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Key Concepts of Economic Regulation PDF Print

Printed in the Business Monday newspaper on March 14th, 2011

Traditionally throughout the world utility services were provided by a single entity. Over time, however, these incumbent monopoly providers were exposed to market forces as governments permitted new players to enter the market during an era of globalisation and liberalisation of traditionally protected markets.

The incumbent providers were forced to become more efficient in the face of increasing competition, while the new entrants were faced with the challenge of competing effectively and accumulating market share against well entrenched and experienced incumbent providers. New entrants therefore faced the significant challenge of competing against very dominant and powerful incumbents who would have occupied this privileged position as a result of legal barriers to entry.

It was recognised that without the threat of new entry or the growth of the new rivals the discipline of a competitive market could not be exerted and these incumbent firms would have been able to continue to exploit their dominant position at the expense of consumers.

With the emergence of this fledgling competitive market it was considered essential that a more modern type of regulation should be formulated. This meant regulation that was not solely concerned with the setting of prices but rather had a wider scope which incorporated issues such as standards of service and encouraging competition.

With the establishment of the new type of regulatory body came questions such as how far and at what point should a regulator intervene into an industry and what are the fundamental concepts that a regulator should place at the pinnacle of all of its decisions?

There are certain broad principles which should guide all regulators. Firstly, a regulator must prevent the possible abuse of monopoly power. An example of such abuse is if a regulated service provider tries to propose the setting of very high rates in relation to the cost of providing the service to ensure excessive profits are gained. It is the regulator’s responsibility to scrutinise through the rate review process the proposed rates to ensure that they are fair. Abuse may also occur through non-price anti-competitive tactics where the incumbent for instance “drags its feet” in completing the interconnection process with new entrants by delaying getting the appropriate equipment even though interconnection agreements have been signed and are in place.

Secondly, a regulator should not be overly involved in utility companies’ management decisions in such a way as to distort such business decisions. Only where there is market or competitive failure, meaning the normal pressures of demand and supply equilibrium have broken down, is there really a need for intervention by the regulator. There are instances where the competitive playing field can be distorted by economic regulation and so due care should be exercised by the regulator when implementing its decisions.

Thirdly, regulation is intended to “mimic” the operation of a competitive market. This will ensure that resources are used efficiently and non-discriminately among industry players. Finally, given costs, regulation should be limited to that which is essential. The cost of regulation is sometimes borne jointly by the government and the regulated company and in its policies and decisions, the regulator needs to be cognisant of these costs to avoid over spending.

Some key tenets which every regulator should hold close to ensure effective regulation are transparency, fairness, autonomy and legitimacy – these are paramount to the credibility of an agency and are important cornerstones of regulation. However, transparency and autonomy are not always absolute and degrees of each should be incorporated as the regulator sees fit. Such concepts must be balanced and in varying degrees applied on a case by case basis.

For transparency and fairness to have its full effect there must be systems and processes in place to allow regulators to gain valuable information, consult all stakeholders, render decisions and justify them based on the public interest and the facts provided. Evidence of transparency and unbiased decision-making will also help to insulate regulators from accusations of arbitrary, closed-door decisions for reasons of personal gain or to benefit a certain company or individual.

Transparency and fairness are critical success factors in achieving all of the regulatory goals. Although many regulatory authorities are not bound by explicit statutory requirements to follow transparent procedures, practice has proven that it can help a regulator avoid many pitfalls.

Independence is another major concept that a regulator ought to encompass. Organisations like the International Telecommunications Union identify “separate regulators” as being “independent” in terms of finance, structure and decision-making from the operator and the relevant government ministry. Another definition of independence is aptly promoted by the Federal Communications Commission in the United States which describes itself as the oldest independent regulatory agency. It states that “An effective regulator should be independent from those it regulates, protected from political pressure, and given the full ability to regulate the market by making policy and enforcement decisions. The regulator should have the authority and jurisdiction to carry out its regulatory and enforcement functions effectively and unambiguously. And the regulator must be adequately funded from reliable and predictable revenue sources.”

In practice however, regulatory independence is much more complex than what is encapsulated in a single quote or definition. Further independence does not necessarily translate into complete autonomy from any government as an agency may rely on funding from government and will have to take government policies into consideration. Regulatory theorist William H. Melody has stated “The term independence… does not imply independence from government policy, or the power to make policy, but rather independence to implement policy without undue interference from politicians and industry lobbyists. It implies independence to acquire special skills to manage without interference and to be accountable for results according to specific performance criteria.” In all of this the overarching point must be that a regulatory agency has independence in its decision making.

Regulation is not going to be flawless and it is not going to be perfect. However, a regulator must strive by incorporating these key elements, to be effective and credible in the eyes of its stakeholders and in pursuit of the public good.

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