Building Regulatory Institutions in Latin America: From Penalties to Incentives

Private sector involvement in infrastructure has required regulatory reform, implying not only a new set of rules but an in-depth review of the way governments traditionally think about regulation. Creating new regulatory institutions in Latin America will not be an easy task. The legal and institutional peculiarities of the region are creating new and different challenges that must be addressed for reform to be successful. In the past, the government's traditional role in infrastructure gave ministries and public officials a full discretionary and active role in setting regulations. "Regulation", as such, is thought of as government's duty, not only limited to the enactment of administrative and legal rules and procedures, but also as an administrative endeavor involving discretion and political will. The increased participation of the private sector in infrastructure requires rethinking the meaning of regulation and the jurisdiction of the institutions involved. This article addresses the implications of asset ownership for regulation and the role of governments when institutional arrangements imply a concession agreement between the public and the private sector.

Why governments prefer concession agreements1
The lack of basic infrastructure services in poor urban and rural areas, the impact of infrastructure on overall economic performance, and its economic and social implications, are powerful incentives for governments to take an active role in the provision of infrastructure services. From a political perspective, state ownership of infrastructure assets and the provision of services is assumed to guarantee that social obligations will be met. It is also believed that ownership will allow the government to intervene whenever it perceives that the service provider is not fulfilling its obligations to provide adequate service.

In the specific case of concession agreements, the regulatory endeavor becomes complex and demanding. The government, as the owner of those assets, not only performs standard regulatory functions (the regulation of natural monopolies to protect consumer interests), but retains another important function; namely, guaranteeing that the concessionaire or the private contractor complies with very detailed contract provisions and obligations. Furthermore, if the private partner does not comply, the government retains the right to intervene unilaterally to sanction, or to declare the contract void.

In this context, regulation can fall into grey areas where the public-private partnership results in the co-administration of the contract and the operation. Inspection and control of the contract is sometimes conceived as the only required regulatory duty, but entails the danger of becoming a permanent auditing and co-administration of the contract. Intrusive regulation thus substitutes for a modem economic regulation (that should conceive its role as an ex-post verification of performance and regulatory compliance), increasing the risks associated with regulatory uncertainty. To avoid the above pitfalls, the design of the concession contract is critical to ensure proper and efficient regulation. Furthermore, the fact that the ownership of the assets remains in the hands of the public sector may not provide the appropriate incentives to the parties involved and will be a factor that increases the regulatory risk.

Regulatory complexities in concession agreements
Contrary to the common belief, regulating a concession agreement is not an easy task. Important issues are the concession contract, who verifies it, how it is verified, and how regulatory capture is avoided.

The Contract
Regulation based on a concession contract can provide greater assurance to the concessionaire since the regulatory provisions are written in the contract. The contract is by itself an instrument to protect the private partner against regulatory risks or to prevent undue interference of the public authority (or the regulator) on the execution of the contract. Nonetheless, in the Latin American legal systems the contract is not the only document to support concession agreements. General legislative provisions (administrative laws, public utilities laws, commercial and civil codes), the bidding documents, and the winner's bid documents constitute an integral part of the contract and, therefore, should be taken into consideration in the fulfillment of contract provisions. This legal determination adds up to the complexity of the concession agreements. Additionally, because the public authority is surrendering only temporarily its duties as the main so-vice provider, the concession contracts usually include very detailed clauses to account for all the complexities of the service and foresee every possible circumstance in the development of the contract. Thus, contract interpretation and the need to adapt it to changing circumstances becomes a major task in the concession performance and could become one of the most important sources of risk for the two parties involved. The government has a duty to avoid noncompliance with the detailed clauses, but there is an asymmetry in obtaining the information needed to verify compliance. On the other hand, contract interpretation by the regulatory authority can impose unforeseen costs or hamper an efficient operation of the service for the private firm. As a result, the regulator will try to intervene very closely in day-to-day affairs, becoming more of an inspector and a policeman rather than a facilitator, controlling inputs and means rather than outputs and results. The problem is exacerbated by the traditional bureaucratic and legalistic approach of the public administrations in some Latin American countries. When the regulator becomes a co-administrator of the contract, it risks the creation of inefficiencies and perverse incentives. For example, to avoid sanctions from an interventionist regulator or to prevent unilateral termination from the public partner, the concessionaire could choose to closely follow the letter of the contract, adopting inefficient and costly technologies or operational procedures.

Who verifies the contract
A concession is by definition a contract between a public authority and a private firm. Therefore, the public authority that signs the contract is one of the parties responsible for its performance and will be the authority in charge of early termination in the event that it is needed. So, in this setting, the role of the regulator is not clear and many overlaps can arise. The law can delegate on the regulator the monitoring of the contract and tariff negotiation, but usually the public authority retains crucial duties with respect to the contract. For example, generally it keeps for itself the final say on the tariff review and is the only authority legally in charge of early termination of the contract or which can unilaterally intervene to declare termination of the contract on grounds of "public interest." Since the regulator is only a delegated party, there is no "independent" regulator as such and political interference will be always present, adding further risks to this type of institutional arrangement. Nonetheless, it is always better that the regulatory institutions be as independent as possible from the public authority, even in cases in which the government is the signer of the contract. Therefore, a clear separation of roles is needed, and it is better to delegate the contract evaluation and all the regulatory duties to a separate regulatory entity to assure technical capabilities and long-term tenure rather than to depend on less skilled and low paid public servants working directly with the public administration.

How to Verify the Contract: The Role of Incentive Regulation
As said before, one of the great difficulties of this type of contract is that the regulator (or the public authority) is not only in charge of the standard regulatory duties but needs to guarantee to the public authority that every clause of the contract is fulfilled. It is, therefore, very important to develop a modem approach to this duty. Incentive regulation is an important way of prompting the private party to comply with the contract. Some examples can illustrate the point. First, contract design is critical to guarantee efficient performance. Rather than design a very detailed contract, it is preferably to introduce in it mechanisms that prompt efficient performance and avoid excessive regulatory supervision. If this is the case, the contract and the bidding process should encourage the private contractor to design, for example, an efficient tariff system. The formulas for tariff regulation become critical in providing the right incentives to metering, to induce efficient consumption, optimize long-term investment requirements and, therefore, reduce the cost of service. Second, longer periods to review the contracted tariff regime will be preferable if profit-sharing mechanisms have been foreseen in the negotiation of the concession agreement and they allow the customer to share some of the efficiency gains without introducing uncertainty about the final outcome of the tariff review. Third, built-in investment incentives or mechanisms are necessary to overcome the disincentive the concessionaire faces in the later years of the concession agreements. Fourth, regulatory authorities have to rely more on ex-post evaluations of results, rather than ex-ante evaluations of inputs and means. A better alternative, and a more efficient instrument to guarantee compliance, is reliance on incentives for desired behavior rather than penalties for undesired behavior.

Regulatory Capture
An additional complication is how to avoid regulatory capture. Since the contract involves a one to one relationship between the regulator and the concessionaire, regulatory capture is more likely to arise in this type of arrangement. "Capture" refers to both political and commercial capture. Political capture of the regulator is a permanent possibility since the general public and the political constituencies believe that they are parties to the contract and the government acts as their representative in its fulfillment. The pressure will be especially acute at the time the price formula is about to be reviewed. Thus, the regulator faces the dilemma of guaranteeing the fulfillment of the contract under public pressure. Commercial capture is also a possibility since the concessionaire is interested in a smooth development of the contract, needs to guarantee the return on the investments made, and must preserve the stability of the business. In addition, the concessionaire must minimize the regulatory risks. An easy way to do this is by capturing the regulator: the one to one relationship (regulator-concessionaire) facilitates this endeavor. In the case of local services or small countries which lack institutional capabilities and skilled regulators, the problem of regulatory capture could become severe and more difficult to handle. As a final point, employment incompatibilities should be established for the regulators in order to decrease the risk of regulatory capture by the companies subject to regulation.

Conclusions
Some of the issues examined above are not exclusive of concession agreements but are exacerbated by the crucial role the regulator plays in the performance of the contract and the role the government maintains through asset ownership. Regulation becomes a grey area and sometimes is confused with contract administration and inspection. A new and modern style of regulatory intervention that relies more on incentives and market mechanisms and less on administrative procedures and indiscriminate prescriptions that create perverse incentives and increase the regulatory risks to private investors is, therefore, needed. A clear separation of roles between the regulator and the public authorities is necessary to preserve the stability of the contract and to avoid political capture. Training is needed on modern tools of economic regulation to stimulate the use of incentives and to reduce excessive dependence on penalties.

-Evamaria Uribe, Infrastructure and Financial Markets Division

1Concession agreements involve the temporary transfer of service assets to the private partner who makes the investments necessary to maintain the service provision in good condition during the term of the contract. The assets are transferred back to the public authority at the end of the concession period.

Last updated: 01/16/07