Regulating Infrastructure

Monopoly, Contracts, and Discretion

José A. Gómez-Ibáñez

• Publisher: Harvard University Press
• Year: 2006
• ISBN:
  9780674263901
• Topic: Business
• Subtopic: Infrastructure
• Index: Business

In the 1980s and '90s many countries turned to the private sector to provide infrastructure and utilities, such as gas, telephones, and highways—with the idea that market-based incentives would control costs and improve the quality of essential services. But subsequent debacles including the collapse of California's wholesale electricity market and the bankruptcy of Britain's largest railroad company have raised troubling questions about privatization. This book addresses one of the most vexing of these: how can government fairly and effectively regulate "natural monopolies"—those infrastructure and utility services whose technologies make competition impractical?Rather than sticking to economics, José Gómez-Ibáñez draws on history, politics, and a wealth of examples to provide a road map for various approaches to regulation. He makes a strong case for favoring market-oriented and contractual approaches—including private contracts between infrastructure providers and customers as well as concession contracts with the government acting as an intermediary—over those that grant government regulators substantial discretion. Contracts can provide stronger protection for infrastructure customers and suppliers—and greater opportunities to tailor services to their mutual advantage. In some cases, however, the requirements of the firms and their customers are too unpredictable for contracts to work, and alternative schemes may be needed.

1

Monopoly as a Contracting Problem

The Search for Commitment

Interest in the regulation of private infrastructure increased during the last two decades of the twentieth century, when many countries turned to private companies to build and operate infrastructure and utility services. In the 1980s Britain was a leader, selling off its telephone, electricity, gas, water, and railway companies in the hopes that the private sector could provide better service at a lower cost. In the 1990s many other countries followed suit, particularly in Latin America but also in Southeast Asia, Austral-Asia, and Europe. For example, almost all of the new high-performance expressways and many of the new power plants opened in developing countries in the 1990s were built by private concessionaires. By the end of the century, most of the major railways and telephone companies and many of the electric companies in Latin America had been sold or offered as concessions to private operators as well.

One fear is that this latest round of privatization will not last. By the first years of the twenty-first century a backlash of sorts had already developed. Investors in many of the newly privatized utilities were voicing disappointment about the returns that they were earning. Meanwhile, consumers were increasingly skeptical that the tariffs they were being charged were fair and the service adequate. Several well-publicized failures—such as the collapse of California’s private wholesale electricity market in 2000 and the bankruptcy of Britain’s private rail infrastructure company in 2001—suggested to many that privatization had gone too far.

History cautions that this disenchantment may grow to the point where governments begin to take back the companies. Private provision of infrastructure was the norm throughout the world during the first half of the twentieth century, but this era ended with most private infrastructure companies being bought out or expropriated by government. Many of the utilities that Britain privatized in the 1980s had been nationalized only in the 1940s and 1950s, for example, while many Latin American companies privatized in the 1990s had been nationalized as recently as the 1960s and 1970s.

The United States managed to retain a significant private presence in infrastructure throughout the twentieth century, which suggests that privatization can be a long-term solution in some circumstances. France also maintained private provision of certain municipal utilities, most notably water and solid waste, although it nationalized its electricity, telephone, and railway companies. But the U.S. and French experiences with private infrastructure have not been wholly satisfactory either. Concern about corruption in the award of private infrastructure concessions increased in France during the 1990s, for example, after French municipalities were granted more autonomy. And in the 1970s and 1980s, while other countries were beginning to shift to private but government-regulated utilities, the United States became so dissatisfied with that strategy that it deregulated its private railroads, airlines, long-distance telephone services, and natural gas pipelines.

Fifty years from now we may look back to view private provision of infrastructure as the norm, and public provision as a failed experiment of the mid-twentieth century. Indeed, the U.S. movement to deregulate suggests that the ultimate goal in infrastructure may be to dispense not just with public provision but, where possible, with public regulation as well. Nevertheless, it is striking that the United States was the only country that was able to maintain private ownership of most of its utilities throughout the twentieth century. In most other cases, the private providers were eventually taken over by government.

Many proponents of private infrastructure view the problem as one of establishing a commitment to a fair and stable set of rules governing the relationship between the government and private infrastructure providers. The usual concern is that the government will renege on commitments to private infrastructure rather than vice versa. Private companies are vulnerable because infrastructure requires expensive, durable, and immobile investments in roadways, power plants, local telephone or water lines, or other facilities that private investors can’t withdraw if the government changes the rules.

In this view, the government usually feels compelled to regulate the prices and quality of infrastructure services because the services are essential to modern life and because infrastructure has elements of monopoly, so that consumers are at the mercy of a single provider. To induce private investment in infrastructure, the government also must commit to a schedule of tariffs and other terms that give the investors a reasonable return. Once the investments are in place, however, the government will be tempted to yield to popular pressures to lower tariffs or renege on other promises to the companies, knowing that they can’t retaliate by withdrawing their investments. A government that engages in such opportunistic behavior is likely to have trouble convincing investors to renew or expand their facilities. If the facilities are long lived, however, the government may hope that some other solution will emerge in the interim, such as a crop of new investors naive enough to overlook a history of broken promises.

This account is one-sided, however, in that it focuses on the company’s vulnerability to opportunism by government and downplays government and consumer vulnerability to opportunism by the company. The government and consumers are vulnerable because the incumbent local infrastructure company usually enjoys a monopoly, and that monopoly stems largely from the durability and immobility of both the company’s and the consumers’ investments. The company’s durable and immobile investments discourage competitors from entering the market to challenge the incumbent. Potential challengers realize that an incumbent, fearful of losing the market, could rationally drop prices so that they just cover its short-run variable costs, leaving little chance for the challenger to recover its investments. And consumers also typically make durable and immobile investments in their local communities that make it difficult for them to move elsewhere in search of cheaper infrastructure services. In these circumstances, the customers of the infrastructure company, or the government acting on the customers’ behalf, will want some commitment that the local infrastructure company will not take advantage of its position by raising prices well above costs. In short, the expensive, durable and immobile investments help make all parties—the company, its customers, and the government—vulnerable to opportunism and desirous of stability and commitment.

The prospects for commitment are complicated, however, by the long lives of most infrastructure investments. In the case of a highway, for example, the paving may last ten or twenty years, the bridges and the sub-base for forty years or more, and the basic grading and right of way indefinitely. How realistic is the desire for commitments that last as long as infrastructure assets, particularly in a world where the infrastructure companies, their customers, and governments have complex needs that may change in ways that are difficult to anticipate? What are the basic forms that commitment can take? And how can one design schemes that balance the desire for commitment with the need for flexibility to accommodate unexpected developments?

The basic perspective of this book is that the problem of infrastructure monopoly is similar to any other long-term contracting problem, and particularly analogous to contracting in private sector procurement. Infrastructure is not the only sector of the economy that employs assets so durable and specialized that their suppliers and users are vulnerable to each other. The developer of a shopping center and the lead tenant are often vulnerable to each other, for example, as are the power plant and the coal mine that supplies it. The usual remedy in other sectors is to sign a long-term contract before such specialized investments are made. One hundred percent of a new shopping center need not be preleased, but a significant portion is usually required before financing is forthcoming. And most lead tenants would never move in without the protection of a multiyear lease.

From this perspective, monopoly does not necessarily require government intervention. Just as private long-term contracts can protect suppliers and users of other durable assets, they may be able to protect utility companies and their customers as well. Whether government regulation is necessary and the form it should take will depend fundamentally on how difficult it is to negotiate and enforce an explicit long-term contract. Before we explore these issues, it is helpful to define infrastructure and review the various reasons, including monopoly, why government is so often involved in its provision.

Motives for Government Involvement in Infrastructure

Infrastructure has special characteristics that have traditionally justified or encouraged government involvement. Infrastructure means beneath (infra) the building (structure), and thus usually encompasses services or facilities that are underground, such as piped water and sewerage, or that lie on the surface, such as roads and railways. Electric power and telecommunications are often included as well, even though they are frequently provided by lines strung on poles or towers rather than in underground conduits. All of these industries involve networks that distribute products or services over geographic space, and in most cases the networks are capital extensive and the investments are durable and immobile. Infrastructure industries are often called public utilities, and the two terms will be used interchangeably here.

One motivation for government involvement, and the primary focus of this book, is the tendency toward monopoly in infrastructure industries. This tendency arises because many infrastructure networks have the characteristics of a so-called natural monopoly, which are a combination of durable and immobile investments and strong economies of scale or traffic density. The economies of scale mean that the cheapest way to serve a community is with a single company, particularly if the local network has a relatively low density of traffic. And the durability and immobility of the investments increase the risk for new entrants who seek to challenge the incumbent. Concern over monopoly often leads the government either to provide infrastructure services itself or to regulate the prices and quality of service of private infrastructure companies.

A second motive for government involvement—and one that often predates and enhances concerns about monopoly—is the difficulty of assembling the right of way required for an infrastructure network. Railroads, highways, and power, water, and telephone lines all require long, linear, and contiguous rights-of-way that would be difficult to assemble without the government’s power to expropriate private property through the process of eminent domain. Absent the threat of eminent domain, private landowners along the alignment could extort high prices for key or missing parcels. The government often exercises the power of eminent domain on behalf of infrastructure companies, or allows the companies to place their pipes or lines in local streets or other publicly owned rights of way. Governments are hesitant to delegate eminent domain powers to private companies or to grant companies unrestricted access to local streets, however, for fear these privileges will be abused. Moreover, the understandable reluctance of the government to expropriate property for new infrastructure rights of way can contribute to monopoly by making it harder for a new company to enter the business and challenge the incumbent.

A third rationale for government involvement is that some types of infrastructure generate benefits beyond those that accrue to its immediate users or subscribers. For example, clean drinking water and sanitary waste disposal protect the general public from the spread of disease and the contamination of the environment. Similarly, a lamp outside a private residence or business reduces the risk of accidents and crime for neighboring properties and passersby. If important benefits of infrastructure services accrue to nonsubscribers, then it may be difficult to persuade subscribers to pay voluntarily for the level of service that is socially desirable. Nonuser benefits have stimulated governments to promote infrastructure provision in a variety of ways. Most city governments contract directly with electricity companies for street lighting, for example, and compel all households and businesses to subscribe to piped water and sewerage services.

Economic development and equity considerations are two additional and related motives for government intervention, and they also often enhance monopoly concerns. Infrastructure is viewed as an important ingredient to local economic development, and thus governments are often concerned about the infrastructure endowments of lagging or underdeveloped regions of their countries. Similarly, ensuring universal access to a basic level of infrastructure services is often thought to be important to the protection of equal opportunity for individual citizens, much as universal access to basic education and basic health care is. Infrastructure may not be deemed as essential to development and equal opportunity as education or health, but it is often just behind.¹

These developmental and equity considerations have led governments to encourage the development of more extensive infrastructure networks than can be financed with the tariffs that users are willing to pay. Many governments have created special programs to support rural electrification, telephones, and roads, for example, in the belief that such important services ought to be available throughout the country. Similarly, many countries try to keep the tariffs for basic levels of service low so that even poor households can afford piped water, electricity, and a telephone. Developmental and equity considerations also have led some governments to promote monopoly and limit competition, so as to allow the infrastructure company to charge some customers prices in excess of costs and use the proceeds to cross-subsidize low tariffs in rural areas or for poor households.

A final motivation for government involvement in infrastructure is to reduce safety and environmental problems. Railroads, highways, and power lines present safety hazards to both users and nonusers, for example, while power plants, locomotives, and motor vehicles pollute the environment. To the extent that these risks fall on nonusers, the government often feels justified in regulating the harms on the public’s behalf. And even if the safety and health risks fall on users, government intervention may be warranted if users are not well enough informed to judge the hazards that they are being exposed to. In most countries, the regulators in charge of safety and environmental concerns are separate from those responsible for controlling monopoly. The separation is designed to avoid any potential conflict of interest between setting tariffs and setting health and safety standards.

The Nature of Monopoly

Sources of Market Power

When one is assessing the degree of competition that a firm faces, the concept of market power is more helpful than that of monopoly. Monopoly is defined as a single seller serving a market. Market power is usually defined as the degree to which a company can raise the prices for its products above its costs without losing too many sales. Monopoly can be misleading, because the presence of only a single seller is neither a necessary nor a sufficient condition for effective market power. Even if there is only one seller in a market, for example, that firm may not be able to charge prices above costs if it believes that doing so will simply invite many other firms to enter the market and compete with it. Similarly, even if there are several sellers in a market, they may find ways to collude so as to effectively inhibit competition.

Two conditions are necessary for a firm to have market power. The first is the presence of some type of barrier that prevents other firms from entering the market to provide competing services. Barriers to entry can be either created by governments or firms or inherent in the technology of the industry. Examples of created barriers are the patent protections that governments award to inventors and the brand loyalty that some firms attempt to develop through extensive advertising. The primary example of an inherent barrier is the combination of large economies of scale and durable and immobile investments commonly referred to as a natural monopoly.

The second condition is that there must be few close substitutes to the good or service in question. Even if there are barriers to entry, the firm serving the market will not have much power over its customers if they can find close substitutes to the services it provides. These substitutes might be similar goods or services or alternative locations where the identical good is produced or sold. The idea is to avoid defining the market too narrowly by overlooking the competition provided by alternative products and sources of supply.

To illustrate these two conditions, consider local buses, which provide an example of a service that is likely to be highly competitive. Buses are mobile and not very durable, and studies show that economies of scale in local bus services are exhausted with fleets of twenty-five to fifty buses. Thus it is usually possible to have several firms serve a single city, or a single corridor within a city. Moreover, the private automobile usually competes with the bus in high-income countries, while walking, bicycles, and motorcycles often provide competition in low-income countries and where climates are mild.

At the other extreme, the distribution of piped water to residential neighborhoods is usually a classic natural monopoly. Underground pipes last fifty years or more, and there are strong economies of scale because it is more economical to serve all the households on a street from a single pipe than from two or three competing parallel pipes. One pipe is cheaper because the cost of digging and back-filling the trench for the pipe and the cost of the pipe itself do not increase proportionately with the pipe’s capacity. Moreover, the alternatives to piped water—such as private wells, tanker trucks, or bottled water—are usually more expensive and less convenient. As a result, a local piped water company often faces little effective competition and could price its services well above costs.

Within any given infrastructure industry, market power often varies according to the types of customers involved or the specific circumstances of the firm. Freight railroads typically have less market power over shippers of high-value, manufactured commodities than they do over shippers of low-value, bulk commodities, for example, since trucks are a more viable alternative for manufactured than for bulk commodities, especially over short distances. Similarly, a railroad may have limited market power even over shippers of bulk commodities if it competes with a navigable waterway.

The degree of market power can also vary among the different...