269 viewpoint NUMBER NOTE 2004 Regulating Utilities APRIL Lorenzo Bertolini Lorenzo Bertolini Contracting Out Regulatory Functions (lbertolini@worldbank.org) is a private sector Regulating infrastructure utilities can be extremely complex and development specialist in fraught with risks of political interference and capture by interest the Infrastructure Economics and Finance groups, especially in countries with little tradition of politically Group at the World Bank. independent government agencies. To deal with these challenges, policymakers and regulators have sometimes contracted third NETWORK parties--such as independent experts and consultants--to provide advisory or binding input into the administration of regulatory functions. This Note examines international experience in this area and explores the key implications for policymakers. INFRASTRUCTURE Over the past decade the provision of infrastruc- tors, particularly in countries with weak or fledg- AND ture services has undergone a big change, with ling institutions, limited human and financial many countries moving away from the traditional resources, and a history of repeated political SECTOR public sector model and introducing private par- interference in regulatory decisions. ticipation. This change has called for establishing To foster regulatory effectiveness, policy- strong, credible regulatory frameworks--includ- makers and regulators in some countries have PRIVATE ing regulatory rules and institutions--to protect contracted regulatory functions or inputs to the interests of consumers but also those of the third parties, such as external experts or tech- public and private parties to infrastructure nical panels. Contracting-out arrangements dif- arrangements. fer: while some are built into the design of the GROUP Institutions administering regulatory func- regulatory framework, others are not, and while tions need to be competent (with access to tech- some involve purely advisory input from the BANK nical expertise in such wide-ranging areas as contracted experts, others call for binding law, finance, and economics), independent input. (free from government interference and cap- Built-in or contracting out by regulators. ture by service providers and interest groups), Contracting-out arrangements are some- WORLD and legitimate (abiding by legal principles and times built into concession contracts, for providing transparency and accountability). example, which may require that indepen- THE Mustering these qualities is not easy for regula- dent experts monitor the fulfillment of R E G U L A T I N G U T I L I T I E S C O N T R A C T I N G O U T R E G U L A T O R Y F U N C T I O N S contractual conditions, review tariffs, or set- the stark information asymmetry between the tle disputes. In other cases established regu- operator and the local regulatory authority. latory institutions may be granted the authority to procure the services of external Tariff setting consultants to strengthen the capacity, For water and sanitation services in Bucharest, autonomy, and credibility of regulatory deci- concessioned in 1998, expert panels are sionmaking. involved in setting tariffs. Funded through a cus- Advisory tasks or binding input. When advisory tomer levy and selected by the concessionaire tasks are contracted out, an external consul- and the municipality, these expert panels com- 2 tant usually develops a menu of options, leav- plement the functions of a technical regulator. ing the final decision to the regulator--an The concession contract gives the panels impor- arrangement allowing room for political tant powers to adjudicate tariff decisions, but influence. When binding input is contracted within a clearly laid out process. The Ministry of out, the external provider gives recommen- Economics still formally clears the tariff reviews, dations that must be applied, allowing no but the contract makes it difficult for the min- choice for the regulator. The success of istry to delay or disagree with panel opinions. arrangements for binding inputs hinges on Delegating decisionmaking on tariffs, as is done the external experts maintaining a reputa- in the Bucharest concession, may give investors tion for independence, fairness, and techni- comfort that sensitive decisions are made by cal excellence. competent and independent parties. It may also reduce regulatory costs. Built-in contracting out Much creativity has gone into designing institu- Dispute settlement tional frameworks that prescribe contracting In Chile arbitration panels of independent out, whether through clauses built into con- experts have been put in place to settle disputes tracts or through sector laws passed by executive between the water and sanitation regulator and decree. private operators, especially in tariff reviews. These panels, staffed by three private, inde- Monitoring pendent experts, deliver decisions that are bind- The 20-year water and electricity concession con- ing on both the government and the private tract in Gabon, one of Africa's first real conces- operator. Establishing arbitration panels with sion contracts, prescribes the use of external binding decisionmaking power lends substan- experts to monitor the service provider's per- tial credibility to the regulatory process. In formance in achieving coverage targets. The Chile, unlike in neighboring countries, the experts, paid from dedicated funds set aside from water sector has seen no substantial disputes. the concessionaire's revenues, produce only non- Dispute settlement--whether through medi- binding studies. This monitoring mechanism is ation, conciliation, arbitration, or litigation-- aimed at strengthening the independence and may also be "contracted out" to international competence of the ministerial department bodies such as the International Chamber of responsible for supervising the contract. Commerce, International Centre for Settle- The Gaza water services management con- ment of Investment Disputes, or London Court tract, one of the first private sector initiatives in of International Arbitration. These bodies, the Middle East water sector, also requires the operating on the basis of their strong reputation contracting out of compliance monitoring. The for competence and independence, draw their contract calls for binding technical and financial legitimacy from obligations undertaken by gov- audits by a private third party to calculate the per- ernments to recognize and enforce arbitral formance-linked management fee. The external awards. Thus arbitral awards may substitute to auditor's binding input has increased the credi- some extent for regulatory decisionmaking bility of the regulatory process and helped reduce (such as in tariff setting) and provide an appeal mechanism for regulatory decisions (such as on countries with weak or fledgling institutions. the rate base). But their practical effectiveness is Regulatory institutions may decide to use limited by the timeliness of the arbitration contracting out at different stages of their life process, the availability of expert capacity, and cycle and for different reasons. New regulators the ease of enforcement. Moreover, for some typically need support during start-up to build stakeholders the confidentiality of most arbitra- credibility and competence. More experienced tion procedures may call into question the legit- regulators may contract out a particular task imacy of the regulatory process. because doing so is less expensive than per- forming it in-house. 3 Regional regulators A recent survey of 51 regulatory agencies Policymakers also obtain regulatory assistance throughout the world shows that most (75 per- from regional regulators or from other countries cent) engage external parties to perform regu- through twinning arrangements. For example, latory tasks and plan to continue to do so.1 the Eastern Caribbean Telecommunications Regulators seek external assistance particularly Authority (ECTEL) serves the member countries for tasks relating to tariff reviews, compliance of the Organisation of Eastern Caribbean States monitoring, and dispute settlement, though as a shared regulatory body. ECTEL not only pro- only a few (15 percent) contract out binding vides regulatory functions to national regulators; input into regulatory decisions. since it is small, it also contracts out--for func- Regulators devote a large share of their tions ranging from tariff reviews to impact assess- annual budgets (more than 20 percent for a ment studies. That reduces fixed costs for third of respondents) to hiring external national regulators, which are too small to effi- experts, and most report that contracting out ciently regulate the rapidly evolving telecommu- reduces costs or improves quality. Survey nications sector. respondents consider contracting out particu- larly helpful in improving competence (92 per- Contracting out by regulators cent of respondents), building trust with key Over the past decade some 130 countries have stakeholders (71 percent), and ensuring inde- established an estimated 200 regulatory bodies-- pendence (62 percent). including independent agencies, government The survey results also highlight challenges departments, and contract supervision units. faced by regulators in contracting out, includ- These institutions may contract out for a range ing budgetary constraints (70 percent of of reasons: respondents), the small market of appropriate To supplement limited in-house capacity. Many consultants (less than 50 percent), and diffi- regulators face sharp peaks in their work- culty in specifying and managing contracts. load or need small amounts of specialized While more than 80 percent of regulators have inputs and technical skills that tend to be in a clear decisionmaking strategy for contracting short supply, particularly in the public out, only 30 percent have performed a legal administration. review to determine which functions they can To reduce costs. Contracting out may help contract out and which they cannot. Moreover, reduce the costs of procuring expertise or, only 44 percent have accounting systems to for a given cost, increase regulatory compe- compare the costs of performing a task in-house tence. Indeed, third parties can spread the and contracting it out. fixed costs of acquiring specialized experi- ence over large markets, both national and Designing contracting-out arrangements global. Policymakers have given a great deal of empha- To improve the quality and credibility of regulation. sis to developing independent regulatory agen- Contracting out may assure investors of the cies. Even so, administering regulatory independence of the regulatory process from functions is complex and demanding, both short-term political capture, particularly in technically and politically. And for countries R E G U L A T I N G U T I L I T I E S C O N T R A C T I N G O U T R E G U L A T O R Y F U N C T I O N S emerging from social strife and with fledgling institutions, setting up an institution with ade- quate independence--let alone competence and legitimacy--may be extremely difficult. Contracting out regulatory functions can viewpoint play a key part in enhancing regulatory effec- tiveness, providing comfort to investors. And in emergency or postconflict situations, contract- is an open forum to ing out may make it possible to establish regula- encourage dissemination of tory arrangements that can start functioning public policy innovations for immediately. private sector­led and But to be effective, contracting out must be market-based solutions for based on a clear strategic framework that development. The views includes: published are those of the Assessing the desirability of contracting out authors and should not be (such as its legal feasibility, its costs relative to attributed to the World in-house costs, and its impact on regulatory Bank or any other affiliated credibility). organizations. Nor do any of Specifying the payment mechanism for the the conclusions represent contracted party, its responsibility and official policy of the World authority, and whether it will have a binding Bank or of its Executive or advisory role. Directors or the countries Maintaining adequate in-house capacity to they represent. specify performance targets and monitor their achievement. To order additional copies Creating adequate arrangements to ensure contact Suzanne Smith, transparency and accountability, including managing editor, mechanisms to avoid capture by external Room I9-009, contractors and to encourage competition. The World Bank, 1818 H Street, NW, Moving forward, policymakers and regulators Washington, DC 20433. will require more effective instruments for assess- ing, designing, and monitoring arrangements Telephone: for contracting out regulatory functions--a 001 202 458 7281 need calling for more attention from donors. Fax: 001 202 522 3480 Email: ssmith7@worldbank.org Notes This Note is based on Environmental Resources Manage- Produced by Grammarians, ment (ERM), "Contracting Out Utility Regulatory Functions" Inc. (report prepared for the World Bank, Private Participation in Infrastructure Group, Washington, D.C., 2004). Printed on recycled paper 1. The survey was conducted in 2003 by ERM for the World Bank, Private Participation in Infrastructure Group. T h i s N o t e i s a v a i l a b l e o n l i n e : h t t p : / / r r u . w o r l d b a n k . o r g / V i e w p o i n t / i n d e x . a s p