In order to analyse the regulatory practices in the water sector, a survey was prepared and disseminated to all regulators on record.
The survey focused on how the economic regulation is performed and whether it considers the quality of service. It was divided in different areas:
The analysis of the survey results does not intend to cast a judgement on the actual regulatory practices of the regulators that answered the survey.
Description of the Sample
The survey was sent to 159 water regulators and 44 replies were received (28%) from 31 different countries (some countries have several regional regulators). All data collected correspond to the year 2019.
The replies to the survey were mainly received from regulators located in America and Europe, with a few answers from Africa and Oceania as seen in Fig. 1a. The authors consider this a representative sample of the sector, given the percentage of regulators represented in the survey and their geographic diversity.
All regulators that replied to the survey were in charge of the regulation of water supply services. Additionally, most of them also regulated the sewerage and wastewater treatment services. More than the half of the sample also covered other services such as gas supply, electricity supply, telecommunications or solid waste services (Fig. 1b).
The survey asked the type of regulation performed according to the 5 behavioural characteristics defined by Baptista (2014). Figure 1c shows that all regulators of the sample supervised the economic aspect of the services. Only the 73% of them were also in charge of the quality of service regulation. 57% of regulators supervised the legal and contractual aspects, 48% the consumers’ interface and 41% the drinking water quality. This does not mean that some of these aspects were not regulated, as in some cases there is more than one regulator, each one covering different aspects. For instance, OFWAT (Office of Water Services), the regulator of England and Wales, covers the economic, quality of service and customers interface regulation (OFWAT 2019) and the Drinking Water Inspectorate (DWI) is in charge of the quality of the water served in the same area (Drinking Water Inspectorate 2017).
Regulators were asked about the body in charge of stablishing tariffs. 3 main actors were identified: the regulator, the service provider and the government (any governmental body, e.g. municipality, regional or national body).
Figure 1d reveals that regulators are the main actors approving tariffs, participating in 82% of the cases (either as a single entity – 55% of cases – or in conjunction with water providers or the government). Governments participate in 24% of the cases (alone, together with the regulator or the water service provider). Finally, water service providers are present in 25% of cases. In 7% of the cases, they are the sole tariff approving body.
Concerning the economic method used for setting tariffs, the options according to the survey were rate of return, price cap, revenue cap and model firm regulation. These methods are briefly described below.
Rate of return (ROR) is historically the most widely used economic regulatory method (Rossi and Ruzzier 2001), used even when there is no economic regulatory body (Marques 2011), for instance in franchise regulation. This method offers the lowest risk for utilities, as they are allowed to recover costs with a pre-stablished profit.
The other economic regulatory approaches consist in using performance incentives that encourage cost reduction when setting tariffs. There are 4 main methods: price cap, revenue cap, yardstick competition and model firm regulation.
Price cap method establishes the maximum price a company can charge for the service. Revenue cap fixes the revenues obtained by a utility. It is similar to price cap but utility has freedom to stablish tariffs as the tariffs structure and concepts are not controlled.
In Yardstick competition the performance of different utilities is compared with the aim of simulating a competitive market (Marques 2006). It can be used either in quality of service regulation (sunshine regulation) and/or in economic regulation. In the case of economic regulation, its results are used for setting tariffs. In its purest form, tariffs are set using the results from the best in class (best results and lowest costs). On in its hybrid form, it is combined with price cap or revenue cap methods.
Finally, model firm regulation consists on the comparison of utility performance against a model firm which is a hypothetical utility based in the same area, with an optimum network system and operating efficiently (Ferro and Romero 2009). Therefore, environmental factors that affect comparisons between different utilities are supressed.
Figure 1e displays the different economic methods used by regulators for approving tariffs and the percentage of regulators using them. As observed, the preferred method in the sector is the rate of return regulation, used by half of the sample. It is followed by price cap regulation (20%) and revenue cap (18%).
The remaining regulators either use a model firm regulation approach (2%), a combination between rate of return and price cap (2%) or other methods such as regulation based in goals. In this last one, performance goals are set for utilities. Then, tariffs are revised according to the achievement of these goals. Finally, 5% of the regulators did not establish methods for the tariff setting process.
These setting tariffs methods were analysed in conjunction with the information on who is establishing them. An analysis of the data reveals that:
Price cap regulation is a method only used when regulators play a relevant role in the tariffs setting procedure.
In all the cases when there is no methodology used for setting tariffs, the service providers are the body setting tariffs.
Rate of return is the preferred methodology in the sector and it is used regardless of the body establishing tariffs.
Usually, when a government body is involved in the tariff setting process, price cap is not used. Rate of return is applied or revenue cap regulation, being both of them the most conservative approaches.
Model firm regulation and regulation by performance goals are the least implemented methods in the sector. They are only used when a regulator is present in the tariff setting process.
Comparative Performance Assessment Between Utilities
The use of comparative performance assessment systems is a practice often used by regulators, as it may stimulate competition between utilities. It consists in the comparison of utilities’ performance through performance metrics (such as performance indicators or indices) in order to identify who is the best performer in each of the evaluated areas (Cabrera et al. 2011).
This section analyses comparative performance and the role this analysis plays in the regulatory system. Comparative performance assessment results can be applied in both quality of service and economic regulations.
When applied for quality of service regulation, comparative performance assessment is carried out through performance assessment systems (with performance indicators or other measures). The results are used to supervise if the quality of service standards are met.
When applied for economic regulation, it is used for setting tariffs with methods that use performance incentives (as previously described). In this case, the tools used are performance indicators or/and econometric methods that can be non-parametric (Data envelopment analysis–DEA) or parametric (Ordinary Least Squares – OLS, Stochastic frontier analysis – SFA, etc.).
An analysis of results discloses that more than three-quarters of the sample perform comparative performance assessment. From them, the preferred method are performance indicators, as seen in Fig. 2a. Econometric methods are also used by a small but non-negligible number of regulators (alone or combined with performance indicators).
Concerning to the use given by regulators to comparative assessment, half of them use it to oversee the quality of service. 20% uses it to set tariffs and 5% for both (Fig. 2b). The remaining regulators do not compare performance between utilities.
Quality of Service
One of the main objectives of the survey was to analyse the impact of the quality of service in the economic regulation. For this reason, regulators were asked about the practices used to promote such quality. As Fig. 2c shows, the preferred action by regulators is to penalise or reward companies according to their quality of service. The public exposure of performance results (sunshine regulation, or “name and shame”) is also popular among regulators.
Other practices for promoting the quality of service make use of tariffs, threats to revoke the license or the comparative assessment between utilities. However, there is a significant percentage of regulators (25%) without any practices established for promoting the quality of service.
Only 70% of regulators consider quality of service aspects when assessing the efficiency of utilities. The remaining 30% do not contemplate the cost that the provision of a higher quality service has when assessing the efficiency of the utility. This fact could penalise utilities with higher quality of service standards, as their higher costs resulting from providing a better service could be considered inefficiencies.
In any case, regulators do not consider all aspects of quality of service that could potentially impact costs. Figure 2d shows different dimensions of service quality with an impact on costs (extracted from the ISO 24510 (ISO 2007)) and the percentage of regulators from the total considering them. As seen in this figure, there is no consensus among regulators in the quality of service aspects to be contemplated. Not a single QoS aspect is considered by the entire sample of regulators and there is seldom a dimension that is used by more than 60%.
The last aspect to be analysed is whether regulators contemplate the quality of service for the purposes of economic regulation. As seen in Fig. 2e, for 41% of regulators, quality of service is not considered at all for tariff-setting purposes. Among the remaining 59% of regulators, the preferred strategy is to set penalties to utilities with under performance. Rewards for performance are also a recurrent strategy. However, only in one case, the regulator rewards utilities based on their actual level of performance above the stablished standards of quality of service, while the remaining ones reward all utilities reaching the quality of service baseline, regardless of how well perform beyond this limit.
Another method used by 27% of the regulators is the tariffs increase/decrease. However, there is little information available on how quality of service affects tariffs.
Other regulators use other methods such as: revoking license contracts if the QoS standards are not met, considering the QoS when setting the funding requirements for utilities or not allowing new tariff rates until the QoS standards are met.
Finally, almost all regulators analysed believe that the quality of service is an important factor in regulation. However, most of them seem to fail to translate this belief into effective policy. The reasons for this are diverse, and include lack of a guided approach for considering the quality of the service, poor data, lack of consensus in the elements of quality of service that affect costs, etc.…
Conclusion of the Survey
It may be concluded from the answers to the survey that, in practice, the quality of service and Economic regulations are considered as separate efforts and there is little influence from one into the other. As a matter of fact, for 41% of the regulators that replied to the survey, quality of service plays no role whatsoever in economic regulation.
This would mean that, if quality of service has a direct impact on costs, the economic regulation function would be undertaken under inaccurate or incomplete premises, as none of the regulators that replied considers all QoS factors that could have an impact on costs.
The next section will consider the relationship between providing a greater quality of service and the associated costs, and its consequences for economic regulation.