in law and not be subject to * The amount of agency expenditures in any political discretion. In practice, however, it is one year might be set by the Legislature, notoriously difficult to establish a levy that will rather than the Executive. provide a "reasonable" level of funding without regular adjustment. While it is possible to * Budget needs could be evaluated through a wrTite formulas linking funding to a fixed transparent process, such as the regulator percentage of industrv tumover or other making a public submission to a commnittee of the Legislature. Regulating infrastructure-Funding RegulatoryAgencies 7 Box 2: Funding Colorado's Public Utilities Commission Colorado's Public Utilities Commission (PUC) was established in 1913. It has responsibility for electricity, gas, telecommunications, water, intra-state aviation and some motor carriers in a State with a population of around 3.5 million. The PUC has three Commissioners and a staff of around 95. Its expenditures in the fiscal year ending June 1993 totaled $6.1 million, all of which was obtained from levies on regulated finns. The PUC's annual funding process includes the following features: * The PUC's total expenditures for the present year are determined by the State Legislature, and are subject to a maximum based on a levy of 0.2% of firms' gross operating revenues from intra-state business in the previous year. * Assessments are calculated by the Department of Revenue to meet the income approved by the Legislature. The percentage contribution is uniform across regulated sectors. * Firmns pay the levy to the Treasurer in quarterly installments. * Levies received by the Treasurer are placed in a dedicated Fund. Surplus income at the end of the year is used to reduce levies in the next period. * Actual levies might be set for two or three 3. Conclusions years at a time, to reduce opportunities for political interference. Funding regulatory agencies from industry levies and user charges offers a number of Where judicial review arrangements are potential advantages over funding from general effective, a lawv could specify that funds taxation. While OECD countries have allocated to the agency be "no less than generally focused on cost-recovery goals, in required for a reasonably efficient agency Latin America this strategy has also been seen to fulfill its statutory functions", or as part of the protective mantle given to language to similar effect. independent regulators. (b) Scrutiny ofA4gency Spending Plans When these arrangements are motivated by Accountability requirements in most systems concems over political interference in the will require the composition, and not just the exercise of regulatory discretion, it must be size, of an agency's budget to be approved. remembered that financial autonomy is only a This responsibility usually falls to the relatively small part of the total picture. Other Legislature, although in some cases the safeguards will usually be far more important. Executive plays a role. Moreover, autonomous funding arrangements Where concerns over political interference loom raise new implementation challenges, including large, it may be possible to direct that the those flowing from the need to balance Executive has no discretion to modify budget autonomy with accountability. Given the proposals presented by the regulator to the difficulties in establishing a firm correlation Legislature. between the reasonable funding needs of an 8 Regulating Infrastructure-Funding RegulatoryAgencies efficient agency and any objective standard, some mechanism to adjust levies is required. The composition of proposed agency budgets will also require scrutiny. Although these requirements present opportunities for political manipulation, it is possible to design schemes that provide agencies with at least some degree of protection from political interference. Annex - Paffe 1 REGULATORY AGENCIES -- SELECTED OECD & LATIN AMERICAN COUNTRIES* AGENCY STAFF BUDGET FUNDING SOURCE I - SELECTED OECD COUNTRIES Canada Federal: NEB (electricity & gas) 343 $37.1 m General taxation (1992) (1992) RTC (telecom, cable, radio & 423 $35.6 m Levies on regulated firms broadcasting) (1992) (1992) Provinces: Alberta PUB (electricity, gas & 31 $3.1 m 33% general taxation, 66% levies on regulated firms telecom) (1993) (1993) Nova Scotia URB (electricity, 31 $1.3 m 64% general taxation, 36% levies on regulated firms telecom & water) (1993) (1992) Quebec TB (telecom) 30 $1.7 m Levies on regulated firms (1991) (1992) United Kingdom OFFER (electricity) 228 $16.0 m Levies on regulated firms (1993) (1994) OFGAS (gas) 31 $6.7 m Levies on regulated firms (1993) OFTEL (telecom) 151 $12.7 m Levies on regulated firms (1993) (1994) OFWAT (water) 138 $13.1 m Levies on regulated firms (1993) (1994) * All figures for 1995 unless otherwise specified. Annex - Pafe 2 REGULATORY AGENCIES -- SELECTED OECD & LATIN AMERICAN COUNTRIES* AGENCY STAFF BUDGET FUNDING SOURCE United States Federal: FERC (electricity and gas) 1,472 $140 m General taxation; some fees recovered to the budget (1993) (1992) FCC (telecom, cable, radio, 1,783 $126.3 m General taxation; some fees recovered to the budget satellite & broadcasting) (1993) (1992) States: California PUC (electricity, gas, 1,029 $83.9 m 92% from levies on regulated firms, 4% from general telecom, transport, water & (1992) (1992) taxation, and 4% from specific transaction and wastewater) investigation fees Colorado PUC (electricity, gas, 95 $6.1 m 1 00% from levies of up to 0.2% of industry gross telecom, transport & water) (1993) (1993) revenues Florida PSC (electricity, gas, 391 $20.5 m 100% from levies on industry gross revenues telecom, water & wastewater) (1992) (1992) Electricity: Up to 0.5% (0.375% actual) Gas: Up to 0.125% (0.0833% actual) Telecom: Up to 0.25% (0.15% actual) Water/Wastewater: up to 4.5% (4.5% actual) New York PSC (electricity, gas, 686 $55.9 m 99% from levies on regulated firms telecom & water) (1992) (1992) 11- SELECTED LATIN AMERICAN COUNTRIES Argentina ENRE (electricity) 85 $15.6 m Levies on regulated firms ENERGAS (gas) 86 $22.6 m Levies on regulated firms CNTF (rail) 74 $9.4 m Portion of concession fees paid by regulated firms CNT (telecom) 400 $22.1 m 0.5% of industry revenues, plus radiospectrum fee ETOSS (water in B.A.) 72 $15.7 m 2.67% of consumers' water-sewage bills * All figures for 1995 unless otherwise specified. Annex - Pa2e 3 REGULATORY AGENCIES -- SELECTED OECD & LATIN AMERICAN COUNTRIES* AGENCY STAFF BUDGET FUNDING SOURCE Colombia CREG (electricity & gas) 35 $3.9 m Up to 1% of industry's functioning expenses, excluding operating expenses and energy purchases Peru OSIPTEL (telecom) 65 $6 m 0.5% of industry gross revenues SNSS (water) 45 $2.5 m' Up to 2% of industry gross revenues Venezuela CONATEL (telecom) 80 $2.9 m 0.5% of regulated firms' revenues (1993) (1992) * All figures for 1995 unless otherwise specified. Bibliography National Association of Regulatory Utility Commissioners (1993), Profiles of Regulatory Agencies of the United States & Canada, Yearbook, 1992-93 (NARUC, Washington D.C.) Schmalansee, R. (1993), "Good Regulatory Regimes", RAAND Journal of Economics, 20, 417-436 Smith, W. & M. Klein (1994), "Infrastructure Regulation: Issues and Options" (miimeo, World Bank, Washington D.C.)