CONTRACT DESIGN FOR REGULATION

A. EstacheWorld Bank Institute

Major issues in Contract Design• Overall design of incentives to all

parties involved• Specific structure of the contractual

arrangement• Conditions for evaluation• Financing and risk allocation• Social objectives

Issues in structuring contracts: A Checklist

• Asset Valuation• Package size• Duration of concession• Tariff conditions• Termination conditions• Performance assurance• Quality Control• Investment plans• Social and other service obligations• Check for the internal consisteny of

requirements

Assessing Assets• what is the minimum price?• how did you get there?• did you check for changes in

demand?• use the underlying financial

model to make sure that all the requirements built in the contract are internally consistent

Determinants of package size

• Economies of scale or scope• Ability to “unbundle”

– vertical (functional)– horizontal (spatial)

• Effects on degree of competition

Determinants of contract duration

• Competitive advantage of frequent retendering

• Versatility of assets (technological changes)• Practicability of asset buy-back or pass-on• Impact on willingness to compete• Impact on asset maintenance

Termination conditions

• Automatic renewal?• Negotiated roll-over?• Asset/New investment buy-

back by government?• Asset/New Investment transfer

to new concessionaire?

Issues in tariff control

• price cap vs. rate of return?• price discrimination allowed?• Degree of external competition• Social and distributional objectives• Impact on commercial efficiency

Performance assurance

• Contractual specification?• Requirement for monitoring?

– information annex (see P. Burns’ presentation)

• Payment incentives?

Investment plans

• Investment requirements in concession contracts– Need for monitoring– Need for flexibility since demand is

often uncertain

Quality requirements

• Technical vs. service quality• Independent quality control• Age specification in contracts• Too much vs. too little quality?• Who pays for quality?• Are penalties for violation built in?

Conditions for Evaluation

• Consortia limitations• Pre-qualification

requirements• Bidding processes• Award criteria

The role of consortia in contract design

• Infrastructure concessions– increased funding base– broader interest in system design– longer term commitment

• Associations in service franchises– changes competitive scope– discipline in larger packets larger package

increased competition

Prequalification to reduce customer risk

• Construction risk– technical experience check, construction

bond• Operations risk

– key staff listing, evidence of insurability, investor equity requirement

• Financial risk – financial balances, institutional support

• Legal risk– guarantee of compliance with conditions

Award criteria • Minimum duration?• Lowest user tariff?• Best financial deal for government?

– flows vs stock payments– revenue vs subsidies

• Highest level or earliest investment?• Highest number of retained employees?• Multicriterion ranking?• Best solution to particular problem?

Example Bidding in Argentina (1)

• Rail freight: 2 envelopes and decision based on points scored– (1)technical & finacnial qualification.; – (2) weighted selection criteria (staff recruited,

experisnce, plans, fees to gvt,...)

• Urban passenger rail: 3 envelopes; award based on highest fee to gvt or lowest subsidy– (1) technical– (2) plan – (3) financial

Example Bidding in Argentina (2)

• Ports: 2 envelopes and winner is highest fee paid to gvt but one forms can’t win more than one terminal– (1) technical and plan– (2) minimum fee guaranteed to gvt

• Toll Roads: 4 envelopes: winner is lowest toll; if = : lottery – (1) prequal on financial staus– (2) technical + payment of $25,000– (3) contract proposed and financial guarantee– (4) specific toll offer

Inclusion of risk mitigation aspects

• commercial, exchange, policy risk

• Guarantees• Exclusivity• Speed of process

Examples of Social Issues to be addressed

by Contract Design

• Social services (more below)• Social tariffs • Safety • Environment

Reconciling Social Concerns and Privatization

A case study of the transport sector • The Context: Social Role of Transport Policy

– in Argentina, % of poor among train riders is around 25% – in Manila, public transport takes 14% of the poor income vs.

7% of the non-poor– walking 10km to work common in rural areas

• so issue is to provide affordable transport to places of employment/education

• The main tools: inclusion of Service Obligations in contract in a financially consistent manner

What Are Service Obligations?• generic definition: Obligations of an operator to offer

either a full range or a specific package of services– of good quality (when is it too much or too little)– to all users (Universal Service Obligations)– at affordable rates (What is affordable?)

• precise definition is needed but it will vary across countries, sectors and situation– railways: obligation of continuity, regularity, capacity,

targeted discounts, affordability– water: much stronger

Checking for Affordability

• Assess the burden of a particular service on the budget of specific consumer groups

• Determine whether that burden is deemed consistent with social concerns of the government

• Check whether the acceptable price is consistent with the other requirements imposed on the private provider (implementation speed, financing requirements, service quality....)

Funding the needs of the poor

• First measure and minimize costs– cost models (US telecoms)– create your own benchmarks (UK, Uruguay and

Brazil in water, New Zeland and Australia in most sectors)

• link costs to benefits and decide if it is worth it• if it is worth it: decide on pricing rules vs

explicit subsidies

Affordability and Pricing

• tariffs design (2 parts, discrimination)

• access surcharges on operators• other surcharges on operators to

finance investment funds (telecoms)

Affordability and Subsidies• targeted subsidies...but only if can target well

(e.g. specific routes) and requires a good tax system

• income supplements– ...better than payments in kind when possible

• subsidies on journey-to-work tickets thru employers– ...but misses the informal sector

• cross-subsidies within clearly delineated service areas

• built in in access pricing pricing rules in the regulatory framework to recover costs

Some subsidy schemes .…Don’t work

• Subsidizing the operator blindly– money does not go to better service (less invest. or

quality)

• control of public fare levels:– kills profitability and hence service – benefit the non-poor– ...unless clear rules for subsidies matching revenue loss

• control of public fare discrimination– poor get less service (airline,...)– poor pay for rich