Regulatory Issues in Infrastructure Sector:Monopoly as a contracting problem

Anagha Deshpande(18)Richa Piplani(46)Rajan Vasani(58)

Vinayak Harer(28)Omkar Agarwal (105)

To begin with…

What is Monopoly in infrastructure projects? Very large investments in durable and immobile

assets single player

What is Natural Monopoly in infra projects? [Very large investments in durable and

immobile assets] + [Strong economies of scale or traffic density]

Note - Many infrastructure projects have an element of natural monopoly

Vulnerability in Monopoly•Gover

nments might be tempted to yield to popular pressure to lower tariffs or renege on other promises to the company

Private Investments

•Investors might take advantage of their durable and immobile investments by raising prices well above costs

Governments

•Consumers also make durable and immobile investments in their local communities that makes it difficult for them to move elsewhere

Consumers

Motives for government involvement in Infrastructure

Tendency towards natural monopoly in infrastructure projects For governments, natural monopolies are difficult to deal

with Difficulty in assembling right of way required for

infrastructure network Government hesitant to delegate eminent powers to

private companies Benefits beyond those that accrue to immediate

users E.g. Street light or clean drinking water projects Difficult to persuade the subscriber to pay for the service

Economic Development & Equity considerations E.g. Rural basic infrastructure Promote monopoly to cross subsidize the

services to rural areas or poor households e.g. Department of Telecommunications

Safety and Environmental Problems Keeping regulation separate from those who

control the monopoly in order to avoid conflict of interest

Motives for government involvement in Infrastructure

Market Power in Monopoly

Degree to which a company can raise prices without losing too many sales

Factors important to market power Entry Barriers Few close substitutes Type of customers Different stages or components of a infra

service Technology

Market

Politics

Private Contracts•Customer negotiates with Private Player•Market plays dominant role, Politics for legislature and enforcement

Concession Contracts

•Government and Private Player•Government sets price & Quality on behalf of customer

Discretionary Regulation

•Govt. regulatory agency unilaterally sets tariff and service standards•Gives Govt. substantial discretion and flexibility•Role of Market is to finance investments required by firms

Public Enterprise•Public or nonprofit enterprise provide service•Private firms play restricted role•Less incentive for private investors to take advantage of monopoly position

Range of Solutions to monopoly

What is concession contract?

Private Player gets exclusive rights from the government.

Private Party pays either a fixed sum or percentage of revenue from the utility.

Types of concession contract- annuity, BOT, etc

Features of Concession Contract

Relationship between regulatory agency and private concessionaire

Duration of Contract InvestmentsRemuneration

Challenges in Design of Concession Agreement

Risk outside the concessionaire’s control

(Eg- Price inflation)

Demand risk (Eg- Toll revenue)

New MCA For BOT Toll Roads

Target Traffic on BOT toll road > 20% -> excess revenue will go to safety fund

Trend continues for 3 years-> contract will be terminated

For Land acquisition- around 150 SLUs will be set up

Risks Faced in Toll Based Concession by Concessionaire

Development Risk

Financing Risk

Construction Risk

Operation Risk

Methods of AwardingConcession Contract

Administrative Decision(Beauty

Contest)

Lottery

Auction

Information, institutions and the Design of Concession Contracts

Design of contract depends on : Information concerning good or service Form and nature of demand Ex-post and Ex-ante information from the

firm Resources the regulating agency can

devote to implement Speed of making concession decision

Design of Concession Contracts

What concession contract should contain? Explicit list of penalties in case rules not

respected Only credible threats should be included Non-credible threats are bad

When work of regulatory commission lead to decreased firm profits, firms have incentive to capture the commissioners

Cost-plus rewarding system

To prevent risks of capture Requires monitoring of costs Manipulated by collusion b/w firm

managers & agency employees To prevent capture by activists

minority of consumers, commissioners be elected for fixed period

Ideal Contract:Short Term vs Long Term

Regulator’s viewpoint: They get information over time on behavior,

characteristics and potential challenges of firm

Postponing decisions until deadline is efficient

Hope to franchise a new firm or renegotiate So, Short term considered ideal

Ideal Contract:Short Term vs Long Term (contd.)

Firm’s viewpoint: Short term contract viewed as device to

extract information today to extract profits tomorrow

They will not disclose all information necessary to implement contract efficiently

Will demand long term contract with no renegotiation

So, Long Term considered ideal

Ideal Contract:Short Term vs Long Term (contd.)

Other viewpoints in favor of Long term: Necessity of sunk investments A short term or renegotiable long term contract will

induce under-investment On the contrary, if reimbursement clause included

for cases of breach or franchisee change by regulator, firms have incentive to over-invest

Other viewpoints in favor of short term: Longer the term, more incomplete contract is Firms with very intense R&D prefer short term

contract

Fixed Price Contract

When uncertainty small, no need to reimburse cost to induce revelation of information

So, under risk neutrality, contract converges to fixed price contract

As a project evolves over time, the contract resembles more and more a fixed price contract

Methods of awarding Concession Contract

Knowledge Extraction: Ex ante Ex post

Three methods: Administrative Decisions Lotteries Auctions

• Based on speed, transaction cost, efficiency, equity and fiscal payoff

Administrative Decisions and Lotteries

Administrative Decisions: Comparative hearings Heavy backlog

Lotteries: Random decision Quick, but not the most efficient

Auctions

• Prequalification of potential bidders• Highest payer or Lowest price

Disadvantages: Slow process Collusion of buyers Capture of auctioneer Redistribution

Types of Auctions

Multiple Round Auction

• Administrative simplicity• Instantaneous plan

revision• Collusion• Predatory bidding

Simultaneous

Auction

• Eliminates disadvantages of multiple round auction

• Multiple Simultaneous Auction:• Clear stopping rules• Aggregation

possibilities

DIAL

Project cost increased by Rs. 2975 crore (up 50%)

Impact: Hike in airport development fee for mitigation

Reasons: Concession agreement(OMDA) did not specify project

cost AERA yet to be fully operational Increase in air travel load not considered Penalties and mitigation plan not in place

DIAL (contd..)

Current Scenario: DIAL not to be allowed to levy ADF if

cost estimates not sent by 15 April 2010 AERA has proposed to cut down the

period for levying ADF from 36 months to 24 months

Pressure from IATA DIAL raised Rs 1472 cr from sale of 45

acres of land Project cost not yet submitted by DIAL

Regulatory Requirements

With increased private participation, regulator has to be Competent (Technical Expertise) Independent (free from Government

interference) Legitimate (accountable and abiding legal

principles)

With limited human and financial resources and political interferences faced, it might be effective to contract out regulatory function to external expert / technical panel

Variations while contracting out

Built in or Contracting out by regulators 3rd party independent expert review might

be built into concession contract as part of fulfillment of contract(E.g. PMGSY)

Alternatively, consultant can play role in regulatory decision making process.

Advisory Tasks or Binding input Whether consultant recommendation is

suggestion to government or binding input

Monitoring

•Technical and financial audit by private 3rd party increases credibility of regulatory process and reduces information asymmetry •What if consultant is contracted to monitor water distribution system?

Tariff Setting

•Tariff proposed by expert panel has to be binding but requiring formal approval of respective Ministry;•May give comfort to customers that prices are fair•May reduce regulatory cost

Dispute Settlement• Expert panels or

reputed bodies like International Chamber of Commerce can be considered for dispute settlement

• However, practical considerations like• Ease of enforcement• Availability of

experts• Confidentiality• Timelines

What Regulatory functions can be contracted out?

Does it work?

Example Eastern Caribbean Telecommunication

Authority (ECTEL) serves member countries of Organization of Eastern Caribbean States as shared regulatory authority

Reduces fixed cost for national regulators

Challenges Budgetary constraints Difficulty in specifying and managing contracts Small market of appropriate consultants

Clear assessment of desirability (eg: cost or credibility)

Clear specification of Payment, Responsibility and Authority

Maintaining in-house capacity for setting target and monitoring performance

Encouraging competition and transparency

Framework for designing contracting-out arrangement

References

Crampes C. and Estache A. (1997) - Regulatory Tradeoffs in Designing Concession Contracts for Infrastructure Networks, Policy Research Working Paper 1854, The World Bank, Washington

Gomez-Ibanez Jose A (2003) – Regulating Infrastructure: Monopoly, Contracts, and Discretion

http://www.livemint.com/2009/08/12002623/Regulator-review-to-nix-DIAL-g.html

http://www.livemint.com/2010/03/24225540/DIAL-to-submit-costs-report-or.html

http://www.livemint.com/2010/02/11225653/DIAL-raises-Rs1472-cr-from-sa.html

THANK YOU