Regulatory Priorities for Reforming Infrastructure Sectors in Developing Countries

Paul L. Joskow

April 1998

Paper prepared for the Annual World Bank Conference on Development Economics, Washington, D.C., April 20—21, 1998. The findings, inteipretations, and conclusions expressed in this paper are entirely those of the author. They do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.
Regulatory Priorities for Reforming infrastructure Sectors in Developing Countries

Paul L. Joskow
The Standard Prescriptions for Regulated infrastructure Sectors	6
Choice of Reform Models	10
Competition for the Market versus Competition in the Market	19
Universal Service, Income Distribution, and Taxation by Regulation	20
Regulatory Agencies: Organization and Procedures	26
Regulatory Mechanism Design	36
Price Structure Issues	-
	ss
Network Access and Competition	58
Regulator’s Role in Promoting Competition	67
Conclusions	69
Notes	71
References	73
Abstract

Economical and reliable supplies of a variety of basic “infrastructure” services such as electricity, water, telecommunications, and various transportation services play a critical role in supporting economic growth and development. Many of these infrastructure services have been viewed as natural monopolies, and supply responsibilities have often been given to state-owned monopolies. The performance of these sectors in many developing countries has historically been quite poor.

In an effort to respond to this poor performance, many developing countries have implemented or are contemplating major industry restructuring and regulatory reform programs. These reform programs often involve restructuring these sectors by shifting supply responsibility to private enterprises (privatization) and relying on competition and associated market mechanisms, rather than price and entry regulation, to allocate resources to and within potentially competitive segments of the infrastructure sectors (competition). However, in most infrastructure sectors subject to reform, important segments continue to be natural monopolies requiring continuing regulation. Moreover, open and nondiscriminatory access by new competitors to the network facilities controlled by these monopolies is nccessaiy for effective competition to flourish in the competitive segments of these sectors. Accordingly, the success of infrastructure sector reform depends in part on the creation of effective regulatory institutions to govern these sectors.

This paper discusses a variety of issues that must be addressed in designing good regulatory institutions to match the chosen sector reform models. They include regulatory goals, the structure and organization of regulatory agencies, the design of practical regulatory
mechanisms to balance efficiency and distributional goals, tariff design issues, the terms and conditions of access to “bottleneck” network facilities by competitors in the competitive segments, and the regulator’s role in promoting competition. The special problems faced by developing countries in implementing effective regulatory reform and their implications for the choice of regulatory institutions are emphasized.
Regulatory Priorities for Reforming Infrastructure Sectors in Developing Countries

Paul L. Joskow

Economic development policies have the objective of reducing poverty and improving the wellbeing of individuals in countries with low per capita income and consumer welfare levels. Economical and reliable supplies of a variety of basic “infrastructure” services such as electricity, water, telecommunications, and various transportation services play a critical role in supporting economic growth and development. Many of these infrastructure services have been viewed as natural monopolies, and supply responsibilities have often been given to state-owned monopolies. These infrastructure monopolies in turn are often vertically integrated and encompass services that are (arguably) natural monopolies as well as services that are potentially competitive but need “access” to “bottleneck” monopoly or certain “essential facilities” to make competition in these supply segments feasible.

While the performance of these infrastructure sectors varies widely from countiy to country, their performance in many developing countries has been quite poor. Large fractions of the populations of many developing countries do not have access to these services at all, or can obtain these services only by paying prices that are high compared to per capita income, waiting for years in queues to obtain legal connections from the supplier, or using informal mechanisms such as bribes, political influence, and theft. The technical performance of these sectors is often low, with high rates of equipment outages, large amounts of excess labor, and generally low levels of productivity. Prices are often set too low to recover the costs of providing the services, and Sector enterprises have poor cash flows and encounter difficulties in mobilizing the financial
resources necessary to maintain equipment and construct adequate additional capacity to meet growing demand. The availability and quality of infrastructure services are often highly politicized, and corruption is rampant. The poor performance of these infrastructure sectors can be a significant drag on economic growth and development.

The reasons for the poor performance of infrastructure sectors in many developing countries are complex and diverse. A country may initially simply be too poor to finance and support, through compensatory user fees, extensive investments in infrastructures that are very capital intensive and characterized by economies of scale and scope. in other cases, political considerations have led infrastructure prices to be set at levels that are not high enough to cover the operating costs of the sector and amortize investments in it. Regulatory and legal institutions can represent yet another source of performance problems if they are view as not providing credible commitments to create opportunities fbr potential investors to recover their investment costs, including the risk-adjusted opportunity cost of capital. Legal restrictions on direct foreign investment in certain infrastructure sectors in some countries further exacerbates the problems of attracting adequate capital to these sectors. The use of the infrastructure sectors to pursue a variety of social and political goals which siphon off revenues from these sectors and increases their costs, poorly developed property rights and contracting institutions, and corruption are frequently significant contributors to perfonnance problems as well.

In an effort to respond to the poor performance record of their infrastructure sectors, many developing countries have implemented or are contemplating major industry restructuring and regulatory reform programs. Discussions of reforms in these sectors focus on three interrelated sets of issues: privatization, restructuring to promote competition, and regulatory reform. Reform programs often involve restructuring these sectors by shifting supply
responsibility to private enterprises (privatization) and relying on competition and associated market mechanisms rather than price and entry regulation to allocate resources to and within potentially competitive segments of the infrastructure sectors (competition). While “privatization,” “deregulation,” and “competition” are the standard prescriptions for improving the performance of infrastructure sectors, these phrases arc merely slogans which can be misleading. In most of the infrastructure sectors subject to reform, certain important segments continue to be natural monopolies, and “competition in the market” cannot be relied upon to yield satisfactory performance. Moreover, “competition for the market” through concession or franchise contracts must confront problems resulting from significant sunk costs, asset specificity, and incomplete contracts. In many cases, segments where “competition in the market” is a reasonable option for allocating resources are likely to be imperfectly competitive and characterized by some degree of market power in both the short and long run. Moreover, the effectiveness of competition will depend on policies governing the initial structure of the competitive segments, the conditions of entry into the market, and the price and non-price terms and conditions of access to “bottleneck” monopoly network facilities for competing suppliers, who need such access to compete effectively.

These considerations imply that simplistic privatization and “complete” deregulation policies are not likely to be realistic or effective policy options in most infrastructure sectors. Certain segments of most infrastructure sectors should and will continue to be subject to some form of price and entmy regulation, because the services they suppiy have natural monopoly characteristics. As a result, effective regulation has the potential to yield outcomes superior to unregulated monopoly or oligopoly. The attributes of the regulatory institutions that are adopted will affect both the performance of the residual monopoly segments and their ability to provide a
platform for competition to supply complementary services that are not subject to price and entry regulation, with good performance outcomes.

This paper discusses issues related to the design of regulatory institutions accompanying the restructuring, privatization, and expansion of competitive opportunities into key infrastructure sectors that were previously legal monopolies (generally, state-owned monopolies). The discussion focuses on telecommunications, electric power, and natural gas transportation systems, but some conclusions, especially as they relate to the regulation of residual natural monopoly services, have implications for railroads, water supply systems, intercity highways, and other infrastructure services. While there are lessons to be learned from the reform experience iof industrial countries during the last several years, it is important to recognize that these lessons cannot be applied mechanically to developing countries. Differences in the current state of development and level of performance in each infrastructure sector, as well as differences in the state of basic market institutions such as property rights and contract enforcement mechanisms, in income distribution and other social concerns related to the pricing and penetration of infrastructure services, in legal and political institutions, and in the economic attributes of different infrastructure sectors, mnust be taken into account in designing the new industrial organization and regulatory institutions that will govern each of these sectors. Not only does one size shoe not fit all feet, but trying to apply a one-size-fits-all approach can severely limit the performance improvements that sector reforms hope to achieve.

The paper takes a comparative institutional perspective in the tradition of Oliver Williamson (1993). There are a variety of institutional arrangements that have been and can be relied upon to allocate resources in these sectors. None of them is likely to yield ideal “first best” outcomes. All regulatomy mechanisms have imperfections. The behavior and performance of
segments that are opened up to competition will depend on numerous market-design, market-structure, and network-access regulations, as well as the cost, demand, and information structure of the products that are being traded in competitive markets. imperfect competition is likely to be the norm rather than the exception in the competitive segments. and vague allusions to “the market” are not particularly productive foundations for analyzing institutional choices. Moreover, the performance of alternative institutional arrangements is likely to vary from country to country, depending upon the state of basic legal institutions and traditions (for example, property rights, contracts, the role and authority of the courts), the nature of political institutions (for example, democracy, the prevalence of corruption), natural resource endowments, the efficiency of the tax system, the size of the relevant product markets, the state of development of markets for capital, labor, goods, and services that are inputs into the production of the services provided by each of the infrastructure sectors, and various social and income distribution policy goals.

In light of these considerations, the appropriate analytical approach is to compare the likely performance attributes of alternative institutional arrangements, given basic economic, legal, and political foundations in each sector and country, and to seek the set of institutions likely to yield the best outcomes from the realistically feasible but inherently imperfect alternatives. What is the best that we can do in the particular imperfect world in which the sector operates? The answer is likely to vary from country to country. As a result, it is likely to be counterproductive to try to apply a simple mechanical formula to all developing countries or to all infrastructure sectors within a developing country.
The Standard Prescriptions for Regulated Infrastructure Sectors

The standard public policy prescription for refonning vertically and horizontally integrated “natural monopoly” industries is fairly straightforward. It has been or is being applied, to varying degrees, to telecommunications, natural gas, electric power, water distribution, and railroads around the world. The basic prescription is as follows:

Privatize state-owned enterprises to create hard budget constraints and to depoliticize the sector. Evidence on the comparative performance of public versus private enterprises, which properly controls for differences in supply opportunities and demand attributes, is limited. In most countries, especially developing countries, basic infrastructure sectors have generally been publicly owned for many years, so the cross-sectional data do not provide a good natural experiment” for assessing the performance of public vs. private ownership that we would desire.’ However, where meaningful comparisons can be made, the weight of evidence favors private rather than public enterprises (Boardman and Vining 1989, Vickers and Yarrow 1988, World Bank Group 1997). My own experience is that privatization helps to depoliticize these sectors, limiting (but certainly not eliminating) their use in pursuing social policy goals (for example, employment and price stability goals) that are not directly related to the services they supply, and more effectively decoupling the financial resources they have available to maintain equipment and finance new investments from the government’s general budgetary and fiscal situation. Governments will find it more difficult to secretly manipulate and control a private firm that has private investors and debt holders and is subject to accounting and auditing standards necessary for its securities to be listed on major exchanges than is the case for state-owned firms. When the state seeks to retain
ownership of infrastructure sectors, commercializing the enterprises and requiring them to be self-financing should be considered as an alternative to situating these sectors in government ministries or government departments.

•	The historical “natural monopoly” industries are typically composed of both potentially competitive segments (for example, long-distance telephone service, electricity generation, unbundled natural gas supplies, railroad rolling stock), where competition “in the market” may be an effective way to allocate resources, and natural monopoly segments (local telephone exchanges, electricity transmission and distribution networks, natural gas pipeline transportation, railroad track and switching networks), where competition in the market is not expected to yield good performance.2 Vertical integration between the natural monopoly segments and the potentially competitive segments, it is argued, has led to an unnecessary expansion of monopoly from one horizontal level (the natural monopoly level) to others (potentially competitive levels) and has extended inefficient regulation to segments where market forces can and should govern better.

•	For all competitors to compete effectively in the potentially competitive segments, and for competition to proceed efficiently in the competitive segments, prices charged for competitive services must be “unbundled” from prices for access to and use of complementary natural monopoly services. More important, competing suppliers of competitive services must have access to the regulated “bottleneck” natural monopoly segments that they rely on to compete, on the basis of “comparable” price and nonprice terms and conditions that do not unreasonably discriminate between competing suppliers, and in particular do not give more favorable access to the regulated monopoly network operator when it seeks to offer services in the competitive segnlents as well.
•	Vertical integration—that is, common ownership and control of facilities providing regulated “bottleneck” natural monopoly services, access to which is necessary to support competition in the competitive segments, and of affiliated entities that provide competitive services— creates potential competitive problems. These problems derive from the incentive to and ability of owners of the natural monopoly segments to discriminate in favor of competitive suppliers in which they have a financial interest, and against those in which they do not. If vertical integration is to be permitted, then effective rules are needed for ensuring comparable access to unaffihiated competitors to the bottleneck facilities. Developing and enforcing such comparability standards is difficult, both in theory and in practice. In the absence of evidence that there are significant economies from vertical integration, divestiture of assets in the competitive segments by owners of assets in the natural monopoly bottleneck segment is often viewed as the most desirable policy. However, this may not be a practical alternative when the incumbents are private firms, when the government must operate subject to constitutional protections against takings without just compensation, or when reasonable speed in accomplishing reform is desirable. Technological considerations may also make vertical or horizontal divestiture impractical.

•	Successful deregulation of the services sold in the competitive sector requires that there be an adequate number of competing suppliers or adequate constraints on prices provided by actual and potential entry of new suppliers. This will ensure that customers are not burdened by prices significantly above competitive levels as a consequence of the horizontal market power exercised in the competitive segments. Either horizontal separations to create more competitors or continuing regulation of dominant firms may be required as a transition to an acceptable level of horizontal competition in the competitive sector, if the current ownership
structure of suppliers is too highly concentrated and entry is not an adequately effective constraint on prices. A “reasonable” level of competition, not perfect competition, should be the goal, recognizing that the costs of imperfectly competitive markets are often less than the costs of necessarily imperfect regulation.

•	It may be necessary to apply appropriate cost separation rules, regulatory incentive mechanisms, or restrictions on entry into certain lines of business to regulated suppliers of monopoly services. This will help guard against distortions caused by cross-subsidization of costs associated with the provision of competitive services through prices charged for regulated monopoly services.

•	Incentive regulation (now increasingly referred to by U.S. regulators as “performance-based regulation”) should replace traditional cost-of-service regulation of residual natural monopoly services. For example, in the United Kingdom price caps are used to regulate the prices gas and electric distribution companies can charge for “wires” and “pipes” services. Alternatively, competition for the market rather than competition in the market, via the use of concession or franchise contracts with incentive provisions and suppliers selected through competitive bidding, may be relied upon as an alternative to more traditional price and entry regulation.

•	Retail customers should have access to wholesale markets for competitive services (such as natural gas supply) when direct access to these markets is technologically and economically feasible. To do so, they need to be offered “unbundled” prices and services from their incumbent, vertically integrated or “bundled” supplier, and to have access to the “bottleneck” network services required to consummate transactions. The obligation traditionally placed on public utilities to plan for and supply all customers located in a designated franchise area
with a full bundle of services should wither away as customers gain the ability to arrange for their own supplies in a competitive market. If suppliers of infrastructure services continue to be used as vehicles for financing social programs (universal service obligations, special low-income rates, internet access for public schools), the associated costs must be identified clearly and included in non-bypassable access charges paid by all consumers in order for them to be sustainable in the face of competition (Posner 1971).

Choice of Reform Models

Restructuring, privatization, deregulation, and competition are not, in my view, economic goals per se (though they may be political goals in support of democratic governments). They are, rather, means for achieving economic goals. Accordingly, the first step in developing effective regulatory institutions and competition policies is to define clearly what the public policy goals are for each infrastructure sector, given its current and expected levels of performance under prevailing institutional arrangements. These goals will naturally include (a) improving the ability of the sector to mobilize adequate financial resources to support the sector investments required to balance supply and demand efficiently; (b) increasing sector productivity by reducing operating costs and investing in more efficient plant and equipment; (c) bringing prices in line with costs to provide consumers with good price signals; (d) bringing aggregate revenues and costs into balance so that the sector’s capital needs can be financed by sector cash flows; and (e) adjusting the prices charged for sector services so that they are compatible with the introduction of competition into the competitive segments (tariff rebalancing), where prices and entry are to be deregulated and competition is to govern the allocation of resources.
The second step is to define the basic structure of the reform model that will be adopted for each sector. The specification of a reform model must go well beyond slogans such as “privatization,” “deregulation,” and “competition.” The model should define which segments of each sector will continue to be regulated monopolies, and whether regulation is expected to be permanent or a transitional mechanism anticipating deregulation of prices and entry in the future. It should also define which segments will be opened up to competition, the form of the competitive mechanisms that will be introduced, how quickly competition will be phased into the competitive segments, which segments will be privatized, and how any remaining state-owned enterprises will be organized (for example, independent state-owned commercial enterprises that are financed from retained earnings and debt, which is a liability of the enterprise rather than the government, or government departments that are financed by sovereign debt). The specification of which segments of each sector will be opened up to competition and which will continue to be regulated monopolies is a choice variable, as is the timing of the introduction of competition (see below). For example, in electricity, competition in the supply of electric generation services can be introduced at the wholesale level, with buyers as distribution monopolies that then bundle these services together with others and supply retail customers within their franchise area with a bundled product at a regulated retail price. Competition is then in the supply of the primary input required by the local electricity distributor to supply these retail consumers. Competition could be introduced at the retail level as well, with some (or eventually all) retail consumers given the opportunity to buy ~~wires” service from their local distribution company and, separately, “electricity supplies” directly in the wholesale generation market or from retailing intermediaries. Similar options are available for natural gas. In telecommunications, competition can be opened up in the international, long-distance, and local-service markets. It could be
facility-based competition only, or nonfacility-based competition, with competitors having the option of leasing from the incumbent network operator some or all of the network facilities they require to compete for consumers, rather than investing in parallel competing network facilities.

The third step is to define an industrial organization for the sector that is consistent with implementation of the chosen reform model—that is, the extent of horizontal integration at each level of the production chain and of vertical integration between levels. For the segments that are to remain regulated monopolies, should there be one large monopoly serving the entire country or several regulated monopolies serving specific geographic areas? This decision has implications for the potential effectiveness of regulatory instruments (for example. the use of some form of yardstick regulation) and potentially for the intensity of competition in those segments that are to be opened to competition. For example, if the reform model anticipates that electricity and gas distribution entities will purchase electric power or natural gas on behalf of retail consumers, rather than act as passive pipes and wires companies through which retail consumers make their own commodity purchasing decisions, an industrial organization with multiple distribution companies may be desirable, both to avoid monopsony problems in the competitive segments and to provide comparative purchasing information that can be used by the regulators of the distribution entities to monitor their behavior. This decision must in turn be informed by considerations of the importance of economies of scale measured over the geographic expanse of the exclusive franchise to be served by the regulated monopoly. In particular. some developing countries may have markets that are too small to support multiple regulated distribution monopolies serving different regions of a country without sacrificing significant economies of scale.
In the competitive segments of the infrastructure sector, the number and attributes of incumbent competitors as well as the conditions of entry will have important implications for both the intensity of competition and the associated inefficiencies and distributional consequences of any significant market power problems in these segments. For example, the electricity restructuring program in Argentina created a large number of private generating companies, and competition at the generation level has been intense. On the other hand, electricity restructuring in England and Wales created only two large fossil fuel generators, and this initial market structure decision has led to market power problems in the unregulated generation market. Similarly, as a consequence of the restructuring of the telecommunications sector in the United States in 1984, AT&T remained the dominant long-distance carrier for many years, and market power continues to be an issue in the long-distance markets despite the emergency of (nearly) three competing suppliers with national networks to compete with AT&T. The local Bell Operating Companies (BOCs) have been kept out of the long-distance market, despite the fact that allowing them to enter and compete would undermine market power in long-distance markets and reduce prices. They have been excluded from these markets largely because of concerns that they would then be able to use their control over local interconnection facilities to favor their own long-distance and local service affiliates over those of independent competitors. further distorting competition.3 The delay in allowing the BOCs to enter longdistance markets, however, has been costly, since the additional competition provided by their cntiy would probably have reduced prices significantly (Hausman 1997).

Specification of the extent of vertical integration raises more difficult problems. In many network infrastructure industries there are good reasons to believe that there are economies of vertical integration between natural monopoly segments and potentially competitive segments.
There are three choices open to policymakers: (a) retain vertically integrated regulated monopoly without competition in potentially competitive segments, to preserve economies of vertical integration; (b) allow the incumbent to remain vertically integrated, but also encourage new entrants to compete to supply potentially competitive services by giving them access to the incumbent’s monopoly network at prices allowing fair competition with the integrated incumbent; (c) require vertical ownership and control separation of suppliers in the regulated natural monopoly segments from suppliers in the competitive segments, thus allowing all suppliers in the competitive segments to have access to monopoly network facilities on comparable terms and conditions.

Option (a) is the status quo in most countries before privatization and deregulation. Option (b) is the approach taken in telecommunications restructuring in Europe and Japan, in electricity restructuring in many parts of the United States, and in natural gas sector reform in the United States, and is the path that telecommunications reform is supposed to take in the future in the United States. Option (c) is the approach taken in electricity restructuring in England and Wales, where monopoly transmission and distribution segments have been separated from the competitive generation segment.4 On the other hand, in England and Wales the distribution business is separated into two components: a “wires” or pure electricity transportation business, and a “supply” or retailing business that involves arranging with retail customers for their energy needs in the wholesale electricity market by buying energy from generators and reselling it to retail consumers. While the “supply business” is a competitive business, distributors are allowed to participate in it through unregulated affiliates, in competition with independent retail electricity suppliers that also need access to the distributor’s “bottleneck” facilities. Rather than barring distributors from the competitive retailing business, cost and functional separation rules
(“ring-fencing”) have been put in place to prevent distributors from using their control of distribution wires to favor their supply affiliates. A similar structural model for electricity has been adopted in Argentina, New Zealand, and Norway, with variations in the extent to which vertical integration is permitted. The initial concept for telecommunications restructuring in the United States clearly separated the incumbent (BOC) companies allowed to provide local exchange service from those authorized to provide long-distance service. On the other hand, the local exchange carriers were permitted to provide a variety of other services that made use of their local network facilities.

It would appear that option (b) offers the benefits of competition in the competitive segments without the potential costs of lost economies of vertical and multiproduct integration. But two things need to be kept in mind when comparing options (b) and (c). First, implementing option (b) successfully requires considerable regulatory effort to insure that the terms and conditions of access to the network do not discriminate against the network operator’s competitors. Second, the open network access rules often implemented to deal with potential vertical foreclosure problems may end up requiring the incumbent to behave as if it is not vertically integrated—for example, by mandating that it separate the operations and accounts of its competitive and regulated monopoly businesses, and restricting private communications between the regulated operator of the “bottleneck” network and its unregulated affiliates. In this case it is not clear that the potential benefits of vertical integration can be realized in the end as a result of these restrictions, since they effectively require the finns to behave as if they are not vertically integrated.

Before proceeding I would like to comment on the alternative view that option (a), combined with privatization and regulatoiy reform, should be given more serious consideration.
When one reads the reports of international financial organizations such as the World Bank, as well as the recent literature on regulatory reform, one may have the impression that regulated monopoly infrastructure suppliers and, in particular, state-owned monopoly infrastructure sectors are inevitably characterized by very poor performance and are an unmitigated evil. This view fails to recognize that over the last century most industrial countries have managed to build reasonably good infrastructure sectors by relying on public or private sector monopolies subject to public regulation. The institution of regulated monopoly in many industrial countries has been especially good at mobilizing adequate capital resources to expand capacity and meet growing demands. This is not to say that there have not been significant perfonnance problems in regulated monopoly sectors. Such problems have existed, and improving the performance of vertically integrated regulated monopolies has been the major motivation for reform in industrial countries. However, the magnitude of social costs associated with these performance problems is generally small compared to the inefficiencies observed in the infrastructure sectors of many developing countries. Moreover, the introduction of competition into infrastructure sectors in industrial countries has not been without its own problems in some cases.

These considerations suggest that one cannot dismiss out of hand the view that developing countries should consider following the path historically taken by industrial countries in these sectors. They typically relied on financially strong, vertically integrated regulated monopolies, incorporating into the regulatory institutions lessons learned about the strengths and weaknesses of alternative regulatory inechanisnis, and expanding competitive opportunities gradually as sector performance improved and the legal, political, and regulatory environments matured. If industrial countries were able to build their economies on infrastructures organized as regulated monopoly suppliers, why can’t developing countries do the same thing? From this
perspective the emphasis of policy reform would be primarily on creating independent and financially viable monopoly suppliers of infrastructure services, that operate in a regulatory environment oriented toward making investment in and maintenance of the infrastructure sector financially attractive and providing good incentives for supplying and pricing services efficiently. The primary goal here would be to eliminate shortages of infrastructure services, strengthen the financial condition of the sector, bring prices into line with costs, and reduce the costs of operating the system.

I believe that the appropriate response to this view is that this is a potentially viable strategy in some countries, where appropriate regulatory and commercial arrangements can be introduced to make regulated monopoly infi-astructurc sectors perform reasonably well. That they have not done so in the past creates a high burden of proof for those who would support this approach to reform. Moreover, at the very least such a strategy should incorporate an opportunity to introduce competition into the sector when it becomes more highly developed and can better take advantage of competitive opportunities. It should also take advantage of competitive opportunities that have a high probability of reducing costs and attracting investment with little risk of losses of economies of vertical integration, scale, or scope. For example, it would make little sense today to base the restructuring of an electric power sector and its regulation around fully vertically integrated electric utilities where transmission and distribution entities own and operate all of the generating plants. At the very least, the sector should be organized so that it can take advantage of opportunities to rely on competitive bidding by the distribution entities for electric generation supplies from independent power producers (TPPs). IPPs can compete to sell electricity under long-term contracts to regulated monopoly transmission and distribution entities, which then provide bundled services to retail consumers on an exclusive basis.
Similarly, it would make little sense to attempt to reform a telecommunications sector without a transition program that anticipated that in the future facility-based competition would be introduced into long-distance, international, and local calling services.

Once the basic industrial structure for the industry is defined, the next step is to decide how the reform models will be implemented. There is a “big bang” approach in which privatization, restructuring, and the introduction of competition is all accomplished in one big step. Electricity restructurings in England and Wales and Argentina took this approach, with fairly short transitional periods. The other approach is to provide for a relatively long transitional period, during which the industrial organization and associated regulatory institutions are allowed to evolve according to apreplanned transition program. For example, in Peru telecommunications policy reform is proceeding in stages. The incumbent telephone enterprise was privatized with a monopoly over local (except cellular), long-distance, and international service and regulated based on a prespecified regulatory contract for several years. At the end of the transitional period, competing suppliers of intercity and international service are to be allowed into the market. On the other hand, the restructuring of the electricity sector in Colombia took a gradualist approach, but failed to specify clearly how it would proceed over time (Gray 1997). Accordingly, I would like to distinguish between clearly structured transition programs and unstructured gradualism.

I view the choice between the “big bang” approach and the “transition” approach as depending largely on (a) the performance attributes of the existing system, focusing on the magnitude and sources of its performance problems; (b) the complexity of effectively implementing a big bang approach, given pricing and other imperfections in the existing system that cannot be fixed instantly; (c) the existing capacity of a country’s legal and political
institutions to support competitive markets for infrastructure services; (d) the speed with which reasonably competitive markets can evolve in potentially competitive segments; (e) the time required to create effective regulatory institutions; and (f) the ability of the country’s government to credibly commit at the outset to a restructuring framework that supports investment and competitive entry.

Whichever model is followed, there is a role for effective regulation, since there will almost always be some residual services that have natural monopoly characteristics, which makes reliance on unregulated markets for these services an unappealing (or at least politically unacceptable) choice. Depending on the sector and the reform model selected, the span of regulatory responsibilities will vary, but the basic regulatory issues will be the same.

Competition for the Market versus Competition in the Market

Some argue that infrastructure industries can be restructured in a way that eliminates the need for regulation. The key to the argument is the distinction between “competition for the market” and “competition in the market.” For natural monopoly segments, competition can still theoretically be exploited by putting up for competitive bids the exclusive right to provide the service with natural monopoly characteristics, pursuant to medium- or long-term franchise or concession contracts. Those who take this view have been reading too much Demsetz (1968) and not enough Williamson (1976) and Goldberg (1976). Franchise bidding works fine for services like trash collection, ambulance service, fire protection, and other local services where the relevant assets are not specific to a particular area, the service quality attributes can be readily defined, and the franchise contracts are of short duration and can be rcbid easily without significant price
penalties due either to incumbent advantages or concerns of suppliers that they will be unable to recover the costs of specific investments once they are sunk. The experience with “pure” franchise contracts for water and sewer systems, highways, and rail networks (tracks) is not particularly good (van den Berg 1997; Crampes and Estache 1997; Ruster 1997). Moreover, many of the infrastructure sectors in industrial countries evolved from enterprises that had franchise contracts which were not sufficiently flexible to make it possible for them to adapt effectively to changing economic conditions.

The fundamental problem with relying on concession contracts or franchise bidding for infrastructure sectors with natural monopoly characteristics is the importance of significant long-lived immobile capital investments in these sectors, the incompleteness of contracts, and associated potential ex post hold-up, renegotiation, and adaptation problems. In the end, longterm franchise and concession contracts need to be adjusted over time, and the contract administrator has essentially the same job as a regulator (Goldberg 1976).

The bottom line is that “competition for the market” does not alter the fundamental conclusion that good regulatory institutions are crucial to improving the performance of the natural monopoly segments of the infrastructure sectors and for supporting the introduction of competition into the potentially competitive segments of these sectors.

Universal Service, Income Distribution, and Taxation by Regulation

One of the standard criticisms of the incumbent infrastructure sectors in both industrial and developing countries is that tariff structures, service connection, and supply expansion policies have been used extensively to engage in subsidization and cross-subsidization, which benefits
some interest groups and burdens others. For example, in telecommunications, it is almost universally the case that long-distance and international calling prices have been kept high (far above marginal cost) so that these services would generate net revenues that could substantially contribute to the fixed costs of the local network, allowing the prices of local service to be kept low. This policy has been justified as promoting “universal service,” which can be viewed as desirable based on assumed network externality problems (the value of the network increases the more people can be reached over it) or simply on the broader social aim of giving all citizens of a country access to basic infrastructure services at “affordable” prices, in many countries (for example. France and Spain), for social and economic policy reasons, electricity tariffs are uniform across the country despite regional variations in supply costs. Most countries have provided direct and indirect subsidies to electricity and telephone services supplied to farms, residences, and small businesses in rural areas. In some countries, electricity tariffs either expressly provide lower prices for low-income consumers or “tilt” tariffs so that consumers with low-consumption levels pay prices below the cost of service to them under the assumption that there is a high correlation between income and electricity consumption. Many countries have used special electricity tariffs to attract or retain electricity-intensive industries either nationally or in particular regions. In developing countries, electricity, telephone, and railroad tariffs have often been constrained below levels that are compensatory in response to a variety of political pressures. Relatively high levels of illegal connections to electricity distribution and local telephone systems and the failure of consumers to pay for service are forms of subsidy that arguably tend to benefit the poor who could not otherwise afford these services.5 Redistributive goals are also reflected in regional or national policies that favor suppliers of local fuel, primarily coal, domestic equipment manufacturers, and construction companies, or finance certain research
and development activities. Accordingly, subsidization and cross-subsidization extends well beyond defined universal service goals or the desire to assist the poorest members of society to pay for access to modern infrastructure services.

The overall result is that the institution of regulated monopoly has been used as a vehicle to finance and implement a wide range of implicit tax and subsidy programs. The institution of regulated monopoly is an effective (though not necessarily efficient) vehicle for engaging in such policies for two reasons. First, monopoly status makes it impossible (or at least extremely difficult) for competitors to respond to and undermine the viability of price increases needed to finance direct and indirect subsidy programs. Second, the magnitude and nature of subsidies and cross-subsidies are buried in complex tariff-setting policies and resource acquisition programs that are heavily insulated from meaningful public scrutiny. This system of hidden taxes and subsidies makes it easier for the interest groups benefiting from them to sustain them, because they are more easily hidden from broader public scrutiny than are more transparent, “on budget” legislative tax and direct subsidy programs.

The future role of the infrastructure sectors in continuing to support some or all of these redistributional goals should be resolved as part of the restructuring, privatization, and regulatory reform program. As Richard Posner pointed out many years ago, competition undermines the ability to use regulated monopoly sectors as vehicles for taxing and subsidizing. Indeed, in some infrastructure sectors—in particular, telecommunications and freight transportation—the cross-subsidies reflected in regulated tariffs have themselves become a major stimulus to competitive entry, since potential entrants saw business opportunities in competing to supply services in segments in which regulated prices were higher than associated stand-alone costs of supply, producing revenue that could be used for subsidies in other segments. The kinds of direct and
indirect subsidies that exist today will not be sustainable in the competitive segments of the infrastructure segments (electricity generation, commodity natural gas, long-distance telephone service), and government efforts to sustain them in the face of competitive entry will distort the nature and direction of competition.

The standard prescription for restructuring and regulatory reform is to remove subsidies and cross-subsidies from the infrastructure sectors. The argument is that if these subsidies are socially desirable, it is better to shift the responsibility for raising revenue and distributing subsidies to the general tax system and budgeting process. infrastructure tariff-based subsidies that are justified as necessary to help the poor are often poorly targeted and may even be regressive. More important, taxation by regulation corrodes democratic institutions, encourages corruption, undermines the ability of the system to produce adequate revenues to cover the costs of supply as interest groups press to keep tariffs low, and increases supply costs by favoring particular (domestic) firms that supply inputs at high cost or low quality and by using infrastructure sectors as employment sinks. Finally, once it is recognized that competition will undermine the existing subsidy and cross-subsidy system, interest groups that benefit from subsidies and cross-subsidies and incumbent regulated firms that fear they will have to live with the distorted tariff structures (having to respond to competition where prices are too high and having difficulty rebalancing prices that have historically been too low) will have powerful incentives to oppose the introduction of competition into the segments where prices have been raised to pay for the subsidies. In short, taxation by regulation tends to be inconsistent with standard universal service goals, leads to costly inefficiencies, and creates a political environment that is resistant to reform.
I have considerable sympathy for the view that one of the goals of infrastructure sector reform should be to end taxation by regulation. However, we must admit a number of things before disposing of universal service and income redistribution goals as policies that should be implemented separately from pricing and procurement policies governing the infrastructure sectors themselves. In developing countries the general tax system may not be particularly efficient, either in its structure or in its ability to deal with tax evasion. Second, incomes of the poorest consumers may be difficult to measure accurately in a cost-effective manner, because the poor may work in the informal economy and not report their earnings to any public authority, or they may produce their own food, clothing, and other necessities. Finally, universal service goals and the goal of helping the poor to obtain access to infrastructure services are legitimate social aims, and it may be necessary politically to take them into account in the restructuring, privatization and regulatory reform program to make the program politically acceptable.

My friends in developing countries do not hesitate to remind me that many industrial countries have managed to develop quite nicely while using electricity, telephone, water, and transportation prices to subsidize the poor, to subsidize rural consumers, and to finance the expansion of infrastructure services to regions where initial revenues were insufficient to support associated costs. Such policies reflect longer-term economic development and social integration goals, as well as political constraints. Accordingly, cross-subsidies and taxation by regulation may not be ideal but are also not fatal to economic development. In my view, the challenge is to respond to widely shared income redistribution goals in a ~vay that does not significantly undermine the efficiency of the infrastructure sector, that is reasonably transparent, and that makes it difficult for taxation by regulation to be abused by interest groups through hidden subsidies that do not reflect widely shared democratic goals, undermine the economic viability of
each infrastructure sector, or become a significant impediment to the introduction of competition into the potentially competitive segments.

The primary rationale for using tariff policy in the infrastructure sector to raise and redistribute revenues should be that it provides both a more efficient tax raising and a more effective redistribution mechanism than the general tax and expenditure system. If this argument cannot be sustained, the end of taxation by regulation is a legitimate and highly desirable public policy goal. In either case, effective infrastructure sector reform makes it necessary to identify subsidies and cross-subsidies in the system and decide whether to end them, shift them to the general tax and expenditure system, or continue to subsidize them through infrastructure sector tariffs. The introduction of conlpetition means that these subsidies can no longer be financed by increasing the prices incumbent firms charge for services in the competitive segments to levels far above their “stand-alone” costs. Competitive suppliers will just enter under the umbrella created by the high prices and steal customers from the incumbent. For these subsidies and cross-subsidies to be sustained in the face of competition, they will have to be reflected in surcharges to prices charged for services provided by the remaining monopoly segments (distribution of electricity, water, and natural gas, and local access to the telephone network). To help ensure that subsidies are contained and reflect shared social values, sums should be clearly measured and identified as separate surcharges (taxes) on bills sent to consumers. This makes them more transparent and visible to the public.

There is, of course, no free lunch here. The same principles of optimal taxation that apply to direct taxes apply to implicit taxes that are assessed as components of regulated infrastructure sector tariffs. Considerations of the relative elasticities of demand and the associated deadweight losses from taxation apply as much to tariff design (Brown and Sibley 1983) as to
commodity taxes. Raising prices for relatively price-elastic infrastructure services to pay for perceived social goods can lead to significant efficiency losses.

Regulatory Agencies: Organization and Procedures

The standard prescription for designing good regulatory institutions typically includes the words “independence,” “transparency,” “accountability,” “expertise,” and “credibility.” These words convey important principles, the implementation of which must be sensitive to the legal and political institutions of different countries. The concept of an “independent” regulatory agency pursuing its goals with procedures that are open and transparent is familiar in the United States, Canada, and a few other countries. Even in the United States, where the concept of the independent regulatory commission was born many years ago and has had nearly a century to evolve, regulatory agencies are not completely free from political pressures, and their information and staff expertise are often inadequate for them to do their jobs effectively.6 The concept of an independent regulatory agency operating with transparent procedures, obligated to make decisions based on a logical evaluation of the facts in light of its statutory responsibilities and subject to judicial review, may be even more alien to countries where governments are used to making policy decisions behind the closed doors of ministries and govermnent departments. with limited due process. transparency, or judicial review opportunities. Moreover, regulatory institutions necessarily take time to create and mature, and their independence and credibility are established on the basis of both their legal foundations and their actual behavior when faced with difficult decisions that involve substantial interest group controversy (Gilbert and Newbery

1994).
In light of these considerations, I can only offer some general guidelines regarding the attributes of good regulatory institutions, which are applicable in a variety of ways to individual countries based on their economic situation and legal and political institutions (Spiller and others). First, however, it is useful to examine why “independence,” “transparency,” “accountability.” “expertise,” and “credibility” are important guiding principles for the creation of regulatory institutions.

The segments of infrastructure sectors that will be served by a monopoly enterprise subject to public regulation are typically very capital intensive and require significant investments in long-lived, highly immobile capital facilities. Since the prices charged by the regulated enterprises are subject to regulation, investors are naturally concerned that once the investments are sunk, the government has an incentive to “hold up” the firm in order to redistribute available ex post quasi rents to influential interest groups. In the absence of credible commitments that rules for price setting will provide a reasonable opportunity for suppliers to recover their investment and operating costs, including an appropriate return on the investments, it is more difficult and more costly for the enterprise to attract capital, and investment decisions may be distorted so that the potential cost of hold-ups is reduced. This is a special problem in many developing countries that lack a strong tradition and legal framework for respecting and enforcing private property rights and contractual commitments. This concern is further enhanced by the past willingness of governments to allow their infrastructure sectors to deteriorate as a result of their inability to sustain prices at levels high enough to cover the total costs of supplying services.

Consumers fear that the authorization of a monopoly supplier will lead to their exploitation in the form of excessive prices and poor-quality service once the regulated
monopoly has established itself Potential entrants into competitive segments that require access to the incumbent’s facilities to provide service are concerned about unreasonable restrictions on access to the network. In other words, there are issues of both efficiency and rent distribution that arise when giving an enterprise a legal monopoly. It is impossible to write a credible complete contingent claims contract that defines cx ante how the regulated firms are expected to behave and what they will be paid under all possible contingencies. Accordingly, effective regulatory institutions must be designed to provide credible commitments that investors will not be held up once their investments have been sunk, that consumers will be protected from excessive prices and poor-quality service resulting from the exercise of monopoly power or supply-side inefficiency, that other goals for the sector (universal service) will be achieved, and that supplier and consumer obligations can and will adapt well to changing economic and technological conditions.

With these considerations in mind, let me offer some thoughts about the organization and procedures of regulatory agencies (Smith 1 997a, b, and c provide good discussions of these issues).

Statutory Framework

The basic legal framework that will govern the operation of each sector subject to regulation must be specified. Typically, a separate statute is used to create an organic legal framework for each industry. The legal framework defines the goals for the sector, the basic preferred structure of the sector (defining regulated monopoly and competitive segments), a restructuring and privatization program for the incumbent suppliers, regulatory goals and responsibilities, the
structure of the regulatory institutions that will govern the sector, methods for selecting regulators, the ways in which the regulatory agency will be funded, and procedures that the regulators must utilize when they make regulatory decisions.

Structure of Regulatory Institutions

There are a number of decisions to be made regarding the structure of the regulatory framework that will govern each sector: single industry versus rnulti-industty regulatory agency; single regulator versus multicomnmissioner structure; regulatory appointment procedures; degree of agency discretion and authority to acquire information from regulated firms; staff resources; administrative procedures; and judicial review opportunities. I cannot go into each of these issues in detail here, but let me offer some comments on a few of them.

SINGLE- VERSUS MULTI-INDUSTRY REGULATORS. There is an ongoing debate on whether it is better to have “single-industry” regulatory agencies (as in England and Wales) or “multi-industry” regulatory agencies (typical of most state public utility commissions in the United States). The primary argument in favor of the single-industry regulatory agency approach is that it ensures deep technical and economic expertise about the attributes of the industry within each agency’s regulatory jurisdiction, and that this in turn leads to more effective regulatory decisions. The arguments against the single-industry approach are: (a) it is inefficient because it duplicates staff with common skills that are needed in the regulation of two or more industries~ (b) it limits opportunities for learning based on experience with new regulatory mechanisms or competition policies that may be applied first in one industry and then later in other industries subject to the
agency’s jurisdiction (for example, price cap mechanisms); and (c) it increases the potential for “capture” of the regulatory agency by a single interest group, in particular, the firms that it regulates.

My own view is that at the present there is enough overlap in regulatory issues, necessary staff skills, and opportunities to learn from experience with policies on other “natural monopoly” industries to make it desirable for a single agency to regulate electricity, natural gas pipelines and distribution networks, common carrier oil pipelines, and perhaps the water sector. Telecommunications regulation involves similar issues, but also often includes responsibilities for spectrum allocation and the supervision of various obligations placed on broadcasters. The sector is also in the midst of very rapid technological change. There are good arguments that there is enough different in telecommunication.s to justify a separate regulatory agency. Similarly, any residual regulation of the transportation sector is probably best assigned to a separate regulatory agency.

SINGLE-REGULATOR VERSUS MULTIPLE-COMMISSIONER STRUCTURE AND APPOINTMENTS. Single-

regulator systems inherently convey more power to a specific individual than do multiplecommissioner systems, which require that a majority of the commissioners agree on major policy decisions. This difference is often diminished somewhat by giving the chairman of a multicommissioner system more power than the other commissioners by way of control over the agenda and staff resources. There is necessarily a tradeoff between the ability of a single regulator to make reasonably quick decisions and the potential that the single regulator will abuse the authority that he or she has been given. It is especially problematic to attract new investment when the regulator has substantial discretion so that policies can change dramatically
with a change in the regulator. The regulator’s power to move decisively and to abuse his authority is necessarily influenced by the policy discretion that the regulator is given by the statute, the procedural requirements under which the regulator operates, and the opportunities affected parties have for judicial review. The more specific the statutory mandate is, the more desirable a single regulator is likely to be. At the same time, the more power the regulator has, the more important are transparent administrative procedures and opportunities for judicial review. While regulators cannot (and probably should not) be completely insulated from political pressure, it is desirable to make the agencies reasonably independent of changing political winds. Appointing regulators for fixed terms that are not coterminous with changes in government can help to contribute to the independence of the agency.

What are the appropriate criteria for selecting good regulators? The “good government” view is that regulators should have the necessary expertise to perform their jobs effectively and should be independent of interest groups that have an interest in the agency’s decisions. Ideally, regulators should have professional expertise relevant to their responsibilities as commissioners (administrative law, engineering, accounting, economics, inanagenient), although it need not be with the specific industries subject to the agency’s regulation; they should not have been employed recently by the firms subject to commission regulation or by other interest groups active before the regulatory agency: they should be appointed for fixed terms that are not coterminous with the election of the executive; and there should be a “cooling off’ period between the end of their appointments and employment by parties with direct interests in agency decisions that were under consideration during their tenures as commissioners.
REGULATORY DISCRETION. There are two ways that statutes can convey responsibilities to the regulatory agencies. The first is to give the regulatory agency substantial discretion by defining a general set of policy objectives that the regulatory agency is directed to pursue and leaves it to the agency to develop the specific regulatory mechanisms that it will use to achieve these objectives. The agency’s discretion is limited by procedural requirements, legislative oversight, and opportunities interest groups have for judicial review. The second approach is to give the regulatory agency substantially less discretion by defining more precisely what it is supposed to do and how it is supposed to do it. An agency’s discretion may be further limited by agency-specific procedural requirements, legislative oversight, and opportunities for interest groups to appeal to the courts.

Many developing countries are privatizing their utilities after years of public ownership, poor performance, prices constrained to too low a level to support new investments, and an unfavorable history of regulatory independence and enforcement of property rights and contractual obligations. In these cases, the second approach giving less discretion to the regulatory agency will often make the most sense. For example, the statute may define a detailed ~~regulatory contract” that prespecifies prices and price adjustment provisions, service obligations, and other factors to prevail for a period of years, after which the agency is given more discretion to develop and apply new regulatory mechanisms. The rationale for this approach is to create a framework that establishes the credibility of the reform program and in this way helps attract capital to these sectors. This approach is also compatible with a singleregulator model combined with transparent opportunities for judicial review of the agency’s implementation of the statute. It is not a costless strategy, however. Rigid contractual terms reduce the flexibility of the agency to make socially desirable changes that adapt to changing
supply and demand conditions, better information, and more experience. As experience and credibility are gained and administrative and judicial review procedures are developed, the agency can be given more discretion to define regulatory mechanisms after the initial period of more stringent statutory mandates.

ADMINISTRATIVE PROCEDURES AND JUDICIAL REVIEW. The choice of administrative procedures and opportunities for judicial review involve a balance between, on the one hand, opportunities for affected parties to express their views on proposed agency actions and have these views and associated facts fairly taken into account in agency decisions and, on the other hand, excessive due process obligations that create significant opportunities for administrative delays, frustrating regulatory actions of any kind. In developing countries with a history of poor infrastructure performance and arbitrary government intervention into the sector, transparent administrative procedures and opportunities for judicial review are likely to be especially important to infrastructure investors. competitors who rely on access to the network infrastructure to compete, and consumers who want to be sure that the objectives of the statute are being realized and regulatory authority is not being abused. Basic due process obligations include notice requirements that agencies publicly announce the initiation of a process to make a policy decision, opportunities for interested parties to comment on major policy issues, rules restricting ex parte nonpublic contacts between the regulators and interest groups affected by their decisions, and the requirement that the regulator explain policy decisions.

Opportunities for judicial review of agency decisions are also important, especially when a single regulator has substantial discretion and agency procedures and policies are in the formative stage. Judicial review is most important and effective in guarding against decisions by
a regulatory agency that clearly fall outside of its statutory mandate or that fail (blatantly) to follow established administrative procedures. Judicial review is likely to be most important in the period immediately following the passage of a new organic statute for restructuring, privatization, and regulation, when regulatory responsibilities, authority, and procedures may not be clearly defined. However, we should not expect the courts to become heavily involved in the details of complex technical issues that are supposed to be addressed by expert agencies. This would just create a second layer of regulation.

AGENCY STAFF AND INFORMATION COLLECTION AUTHORITY. To fulfill its obligations effectively, an agency needs a staff composed of individuals with the qualifications necessary to support the agency’s regulatory responsibilities. A regulatory agency cannot do an effective job if it does not have the authority to require the firms subject to its jurisdiction to submit cost, price, and other information necessary for assessing their behavior and performance. Moreover, it must have the authority to define accounting systems for use by regulated firms and to audit the regulated firms. The specification of uniforni systems of accounts and auditing authority are powerful tools that are routinely established and utilized by effective regulatory systems. information requirements for firms in the competitive segments may be less stringent, and procedures can be adopted that ensure that sensitive business information is held in confidence.

Developing adequate staff resources and skills. uniform accounting systems. and the collection and evaluation of relevant cost, price, and performance quality data can take several years. The likely availability or unavailability, of the staff, analytical capabilities, auditing authority, databases, and experience should be taken into account when designing regulatory mechanisms to be used to regulate the firms in the sector. These considerations imply that
utilization of relatively simple regulatory rules and procedures may initially be more effective in practice than more complicated mechanisms that are theoretically superior. Opportunities to evaluate, adapt, and enhance regulatory procedures as experience is gained can be built into the program at the outset so that investors are on notice that reasonable changes may be anticipated as time goes on.

CONSUMER ADVOCACY. Due process and judicial review opportunities are not very meaningful if interest groups do not have the capability to take advantage of them. One should presume that the regulated supplier of monopoly infrastructure services, actual and potential competitors that rely on the regulated finn’s network, and large industrial and commercial consumers will have the resources and ability to represent their own interests before the regulatory agency. This is not likely to be the case for small residential and small commercial consumers.7 The designation of an independent public advocate to represent their interests before the regulatory agency is a desirable component of the regulatory environment. Consumer advocates play a potentially important role in regulatory proceedings by representing the interests of a large number of small consumers who cannot represent themselves or easily organize to do so collectively. This consumer advocacy function could be given to another agency in the government (for example, the justice ministry) or even to an independent agency with its own funding. Not only can a public consumer advocate represent the interests of small consumers, but by doing so it can also diffuse criticisms of restructuring and privatization in some countries as too heavily focused on the interests of suppliers and large consumers and not sufficiently concerned about the effects of reform on individuals and small businesses.
Regulatory Mechanism Design

In this section 1 will focus on general principles for designing mechanisms to regulate prices charged by firms or segments of firms that are legal monopolies. In the next section I will discuss access to regulated monopoly “bottleneck” facilities that is required to efficiently support competition in the competitive segments.

Regulators of legal monopolies typically are given multiple explicit or implicit goals and must achieve them subject to a number of constraints. These goals include:

•	Charging consumers “reasonable” prices overall for services provided by the regulated monopoly (the rent extraction goal).8

•	Inducing the monopoly supplier to perform its services efficiently (the supply-side efficiency goal).

•	Providing consumers with incentives through the level and structure of prices to make efficient utilization (consumption) decisions regarding their use of the services offered by the regulated monopoly (the demand-side efficiency goal).

•	Providing adequate incentives for the economic environment to attract additional capital to the regulated monopoly sector (and to invest in maintaining the existing capital stock) to balance supply and demand over time. This requires regulatory rules and procedures that allow the regulated firm to anticipate revenues that will at least cover the (efficient) costs of supplying services, including a return on investment at least equal to the firm’s cost of capital (the capital attraction goal orfirm viability constraint).

•	Ensuring income redistribution in a variety of ways, including constraints on the speed of any tariff rebalancing from the status quo, through the use of regulatory instruments rather than
“external” public finance instruments (for example, taxes and subsidies) (income

redistribution goals).

If the regulator had complete exogenous information about the regulated firm’s present and future production and cost opportunities about the demand structures for all types of consumers and how they will evolve, about the variables necessary to implement income distribution goals, and about the public’s assurance that the regulator can be trusted to pursue its goals fairly and efficiently, the regulator’s task would be fairly straightforward. The regulator could fairly mechanically calculate the (second-best) optimal price levels and tariff structure for the regulated firm at every point in time and adjust them over time as demand, cost, and income distribution conditions change.9 Elaborate procedures would not be required because the regulator is assumed to pursue a well-defined set of “public interest” goals efficiently.

Unfortunately, this happy situation never exists in reality, no matter how useful the theoretical benchmarks derived from models that assume that it does may be. Moreover, if one were to believe that these were reasonable characterizations of reality, there would be no need to separate the regulator from the regulated firm, since the public regulator would have all the information necessary to produce and price the output of the regulated firm efficiently. The explicit or implicit assumption that these conditions hold in reality has sometimes been used to rationalize public ownership of natural monopoly sectors. That these public enterprises have often failed to achieve the goals enumerated above suggests that regulatory mechanisms built on these assumptions arc useful primarily for deriving theoretical pricing benchmarks that regulators can use to guide their behavior in a world of imperfect information.

The fundamental problem that regulatory agencies must confront in designing regulatory mechanisms is that the regulated firm possesses more information than the regulator about its
overall production cost opportunities, the costs of the individual services it supplies, the operating characteristics of its network ex ante and in real time, the effort it expends to keep costs low, the attributes of its customers’ demand patterns, the quality of the ser~’ices it provides, the costs of improving that quality, and the responsiveness of its customers to various tariff structures. That is, there is an asymmetry of information between the regulatory agency and the regulated firm. This information asymmetry can be reduced by requiring the regulated firm to report to the regulator on its costs, prices, demand patterns, technical operating characteristics, and providing for associated auditing authority. Moreover, the regulator’s capability to obtain good information about cost, demand, distribution, and other relevant variables may improve over time as it gains experience and its auditing and analysis capabilities grow. But information asymmetry can never be eliminated completely. Accordingly, the regulatory game is one in which the regulated firm will always know more about its economic environment than the regulator and will try to extract some rent from consumers as a result of its information advantage. In addition, both the regulated firm and the regulatory agency operate in a world where future cost opportunities, demand characteristics, and relevant income distribution variables are uncertain and credible full contingent claims contracts are not a viable option. Finally, interest groups are unlikely to trust the regulatory agency to pursue reasonable public interest goals without regulatory procedures that are open to public scrutiny and judicial review. The design of regulatory mechanisms and regulatory procedures should take these considerations into account.

There are two polar case regulatory mechanisms that provide useful benchmarks for thinking about the development of practical regulatory mechanisms, given the initial conditions
of the infrastructure sector and regulatory and legal capabilities in a particular country. The first is a fixed price regulatory mechanism and the second is a cost-plus regulatory mechanism.

Fixed Price Mechanisms

Under a fixed price regulatory mechanism, the regulator defines ex ante a set of prices (or a weighted average of prices for different services) that the regulated firm will be allowed to charge consumers for the services it provides and price adjustment formulas tied to exogenous variables (for example, general inflation and an assumed rate of productivity growth) going forward. The prices are not tied directly to the regulated firm’s costs or profits. Fixed price mechanisms include pricing mechanisms that define specific prices for specific services going into the future, mechanisms that specify initial prices for each service and a formula for future adjustments, and price cap mechanisms that set initial prices for services and allow both adjustments in the overall price level and a rebalancing of the structure of prices over time. In the latter case, a price cap formula is specified as a weighted average price for all regulated services supplied by the firm, and provisions are made for adjusting the weighted average price over time to reflect input price inflation and expected productivity growth rates. In all cases the decoupling of prices from the actual costs and profits realized by the firm provides high-powered incentives for the firm to supply output efficiently. Depending on how the mechanism is designed. it may also give the regulated firm incentives to use its information about consumer demands to implement (second-best) efficient prices.

However, designing a good fixed price mechanism must confront a number of potential problems. The first problem is that without good information about the firm’s cost opportunities
and attributes of demand for the services it supplies, the regulator will be uncertain as to the proper level at which to set initial prices and how these prices should be adjusted over time as economic conditions change. Prices that are set too high will shift income from consumers to the regulated firm and may conflict with remit extraction goals. For countries with infrastructure sectors starved for capital investment and facing serious shortages of infrastructure services because prices have been too low, a credible fixed price contract (including provisions to adjust prices for inflation, productivity targets, and other factors) that sets prices high enough to yield attractive expected investment returns can be very effective in attracting investment funds and in closing the gap between supply and demand (see the discussion below of telecommunications in Peru). On the other hand, prices that are set too low will not provide adequate incentives for new investnient and maintenance of equipment, conflicting with the supply-side efficiency and firm viability goals. Beyond the issue of the overall price level, without good information about marginal costs and demand patterns, it will be difficult to specify an efficient price structure (prices for different services or types of customers, nonlinear tariff structures, and so on) or the weights on a global price cap that would provide incentives for the regulated firm to seek to establish the (second-best) optimal tariff structure itself.

Fixed price contracts can also create perverse incentives regarding the quality of service provided by a regulated monopoly. These mechanisms can create powerful incentives to keep costs low to maximize profits, but inadequate incentives to invest in some service dimensions that I will siniply call “service quality.” Accordingly, fixed price mechanisms need somehow to reflect the value of service quality in the mechanism either by tying prices directly to levels of service quality or by specifying minimum quality standards and associated penalties if they are not achieved.
Let me now discuss briefly three examples of fixed price mechanisms and the pluses and minuses associated with each of them.

REGULATiON OF TELECOMMUNICATIONS IN PERU. Telecommunications regulation in Peru provides an interesting example of both a sector reform model and the use of a fixed price regulatory mechanism applied to an incumbent privatized with a temporary monopoly concession.’0 In 1970 the Peruvian government nationalized the private firms making up the telephone sector and created a state-owned company to run the telephone system. Over the next 20 years, and especially as a consequence of the hyperinflation of the late l980s, the quality of telephone service deteriorated and the telephone system canie close to collapsing, as the state-owned companies (CPT and ENTEL) were essentially bankrupt. Price increases had seriously lagged behind cost increases, and prices were inadequate to cover operating costs or to support new investment. As in most other countries, local-service prices were kept very low, while intercity and international service prices were set at high levels to produce net revenues that would help to cover the costs of the local network. There was low telephone penetration (the lowest in Latin America by far), a huge excess demand for telephone service, with queues for legal connections as long as six years (along with the inevitable corruption associated with jumping the queue), poor service quality, and limited investment in new facilities.

In 1993 the government formed Telefonica del Peru (TDP) out of the existing stateowned enterprises and then auctioned it off to the private sector with a fixed price regulatory contract. TDP was acquired by the Spanish national telephone company. The basic reform model under which TDP was privatized envisioned giving it a monopoly over both local and intercity service (except cellular) for a fixed period of time (roughly five years), subject to a form of fixed
price regulatory contract. At the end of the five-year exclusivity period, competitors would be allowed to enter the local, intercity, and international markets and compete with TDP. At that time, a new regulatory mechanism would be applied to any of those services provided by TDP that required continued regulation. An independent telecommunications regulatory agency was created to enforce TDP’s obligations under the regulatory contract, develop policies to promote competition at the end of the exclusivity period, and regulate TDP after the initial five-year regulatory contract ran its course. The terms and conditions of the initial regulatory contract are enforceable under commercial law, giving the regulator little discretion during the exclusivity period.

The rationales for privatizing TDP as a monopoly with a fixed exclusivity period, rather than opening up the intercity and long-distance markets immediately to competition, were that (a) attracting new investment to improve the infrastructure quickly was the highest priority; (b) Peru needed to establish a reputation for credible regulatory rules to attract investment to the sector; and (c) introducing competition before significant tariff rebalancing was accomplished would lead to cream skimming, uneconomic bypass, and undermining of needed investment in the basic telecommunications infrastructure. Similarly, specifying a regulatory contract enforceable under commercial law was motivated by the desire to make the price commitments credible.

The regulatory contract that applies to TDP during the exclusivity period has the following features:

•	It specifies maximum real prices for various service components for each year the contract is in effect. The prices change over time so as to affect a tariff rebalancing, which increases local service prices and reduces intercity and international service prices. The idea here was
to gradually bring intercity and international prices into line with what they would become in a competitive market when these markets are opened to competition.

•	It specifies a minimum number of new lines that TDP is required to install each year and various minimum service quality improvement obligations (waiting time for new service requests, network failures, waiting time for operator assistance), including obligations to install additional public telephones. TDP files compliance reports with the regulator monthly and annually to demonstrate that it is fulfilling its contractual obligations.

This program appears to have been successful in a number of dimensions. TDP has generally exceeded all of its major investment and service improvement goals. Indeed, the installation of new lines and public telephones proceeded more quickly than required by the contract. Between 1993 and mid-1997 TDP increased the number of telephone lines in Peru by about 250 percent and the number of public phones (important in remote rural areas) by about 400 percent. The telephone network has gone from being less than 40 percent digital to more than 90 percent digital in less than five years. Average waiting time for a new line has been reduced from 70 months in 1993 to 5 months in 1996. At the same time TDP has reduced employment by 50 percent. Finally, a significant tariff rebalancing will have been completed by the end of 1998, setting the stage for competition to begin in intercity and international service.

Several concerns have been raised about this reform program and the associated regulatory contract. Some observers argue that the contract prices were too high and that TOP has been able to earn excess profits during the contract period. The regulator does not appear to have the kind of financial information that would be necessary to determine whether this assertion is right or wrong. However, TOP’s willingness to make very substantial investments suggests that the contract is both credible and provides prices that are at least high enough to
cover TOP’s risk-adjusted cost of capital. Concerns have also been expressed that the reform program does not adequately deal with the needs of the poorest citizens with special low-use tariffs or direct subsidies. In addition to the issues related to price levels and price structures, there appears to be widespread concern that the five-year exclusivity period has given TDP the power to establish an entrenched position that will make life difficult for competitors that seek to enter the markets that are to be opened up to competition in the future. The entrenchment concerns are both economic and political. These problems may be the inevitable outcome of the development of a reputation for making credible commitments to investors, limited regulatory information and expertise, the resulting reliance on simple rather than complex mechanisms, investment, rent extraction, and supply-side efficiency goals.

PRICE CAPS FOR ELECTRICITY DISTRIBUTION COMPANIES IN ENGLAND AND WALES. In 1990 the

electricity sector in England and Wales was restructured and privatized. Prior to restructuring, the state-owned CEO B was a vertically integrated monopoly that operated the transmission network and electric generating facilities in England and Wales and sold electricity on an exclusive basis to a dozen state-owned monopoly distribution companies (Area Boards) and a few large industrial customers pursuant to a regulated bulk supply tariff. The Area Boards distributed this electricity to retail customers in exclusive geographic areas pursuant to regulated “bundled” retail tariffs. In 1990 the CEOB was broken up into three generating companies— National Power (NP), Power Gen (PG), and Nuclear Electric—and a transmission company (NGC). Two of the generating companies (NP and PG) were privatized by selling shares to the public. The third generating company held the CEGB’s nuclear generating plants, remained in state hands initially, and was only recently privatized. An organized half-hourly spot market for
generation service (“the pool”) was created into which all generators must offer physical supplies of electricity. Prices for electricity determined in the pooi were initially completely unregulated, but temporary price caps were imposed on the two large fossil generators to mitigate their market power pending divestiture of some of their generating assets.

NGC was created from the transmission and network operations division of the CEGB. It is a regulated private monopoly that manages the pool and is responsible for scheduling and dispatching generators economically based on bid-prices, running a billing and settlements system to match buyers and sellers together, operating the transmission system, and planning and investing in new transmission facilities. The Area Boards were also privatized by selling shares to the public. Their businesses were separated into a “wires” business and an electricity “supply” business. Tariffs unbundled to reflect separately the costs of distribution service, the costs of generation and transmission service, and the costs of certain retail services such as metering and billing was required. The distribution wires business remained a monopoly subject to regulation. The electricity supply business involves contracting with retail customers to arrange for their supplies of electrical energy acquired in a wholesale electricity market by these electricity suppliers. Retail electricity supply was opened up to competition and deregulated. The opportunity for customers to buy generation service separately from distribution service from competing electricity suppliers has been gradually extended from large to small customers, with all customers expected to be eligible sometime in 1998. A regulatory agency (OFER~ was created to oversee the evolution of the sector. OFER was given defined regulatory responsibilities regarding the residual monopoly services provided by the distribution companies and the NCTC and the monitoring of the performance of the entire system, including those segments that had been deregulated.
Much has been written about the experience with privatization, restructuring, and competition in the electricity sector in England and Wales (Newbery and Pollit 1997; Wolfram 1997; Armstrong, Cowings, and Vickers 1994). Here 1 will briefly discuss the regulatory mechanism used to regulate the monopoly distribution wires business and will comment separately below on the mechanism used to regulate NGC as well. The law restructuring the sector provided that the distribution wires business would be regulated using a price cap mechanism. Basically, the initial distribution tariffs that were in place could be adjusted annually to reflect inflation and a prespecified productivity factor (which initially assumed declining productivity in most cases, due to significant investments required to upgrade the distribution systems). The distributors were also subject to a variety of service-quality standards. Failure to meet them involved the assessment of financial penalties. The costs of generation serviced acquired by a distribution company and made available to retail customers who were not yet able to access the competitive energy supply market or chose not to do so were effectively passed through in final prices. The parameters of the price cap mechanism and associated quality standards were subject to review and adjustment by the regulator every few years. Thus the mechanism anticipated continued regulation of the distribution wires business using a “fixed price” price cap mechanism, but built in a “ratchet” process that provided for regulatory review every few years. The review includes an assessment of the profitability (rate of return) of the distribution business, which in turn requires an operating and capital costs accounting system that can be used to make meaningful assessments of economic profits. Thus the regulatory mechanisms is a price cap mechanism with a cost-of-service “ratchet” to the price level every few years.
The price cap mechanism has worked reasonably well in terms of providing good incentives for cost reduction and maintaining service quality. Labor productivity has improved in the distribution companies and service quality deterioration has not been a significant problem. The major problem has been that distributors have achieved much more significant productivity improvements than originally anticipated by the productivity factors in the initial price caps, and this has made it possible for the distributors to earn high profits.” The high profits have in turn led to public criticism of the system and enormous pressures on the regulator to reset prices and tighten the productivity targets, which he has done. In short, it has proven difficult to find the ~‘right” productivity adjustment factor and this in turn has conflicted with rent extraction goals. However, the provisions built into the regulatory design at the outset for periodically resetting both the price level based on actual performance and the productivity factor going forward made it possible to adjust price levels and their future trajectory as more information and experience were obtained by the regulator. In this way rent extraction goals were furthered (Laffont and Tirole 1993: chapter 9). The “ratchet” of course dulls the regulated firm’s incentives to minimize supply costs and there is a clear tradeoff between rent extraction, supply-side efficiency, and (if the productivity standard had alternatively been too tough rather than too soft) firm viability goals. The experience with price cap mechanisms around the world suggests that to be credible they almost certainly should include a prespecified review and adjustment protocol cx ante, since either excessive profits or nonconipensatory prices will almost certainly create political pressure to reopen the mechanism anyway.

THE PRICE CAP APPLIED TO THE TRANSMISSION COMPANY (NGC) IN ENGLAND AND WALES. The

NGC also had a simple price cap (RPJ-~ X+ Z) applied to the charges that it could assess to
generators and distributors for use of the transmission network. However, the price cap applied was in fact only a partial price cap in the following sense. It assumed that the only costs relevant for providing transmission service were the costs of operating the transmission wires business and amortizing the investments in it. It ignored the fact that a potentially important transmission cost is the cost of congestion on the network. When congestion arises, NGC must redispatch generators out of merit order to meet demand reliably when the network is constrained. These redispatch costs, though technically generating costs, are properly thought of as transmission-related. Investments in additional transmission capacity of various kinds can reduce these redispatch costs. However, under the price cap initially applied to NGC, these congestion costs were simply passed through to the consumers relying on the transmission grid. As a result, the price cap mechanism created no positive incentives to reduce these costs by investing in transmission capacity to alleviate the congestion. Indeed, the structure of the price cap mechanism probably gave NGC disincentives to make major investments on the network, and certainly provided no incentives to make the investments in the right places on the network. This is the case because NGC’s revenues under the price cap were determined largely by the peak demand on the network and its profits depended on both these revenues and its ability to keep the (narrowly defined) costs of operating the network low, ignoring the costs of congestion.

These three examples demonstrate both the benefits and the costs of various types of ~‘fixed price” regulatory mechanisms. It is important to recognize, however, that the balance of costs and benefits of alternative mechanisms is likely to differ significantly from country to country, based on the initial economic conditions of the sector, the legal and political environment, and the information available to and technical capabilities of the regulator. For example, the balance of benefits and costs of privatizing the incumbent telephone company with
a five-year monopoly, as in Peru, may be very different in a country with a well-developed telephone network, where performance is relatively good, there is no urgent need to attract large amounts of capital into the sector, and there are experienced regulators with good information and a reputation for protecting private property rights associated with investments in infrastructure. Moreover, a fixed price contract of this type might not have been feasible in Peru if there were not also macroeconomic reforms that sufficiently stabilized the economy to make it feasible to define the prices in terms of real values of the local currency without creating enormous financial risks for investors. On the other hand, a price cap mechanism such as that deployed for NGC could have been much more costly in a country with rapidly growing electricity demand and the need to significantly and rapidly expand its transmission network by attracting new investment to accommodate efficient use of and investment.

cost-plus Mechanisms

At the other extreme of the spectrum of regulatory mechanisms lies “cost-plus” regulation. Under cost-plus regulation, the regulated firm effectively submits a bill for its operating expenses and capital costs, including an after-tax return on its investment that equals or exceeds its cost of capital (the “plus”), and the regulator passes these costs through in the prices charged to consumers of the sector’s services. The potential problems with pure cost-plus regulation when regulators have imperfect inforniation about a firm’s cost opportunities are well known. At the extreme, unless the regulator has established a good operating and capital cost accounting system. can measure the firm’s cost of capital accurately, and can audit the regulated firm’s actual costs, the firm is in a position to misrepresent its costs, effectively passing itself off as the
12

highest-cost firm that the regulator would find credible. This leads the regulator to set prices that are too high, a result that conflicts with rent extraction goals. Even if the regulator has good cost accounting, measurement, and auditing procedures in place, in the absence of good information about the firm’s cost opportunities, its managerial effort, and associated costs, pure cost-plus regulation dulls incentives for the regulated firm to minimize costs, meaning that the audited costs that the regulator observes and passes through to consumers will be too high. This conflicts with both rent extraction and supply-side efficiency goals (Schmalensee 1989). The rent extraction issues here are more subtle, as consumers pay the firm’s “costs,” but the costs are too high and the rents may accrue largely to the managers, workers, and input suppliers of the firm. Cost-plus regulation with accounting and auditing standards can also provide useful information to the regulator for designing tariff structures, although additional information about consumer demand is still necessary to design (second-best) optimal tariffs.

The potential benefit of a credible cost-plus regulatory system is that it is likely to be very effective in attracting capital investment to the sector, since investors are assured that they will recover their operating and investment costs, perhaps with a return far exceeding their cost of capital. The capital mobilization goal or firm viability constraint is easily satisfied and this can be attractive to investors. Pure cost-plus systems shift a variety of firm-specific and market risks from the firm to consumers and reduce the regulated firm’s financial risk and cost of capital. Infrastructure sectors in the United States and other industrial countries all evolved under some variant of cost-plus regulation and, whatever the faults of this system, inadequate investment and shortages of capacity to meet demand are rarely among them. Accordingly, some form of costplus regulation is potentially attractive to a country where attracting a large amount of capital investment quickly is viewed as important given the current state of the sector and challenging
given the legal and regulatory environment and associated reputation that the country has at the start of the reform program. The history of cost-based regulation in the United States is replete with economic and regulatory debates over accounting and auditing procedures, capital valuation and depreciation rules, and methods for calculating the firm’s cost of capital. However, there is no reason for a developing country to replicate all of this work (or to repeat mistakes), and there is much to learn from practice in the United States and Canada, where cost-based regulatory principles historically have been applied in the most transparent way.

In practice, a pure cost-plus regulation is a bit of a straw man and has probably gotten a worse reputation than it actually deserves. The United States has had the most experience with a form of cost-plus regulation called “rate of return” regulation, which is applied to legal monopolies in the electricity, telephone, natural gas pipeline and distribution, and water distribution sectors. As applied in practice in the United States, prices for regulated services are not continuously tied to accounting costs. Prices are set in public hearings based on an evaluation of capital and operating costs that conform to a specific accounting system and have been audited along with an estimate of the firm’s financial cost of capital. Once these base prices are set they are not adjusted (or are only partially adjusted) automatically for changes in costs over time. Prices are fixed until they are reviewed by the regulator again (Joskow 1974; Joskow and Schmalensee 1986). Depending on which phase in history one examines, the period between regulatory reviews—knows as regulatory lag—has often been several years. Regulatory lag effectively turns cost-plus regulation into a fixed price regulation system with a cost-based “ratchet” adjustment taking place every few years. It also has similar incentive properties. This type of regulation worked best in the United States when the lags were relatively long because nominal unit costs were falling due to productivity growth and low input price inflation, and
formal regulatory reviews were few (Joskow 1974). Consumers left some rents on the table for the regulated firms, but the system provided reasonably good efficiency incentives and high rates of productivity growth. In addition, not only are costs subject to elaborate accounting and auditing requirements in the United States, but regulators do not have to accept the costs that are presented to them if they determine they are “unreasonable” or imp~dent.” Regulators can make these judgments through nianagetnent audits or benchmarking of the firnis costs against comparable firms (or statistically comparable firms), effectively applying some “yardstick competition.”

Managing a reasonably good cost-based regulatory system places an enormous information burden on the regulator. A good accounting and auditing system needs to be put in place. Methodologies for measuring the firm’s cost of capital and evaluating its behavior through management audits and benchmarking studies need to be implemented. These tasks are especially challenging when technology is changing rapidly and good coinparables for benchmarking are not available. At the very least, these are capabilities that a new regulatory agency is unlikely to be able to acquire instantly and it may require years to develop the necessary capabilities and experience (The Economist, January 3, 1998, pp. 59—60). These considerations suggest that newly created regulatory agencies are unlikely to have the capability to implement (roughly) cost-plus systems effectively.

Hybrid Sv~tems

Neither a pure fixed price (including price cap without a ratchet) system nor a pure cost-plus system is likely to be the most desirable regulatory mechanism for an infrastructure segment
expected to continue as a regulated monopoly for the foreseeable future (Schmalensee 1989))~ Moreover, the regulator’s capabilities and information are likely to improve over time with experience if it is given adequate resources and independence. This evolution is likely to make more sophisticated mechanisms a credible option as the regulatory framework matures. A variety of hybrid forms arc available that take some account of the firm’s realized costs, but also embody decentralized incentives that better align the objectives of the regulator and the firm. The choice among them depends on the initial economic problems faced by the infrastructure segment, the nature and credibility of legal and regulatory institutions, the state of cost accounting and auditing capabilities, the information regulators have about cost opportunities and demand, and the human resources available to perform regulatory tasks.

We have already discussed price cap systems that have a built-in program to reset the cap and the adjustment factors that will be used going forward. The regulatory contract used for the telephone company in Peru has some of the same features, but also embodies a specific tariff rebalancing process to prepare for competition in intercity and international service. However, the regulatory mechanism that will replace the contract at the end of its term is not clearly specified, and the terms and conditions of follow-on regulatory arrangements are likely to lead to significant disputes between TDP and its regulator. Mechanisms that are more closely tied to audited costs but that build in incentives for cost reduction are also available. These include a variety of profit-sharing mechanisms that ensure the benefits and burdens of cost savings are shared by the regulated firm and consumers (Joskow and Schmalensee 1986; Laffont and Tirole 1993). These mechanisms, however, are only viable if a satisfactory cost accounting, reporting, and auditing capability exists. They, too. eventually require a ratchet to evaluate their performance and to reset the base price.
The choice of regulatory mechanism also depends on the macroeconomic stability of a country. Cost-based systems are likely to work poorly in countries where rapid inflation is a possibility, interest rates fluctuate widely and are subject to government controls, and exchange rates also fluctuate widely and are subject to government management. This is the case because capital cost accounting systems and associated methods for calculating costs of capital and allowed rates of return do not work very well in unstable macroeconomic environments. Regulatory lag can become a big obstacle to attracting investment in those environments as well. Price cap mechanisms may more easily incorporate adjustment factors to take these variations in economic conditions into account cx ante.

Given the poor state of the infrastructure sectors in many developing countries, the absence of ~ve1l-established cost accounting and auditing protocols, the likely resistance of firms to detailed audits, the need to develop capital accounting and cost of capital measurement systems, a need for tariff rebalancing in anticipation of competition, and a history of macroeconomic instability, a fixed price/price cap mechanism with quality of service and performance nonns and specific provisions for evaluation and adjustment over time is like/v to provide the most ejfective regulatori’ approach in many cases. Prices initially need to be set high enough so there is a high probability that the investment incentive goal and firm viability constraints are not violated. It should be expected that consumers will leave some rent on the table during the initial years of the program. The loss of these rents should be more than compensated for by investment and supply-side efficiency incentives, which can be reflected in lower prices and improved service quality in the long run. For this approach to work well, however, there must be adequate legal protections through commercial contract law or specific regulatory law to ensure that the “ratchet” will not be utilized to hold up the firm.
Where this approach is taken, the regulator must use the “fixed price” period to develop the cost accounting, auditing, cost of capital measurement, benchrnarking, and related information about costs and demand to do a good job evaluating the performance of the fixed price mechanism at its pre.speci tied anniversary review. The regulator also and must be prepared to reset the parameters of the price cap mechanism in light of historical experience and the set of regulatory goals discussed earlier.

Price Structure issues

The previous section discussed issues related to the basic structure of the regulatory mechanism or contract that determines the incentives that the regulatory system provides to regulated firms to achieve supply-side efficiency, rent extraction, capital attraction, and firm viability goals and constraints. In the United States these issues would be reflected in mechanisms used by regulatory agencies to determine the total expected revenues or “regulatory requirement” of the regulated firm. However, demand-side efficiency goals and income distribution goals are generally implemented through a “rate design” or “price structure” defining specific prices under which the regulated firm sells its services to consumers. (The prices at which the regulated firm sells “network access” to its competitors are discussed in the next section.)

Demand-side efficiency goals can be achieved by setting all prices equal to their respective marginal or incremental costs. The relevant marginal or incremental cost is likely to differ among customer types (for example, residential or industrial) and for different services offered by a multiproduct firm. For many infrastructure sectors, demand varies widely over the course of a day and a year and supplies of the services cannot be stored. As a result, demand on
the market must clear based on the capacity instantaneously available to meet demand at any point. Enough capacity is typically built to meet expected peak demand (taking into account uncertain equipment outages). Moreover, a mix of supply techniques with different ratios of capital to variable inputs is often selected to minimize total supply costs, reflecting the fact that sonic capacity will be operated for long durations (base load), while other capacity will be operated for short durations (during the peak period), due to variable demands and the absence of storage. This means that the marginal cost of supplying services can vary widely with variations in demand, and that the first-best efficient prices will vary as well over the demand cycle (ioskow 1976).

Pure marginal cost pricing, however, typically conflicts with budget balance or firm viability constraints and may conflict with income distribution goals as well. There is a long literature on second-best pricing that relies either on linear prices (Ramsey-Boiteux pricing) or more general nonlinear pricing mechanisms (two-part tariffs and more complex schemes in which average prices vary with the amount consumed by individual consumers). Brown and Sibley (1983) provide a detailed discussion of the various options. It is important to recognize that effective tariff design policies have important implications for many of the regulatory goals discussed earlier. Prices that do not depart (upward) from the marginal cost of supplying services may not produce sufficient revenues to allow the regulated firm to cover its total costs, thus undermining firm viability and long-run capital investment goals. Good tariff design generally will not lead to uniform prices for all types of consumers or for services taken at different time periods, because both the marginal costs of supplying them and their demand attributes may differ. Moreover, good tariff design policies generally require information on both the regulated firm’s cost structure and the demand characteristics of its customers. Finally, what is good tariff
design policy in industrial countries with high income levels and high penetration of infrastructure services to the population may not be good tariff policy in developing countries with large low-income populations and low infrastructure service penetration rates. For example. two-part tariffs or sharply declining block rate designs (that is, more general nonlinear tariffs based on second-degree price discrimination), which recover most of the fixed or joint costs of the system from lump sum “hookup” fees and largely “inframarginal” utilization charges, may not be desirable in developing countries because too many consumers will be excluded froni the system by high hookup prices. Moreover, the impact in terms of income distribution on those who take service is unattractive.

It is also important to recognize that there is typically a wide divergence between the theory and practice of optimal tariff design in many industrial countries. This departure from optiniality has not been catastrophic, and improvements in tariff design have evolved slowly. Tariffs for regulated firms in industrial countries have typically been reasonably effective at allowing regulated finns to (at least) meet their budget constraints, except during periods of rapid inflation or major cost-reducing technological change. They are also often reasonably good at separating costs that are directly attributable to the supply of additional services to different types of consumers or an increase in the supply of different products, from joint or common costs, which are difficult to relate directly to changes in output. Prices generally include at least attributable costs in basic tariffs. The allocation of joint or common costs tends to be more arbitrary. relying on some “fully allocated cost” rule (most often proportional to output). Sonic form of nonlinear tariff with a small fixed nionthly charge and usage charges that decline with consumption are found in many regulated sectors in industrial countries, although joint costs tend to be spread more widely than theory would suggest, reflecting income distribution and universal
service goals as well as political constraints. Ramsey-Boiteux pricing is rarely relied on directly (and is generally dominated by nonlinear pricing in any case) in most industrial countries.

The implementation of optimal tariff design policy is very information-intensive. New regulatory agencies are unlikely to have the information needed about cost and demand structures. Moreover, with all the challenges new regulatory agencies face it is unlikely that their scarce resources are best expended on implementing theoretically ideal tariff structure policies. The way to start is by applying simple rules such as a floor on prices equal to the marginal supply costs of the relevant services, a ceiling on prices reflecting the stand-alone costs of supply (see below), prices that reflect variations in marginal costs as system load varies (where these variations can be metered cheaply), a simple output-based, fully allocated cost scheme to allocate responsibility forjoint or common costs of the system and include them in prices, and hookup charges or niinimum bills to recover as much of these common or joint costs as feasible without excluding a significant number of consumers or causing serious adverse income distribution (or political) effects. Tariffs can be refined over time as more regulatory experience and cost and demand information is accumulated.

Network Access and Competition

One of the most difficult, contentious, and important tasks regulators must confront is defining the terms and conditions under which suppliers of competitive services (for example, intercity telephone, electric generation service, and natural gas production) will have access to the regulated “bottleneck” monopoly network facilities that they need to provide services to consumers. Without good access rules, efficient competition will be difficult to realize in the
competitive segments. The issues are complicated further and become even more contentious when the owner of the regulated monopoly network is also a supplier of services in the competitive segment, both supplying network services to and competing with competitors in these segments. An obvious way to deal with these complications is to bar the network owner and operator from participating as a supplier in the competitive segments (as was the case with the local Bell Operating Companies’ participation in the Inter-LATA market in the United States since 1984). 14 This kind of restriction on the lines of business that the network operator may participate in raises difficult economic, technical, and political issues that vary from sector to sector and country to country, as I have briefly discussed. In what tbllows, I will simply assume that the “bottleneck” network operator also has an unregulated affiliate that competes in the competitive segments.

Most theoretical discussions of network access have focused on the prices charged for access. While access pricing is certainly very important, network access issues encompass a much broader set of terms and conditions than pricing alone. These include cost separations between regulated and unregulated businesses to guard against cross-subsidization, the speed and quality of physical connections of competitors to the network, billing arrangements, the provision of information about network characteristics and how they are likely to change over time, information transfers about customer characteristics by the vertically integrated network operator, and customer referrals by the network operator. In all of these areas a primary concern is the possibility that the network operator may give favorable treatment to its affiliate in the competitive segment and try to use its control of the full range of network resources to place its competitors at a disadvantage. Thus the frill range of the terms and conditions of access and the possibility that the network operator will behave in ways that foreclose comparable access to the
bottleneck facilities by its competitors are all relevant and important policy considerations. The nonprice terms and conditions often involve much more subtle issues than does narrow access pricing.

Let’s work with a very simple example to frame the access pricing problem and alternative solutions to it (following Laffont and Tirole 1996). We have a network N that is a regulated monopoly. Think of this as a local telephone network. The costs of the network that are recognized by the regulator as being recoverable from network customers consist of a fixed cost (KV?~ (which is a joint cost of supplying local and long-distance service) and marginal costs ~‘N per unit of throughput on the network. The number of local calls is then given by q~v. The network operator is also a competitor in the long-distance market, can supply long-distance service at a marginal cost of cm per unit of throughput, and supplies total throughput of long-distance traffic of qcm. There are one or more unaffiliated competitive long-distance companies that need to interconnect with the network to reach consumers. Assume that these competitors are symmetric and have constant marginal costs of c2 per unit of throughput of long-distance service and total throughput to the network of qc2. The costs for the local network, the competitive long-distance carriers, and the network operator’s long-distance affiliate are given by:
	(7N	= KN ± c,v(qv + + q~)	local network monopolist
	Ccm	= ciqci	network owner’s long-distance services
	CY2	= c2qc2	competitive long-distance service
	Q	 (q~’ + C/cm + qc2)
Prior to the introduction of competition, prices have been established by the regulator that produce revenues equal to the incumbent’s total costs (budget balance). We assume that prices for local and long-distance service include fully distributed fixed costs allocated in proportion to output, but there are an infinite number of other joint cost allocation schemes that satisfy the budget balance constraint. That is, the regulated price for local service PN has been set at a level that covers the marginal cost of network service, plus a fraction of the fixed (or joint) costs of the local network (where qci is zero before competition is introduced).

pv = K,v/Q + c~

The regulated price fur long-distance service has been set at a level that covers the marginal cost of long-distance service plus the marginal cost of using the local network plus a fraction of the fixed costs of the local network (where qcm is zero before long-distance competition is permitted).

P1 KNIQ + c.~ +

Assume that the regulator is now contemplating allowing competitive (facility-based) long-distance carriers to enter the market. What “access charge” should these competitors pay to make use of the local network? One approach would be to require competitors to pay the marginal cost of using the local network (ci) per unit of throughput. Assuming away any market power for the moment, the price that competitive long-distance carriers competitors would charge in this case is given by:
P2 = Cv + C2

It should be clear that this access pricing rule (access price equals marginal cost of access) creates some problems. First, for every unit of long-distance service that competitors capture from the incumbent, the incumbent loses K,v’Q of revenue, which helps to cover the fixed costs of the network. Where does the incumbent get the revenue to cover this “access deficit?” Second, the incumbent is implicitly paying a much higher access charge than its competitors in the long-distance market, since the implicit access charge being paid by the incumbent in connection with supplying long-distance service is:

UKN/Q+cN=pI -c1.

The incumbent will not be able to compete with equally efficient rivals unless it reduces its price, incurring a further loss of revenues (access deficit) needed to cover the fixed costs of the local network. Moreover, if it does not reduce its prices it will encourage entiy of inefficient rivals.

How is the regulator to deal with this problem? One approach would be to apply a parity principle and require the competitive entrants to pay the same access charge as the incumbent implicitly pays. In the example above, the access charge a is given by an allocation of the fixed costs of the network that is proportional to the competitors’ throughput on the network (KN/Q per unit of throughput) plus the marginal cost of using the network. With homogeneous products,
symmetric firms, and no market power, the price charged by competitive firms would be given by:’5

P2 = Cl ± c2

P2 = K.v/Q ± C~v + C2

In general, the access charge implementing the parity principle would be given by (p, — c,). This more general formulation is referred to as the efficient component pricing rule (ECPR) and is attributed to Baumol and Willig (Baumol and Sidak 1994). It can be extended directly to the case where the incumbent network operator supplies two or more competitive products with different prices and marginal costs. Variants on ECPR have been adopted in a number of jurisdictions and I believe it is a good practical benchmark approach for establishing access prices.

There are a number of theoretical and practical problems with both the parity principle arid ECPR. and [will discuss them briefly below. First, however, it should be recognized that even in the simple world where the competitive segment involves a homogeneous product, symmetric competitors, and no market power, the access price could still lead to costly inefficient behavior by competitors. If the access price (for example, KN/Q + civ) is higher than the cost of bypassing the local network, competitive suppliers may be induced to spend money to ineflicientlv bypass the local network. For example, it might pay the competitive supplier to build a separate access line to make it possible for a large user of the network to connect directly to the long-distance supplier, bypassing the local network and the associated access charges entirely.

The problem here is essentially that allocation of the fixed costs of the network to competitive services is too high to be sustainable in the face of competition without creating
inefficiencies. There are two types of solution to this problem. One solution is to require competitive suppliers to make a contribution to the fixed costs of the local network, that is, to pay an access charge whether they use the local network or not. In effect, all long-distance calls terminating in a particular geographic area either pay the access charge to the network operator or pay a tax that is transferred to the network operator equal to the contribution to the fixed cost of the network that the competitive supplier would make if it used the network.

An alternative solution is to first rehaiance tan/ft so that a smaller proportion of the costs of the local network are recovered from competitive services. This would mean increasing p~v and reducing pi (and p~). So, for example, the regulator could shift responsibility to recovering the fixed costs of the network entirely to local calls, increasingpN (or more likely the fixed monthly charge fir a local line) so that local calls produced enough revenues to cover all of the fixed costs of the network as well as the marginal cost of local calling:

PN = KN/qN + Cv

The access charge for competitive suppliers would then simply be set equal to the marginal cost of using the local network fèr all competitive suppliers. The result is that local service pays the titll “tax” necessary to cover the fixed costs of the local network, while long-distance service pays none of it. However, there is no reason to believe that shifting all of this tax burden to local calling (or to a fixed charge for local access) is optimal unless the demand for local calling or local access is perfectly inelastic and we ignore income distribution effects. This is not likely to be the case in many developing countries where incomes and telephone penetration are low.
The possibility of tariff rebalancing and questions raised by the extreme case of rebalancing just examined naturally call for a deeper exploration of the rationale for and efficiency of the regulated pricespN and p~, as well as the associated allocation of the fixed costs of the network. The ECPR and related rules are essentially “top down” rules that start with the prevailing regulated prices, implicitly assume that they are optimal, and then derive access prices that implement the parity principle. An alternative approach is to reexamine the attributes of the optimal prices and then look for access prices that will lead competition (including imperfect competition) to produce optimal prices. This analysis is presented very elegantly by Laffont and Tirole (1996).

A number of practical and theoretical objections have been made to applying the ECPR. The first is that it requires the regulator to measure accurately the marginal or avoided cost that the incumbent incurs in supplying the competitive service. The incumbent in turn has the incentive to underestimate these cost components to increase the access prices its competitors must pay. The information disadvantage for regulatory agencies in developing countries may be especially severe here. A related objection is that the incumbent can indirectly manipulate the access charge in the regulatory process by requesting that the regulator adjust regulated prices for local and long-distance service (both levels and structure). This makes the access charge a moving target for the incumbent, which is the outcome of a regulatory process that it may have difficulty monitoring and influencing. More generally, competitors are concerned that the parity principle will be violated to their disadvantage as a consequence of manipulation by the regulator of regulated final prices that determine the access price as a residual. These concerns can be addressed by building up the access charge (from the bottom up rather than top down) directly from a clearly specified set of cost allocation rules (which could change in a predetermined way
over time), unbundling the access fee from the incumbent’s local and long-distance prices, and requiring that both the incumbent (if it chooses to compete in the competitive segments) and its competitors pay the same access price. That is, a cost-based access price is clearly defined that is consistent with ECPR (as long as the components of the tariff add up to the bundled prices), and all competitors must pay the same price. The cost allocations can reflect those embodied in the existing prices or new prices that rebalance tariffs to reflect demand considerations (for example, Ramsey-Boiteux pricing) and income distribution goals. However, the cost allocations need to be visible and verifiable and support unbundling of the incumbent’s tariffs to include an access charge that is (roughly) a fixed point.

Laffont and Tirolc (1996) argue that ECPR may be inconsistent with optimal access pricing if (a) the competitive segments exhibit market power (so the access price gets marked up by competitors in the competitive segments); (b) the competitors are asymmetrically supplying differentiated products, reflecting brand loyalty, name recognition, switching costs; or (c) the network operator has lower costs in the competitive segment than its rivals. These considerations may imply access prices higher or lower than ECPR and implicitly different access charges for the incumbent and its competitors. The theoretical rationales developed by Laffont and Tirole (see also Economides and White 1995) for departing from ECPR and the parity principle is clear. However, as a practical matter I believe that it would be a mistake to fiddle with the access charges to deal with market imperfections in the competitive segments when it leads to different access charges for different competitors. Once we leave the parity principle behind or create other rationalizations for manipulating access prices that do not follow some simple comparability rule we are inviting rent-seeking behavior and regulatory mischief. Furthermore, new regulatory agencies are unlikely to have the information or expertise to implement more
complex access pricing rules effectively. Nor do I believe that the network operators’ competitors will ever find the global price cap proposed by Laffont and Tirole (1996), no matter how elegant theoretically, to be an acceptable approach. They will be concerned that effectively allowing the incumbent network operator to set its own access fees will encourage predatory behavior. For similar reasons, market power problems should be directly addressed as well as they can be with structural and behavioral mitigation measures, rather than manipulation of access prices to counteract distortions in consumer prices related to market power.

Regulator’s Role in Promoting Competition

Before concluding, there is one final issue I would like to address briefly. The goal of reforms that identify competitive segments, open them up to competitors, and deregulate prices is predicated on the assumption that these segments will in fact be reasonably competitive. However, there are good reasons to believe that they will never be perfectly competitive and market power could be a significant problem, at least in the short run. This has certainly been the case with the electricity generation and long-distance telephone segments in England and Wales and in intercity telephone service in the United States. The issues associated with creating reasonably competitive markets should be addressed as part of the restructuring program. They involve questions (tèr example, in electricity and natural gas) regarding the number of competing firms to be carved out of the incumbent, the feasibility and desirability of vertical separation and the use of transition mechanisms (for example, contracts or price caps applied to the incumbent) to mitigate market power problems, consumer infcrmation provision and education, assignment
policies for the incumbent’s customers, and the price and nonprice terms and conditions of access to the network.

The broad array of competition policy issues, aside from access pricing discussed above. is beyond the scope of this paper. However, questions that frequently come up are whether, once the initial structural and transition mechanisms are in place, there is any continuing role for the regulator in promoting competition in the competitive segments, or alternatively, whether ongoing competition issues should be left to the antitrust authorities. There is a delicate balance between, on the one hand, the regulator’s continuing to play a role in monitoring the performance of a recently restructured sector and implementing policies to fix serious performance problems and, on the other hand, his interfering excessively in the natural evolution of the competitive segments. 1 believe that there is a useful ongoing monitoring role that is properly delegated to the regulatory agency. The regulatory agency is likely to have the best information about the sector to monitor it, identify performance problems, and either fix the problems with instruments at its disposal or make recommendations for actions by antitrust authorities or the legislature. The regulator’s role is likely to be especially important in developing countries that do not have strong antitrust enforcement authorities. Some of the competition problems may be classic market power problems arising from few competitors and slow entry, while others may result from imperfect price and nonprice conditions of access to the network or cross-subsidy problems that the regulator is in the best position to control. However, it is important for the regulatory agency to focus on identifying serious, long-term performance problems, rather than to adopt unrealistic goals for perfect competition in the competitive segments, or become a micromanager of the competitive segments. I believe that the telephone, electricity, and gas regulators in the United Kingdom have generally struck the proper balance
among monitoring, identifying competition problems, fixing the problems, and excessively interfering in the market. So too have the telephone regulators in Argentina and Chile. On the other hand, electricity and telephone regulators in the United States have done too much micromanagement and may have ended up reducing rather than promoting competition. Their role in unbundling and introducing competition in the natural gas industry has been better, but they have been too slow to allow trading of pipeline capacity rights unencumbered by rigid price caps based on historical accounting costs.

Conclusions

As infrastructure sectors are privatized and restructured to promote competition in potentially competitive segments, the creation of supporting regulatory institutions is a necessary component of the reform program. These regulatory institutions should be created as an integral component of the entire reform program. not as an afterthought. These institutions must be part of an economic environment for each infrastructure sector that can protect consumers from exploitation resulting from the exercise of market power, promote efficient supply behavior by firms providing residual monopoly services subject to public regulation, facilitate competition in the competitive segments by implementing appropriate terms and conditions for access to “bottleneck” network facilities, and guard against cross-subsidization and unreasonable discrimination among competitors using these facilities. An environment must be created in which investors perceive that regulatory rules and procedures represent credible commitments that they can rely on when making investment decisions. The general principles of “independence,” “transparency,” and “regulatory expertise and capability” should guide the
development of good regulatory arrangements. Ideal regulatory institutions cannot be created instantly, and the reform program should anticipate and encourage improvements in regulatory capabilities and experience over time. Regulatory agencies may do best by starting to work with simple regulatory rules and procedures and refining them as they gain more information and experience. In the end, there is a delicate balance that must be struck between elaborating a complete regulatory framework at the outset, and allowing regulatory rules and procedures to evolve in response to the development and performance of the sectors subject to regulation and growth in the experience and capabilities of the regulators. That is, there is a tradeoff between rigid regulatory rules and procedures and regulatory discretion and flexibility. Going too far toward either extreme is not likely to yield regulatoiy institutions that perform well over long periods.
Notes

Paul L. Joskow is James and E1i~abeth Killian Professor ofEconomics and Management, Department of Economics,

Massachusetts Institute oI’ Technology, Cambridge, MA 02139.

1.	In many cases these sectors were once privately owned and were nationalized either before or after World War II.

2.	Where competition “in the market” is unlikely to yield good perfomiartce outcomes, competition “for the market”

based on concession or franchise contracts selected through competitive bidding is an option for governing the

natural monopoly segments. I discuss this option briefly below.

3.	As a consequence of the Telecommunications Policy Act of 1996. BOCs can enter the long-distance market if

they satisfy criteria established by the Federal Communications Commission. To date none have been able to meet

these criteria.

4.	However, distributors can acquire a small amount of generating capacity for their own accounts.

5.	However, in many countries the customer with the worst payment record is the government itself.

6.	Indeed, independent regulatory agencies in the United States have a somewhat ambiguous place in the country’s

constitutional structure, which is built on the separation of powers of the three branches of government: executive,

legislative, and judicial. Some have argued that independent regulatory commissions at the federal level represent a

fourth branch of government that is not provided for in the U.S. Constitution.

7.	One might argue that the facts that infrastructure sector prices have been kept at too low a level in many countries

and that prices for residential customers are the farthest below cost imply that small consumers already have too

much political power.

8.	In what fr,llows. I will assume that regulated firms must cover their costs from revenues generated by sales to

consumers (Schmalensee 1989). Government transfer payments such as those that are central to the incentive

mechanisms analyzed in Laffont and Tirole (1993) are assumed not to be available as regulatoty incentive

instruments.

9.	Given the balanced budget constraint.

10.	See 0S1PTEL (1995, 1997) and Telephonica del Peru (1996, 1997).

11.	The provisions for pass through of generation-related costs may also have caused some distortions and induced

distributors to enter into contracts with and lake ownership positions in new generating plants that entered the
market. However, the distributors are not allowed to own generating capacity in excess of 15 pet-cent of the peak demand on their networks.

12.	This is conceptually different from Laft’ont and Tirole (1993: chapter 1), where the regulated firm passes itself off as a high-cost firm by choosing a more lucrative regulatory contract than the one that merely satisfies the incentive compatibility constraint for the low-cost fi,m.

13. The considerations are different for a sector that is potentially competitive, but where price regulation is thought to be required to respond to market power problems during a transition period until a sufficiently competitive market emerges.

14. As a consequence of the Telecommunications Policy Act of 1996, these entry restrictions may now be removed by the FCC if the BOCs meet a long list of conditions to open up their local networks to competing suppliers of both local and long-distance set-vices.

IS. With these assumptions there are either no active cotnpetitors other than the incumbent if c1 <c2 or the incumbent exits from the market if c2 < c~.
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