40915 noTE no. 23 ­ MaY 2007GRIDLINES Sharing knowledge, experiences, and innovations in public-private partnerships in infrastructure Matching regulatory design to country circumstances The potential of hybrid and transitional models Anton Eberhard D eveloping countries attempting to imple- the degree of regulatory commitment--the will- ment the standard model of independent ingness of governments to minimize political regulation have encountered many prob- opportunism in tariff setting and service stan- lems and challenges. These may arise when a dards and to transfer regulatory decision-making regulatory system is incompatible with the coun- powers to an independent regulator, a regulatory try's regulatory commitment and institutional and contract, or an expert panel. Regulatory commit- human resource endowment. Selecting from a ment is expressed in strong political support for menu of regulatory options to create a hybrid constitutional and legislative frameworks that model--one that best fits a country's own circum- underpin transparent regulatory systems and stances and challenges--can improve regulatory encourage the honoring of contracts. performance. The most common feature of infrastructure reform in developing and emerging economies in 15 years Challenges and problems has been the establishment of independent regula- tory agencies. The aim of regulation is to encourage Many challenges and problems have emerged with efficient, low-cost, reliable service provision while utility regulation in developing countries. Two of ensuring financial viability and new investment. these are limits to independence and institutional And regulatory agencies, it was hoped, would fragility and capacity challenges. reduce risk for private investors by insulating tariff setting from political opportunism and making Limits to independence decisions more transparent and predictable. The creation of separate regulatory agencies was intended to foster independent decision-making. How well have these regulatory agencies But regulators often are far from independent. performed? International debate and research on Government can exert pressure on regulators to infrastructure regulation are increasingly focusing modify or overturn decisions. In some countries on these issues. Ironically, many now argue that commissioners have been forced to resign. As a some of the new regulatory agencies have exacer- result, there is often a large gap between law and bated the problems they were meant to address practice. and led to a new risk for investors--regulatory risk. Some view this risk as arising from incapable Tariff setting remains highly politicized, and regulators making unpredictable or noncredible governments are sensitive to popular resentment decisions. Others see it as simply the result of against price increases, often necessary to cover regulators--given wide discretion and broad objec- costs. Establishing new, "independent" regulatory tives--attempting to make difficult decisions with agencies in these contexts can be a risky strategy important social and political consequences. for all stakeholders--government, utilities, inves- tors, and customers. Alternative regulatory models that offer a better PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY fit with a country's circumstances can alleviate Anton Eberhard is a professor at the University of Cape some of the problems and thus improve regula- Town, South Africa, and a member of PPIAF's Technical tory performance. These circumstances include Advisory Board. Helping to eliminate poverty and achieve sustainable development through public-private partnerships in infrastructure PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY fIguRe 1 The World Bank rethinks the classic independent regulator model THeN NOW A requirement of all power lending will be explicit A credible regulatory system requires more than a movement toward the establishment of a legal frame- formally independent regulatory entity ...Other tran- work and regulatory processes satisfactory to the sitional arrangements may need to be established Bank ...This requires countries to set up transparent . . . including limiting the amount of discretion that regulatory processes that are clearly independent regulatory bodies have in setting prices and key . . . parameters. --World Bank 1993 --World Bank 2004 Institutional fragility and capacity institutions may remain a goal in many countries. challenges But the challenges and problems point to a need Many regulatory institutions in developing coun- to start considering complementary, transitional, tries are no more than a few years old, and few or hybrid regulatory options and models. These are older than 10. The challenge of establishing include regulating by contract and outsourcing new public institutions in developing countries regulatory functions. has often been underestimated. It takes time to build and entrench governance, management, and Regulating by contract organizational systems and practices and to build Regulating by contract involves pre-specifying new professional capacity. Many regulatory insti- regulatory regimes (including multiyear tariff- tutions are still quite fragile and lack capacity. setting systems) in detail in such legal instruments as basic law, secondary legislation, licenses, conces- In a recent global survey of regulators the most sion contracts, or power purchase agreements frequently reported constraint was lack of special- (Bakovic, Tenenbaum, and Woolf 2003). Regula- ized skills in utility regulation: 30 percent of tory contracts are generally constructed for private Some respondents cited insufficient training as a signifi- participation but may also be used to improve the regulators cant constraint, and 61 percent characterized performance of state-owned utilities. training as deficient because it lacked continuity are far from and was poorly targeted. The survey concludes A regulatory agency can successfully coexist with independent that "quality human resources are scarcer than a regulatory contract where it is incomplete and money" (Tremolet and Shah 2005, p41). additional regulatory mechanisms are needed. The law or contract could explicitly define the role of the regulator--for example, in periodic tariff Regulatory options setting, monitoring of performance, or mediation and arbitration. The regulator could also enhance Clearly, independent regulation requires strong the transparency of regulatory contracts by collect- regulatory commitment and competent institu- ing, analyzing, and publishing performance data. tions and people. The reality is that developing countries often show only weak political commit- But welding legal traditions together can also lead ment to independent regulation and face big to problems. Even when the contract specifies the constraints in institutional capacity (Tremolet and tariff-setting formula, the regulator might feel Shah 2005). These limits of independent regula- obligated by its legislative mandate to intervene tion are beginning to be recognized, including in in the public interest. In these cases, clarifying policy documents at the World Bank (figure 1). regulatory roles and functions is essential. Acknowledging that limits might need to be Outsourcing regulatory functions imposed on regulatory discretion--because of Outsourcing or contracting out regulatory func- weak regulatory commitment, political expediency, tions involves relying on external contractors to fragile institutions, and capacity constraints--does perform such functions as tariff reviews, bench- not mean that independent regulation is not desir- marking, compliance monitoring, or dispute able. Building credible, independent regulatory resolution. Outsourcing might be considered Improving regulatory performance by matching country circumstances or disputes that arise out of contested interpre- fIguRe 2 tations in regulatory contracts. In contrast with Different regulatory options can often coexist conventional arbitration mechanisms, expert panels have the specialist expertise needed to analyze comprehensive tariff reviews and use procedures that are less formal and adversarial. Regulation Regulation One interesting use of expert panels could be at The level of by agency Regulator by contract regulatory (or ministry) the regional level. Regional economic bodies or Independent regulator administers Regulatory regime sets tariffs and regulates contract (such as (including tariff setting) regulatory associations could employ an expert discretion access, quality of supply, a concession prespecified in detail customer service, contract) in legal instrument panel to provide technical assistance to a number dispute resolution of national regulators. Regional panels would should Advisory provide greater continuity and consistency in regulators specialist support and could make better use of depend on Regulatory Expert outsources the context Regulatory scarce regulatory expertise. They could also assist some support panels contract provides functions for external in harmonizing regulatory regimes, aiding the Government Independent reviews contractors Government policy and policy and integration of regional networks. legal legal framework Outsourcing of regulatory functions to third parties framework Consultants or expert panels undertake or assist with tariff reviews, standard setting, monitoring, arbitration Toward better regulatory systems The different regulatory models embody varying degrees of regulatory discretion. But they are not mutually exclusive and often coexist (figure 2). How to choose between these options or decide where there are challenges or problems relat- on an appropriate combination? ing to a regulator's independence, capacity, or legitimacy--or where regulatory contracts need Some have argued that the fundamental chal- additional support for effective administration. lenge in regulatory design is to find governance Outsourcing might also be used for cost-benefit mechanisms that restrain regulatory discretion reasons (Tremolet, Shukla, and Venton 2004). over substantive issues such as tariff setting (Levy and Spiller 1994). Others argue that some There are two main models of regulatory outsourc- regulatory discretion is inevitable (and even desir- ing. The first involves consulting or technical able) and so the fundamental problem is how to support for regulators or the parties to a regulatory establish governance arrangements and proce- contract. The second involves the government's dures that allow a "nontrivial degree of bounded contracting of separate advisory regulators or and accountable discretion" (Stern and Cubbin expert panels. In the strongest version of this model 2005, p7). the advisory regulator or expert panel must give its advice in a publicly available document that A model to fit the context clearly explains the decision. The minister (or other The level of regulatory discretion should be relevant authority) may request reconsideration determined by the context. Regulatory models of the recommendations, but must do so within a and governance systems should be securely specified period. If the minister fails to react, the located within the political, constitutional, and recommendations are enacted. And if the minis- legal arrangements of the country. They should ter rejects or modifies the recommendations, the also fit the country's regulatory commitment, minister must provide a written public explanation. institutional development, and human resource The minister's policy directives and other commu- capacity. nications to the regulator or expert panel must be in a public document. The regulator or expert panel Where there is weak regulatory commitment holds public consultations with the parties affected and capacity, the initial choice might be a set and is funded from an earmarked budget outside of low-discretion regulatory contracts without a the line ministry (Brown et al 2006, p100). regulatory agency (figure 3). Where there is strong regulatory commitment but weak institutional Expert panels may also be used to arbitrate development and capacity, regulatory functions disputes between regulators and utility operators could be contracted to an expert panel. Hybrid and transitional models We have already noted the possibility of hybrid fIguRe 3 models. Yet another possibility is a transitional The choice of regulatory option should path (as indicated in figure 3). The situation in a fit the context country may change over time. While regulatory High commitment is being increased, strong advisory Strong advisory Independent panels could be contracted or a separate regulatory regulators regulator agency established, perhaps initially with limited Expert panels Contracting-out discretion. As institutional and human resource Regional regulators if cost-effective capacity is built, the responsibilities and functions of the regulatory agency could be expanded. And ? as these transitional and hybrid models evolve, commitment Country X sensible decisions could be made on outsourcing certain regulatory functions where cost-effective. Regulatory There is no ideal destination. The transition may not always lead to a full-fledged independent regu- latory agency. There may well be situations where Regulatory an independent agency is simply not justified Regulatory contracts with and an expert panel or a well-designed regulatory contracts contracting-out contract would suffice. Low Institutional and human resource capacity High Conclusion Source: Adapted from Brown and others 2006. The idea that infrastructure reform should World Bank, Washington, D.C. involve setting up independent regulators became Brown, Ashley, Jon Stern, Bernard Tenenbaum, and Defne Gencer. a mantra over the past 15 years. But mantras 2006. A Handbook for Evaluating Infrastructure Regulatory Systems. become substitutes for thinking--and may not Washington, D.C.: World Bank. fit all settings. The success of a regulatory system depends on its compatibility with a country's regu- Levy, Brian, and Pablo Spiller. 1994. "The Institutional latory commitment and institutional and human Foundations of Regulatory Commitment: A Comparative Analysis resource endowment. Each country needs to of Telecommunications Regulation." Journal of Law, Economics and select from a menu of regulatory options to create Organization 10 (2): 201­47. hybrid models that best fit its own circumstances Stern, Jon, and John Cubbin. 2005. "Regulatory Effectiveness: The and challenges. And as the country builds regu- Impact of Regulation and Regulatory Governance Arrangements latory independence and capacity, these hybrid on Electricity Industry Outcomes." Policy Research Working Paper models will evolve. Designing and implementing 3536. World Bank, Washington, D.C. legitimate, competent regulatory institutions in developing countries will always be a dynamic Tremolet, Sophie, and Niraj Shah. 2005. "Wanted! Good challenge. Regulators for Good Regulation: An Evaluation of Human and Financial Resource Constraints for Utility Regulation." Report by Environmental Resources Management and Tremolet Consulting for Note the World Bank, Washington, D.C. GRIDLINES This note is based on a number of papers by the Tremolet, Sophie, Padmesh Shukla, and Courtenay Venton. author. The papers can be accessed at www.gsb. 2004. "Contracting Out Utility Regulatory Functions." Report Gridlines share emerging knowledge uct.ac.za/mir. on public-private partnership and give an by Environmental Resources Management for the World Bank, overview of a wide selection of projects from References Washington, D.C. various regions of the world. Past notes can be Bakovic, Tonci, Bernard Tenenbaum, World Bank. 1993. The World Bank's Role in the Electric Power Sector. found at www.ppiaf.org/gridlines. Gridlines are a publication of PPIAF (Public-Private Infrastructure and Fiona Woolf. 2003. "Regulation PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY World Bank Policy Paper. Washington, D.C. Advisory Facility), a multidonor technical assistance by Contract: A New Way to Privatize ------. 2004. "Public and Private Sector Roles in the Supply of facility. Through technical assistance and knowledge Electricity Distribution?" Energy and Electricity Services." Operational Guidance for World Bank Group dissemination PPIAF supports the efforts of policymakers, Mining Sector Board Discussion Paper 7. nongovernmental organizations, research institutions, and Staff. Energy and Mining Sector Board, Washington, D.C. others in designing and implementing strategies to tap the full potential of private involvement in infrastructure. The c/o The World Bank, 1818 H St., N.W., Washington, DC 20433, USA views are those of the authors and do not necessarily PHONe (+1) 202 458 5588 fAX (+1) 202 522 7466 reflect the views or the policy of PPIAF, the World Bank, PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY geNeRAL eMAIL ppiaf@ppiaf.org WeB www.ppiaf.org or any other affiliated organization.