1 Privatization and Regulation Robert E. Anderson World Bank June 7, 2001

2 Main Messages l The privatization and regulation strategies must be developed together and support each other. l Regulatory uncertainty or risk is the major obstacle to successful privatization.

3 What is Regulatory Uncertainty? l The inability of investors to predict with confidence what tariffs they will be allowed to charge after privatization. l Their concern is not the level of tariffs but their certainty. l Uncertainty about tariffs in the near future is the most important.

4 Regulatory Uncertainty Reduces Privatization Revenues Regulatory Uncertainty Present Value of Cash Flow Purchase Value/Bid* *If value less than zero, no bid.

5 Investors Will Do a Discounted Cash Flow Analysis Risk NCFr Value Example

6 United States Has Low Regulatory Risk l High risk factors »Vague legal standards – tariffs must only be “just and reasonable.” »Strong consumer political power and influence. l Low risk factors »100 year tradition of independent regulatory agencies »Tariff setting constrained by many legal precedents. »Tariffs mostly determined by objective standards rather than political pressure »Investors protected by strong, expert courts

7 Measures to Increase Independence of Regulator l Members appointed by and accountable only to President. l Members can not be removed except for gross misbehavior l Fixed staggered terms and salaries. l Independent source of revenue. l Open transparent procedures l Only the courts can review decisions.

8 Is Creation of an Independent Agency Good Enough? l Investors see: »Vague legal standard »Regulatory discretion is high (e.g. Pakistan) »Little experience or history »No precedents established »Weak court system »Politicians often ignore the law l Example: Privatization in Orissa, India »Most international investors not interested »Low purchase price of $37 million for distribution companies with 13 million customers.

9 What Else Can be Done to Reduce Regulatory Risk? l Establish precise standards in the law. l Raise tariffs prior to privatization. l Government contracts with investors (e.g. concession). l Regulatory agency establishes multi-year tariff instead of annual cost-of-service reviews l Government guarantee l World Bank guarantee l International arbitration

10 Precise Standards in the Law Reduce Regulatory Discretion l Law specifies details of how cost of service must be calculated. »Rates of return »Depreciation rates »Capital structure »Allowed losses l Examples: Chile and Jamaica

11 Will Politicians Honor Promise to Raise Tariffs after Privatization? l Political pressure may be overwhelming. l Example: Hungary l Only certainty for investors is if politicians implement increase before privatization.

12 Investors May View Contract With Government as Less Risky l Example: concession contracts in Latin America »Transfers control of state assets »Specifies tariffs that concessionaire may charge, quality standards, and other terms and conditions. l Role of regulatory agency limited to interpreting and enforcing terms of concession contract. l Government can not unilaterally change terms of a contract in the same way it can change the law or regulation. l Contract disputes subject to international arbitration.

13 Multi-Year Tariff Reduces Risk l Regulatory agency sets a multi-year tariff prior to privatization. l Multi-year tariff is a formula or a detailed methodology that specifies how tariffs will change in response to changes in costs, e.g. RPI-X. l Issue: how long should be the term of the tariff – 2 years, 10 years, 20 years? »Longer term reduces risk for investor, but »Circumstances will undoubtedly change requiring changes in the tariff formula/methodology. »Certainty about the distant future is not so important to investors.

14 Guarantees l Government could provide a written guarantee to investors concerning the future tariff, for example: »The detailed specifications in the law will be followed and not changed. »The regulatory agency will abide by its multi-year tariff. l But consider the example of Enron in India. l The World Bank could guarantee that the Government will honor its guarantee.

15 International Arbitration Under its bilateral investment treaties, the Government may be forced to defend its regulatory decisions before an international arbitration tribunal in the case of: l Failure to honor contract terms (concession, guarantee) l Creeping expropriation or a regulatory taking.

16 Combination May be Needed to Reduce Regulatory Risk For Example l Detailed standards/methodology in law. l Create independent regulatory agency. l Raise tariffs prior to privatization. l Set multi-year tariff for say, 7-10 years. l Government guarantees that tariff will be followed. l World Bank guarantees the Government guarantee. l International arbitration applies.

17 In Conclusion: Ask Investors The privatization agency and the regulatory agency should jointly consult with prospective investors about what measures are needed to reduce regulatory risk to reasonable levels.