Argentina - Reforming provincial utilities : issues, challenges and best practice

Report No. 1 5063-AR Argentina Reforming Provincial Utilities: Issues, Challenges and Best Practice June 6, 1996 Infrastructure Division Country Department I Latin America and the Caribbean Region 4 ' '2' ' ,,.''0 , :, -:,,,:f... . , ,.,_ . * ou~v r - h W -, - ,, ,.,*  CURRENCY EQUIVALENTS Currency Unit - Argentine Peso (A$) US$ = A$1 WEIGHTS AND MEASURES The Metric System is used throughout this report. FISCAL YEAR January I to December 3 1 ACRONYMS AyE Agua y Energia CAMMIESA Compafiia Administradora del Mercado Mayorista Electrica Sociedad An6nima CFE Federal Council of Electric Energy COFAPYS Consejo Federal de Agua Potable y Saneamiento ENOHSA Ente Nacional de Obras Hidricas de Saneamiento ES The National Energy Regulator ENRE Ente Nacional Regulador de la Electricidad ETOSS Ente Tripartito de Obras y Servicios Sanitarios GUMA Gran Usuario Mayor GUME Gran Usuario Menor LRMC Long-run marginal cost NARUC National Association for Regulatory Utility Commissioners NRRI National Regulatory Research Institute PPAD Precio de la potencia puesta a disposici6n RMBA Reforma Metropolitana de Buenos Aires SADI Sistema Argentino de Interconexi6n SRNAH The Secretariat of Natural Resources and Human Environment SPAR Provincial Service for Drinkable Water and Rural Sanitation SWR Subsecretariat of Water Resources PWS Public Works Secretariat W&S Water and Sanitation Services  PREFACE This report has been prepared by a team led by Antonio Estache (LA1IU) based on the findings of missions to Argentina in February 1995 and in June 1995. The core team included Claude Crampes (Universitd de Toulouse, Institut d'Economie), Marianne Fay (AF lET), Walter Garcia-Fontes (Universitat Pompeu Fabra, Barcelona), Frannie Humplick (PRDEI), and Thomas-Oliver Nasser (MIT and Institut d'Economie Industrielle, Toulouse). The report also benefited from background papers by Xavier Freixas (Universitat Pompeu Fabra, Barcelona), Felix Helou (Consultant), Martin Rodriguez-Pardina (Consultant), Ben Shin (PSD) and Warrick Smith (PSD). Also we would like to thank Secretary Zapata, Mr. Segnana and Mr. Vega, our main counterparts during the mission, for providing us with a tremendous amount of information and allowing us to meet key counterparts from the Provinces of Buenos Aires, C6rdoba, Mendoza, Neuqun, Santa Fe, Santiago del Estero, Tierra de Fuego and Tucumn. Finally, we would like to thank Secretary Bastos and Undersecretary Rotaeche for very useful discussions and insights. Background Papers Supporting the Report Fay, M. (1994), "Infrastructure and Growth in Argentina", mimeo, the World Bank, LAIIN Fay, M. and A. Estache (1995), "Regional Growth in Argentina: Determinants and Policy Options", mimeo, The World Bank, LAI IN Freixas, X. and W. Garcia-Fontes (1995), "Infrastructure Financing for Argentina's Provinces: Issues and Options", mimeo, the World Bank, LA1fl4 Humplick, F. (1995), "Infrastructure Performance in the Provinces of Argentina", mimeo, The World Bank, LAlIN Humplick F., and T. 0. Nasser (1995), "Risk in Provincial Infrastructure Provision: An Investor's Perspective", mimeo, The World Bank, LAlIN Rodriguez-Pardina, M. and F. Helou (1995), "Comparaci6n de Marcos Regulatorios en Argentina", mimeo, The World Bank, LAIIN Smith, W. and B. Shin (1995), "Regulating Infrastructure: Funding Regulatory Agencies", mimeo, The World Bank, LAlIN Smith W. and B. Shin (1995), "Regulating Infrastructure: Perspectives on Decentralization", mimeo, The World Bank, LAI IN   ARGENTINA REFORMING PROVINCIAL UTILITIES: ISSUES, CHALLENGES AND BEST PRACTICE TABLE OF CONTENTS' Executive Sum m ary ..............................................i Chapter 1: INTRODUCTION ..........................................,.1 The Need for Credible Provincial Commitment .................... .......................I What Competition in Utilities Entails ........................................... , . 2 What Contract-Based Regulation Entails ...........................................5 Does the Provincial Choice of Regulatory Regimes Matter to a Potential Investor? ...........................................6 What Decentralized Regulation Entails ...........................................7 Chapter 2: REFORMING ELECTRICITY DISTRIBUTION IN THE PROVINCES ................9 Overview of the sector's Organization ...............................................................9 The "Regulators" ....................... 14 Contracts as the Main Regulatory Tool ........................... 17 How Competition Works ........................... 18 Pricing ......, ..,,,,,.,.... 18 Investment and Tariffs ................................. 26 Summary of the Main Recommendations ................................. 29 Generation ................................. 29 Transmission ................................. 29 Distribution ................................. 29 Regulation ................................. 30 Chapter 3: DELIVERING WATER AND SANITATION SERVICES IN THE PROVINCES ......................................... 31 Overview of the Sector's Organization ......................................... 31 The "Regulators" ......................................... 32 Contracts as the Main Regulatory Tool ......................................... 33 How Competition Works ......................................... 36 lThis report was produced under the supervision of Mr. Gobind Nankani, Director; Mr. Asif Faiz, Division Chief, Infrastructure and Urban Development; and Mr. Danny Leipziger, Lead Economist, Country Department I, Latin America and the Caribbean Regional Office. The peer reviewers for the early drafts were Messrs. 1. Kessides, PSD and L. Guasch, LATAD.  Pricing .............................................. 37 Investment and Tariffs ............................................. 40 Summing up the Main Recommendations ................ ............................ 41 On Tariff Design ............................................ 42 On Contract Selection ............................................ 42 On Institutional Reform ............................................ 42 Chapter 4: DEVELOPING A PROVINCIAL REGULATORY CAPACITY ....... 43 Breaking with the Past ...................................................... 43 Constraints and Trade-Offs ...................................................... 44 Sectoral Breadth of Authority ...................................................... 45 Is Representation Needed in Each Municipality? ..................................................... 46 Minimization of Regulatory Demands ....................................................... 46 Size of Agency Staff ...................................................... 47 Strengthening Regulatory Capacity ...................................................... 48 Funding the Regulatory Agency ...................................................... 49 Organizing Interprovincial Cooperation on Regulatory Matters ............................... 50 Summing Up ....................................................... 50 TABLES Table 1.1 a Status of Provincial Reforms in Electricity .......................................................1 Table 1. lb Status of Provincial Reforms in W&S ...................... ..1..............................I Table 1.2 Summary of Main Concession Contracts .......................................................4 Table 2.1 Structure, Financing and Functions of ENRE, the National Entity for the Regulation of Electricity ........................ .............................. 15 Table 3.1 Impact of the W&S Reform in the Greater Buenos Aires .......................... ................ 31 Table 3.2 Main Provincial Water Contract ...................................................... 34 BOXES Box 1.1 How to Check if the Reform is being Captured by the Bidders? ............. ......................3 Box 1.2 Comparing Concession Process in W&S and in Electricity ......................................... ... 5 Box 2.1 Who are the Main Generators? ...................................................... 12 Box 2.2 Who Transmits where in Argentina? ...................................................... 13 Box 2.3 What did the Concessionaires do with their Property Rights in Distribution? ...................................................... 14 Box 2.4 How are the Marginal costs Computed? ...................................................... 19 Box 2.5 Dealing with the Seasonality of Prices ...................................................... 23 Box 2.6 A Comparison of Tariffs across Provinces ...................................................... 24 Box 3.1 The Timing of the Privatization Process in Greater Buenos Aires ............... ................. 33 Box 3.2 Goal-Based vs. Process-Based Contracts ...................................................... 35 Box 3.3 What Contract Renegotiation Reveals ...................................................... 36 Box 3.4 What Yardstick Competition Entails ...................................................... 37  Box 3.5 Why does the Concessionaire Want Meters Everywhere ............................................. 39 Box 3.6 What's Wrong with the Average Price of Water in Argentina's Provinces? ................................................ 40 Box 3.7 Willingness to Pay for Sewerage ................................................ 41 Box 3.8 Dealing with Social Concerns ................................................ 41 Box 4.1 How to Appoint Regulators? ................................................ 44 Box 4.2 Consumer Representation ................................................ 48 FIGURES Figure 2.1 Financial Flows ................................................ 11 Figure 2.2 Marginal Cost and Inverse Demand ................................................ 20 Figure 3.1 ................................................ 39   ARGENTINA - REFORMING PROVINCIAL UTILITIES: ISSUES, CHALLENGES AND BEST PRACTICE EXECUTIVE SUMMARY This report analyzes the reform needs and options in electricity distribution, and water and sanitation services (W&S) in Argentina's provinces. The main focus is on the regulation of private operators since many provincial governments are considering concessioning all or part of these services to the private sector to improve quality and rely more on private financing of the sectors' expansion needs. Tariff design and institutional concerns are emphasized in a detailed analysis of the specific regulatory framework of both sectors, including some issues raised by federal regulation relevant to the decisions of potential investors in provincial utilities. Main conclusion. The report strongly endorses the general concessioning strategy followed by most provinces. This strategy has already generated substantial gains in utilities under Federal control. In electricity for instance, tariffs have slightly decreased on average since privatization and quality of service have improved significantly. For instance, the average number of annual service interruptions was cut from at least 7.6 to 5, and the average duration from 23 hours/year to 9.9 hours/year. However, not all provinces will be able to follow a strategy relying on private investors as they vary tremendously in terms of potential rate of return and commercial as well as non- commercial risks (including political and fiscal risks). Some of the poorest provinces combine low potential return and high risks' levels and are unlikely to be very attractive under deals and regulatory arrangements that try to shift most of the risk onto the private investors. For these provinces or for those not wishing to transfer outright the W&S and electricity distribution services to the private sector, the report offers alternatives. It suggests, in the short run, the commercialization of these services through management and service contracts with private companies can serve to establish the credibility of the provincial commitment to reform. But this should be viewed as a first step towards the implementation of concession as it gives investors a chance to obtain more independent information on the value of the assets for which they would be bidding The keys to successful provincial utilities reforms. The National Reforms demonstrate that to maximize the gains from the "privatization" strategy, the following steps are needed: * make the most of what competitionfor the market allows, * give an incentive to new owners to remain concerned with the public interest; * assign rights and obligations in the contract as clearly as possible, * anticipate the potential needs for renegotiation; * define the nature and form of property to maximize accountability, * do not underestimate the importance of tariff design; and * prepare and develop the provincial regulatory capacity as carefully as the contract.  ii Do not underestimate what can be achieved through competition for the market. Whether in the area(s) of operations, management or specific services, competition for the service is crucial to the success of the current reform efforts. Competition and increased private sector involvement also reduce arbitrary political interference in price setting or employment decisions, for instance. Although the specific form of private sector involvement in each province will have to be tailored to fit local needs, constraints and preferences, the introduction of competition, if implemented correctly, will cut total service costs, pass a large share of these cuts to all consumers and improve responsiveness to users. The success of the approach (in terms of fiscal impact but also in terms of service quality and price) depends a lot on the design of the bids to assign the operator's role in a concession, management or service contract. Some of the provinces are clearly aware of the importance of this step in the reform process: it ensures the credibility of the provinces' announcements and their commitment to change. For instance, the province of Santa Fe commissioned an independent assessment of the value of the net assets of its utilities (done by an internationally recognized external expert). This provided independent information on the potential fiscal impact of the reform. It also revealed up front as much reliable information as possible to potential investors. This type of assessment can also avoid some uncertainties in terms of rehabilitation needs and reduce the risk of unexpected tariff adjustments as those approved for Aguas Argentinas over and above what was agreed in the original contract. Ensure the managers' and workers' accountability. If property is distributed, the way it is done can also contribute to the success of the reform. Shares can be sold on the stock market to widen the dissemination of property and hence of accountability as was once considered (but eventually rejected) for Aguas Argentinas. Shares can also be allocated to workers and employees, as for electricity transmission under federal jurisdiction, giving them an effective incentive to support the reform and to act in the interest of the enterprise. But there are risks in spreading accountability too thinly. This is why it is generally suggested to allow the bidding of packages of shares large enough to allow control by one major interest i.e., to have a strategic investor. Clearly spell out the rights and obligations of all parties. Under the strategy adopted by the provinces, contracts (concession, management or services) are the main regulatory instrument during the tenure of the private operator. Where and when governments do not have a long track record in dealing with the private sector, contracts need to be drawn as tightly as possible to reduce opportunities for discretionary government actions. Contracts are intended to be enforced according to their terms. The provincial reforms will only work if the provincial governments recognize that once a private operator takes over, this operator is in charge within the specific terms of its contract. Anticipate the potential needs for renegotiation. Even if a province has well prepared its contracts, unforeseen events will happen. This means that even if contracts should be prepared as documents that are not intended to be modified and include adjustment mechanisms to avoid the costs and uncertainty of renegotiation, under very specific and very limited circumstances, a limited degree of contract flexibility may be good public policy. To ensure that the contract is a credible regulatory instrument, contract modifications should be based on some fair and workable rules based on clearly spelled out policy criteria (discussed in the report). These rules should be agreed upon by all involved parties, and the guarantee of this agreement should be provided by an independent regulator as an honest broker. Unilateral modification of the rights defined in the contract or the bidding documents (say through request to accelerate investment programs or impediments to tariff adjustments) without  iii full compensation is tantamount to expropriation and defeats the purpose of the reform. It is the risk of arbitrary government behavior of this kind that historically created the biggest risk for private investors in infrastructure and that continues to deter many deals. Keep the new private monopolies working in the public interest. Once the contracts have been awarded, it may be difficult for the government to get the private operator or managers to focus on the interest of consumers as much as on their own interest. To maximize the incentive for efficient behavior during the concession, the contracts can require that new auctions be organized at regular intervals as it was done in the case of the electricity distribution concessions orchestrated by the National Govemment. Another incentive for provincial monopolies to maintain their concern for the interest of consumers is to rely on some formal comparison of performance across provinces. These comparisons should be widely disseminated (in the media) to increase the public pressure for accountability. These comparisons can also be used more formally by regulators to push prices to their lowest possible level ("yardstick competition"). This requires a strong inter-provincial coordination to standardize information which could be organized by the National Regulators. Get the tariffs design right. All reformers recognize that the design of tariff formulas are at the core of effective regulation. However, few appreciate its complexity and relevance to the long- term sustainability of the provincial utility reforms. The report discusses how tariff design matters to ensure the best allocation of scarce provincial resources. In the context of this analysis, it identifies a few issues that deserve their immediate attention. Some of these issues are under their direct control and should be handled as part of the reform process. Some are under the responsibility of the National Government but need to be monitored by provincial reformers to allow them to anticipate the concerns of potential investors in provincial utilities. In Electricity, the provinces trying to introduce more efficient pricing of distribution services (including an incentive to maximize productivity gains) should adhere to the tariff methodology contained in the national electricity law with some adjustments. Chapter 2 shows that: * If regulation continues to be based on price capping (aims at giving incentive to minimize costs), there is a need to very quickly define a methodology and gather the information needed to calculate the productivity gains that should be passed on to consumers. * There is also a need to review the current tariff methodology in order to make sure that the interest of "captive consumers" are protected. The current approach creates a distortion due to the possibility of direct contracts between "large users" and "generators". The consequence of these contracts is that captive consumers (i.e., those who are not large enough to be able to buy without having to go through the distribution companies) may have to pay much higher rates because they are paying for more expensive wholesale contracts transferred at the time of privatization and large users opt out to negotiate cheaper contracts in the wholesale market. This could lead to difficult political problems as "privatized" tariffs may end up increasing significantly in relative terms for a large share of the consumers. This could be avoided by allowing some more pricing flexibility and some degree of discrimination in prices. In addition, the provincial governments will have to monitor the developments in transmission pricing, one of the very few serious outstanding issues in the otherwise very impressive National Sector Reform. Better and clearer rules (based on economic benefits rather than on energy flows) are  iv needed to avoid the type of difficulties recently met in discussions of the construction of a fourth transmission line in the Comahue corridor. Existing rules have a bias towards underinvestment because they fail to assign a clear responsibility for the payment of the construction costs of any expansion. Since transmission is the physical instrument to guarantee competition in generation and supply, this underinvestment is increasingly a concern to potential investors in distribution. Moreover, as more and more provinces privatize their distribution companies, the relationship between the transmission concessionaires and the distribution concessionaires is likely to change, and the tolls may have to be revised to ensure consistency with economically efficient pricing rules and revenue adequacy. In W&S, Chapter 3 shows that the regulatory challenge is much wider and complex: * A radical tariff reform is needed to achieve efficiency in the use of water and to finance growing long-term investment needs, particularly in the sewerage systems. It will involve increased metering, eliminating the current tariff for unmetered consumption and redesigning the fixed part of the current two-part tariff used for metered consumption, since it currently leads to multiple types of cross subsidies, and since it fails to provide much incentive to minimize cost and to invest in the expansion of the sewerage system. * This tariff reform will have to be implemented as part of a wider reform which should aim at the adoption of commercial practices in the sector. This means that the provincial governments will have to give up many of the controls they are now imposing on their public enterprises and aim at regulatory simplicity when identifying what needs to be controlled/regulated and what need not be (and this will require strong coordination with the National Government). * The concerns with the high level of uncertainty regarding the asset value and the costs of the rehabilitation needs expressed by potential private investors interviewed by the Bank are such that some of the provinces will have to consider a slower pace of reform, and will have to focus on short-term management contracts with an option to transform them into concession contracts in the longer run. It may also be worth considering the bundling of W&S assets across provinces, or their bundling with other assets such as electricity to reduce the overall risk faced or perceived by private investors. None of this should affect the efforts to reform tariffs and increase metering. Develop the provincial regulatory capacity. The most difficult provincial challenge addressed in the report may be the need to monitor that the behavior of the privatized monopolies are consistent with the terms of the contract as well as with public aims. This monitoring is needed because concessionaires will have strong incentives to behave inefficiently when left unsupervised. The creation of regulatory bodies or the use of the strength of law and courts will be an important element in the success of the provincial reform of utilities and Chapter 4 focuses on this exclusively. But there is a need to distinguish between technical and economic regulation in both sectors. Economic regulation does not have the same goals as technical regulation so that its organization is not necessarily identical to the technical one. For the electricity sector, the difference can be illustrated as follows: at the terminal nodes of the interconnected electric network there is little need for technical control, but it is a place where provincial distributors can try to exploit their exclusive position in front of captive consumers and hence economic regulation may be needed even if technical regulation is not. Therefore, the skills needed to develop the provincial regulatory capacity are not simply a recycling of the skills needed to provide the service in a public enterprise. Some of the staff  v of the former public utility will have to be dismissed and new staff will have to be recruited to introduce these new skills in the provincial regulatory entities. Aim at a single independent sector specific agency. While the Report shows that some economic regulatory responsibilities may be justified at the provincial level in electricity and W&S even when technical regulation is not needed, it also shows that if each province must have its own regulatory capacity, the local entity should be kept to a minimum and only have specific prerogatives, essentially auditing and reporting to the national regulation body. This is particularly important in electricity because technical dependencies within the network are very strong. Moreover, the recognition of a role for provincial regulation is not an endorsement of the creation of multiple sector specific regulatory agencies. The international experience suggests that most provinces would be better off with a single independent entity for all utilities. Chapter 4 explains in detail how to achieve that independence in terms of nomination of regulators and financing of the agency. Do not simply staff the agency with the employees fired by the private operator. The staffing level of the agency should be modest and its composition should depend on the requirements of specific tasks assigned to the regulatory agency. As discussed in the Report, there are many good possible criteria for selection (i.e., technical excellence, political representation, ...). With a few exceptions, the experience considered relevant in the staffing process at the national level was based on engineering aspects of the sector while economic regulation, the main purpose of these entities, is quite different from technical regulation. This suggests that the selection criteria for the regulators should include expertise in economic fields. While the skills needed to be a good regulator are hard to find, they are very similar in both, the water and electricity sector, and hence the same resources can be shared within a single provincial regulatory entity. This means lower resource needs (not only in terms of staff but also in terms of equipment) and hence a lower burden on the taxpayers or the beneficiaries of the services. There are other benefits. For instance, it facilitates learning between sectors, ensures consistent approaches to central policy questions, and makes the regulator less vulnerable to industry or political capture. This lower vulnerability enhances the credibility of the agency and reduces risks for investors. Spell out the implementation strategy. The strategy to implement this regulatory agency can be flexible. If no agency has been established yet, a core multisectoral framework can be set up first and then sectors can be added to the core entity when appropriate. There is no need to wait until any contract has been signed. The creation of an entity can be instrumental in assisting in the implementation of the concessioning process. If one agency has already been established, it should not be too difficult to expand the jurisdiction of the existing agency. This depends of course on how sector specific in design and composition the initial agency is. Finally, if several agencies have already been created, the best option is to develop a strategy for merging the agencies after an initial period. This strategy tends to be the most difficult and will often be resisted by both the existing regulators (concerned about losing their autonomy and possibly their job) and investors (often preferring the counterpart they know). Next Steps. The main conclusion of this report is that there is no single blueprint for the provinces but that there is strong evidence of a need to further understand regulatory objectives and establish regulatory rules and regulatory behaviors whatever the specific strategy adopted by a province. The ultimate aim is better and cheaper service provisions to the Argentine consumer,  vi whether she/he lives in Bs.As. or Salta or Tierra del Fuego. The Report also aims to be a discussion report, namely a vehicle to raise issues and begin the public dialogue necessary to extract the benefits of a private sector participation in key utilities in Argentina's provinces.  Chapter 1: INTRODUCTION 1.1 Objectives of the report. Most provinces Table 1.la Status of Provincial Reforms in Electricity in Argentina are concerned with the high cost and _ y 1996) poor quality of service in electricity distribution Already concessioned Catamarca, Entre Rios, Formosa, La Rioja, Rio Negro, and water and sanitation (W&S) as well as with San Juan, San Luis, S. Del the lack of public resources for their rehabilitation Estero, Tucuman and expansion. The report analyzes the reforn At the bidding stage Jujuy, Salta needs and options in these two sectors in With privatization and Misiones, Neuquen Argentina's provinces. The main focus is on the regulatory frarnework regulation of private operators since many defined pregulatio gofprivaterr peratos ansincern m With regulatory Bs.As., Corrientes, Misiones, provincial governments are considering framework pending Santa Fe concessioning these services to the private sector No legal framework C6rdoba, El Chaco, Mendoza, (see Table l.la and 1.lb on the current status) yet or irrelevant Santa Cruz, T. d. Fuego (Chubut and are requesting technical assistance in and La Pampa will keep their identifying the main regulatory issues they will cooperatives). have to address. The lessons of the national experience with contract-based regulation and Table 1.lb Status of Provincial Reforms in W&S tariff design as well as institutional issues are 1996_______________ s & particularly detailed throughout the report--much Already concessioned Corrientes, Formosa, Santa Fe, more so than in previous recent Bank publications TucumAn on these two sectors.' This detailed analysis is At the bidding stage C6rdoba, needed to show explicitly the linkages between: With privatization and S. del Estero, Mendoza (i) tariff design on one hand, and investment regulatory framework targets and financing on the other hand, and defined With regulatory Catamarca, Jujuy, La. Rioja, (ii) national and provincial regulatory issues. framework pending Neuquen, Salta, San Juan No legal framework Bs.As., El Chaco, Entre Rios, 1.2 Road Map. Chapter 2 covers the main yet or irrelevant Rio Negro, San Luis, Santa issues in the privatization of provincial electricity Cruz, Tierra del Fuego; distribution companies. Chapter 3 deals with (Chubut, and La Pampa will W&S services. Chapter 4 discusses the probably maintain their institutional demands of the regulation of private cooperatives) operated utilities. The remainder of this first chapter reviews the main general policy issues the The Need for Credible Provincial Commitm t provincial governments will have to address and 1.3 If efficiency in the allocation of scarce that apply to both sectors: provincial resources and better responsiveness to * what limited credibility entails user needs are the main policy objectives of the * what competition entails provincial governments, the report endorses the * what contract-based regulation entails general concessioning strategy being followed by * what decentralized regulation entails. most provinces. But not all provinces are equally attractive to private investors as they vary tremendously in terms of potential rate of return See for example, World Bank Report No. 35 The Power and commercial (some have low potential return Sector in LAC: Current Status and Evolving Issues by R. A. and high risks level) as well as non-commercial Moscote, S. B. Maia, and J. L. Vietti, June 1995.  2 risks (including political and fiscal risks). The these rights (say through request to accelerate reform strategy may have to be tailored to the investment programs or impediments to tariff constraints imposed by these differences. So what adjustments) without full compensation is are the short run alternatives to concessions? tantamount to expropriation. It is the risk of arbitrary Government behavior of this kind that 1.4 When a province does not succeed in historically created the biggest risk for private awarding a concession contract (or does not wish investors in infrastructure. Where and when the immediate transfer of the service to the private nnvestors do not as thtyhe Goverinlent, contracts sector), the report suggests not to give up on need to be drawn as tightly as possible to reduce trying to introduce more incentives to cut costs in opportunities for discretionary actions by the the sector but to try instead to rely, at least in the Govemment short run, on some form of commercialization of these services through management contracts: this 1.6 This suggests that the success of the can serve to establish the credibility of the privatization process depends closely on provincial commitment to reform in the view of . how property rights are defined and private investors before concessions can become a allocated initially (i.e., will the Governent realistic option. This gives investors a chance to really give up control in exchange for obtain more independent information on the value efficiency and financing?); and of the assets they would be bidding for (a major * under what circumstances could these rights issue in the W&S sector) and get the be eventually reallocated (i.e., what are the commercialization of the service going withoutpulcoiycrtiahtcudledoa dea2 public policy criteria that could lead to a delay. *2renegotiation of a contract ?).3 What Competition in Utilities Entails 1.7 In the national level reforms, the overall 1.5 It seems clear that provincial governments allocation of property rights to maximize the gains have generally accepted to introduce competition from competition is the outcome of the following in their local service monopolies through the three prong strategy: organization for competitive bidding. But the . assign property rights as clearly as possible in main lesson from the national reform experience the contract; that Argentina's provinces may not have yet been able to intemalize fully is that the key to * define the nature and form of property to successful competition is to assign property rights maximize the manager's accountability; and on all the resources unambiguously. In other . give an incentive to new owners to remain words, the Government has to give up control efficient throughout their tenure. over the service and recognize that once a private operator takes over, the private operator is in charge within the specific terms of its contract 1 8 The first prong was to rely on sealed-bids with the Government. Contracts are intended to to assign the operator role in a concession be enforced according to their terms. This is what contract for a specified period (electricity, water, creates property rights. Unilateral modification of 3 The existence of market failures such as 2 To avoid the creation of an information monopoly in environmental concerns often limits the extent to favor of the winner of the management contract, clear which property rights can be shifted from the data publications requirements should be spelled out in Government to a private operator. the contract.  3 etc.). As discussed later, the specific design of the 1.11 The third prong is relevant because the bids is a key determinant of the success of reform. provincial services at stake are local natural Some of the provinces are clearly aware of the monopolies. Once the concessions have been importance of this step in the reform process. The awarded, it may be difficult for the Government to water company in Santa Fe, for instance, get the private operator or managers to focus on commissioned an independent assessment of the the interest of consumers as much as on their own value of its net assets (done by an external expert interest. Once more, the national reform of the in whom prospective investors had confidence) to electricity sector shows how to reduce the risk. reveal up front as much information as possible to To maximize the incentive for efficient behavior potential investors. This avoided some (but not during the concession, the concession contracts all) of the uncertainties in terms of rehabilitation awarded by the National Government in electricity needs observed in the privatization of Obras require that new auctions be organized at regular Pfiblicas in Buenos Aires. (Table 1.2 gives a intervals according to a procedure explained in checklist of the main features that contracts in any paragraph 2.32.4 Basically, while the electricity province should cover). distribution concessions have a duration of 95 years, they are divided into management periods 1.9 Just as important, all the requirements of of 10-year (except the first one which lasts for 15 the bidding documents have to be internally years) which are allocated every 10 years. consistent and reasonable. They should be checked for inconsistencies between the tariffs and the investment and rehabilitation requirements. Box 1.1 How to Check if the Reform Process is being This may have been an issue in the bids organized Captured by the Bidders? for the water concession in C6rdoba. Any serious discrepancy between various financial Requirements to participate should also strike a indicators provided in the bidding documents of the furm to be balance between quantity (as many as possible) regulated and one of the benchmarks listed below can reveal and quality (serious investors) of the offers. They abuses of the regulatory system by the potential operator. should also strike a reasonable balance between Compare the rate of return (ROR) implicit in the bid and: risks and return for the private investor as 1. the ROR in unregulated firms in similar activities in the discussed in Box 1.1 region.; 2. the ROR the average ROR of the market in Argentina; and .10 The second prong of this strategy focused 3. the ROR in similarly regulated firms in other provinces on the nature and form of the dissemination of Over time, the comparison of the variance of rates of property. In the case of Aguas Argentinas, shares return in the sector before and after the inclusion of the new firm were sold on the stock market to widen the can also provide useful insights on the potential financial impact of the privatization. Typically, utilities are expected to be below dissemination of property and hence of average risk and their return should vary by less than the market accountability. For electricity transmission, shares average. If the bids show anything else, it may reveal that the were allocated to all staff, giving an incentive to bidder is asking for too much to provide the service. It may also reflect an attempt b the bidder to compensate for a province act in the company's interest. But there are also specific risk that is well above market average. In this case, the risks in spreading accountability too thinly. This specific form of regulation may need to be tuned up as discussed is why it is generally suggested to allow the later in the chapter bidding of packages of shares large enough to allow control by one major interest (i.e., to have a strategic investor). 4 While reducing the problems due to monopolies, this approach still implies a need for regulation.  Table 1.2 Summary of Main Concession Contracts - Bidding Procedure Term Contract Requirement Rate Regulation Quality Requirements Investment Water & Sanitation * technical pre-qualification by OSN * 30 years 0 obligation to provide the public 0 cost plus; 0 water quality * include (Aguas Argenninas for and the Privatization Commission; based on * could be extended by I y service of water and s nitation in a * inal tiff level leves are pelled out, improvement and the Greater Buenos Aires economic capachy (billing no less than $600 way tht ensures the continuity. at in the prvatization icreingy dem expion pls u pai Area) mnillion/year and net assets no lower than SI * at the endrofte concession, anewbid regularity, quality and generality to procem nd applied to a over tine ofthe contract billion)andtechnical capacity(toatendin couIdbeorganized usr andtheprotcti onofthe specifictariffstndcure * servicquality * invetmentahave urban centeri of more than 500,000 nd environment; * trigger rule for target (minimum to be bidden out; total population of 2,500,000); * must extend, maintain and changes based on an Icvels) but no quality * timing a then, two envelopes: envelope one renew as needed the external network agreed cost structure. norms with respect to requirement for the includes detailed technical offes (legal and connect them to all inhabited service cuts or water investment program, but aspects of the bidders, mission statement, buildings in the concession zone. * reviisons every 5 pressure levels subject to renegotiation aspects afthe biddem, miuion daten-C ~ ~~~~~~~~~~~~~~~years to increase operational plans, regulation for users, ...); * will have to comply with incentive to efficiency * quality levels for envelope two includes the financia and specific minimum coverage in time treated sewage and for economic offers (including the coefficient of slices, ending with 100% by the end sewerage infrastructure adjustment to the current tariffto be of the conitract * fines for non- expressed in value--this is the coefficicnt by which the current tariff will be multiplied to * maintain and rehabilitate complvane r ith obtain the new tariff, financial commitment according to needs and minimum revenue returnd to and aptitude and all the information criteria spelled out in contracts users explaining how the bidder would achieve the 0 meet demand of both of and adjustment coefficient); new users * the winner of the bid is the one with 0 meet increasingly demanding lowest adjustment coefficienL quality standards * beforc bid, create a company with a 0 do secondary treatment of all minimum capital of S 20 m., get guarantee sewage for S150, niillioii and various insurance; ___ ___ Electricity Distribution * two envelopcs: envelope I specifies * concession for 95 years for exclusivity * obligation ol public service of * RPI - X f- Y; * mininium quality * no conitrol of in Greater Buenos Aircs die technfical requirements anud detemiincs in a specific zone aller whici new bidding distribution in the concession zone; * maximum price standards covering: investment by the public the prequalified bidders; it contains the share will have to be made; proceeds of bid go to * commit to specific quality with total pass-through (i) product (tension); sector although of actions to be subscribed by each co- the incumbent who is also allowed to bid; levels of the costs of energy in (ii) technical service investments over USS2 bidders, shows a single unified local * the term can be extended for a pefiod , respect the rights of users as the wholesale market (duration and frequency million need ENRE's residence, proof of legal existence; S10 up to ten years to be determined by the specified in the "reglamento de (Y) and indexation to of outages); and approval and a public million guarantee for offer, proposed action (iii) commercial service hearing.onunrcialservce hering pillion guarantee for offer, proposed aclion regulatory entity (ENRE) who can also suministi-o,. U. S. price index (RPI); (complaints by clients, plan for contractual obligations Envelop 2 modify or suppress the zonal exclusivity; has the economic offer with amount in cash * satisfy th total demand for * the index used in time to get connection, and public bonds; bidders had to, have assets 0 the term of the concession is divided service, including demand for new 67% PPI and 33% CPI; bill estimates); of at least $300 million and proven net into management periods of 10 years services; * initially X was set a for measurement, wealth of no less than $200 million which (except for the first,. lasting for I 5 years); 0 poieeeg o ulc 1 ;toseswr eie did not decline by more than 5 to 10% over * at the end of each management period, lighting; * the RPI is applied with different goals; the previous year. ENRE organizes an international bidding to poiecctctyatoascfctrff (i) durirng the first 36 * all bids must identify at least one but sell n ajority bundles ofstock and will set 3X380p220 Ve 13t 2iV, 33kV, *rtose tRi months, measurement of no oretha tw exerince opratrs the tariffregime tobe applied for the 3~o20,1,k,3V tutr;medium tension; and (ii) belonging to the consortium created with following five years; the conditions of0these 132kVd 22kh oR * tariffs are set in as of 37th month specific requirements of experience for the biddings have to be similar to the original agreed with ENRE; USS measurement of every Gperator. bidding conditions; the ownier of the 0 made the invcstment and user;, majority package; if the price offered by the niaintenance required to achieve * the economic offer has to be valid for incunmbent is the highest, he keeps the established quality requirements; * failures to meet at leat t godays s fromthe oening f othequality standards are at evle 180 days as from he opening of the propety; if he is outbidden, the highest * allow non-discriminatory penalized through a envelope and at least S30 million would bidder has to pay the bid price to the access to the grid to third parties as dpetailed fin systeru the have to be paid in cash after 3 days of the incumbent and becomes the new majority long as it does not impede its own proceed to te e winner selection; 90 days for public bonds. owner, an independent inspector nominated capacity to deliver, victim of the gaps * the winner would have to pay the by ENRE will ensure I year before the end v of the gaps consulting fees for the lawyers (USS 1.5 of the management period and for the first ensure that their activities do million each for the transmission and the year of the ne w e not damage ecosystems; distribution deals) and the finacial proper fiusctioning of the company * promote rational use of energy. consultants (paid only if there is a deal and (including disclosure of information). equal 1% ofthe value ofthe deal).  5 What Contract-Based Regulation Entails contract by redefining one of the variables (the capacity price) in such a way that the distributors 1.12 The concession contract is the main would no longer be penalized (or favored). This instrument used by the national Government to left formula in a range consistent with the "pass regulate utilities--although its exact nature varies through ranges" and avoided the original concern. across sectors as seen in Box 1.2. Concession contracts and possibly management in some of the 1.14 Should contract revisions be allowed? poorest regions, are likely to be the main This (as well as the national experience with instrument for the provinces as well. As a rule as transport contracts) shows that even if, as a rule, mentioned before, they should be drawn up as contracts should be prepared as documents that tightly as possible to reduce the need for are not intended to be modified and include discretionary adjustments. adjustment mechanisms to avoid the costs, uncertainty of ex-post negotiation, under very specific and very limited circumstances, a limited Box 1.2 Comparing Concession Contracts in W&S degree of contract flexibility may be good public and in Electricity, policy. But to ensure that the contract is a The term concession is used for both the W&S and for credible regulatory instrument, the contract the electricity distribution contracts. Yet these contracts modifications should be based on some fair and are quite different. No shares were sold in the W&S case. All assets remain public and the Government has given the workable renegotiation rules based on clearly right to a private firm to operate these assets in exchange spelled out policy criteria (as discussed below) for certain obligations in terms of investment which is one and agreed upon by all involved parties. They of the main reason why provincial water utilities are trying should always respect the original contractual to attract the private sector. In electricity, the Government rights of the investors; ad-hoc solutions are not did sell shares, and hence part of its assets, but has . . c attached to it public service obligations--expressed in terms always i the best iterest of all the parties of service coverage and quality-- instead of specific involved. This is one of the main rationale for an investment requirements. independent regulator who can have some discretion in the implementation of the rules as an honest broker. 1.13 However, these contracts, as any other type of contract, cannot anticipate all exceptions 1.15 When should contract revisions be or qualifications and that corrections are allowed? The challenge is to find a transparent sometimes needed later. Argentina's National mechanism for modifying specific terms of a electricity regulator (ENRE) was recently contract that do not result in private investors or confronted with the need to revise a distribution consumers lacking confidence in the contractual contract. The formulas for the calculation of instrument (i.e., adjusting the price terms of a tariffs prevailing initially resulted in a significant contract in line with the terms of that contract). reduction in the profits of distributors in May This mechanism was missing in the otherwise very 1994 (although the mistake led to significant impressive national reforms. It is also a key profits over the previous 18 months without much ingredient missing from the provincial debate. complaints about this problem then). The distributors complained about their profit losses 1.16 The contractual rigidities built into the and ENRE conceded that there was a need to concession agreements are necessary to close revise the contract but that this required some deals and to create binding commitments among research. The Energy Secretariat (ES) took the participants. However, they make it difficult charge of the debate and de facto revised the to adapt when there is a need to resolve emerging  6 problems because many of the actors find 1.18 Which public policy criteria? The adaptation threatening to the privatization public policy criteria to test if a revision is needed commitments that protect their interests and the have to be spelled out as soon as possible to make whole fabric of reform. Moreover, clearly each the rules of the game clear to all parties involved. franchisee is likely to attempt to interpret most of They should ensure a transparent basis for the contractual ambiguities to its own advantage. contractual dispute resolution and related policy This is why there is a need to continuously decisions, as well as to avoid excessively monitor the concession agreements and to assess subjective decisions on the need for or nature of any need to adjust them. contractual changes. These criteria ease the judgment as to whether the maintenance of 1.17 The assessment of any modification existing provisions is suboptimal to all parties in requirements, however, needs to be based on a view of a fundamental change in external good sense of what went wrong and on a clear set circumstances (e.g., a permanent demand shift) or of public policy criteria: a change in policy priority (e.g, the relative . How realistic are the government requests importance of services to the poor increases) once more is known about the state of assets? Possible criteria include: Were there trade-offs not well identified at the * Is the protection of the interests of investors at initial stage by either the Government or the the baseline levels established in the original private bidders who could have asked then for privatization terms guaranteed'? Should it be? a revision of the specification of the needs, as . How would the overall operation (flexibility, observed in the privatization of the Santa Fe water company. ~~~~~~variety, responsiveness of operators, quality of omaintenance and of investment strategies) be * If minimum demand levels were spelled out in affected by the changes? the contracts, were they over- or * Would the composition of the financing of the underestimated? This is common. It may activitybe altered? Would it reduce the public have been a problem in any of the water concessions in Argentina as elsewhere in the share in this financing? world. But was this due to a mistake in the * Would consumer interests be protected? organization of the concession or was it due to What is the nature and source of change in a mistake by the private operator such as scale of operations in response to demand? insufficient market analysis? * Did the state of the assets deteriorate between If the answers warrant a change to the contract, it the time the bids were made and the time they should be limited to the specific issue. were actually transferred? If yes, was this due Negotiations should not be reopened for the to the natural phenomena (e.g., the weather) whole contract. or to the fact that the public operators stopped maintaining these assets? If it is due to the Does the Provincial Choice of Regulatory former, the responsibility may be shared by the Regimes Matter to a Potential Investor? Government and the private concessionaire. In the second case, the concessionaire may 1.19 The two main regulatory options have a fair claim on a request to revise the provincial reformers should be picking from are: contract. (i) rate of return (ROR) regulation (as used for over 20 years the U.S. utilities) and (ii) some form of price cap regulation (recently introduced in the  7 UK privatizations and in the electricity distribution What Decentralized Regulation Entails in Greater B). Under a ROR regulation, the regulator set a revenue requirement based on a 1.22 The last provincial challenge addressed firm's accounting costs reflecting operating costs, here is the organization of the monitoring of the taxes, amortization and allowed ROR. Once the consistency of the behavior of the privatized revenue requirement is computed, the regulator monopolies with the public aims. This monitoring determines the tariff structure design needed to is needed because concessionaires will have strong recover aggregate costs. Under a price cap, incentives to behave inefficiently when left instead of setting a ROR, the regulation sets a unsupervised. The creation of regulatory bodies price ceiling above which the concessionaire or the use of the strength of law and courts will be cannot raise prices. Under that cap or ceiling the an important element in the success of the regulated firm can set prices as it wishes. The provincial reform of utilities. They are needed to ceiling must be reviewed every two to five years guarantee the increase in efficiency through to account to productivity improvements, competition in services delivered by natural monopolies.5 But there is a limit as to how much 1.20 Price capping has many potential this institutional role can and should be advantages over ROR regulation. The main decentralized. advantage for Argentina's provinces is that it generates stronger incentives to cut costs and that 1.23 The main economic argument in favor of these costs cut eventually get passed on to some degree of decentralization stems from the consumers. One of its problems is its very need to distinguish between technical and demanding informational requirements. This can economic regulation. An interconnected electric be overcome as ENRE's experience is showing network will always need technical regulation although it is not straightforward as shown by the with strong coordination between the different British experience. But the main reason why regulating agents, for example through a central provincial reformers have to be careful in their dispatching unit. Economic regulation does not choice is that the specific choice has an impact on have the same goals, so that its organization is not the risks faced by potential private investors. The necessarily identical to the technical one. The two regimes place very different levels of risks on controllers should be located at the nodes where the regulated utilities and hence affect the rate of inefficiencies will more probably occur and these return and the cost of capital in very different nodes may differ for the technical and the ways. economic concems. 1.21 A price cap approach implies that the 1.24 Economic Regulation of Electricity. investors puts up with all the risks on its The technical dispatching of energy supply to investment. ROR can pass on these risk onto the meet demand is a good opportunity to induce consumers. So if demand for utility service in any efficiency through merit order. On the contrary, province is highly dependent on the level and type at the terminal nodes of the network there is little of economic activity in the province, ROR need for technical control but it is a place where regulation will generally be more effective at distributors can try to exploit their exclusive protecting the investor. In other words, high risk position in front of captive consumers. provinces should consider allowing rate of return Consequently, economic regulation is necessary at regulation when it is not finding any private investor interested in providing the services under 5 This has to be supported by a strong commitment to a price cap regime. antitrust but this is a commitment that has to be made at the national level, not by the provinces.  8 the regional level. But this means neither that one with a single independent entity for all utilities agency is necessary in each province nor that the with a modest staffing level dependent on the provincial regulators are to be independent from requirements of specific tasks assigned to the the central agency (e.g., ENRE). regulatory authority rather than multiple sector specific agencies. The main reason is that the 1.25 In view of the similarity of problems in skills needed to be a good regulator are hard to several provinces, a small number of three or four find. Luckily, the skills needed to be an effective inter-provincial agencies should be sufficient. If regulator are very similar in both the water and the political situation is such that each province electricity sector and hence the same resources must have its own regulatory body, the entity can be shared within a single provincial regulatory should be kept to a minimum. Moreover, entity. This means lower resource needs (not only whatever their number these local agencies should in terms of staff but also in terms of equipment) have only specific prerogatives, essentially and hence a lower burden on the taxpayers or the auditing and reporting to the national regulation beneficiaries of the services. There are other body. This is because technical dependencies benefits. For instance, it facilitates learning within an electric network are particularly strong. between sectors, ensures consistent approaches to central policy questions and makes the regulator 1.26 Economic Regulation of W&S. In less vulnerable to industry or political capture. W&S, things are somewhat different since water This lower vulnerability enhances the credibility of cannot be collected anywhere, neither dispatched the agency and reduces risks for investors. in any direction independently of geographic considerations unlike electricity. Water networks 1.28 The implementation of this strategy can be are not national. But this does not imply that each flexible. It is easier to do when agencies have not local network in each municipality should be yet been established. A multisectoral framework regulated by an independent body, because there can be established first and then sectors can be are important economies of scope in the added to the core entity when appropriate. There regulation of pumping, treating and distributing is no need to wait until any contract has been water at the local level. The informational, signed. The creation entity can be instrumental in technical and organizational problems are assisting in the implementation of the isomorphic from one municipality or province to concessioning process. If one agency has already the other. Consequently, the optimal organization been established, it should not be too difficult to for the regulation of this sector should include a expand the jurisdiction of the existing agency. national entity in charge of the definition of This depends of course on how sector specific in general principles like pricing rules, quality design and composition the initial agency is. standards, uniform statistics (for yardstick Finally, if several agencies have already been competition) and provincial entities controlling created, the best option is to develop a strategy and overseeing the application of these rules. for merging the agencies after an initial period. This strategy tends to be the most difficult and 1.27 The institutional dimension of will often be resisted by both the existing provincial regulation. If most provinces regulators (concerned about losing their autonomy deciding to rely on concession contracts for the and possibly their job) and investors (often delivery of electricity and W&S service end up preferring the counterpart they know). deciding to create their own regulatory entities, a few words of caution are needed. Chapter 4 shows that most provinces would be better off  9 Chapter 2: REFORMING ELECTRICITY DISTRIBUTION IN THE PROVINCES 2.1 The main purpose of the reform of of this report. To be able to identify the options Argentina's electricity sector was to reach for reform in the provinces, however, an efficient pricing and production levels in the short- assessment of the achievements of the National term, and an investment level sufficient to meet program so far is needed. This is why this chapter demand in the long run. This entailed a major starts with a general overview of the sector as it restructuring of the sector which started with the stands after the main national reforms. Next it legal initiative expressing intentions in 1989, was discusses the main institutions that could influence followed by the first implementation steps in 1992 the regulatory environment of privatized and is still going on. provincial distribution companies. It makes it clear that the provincial regulatory authorities are 2.2 The legal basis of the restructuring process not going to be the only institution that will have a is spelled out in the 1989 laws deciding the global strong impact on the return to investment in the reform of the state. For the electricity sector, the provinces. This is also clear in the discussion of process began when the federal government the main regulatory instrument--the contract--and franchised the distribution and commercialization of the mechanisms of competition. The chapter activities of SEGBA,6 the vertically integrated concludes with a discussion of pricing in utility supplying electricity to 15 million people in generation, transmission and distribution as the the Greater Buenos Aires area. The main next rate of return of the private investors in provincial step was in 1992, with the privatization of the companies will be influenced by the full pricing electric generation and transmission activities that chain. The chapter concludes with a discussion of SEGBA was still carrying.7 With these two the importance of an explicit linkage between changes, the original public firm had been tariff design and investment needs in distribution 8 vertically disintegrated into seven business units: services. four generation firms, and three distribution firms. These units were either sold or concessioned to Overview of the Sector's Organization the private sector through international bids. The reform in two other state-owned entities, Agua y 2.4 An effective way of visualizing the extent Energia Elctrica (AyE) and Hidronor, had some of reform in the sector is to follow the financial implications for a few provinces as some of the flows. Depending on whether a specific activity assets were privatized while the plants located in between generators, transmitters, distributors and areas under provincial responsibility were users is done in a competitive market or not, the transferred to the provinces concerned. related transactions are regulated in different ways, as Figure 2.1 illustrates. It shows that 2.3 The remaining step in the restructuring of contracts between distributors--and large users-- the sector is the reform of the provincial and generators are not regulated and that the spot distribution companies which is the main interest prices and seasonal prices are also set by the market. Final users tariffs are, however, regulated 6 Servicios Electricos del Gran Buenos Aires. which should matter to investors in provincial Law No. 24.065 (December 1991) and Decree No. 1.398/92 (January 1992) establishing the 8 Most of the background on the description of the "Electricity Regulatory Framework". In January 1991, sector presented in this chapter is from Bastos, C.M. SEGBA had a generation capacity of 2500 MW and A.A. Abdala (1993), Transformaci6n del sector supplying 10.33 TWh. to 4.5m connected customers. electrico argentino, Editorial Antartica, Chile.  10 utilities. So is transmission price and this is 2.7 The market matches electricity demand important to these investors since depending on and supply with an hourly price.10 The market the effectiveness of this regulation, transmission also allows trade-in contracts, in which suppliers expansion will be responsive to the distributors' and buyers can freely agree on long-term needs or will not. The chapter shows how and contracts in quantities and prices as well as more why these activities work the way they do and qualitative aspects such as voltage, point of why it matters to the provinces. reception, timing, back-up, etc. But these do not imply any reranking in the order of dispatch as 2.5 The discussion starts with a brief overview discussed below." of the characteristics of each one of the main activities, then moves on to discuss the main 2.8 The co-existence of three different types of "regulators" of the sector (in a broad sense). players on the demand side is important to Next, the chapter explains how contracts have recognize as it matters to the value of the assets of become a key regulatory instrument for these a distribution company and for the design of their federal regulators and how competition works in tariff policy as discussed later. These players that regulated environment. Because pricing is include distributors and (potential) foreign buyers such a key component of the effectiveness of the but also large users. Defined as those whose peak reform and of the regulatory function, it is demand is equal or higher than 0. IMW, large discussed next in some detail. This discussion users have the advantage over other consumers: spells out all the payments for service obligations they are allowed to sign direct contracts with as these are likely to be accepted and internalized generators without having to commercially go by provincial governments in their own reforms. through provincial distributors and hence The discussion also addresses the linkages increasing the incentive to minimize costs for the between tariff design and incentives to invest as operation of distributions services. They are able this is, or at least should be, a major concern of to access the MEM directly for at least 50% of most provincial governments. It highlights the their total demand. potential consequences for the provinces of failing to address the linkages between tariff design and transmission expansion. 2.6 Generation. The core of the reform in generation was the creation of a wholesale spot market, MEM. The provincial companies are major actors in this market as it is open to any generator--whatever its technology--and the main users (distribution companies but also deregulated large users). These can directly buy from any provider they chose to on that market9 (see Box 2. 1). '