Urjit Patel: Regulation: Panacea or placebo?

An industry structure with incentives for operators must be complemented with regulation

Recently, while announcing that he would chair a high-level panel on infrastructure, the Prime Minister said that he would request the Planning Commission to prepare a paper on Infrastructure Regulation.

The paper is envisaged to delineate frameworks for power, roads and ports that are transparent, independent of government and based on international best practices.

Clearly, expectations from regulation are high; the government is planning to rely heavily on public-private partnerships to give impetus to infrastructure development and has recognised regulation as the key to facilitate such partnerships.

Lest there are any doubts, it is important to underscore that effective regulation is indeed essential for private participation in infrastructure.

Private investors derive comfort from a transparent and consistent regulatory framework before they actually commit investments that are huge, largely sunk and have long pay-back periods.  Moreover, governments worldwide routinely rely on (selective) economic regulation to safeguard interests of consumers.

One must, however, recognise that independent regulation is not a sufficient condition to boost investment in infrastructure. One only needs to look at the power sector to appreciate this point.

Since the advent of the Electricity Regulatory Commissions Act in 1998, as many as 23 states have constituted Electricity Regulatory Commissions (ERCs), but very little has come by way of additional private capital into the sector.

This experience embeds another valuable lesson "� for the most part, regulation of government-owned utilities is a chimera. While commenting on a study on the ERCs in India, an eminent panel (comprising of Madhav Godbole, E.A.S. Sarma and S.L. Rao) has observed: "...many State Governments have been brazen in defying the orders and directives of the ERCs, year after year.

Even the basic requirement of submission of full data in support of the tariff increase proposals is not being met by the utilities. This does not augur well for the ERCs...".

In view of this, the Planning Commission may, in fact, be well advised to expand the scope of its work to highlight the other prerequisites that should accompany regulation to make infrastructure investments happen.

It is important to keep in mind that the still predominant mode of infrastructure service provision "� that is, through a government agency supported by subventions and cross-subsidies "� is fraught with several limitations, viz., monopoly, mixing of social and commercial objectives, and lack of transparency.

The drawbacks of monopolies and cross-subsidies are by now too well known to bear repetition. In addition, intertwining of commercial and social objectives accentuates information asymmetry between governments and their agencies, and thereby leaves ample scope for agencies to hide inefficiencies and impose their preferences.

The track record of State Electricity Boards in camouflaging line losses and other shortcomings under unmetered agricultural consumption year after year is a case in point. The bedrock of government ownership, in practice, is a veritable quicksand.

For instance, lack of hard budget constraints, characteristic of the public sector, enables these entities to keep their underperformance under wraps for that much longer. 

In the case of roads, as agencies have relied solely on devolutions from the exchequer, road construction and maintenance activity has aligned more with political interventions and budgetary compulsions, and less with user priorities. 

Thus, there is a strong case for divesting government from the direct provision of infrastructure services and for separating services that are commercially viable from essential but uneconomical ones (which require subsidy support).

These major, and therefore, difficult ("catching the bull by the horns") steps are required to promote transparency and accountability, both of which are sine qua non for efficiency. Concomitantly, within each sector, services that can be competitively provided should be distinguished from natural monopoly segments.

Thanks to various developments and declining transactional costs, relatively fewer segments of infrastructure sectors are now not easily amenable for competition, as for example, transmission and distribution networks for electricity and gas, and railway tracks.

In this context, it is useful to recognise that the proximate role of regulation is to ensure, inter alia, efficient price discovery for services. In other words, it is analogous to throwing light in a dark area; hence, it makes eminent sense to rely on competition to light up as much area as possible so that the area that remains to be "illuminated" through (heavy-handed) regulation can be minimised.

Also, divesting government from service provision will impart an additional edge to regulation. To begin with, a private utility is likely to be more responsive to regulatory directives and incentives compared to a government-owned utility. Furthermore, once utilities are not under its ownership, government is less likely to stymie the regulatory process.

Accordingly, where there is scope for competition and service provision on commercial terms, we should rely on market forces to promote efficiency as well as safeguard consumer interests.

The positive experience with private participation and competition in unleashing unprecedented growth in urban teledensity coupled with the rapid fall in tariffs, makes a compelling case for replication in other sectors. Hence, consumers should be allowed to procure electricity, gas and water from a supplier of their choice.

To bring this about, natural monopoly elements like transmission and distribution networks have to be pried open by governments, to allow fair access to multiple suppliers.

Given the inadequacy of certain preconditions for implementing open access provisions, namely, robust metering and accounting systems, consumer choice may have to be introduced in a gradual manner, beginning with large buyers. 

Once the scope for harnessing competition is exhausted, residual areas of natural monopoly may be contained through regulation. In order to induce efficiency, regulators should eschew cost-plus regulation and instead adopt light-handed approaches such as price-caps.

Essential but uneconomical services too can be thrown open to private provision and competition using methods such as minimum subsidy bidding, wherein a potential service provider that quotes the lowest amount becomes eligible for subsidy payments subject to fulfillment of specified level of performance (service provision) obligations.

This approach is promising for extending infrastructure services to poor consumers in commercially unviable (sparsely populated) rural areas, and also for facilities such as roads, sanitation and waste management, for which complete cost recovery may not be feasible through direct user charges alone.

Already, many countries have successfully deployed this approach in sectors as varied as telecom (Chile, Colombia, Peru and South Africa), electricity (Argentina and Chile), road construction and maintenance (Argentina, Australia, Chile and United Kingdom), and civil aviation (Australia and United States).

To sum up, it is useful to recognise that regulation is neither a panacea nor a placebo.  A regulatory framework is necessary but, per se, it cannot "crowd-in" capital flows into infrastructure.

In order to be effective, regulation has to be complemented with an industry structure that aligns operators' incentives towards pursuit of value for money.  Else, a singular emphasis on regulation will be akin to chasing shadows, particularly if it is at the expense of other key aspects of reform such as fostering competitive markets (for which privatisation is essential).

(The author is with IDFC Ltd.; views expressed here are personal)