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Private Sector is an open forum intended toencourage dissemination of and debate onideas, innovations, and best practices for ex-panding the private sector. The views pub-lished are those of the authors and should notbe attributed to the World Bank or any of itsaffiliated organizations. Nor do any of the con-clusions represent official policy of the WorldBank or of its Executive Directors or the coun-tries they represent.

Private Sector is a quarterly publication distrib-uted free of charge. To subscribe, please sendyour name, mailing address, telephone num-ber, and fax number to the editor (SuzanneSmith, Room G8105, The World Bank, 1818 HStreet, NW, Washington, D.C., 20433, email:[email protected], fax: 202-676-9245,phone: 202-458-1111).

Most Notes from Private Sector also are avail-able on-line. The full text is in HTML formatfor on-screen viewing, as well as in a down-loadable file in Adobe's PDF format (http://www.worldbank.org/html/fpd/notes/notelist.html).

The International Forum for Utility Regulationundertakes the following activities:* It organizes international Expert Group meet-

ings on utility regulation (the next one isscheduled for mid-1997).

* It'organizes training courses for utility regu-lators and private sector regulatory strategystaff. The first one is scheduled for January1997 in the United States. In 1997-98, coursesare to be held in Africa, Asia, Eastern Europe,and Latin America.

* It compiles a worldwide directory of infra-structure regulatory institutions (ready inSeptember 1996) and regulatory strategydepartments of major infrastructure compa-nies (ready in early 1997).

For more information call 202-473-6566 or [email protected].

1

Introduction

Over the past decacde, there has been a fundamental shift in the role government plays in provid-

ing infrastructure. Most governments are moving away from being owners and operators of such

infrastructure services as power, water, transport, and telecommunications. More and more they

are acting as regulators of infrastructure services provided by private firms.

Designing and implementing new regulatory systems poses big challenges for all reforming

countries. Despite the potential pitfalls, a rapidly growing number of countries in Africa. Asia,

Latin America, and Central and Eastern Europe are grappling with major reforms in utility

regulation, often experimenting with approaches more innovative and comprehensive than

those seen in many industrial countries. But many recent regulatory innovations remain little

known beyond a few sector specialists. And new insights are just beginning to cross sectoral

and national boundaries.the international forum for

utilityregulation

This special publication collects short policy briefs on competition, regulation, and private par-

ticipation in infrastructure published over the past eighteen months in Pu b/ic Policyfor the PHi-

voate Sector. Sponsored by this Vice Presidency, this new quarterly is designed to help disseminate

knowledge about successful policy innovations. This special compendium edition is timed to

coincide with the first Expert Group meeting in June 1996 on utility regulation-part of a recent

World Bank-sponsored initiative to set up the International Forum for Utility Regulation.

The purpose of this forum is to expand international contacts and information exchange among

utility regulators (see inside cover).

2

Contents

Private Participation in Infrastructure-The Industry

The 5 A Global Market of $60 Billion a Year

Market Jae So and Ben Shin

9 Company ApproachesJae So and Ben Shin

Competition and Regulation

The 13 Back to the Future-The Potential in Infrastructure Privatization

Sectors Michael Klein and Neil Roger

17 Franchising and PrivatizationAntony W. Dnes

21 Concessions-The Way to Privatize Infrastructure Sector MonopoliesPierre Guislain and Michel Kerf

Power25 The Real World of Power Sector Regulation

Bernard Tenenbaum

29 A Template for Power ReformDavid M. Newberv

Telecoms 33 Competitive Contracting for Privately Generated Power

Robert Bacon

37 The Dynamics of Independent Power-IPPs Seed Top-to-Bottom ReformElliot Roseman and Anil Malhotra

Railways 41 Reshaping Power Markets-Lessons from Chile and ArgentinaR. Peter Lalor and Hernan Garcia

45 The England and Wales Electricity Model-Option or Warningfor Developing Countries?John E. Besant-Jones

Airports 49 Restructuring the Power Sector-The Case of Small Systems

Robert Bacon

53 International Power Interconnections-Moving from Electricity Exchangeto Competitive TradeJ.P. Charpentier and K. Schenk

Water57 Subscribing to Monopoly-the Telecom Monopolist's Lexicon Revisited

Peter Smith

3

61 End of the Line for the Local Loop Monopoly? Technology, Competition, Editor: Suzanne Smith

and Investment in Telecom Networks The World Bank

Peter Smith 1818 H Street, NWWashington, D.C. 20433

65 Regulating Telecommunications-Lessons from U.S. Price Cap Experience Telephone:

Jeffrey H. Rohlfs 202 458 7281Facsimile:

69 Testing for Regulatory Capture-Regulating Telecoms in the U.K. 202 676 9245

Antony W. Dnes worldbank.org

73 Restructuring Regulation of the Railroad Industry Illuatratinas by RuthSofair Ketler. Photo on

loannis N. Kessides and Robert D. Willig page 4 provided by FPG

International and on

77 Privatizing Airports-Options and Case Studies page 25 by James Liles.

Ellis J. Juan The entire contents ofPrivate Sector ©1996

81 Tradable Property Rights to Water World Bank. You areauthorized to

Mateen Thobani reproduce, duplicate,and disseminate all or

85 Regulating Water Companies part of this pub ication

Michael Klein and Timothy Irwin the name of thepublication and the

89 The Guinea Water Lease-Five Years On name of :he respectiveauthor. You may not,

Penelope J. Brook Cowen however, modify, alter,

or otherwise change

93 Sydney's Water-A Suitable Case for Private Treatment? any part of thispoblication or sell,

Ross Chapman and Sandy Cuthbertson transfer, or otherwise

disseminate any part of

Finance the publication forprofit.

97 Mitigating Commercial Risks in Project Finance o Printed on recycled

Jeff Ruster paper.

101 Mitigating Project Risks-World Bank Support for Government GuaranteesPhilippe Benoit

105 Private Power Financing-From Project Finance to Corporate FinanceKarl G. Jechoutek and Ranjit Lamech

World Bank Operations

109 The World Bank Contribution to Private Participation in InfrastructureOmer Karasapan

113 Private Infrastructure-A BibliographyOmer Karasapan

,S~~~~~~~a

I ..4a.\ ................. _

1.~~~ V

5

The Private Infrastructure IndustryA Global Market of US$60 Billion a YearJce Sc) aiid Benl Siun

Private infrastructure projects have boomed eightN-six Countries have privatized *-4t infra-around the world since the 1980s, in suclh sec- structure companies, ancl at least 5-4 privatetors as waste, power, water, transport. telecom- greenfield infrastructure projects are uncder wavmunications, and natural gas. ILucIh of this in some eighty-two co1untries (see figur-e 1 foractivitv has its origins in the deregulation poli- sectoral distribution). This Note sketches thecies in the tnitecd States during the 19'0s ancl growvth of the private infrastructure industr .in the privatization experiences of Chile, NewZealand. and the U-nited Kingdom during the A US$60 billion annual market1980s. These deregulation and privatizationpolicies -were driven by disenchalntment with Since Tanuary 1984, the vIalue of privatizationspublic sector performance. fiscal crises (often has totalecl ITSS357 b>illion ancl that of new in-related), and technological changes that have vestmnent projects more than t'SS30)8 billion.increased the scope for conmpetition. Since 198-I. Thus, private investment activ ity in infra-

PRIVATE PARTICIPATION IN INFRASTRUCTURE Number of projects(number of projects by region, 1984-September 1995) o al

1-5E6-25 E

-S 1e1b, 26+

.,~ ; < - -v- * >WEastern EuropeNorth 'OECD -and CISAmerica Europe _ 2 ______

20 120120-

Privatitations New eat i vatons tinP New NePr-Ie n ens Newsntest N h

Asia

The boundaries, colors. denominations, and any other information shown on this map do cot imply, on the part of the World Bank Group, any judgment on the legalstatus of any territory or any endorsement or acceptance of such boundaries.Source: World Bank, Private Infrastructure Project Database.September 1995

6 The Private Infrastructure Industry-A Global Market of US$60 Billion a Year

TABLE 1 TOP TEN NEW PRIVATE INFRASTRUCTURE INVESTMENT PROJECTS,1984-SEPTEMBER 1995

CostLocation Project Contract (US$nmillions)

France/United Kingdom Channel Tunnel BOT, 55 years 19,000Taiwan (China) Taipei mass rapid transit system BOT 17,000Japan Kansai International Airport BOT 15,000Europe Concert Pan-European Telecom Services BOO 5,300Argentina Buenos Aires water and sewer services ROT, 30 years 4,000Thailand TelecomAsia communications network BTO, 25 years 4,000China Daya Bay nuclear power plant, phase 1 BOO 3,700Malaysia North-South toll expressway BOT, 30 years 3,400Mexico Petacalco coal-fired power plant BOT 3,000Thailand Bangkok Elevated Road and Train System BOT, 30 years 2,981

BOO = build-own-operate; BOT = build-operate-transfer; BTO = build-transfer-operate; ROT = rehabilitate-operate-transfer.

Source:World Bank, Private Infrastructure Project Database.

TABLE 2 TOP TEN INFRASTRUCTURE PRIVATIZATIONS, 1984-SEPTEMBER 1995

Share sold PriceLocation Entity privatized (percent) (USS millions)

Japan Nippon Telegraph & Telephone (NTT) 35 70,500United Kingdom British Telecom 100 22,800United Kingdom British Gas 100 7,600Mexico Telefonos de Mexico (Telmex) 100a 7,540France Elf Aquitaine 38 6,200Germany Veag 100 5,144Singapore Singapore Telecom 11 3,800Netherlands Koninklijke PTT Nederland 30 3,750United Kingdom Scottish Power 100 3,665Argentina Telecom Argentina (Entel North) 100 3,200

a. Company was already 49 percent privately owned before the first sale of government shares in 1990.

Source: World Bank, Private Infrastructure Project Database.

structure amounted to some tJSS60 billion a prevalent in power and transport infrastructureyear on average during the past decade. Pro- projects. withi most transport investment goingjects averaged about tJSSO.6 billion in value, to toll roads, tunnels, and bridges. Of coursealthough about 80 percent of projects wvere val- the line between privatization and greenfielduied at less. investment is blurred-many newvly privatized

telecommunications companies invest heavilyPrivatization activity has been dominated by in new facilities.sales of power companies and telecommuni-cations companies andl licenses. Sales of waste Telecommunications investments tend to heand transport companies have also been im- funded mostly with retained earnings, reflect-

portant. Greenfield investment has been most ing strong market growth and consume-s' will-

The World Bank Group 7

THE PRIVATE INFRASTRUCTURE PROJECT FIGURE 1 PRIVATE INFRASTRUCTURE PROJECTS,DATABASE BY SECTOR, 1984-SEPTEMBER 1995

The database tracks private infrastructure 240220

activity in gas, power, telecommunications, 200

transport, waste, and water since 1984. In 180

transport, the database covers roads, 160

railroads, airports, and ports, but excludes 140

rolling stock and airline privatizations. It 120100

does not track waste collection contracts. 80

The database includes information on: 602_ _f_

* A total of 3,394 projects as of September 40

* New investment BOO, BOT, LRO (lease- GtTrehabilitate-operate), and other similar Gas Water Waste Transport Telecom Powerprograms. Privatization and operation and maintenance

* Privatization and 0 & M: asset sales, New investmentoperation and maintenance contracts,management contracts, and operating Source:World Bank, Private Infrastructure Project Database.

licenses.* Actualprojects: new investment

projects underconstruction, completed, FIGURE 2 POTENTIAL PRIVATE INFRASTRUCTUREoroperational and privatization and PROJECTS, BY SECTOR, SEPTEMBER 1995O & M projects that have been awarded 1,164

or have begun operation.* Potentialprojects: all projects under 400

active study, bidding, or negotiation. 380

The first version of this Note, which 360340

appeared in May 1995, estimated the private 320

infrastructure market at US$30 billion. After 300

a more intensive data gathering effort, this 280

estimate was revised upward to US$60 260

billion. There are several reasons for this 240

dramatic increase: 220200

* The number of projects in the database 180

had grown from 1,346 to 3,394, mostly 160

because of the addition of projects but 140

also because of existing ones whose 120

status as privately owned or operated 100projects could be confirmed. 60

* The status of some projects had shifted 40

from potential to actual. 20

* Some project cost estimates had been ° 0 increased on the basis of more recent Gas Water Waste Transport Telecom Power

information. M Privatization and operation and maintenanceThe database will continue to be regularly M New investmentupdated, and additional project informationis thus actively sought. Source: World Bank, Private Infrastructure Project Database.

8 The Private Infrastructure Industry-A Global Market of US$60 Billion a Year

TABLE 3 TOP TEN POTENTIAL PRIVATE INFRASTRUCTURE PROJECTS, SEPTEMBER 1995

Cost/priceLocation Project Contract (US$ millions)

Russia National long-distance telephone network BO license 40,000Belarus/Germany/Poland/Russia Yamal gas pipeline BOO 39,700Hong Kong Chek Lap Kok airport LO 20,000Russia RAO Gazprom Privatization, 60% 20,000Taiwan (China) Taipei-Kaohsiung high-speed rail BOT, 30 years 17,400India West Bengal coal-fired power plants BOT 12,700Germany Deutsche Bundespost Telekom Privatization, 25% 9,750United Kingdom Railtrack Privatization 9,500China/Hong Kong Beijing-Hong Kong highway BOT 8,000Taiwan (China) Kaohsiung rapid transit system Privatization 7,600

BO = build-operate; BLO = build-lease-operate; BOO = build-own-operate; BOT = build-operate-transfer.

Note. Excludes the US$52 billion Three Gorges Dam in China. The dam is under consideration as an independent power project but no detailed proposal has appeared.

Source: World Bank, Private Infrastructure Project Database.

ingness to pay for service. Many other infra- two infrastructure companies, and Argentinastructure ventures face more uncertain finan- forty-eight. Major privatization programs are un-cial prospects because of political difficulties der way in Chile and Mexico, as well as a hostin raising and regulating utility tariffs. Inves- of privatizations, mostly in telecommunications,tors often t-y to manage these risks by seeking in countries ranging from Belize to Uruguay.limited recourse or nonrecourse project finance.

And the future? l1he database is tracking 2,2173Some geographic patterns have emerged in the potential projects-349 privatizations worthpast decade in private infrastructure investment. some US$480 billion and 1,924 new investmentNot surprisingly, the fast-growing countries of projects that could cost up to USI 1,347 billion.Asia are emphasizing new investment, which The average size of these potential projects isaccounts for more than 70 percent of the pri- about US$0.8 billion, suggesting that seventy-vate infrastructure activity in these countries. five new deals a year would keep the marketTwo countries in the region are the clear front- at US$60 billion. That would be in line withrunners-the Philippines, with forty-four new recent trends, although new investment willinvestment projects, mostly in power, and probably take over from privatization as theChina, with thirty-five, mostly in transport and driver of the market.power. Other countries with significant num-bers of projects are Mexico, with fifty-four, Jae So, Private Sector Development Specialistmostly in toll roads, and the United Kingdom, (email: [email protected]). and Ben Sbinwith fifty-two. With 113 projects, the United (email: [email protected]). Private SectorStates still leads overall, in large part because Development Departinentof its active independent power industry.

The United States also leads in privatizations,with 147. Many of these transactions are re-lated to the recent sale of regional cellular li-censes. But most privatization activity wasconcentrated in Latin America and OECD Eu-rope. The United Kingdom has privatized fifty-

9

The Private Infrastructure Industry-Company ApproachesJcae So cizid( Beni Shl7in

The global priv ate infrastructure industry h.ts treattment plants and \aste-to-crnergv ventures

experiencecd rapict growth over the past fifteen to its waste managemaent repertoire.years and attracted some 17(10 comiipanies. In-

frastructure was generally managed by national, This Note briefly surveys the origins of some

single-sector utilities, but technological ancl of these global infrastructure companics (see

regulatory change has allowed companies to table 2 for the ten most active ones) and shows

cross traditional boundaries. Although core how major companies are diversifying acr-oss

cotnpctencies in specific sectors are still im- sectors and regions (tables I and *). It also

portant, companies are beginning to exploit giv-es a flavor of the approacches companies use

ne,w sources of competitive advlantage, such to compete in the evolving market and dis-as the ability to efficiently manage an integrated cusses some of the risks thev face.'

network of diverse services (table 1 ). Electric

utilities in Germany-RNVE, Viag, and Veba- Originsare entering telecommunications markets on

the strength of their extensive cable and elec- The grow\th of some companies has its origins

tricity distribution networks and their experi- in recent deretgulation and privatization. Mlany

ence operating massive. companN-wide internal tT.S. utilities, faced wvith an increasingl- ma-

telecommtinications networks. NWMNIX Technolo- ture homiie market, are taking advantage of the

gies oif the United States is adding wastew-ater Public tTtilities Holdling Companies Act of 1992.

TABLE 1 COMPANIES' SECTORAL DIVERSIFICATION, 1984-SEPTEMBER 1995

Company Gas Power Telecom Transport Waste Water

Bechtel Group, Inc. (United States) * * * UBouygues SA (France) pActual

Compagnie Generale des Eaux (France) p r o * *

Electricite de France Potential

Grupo ICA (Mexico) E * * * * projects L

Lyonnaise des Eaux-Dumez (France) * * * USevern Trent Plc. (United Kingdom) * * *Siemens AG (Germany) Li * * U

Soldati (Argentina) * * * *Tractebel SA (Belgium) * * * *Source: World Bank, Private Infrastructure Project Database.

10 The Private Infrastructure Industry-Company Approaches

which allows them to venture into new markets.Privatization has prompted such companies as

TABLE 2 TOP TEN DEVELOPERS BY NUMBER OF PROJECTS, British Gas and British Telecommunications to

1984-SEPTEMBER 1995 seek additional shareholder profits in overseasventures. Some investors are driven by a needfor secure supply. Germany's largest gas com-

Compagnie Generale des Eaux (France) 74 pany, Ruhrgas, is investing in countries key toCable & Wireless Plc. (United Kingdom) 49 regular supply-countries in Eastern EuropeWMX Technologies Inc. (United States) 39 and the former Soviet Union. Other compa-Lyonnaise des Eaux-Dumez (France) 38 nies are taking advantage of a historical headFrance Telecom 34 start. French water companies, for example, areSprint Corp. (United States) 33 exploiting their long experience in operatingCox Cable Communications Inc. (United States) 31 private water concessions at home in newlyAT&T (United States) 30 private ventures abroad.Comcast (United States) 29Tele-Communications Inc. (United States) 29 Many companies competing in private infra-

Source: World Bank, Private Infrastructure Project Database. structure markets are publicly owned at home,such as Electricite de France (see table 3 forthe top ten developers with state ownership).

TABLE 3 TOP TEN DEVELOPERS WITH STATE OWNERSHIP, - Telef6nica of Spain and France Telecom bid1984-SEPTEMBER 1995 aggressively for telecommunications companies

S,tate share in emerging markets. And firms from emerg-ing markets are themselves poised to become

Company (percent) Projects developers. Tribasa, a Mexican construction

France Telecom 100 34 company, building on its toll road experience,Electricit6 de France 100 24 acquired the capability to arrange financing andTelef6nica de Espania (Spain) 32 9 is branching out into other infrastructure ven-China International Trust and Investment Co. 100 7 tures, including water supply and waste dis-Deutsche Telekom (Germany) 100 6 posal (see table 4 for the top ten developersRWE AG (Germany) 29 5 from emerging markets).IRI Group (Italy) 100 4Telecom Finland OY 100 4 Companies such as Asea Brown Boveri andTelia AB (Sweden) 100 4 General Electric, traditional equipment suppli-Singapore Telecom 89 3 ers for public and private utilities, are diversi-

fying into project development so as to benefitSource: World Bank, Private lufrastructure Project Database, from control over the entire project, rather than

only bidding for the equipment contract in theTABLE4 TOPTENDEVELOPERSFROMDEVELOPINGCOUNTRIES, final stages. Along with equipment suppliers,

1984-SEPTEMBER 1995 engineering companies such as Fluor Danieland Black & Veatch are taking a more active

Company Projects role in financing projects previously in the pub-

Grupo ICA (Mexico) 16 lic sector and in some cases are functioning asTribasa SA (Mexico) 16 developers. And companies such as HopewellGrupo Mexicano de Desarrollo (Mexico) 12 Holdings have built on their experience asChina International Trust and Investment Co. 7 project managers to become project develop-Naviera Perez Companc (Argentina) 7 ers; able to build good working relationshipsEmpresa Nacional de Electricidad SA (Chile) 6 with governments, they can expedite complexCompania Chilena de Generacion Electrica SA(Chile) 5 contractual arrangements in uncertain regula-Grupo Macri (Argentina) 5 tory and legal environments.Soldati (Argentina) 5Techint Compania Tecnica Internacional (Argentina) 5 Approaches

Source: World Bank. Private Infrastructure Project Database. From these origins, infrastructure companies

are adopting a range of competitive strategies,


TABLE 5 COMPANIES' GEOGRAPHIC DIVERSIFICATION, 1984-SEPTEMBER 1995

Latin America EasternNorth and the Europe Middle EastAmerica Caribbean OECD Europe and CIS and Africa Asia and the Pacific

FRANCE TELECOM US$13,300

Canada Argentina Germany Poland Central Guinea IndiaUnited States Mexico Greece Russia African Israel Japan

Italy Turkey Republic Madagascar NewPortugal Chad Mali ZealandSpain Djibouti Mayone PakistanUnited Egypt Morocco VanuatuKingdom Equatorial Niger

Guinea ReunionGabon South Africa

CABLE & WIRELESS PLC. (UNITED KINGDOM) US$3,949

United States Barbados France United Belarus Bahrain Australia RepublicJamaica Germany Kingdom Bulgaria Republic of Bangladesh of KoreaPuerto Rico Ireland Kazakstan Yemen China SolomonTrinidad Italy Latvia Seychelles Hong Kong Islandsand Tobago Netherlands Russia Sierra Leone Japan Taiwan

Sweden South Africa Maldives (China)Pakistan Vanuatu

COMPAGNIE GENERALE DES EAUX (FRANCE) US$28,227

Canada Argentina Belgium Portugal Hungary Gambia AustraliaUnited States Mexico France Spain Guinea Malaysia

Germany United PakistanItaly Kingdom

LYONNAISE DES EAUX-DUMEZ (FRANCE) US$27,528

United States Argentina France Czech Republic Gabon Australia MalaysiaMexico United Hungary Guinea-Bissau China Thailand

Kingdom Lithuania Macao

TRACTEBEL SA (BELGIUM) US$7.204

Canada Argentina Belgium Portugal BelarusUnited States France Spain

Germany UnitedLuxembourg KingdomNorway

ELECTRICITE DE FRANCE US$11,643

Argentina Belgium Poland Cote d'lvoire Guinea- ChinaPortugal Gabon BissauSpain Guinea Mali

AT&T (UNITED STATES) US$6,363

Canada Argentina France United Ukraine New ZealandUnited States Puerto Rico Spain Kingdom Philippines

Venezuela

EMPRESA NACIONAL DE ELECTRICIDAD SA (SPAIN) US$2,830

Argentina SpainColombia PortugalCosta RicaEl SalvadorGuatemalaHondurasNicaraguaPanamaPeru

Note: Dollar amounts indicate total cost of projects (in millions); for a project involving more than one developer, the lull cost is added to each developer's total.Source:World Bank, Private Infrastructure Project Database.

12 The Private Infrastructure Industry-Company Approaches

from sectoral diversification based on core func- ownership approach to infrastructure projects,tional skills to a focus on subsectors and single they must have the ability to pull the deal to-functions: gether and connect the network of companies* Municipal focus. France's Compagnie Generale that will supply services. Development costs-

des Eaux focuses on developing and main- mostly staff time and travel to put the deal to-taining relationships at the municipal level and gether-can be 3 to 5 percent of the cost ofhas expanded into other municipally oriented projects worth several hundred million dollars.services, such as hospitals, cable television, Second, to conclude a deal, companies mustparking facilities, passenger transport, and also be able to arrange a favorable financingurban property development. Citizens Utili- package. Companies have approached the is-ties in the United States is beginning to ex- sue in a variety of ways. Asea Brown Boveriplore the potential for efficient distribution and makes full use of export credit financing for itsdelivery of an integrated range of services to projects. Enron constantly pushes the frontierthe household, including gas, power, water, in tapping capital markets.and telecommunications.

* Regional focus. Telef6nica de Espana, in its Third, although development teams breathe aaggressive pursuit of Latin American telecom- sigh of relief once a project is funded and con-munications privatizations, can be seen as struction begins, regulatory problems may becapitalizing on its knowledge and common just about to start. Highly visible problem casesunderstanding of the consumers' culture and have been Cogasco, a natural gas pipelinelanguage. Hong Kong-based Hopewell Hold- project in Argentina that went awry in 1982,ings' familiarity and trust with the Chinese and the more recent troubles of the Bangkokgovernment resulted in the opportunity to Expressway. In both instances, regulatory au-develop two power plants in China. thorities failed to live up to the spirit of the

• Vertical development. Some companies are contract. Whether the trend toward private in-hoping to realize vertically integrated infra- frastructure is sustained will depend on trans-structure networks. Tribasa plans to develop parent and competitive solutions that renderintermodal transport corridors in Mexico with price regulation unnecessary or, where that isports, toll roads, and service facilities that not possible, on price regulation that balancesimprove logistics for manufacturing firms re- the interests of developers, consumers, andlying on just-in-time delivery methods, governments. Ultimately, it is in the develop-

• Construction focus. Large construction corn- ers' interest to help establish the system thatpanies such as Grupo Mexicano de Desarrollo will regulate their behavior. Such companieshave focused on projects with significant con- as AT&T of the United States, Germany's RWE,struction components, such as toll roads and and Hong Kong's China Light and Power havewastewater distribution systems, to take ad- actively helped to develop regulatory solutions,vantage of their expertise. which allowed them to deflect pressure for

* Narrow segment focus. Enron of the United nationalization.States bases its strategy around natural gas,concentrating on gas transport and distribu- This Note draws on a new database Linder development in thc

tion and gas-fired power plants. Its financial Private Sector Development Depanment of thie World Bank. See

and risk management skills have allowed it box on page 7.

to develop innovative financing schemes andtap new classes of investors. Jae So, Private Sector Development Specialist

(email: [email protected]), and Ben ShinRisks (email: [email protected]), Private Sector

Development DepartmentInfrastructure companies face three key chal-lenges. First, as companies adopt more of an

13

Back to the FutureThe potential in infrastructure privatization

Michael Klein a d Veil Roger

7bis NVote is a synopsis ofan essay byMichaelKlein Why ever nationalize infrastructure?and Veil Roger that won the Silver Auward in the1994 Amex Bank Review essay competition. In the nineteenth century, railways, canals, roads,

and gas, power, and water systems were ini-The wave of infrastructure privatizations that tially privately owned, operated, and funded inswept Chile, New Zealand, and the United most countries. But with time, more and moreKingdom in the 1980s is now sweeping the infrastructure companies were regulated or na-globe. At least 300 infrastructure privatizations tionalized, although the pattern varied substan-and greenfield projects have been undertaken tially across and within countries and sectors.since 1989-mostly in Latin America, East Asia, Wars and economic depression gave anotherand certain OECD economies. The momentum boost to nationalization and stronger regulation,is driven by disenchantment with state provi- which increased in the 1940s and 1950s. Disen-sion, precarious government finances, and new chantment with the performance of regulatedtechnology. Whether this privatization wave or nationalized firms led again to deregulationwill lead to lasting welfare gains or is just part and privatization in many countries from theof a historical cycle of privatization and na- 1970s onward. A stylized illustration of the cycletionalization is not vet clear. The answer will described above appears in figure 1.depend on whether governments can find com-petitive solutions for the provision of infrastruc- Some of the motives underlying nationaliza-ture services. tion have been misguided. For example, gov-

ernments have justified nationalization as a wayThe advantages of private ownership to provide subsidies to industry, to control

prices, and to extend patronage. These werePrivate firms can be more efficient than public never sound reasons. Other concerns aboutentities to the extent that they are better able system integration, national security, health andto resist nefarious political interference. Gov- safety, and foreign domination could be ad-ernment ownership almost certainly blurs the dressed while still maintaining private owner-line between the firm's finances and the gen- ship. For example, where private firms wereeral budget. Typically, firms getting budget sub- allowed to work out suitable arrangements,sidies have trouble maintaining quality they managed to establish voluntary demarca-operations when fiscal problems arise. Or gov- tion agreements between service areas as wellernments may be tempted to dip into the firms' as interconnection agreements. While it is cleartreasuries in times of fiscal distress. The cost that emergency national security situations mayof this blurring of lines can be measured by trigger government intervention, it need notthe rapid system expansion after privatization, take the form of prior nationalization. Nationalwhen corporate finances were freed from the emergency regulations affecting all sectors ofpublic purse (Galal and others 1994). With this market economies can cover infrastructure asseparation, shareholders and debtors have well. Health, safety, and environmental con-some confidence that the firm's financial in- cerns can be dealt with through the setting andtegrity will no longer be in danger. monitoring of standards independent of own-

14 Back to the Future

ership arrangements. And concerns about for- temptation for governments to exploit monopolyeign ownership are subsiding. The profitabil- rents for political advantage. While in theoryity of the emerging international infrastructure such arrangements can be implemented throughfirms will depend on their ability to maintain a well-designed regulatory frameworks, historyreputation for reliability in all countries, lead- shows that satisfactory regulatory regimes haveing them to become world citizens not to be rarely been achieved.feared by individual countries.

Regulatory pressuresCan private infrastructure last?

Pressures for some kind of regulatory mecha-While government can pursue all its social ob- nism arise soon after a new infrastructure net-jectives for infrastructure provision under pri- work is set up. Rail, gas, and water networks

all emerged in the first decades of the nine-teenth century in Britain. The first attempts tolimit wasteful competition in the water and gas

FIGURE 1 THE PRIVATIZATION-NATIONALIZATION WHEEL networks by establishing monopoly franchises

started around 1820. Rent regulation arrivedwith Gladstone's 1844 Railway Act, followedby dividend limits (10 percent) for gas andwater companies under the Gas Works and

Dilemma of Water Works Acts of 1847. Similarly, limits onsubsidycuts,tee prices or returns were introduced in Canadaincreases, se v (Toronto) for town gas and in some U.S. rail-

efficiencuts 7;! 11 ! road statutes in mid-century.Decliningefficiency The notion of a "fair" price or return has played

a role in all regulatory systems. It has alwaysPublic 2 2 t | been clear that price or return regulation risked

subsidies undermining the incentives for firms to investand operate efficiently, and various mechanisms

takeover ; X Shave been used to cope with the tradeoff be-tween fairness and efficiency. When prices arecontrolled, quantity and quality are regulated.Typically, service and access obligations areembedded in all regulatory mechanisms. But

Source: Gomez-lbanez and Meyer 1993this opens the door to endless arguments andpolicies about whom to serve and at what price.

vate ownership, important policy issues exist There's a good chance, then, that governmentsbecause many users are dependent on a com- will introduce inefficient and unjustified subsi-mon facilitv-such as an electricity network- dies and cross-subsidies for different customerthat does not face head-to-head competition. groups.Whoever controls such a "natural" monopolycan extract excessive profits (rents) from it. The The institutional solutions to regulatory goalsnetwork owners, consumers, and the body poli- have varied according to the balance of inter-tic all try to get their hands on these rents. There- ests in each situation and the country's politi-fore, a sustainable ownership arrangement cal and administrative system. Ownership mayrequires a rent-sharing system that protects con- be private, mixed, or public. Regulatory pow-sumers, provides owners with incentives to opers rest in varying degrees in the legislative,erate the network efficiently, and reduces the executive, or judicial branch of the government.


Separate regulatory institutions may exist. Dif- are kept artificially low, demand will be largeferent levels of government may be involved- and supply will be insufficient and of poormunicipal, provincial, or central. quality. More government intervention culmi-

nating in nationalization will cloak the prob-Points in a continuum lem. When the public purse can no longer pay

the level of subsidies required to get accept-These various institutional arrangements are able service, privatization will once again bepoints in a continuum. All interfere with firm- seen as a remedy. And so it could go on.level pricing and investment decisions. At oneend of the spectrum, full nationalization places Can the costs and failuresall decisions in the hands of the state. Decisions of regulation be reduced?are not transparent, and consumers are not rep-resented directly, but only in their capacity as The only way to reduce the need for adminis-voters. Further along the spectrum, the state es- trative solutions to the rent-sharing problem istablishes autononmous corporations governed byperformance contracts, which generally specify 7t/ o w t rkey pricing and investment decisions. Transpar-ency is enhanced. Still further along, private firms for administrative solutions to themay be subject to regulatory oversight by agen-cies that influence price and investment deci- rent-sbaringproblem is to e1pand thesions, as in the United States. At the other end 6katnof the spectrum, as in French municipalities, no scope for more anutonatic "regulation"separate regulatory agency exists. As in the caseof nationalized firms, consumers can exercise ttheir rights through complaints and by voting tbrough competition.in mayoral elections.

to expand the scope for more automatic "regu-No best solution lation" through competition. Competitive so-

lutions are feasible where consumers ofResults of empirical work on the merits of al- infrastructure services can migrate to the ser-ternative arrangements remain inconclusive. vice area of their choice (for example, resi-With different combinations of ownership and dential developments) and where competitionoversight exhibiting similar problems, it is not among providers can be introduced (for ex-clear why and how performance should sys- ample, among airlines). Technological changetematically varv among them. However, it is and innovative policies for services until nowclear that regulatory systems are costly and considered natural monopolies have further en-often fail to achieve their goals. Recent esti- larged the scope for head-to-head competition.mates put the benefits derived from deregula- Prominent examples are long-distance telecom-tion in the United States at some 9 percent of munications and power generation. The bestthe output of formerly regulated infrastructure hope for subjecting remaining inescapable natu-sectors (Winston 1993). ral monopolies to competition lies in repeated

franchise bidding, under which monopoly ser-For this reason, another turn in the privatiza- vice franchises are auctioned off from time totion-regulation-nationalization cycle is possible. time and awarded to the firm offering accept-As in the past, regulation imposed on private able service on the best terms-for example,firms tends to weaken their incentives to per- at the lowest price.form and involves "the public" in decisionsabout levels of income and subsidy. When firms Franchise bidding can clearly be effective forreceive insufficient revenues and when prices infrastructure services that do not require in-

16 Back to the Future

vestments tied to a particular service area-for ing incumbents is that of the private Frenchexample, many forms of transport services or water companies, established in the nineteenthsolid waste collection. Problems may arise for century. Despite incentives to collude and tothe remaining natural monopoly services- abuse the nontransparent and discretionary re-mainly water pipelines and power transmission lationship with municipalities, they have de-and distribution. Problems in railways, telecom- veloped a worldwide reputation for quality andmunications, and gas pipelines tend to be less efficiency and simultaneously a relationshipsevere because of the stronger intermodal with municipalities that has p)rotected themcompetition. from attempts at nationalization.

But is franchise bidding really substantially dif- Implications for policymakersferent from utility regulation? First, no contract and financial marketscan cover every conceivable circumstance.Therefore, either party may have (good or bad) For the policymaker interested in efficiencyreasons to renegotiate after the award. Second, gains, the pursuit of private infrastructure con-at the time of transfer of the franchise to an- stitutes a risk-minimizing strategy. Private solu-other firm, the assets to be transferred need to tions are generally no worse than public ones,be correctly valued to ensure that the incum- but hold the potential for greater benefit throughbent maintains them in good condition (Laffont competition. If policymakers follow the currentand Tirole 1993). The franchiser therefore needs fashion of promoting private competitive fran-to maintain a capability to prepare, award, chises throughout the world, the emerging in-monitor, and renegotiate the contract, includ- ternational infrastructure industry will grow. Ining the capability of valuing the assets fairly. its wake, private cross-border flows financingSuch a capability is similar to that required for infrastructure will increase. In the nineteenth"normal" regulation. Franchise bidding will only century, annual cross-border flows for privatebe superior if abuses after franchise award are infrastructure projects amounted to the equiva-contained and repeated bidding is practical. lent of several hundred billion dollars (adjust-

ing for output grovw th and inflation)-comparedReputation and competition for the market with only US$10 billion a year today.

Whether contracting parties abuse their posi- Referencestion depends on their interest in maintaining agood reputation and on the availability of in- 1a Ahmed, Leroy R. Jones, Pankaj Tandon. and logo Vogelsang

1994. Wle/fare Consequences ofSelling Public Fnteiprises. New York:formation crucial for judging adherence to the Oxford University Press.

contract. A review of the experience of over Gomez-Ibanez, Jose, and John R. Mleyer 1993. Going Ptuaje: The In-

3,000 cable TV franchises in the United States terootional Experience witn Transport Pionant ion. Washington,

in 1980-86 found fewer than sixty cases of Laffont, Jean-Jacques, andJean Tirole. 1993. A 7beorv ofIncentivs sin

operators' reneging on contracts (Zupan 1989). Procurenwenr and Regulation. Cambridge. Mass.: MIT Press.Winston, Clifford. 1993. "Economic Deregulation: Days of Reckoning

Reputation was found to be the main explana- for Microcconomists." JouIrnl /of,c iLlorntn Dature 31 (3).

tion for companies' not exploiting loopholes Ztopan, Mark. 1989. The Efficiency of Franchise Bidding Schemes in

in their contracts. the Case of Cable Television.' journal of Law anzd Economics 32.

The key problem of repeated bidding schemes Aficbael Klein, Manager (email mklein@-asset valuation-may be more difficult to deal worldbank.org), and ,Neil Roger. Seniorwith. In particular, it may require a preference Economnist jemail: [email protected]),in favor of the incumbent at the time of fran- Private Sector Develop ment Departmentchise rebidding (Laffont and Tirole 1993). Oneexample of a successful system that allows re-bidding but provides strong incentives favor-

17

Franchising and PrivatizationAnton' W. Duies

Increasing private sector participation to improve the efficiency of infrastructure services is a

growing trend around the world. This trend reflects dissatisfaction with state solutions, ever-

tightening government budgets, technical change, and policy innovation. One approach to

increasing private participation that is attracting much interest is franchise bidding. Improved

understanding of franchise contracting techniques could foster the successful revival and

development of Sir Edwin Chadwick's idea of competition for the field.

Competition for the field for example, the lowest price to consumers.Competition through bidding ensures minimum

Some elements of most infrastructure activities selling prices because the winning franchiseeexhibit "natural monopoly" characteristics, mean- will lower prices until revenues just cover costs.ing that one or more services or products can be Franchising schemes also may avoid pitfalls as-produced most cheaply by a single firm. Examples sociated with traditional regulation of such in-include electricity transmission and distribution dustries or with their nationalization.and gas and water pipelines. This raises the is-sue of organizing an infrastructure industry so as Letting monopoly franchises has a long his-to gain the advantages of production by a single tory: France and Spain, for example, have beenfirm without encouraging monopolistic conduct. letting water concessions for over one hundredHappily, not all elements of infrastructure exhibit years. With the recently increasing interest innatural monopoly characteristics. Market compe- private participation in infrastructure, franchis-tition is both possible and highly desirable in ing has taken root in power, solid waste, tele-many activities, such as electricity generation and communications, and water enterprises inlong-distance and cellular telephony. developing countries as diverse as China,

Guinea, Hungary, and Mexico. In a recent caseSir Edwin Chadwick, a Victorian social reformer, closely resembling the Chadwick-Demsetz pro-proposed a franchise solution to problems of posal, Buenos Aires awarded a water conces-natural monopoly, an approach later promoted sion to the company offering the lowestby Harold Demsetz in the United States.! evaluated price, which was notably 20 percentChadwick distinguished between competition or more below the price previously charged'within the field" and competition "for the field." by the state-owned water company.Where competition is not possible within an in-dustry, Chadwick surmised, competition for the Natural monopolyright to be the natural monopolist may be anadequate substitute. The essential idea is that To examine natural monopoly at its most un-monopoly franchises could be auctioned off to adorned, consider an industry in which de-the bidder offering the most attractive terms- creasing cost gives rise to natural monopoly.

18 Franchising and Privatization

In this case, larger output means lower average large barriers that impede new firms' entry intocosts per unit, and only one firm can survive. If an industry, such as a need for large, irrecov-there were two firms, one could expand to re- erable investments that could be lost if the in-duce costs and thereby eliminate the other. Tra- cumbent firm responds by lowering prices.ditionally, this kind of situation precipitates a National grids for distributing electricity are apricing problem because the surviving producer good illustration of this problem.may be able to set prices well above the pricesthat would rule under competitive conditions. In franchising schemes, competition for theThis is often the argument for regulating or na- market can occur "on paper" without the needtionalizing a natural monopoly. for anyone to incur irrecoverable (specific) in-

vestments. A franchise authority simply awards

Chcacduick dfistinguishedX betweenz a franchise to the producer offering the lowestprice for a given quality and quantity of prod-

competition wivithin the field" and uct. The auction may be systematically repeatedto ensure that consumers continue to obtain

competition for the field. " Where the best price.

But to test whether franchising is useful, it mustcom~zpetition is+notpossible u4tn an be compared with other approaches to natural

industry Chadwicksurmised com etitin monopoly. One traditional solution is for thecompeion nstate to nationalize the natural monopoly, which

yror the *ight to be the nnzturczl mtlonopolist is how gas, water, electricity, and tclecommu-rfg naura nications were supplied in the United King-

mazy be an adequate substitute. dom before the 1980s. But disenchantment withnationalization has become widespread. Inmany countries, nationalized industries devel-

Demsetz recognized that the threat of entry into oped a reputation for inefficiency and controlan industry gives rise to potential competition problems that offset any possible pricing ad-that can stop a firm from adopting monopoly vantage of a public enterprise operating underpricing. If inputs such as labor could be bought conditions of decreasing cost.in competitive markets and if the costs to firmsof colluding were prohibitively high, there Another traditional solution to natural monopolywould be many rivals ready to enter into sales leaves such industries in private hands but regu-contracts with buyers-with the firm offering lates against monopoly abuses. In the Unitedthe best terms winning the contracts. In a natu- States, rate-of-return regulation has been appliedral monopoly, this would lead to production to utilities to discourage monopolists from re-by a single firm; but to beat off rivals, the natural ducing output to increase profits. But rate-of-monopolist would be driven to price at aver- return regulation can reduce the incentives forage cost, enabling the firm to just cover costs. cost efficiency. To boost profits, some firms mayThis is a much better result than the higher try to increase the capital base on which a ratemonopoly prices that traditional theory predicts. of return is calculated. To provide better in-

centives for cost control, regulation of recentlyFranchising schemes privatized utilities, such as gas and telecommu-

nications, has imposed caps on prices.2

Demsetz also argued that a deliberately de-signed franchising scheme is useful where po- Contract designtential competition cannot be relied on to exertdiscipline on a natural monopolist's pricing. In theory, franchising avoids problems associ-This situation is likely to arise when there are ated with nationalization or regulation. It also


avoids the need to calculate and revise price tract is written, to try to renegotiate-or to chiselcaps or to incur many of the costs of more on quality. Such post-contract opportunismactive regulatory schemes. These benefits must relies on the disruption costs faced by the fran-be weighed against the costs of organizing bid- chise agency. To avoid these costs, the agencyding for franchises and of controlling cheating might renegotiate to improve the returns to thewithin franchise contracts. franchisee. It is not enough to argue that the

contract is enforceable in courts of law. TheIf a franchise system is to be successful, a great commercial world is full of cases in which adeal rides on contract design, capable procure- bidder claims that costs have changed and, onment, and monitoring agencies. Some of the that basis, tries to win price renegotiations, withmajor problems concern adapting to changing the implied threat that otherwise it will fail.circumstances, transferring long-lived assetsbetween franchisees, and ;underbidding." Iaf franchise system is to be successful,Changes in conditions require that contractshave adjustment rules. This much is clear from a great deal rides on contract designearly-twentieth-century municipal franchisingof such services as transportation and gas dis- capable procurement and monitoringtribution. To generate sufficient interest at thebidding stage, a franchise authority needs to agencies.devise a means for sharing the risks attachedto changes in demand or to increases in thecosts of inputs. But there is evidence that underbidding is

held in check by the desire of franchisees toAn even greater problem arises when specific maintain reputation, as in the case of U.S. cableassets are longer-lived than the franchise con- television-the only case comprehensivelytract. An incumbent franchisee would tend studied.5

to view the current cost of these locked-in in-vestments as effectively zero and could easily Fully developed franchising schemes are prob-outbid any rival building a plant from scratch. ably best seen as an alternative form of regula-How can a franchise authority ensure the con- tion for natural monopoly.6 They do not removetinuing interest of would-be bidders and cre- the need for a great deal of careful work inate a competitive bidding environment for the designing and administering contracts. None-renewal of the contract?3 The problem can be theless, franchising has advantages where itovercome by stipulating in the contract the would be difficult to privatize an industry out-terms under which assets must be transferred right, where limited private sector involvementto a successor company. But further problems is required, or where a government wishesmay arise in asset transfer:4 an incumbent could to avoid the costs of traditional methods ofmanipulate the original cost of assets to a regulation.would-be entrant's disadvantage by, for ex-ample, arranging false costs with suppliers. Franchise schemes have been applied by gov-Nonetheless, there are examples of smooth ernments around the world in a number of situ-asset transfers, such as in the replacement of ations. An interesting example is the schemeindependent television broadcasting franchisees proposed in the United Kingdom for passen-in the United Kingdom in 1967, 1980, and 1991. ger rail.7 The U.K. government is convinced

that private enterprise can reduce costs. The"Underbidding" arises from the incentive for catch is that many rail services run at a loss,would-be franchisees to make adventurous and therefore it is unlikely that private inves-bids. The temptation is to bid a high service tors would be interested in buying British Railquality at a low price and then, once a con- outright. The proposed franchising scheme

20 Franchising and Privatization

would award rail routes to companies biddingfor the lowest subsidy to operate the servicefor a specified period, and subject the winningcompanies to a requirement to not increasefares in order to maintain the existing level andquality of service. This scheme, which usescompetitive bidding to minimize subsidiesrather than prices, is a variant of the originalChadwick scheme.

Eduwin Chadwick, 'Results of Different Principles of Legislation inEurope: Of Competition for the Field as Compared with Competi-tion within the Field of Service," Journal of the Royal StatisticalSociety, series A22, pp. 381420 (1859); and Harold Demsetz, "WhyRegulate Utilities," Journal ofiat and Economicsa 1: 55-65 (1968).See R.R. Braeutigam and J.C. Panzar. "Effects of the Change fromRate-of-Return Regulation to Price-Cap Regulation," American Eco-nomic Reotiew 83(2): 191-98 (1993).Alan T. Peacock and Charles K. Rowley. "Welfare Economics andthe PuLblic Regulation of Natural Monopoly," Journal of PublicEconomics 1: 227 4 (1972).Oliver E. Williamson, "Franchise Bidding for Natural Monopolies:In General and with Respect to CATV," BellJournalofEconomics7: 73-104 (1976).Mark Zupan. "The Efficiency of Franchise Bidding Schemes in theCase of Cable Television: Some Systematic Evidence," Journal ofLao and Economics 32: 401-56 (1989).See Antony W. Dnes, "The Scope of Chadsvick's Bidding Scheme,"Journal of Inslitutional and Theoretical Economics 150: 524-36(1994), for further comparative institutionalist analysis of biddingschemes. Also see Antony W. Dnes. "Franchising, Natural Mo-nopoly and Privatization," in C. Veljanovski, ed., Regulators andthe Market (London: Institute of Economic Affairs, 1991), for fur-ther analysis of the practical issues affecting the design of con-tracts for these schemes.See Antony W. Dnes, "Franchising Passenger Rail," ScottishJotur-nal of Political Economy 40 (November): 104-15 (1993).

Antony WK Dnes, Professor of Econonzics, TheANottingham Trent University, Nottingbam,England (emait [email protected])

21

Concessions-The Way to Privatize InfrastructureSector MonopoliesPierre Guislain and Michel Kerf

Concession-type arrangements are well suited cluding operating and maintaining the infra-for privatizing sectors with monopolistic char- structure, typically against payment of a lease RANGE OFacteristics.1 Under this approach, the state (or fee. In the second, concession stricto sensu, PRIVATEmunicipality or other public entity) delegates the private contractor is also responsible for SECTORto the private sector the right to provide a ser- building and financing new investments. At OPTIONSvice, yet retains some control over the sector the end of the concession term, the sector Privateby incorporating in a concession contract or assets are returned to the state (or municipal-license the terms and conditions-including the ity). The term BOT (build-operate-transfer) isrights and obligations of the service provider- often used to refer to greenfield concessions,that will govern the infrastructure project or and ROT is sometimes used to describe con-company. This Note outlines the concession- cessions in which investments entail prima-type approach and some of its operational rily rehabilitation (hence the "R") rather thanimplications. construction.

Options for private sector provision BOO (build-own-operate) is a similar scheme,but does not involve transfer of the assets. Di- aBTOIII

concessionThere is a continuum of options for involving vestiture, finally, involves the transfer to the (strlctothe private sector in the provision of infra- private sector of the ownership of existing as- sensui

structure services, as illustrated by the figure sets and the responsibility for future expan-On the right.2 At the base (in white) are supply sion and upkeep. In both cases, the private Leasing

and service contracts, which tend to be of short company is responsible for financing and car- (affermage)duration and require less private commitment rying out the investments required to meet thethan the options higher in the continuum. The obligations specified in its license or by theprivate contractor is not directly responsible regulator. Managementfor providing the service, but instead performs contracts

specified tasks, such as supplying inputs, con- In all these concession-type arrangementsstructing works, maintaining facilities, or bill- (hereafter, concessions), a public entity, typi- /X\ing customers. In this first category, private cally the state or a municipality, grants the right Sub-

sector involvement is highest in management and the obligation to provide an infrastructure contractingcontracts. When these include mechanisms link- service to a private company (the concession-ing the contractor's compensation to the per- aire).3 The service, whether gas, power, water,formance of the utility it manages, they come transport, sanitation, or telecommunications, is Technical

closer to the concession-type arrangements (in provicded under terms and conditions specified assistancepink and purple in the figure) that are the fo- in a contract or license. The private sector takes contractscus of this Note. over operational responsibility and at least part

of the commercial risk of service provision. The Supply andThe first of these arrangements is the lease- concessionaire is by and large held responsible civil worksand-operate (or afferrnage) contract, under for achieving specified results in service deliv- contracts

which the private contractor is responsible for ery and is given some freedom to choose the Publicprovision of the service at its own risk, in- means for meeting those targets.

22 Concessions-The Way to Privatize Infrastructure Sector Monopolies

Sizing up concessions The contracts' duration tends to reflect the num-ber of years investors need to recoup their in-

Despite these common features, important vestment. That is the case for French-styledifferences do exist between the different types concessions, under which assets return to theof concessions. These variations can have im- state at the end of the period free of charge orportant operational implications. for a nominal amount. Lease-and-operate con-

tracts (afferrnages), under which the publicResponsibility for new investments authority remains responsible for financing

most investments, are shorter (ten to fifteenAlthough the responsibility of the private sec- years) than greenfield BOTs or concessionstor under a concession always includes the op- stricto sensu requiring major up-front capitaleration and maintenance of the system or expenditures; these can exceed thirty years.facilities and the supply of the infrastructure Similarly, the transfer of existing sector assetsservice, it may or may not include the design, (for example, a distribution network or a par-construction, and financing of the new infra- allel bridge) free of charge at the time of thestructure. contract award not only reduces the relative

size of new investments. it also provides a freeLegal ownership cash flow for financing these investments, al-

lowing a shorter payback period and a shorterThe legal status of assets built and financed contract period.by the private operator may also vary. Underthe traditional French concessions, for ex- Matching the contract term to the amortizationample, the state owns these assets from the of investments is not essential, however. Themoment they are built, but the private opera- government generally reserves the right to ter-tor retains full control over them until the end minate the contract before the end of its nor-of the concession period. In other cases, in- mal term. In addition, infrastructure servicescluding many BOT or ROT schemes and even require continuous investment that cannot besome French concessions, the legal owner- adequately predicted decades in advance. In-ship of assets built and financed by the pri- vestments will almost always have to be madevate operator will remain private until their toward the end of the concession that cannottransfer to the state at the end of the conces- reasonably be amortized before its expiration.sion term. Finally, under BOO contracts and Moreover, the true value of the business is indivestiture schemes, these assets remain pri- no way limited to the value of the unamor-vate. Private ownership may give investors tized assets built by the incumbent. It also in-more protection and facilitate the financing cludes intangible assets, know-how, reputation,of concessions by making these assets avail- and billing and collection systems.able as collateral.

Schemes should thus be designed with properDuration incentives for maintenance of the facilities and

for valuation of assets that have not been fullyLeases, BOTs, and concessions stricto sensu (in amortized. For example, a payment might bepink in the figure) are generally granted for made by the public authority to the private op-fixed periods. At the end of the specified term, erator on the basis of an evaluation by inde-most assets (including those financed by the pendent experts. Another option would be toconcessionaire), as well as the right to carry stipulate that the concessions awarded will beout the activity, return to the public entity. In rebid periodically-as the Argentines have doneFrance and other countries with a long tradi- in the power distribution sector. Though thetion of using concessions, however, these con- Argentine concessions are for a period oftracts are often renewed or retendered. ninety-five years, they are rebid after the first


fifteen years and every ten years thereafter. If Regulatory implicationsthe incumbent bids the highest price, it retainsthe concession. If it doesn't, the highest bid- Concession arrangements embody a regulatoryder pays the amount of its bid to the incum- framework and should be seen as an integralbent, not to the public authority. In this way, part of economic regulation, rather than as aassets that are not fully amortized are valued substitute or alternative. The key elements ofby the market, not at the discretion of the state the regulatory framework, including tariffs, de-or a regulator. gree of competition, interconnection regime,

and performance targets, are defined in the con-In monopolistic sectors, even BOOs and full cession contract or operating license. Becausedivestiture do not imply permanence. The pri- of the element of monopoly, public service ob-vate company does have indefinite ownership ligations tend to include detailed specificationsrights to the assets. To be allowed to provide on the service to be provided, the obligationthe service, however, it typically also needs an to supply, equal treatment of users, continuityoperating license, which the government can of service, and so on. In consideration of thesewithdraw, revoke, or not renew. In England obligations, concessions often grant certain ex-and Wales, for example, the privatized water clusive rights to the private operator.utilities have a license in perpetuity, but thegovernment can terminate these licenses after These terms need to be monitored and enforcedtwenty-five years with ten years' notice. In ad- and may need to be revised from time to timedition, licenses can be revoked at any time for to reflect changing conditions. Thus, concessionsnoncompliance. The difference between a tra- (or the legal framework that governs them) mayditional fixed term concession (in pink in the grant the public authority or a regulator a cer-figure) and an indefinite divestiture thus may tain amount of discretion and, at the same time,not be as big as it might at first appear. provide recourse against the decisions of the

authority or regulator. In view of concessions'Bulk or retail supply public service nature, public authorities will of-

ten reserve the right to unilaterally modify someIn its classical (or narrow) sense, a concession of the provider's obligations or even to termi-is a public utility: it provides a public service nate a concession before its stipulated term.5

to end users. Direct payment of the conces-sionaire by the users, who are not party to the Whatever the approach, all concessions includeconcession contract, was seen as a defining some form of regulatory mechanism. Under thefeature of this scheme. Examples of such con- French model, the concessionaire is regulatedcessions include bridges, tunnels, toll roads, in part by the public authority that awardedand water and power distribution systems. the concession and to a lesser extent by that

authority's supervising agencies. The authorityIn the broader sense suggested by this Note, and agencies themselves are kept in check byconcession-type arrangements also include the political process (including elections) andschemes under which an independent producer the courts. Concessions also may be regulatedof, say, power or bulk water sells its product by independent regulatory bodies, as in Ar-to a single buyer the public utility. Examples gentina. The selection mechanism can play aninclude the fifty-year bulk- water supply BOT important regulatory role by awarding the con-in Casablanca signed in 1949 and the many cession initially on a competitive basis and byprivate power deals signed in recent years in putting it up for bid periodically thereafter. In-such countries as China, Indonesia, Pakistan, deed, repeatedly auctioning off the concessionand the Philippines. The risks associated with right allows monopoly rents to be extracteda public utility and a bulk supply concession without discretionary intervention by the regu-differ significantly.4 lator or government.' Self-regulation also may

24 Concessions-The Way to Privatize Infrastructure Sector Monopolies

play an important role: most concessionaires In sum, what matters most are the incentivesare concerned with protecting their reputation built into a specific scheme, not whether it is(or their shareholder's) in the market. labeled as a concession, a BOT, a privatiza-

tion, or by any other name.A customized instrument

The concession technique is less suited to situations in whichThe concession is a flexible mechanism that competition can and should be introduced in the market-distinct

can be designed to overcome a broad range of from competitionJfrthe market through competitive bidding for

obstacles to private participation in infrastruc- the exclusive right to providce a service. Where multiple finsmust comnpete with one soother for the provision of services,

ture. The option of leaving formal ownership competitive discipline tends to reduce the need for economic regu-

of existing sector assets to the state makes it lation. Such firms should operate on a level playing field under a

particularlwT useful in countries in vwhich the uniform regulatory framework (such as antitrist legislation), notparticuary ~~~~~~~~~~~~~~undter the termns of individual regulatory deals that would dis-

law or constitution excludes private ownership criminste among players. And. under normal circuLmstances, the

of specific infrastructure assets. For the same state would no longer have the option to terminate the operator's

reason. recourse to a concession is an elegant right to provide the service.reason, recourse to a \v~~~~~~~ith any of these schemes, private participation would hie less

solution when the sale of the infrastructure where the state or other public entities are shareholders of the

company or assets would not fetch the "right service provider.

price" and would expose the government to Concessions have also heen granted to autonomous poblic enti-ties. for example, ADMI, the Moroccan toll roadl companyv. In

accusations of a giveaway. Public ownership France. state-osvned companies are concessionaires of toll roads

may also provide tax advantages where tax laws ancd hold monopoly concessions in the gas, poser, and railroad

treat public ownership more favorably-for ex- sectors. In other cases, the state is a mntnority shareholder of theconcession companiy (for examnple. SEGm, the Consikry. Gulinea,

ample, by allowing a concessionaire to depre- water company).

ciate investments faster than if it owned them. Collecting from hundreds of thousands of households, enterprises,and administrations may be more difficult, but in addition to strongincentives to collect, the concessionaire possesses the tools re-

Because concession-type agreements can be quired to make users pay (including thie right to cut off service in

made as specific as required, they are well case of arrears). hxposure to a single buyer, hf contrast, may

suited to situations in which more general and require more government guarantees or comfon, especially whensuited tosituatios in whic more geeral and the hoiver is a state enterprise that may be uncreditworo hy and

vaguely defined regulatory approaches would protected from the concessionaire's power to cut off service. In a

deter investors. And they can be tailored to ptublic utility concession, the private operator beats the market

allocate risks in a variety of ways to give in- risk directly, such as the risk of a drop in demand. With a singlebaLver, this risk is usually taken by the public utility through take-

vestors the comfort they need to venture their or-pay arrangements, although wnhere the utility may limit its take

capital in specific countries and markets. to a cetntractuLal minimum that is lower than capacity, the privateoperator would still face a residual demand risk.Some form of compensation is uisually called for svhen modifiea-

The flexibility of this mechanism is clearly one tions create more onerous operatidg conditions or in case of early

of its main strengths, but it can also be per- termination.plexing. Designing a scheme that strikes the See also the section ahove on duration of concessions and Antonyplexing. Designing a ~~~~~~~~~. ones. 'Franchtising and Plrivatization' (page 17 in thtis vol-

right balance among the interests of the inves- ume). The competitive award of a concession is a form of fran-

tors, the consumers, and the public authorities chising, as this term is uIsed in the economics literature.

and that fits the conditions of the sector andthe country concerned is pivotal. It requires a Pierre Guislain, Principal Private Sectorclear identification of the objectives and of the Developnment Specialist (emiailt pguislain@tradeoffs that must be taken into account to worldbank.org), and M41ichelKeif Consultantachieve them. Blueprints and model contracts (email: [email protected]), Private Sectorcan rarely be transposed from one country and Development Depairtmentsector to another. With time, countries willdevelop their own precedents, and the pro-cess will become easier. But each concessionis likely to remain a special case requiring spe-cial attention and unique features.

25

The Real World of Power Sector RegulationBern,ard Tenenbaum

"Governments throughout the world engage in three main activities: they tax, .-

they spend, and they regulate. Regulation is the least understood .. q. |

Confusion reinvent the past and put a new DD

label on it." ~ ~ ~ ~ ~ ~~~~la

Regulation is government intervention. Whenan I

a government regulates, it imposes direct and WVhat the prime minister L iindirect controls on the actions of state-owned needs to know: One word, !or private enterprises in a particular sector. Gov- two meanings a teinoent controls on prices are the most common form of economic regulation in t he power Much of the confusion comessector. But regulation often goes beyond simple from one word being given twoprice or tariff controls. State-owned power en- meanings. There is old-style woterprises are commonly required to get gov- regulation and new-style regu-eminment approval for many minor operating lation. Old-style regulation (of-iand investmenlt decisions, ten labeled coordinationl, rev iexv,m

or oversight) has been the pine-A government may regulate openly and directly vailing mode in countries where state monopo-through published rules, decrees, and licenses, lies run the power sector Typically, it involvesOr it may regulate through informal contacts extensive control by one or more ministries overbetween ministries and the managers of the the operations and investments of a verticallyregulated enterprise. State-owned enterprises integrated state power enterprise. This stateare especiallyvulnerable to this "uhidden" regu- power enterprise is protected from competi-lation. As a top official in an Asian govern- tion but usually is not allowed to charge tariffsment-owned utility explains, "What matters that recover its costs.most is not what the ministry writes in its de-crees, but what the minister says in his tele- Old-style regulation is not an option for anyphone calls.' Regulation is therefore not a new country serious about encouraging significant,phenomenon for most countries, but there is sustained private investment in its power sec-often much confusion about what it means. A tor. Private investors simply will not show uptypical reaction from politicians and officials (or, if they do come, they w-on't stay long) if ahoping to privatize some or all of their power country tries to maintain a regulatory systemsector, and at the receiving end of advice on that is unlimited in scope, unclear in opera-regulatory policy, is, "But this is nothing new! tion, and inclined toward micromanagement.Our government has always controlled the ac- Private investment requires new-style regula-tivities of state-owned enterprises through dif- tion that is limited, transparent, and "lets man-ferent ministries. And these controls have agers manage." The choice between the twocreated many problems. Wale don't need to regulatory approaches is ultimately a pragmatic

26 The Real World of Power Sector Regulation

one. If a country really wants private invest- from monopoly prices. If they believe that thement in its power sector, it has no choice but government is not protecting them from the newto adopt a new regulatory system that keeps monopolists, privatization won't last long.promises and exercises self-restraint.

Investors also want protection. Once they haveWhy sector-specific regulation? invested in generating plants or distribution sys-

tems that have no value in other uses, they areWhy should there be a special set of rules for vulnerable to being held (economic) hostage.the power sector? The usual answer is that regu- Independent power producers (IPPs), for ex-lation is needed to prevent the exercise of mo- ample, often talk about the need for a "stablenopoly power by a natural monopoly. There is, regulatory environment." This is a polite wayof course, no point in having sector-specific of saying, "'Once I have signed the power salesregulation when competition is feasible. But for contract, I expect it to be honored.'' Investorsa developing or formerly socialist economy just will not invest in a country if they believe thatbeginning to privatize its power sector, the main their investment will disappear through directbenefits of regulation do not come from elimi- expropriation or through many small regula-

tory actions that add up to de facto expropria-tion. In a countrv with little or no historv of

BOX 1 THE EIGHT BASIC DESIGN QUESTIONS private ownership in the power sector, regula-

tion is needed to convince private investors* Should there be a single regulator or a commission? that they will recover reasonable costs and earn

Should the regulatory entity have jurisdiction over one sector or a profit commensurate with the risk they take.

several?Regulation, then, is simply a system that al-

* What activities or parameters should be regulated? latgovernment to fomalize and titu-lows a government to formalize anld institu-

* What are the control mechanisms for price and quality? tionalize its commitments to protect consumers* How are regulatory rules created and enforced? and investors. Ideally, the policies to be imple-* What are the desired political and legal attributes? mented by the regulatory entity should be

- Should the regulatory entity be "independent" of government? specified in the energy or regulatory law. But

Should the regulatory process be transparent? a new regulatory institution is not always re-quired. If privatization is limited to IPPs' mak-

* Who "regulates the regulator?" ing long-term power sales to state-owned* Howshouldresponsibilitybedividedbetweentheregulatory utilities, regulation need be no more than a

entity and other government authorities? series of transaction-specific contracts between

the government and the IPPs. When privatiza-tion is more comprehensive-involving, for

nating the efficiency losses due to monopoly example, privatization of distribution-a regu-power that are described in economics text- latory agency must be created because it is im-books. The big gains come from creating a sys- possible to prespecify the complete terms oftem of private ownership that can reduce the regulation in one or more contracts.economic losses produced by the capacity short-ages, cost overruns, and inefficient operations The "independence" questionso common in state-run utilities. Privatization,by itself, does not always trigger a need for sec- Eight basic design questions must be answeredtor-specific regulation. But privatization in the whenever a new regulatory system is requiredpower sectors of developing and formerly so- (box 1). While it is not possible to address allcialist economies usually goes hand in hand with eight questions in this Note, it is worth focusingthe government's granting legal monopolies to on the question that always generates the mostone or more new private entities. Consumers controversy: Should the regulatory entity be in-don't care whether a new monopoly is natural dependent of the government? Most presidentsor unnatural; they simply want to be protected and prime ministers react to the idea of an inde-


BOX 2 MINISTER VERSUS REGULATOR: WHO DOES WHAT... Electricity regulatorIssues and enforces licenses and concessions.

Minister of energy Sets prices when there is no competition.* Translates general government policy into sector policy. * Monitors financial viability of operators.• Approves major capital expenditures (while state owned). * Sets service standards and monitors compliance.* Mandates fuel stocks for national security reasons. * Arbitrates disputes between operators.* May require use of certain fuels during supply interruptions. * Arbitrates disputes between operators and consumers.* Controls imports if there are real national security concerns. * Provides information and advice to the ministry.

pendent regulatory entity with dismay and dis- son for independence. Inclependence is not anbelief. The typical response is. 'Why would I want end in itself. Instead, it is a means to an encl.to create a regulatory entity that I can't control' -What ultimately matters is not -whether the regu-Elections can be won or lost becatuse of electric latorl- entity is independent, but whether theity prices. Electricity prices are too important to gov ermnent can giv e a credible commitment tobe left to an independlent regulatory comiimission. investors and consumers. If a government can

give credible commilitments vithout an indepen-This strongly negative reaction to the notion of dent regulatorv entity. there is no real neecl foran independent regulatory commission is the independlence. But in most countr-ies. prime mmin-

result, in part. of three misunclerstandings. The isters and presiclents have found it difficult tofirst comiies from the fact that the wN-ord indepen- resist the temptation to keep tariffs low whendleulce is confusing. 'No regulatory entity can he they have direct control or hiddlen, indirect con-truly independent. Ev-en if a regulatory entity is trol over tariffs. Thus, the hasic rationale for cre-a nonministerial commission or office, it is still ating an indepenclent regulattorv entity insulateda creature of government because it was cre- fromi dlay-to-day political pressures is that suchIated by government. WXhat people reall- mean an entitv mavy be better able to give a commit-by an independent regulatory entity is a gov- ment that investors can believe in. Of course, aernment entitv that cloes not hax e to get the regulator-y entity could he legally independentapproval of the prime minister or other highi- and still renege on its commitments, becominglevel political authorities to raise (or lower) tar- a rogue" regulatory body. Therefore, indepen-iffs. A conscious political decision has been made dence must be combined w, ith well-specifiedto give the regulator autonomy in tariff changes tariff-setting criteria-and backstops that encour-and other clecisions. Independence dcoes not age compliance.mean the absence of accountability. There is

still accountability. but it is to the tariff stan- An alternative to independence is a comripletelyclards in the law., not to the minister. specifiecl regulatory regime that leaxes little or

no discretion to the regulatory entity. This isA second misunderstanding is the belief that the approach takcn in Chile and Peru. It arisesthe regulatory entity must be given complete out of a fundamental mistrust of government.authority over all policy decisions that affect both inside and outside the regulatory coini-the poxer sector. This is a mistaken presump- mission. It is appealing because it is perceivedtion. In cotintries w ith indlependent regulatorv as the regulatory equiva,lent of going on auto-entities, executive departments or ministl-ies pilot." but it is likelv to wvork only when a gov-retain control over many fundamental policy ernment has a clear idea of the industrydecisions affecting the sector. The basic split is structur-e it wants, moves quickly to this struc-between policy development by the ministry ture. and then doesn't clhange its mindl.

and policv implementation by the regulatornentity (box 2 shoxws how decisions could be Backstops to regulation?divided betwveen a ministrv and an indepen-clent regulatory entity). A country may aclopt all the formal trappings of

an independent regulatory entity xb-hile, behindlThe third andc per-haps most important misunl- the legal facadle, the prime minister still retainsdlerstanding arises from conftision about the rea effective control ox er the fundamental regulatory

28 The Real World of Power Sector Regulation

decision-tariff levels. Are there "backstops to is to have any legitimacy, it must be able to con-regulation" that will make the prime minister think vince the public that the price increases reflecttwice about reneging on regulatory commitments? costs previously suppressed or subsidized by theTwo backstops are worth considering. The first government, not monopoly profits.is widespread domestic ownership of the privatepower companies. This backstop works when The best way to do this is to make the regula-enough voters have been converted into inves- tory process as transparent as possible. Trans-tors. For example, in Chile, about 35 percent of parency means openness. It has three principalthe equity shares of private electricity companies dimensions: specifying the rules, opening upare owned by Chilean pension funds. It is rela- the process, and explaining the decisions. Thetively easy for authorities to quash tariff increases British regulator, for example, specifies iLs ruleswhen the owners of the power companies are in the licenses issued to each power sector en-foreigners or a few friends of the former prime tity. The advantage of putting all the rules in aminister. It is much harder to do so when the single place is that it increases certainty. Thepensions of many local citizens depend on the U.S. system, dominated by lawyers, places andividends paid by these companies. excessively high premium on the openness of

the process. The typical U.S. rate case involvesThe second backstop is international guarantees expert, witnesses, cross-examination, writtenof regulatory performance. The WTorld Bank re- briefs, and counterbriefs-all open to publiccently created stand-alone guarantees for vari- view-and strongly resembles a court case. Itous sovereign risks, including government is a slow and costly system, and there is noregulatory actions. The guarantees are limited to clear evidence that it produces better decisions.protecting private lenders against debt service Probably more important than the opennessdefault. The guarantee fee ranges from 40 to 100 of the process is the requirement that the regu-basis points and is in addition to the interest rate lator issue written explanations of its decisions.charged by lenders. As a condition for issuing a The discipline of justifying in writing decisionsguarantee, the Bank will require a counterguar- that could be appealed reduces the chances ofantee from the government that, if it fails to live the regulator's becoming a "rogue" regulator.up to its regulatory commitment, it will reimbursethe Bank for the amount paid out in compensa- A common mistaketion. The guarantee program is likely to workonly if governments can be persuaded to take Currently, more than twenty countries are re-out insurance against their own possible misbe- forming their power sectors. For most primehavior and if future regulatory performance can ministers, this reform simply means restructur-be described precisely enough to make it clear ing and privatizing state-owned enterprises.when the guarantee would be triggered. What they forget or may not know is that a

government cannot regulate private powerTransparency companies in the same way that it regulated

state enterprises. Power sector reform will suc-Regulators are always under suspicion-espe- ceed only when governments reform both thecially new regulators in developing and formerly sector and the way it is regulated.socialist countries, because often their first bigtask is to lift prices up to costs. (In contrast, regu- Scott H. Jacobs, "Building Regulatory Institutions: The Search for

lators in the United States and other industrial Legitirnac' and Efficiency" (OECD, Centre for Cooperation with

countries work hard to get prices down to costs.) Econonlies in Transiion, Paris, 1994).

The need to raise prices often coincides withprivatization, so consumers will inevitably sus- Bernard Tenenbaum, Industry and Energypect that the regulator has "sold out" to the new Department (email: btenenbaumPiworldbank.private power companies. If the regulatory agency org)

29

A Template for Power ReformDavid M. Newvbey

In the electricity supply industry, high-tension enough to justify their investment. Experience,transmission and low-tension distribution sys- however, shows that the politics of pricing aretems are natural monopolies, but generation is often heated. For social reasons, many govern-potentially competitive. Because competition ments have set unremunerative prices, and manyis more effective than regulation in promoting have failed to index public utility prices ad-efficiency, separating the potentially competi- equately to offset the effects of inflation.tive parts of the electricity supply industry fromthe natural monopoly parts that must inevita- Therefore, to give investors the confidence tobly remain regulated is good public policy. But tie up money in an investment that might notthe potential for this kind of industry reform pay off for years, governments must reassurewill vary by country-depending on whether them that the rule of law-specifically, prop-the system is government owned, investor erty law-is sufficiently strong to ensure prop-owned, or under mixed ownership. If a coun- erty rights. And to reassure consumers andtry can de-integrate its electricity supply indus- investors, a regulatory system must set ratestry in this way, however, it should do so, or at satisfactory to both. Investors, in turn, must co-least keep the possibility open through con- ordinate investment in transmission and gen-tinued public ownership of the transmission eration to find least-cost ways to expand thesystem. And to create effective competition, system and to prevent system failures, fuelgovernments should privatize generation-and shortages, and price shocks. And because elec-possibly distribution-to pave the way for a tricity is vital to production, they need to reas-market in bulk power. This Note provides a sure governments that supplies will be availabletemplate for such industry reform. at all times. How to satisfy this set of objec-

tives constitutes the regulatory problem.The regulatory problem

What industrial countries have doneA natural monopoly arises when a single firmcan provide a range of goods or services at lower The history of the electricity supply industry incost than a set of firms. Electricity networks are different countries illustrates the variety of so-natural monopolies in this sense. Moreover, their lutions that have been found to the regulatolymonopoly is in the supply of a necessity, and problem. The solutions are of three main types.they have a direct connection to consumers. This The industry may be entirely publicly owned,combination of necessity and direct connection and thus subject to direct political control; itimplies large potential exploitative power and may be entirely private, but regulated explic-ensures that regulation or public ownership is itly or implicitly or it may be a mixed systempolitically inevitable. Investors in the electricity in which the private sector is implicitly con-industry must therefore expect limits on the trolled by the potential of the remaining pub-prices they can charge and sometimes onerous licly owned system to take over its function.obligations relating to safety, supply, and sta-bility. In exchange, though, investors need re- The simplest structure is a publicly owned na-assurance that future prices will be set high tional monopoly such as exists in Belgium,

30 A Template for Power Reform

A GLOBAL FINANCING PROBLEM The performance of the state-run power sectors was frequently

unimpressive-particularly when high inflation followed the oil

Industrial countries' demand for electricity increased sharply shocks of the 1970s. Despite excess demand, prices hovered

after World War II. Improvements in reliability and high but below long-run marginal costs, and the rate ef return fell so that

falling electricity prices financed the huge investment profits could not finance needed investments. In 1991, with only 60

programs needed to meet demand and to modernize genera- percent of power sector costs covered by revenues, self-

tion and transmission. Until the oil shocks of the 1970s and financing ratios fell to only 12 percent of investment requirements.

growing fear about nuclear power, therefore, public criticism In fact, by the late 1980s, continuing in this vein was no longer

of the power sector was muted. financiallyfeasible for utilities orfor governments, especially in

In developing countries, the electricity supply industry was Latin America. Fundamental sector reform (including privatiza-

almost invariably state controlled, with international orga- tion) was proposed as the solution. In 1978, Chile had begun

nizations such as the World Bank helping to meet investment radically restructuring its electricity industry as a prelude to

requirements. In 1984-91, nearly 9 percent of official develop- privatization. Deregulation was on the agenda in the United

ment finance went to the power sector, and power accounted States, with modest beginnings in the power sector under the

for about 15 percent of World Bank lending until 1991. In the Public Utility Regulatory Policies Act of 1978. But the pace

1980s, infrastructure accounted for more than 55 percent of quickened with the simultaneous restructuring and privatization

public investment in middle-income countries, and roughly 40 of the electricity supply industry in the United Kingdom in 1990-91.

percent of that share-or a quarter of total public investment- This reform demonstrated the importance and feasibility of

went to power. Official development assistance financed about restructuring the industry and changing the system of regulation,

10 percent of the annual power sector investment-roughly usually as preconditions for privatization (though, as Norway

US$80 billion-and the World Bank financed about 3 percent. shows, this last step is not logically implied by the first two).

France. Italy, and Portugal and used to exist in Structural choices and the designEngland before 1990. Austria, the Netherlands, of regulationand Spain have de-integrated their industriesto varying degrees and formed cooperative Reforming the electricity supply industry in coun-power pools that dispatch in order of cost. In tries with nationalized industries (owned andthe Netherlands, four regional generation com- controlled by the central rather than the localpanies own the grid and the dispatch company, government) raises different problems than inand the industry draws up plans subject to gov- those with private (investor-owned) industriesernment approval. In Spain, the grid is under or mixed systems. Governments without directpublic control, and the government determines control over assets will be constrained in regu-the investment plan. And in Austria, the na- latory reform by the rights of the existing own-tional power company owns the grid and also ers. Radical restructuring is far easier under publichas ultimate responsibility for ensuring sup- ownership, although in countries with unclearply, but coordination of power sector invest- or overlapping property rights (of workers, lo-ment is decentralized. cal municipalities, and ministries), it may require

clarifying the state's control over the industry.Unlike most other European electricity supply For countries undertaking reform, advisers willindustries, those in Germany and Switzerland need to answer the following questions: Howare complex and fragmented. This reflects the should the industry be structured? Which partsfederal structures of these countries and the fact should be public and which private? And whichthat, because their power sectors were not na- parts should be regulated and how?tionalized, they have not been restructured. TheScandinavian electricity supply industries are Industry structureunder mixed public and private ownership andare largely self-regulating, coordinating electric- Since generation is potentially competitive andity supply through cooperation and negotiation. transmission is a natural monopoly, separating


the ownership of the two systems might allow cult, because it requires overriding private prop-competition to effectively take the place of regu- erty rights or paying expensive compensation. Iflation in generation. But for competition to be generation is to be transferred to private owner-effective, there must be enough independent ship, transmission should be kept separate, per-generators actively competing in setting the price. haps initially in public ownership, or as a separateThis active competition may be difficult to achieve company with restrictions on control by genera-if new power stations are large relative to the tors or by large users or distributors.total capacity of the country or if the transmis-sion system is unable to ensure adequate com- Public or private ownership?petition in each region. If competition fails tokeep prices low, regulation may be necessary. Most studies comparing the performance of pri-

vate electric utilities with that of publicly ownedWhen generation and transmission are inte- utilities conclude that there is little differencegrated, only the delivered power price needs in technical or cost efficiency, though very re-regulation. But if transmission is separate, cent studies indicate better performance un-charges for access to and use of the transmis- der private ownership.sion system will need to be regulated to en-sure efficient generation in the short run and . erience suggests thator.efficient choices in plant type and location in . t >st efficiencythe long run-a challenging task. depends more on theform of regulationSome of the considerable benefits of competi- t otion in generation can be achieved by inviting tpcompetitive tenders for the construction of newplant, built and operated under long-term con- In the United Kingdom, privatizing the genera-tracts with the transmission company. But verti- tors and forcing them to compete in the bulkcal de-integration offers potentially greater electricity market doubled labor productivity inbenefits. It creates competitive pressure at stages three years and improved control over invest-where entry is feasible, and it may result in over- ment costs. The publicly owned Nuclear Electricall improvements in efficiency sufficient to offset and British Coal, both forced to sell in marketsthe inefficiencies of transactions through the net- where there was competition from private firmswork. Vertical de-integration also hinders cross- or imports, also improved their productivity dra-subsidization and makes pricing more transparent. matically. In Argentina, generation availability im-

proved within a short period after privatization,Given these considerations, what course should with Central Costanera increasing availability frombe taken by a government contemplating a po- 20 percent to 50 percent and doubling its out-tentially radical restructuring of the industry? Such put. Norway introduced competition in the bulkopportunities are rare and should not be wasted. electricity market and in 1993 created StatnettThe guiding principle should be whether the pro- Marked (as a subsidiaty of the state-owned ownerposed reform forecloses options or keeps them of the transmission system, Statnett) to operateopen. If de-integration is possible, a government the power pool, without altering the ownershipshould choose that course-or at least keep that structure of the industry. The result has beenoption open through continued public ownership substantial trade across former franchise bound-of the transmission system. Continued, central- aries and decreased dispersion of prices. In dueized public ownership keeps most options open, course, the Norwegian reform should provide abut municipal ownership appears to create ob- good test of whether, in creating contestablestacles to further reform, at least in some political power markets, it is more important to restruc-systems. Reforming a privately owned, vertically ture the industry or to privatize it. Note, how-integrated generation system appears most diffi- ever, that the Norwegian system allows private

32 A Template for Power Reform

generators to compete with state and municipally and new investment in transmission and gen-owned systems. In the United Kingdom, as in eration is required, prices will need to be ad-Argentina and Chile, distribution companies re- equate to reward private investors.main natural monopolies, and the rate of improve-ment in their performance has not changed The major challenge in designing regulationmarkedly since privatization-although neither for a de-integrated industry is to provide ad-has it deteriorated. Altogether, this experience equate assurances of investor protection, so thatsuggests that efficiency depends more on the form the necessary expansion will take place, whileof regulation than on the form of ownership. preserving the benefits of market competition.

Policymakers must ensure that the bulk elec-Criteria for regulation tricity market is adequately competitive to avoid

a need for the burdensome regulation that un-A good system of regulation should do two dermines investor confidence.things. It should enable a utility to raise financefor investment at an acceptable cost. And it Priorities in developingshould provide incentives for efficiency in op- and transition countrieseration, pricing (and thus use), investment (inchoice of type, location, size, and cost), and In developing countries, the main problem isinnovation. These requirements may conflict, to improve the financial and economic perfor-however. Rate-of-return regulation guarantees mance of the industry-by rebalancing tariffs,an adequate return on capital and thus enables eliminating costly interruptions in supply, re-a utility to finance investment cheaply, but it ducing construction and operating costs, andgives little incentive to increase efficiency. Price avoiding construction delays. Private invest-cap regulation does provide good incentives to ment in generation-and possibly in transmis-reduce costs. But by increasing profits, it ends sion and distribution as well-looks attractiveup creating pressure to tighten price regulation, on all scores, as long as entry is competitivewhich increases regulatory risk and raises the and the regulatory environment keeps risks andcost of investment. Regulatory reviews must be costs low. The evidence from Chile in particu-carefully designed to ensure investor confidence lar-where regulatory reform and the restruc-and continued political support. The U.K. solu- turing of state enterprises occurred first andtion is to grant licenses to the utilities that clearly privatization proceeded quite slowly-showsspecify their rights and obligations and can be the importance of creating a sound, indepen-defended or enforced in the courts. dent system of regulation, commercialization,

and competition, even for state-owned utili-Creating competition ties, and the relative unimportance of rushing

into privatization. In Eastern Europe, efforts toCreating effective competition requires separat- privatize utilities to reduce public debt haveing transmission from generation and privatiz- been hampered by low tariffs and unsatisfac-ing generation (and possibly also distribution) tory regulation. Solving these problems wouldin order to create a market for bulk electricity. remove the financial urgency of privatization.This restructuring has far-reaching effects on therelative price structure, reducing the ability to This Note is based on a chapter by the author in ClaLidio Frischtak,

cross-subsidize and putting competitive pressure ed ' Regulatory Policies and Reform A Comparative Perspective'on fuel upplv inustries,making sbsidies (World Bank, Private Sector Development Deparnment. \Xbshington.on fuel supply industries, making suhsidies (gotld Bank priO e Se.DC.9). To order, rontact Cindy Wong at (202) 473-3606 or by

harder to justify. Paradoxically, when costs fall email (cwong5,worldbank.org).

as efficiency increases, labor is shed, and costlyfuels such as coal and nuclear are replaced by David .ll. IVewbeiy, Department of Appliedgas, prices may rise as subsidies to capital and Economics, Cambtidge University, Cambridge,fuel are removed. If demand growth resumes England

33

Competitive Contracting for PrivatelyGenerated PowerWhat to do in the absence of competition in the market

Robert Bacon

The importance of competition IPP as base load might no longer be optimal.When a contract does not allow for such a con-

Independent power producers (IPPs) are an in- tingency, the operational efficiency of the sys-creasingly important type of power generation tem tends to decline. And contracts that provideproject in developing countries. In many of these for guaranteed sales to reduce private investors'countries, power sector reform involves unbun- risk reduce the competitive pressure on them todling generation from transmission and introduc- operate their plants efficiently.ing private capital. Rather than privatizing existinggenerators, some governments prefer to create There is inevitably a tension between design-an enabling environment for IPPs. They have two ing contracts to reduce uncertainty for the pri-objectives in doing so. First, by using truly com- vate investor and running the power system aspetitive bidding to procure new generation ca- efficiently as possible. The characteristics ofpacity, governments seek to minimize the costs power sales agreements are pivotal in resolv-of expanding power supply. And second, by ining this tension. This Note surveys a range oftroducing the profit motive and competition in selling agreements-from the most rigid to thethe power and energy sector, they seek gains in most flexible-and highlights their risks andoperational efficiency that lead to lower prices benefits for operational efficiency.for electricity users than would otherwise havebeen possible without subsidies. Some of the most common contractual ar-

rangements for IPPs place no competitive pres-The second result is especially hard to achieve, sure on existing suppliers. These arrangementsand when achieved, it can be even harder to will not help improve the efficiency of thesustain. Governments in most developing coun- sector. They will only increase supply capac-tries lack the proven track record of transparent ity-though that can be valuable in a systemregulation of their power sectors that is needed facing public financing constraints. When theto attract private investment. Thus, long-term con- entry of IPPs fails to put competitive pressuretracts (power purchase agreements) are required on other suppliers, governments need to de-both to encourage entry by potential investors sign other efficiency-enhancing reforms, suchand to safeguard their interests. Such contracts as performance contracts for the nonprivateattempt to share the risks between the parties in generators. And if the contract does not leada predictable fashion. But because it is difficult to head-to-head competition between newto write legal clauses that cover uncertainties IPPs and the other suppliers, it should includeabout future marketing conditions, they cannot performance incentives to ensure that the IPPbe fully contingent, so inefficiencies arise in sys- remains an efficient supplier.tem operation. For example, at the time of sign-ing a power purchase agreement, the IPP may Methods of contracting for the salebe the most efficient plant in the merit order of IPP power and energyand should indeed run on base load as speci-fied in the typical contract. But circumstances There are three principal dimensions to powercan change, and after a few years, running the sales agreements: the selling prices for power

34 Competitive Contracting for Privately Generated Power

and energy, the amount of power and energy tors. An initial heat rate and initial fuel and op-sold, and incentives to improve performance and eration and maintenance (O&M) costs are as-disincentives to ensure that performance does sessed for the plant, together with the appropriatenot fall below a basic standard. Sales agreements indexes (for example, the consumer price indexgenerally are based on a two-part pricing struc- for O&M costs and the average fuel price indexture-with separate payments for capacity and of the sector for fuel costs). These determineenergy. But there are substantial differences in the energy price. Often, the price is set to justthe way they deal with quantities-ranging from cover such costs, and as long as the indexes'must-run" or "take-or-pay" contracts on the track the actual costs exactly, there will be noplant's entire output to competitive dispatch. The change in the net revenue per unit of energystronger a sales agreement's guarantee of a mar- supplied. The energy price is then designed, asket for the IPP's output, the more attractive the in certain U.S. power pools, so that the IPP isIPP becomes for the IPP sponsor and financiers, indifferent to whether or not it is dispatched.but the less pressure is created to generate that The capacity price is collected because the plantoutput efficiently and the less competitive pres- was declared available, not because it actuallysure is applied to other generators. The choice ran, and since it earns no net revenue per unitof contract structure must therefore take into ac- of energy, there is no gain from being dispatched.count the two-sometimes conflicting-aims of If strong enough, the profit motive can encour-attracting private finance and improving sector age the firm to try to "beat the index" in fuelefficiency. purchases or O&M costs so that the firm's actual

costs rise less than its allowed costs. (The firm isThe price of capacity in the power sales agree- allowed to keep the difference-it is not passedment usually is related to the capacity declared on to the consumer.)available, rather than to the actual capacity run.It is likely to be set so that, at a given level of The contractual arrangements for determin-operation, the discounted revenue from capac- ing how much energy and power are sold canity payments will cover capital costs over the vary greatly. The rest of the Note examineslife of the project. Contracts tend to set a target their importance for the sector.level for availability (say, 80 percent) over theyear, plus a bonus zone above this availability Must-run or take-or-pay contractsand a penalty zone below it. Setting the targetwell below the feasible availability under good The least risky form of contract for IPPs guaran-operating practices reduces the financing risk tees the sale of a stipulated amount of powerof the IPP and thus the incentive for the opera- and energy for the life of the contract. Whentors to be efficient. If the IPP is one of the low- this guarantee covers the entire projected out-est-cost generators, it should be used as much put of the plant, the IPP has an assured marketas possible. A bonus payment for availability that it cannot lose without compensation, but itabove the target can be used as an incentive also cannot increase its market share. Under thisfor higher production. Similarly, if the price for must-run contract, there is no issue of economiccapacity allows an IPP to earn an economic dispatch for the plant even when other plantsreturn on capital at a capacity utilization below have lower costs. The subsequent entry of addi-the target, penalties are needed to ensure that tional IPPs, each with a long-term contract, canthe IPP remains efficient. Recent U.S. experi- compound this problem. The purchaser must payence with IPPs shows that, in most cases, pen- for any contracted output that it does not takealties and bonuses are an important part of the from the IPP.incentive scheme.

This arrangement has three separate effects onThe price of energy usually is tied to an initial the performance of the sector. First, there is nocost estimate and a series of cost indexation fac- conmpetitive pressure for the IPP to lower costs,


so that efficient operation depends solely onz the The use of bonuses and penalties for capacityprofit motive. For costs that are indexed, the in- availability can lead to some competitive pres-centives to improve performance center on "beat- sure between plants. If the IPP tries to increaseing the index" to benefit from the difference. its market share by bidding a higher availabilitySecond, dispatch can occur out of merit order, (under the incentive of a bonus payment), otherleading to the loss of a system's productive effi- generators may lose market share and respondciency. And third, the lack of competition for by trying to reduce their capacity costs so as tomarket share between the IPP and other gen- improve their availability. Dispatch based on eco-erators means that, even if operated efficiently, nomic costs, however, provides no competitivethe IPP poses no threat to other generators be- incentives for the supply of energy. Because gen-caiuse it has no spare capacity to capture their erators cannot bid market prices, hut instead of-market share. In the United States, early PURPA' fer cost-related prices determined at the outsetprojects were of this kind, and the result was of contracts, there is no way for IPPs or for othersuch problems as excess production of off-peak generators to increase market share through priceenergy, which the buying utility was obligated competition. Contracts that guarantee a "mini-to purchase. The IPP projects in the Philippines mum take" below normal capacity availabilityare on a take-or-pay basis, as is a project in Belize combine aspects of the must-mun contract withand another in Colombia. those of an economic dispatch contract. Economic

dispatch is used in IPP contracts in Jamaica andEconomic dispatch the Dominican Republic, and a second project in

the Dominican Republic has take-or-pay for upThe natural development from must-run contracts to 130 megawatts (MW) of its 185-MW capacity.has been to introduce economic dispatch. Inthese contracts, capacity price is again related to Generator tradingavailability, and the energy price is paid only forthe energy dispatched according to costs. The Another step to improve efficiency is to allowIPP can declare its available capacity and thus generators to trade in a market based on eco-can cover its capital costs, but it is not guaran- nomic dispatch. The contract prices for energyteed energy sales. Under this form of contract, are predetermined for all generators, but thethe plants are dispatched according to their eco- generators bid availability for the next periodnomic ranking. That is the main benefit of the (typically the next day). The dispatch agency orarrangement, but it requires establishing an en- power purchaser determines least-cost dispatchtity to determine dispatch on a cost-related ba- on the basis of the contract prices and announcessis. Energy prices linked to a cost index, however, the schedule. Generators can then trade energydo not allow cost savings to be passed on to among themselves, buying from lower-cost gen-consumers or reflected in the prices that influ- erators not fully committed in dispatch to meetence dispatch decisions. That is because this ar- some of their contractual commitments.rangement bases dispatch on the contractualenergy costs, which relate to the initial settle- Opportunities for trade emerge when actual costsment level and the values of the indexes since for energy are below the contract prices. Thethe start of the contract. If the initial costs (for power purchaser is informed of such trades andexample, the heat rate) were incorrectly estimated adjusts the dispatch schedule while paying inor if the fuel prices obtained by the IPP diverge accord with the original schedule. This systemfrom the index, the actual cost of generation can lowers the total cost of generation, but oncebe quite different from the cost taken into ac- again the benefits are not passed on to con-count for dispatch. In this case, dispatch might sumers, because generator prices are tied to thenot occur according to a true merit order, and cost index. The system can lead to competitivesystemwide generation costs could be unneces- pressurc for generators to improve efficiencysarily high. once actual costs start to diverge from the in-

36 Competitive Contracting for Privately Generated Power

dex. But it is complicated to operate because achieve none of these benefits. Economic dis-the power purchaser must determine dispatch patch contracts, possibly coupled with mini-in advance and keep records of transactions be- mum-take provisions, can be designed totween companies, and generators need to have provide incentives for the IPP to generate effi-sophisticated systems. Generator trading is used ciently and can ensure merit order dispatch onin the reformed power sector in Chile. indexed costs. Where dispatch is related to a

predetermined cost index, however, there is noCompetitive pool competition between generators to sell energy.

But including a bonus in the capacity price struc-The distinctive feature of competitive pools (as ture can create limited competition for the salethey exist in Englanid and Wales, Argentina, the of capacity declared available. Generator trad-ELEX pool in New South Wales, and, to a limited ing can ensure that dispatch occurs on the basisextent, Norway) is that prices for energj are bid of actual costs. Where these costs are likely torather than related to costs by a formnula. That diverge substantially from the cost indexes usedallows prices to be lowered when there is real in the IPP contract, generator trading can be ancompetition, as generators struggle to increase attractive option if there are enough generatorsor to hold onto their market shares. Generators to create a true market and a pool of suitablybid their capacity availability and their offered qualified managers to operate the system.energy price. The pool operator then determineseconomic dispatch and pays for energy on the Full competition through an open pool is suit-basis of marginal bid prices and for capacity on able only for large, mature systems with sparethe basis of declared availability and a formula capacity. Even in the system in England andthat gives signals for long-term investment. In WVales, generators have taken several years toprinciple, this system can be highly efficient in learn how to benefit fully from the complexi-producing the lower consumer prices associated ties caused by rapid changes in prices. Thesewith competition. But experience in the system prices sometimes have been too high becausein England and Wales suggests that there are many the two dominant generators have taken ad-problems associated with setting up and running vantage of their market power, restricting thesuch a pool. This demanding system is probably capacity offered to the market to drive up thefeasible only for a sizable market with several price of available capacity.generators and sophisticated management.

Among developing countries, only the largestConclusion can expect to establish systems that bring the

benefits of true competition, such as a competi-Introducing independent power producers in tive power pool or generator trading. Countriesa power system where existing generators are with small power systems (about ninety haveinefficient can bring about more efficient in- less than 500 MWV) that are growing slowly couldvestment, but it is not sufficient to achieve the introduce IPPs only slowly. Here, the need tooperating benefits of competition. Power and provide low demand risk to potential investorsenergy sales contracts are crucial to ensuring (to compensate for the other risks of doing busi-efficient operation of the IPPs, true merit or- ness in unfamiliar markets) suggests using long-der dispatch is essential to achieving least-cost term contracts that are carefully designed.generation with current operating practices, andcompetition among generators is needed to en- PURPA is Public Utility Regulatory Policies Act (197).

sure efficient operating practices throughout

the sector. Robert Bacon, Oxford University. Oxford,

Take-or-pay contracts, although attractive to pro- England (email [email protected])ducers because they remove demand risk,

37

The Dynamics of Independent PowerIPPs seed top-to-bottom reform

ElliotRosemnan andAnilffalhotra

The desirability of government ownership of the seeds for a top-to-bottom change in thepower generation has increasingly been called structure and operation of the government-into question, particularly in the past five years. owned utility-seeds that are hard to stop fromAround the globe, many incumbent power com- growing once they take root. Other vehiclespanies have offered independent power pro- for private sector entry that are gaining in popu-ducers (IPPs) the opportunity to tender for new larity include privatizing management and leas-or existing generation. Outside the United States ing and franchising utility operations. Fromand Canada, there are now more than 600,000 modest beginnings, IPPs and these othermegawatts (MW) either on line or under devel- mechanisms can lay the groundwork for anopment in more than 1,500 project initiatives. upheaval ending in private ownership of muchIn the Philippines, for example, private devel- of the generation, transmission, and distribu-opers have, just in the past two years, brought tion sectors of utilities.on stream 1,200 MW of the 8,000 MW in place,for sale of power to the national utility, and are Such top-to-bottom restructuring is now underdeveloping more than 6,500 MIW of additional way in a number of countries, some of whichcapacity. In Australia, several existing plants were among the first to use IPPs, includingowned by provincial utilities have been auc- Argentina, Australia, Bolivia, New Zealand, thetioned off to IPP bidders, and other developers United Kingdom, and the United States. In thehave won the right to develop new plants for United States, restructuring is well under waysale of power to these utilities. In Argentina and even though most generation was not govern-the United Kingdom combined, well over 12,000 ment owned when IPPs were introduced.MW of government-owned hydro and fossil fuel-based generating capacity have been sold, The process of changelargely to private developers from Chile, France,the United Kingdom, and the United States. In At first sight, IPPs seem innocuous and desir-the United States, which has allowed private de- able in reasonable doses. Properly done, theyvelopers to own new generation since 1978, generally are. But during their development,about 7 percent of existing capacity-nearly they raise nagging questions about the effi-60,000 MW-is owned by IPPs. ciency and competitiveness of the integrated,

government-owned utility and the means byThe reasons supporting the introduction of IPPs which it is regulated. Once IPPs are introduced(outside the United States) into government- into the mix, these questions tend to ferment,owned utilities are legion: reducing public leading the more progressive forces within andspending, expanding capacity, improving reli- outside the country to seek answers, exploreability, introducing foreign capital, introducing alternatives, and set about to change the exist-competition, transferring technology, respond- ing industry's structure. The phasing of the re-ing to pressure from large consumers seeking structuring process revolves around three mainmore cost-effective alternatives, and so on. Less sets of questions that IPPs raise-about whetherrecognized is what may be an unintended con- the existing utility is efficient in generation andsequence of the introduction of IPPs: they plant what the proper level of prices should be, about

38 The Dynamics of Independent Power

the regulatory framework, and about the struc- system? Underlying question: Is the govern-ture of the entire industry. ment-owned utility's transmission system ad-

equate and well planned?The pace of these phases, their overlap, the * Did the regulatory, permitting, and politicalresistance they meet, and their outcomes dif- approval process work well for the IPP? Un-fer from country to country, depending on the derlving question: What decisionmaking andinitial structure of the industry and the relative approval process for procuring capacitystrength of the stakeholders. Regardless of the should be in place for the long haul?country, however, the questions do get asked, * Was the IPP's contract financeable-given theand their very asking leads to incremental- guarantees, if any, that the utility provided-and sometimes wholesale-change. and did it bring in new capital? IUnderlying

questions: Is the utility creditworthy? DoesPhase 1: Generation and project development the country need model contracts? Do IPPs

really leverage domestic capital? Will guar-Assume, for example, that an IPP is introduced, antees be required in the long term?through negotiation, into a national, govern- * Was the project financed using primarily for-ment-owned, vertically integrated utility that is eign capital and multilateral loans? Underly-largely or wholly unregulated. If this IPP rep- ing question: Can the country improve itsresents a substantial amount of capacity (a domestic capital market? A number of coun-small, inside-the-fence cogeneration plant, for tries are trying to determine how to emulateexample, might not be noticed), it will raise a Malaysia's success in raising all the debt andset of issues relating to developing, construct- equity capital domestically for its 1,300-MWing, financing, operating, and maintaining a Lumut project.generation unit that is not part of the govern- * Was the IPP efficient in construction, and doesment-owned utility system. This is a plant that it operate efficiently? Underlying questions:can allow more foreign control in the power Should the utility modify the operation of itsindustry than ever before, and that takes much existing generation? Should the governmentof the decisionmaking for a power plant out of consider private sector operation while retain-the utility's hands. And it raises questions that ing ownership, or set up incentives for thenot only require negotiation with the IPPR but utility to be more efficient? Does the countryalso reveal underlying issues about how IPPs have the capability to produce the equipmentcompare with the utility, how the process of for its own modern power plants?adding generation capacity should be changed, * How should the IPP procure fuel-on theand whether there are inadequacies in the cur- open market or from a state-owned mo-rent utility system. nopoly? Which is most efficient for the IPP?* Does the IPP deliver power at a lower price Uinderlying question: is the way the govern-

than the utility? If the costs of production ment oversees fuel procurement for all powerare not broken out and tariffs are highly sub- stations efficient and conducive to privatesidized, as is true in many countries, how sector investment?can the country know? Underlying questions: * Was the IPP developed by a company fromAt what price should the utility buy power? an industrial country? Underlying question:Should retail rates be restructured? Are there local firms that could do the job

* Is the way the IPP was selected-through just as well, keeping the revenues in thenegotiation-the best way? Underlying ques- country, or that could establish a regionaltion: Should there be a competitive bidding presence? The initial wave of IPP projectsprocess that gives IPPs the right to compete were carried out by developers from suchfor all future generation? countries as the United Kingdom, the United

* Can the power generated by the IPP be States, and other NWestern countries, but cur-smoothly integrated into the transmission rent IPP projects include many with strong


lead participation from companies headquar- * Should generation, transmission, and distri-tered in such countries as China, India, Ma- bution be regulated differently, dependinglaysia, and Thailand. on whether they are natural monopolies?

* Shouldn't the country standardize the provi-The IPP negotiation process can reveal weak- sions relating to country and commercial risknesses in the government-owned utility sys- in its contracts with IPPs?tem-including in the way power plants are * What is the best bidding and approval pro-authorized, financed, granted permits, con- cess for IPPs? How should it be implemented?structed, operated, and priced. The first IPPs Should prices paid to IPPs be determinedcan plant the seeds of change, as one question through bidding, or through some otherleads to another. Even an initial failure with method?IPPs does not necessarily lead to a reactionary * Should foreign developers be required toreturn to the traditional government-owned util- work with local firms?ity. In the Philippines, for example, the failureof contract negotiations with a U.S. developer Phase 3: The structure of the industryin the early 1990s forced questions about whythe process did not work, and made it easier By the third phase, the introduction of IPPsto consider IPPs when the country was in the has already affected the generation and regu-midst of a power crisis in 1992. latory framework, and the entire structure of

the power industry is at stake. The overridingPhase 2: The regulatory framework goal shifts to creating a competitive framework.

The key questions become:In many countries, government-owned utilities * Should all new generation be allocated toare largely self-regulating monopolies. No in- IPPs?dependent regulator charged with protecting the * Should the government utility continue topublic interest reviews their rates, and the util- own existing generation, or sell it?ity itself oversees the quality of service. There is * Should there be a power poot into which alllittle input by public interest groups or others generation, by both IPPs and the utility,into decisions affecting tariffs or service. Financ- would be sold? How would this pool be ad-ing comes from the public treasury or, for the ministered?more efficient utilities, from internally generated Can the country allow private sector owner-cash, not from capital markets. After one IPP ship of transmission and distribution? Shouldhas come to financial closure, country officials parties be allowed to own shares in moremay be tempted to put off any changes in regu- than one sector of the industry?latory structures and financing arrangements un- * Should power generators be able to sell onlytil they see what happens. But at this point, the to the utility and at wholesale? Should directunderlying questions become explicit. contracting between power users and sup-* Shouldn't there be a permanent, independent pliers be allowed?

regulator with sufficient authority to ensure * How should utilities streamline their opera-that the utility delivers the best service the tions to remain competitive, and should theypublic has the right to expect? Should this diversify into related businesses (for ex-regulator oversee both wholesale and retail ample, third-party plant operation, or realprices? estate)?

* Rather than an ad hoc IPP negotiating team, * How can the country provide equal accessshouldn't there be a standing, transparent to the transmission system to private parties,approval process? yet still provide incentives to build new trans-

* What should the country's import and for- mission when and where it is needed?eign exchange policies with respect to power * How must the regulatory framework adaptgeneration he? to the new industry structure?

40 The Dynamics of Independent Power

Phase 4: Competitive markets system are compared with those who stand tobenefit from the new one. Who can expect to

In the final stage, the government-owned util- win under the new system? Consumers can beity starts to operate more like a private sector big winners if reliability increases and pricesfirm, with regulatory controls in place to guard fall. But whether tariffs can be lowered dependsagainst business abuses and for oversight of on the subsidies built into rates and on howthe sectors that remain natural monopolies. Util- much utilities can improve their operations andity monopolies are broken up or prepared for pass on the savings. Politicians can positionsale, and regulatory frameworks are reformed. themselves to win if they support change as aSome countries, most of them among the first way to make power more reliable and cheaper.to use IPPs, are at this stage. Others may "win' by being initially opposed to• In the UInited Kingdom, distribution compa- IPPs and utility restructuring, or by driving a

nies have been opened to private ownership. hard bargain. IPP developers win if their con-A power pool with open access to transmis- tract and the industry's new structure allow themsion has been set up. Existing generation has to earn adequate returns at acceptable levels ofbeen sold to break up generating monopo- risk. Commercial banks and foreign fuel andlies. And a new regulator was set up with equipment suppliers are also usually winners.sweeping powers to oversee the industry.I In Argentina, existing generation, transmis- Utility distribution companies are potential los-sion, and distribution companies have been ers. Jobs and control by existing managers mayauctioned to the highest qualified bidders. be at risk from private ownership-though inFederal and provincial regulators oversee the the longer term the distribution entities and theirsetting of prices. End users can negotiate employees should benefit if their ability to servefreely with power generators for supply. customers improves. Utility procurement offic-

* In Bolivia, all sectors of the formerly public ers could also lose influence. Still others couldpower industry are being sold, building on be winners or losers depending on how thingsthe examples of Argentina and Chile. Colom- play out. Ministry officials may gain new IPPbia may soon follow suit. review responsibilities in the short term, but in

* In Indonesia and the Philippines, private the medium term they could lose control tofirms have successfully bid to develop and newly created regulators. Local workers and sup-finance new plants. The breakup of the gov- pliers can learn new skills from IPPs, or theyernment-owned monopoly is scheduled to may lose out on business until new manufac-take place in the near future. Other reforms turing capabilities are set up. And multilateralare being implemented, such as open access institutions, with fewer loans needed to buildto transmission for private parties. power plants, may have to redirect their focus.

* In the United States, some utilities (for ex-ample, Consolidated Edison) have begun to The benefits of restructuring may sometimessell existing generation. The Federal Energy be hard to prove and to quantify, and there isRegulatory Commission (FERC) is promoting a risk of backlash against IPPs and industryan agenda of open access to transmission, and reform if improvements are not realized anda number of states and utilities are consider- recognized. But there is nevertheless no re-ing restructuring the industry to set up power turn to the old system.pools, separate generation from other func-

tions, and provide better customer service. This Note is an abbreviated version of an article that appeared inElectricitvJoiirnnl 9 (2): 21-27 (Uarch 1996).

Winners and losersElliot Roseman, Resource Management Interna-

Once this process of change has begun, it is tional, Washington, D.C., andAnilMalbotra.hard to stop. Its spread depends largely on how Regional Energy Adviser, Asia Technicalpowerful those who benefit from the current Department

41

Reshaping Power Markets-Lessons from Chile and ArgentinaR. Peter Lalor and Hernin Garcia

The first experiment in transforming a govern- Chile's bold initiativement-owned and -operated power industry be-gan in Chile in 1980. A 1982 law restructured Chile instituted market mechanisms to encouragethe sector and defined basic regulations, and competition. First, it allowed large consumersutilities were privatized between 1986 and 1989 to purchase from any generator or distributionafter financial and corporate restructuring. The company, giving suppliers an incentive to lowersector had been operating fairly well, but was costs in order to capture more of this market.reformed as part of a broader rationalization of Second, it linked the regulated price to the mar-the economy. In Argentina, by contrast, the ket price, so that small consumers would sharemarket-based structure and privatization intro- in the efficiencies resulting from competition.duced in 1992 were intended to improve effi- Third, it used the unregulated price as a signalciency and reliability and to attract the substantial for investment, so that expansion decisionsinvestment needed to upgrade the system. would reflect market forces.

The "Southern Cone" model underlying the sys- The reforms have demonstrated the effective-tems in Chile and Argentina is now being ap- ness of having a central dispatch and clearingplied elsewhere in Latin America, including system dispatching privately owned generatorsPeru (starting in 1993), Bolivia (1995), and Co- and the practicality of the competitive marketlombia (1995). This model divides the industry mechanics the system uses. The northern sys-into five functions-generation, dispatch, trans- tem, the SING2 (dominated by large, sophisti-mission, distribution 'wires," and distribution cated industrial purchasers), has developedsupply-and deregulates the utility systems at fierce competition to supply consumers. Theboth the wholesale and the retail levels. The other system, the SIC, has also seen efficiencywholesale portion of the model, fully unregu- gains, price reductions, and high service quality.lated, relies on open competition in genera-tion. The model's retail portion ensures direct As in England, however, there have been tran-access to generators for medium-size and large sitional problems in converting to a competi-users under freely negotiated contracts, and tive market structure. A major concern is theregulated prices for smaller consumers.' predominance of one generator in the SIC. At

the time of privatization, there were no restric-The reforms in Chile and Argentina, now tions on cross-ownership of assets in differentroughly fourteen and four years old, show that segments; the bulk of the generating capacitylarge efficiencies can be realized through re- and all of the transmission capacity serving thestructuring and deregulation. By any standard, SIC were acquired by one private company. Aboth systems have improved. There has been controlling interest in this company was lateractive entry by new generators, the quality of purchased by an investment group that also hadsupply has improved, and prices have fallen a controlling share in the largest distributionin constant terms. But experience shows that company. Thus, one investment group controlsprecautions must be taken to introduce and most of the system's generating capacity, thepreserve competition. largest distribution company, and the transmis-

42 Reshaping Power Markets-Lessons from Chile and Argentina

sion assets. Cross-ownership and consequent allows free entry into the generating market. Cur-conflicts of interest have hindered the develop- rent and prospective generators make their ownment of a more competitive generation market. judgments, and take their own risks, on demand

growth, investment levels, fuel market trends,Argentina: The next generation the evolution of production technologies, and

so on-just as producers in other commodityArgentina, privatizing much of its power sys- markets do. New generators must construct anytem more than ten years after Chile. benefited transmission facilities needed to deliver their out-greatly from observing that country's successes put to the trunk system, and meet industry con-and problems. It adopted the basic market me- ventions for interconnection in accordance withchanics that had worked in Chile: open access a grid code.to the wholesale capacity and energy pool forgenerating facilities, and least-cost centralized Transactions between sellers and large custom-dispatch. But it replaced or modified the less ers are normally based on long-term contracts,successful aspects-most important, adopting and bulk power transactions between genera-mandatory separation of dispatch and transmis- tors are normally made at spot prices. In fulfill-sion from generation and distribution and es- ing long-term contractual ohligations, generatorstablishing an independent dispatch agency. No can use their own energy or purchase energygenerator is permitted to control more than 10 from other generators at freely negotiated prices,percent of the system's capacity, and restrictions or from the pool at spot prices. Generators re-on reintegration and cross-ownership are en- ceive two types of payment from the pool: aforced. In the generation sector, of the thirty- payment for energy dispatched and a paymentthree units with about 16 gigawatts (GW) of for capacity offered to the grid. They are paidcapacity, twenty-six units were sold to the pri- only the market value of their output, not thevate sector and seven remained under national actual cost of generation. In other wvords. fullor provincial ownership. 3 The resulting diver- cost recovery is not guaranteed.sity in ownership ensured a more competitiveenvironment for generation than in Chile. A generator is paid a price for energy, when dis-

patched, based on the system's short-term mar-The Argentine privatization has been a clear ginal cost of production (for example, the variablesuccess. Plant performance has noticeably im- operating cost of the most expensive unit in op-proved, wholesale and retail prices have de- eration). Plants are selected for dispatch by a dis-clined, and consumers have also benefited from patch center on the basis of their variable costs,reduced outages and increased reliability. as posted with the dispatch center. Because the

price a plant receives is unrelated to its postedDeregulation price, there is no advantage (assuming the mar-

ket is truly competitive) to be gained from "bidThe following sections describe general features strategies." Generators maximize their profits byof the model for each of the five functions. keeping costs low and posting accurately.

Generation Pooling and dispatch

Effective competition requires that there be Chile and Argentina have adopted somewhatenough companies generating power to prevent different pooling arrangements. In Chile, eachdominance by one or a few, that capacity and of the two principal integrated systems has aenergy payments at system marginal cost be coordinating committee (Centro de Despachoavailable to new market entrants, that genera- Econ6mico de Carga, or CDEC) responsible fortors lack the ability to affect access to or pricing system operation (ensuring security of supplyof transmission or dispatch services, and that and optimizing generation). The coordinatingthe retail market be at least partially open (for committee for the SIC is limited to representa-example, for large users). The model therefore tives of the largest generators. And it turns out


that committee members have the ability-and the replacement values of transmission lines. Notperhaps the incentive-to 'interpret" data and surprisingly, there have been disagreements-asresults in favor of the generation company well as some cases of unsuccessful wheeling-shareholders. The asymmetry of information in negotiations, attributed to an investor's cross-Chile may have benefited the large generators, ownership of generation and transmissionwhich are able to use their superior access to companies. But some large consumers havemarket information, and to the market itself. successfully opted for independent supply.to the detriment of smaller competitors.

Transmission companies in Argentina do notTo avoid such conflicts of interest, Argentina have an obligation to invest in new transmis-set up an independent dispatch entity, Compania sion capacity. Investment in transmission mayAdministradora del Mercado Mayorista EFectrico be undertaken by existing companies or by newS.A. (CAG MESA), owned in equal parts by the entrants, subject to an assessment of need bygeneration. transmission, and distribution sec- the regulatory authority.4 Concession agree-tors, as well as by large consumers and the gov- ments for transmission and distribution wereernment. Because each generator has a relatively granted under fifteen-year agreements with ten-small share of total capacity, no one generator year extension periods (except for provincialcan "game" the system to its own advantage-a distribution companies, which were not priva-major strength of the Argentine reform. tized). There is international competitive bid-

ding for the right to take over the asset at theTransmission time of each extension, with the winner pay-

ing the bid amount to the former concession-Privately owned, transmission companies must aire in the event of change. There are someprovide open access to all generators, but may concerns that the system lacks the right incen-not buy or sell energy for their own account. tives to encourage optimal new investment inThey deliver power from the generators to distri- transmission. The recent decision by new en-bution companies, or directly to large customers. trants to install additional generation close to

consumption centers while there is availableWith transmission considered a natural monopoly capacity in the system suggests increasing trans-and therefore subject to government regulation, mission constraints that the current institutionaltransmission companies are entitled to payments arrangements are not properly addressing.from generators adequate to cover the costs thatwould be incurred by an efficient transmission Distribution wires and supplycompany of comparable size. In Chile, these costsare based on the replacement value of the assets Distribution services are separated into wiresplus the operating expenses of a "model" com- and supply sectors. Like transmission facilities,pany. In Argentina, transmission charges are they are considered a natural monopoly andcapped, and a transmission company that can are privately owned and regulated. Distribu-exceed the benchmark performance can retain tion companies operate under concession andall the benefits for its stockholders. have an obligation to serve. They can meet

their power needs with long- or short-term con-In Chile, independent generators can sell energy tracts or spot market purchases. Under theto large consumers at negotiated prices and to principle of third-party access, supply is un-distribution companies at regulated prices. The regulated for consumers larger than a certainlaw establishes general guidelines for setting size,5 but the wires portion of the services iswheeling charges, but the method for calculat- regulated. Both supply and wires charges areing both the cost and the cost sharing formula regulated for smaller consumers.for transmission assets has proved contentious.The calculation requires determining the "influ- The main difference between the Southernence areas" for each generator, the allocation of Cone model of regulation for distribution com-the load served by it and other generators, and panies and the conventional rate-of-return

44 Reshaping Power Markets-Lessons from Chile and Argentina

model is that the first does not base estimates must strike a difficult balance between increas-of cost of service on the distribution compa- ing efficiency and maintaining employment.nies' assets. Instead, it uses as a benchmarkthe facilities that an efficient company would Conclusionsrequire to properly run the corresponding dis-tribution services. In Chile, the benchmark is The power sector reforms in Chile and Argen-based on a hypothetical "model utility." Chile's tina have brought real benefits to consumers largedistribution sector has become more efficient, and small, though public and political pressuresit has made comfortable returns since the re- may have supplemented market forces in ensur-structuring, and rates to end users have de- ing that efficiency gains were shared with con-creased (though there is a perception that more sumers. Still, the Southern Cone model showsof the efficiency gains could have been passed that several conditions are important for creatingon to consumers). But competition for retail competitive and efficient energy markets:customers has been slow to develop. Because u Mandatory separation of functions, and clearthe largest distribution company is also the larg- delineation of the limits on cross-ownershipest wholesale consumer, its importance as a and vertical integration.purchaser may have suppressed competition - Limits on the size of generators to ensurefor customers in its market area. competition.

* The unbundling of transmission charges andSome problems have been reported in the pro- the provision of fair access to transmission.cedures for regulating distribution rates in Chile. * Clearly defined, published transmission pricesThe regulated price to small consumers has two reflecting incremental costs.elements: the energy purchases passed through * Establishment of a centrally dispatched bulkby the distributor, and a distribution value-added supply market, with energy priced at thecomponent. The value-added component is the system's marginal cost, and a parallel bilat-problematic one. During its review every four eral market based on long-term contracts.years, the regulators and the utility each pro- Access by generators and marketers to at leastpose a tariff structure, based on the infrastruc- part of the retail market.ture necessary for a model utility to serve actualand projected loads in an optimum manner. But This Note is an abbreviated version of an arnicle that appeared in

the criteria for determining the appropriate in- Electncity..outr-oI9 (2): 63-71 (March 1996).

frastructure are in dispute, and price setting has l In Chile the cutoff for users considered medium-size and large is 2megawatts (MDW; in Argentina it started at I NWL and svas reduced

become complex andl crisis-prone. The asym- t o 10 kilowatts (KW) in 1995.

metry of resources between the distributors and 2 Because of its geographical characteristics, Chile has twvo power

the regulators, and the stakes, emphasize the systems, the Sistema Interconecado del NonTe Grande (SING) andthe Sistemna Interconectado, Central (SIC). The SING, shoot 1.2 GWX,

importance of continuing scrutiny of financial is predominately thermal, with less than 2 percent hydro. The SIC,

returns in "deregulated" systems. about 4 GW, includes about 75 percent hydro and 25 percent thenmal.Before privatization, the Argentine power sector consisted of fournational uitilities, one international hv'dro plant, nineteen provincial

Distribution tariffs in Argentina are regulated utilities, and seveml cooperatives. Three of the federally otwned utili-

through a price cap mechanism and do not dis- ties were privabzed. The fourth, the power generation brancit of the

tinguish betwen wires and suply. Increases CNBA, the national atomirc energ' agency, remains in state hands.tinguish between wires and supply. Increases 4 The licensing arrangement for new transmission requires potential

in electricity costs and transmission tariffs are beneficiaries to propose new lines. The need is then evaluated by

reflected in periodic reviews, but cost reduc- the regulator, CtAMBvESA, and the high-voltage transmission com-

tions due to productivity increases are to be pany. If they agree that there is a need, the project is opened totions due to prductivity incrases are to be competitive bidding.

shared betvween the investor and the consumer. See note 1.

The distribution utilities have found it difficultto improve efficiency. Electricity theft has re- R. PeterLalor President, Commonwealthmained high, and it has proved difficult to col- Power Corporation, and Herndn Garcia.lect overdue payments. Provincial distribution Principal Power Engineer, Industry and Energycompanies, which are still not privatized, also Department (email: [email protected])

45

The England and Wales Electricity Model-Option or Warning for Developing Countries?

Johnl E. Besat t-Jones

In the late 1980s and early 1990s, the England Important features of the E&W model that otherand Wales power supply industry underwent countries pioneered include the following:the most radical transformation ever experi- * Unbundled supply systems, with manyenced by such an industry. It went from being wholesalers and retailers serving a powera state-owned, state-controlled, integrated struc- market (Finland, the Netherlands, Norway).ture to being a privately owned, autonomously - Competition in the wholesale market (Chile,regulated, unbundled structure. This change but cost-based rather than price-based).happened too recently to allow unequivocal * Competition through periodic bidding forjudgments about the suitability of the England long-term contracts to supply distributionand Wales electricity model (the E&W model) companies and large power users throughfor developing countries. But experience with independent power projects developed withthe model has generated some useful options limited recourse financing (the United States,and warnings for power sector reform in following passage in 1978 of the Public Util-developing countries, even though the charac- ity Regulatory Policies Act).teristics of their power markets differ sub- * Formal sector regulation (the United States,stantially from those of the England and Wales but regulation of profits by multisectoral pub-power market.' Some of the lessons arise from lic utility commissions that control prices; theinnovations in the E&W model. But the dem- E&W model uses price caps set by a singleonstration that such a radical model can be regulator for the sector).introduced is also setting a challenging example * Private ownership of power suppliers (Fin-for other countries. land, the Netherlands, Norway, the Philip-

pines, the United States, Venezuela).Innovative features anddemonstration value The E&W model is important for countries con-

templating power sector reform because it dem-Many of the features of the E&W model typi- onstrates that a package of radical reforms tocally viewed as innovative were first introduced stimulate competition is a plausible alternativein other countries. The misperception probably to the traditional European state-owned, inte-arose from the combined impact of the many grated structure and to the rate-of-return-based,radical changes that occurred in the reform of investor-owned utility model developed in thethe England and Wales power market. United States. It is also an alternative to the

Chilean model for countries that want to moveThe three truly innovative features of the E&W toward competition in their power markets.model are price-based competition in the bulksupply market, price-based regulation for fran- The demonstration effect of a successful modelchised services through caps on average revenues, is easily underestimated. In the 1940s andand a structure giving ownership and operation 1950s, developing countries generally modeledof the transmission network to an entity that is their power sectors on that of their main part-separate from generators and distributors in or- ner among industrial countries (Britain, France,der to ensure open access to the network. the United States). In the 1980s and 1990s, the

46 The England and Wales Electricity Model-Option or Warning for Developing Countries?

Chilean model has been sweeping Latin England and Wales and including Argentina,America (Argentina, Bolivia, Colombia, Peru). Bolivia, Hungary, Peru, Poland, and Ukraine.Also in the 1990s, the independent power Thus, there is a sufficient track record to pro-projects approach to attracting private invest- vide assurance that unbundling is possiblement has been spreading across Asia (China, while still ensuring coordination among powerIndia, Indonesia, the Lao People's Democratic system components and maintaining securityRepublic, Malaysia, Nepal, Pakistan. the Phil- of supply to users. But it is also very importantippines, Thailand, and, recently, Vietnam) and that competition be introduced in the poNwerCentral America and the Caribbean (Guatemala, market by structural reforms at the start of aHonduras, Jamaica, Panama), although with less reform process, rather than by relying later oncompetition than in the United States. Using regulatory interventions to reduce the marketmodels pioneered in France, Francophone power of the largest generating companies, asAfrica (Cote d'lvoire, Guinea, Senegal) has been occurred in England and Wales.experimenting with privatizing utility manage-ment under contract. Second, private financing of power investments

in a competitive market is feasible in a soundNow the United Kingdom has entered this com- business environment. The key is to ensure thatpetition of models with one that is more radi- private developers carry the risks that they cancal than the others. The model was made manage, and that government guarantees arepolitically possible by the market liberalization limited as much as possible to sovereign risks.in the United Kingdom during the 1980s, andtechnically feasible by the explosive growth in Third, power sector reform can yield huge pro-computing power and the dramatic decline in ductivity gains, particularly through dynamiccomputing costs. This model offers the most efficiency gains under competitive pressures.sustainable long-term benefits because it gives These gains have therefore appeared earliestthe strongest efficiency incentives to suppli- in the England and W\Vales wholesale powerers. But it is also risky, especially for develop- market, where competitive entry has been easi-ing countries, because the strong incentives est. But regulators have difficulty making pro-have to be regulated firmly, impartially, and ducers pass on some of their productivity gainstransparently to ensure that they remain con- to franchised electricity consumers throughsistent with the interests of consumcrs and so- lower prices without creating undue uncertaintyciety. This high-risk but high-reward option has for investors (similar issues are arising in Ar-already attracted serious interest in such coun- gentina and Chile). Those who lose from pro-tries as India (Orissa State), Pakistan, Poland, ductivity gains and other consequences ofand Ukraine, though it will require some ad- reform, such as displaced workers and subsi-aptation to local situations, notably in the dis- dized power consumers and primary energypatch and pool trading arrangements. suppliers, have to be dissuaded from undcr-

mining the reform process (for example, byKey lessons compensating workers and helping power con-

sumers and energy suppliers adapt to the newExperience with implementing and operating market conditions).the E&W model yields six general lessons forpower sector reform. First, it shows that radi- Fourth, an extended transition period is neededcal unbundling is feasible-that generation, after radical reforms are introduced, duringtransmission, and distribution can be separated which the government and the regulator mustfrom one another even in power sectors that expect to face unanticipated challenges. Indid not adopt this structure from an early stage England and Wales, the unexpectedly largeof development. Several countries have recently profits made by the privatized distributors un-unbundled their power sectors, starting with der the new price cap regulation have provoked


unscheduled price cap reviews by the regula- these priorities, as in Argentina (macroeco-tor and created political pressure for a tax on nomic financing pressures), India and the Phil-these so-called windfall profits. ippines (extreme, long-term power shortages),

Brazil, Colombia, and most countries attractingFifth, the sequencing of reforms is critical. The independent power projects (long-term financ-legal and regulatory apparatus should be in ing concerns).place before restructuring and privatization, andmajor restructuring should precede the creation In view of thcsc prioritics, thcrc arc fivc mainof private ownership rights to avoid problems features of the E&W model that have relevancewith stranded assets. The timing of reforms is to developing countries:also critical, particularly the timing of the * The pricing of electricity supply as a com-privatization of electricity suppliers and any mercial service, rather than as a public obli-supporting increase in electricity tariffs rela- gation or a means of supporting low incomes.tive to the electoral cycle. The success of a This policy not only gives users the correctprivatization program often depends on divest- price signals to use electricity efficiently; iting all or most of the state's ownership before also relieves hard-pressed government bud-the government faces the next election, and gets of the burden of subsidizing the wealthy.this can force a compromise with long-term But some help to enable low-income house-efficiency objectives. In England and Wales, for holds to obtain connections to the electricityexample, an upcoming general election led network can substantially raise their real in-reformers to accept a virtual duopoly in a sup- comes without blunting incentives for effi-posedly competitive wholesale power market. cient supply and use of electricity.

The explicit separation of the state's regula-Finally, the government's full and sustained com- tory functions from its ownership and policymitment is vital to the success of its reform pro- responsibilities. to allow state-owned utilitiesgram. This requirement was evident for the the necessary autonomy and accountabilityEngland and Wales power market reforms dur- and to provide fairness in regulation for alling the difficulties of designing, restructuring, suppliers, both state-owned and private.and privatization, and it continues after the re- * The vesting of regulatory duties in a sector-forms, as the government must resist tenden- specific regulator as an alternative to thecies by some power entities to revert to the lengthier and costlier U.S.-style judicialpre-reform structure. process.

- The establishment of an independent trans-Relevance of the E&W model mission company with nondiscriminatory ac-to developing countries cess for suppliers to prevent the incumbent

supplier from frustrating attempts to facili-Because the power markets of developing tate competition.countries have development priorities that dif- * The market-based approach to planning ex-fer from those of the England and Wales power pansion of the system with due considerationmarket, it is important to identify the features of investment risks-because investors, notof the E&W model that are relevant to these taxpayers, must bear the consequences of un-countries. The main development priorities for certainty in construction costs and schedules.power sectors in developing countries are to plant availability, and fuel prices.meet rapidly increasing industrial and commer-cial needs and to expand the population's ac- In two important respects, establishing com-cess to electricity under severe public financing petition in the market-such as through aconstraints and with weak institutional endow- price-based pool-and the functioning of au-ments. Power reform in developing countries tonomous regulatory agencies, the E&NW modeltends to be driven by failure to meet one of may have only limited or long-term relevance

48 The England and Wales Electricity Model-Option or Warning for Developing Countries?

for many developing countries, because of the by suppliers and regulators; thus, develop-following concerns: ing countries must avoid giving perceptions* The small size of the power market in most of excessive risk to foreign investors in the

developing countries would result in trans- global competition for finance to developaction costs that exceed the efficiency gains their power sectors.from vertical unbundling.2

* The power markets in many developing Conclusioncountries also are too small to allow enoughsuppliers for effective price-based competi- There can be no doubt that the E&W modeltion without serious loss of scale economies provides an ultimate target for reform programsunder horizontal unbundling (about 100 de- in developing countries moving toward com-veloping countries have power markets of petition and private participation. The questionless than 1,000 megawatts). is whether a developing countrv should embrace

* Operating a competitive pool based on spot the model entirely, or even largely, without al-pricing is too complex for all but the most lowing a long period of adaptation. Some ad-advanced developing countries. There are vanced middle-income countries could considersimpler approaches to managing the whole- this approach. For most developing countries,sale power market structured around a however, a policy of selecting only the featureswell-designed set of market rules based on that can be adapted to local conditions is advis-production costs. By allowing competition able. The key is to find the reform path thatfor market share, these approaches can give best suits a country's circumstances.producers incentives to reduce costs. Suchmarkets are operating in Argentina, Bolivia, See Rober Bacon, Lessons from Power Sector Reform in Englanoc

Chile, Peru, and Poland. andWales" (Public Policy.for the Private Sector, September 1995).

* For developing countries that are fast grow- 2 See Robert Bacon, "Restructuring the Power Sector-The Case ofSmall Systems" (page 49 in tbis volume).

ing, financially constrained, or both, the per-sistence of large supply shortages rules outthe possibility of competitive power pools: John E. Besant-Jones, Power-EnerT I Utilitiesfor competition to develop, adequate sup- Team, European BankforReconstructionply capacity must be available to meet all and Development, London (email: besant@load segments (base, peak, and so on). ebrd4.ebrd.com)

* The substantial discretion given to the regu-lator in the E&W model over such matters assetting pricing rules would deter foreign in-vestors in most developing countries becauseof the lack of institutional checks and bal-ances. Protection against regulatory uncer-tainty must be offered instead throughlicenses (to distributors) and contracts (forindependent power projects).

• The poor credit ratings of many developingcountries greatly complicate the contractualprocess for mobilizing the large amounts ofcommercial finance needed for power invest-ments, and thus require extensive perfor-mance guarantees by governments.

* Domestic capital markets are too under-developed to replace foreign finance or toprovide a market assessment of performance

49

Restructuring the Power Sector-The Case of Small Systems

Robert Bacon

New paradigm The arguments for this vertical separation arequite different from those for horizontal sepa-

The recent worldwide interest in power sec- ration and need to be individually addressed.tor privatization and restructuring has focused Indeed, even when it is possible to introduceon a few high-profile cases, such as Argen- limited competition in generation and hencetina, Chile, and the United Kingdom. As a re- achieve some benefits, the costs of verticalsult, the pattern of restructuring now taking separation may be so large as to offset the gainsshape in many power systems largely reflects from competition. Therefore, any restructuringthe experience in these few countries. Con-sultants working in locations as diverse as Eve w it i o be in trd+Jamaica, Kenya, and Poland are applying a E it possible to introduceprivatization model in which generation is limited competition in generationseparated from transmission, which in turnmay be separated from distribution. The gen- and hence achieve some benefits,eration sector is then split into several com-peting firms. This model of restructuring, tbased on capturing the benefits of competi- ojveacat scyudtdo t maytion in the generation sector, is accompaniedby regulation for those parts of the new sys- battem that cannot be competitive and that may ftherefore open up possibilities of monopol, from competition.exploitation.

plan for a small system must take into accountRelevance to small systems that it may be harder to achieve real competi-

tion in the generation sector.In small power systems, however, the balanceof advantages and disadvantages from these This issue is relevant to many small countrieschanges may be quite different from that of contemplating power sector reform. In 1990,systems in larger economies. When there is only there were sixty countries with capacity of lessa single generator, it can be more efficient to than 150 MW, thirty with a total net public ca-leave it joined to the transmission system. But pacity of between 150 and 500 MW, and seven-that is not the advice some countries are re- teen with between 500 and 1,000 MW. Theceiving. For example, a consultant report for experience of countries that have already re-Kenya, a country which had net installed pub- structured their power sectors (United Kingdom,lic capacity of 706 megawatts (MW) in 1990, system size 70,000 MW; Argentina, 15,000 MW;concluded that there was no scope for compe- and Chile, 3,000 TMW) may be of very limitedtition between the existing generating plants. relevance to systems of, say, 1,000 MW or less.Yet consultants still advised separating the The most efficient structure for a small systemsingle private generator from the transmission may be quite different from the fully disaggre-and distribution company. gated model. Reform proposals thus need to

50 Restructuring the Power Sector-The Case of Small Systems

be flexible, and alternative systems under con- The allocative gain or loss from a change insideration need to be closely evaluated. pricing due to a shift from a state monopoly to

a private monopoly depends on the extent toThis Note reviews the sources of the kinds of which prices were being held below costs ingains and losses from privatization and restruc- the first case and the extent to which pricesturing that need to be considered in any pro- are limited by regulation in the second. Withposed power sector reform strategy. It also no subsidization, a move to unregulated pric-looks at the preconditions for effective coming by a private monopoly produces a "dead-petition in the generation sector. Each of the weight" loss of consumer surplus as well as aissues raised relates to system size. transfer of consumer surplus to producer sur-

plus. If the public sector were pricing belowCosts and benefits of privatization cost, the removal of this implicit subsidy would

produce a 'deadweight" gain, and a transferComparing the performance of a vertically in- back to taxpayers and away from power con-tegrated public monopoly with that of a verti- sumers. Because subsidies have been very largecally integrated private monopoly exposes the in many countries and the state has financedgains and losses due to privatization alone. The new investment, moving from public owvner-key change that privatization introduces is the ship to regulated private ownership (even ifprofit motive. The impact of this change should monopolistic) can produce large allocative netnot be confused with the effect of restructur- benefits for the economy.ing. In fact, the benefits to society as a wholefrom ending state control of the power sector This shift involves a potential gain in produc-can be so large that the additional gains due to tive efficiency if private industry can cut costs.restructuring may be relatively unimportant. Public ownership tends to result in productive

inefficiency, both because managers have littlePerformance assessments of publicly owned incentive to reduce costs and because politiciansentities should make a distinction between often are willing to increase costs to serve otherentities that have been corporatized and com- purposes-for example, providing secure em-mercialized and those that have not been. Com- ployment. The political incentive to collect reve-mercialization is possible only if the government nues or prevent theft of power can also be low.removes itself from day-to-day interference insuch issues as tariff setting and employment. Whether a private monopoly will be produc-Some countries that have not been ready to tively efficient (that is, produce a given outputprivatize their power sector have introduced at minimum cost) is uncertain. The few well-commercialization (New Zealand, Portugal), an established private monopolies (Barbados,important intermediate step between the most Bermuda) appear to work well. The poor per-interventionist form of state ownership and formance of many state companies is moreprivatization. Commercialization may allow likely to be attributable to the nature of theirmany of the potential gains in efficiency to be ownership than to their structure.captured, especially where there is little scopefor competition. Small systems may thus find it Costs and benefits of vertical separationof little incremental benefit to privatize, providedthat the government maintains an "arm's length" Vertical separation-the separation of distribu-relationship with the company. Where this is tion. transmission, and generation into privatemore difficult, because of the political situation monopolies-has two important implications foror because of the traditional approach to state private capital. It can increase monopoly power,companies, privatization may bring permanent but it can also lead to the loss of economies ofbenefits that would not be sustainable with a coordination. When each stage is monopolisticcommercialized state entity. and the technology is relatively fixed, a classic


result is for an unregulated chain of vertical mo- a strong incentive in bargaining not to divulgenopolies to sell at a higher price than an un- information to the other, leading to contractsregulated integrated monopoly (the 'cdouble that are suboptimal for the system as a whole.wedge" problem). Regulation becomes more In addition, there are transaction costs in ne-important in this case. But the fact that many gotiating and contracting.private industries, even in competitive markets,show evidence of vertical integration indicates A key argument in favor of separation is that itthat there are gains to be made from unified increases transparency and allows the respon-ownership, as in the U.S. power sector. sibilities of managers to become more focused.

The larger the firm, the more difficult it is for aThe first general reason for the success of verti- manager to have oversight of all its compo-cal integration is the existence of economies of nent parts and their interrelationships.scope. Certain activities need to be undertakenby each part of the industry, but there is the Costs and benefits of horizontalpossibility of sharing some inputs. A typical ex- separation in generationample would be the need to have an account-ing department in each company. The activities The possibility of introducing competition intoof these departments would include handling generation is critical to a power restructuring strat-the transactions between the two companies. egy. The key issue is the mechanism by whichIntegration would not do away with such trans-actions, although they become internalized, but he arrangement in England arndthey would be accounted for just once ratherthan twice. Related to this would be an economy W * tof scale. An accounting department would notneed to be twice as large to deal wvith a co m - plts a smaller, subsidizedpublicpan' double the size. Some basic setup costs ((computers) could be shared. A verv important nuclear company), has alreadyaspect of this argument is the existence of econo-mies of scale to top management. Good man- dagers often are scarce (especially in smalleconomies), and integration will likelv save on i * t * tthis resource. There can also be financial econo- companies a r toaL>trlmies of scale, which can be achieved when the * beha vicomponent firms combine their borrowing cormyctive cenijvior.needs, reducing the cost of borrowing money.

competition takes place. If it is not possible toA separate argument concerning vertical sepa- introduce effective competition through verticalration, or de-integration, relates to the decision- separation, on balance it may be better to leavemaking process itself and economies of the industry integrated even though it has beencoordination. This issue affects both day-to-day privatized. Nor does the existence of several gen-working of the system (dispatch) and its longer- erating companies by itself necessarily introduceterm size (investment). In an integrated com- competition. So, breaking up the state companypany, coordination takes place through physical into several private generators could lead to thecommands and, to be effective, requires com- loss of some benefits of scale or scope, yet with-plete information about all parts of the system. out producing any benefits through competitiveIn a de-integrated structure, the coordinating downward pressure on prices.mechanisms are the prices and contracts agreedbetween the two parties. Since each firm is try- In large privatized power systems (Argentina,ing to gain more of the profit for itself, there is Chile, England, and Wales), repeated bidding,

52 Restructuring the Power Sector-The Case of Small Systems

in which the generators bid to supply power force of competition must come from new en-on a daily or even half-hourly basis, allows try (such as independent power producers). Ifcompetition to be effective. If costs can be cut, entry is easy and rapid, the threat of entry maythen prices can immediately reflect this, forc- be sufficient to induce existing firms to becomeing a higher-priced rival out of the way. This cost-efficient. But where entry is difficult (be-bidding system is too complex for most smaller cause of problems in obtaining licenses andpower systems and for economies at lower lev- constructing the plants, for example), the threatels of development, which instead use a con- of entry may be too small to affect the behav-tract system. WVith a long-run contract system, ior of established firms. Where existing firmsopportunities for generators to use cost reduc- have some cost advantage not available to newtions to gain market share are much more entrants, there is an "intrinsic margin" that mayinfrequent. not be competed away. Common intrinsic ad-

vantages are privileged access to local fuel sup-A second condition for effective competition plies (especially hydro) that cannot be bid awayis that there be a sufficient number of firms to by higher contract prices for the fuel, proxim-avoid implicit collusion and "gaming" in the ity to fuel source or to market, and environ-system. A two-generator industry, for example, mental suitability of existing sites or even themay be susceptible to each firm's tacitly allow- nonavailability of new sites.ing its rival to behave in their mutual interest.The arrangement in England and Wales, with In existing systems, de-integration may bringtwo large private generators (plus a smaller, about some losses of economies of scale. Onesubsidized public nuclear company), has al- factor in such losses is the need to maintain aready demonstrated that a larger number of 'reserve margin" against uncertainties. The ex-companies is required to induce truly competi- perience of U.S. power pools has shown thattive behavior. In small systems, the market can pooling has enabled individual firms to reducebe too small to support enough firms to achieve reserve margins, and thus to reduce costs. incompetitive conditions-unless the firms are developing countries, it is unlikely that suchso small that they lose economies of scale. sophisticated devices can be made to work, so

a de-integrated system will incur the extra costA third condition for effective competition is of maintaining reserve margins. Similarly, sepa-that the size and cost structure of the generat- ration will increase the demand for managers,ing firms must be fairly similar. If they are not, who may be in scarce supply in many smallthere would be no possibility of using cost sav- and less developed economies.ings to increase market share (by altering the'merit order" with respect to a rival). A related For more information see Robert Bacon, 'Appropriate Restrocturing

issue in determining the competitiveness of rival Strategies for the Power Generation Sector: The Case of Small Svs-

generators is the "strength" of the transmission tems." IEN Occasional Paper No. 3, World Bank. Washington, D.C.,

system. A system with very high transmission 1995.

costs per unit of distance can allow some gen-erators to be virtual monopolies, since the extra Robert Bacon, Oxford University, Oxford,costs of delivering supply across the transmis- Enzgland (tenail: [email protected])sion system to meet demand at a given nodeeffectively prevents competition from more "re-mote" sites.

In an existing industry, there must be excesscapacity for competition to be successful in theshort run. If all plants are needed on a regularbasis, there is no incentive to cut costs. The

53

International Power InterconnectionsMoving from electricity exchange to competitive trade

J. P C(hatpentier anzd K. Schenk

International electricity markets are complex, and experience with them is limited. Purely physical

exchange between countries already occurs where interconnection lines are in place. But trade

requires more sophisticated organizational structures and coordination. Harmonizing national

organizational structures is a first step toward the freer flow of power across borders. Unbundling

national power sectors could help further in breaking bottlenecks, particularly in transmission. But

coordination needs much attention. Here, the key issue for policymakers is this: What terms and

conditions are needed to establish competitive regional electricity trade in which buyers and sellers

can, at any time and regardless of their locations, negotiate power and energy contracts covering a

wide spectrum of commercial products? This Note suggests some answers.

Rationale and typology of internationalinterconnections A SHORT HISTORY OF POWER TRADE

Countries, companies, and even conmplete sys-tems all seek to interconnect for three basic rea- Historically, it was the search for more reliability that led smallsons: (1) emergency support, (2) savings on independent systems to group or pool together. Later, this pooling wasoperating costs resulting from the structural dif- extended to regional, interregional, and international systems. The firstferences of load profiles and (3) savings in recorded international interconnection was a tie-line between Canadainvestment (and operating) costs from comnple- and the United States in 1901. Europe's first was in 1929, betweenmentarv means of production. Utilities often P neen

expect nd acheve cosiderabe opertionalAustria and Germany. Now, many regional interconnected systems areexpect and achieve considerable operationalsavings through their interconnections with in operation-in Western Europe (UCPTE), Scandinavia (NORDEL), theneighboring countries. For exanmple, tTCPTE. an United Kingdom, Central Europe (CENTREL formerly IPS), Eastemassociation of 'Western European companies, Europe (UPS), North America (three U.S. networks-East West, andsaves between 3 and 10 percent overall thanks Texas-and four Canadian networks), Central and South America,to regional interconnection. Similar savin,gs are southern Africa (SADC), and Asia. More systems are under construc-achieved in the U nited States through inter-aconnvetion.But the poitenlStiale fhrorvin in.e- tion or consideration. And recent sector reform efforts around theconnection. But the potential for savings on in-vestment should not be exaggerated. Most world are prompting a new look attrade issues. The European Union,generation companies still aim for self-sufficiency for example, has looked at open access and free transit in electricityin their territories and so are committed to a networks. It has in mind not just time-honored "gentleman's agree-certain level of investment in any case. Thus, ments" among utilities to supply emergency power, but the systematicwvhen utilities asscss the need for expandinu theirn trade of electricity on a competitive basis across national borders.generating facilities and transmission networks.they seldom take systematic account of the pos-

54 International Power Interconnections

Acronyms and sibilities of importing and exporting-although, Need and willingnessabbreviations increasingly, they should.

Many governments have long viewed electric-of 22 Western European At present, five main types of exchange take ity as a specific strategic asset-one that, be-companies. place between interconnected partners: cause it cannot be stockpiled, had to remain

* Firm energy sales-a continuous exchange under state control. Therefore, governmentsN16RisEL, formed in of base load energy, which may include slight have favored electricity self-sufficiency, oftencompanies from Den- variations provided for in the contract, as well through vertically integrated, state-controlledmark, Finland, Iceland, as interruptible power. companies. This concern goes a long way to-:Norwray, and Swreden * Backup exchanges for emergency support. ward explaining the still quite limited volume

CENTREL is an associa- * Marginal exchanges of spinning reserves. of international electricity exchanges.tion of companies from * Occasional or d bien plaire (economy en-H1ungary, Poland, andthe ergy) exchanges, in which no guarantee of In many countries, however, recent restructur-Czech and Slovak Repub-lics. Before the collapse capacity is given. These arrangements are ing in power sectors has introduced more flex-of the Soviet Union, the designed to take advantage of excess avail- ibility into the operations of the entire electricityassociation was known ahility at advantageous marginal costs. sector. For example, unhundling of power sec-as IPS.

* Compensation exchanges made in kind. In tor activities, along with increased competitionSADC, the Southern Afri- the case of UCPTE, the exchange also is de- in distribution, could well lead private distri-can Development Com- signed to compensate for financial losses bution companies to look for the cheapest sup-munity, comprises 12countriesinsouthernAf- caused by lags between the supply and the plies-whatever their national origin. Thatrica. A Southern African pavment for the electricity delivered. could be a real stimulus to regional and inter-Power Pool (SAPP) has national trade in electricitv.recentlv been formed.

No standard model of electricity export con-tract has yet been developed-though contracts In addition, increased global competition isinclude certain common features, such as the forcing electric utilities to operate their sys-technical characteristics of the power and en- tems as economically as possible to maintainergy to be delivered, the financial rates and their country's or region's competitive edge.charges, the effective dates and duration, and Under conditions of rigorous cost-cutting, self-the cases of force majeure. The great majority sufficiency may be a strategic luxury that fewof exchanges take place under bilateral utilities can afford.agreements, often on the basis of long-termcontracts (more than 90 percent of UCPTE ex- Technical meanschanges take place under these conditions, andabout 50 percent of NORDEL exchanges). The Whether transmitted by alternating current (AC)most active exchanges occur hetween compa- or by direct current (DC), electricity has twonies or countries with a history of cooperation specific characteristics: it cannot be stored, andand mutual trust. it does not flow according to the simple laws

that apply to fluids and gases. Instead, electric-Strictly speaking, however, there still is no elec- itv flows according to Kirchhoffs law, in thetricity "trade" in the full sense of that term-an path of least resistance-a path that cannot nec-immediate and competitive transaction between essarily be determined by contract. The samethe buyer and the lowest-cost supplier, irre- holds true during the accidental loss of a meansspective of geographic location. of production. Therefore, correcting the distur-

bance requires close cooperation and good ex-Improved terms and conditions change of information between partners.for trade

Synchronous AC network links are well adaptedThere are several prerequisites to achieving true to short and medium distances and for heavilyelectricity trade. interconnected networks, but these systems are


vulnerable. A major disturbance can lead to a Harmonized structures are particularly impor-system's complete collapse. Maintaining the sta- tant for pricing systems. In a competitive mar-bility of such a system requires great technical ket, only a pricing system based on bidding isrigor and close cooperation between partners viable because it does not require the publica- abased on instant exchange of information. tion and verification of detailed economic in-

formation. Traditional approaches based onDC interconnection and transmission do not marginal costs, profit sharing, and "avoided'require such rigorous operation and coopera- costs cannot work in a competitive environ-tion. But the use of DC is reserved for ex- ment because economic information will nochanges over large distances and large transit longer be shared or easily verified.capacities or for linking systems with differentoperational frequencies or technical standards. Second, a cooperative structure-or poolingApart from the technical necessity of isolating arraiigemrent-between partners is necessarynetworks with different technical characteris- to provide a trading center and to oversee thetics, the decision about whether to use syn- physical stability of the entire system. Interna-chronous (AC) or asynchronous (DC) links is tional experience here is still limited. But theoften purely economic. In general, a direct cur- national experience accumulated in the tightrent line can be economically justified only and loose pools operating in the United Statesbeyond a certain distance (labout 600 kilome- could be used as a model for international pool-ters for aerial lines and 50 kilometers for un- ing arrangements. A tight pool is a group ofderwater cables) and for high transit capacities. production and transmission companies withA DC line requires converter stations, which a common dispatch center to ensure technicalare expensive (labout USS250 per kilowatt). and economic management and coordination

of the network. A loose pool arrangement, byNational institutions and regional operations contrast, has no common technical dispatch

center. Instead, each company in the group hasThe accumulated experience of national struc- its own dispatch center. But a common infor-tures for electricity exchange is very uneven.1 mation center supplies each member with in-Although it is therefore not possible to pre- formation in real time on supply and demandscribe a universally applicable framework and and transmission constraints.industry structure to stimulate electricity trade,three factors seem to be critical. Whatever pooling arrangement is selected in a

region, the most important technical objectiveFirst, it is essential to harmnoniize the national is to ensure the physical stability of the entirepowersectorstraictuires of each partner country. system. At the international level, a commonThis harmonization is even more important for technical dispatch center seems utopian. A sys-the development of trade than the type of struc- tem of coordination similar to the Americantural organization is. In NORDEL, for example, 'loose pools" is more appropriate.exchanges decreased rapidly in 1991-92 follow-ing the unilateral restructuring of Norway's Third, trzansit rights.-open access and free transitpower sector. Norway's net exports to Sweden -are essential in both national and internationaldropped from about 12,000 gigawatt-hours systems. At the national level, ensuring transit(GWh) in 1990 to about 2,000 GWh in 1991 and rights requires separating production from trans-6_000 GWh in 1992. The deregulation and re- mission. Electricity transmission should be con-structuring of the Swedish and Finnish electric- sidered a transport service, not an energy activity.ity sectors along the lines of the Norwegian At the international level, to benefit from a re-model, scheduled for 1995 and 1996, are seen gional competitive market, any buyer must beas key to reviving and expanding electricity tradable to obtain supplies within the interconnecteding in the region. system from any location.

56 International Power Interconnections

Regardless of the production and distribution used for setting taxicab fares in some cities. Instructures in place, the transport sector enjoys Argentina, the price of transmission is baseda national monopoly because of the need for on the average marginal cost plus losses. Manytechnical integrity and reliability. The transmis- formulas, most of them complex, are beingsion system must therefore be regulated to studied.ensure that the pricing system provides cor-rect signals to both the user and the transporter. Other issues still need to be resolved. Con-

tracts must be carefully written, and probablyWheeling rights, particularly their legal basis, standardized to accelerate their use. As in theneed to be clearly defined. Trade will grow gas sector, "take or pay" contracts for buyersonly if (1) transport is supplied by companies that include penalties for the sellers may be-that specialize in this activity and therefore do come the norm. One difficult problem will benot design their networks solely on the basis monitoring the exchange of electricity and de-of local supply and demand conditions, as in- signing a system to resolve disputes. Propertegrated companies do; and (2) international metering will be essential, and it may be nec-or at least regional regulations are implemented essarv to set up an international arbitration orto eliminate any possibility that transit will be court system to handle conflicts that arise. Ex-refused by a third party. perience in other energy sectors, such as gas,

coal, and petroleum, and in the telecomimluni-Environmental issues are a potential constraint cations and international banking sectors couldon transit. Electricity transporters have increas- help provide solutions.ing difficulty getting permission for new lines.In the case of existing corridors, the transit This Note draws heaily from "A Review of International Power Sales,"

capacity could be increased by using sophisti- Industry and Energy Department Paper, Energy Series 42 (World Bank,

cated electronic control, or the liine could be Washington, D.C., 1991); and"Development of Regional Electric lower

transformed to direct current. DC lines have Networks" (World Bank, Industrv and Energy Department, Washing-ton, D.C., 1994>~

the dual advantage of allowing the transport 1 The conclusions that follow are based mainly on the issues faced

of higher quantities of energy with less loss by such international interconnected networks as UCPTE NORDEL.

and reducing the need for right of way. the U.S.-Canada links, and the England-Scotland links; the operat-ing methods of a few large national networks, such as the NEPOOL(a tight pool in the eastern U.S. interconnected system) and MlAPP

Pricing and contractual issues (Mid-Continent Area Power Pool, a loose pool in the nonhwesternUnited States), the England-Wales interconnector, and some regionalnerworks in India: and the results of a recent studv commissioned

In a framework that is more competitive than by the World Bank.

cooperative, prices based on marginal costs, 2 Of course, if prices fail to converge to marginal costs under bid-

profit-sharing, or avoided costs are difficult to ding arrangements, that will mean that the increments of supplyuse becaue competiors willno longerbe will- are being provided at prices above or below incremental costs.

use because competitors will no longer be will-

ing to declare all their pricing information asthey do in exchange-based systems.2 Therefore, (emailpcbarpeiorEngSe alsin an internationally competitive svstem, elec- (Sbna , jPch r Eter rldbntry andK. Scbenk, Power Eng,ineer; Induzstry andtricity pricing must be based on market bids, Department (email: kschenk@.. . . ............ Energy eat7n (nilkshk@as in the British and Norwegian systems and in worldbank.org)certain U.S. pools.

Setting tariffs for high-voltage transmission is acomplex pricing issue. Several approaches tothis issue are in use. In Norway, the pricing isbased on transmission capacity. In the UnitedKingdom, prices are set on a lump-sum basisby geographic zone, similar to the principle

57

Subscribing to MonopolyThe telecom monopolist's lexicon revisited

Peter Smith.

The advocates of monopoly provision of telecommunications service in a monopoly regime,communications services have consistently relied the largest economic loss has not been loss ofon a small lexicon of catchphrases to support economies of scale and scope, but a massivetheir case-wasteful duplication offacilities, utn- failure to meet economic demand for service.economic entry, utniversal service, creami skim-ming. These phrases convey a simplistic and Second, there are many examples of other veryoften fallacious rationale for monopoly that is large economic losses resulting from the pro-deeply entrenched in the thinking of telecom- ductive inefficiencies that arise in the absencemunications executives, civil servants, and in- of competition. In many developing countries,vestment bankers around the world. Although capital costs range from US$3,500 to US$4,000the monopoly approach has had some successes, per telephone line, compared with achievableit has also resulted in chronically poor telecom- costs of about US$ 1 000 to US$1,500. High lev-munications services in many developing coun- els of productive inefficiency are also confirmedtries. This Note assesses each catchphrase and by the responses of industrial country telephoneits underlying arguments. companies exposed to competition. For ex-

ample, BT (formerly British Telecom) is in theWasteful duplication of facilities process of reducing thae number of its employ-

ees from about 240,000 in 1984 to about 140,000Wasteful duplication evokes an image of mul- by the end of 1995. Similarly, in the Unitedtiple cables-owned by different telephone States, competition and divestiture are widelycompanies-stretching between buildings and recognized as having caused AT&T to makeacross the countryside. The underlying eco- substantial efficiency improvements.nomic argument is that the telecommunicationssector is characterized by economies of scale Third, the "wastefu-l duiplication" argumentand scope-that it is a natural monopoly. in in support of legal monopoly assumes thatthis view, one supplier can produce a range of economies of scale and scope can be "bar-telecommunications services at lower cost than vested" only by a single supplier. That is clearlymultiple suppliers. Consequently, it is argued, not the case-network interconnection is ato avoid wasteful duplication of network fa- well-established mechanism for reaping econo-dilties, telephone comnpanies should continue mies of both scale and scope in a multi-operatorto have a legal monopoly. environment.

This argument is a dubious one. First, it as- Fourth, the natural monopoly argument implic-sumes that losses of economic efficiency re- itly assumes that the economies of scope existsulting from potential losses of scale and scope only within the telecommunications sector (forare likely to be the most important consider- example, in the provision of both local andation. But there is now plenty of evidence that long-distance service by a single supplier). Notthis is not the case. In the vast majority of de- only have these economies of scope been dif-veloping countries that have suffered from ficult to verify in econometric studies (Cooperschronic and often acute undersupply of tele- &c Lybrand Consulting Group 1988), buTt the as-

58 Subscribing to Monopoly

sumption ignores the potential for supply con- thorize it in highly profitable market segments.vergence-the probably much larger economies "Taking the cream away" greatly increases in-of scope available to companies that also pro- centives for incumbent operators to rebalancevide other network services, for example, cable rates to reflect costs as well as to reduce theirtelevision or electricity distribution. In the costs in order to remain competitive.United Kingdom, local telephone service is pro-vided not only by BT and Mercury but also by Universal servicecable television companies and by Energis, anew entrant that uses electricity distribution A widely accepted public policy objective inducts and rights of way for local telephone net- the telecommunications sector is universalwork facilities. telephone service-often defined as a tele-

phone line (or a shared telephone line) forUneconomic entry every household. Depending on prices, house-

hold income, and consumption preferences,The "uneconomic entry" argument is an off- however, many households would choose notshoot of the wasteful duplication one. It con- to subscribe to telephone service, particularlytends that when telecommunications prices are in developing countries. So it is argued thatvery distorted-as they often are, by high prices the objective of universal service requires

massive cross-subsidy managed within a mo-

The largest economic loss has not been nopoly regime-and therefore a pricing struc-ture that bears no relation to costs. Monopoly,

loss of economies of scatle alnd scope it is argued, is necessary to generate the prof-loss oecn m sosc,its to be used to cross-subsidize service to "un-

but a massive failure to meet economic" market segments or regions.Cross-subsidies normally run from interna-

demandl for service. tional and national long-distance service tolocal service, from urban to rural subscribers,and from business to residential service. Ironi-

(relative to costs) for long-distance telephone cally, this argument for universal service hasservice and by rate averaging-new entrants often been used to justify the worst of all pos-could achieve profitability while at the same sible economic outcomes in the sector-a mo-time increasing the sector's total cost of meet- nopoly on a service that is not provided at alling demand for service. In other words, price (in the rural areas of many developing coun-distortions could enable a new entrant to make tries) or not provided to any adequate stan-a profit at lower prices than an incumbent de- dard (in both urban and rural areas of manyspite higher unit costs. On this basis, it is ar- developing countries).gued that new entry should be prohibited untilprices are rebalanced to reflect costs. Although achieving universal service has been

the rationalization for maintaining a legal mo-Although the potential for uneconomic entrv nopoly, there are fundamental problems withis real, the assumption that the appropriate this objective. First, universal service. if it meanspolicy response should be to prohibit entry until a telephone for every household, is not neces-prices are rebalanced is wrong. This approach, sarily the right goal for every countrv: whereagain apparently based on a public interest in per capita income is low and capital scarce, thereminimizing total system costs, would have the are likely to be higher priorities. Second. theeffect of postponing new entry indefinitely idea that low, subsidized local telephone ac-where politicians find rebalancing rates diffi- cess prices are the best route to universal ser-cult. In fact, often the fastest way to rebalance vice is wrong. In most developing countriesrates is not to postpone new entry but to au- suffering from chronic unmet demand for tele-


phone service, the key problem is inadequate Cream skimmingsupply (inadequate investment and inefficientinvestment and operations), not inadequate 'Cream skimming," together with its cousin t_

demand. Furthermore, the lower costs and in- cherry picking," is the argument that new en-creased innovation in service provision that re- trants in telecommunications are likely to focussult from a competitive market are likely in the on the most profitable parts of the market- -long run to be at least as important as subsidies typically international and national long-distancein improving the affordability of telephone ser- and local business telephone service-or on thevice. In addition, there is evidence from some largest customers in these market segments. Ascountries that household subscribers who lose a result, it is argued that a cross-subsidy schemetelephone service when they cannot afford to would not be sustainable in the face of "creampay for it do so because of the high-priced long- skimming" new entrants and that politiciansdistance service component of their bill (Cana- would not be comfortable with the resultant ratedian Minister of Supply and Services 1986).Third, assumptions about the uneconomic char- *acteristics of some market segments may be T argumeutforuniversalservice haswrong. What is uneconomic for one operator been used tojustpfy the worst of allcan be profitable for others and therefore maynot need to be cross-subsidized at all. possible economic outcomes in theCross-subsidies raise some complex issues. The e e

argument for them assumes that the scale of sector-a monopoly on a service that IScross-subsidy required is very large. But a study notprovided at all or notprovided to anyin Australia found the required subsidy to bequite small (AUSTEL 1994). The argument also dequate standard.assumes, incorrectly, that monopoly is requiredfor cross-subsidy to be possible. That is clearlywrong-there are many examples of cross-sub- rebalancing, involving possibly unpopular in-sidies coexisting with competitive markets for creases in local network access subscriptiontelecommunications services. Also wrong is the charges. The discussion of this issue is thenassumption that subsidies must be cross-subsi- essentially the same as the cross-subsidy dis-dies, between large groups of customers within cussion above. The cherry picking argument as-the telecommunications sector, and effectively sumes that in a competitive telecommunicationsadministered by the monopolist. If subsidies are services market, corporate customers are therequired to achieve political goals, direct, tar- most profitable. This is not always the case. Ingeted ones may be more appropriate. An im- the United Kingdom and the United States, forportant concern is that both cross-subsidies and example, this market segment has one of themonopoly reduce incentives for efficiency. In- lowest profit margins, and there is also vigor-deed, it is very difficult for a regulatory agency ous competition for residential customers fromto tell whether it is customers who are being both incumbent operators and new entrants.cross-subsidized-or employees, investors, Cream skimming should be viewed not as aequipment manufacturers, and inefficiency. Fi- negative and unwholesome activity, but as nor-nally, in developing countries, the typical case mal market behavior that, by "taking the creamof cross-subsicly of urban residential telephone away," helps correct price distortions and en-service is the equivalent of a regressive tax and hances incentives for cost reductions.income redistribution policy. This de facto taxand transfer scheme, established without legis- For the criticisms of cream skimming to belative approval, benefits primarily the urban valid, three assertions would have to be true:middle class. that the "cream" is necessary to promote ex-

60 Subscribing to Monopoly

panded demand for service; that it is used ef-fectively by the monopolist to expand serviceand not dissipated in inefficient operations,overstaffing, unnecessarily high payments forequipment, and transfers to shareholders; andthat the monopolist's cost structure is so closeto optimal that competition would bring mini-mal efficiency gains. In practice, in many, manycases, these assertions are not true.

Obstacle to liberalization

Each catchphrase-wasteful duplication offa-

cilities, uneconomic entry, universal service,and cream skimming-packages complex is-sues with a superficial and flawed appeal to apublic interest agenda. Very often, the objec-tive is to bolster the case for continuing a mo-nopoly and maintaining the role of themonopolist as the vehicle for cross-subsidy. Therisk that this approach will create the wrongincentives for investment and efficiency andsustain poor performance is very high. Themonopolist "mind-set" has slowed liberaliza-tion in many developing countries, and the re-sulting absence of competition has led topersistently poor telecommunications services.

References

AUSTEL. 1994. Telecommunications Universal Service Obligation. Aus-tralian Telecommunications Authority Occasional Paper.

Baer, Walter S. 1995. "Telecommunications Infrastructure Competition-The Costs of Delay." Telecommutnications Policy (July).

Canadian Minister of Supply and Services. 1986. Federal-ProvincialExamination of Telecommunicaotios Pricing and the UniversalAvailability of Affordable Telephone Service. Report and Working

Papers. Ottawa.Coopers & Lvbrand ConsuLting Group. 1968. "The Effect of Chang-

log Technology on the Structure of Costs for the Provision ofPublic Long-Distance Telephone Service.` In Federal-Provincial-Tenitorial Task Force on Telecommunications, Competition in Pub-lic Long-Distance Telepbone Service in Canada. Ottawa, Canada:Mirister of Supply and Services.

Mueller, Milton. 1993. "Universal Service in Telephone Historv: AReconsLructioln." TelecounmmciicationsPolicy(July).

Smith, Peter, and Gregory Staple. 1994. Telecommunications SectorReform in Asia: Totvard a \Vew Pragmatisos. World Bank Discus-sion Paper 232. Washington, D.C.

Peter Smith, Senior TelecommunicationsPolicy Specialist, Industry and Energy Depart-

ment (email: [email protected])

61

End of the Line for the Local Loop Monopoly?Technology, competition, and investment in telecom networks

Peter Smith

Local telephone service is the last bastion of a still frequently asserted public policy preference

for monopoly provision of telecommunications. This Note challenges the rationale for that

preference, addressing four issues: First, is local network competition feasible from a technical

and cost point of view? Second, is telecommunications competition accepted by major

investors? Third, how important is competition from a public policy point of view? And fourth,

briefly, how can it be made to work?

A traditional and now outdated view in the nificantly to the expansion of telephone servicetelecommunications sector is that competition in Sri Lanka-and demonstrated the transitionis suitable for terminal equipment, for value- of cellular service from a small, specialized, pre-added services, and possibly for long-distance mium part of the market to a substitute for con-telephone service after universal service is ventional service.achieved-but not for local telephone service.This position is usually accompanied by the Feasibility and viabilityview that cellular mobile telephony is not lo-cal telephone service (which it clearly is) but a To assess the feasibility and viability of localseparate "mobile" market segment. network competition, we need to review two

groups of factors: first, technology and the costA modified traditional view is that local service characteristics of different technologies; andcompetition is appropriate only for large mar- second, the views of investors, since it is nokets (such as the United Kingdom) and in rich good being right about the technology if inves-countries that have already achieved universal tors don't believe in it.service (for example, Finland, New Zealand, andthe United Kingdom). This is wrong. Even in a The choice of technologies for the provision ofrelatively small market such as Sri Lanka, local local telephone service is now broader than ever.network competition is beneficial. Sri Lanka has There are several wireless options: analog andfour cellular operators and some of the lowest digital cellular radio, digital cordless telephonycellular telephone service prices in the world. (for example, Digital European Cordless Tele-In 1994, the number of telephone lines in the communications, or DECT), proprietary (non-country increased by about 47,000. Of these, cellular) wireless local loop systems such asabout 30,000 were conventional lines provided lonica (being installed in Finland), and mobileby state-owned Sri Lanka Telecom-a record satellite. There are also fiber-optic cable TVincrease. The remaining 17,000 lines came from options and hybrid solutions combining, for ex-the provision of cellular service. Thus, the cel- ample, cable TV and DECT.lular operators installed about 35 percent of allnew lines in 1994, a surprisingly high percent- Figure 1 compares lifetime costs for two ge-age. These cellular operators contributed sig- neric technologies: traditional underground

62 End of the Line for the Local Loop Monopoly?

copper cable and wireless. The figure is, of recommendations that do not necessarily leadcourse, simplified and generalized, showing just to the best public policy for the development ofone cost line for each technology. (The wire- the telecommunications sector as a whole.less cost curve is for Global System Mobile, orGSM, cellular.) Actual cost structures vary ac- But do investors think that network competi-cording to the technology, market, topography, tion poses unacceptable risks? Apparently not.network configuration, and grade of service. In New Zealand, Telecom NZ was successfullyNevertheless, the figure shows that in areas of privatized in a policy environment of open en-low subscriber density (fewer than 250 to 300 try in all market segments. In the Philippines,subscribers per square kilometer), wireless sys- such foreign investors as N YNEX, Cable & Wire-

less, and Telstra have entered-or are prepar-ing to enter-the market as competitors orpartners of competitors. In Mexico, a large do-

FIGURE 1 WIRELESS VERSUS WIRELINE: COMPARISON OF mestic cellular operator with support from BellLIFETIME COSTS PER SUBSCRIBER Atlantic has proposed installing a fixed wire-

less network to serve 1.5 million customers. Insouthern India, US West has proposed a tele-communications build-own-operate schemeand has not asked for an exclusive franchise.Investors have also accepted competition in

Cost Australia, Malaysia, Sweden, the United King-

Wireless dom, and the United States and in the cellularmarket of almost every country.

Underground copper cable

Why competition is so important0 250 500

Subscriber density (subscribers per square kilometer) Many of the benefits of telecommunications

Source: Davies and ethers 1995. competition are well known-lower costs,lower prices, greater innovation. Less recog-nized and more important benefits, however,particularly for developing countries with sig-

tems have lower costs. Furthermore, because nificant underinvestment in the sector, are in-wireless costs are falling relative to the costs creased investment and better service.of cable systems, the crossover point is mov-ing to the right. Thus, wireless systems are be- By way of comparison, the alleged benefits ofcoming more competitive, in larger parts of the exclusive franchises are short-term stability inmarket, every year. a difficult privatization environment (as in Ar-

gentina in 1990), higher profits, and more in-What do investors think? vestment ('no one will invest unless you grant

them a monopoly"). In some cases, it is trueThe issue of exclusivity often arises in the con- that a very short period of exclusivity (say, onetext of telecommunications privatizations. In year) can contribute to stability in a difficultmany of these transactions, a policy decision environment. But the second alleged benefit.has been made to continue monopoly rights, higher profits, is not, of course, a customersometimes on the basis of an investment bank's benefit. Thus, the question of whether compe-recommendations. In Mexico, Argentina, and tition or monopoly is the better public policyVenezuela, for example, exclusivity periods of in an environment of underinvestment hingessix, seven, and nine years were granted. In these on which leads to more investment. This isand other cases, privatization advisers have made really an empirical question. But it seems likely


that competition will stimulate more investment, Mexico, and Sri Lanka and could become verybecause it opens more channels for investment important in China.and it creates incentives to invest to meet de-mand-companies that do not invest will risk How to make it worklosing market share. This stimulus is exactlywhat is needed in countries with chronic under- For competition to work, new entrants needinvestment in telecommunications-such as reasonable interconnection, reasonable prices,Bangladesh, India, the Philippines, and Sri telephone numbers, and, often, radio li-Lanka. Two exaiimples fromi GlhaIna and the Phil- censes-in a sense, all technlical issues witlhippines confirm that competition will stimu-late investment in the sector.

Ghana, a small West African country with less FIGURE 2 ANNUAL INVESTMENT BY PLDT, 1990-94than 20 million people and low per capita in- Millionsofconstant U.S.dollarscome, is regarded as a relatively high-risk lo-

Z, 0 ~~~~~~~~~~~~~~~~500cation by some foreign investors. In 1992, asmall, mainly foreign-owned cellular opera-tor, Mobitel, began operations in the capital,Accra. Mobitel's business plan called for it to 400

extend service to Kumasi, the second maincity, only when the required investment couldbe financed out of retained earnings. Thisdecision changed in 1994. Mobitel rushed to 300provide service in Kumasi after a new opera-tor, Celltel, announced plans to provide ser-vice in both Accra and Kumasi within a fewmonths. Furthermore, Mobitel has halved its 200connection charges since Celltel began opera- 1990 1991 1992 1993 1994

tions earlier this year. SofrrCe:Author's calculations based on PLDT annual reports.

In the Philippines, the threat of competitionsimilarly prompted a quick response from themain telephone service provider. PLDT. Only technical solutions. But even more importantin 1993-after PLDT came to believe that the is that the government must have the will togovernment was serious about authorizing new enforce reasonable rules of competition in theentrants to provide local telephone service on sector. This is particularly clear in the case ofa large scale-did it announce its 'zero back- interconnection, where, in the absence of ef-log program." PLDT's investment program fective regulation, "strategic" conduct by theturned sharply upward after 1993 (figure 2). incumbent telephone company can hinder or

prevent new entry. For a new entrant to in-These are not isolated examples. The issue of terconnect its network with that of the incum-local network compctition is bccoming impor- bent, it needs information on the type oftant in many countries. Finland has authorized equipment that exists at different interconnec-duopolistic competition in the provision of both tion points. The incumbent can impede inter-local and long-distance service, and Indonesia's connection by providing no information,government has authorized Ratelindo to pro- wrong information, or changed information.vide fixed wireless local loop service in the It can make only a limited number of inter-Jakarta and Bandung areas of West Java. Local connection points available, forcing the newnetwork competition is also pending in India, entrant to send traffic along unnecessarily long

64 End of the Line for the Local Loop Monopoly?

routes. The incumbent may lease lines to newentrants that are incorrectly dimensioned andunreliable. And it may provide revenue settle-ment arrangements that are unsatisfactory, andmake payments late. In short, without effec-tive regulation, an incumbent can keep newentrants out of the business-and put themout of business.

Conclusion

This Note has made the case that local net-work competition is increasingly feasible froma technical and cost point of view, that it isincreasingly accepted by investors, and that itoffers important benefits from a public policypoint of view-particularly its potential tostimulate investment. But in order to work, itmust be supported by effective regulation.Much remains to be done in many countries tomove toward a competitive telecommunicationssector. Policymakers should be encouraged toaddress the critical issues of this transition-and discouraged from losing time on counter-productive efforts to maintain monopolies inthis dynamic sector.

References

Davies, Gareth, Steve Carter, Stuart Macintosh, and others. 1995. "KeyTechnological and Policy Options for the TelecommunicationsSector in Cenrral and Eastern Europe and the Former SovTiet Union."Paper prepared for the European Bank for Reconstruction andDevelopment, Coopers and Lybrand, London.

Organization for Economic Cooperation and Development (OECD).1995. Telecom,municatio7ns Infrastructure-T7beBenefits ofComnpe-tition. Paris.

Smith, Peter, and Gregory Staple. 1994. Telecommnunications Sector

Reform in Asia- Toward a A7ew Pragmatism. World Bank Discus-sion Paper 232. Washington, D.C.

Peter Smith, Senior Telecommunications PolicySpecialist, Industry and Energy Department(email: psmith2@worldbank. org)

65

Regulating TelecommunicationsLessons from U.S. price cap experience

Jeffrey H. Rohlfs

Regulatory shift case) to recoup those lost profits.' In addition,price cap plans usually allow the firm substan-

Rate-of-return (ROR) regulation has been used tial flexibility-within the price cap constraintsfor many years to regulate telecommunications -to restructure rates, with minimal regulatorycarriers in the United States. This regulatory delays.approach has important desirable features: itlimits monopoly rents, and it provides a stable The primary drawback of price caps is that theyenvironment to attract investment. But it also create incentives for firms to cut costs byhas serious flaws. Like cost-plus procurement, degrading the quality of service. Many priceROR regulation provides limited incentives for cap plans deal with this problem by imposingfirms to cut costs or otherwise to improve effi- penalties for quality degradation. Anotherciency. As markets become more competitive, drawback is that price levels may become in-the incumbent may overprice monopoly ser- appropriate over time as a result of unexpectedvices to subsidize competitive services. All firms changes in demand or in real costs. Shorten-may use the regulatory process strategically to ing the term of the plan helps ensure that ratesundermine rivals' ability to offer better value do not drift too far out of line, but it also re-to customers. duces efficiency incentives. (A firm faces the

prospect of earlier unfavorable adjustments toFor these reasons, many U.S. telecommunica- prices if it improves efficiency.) U.S. regula-tions regulators have recently replaced ROR tors have generally opted for terms of three toregulation with price cap regulation. Price cap five years. Longer terms will become appro-regulation uses a formula, set in advance, to priate as regulators gain more experience withdetermine the price increases for a firm's ser- price caps and uncertainty is reduced.vices for a period of several years. During thisperiod, the firm may keep all the benefits of This Note reviews the U.S. experience withits incremental productivity gains. Customers price caps, focusing primarily on federal regu-can also benefit, in several ways. The price lation. It then briefly discusses the lessons ofcap formula may cause prices to rise less rap- this experience for developing countries.idly during the period than they did histori-cally. The sharpened incentives created may Competition and the regulation of AT&Tencourage the firm to offer innovative new ser-vices. And after the period ends, regulators may AT&T has been subject to competition in long-order price reductions that reflect productivity distance services since the 1970s, though thegains during the period. competition intensified substantially after equal

access was implemented in the mid-1980s. InAnother advantage of price caps is that they this more competitive environment, federalreduce firms' incentives to cross-subsidize. regulation of AT&T has been reformed andCross-subsidy generally reduces a firm's prof- relaxed. The Federal Communications Commis-its, and during the price cap period the firm sion (FCC) began granting AT&T pricing flex-has no opportunity (as it would in an ROR rate ibility shortly after its breakup into the seven

66 Regulating Telecommunications

regional operating companies in 1984. In the sumers over the 1990-93 period.2 Estimates byearly 1990s, the FCC streamlined regulation of Schmalensee and Rohlfs show that 90 percentAT&T's large-business and 800-number services, of the gains from price cap regulation went toand it has just streamlined regulation of AT&T's consumers and 10 percent to AT&T stockhold-remaining services. Thus, although AT&T still ers.3 Consumers enjoyed real price reductionshas to file tariffs with the FCC, its prices are no as the price cap declined (in real terms) andlonger subject to regulatory review. AT&T has from AT&T's voluntarily pricing below the cap,generally responded to regulatory freedom by and they also made greater use of discountedcompeting more aggressively for large customer pricing plans.accounts. Its competitors have stopped gain-ing market share at AT&T's expense, but re- For AT&T, the most dramatic gains were reduc-main prosperous. tions in its real noncapital expenses (figure 1).

The rising trend in AT&T's real noncapitalexpenses was reversed in 1989. In 1988, thecompany took a US$6.8 billion write-down of

FIGURE 1 REAL NONCAPITAL EXPENSES OF AT&T, 1985-91 antiquated analog equipment and started toreplace it with digital equipment, primarily

Billions of U.S. dollars fiber-optic systems, to thoroughly modernize6.2 its network.

Transition to competition

6.0 Competition, rather than price caps, was un-

doubtedly the primary impetus for AT&T's mod-ernization effort. When Sprint began to advertiseits all-fiber network in the mid-1980s, AT&T per-

5.8 ceived an urgent need to improve its network

to maintain the company's reputation for qual-ity. But price caps have eased the transition to

5.6 streamlined regulation. Under ROR regulation,a detailed cost allocation manual would havehad to be developed to ensure that prices inmarkets not subject to streamlined regulation

5.4 1 covered the costs allocated to those markets.1985 1986 1987 1988 1989 1990 1991 By contrast, under price caps, the FCC simply

had to order streamlined regulation for someSource: Richard Schmalensee and Jeffrey H. Rohifs, "Productivity Gains Resulting from si lea thefmlas for pca eInterstate Price Caps for AT&T," filed with U.S. Federal Communications Commission, servlices, leavg the formulas for prce cap regu-

Docket 92-134, September 3,1992. lation of other ser-vices unchanged.Docket 92-134, Septemher 3, 1992.

Because of the altogether favorable experiencewith the price cap regulation of AT&T, the FCCrenewed AT&T's price cap plan without change

The FCC began to use price cap regulation for in 1994.AT&T in 1990-though AT&T had started toact in anticipation of price cap regulatioin even Regulation of local exchange carriersbefore then. The FCC's 1993 reviewv concludedthat the price cap plan was working well. After implementing price cap regulation forAccording to the FCC's calculations, price AT&T, however, the FCC backslid, adopting acaps yielded USS1.8 billion of gains to con- hybrid of price cap and ROR regulation for local


exchange carriers. This hybrid plan allowed the The drawback of this approach-indeed, thelocal exchange carriers to keep all their mar- problem with benchmark regulation generallyginal productivity gains until their rate of re- -is that one size does not fit all. Price reduc-turn reached a certain level. Above that level, tions that are not onerous for some firms maythe carriers had to share further efficiency gains cause financial distress for others. The FCC dealtequally with their customers, which reduced with this problem by offering a range of op-their efficiency incentives by 50 percent. At a tions. Firms could opt for smaller annual pricestill higher rate of return, the plan reverted to reductions, but would then have to share mostpure cost-plus regulation. of their productivity gains with customers. Or

firms could opt for pure price caps (with noDespite this declining incentive structure, lo- sharing of gains with customers), but wouldcal exchange carriers have significantly in- then have to agree to larger annual price re-creased their efficiency under federal price cap ductions. Several large local exchange carriersregulation. To ensure that consumers did bet- chose the second option.ter under price cap than under ROR regula-tion, the FCC included in the plan a "consumer Lessons for developing countriesdividend' of 0.5 percent a year. But local ex-change carriers have still been highly profit- For developing countries, which generally lackable. Their rate of return on capital averaged strong regulatory institutions, creating and staff-about 10 percent a year in 1991-94,1 compared ing a regulatory agency that can perform RORwith the yield on short-term U.S. Treasury regulatory functions competently would besecurities of less than 5 percent a year.

The improved efficiency of the local exchange Developinrg couintries are wellcarriers is onlv partially attributable to federalregulation: many states also adopted price cap cdvised to avoid rate-of-returnregulation or one of many variants of incen-tive regulation during the period. Because lo- -oegulation nltogetherandcal exchange carriers were so profitable underprice caps, the FCC made adjustments when it to leapfrog to price caps.renewed the plan. Rates have been reducedand will decline more rapidly than under theoriginal plan. costly and take considerable time. Furthermore,

ROR regulation is subject to abuse-especiallyHybrid drawbacks in the absence of judicial precedents. For these

reasons alone, price cap regulation may beThe FCC applied the same percentage adjust- more feasible than ROR regulation for newlyments to all price cap-regulated local exchange privatized telecommunications companies.carriers-a form of "benchmark" regulation,often used in industries with many regulated But the U.S. experience suggests that evenfirms. Thus, the adjustments to each firm's rates where regulatory capacity is strong, price capwere largely unrelated to its productivity gains, regulation may be better. Price cap regulationso each firm was able to retain most of the in the United States has been highly success-incremental benefits of its productivity gains, ful-the theoretical benefits of price caps foreven after the end of the price cap period. As industry performance appear to have beena result, the plan provides much greater effi- realized in practice. Moreover, because priceciency incentives than one that makes adjust- cap regulation is simpler and more transparentments for each firm based on that firm's than ROR regulation, it may be less subject toproductivity gains. abuse. And the U.S. experience in long-distance

68 Regulating Telecommunications

telecommunications suggests that price capregulation works well during an industry's tran-sition to a competitive structure.

Price cap plans have the additional advantageof being indexed to inflation. But even thoughthey adjust automatically to unexpected changesin inflation, as occur often in developing coun-tries, the adjustments do not fully compensatefor the effect of inflation on capital costs. Thus,where inflation is unstable, an additional ad-justment factor may be desirable.

This comparison of regulatory performancesuggests that developing countries are welladvised to avoid ROR regulation altogether andto leapfrog to price caps. By doing so, theycan benefit from the greater efficiency incen-tives of price cap regulation while avoiding theadministrative costs and difficulties of RORregulation. Hybrid regulation incorporatingformal mechanisms for sharing efficiency gainswith consumers is a third alternative. But hv-brid regulatory plans require having ROR regu-latory institutions in place, offer weakerefficiency incentives than price caps, and pro-vide less protection against cross-subsidy. Thus,pure price caps are the best alternative.

For the same reason, price caps increase the firm's losses fromproviding subsidies mandated by regulators-for example, subsi-dies of residential ser-ices in rural areas. Consequently, regulatedfirms may carry out subsidized programs with less vigor underprice caps.U.S. Federal Communicatiuos Commission. "In the :latter of PriceCap Performance Review for AT&T,' CC Docket 92-134, adoptedJune 24, 1993, released July 23, 1993. at para. 9.Richard Schmalensee and Jeffrey H. Roblfs, 'Productivity Gains Re-sulting from Interstate Price Caps for AT&T," filed with U.S. FederalCommunications Comnmission, Docket 92-134, September 3, 1992.The Schmalensee-Rohlfs estimate, unlike the FCC's, includes thecustomer benefits fror greater use of discounted services.Derived from U.S. Federal Communications Commission, Preioti-nary Statistics ofContnmunicattons Common Canlets (Washington,D.C.: U.S. Government Printing Office. July 7, 1995) and StatisticsofCommonications Cosmmon Can7ies:(Washington, D.C.: U.S. Gov-ernment Printing Office, various editions).

Jeffrey H. Robhfs, Strategic Policy Research,Bethesda, Ma; 'land

69

Testing for Regulatory Capture-RegulatingTelecoms in the U.K.Antony W Dnes

After privatizing British Telecom (BT) in 1984, tory regime with two main elements. The re- ,the British government privatized all other ma- gime was designed to substitute for competi-jor utility industries in succession-gas in 1986, tion by encouraging the regulated firm to operatewater in 1989, and electricity in 1990. Debates efficiently, and to promote competition when-soon emerged about whether the benefits from ever possible. The regulatory agencies adoptedprivatization in these industries have been eq- price capping (rather than rate-of-return regu-uitably distributed between slhareholders and lation) to limit the exercise of monopoly powerconsumers. This Note discusses the post-priva- and simultaneously sought to stimulate entry.2

tization performance of BT, the longest-stand- This regime was based in part on the U.K.ing privatized utility in the United Kingdom, to government's view by the 1980s that technicalshed light on some of the problems of regulat- advances (fiber optics, for example) had weak-ing privatized utilities. A recent event study of ened traditional arguments for limiting entry inBT suggests that regulation has checked mo- industries once thought to be natural monopo-nopoly power and that the impact of the lies. Even in utility industries still thought to beregulator's decisions has been heterogenous- natural monopolies because of the cost advan-with some decisions favoring consumers, some tages of having just one firm operate (for ex-favoring BT, and some favoring BT's competi- ample, gas distribution), the government cametors. This event analysis could usefully be ex- to believe that the cost control discipline ex-tended to the other utilities, which were erted by competition would produce netprivatized on different terms and are subject benefits. Tllerefore, a key feature of post-to different regulatory packages. privatization regulation has been the regulatory

agencies' assumption of antitrust responsibili-The problem of utility privatization ties. The Office of Telecommunications Regula-

tion (Oftel), the Office of Electricity RegulationNationalized utilities invariably operate with (Offer), the Office of Gas Regulation (Ofgas),little or no competition, as many are natural and the Office of Water Regulation (Ofwat) allmonopolies or perhaps natural oligopolies. have responsibility for encouraging competitionCompetition, where it is possible, cannot in their industry.3

emerge until a private market has been cre-ated. A privatizing government therefore is im- There is at least some evidence that post-priva-mediately subject to the criticism that it is tization regulation has checked monopolycreating private monopolies-especially when power. A series of decisions to open utility mar-newly privatized utilities have to rebalance their kets to competition gave the regulatory bodiescharges-raising some and lowering others- a distinctly pro-competitive look. A notableto remove the inherited cross-subsidies that are early example of this pro-competitive stancea major financial liability.1 was the October 1985 decision to grant BT's

only serious competitor, Mercury Communica-With these hurdles in mind, the U.K. govern- tions (a wholly owned subsidiary of Cable &ment decided early in the privatization process Wireless), the right to interconnect with BT'sto subject newly privatized utilities to a regula- local networks at advantageous access prices.

70 Testing for Regulatory Capture-Regulating Telecoms in the U.K.

Comparable rulings from Ofgas have allowed ics, who often expect to find evidence of cap-entrants to compete in the supply of domestic ture or of regulation working as a tax and sub-and industrial gas. The impact of post-privati- sidy arrangement.zation regulation has not been uniform, how-ever. For example, BT benefited from the Testing for captureduopoly policy that limited its potential com-petitors to Mercury until 1990. And Oftel's plans One way to test whether a regulatory packageto open the U.K. telecommunications market has been captured is to compare the stock mar-(in practice, to U.S. cable operators) were not ket returns for a regulated company or groupas tough as BT had feared. of companies over a long period with the re-

turns for a comparable sample of firms not afA recent detailed study of the post-privatiza- fected by the regulation. Abnormally high returnstion period assessed the overall effect of regu- could indicate capture by the regulated indus-latory events in U.K. telecommunications. 4 This try if they can be associated statistically withstudy is outlined below. changes in the regulatory environment (regula-

tory events). Lower-level capture would be re-Regulatory capture flected in an association between returns andand the public interest individual regulatory events. A cumulative ef-

fect from all the regulatorty events is consistentTheories of regulation may be broken down with top-level capture (bear in mind that someinto public interest and private interest ap- events will have a positive effect, and someproaches. 5 There is also a mixed view, which negative). Standard statistical techniques existargues that regulation should be seen in pub- for testing for association between regulatorylic finance terms as benefiting some groups at events and abnormal returns while controllingthe expense of others.6 Among the private infor the effect of other possible influences.8

terest approaches is the capture hypothesis,associated with the work of the late George DataStigler. This hypothesis is now generally un-derstood as arguing that it is in the private Event data for BT are available from the ar-interest of a vote-maximizing government to chives of the Financial Ti,nes or WVall Streetallow regulatory programs to reflect the inter- Journal for the period 1984-94. A basic eventests of powerful electoral groups. A particular diary includes both regulatory and non-concern is that firms in a regulated industry regulatory events. An important nonregulatorywill influence the regulatory environment in event that affected all quoted companies wastheir favor-or capture the regulatory process. the perturbation in stock markets in OctoberThis capture may occur in the legislature (top- 1987. Data on the daily share prices for a com-level capture), as policy is formulated and leg- pany are most conveniently drawn from a com-islation passed, or in the regulatory agency and mercial service such as Datastream. An eventthe ministerial decisionmaking (lower-level study also needs an index of normal marketcapture), as regulatory decisions are made af- returns for comparison, which in the Unitedter the regulation is in place. Kingdom is usually based on a market index

such as the Financial Times Stock ExchangeThe private interest view is often contrasted Index of 100 leading firms (FTSE-100).9 Thewith the public interest approach that emerges technique, which may involve measuring thou-from traditional welfare economics. The pub- sands of changes in share prices for each com-lic interest view sees government as an impar- pany, has heavy data requirements.tial referee working to maximize the value oftotal output. This view tends to be regarded as The use of a market index based on the FTSE-naive by economists working on regulatory top- 100 (but excluding utility companies) implies


that BT is in a risk class similar to that of blue- cant result that accords with expectations re-chip companies. That is in fact a reasonable as- lates to the ending of the duopoly policy in 1990.sumption if utilities' lower risk is linked to their Although it was always known that this policymonopoly status and, ultimately, to regulatory would end, press reports that its end was immi-tolerance of their situation. In explaining utili- nent in the period just before publication byties' low risk, their monopoly status should be the U.K. government of a consultative paper,emphasized rather than the fact that they sup- "Competition and Choice," produced a signifi-ply necessities: after all, food retailers also sup- cant negative effect. The publication of the pa-ply necessities, but their returns in the United per in 1990 produced a robustly significantKingdom have been anything but stable since positive effect on BT's returns that can be inter-they entered into a competitive price war a few preted as reflecting the removal of uncertainty.years ago. The use of the FTSE-100 allows iso- Similar relief among investors may explain thelation of abnormally high returns (or, indeed, robust positive effects on BT's returns stemmingany reduction in the variance of returns) for from Oftel's decision at the end of 1988 to re-utilities attributable to their monopoly status. solve a lingering dispute over the nonprice terms

for interconnecting Mercury. Investors also ap-Results pear to have been reassured by the outcome of

the August 1992 negotiations between BT andIn the event study of BT's post-privatization Oftel, which led to a decision not to refer BT toperformance, the company's average daily re- the Monopolies and Mergers Commissionturns turned out not to be significantly higher (MMC). the entity responsible for applying manythan the market index, ruling out top-level cap- aspects of U.K. antitrust law-even though theture. The results do not, of course, rule out the decision was also associated with proposals topossibility that BT had attempted such capture, tighten the price cap.wasting resources in the process.

The decisions to liberalize private networks andRegulation may go through a life cycle, how- to license new mobile services (including Mer-ever, and can become lower-level captured "in cury) in mid-1989 and the publication of an-action" over time. Individual events or groups other consultative document taking a tough lineof events may favor industry interests, creating on price controls in 1992 all appear to haveshort-term abnormal returns, even if abnormal had a negative impact on BT's returns. Thesereturns do not show up for the full period un- events can all be reasonably regarded as regu-der examination. The event study for BT there- latorv moves that oppose BT's commercial in-fore also examined the effects of particular terests. Another event that could be added toregulatory events by isolating the impact of min- this list is the February 1988 decision to relaxisterial and Oftel decisions during 1984-94. The the rules on entry into satellite services, whichevent study showed few statistically significant favored competition from U.S. soturces and hadregulatory events affecting BT over the post- a negative effect. But it occurred too close toprivatization period: of seventy-five identifiable an event that followed to allow reliable infer-regulatory events, only twelve were signifi- ences to be drawn.cant."' Furthermore, within this group of sig-nificant regulatory events, some were more At least two pro-competitive decisions appearrobustly significant than others (as measured to have had a significant positive effect on BT'sby standard statistical tests). returns. These are the decisions to suspend the

monopoly on installation approval (JanuaryReassuringly, Oftel's interconnection ruling in 1987) and to open the market to more compe-October 1985, which set low interconnection tition (October 1993). Another potentially posi-charges for Mercury, showed up as a robust tive event is the 1988 decision to opennegative effect on BT's returns. Another signifi- competition in specific services, although this

72 Testing for Regulatory Capture-Regulating Telecoms in the U.K.

event also is too close to another to allow reli- Although precise statistical tests need to be car-able inferences to be drawn. At first sight, these ried out for gas, water, and electricity, presspositive effects are counterintuitive. But inves- reports suggest that a heterogenous pattern oftors may believe that creating a generally com- regulatory effects also characterizes these util-petitive environment forces BT to become ity industries.1 2 Thus, the post-privatization per-cost-efficient and ultimately improves its formance of utilities in the United Kingdomprofitability. shows how decentralized regulation, based on

price capping and promotion of competition,The event study of BT also revealed some "dogs can prevent privatized utilities from becomingthat failed to bark.1 1 Threats by Oftel to exam- private monopolies.ine BT's prices or to refer BT to the MMC overpricing issues appear to have had no impact Cross-subsidy cannot be justified bv social welfare economic analy-

on BT's returns. These threats usually resulted sis either. See D. Swann, The R.etreat of the State (Harvester

in negotiated settlements, which sometimes had Wheatsheaf, 1989).

significant positive effects on BT's returns. This 2 M.E. Beeslev and S.C. Littlechild, "The Regulation of PrivatizedMonopolies in the UK," RAANDJournal ofb.conoinics 20: 454-72

outcome is consistent with the view that BT (1989).

has earned normal market returns and with fi- 3 SeeJohn loore, "The Success of Privatization," injohn Kay, Colin

nancial market expectations that BT will face Ma'er, and David Thompson, eds., Privatization and Regruation-7Te UK Experience (Oxford: Oxford University Press, 1986). John

such scrutiny. Announced revisions of the price Moore was hnancial secretary to the Treasure in the early Thatcher

cap had no significant impact on BT's returns, government.

probably because financial markets fully an- AAW. Dnes and J.S. Seatoin, "The Regulation of British Telecom:An Event Study," Discussion Paper (The Nottingham Trent Uni-

ticipate changes that hold BT to a normal mar- versity. Department of Econimics, Nottingham, Marchl 1995).

ket return. Although not strictly regulatorv $ See T. \Veyman-Jones, "Deregulation," in P.M. Jackson and C.MPrice, eds., Pnvatization and Regulaton (New York: Longman,

events, the commencement of share trading fol- c9,ed.1994).

lowing the BT1, BT2, and BT3 share offers See R. Posner, "'taxation by Regulation," BellJournalofFconom-

between 1984 and 1993 had no significant im- icsSa: 22-51(1974).

act on returns. G. Stigler, "The Theory of Economic Regulation," BellJournal ofpact Economiics and M1anagement Science 2: 137- 46 (1971).See Dncs and Seaton, "The Regulation of British Telecom."

Conclusions 9 The analv-st must exclude the companies in the event sample fromthe market index.

' Significance refers to statistical significance (that is, the associa-BT seems to have earned normal market re- tion could not have been generated by chance). Similarly, ro-turns for the most part and thus does not ap- bustlysignificantmeans that the significance is maintained through-

out different formulations of the economic model used in thepear to have captured the regulatory process. event study.

There were no individual events suggesting the " Is there any other point to which you WOilld wish to cIrasv my

early capitalization into share prices of antici- attention?"

pated future abnormal returns. And a detailed "To the curious incident of the dog in the night-timne.""The dog did nothing in the night-time."'

review of regulatory events revealed no clear "That svas the curious incident." remarked Sherlock Holmes. (Sil-

pattern favoring or opposing BT's commercial cer Blaze, from the .tieatoii's of Sherlock Ifoltne.s, by Sir Arnhur

interests. M4oreover since BT has not been Conan DoyLe, 1892)interests. Moreover, since BT has notbeen 12 NVWork is being carried out bv economists at the Universitv of Ox-

pushed below a normal market return, there is ford on a recent tightening of the electricity price cap. And econo-

no evidence of capture by consumer interests. mists, including the author, based at the Nottingham Trent Uni-

Instead, the regulatory pattern of events is het- versity and Loughtbrough University of Technology are carryingout studles of the post-privatization performance of all the priva-

erogenous, with some events favoring BT, some tized utilities.

favoring its competitor, Mercury, and some fa-voring consumers. Antony W Dnes, Professor of Economics, The

Nottingham Trent University, NVottingham,The event study of British Telecom therefore England (email: EPA3Dnesaw@:ntu.ac.uk)suggests that Oftel has carried out its regula-tory function effectively and avoided capture.

73

Restructuring Regulation of the Railroad IndustryJoannis AU Kessides anzd Robert D. Willig

Throughout the world, the rail industry has cost conditions. Because rail infrastructure is ofbeen one of the most heavily regulated sec- minimal value for other purposes, the fixed coststors. The public utility paradigm of government are largely sunk. These sunk costs of infrastruc-regulation has failed to handle the central regu- ture create significant entry barriers, especiallylatory problem-the mixture of competitive and where there are natural monopoly conditions.monopoly elements in supply-and is nowbeing blamed for the poor financial condition The cost conditions relating to the operationi ofof the railroads, for the deterioration of rail services on this physical network, however, mayplant, for the lack of innovation, and for the be more consistent with active and potentialmediocre quality of rail services. This Note out- competition. To operate a service, it is neces-lines a set of principles, called constrained sary to have trains, staff, support, and rights ofmarket pricing, for regulatory reform in the way. Although hiring staff and buying or leas-public interest and considers their implications ing rolling stock inevitably involve some sunkfor railroad restructuring. costs, they are small relative to the massive sunk

costs of establishing network infrastructure. AndCatalyst for new thinking most of the cost of locomotives and freight cars

might be easily and quickly recovered by roll-Contestability theory offers a new, improved ing them to other markets.set of guidelines for appropriate governmentintervention in the structure and conduct of Thus, contestability suggests a modulated ap-firms and industries-including sound criteria proach to regulation. In activities subject to ef-for distinguishing between cases in which in- fective competitive pressure from the actual (ortervention is warranted and those in which it potential) supply of substitute services, and inis not. It focuses increased attention on entry markets in which efficient technology does notbarriers and their defining characteristics. Con- require significant sunk costs, traditional regu-testability analysis shows, for example, that high latory constraints should be avoided and openfixed costs and the consequent economies of entry and more flexible pricing permitted. Andscale, traditionally considered impediments to in markets in which the railroad has significantentry, need not permit excessive prices or prof- market power, regulation should constrain theits or any of the other symptoms usually asso- prices and terms of services no more (and nociated with market power. It is the presence of less) than the forces of active or potential com-sunk costs, rather than economies of scale petition would in competitive or contestablealone, that matters for market performance. markets. This theory of contestability, together

with other advances in regulatory theory andIn the rail industry, fixed costs are large because practice, is the basis for the following threeof the infrastructure-track, stations, and the principles for railroad regulation:like-that must be provided before any trains * Permit a private sector railroad freedom incan run on a route. Duplicating this infrastructure pricing and operations in services facing ef-is generally inefficient, so provision of the physi- fective competition in the relevant market,cal network is characterized by natural monopoly whether from other railroads, other transport

74 Restructuring Regulation of the Railroad Industry

modes, other origins, other destinations, or to all its traffic, it would lose the traffic forother commodities. which demand could not support the price

* Permit a railroad to set prices that are re- assigned. The remaining shippers would thensponsive to differences in demand and in be saddled with a larger portion of the carrier'smarginal costs and to enter into voluntary unattributable costs since they would no longercontracts with shippers that have individual- share those costs with the lost traffic.ized terms, conditions, commitments, andcompensation mechanisms. Ramsey pricing overcomes this problem by ap-

* Permit a railroad to charge "captive shippers," portioning all unattributable fixed and commonthose over which the railroad has monopoly costs of the railroad among its services on thepower, prices that are no higher than the basis of their demand characteristics. Each ser-stand-alone costs of the shipper's service and vice is priced at a markup over marginal costthat do not generate earnings that consistently that is inversely related to the elasticity of de-exceed the railroad's replacement costs, in- mand for that service. Under Ramsey pricing, itcluding a competitive return on capital. is the shortfall between total costs and the rev-

enues that would accrue from pricing each ser-The regulatory challenges vice at its marginal cost that is apportioned on

the basis of demand. Ramsey prices thereforeThe substantial economies of scale and scope deviate from marginal costs only to the extentin the railroad industry create several challenges necessary to provide adequate revenues-theyfor this regulatory framework. Perhaps the most permit the railroad to achieve revenue adequacytroubling is the cost allocation problem-the im- with the least sacrifice of economic welfare com-possibility of allocating, in a nonarbitrary way, pared with marginal cost pricing.a share of fixed and common costs to any oneof a railroad's many activities. There is no way Price ceilings-stand-alone costto subdivide those costs in a mechanical fash-ion that is unique and is founded in economic A critical issue for efficiency is the criterion usedlogic. Historically, regulatory authorities have de- to set the ceiling on rates where there is markettermined tariffs on the basis of so-called fully dominance. While rate ceilings derived from fullydistributed costs. Under this method, regulators distributed costs are inimical to the public inter-allocate shared production costs to individual est, economically rational ceilings can be ob-services in terms of some common basis of uti- tained from the stand-alone cost. This is the costlization, such as gross ton-miles. of serving any captive shipper or group of ship-

pers that benefit from sharing joint and com-Fully distributed cost (FDC) pricing suffers from mon costs as if the shipper or group wereseveral defects. The most serious one is that it isolated from the railroad's other customers. Thedoes not necessarily use a causal approach in stand-alone cost method finds the theoreticallymeasuring marginal cost responsibility-taking maximum rate that a railroad could levy on ship-into account how much costs would increase pers without losing its traffic to a hypotheticalif more of a particular service were used, or competing service offered by a hypotheticalhow much they would fall if less of that ser- entrant facing no entiv barriers or by a shippervice were used. Instead, costs are averaged ar- providing service for itself. Thus, the stand-alonebitrarily. A further defect of FDC pricing is its cost criterion serves as a surrogate for competi-neglect of demand data. tion and leads to a simulated competitive price.

Ramsey pricing The stand-alone cost test does not applv-andcannot be made to apply without disastrous

FDC pricing frequently "overassigns" or "under- consequences-if railroads are not allowed toassigns" a carrier's unattributable costs to par- abandon unremunerative facilities or services.ticular services. If a carrier applied FDC pricing Where that freedom is denied, a railroad can-


not earn adequate revenues if its rates on po- out, however, it is unclear how effective an equaltentially remunerative activities are constrained access mandate is likely to be.by stand-alone cost ceilings. For this reason, itis unwise for public policy to limit the free- If the integrated carrier is regulated in a waydom of railroads to curtail unremunerative ser- that permits it to charge higher prices to cap-vices without providing public funds to help tive shippers the more of their business it has,defray the costs of those services. it would have an incentive to exclude other

participants. Similarly, if regulation limits theOptions for railway restructuring amount the integrated carrier can earn from

the share of service it provides when it doesThe historical model of railway operations is cooperate with other entities, the carrier wouldthe monolithic organization, where a single en- have an incentive to undermine or avoid effi-tity controls all facilities and operating and ad- cient cooperation in order to enlarge its shareministrative functions and determines what of the service. The integrated carrier would alsoservices to provide to generally captive markets. have an incentive to exclude an efficient par-The conditions that gave rise to this model no ticipant if by doing so, the carrier, acting in alonger exist in most countries, and governments predatory manner, could weaken the potentialhave had to consider a fundamental restructur- entrant's ability to compete in another market.ing of the railway entity and of its relationship Under classic rate-of-return regulation or un-with the state. The two main options are verti- der a system of regulated 'divisions" that speci-cal separation and competitive access. fies what an integrated carrier can earn from

an activity in which there is cooperation, anVertical separation integrated carrier does have incentives to un-

dermine efficient cooperation.Vertical restructuring options that separate theownership of facilities from other rail functions, In sharp contrast, under constrained market pric-such as train operations and marketing, have re- ing, an integrated carrier would generally havecently attracted much favorable attention because a real profit motive to cooperate with an effi-they seem to segregate the difficult regulatory cient participant in its business. Under this sys-problems associated with the largely sunk road- tem. 'divisions' are not specified by regulationbed costs. If ownership of track and trains is -even on service provided to a captive ship-separate-with the track assets held by the gov- per. Instead, the stand-alone cost ceiling appliesernment, by a consortium of operators, or by a to the price charged to the shipper, and coopera-regulated private entity-there can be vigorous tion with an efficient entity enlarges the pot ofactive and potential competition over railway returns available from the service, allowing theservices provided by operators with equal ac- integrated carrier to earn more money rathercess to the roadbed. This competition would than less. Consequently, except for the rare pos-eliminate the need to regulate the operators and sibility of predation, an integrated carrier wouldgive them powerful incentives to provide effi- have ordinary business incentives to find andcient services that are responsive to the needs of to cooperate with efficient participants in its busi-shippers and a growing entrepreneurial economy. ness and to negotiate mutually beneficial terms

with them. This is just a railroad version ofCompetitive access "make-or-buy" decisions in other industries.

Unlike vertical separation, competitive access Despite the incentives for efficient behavior bypermits integrated operations by the rail entity. integrated carriers provided by constrained mar-It implies a requirement that the integrated car- ket pricing, it is useful and wise to augment therier make its facilities available to other entities system of regulation with a fallback set of stan-on a "fair and equal basis." If the integrated car- dards to apply if disputes about predationrier has strong incentives to keep other entities through competitive access should arise. These

76 Restructuring Regulation of the Railroad Industry

standards would be based on the principle that Separating track assets from operations is likelyan integrated carrier that possesses a "bottle- to be a particularly attractive option where aneck"-a facility without which the competitor dense and extensive rail network permits manycannot offer its services-should not refuse an operators to function, ensuring both active andagreement that provides for full compensation potential competition. It is also likely to workof all its costs, including opportunity costs. well where fixed facilities are mature and well

developed, limiting the domain of new infra-Efficient com7ponent pricing and parity pricing structure investments, where incentive problemsare both names that have been given to the are more likely to arise. Where fixed facilitiesprinciple that an integrated carrier should of- are not well developed, regulation of the infra-fer the services of its bottleneck at a price that structure entity should permiiit it to enter intoyields it the same return as if it had performed medium- or long-term contracts with shippersthe end user's service itself. Behavior consis- or with operators that themselves have contractstent with this principle leads to efficient verti- with shippers, so that the risks and rewards fromcal relationships and is thus consistent with investments can be efficiently shared by ship-nonpredatory incentives under the constrained pers, operators. and the infrastructure entity. Ifmarket pricing rules. Such pricing of bottle- the infrastructure entity is expected to seek re-neck facilities does not place additional com- covery of its replacement costs, it should bepetitive pressure on pricing to shippers, since permitted and even encouraged to use price dis-it is based on the return that could be earned crimination to help bring shippers' prices intofrom the shipper's service at the extant price. line with principles of Ramsey efficiency.But it does generate incentives for supplyingan efficient combination of transport services, The competitive access option could also beit does provide quality and cost competition fraught with problems if the incentives of bottle-among potential and actual participants for sup- neck holders are adverse to efficiency and com-plying part of that efficient combination, and it petition. But under rail regulation that focusesdoes help to ensure that those with efficient on the rates charged to shippers rather than oninnovations in logistics or in marketing trans- other prices, such as those charged for access toport services will be able to work with carriers bottleneck services, incentives generally promoteto implement their ideas. efficient vertical relationships. As a result, if inte-

gration is permitted under this system of priceSeparation versus competitive access regulation, the outcomes are predictably consis-

tent with efficicnt participation by the intcgratcdThe primary virtue of separation as a policy op- carrier and by other, nonintegrated carriers, ontion is that it may ensure active or potential com- terms that permit compensatory support for thepetition among rail operators or retailers-and efficient participants. Further, prices to shippersefficient selection among them for provision of can be selected in accordance with Ramsey effi-their services. However, prices are unlikely to ciencv, even as they are constrained by regula-be fully Ramsey-efficient for the coverage of re- tion where the carrier has monopoly power.placement costs, because of the difficulties ofreflecting the differences in shippers' demands This Note is based on a chbpter by the authors in Claudio Frischtak,in the prices charged for infrastructure services. ed., "Regulatory Policies and Reform: A Comparative Peispective'

At the same time, separation mav create serious (World Bank, Private Sector Development Department, Washington,At the ame tim, separtion ma createserious D.C.. 1995). To order, contact Cindy \vong at (202) 473-3606 or bycoordination problems, loss of economies of emali ([email protected]).

scope, and otherwise unnecessary transactioncosts. In addition, in thin markets, rail opera- IoannisN Kessides, Principal Economnist Privatetors may not face effective active and potential SectorDeveloprioentDepartment (email ikessides@competition, undermining the potential for re- uorldbank.org), andRobertD. Willig, Professorofalizing the primary benefit of this option. EcononmicsandPublicAffairs, Princeton Uniuersity

77

Privatizing Airports-Options and Case StudiesEllisJ Juan

The air transport sector will require large capi- Can$1.5 billion to a not-for-profit corporate en-tal investments over the next fifteen years-by tity whose board of directors will include pri-one estimate, lUS$250 billion to USS350 billionl- vate sector representatives appointed by theto modernize aircraft fleets, improve airport infederal government and end users.frastructure, introduce more sophisticated airnavigation systems, and meet the demand of Consistent with the global trend in other infra-new markets in China, Eastern Europe, and the structure sectors, in air transport the state's rolecountries of the former Soviet Union and the is shifting from owner to regulator and policy-strong growth in Southeast Asian and Latin maker, and operational, investment, and man-American markets. These large investments, toagement responsibilities are moving to thegether with a redefined role for the state, are private sector. The government's role as eco-transforming the air transport sector. nomic regulator is particularly important in light

of the fact that some airport services are inher-Traditionally, the air transport sector-airlines, ently natural monopolies.airports, and air navigation services-has beenin state hands. The private sector became in- The business of airportsvolved in the sector only recently, beginningwith the airlines. By the end of 1995, 70 per- The airport business is becoming increasinglycent of airlines were privately owned, directly multifaceted, extending into real estate, com-or indirectly. Private sector participation in the mercial. and other ventures. These activities areairports subsector is just starting, with only two of two main types: the provision of airside, orsuccessful cases of complete privatization of aeronautical, services (runways, taxiways,airport infrastructure: the U.K. government's aprons, terminals)-services that by their natureprivatization of the British Airport Authority are still considered monopolistic within each air-(BAA) in 1987 and of the Belfast International port-and the provision of landside servicesAirport (BIA) in 1994. By the beginning of 1995, (passenger and aircraft services, food and bev-however, some form of private sector partici- erage concessions, duty-free shopping, parking,pation was being implemented or was under hotels), where a wider variety of suppliers isconsideration in fifty-four countries. possible. The current trend in airport econom-

ics is to rely on commercial operations to contri-Private sector participation in air navigation is bute an increasing share to airport revenues,2

also at an early stage. Several countries, in- resulting in less dependence on increases including Germany, New Zealand, and Switzer- airside charges. In industrial economies. airsideland, recently corporatized their air navigation charges are falling in real terms, leading to higherservices through the creation of corporations traffic levels and greater airport revenues. 3

with independent financial and legal status, asa step toward eventual privatization through Private sector optionspublic offerings. And in March 1996, the gov-ernment of Canada announced its intention to Private sector participation in airports, throughsell the country's air navigation system for ownership, management, or new investment pro-

78 Privatizing Airports-Options and Case Studies

TABLE 1 OPTIONS FOR PRIVATE SECTOR PARTICIPATION IN AIRPORTS

Option 1 Option 2 Option 3

Allocation of responsibilities

Ownership State State Private sector

Investment State Private sector Private sector

Management and operation Private sector Private sector Private sector

Common strategies for Service concessions Build-operate-transfer Wraparound additions

private participation Contracting-out schemes Trade sales

Management contracts Long-term leases Build-own-operate schemes

Multiple concessions Master concessions Strategic buyouts (manage-

ment-employee buyouts)

Capital markets

Recent cases Aeroports du Cameroon Athens International Airport British Airports Authority

Pittsburgh International Lester B. Pearson Airport, Sangster International Airport,

Airport, United States Canada Jamaica

Kai Tak Airport, Hong Kong La Chinita Airport, Venezuela Belfast International Airport

Palma de Mallorca, Spain

Note:The options include alternatives for selected airside activities, selected landside activities, and all airport activities.

grams, can take many forms, including outright sector participation in airports could choose asale of shares or assets, concessions, and long- combination of the two options, beginning withterm leases (table 1). Historically, the private a BOT scheme that gives way to corporatizationsector has managed most of the landside con- with full or partial divestiture.cessions, but governments are now increasinglyseeking to involve the private sector in the pro- The following paragraphs outline cases of air-vision of airside serTices as well. The goal is to port privatization in Colombia, Jamaica, Canada,improve efficiencv, increase fiscal revenue by sell- and Northern Ireland."ing profitable concessions, and improve infra-structure through privately financed investments. Colombia-innovative financing

Although there have been only a limited num- At the end of 1993, the government of Colom-ber of privatization transactions, two options bia corporatized its Civil Aviation Authorityseem to be the most suitable for transferring (CAA), separating airport operations from airairport activities to the private sector: (1) build- navigation activities. At the same time, it under-operate-transfer (BOT) schemes (a project fi- took the development of a second runway at Elnance mechanism generally used in developing Dorado International Airport in Bogota, using acountries, where the priority is new investment BOT scheme for construction and maintenanceto upgrade and expand facilities), and (2) of the new runway and maintenance of the ex-corporatization followed by full or partial di- isting runway. In May 1995, the governmentvestiture (generally used in industrial countries, awarded the BOT concession, stipulating invest-where the priority is to obtain privatization ments of US$97 million, to the consortium ofrevenues and improve efficiency) (table 2). Ogden, Dragados, and Conconcreto. The con-Developing countries trying to promote private cessionaire's investment and operating costs, fi-


TABLE 2 CONSIDERATIONS UNDER VARIOUS AIRPORT PRIVATIZATION OPTIONS FOR DEVELOPING ECONOMIES

Option Considerations

Build-operate-transfer - Facilitates relatively large new investments

(or variants, such as build- * Maintains government ownership (transfer at a later date limits political conflict)

own-operate and build- * Requires relatively complex procedures and an array of technical and financial specifications

own-operate-transfer) * Lack of ownership rights could make raising capital funds more difficult and costly for private

sector investors

Full or partial divestiture * Generates fiscal revenues

through a public offering, * Full divestiture limits state intervention

capital markets, a trade * Public offering requires track record of profits and audited financial statements

sale, or a combination * Public offering requires developed capital markets (rare in developing economies)

nancing expenses, and profits wvill he covered Sangster Internaltional Airport (SIA in Mlontegoby the landing fee revenues, which the CAA Bay, the prograinms core case, will he expa,indedWill cede during the twenty-year concession, through the constr-uction lw SIA Ltcl. a newOnce hidders had fulfillecd the technical reqjuire- corriparnv created hv the governmient, of a newments. hids Wx Cre eValuated on the hasis of the passenger term-ninal under a huild-operate -ownnet present v-alue of the mininmm landing fee (1B00) sclhemie. Air-ports Authority of Jamaicarevenue the hidder xvould reqtuire throughlout (AAJ) will transfer- throti(gh a fortv-nine-vearthe concession periocl (lancling fees multiplied lease a',rranueinent, the operation of the exist-hy estimated traffic xolumne) and the xveighted ing passenger terlminal and the remalining land-average landing fee in U.S. dollars. The govern- side facilities to SIA Ltcl. The goxernmtent xx illment has guaranteed a mininiumu level of rexv- grant a nmanagement contract to SIA Ltd. forenues (floor pricing), in a rare case of a the operation of the airside serx ices now pro-government's accepting comnmercial Iisk. If the Xided bh AAT. So the nexx expansion, the ex-landing fee structure or traffic xolume, or hoth, isting terminal, ancl the airsicle facilities will allcannot support the required revenue stream, the he undler one nlan;igement. SIA Ltd.government xx ould compensate the concession-aire from a trust fund equixalent to 3( percent The financial capital structuL-e for SIA Ltd. callsof the annual landing fee revenue. The El for funcds to he raisecd on domiiestic, regional,Dorado transaction demrionstrates the flexihilitv and interniational markets. At least -O percentof BOT sclhemes and is hccomuing a model for of the entity's shares xwill he held hv the pri-prixvate sector participation in developing suclh xate sector, and up to 30 percent hy the gov-airside airport infrastructure as runwxays, taxi- erineint. The gox-er-nmient plans to sell sharesw-ays, and aprons. on a phased hasis in order to maximize the

gains on its inxvestrnent.Jamaica-wraparound mechanism

Canada-joint ownership structureIn an effort to expand airport facilities to ac-comniodate tourist flox s the lamaican govern- Toronto's Lester B. Pearson Airport is a rare casement establishiedl three premises to goxern both of joint public-prix'ate oxnership of fLcili-airport prixatization andl expansion: upgrades ties on shairedl premises ancl of competitix e pr-xx'ouldl hc funded primarily by the prix'ate sec- vision of airport infrastrLcture serx ices. Termiinalstor, airport operations wvould be transferred to one and t-xxo are oxxnecl and operatedl b- Trans-the prixate sector, andl the goxernment Would port Canacla, the goxernment transport author-not prov'ide guarantees. itv. ancl ter-minal three. operating since 1991. is

80 Privatizing Airports-Options and Case Studies

owned by the Tcrminal Three Limitcd Partncr- ern Ireland (DOE) retains ownership of theship (TTLP). Terminal three is operated under a golden share, which allows it to exercise powermanagement contract by Lockheed Air Terminal in instances related to matters of security and theof Canada Inc. (LATC), and it was developed public interest. In addition, under leasehold con-under a build-own-operate-transfer (BOOT) ar- trol over the 999-year lease agreement betweenrangement that includes a sixty-year renewable NIAL and the DOE, the DOE and the Ministry ofland lease contract. The development cost for Defence are authorized to enter airport land ifthe terminal, which has capacity for 10 million to NIAL fails to honor its obligation to provide fa-12 million passengers, was about Can$570 million. cilities and access to the Ministry of Defence.

Transport Canada coordinates activities between Since privatization, passenger traffic throughLester B. Pearson's privately and publicly owned the airport has increased by 17 percent, cargoterminals. It also provides air navigation services, freight by 17 percent, and turnover by 13 per-owns all runways and taxiways, and receives cent-no doubt helped by the cease-fire ac-all revenues from landing fees, passenger fees, cord in Northern Ireland.airline fuel taxes, and ticket taxes. LATC con-trols the landside activities for terminal three, The challengewhich begin when aircraft switch from generalto terminal three tower control. While airside The limited experience with airport privatizationcharges for terminals one and two are purely -especially in developing countries-makes iton a cost-recovery basis, terminal three gener- hard to draw firm lessons. There is no doubt,ates revenues through airline rents and charges however, that governments will be unable to(aircraft taxiing and parking, and terminal fees), fund all the necessary investment in airport andconcessions, and parking to cover not only air navigation infrastructure, and that the pri-higher operating costs and capital costs but also vate sector will therefore play an increasing roleprofits.5 The market is segmented: the average in meeting the sector's needs. The challenge forper passenger airside charges at terminal three developing economies is to find creative mecha-are twice as high as those at terminals one and nisms to foster private sector participation intwo, and the more prestigious international car- markets where traffic has not yet reached a lu-riers tend to use terminal three, while lower- crative threshold or transaction risks are per-cost regional or local carriers use the others. ceived to be higher than normal.

Northern Ireland-public security Internationalcivil Aviation Organization, Investment Requirements

concerns for Airporn and Route Facility Infrastructure to ihe Yeal 2010,"ICAO Circular 236-AT,95 (1992).

The privatization of Belfast International Airport 2 At a March 1995 airport conference in East Asia, an official of theThe privatzation ofBelfast Iternationl Airport International Civil Avciatiton organization com-mented that "air ports

(BIA), one of the two cases of full airport dives- todav could be viewed as large shopping malls with aircraft

titure, illustrates the complexity of dealing with cess gates instead of street exits."nationalsecurit mattersin a gepoliticalv sen- The Econcmiitf in an snidce titled 'WhIy Heatihrowv Is Hell" (Augustnational security matters in a geopolitically sen- *26,1995), argued that, theoretically, it is perfectly possible for in-

sitive context and the government's creativity and creasing commercial revenues to obviate the need for aeronautical

determination in coming up with viable solutions. charges, which, in turn, could satLfate an airport's operating capacity.

The winning bid came from a management and For more details, see Cilias. Juan, "Airpon Ircfrastmcture: The nmerg-ing Role of the Private Sector-Recent Cxperiences Based on 10

employee buyout team (MEBO Co.), which pur- Case Studies," CFS Discussion Paper Series 115 (World Bank, co-

chased the Northern Ireland Airports Limited financing and Financial Advisory- Services Deparnment, Washing-(NIAL) publc corporatin, entruste with oper- ton, D..,51995)(NIAL) public corporation, entrusted with oper- ;EBecause of the relative age of its terminals, Transport Canada

ating BIA, for about US$72 million. The airport does not include capital costs in the calculation of airside charges.

contract was awarded to MEBO Co. in July 1994,and all the share capital in NL\L was transferred EllisJ Juani, SeniorPrivatization Specialist,to MEBO Co. except for a golden share of £1. Private Sector Development Department (email:

The Department of the Environment for North- [email protected])

81

Tradable Property Rights to WaterHow to improve water use and resolve water conflicts

Mateen Tbobani

In most countries, water is still regarded as pub- Instead, governments should establish mecha-lic property. Public officials decide who gets it, nisms that provide better incentives for peopleat what price, and how it is used. The govern- to use water efficiently. One way to do so is toment also takes responsibility for building and charge a price for water that reflects its trueoperating the necessary hydraulic infrastructure scarcity. But this is difficult to do in practice,for water delivery. The track record of such ad- especially for irrigation water, which accountsministered systems of water allocation has not for the bulk of water use. Irrigation waterbeen impressive. Despite growing water scarcityand the high costs of hydraulic infrastructure, Tradable waterproperty rightswater is typically underpriced and used wastefully, the infrastructure is frequently poorly con- endow water with an i c it m oceived, built, and operated, and delivery is often implicit lue,L orunreliable. Water quality has not been well main- 't cttained, and waterlogging and salinity have not opportunity cost. 7at creates a built-inbeen properly controlled. These systems also have *to consere water and toput ittended to favor the relatively wealthy. Wealthier incentive tr ofarmers manage to get easier access to water the mostproductive vse.rights, which are usually obtained without charge to IIte os t tUvand for whose use farmers pay only a small frac-tion of the cost of building and operating the charges are typically well below the cost ofassociated irrigation infrastructure. Similarly, while obtaining additional water (its long-run mar-the better-off residents in many cities in devel- ginal cost) and often below the cost of operat-oping countries enjoy access to cheap, munici- ing and maintaining the irrigation infrastructure.pally supplied water, many of the poor in the Raising water charges to the long-run marginalsame cities must resort to very expensive private cost would result in prices that would bank-water truckers to meet their daily needs. rupt many farmers-an option that is usually

politically and socially unacceptable. A moreRecent government efforts to improve the man- realistic way to bring about efficient use is toagement of water resources have moved away allow water trading. Some water-scarce coun-from building hydraulic infrastructure to strength- tries have adopted this alternative, permittingening institutions, improving pricing policies, informal sales of water for a season or perma-and handing management down to water asso- nent sales of property rights to water (box 1).ciations and communities. This approach hasworked well when public funds have been avail- Advantages of tradable propertyable, when institutions have been strong and rights to watereffective, and when there has been close coop-eration among water users. But as public fi- Improved productivity of waternances become more strained and conflictsamong users grow, the chances of this approach Tradable water property rights endow water withbeing successful grow slimmer. an implicit value, or "opportunity cost." That

82 Tradable Property Rights to Water

BOX 1 WATER MARKETS ATWORK

Poor public sector allocation of water has led some water users utilities) property rights to water without charge. It auctions

in developing countries to buy and sell water commercially, new water rights. Subject to certain regulations, these rights

which helps resolve water shortages and improve the produc- can then be sold to anyone for any purpose at freely negotiated

tivity of water. Most of the water trading has taken place prices. They may also be used as loan collateral.

between farmers. A 1990 survey of surface water systems in *In recent years, Mexico and several states in Australia

Pakistan found active trading for irrigation water in 70 percent have established property rights to water, though they have

of the watercourses studied. In India, an estimated one-half of initially placed substantial restrictions on intersectoral

the area irrigated bytubewells belongs to farmers who buy trading.

water. In the Maghreb countries, private arrangements for * In the Northern Colorado Water Conservancy District in the

trading water exist among farmers, even though it is illegal. But United States, water brokers assist in millions of dollars of

such transactions have been limited to spot sales of water or to water trades annually and commercial bankers routinely

the sale (lease) of water for a single year rather than to accept water rights as loan collateral.

permanentsales of water rights.The difficulty in enforcing X Peru's 1993 constitution treats land and water resources

contracts in such a market has tended to confine the transac- equivalently, and thus permits tradable property rights to

tions to users in the same sector, often neighboring farmers. The water. A draft water law proposes that these rights can be

lack of secure, long-term access to water under such a system traded, leased, or used as collateral. Property titles would be

discourages investment in activities that require access to large given free of charge to those who already hold water rights

quantities of water. Thus, such water markets realize only a either implicitly by custom or explicitly through licenses and

small part of the potential gains from trade. permits. Rights for presently unused water would be

To allow water users to secure water on a permanent basis, auctioned subject to protections that ensure that the

and to facilitate water leasing, some countries have begun to availability of water to others is not reduced, that there is

pass legislation to permit tradable property rights to water: enough water to maintain a minimum ecological flow, and

Under Chile's 1981 water law, the state grants existing that people in neighboring towns retain their accustomed

water users (farmers, industrial firms, water and power access.

creates a built-in incentive to conserve water ment. Despite the lower water charges, the op-and to put it to the most productivc usc. For portunity to sell water ensures that scarce waterexample, if farmers were able to sell their water is not used wastefully.rights at freely negotiated prices, some mightchoose to generate extra income by selling any Sound investmentsurplus rights to a neighboring city where thewater has a higher value.' Often they can gen- Tradable water rights can help shift water toerate a surplus by using morc cfficient irriga- highcr-value uses in a way that is chcapcr andtion techniques or by switching to less fairer than some of the present alternatives.water-intensive crops. Thus, a tradable water These alternatives include building expensiveproperty rights system can lead to voluntary con- new hydraulic infrastructure, confiscating wa-servation and increases in the productivity of ter from farmers, or substantially raising waterwater without having to increase water charges. charges to force farmers to conserve water andIn fact, in Chile, water charges fell following the to free up water for higher-value uses, such asintroduction of the tradable water rights regime. for "raw" city water. Although the conveyanceThe fall occurred because this regime facilitated infrastructure to transfer traded water must al-the transfer to user groups of the responsibility ready exist or be built, the cost of building it isfor carrying out operation and maintenance often less than that of developing new sources(O&M) activities and for setting water charges of water. Thus, the city of La Serena in Chileand because users were able to carry out O&M was able to meet its rapidly growing demandactivities at a much lower cost than the govern- for water by purchasing excess water rights from


farmers at a lower cost than the alternative of it will be theirs to keep or to sell to others (farm-contributing to the construction of the proposed ers, industry, hydropower and water companies).Puclara dam. (The construction of the dam has Secure rights to water could also attract privatenow been postponed indefinitely.) Farmers got investment to large public hydraulic projects un-a good price for their water and faced incen- der construction, enabling them to be completedtives to use more efficient irrigation techniques. faster and more cheaply. Public projects tend toBetter incentives to conserve water also help run into enormous delays and cost overruns be-control soil salinity, which is caused primarily cause governments run out of money and be-by overwatering. Therefore, by creating trad- cause there is less incentive than in privateable water rights, Chile was able not only to projects to control costs. If a government wantedavoid the water conflicts that often arise when to privatize an ongoing project, it could do sogovernments confiscate water from farmers and by selling the hydraulic infrastructure anddivert it to urban domestic consumption, but unallocated water and land rights associated withalso to avoid the environmental costs associated the project, but with the condition that the buyerwith new dam construction and soil salinity. respect existing land and water rights.

Farmers also benefit from having more secure Creating tradable rightswater rights and an asset that can be used ascollateral for lower-interest loans. Secure water Water has several unique characteristics thatrights are particularly beneficial for small farm- present special challenges for policymakers de-ers, who have been most vulnerable to reduc- signing a framework for a well-functioning mar-tions in their water allocation over time and who ket in water rights. The issues relate to defininghave few other sources of collateral. And water water rights when water flows are variable, mea-rights, because of their divisibility, give large suring water, enforcing contracts, building thefarmers the possibility of mortgaging only part necessary infrastructure to transport water, mini-of their water rights for small loans, rather than mizing damage to third parties. protecting againsttheir entire land and water holdings. environmental degradation, and avoiding mo-

nopolistic pricing practices. Finally, a market forIncreased investment and growth water rights will not lead to adequate invest-

ment in some potentially high-return activitiesIn addition to stimulating growth directly by (flood control, drainage, prevention of soil ero-improving the productivity of water, tradable sion, siltation reduction) that by their nature areproperty rights to water will encourage invest- not profitable for a private investor.ment and growth in activities that require as-sured supplies of large quantities of water. The Most of these market imperfections and theexistence of such rights assures investors that policy issues they raise are not peculiar to atheir water rights will not be subordinated to water system based on tradable rights. All wa-those of other users during times of shortage ter systems must deal with them. Water rightsand that, in fact, they will be able to buy water need to be assigned and enforced even underfrom those with a less valuable use for it. Thus, an administered system. and the conveyanceChile's 1981 water code allowed investment in infrastructure still must be built. But a marketfruit production to proceed rapidly, and helped system increases the value of water, so there ismake Chile a major fruit exporter. more incentive to clearly define water rights,

to improve measurement and enforcement, andTradable rights should also stimulate private in- to establish an efficient mechanism to resolvevestment in new hydraulic projects. The secure disputes. Similarly, the same environmentalrights will give potential investors the confidence laws and institutions needed to enforce envi-that, once they obtain the rights to the water ronmental quality under an administered re-generated by their investment (for example, stor- gime can operate under a tradable water rightsage reservoirs and conveyance infrastructure), regime. Moreover, water user associations,

84 Tradable Property Rights to Water

which can play a useful role under either an Conclusionadministered allocation system or a market re-gime, are more likely to be established or Under a tradable water rights system, the pub-strengthened if water rights are well defined lic sector's role in the construction, operation,and transferable. and maintenance of hydraulic infrastructure can

be reduced to financing selected high-returnMarket imperfections can best be addressed by activities with strong positive externalities orappropriately formulated laws, regulations, and public good characteristics. The market-nottaxes. For example, difficulties in defining wa- the government-will determine the allocationter rights in the face of variable water supply and pattern of water use and the prices chargedcan be handled by defining water rights as a for water rights. Water user associations willpercentage of stream flow (as in Chile) or by determine water charges for operation andspecifying different classes of rights (as in Colo- maintenance. But there is an important rolerado).2 Similarly, defining water rights suitably for government in formulating laws and regu-or implementing appropriate legislation can lations to establish tradable property rights tohelp reduce negative hydrological effects on water. The design and implementation of thisthird parties that could occur when water is legislation should pay particular attention totransferred to other activities.3 the initial allocation of water rights, dispute

resolution mechanisms, creation and mainte-For the most part, there is little danger of wide- nance of a water rights registry, and the mini-spread monopolies in consumptive water rights. mizing of negative hydrological effects for thirdMonopolies could occur, however, following parties. Public authorities also will need to de-privatization of hydraulic projects with large sign and enforce environmental laws.amounts of unallocated water rights or innonconsumptive water rights for hydropower. This approach has the potential to increase theTo avoid this risk, countries should develop productivity of water use, improve operationan appropriate regulatory framework before and maintenance, stimulate private investmentprivatizing any large hydraulic infrastructure, and economic growth, reduce water conflicts,introduce a tax on water rights holdings while rationalize ongoing and future irrigation de-simultaneously removing any land tax sur- velopment, and free up government resourcescharges on irrigated land, and establish regu- for activities that have a public good contentlations determining power tariffs. or positive externalities. And it is likely to es-

pecially benefit the poor and to help conserveHow the initial property rights to water are al- natural resources.located is crucial to the acceptance and suc-cess of a water market. The approach will vary The price of properto rights to water has little relation to the water

by country. Where there is already a well-func- charges or tariffs for operation and maintenance activities. To use

tioning registr-y of water rights, it is sufficient an analogy from the condominium market, one can think of the

to simply reregister the rights in a newly cre- pore of water rights as the purchase price for the aparnment andreregister ~~~~~~~~~~~the water tariff as the condlominiuim fee.ated property rights register. Where the exist- 2 To learn more about these and related issues, see Mark Rosegrant

ing registrv contains manv overlapping property and Hans Binswanger, ' Markets in Tradable Water Rights: Potential

rights (with the sum of water rights exceeding for Efficiencv Gains in Developing-Country- Irrigation, W'orld De-rights (wit the sum ofwater right exceeding relopmenetl22 (It, 1994).

the water available), however, it would be bet- For a discussion of third party effects and various solutions, see World

ter to base the initial allocation on past use. Bank, 'Peru: A User-Based Approach to Water Management and Irri-

Where there are gross abuses of water rights, gation Development," Report No. 13642 PE (Latin America and theCaribbean Country Department III, \vashington, D.C., 1995). TMe

it is probably best to assign rights on the basis paper discusses many of the issues in this Note in greater detail.

of need or with a reasonable upper limit onirrigation water per hectare. In all cases, it is Mateen Thobani, SeniorEconomist, Latinimportant to ensure that the rights of the poor America and the Caribbean, Technical Depart-are respected. ment, (email: [email protected])

85

Regulating Water Companies

.MVichael Klein and Timoth-y Irwin

The water industry differs in two key respects ter sellers have an incentive to sell water at afrom other network industries, such as gas, elec- price not much higher than its cost and to taketricity, and telecommunications. First, there are steps to show that the water is safe to drink.fewer opportunities for introducing competi- But the arrival of piped water changes every-tion among suppliers, since the network of thing. It is much, much cheaper than waterpipes is a major element of the total cost of sold by vendors, as table 1 suggests. In thewater and can be operated efficiently only as a Asian cities in the table, these lower prices aremonopoly. Second, the quality of water is cru- due in part to government subsidies. But evencial, but hard for consumers to check. Together, when the subsidies are taken into account,these problems mean that getting the best per- piped water is still at least 50 percent, and usu-formance out of water companies requires regu- ally 75 percent, cheaper. At the same time,lation by the government of the price and however, consumers lose the choice of suppli-quality of water. ers that they used to have.

To regulate well, however, the regulator needs In the nineteenth century, water companies laidto have an idea of how much it would cost an competing pipelines in towns in Canada, theefficient company to supply high-quality water. United Kingdom, and elsewhere. But it is usu-One way of generating that information is to ally efficient to have just one network of pipes,auction the right to supply water every twenty and as a result of either free competition oryears or so. Firms state the price at which they municipal regulation, the compeLing networkswould be willing to supply water of a specifiedquality, and the firm offering the lowest pricewins the contract. In between auctions, how-ever, regulators need to use other methods to TABLE 1 PRICE OF VENDED AND PIPEDadjust the price in response to changing circum- WATERstances. No method is perfect; the best may be (U.S. cents per cubic meter)to increase the price every year by the rate ofinflation, perhaps with an adjustment for ex-pected productivity changes, and review the City Vended Pipedprice every three to five years to ensure that thewater company's profits are reasonable. The im- Bandung 616 10portance of investments to maintain the quality Jakarta 185 17of water means that regulators should be care- Manila 187 11ful, when reviewing prices, to allow the firm to Karachi 175 8cover the costs of such investments. Ho Chi Minh 151 8

Why regulate water companies? Sot,rce:Asian Development Bank, Water Utilities Data

Pooh-Asiarn and Pacific Regioni IManila, 1993).When water is sold by street vendors, consum-ers have a choice of suppliers. As a result, wa-

86 Regulating Water Companies

of the nineteenth century soon turned into mo- plants (figure 1) could sell water to a companynopolies. Technically, the water supply system that distributed it to consumers through oneis a natural monopoly: the cheapest way to network of pipes. Although such a system hassupply water involves just one firm owning a recently been proposed in Chile, no one hasnetwork of pipes. Water monopolies, of course, yet succeeded in implementing this sort of com-can and do exploit their privileged position. In petition. The reason is probably that network-the worst case, they may even be able to charge related costs are a larger proportion of totalas much for water as the street vendors, in costs in the water industry than in gas, elec-which case all the benefits of piped water ac- tricity, and telecommunications. The gains tocrue to the monopoly. be made from introducing competition in, say,

water collection and water treatment are thusrelatively small, and they have to be weighed

FIGUR 1 MAIN COMPONENTS OF WATER AND SEWAGE SYSTEMS against the coordination problems introducedFIGURE 1 MAIN COMPONENTS OFWATER AND SEWAGE SYSTEMS by splitting up ownership of the system.

Competitive water supply may be efficient nearBulk storage the boundarv of two water companies' territo-_ ~~~~Bulk storageIreservoirs ries or in regions where water is very scarce

and therefore where the cost of the network islower relative to the cost of the water. Compe-

; Service tition is also possible for services peripheral to=-n ~~~~~~~~~~~storage

\ i - / _ l reservoirs the main service, such as connecting new us-ers to the system. But for the time being, mostwater will be supplied monopolistically, and

'Nater ^ society needs some way to encourage efficiencytreatment T despite the monopoly.

Wastewater e Distribution The difficulty of regulating welltreatment & \ to customers

IIF----and waste- In villages, consumers can form cooperatives towat1 coietion run the water system themselves; since the pro-

collection ducers are also the consumers in such a system,

Surface drainage they have good reason not to charge too muchfor water or to be careless about its quality. But

t in larger regions, consumers need to delegateSource:North West Water,'TheAdvanced Water Cycle"(1994). the problem of setting prices and quality stan-

dards to someone else. The traditional option isto delegate it to the government. Government

In some industries in which networks are impor- ownership doesn't automatically solve the prob-tant-gas, electricity, and telecommunications- lem, however. Monopoly suppliers of all typesgovernments have limited the scope of the natural are tempted to charge high prices or to lowermonopoly problem by separating production quality. And government ownership introducesfrom transmission through the netvwork. Thus, its own problems, since the government, as ancompeting electricity generators, for example, can owner, usually exerts relatively weak pressuresend power to consumers using one network. on firms to lower their costs.Theoretically, this is possible in water too.

Whether the water firm is publicly or privatelyCompeting water "production" firms that own owned, the key to achieving efficiency lies inthe bulk storage reservoirs and water treatment the choice of a regulatory mechanism to over-


see the firm's performance. Good mechanisms A big part of the regulatory problem, there-protect consumers from high prices and low fore, is to design rules that give the regulatorquality. But they also safeguard the legitimate access to better information about the appro-interests of the water companies, since, if the priate price of water.companies are to invest, they need to believethat the regulators will let them earn enough How to generate good informationrevenue to make a reasonable profit.

Probably the best way of discovering the ap-If the regulator had enough information-in par- propriate price is to establish a competitive sys-ticular, if it knew what it would cost an efficient tem of tendering-or "auctioning"-the right towater company to produce water of different supply water. The regulator says, for example,qualities-it could simply rule that the actual that it wants a firm to provide water of a speci-water company had to sell water of a certain fied quality. It then asks firms to propose a pricequality for a price equal to the efficient firm's for supplying the water. The firm that proposescost of production. That price would be just high the lowest price wins the right to supply theenough to allow an efficient water company to district at that price (or perhaps at the price ofmake a reasonable profit, but no higher. Nei- the next-lowest bidder-the details of the auc-ther the company nor the consumer would be tion can vary). In principle, the most efficientexploited. And, as technology and demand supplier of water will win the auction, and thechanged, in this perfect system. the regulator resulting price will be appropriate.would revise the price and the quality standardso that they were always at the right levels. Experience confirms the value of auctions. In

Buenos Aires in 1993, for example, the winningIn fact, of course, the regulator cannot easily bidder offered to deliver water at a price abouttell how much it would cost an efficient firm 27 percent lower than the price under state own-to produce water. At best, it can observe ac- ership. Although the price later increased, it re-tual firms' costs, but these can be concealed mained lower than it had been. What's more,by clever accountants. Moreover, an important the new supplier agreed to invest USS200 mil-part of a water firms cost is the cost of the lion a year for the first five years, comparedfinancial capital tied up in the firm. Estimating with annual investment of USS20 million tothe cost of that capital requires an estimate of US$40 million in the preceding years. In anotherthe riskiness of the investment, complicating example, a small town in France managed tothe regulator's information problem yet further. cut the price of water from 3.0 francs per cubicWith imprecise cost estimates, there's always a meter to 1.7 francs when it decided in 1994 torisk that the regulator will set the price too auction the right to supply water.high. hurting consumers and unnecessarily dis-couraging water use, or too low, encouraging Yet auctions are no panacea. To keep up withthe wasteful use of water and discouraging in- changes in technology and demand would re-vestment by water companies. quire repeating the auctions every couple of

years-which is what happens. for example,In addition, because the regulator probably with garbage collection in many cities. Waterguesses what it would cost an efficient firm to companies. however, must make investmentsproduce water partly by observing the actual with a life of decades that have little value inwater company's costs, the water company no other uses. Pipes, once laid, will last for years,longer has such a strong incentive to produce and digging them up later to move them to aefficiently. Since lower costs would lead the new site is prohibitively costly. A water com-regulator to lower the price the company can pany that could easily lose its contract in ancharge. the company would not get all the ben- auction next year would therefore be justifi-efits of ctitting costs. ably cautious about long-term investments.

88 Regulating Water Companies

The problem is partially addressed by requir- by water companies. Care needs to be takcn,ing a new winning firm to pay the old firm for however, to avoid re-creating the problem ofthe pipes and other immovable assets. But compensating the company for cost increasesworking out the price the new firm should pay it could have avoided.is difficult. For one thing, the pipes are under-ground and their condition is hard to assess. RPJ-X price adjustments are probably betterTo encourage valuable investments, then, auc- than rate-of-return price adjustments, but thetions must be repeated only infrequently (ev- difference between them is not as big as it mightery twenty years perhaps), or the incumbent seem. RPI-X formulas need to be reviewedmust be given an advantage over other bid- every three to five years or so, since the regu-ders. But either way some of the benefits of lator does not know exactly how large Xshouldthe auction are lost. First, an incumbent with a be and, in reviewing whether X was set ap-privileged position has weaker incentives to propriately, will take into account the profitsoffer the lowest possible price at the next auc- being made by the firm: for example, if theytion. Second, technology and demand-and are very large, X is probably too small. In ad-therefore the appropriate water price-change dition, the importance of quality means thatduring the term of a twenty-year contract. Be- regulators should allow firms to pass on thetween auctions, the regulator must again try to costs of reasonable investments that maintainestimate how the right price has changed. water quality.

How to adjust prices The undesirable incentive effects of both RPI-Xbetween auctions and rate-of-return adjustments can be reduced

by comparing the prices charged by other wa-How should regulators adjust prices between ter companies in different, but sufficiently simi-auctions? Ovcr three- to five-year pcriods, the lar locations, as happens in thc United Kingdom.best option is probably to adjust them in a If comparable companies can profitably sell wa-mechanical way. Traditionally, regulators in the ter at lower prices than the company under ex-United States have adjusted prices so as to keep amination, the regulator may be justified inthe company's rate of return on capital at a keeping prices low despite low profits.constant level: if the company's rate of returnfalls below that level, the regulator allows prices Michael Klein, Alanager, Private Sector Devel-to rise. The problem with this method is that it opnient Department (email: mklein@gives the company little incentive to limit its worldbank.org), and Timothy Irwin, Privatecosts and, when the target rate of return is Sector Develop ment Department (email:higher than the cost of capital, it gives the com- tirwinaworldbannk.org)pany a strong incentive to invest more-in any-thing at all.

More recently, therefore, the United Kingdomhas chosen to change the price by means of aformula, known as RPI-X, that increases thewater price by the increase in the retail priceindex adjusted by a factor, X, to account forexpected productivity gains and other changes.Under this method, the company has incen-tives to lower costs, since it keeps the result-ing profits. The method can also be refined bychoosing a price index that relates more spe-cifically to the input price inflation experienced

89

The Guinea Water Lease-Five Years OnLessons in private sector participation

PenielopeJ. Brook Cowen

Until the late 1980s, Guinea had one of the In the contract's first five years, connections in-least developed urban water supply sectors in creased from 12,000 to 30,500. (But as many asWest Africa. Less than 40 percent of urban 10,000 are now inactive as a result of nonpay-dwellers had access to piped water through ment.) Metering has increased from about 5 per-either connections or standpipes. Where con- cent to 95 percent of all connections. Investmentsnections existed, service was often interrupted, in new supply capacity (external to the lease),and water treatment inadequate. To improve combined with rehabilitation and maintenance,this situation, the government of Guinea in 1989 have brought about a substantial increase in theentered into a lease arrangement for private population with access to safe water, from 15sector operation of water services in the capi- percent in 1980 to 52 percent in 1994. And withtal city, Conakry, and sixteen other towns.' progressive tariff increases, the average tariff

(US$0.90 per cubic meter) now more than cov-Two organizations are central to the lease ar- ers costs. SEEG's water revenues rose almostrangement: a state-owned national water au- tenfold between 1989 and 1994, and the oper-thority, Societ6 Nationale des Eaux de Guin&e ating ratio (the ratio of operating costs to oper-(SONEG), and a water management company, ating revenues) improved from 122 percent toSociete d'Exploitation des Eaux de Guinee 71 percent. In an environment in which earlier(SEEG). SONEG owns the water supply facili- attempts to secure reliable access to safe waterties in the cities and towns covered by the lease. had foundered, and in which financial sustain-it is responsible for sector development, inability had seemed unreachable, these achieve-cluding planning and implementing new in- ments are truly impressive.vestments, and for servicing sector debt.SONEG also has responsibility for setting tar- Ongoing issues and problemsiffs. SEEG is jointly owned by the state (49 per-cent) and a foreign private consortium (51 Despite these gains, two broad concerns arisepercent). SEEG holds a ten-year lease contract about the performance of Guinea's lease con-with SONEG under which it is responsible for tract. First, the water supply system, particularlyoperating and maintaining urban water supply in Conakry, has not improved and expanded asfacilities, billing customers, and collecting fast as had been hoped. Unaccounted-for watercharges. The private partner provides manage- remains high, at about 47 percent. New con-ment services to SEEG through a separate man- nections to the system have been added slowlyagement contract. At the start of the lease, the -though the lease did not specify targets. Sec-consumer tariff was raised from US$0.12 to ond, the relationship between SONEG and SEEGUS$0.25 per cubic meter. This tariff was still has not been smooth, lessening the efficacy oftoo low to cover operating and debt servicing SONEG's monitoring and regulation.costs, so in the initial years of the lease thedifference between tariff revenues and costs Physical progresswas funded by an International DevelopmentAssociation (IDA) credit. This subsidy has de- Both SEEG and SONEG have some capabilityclined stepwise as tariffs have increased.2 to influence the rate of new connections and of

90 The Guinea Water Lease-Five Years On

reduction in unaccounted-for water. But each In Guinea, the government has had limited suc-tends to attribute slow progress to failures by cess in bringing clear commercial incentives tothe other. For example, SONEG attributes the bear on the private sector company in its op-slow pace of new connections to SEEG's reluc- eration and maintenance roles. NWeakness intance to make connections from existing exten- SONEG's monitoring of SEEG could have broadsions to the network, while SEEG argues that repercussions. For example, in the absence ofmuch of the demand for new connections is in adequate reporting and monitoring, SONEG will

areas where SONEG has yet to invest in net- have difficulty assessing the soundness of SEEG swork extensions. For unaccounted-for water, requests for increases in the overall tariff and inSONEG's slowness in procuring rehabilitation its share. To the extent that SONEG respondsworks is probably a factor, but SEEG's incen- passively to proposals from SEEG for tariff in-tives to reduce losses have almost certainly been creases, SEEG's commercial risk is lessened. Atweakened by its low production costs. Commer the limit, if the tariff is set on a cost-plus basis,cial losses are rising as tariff increases lead to the lease will approximate a management con-more defaults on bills and stronger incentives tract (and one without specific performance tar-for illegal connections. Nonpayment by govern- gets and enforcement mechanisms) andment departments was a major problem in 1995. commercial risk will be borne exclusively by

the government. (In practice, tariffs have risenAttempts to improve coordination between steadily. The current US$0.90 tariff is high bySEEG and SONEG are unlikely to resolve con- the standards not only of developing countries,cerns about unaccounted-for water and new but also of industrial countries.)connections. The coordination of new invest-ment with operation and maintenance will re- A second cost of weak monitoring and enforce-main problematic as long as commercial risks ment is a reduced capacity to enforce separationare shared between the two entities and SONEG between SEEG's extension and rehabilitationremains the principal financier of works that activities and its operation activities. For ex-contribute to SEEG's effectiveness as an op- ample, where monitoring is weak. financialerator. The problem is further aggravated by a transfers between activities putatively subjectlack of clear separation between SEEG's ac- to comrmercial risk and those performed on ativities as an operator, for which it theoreti- cost-plus basis might go undetected. Again, thecally bears some commercial risk, and its result could be a reduced capacity by SONEGactivities as a serivice contractor to SONEG for to control its own commercial risk.rehabilitation and extension works, which areperformed on a cost-plus basis. Lessons

Institutional efficacy The Guinea lease represents an innovative,broadly successful attempt to draw on the

Lease contracts require a high level of adminis- strengths of the private sector to improve watertrative capacity, and solid political will to en- services. It wvould be unfair, and inappropriate,force their letter and spirit. They are not to use hindsight to criticize arrangements thatnecessarily easier to administer and regulate than are a major advance over earlier attempts to im-contracts for more fully fledged private sector prove water service delivery in low-incomeinvolvement, such as concessions. A lease may countries and that have produced real gains forbe simpler to administer than a concession be- consumers. But hindsight can provide guidancecause the administrator does not need to define for ongoing improvements in Guinea and foror monitor investments by the lessee. But leases future projects in other countries. Many low-require coordination and the allocation of com- income countries, from the transition econo-mercial risk between the government, as inves- mies of Central Europe to African nations suchtor, and the private sector, as operator. as Angola and Mozambique, share Guinea's


problems in improving water services. Im- planned. The risk sharing implied by a step-proving and expanding service requires large wise process has proved difficult to implementinvestments. The government's capacity to un- and enforce, with the result that gains to con-dertake the required investments directly or to sumers have been less than hoped for andoversee their implementation is limited. Pass- much suspicion remains between the publicing as much investment responsibility to the and private sectors. The question then arisesprivate sector as possible-as soon as possible as to what other countries might do to repli--is thus highly desirable. cate the gains of the Guinean approach while

avoiding some of its shortcomings. Two broadPrivate sector companies, however, have been options present themselves: privatization by lessassumed to be unwilling to make large invest- ambitious steps than were attempted in Guinea,ment commitments in the water sector in very or an altogether bolder, larger step towardpoor developing economies. Water sector as- privatization.sets amortize over long periods and have lim-ited or no resale value. Where capital markets Privatization in small stepsare underdeveloped, an investor who wants tosell out may have limited ability to dispose of The key to an effective gradual move to pri-his shares. On top of this, the water sector is vate participation is, at each stage in the pro-prone to government intervention. In this kind cess, a realistic and enforceable allocation ofof environment, the credibility of the govern- functions and risks between the parties. Func-ment as a long-term contractual partner or regu- tions and risks should be allocated in accor-lator, or both, is critical to the willingness of dance with the comparative aclvantages of theprivate companies to invest in the sector, and parties in performing the functions and man-to the price tag that the private sector will, one aging the risks. For example, if exposure toway or another, place on its involvement. commercial risk is the primary source of per-

formance incentives for a private partner, thatGuinea sought to resolve these problems by in- risk should be borne by the private partner. Iftroducing private sector involvement and com- the private partner is unwilling to take on anymercializing the water business in a gradual, substantial commercial risk, a lease or a con-stepwise manner. Using a lease arrangement, cession should be abandoned in favor of a man-rather than a full-fledged concession or asset agement contract with few, largely indisputable,sale, meant that the private sector was not re- performance targets (as is proposed, for ex-quired to commit any investment funds. Using ample, for Angola).an IDA credit to smooth the process of tariffincreases meant that the operating business If government agencies lack the capacity tocould function on a quasi-commercial basis from monitor and enforce contracts with the privatethe beginning. The government's minority share sector, the factors to be monitored should bein the operating company presumably gave as- as simple as possible. This again favors a man-surances that there would be some local share agement contract over a lease. Industrial coun-in the benefits of commercialization, beyond the try blueprints for regulatory structures andbenefits from improved services. The expected functions should be avoided in favor of care-benefits were twofold: early and lasting gains ful analysis of the minimum administrative andin the availability of services and the efficiency regulatory functions required, and of the com-of service delivery, and, in the medium term, parative advantage of different agencies in per-the creation of an environment more attractive forming these functions without undue politicalto private sector investment and risk taking. interference. One option is to contract out parts

of the monitoring function to private sectorThe Guinean approach, while producing im- auditors. (This approach has been proposed,portant gains, has not worked out exactly as for example, in Albania.)

92 The Guinea Water Lease-Five Years On

If investment needs are substantial and require isting assets, to the establishment of a crediblesome contribution of government (or multilat- regulatory authority, to the development oferal) funds, the contractual arrangement cho- passably liquid domestic debt and equity mar-sen should be cognizant of the tradeoff between kets. The question that then must be asked isthe costs of relatively inefficient government ad- whether the benefits of these actions exceedministration of investments and the risks of con- their combined costs and the costs imposedtracting with the private sector to administer by delays in mobilizing the incentives for theinvestments it does not fund. If investment re- private sector to improve efficiency. Welfaresponsibility is passed to the private sector, rela- might be increased more by immediate, fulltively sophisticated monitoring may be required privatization, even if that requires a subsidy,to control profit transfers between investment than by postponing privatization while usingand operation activities and to minimize gold- various government instruments to make thingsplating. Realistically, the private sector partner better. Full private involvement is likely to bringmust be expected to take some rents. Monitor- larger and more immediate welfare gains, foring will not eliminate these rents, but it can help example, if the private sector partner is in akeep them within socially acceptable bounds. better position than the government to rapidly

improve and use information about the utility'sIs a big jump better-or even possible? physical and commercial status or to develop

risk management programs. Such an approachTwo arguments might be made for a stepwise may never be politically attractive, but it is anapproach to private sector participation. First, alternative that should be recognized when-a stepwise process may be necessary if no repu- ever gradualism is advocated.table private sector company is willing to in-vest in the water sector in poorer developing In arguments for gradualism in involving thecountries. Second, a stepwise process may private sector in water, there is an implicit ten-improve the terms of private sector involve- dency to gamble more on the likely benefits ofment from the perspective of consumers. government initiatives than on the likely ben-

efits of private initiatives. Policy advisers haveThe first argument can be put to a market test. traditionally been more concerned about pri-A likely result in many low-income countries vate sector rent seeking at the expense ofis that no experienced private sector water com- customers than about the costs, failurcs, or rent-pany will take on full operational and invest- seeking activities of government utilities. In prac-ment responsibilities unless it is paid to do so, tice, the most feasible and least risky strategy isbecause of the high risk. Such a payment may rarely that which relies least on the private sec-well be politically infeasible. Still, the need to tor. Market testing of the kinds of deals that thesubsidize entry does not in itself mean that a private sector is prepared to take on, and ofstepwise process would be objectively better their price, is essential in continuing to identifythan a "big jump." A negative valuation of a the best options for the neediest countries.water company by private bidders might re-flect a compound of expectations and risk as- Lease arrangements are discussed in Pierre Guislair and Michel

sessments-about the relation between the Kerf, "Concessions-The NVay to Privatize Infrastructure Sector

tariffs that the government would likely allow Monopolies' (page 21 in this volume).and the costs of establishing a reasonable level 2 Thelma Triche, "Private Participation in the Delivery of Gulinea's

Water Supply Services," Policy Research Working Paper 477 (World

of service, about the uncertainty over the gov- Bank, Washington, D.C., 1990).

ernment's future regulatory behavior, and aboutthe salability of the private company's stake. PenelopeJ Brook Cowen, Private Sector Devel-Thus, to secure a positive price, the government opment Specialist, Transport, WXater, and Urbanmight need to take actions ranging from inten- Development Departmnent (email pbrook@sive information gathering on the state of ex- wvorldbank.org)

93

Sydney's Water-A Suitable Casefor Private Treatment?

Ross Chapman and Sandy Cuithbertson

Until recently, Sydney's water was captured, sumed in Sydney will be treated by these plants.stored, treated, and reticulated by Sydney Wa- This analysis of the Sydney experience may pro-ter, a state-owned corporation. Sydney Water vide insights for other agencies contemplatinghad been a statutory authority, the Sydney Wa- the private provision of treatment services.ter Board, until it was corporatized in 1995.The water supply system, designed in the nine- Choosing the operatorteenth century and restructured in the mid-twentieth, drew on raw water that was of good Once the decision had been made to involvequality by world standards, and until 1989 treat- the private sector in providing treatment sys-ment went little further than screening, disin- tems, important questions arose about howfection, and fluoridation. But as water quality many contracts should be awarded and whatguidelines became more stringent, Sydney's raw restrictions should be placed on successfulwater came under increasing stress. tenderers. The Board determined that three con-

tracts would be awarded for the four proposedAfter establishing that consumers were willing treatment systems, combining the two smallestto pay for maintaining the quality, the Board systems under a single contract. The successfuldecided to contract for a privately built, owned, bidder for the largest project would be ineli-and operated (BOO) system for water treatment. gible to tender for the other two. Under the pro-Responsibility for harvesting and storing raw tocol for accepting bids, only bidders that hadwater and delivering treated water would re- not successfully bid for one of the other con-main with the Board (and later, Sydney Water). tracts, and that met the minimum acceptableSeveral factors persuaded the Board to adopt technical standards, would be considered.the BOO system for water treatment. It facedmajor capital outlays to upgrade and expand The initial allocation of bargaining power underwastewater treatment capacity. There was a these procedures helps set the basis for negotia-growing likelihood that it would be corporatized, tions that may be required during the life of amaking a "delegated service" approach involv- contract. For example, if it became necessary toing the private sector and providing access to a expand plant capacity during a contract, the waterfull range of international technology attractive. treatment company would need to renegotiateAnd the subsequent involvement of seventeen water tariffs to recover its expansion costs. Byconsortia in the "tournament" for the market re- opting for several operators, the Board gains ac-vealed a level of competition likely to produce cess to information from each that can be usedoutcomes that the Board, relatively inexperi- as a benchmark in assessing the performance ofenced with filtration systems, would find diffi- the others and in negotiating tariff adjustments.cult to match. In 1993, the Board contracted with It also gains access to a wider range of watertwo consortia-Australian Water Systems and treatment technologies, strengthening its hand inNorth-West Transfield-for two water treatment future expansions and upgrading.plants. A third contract was let to another con-sortium, Wyuna Water, in 1994. By the end of This approach has costs, however. For example,the century almost all the drinking water con- the successful bidders for the second and third

94 Sydney's Water-A Suitable Case for Private Treatment?

contracts may not have been the lowest-cost Risk sharingbidders meeting the Board's minimum techni-cal specifications. And if firms could win all The Board put the tariff structure in the bench-three contracts, they might offer more attrac- mark tenders to provide what it considered ad-tive bids, reflecting size economies and any equate protection for the financiers against theexpected benefits in subsequent bargaining. financial risks associated with the projects' largeThe Board minimized the cost to the system of fixed costs, while leaving the consortia to bearthis exclusionary protocol by awarding the larg- risks relating to volume-related operating costs.est of the three contracts first. It priced treatment at cost at the margin to pro-

tect consumer interests. And as the followingTwo other factors affected the selection pro- paragraphs show, the Board structured the wa-cess. The Water Board prepared its own re- ter treatment agreements according to the prin-ports and design plans. This gave it a fallback ciple that specific risks should reside with theoption should the BOO approach have to be parties best able to assess and manage them.abandoned for some reason. The detailed pro-cess specification in these studies, later pro- Completion and commissioning risks. The wa-vided to the tenderers, yielded important time ter treatment company is responsible for com-and cost savings to the successful tenderers. pleting the project on time and to specificationsThe Board also established a capability to as- that meet agreed acceptance tests demonstrat-sess bids and negotiate the final terms of wa- ing that the plant is ready for continued use atter treatment agreements. This required the the required capacity. The water treatment agree-Board to incur substantial costs in setting up a ment assigns the completion and commission-new legal and commercial "infrastructure." The ing risks to the water treatment company throughBoard wanted to be able to deal with the risk- the availability component of the tariff, whichsharing implications of the BOO path, and the is based on the fixed costs expected under timelyBoard's legal advisers recommended that it completion of the construction phase.cover contingencies in great detail and antici-pate a wide variety of specific events that could Market risks. Although the fixed availabilityaffect its risks. charge in the tariff partly insures the water treat-

ment company against plant usage that fallsThe water treatment tariff structure short of the designed capacity, the company

otherw,ise bears the risks of fluctuating demandThe water treatment tariff structure agreed to from Sydney Water by agreeing to meet allhas two parts.' First, an availability charge is demand. The contract specifies that Sydneyfixed, independent of the volume treated, to Water must assist the water treatment companycover about 80 percent of the financing, es- in designing capacity to meet demand by pro-tablishment, and fixed costs incurred by the viding information on its demand managementwater treatment companies in the timely con- strategy, including demand projections for thestruction and operation of the plant. Penal- next two, five, and ten years.ties are charged in the event of breakdown.Second, a usage charge is set, a megaliter rate Granting exclusive rights to treat water for athat declines with quantity. The agreed tariffs designated market involves tradeoffs. The gov-are subject to change if the treated water falls ernment-through the Board-has tied itsshort of the quality specified in the contract hands with respect to competition for the con-or the quality of the raw water supplied for tract-winning treatment plants. But the contractstreatment either exceeds or falls below pa- themselves should reflect this exclusivity, inrameters based on the highest and lowest the terms offered by the treatment companies.water quality over the preceding twenty-five If the Board's demand projections miss the markyears. and capacity increases are called for, the con-


tract provides for adjustments to the tariff to accords with the company's full autonomy inshift risk arising from inadequate projections daily operations under the water treatmentaway from the water treatment company. agreement. The operators expect that contracts

will be renewed at the end of the contract pe-Performance quality and quantity risks. These riod. This expectation and a provision allowingrisks lie with the water treatment company pro- Sydney Water to buy the plant assets at a pricevided they do not involve plant expansion, in based on its own evaluation provide incentiveswhich case the risks would be shared through for the operators to avoid running down thea renegotiated tariff. If the water treatment com- assets toward the end of the contract period.pany fails to meet quality standards or requiredvolumes, Sydney Water has recourse to three Upstream risks. Sydney Water will continue tomeasures: tariff reduction or nonpayment, step- be responsible for operating and maintainingin rights, and termination of the contract. Moni- assets 'upstream" of the treatment process.toring provisions give Sydney Water the right These include the catchment, the river systemsto satisfy itself that the water treatment com- within it, and anv canals, pipelines, dams, andpany is operating and maintaining the plant in reservoirs used in storing and reticulating theaccordance with the water treatment agreement. raw water. In announcing its catchment man-If Sydney Water finds that the company is fail- agement policy during the bidding process, theing to do so, it will notify the company, which Board committed itself to a set of environmentalmust respond with an action plan to be agreed standards to reduce uncertainty for tenderers.upon. The company will carry out approvedquality tests whose results will be subject to Financing and economic risks. The water treat-audit, and Sydney Water will have the right to ment company carries the risks of changes inconduct its own tests. Disputes over results will interest or inflation rates during the construc-be settled by a third party. tion period. But once the plant is commissioned,

an indexing formula will take effect that willRaw water supply risks. Whereas the risks re- allocate the risks of inflation and changes inlating to the output (clean bulk water) reside operating costs between the company andentirely with the water treatment company, risks Sydney Water. Few details have been revealedrelating to the variable quality of the input (raw about this important aspect of risk sharing.water) are shared by Sydney Water and the com-pany. The quality of the raw water that Sydney Technology risks. The water treatment companyWater harvests in its catchments is only partly bears the responsibility for technology, whichunder its control because of storms and floods. must be proven and must meet required stan-The water treatment agreement accounts for this dards and specifications. But the contract speci-partial control by specifying that, to avoid a pen- fies that changes in water quality requirementsalty tariff under the terms of the contract, Sydney that call for new technology will trigger a re-Water must provide raw water whose quality negotiation of the tariff, thereby sharing thefalls within a range established over the past risks of unforeseen changes in the standardstwenty-five years. This provision gives Sydney agreed to in the water treatment agreement.Water an incentive to manage its catchments sothat raw water quality is at least maintained in The water treatment agreement specifies ap-the established range. propriate contractual terms for technology

transfer to Sydney Water and serves as the ba-Operation and maintenance risks. The risks of sis for a collaborative and cooperative relation-operating and maintaining the plant-functions ship betvw,een the Board and the water treatmentthat include providing staffing, skills, chemical company. The water treatment company is ex-supplies, power, process control, and disposal- pected to keep abreast of technology, performreside with the water treatment company. This on-site research, and share findings with Sydney

96 Sydney's Water-A Suitable Case for Private Treatment?

Water. This expectation is formalized by a com- treatment costs for a desired standard. By shift-ponent in the negotiated tariff to cover research ing the risk of poor catchment managementand development costs of the water treatment back to Sydney Water, the tariff structure pro-company. vides an incentive for Sydney Water to man-

age the catchment well. The agreement alsoNatural disasters. In an emergency, whether gives a discount in the tariff for raw water thator not caused by natural disaster, Sydney Wa- is of exceptionally high quality. If Sydney Wa-ter has the right to take whatever action it ter had built and operated the treatment plantsdeems necessary to safeguard the system's se- itself, there would also have been incentivescurity and maintain supply, including bypass- to find efficient combinations of treating watering tihe treatmenL plants. In suchi events, Sydney and improving catchmient managemnent.Water will compensate the water treatmentcompany, reimbursing access fees and treat- Conclusionment costs.

The BOO option adopted by the W%Tater BoardRegulated pricing and the BOOs for its new water treatment plants will receive

its first real test as the largest of the plants comesThe Government Pricing Tribunal of New South on line and Sydney Water's costs start to re-W'ales was established in 1992 to review and flect the price of delivering better-quality wa-set prices for services considered government ter. Willingness-to-pay studies support themonopolies, including those of the Water decision to meet more stringent water qualityBoard. The Tribunal (now the Independent guidelines, but how much of the cost of rais-Pricing and Regulatory Tribunal) regulates ing quality is actually passed on to consumersSydney Water's prices by capping its revenues. will be determined by the Independent Pric-Its approach to the BOO treatment plants has ing and Regulatory Tribunal, which has sentbeen cautious. While noting that the BOO clear signals that it will not rubber-stamp a fullprojects were proposed long before it was es- pass-on of the costs of the new contractualtablished, the Tribunal has made clear that it arrangements. Despite efforts to meet the de-expects Sydney Water to inform the Tribunal mand for increased quality through the leastabout the contracts and about Sydney Water's expensive route, Sydney Water may find itselfobligations, to explain the risks involved and having to reduce costs (and services) elsewherethe sharing of these risks, and to demonstrate to achieve acceptable rates of return. A failurethat the scheme is more cost-effective when to achieve substantial cost savings elsewhereadjusted for risk than alternatives, including may mean politically unacceptable price in-direct provision by Sydney Water. The Tribu- creases for some consumers as Sydney NWaternal has warned that it will not automatically introduces volumetric pricing and phases outpass on cost increases to customers unless the cross-subsidies.increases can be justified on economic or en-vironmental grounds. This Note is based on a longer article by the authors: "Privatising

Sydney's Wrater Treatment, Agenda: AJotrnal ofPolicy Analysis and

Environmental regulation Rcform 3 (1): 45-58 (1996).Although the detail of final contracts is confidential. the essentialdetails of pricing and deliven' structure were specified in the origi-

Critics have argued that the treatment plants nal tender docunments and have been amplified in interviews.

reduce the incentives to improve catchmentmanagement and that better catchment man- Ross Chapman, Director, Centrefor Interna-agement is an alternative to more intensive tional Economics, Sydney, and Sandytreatment. The tariff structure in the water treat- Cuthbertson, dMianaging Director, Centre forment agreement, however, recognizes that ab- InternationalEconomics, Canberra (email:normally low raw water quality will raise [email protected])

97

Mitigating Commercial Risks in Project FinanceJeff Ruster

In project finance, risks are allocated to the par- curement, performance testing, obtaining permitsties best able to manage them. However, the risk and insurance, provision of required services (wa-mitigation instruments incorporated in the ter, electricity, fuel), and relief under force ma-project's contractual and financial arrangements jeure events. The contractor may be responsibleneed not be all-encompassing to provide the se- only for bringing a project to mechanical comple-curitv investors require. Commitments may be tion according to the owner's design and specifi-limited in scope (restricted to geological risk, la- cations, transferring to the sponsors responsibilitybor and equipment productivity, operation and for start-up and testing. Under an engineering,maintenance, market demand, or force majeure), procurement, and construction contract, however,amount (limited to a percentage of project debt the contractor accepts full responsibility foror capital costs, contract price, or operating delivering a fully operational facility on a date-budget), and duration (applicable only during certain, fixed-price basis.construction, performance testing, start-up, or op-eration, or on failure to achieve certain milestone If the contractor fails to meet its obligations, itdates or operational or financial indicators). This may be required to pay compensation to theNote provides a checklist of commercial risk miti- project sponsors, often in the form of liquidatedgation instruments commonly used in project fi- damages (LDs, typically assigned to lenders asnance by private lenders and sometimes by equity part of their security package). Delay LDs, pay-investors. The checklist is structured around a able when the contractor fails to meet certainproject's development cycle, which, for sim- milestone dates, normally cover additional inter-plicity's sake, is divided into the construction (in- est costs arising from the delay and may com-cluding start-up and testing) and operating pensate equity investors for lost income and fixedphases. (See tables 1 and 2 for summaries of costs incurred. Buydown LDs compensate apossible risks and coverage.) project's owners for the contractor's failure to meet

project operating criteria (output, input efficiency,Construction period and emissions). Buydown LDs, used to pay down

project debt to offset the expected decline in netThree main groups of instruments are used to operating cash flow, are set at a value that willmitigate risk during the construction period: con- allow the debt service coverage ratios (DSCR) totractual arrangements and associated guarantees, remain unchanged. But contractor liability undercontingency funds and lines of credit, and pri- the LDs is almost always capped at some per-vate insurance. centage of the construction contract price. LDs

are often 10 to 15 percent of the contract priceContractual arrangements for many gas pipelines, for example, while for

longer-gestation and more technically compli-Contractual arrangements offer a broad range of cated coal-fired power generation projects, theypossibilities for allocating risks among project par- may be as high as 35 to 40 percent.ticipants. The construction contract, for example,assigns responsibilities to the project sponsor and Material, workmanship, and equipment war-the construction companies for engineering, pro- ranties cover defects discovered following a

98 Mitigating Commercial Risks in Project Finance

TABLE 1 POSSIBLE RISKS AND COVERAGE DURING THE CONSTRUCTION PERIOD

Start-up ContractorCost and testing payment Hidden Force

Instrument overruns Delays problems defaults defects majeure

Liquidated damages X X XPerformance bonds XRetainage accounts XWarranties XContingency funds X X X X XInsurance X X

Note:Table shows principal applications of instruments.

project's final completion. W`arranties may be may be provided by third-party contractors,issued on an evergreen basis, guaranteeing the standby letters of credit, or sponsor guaran-reliability of a stipulated item for a period fol- tees. These instruments may be limited inlowing final completion, typically one to two amount (available only for the first 10 percentyears. If any repair is required, the clock starts of overruns), scope (not callable upon a forceagain and the item must perform without prob- majeure event), and time (applicable only af-lems for the full warranty period. ter a project achieves mechanical completion).

Lenders often require a performance bondd or Insuranceother type of surety instrument from third-partyfinancial institutions to backstop the contractor's A project is generally covered by several typespayment obligations. In addition, because of fre- of insurance. Construction All Risk insurancequent delays in collecting under LDs and per- protects against property damage and is effec-formance bonds, 5 to 10 percent of monthly tive from the commencement of procurementpayments owed by project sponsors to the con- to transportation to the project site throughtractor may be escrowed in a retainage account. completion of construction and performanceThis cash reserve further backstops the con- testing. Risks covered include acts of God andtractor's payment obligations. standard perils (fire, lightning). Adjunct liability

coverage insures against bodily injury or prop-Contingency funds and lines of credit erty damage to third parties resulting from

project work. Advance Loss of Profits insuranceConstruction budgets often include a 5 to 15 covers income losses due to delays resultingpercent line item to cover unexpected cost in- from the same risks covered under Construc-creases. This financing may be provided pro tion All Risk insurance. Miscellaneous coveragerata between debt and equity or under some may include employer's liability, architect er-other sharing arrangement (for example, 100 rors and omissions, and force majeure insur-percent equity for the first 5 percent of cost ance, which can cover losses due to strikes,overruns and pro rata thereafter). Contingency contractor insolvency, and delays in obtainingfunds can be used to cover all types of cost permits.overruns or earmarked for specific contingen-cies such as environmental cleanup. Operating period

In addition to, or in the absence of, such in- The instruments most commonly used tostruments, contingent lines of subordinate debt mitigate risk during the operating period are


TABLE 2 POSSIBLE RISKS AND COVERAGE DURING THE OPERATING PERIOD

Operating Increase Increase Market

efficiency in routine in major demand Input Force

Instrument problems O&M O&M and pricing availability majeure

Take-or-pay X

Put-or-pay X

Pass-through X X X

Debt service reserve funds X X X X

Maintenance reserves X

Cash traps X X X

Insurance X

Tracking accounts x

Equity kickers X

Note: Table shows principal applications of instruments.

contractual arrangemrients, contingency- re- it agrees to indemnify the project comnpanyserves, caslh traps, insurance, ancl risk corni- for excess costs incurred in secuLring the in-pensation devices, puts from third parties or, if third-party sup-

ply is unavailahle, for rev enue losses due toContractual arrangements the project's resulting inahilitv to complx xx ith

its offtake arrangements.

Of the many- contractual structures that canallocate risks duLring the operating periodl Pass-th1wmigi structures often link the offtaketake-or-pay. put-or-pay, anid pass-through and input agreemiients to shield insestors fromstructures are perlhaps the most commonly adverse clhanges in the prices of project inpultsapplied. Take-or-pay arrangements require the or outputs.' For a poxx er project, fuel price es-offtaker to pay for the goocd or serv ice regard- catlation formtlas mliglht h)e tiecl to a hasket ofless of xxhether it is neecdec. This ohligation is international reference prices. The offtaikenormally conditioned on, amrong other things. agreemnenrt. referred to as the poxxwer purchasethe project's compliance with the terms of the agreement (PPA), would inclucle an energy pax-offtake or concession aigreement (for example. ment to cov er the projects sariahle operatingminimum axailahilitv factor. enx-ironmental expenses, inclucling fuel costs. The price esca-permitting). Pay iments tinder take-or-pay con- lation formula for the energy payment ty picallytracts may he set to cox-er all fixed costs of matches that of the fuel stpply agreement.

the project (fixetl operation ancl maintenance Howex-er. althoLughl PPA escalation formulascosts, deht service, after-tax equity- return.) or may- inclutle pass-throughs for fuel pricemay cox-er only part of the project's availahle clhanges. they ty'picallv do not include cost pass-capacity-. In the seconcl case, project sp rn- throughls related to lower than expected fuelsors must sell the uncommiiittecl portion to the consuLmlption efficiency. Thus, if the project re-spot manlrket or seek long-termii offtake arrange- quires mtore fuel than expectecl to procduce aments with thirtl parties to achieve their re- gis en amriount of electricity, its net operatingquiretl equity retturn incolmie woultl clecline. This risk can he miti-

gatecl through penalty prosisions in the project sPitt-or-pay, contracts pros ide for a secure sup- operation and maintenance agreements-ply- of project feeclstocks or raxx materials. If throughi sponsor guarantees. or through othlerthe supplier is unahle to proxitle the inputs, mechanisms descrihetl helos-

100 Mitigating Commercial Risks in Project Finance

Contingency reserves property damage. Third-party general liabil-ity insurance might include coverage for work-

To cover cash flow shortages, a debt service ers' compensation, automobiles, and pollutionreserve fund can be established through spon- cleanup.sor equity contributions, excess cash flow (avail-able cash flow after debt ser-vice payments but Risk compensation devicesbefore dividend distributions), standby lettersof credit, or sponsor guarantees. A separate Sometimes investors and contractual participantsfund to cover extraordinary maintenance can assume certain risks in return for an opportu-also be created to ensure proper operation and nity to share in the project's upside potential.imlainltenlance in the future. Tracking accounts are often used to compen-

sate input suppliers or offtakers for offering fixedCash traps price agreements, which shield project spon-

sors from market risk. Under an offtake agree-Sometimes a project can meet its debt service ment that provides for tracking, if the contractobligations, but not with the cash flow margins price exceeds spot market prices, the differencethat lenders had expected. Cash traps can be between the two would be tracked. Amountsused to ensure that lenders continue to receive tracked may be 100 percent of the price differ-timely payments. For example, if a project is un- ence or a lower proportion, with payments owedable to maintain a required DSCR (typically de- only if the difference exceeds a certain thresh-fined on a pretax basis as gross revenues minus old. Equity kickers, such as convertible deben-operating expenses divided by interest and prin- tures, stock warrants, and contingent interestcipal payments), no dividend distributions would payments, allow investors to share in the up-be permitted. Until the project achieves the reside potential of the project while still provid-quired DSCR, "trapped" cash flow could be es- ing them priority over common equity investorscrowed or applied in inverse order of maturity with regard to claims on project assets and cashto prepay debt (often referred to as a "clawback"). flow if the project is unable to generate suffi-If noncompliance persists beyond a certain date, cient cash flow to meet its financial obligations.the project may be considered in default, andall excess cash flow would be permanently ap- l Other types of pass-through structures relate to nonprice con-

plied to prepay project debt. One possible ap- tractual terms such as force majeure and coLre perioC provisions.

plication is as follows: If the expected DSCR is For example, if a third-party contractor is relieved from its obli-

2:1, but the actual is betwveen 1.75 and 1.90, gations upon the occurrence of a specified force majeure event,the project will seek simnilar relief in its iopot or offiake agree-

excess cash flow would be escrowed until the ments for failuire to meet its contractual ohligarions as a result of

project achieves the required DSCR for two con- the same force majeure event.

secutive quarters, at which time dividends wouldc Deht service reserve fndos aod cash traps are designed to coververy different scenarios. Deht service reserves protect against cata-

once again be permitted, 50 percent of excess strophic events (for examplc, a turbinc blade breaking) that sould

cash flow would be "clawed back" if the actual prevent the project from generating revenue for an extended pe-

DSCR falls between 1.35 and 1.74, and 100 per- riod, Cash traps cover a scenario in whicl the project may be limp-ing along, still meering its deht service ohligaitioos hoit not with the

cent if it falls to between 1.20 and 1.34. An event cash flow margins that lenders had anticipated. This situation could

of default may be called if the DSCR falls below arise, for example, if spot prices are helow hase case pr-ojections,

1.20 for more than two consecutive quarters.2 operation and maintenance costs are higher than projected (perhaps as a result of quicker than expected svstem degradation), orproduction is helosw expected levels because of lower than ex-

Insurance pected plant dispatch resulting from the entry of new low-costproducers or an inability to meet required emissions standards atbase case production levels.

Coverage for the operating period typicallyincludes property insurance with extensions Jeff Raster, Financial Specialist, Private Sectoravailable for loss of revenue from machinery Development Department (email: jruster@breakdown and for business interruption from worldlbank.org)

101

Mitigating Project Risks-World Bank Supportfor Government GuaranteesPhilippe Benoit

Project risks and risk mitigation example, a letter of credit). Under this struc-ture, often used to provide coverage to for-

Private investors try to mitigate the risks facing eign investors concerned about timely paymenta proposed project before they invest. Foreign from a host government guarantor, the inves-investors in developing countries are often con- tors look to the third-party guarantor for pay-cerned about two kinds of risk in particular. ment, and the third party relies on the hostThe first is political risk-risk relating to politi- government for reimbursement.cal acts of government and to the general coun-try context, including war, expropriation, and World Bank support for guaranteesrestrictions on repatriation of earnings. The sec-ond kind of risk, referred to here as "parastatal The World Bank has employed two distinctrisk," relates to the performance of parastatal financial vehicles to support developing coun-companies and includes such risks as failure try governments that decide to provide guar-of the government-owned power company to antees to attract private investment: issuingsupply electricity to a project. guarantees to investors and making loans to

host governments to fund guarantees.'To mitigate project risks, investors generallyrequire guarantees from the project sponsors. World Bank guaranteesFor protection against political risks, specifi-cally, investors often procure insurance or guar- The International Bank for Reconstruction andantees from specialized institutions, such as Development (IBRD), one of the World Bank'sexport credit agencies or private political risk two constituent organizations, has establishedinsurers. Another source of political risk insur- a guarantee program to issue guarantees toance for forcign investment in developing coun- lenders covering cither all or a part of thcirtries is the Multilateral Investment Guarantee loan against certain specified risks (partial riskAgency (MIGA), a specialized organization in guarantees), or certain specified payments un-the World Bank Group. der their loan against all risks (partial credit

guarantees). The Bank's other constituent or-In addition, foreign investors in developing ganization, the International Development As-countries often approach host governments for sociation (IDA), which lends at concessionalguarantees, particularly for political and rates, has never issued guarantees and has noparastatal risks. Host governments structure guarantee program in place.these guarantees in a variety of ways. Theymay issue guarantees directly to investors. Or When the IBRD issues its guarantee, it receivesthey may establish a special facility to do so, a counterguarantee from the host country, un-such as a facility to issue guarantees for export der which the country remains financially re-financing. In both these approaches, investors sponsible for any payments that the IBRD makesrely on the host government to finance pay- to lenders (figure 1). The IBRD has issued guar-ments under the guarantee. But in some antees for several large infrastructure projects.projects, governments have a third party, such For example, in the 1994 Pakistan Hub Riveras an offshore bank, issue the guarantee (for Power Project, the IBRD issued a partial risk

102 Mitigating Project Risks-World Bank Support for Government Guarantees

FIGURE 1 IBRD GUARANTEE

gourntee-guarantee guarantee protecting lenders against debt ser-

Guarantee vice defaults resulting from a breach by the Pa-

kistan government of its undertakings to theproject company. These undertakings relate toparastatal performance and certain political risks

I Loan (such as currency transfer). Projects involvingthe partial credit guarantee include the 1994China Yangzhou Thermal Pow er Project and the1994 Philippines Leyte-Luzon GeothermalProject; in both cases, the IBRD guarantee cov-ered long-term maturities.2

FIGURE 2 WORLD BANK-FINANCED THIRD-PARTYGUARANTEE World Bank financing of government

S ~~~~~~~guaranteesL.a.

The World Bank can also support host govern-

Reimbursement agreement . ment guarantees by providing loans to financethem. The host country provides investors witha guarantee, the NVorld Bank provides a loan tothe country, and the country draws down the

Guarantee loan if and as required to finance payments dueto the investors under the guarantee. Such WorldBank loans could be provided to finance a widerange of government guarantee structures, includ-

Investment ing the third-party guarantee structure (figure 2).

The World Bank has provided loans to fund guar-antees and other forms of coverage in only afew projects to date. One such project, the 1995Moldova Pre-Export Guarantee Facility Project,

FIGURE 3 WORLD BANK-FINANCED AND involves both a government guarantee facilityMIGA-ADMINISTERED GUARANTEE and a third-party guarantor. Moldova established

a guarantee facility to cover foreign supplierLoan credit provided to its exporters against speci-

fied political risks. In parallel, an offshore bank

Administration agreement (the agent bank), acting as a third-party guaran-tor on behalf of Moldova, issued standby lettersof credit to the foreign creditors, backstoppingthe government facility's guarantees. The agentbank could draw down the IBRD loan to fund

Guarantee payments to be made under its letters of credit

to the foreign creditors. In a second project, the1994 Argentina Capital Market DevelopmentProject, the government created a backstop fa-lnvestmentt cility to purchase eligible commercial bankbonds from banks otherwise unable to placethem because of specified market disruptions.The IBRD provided a loan to Argentina to fundeventual payments from the facility.


Integrating Bank and MIGA support vestors over developing country govern-ments-in large part because of its financial,

The World Bank and MIGA are exploring an contractual, and cooperative relationships withintegrated approach to supporting host gov- these countries, as well as its multilateral char-ernments of developing countries in providing acter. It can use this leverage to discouragepolitical risk coverage for foreign investments unreasonable government actions that wouldwhere insurers are unwilling to issue insurance threaten the success of a project. Second, afunded from their own resources (figure 3). payment by the World Bank always entails aUnder this approach: corresponding obligation from the host gov-* The World Bank would provide a loan to the ernment-under the counter-guarantee for an

host country. IBRD guarantee, and under the loan itself for* The country would use the loan to provide a loan financing a guarantee. This obligation

designated investors with coverage against creates a financial disincentive for a govern-specified political risks. ment to take actions that would trigger pay-

: The country would have MIGA administer ments to the investors.the coverage. * Guarantees and loans to finance guarantees

* Both the investors and the country would allow host governments to shed project risksrely on MIGA to evaluate and process any that they would assume under a traditionalinvestor claims. World Bank loan. Under traditional debt fi-

t As administrator. MIGA would pay investors' nancing, the country must repay the Worldclaims, using the proceeds from the country's Bank loan even if the project fails, regard-Bank loan. less of the reason. Under guarantees, the

* The country would be obligated to repay to Bank makes payments, which triggers thethe Bank all amounts withdrawn under the government's financial liability, only for speci-loan-but the loan would be drawn down fied risks. These instruments thus provideonly if and as required to pay valid claims. governments with a straightforward mecha-

nism for shedding project risks, particularlyThis approach is being considered for a power commercial ones, by leaving the exposureproject whose foreign sponsors are concerned for them with private investors.about their ability to convert local currency * Guarantees also provide a mechanism forearnings into foreign exchange. The host gov- governments in transnational projects, suchernment has requested an IDA loan to finance as the construction of a pipeline between twocurrency transfer coverage for these investors, countries, to allocate political risks betweento be administered by MIGA. the host countries. In such a project, each

host government could provide lenders withThe implications of Bank support a guarantee covering the political risks relat-

ing to its country. The lenders would be cov-World Bank support for guarantees presents ered against all political risks, while eachseveral advantages: government's liability to the lenders would* The IBRD, under its guarantee program, be limited to the political risks its country

serves as an independent offshore guarantor poses.with strong financial standing-to which * The World Bank can provide developinglenders can turn to for payment regardless countries with the financial resources (typi-of the host government's actions or financial cally in foreign exchange) to fund paymentsweaknesses. to investors or to a third-party guarantor.

* The World Bank's involvement in a transac- * Guarantees often allow a project to obtaintion can mitigate political risks in two ways. lending on relatively favorable terms by pro-First, the World Bank has greater leverage than tecting lenders and mitigating political andmost commercial banks and other private in- parastatal risks. This can lead to a lower in-

104 Mitigating Project Risks-World Bank Support for Government Guarantees

terest rate or extend the maturity of the loans, tory reforms-which reduce the cost to gov-as has been the case with the IBRD partial ernments of attracting private investment andcredit guarantees. But guarantees can also eventually obviate the need for host govern-add to the transaction costs: there typically ment guarantees.are guarantee fees, and legal expenses maybe higher if the guarantee makes the trans- Use of guaranteesaction much more complex.Obtaining the services of a third-party guar- Whether the World Bank should provide anantor can be costly for governments of de- IBRD guarantee or a loan financing a govern-veloping countries that do not enjoy a strong ment guarantee for a proposed project dependscredit rating. Commercial institutions may on the assessment of the project and the costsrequire the government to provide escrow and benefits of such Bank support. The Bankaccounts and other costly security arrange- assesses the project's development impact, thements to back the government's reimburse- investor's need for the guarantee, the naturement obligation. But the World Bank, because of the risks to be covered, the government'sof its development character and leverage in actions to mitigate those risks, the cost of suchsecuring reimbursement by member country coverage to the government, and the benefitsgovernments, can fulfill the role of third- to the country from the investor's involvementparty guarantor at a relatively low cost to in the project. Another factor considered bvthe government. the Bank is the ability of the government and

the investors to obtain alternatives to Bank sup-An intcgrated World Bank-MICA approach port. These include MIGA insurance and riskwould present several additional advantages. mitigation provided by the International Fi-It would permit a developing country govern- nance Corporation, another member of thement to finance political risk coverage for in- World Bank Group.3

vestors in order to secure their participation inpriority development projects. It would give To date, the World Bank has issued few IBRDthese governments access to MIGA's expertise guarantees and loans to finance governmentin designing and administering political risk guarantees. Their use has been hampered in partinsurance. And it would provide investors with by their newness. As government officials, thean offshore, independent third party to admin- private sector, and Bank staff become more com-ister the coverage. The result of this integra- fortable with these instruments, and as the em-tion of the Bank and MIGA would be a structure phasis on private sector investment in projectsthat makes the most of the comparative ad- increases, the number of projects in which thesevantages of each institution. instruments play a part will likely grow.

But World Bank support for government guar- I For a fuller discussion, see Philippe Benoit. Projecrt Finance at the

antees can raise concerns in certain circum- lworld Baok, World Bank Technical Paper 312 (Washsington, DC.,

stances. Guarantees are generally inefficient 1996).instrumens where here is astrong lkelihood 2 For a fuller description of IBRD guarantees, see The World Bank's

instruments where there is a strong likelihood Guarantees and the Project Finance and Guarantees series, puB-

that the risks guaranteed against will occur. In lished by the WVorld Bank's Cofinancing and Project Finance

these cases, efforts should focus on reducing Department.

the risks to a reasonable level. Furthermore, For example. the IFC offers a loan syndication program that pro-vides commercial lenders with the protection of its lendler-of-record

the availability of guarantees might encourage umbrella. For a fuller description of MIGA and the IFC, see their

investors to seek broader protection from host 1995 annual reports.

governments than they would otherwise re-quire. And while guarantees provide protec- Philippe Benoit, Senior Private Sector Develop-tion to specific investors in specific transactions, ment Specialist, Private Sector Developmentthey are no substitute for substantive regula- Deparinent (email pbenoit@worldbank. org)

105

Private Power Financing-From Project Financeto Corporate FinanceKarl G. Jechoutek and Ranjit La mece

Limited recourse project financing of power consumers, and thus increase demand uncer-generation projects has been widely promoted tainty, balance sheet support by IPPs will playas a solution to the intractable problem of get- an important role in sharing demand risk amongting private credit to a sector dominated by key participants.noncreditworthy borrowers and public agen-cies-from the point of view of both those sup- Project finance is more expensiveplying capital and those needing it. When the for an IPPlights are going out, incumbent power enter-prises are financially unviable, and the public Project finance implies that the lenders to apurse is nearly empty, project financing of in- project have recourse (or claim) only to thedependent power producers (IPPs) may seem project's cash flows and assets. In effect, then,the only way to get new capacity fast. In the the project is financed "off the balance sheet"developing world, however, the public-private of the project sponsors. Such project finance ispartnership in project-financed IPP ventures has termed nonrecourse and is at one extreme ofbeen disappointingly slow to produce results. the project finance-corporate finance con-

tinuum of financing possibilities. In practice,This Note argues that, to achieve substantive project finance in developing countries isprogress in IPP financing, limitcd recoursc backed by sponsor or government guaranteesproject financing will have to evolve toward provided to give lenders extra comfort. This isstructures with greater balance sheet support. li, ited recoutrse projectfinancing, involving atThe need for corporate balance sheet support least a small degree of corporate, or balancefor private power sector investments is gradu- sheet, support.ally being recognized, and the benefits of thisshift in financing structure are worth reflecting In traditional corporate financing, at the otheron. First, balance sheet support by the main extreme of the financing continuum, lenderspartners in an IPP financing offers greater se- rely on the overall creditworthiness of the en-curity to lenders and provides easier (and per- terprise financing a new project to provide themhaps cheaper) access to long-term debt-critical security. If the enterprise is publicly held, in-to sustainable power sector financing given that formation on its performance and viability isIPPs typically depend on debt for 60 to 75 per- usually available through stock markets, ratingcent of their financing requirements. Second, agencies, and other market-making institutions.while equity in limited recourse project finance This combination of security, liquidity, and in-is almost exclusively private, balance sheet sup- formation availability allows debt to be issuedport by IPP sponsors can open access to pub- at a lower cost than through project finance.lic equity markets, which are deeper and Further, because the enterprise's overall risk isgenerally cheaper. Third, increased corporate diversified over all the activities in which it isbalance sheet support is a corollary to the re- engaged, the cost of equity is also usually lower.structuring in the world's power sectors. As sec- The financing advantage for both debt andtor unbundling and self-generation expand equity makes the overall cost of capital lowerchoice for wholesale and (potentially) retail for corporate finance.

106 Private Power Financing-From Project Finance to Corporate Finance

Systematic empirical evidence specific to the find financing at the lowest cost. as differencespower sector in the developing world is lack- in technical and operating abilities becomeing, but anecdotal evidence suggests that cor- virtually indistinguishable among the front-porate finance is indeed cheaper than project runners. (Other attributes may predominate infinance. Corporate financing also has signifi- negotiated, noncompetitive IPP deals.) In thecant transaction cost advantages because it competitive international IPP market, severalavoids the high cost of negotiating the web of trends indicate that balance sheet support iscarefully structured legal contracts with pur- the preferred means for achieving this cost-of-chasers and commercial lenders necessary un- capital advantage.der project financing.'

Raising capital using a parent's balance sheetThe IPP experience in the United States offersuseful insights, and indicates that the project- Project developers are putting their own bal-financed independent generation model may ance sheets at risk-or those of their parentnot necessarily be the most efficient mode for companies-to raise cheaper debt for projectscapital formation in generation. Nor is it the and to finance their equity contribution. Projectsdominant mode in other countries. The United in which sponsors have used their own bal-States pioneered generation by independent ance sheets to raise finance include the Puertooperators on a merchant basis, and it is where Quetzal project in Guatemala (Enron), thethe now ubiquitous term independent power Puerto Plata project in the Dominican Repub-producer, or IPP, originated. Project-financed lic (Enron), and the Upper Mahaiao andindependent generators have thrived in the Mahanagdong projects in the Philippines (Cali-United States, contributing more than half the fornia Energy). Chinese IPP developers, suchadditions to generation capacity in recent years. as Huaneng Power and Xinli (Sunburst Energy),It has been shown that the cost of capital for a an affiliate of CITIC, have also used this strat-purchasing U.S. utility may be higher if it egy. California Energy pioneered the largest cot-chooses to build its own generation capacity porate financing in the independent powerrather than purchase power from an Ipp.2 But business, raising USS530 million through ten-much of the advantage is due to the adversarial year securitized bonds in March 1994.regulatory environment in the United States,which favors IPPs. Purchasing utilities weigh Creating consolidated balance sheetsthe risk that state regulators will disallow in-vestment costs against the perceived low7er risk Developers are pooling projects into entities(and lower profits) of purchasing electricity that are then able to raise capital on the strengthfrom an IPP, an arrangement in which all costs of a combined balance sheet comprising thecan be passed through or expensed. The pref- 'pooled" assets of the different projects. Pro-erence for purchasing power from IPPs is eas- viders of equity and debt then finance theily rationalized when one notes how many business of building and operating private gen-utilities and their bondholders were hurt in the eration facilities rather than an individual power1970s and 1980s, when regulators disallowed plant. Pooling spreads project risk. For a mul-cost recovery for large investments in capacity. tinational developer, it also reduces country-

specific risk. And for a developer with a fewIncreasing balance sheet support projects already under commercial operation,for IPPs-The evidence corporate finance obtained through pooling is

an important source of revenue for repayingProject developers operate in a fiercely coni- debt and paying dividends.petitive market for international projects. As-suming competitive bidding, the primary source Pooling has two other benefits. First, it enablesof competitive advantage lies in the ability to project developers to tap public equity mar-


kets-most private project developers finance Core generation, transmission, and distributionthe equity component of a project privately. functions are being separated, competition isSecond, it enables developers to raise cheaper being introduced in wholesale and retail mar-debt on a corporate finance basis. IPP spon- kets, and technological progress is rapidly in-sors that have used this approach include Con- creasing the number of cost-effective optionssolidated Electric Power Asia (CEPA), the San for decentralized self-generation or coopera-Francisco-based Bicoastal Energy Investors tive generation. This restructuring will requireFund (EIF), and Huaneng Power International a redefinition of the underlying assumptions(HPI) of China. CEPA raised debt and equity in in power sector financing.the capital markets on the basis of its corpo-rate strategy of building multiple power plants The financial challenge will be to find ways toin Asia. EIF securitized its equity interests in provide lenders with adequate long-term rev-sixteen independent power projects in the enue security when the new industry structureUnited States, creating a synthetic balance sheet might not allow utilities to guarantee demandand issuing US$125 million of seventeen-year risk and price risk for the maturities required.bonds. And HPI, which owns 2,900 megawatts Traditional project finance is based on allocat-of capacity under commercial operation and ing demand risk to the purchaser, whether anhas another 5,900 megawatts under construc- integrated utility, a central generator and pur-tion, raised US$332 million by listing its IPP chaser, a distribution utility, or a large consumer.business on the New York Stock Exchange in This risk allocation works well because purchas-October 1994.3 ers have a monopoly franchise area, which they

are obliged to serve. But as direct access to con-Pursuing mergers and acquisitions sumers is encouraged-whether or not the sec-

tor is broken up-purchasing utilities will faceindustry consolidation has become a steady increased demand risk as the loss of retail cus-trend in the IPP business. Notable transactions tomers becomes a greater possibility.among international players include the pur-chase of CMS Generation by HYDRA-CO En- The key to any debt-based financing is theterprises, the purchase of Magma Energy by ability to provide adequate security through aCalifornia Energy Inc. (creating an enterprise contract or other credible evidence of futurewith annual revenues exceeding USS400 mil- revenue streams. Innovative sharing of demandlion), and the acquisition of J. Makowski Co. risk between market players-the power seller,Ltd. by PG&E Enterprises and Bechtel Enter- the power purchaser, and the financier-willprises to form International Generating Co. Ltd. become necessary. An IPP developer's abilityIt has been argued that the increasing size and to bear any of the demand risk will depend inscope of projects is the main factor driving this part on its willingness to provide corporate as-change. Smaller companies are at an impor- sets and revenues as a backstop for lenders.tant disadvantage in international capital mar-kets compared with larger players, with their The view that well-capitalized corporate enti-greater experience, capitalization, and track ties will be the ones able to meet financialrecords. Although these mergers and acquisi- markets' requirements in a competitive envi-tions could be driven by a number of strategic ronment seems to be confirmed by market re-objectives, increased balance sheet support in sponses. Most recent additions to generationproject development is clearly one of them. capacity in the United Kingdom-the model

of sector unbundling-have been corporate-The IPP financing challenge financed IPPs. And witness the efforts by in-

dustry players in the United States to createPrivate financing needs to be tailored to the highly capitalized enterprises as competitionchanging structural relationships in the sector. for final consumers looms on the horizon. The

108 Private Power Financing-From Project Finance to Corporate Finance

recently announced USS1.26 billion merger of strategy would ease the overall financing costsPublic Service Co. of Colorado and Southwest- of projects and could be a transitional strat-ern Public Service Co. is a reaction to the per- egy for meeting the huge financing needs forceived increase in demand risk stemming from IPPs in developing countries.plans for wider retail competition-the utili-ties are noncontiguous and plan to build a con- See Anthony A. Churchill, Beyond Project Finance, ElectrcitvJoour

necting transmission line to share generating nal 8(5): 36-44 (1995).

resources. 2 For the only systematic presentation of information on this issoe.see Edward Kahn. Steven Stoft, and Timothy Belden, "Impact ofPower Purchased from Non-Utilities on the Utility Cost of Capital,'

Conclusion Utilities Policy 5(1): 3-11 (1995).

T3he proclaimed soiccess of this transaction is controversial, as theGreater corporate finance support will make it share price of Huaneng dropped from USS14.25 at listing (October

1994) to abuUt US$9 in iimid-1995.possible to raise private capital for financing in-dependent power projects from wider, deeper, Karl G. Jechoutek, Division Chief Powerand cheaper sources. But innovative strategies Development Efficiency, and Hou.sehold Fuelswill be required from governments, lencders, in- Division (email: [email protected]),vestors, and power sector enterprises alike. The and Ranjit Lamech, Restructuring Specialistfollowing strategies are worth considering:

Encourage the formation of large, well- (ea rameIcapitalized independent generation compa-nies. Purely private and quasi-private variantsof the Huaneng merchant generation modelin China might be workable in large powersystems. Healthy competition should be en-gendered through prudent regulatory reviewsof the market power of the IPP in a particu-lar system.Encourage divestiture of commercially oper-ating (and perhaps underperforming) gen-eration plants by incumbent utilities to IPPdevelopers. These sales should be conditionalon the purchaser's commitment to makingspecified investments. By making positiverevenue streams available to IPP developersimmediately, such transactions would givethem the financial base to invest in multipleplants.

• In IPP prequalification under competitivebidding, give greater weighting to IPP de-velopers with businesses listed on a stockexchange and to those with well-capitalizedbalance sheets. The strategic goals of pub-licly held entities are likely to be more trans-parent and longer term because of theseentities' obligations to public shareholders.

• Encourage project sponsors to use balancesheet support for subordinated debt and quasi-equity portions of the project financing planin order to increase corporate financing. This

109

The World Bank Contributionto Private Participation in InfrastructureOmer arasaipan

The wave of private sector participation in infra- Adjustment loansstructure (PPI) nowv sw-eeping the globe startedin Chile. Nexev Zealand. and the UTnited king- The Bank has developed adjustment loans-dom in the early 1980s. Mlore than 900 Pl' pro- loans to support major multisectoral policyjects got under way between 1984 and 1994- improvements-in Argentina, Mlexico, and Ven-ranging from telecommunications in Cuba to ezucla and is w-orking on similar arrangementsmultisectoral initiatives in countries as dispar- in Boliv-ia and Peru. All these loans depend onate as Albania ancl Colombia-and more than anci require a long-term comml11itmiient bNy the2,200 are under preparation. The World Bank's government to anl infraStlruCtUre privatizationlending operations have supported this world- agencla. They also involve technical assistancewvide PPI movement. In 1988-94, the Bank pro- and, for Bolivia and Peru, related investmentvided funds for more than 500 infrastructture loans. Support to multisectoral 111FB agendas hasprojects-about a third of all Bank operations also been provided througlh stand-alone techi-in this period. Of these projects. ninety-two nical assistance loans to Turkey and lTruguay.contained significant PlI components, inclucd-ing the privatization of public utilities, on-lend- These PPI programs have three main compo-ing to private sector operators,' and franchlising nents. They support the design of a stable, coIII-operations involving leases, concessions. andm1anagement contracts. In keeping w-ith theBank's mandate, its focus in supporting PPIhas been on policy-related wvork and less de- TABLE 1 WORLD BANK AND IFC PPI PROJECTS BY SECTOR, 1988-94* eloped regions-particularly Africa.

World Bank instruments and PPI Sector World Bank IFC

Multiple 10 3aThe Bank's support to the PPI agenda has uti Telecommunications 10 23lized traditional lending instruments-adjust- Transportment, technical assistance, ancl investment loans, 21 11and on-lending to the private sector. Increeas- Water and sanitation 6 2ingly. the Bank is also trying new and innovative Power 22 29approaclhes, such as guarantees and investment Energy 6 6funds designed to catalyze priv-ate sector- invest- Solid waste 1 0ment. These new approaches are being refined Direct poverty alleviation 16 0in the light of experience. Table 1 summlaarizesthe sectoral spread of the Bank's PPI operations Total 92 74in 1988-94-as well as those of the International

Finance Corporation (IFC), anotlher imember of a. Refers to infrastructure leasing operations, all in India.the World Bank Group-and table 2 summa- Source:WorldBank,PrivateSectorDevelopmentDepartment,PPIGroup.

rizes Norld Bank operations by instrument andregion for the same period.

110 The World Bank Contribution to Private Participation in Infrastructure

TABLE 2 WORLD BANK PPI OPERATIONS, 1988-94

Middle East Europe East AsiaLatin and and and the

Instrument America Africa North Africa Central Asia Pacific South Asia Total

Adjustment: single sector 2 1 0 0 0 0 3Adjustment: multisector 5 0 0 0 0 0 5Technical assistance 4 2 0 1 1 0 8Investment lending 14 33 1 6 10 12 76

On-lending to private sector 3 1 0 1 3 5 13Direct povertyalleviation 3 12 0 0 1 0 16Public investment facilitating PPI 8 20 1 5 6 7 47

Franchising 2 12 0 0 1 0 15Funds 0 0 0 0 0 2 2

Total 25 36 1 7 11 12 92

Source: World Bank, PPI Bank Projects Database.

prehensive, and consistent legal and regulatory nents have been undertaken in forty-five otherbasis for PPI, addressing common cross-sectoral countries, including China (telecommunica-and sector-specific issues. They promote local tions) and India (power).capital market development-to foster thegrowth of long-term funding sources for PPI Franchises-big in Africaprojects. And they address the social and politi-cal risks associated with the reform agenda by Fifteen investment loans involved franchise ar-supporting social safety net frameworks and rangements. Under these loans, the Bankpublic education campaigns to build support helped to design management contracts, leases,for the reforms. or concessions for infrastructure services. Fran-

chise arrangements are most common in Af-

Investment loans rica, where twelve were supported by Bank

infrastructure loans in 1988-94. These included

World Bank investment loans for physical in- management contracts for airlines (Chad),

frastructure can play a catalytic role in the priva- telecommunications (Guinea), and power

tization of infrastructure services. These loans (Guinea, Mali, Sierra Leone); leases in power

are now the most frequently used instrument (C6te d'Ivoire, Rwanda) and water (Gambia,

for PPI operations, accounting for seventy-six Guinea); concessions in water (C6te d'Ivoire);

of the ninety-two PPI operations. Most of these and contracting out of rail services (Tanzania)

loans (forty-seven) support establishment of the and government contract services (Tanzania).

legal and regulatory basis for PPI and fund

public investments that complement and facili- Direct poverty alleviation

tate private participation. Transport sector

projects in Albania and Poland, for example, While the operations discussed so far have fo-

provided funds for road maintenance and in- cused mainly on improving the delivery of in-

vestments in new transport and maintenance frastructure services through private sector

equipment, paving the way for the privatiza- participation, the Bank has also used PPI com-

tion of trucking, road maintenance, and repair ponents in projects designed primarily to reduce

operations. Similar loans with policy compo- poverty. One example is the AGETIPs (Agences


d'Execution des Travaux d'Interet Public) model, by the Energy Sector Deregulation and Privati-first used under the Senegal Public Works and zation Loan (1992), the fund was administeredEmployment Loan (1989). AGETIPs are inde- by the government-owned National Investmentpendent and privately managed agencies for Bank of Jamaica. In Pakistan, the Private Sec-executing public works. The agencies evaluate tor Energy Loan (1988) set up the Energy De-small (US$50,000 to US$100,000), largely velopment Fund (EDF) to cover up to 30community-initiated civil works and mainte- percent of the cost of subprojects using build-nance projects, such as schools, roads, and own-operate (BOO) arrangements. A similarhealth centers, and run competitive bids for po- loan finalized in 1994 replenished the EDF.tential contractors. Because the contracts stipu-late labor-intensive methods, only small and World Bank guaranteesmedium-size private enterprises are likely to bid.The aim is to promote employment and to con- The first Bank guarantee for a PPI project-tribute to private sector development, in part and the only one issued to a private sector op-through technical assistance to private contrac- erator so far-went to the Hub Power Projecttors and local consultancy services. To ensure in Pakistan under the Private Sector Energylocal "ownership," the projects must include a Loan (1988). The financing required for thiscontribution from the locality-usually 5 to 10 1,300-megawatt project was US$1.9 billion, ofpercent of the total cost. Besides the initial which 75 percent was to be funded in debt,project in Senegal, such operations have been including UTS$680 million in syndicated com-mounted in Burkina Faso, Chad, Cote d'Ivoire, mercial bank loans. The Bank provided a par-Gambia, Madagascar, Mali, Mauritania, Niger, tial risk guarantee on principal repayments ofand Togo, and follow-up projects have been US$240 million, and Japan's EXIM Bank guar-initiated in Senegal and Togo. Outside Africa, anteed an additional US$120 million. The Banksimilar operations have been undertaken in guarantee covers the obligations of governmentBolivia, Guatemala, the Lao People's Democratic agencies (for public utility payments, fuel sup-Republic, and Peru. ply, and provision of foreign exchange) and

force majeure events (legislative changes, po-On-lending litical events in Pakistan, and specified natural

events).In eleven PPI operations, Bank funds were on-lent to private sector operators of infrastruc- The Bank also provides partial credit guaran-ture services. These operations, most of which tees. In China, Jordan, and the Philippines,involved existing private sector operators, in- guarantees have gone to government entities.cluded power projects in India and Turkey, In the Jordan Telecommunications Projectwater and telephony projects in Argentina and (1994), a US$50 million Bank guarantee facil-the Philippines, and transport sector operations ity will support a bond issue by the Jordanin Ethiopia and Mexico. Telecommunications Corporation (TCC). This

foreign currency bond offering will take placeTwo other on-lending operations, in Jamaica in the Eurobond market as well as in Jordan,and Pakistan, have involved new private op- to allow for broader distribution. The bond of-erators. Both loans have focused on creating fering incorporates an equity feature, giving in-an enabling environment for PPI and mobiliz- vestors an option to convert the bonds intoing finance from different sources through a shares should the TCC be privatized before theprivate infrastructure fund. In Jamaica, this bonds mature. And it both promotes thefund-the Private Sector Energy Fund-was set commercialization of TCC by exposing it toup for a private sector power project con- debt market discipline and facilitates privati-structed on a build-operate-transfer (BOT) ba- zation by paving the way for the debt-equitysis using limited recourse financing. Established conversion.

112 The World Bank Contribution to Private Participation in Infrastructure

PPI and the World Bank Group

PPI work is also carried out by the othier instiLu- TABLE 3 WORLD BANK AND IFC PPItions of the World Bank Group-the Multilat- OPERATIONS, 1988-94eral Investment Guarantee Agency (MIGA) andthe International Finance Corporation (IFC). Year World Bank IFC

MIGA guarantees 1988 3 2

1989 7 6The value of guarantees benefiting infrastruc-ture projects in MIGA's portfolio was more than 1990 11 6USS150 million by May 1995. These guaran- 1991 13 6tees had facilitated more than US$550 million 1992 18 9in foreign investment in infrastructure through 1993 17 18twelve contracts, including the first foreign pri- 1994 23 27vate power projects in Honduras and Jamaicaand a toll road in Argentina. Total 92 74

IFC operations Note:The IFC total includes all approved projects

except infrastructure funds and projects later canceled.

The IFC initiated assistance to PPI projects atroughly the same time as the Bank (table 3) andhas kept pace with the global growth in PPI TABLE4 IFC PPI PROJECTS BY REGION,projects. In 1988-94, the IFC was involved in 1988 E9Gseventy-four PPI projects. The IFC has focused 198W4on projects in Asia and Latin America and in thepo,wer and telecommunications sectors, where Region Projectsthe basis for PPI is better established (tables 1and 4). It has also participated in four funds cre- Latin America 40ated to take equity positions in infrastructure Asia 23projects. IFC participation in the Scudder Latin Europe 7America Trust for Power was approved in 1993. Sub-Saharan Africa 3In 1994, the IFC also participated in the multi- Central Asia, Middle Eastsectoral Asia Infrastructure Fund, the Global

Power Investment Fund, and the Central Euro- and North Africa 1

pean Telecoms Fund. Total 74

The Note uses the number of oDerations rather than their value be- Source: Gary Bond and Laurence Carter, Financingcarese of the different leverage s-ructures used by the Bank, the IFC, Private Infrastructure Projects, IFC Discussion Paper 23and MIGA and because. with ntanv of the Bank PPI operations com-ponents of bigger loans, using the total loan figure would exaggerate (Washington, D.C.: World Bank, 1994).the volume of the Bank's PPI work. The data for the IFC in the Noterefer to the period 1988 throughJune 1994.

Funds are recorded as a deposit in the central bank, and the con-tractual borrower (usually the central bank) agrees that the loanmoney will be made available to a third panrs within the country.

Omer Karasapan, Consultant, Private SectorDevelop ment Department (email: okarasapan@worldbank. org)

113

Private Infrastructure-A BibliographyA guide to World Bank publications on private participation in infrastructure

Omer Karasapan

The annual global market for projects involv- (PUB, 1993, C. Kessides), evaluates Bank ex-ing private participation in infrastructure (PPI) perience in infrastructure reform, including PPI.is estimated at US$60 billion for the past de- The recent Bureauicrats in Businiess (PUB,cade, and nearly 2,000 new investment projects, 1995) discusses PPI options in the context oftotaling US$1.4 trillion, are under preparation. 1 public sector reform. "Competition in NetworkThe WVorld Bank Group-the World Bank, the Industries" (PSD, 1996, Klein) argues that theMultilateral Investment Guarantee Agency regulation required in areas with natural mo-(MIGA), and the International Finance Corpo- nopoly features may become too intrusive andration (IFC)-is playing a growing part in this undermine reform. To generate sizable and last-global trend. The Bank has well over 100 PPI ing welfare gains, real competition is neces-projects in the pipeline, the IFC has partici- sary. The paper looks at options for introducingpated in 100 more PPI projects, and MIGA is competition in the network industries. Anotherincreasingly involved in providing guarantees multisectoral overview, Financing Privateto PPI projects. Infrastructure Projects: Emerging Trendsfroom

FEC'sE,xperience (PUB, 1994, Bond and Carter),in the course of its work, the Bank Group is covers the IFC's experience with PPI and looksamassing and disseminating information on the at project risk management and options for mo-legal, regulatory, institutional, and transactional bilizing finance for PPI projects. An IFC over-issues confronting PPI projects. This Note is a view of PPI projects and emerging issues canguide to some especially useful English-language be found in Privatization: Principles and Prac-publications and reports relating to private par- tice (PUB, 1995, Donaldson).ticipation in infrastructure that the Bank Grouphas issued since 1992. Information on how to Mfeeting the Infrastrulcture Chiallenge in Latinget copies is given in the margin on page 115. America and the Caribbean (PUB, 1994) cov-

ers lessons, investment needs, and the role ofMultisectoral reports the Bank and other multilateral institutions. "In-

frastructure Development in East Asia and Pa-The mnost wide-ranging Bank publication on cific: Toward a New Public-Private Partnership"PPI is World Development Report 1994: Infra- (EAO, 1995, Kohli) reviews constraints and of-strtucturefor Development (PUB, 1994), which fers a framework for supporting PPI in the lightexplores ways in which developing countries of East Asia's experience. Decentralizing In-can improve the provision and quality of in- frastructutre: Advantages and Limitations (PUB,frastructure services. The report discusses and 1995, Estache) looks at decentralization and ef-evaluates options for private provision in the ficient delivery of infrastructure services by lo-light of experience in infrastructure projects. cal governments. A single-country, multisectoralIts bibliography is a good guide to further PPI study, "Thailand: Increasing Private Par-sources of information on PPI issues. ticipation and Improvirng Efficiency in State En-

terprises" (PIC, 1994, #13132-th), spans theAnother cross-sectoral overview, Institutional energy, power, telecommunications, transport,Options for the Provision of Infrastruictutre and water and sanitation sectors. Welfare Con-

114 Private Infrastructure-A Bibliography

sequences of Sellinig Public Enteiprises: An Em- approaches in Asia, Europe, and Latin America.pirical Analysis (PUB, 1994, Galal, Jones, "Regulating Telecommunications in DevelopingTandon, and Vogelsang) analyzes the post- Countries: Outcomes, Incentives, and Commit-privatization performance of some telecommu- ment' (PRD, 1995, Galal and Nauriyal) analyzesnications, power, and transport firms and the experience of seven countries in designingestimates welfare gains from privatization. regulatory frameworks for PPT and assesses the

impact of the frameworks on private investors.Telecommunications "Regulation, Institutions, and Commitment in

Telecommunications: A Comparative Analysis ofThe Bank Group has been involved in many Five Country Studies" (PRD, 1994, Levy andmajor telecommunications privatization projects Spiller) looks at how the institutional endow-in developing countries over the past ten years. ments of five countries-Argentina, Chile,The issues arising from these operations are Jamaica, the Philippines, and the United King-reviewed in Implementing Reforms irn the dom-shaped the countries' regulator-y frame-

works. Telecommunications Sector Reform inAsia: Toward a ANew Pragmatism (PUB, 1994,Smith and Staple) focuses on the challenges of

PPI PROJECTS AND GUARANTEES reform in the dynamic Asian economies. It ex-amines regulation, implementation, PPI options,and supplv diversification.

The Project Finance and Guarantees series of short notes from the

former Cofinancing and Financial Advisory Services Vice Presidency Power(CFS) looks at PPI projects. "World Bank Guarantee Sparks Private

Power Investment in Pakistan" (CFS, 6/1995) examines the Hub power "Electricity Demand in Asia and the Effects on

project. The first private sector power project to use a World Bank Energy Supply and the Investment Environment"

guarantee,thisremainsthe largestprivate sector infrastructure (IEC, 1995, Ishiguro and Akiyama) argues that,gurantee,this suportem the largest p Rokpotrivate sectorPowfras rer to meet the rapid increase in demand for energy,project supported by the Bank. 'Jamaica's Rockport Private Power countries in Asia must go beyond build-operate-Project' (CFS, 1/1995) describes Bank support to Jamaica's first transfer (BOT) and build-own-operate (BOO)

build-own-operate power project. Jamaica's largest private sector schemes and develop or strengthen domestic

infrastructure project, the project was also the first undertaken stock and bond markets. "Power Sector Experi-

jointly by the Bank and MIGA. For a longer discussion of Bank ences in Asia" (PIC, 1994, Malhotra) draws on

guarantees to power projects (Pakistan's Hub, the Yangzhou thermal the Asian experience for insights into reform strat-

power project in China, and the Philippine's Leyte-Luzon geothermal of private participation. pReform and Private Par-

project), see "The World Bank's Guarantees: Catalyst for Private ticipation in the Power Sector of Selected LAC

Flows" (CFS, 1994). and Industrialized Countries" (LAT, 1994,Covarrubias and Maia) examines sectoral reformand PPI issues through case studies from Argen-tina, Chile, Colombia, Costa Rica, Jamaica, Nor-

Telecommunications Sector Lessons from Ex- way, Peru, the United Kingdom, and the Unitedperience (PUB, 1994, NVellenius and Stern). Tele- States. For a more recent overview of power sec-communications and Economic Development tor structures and PPI options, see "The Power(PUB, 1994, Saunders, Warford, and Wellenius) Sector in LAC: Current Status and Evolving Is-examines the links between the performance of sues" (LAT, 1995, Moscote, Maia, and Lorenzo).the telecommunications sector and economic de-velopment. It reviews PPI options and evalu- "Bolivia-Power Sector Reform Technical As-ates investment, regulatory, and implementation sistance Project, Technical Annex" (PIC, 1995,


#T6662) reviews the different stages in priva- Transport To Order

tizing Bolivia's power sector. Another single- For publications

country study on sectoral reform is "Colombia Regutlatory Reform in Transport: Soine Recent designated:

-Energy Sector Technical Assistance Project, Experienzces (PUB, 1993, Carbajo) presents caseTechnical Annex" (PIC, 1994, #T6469). For an studies of deregulation and private provision publications sales unit),

analysis of sectoral reform issues in a country in shipping, railways, trucking, and bus trans- call (202) 473-1155 or

with a great deal of recent experience with pri- port in Africa, Latin America, the United King- fax (202) 522-2627.

vate participation, see "The Philippines-Power dom, and the United States. Single-country, PlC (World Bank Public

Sector Study: Structural Framework for the multisectoral studies of deregulation and Information Center),

Power Sector" (PIC, 1994, #13313-ph). This privatization include "India Transport Sector: call (202) 458-5454 or

study focuses on the structural framework for Long-Term Issues" (PIC, 1995, #13192) and fax (202) 522-1500.

meeting long-term power needs, providing ad- 'Cameroon Transport Sector Technical Assis- CFS ICofinancing and

vice on post-privatization issues. Another sec- tance Project' (PtC, 1995, T6559). Finarcial Advisory

tor report, "China-Power Sector Reform: 473-122vcsr fax (202)

Toward Competition and Improved Perfor- "Airport Infrastructure: The Emerging Role of 477-3045.

mance" (PIC, 1994, #12929-cha), provides an the Private Sector-Recent Experiences Basedoverview of China's efforts to decentralize on 10 Case Studies" (CFS, 1995, Juan) evalu- EAOfExternal Affairs

decisionmaking and encourage private entry ates private provision in the airport sector in 0358 or fax (202) 522-

in its power sector as it tries to meet rapidly ten developing and industrial countries. This 3405

growing demand for electricity. report complements Aibport-Infrastructure: The IEN (Industry and

Emerging Role of the Private Sector (PUB, 1995, Energy Department),

Submission and Eva/lation of ProposalsforPri- Kapur), which looks at different ownership call (202) 473-3672 or

vate Power Genzeration Projects in Developing structures. fax (202) 477-0542.

Countries (PUB, 1994. Cordukes) is a "manual" IEC (International

for running competitive bidding processes for The Evolution of the World Bank's Railwav Economics

private power generation projects. For a joint Lending (PUB, 1994, Galenson and Thompson) Dpte)cl52

USAID-World Bank overview of IPP experi- proposes a new framework for Bank lendingences and options in a range of countries, see operations in the sector, reviews the private LAT (Latin America and

"Mobilizing Private Capital for the Power Sec- participation in the rail sector, and evaluates the CaribbeanTechnical Department).tor: Experience in Asia and Latin America" (CFS. the potential for further private participation. call (202)473-9444 or fax

1994, Baugham and Buresche). And for an over- "Best Methods of Railway Restructuring and (202) 676-1039.

view of Bank experience with power projects Privatization" (CFS, 1995, Kopicki and Thomp- LA1IU (Latin America

to 1992, see The World Ba nk s Role in the Elec- son) gives an overview of private participation and the Caribbean

tric Power Sector: Policies for Effective Inistitu - issues in the rail sector, and "Japanese National Country Department 1,

tiozal, Regulatoty, and FinancialReform (PUB, Railway Privatization Study II: Institutionaliz- Infrantrvctereand

1993). "Appropriate Restructuring Strategies for ing Major Policy Change and Examining Policy Division), call (202)473-

the Power-Generation Sector: The Case of Small Implications" (CFS, 1994, Fukui, Nakamura, 0933.

Systems" (IEN, 1995, Bacon) looks at the spe- Ozaki, Sakmaki, and Mizutani) evaluates Japan's PRD (Policy Research

cial circumnstances of power sector reform in privatization experience. "Restructuring Regu- Department), call (202)

small systems, including implications for pri- lation of the Rail Industry for the Public tnter- 473-5261.

vate participation and competitive structures. est" (PSD, 1995, I. Kessides) suggests principles PSD (Private Sector

"Power Supply in Developing Countries: Will for railway restructuring based on a rethinking Development

Reform Work?" (IEN, 1993, Besant-Jones) draws of the public sector's traditional role (also see Department), call

on the discussion at a roundtable sponsored "Restructuring Regulation of the Railroad In- (202) 473-7161.

by the World Bank and tlectricite de France dustryv page 73 in this volume).that looked at public sector reform and op-tions for private participation in developing "India-Port Sector Strategy Report" (PIC, 1995,countries. m414059) focuses on operational, institutional,

116 Private Infrastructure-A Bibliography

and financing reforms. Urban Transport in Asia:An Operational Agenda for the 1990s (PUB,1993, Midgley) analyzes problems confrontingAsia's rapidly growing urban centers and pro-poses options for reform. "Concessions ofBusways to the Private Sector: The Sao PauloMetropolitan Region Experience" (LAIIU, 1995,Rebelo) evaluates private provision of urbanbus services in Sao Paulo.

Urban water and sanitation

Private Sector Participation in Water Suppljyand Sanitation in Latin America (PUB, 1995,Idelovitch and Ringskog) analyzes options forPPI in water supply and sewerage using a casestudy in Buenos Aires. For an industrial coun-try experience, see "The German Water andSewerage Sector: How Well It Works and WhatThis Means for Developing Countries" (PIC,1995, Briscoe). Private Sector Participation inMunicipal Solid Waste Services in DevelopingCountries (PUB, 1994, Cointreau-Levine) looksat options for private participation, linking thcmwith local government capabilities and respon-sibilities. Better Urban Services: Finding theRight Incentives (PUB, 1995) draws lessonsfrom Bank experience to develop a concep-tual framework for improving service delivery.Strategic Optionsfor Urban Infrastructure.lMan-agemTent (PUB, 1994, Fox) looks at how pri-vate delivery in the context of reform can gobeyond simple capacity expansion to increaseeconomic productivity.

Private Infrastructure Project Database, see box on page 7 of thisvolume.

Omer Karasapan, Consultant, Private SectorDeveloppment Depaitment (email: [email protected])

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