Commitment in Regulation: A Necessary Condition for Investment

Many believe that lack of investment in infrastructure is one of the major impediments to economic growth in Latin America and the Caribbean. Although estimates of the resource requirements vary, there is a general consensus that massive investments in transportation, water, energy, and telecommunications are needed to ensure sustainable growth in the region. In the past, public utilities made most of these investments, but a combination of inefficient management, macroeconomic problems and high external debt led to a situation where the public sector can no longer provide the necessary resources for both maintenance and new investments in infrastructure.

In an attempt to foster private participation in infrastructure, most countries in the region have started (or are at least considering) a comprehensive program to privatize utilities. A broad range of schemes is being proposed and used to undertake this reform. Most industries involved in the process are considered "natural monopolies," or are closely related to one. Thus, the proposed schemes usually involve the creation of a regulatory framework to prevent the creation of an inefficiently large number of firms and/or prevent the participating firm(s) from raising prices to monopoly levels.

Despite those efforts, only a few countries have been relatively successful in attracting private capital to infrastructure. The public sector is still providing the bulk of investments in most countries in the region. To understand this lack of interest of private capital, it is important to understand how the regulatory framework, and the authority's commitment to enforce it, influences the investment decisions made by private firms.

Investment Decisions Made by a Regulated Firm
A regulated firm will undertake an in-vestment if the price that it will be al-lowed to charge covers the cost of doing business. If investors have no confi-dence that regulatory officials will allow future prices to cover the cost of sunk investments, then socially beneficial and potentially profitable investment projects will not be undertaken.

The returns to investment in an industry characterized by high sunk costs and asset specificity are vulnerable to opportunistic behavior." Prices can be altered but in general investment is rigid. Thus, after the investment has been made, the regulatory authority might have incentives to behave opportunistically and set prices at a level that will only cover operating expenses. In an attempt to serve the consumers' short-term interests, a regulatory agency may disallow recovery of investments, therefore indirectly expropriating the firm's assets (creeping expropriation). For instance, water, electricity and telecommunications companies make substantial investments in specialized and immobile plants and equipment before beginning to serve customers. As a result, the owners of these assets are particularly exposed to the risks of creeping expropriation (also referred to as regulatory risk). If the regulator is unable to commit to a long-term regulatory policy, the private firm's expected returns to investment become highly uncertain. A firm manager that foresees acts of opportunism will not be willing to commit resources to new projects.

Governments can attract investment if they develop means to limit opportunism. However, this requires some form of long-term credible commitment. As has been widely recognized, the successful participation of the private sector will be highly dependent on the development of institutions that safeguard against opportunistic intervention by the government.

Conditions that Could Attract Private Capital to the Region
Authorities of countries characterized by weak judiciary and regulatory institutions, unstable politics and lack of political consensus will find it difficult to commit to a credible long-term scheme. The inability of one government to bind future administrations to a particular policy makes commitment difficult to assure. Since lower prices will yield substantial political support, the government will sometimes attempt to force regulatory agencies to alter policies either directly or indirectly through the appointment process or budgetary appropriations.

A politically independent regulatory institution, combined with a regulatory regime that does not allow for much administrative meddling, may provide assurance to investors. Long-term appointments of regulatory authorities and the institution's financial autonomy can achieve some degree of independence. A very specific and transparent mechanism of price adjustment can avoid administrative discretion. In Chile, for instance, regulatory discretion was limited by specifying in the law how prices had to be computed and adjusted. Limiting administrative discretion restricts the chances of distorting regulation and opportunistic behavior, but it makes it more difficult to adapt to changes in technology or demand. Losing some degree of flexibility may be the cost of attracting private capital when there is no other way of gaining commitment.

Lengthening the tenure of regulators would help them gain independence from short-term political interests and might enable them to gain a reputation of fairness among private investors. A regulator involved in several rate hearings with a regulated firm, or else in the rate hearing of several regulated firms, may develop a reputation for not expropriating a firm's investment. A reputation of being fair may substitute for long-term contracts and guarantee appropriate levels of investment.

Using licenses to stipulate the way utilities are to be regulated could provide a safeguard in countries with a judicial system which has a tradition of respecting private contracts. The government or the legislature could not unilaterally change these licenses. Moreover, any regulatory change would have to be accepted by the company. Otherwise, the firm could initiate legal actions against the public agency. This licensing mechanism proved to be an effective safeguard in the United Kingdom, Jamaica and Bolivia.

Investment incentives might also be restored if outside parties oversee the actions of the firm and the regulator. Legislatures, courts or other arbitrators chosen by the parties to resolve conflicts, could, in principle, constrain behavior. Nevertheless, limited information usually makes their control imperfect.

Widespread domestic ownership and the promotion of competition in some areas of the industry have also been advocated as ways to make regulatory promises more credible. This argument was, in fact, used in the privatization of the United Kingdom's telephone company. The larger the number of domestic owners and competitors, the lower the political support for opportunistic behavior. Competition can be an effective regulator. However, this approach does not come without costs. Increasing competition may be inefficient if the industry is a natural monopoly, and assuring widespread ownership might reduce the interest of outside investors.

Conclusion
During the design of a regulatory scheme, special attention should be given to the institutions established, in particular, the extent to which the institutional framework allows the regulator credibly to commit to long-run regulatory policies. Countries characterized by weak judiciary and regulatory systems may have difficulties promoting private participation in industries involving high sunk costs. The political incentives to respond to an ex-post opportunity maybe unavoidable. In those cases, institutional and judicial reform will have to precede the process that seeks to attract private capital.

-Carlos Federico Basaņes Junior Professional, IFM.

GLOSSARY
Natural Monopoly: An industry is said to be a "Natural Monopoly" if a single firm can produce output more cheaply than any group of two or more firms. In this case, an unregulated market would lead to prices or costs that are too high and to price structures that maybe inefficient.

Sunk Costs: Costs that cannot be eliminated or avoided (for some period of time) even if an enterprise ceases production altogether.

Creeping Expropriation: Indirect expropriation of the firm sunk investment. One form of expropriation, is allowing the firm to charge a tariff that only covers operating costs.

Last updated: 01/16/07