Cover Image
close this bookWater for Urban Areas (UNU, 2000, 243 p.)
close this folder7. The role of the private sector in the provision of water and wastewater services in urban areas
close this folderCompetition and regulation
View the document(introduction...)
View the documentCompetition
View the documentRegulation
View the documentConsiderations in defining a regulatory framework

Considerations in defining a regulatory framework

In defining a regulatory system, several important questions must be answered: What should be regulated and what left to the contract? Who should regulate? What discretion should a regulator have? How can it be ensured that the regulator is independent and accountable?

Areas to be regulated

The duties of the regulator will depend on the kind of private sector arrangement adopted, the degree to which service conditions and price adjustments are already specified in law or contract, and the existence of regulators concerned with the water and wastewater business. For example, many countries do have anti-monopoly agencies, river basin and environmental authorities, health and safety inspectorates, or utility commissions. In many cases, however, some regulatory capacity is generally required to deal with increases in pricing, to monitor private operator performance and contractual compliance, to receive complaints and arbitrate disputes between a utility and its consumers, and to impose sanctions if agreed standards are not met.

Price regulation

A central task of regulation is usually to deal with prices and preventing hidden price rises through reduced standards of service. There are two basic types of price regulation: (a) rate of return or profit control, under which the regulator places limits on the returns on invested capital, dividends payable to shareholders, or capital reserves; and (b) price control - regulators peg allowable price increases to an independent measure such as the retail price index, possibly adjusted for expected efficiency gains.

Rate of return regulation is used with capital investments. After determining an appropriate rate of return on the investment, the regulatory agency sets the maximum return that the utility may earn on its assets for a specified period. The advantage of this approach is that it keeps prices at competitive levels and gives comfort to investors that they will be able to earn a return on their investment - which may lower the cost of capital. But in practice there are several problems. It can reduce the incentives of regulated utilities to lower maintenance and operating expenditures while over-investing in capital outlays. If the allowed rate of return is greater than the utility's cost of capital, the utility will be inclined to maximize its profits by substituting capital investments for other inputs to its production. And if the allowed rate of return is less than the cost of capital, the utility may have an incentive to use a less capital-intensive method of production than it otherwise would. In both cases the result will be higher costs than necessary.

Price control regulation involves the setting of a general "cap" on prices. This cap is usually determined by reference to the inflation rate and to an assessment of the potential for efficiency improvements by the regulated utility. The main advantage of this approach is that it provides utilities with an incentive to reduce costs and operate efficiently, because they keep any profits generated by increases in productivity above those postulated by the regulator. The approach has several drawbacks. If the price is set too high, the private trade operator or investor will earn high profits, which may be unacceptable to the public. If the price is set too low, the level and quality of service may fall because the operator finds it impossible to earn a reasonable rate of return; investors are then placed at risk and the cost of capital may increase accordingly. Expected productivity gains may also be set too high, a risk the investor must confront each time the cap is renegotiated, which may be five to six times over the life of a 30-year concession. Price caps may not be attractive if the primary concern is to promote new investments by the regulated utility. Price cap regulation is used in England and Wales, where a national agency reviews pricing policy and tariffs every five years. Both rate of return and price cap regulation require extensive and reliable information on all aspects of the utility business.

Locus of regulation

As the responsibility for the provision of water and wastewater services is being more and more decentralized throughout the world, municipal government increasingly assumes the responsibility for regulation. Decentralized regulation can generally be more responsive to local needs and conditions, ease monitoring, and ensure better access to information, but it can increase regulatory cost through replication of regulatory agencies, reduce regulatory effectiveness, and, because of lack of capacity, increase the danger of poor regulation. Where regulatory functions are decentralized, national governments can still put in place arrangements to support effective and consistent regulatory decisions. Options include: providing training for regulatory staff; publishing national performance indicators; creating a central or regional agency with auditing functions to monitor the effectiveness of local regulators and reduce the risk of regulatory capture; requiring local regulators to publish the results of their monitoring activities and regulatory decisions; providing reporting and monitoring guidelines to help ensure that utility performance is measured consistently and in a way that eases comparison; and requiring local regulators to employ professional independent monitors - private audit firms, for example. All of these measures leave regulatory authority at the local level, where it may best be located, but attempt to ensure that a higher level of government has a role of monitoring the performance of utilities and local regulators.

Discretion of the regulator

Regulating the performance of a private operator with a contract that may cover 10, 20, or 25 years requires that the regulator has room to manoeuvre and adjust the contract to unforeseen situations. In these circumstances, some level of regulatory discretion is desirable and necessary. On the other hand, a regulatory system that involves too much discretion may deter private participation because it increases risk and arbitrary decision-making. To avoid this, it is necessary to ensure that: clear limits to discretion are specified in applicable laws and the contract; the criteria and processes to be employed by the regulator are established in law; and adequate provisions are in place for appeal against the regulator's decision. The definition of the discretion given to the regulator should provide assurances to operators and investors that regulatory discretion will be exercised in a way that protects their legitimate interests and does not subject them to undue political influence; to consumers that it protects their right to an adequate and safe service at a reasonable cost; and to elected officials that the regulatory agency will remain true to its mandate and accountable for its performance.

Regulator's independence

To be effective, the regulating agency must operate independently from both short-term political pressures and the regulated companies. If regulatory authority lies within the political control of government, there is always the danger that prices, service standards, and investment priorities will be manipulated to serve short-term electoral interests. With a more independent regulator, there is a greater chance that the sector can be managed to meet long-term service and efficiency goals that ultimately will lead to lower cost and better service. Achieving this goal is not easy but several safeguards could be employed, including: making regulatory appointments on the basis of professional, not political, criteria; appointing regulators for a fixed period; funding the regulatory body out of levies on utilities or consumers and not from government budgets; remunerating regulators competitively to attract and retain competent staff; and barring regulators from political activity and from having financial interests in water- and sanitation-related business. Several strategies could be used to reduce the risk of capture of the regulator by private regulated firms or political interests and to make best use of generally scarce regulatory skills: establish a multi-sectoral regulatory commission, for example one that deals with other related infrastructure such as electricity or telecommunications; contract-out some elements of regulation (such as financial auditing and monitoring service standards and asset conditions) to reputable competent private sector firms; use an existing regulatory body with a reputation for independence and honesty.

Accountability of the regulator

Although regulating agencies ought to have a high degree of independence from the political environment, there is still a need to ensure accountability. Ways to do that include: specifying the regulator's duty clearly in law; adopting transparent decision-making processes; requiring regulators to publish decisions and the reasons for those decisions; making decisions subject to review by the courts or some other independent forum; and requiring regulatory agencies to present annual reports on their activities and to be subject to independent audits.

Finding the appropriate regulatory system

In dealing with these issues, governments throughout the world have come up with greatly different solutions. Service and management arrangements are generally governed by detailed contractual arrangements managed directly by the utility or local government. Leases and concessions are usually subject to higher-level government oversight. In France, for example, where leases and concessions are largely a local matter, the national government has recently introduced national laws and regulations that govern important aspects of how these contracts are acquired by publishing model contracts and requiring competition. In Conakry in Guinea, the Soci Nationale des Eaux, an autonomous state-owned national water authority responsible for water sector planning and investments, regulates the lease contract, but ultimate authority over tariff setting remains with the government. In Buenos Aires, an independent state agency representing local, provincial, and federal governments and funded from water and wastewater tariffs provides tight regulation, but its decisions can be repealed by government. In the BOO water treatment plant scheme in Sydney in Australia, the newly formed Sydney Water Corporation is overseen by the Pricing Tribunal of New South Wales, an independent authority that regulates retail water rates. In the United States, many states have utility commissions that regulate prices for an array of public utilities, including water. The Office of Water Services, the national regulatory body in England and Wales, is a national independent agency created specifically for the purpose of overseeing the privatized water and wastewater companies. In Chile, a national regulatory commission establishes price guidelines based on yardstick comparisons for all water companies in the country.

Governments interested in working with the private sector must realize that regulation is a critical part of any private sector arrangement. Basic decisions about the regulatory framework need to be made early. Regulatory capacity can determine which private sector option is most appropriate in a given situation. The regulatory system chosen can affect the willingness of the private sector to participate and the cost of its participation. There is no one right way to mix contracting and regulation or to define the most advantageous regulatory set-up. Options have advantages and disadvantages, and what works best will vary across countries and within cities in countries.

In developing a regulatory system, governments need to keep several broad principles in mind. First, the very purpose of regulation is to ensure that the interests of the consumer are protected. Secondly, the choice depends on the type of private sector intervention. A concession contract requires immensely more regulation and capacity to regulate than a management contract, where a simple contract may suffice. Thirdly, any choice must be realistic and compatible with the country's legal framework and its human resource capacity; a balance must be struck between the ideal and the achievable. Unless there is sufficient capacity, a concession may not be the way to go. Fourthly, regulation should not be too restrictive or controlling. Overly restrictive regulation could deter private companies from entering into private sector arrangements or limit their ability to introduce innovative and efficient operating practices. Any regulation that seeks to control in detail how the private contractor runs its business risks defeating one of the central purposes of private sector participation - improving the efficiency of service delivery by unleashing the know-how and creativity of the private sector. The very reason for choosing the private sector is that the private sector can operate in a less restrictive business environment compared with public entities. For example, if private participation is motivated by the desire to insulate the sector better from direct political intervention and to reduce public subsidies, giving regulatory authority to agencies dominated by short-term political interests would be counter-productive. If the private operator is subject to the same restrictive practices, standards, and norms that hobble public companies, even the best private operator cannot succeed. Without appropriate tariffs, for example, the private sector operator cannot raise the financial resources to meet its obligations. Governments must realize that bringing in the private sector cannot compensate for misguided and restrictive policies.