Summary and OverviewLatin America has kept in step with the worldwide trend towards the privatization of public utilities. Motivation for doing so stems from a number of factors including: economic philosophy, quest for greater efficiency, macroeconomic situations, debt-equity swaps, and need to bring private capital and management into public utilities at a time of fiscal limitations, and others. The report analyses the characteristics and components of public utilities. It also examines some regulatory concepts, such as administrative controls, the notion of reasonable charges,holding companies, monitoring , and terms and conditions of service, including water use and public utilities. Among specific cases of reviewed, particular attention is devoted to the case of the United States and the United Kingdom.The author suggests that the countries in Latin America should take comparative legislation and the experience of other nations into account, to set up suitable regulatory and monitoring systems prior to privatization.Much of the ongoing political and legal debate in the Region is related to the privatization and regulation process and the conditions, quality of service and level of returns under which public utilities currently operate. Argentina, Chile, and, although to a lesser extent, Perú, are presently discussing the conditions under which public utilities perform and the need for improved regulation.A global economy can be expected to expand well-being under certain commonly accepted rules. The analogy with the Roman “ius gentium” is tempting. The ius gentium was a liberal and progressive element in Roman Law, which was believed to be of universal application, its principles being regarded as so simple and reasonable that it was assumed they must be recognized everywhere and by everyone. Later, the concept was reinforced by the concept of “ius naturale”, incorporated into the teachings of Thomas Aquinas.The intent of this paper is to bring some concepts of comparative law, particularly American and English Law, into the discussion of public utilities, with a view to provide information to practitioners and governments.I. INTRODUCTIONThe privatization process in South America, has been undertaken not only with a view to increasing the efficiency of public services but also as a means of bringing about structural changes in the economy ( Gerchunoff and Cánovas, 1993, p. 2).In some countries, therefore, privatization operations have been, at least initially, a “macroeconomic tool” for stabilizing the economy, which has meant that the increased efficiency of production resulting from privatization has not necessarily been passed on to society in the form of lower rates and charges (as has occurred in the privatization of monopolies in various regions and countries of the world). Gains in efficiency have not necessarily resulted in lower rates for users. In some cases privatization has been accompanied by light regulation under limited competition. This triggered demands for a fine-tuning of the regulatory system (Gerchunoff and Cánovas, 1993, p. 2).There is a trend to the internationalization of utility concerns.Public utilities are a structural feature of modern societies. Without them, today’s cities and forms of production would simply be inconceivable. In a number of cases they entail monopolistic elements and have a bearing on the public interest, since they are connected to public health and economic development (Tieman and others, 1995).Historically, public utilities have involved significant economies of scale and scope, and called for fixed non-liquid investments and production capacities designed to meet peak demands. Regulatory systems primarily focused on service quality and rates, with the latter being pegged, in some systems, to reasonable profit levels for the purveyor. Traditional regulation has expanded to include environmental concerns.Legal instruments governing the provision of essential services entail elements of public interest which set them apart from civil-law contracts. Governments and users take an active part in their implementation, regulation, monitoring and follow-up. Institutional structures for the regulation of public utilities consist of commissions and agencies in respect of which a special effort is usually made to ensure their technical and financial capabilities and independence.In terms of water, service providers are large institutional users which are normally required to obtain water use permits, to comply with regulations concerning water discharge and pollution, and to respect general obligations regarding the efficient and beneficial use of the resource.Utility companies often tend to become internationalized, to diversify and to integrate. Consequently, evolved systems devote particular attention to monitoring the composition, integration, and ownership of stock and shares of utility-related firms and also their contractual arrangements and trading practices.Countries that are now turning to systems of privately-owned (or operated) public utilities need to develop relevant regulatory mechanisms and institutions. An institution-building process is essential for a proper understanding of utility-related activities. Institutions created for this purpose, which perform a role of fundamental importance, require constant updating.Familiarity with comparative legislation and management systems is highly valuable in this area. The creation of systems, programs and projects for transferring relevant knowledge from countries with mature and long standing private-public arrangements would be useful capacity building exercises for the countries in the Region. These exercises are particularly valuable in the discussion of a subject which does not only represent a considerable portion of the wealth of the Region, but is also intrinsically related to the well being of its population.II. THE IMPORTANCE OF PUBLIC UTILITIES IN MODERN SOCIETYPublic utilities perform a structural role. They are outstanding elements in social and economic organization, similar in importance to monetary, credit and educational systems. Existing systems for organizing production and population centers would be inconceivable without efficiently run, mass scale, public utilities. Public utilities have a number of characteristics which have made them a highly important area of the law:i) They are activities in which competition is not always present, and are usually subject to government regulation designed to protect the public interest (Phillips Jr., 1993, p. 3).ii) Some utility industries seem to operate more efficiently when they are monopolies; (such as water and sewerage) however, in such cases public utilities often must be compelled (by means of regulations) to contribute to the general welfare rather than doing so voluntarily (Kaysen and Turner, 1959, pp. 48-49, as cited in Phillips Jr., 1993, p. 4).iii) The regulation of public utilities is a result of the public interest associated to their activities; and is mainly expressed in the control of rates and services (Phillips Jr., 1993, p.4).iv) Conflicts often arise between public and private interests as they relate to public utilities. They stem from the difference between private firms’ main objective (profit maximization) and the public interest (adequate service at the lowest possible price). Some countries have created institutions specifically devoted to research on public utilities, since the regulatory process is not only controversial but also analytically demanding.v) At present, there are clear differences in the openness to technological change of the various types of public utilities; this gives rise to differing regulatory needs and, in some cases, even to a reformulation of the concept of natural monopolies in certain activities.vi) Although regulation is certainly a characteristic of public-utilities, its content and scope is not fixed, but instead tends to undergo adjustments as time passes and as circumstances and needs change (Phillips Jr., 1993, p. 7).vii) At the same time, some authors contend that regulation has not served its purpose and that, in practice, it has become “the haven of refuge for all aspiring monopolists who found it too difficult, too costly or too precarious to secure and maintain a monopoly” under a deregulated system (Gray, 1940, pp. 8-20, as cited in Phillips Jr., 1993, pp. 8 and 31). However, the result of competition will be accelerated consolidation and aggregation. Therefore, governments may want to assure that companies compete fairly. If deregulated markets do not produce the results expected, governments may have to re-introduce regulation.III. THE ECONOMIC CHARACTERISTICS OF PUBLIC UTILITIESThe main economic characteristics of public utilities have traditionally included:1. Economies of scale and of scopePart of the justification for having public utilities lied in the notion of natural monopolies, i.e., activities involving economies of scale (the greater the scale of production, the lower the unit cost) and of scope (certain types of services are less expensive when provided by one, rather than two firms).Drinking water and sanitation services provide ready examples of such situations. It has been determined that the investment required to supply water and sanitation services via a small-scale system for an average three-person household is US$ 1,600, whereas with a larger system, the figure is only US$ 200 (economies of scale).The concept of economies of scope, for its part, has been advanced as an explanation for the tendency to integrate water and sanitation services.Small-scale systems experience financial problems which give rise to difficulties in technical areas, in management and in the general adaptation or improvement of services (Lawton and Davis, 1983, as cited in Phillips Jr., 1993, pp. 851 and 836-839).Economies of scale are thus a factor in the establishment of monopolies (Phillips Jr., 1993, p. 56), whose existence, in turn, partially justifies the regulation of prices (rates) and products (services).In the electricity sector the notion of economies of scale is undergoing accelerated revision. New technologies are challenging traditional concepts.Yet, a recent decision of the Chilean Antimonopoly Commission has concluded that the disintegration and disaggregation of generation, transmission and distribution activities in the electricity industry in Chile was not called for, therefore rejecting a request to effectively order the disintegration of the sector, both at horizontal and vertical level. Rather than radical restructuring the Commission recommended a mix of measures to regulate conduct and to incrementally improve the present structure of the sector. Some expert witnesses estimated the economic losses resulting from disintegration in 21%. (Larrain, Quiroz, Chumacero). Others stressed the prudence of utilizing conduct regulations [as opposed to structural regulation] (Paredes).The decision may have been influenced by studies suggesting that the electric power industry have classical properties favoring vertical integration.Environmentalists have noticed that disintegration and competition at generation level are the result of utilizing gas fueled generation plants. In Chile, this type of technology would affect the ozone layer in the central part of the country, particularly in the boundaries of the metropolitan region. However, the Commission did not consider environmental arguments.2. Fixed non-liquid investmentThe attainment of economies of scale frequently requires heavy non-liquid investments in large-scale infrastructure. Fixed investment usually represents a sizeable portion of total costs, and this means that organizations providing public services are often capital-intensive. This trait, too, is particularly marked in the case of drinking water and sanitation utilities, in which the revenue/capital ratio is low (Phillips Jr., 1993, p. 15).Demand for these essential services, for which there is no substitute, is continually growing. There have been no major technological advances in recent years in the field, and this, coupled with inflation, environmental requirements, the cost of compliance with established standards and the need to secure and protect new sources of finance, has led to a constant increase in costs, with the resulting capital/revenue ratio ranging from 6:1 to 10:1 or, according to some authors, even as much as 12:1 (Wade Miller Associates, Inc., as cited in Haarmeyer, 1994, p. 43).In fact, drinking water and sanitation services have been described as the most capital-intensive of all the public utilities (Environmental Protection Agency, 1977). This trait influences the legal conditions under which the private sector invests in drinking water supply and sanitation services, as well as these utilities’ financing systems and the regulation of private activity in this sector.It should be noted that not all public utilities have the same capital/revenue ratio. For telephone services, the ratio is 3:1, for electricity it is from 3:1 to 4:1. and for airlines it is 1:1. This clearly influences private sector’s propensity to invest, the existence of real competition, the likelihood of monopolies and, in consequence, the various activities’ differing needs in terms of regulation. In this connection it is interesting to notice that in 1991 out of 1.200 millions of capital expenditures in France (in british pounds) for water and sewage, 160 came from river authorities, 10 from regions, 150 from departments, 65 from national funds, 400 from water companies and 415 from local communities.3. Idle capacityFixed investment in public utilities is carried out in order to meet peak projected demand and to cover increases expected in that demand over time. Some factors of production cannot be divided up, and for technical reasons must therefore be structured in a single bloc. Idle capacity can be regarded as a result of the diversity of demand levels, which prompts service providers to try to attract that demand through the use of consumer incentives. Since this may lead to undue discrimination, it becomes a factor in the adoption of controls for preventing such an eventuality.4. Operational limitationsIn some cases, the possibility of competition among service providers is limited by the nature of the service itself and by the carrying capacity of the facilities in question (e.g., pipes and available areas for installing and laying them), which normally do not have enough physical space available to support a large number of suppliers and thus set the stage for competition.5. Market structureIn the case of the water supply and sanitation industry there are experiences indicating that often the structure of the sector is at best oligopolist, with opportunities for competition fairly limited.6. Legal implicationsOwing to the above characteristics, entry into the public-utility market is usually subject to government control and to regulatory measures aimed at forestalling transfers of income from consumers to investors. This is accomplished through consumer-complaint mechanisms and controls that have been expressly designed to keep the social, economic and political power of public utilities in check.IV. LEGAL CONCEPTS RELATING TO THE REGULATION OF PUBLIC UTILITIESSome activities have the potential to affect general welfare, public health, collective security and other social concerns.They are subject to government control in order to safeguard the general welfare (Spota, 1941, p. 917, note 189; Phillips Jr., 1993, p. 87). Regulation is justified by the monopolistic nature of many such activities, by their importance as essential consumer services, by their relevance to socioeconomic organization and by the absence of other alternatives.Regulation, as well as the philosophical grounds for its existence, is nothing new. Some precedents in this area were laid down in the doctrine of the early Church Fathers –“just price” (justum pretium) and “natural price” (verum pretium)– and in the regulation of the guilds of medieval times and of activities regarded as being of common interest (Glaesser, 1957, pp. 196-201, as cited in Phillips Jr., 1993, p. 122). Regulation included prices, quality and type of services provided, discrimination and other elements.Although American authorities acknowledge that “public utility” is a term of popular usage, rather than a precise definition, they also indicate that it refers to services, more or less essential to the economy, which are public in nature.Companies providing public services are a substitute for the State in the performance of public services, thus becoming a public servant, in the performance of a function of the state. Therefore, they are subject to regulation.Within certain limits such regulation can be imposed ex post as exemplified by the historical development of regulation in the United States.Corporate concentration resulted in competition being not as perfect as indicated by economic theory. As a result private corporations contracting essential services were able to take advantage of their economic predominance in conducting business so pervasive and varied as to require detailed supervision and a very high degree of regulation.The legal concepts involved in regulation are not static, allowing broad range of measures within “ends of the spectrum standards” resulting from the interpretation of constitutional guarantees. Business subject to regulation are deemed to be “affected with a public interest”.Following English common law American courts have ruled that such business are not juris privati only and that “it matters not that….[ the activities] were established before the regulations were adopted” ” if plaintiffs did not want to be subjected to regulations they should not have had clothed the public with an interest in their concerns”. (Munn Vs. Illinois, US Supreme Court)The public interest of the activity and its importance were such as to create a common burden upon the citizens. That justified regulation, even ex-post regulation, within certain constitutional limitations. Monopolistic elements justified regulation, even when in the commented case, two judges, Field and Stone, argued that public regulation required a franchise.Later in the development of American regulations monopoly was no longer required, reasonability and public interest being the foundation of regulation, always within the limits of constitutional guarantees. Imperfect competition became also part of the legal cosmogony justifying regulation including not just monopoly, but also excessive competition.An important methodological question is how should regulations be instrumented. Mature regulatory systems do not favor the instrumentation of regulations through contracts or franchises. Experience, according to American authorities is that “franchises proved to be defective instruments…little regard was paid to public interest…they were often exclusive…poorly drafted…due to inexperience…it was common for the utilities lawyers to draft the franchise and then present it to the city council for approval.Moreover, in Cedar Rapids Justice Holmes explained “…if the franchise is interpreted to mean that the most profitable return that could be got free from competition is protected by Constitutional property guarantees, then the power to regulate is null. If the power to regulate altogether withdraws [the Constitutional guarantees] then the property is nought. This is not a matter of economic theory, but of fair interpretation of a bargain. Neither extreme can be meant. A midway must be hit”.A recent decision of the Argentinean Supreme Court remarked that public utilities have a right to rates allowing cost recovery, including investment, plus a just and reasonable profit, for it would not be acceptable to maintain that they have a right to profits objectively unlimited.Accordingly, administrative contracts under which a private person is granted the right to operate a public utility usually contain special clauses regarding the provision of guarantees, the administrative authority to interpret the contract, modifications for the purpose of serving the public interest, dispute settlement, determination of effects and the clarification of any doubts that may arise.Broadly stated, regulations may address a wide variety of issues, including the quality of the service provided, its scope and coverage, frequency or consistency, price and, in the case of drinking water services, environmental impact and conditionalities of water use. Moreover they can address market structures, such as the Public Utilities Holding Act of the United States (1935), or the legislation requiring disintegration of the electricity sector; contracting practices; ownership and transfer of stock; access to infrastructure and related conditionalities and procedures; separation or prohibition of activities; transfer pricing, information, accounting, disclosure of profits, etc.1. Licensees’ earningsThis section will make no attempt to delve into the technical complexities of different rate systems but will simply describe some of the legal criteria used to set the parameters which determine the profits realized by public utility licensees and their connection with the rates charged. Existing legislation offers examples that set precedents in this area. The laws of the State of New York, for example, require that water use rates shall be fair and reasonable and may not exceed the limits authorized by law or by order of the relevant regulatory commission. This question is clearly linked to the issue of reasonable profits for the licensee.An important point is to determine what constitutes a reasonable profit. Providers of public services cannot be forced to operate at a loss, but this does not mean that they are everywhere guaranteed an actual return on their investment. The rate should be such as to cover operating costs and provide a reasonable return on the investment. It should also be enough to attract resources in the capital market. Legal experts in the United States have discussed the idea that the returns on such an investment should be comparable to those realized in activities involving similar levels of risk and uncertainty, in similar areas, at the time the activity is being conducted. They have also said that such returns cannot be set at a specific level or according to a pre-determined formula, since they are subject to changes in economic conditions stemming from the state ofthe general economy and the positions of the specific companies concerned. Indeed, in some cases rates have been lowered as a means of punishing companies deemed to be inefficient (Phillips Jr., 1993, p. 427).Not all systems regulate the return on investments. Haarmeyer claims that since French water companies have not been subject to profit controls that hinder the innovation process, they have led the field in technological and managerial innovations (Haarmeyer, 1994, p. 48).In the United Kingdom, drinking water and sanitation utilities were privatized in 1989. Rates have been regulated through the establishment of price caps. The system functions on the basis of the wholesale price index plus an adjustment factor (“K”). In the water industry, this factor is positive owing to the characteristics of the subsector, which include capital-intensiveness, high investment needs and low productivity (Haarmeyer, 1994, p. 49).The United Kingdom’s experience merits analysis because it has sparked a widespread public debate on the subject which is in some ways unique in its conceptual richness, ideological seriousness and transparency. The English system is based on the idea that earnings should not be limited but that caps should be placed on the rates charged. In so doing, the Government “slanted the playing field in the investors’ favor at the expense of consumers” (Stelzer, 1995). By 1992-1993, water company earnings had climbed by an average of 23%. Operating profits were up by 34.3%, on average. These returns were felt to be excessive (Tieman and others, 1995). As of March 1994, water rates were absorbing a sizeable portion of the income of the poorest sectors of the population, and these sectors’ ability to pay became the primary consideration in the determination of prices for 1994 (Booker, 1994, p. 61).The British system was overhauled in July 1994. The Office of Water Services lowered the adjustment factor in the midst of a climate of consumer discontent, with users charging that the directors of water companies were doubling their salaries by doubling the cost of water to consumers (The Times, 1994), that the water companies’ costs were not rising as fast as inflation, that capital expenditures were not as big as planned, that money had been lost on sideline businesses that had nothing to do with the main activity, and other problems. All this has prompted some commentators to forecast that regulatory provisions which are more closely tied to profit levels may be implemented in the future (Helm, 1994). Others do not so much predict but rather recommend that some means of controlling earnings and profits should be introduced into the regulatory system (Stelzer, 1995). In addition, in view of how much the stock in these companies is worth, the possibility of taxing windfall profits has been mentioned (Tieman and others, 1995) and a bill to such effect was submitted in July 1997.The relevant regulatory decree in Buenos Aires includes references to the rationality and efficiency of the system, to a balance between supply and demand, to health and social objectives, to the need to reflect economic costs as well as the licensee’s profits, and to transfers between different sectors of users. Rates are subject to review in the event of any significant change in operating costs, in the quality or level of service, in the taxes to be paid by the utility company, in the exchange rate for the dollar or in environmental or other laws.It is interesting to compare the above Act with Spain’s Public Administration Contracts bill, which calls for a set price in local currency and stipulates that the price should be geared to the market (article 13). Readjustments must reflect actual market fluctuations (the markets in question may be regional ones), including changes in the cost of labor and of basic factors affecting the contract (articles 100 and 101 of the Public Administration Contracts bill).2. The provision of public servicesEntry of service providers into the public utility system has normally been subject to State authorization. The fact that some of these utilities are monopolies has another legal implication as well: the conditions under which such services are provided are (or should be) monitored in order to ensure that utility licensees are not obtaining monopoly rents at the expense of users.Spain’s Public Administration Contracts bill permits the private management of public utilities when they have an economic content and the services provided are of a sort that can be delegated. Concession contracts cannot be implemented until a legal framework for the utility has been formed, areas of administrative responsibility have been defined, the benefits to be provided to the persons subject to that administrative jurisdiction have been specified, and it has been established that the activity corresponds to the administrative authority in question and is subject to the police powers necessary to ensure the satisfactory operation of the utility in question (article 151).Consequently, the legal instruments by which authorization is given for the operation of public utilities have certain features which differentiate them from other contracts. One important feature of this sort, is that rate guidelines are subject to periodic review to ensure that the rate is reasonable and that it is performing its assigned functions of attracting investment and covering costs while not representing a monopolistic levy on users.Under Argentine law, whose legal doctrines and jurisprudence have been strongly influenced by European experiences, “the licensing agreement is not a civil -law contract … between equal parties … but rather the delegation to a company of the responsibility for duly providing a public service …”; following along the lines laid down by Mayer, it is stated that “the licensing arrangement is an administrative act that cannot be covered satisfactorily by private-law contracts”; therefore, “in the event of disputes, the application of civil law is suppletory” and is applicable only in so far as it does not contravene the general interest; “the rights which arise are public civil rights”. United States law applies similar concepts, since the possibility of providing a public service is contingent upon the issuance of licenses, franchises or administrative permits, all of which imply the existence of special terms and conditions. This circumstance has important implications, since the legal act is subject to police power, and the licensee is obligated to comply with regulations and provisions even if they are subsequent to the issuance of the license.A decision handed down in the United Kingdom holds that drinking water and sanitation utilities operate under the control of the State. In the case of South West Water, the court found that, despite its private character, South West Water derives from the State, since it operates a public utility which is controlled by a State-designated regulator. The legal character of the organization providing the service is irrelevant because the public utility is under the control of the State (Financial Times, 1994).The activities of the State may not cause the licensee to operate at a loss or to suffer confiscation. Nevertheless, the methodology and concept of “reasonable” profits, both in regard to public utilities and as they relate to their conceptualization (in line with the Penn Station case mentioned earlier), are a legal tool with financial, economic and technical underpinnings which should be properly understood, analyzed and applied in countries that have privatization processes under way.3. Licensees as institutional water usersThe management of water-related utilities has an impact on both the quantity and quality of the resource. For this reason, licensees are regarded as large-scale users and are subject to water-use controls and requirements. The proliferation of water uses, their reciprocal effects and their aggregate impact on the environment have made it necessary to establish organizational and legal structures to monitor, plan and reconcile those uses.There is also a trend to separate water demands for specific uses from national water policy and management. Responsibility for water policy and planning in general is being handed over to ministries responsible for the environment, natural resources or water resources. The idea here is that this is a suitable way to ensure impartiality and objectivity in the management of a resource subject to both environmental degradation and multiple demands. A report by the Secretary-General of the United Nations to the Committee on Natural Resources (United Nations, 1994) cites examples of this tendency in a number of countries, including Canada, France, Guatemala, Israel (with some differing characteristics), Oman, the United States and other nations.In addition, some countries have modified their integrated water monitoring and management systems along with the system under which their drinking water and sanitation utilities operate.Thus, in 1992 Mexico reformed its water-resource legislation with the introduction of a package that includes the adoption of a system of tradeable water rights, the creation of watershed authorities as a means of reducing the fragmentation of the water sector, the imposition of fines for polluting, and the possibility of privatizing the country’s drinking water and sanitation utilities (Casasús, 1994).One of the merits of the United Kingdom’s reform of its drinking water supply and management system is that it separates water companies from the water-resource monitoring and management system; in other words, the regulator has been separated from the object of regulation. Today, the English system applies a series of controls on water companies. They include controls on the system as such, and environmental and water-use controls which are administered by different public authorities (Jeffrey, 1994, p. 64).England’s water companies have certain environmental obligations
