WATER P-NOTES ISSUE 6 JUNE 2008 44726 Economic Regulation of Urban Water and Sanitation Services T he design of regulation for water supply and A good regulatory system should be (a) coher- sanitation (WSS) services has tended to follow ent; (b) predictable and credible; and (c) legitimate, a check-box approach: diagnose the need, transparent, and accountable. prescribe an independent regulator or similar model (often developed in a different sector or country), · Coherent. Regulatory decisions must be con- and hope for the best. This approach has not al- sistent with each other and with underlying as- ways worked well. Regulation cannot solve all the sumptions. For example, when higher service problems that confront WSS services, and imported standards require higher costs that must be cov- models may not work locally. Regulation must be ered by higher tariffs, a coherent system ensures based on a clear understanding of its capabili- that customers receive the value promised and ties and limits. Its design must reflect not only key that providers recover costs. principles of regulation, but also local needs, local · Predictable and credible. When regulations are legal instruments, and local organizations. clear, predictable, and visibly enforced, provid- ers are more willing to invest to improve and expand WSS services. What is regulation? · Legitimate, transparent, and accountable. What can it accomplish? Regulatory processes and regulations must be understood and accepted by consumers. Lack Economic regulation addresses the problems posed of transparency leads the public to question the by natural monopolies by compelling service pro- legitimacy of both regulations and regulators, viders to keep costs down, charge fair prices, and and to feel that their interests are not being provide good service. An effective system also protected. Such situations can become volatile. designates an entity to implement and enforce the regulations. Together, these functions remain limited in scope. To complement and reinforce economic Steps in the design of a regulation, a supportive policy environment and good governance of service providers are required. regulatory system In short, economic regulation should be designed in tandem with other reform efforts. Designing the regulatory system involves several steps: (a) defining underlying problems; (b) assess- This note reports the key messages and findings of Economic Regulation of Urban Water and Sanita- tion Services: Some Practical Lessons, by David Ehrhardt, Eric Groom, Jonathan Halpern, and Seini O'Connor (Washington, DC: World Bank, 2006), drawing on a related document, Explanatory Notes on Key Topics in the Regulation of Water and Sanitation Services, by Eric Groom (egroom@worldbank.org), Jonathan Halpern (jhalpern@worldbank.org), and David Ehrhardt (Washington, DC: World Bank, 2006). The complete documents may be downloaded from www.worldbank.org/water. WATER P-NOTES ing whether regulation can solve the problems; Choosing appropriate legal instruments and (c) determining regulatory objectives, and (d) choos- organizations. The choice of the regulatory model ing or creating appropriate regulatory instruments should be based on whether it is likely to perform and organizations. the necessary functions competently, predictably, Defining the underlying problems. To improve and in a manner consistent with local culture and services, the causes of poor performance must be capabilities. Figure 1 illustrates the instruments and identified and remedied. These often include inad- organizations available to create systems that are equate investment or maintenance; poor operating structurally different but functionally equivalent. practices; poorly defined or enforced standards; The regulatory organization must fit with exist- lack of clear policies; and barriers to entry for ing institutions and with the legal instrument used small, private providers. for regulation. Most Anglo-Saxon countries have a Assessing whether regulation can solve the history of support for independent regulatory bodies problems. Not all problems can be solved by a with regulatory rules embodied in a statute that can regulatory system. Regulation sets and enforces deflect political interference. However, that model reasonable tariffs and service standards, and it can will not necessarily be effective in developing and help inspire lender and investor confidence. But it transition countries, where political intervention cannot, at least on its own, attract investors or solve often undermines regulatory independence. In en- internal problems, such as inefficient management vironments where politicians may make incoherent, or inadequate planning. unpredictable, or illegitimate decisions--but where contracts can generally be enforced--a contract Determining regulatory objectives. Regulatory may be a more effective regulatory instrument. objectives depend on the country context. In devel- Francophone countries often have a culture of regu- oped countries, regulators usually aim to keep tariffs lation by contract. low and service standards high. In developing coun- tries, the goal may be to ensure that tariffs can be in- Combining different models that have developed creased when service improvements prove necessary. in different legal contexts--for example, combining Figure 1. Selecting legal instruments and organizations for good regulation Regulatory rules and roles Legal instruments Organizations Choose right options Contract Contracts Licenses Statutes Ministry Monitoring Regulatory Unit Office Source: Castalia. ISSUE 6 · JUNE 2008 an Anglo-American style regulatory agency with con- coherence, predictability, legitimacy, and account- cession contracts from the French tradition--will not ability of a regulatory regime. Chief among them be optimal. are (a) working within the existing organizational framework; (b) creating an appropriate role for politics; (c) limiting discretion in decision making; Regulating public service and (d) trading sophistication for simplicity. providers Working within the existing organizational framework. The regulatory system has to be able to Effective regulators are able to reward good perfor- get results within the existing environment of laws, mance and punish poor performance. The refusal policies, organizations, and established relation- of a regulator to grant a tariff increase to a privately ships among politicians, service providers, and the owned utility will usually induce the owners into cor- public. Building on an existing foundation, even if rective action to protect their profits. But indepen- imperfect, promotes credibility and legitimacy. dent regulation of public utilities has often failed to produce similar results because of the difficulty of Creating an appropriate role for politics. De- applying sanctions to public utilities. If the regulator signers of regulation often strive to keep politics out punishes a publicly owned utility by withholding a of their decision making. But political engagement tariff increase, the government, as the utility's own- may be inevitable and even beneficial. Providing a er, will have to cover the deficit through taxes or by legitimate, limited role for politics helps build pre- cutting spending. In either case, the public suffers. dictability and accountability into the system. To deal with this problem, it often makes sense When politicians are involved in regulation, to separate the government's regulatory responsibili- their decisions are often based on immediate in- ties from its responsibilities as owner. For example, terests. To curry favor with the public they may when government-owned companies are asked to call for lower tariffs or demand service improve- pursue objectives similar to those of private utilities, ments--without fully understanding the trade-offs they may need to be regulated in the same way and required. The proper role for politics is to encour- for the same reason as private utilities. An inde- age the government to make decisions consistent pendent regulator may protect governments from with the regulatory framework and its contractual political pressure, making necessary tariff increases commitments. One regulatory mechanism that gives easier. And a competent independent body can politicians some discretion is to allow them to set or provide an alternative source of information, bench- approve tariffs--but within a structure that guaran- marking data, and oversight. It may be able to force tees service providers a fee that is independent of the utility to collect and disclose information related tariff revenues. to its performance and to respond to criticism. Limiting regulatory discretion. The extent of When a government wants to separate the discretion held by regulators depends on the preci- functions of ownership, policy, and regulatory func- sion of the regulations. The regulation-by-contract tions, it has a spectrum of options from which to model usually allows only limited discretion; the choose, ranging from no regulatory oversight to a independent-regulator model (regulation by agency) full-fledged independent regulator. Mid-range op- is associated with greater discretion. Beyond these tions include a unit in a government ministry that generalities, practices vary. Many contracts fail develops a competence in water utility monitoring, to adequately specify provisions for revising tar- or an independent body that issues public reports iffs--giving rise to a high degree of discretion. On on the efficiency and service performance of the the other hand, the discretion of an independent utility but does not set tariffs or service standards. regulatory agency may be limited if legislation or subsidiary instruments specify the schedule for tariff increases and the criteria to be used in adjusting Improving regulatory design them. Low-discretion rules are usually a better Observation and experience in developing coun- choice for countries with limited institutional ca- tries have identified several ways to improve the pacity and regulatory traditions. They result in WATER P-NOTES more transparent and predictable decisions and marking and modeling techniques to calculate allow decisions to be made more quickly and with theoretically efficient tariffs may have technical merit fewer resources. but be relatively costly--and incomprehensible to Trading sophistication for simplicity. Regula- most stakeholders. Simpler methodologies, based tions must always be detailed, but they should not on the service provider's actual costs, enable the be complex or difficult to apply. Rules that require provider to cover costs and invest in improvements. large amounts of information or technical expertise While not ideal, the simpler methodology may be may actually reduce effectiveness. For example, a adequate and appropriate within the country con- tariff-setting methodology that uses complex bench- text, especially if other mechanisms are used to promote efficiency. The Water Sector Board Practitioner Notes (P-Notes) series is published by the Water Sector Board of the Sustainable Development Network of the World Bank Group. P-Notes are available online at www.worldbank.org/water. P-Notes are a synopsis of larger World Bank documents in the water sector. THE WORLD BANK | 1818 H Street, NW | Washington, DC 20433 www.worldbank.org/water | whelpdesk@worldbank.org