Monday, December 13, 2021

Regulatory commitment in twenty-first century democracies

It is well-known that one of the key challenges in utilities’ regulation (to some, "the" key challenge)  is the commitment problem. Regulated firms have the opportunity to undertake massive long-lived specific investments, and then the regulator, once the investment has been sunk, decides whether and to what extent to remunerate the investment. In democratic societies, regulators face strong political pressure not to remunerate the sunk investments, or at least strong political pressure to remunerate them below the opportunity cost of capital. This is so especially in low or middle income countries, where there is a strong demand to use the utilities’ quasi-rents to fund social programs or to address other urgent political priorities. Anticipating this behavior by representative regulators, the regulated firms are tempted not to invest in the first place, leading to an underinvestment problem. Although there is investment in utilities, for this reason it is almost surely sub-optimal.

Throughout history, different polities have developed different institutions to alleviate this problem, from public ownership to independent regulators. I wrote about it here, among other places. Pablo Spiller and his co-authors emphasized that each country tries to fix this problem according to its institutional endowment. The recent book by Auriol, Crampes and Estache addresses this and other pressing institutional problems in regulation in a specific chapter.

Last week I was in Chile to attend an event on water regulation where I gave a presentation on some ideas about how the Chilean regulatory model may evolve after the crucial presidential election they hold this week on Sunday. Of course, much will depend on which of the two presidential candidates wins in this very polarized vote (between the right-wing Kast and the left-wing Boric), but both the two contenders and the candidate who was third in the first round can fairly be characterized as different brands of populists.

The Chilean case in the Spiller framework about commitment institutions that are adapted to the institutional endowment (in comparison for example with the UK, where commitment is based on licences and independent regulators), consists of achieving commitment through detailed legislation (guaranteeing a safe rate of return to private investors) and legislative institutions where it is very difficult to introduce legal reforms. These legislative institutions are based on the Guzmán Constitution of the General Pinochet years, which has been the main motive of the social mobilizations that have triggered the political changes that is experiencing the country: the Boric movement, the Kast reaction, and the Assembly to write a new Constitution. The text of the current Constitution can be interpreted as just one aspect of a system of extreme protection of private property rights that was the legacy of the military dictatorship.

This framework has not prevented Chile (some may even say that it has facilitated it)  from achieving high levels of service availability in water (and other utilities), although now it faces serious challenges in terms of droughts and climate change. The protection of property rights and the center-left governments immediately after the dictatorship that prioritized the eradication of poverty allowed for the extension of service, but probably are not enough today to guarantee the levels of private and public investment and government intervention that are going to be needed to fight climate change, severe drought and water imbalances.

Chile is a good example where the second best institutional fixes to the commitment problem do not really solve, but they relocate, such commitment problem, which becomes a problem of the political system committing or not to preserve these second best institutions. For example, the straightjacket on Chilean legislators has not proven robust to a generation of citizens that are less ready to support with their votes an extreme level of protection of property rights.

It will be very interesting to analyze how the Chilean regulatory model evolves in this disruptive, but happily democratic, times. Second generation commitment devices will be needed if underinvestment is to be avoided. Some experts on the relationship between populism and economics have claimed that the risks of the current wave of populism are more microeconomic than macroeconomic as they were in the past (perhaps climate change denial on the right, and property fetishism on the left?). The younger and left wing candidate, Gabriel Boric, has been advised for the second round by what the Chilean media has called a center-left technocrat, former Yale academic and current professor at University of Chile, Eduardo Engel, co-author of a widely read book on public-private partnerships. One can see that the existence of a second round is also a commmitment device to avoid extremisms… although the new Constitution could in theory also change that.

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