Regulation of the Argentine network utilities : issues and options for the national government

Ceun" Dept I Lade AnbenCa and the Clanbbean Revion Economic Notes Regulation of theA Utilities: Issues nsf N = ~~~~~~~~~~~~~~~~~~~~~~~~~.... ..C  Country Dept. I Latin America and the Caribbean Region Economic Notes Regulation of the Argentine Network Utilities: Issues and Options for the National Government loannis Kessides June 1997 The World Bank  9  FOREWORD At the request of the Government of Argentina, a team of regulatory experts visited Buenos Aires in June 1996 to provide a diagnostic assessment of post-privatization regulation in the electricity, telecommunications, and gas sectors. The team led by loannis Kessides (PSD) comprised Alfred Kahn (Comell University), Jeff Makholm (NERA), Janusz Ordover (New York University) and Pablo Spiller (UIniversity of California at Berkeley). Clemencia Torres (Boston University) assisted with the analysis of the electricity and telecommunications sectors. We would like to express our gratitude to the Ministry of Economy for providing most of the funding for the mission, and especially Rodolfo Martinez de Vedia, our principal counterpart for his invaluable contribution in framing the scope and program of the mission. We would also like to thank Gobind Nankani, Homi Kharas, Danny Leipziger, and Patricio Millan for their support and guidance. This report was written by Ioannis Kessides and summarizes the findings of the mission. The members of the team prepared the following background papers: Alfred Kahn, "ARGENTINA-The Reform of Regulation: An Overview" , July 1996 (revised October 1996) Jeff D. Makholm, "Regulating Argentina's Gas Industry", August 1996 (revised November 1996) Janusz Ordover and Clemencia Torres, "Regulation of Telecommunications in Argentina: Diagnostic Report", September 1996 (revised November 1996) Pablo T. Spiller and Clemencia Torres, "Argentina's Electricity Regulation: Its Performance, Credibility and Options for the Future", August 1996 (revised November 1996) This work was carried out under the direction of Asif Faiz, Division Chief Infrastructure and Urban Development. Claudia Kandel provided secretarial support.  I I  REGILATION OF THE ARGENTINE NETWORK UTIlLITES: ISSUES AND OPTIONS FOR THE NATIONAL GOVERNMENT OBJECTIVE AND SCOPE 4. Despite the progress already experienced in moving towards competition in 1. The objectives of this report are to: (i) these sectors in Argentina, additional policy provide a diagnostic assessment of post- changes are needed in order to harmonize privatization regulation in the regulation with open entry, thereby enabling the telecommunications, electricity and gas sectors realization of more of the benefits of of Argentina; (ii) identify the major regulatory competition and free entry, and avoiding some issues that need to be addressed in the medium of the predictable harms from a mismatch term by the Argentine regulatory agencies and between open entry and traditional regulation. propose strategies for addressing these issues; The report identifies several facets of the (iii) synthesize the emerging international requisite policy approach. It places particular experience in the regulation of network utilities emphasis on the rational determination of that are subject to increasing competition and prices of end-user (retail) services that are determine its applicability to the unique based on both cost and demand conditions; and circumstances of the Argentine sectors, the design of access (interconnection) prices which promote dynamic efficiency through 2. The report has both procedural and efficient entry and investment decisions while substantive aspects. It gives almost equal enabling the owners of the respective networks emphasis to how regulators make their to remain financially solvent. decisions, as it gives to the substantive regulatory policies and determinations. So 5. An important source of impediments to long as regulation is necessary, if only to effect solving the regulatory problems of the a transition to an essentially unregulated Argentine network utilities is the inflexibilities competitive market, regulatory procedures may built into the privatization agreements that be capable of performing that function established the structure of these sectors. Such efficiently or rendering achievement of the inflexibilities were necessary to create substantive goal impossible. commitments to reform, to ensure consumer protection, and to mobilize the private capital 3. One of the fundamental tenets of the needed for privatization. However, they have report, that is shared by the Argentine policy also made it difficult to create adaptations to makers, is that undistorted and effective help solve emerging problems, because many competition is the most powerful force towards find such adaptations threatening to the economic efficiency and towards the guidance privatization commitments that protect their of technological change to serve the public interests and the whole fabric of reform. The interest. However, the potential benefits of report highlights the primacy of the competition could be significantly undermined, privatization commitments and strongly and indeed perhaps transformed into hanns, if recommends the avoidance of any steps that the traditional regulation that evolved in a "smack of retroactivity". Still, it advocates a franchise monopoly environment in other process for creating problem-solving countries is uncritically applied to the Argentine adaptations of the regulatory regime to protect network utilities while they are subjected to the the interests of investors at the baseline levels pressures of competitive entry. established by the terms of privatization, to  Regulion oftheArgenhtneNetwkrk Utilities: Issues and Optwonsfor the National Government 2 safeguard the interests of consumers, and to BACKROUND promote economically efficient competition. 8. Argentina has implemented one of the 6. The report adopts the basic premise world's most ambitious and successful that the efficiencies of privatization stem structural reform and privatization programs m fundamentally from the insulation it provides infrastructure. Since 1990, the Federal from arbitrary politicized influences. Indeed, a Government has divested its holdings in prerequisite for effective privatization and telecommunications, natural gas and sustained large-scale private investment in petroleum, electricity (except the nuclear network utilities is the country's institutional segment and the Yacyreta hydroelectric plant), capacity to restrain arbitrary administrative railroads, water and sanitation, and ports. By- action and ensure a stable regulatory regime. and-large, divestiture in these sectors was The stability of the regulatory process in carried out in a manner that reflects the state- Argentina has been undermined by the lack of a of-the-art in policy and has brought already clear demarcation of responsibilities between several of the expected benefits of private the regulatory agencies, the Ministry of enterprise: enhanced productivity and cost Economy, and other governmental bodies. effectiveness, improved output quality, and Especially problematic has been the extent to increased investment driven by market demand which ultimate power for making regulatory and considerations of efficiency rather than decisions rests with the Ministry, and the political and bureaucratic interference. In the willingness of the Ministry to adopt an newly-privatized finns, there is clearly interventionist stance. The report makes increased entrepreneurial spirit and greater several proposals for an appropriate division of attention to customers and service. responsibilities between the public authorities involved in the regulatory oversight of the 9. The electricity and gas sectors network utilities, in particular the regulatory underwent significant restructuring prior to agencies and the Ministry, in order to ensure privatization. The new structures, introduced that policy and implementation functions are in 1992, divided these sectors into three clearly defined and coherently harmonized. activities: generation/production, transmission and distribution. Transmission and distribution 7. Finally, the report emphasizes that the being bottleneck segments for most customers Argentine network utilities are business firms of delivered power/gas were to be regulated with the responsibilities, problems and needs of under a price-cap regime, while the increasingly other commercial enterprises. Their special competitive segments of generation and cost structure does, however, raise problems production were opened to entry without that many other finns do not face, and that lead detailed regulatory scrutiny. The restructured to their special pricing requirements. Along electricity and gas industries entailed non- with other business firms, they and the general discriminatory access to their transmission public will benefit from as much freedom from networks. regulation as can reasonably be allowed, given their circumstances and the requirements of the 10. In telecommunications, the 1990 public interest. privatization led to the creation of two regional monopolies. The two monopolists provide  Regulaon ofthe Argentine Netwrk Utiditia: Issues and Optionsfor the National Govemnt 3 basic telecommunications services in market-like signals and incentives for efficient geographically distinct markets, and are owners behavior. in equal parts of two subsidiaries offering international and value-added services. In the 13. It is not surprising that even an provision of basic services (local, domestic long excellent process of restructuring will leave distance, and international), the privatized open some opportunities for further operators were granted exclusivity for a period improvements, especially as experience of 7 years (with a 3-year extension if certain accumulates in the workings of the new performance targets are met), and are subject systems. The emerging regulatory problems in to incentive regulation. Value-added and the Argentine network utilities are endemic to cellular services were immediately opened to infrastructure sectors everywhere and largely competitive entry. reflect issues that arise after privatization, particularly when combined with unbundling. CuRRENT AND FoRTncom1NG In fact, the asserted deficiencies of the REGULATORY LSSUES Argentine system are characteristic of the performance of economic regulation as 11. The Argentine network utilities have observed all over the world. been privatized, restructured and placed under regulation in a manner that reflects genuine Establishment of Conditions creativity applied for the public interest. There for Efficient Competition is much to applaud in these sectors from their new architectures to the skills and vitality of 14. The electricity, telecommunications and those who crafted them, who operate them, gas sectors are vertcal industries characterized and who regulate them. by transportation and distribution networks linking upstream production with downstream 12. The Argentine policy makers deserve consumption. These networks consist of a high praise for their forthright privatization of hierarchy of transmission links in electricity; utility industries and commitment to subjecting transmission media and switching centers in them to the greatest extent possible to the telecommunications; and national pipelines and disciplines of the market. However, the regional distributional links in gas. second of these tasks has been incompletely Infastructure networks entail substantial fixed achieved. Several aspects of industry costs that are largely sunk because the assets performance can be identified where are of minimal value for other purposes. These unintended consequences of privatization and sunk cost pose restrictions to freedom of entry, restructuring seem likely to arise and cause especially when there are natural monopoly problems with some measure of significance. conditions as well. In particular, the report contains criticisms both of perceived failures to establish the conditions 15. The cost conditions relating to necessary for effective competition; to permit upstream production and downstream supply the free play of competitive forces and, where activities (electricity and gas), certain portions direct regulation continues necessary, to of the network (interexchange services in institute policies and devices that supply telecommunications), or the operation of services on the physical network, are less  Regulation oftheArgentineNetwork Ut;: IssuaL andOptonsfortheNatiownal Gonment 4 inimical to competition. Although there are sufficiently high to be compensatory (at least important economies of scale and inevitably cover the long-run incremental cost of the use some sunk costs associated with these of the network by the entrant), yet not so high activities, they are small in relation to those as to preclude efficient operations by the encountered in network infrastructure. entrant. Therefore, there is no question that substantial competition could emerge in many activities in 18. The removal of legal barriers to these sectors. Still, in some portions of their competitive entry is therefore not sufficient in networks, competition is weak or nonexistent. itself to install regimes of effectively functioning When competition is introduced in the competition in the network utilities. competitive segments, rival firms will often Competitors must have access to essential seek to gain access to "bottleneck" facilities network facilities on non-discriminatory terms which are essential inputs for the provision of if they are to have a reasonable opportunity to services-inputs without which suppliers cannot compete. If then competition is to prevail, it hope to operate. will ordinarily require explicit regulatory intervention to ensure such access, particularly 16. One of the primary challenges facing in situations where, as is the case in the the Argentine regulators is to set a level and telecommunications sector, those essential structure of access prices which promote facilities are themselves owned or controlled by dynamic efficiency through efficient entry and the incumbent monopolists, who will have investment decisions while enabling the owner every incentive to deny rivals access to those of the network to remain financially solvent. facilities on fair terms. Establishment of the Indeed, perhaps the single most important rules for such access and interconnection is an element in the design of public policy towards extremely complex as well as tendentious the Argentine network utilities should be the process, which clearly requires governments to design of arrangements which render benign play an active role in propagating rules for fair the exercise of market power associated- with competition and arbitrating disputes over the operating sunk bottleneck facilities. Regulation terms of access. should, therefore, ensure that there is sufficient pressure on the owner of the infrastructure to 19. Electricity. In the electricity sector, the operate in an efficient manner, but that no methodology used to apportion the revenue unnecessary duplication of network requirements of an existing transmission line is construction takes place. based on a determination of the "energy" benefits of the various beneficiaries. These 17. As technological change and assessments, therefore, are somewhat unrelated deregulation reduce entry baniers in utilities, a to economic or market benefits and unrelated greater number of rival firms will seek to as well to incremental transmission costs of interconnect their networks than in the past. At service. Since this methodology sets the each interconnection point an access price will payments that the "beneficiaries" are required have to be determined. The termns of access to make for transmission services, and since should not distort the process by which prices these payments will vary by the location of a are adapted to consumer preferences and generation plant, the beneficiary methodology demands for services. Prices should be may influence the location that is chosen for a  Regqdtn of the Argentine Network Utilm: sues and Optionsfor the National Goenn 5 new generation facility. In fact new generation service providers and will be indispensable plants are likely to be gas-fired, so that the preconditions for transforming the business decisions on their locations will be monopolistic structure of the Argentine driven by the balance of the costs of receiving telecommunications industry into a competitive gas via pipeline at the various possible one after the expiration of the exclusivity generation sites and the costs of transmitting period. electricity to centers of load from these sites. As a result, the economic inaccuracy of the 22. One of the most difficult regulatory beneficiary system that is embedded in the issues in telecommunications is the pricing of present structure of access prices may have access to the local loop and other monopolized significant adverse impacts on the economy. segments of the network. This problem is especially acute when the carrier who controls 20. The design of an appropriate structure the monopolized part of the network--the of access prices is complicated by three factors. "bottleneck"--competes with other providers of First, the addition of new sources of supply on telecommunications services who require the network may have considerable but not access to the bottleneck in order to offer their readily predictable consequences upon the services. Monopoly control of bottleneck costs of operating the network. The question facilities can create irresistible incentives to then arises as to what extent should these behave anticompetitively and cross-subsidize indirect costs be attributed to particular unregulated competitive activities from suppliers in setting prices. From the standpoint regulated monopoly ones. Absent regulatory of providing efficient entry signals, access constraint, the holder of the bottleneck charges should reflect all the costs that entrants monopoly could repress competition by irnpose on the network by breaching capacity creating artificial handicaps for its rivals in the constraints, wherever those costs were market for the final products sold to incurred. The effects might, however, be highly consumers. Indeed, it is very difficult to ensure adverse to entry. Second, a considerable that competition in the final product market degree of averaging is often present in retail will be preserved and not tilted to favor either tariffs. If access prices, by contrast, are based the owner of the essential input or its rivals. upon the fully deaveraged costs of individual The monopolist can impose costs on its components of the network, a combination of competitors by impeding their access to the averaged retail prices and deaveraged bottleneck, thereby raising the prices that they interconnection prices will clearly divide must charge to cover their elevated costs, and customers into those that are profitable and thus weakening their ability to compete. those that are not. The third element to be considered is the extent to which access prices 23. The problem of establishing a level- should reflect peak loading. playing field (competitive neutrality) has not reached its full dimension in Argentina yet. 21. Telecommunications. Interconnection This is due to the line-of-business restrictions and access to unbundled network elements on that have been imposed on the monopoly rates, terms, and conditions that are just, carriers that prohibit them from directly reasonable, and nondiscriminatory are essential participating in competitive markets (such as to effective competition among alternative data transmission and mobile telephony).  Regulation of theArgentineNatwrk Utiit: Isues and Optionsfor dte Nationad Govenment 6 Instead, they provide these services through interest. As a second step, CNT must issue jointly-owned subsidiaries. This regulatory interconnection regulations which move these arrangement lessens, but does not obviate, the principles towards implementation. These regulator's task to ensure that the owner of the regulations should provide all industry bottleneck provides interconnection on fair and participants with a clear understanding of how, nondiscriminatory terms. Clearly, the problem and on what basis, regulatory action would be of ensuring provision of interconnection on taken and also commit CNT simultaneously to nondiscriminatory terms will become much uphold these principles and to adhere to a more acute when the period of exclusivity ends. restricted set of interventions. 24. The Comision Nacional de 26. Gas. In the gas sector, there are Telecomunicaciones (CNT) has not formulated important issues pertaining to access pricing for as yet principles or procedures for resolving the pipeline. Currently, there are no off-peak disputes involving the level of access charges pipeline rates available, reflecting rigidities in imposed on independent firms, who offer the tariff structure. Economic efficiency clearly services that may be imperfect substitutes for requires reductions in the price of services sold by the regulated operator (e.g., transportation service, perhaps on an store and forward voice mail and fax services), interruptible basis if necessary, all the way as well as for directly competitive services that down to the very low variable costs in these may be forthcoming after the end of the circumstances. Such off-peak pricing would exclusivity period. Some disputes have already not in itself be discriminatory, since marginal arisen. However, CNT has been unduly slow costs are lower off- than on-peak. But these to respond and largely unable to resolve these reductions are highly likely to take the form of disputes. Many more disputes will surely arise pricing on the basis of what the respective as time goes on, and the competitive health and traffics will bear. It may take a very low price vitality of the industry requires that appropriate to achieve the more efficient and fuller use of principles be announced and applied the capacity in sales to large customers that consistently by the regulator. have access to substitute fuels, for example; or to big users that make very intensive use of 25. The definition and implementation of natural gas but can either by installing storage an access regime is not a matter that can be or shutting down or turning to alternative fuels settled once and for all; rather it is an on-going operate on an interruptible basis alone. process. Nor is this a process that can be guided by simple rules--there are inevitably 27. The gas regulatory agency, difficult issues of interpretation which must be ENARGAS, prohibits such discriminations. tackled and resolved by the regulatory agency. Any reduced rates for interruptible service must A first crucial step is for CNT to announce be posted and made available to all applicants fundamental principles that will govern on the same terms. Such prohibitions may intervention in the sector, establish clear make pipelines or distribution companies flatly guidelines by which it will judge operators' unwilling to cut prices-that is, while willing to behavior, and set the conditions under which it do so selectively in places where demand is will intervene in private negotiations when highly elastic, they could find themselves losing necessary to obtain outcomes in the public money if they had to extend those same  Regu*ion of theArgentine NMetwrk UtDli: Issues wad Options for the National Governn 7 discounted prices to all. The result of the the utility will either earn less than the optimal prohibition could therefore be an inefficiently contribution or no contribution at all. In short, low utilization of the pipeline capacity. This is in industries with substantial fixed and common the anticompetitive situation that has blocked costs, the pricing of individual services on the the off-peak rates needed to make storage basis of any cost allocation is contrary to the facilities profitable as a way to alleviate peak interests of both the operating entities and the congestion of the pipeline. Moreover, these public. Rational determination of prices must regulatory restraints on price differentiation be based on both cost and demand represent a clear instance in which regulatory- conditions-demand considerations as well as prescribed access pricing rules interfere with cost data must enter into decision making, in free competition and produce inefficient results. order to permit adequacy of revenues and achieve efficiency. EconomicaLly Efficient Pricing/Competitive Pricing Flexibility 30. Ramsey (demand-differentiated) prices apportion all unattributable fixed and common 28. In industries without substantial fixed costs of the utility among its services on the costs, competition tends to result in prices basis of their demand characteristics. Each which approximate marginal or incremental service is priced at a mark-up over marginal costs. However, in the utility industries, the cost which is inversely related to the elasticity prevalence of large fixed and common costs of demand for that service--services whose make it impossible for the supply of services to demands are highly elastic are assigned prices become financially self-supporfing with that are very close to their marginal costs, while marginal cost pricing. The financial infeasibility services whose demands are very inelastic are of marginal cost pricing rules out any sensible priced well above those costs. The magnitude mechanical or formula-based procedure for of these mark-ups among all services must be regulatory determination of rates. In particular, sufficiently high to earn net revenues that cover compensatory rates cannot be determined by fixed and conmmon costs and, hence, achieve the regulator on the basis of cost data alone revenue adequacy. since the financial viability of any price depends also on the quantity of services customers are 31. Regulators, typically with a mandate to willing to buy at that price. This is true prevent or disallow unreasonable price because there is no correlation between discriminations, have a natural tendency to demand considerations and any cost accounting insist that all prices be openly published and convention. available to all buyers on the same terns. Competitive markets in the real world, 29. Allocation of fixed and common costs however, are frequently characterized by a in accord with any non-demand based great deal of price discrimination. In the apportionment rule will almost invariably deregulated United States airline industry, for produce inconsistencies with the patterns of example, as markets have become more customer demands. Some rates will be too competitive, discrimination has tended to low, and consequently the utility will receive increase-taking the form of special discounts less than the optimal contribution from those to particular classes of customers on special services. Other rates will be too high, so that occasions, in the presence of excess capacity or  Rqeulation of theArgetineNetwork Utilities: s and OponsfortheNational Government 8 incompletely exploited economies of scale or 34. For the economy to receive the scope. benefits of competition that motivate pro- competitive policy in the first instance, the 32. Electricity. There is now, to a rapidly LDCs must be permitted to compete with increasing extent, the opportunity for and the flexibility of prices and terms. In order to reality of competition for large electricity users. cover their fixed costs, sunk cost, costs of Since privatization, the Secretary of Energy various obligations, and the revenue has twice lowered the threshold for users to requirements promised by the privatization contract directly with generators, from 5MW at agreements, the LDCs' prices will best serve the time of privatization (accounting for 8% of the total interests of users and the economy if consumption) to 1 MW and then 100kW they are permitted by regulation to vary among (roughly 40% of consumption). On the one users and classes of users in accordance with hand, competition cannot work to do its job of value of service (or elasticity of demand) as assuring efficiency and appropriate pricing well as in response to marginal costs of service. without cross-subsidy unless the rules defining Within the boundaries determined by the the extent of the freedoms of response by the avoidance of cross-subsidization, the need to local distribution companies (LDCs) are well- set some prices aggressively low in order to constructed. On the other hand, if those rules retain the business, means that other prices are too restrictive of LDCs' market freedoms, should be permitted to take up the slack to then the financial health of the LDCs and the secure adequate retums. commitments implicitly made to their shareholders will be compromised. 35. The methodology used to determine the "beneficiaries" of a new transmission line 33. Prices and proffered contract terms in and what are the percentage levels of the undistorted effectively competitive markets benefits of the various beneficiaries seems to be respond flexibly and rapidly to changing based on "energy benefits," rather than on conditions. Such prices are important elements economic or market benefits. Since this in the market mechanism that assure efficient methodology sets the payments that the match-ups between supply and demand. Rival "beneficiaries" are required to make towards suppliers may bid for business, and the more the costs of constructing a new line, significant efficient will prevail by offering prices and problems are likely to arise from the terms that are at once compensatory to the unwillingness of some parties to pay more for bidder's costs, attractive to the customer, and new facilities than they expect to gain from the too low for rivals to beat. Under the existing facilities in economic benefit. Moreover the regulatory constraints, by contrast, the LDCs danger arises that the proposed new line is cannot flexibly and rapidly respond to bids and actually not a worthwhile investment, or not counterbids of rivals, and to requests for bids the best choice of an investment, or not a well- by large users. In the face of such constraints, timed investment. There is also the allied the outcome of price competition for large danger that a desirable project would be users' business cannot be assured to be missed, because those to whom the project efficient. might bring the most benefit would be unable to pay accordingly for an assured portion of its services.  Regulation of theArgentune Netwrk Utilt: Issues and Optionsfor the National Government 9 36. These dangers are a consequence of long-term costs. Distorted telephone rates any methodology that fails to focus on impose significant costs on the economy by economic benefits, and that fails to require that providing wrong economic signals to the users a new private-sector project meet the market of the telephone network. Low rates for local test of voluntary and flexible payment of its calling over-stimulate local usage while long- costs by the users of its services. Only distance calling is inefficiently repressed voluntary payments that can be differentiated because of excessive rates. In addition, on the basis of demands, or economic benefits, unbalanced rates create incentives for consistent with the regulatory and market uneconomic bypass. principles of "Ramsey Pricing", can assure incentives for efficient investment in 39. Whatever its rationale, such an infrastructure facilities and for the efficient unbalanced tariff structure is not sustainable in allocation of their services. a competitive environment. Entrants will be impelled by the profit motive to deliver the 37. It seems that some of the problems overpriced business, regardless of these associated with the unintended consequences entrants' efficiency, while entrants are unlikely outlined above have already arisen in the to relieve the incumbent from the financial context of the issues surrounding the burden of serving the customers whose prices construction of the "Fourth Line." On the one are not compensatory of the costs required to hand, some generators were unwilling to pay serve them. The outcome then must be the end the amounts dictated by the "beneficiary of cross-subsidies--the incumbent loses its method", because their economic benefits were ability to cross-subsidize the underpriced local not consonant. On the other hand, there was services, including network access, with some uncertainty about whether the proposed revenues from over-priced services (such as new line was indeed the best project--perhaps a inter-urban or international calling). Therefore, different line would also alleviate the capacity either new sources of subsidy must be found, constraint to the south, while adding important or the rates that were below incremental costs reliability to the country-wide system. While must be raised to compensatory levels. interventions and negotiations anranged by the Ministry, the Ente Nacional Regulador de la 40. The incumbent operators claim that the Electricidad (ENRE), and CAMMESA may existing rate structure does not allow them to resolve the existing issues and disputes, any compete fairly with their wireless rivals. The such solution will not inspire the same incumbents' problems will be greatly confidence that would be assured by a market aggravated after wireline competition is test fully lodged in the private sector. introduced. As Argentina moves towards a fully liberalized telecommunications market, its 38. Telecommunications. Like in many rate structure must be rationalized. Such other countries, rates for basic rebalancing will surely be necessary--both for telecommunications services are unbalanced. the operators and for the public interest-as For historic and other reasons, rates for local competition becomes closer with the end of the calling and access are too low relative to exclusivity period, as international call back and underlying long-term costs, while inter-urban other arbitrage mechanisms spread, and as and intemational rates substantially exceed  Regulaon oftheArgentineNawork Utilities: Issues and OptonsfortheNational Governme 10 value-added services become ever closer transportation capacity and then to sell those substitutes for basic services. rights to the highest bidder, it would ensure the most efficient use of that capacity, in the same 41. Although it is widely recognized that way as if the charges were set at incremental the tariff structure in Argentina is extremely capacity costs-to the holder of such a contract, unbalanced and that this structure needs to be the true economic cost of exercising that right reexamined, there is a widespread concem that would be its opportunity cost, i.e., the price it there is insufficient infonnation to estimate would receive if the shipper were to sell the what the appropriate structure of tariffs should right to the highest bidder. This price be. Moreover, there are significant (reflecting marginal congestion cost) could of disagreements among policy makers and course be as low as zero in time of excess operators on what standards to apply to capacity and at whatever level was necessary to rebalancing and how fast to proceed. In clear the market in time of shortage. addition, no principles have been articulated for the promotion of universal service in a manner 44. Moreover, provision of efficient that is competitively neutral. This issue will incentives to the pipeline owners with respect become particularly vexing after the end of the to capacity expansion would require that the exclusivity period. charges for new capacity be based on incremental capacity costs rather than rolled-in 42. Gas. In the gas sector, there is a costs (combining the new capacity costs with fundamental issue of rate rigidification-- the old and charging all customers the same currently all customers must pay the same rates price. Shippers seeking transport capacity for the same distance move--whether or not the would, if confronted with charges that reflect customers have the same value for the service. the long-run incremental costs of capacity While this rule may have the best of non- construction, willingly pay those charges only if discrimination intentions, it particularly means they could not purchase the right in the market that a pipeline cannot give a discount to from existing holders at a lower cost. At times encourage business without giving the same of congestion, then, when short-term marginal break to everyone else shipping at roughly the or congestion costs (and therefore the price of same time and distance. There is need to capacity in the secondary market) exceeded the analyze a more flexible pricing for the sake of cost of adding to capacity, the pipeline encouraging more appropriate capacity company would itself have the proper utilization, and assess the market power that incentives to follow the latter course. It may underlie a pipeline's unwillingness to bring instead, shippers could purchase those rights in down a rate element because other similar rates the second-hand market, from existing holders, have to follow. at rates below cost of building additional capacity, they would choose that former 43. Another powerful potential use of the alternative and it would have the efficient market to produce economically efficient result--no new capacity should in those results but so far not exploited in Argentina, circumstances be constructed. would be promotion or development of secondary markets for transport capacity. If shippers were permitted to contract for  Regulaton oftheArgentine Network Ultid: Issues and Optionsfor the National Governmn 11 Complementing Regulation countries, it is generally felt sufficient, for the with Antitrust Policy preservation of reasonably effective competition, merely to frame antitrust policies 45. The first step in instituting a regime of in terms of prohibiting or correcting actions by direct economic regulation-prescription of firms operating in those markets to restrain prices, conditions of entry, service quality and competition among themselves or by a market- the like-is to determine which markets or dominating firm to exclude potentially equally services are to be subject to such a regime and efficient competitors. which are best left instead to the discipline of the market. The determination is rarely an easy 47. One important distinction between the one--competition in the real world is almost antitrust and the direct regulatory approach is invariably imperfect, as is regulation, as well. that whereas direct regulation tends to be Conventional wisdom predicts that the benefits industry-specific--and administered by agencies of even highly imperfect competition will each specializing in the control of a particular typically exceed those of thoroughly regulated industry-antitrust or anti-monopoly franchised monopoly. Still it will ordinarily be enforcement authority is typically better vested necessary to regulate directly essential services in an agency with surveillance over the entire supplied under conditions of natural range of industries and markets. Such agencies monopoly-although, here again, it is often tend to develop a high degree of expertise in impossible to be certain which markets or appraising the structure, behavior and services are naturally monopolistic, which performance of markets, the identification of perhaps only temporarily so, and which possibly excessive market power and in sufficiently so to justify imposing direct fashioning remedies that permit competition to regulation on them. continue as the major governor of industry performance-remedies such as the 46. In the case of industries that are not to dissolution of excessively monopolistic be subject to direct regulation, pure laissez- companies, mandatory divestiture of assets by faire will rarely be adequate to protect the dominant companies, the prohibition of specific public: unregulated businesses may pursue tactics such as predatory pricing, tying-in, their interests by colluding or combining to requirements of exclusive dealing or mergers, suppress competition or excluding rivals from a acquisitions or other business combinations that fair opportunity to compete. For this reason, are deemed to threaten to impair competition. most societies relying on open markets have felt it necessary, in the absence of 48. Gas. It is now plain that YPF comprehensive direct regulation, to enforce (petroleum company) has substantial monopoly general, non-industry-specific antitrust or anti- power over gas production, and it may be monopoly policies, directed against private seeking to exercise it through its pricing. YPF suppressions of competition. The nature of produces some forty percent of total national such laws varies from country to country: output and in addition acts as a purchasing some statutes envision the possibility of agent or broker with control over an additional remedying unacceptably monopolistic markets 35 percent or so. It may have therefore been by subjecting them to restructuring or direct taking deliberate steps to augment and preserve regulation of one kind or another. In other its market power by buying gas in order to  Regulaon of the Argentine Net work Utildit: Isues and Options for the Nationa Gornment 12 control its resale, and by taking equity positions or equity positions in other production assets; in other producing firms and in reserves. or with less formal and less transparent pressures towards deconcentration over time. 49. YPF's consequent market share of some seventy-five percent would almost 52. Gas production is not a natural certainly invite scrutiny in a countiy with a monopoly and should therefore be subject not strong antitrust policy. Such an agency might to direct regulation but to the discipline of well conclude that YPF's contracts with competition. If there were a separate independent producers giving it the exclusive aggressive agency charged with enforcing anti- right to distribute their gas-and subjecting monopoly laws, it would be in a superior them to penalties if they seek to market the gas position to evaluate the conflicting claims about themselves-which accounts for the large the presence or absence of effective augmentation of its own market share beyond competition at the production end of the what it obtains from its own production are business and to seek remedies, if necessary- neither required for efficient functioning of the such as voiding the exclusive sales contracts market nor are compatible with effective with independent producers-that might on the competition. one hand invigorate competition and, on the other, make it unnecessary for ENARGAS to 50. In the absence of an effective antitrust regulate the field price by the indirect method it policy and in the belief that the field price of has actually chosen. In our view neither direct gas is excessively high, ENARGAS has used its price regulation nor the indirect method authority to regulate the transportation and adopted by ENARGAS is the proper way to distribution part of the industry in effect to prevent exploitation of consumers by an regulate the field price as well, by refusing to industry that ought to be competitive. permit the regulated entities to pass it through entirely, reasoning that the ultimate purchasers Regulatory Commitment of gas should not be subjected to . such assertedly monopolistic exploitation. The 53. In many of the infrastructure sectors, representatives of YPF protest that they do not the establishment of transportation and have monopoly power; that the concentration distribution networks requires very large of control in their market is no greater than in investments that are mostly sunk. Private other industries that are not subjected to direct utilities that are vulnerable to administrative regulation; and that ENARGAS is in effect intervention can be expected to invest less than illegitimately regulating themn under the guise of the optimal amount, and to make regulating transportation of the gas. disproportionately low investments in activities characterized by large sunk costs. Without 51. There is a fundamental policy issue as Government commitment to regulatory to whether YPF's alleged market power should stability, frequent changes in the regulatory be regulated through refusals by ENARGAS to regime can have the same effect as outright permit pass through of "excessive prices" to expropriation of sunk investment. distribution companies' prices; through structural remedies such as mandating that 54. A necessary condition for effective YPF divest some reserves, resale arrangements, private participation and investment in network  Regulation of theArgentine Network Utilties: Issues and Optionsfor the National Gowvnment 13 utilities is the creation of mechanisms that 56. Gas. In the natural gas sector, enforce substantive and procedural restraints investors are concerned about the transparency on regulatory discretion and limit regulatory and predictability of decisions by ENARGAS opportunism. However, regulatory mandates and point to two examples. In one case, and rules should adopt to new problems, ENARGAS did not permit the pass-through to changed circumstances, and new information consumers of wholesale prices charged by YPF and experience concerning the workings of the to distribution companies. ENARGAS' regulated sectors. Regulatory flexibility is decision was a means of indirectly controlling especialy imperative in sectors that are the market power of YPF, the dominant experiencing rapid technological and market producer. ENARGAS has stated no coherent changes. Too much regulatory flexibility, on principles or predictable basis for what it would the other hand, leaves inordinate scope for consider to be acceptable levels of the price of administrative expropriation. Thus, striking a gas. In a second example involving gas quality proper balance between regulatory flexibility standards, ENARGAS reversed its earlier and commitment is an indispensable decision after operator complaints. Although precondition for the success of regulatory investors were ultimately satisfied with the reform. decision, there was criticism about the lack of structure and transparency of the process. 55. Telecommunications. The lack of a well-defined regulatory regime and the high 57. In a way, it may be plausibly argued level of policy uncertainty during the that the regulatory agency should have some privatization process in telecommunications discretion (over pass-through of wellhead price resulted in investors demanding high risk increases) given the lirited number of premia. Subsequently, these risk premia seem producers. However, this "discretion" by to have declined as the government made ENARGAS, in the absence of clearly progress in implementing its regulatory regime. articulated principles, is precisely what The reduction in regulatory risk - was concerns investors. In reecting the pass- accompanied by substantial investment by the through, ENARGAS did not provide a two newly privatized entities. However, recent transparent rationale. Investors have since executive decrees, as well as a number of expressed serious concerns with the continuing policy fluctuations, have generated lack of transparency, stability and predictability, considerable uncertainty and confusion in the and may delay or add new uncertainty premia sector. First, these decrees have created to new energy projects. Arbitrary steps like contradictions and instability in the demarcation those taken by ENARGAS should be avoided of responsibilities between CNT, the Secretaniat in favor of ones that protect privatization of Communications and other governmental commitments, while promoting the public bodies. Second, frequent interventions by the interest in efficiency and competition. Ministry of Economy have created instability in the CNT management at the highest level, Providing Signals and leading to policy shifts and frustrating the Incentives for Efficient Behavior establishment of a credible and sustainable regulatory regime. 58. Industry observers have raised a number of contentions that specific policies of  Regul wof theArgentineNet wrk Utilitid: Issues and OptionsfortheNatwn,d Gevernment 14 regulatory authorities have been insufficiently time, the social cost of poor quality deviates guided by a rational costibenefit calculus. The significantly from the pre-set penalties. fundamental principle that should underlie such decisions is quite clear: the costs of deficient 61. There is no doubt that TRANSENER performance be borne by the parties has succeeded remarkably well in reducing responsible and in a position to remedy them, transmission down-time and time for and that the penalties be correctly reflective of restoration of service. However, the penalty the costs imposed on the public by those system has what seem to be inefficient deficiencies, so as to provide those parties with unintended consequences. For example, the proper signals and incentives to incur (or TRANSENER now does as many as possible not incur) the costs of abatement. of its repair and maintenance operations with the lines live, whether or not they are needed 59. Electricity. The current regulatory for service at that time, so as to avoid penalties scheme in the electricity sector entails an for time unavailable and down. inappropriate allocation of rights and responsibilities. The actual price in the spot 62. Gas. ENARGAS has inflexibly market--and the system of penalties ultimately enforced the terms of the privatization contract reflected in such price-does not appropriately related to the schedule of pipeline maintenance reflect the costs that generators, distributors, and replacement investment by TGS. Ex-post and transmission companies impose on the some of these terms have proven to be very system. inefficient. Should ENARGAS be inflexible about inefficient terms of the contract, or 60. Penalties levied on the transmission should there be a process that practically company TRANSENER, are paid to the grid permits adjustment of the terms, with users affected by the problems, but the appropriate offsets? On the issue of quality reciprocal is not true--TRANSENER cannot standards, ENARGAS has reached decisions recover part of the penalty for transmission unsupported by genuine rationale. As a result failures even if such failures are caused by the the industry has expressed well-founded fears generators. Similarly, the distribution about the exercise of discretion by ENARGAS companies do not have to compensate the unsupported by transparent principles. transmission company when the problem in the high voltage grid originates in a failure of the TU REGuLATORY PROCESS distributor. Moreover, the penalties levied on TRANSENER for transmission failures- are 63. In view of the importance and number unrelated to the costs that they impose on the of the substantive regulatory issues that have system--they are computed on the basis of a already been identified, as well as the depth of pre-set value for energy rather than actual spot concem over the regulatory process, the prices. So far, the difference between penalties regulatory agencies must: and costs imposed has not prevented TRANSENER from fulfilling the quality . have competent, non-political, professional standards stipulated in the concession. stagf expert in the relevant economic, However, this may become a problem if at any accounting, engineering and legal principles  Regulaton of theArgenune Netwrk Util;i&: Iues and Op'tons for the National Government 15 and familiar with good regulatory practice informal negotiations between expert staff and elsewhere; interested parties-as always, open at some point to public scrutiny, review and possible * operate within a statutory framework that appeal-or other informal dispute resolution stipulates a preference for competition and procedures-such as reliance on negotiations market-like regulatory policies and among interested parties, with the regulatory practices; and agency intervening only as an arbitrator of otherwise unresolvable issues. * be subject to a variety of substantive constraints and procedural requirements, 65. The mandate to rely to the greatest such as those developed in other countries extent feasible on market-like solutions-such to ensure the integrity, independence, as price caps, auctions and negotiated transparency and accountability of the settlements-is one aspect of the quest for regulatory process, particularly (1) administrative efficiency as well as of insulation from the executive and legislative compliance with the overriding policy of branches of government, (2) accountability minimizing the need for direct regulatory for decisions to some non-political review determination of results. Another example agency such as the courts and (3) would be a preference for price caps over procedural requirements such as affording continuous cost-plus or rate base/rate of return all competent interested parties an regulation, with the caps offering the regulated opportunity to be heard on major issues of companies competitive market-like incentives policy; stipulated deadlines for reaching for efficiency and innovation while also decisions; and the obligation to supply providing a reasonable opportunity for efficient reasoned justifications of decisions. providers to recover prudently-incurred costs, including a going return on investments 64. It is not easy to characterize these commensurate with risk. requirements clearly and unequivocally because the ideal is a balance between affording the 66. At the same time, there is a widespread protections of "due process" to all interested feeling in Argentina of need for the procedures parties-which means quasi-judicial and decisions of the regulators to be subject to procedures, hearings, written opinions and prescribed deadlines and to the requirement formal avenues for appeal-on the one side, that both the processes of decision-making and and administrative efficiency-the intent of the decisions themselves be transparent, which may be more clearly characterized as rationally defended, apolitical and accountable avoiding overjudicialization of the regulatory to some impartial non-political arbitrator-and process. Not all policies should be fornulated, not be subject to review or alteration by not all decisions made via a quasi-judicial officials from the executive branch of process, with open testimony subject to cross- government. examination, filings of briefs and all the complementary protections such as are Due Process necessary in criminal cases. Wherever feasible, for example, recourse should be taken to 67. There are many claims of abuse of power by the regulatory agencies, of failure to  Regulaton of theArgentine Netwrk UtiLts: Issuw and Options for the National Gonent 16 meet deadlines, of a rigid insistence on the Political Independence enforcement of rules in situations in which the result was manifestly irrational and failure to 69. Effective regulation clearly requires respond to requests for relaxation of rules in some independence of the regulators from such circumstances. Beyond observing that political influences, especially on a day-to-day such controversies are inevitable under even or decision-by-decision basis. The posture of the most enlightened regulation, it is very the agency must be one of an impartial, difficult to ascertain the merits of such objective, non-political enforcer of policies set complaints and of the often conflicting versions forth in the controlling statutes, free of of the asserted problems by the opposing transitory political influences. parties. 70. The question of the extent to which 68. One possible way of resolving such members of the Executive branch should have issues and, more important, suggesting authority to determine regulatory policies is not methods of producing satisfactory resolutions a simple one. The argument becomes might be to institute management audits of particularly difficult when the performance of a regulatory agencies by outside consultants regulatory role by such officials is justified in capable of examining asserted incidents of terms of ensuring continuation of the spirit of excessive regulatory rigidity or irrationality. the Cavallo reforms beyond the possibility of Another arrangement that might come closer to regulatory reversal. resolving issues promptly as they arise, rather than subjecting them to major reexaminations 71. Clearly absolute independence of these after the fact, would be the constitution of agencies is neither possible nor really desirable. some such office as an ombudsman for each The Executive can hardly be denied the regulatory agency or for regulatory agencies authority to ensure that regulators appointed by collectively-an agency, independent of the it are sympathetic with the reforms and with regulators, competent to resolve such disputes Administration policy generally. On the other at the time of their occurrence. Conceivably hand, if the regulators have no insulation from committees of the legislature could serve such political intervention, then the regulatory an oversight function; but there is a genuine process will itself be politicized, its decisions danger, particularly if such committees discredited with no policy continuity, resulting attempted to resolve specific controversies, that in situations in which the only legitimate way of the entire purpose of preserving the political redress would be via the legislative process. independence of the regulatory process would be defeated. An office of ombudsman located 72. Reconciliation of these two in the Executive branch of govermnent might imperatives-insulation particularly on a day- combine in optimal proportions the objectivity to-day basis from political pressures and the and independence of regulatory agencies necessity or inevitability of regulatory policy necessary for prompt, expert and non-political being broadly consistent with the philosophy of resolution of such controversies and democratically chosen leadership-clearly accountability of the regulators to informal, requires some compromise between continuity impartial, external scrutiny. and independence, on the one side, and responsiveness to the broad policies of the  Regdtion oftheArgeineNenrkUlities: Issuesand OpionsfortheNationa Govenmt 17 elected Administration, on the other. One such expropriation, with regulators setting prices compromise would be to have the regulators below long-run replacement costs so as to serve staggered terms, so that an incoming capture the quasi-rents associated with the Administration could replace them only operation of assets with high sunk costs. Faced gradually-and perhaps with a Chairman with this risk, private utilities might be expected subject to annual appointment or to make disproportionately low investments in reappointment by the President. This solution services where sunk costs are high, investing is clearly not directly feasible where the less than the optimal amount in order to reduce regulator is a single individual. Such their exposure to administrative expropriation. appointees should, at the least, have some fixed tenure, which cannot be terminated except in Su[MARY AND RECOMMENDATIONS case of abuse of authority. 75. Argentina's transformation of its major Avoidance of Regulatory utility industries in the short space of a few Opportunism years has been a truly impressive achievement. It should not be surprising that the 73. While all these procedural development of the requisite accompanying recommendations are designed to ensure that regulatory institutions and policies has been a regulatory agencies will be responsible in slower process; and that it has generated exercising their authority, their policies criticisms of the kinds that we have predictable and their individual decisions summarized in this report. Our listing of the consistent with one another, the report also is most prominent among these--which should be emphatic in warming against arbitrary changing interpreted as questions that need to be ofthe rules of the game and thereby frustrating answered rather than formal criticisms--is the reasonable expectations of investors. The intended in no way to detract from the World importance of this caveat is clearly intensified Banks expression of appreciation of the to the extent that Argentina continues to impressiveness ofthat achievement. depend in part on the importation of foreign capital and managerial skills for the efficient 76. Still, several of the issues that have development of these industries. been identified are fundamental in nature rather than questions of fine-tuning. Perhaps the 74. All the procedural recommendations economic language of the report has obscured that are made by the report are in effect somewhat the significance ofthese issues to the attempts to assure investors that the rules will operation and growth of the Argentine utility not be changed arbitrarily to their sectors. Any program for restructuring the disadvantage-a practice that cannot, but, relationship between Government and industry, discourage economically efficient investments and developing effective regulatory policy, in the future and be ultimately inconsistent with should explicitly derive from the industrys reliance on a privatized system of industrial underlying economic characteristics. The organization. This issue is especially significant Argentine Government has not clearly in the case of network utilities which entail articulated a set of principles delineating the large sunk investments. Utilities are role of the State in these sectors, nor particularly vulnerable to administrative established economically sound criteria  RegLdaion oftheArgenti,wNdork Utieitis: Issues and OptionsfortheNaionw Gov _nmt 18 distinguishing between those activities in which the regulators and the private operators. This intervention by the public sector is warranted transition requires a major change in focus and and those in which it is not. In addition, the skills on the part of the government. No design of regulatory mechanisms should place regulatory entity has, as yet, articulated a set of greater emphasis on identifying the issues that principles guiding its decision-making. In require regulatory resolution, and on general, the regulatory agencies have not developing the requisite expertise in critical clearly defined their regulatory responsibilities, regulatory areas. In fact, the present structure nor developed a medium-term regulatory of the regulatory entities is likely to accentuate agenda, identifying the issues that are likely to the tendency of regulation to expand its emerge and the types of decisions which will be jurisdiction, often with dysfunctional required. Moreover, many agencies are staffed consequences, and spread to situations in in part by former employees of the state-owned which it is not justified. companies or ministries who lack the requisite expertise to handle the new regulatory issues. 77. In Argentina, achieving the benefits of In addition, many of the agencies are privatization and competition in network generously funded by fees on the operators, utilities requires that significant new policy which has led to unnecessary expansion and measures be adopted in parallel with the overstaffing (with resultant incentives to opening of these markets to entrants. intervene). Otherwise, impediments to reaching regulatory goals and harm to the public interest will arise if CuRRENT AND EMERGING the regulators apply, within the new market REGuLAToRY IssuEs setting, traditional approaches to regulating franchise monopolies. For example, some of 79. In the post-privatization period, the franchised private utilities are subject to Argentina will face several important restraints and burdens that are not present in regulatory challenges. unregulated markets, and that do not apply to potential new entrants. These restraints and . First, there is a need for a clear burdens distort the forces that would otherwise demarcation of responsibilities between the drive market outcomes to efficiency, and might Ministries, national-level regulators, and systematically tend to create inefficiencies of provincial regulators. Regulatory supply. Also, regulation-induced inefficiencies responsibilities that must be coherently and in pricing (e.g. cross-subsidization) that may be delicately harmonized should be kept tolerable in the traditional monopoly setting can together within a single agency and not create instability and serious social costs in the counterproductively splintered. Moreover, new market context, by encouraging various to provide regulatory stability, an forms of uneconomic bypass and discouraging indispensable precondition for attracting efficient entrepreneurial and competitive private investment, substantive restraints on activities. administrative action must be embedded in the regulatory framework-it is especially 78. The government's transition from being important to mitigate political intrusion on a direct operator to a regulator of private the sectors' tariff policies. utilities has been a learning experience for both  Reguion of theArgeniineNetwork UIes: Isss andOptionsfortheN National Govument 19 Second, the regulators will need to adopt efficient entry and investment decisions measures that seek to harmonize while enabling the owner of the network to competition with regulation and create a remain financially solvent. "level playing field". Such policies should ensure that regulatory obligations (e.g. * Fourth, the regulators will need to adopt universal service goals, lifeline services to pricing principles which promote economic the elderly and poor, etc) are pursued in a efficiency while simultaneously removing manner that is competitively neutral--i.e. impediments to adequate returns for the that avoids interference with the ability and privatized operators. These principles incentives of any firm to compete for would: (i) lead to economically efficient business on the basis of its efficiency. demand-differentiated prices which Otherwise, incumbent burdens (e.g. apportion all unattributable fixed and obligation to provide service on demand to common costs of a utility among its all customers at rates that do not cover services on the basis of the value of those their incremental costs) can distort services to consumers; (ii) discourage competition to the point that entry may regulatory intervention in any market become inefficient. In addition, the where there is evidence that competition is reciprocal interpenetration of markets by sufficiently powerful to protect the public regulated and unregulated companies will interest; (iii) readily permit an assessment require regulatory prevention of cross- of the reasonableness of those rates which subsidization and abuse of monopoly are judged to require continued regulatory power. oversight. - The third challenge is to design and . Fifth, a general issue that needs to be implement efficient access pricing and addressed by all regulators is dispute interconnection rules. All the infrastructure resolution. Consumers' expectations for sectors are characterized by transportation improved service have led to extensive and distribution networks linking upstream consumer complaints with the operators. production with downstream consumption. At the same time, there will be increasing These networks consist o