No.10/1997

Objectives of regulatory reforms
General principles of designing a regulatory framework
The Sappington Framework
The Regulatory Outcome: Form, Function and Scope
In specific terms……
The Electricity Sector
Conclusions
Recommendations

A central function of  any democratic government is to promote the social and economic well-being of its people. This would require governments to achieve macroeconomic stability, create employment opportunities, promote innovations, ensure high standards in the area of environmental quality, safety etc. Regulations is an important tool that is being increasingly utilised by governments for achieving these public policy objectives to ensure smooth functioning of  democracy. 

Objectives of regulatory reforms

Regulations affecting a particular sector (or broadly on a macro scale also) can be broadly classified as: economic regulations, administrative regulations and social regulations. For e.g. while initiating regulatory reforms in the transportation sector (let’s restrict ourselves to roads), reforms will have to be undertaken with respect to 

• tolls that will have to be set on different kind of roads, an example of economic reforms,
• the way the tenders are floated, an example of administrative reforms and
• the means of protecting the green cover which might be lost while constructing a new road, an example of social reforms.

• revision of incentives (already existing) to make the players more innovative and competitive;
• introduction of greater transparency thereby encouraging entrepreneurship; and
• sometimes swift reduction in prices and improvement in the quality of products/services supplied.

To understand the various facets under this head, we borrow in particular from the work of David Sappington, “Principles of Regulatory Policy Design” (World Bank Policy Research Working Paper # 1239, January 1994). This work synthesises theoretical and practical aspects of regulation to develop a set of operating principles for the regulation of sectors. These operating principles give due regard to the overall environment in which the sector and the regulator function. 
 
 

The Sappington Framework

The Operating Environment: According to Sappington, three important aspects of the environment affect the operations of a regulator. 

(1) The Regulator’s objectives and resources

Before embarking on regulating (deregulating or re-regulating) a particular sector, the regulator/regulatory agency should consider the following broad objectives. Of course, while pursuing these objectives the regulator/regulating agency will require resources in the form of manpower, information and technology. 

(a) Objectives: The regulator cannot afford to be highly consumer-centric while framing 
regulations. s/he also has take into consideration, the interests of the other player in the market, viz. the producer.  Pooling the consumer and the producer into the design process, Sappington suggests six general objectives for a regulator to pursue. 

(i)  Fostering industry development and investment: Under normal circumstances, the regulator should not create conditions so as to deter producers from investing in new capacity, particularly in new technologies. 

(ii)  Ensuring safe and high quality service: This means that the regulator should not foster growth of a particular sector, at the cost of consumers. Hence there should be adequate checks-and-balances (e.g. maintenance of performance and safety standards [ISI mark, AGMARK etc.]) which screen the quality of the goods/services supplied by the producers before they enter the market. 

(iii)  Promoting lowest cost production: The regulator should promote a climate that would encourage producers to produce at the lowest cost. While pursuing this objective the regulator has to be careful that the objective mentioned under (ii) is not watered down. 

(iv)  Achieving desired consumption levels:  Achieving this objective depends on the sector that is being addressed, and more importantly, on the ‘merit’ and ‘social’ value of that sector. For example, if the regulatory reforms are being implemented in the aviation sector, then it would be impossible for the regulator to set a price that would enable every person to fly. But it would be desirable from a social point of view that every citizen is covered by a minimum amount of life and health insurance to cover accidents and losses. 

(v)  Promoting more equitable outcomes: Again from a social point of view, we may consider it desirable that all consumers, regardless of their income status, have access to certain services, for example, electricity, which they might not have  in the absence of regulatory control. 

(vi)  Limiting the earnings of producers: Particularly in situations where the promotion of lowest cost production requires that only one or a very small number of producers operate (because of economies of scale, i.e. the process in which the per unit cost of production decreases over large period of  time as the firm’s output keeps on increasing), we would want to ensure that such producers cannot exert their monopoly power to extort from consumers. 

Although the above list of regulatory objectives are desirable, it is evident that they are internally conflicting. When a conflict between objectives arises, the regulator must have a criterion by which s/he is able to assign priorities. 

(b) Resources: The framework emphasises three broad aspects of the potential  resource requirements for any regulatory authority. 

(i)  Size, training and experience of the staff: The staff resources of the regulator must be consistent with its objectives. Given particular objectives, the more familiar the staff is with the industry it is regulating, the more effective  their performance is likely to be. But familiarity and experience with the industry comes at a price. Industry experts who join the regulatory agency for short periods would naturally look for job opportunities in the same industry when they leave the agency. This provides some incentive to compromise their regulatory responsibilities. Therefore, from the agency’s viewpoint, it has to find a balance between skills and experience and the vested interests that industry specialists tend to develop. 

(ii)  Information: Many of the objectives referred to earlier are crucially dependent on the nature of information that the regulator can get from producers and consumers. For example, if the regulator is to set a maximum price to be charged for the product, s/he must know what it costs to produce it under a variety of conditions. or, if certain activities are deemed to be undesirable, such as insider trading in stock markets, the regulator must have a way of scrutinising market activity in order to be able to detect signs of such activity. There is no point in pursuing an objective based on extremely costly or non-available information. Repeated violations of prescribed standards only undermine the credibility of the regulator. 

(iii)  Technology: The gathering and processing of information is itself crucially dependent on technology. Many a time, technology can reduce the cost of collection of desired information. Access to information will influence the speed with which the regulator is able to detect violations and act on them. 

(2) The Institutional structure

The perception of the polity towards regulatory reforms is important vis-à-vis delegation of powers to a regulatory authority. 

A regulator is aware (or in the process of regulating comes to know) of the conflicting objectives vis-à-vis different interest groups, which affect the economic, social and administrative reforms within the sector under regulation. Also as the regulations in certain sectors (e.g. roadways, watersupply etc.) interfere with policies of different ministries,  the regulator has to be cautious about guarding the interest of the concerned ministries and carry the reforms ahead. More so the constitution of other complementary institutional infrastructure (e.g. enforcement authorities) is also important while carrying out regulatory reforms. 

The necessary institutional structure should be framed realising these hurdles. The Sappington framework emphasizes two aspects of the discussion above. 

(a) Commitment powers of the regulator:

The effectiveness of regulation depends heavily on the fact that s/he has the final word with respect to her/his decisions. A regulator that is not backed by the government cannot be effective. For  example, if every decision taken by a regulator with respect to prices is overtuned by the government because of pressure from manufacturers, the logic of having a regulator in place is lost. Of course, manufacturers also need some protection against arbitrary and unreasonable regulation, but this protection should come by way of judicial and not administrative or political recourse. 

(b) Complementary control instruments:

We must appreciate the fact that a regulator deals with issues that are specific to the activity he is regulating. Her/his ability to enforce regulations is dependent on the support s/he gets from the overall administrative and judicial system. For example: in  cases of cheating, the ultimate redress has to come from an institution  using information provided by the regulator. Here, it is the cooperation of the consumer and the regulator in using the judicial system that provides the “complementary control”. Conversely, a strong regulator is of no use if he is only backed by a weak judiciary. 

(3) Industry Conditions

The third aspect of the operating environment described by the framework is the nature of the industry being regulated. The framework emphasizes three components in this connection. 

(a) Production technology:

The most illustrative example of this component is the one we have used in examples earlier in this paper - the presence of scale economies. Many of the sectors we will be discussing in the next section are characterized by scale economies in at least some of their  activities. At one level, the role of the regulator is simple; lowest cost production can be achieved by a monopoly producer, so there must be some curbs imposed on her/him to prevent her/him from exploiting her/his monopoly position. At another level, however, the task is much more complex. Technology  is continuously evolving so the requirement of a monopoly for lowest cost production may not remain. The regulator has to be able to monitor the evolution of technology in her/his sector of responsibility to make sure that products and services based on new technologies can be brought to the consumers as soon as they are viable. In the absence of such a capability, regulation that started of with the intention of serving consumers can very quickly turn to harming them by denying them the benefits of new technologies. 

(b) Consumer Demand:

The essential point here is whether the consumer can switch between products, i.e, whether the product has close substitutes being produced by some other sector. In this case, even if monopoly production is the most viable arrangement in a particular sector, the competition from other sectors imposes a natural limit on the monopolist’s ability to exploit consumers. In other words, the concern here is how “necessary” a particular commodity or service is for the consumer.This is another way of describing the problem of switching costs. 

(c) Information Structure:

In describing the consumer’s ideal, one crucial condition  was that consumers were fully informed. On many occasions there exists “information gaps” between producers and consumers. Since the essential objective of the regulator is to try and simulate the crucial conditions, for achieving her/his regulatory objectives, s/he has to specifically address the problem of bridging such information gaps, wherever prominent. 
 

The Regulatory Outcome: Form, Function and Scope

The combined influence of all the factors contributing to the operating environment determines the regulatory outcome. This in turn, with reference to the Sappington Framework,  has three aspects. 

(1) Regulatory Form: This aspect refers to the extent to which the regulator centralises decision-making within itself, or allows decision-making to be decentralised among the regulated producers. For instance, the regulator may set a maximum selling price and then allow producers complete discretion as to the technology that they use to produce the commodity. This is an example of decentralisation, and is valid in a situation where the regulator may not have the resources to keep up with 

(2) Regulatory Function: The main issue in this aspect of the regulatory outcome is whether the regulator confines itself to an “informing” role. In the former, it simply lays out the boundaries of acceptable standards on the part of producers, and allows natural competitive forces, reinforced by informed consumers, to ensure that these boundaries are adhered to. In the latter, the regulator cannot rely on these market forces, and has to play more active role in keeping procedures within the boundaries. 

(3) Regulatory Scope: This aspect refers to whether a regulator is interested in regulating all aspects of a product or service, or only some aspects. For example, in the telecommunications industry, the regulator may impose a price ceiling on certain types of services, but allow the same producer to price other service freely. 

In specific terms……

We now apply the general principles of regulatory design that we discussed in the preceding section to the Electricity sector in India. We can perform a similar exercise in the case of the telecommunications sector, road transport sector, financial services sector, insurance sector, and other sectors which are undergoing regulatory reforms. 

We will first analyse the operating environment of this sector. Based on this we will outline a regulatory strategy for the sector, or specific activities within it. In the process, we will make a comparison between the existing (or proposed)  regulatory framework and the strategy that emerges from our analysis. At the end of the exercise, we would have achieved two things: 

(1) provided a logical foundation for thinking about regulatory issues in concrete terms with respect to each of these five sectors; and 

(2) provided some indicators about the gaps (if any) between “desired” and existing regulatory regimes. 
 

The Electricity Sector

(1) The operating environment

Product and technology

• There are two distinct activities in the industry: generation and transmission & distribution.
• Significant scale economies arise in both activities, but they need not necessarily go together; i.e. international trend in the industry show that these activities can be handled by separate organisations.
• The relationship between generators and distributors would be akin to that between producers and wholesalers of any commodity; it would be the distributor’s business to deal with customers, either directly, or through a retailing network.

• No close substitutes exist for the product as a whole; perfect substitutability between electricity generated by competing producers. The first factor reflects high switching costs, creating the potential for price exploitation.

• This is a relatively transparent industry with respect to technology and costs of production. There are only a small number of basic ways in which to generate electricity, and to get to the consumer.
• Usage can also be monitored when users are honest, but theft is always a problem. The task (and associated costs) of identifying thieves creates a information gap in the industry, which has an influence on the pricing.

• The key characteristic in the Indian electricity sector is that most of the generating capacity and all of the distributing capacity is owned by the government;  the state governments, through the State Electricity Boards (SEBs) and the central government through the large generating companies like the National Thermal Power Corporation, the National Hydroelectric Power Corporation and the Nuclear Power Board. There are a small number of private electricity suppliers, mostly in major cities, such as the Tata Power Company in Mumbai, and the Calcutta Electricity Supply Corporation. They generate and also distribute power.
• After 1991, the government’s vision was that a very large proportion of the increase in generating capacity would be set up by  private producers although they would generate the power and sell it to the SEBs, who would then act as wholesalers for this power. Private generators were not supposed to be supplying power directly to users.
• The entry of the private producers has proved painful. Until now, no large private generator has begun commercial supply, despite the passage of seven years having passed since they were allowed entry.

(a) Commitment Powers

• There are potential problems in the sector, because despite allowing private generation, for a long time to come, the government, at some level, will continue to own the bulk of the generating capacity in the country. Also, it has shown no desire (with the possible exception of Orissa, which has set in motion the process of privatising the distribution activity) to cede control over distribution. With the government remaining such a big presence in the production aspect of the sector, any regulatory agency is clearly going to be subject to all the political pulls and pushes that we see going on in the SEBs today.

• Environment related regulation is very important for this industry; it narrows the range of technological choices that producers can access.
• Detection and punishment of  theft is another important complementary control instrument. In the absence of effective enforcement of anti-theft laws, the problem of how exactly to distribute the burden of the loss (between consumers, government and producers) will be an extremely difficult one for the regulator to solve.

(a) Objectives

• In this sector the primary objectives would be:

(i)  achieving lowest cost of production; and 
(ii)  limiting the earnings of (private) producers 
• Other objectives are important, and there are potential conflicts between these primary objectives and the objectives of fostering industry development and investment and ensuring safe and high quality of service. Too low a price in the interest of limiting earnings may deter new investment. Too much of pressure to control costs may lead to compromises on safety and other quality aspects. Yet, given the relative transparent nature of technology and operations in this sector, it should not be much of a problem to resolve these conflicts.

• Currently given the predominance of public ownership in this industry, there has been no role for price regulation in this sector. The only form of regulation has been  the capacity approval process that is overseen by the Central Electricity Authority (CEA) of the Government of India.
• Even in cases where large private projects have got off the ground, such as Enron, Cogentrix and Reliance, the price setting process has been one of negotiation between the private generators and concerned SEBs. The objectives of the SEBs in such negotiations have certainly been consistent with the objectives of a regulator,  as we have stated above. The difference, however is in the fact that the SEBs are interested parties, and not the impartial referee that a regulator is supposed to be.
• We should emphasize that as long as the SEBs are acting in “the public interest”, the difference between a negotiated outcome and a regulated outcome may be negligible. Both, after all, have the same general objective.

• As the number of private generators gets larger and more regionally diverse, there is some logic to centralising the function of price (and profit-margin) setting in a single agency, which can develop the information base and skills necessary to assess costs based on technology, scale, location and other factors. The assessments of such a agency may be binding, or they may serve as inputs into the negotiating positions of SEBs. Either way, since one does not visualise distribution activity being privatised in the near future, the government’s role as a wholesaler of power limits the role of any potential regulatory agency.
• Such capabilities could be obtained by building on the technological resources of the CEA.
• The picture would change if distribution was privatised in any significant way.

The above discussion clearly highlights the role of the different stakeholders, other than the government, in making the reform process successful. The crucial question is how does one ensure the participation of these stakeholders. 

The answer to this question lies in a process which starts before initiating the reforms, viz. communicating and selling the reforms to the sceptical lobbies and interest groups. Open dialogue and communication can  improve understanding on all sides of short and long-term effects pertaining to reforms and other ancillary actions pertaining to these reforms. 

Another issue that is important in terms of mobilising support of the interest groups deals with whether the reforms are going to be comprehensive or piecemeal in nature. Comprehensive reforms are based on a complete and transparent package of reforms designed to achieve specific goals with a well-defined time-table. The major advantage of a comprehensive reform process is that benefits appear faster, vested interests have less opportunity to hurdle reforms and the balancing act within the package are good negotiating baits. 

In the end, having an understanding as to sequencing of reforms is very important. The optimal sequencing from an economic point of view, in the sense of reducing transition costs and achieving benefits quickly, may differ from the optimal sequence from the political perspective. Hence strategic sequencing can lead in a self-sustained and expanding reform movement. 
 
 

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