21460 Viewp olnt Note No. 203 December 51 Infrastructure Concessions, Information Flows, and Regulatory Risk Phil Burns and Prices for monopoly infrastructure services have a history of controversy. But regulatory Antonio Estache experience in newly concessioned infrastructure sectors in Argentina and the United Kingdom shows that even the arcane rules and data requirements for setting prices can end up being fiercely contested. Regulators typically start the price review process with limited sectoral and corporate data. To move toward more realistic regulatory targets, they must ensure that this information base grows and that their ability to process it improves-a costly undertaking but worth the expense. Getting it right-with well-conceived rules, data, and methodologies-helps to avoid time-consuming regulatory disputes and contract renegotiations, reduce regulatory capture by the new private operator, and assess who gains and who loses from utility privatization. Getting it wrong can cause the concessionaire to operate and invest inefficiently, raise its cost of capital, and ultimately jeopardize privatization. This Note outlines the accounting requirements that a regulator should impose on new concessionaires to navigate these waters as smoothly as possible. Contest of unequals mation burden. The regulatory instruments fall roughly into three categories: pure price caps, The control of prices charged by monopolists is price control with frequent adjustments to ensure often characterized by economists as a "contest" that profits are normal ex post, and price control between the regulator and the service provider that attempts to achieve. ex ante, a normal rate of in which the two players do not share the same return for the firm. information. The asymmetry of information places the regulator at a disadvantage. Thus the Price caps, a high-powered regime, were the regulator must define its information require- starting point for regulation in some sectors in ments and data processes early in the design of Argentina and in all sectors in the United the concession contract and transaction. And it Kingdom. The regulator sets (and periodically should take advantage of the government's resets) a CPI - X target from the existing price leverage during bidding to extract information level, where CPI is the consumer price index from concessionaires and commitments from and X is the regulator s best estimate of future them to provide continued flows of information productivity growth. Whether these high- to aid price review. powered regimes are sustainable enough to deliver efficiency gains is yet to be proven. A variety of regulatory instruments are available Implicit in high-powered regimes is the to a regulator of monopolies, and the choice has assumption that increased profits for utilities profound implications for the regulator's infor- are not a failure of regulation. But they tend to The World Bank Group _ Finance, Private Sector, and Infrastructure Network 2 Infrastructure Concessions, Information Flows, and Regulatory Risk be politically unpopular, and regulators may be with the cost of capital, in an attempt to deliver under constant political pressure to recontract ex ante a fair distribution of returns bemeen when a firm reports higher profits, as has been shareholders and customers. This approach the case in the United Kingdom. coincides broadly with U.K. regulation today. The U.K. regime has served as a model in Under a simple design in which prices of differ- Argentina and B3razil, where the main imple- ent products are capped individually, as in gas mentation problems so far have centered on and electricity in Argentina, a price cap regime controversies about information requirements. simply requires the regulator to forecast future productivity growth, not to adjust prices for past How to prepare for shocks, conflicts, excess profits. To forecast productivity growth, cheating, and mistakes the regulator can look at the firm's historical achievements or use comparative information The experience of price reviews in Argentina from similar businesses, or yardstick competition andI the United Kingdom suggests that regulators (box 1). This type of control requires only the can easily become embroiled in methodological most basic checks to ensure that the profits debates with the regulated companies. To pre- resulting from its application are reasonable. In pare for these debates and prevent their escala- practice, it has tended to underestimate profits, tion into prolonged disputes, regulators must be especially in the United Kingdom, and Ieads to able to: political sustainability problems. * Compare utility performance outcomes with expectations. The second option, rate-of-return regulation, * Evaluate the cost of adverse shocks that may guarantees that ex post profits reach certain lev- warrant relaxing the regulatory regime for the els. The U.S. system in the 1970s was represen- utility. tative of this regime. Rate-of-return regulation * Evaluate whether lower-than-expected costs gives operators little incentive to cut costs. But it are due to better performance or a reduction protects investors in risky environments and may of output. persuade some of them to bid for deals they * Evaluate the asset base and charge for the con- would not otherwise have considered given the sumption of the utility's capital. risks involved. The problem with this regime is its demanding information requirements. To The rest of this Note looks at how regulators allow regulators to retain control, especially over should prepare for and sequence the information investment decisions, the regime virtually places requirements for price reviews. them in a position to run the business, confus- ing the roles of managers and regulators. The first step is to establish the allowable rev- enue of the business on which to base a price An intermediate scheme-and the one assessed control. This is required regardless of the specific in this Note-is one in which regulators attempt control the reformers have selected: a control on to set prices that recover an efficient level of price per unit sold, a control on revenue, or a costs ex ante, but ex post the firm is given incen- hybrid of the two. There arc two cquivalent tives to beat the control because it will not be methods for calculating allowable revenue: the reviewed for some time. When the price control traditional accountinig-based method and the is reviewed, however, the regulator passes the cash flow approach. benefits of efficiency improvements to the cus- tomers. Regulators applying this form of control In the traditional accounting-based method, over use an accounting approach in which they fore- the price control period revenues should be cast asset values, capital expenditure, deprecia- expected to cover operating costs plus deprecia- tion, and operating expenditure profiles, along tion plus a return on capital. The cash flow The World Bank Group 3 approach sets regulated rev- compare the performance of enues over a price control Regaulators may regulated companies, taking period equal to the present into account technology, asset value of operating and capital use model age, and reasonable operating expenditures over the period conditions. Another bench- plus the present value of the companies or mark can be obtained through change in the asset value over yardstick competition, in the period. The first coiipoiient yardstick which a business is regulated ensures that the business can tit to by reference to its actual peers. conduct its ongoing activities; competitiont Under this approach, if all the second maintains the value provide a firms are expected to achieve of existing assets. Any expro- the same rate of productivity priation of asset value is made benchmark growth, the firms that do best transparent. end up with the greatest prof- its, while poorer performers The inputs into the calculation of allowable rev- make lower profits. This form of regulation is enue are the same under both methods: predicated on the assumption that enough com- * Operating costs. parators exist for each business. * Capital expenditure. * An opening asset value. An important issue is how incentives affecting * Depreciation. operating expenditure and investment work * Cost of capital. together. If operating expenditure is subject to strong incentives through yardstick competition How to count operating costs but capital expenditure is automatically rolled for- ward into a regulatory asset base, this may distort The regulator needs to evaluate the current level efficiency incentives and input choices. That does of operating costs and the efficient level of oper- not mean that yardstick competition should not be ating costs. Forecasts of operating expenditures used. It merely implies that models should take may be based on information on other firms account of investment and that the regulator's (exogenous information) or firm-specific infor- treatment of investment and operating expendi- mation (historical or current). Regulators cannot ture should not affect input choices arbitrarily. directly observe firm-specific information and may find it difficult to build up a reliable picture How to count investment of firm-specific costs. Bidding documents often cover some of this information, but in most While productivity trends in infrastructure are rea- developing countries the private operators will sonably stable, those associated with capital have to revise the forecasts once they get a bet- expenditure are not. Investment is lumpy, and it ter idea of the value of the assets. If the regula- can be postponed or brought forward by the oper- tor uses firm-specific information based on these ator. Two major problemns emerge: how to forecast forecasts, the company may be tempted to investment, and how to deal with divergence change some of its accounting outcomes to between expected and actual capital expenditure affect regulatory behavior. That is why it is often at each review. suggested that using exogenous information provides sharper incentives. Engineers' reports, benchmarking against other businesses, and submission of business plans can In Chile's water sector and Spain's electricity sec- help in forecasting investment requirements, but tor, for example, regulators use model compa- expectations and outcomes will inevitably nies to provide a benchmark with which they diverge. The crucial issue in providing investment 4 Infrastructure Concessions, Information Flows, and Regulatory Risk Under yardstick competition the price that a regional monopolist may charge is determined by the costs of the other regional monopolists. If the businesses are perfectly comparable, setting prices for each business at the average level of costs in the industry gives strong ation profile of both old and new assets there- incentives for the businesses to reduce their costs, which then has fore assume particular importance and should the effect of reducing costs and prices across the industry. If the businesses differ in some respects (because of geographical be sinaed b or topographical characteristics) and the way in which they differ can dig process. be unambiguously identified, the regulator can simply adjust the prices for each business by the share of the costs that is outside its If the success criterion for a bid is the lowest cus- control. But if the cost differences due to inefficiency and those due to tomer prices offered, old assets are explicitly writ- factors beyond the firms' control cannot be distinguished with cer- ten down to zero, hut there will still need to be tainty, econometric techniques need to be used to separate them. regulatory treatment of any exit payments to con- cessionaires for the value of undepreciated assets. If the criterion is the largest lump sum offered to incentives is how to treat investment over- or run a franchise, however, the outgoing conces- underspend relative to forecasts at each regula- sionaire could receive the highest bid, since this tory review (see below). bid reflects the value of the assets as they currendy exist. But this value is based on the future stream How to value assets of earnings, which is determined by the price set by the regulator throughout the new franchise. If Asset valuation and depreciation have proved to the regulator unreasonably ratchets down prices be extremely controversial issues in regulation. for the period of the new concession, this effec- Regulatory asset valuation should be the fixed tively expropriates the value of the assets built in point of any regulatory system: the rules should the previous concession. Generally, therefore, be clear and transparent to minimize the risk to new investment by the concessionaire needs to be shareholders that their investments will be expro- transparently treated by the regulator at each priated by an opportunistic regulator. The prob- review, as part of the process of rolling forward lem in privatized utilities is that the assets are the asset base and charging depreciation on it. usually sold at a value quite different from (usu- ally less than) the current cost valuation. How to measure the cost of capital Which value should regulators use? Where pos- The cost of capital has also been a contentious sible, regulators have steered away from using issue in regulation. Regulators need to compute current cost values as a basis for regulation and the weighted average cost of total capital (debt instead have derived a regulatory value based on plus equity) to ensure a return to investors and the flotation value of the assets, rolled forw,ard sustain the asset base. The cost of debt capital by net investment. The depreciation profile can be observed from published information. reflects this choice, for it is charged on the reg- but the cost of equity capital needs to be esti- ulatorv value rather than the current cost value. mated from market data using such techniques This approach avoids giving investors a return as the capital asset pricing model. on assets valued at a higher price by the regula- tor than the investors actually paid. In developing countries, however, concessionaires are often unlisted, so market data are not available. For a concessionaire that has paid a transfer to Ancd concessionaires may be part of a larger con- the government to operate a business at a pre- glomerate, so market data will cover not only the determined set of prices, these issues could be regulated activity but others as well. In most recent important. Regulatory disputes could emerge Latin American privatizations a few large local relating to what the concessionaire actually groups involved in many activities joined foreign bought with that transfer-a stream of future investors and operators in a consortium, and little earnings or a return on the preexisting and information on their infrastructure activities could future asset base? Issues relating to the depreci- be extracted from local stock markets. The World Bank Group 5 TABLE 1 INCENTIVE EFFECTS OF ALTERNATIVE VALUATIONS OF NEW INVESTMENTS m 3;3 Positive incentives Negative incentives Since the company keeps efficiency savings forever, The company has an incentive to quote high prices for *= . m it faces the maximum incentive to push the actual investments to maximize its savings, increasing the need cost of investment down as low as possible. for intrusive regulation. The company has an incentive to delay the projects that should be delayed. is The company has an incentive to undertake investment The company may not seek small efficiency gains if the _ * C as cheaply as possible, since it keeps the gains additional return is minimal. for a maximum of five years Since the company keeps efficiency savings only for The company's incentive to delay investments is the lifetime of the project, there is a bias toward under- minimized, which may lead to unnecessary investment. taking investment early in the control period. This may be desirable when there is an important need to expand coverage fast. A common solution to these problems is to rely it is preferable to specify the period ex ante to on close comparators. Other domestic or preserve the operator's incentives. regional coml)anies quoted locally or similar international companies can provide useful Prices may be reset by moving the regulated comparators in such sectors as telecommunica- price level to the prevailing level of costs; there- tions, where private operators are common in after, a new X factor would apply. Companies many rcgions. An alternative is to use bench- would keep the profits from extraordinary or mark ratios based on international best practice, unexpected efficiency improvements until the information increasingly available from interna- end of the price control period (up to five years), tional organizations and watchdogs. For the when the gains would be transferred to cus- water sector, for example, the Asian Develop- tomers through lower prices. Alternatively, the ment Bank and the World Bank are putting regulator could choose not to impose a price cut together a database that includes data on the cost and instead set the X factor so that expected eco- of capital. Many publications provide informa- nomic profits are zero at the end of the period tion for the energy and telecommunications sec- rather than throughout the period, allowing the tors. Although the quality is not always ideal, the company to enjoy the profits from its efficiency data do provide a feeling for the international gains longer. In either case a kind of intertem- experience. poral profit sharing system operates. No solution is perfect, of course. But a mix of During the price control period, however, the approaches suited to the types of problems treatment of capital expenditure poses some diffi- faced is likely to provide an acceptable range for cult questions. Investment may be postponed or the allowed rate of return. even canceled-often because the new conces- sionaire overestimated demand on the basis of the How to monitor investment information made available by the govemment (public enterprises typically have little relevant Regulatory reviews are required at periodic inter- information on demand). Investment also is often vals to adjust prices to reflect the underlying cost lumpy rather than spread uniformly over a num- structure of the business, to maintain business ber of years, and the assets invested in are long- viability in the face of bad outcomes, and to share lived. That makes forecasting investment the benefits with customers when outcomes are extremely difficult, and regulators will almost better than expected. In the absence of profit inevitably make errors in the early years of con- sharing mechanisms built into the price formula, cessions. Moreover, once they have forecast 6 Infrastructure Concessions, Information Flows, and Regulatory Risk investment, the firm has an the United Kingdom hy the incentive to pass the cash that If companies Monopolies and Mergers would have been used for Commission with respect to investment to shareholders, to believe aunspent the price review of Northern boost the value of the business. Ireland Electricity. The debate Northern Ireland Electricity, for money will be provides a useftil conceptual- example, spent £50 million less ization of the problem. on investment by the end of the clawed back, first price review period than . The issue at stake was whether was expected at the beginning. they wull spend underspend on investment all the are should be clawed back. In prin- The regulatorv treatment of Y ciple, clawing back unspent this problem has implications forecast to money goes against the philos- for the incentive to invest. ophy of incentive-based regti- When regulators update the spend, lation. The first step is to regulatory asset base from one understand the reasons for price review to the next, they udnerm in ing underinvestment. can use ex ante or ex post data. Using ex ante values maxi- efficiency There are three possible rea- mizes the incentives for the souns that a company wouldl company to undertake invest- underspend on capital expen- ment at a lower price than that forecast (table 1). diture (or even operating expenditure): The decision to use ex ante or ex post data, or a Owing to unexpected efficiency savings, the possible compromise between the two that might money was not needed (except as an incen- allow the company to keep efficiency savings for tive to be more efficient). a maximum of ten years (two review periods) The expenditure was delayed for a variety of rather than five, depends on several factors. reasons that may not be equally valid. These include: * The company mislecd the regulatory bodvl * The importance of the investment program. about the expenditure required. * The expected efficiency savings. * The ability of the regulator to establish the effi- The first reason is an entirely acceptable justifi- cient level of investment for the company. cation of underspending. The last reason, while * The strength of the incentives applied to oper- not acceptable, is the fault of the regulatory body ating expenditure and investment (where pos- (or its design) and so is part of a learning sible, these incentives should be symmetric). process-and a sign that some rules and processes need to be clarified. Whether to claw back capital investment underspend The second explanation is more subtle. It can be interpreted in two ways: Capital expenditure was In developing countries, where one of the main not undertaken because it was possible to delay reasons for privatization is to attract private the project, achieving the desired outpUt from a investment to meet pressing needs for expanded cheaper alternative. Or capital expenditure was service, an important concern is that the not undertaken because the company simply did investors will face incentives to underinvest. In not get around to it. The first option is an accept- Argentina's toll road concession program, for able efficiency savings, but the second is unac- example, investment was behind schedule from ceptable. It was this reason that Northern Ireland the beginning. The issue is also relevant in some Electricity put forward for some of its industrial countries. It was recently debated in underspend-that management was distracted The World Bank Group 7 from investing by the need to concentrate on the * Thie targets for the outputs (including quality). privatization of the company. Since the under- * The information required from bidders. spend exceeded £50 million, both the regulator and the Monopolies and Mergers Commission Although concession processes vary, they nor- decided that some clawback was required, espe- mally have three stages. First, there is a pre- cially since it was unclear whether Northern qualification assessment. Before the tender is Ireland Electricity had included the delayed pro- formally opened, the authorities define the min- jects in its new capital expenditure forecast. imum requirements for bidders, such as relevant experience as a utility business and financial Clawing back money creates perverse incentives ability, with the experience and resources to for companies, however. If companies expect invest in and operate the system. Next, groups that unspent money will be clawed back, they that have prequalified are invited to submit will spend all that they are forecast to spend and technical bids to run the system. The technical there will be no incentive to become efficient. submission covers a wealth of information, and There are ways to overcome this problem when it is in making the information requests for the it arises primarily from unexpected efficiency technical bid that the concession process has a savings. Regulators in the United Kingdom are significant impact on future regulation. The looking at how companies should report their technical bid should contain engineering annual investment outcomes to provide the reg- reports that reveal how the bidder intends to ulatory body with sufficient information to deter- meet the targets in the draft concession. It mine the levels, and possibly the causes, of should also contain financial information relat- unexpected savings. ing to expected operating and capital expendi ture. Finally, each rival submits a financial This approach may seem intrusive. But there are bid-the amount it is willing to pay to operate tradeoffs between allowing companies to keep the system or the price it would be willing to what may be significant amounts of underspend charge to customers. and creating perverse incentives through arbi- trary clawback, and between requiring intrusive The key concerns of regulated businesses are regulation at the price review and requiring whether their assets will be expropriated, annual reporting. Once more the core issue is whether changes in exogenous factors will be rec- the design of the information needed to support ognized by the regulator, and how long they will effective and fair decisions by regulators. be able to keep the benefits of efficiency improve- ments. It is, of course, impossible to write a reg- How and when to define the rules of ulatory or concession contract that covers every the game eventuality, because monitoring and enforcement would be costly and the contract would encotir- Information provision is a two-way street. The age game playing by the concessionaire. Thus flow should start at the time the concession con- many issues have to be resolved over the course tract and the bidding process are being of a concession. It is important that the informa- designed. The government first needs to provide tion provided by the government give clear sig- enough informaLion to potential bidders to nals to the bidders about the set of principles that ensure the long-term success of the concession will apply in resolving these issues. strategy. This includes: * The bidding rules and the success criteria. Clear signals also need to be given about the * The duration of the contract. process for adjusting prices. The concession for * The scope of the contract (operational or the Manila water franchises stipulated the princi- investment requirements). ples for rebasing prices to cost at each review. If * The regulatory principles that will apply. prices are below cost at the time of a review, they 8 Infrastructure Concessions, Information Flows, and Regulatory Risk would be immediately adjusted upward; if they The regulator should also obtain financial infor- are above cost, a glide-path would be put in place mation from the bidders to evaluate the winning so that they fall to cost over time. This provides bidder's financial soundness throughout the the concessionaire with financial safeguards concession. The cost information they provide while also giving it incentives to make efficiency should be unified with the turnover information improvements by allowing it to keep the profits in a financial model to provide forecasts of: from those improvements longer. An important * The debt profile (both short and long term). issue, however, is defining cost appropriately, so * Liquidity. that raising prices to cost does not reward ineffi- The dividend policy. ciency. Establishing this definition requires that The targeted minimum rate of return. bidders provide relevant information during the VThe equity rate of return. bidding process, as discussed below. V Interest cover. VThe debt-equity ratio. Why, how, and when to size up the players Conclusion ldcally, the regulator would like the bidding Adequate information makes it easier to scruti- process to reveal each bidder's expectations nize regulatory decisions because it makes it eas- about the future so that it can benchmark them ier to understand who gains and who loses from against outcomes. If the outcomes are the same them. And that makes it easier to understand the as the expectations, good information provided underlying politics and the incentives of the Viewpoint is an open forum intended to at the time of the bid will enable the regulator players to pull strings. Thus the information encourage to prove this and thus to resist any demands by should be used to increase the transparency of dissemination of and the business to relax the regulatory regime. If the regulatory decisions and reduce the risk of cap- debate on ideas, innovations, and best outcomes differ from the expectations, however, ture of the regulators by private providers. More practices for expanding the information will enable the regulator to act transparent decisions are not only possible given the private sector. The reasonably to change the regulatory parameters. the regulatory tools that exist, but also desirable views published in this series are those Df the because they will mean fairer and often more authors and should not The regulator should therefore request from the efficient decisions. be attributed to the bidders all the information that anv sensible World Bank or any of its affiliated organizations. business wxould use before committing itself to a In Chile, for example, the privatization of Nor do any of the twenty-five-year investment (the duration of monopolies led to significant gains in efficiency, conclusions represent many concessions): customer connections, cus- but it took a long time before even part of the official policy of the World Bank or of its tomer volumes, cost of connections, and disag- gains were passed on to consumers. Neither the Executive Directors or gregated investment and operating costs. Since firrns nor the regulators were held accountable the countries they the cost estimates will be commensurate with the for this situation until recently, when the represent, regulatory targets and with the bidders' expec- Congress became reluctant to endorse a new To order additional tations about volumes and connections, thev wavc of privatization in the water and ports sec- copies please call should reveal information about costs under dif- tors, arguing that consumers benefited too little 202 458 1111 or conotact Suzanne Smith, editor, ferent volume scenarios. from earlier waves of infrastructure privatization. Room Ft 1 K-208, The World Bank, 1818 H Street, NW, Washington, Pro forma accounts for each business, including Phbi Burns (philip. burns@frontier- D.C. 20433, or Internet standards for the allocation of fixed and com- economics.com), FrontierEconomnics, addresssosmith7e mon costs, are a good technique for extracting and Antonio Estache (aestache(. series is also available comparative information from all the businesses worldbank,org), World Bank Institute on-line lww.worldbank. for use at regulatory reviews. These accounts org/html/f pd/totes/I. cover not only operating costs but also existing ® Printed on recycled assets and investment in disaggregation. paper.