Indicus Analytics, An Economics Research Firm

http://indicus.net/Media/index.php

Lessons from power sector reforms for the reform

of the Indian urban water sector

Payal Malik
Tuesday, 18 March 2008 00:00

Although in the larger hydrological picture, the urban consumer's water

demand necessarily competes with that of the rural consumer and the
farmer's demand for water as an input, the management of any given amount
of urban water is a problem that can be sensibly isolated from the larger
picture. This partial equilibrium problem was the object of this study.

If one were to compile two lists, one of the areas of economic management
that directly impinge on the day-to-day quality of life of all citizens, and
another of the areas in which misguided policies have resulted in outcomes
far short of potential outcomes, then it is reasonable to conjecture that the
electricity and water sectors would have pride of place in both lists. In both
cases, not only were policies followed that were contrary to good sense as
dictated by the science of economics, but more perversely, they undermined
the very political and economic interests whose furtherance was proclaimed
by socialist rhetoric to be the raison-de-etre for these policies. Indian economic
policy failures are often charitably excused by the plea that policy-makers
were soft-hearted, but presumably hard-headed. However, an ex ante
appraisal of the economics underlying these policies leads one to believe that
they were soft-headed, while the ex post impact on the populace points to
hardness of heart. While the continuance of these policies in the short run
may be attributed to naivete and an ideologically blinkered world-view, or an
inability to recognize and repair the unintended consequences of well-
meaning efforts, their longevity points elsewhere. It is evident that the
political and economic elites coalesced into a nexus that supped at the high
table on the rents created by the misguided policies while placating the
electoral vote-banks with a steady diet of socialist rhetoric and some populist
crumbs from the table.

As in every other area of economic policy-making, the populist consensus on

so-called socialist strategies has been sturdy and tenacious enough to
withstand all challenges short of a crisis or voter rebellion. The crisis in the

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

electricity sector stems as much from the consumption aspirations of the

citizenry as from the demands of factories, farms and service-providers who
increasingly have to compete not only among themselves domestically, but
also with the rest of the world. Somewhat differently, the crisis in the water
sector is caused largely by the inability of existing water-management
institutions to slake the thirst of consumers. Although in the larger
hydrological picture, the urban consumer's water demand necessarily
competes with that of the rural consumer and the farmer's demand for water
as an input, the management of any given amount of urban water is a
problem that can be sensibly isolated from the larger picture. This partial
equilibrium problem was the object of this study.

Intellectual map of the dirigeste

What did the dirigeste view of the electricity and water sectors amount to?

First, water and electricity are often viewed as ``public goods'', although they
do not have the properties required of public goods. Applying standard
definitions, water and electricity are private goods. This seemingly innocuous
error has been used to dictate inappropriate institutional design, and distort
investment and pricing decisions. However, this error does not stem merely
from intellectual lethargy. As in many other policy problems where the
commodity in question is inappropriately labelled a ``public good'', the
reason for this inappropriate categorization is not difficult to see. The inherent
nature of a true public good does not allow straightforward commercial or
economic cost-benefit analysis. As such analysis is invariably vitiated by
considerations of externalities and some of the concerned goods being ``merit
goods'', the planner or policy-maker has wide latitude and discretion in
skewing decisions in a chosen predestined direction. Thus, by the sleight-of-
hand of simply labelling private goods as public goods, headroom is created
for policy intervention and distortion.

Another peculiar view espoused by radical Greens and anarchists is that

water is a common property resource of the community and its allocation and
value cannot, indeed should not, be determined using the standard economic
paradigm. This warm and fuzzy view may be appropriate for small
communities drawing their water from an unspoilt mountain stream or

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

natural spring, but wholly inappropriate for large urban areas with treated
and piped water. Water treatment and transport are costly activities and
represent value addition to the raw water. The problem of designing
institutions for the allocation of these costs is no different from that faced in a
host of other commodity markets in which transport depends on a fixed
common network.

Secondly, in line with the philosophy of Soviet-style planning, which in its

purest form sought to reduce the entire economy to one monolithic enterprise
whose technology was represented by a vast input-output table that the
planner used for decision-making purposes, electricity and water were
viewed as the products of centrally controlled and very highly vertically and
horizontally integrated ``sectors'' run by bureaucrats. Undoubtedly, the nature
of technology involved (e.g., the network nature of the distribution system)
organically forces a degree of horizontal and vertical integration. However, it
stretches credulity to argue that the full integration of the value-addition
chain with respect to both water and electricity were technologically
determined. Clearly, scant attention was paid to the possibility of using
functional distinctions to disaggregate the value-addition chain so that
appropriate institutions could be designed for these functionally distinct
activities. For instance, it is by now clear and well-accepted that electricity is
not the product of a single vertically integrated industry but consists of at
least three functionally distinct activities, namely generation, transmission
and distribution, which admit quite different industry structures and
allocation institutions.

Thirdly, populism reduced prices, literally and figuratively, to ciphers that

were incapable of conveying any useful economic information. As politically
determined prices were divorced from the underlying economic
fundamentals of consumer preferences and production technology,
represented by the forces of demand and supply respectively, they were
incapable of serving any useful economic function such as guiding investment
choices, technological choices, or consumption choices. For instance, apart
from legal and institutional barriers to entry, absurdly distorted prices rule
out private investment in most parts of the electricity and water sectors except
when all commercial risks are eliminated by the provision of comprehensive
state guarantees. Distorted pricing of inputs and outputs forces inappropriate
choice of technology and spatial location of production activities. Finally,

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

populist pricing provides final consumers with no incentive to economize and

wisely use electricity and water, should they be lucky enough to actually get
these goods. In short, lower than ``equilibrium'' prices of water and electricity
encouraged demand and discouraged supply, thereby quantity-rationing a
(substantial) number of potential buyers.

It is telling that in the popular imagination water tariffs are often referred to
as ``taxes'' rather than as ``prices''. This confusion neatly encapsulates a basic
flaw in the status quo and indicates a direction for policy reform. Taxes as an
economic category describe an impost by the state for the purpose of
providing public goods or for redistribution of resources by fiat. Being
artificial impositions by the state, they carry information about the state's
moral stance, but little useful information regarding economic values,
preferences, technology, etc. On the other hand, as was stressed by von
Hayek, prices are the life-blood of the economic system as they incorporate
and disseminate vital economic information with an efficiency that a tax
cannot hope to match. So, changing tariffs from whimsically imposed ``taxes''
to economically-justified ``prices'' is a major part of the reform agenda.

Fourthly, it is a corollary of the above characteristics that, as the management

and pricing of water and electricity eliminated the possibilities of private
investment and curbing demand, using public investment to augment supply
was the only way to bridge the demand-supply gap. This reliance on a single
policy instrument resulted in a Soviet-style obsession with building visible
``temples of modern India'' without any effort to justify them commercially, or
efficiently exploiting existing assets, or maintaining and upgrading existing
systems, or finding appropriate alternative technologies instead of big
projects. For instance, in the power industry, the obsession was to build new
power plants rather than improve the woeful PLFs of existing plants, or to
eliminate power theft; in the case of water, the obsession was to augment the
amount of water going into municipal networks, without caring that most of
the water simply leaks out of the network before reaching the consumer.
Unfortunately, the statist planning mentality inevitably reduced the assets
created by public investment to ends in themselves. Once created, these assets
usually languish without a determined effort to see that they deliver the value
that the planners expected from them.

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

Populism implies that it is politically more advantageous to build new assets

rather than do the harder work of maintaining existing ones. After all, a new
water treatment plant or electricity generation plant built with public money
is decidedly more visible and politically bankable than a less visible project to
strengthen the distribution network. Such public investment has a number of
other aspects. First, the paucity of public resources and the myriad demands
on these resources for purposes that properly lie in the state's eminent domain
(e.g., the provision of true public goods) mean that the opportunity cost of
these funds is high. Secondly, public investment in projects with low average
revenue implies large implicit subsidies to those who can access the resulting
outputs. Thirdly, by subsidizing the consumption of the ``lucky'' (and
needless to say, affluent and politically well-connected) few, public
investment has (inadvertently?) served as a means for significant transfers
across economic classes, albeit of the type purportedly not favored by
promoters of populist policies.

What is to be done?

The solutions of the problems afflicting the water and electricity sectors
require concerted policy responses in a number of directions. As the details of
the required policies have been studied above, it suffices here to place these
policies in a broader intellectual and political context.

First, it needs to be recognized intellectually that both water and electricity are
private goods. A practical corollary is that the consumption of these goods
needs to be accurately metered for each consumer. Treating these goods as
``public'' goods that are jointly consumed by a community implies a moral
hazard problem leading to a tragedy of the commons. The broad principles
governing the design of institutions for the welfare maximizing provision of
private goods are well-understood, indeed staple, parts of the economics
literature. These insights are being sharpened at the level of market micro-
structure in sophisticated economies; see Wilson (2002). However, in India,
the debate is still at a relatively rudimentary stage as we are still grappling
with first-order problems of institutional design such as the role of the private
sector in these markets, whether these goods should be allocated via the price
mechanism, what should be the nature of regulatory design and the nature of
contracts governing relationships among the players in these markets. In
sophisticated economies, most of these elementary issues have been dealt

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

with over the past two decades or so and the debate has moved on to second-
order technical issues, e.g., the design of market micro-structure for spot,
futures and option trading in these goods. However, as a latecomer to the
party, India does have the great advantage of being able to learn from the
experiences of other countries and being able to take into account the possible
market micro-structure issues even while resolving the first-order problems.

At this point, however, one encounters an ideological shibboleth that has

characterized Indian policy-making over a long period: a desire to constantly
re-invent the wheel. There is a self- serving myth perpetuated by generations
of Indian policy-makers in myriad contexts that Indian problems are
somehow unique and not amenable to solution using standard economic
science. These assertions are little more than an attempt at brand
differentiation and the creation of an intellectual local monopoly. In every
area of reforms in India, this assertion has been shown to be spurious. To be
sure, there are historically determined local variations that have to be
accommodated, but the broad architecture of successful policy design does
not vary very much. So, the second essential intellectual reform necessary for
successful policy reform is to shelve the notion of India being an economic
curiosum and be willing to learn from international experiences.

Thirdly, as we know from economic theory and the experiences of other

countries, changes in market design are required. In electricity, it is necessary
to disaggregate functionally and develop markets that are consistent with a
functional classification of value-addition activities. The electricity sector
consists of three distinct commercial activities: generation, transportation and
trade. An analogous classification is applicable to the provision of water too:
water treatment, transportation and trade. While some Indian states have
gone some way towards implementing this functional separation in the
electricity sector, the water sector has seen no movement.

Electricity is traded at two levels: bulk/wholesale and retail. In the market for
bulk electricity, the generators are the ultimate source of supply and the
distributors are the ultimate source of demand. As in any other market, there
can be pure traders who neither generate electricity nor distribute it to the
ultimate consumers. In India, the bulk electricity market has been strangled
by vertically integrating the generation and distribution businesses in the
form of SEBs, with almost no economic room left for genuine trading activity.

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

Moreover, private generators have been discouraged by subjecting them to

bureaucratic barriers in the form of licensing requirements and forcing them
to sell their output to monopsonist SEBs. Opportunistic rent-gouging and
capricious payment behavior by SEBs substantially raises the riskiness of
private investment in generation, thereby rendering many potential projects
infructuous. In the wholesale markets, the SEBs have, with very few
exceptions, acted as monopolist distributors to hapless consumers, with
plainly evident disastrous results.

It is technologically and economically feasible to make the bulk electricity

market competitive. The following steps are essential for this to happen. First,
it is necessary to bring about a pan-Indian market by eliminating barriers to
movement of electricity. The strengthening of the national grid is an
important technological step in this direction. Secondly, it is essential to
eliminate the SEBs distribution monopolies, which also automatically does
away with the SEBs monopsony status in the bulk market and creates a
diversified and competitive set of buyers of bulk electricity. Thirdly, it is
necessary to eliminate all unreasonable legal barriers to entry in generation,
distribution and trading of electricity. These changes are essential in order to
bring about some economic rationality to electricity prices by loosening the
state's grip on the sector, improve the quality of service to consumers, and for
the long-run, induce investment in all aspects of the sector without having to
offer investors ironclad inefficient state guarantees that are opaque and
therefore subject to unending controversy and litigation.

Thanks to technological improvements, some large urban bulk electricity

markets can be made competitive by allowing multiple distributors to
compete for the same set of customers. Other wholesale markets may not
allow multiple suppliers to compete in the market. In such markets,
competition can be in two forms. First, potential distributors may be forced to
compete for the market via an auction of the concession contract. Secondly,
incumbents can be disciplined by the possibility of entry by competitors.
Whatever be the nature of the bulk market, it is important to make the market
contestable by lowering the legal and cost barriers to entry. There are two
prerequisites for these conditions to obtain. One, sensible regulation is
required to curb the variety of rent-seeking and entry-prevention strategies
that the incumbent may employ. Two, it is necessary to divorce the
distribution business from the ownership of the wires because transportation

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

is the only part of the value addition chain that is a natural monopoly.
Exclusive control of the transportation infrastructure by a distributor is a
source of market power and a means for preventing entry into the
distribution business. Even when a distributor owns the wire network, it is
necessary that the regulator enforce a fire-wall between the two businesses by
requiring open access to the network by all electricity traders in exchange for
a regulated access charge. Apart from providing efficient transportation to
traders, the other task of the electricity carrier is to expand and maintain the
network by making the necessary investments. For this, it is necessary to
provide this entity with a budgetary transfer. There is an extremely rich
literature (use Laffont and Tirole (1993) as a starting point) analyzing the
relationship between the regulator and the firm and we refer the reader to it
for details.

Electricity Act goes some way towards providing a legal framework for
bringing about the market structure described above. For instance, the de-
licensing of electricity generation, the legal requirement of open access to
retail markets and the creation of independent regulators to oversee consumer
interests are very sensible provisions.

However, mere market design is not enough as the efficient operation of any
market requires it to be embedded in a nurturing system of laws and their
effective enforcement. For instance, laws related to property rights and
contract execution need to take into account not merely broad philosophical
aspects of fairness, ``rights'' and ``social justice'', but they should marry these
principles sensibly with anticipated incentive and informational constraints
under which any law-enforcement executive operates. Failure to harness
together the law with sound economics has yielded laws in India that make
most contracts not worth the paper on which they are written. It is a matter of
everyday experience for every Indian citizen that contracts are flouted with
impunity and any attempt for redress is drowned in ceaseless litigation. The
most obvious instances of these problems are the very high incidence of
electricity theft by consumers, and more disturbingly, the theft of electricity
by many SEBs that callously exploit their state-owned and legally sanctioned
monopsony status to simply not pay for the electricity or coal that they ``buy''.

Therefore, a fourth essential and practical ingredient for the effective operation
of electricity and water markets is the enactment of appropriate laws and their

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

enforcement. For instance, Commercial or regulatory contracts specifying

price, quantity, quality, etc., need to be easily enforceable, with enabling
legislation and a judiciary that effectively punishes deviations from the terms
of a contract. In the case of electricity and water markets, a legal and political
culture that enables routine and effective price exaction by sellers is a sine qua
non for any market design to work. Unfortunately, India's legal culture in this
respect has been steadily eroded by decades of politically sponsored loot
masquerading as socialist populism.

As we have argued above, Electricity Act provides a legal matrix in which the
structure of electricity markets is brought in line with sound economic
principles. Even more fundamentally, for the first time there is an attempt to
fix and protect property rights by making electricity theft and manipulation of
meters a penal offence. It is remarkable indeed that purloining electricity has
not been ``theft'' for so long!

Even as one deplores political populism, it is undeniable that there are

significant distributional concerns regarding both electricity and water, but
especially the latter. In a democracy, it is appropriate that the political process
and the constitution should define the ends that the state should strive
towards. However, most problems admit a number of solutions and it is the
policy-maker's job to pick the one that achieves the mandated goal most
efficaciously. For instance, suppose the political process mandates a specified
amount of ``access to water and electricity'' by the ``poor''. This outcome can
be achieved by forcing utilities, for all practical purposes, to give away these
goods for free, or by directly transferring purchasing power to the poor
without distorting prices for this purpose. Clearly, the Indian state has chosen
the decidedly inferior former course. The reasons are not difficult to find.

With a decrepit fiscal system, it is politically and fiscally expedient in the

short-run to allow utilities to lose money through under-pricing and theft,
rather than bear the subsidy burden directly and transparently. Moreover,
price distortions can be used to buy off powerful constituencies, such as
farmers, with favors of cheap power. Naturally, the only real beneficiaries of
these give-aways are the large farmers who have pump-sets to run in the first
place. Even for them, this stratagem has limited benefit as the tyranny of
double-entry bookkeeping rules out any more than a token amount of
electricity supply at the absurd prices promised by politicians.

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

One may wonder how this Mad Hatter's tea party, with ``Jam yesterday and
jam tomorrow but never jam today'', is sustained. This has been done by the
sleight-of-hand of confusing ends and means: instead of a clear objective of
providing well-defined amounts of water and electricity to the poor, with
subsidized prices as just one of the possible means, the politicians have
managed to shift the goalposts and framed low prices as an end in itself! In
both cases, the state has attempted to address distributional concerns via a
high degree of de jure price discrimination and cross-subsidy. Of course, the
pattern of de facto price discrimination is not congruent with the de jure
pattern. By imposing wedges between marginal cost and de facto prices, the
system imposes significant deadweight welfare losses on society.
Furthermore, de jure price discrimination motivated by politics defeats any
attempt at sensible ex ante economic calculus, e.g., what is the right amount to
produce, by what means, by whom, who should consume the output.
However, the ex post effects are easily discerned. As the prices do not convey
appropriate economic signals, there is a mismatch between demand and
supply across all the various artificially created segments of the markets. In
every segment, there is excess demand, indicating that the price is below the
equilibrium level. The effective price received by the supplier is the realized
revenue per unit of output. The persistent supply deficit points to this
incentive being inadequate to induce investment and augment supply to meet
the demand.

One reason for the parallax between de jure and de facto prices is the rampant
corruption that enables many consumers to undermine the attempted market
segmentation. For instance, a well-entrenched system of bribes allows
households and industries with high electricity loads to masquerade as those
with low loads and to manipulate their meters.

Another reason is the ``coping cost'' imposed on a consumer by the endemic

scarcity of water and electricity. As this cost is particularly onerous for the
poor, the result is a significantly regressive distortion of true economic prices,
especially of water; in the case of electricity, the poor cope by simply doing
without it, which does not impose a monetary coping cost but does impose
significant costs by reducing the effective length of a day for the poor. High
coping cost have also brought about a de facto market segmentation of a
particularly inefficient and socially invidious kind: industry and the affluent

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

have simply seceded from the decrepit public system by setting up a parallel
private system. This islanding strategy not only undermines the price
discrimination attempted by the state, but more seriously, it reduces the stake
of the affluent segment of the market in sustaining and improving the public
system. By impeding the expansion of the public system, the islanding
strategy also sustains and reinforces the socio-economic wedge between those
``inside the system'' and those ``outside looking in''. Thus, the policy
undermines and defeats the very objectives it is purportedly designed to
serve.

So, the fifth policy reform required is to replace the opaque system of price
discrimination with a transparent system of direct budgetary transfers to
well-targeted groups of consumers, e.g., a voucher-based system of transfers.

Regulation and contracting

Our discussion so far has touched upon some aspects of the regulator's job,
e.g., price and quality regulation, ensuring open access to the market,
inducing investment, etc. Given the Indian policy-makers’ new-found faith in
``regulators’’ as a panacea for all problems, it is important to delineate the
regulator's role and the limits on his ability to bring about desired outcomes.

With respect to the scope of useful regulatory activity, one needs to state the
obvious: a regulator has no legitimate economic role in a market where competition
can ensure first-best outcomes by means of conventional commercial contracts. The
demand for regulators in such markets is silly at best or an attempt to re-
introduce state interference at worst. All that such markets require are well-
functioning judicial and executive institutions for contract enforcement,
prevention of market collusion and anti-trust activities, etc. However, the
regulator is of crucial importance in a non-competitive market where a firm
has the power to exact rents. Here, a regulator is charged to act as society's
fiduciary to provide incentives to the firm to act in the social interest,
howsoever this social mandate is defined. The regulator’s interaction with the
firms is governed by the contracts between these entities and the regulator’s
fiduciary responsibility to pursue the social mandate. Once they frame the
regulator’s mandate, the state actors lose their ability to interfere with this
interaction on a day-to-day basis.

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

The potential benefits of regulation are well-understood. If the regulator has

complete information, and the regulated firm's actions can be monitored
perfectly, and the firm's actions are contractible, then the regulator can
achieve the first best outcome by eliminating the firm's rent, i.e., reducing the
firm's return to its opportunity cost. However, in a regulatory setting with
asymmetric information, the regulator cannot achieve the first best outcome
as it must compromise between the competing requirements to limit the firm's
rent while ensuring that the firm's incentive compatibility condition is
satisfied in the presence of private information. It is a staple result of the
regulation literature that this trade-off forces the regulator to optimally
compromise between the twin objectives, thereby leaving some rent for some
types of the regulated firm; see Laffont and Tirole (1993).

As the regulator is the state’s fiduciary, it is important to delineate the

appropriate means and degree of control exercised by the state over the
regulator. In this regard, it is vital that the political system provide a clear
objective and mandate to a regulator. The regulator should have the legal
basis and the incentives to pursue his mandate free of day-to-day political
interference. For this, it is important that the process of hiring-and-firing
regulators be extremely transparent and open to judicial and public scrutiny.
Needless to say, very high standards of probity, knowledge, insight and good
judgement should be prerequisites for a person to be hired to the regulator’s
office. Equally, very strong evidence of the violation of these standards should
need to be presented in order to fire an incumbent regulator. The regulator’s
day-to-day functioning should be disciplined not by the executive but by the
judiciary in the light of the regulator's legal mandate, relevant case-law and
precedents.

It is sometimes argued that the regulator can be dispensed with and the
relationship between the state and the firm can be governed directly by a
contract. This is possible if one can draw up a complete contract, i.e., provide
for every possible eventuality that might arise. That being practically
impossible, a regulator is required for the quasi-judicial task of interpreting
the social mandate and providing direction in states of the world not foreseen
by the contract. In the absence of a regulator, even trivial conflicts caused by
contract incompleteness would end up in the court's lap.

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

The regulation of markets with state-owned participants poses peculiar

political-economic problems.

First, the regulator’s independence is especially crucial in markets where

private and state-owned firms may coexist and compete. Without
independence, there is insufficient institutional distance between a regulator
and a state-owned firm, especially when there is no firewall between the state
actors and the regulator. As both are manifestations of the state, it is not
credible that a feeble regulator will be impartial and even-handed. Regulatory
capture by state-owned firms is a very real threat, as has been the case in the
power sector. In markets that were hitherto the preserves of the public sector
and which are only now being opened up to private participation, potential
private entrants have a justifiable fear of being exploited and treated
capriciously by the state once they bear the sunk costs and enter the market.
The only way to allay such fears is to set up strong independent regulators
who can withstand the inevitable political pressures to play favourites with
the public sector incumbent. However, creation and sustenance of
independent regulatory institutions requires a substantial degree of political
and judicial maturity. Ultimately, the state actors have to forbear routine
interference in areas that they have considered to be a part of their eminent
domain. The Indian political class has hitherto been unwilling to part with
this fiefdom. Legitimate mandated regulatory functions are routinely
compromised by the issuance of opportunistic “policy” directives.

Secondly, it has been argued that regulation is a means for disciplining and
improving the performance of state-run utilities. This seems true in principle
as one might expect state-owned firms to respond to incentives in the same
way as private firms. Indian political reality, however, destroys this apparent
parity. The regulator's ability to bring about desired outcomes depends on the
regulated entity's sensitivity to financial incentives in the form of tariffs,
transfers, penalties, etc. Historically, Indian state-owned entities have been
motivated by myriad considerations, many of the non-commercial and non-
financial kind. These considerations have been used as an alibi for poor
commercial and financial performance by the managers of these entities and
the political class that oversees and exploits these entities. The alibis of the
``social responsibility'' variety are routinely seized upon by the political class
to open the public purse to provide open-ended non-performance-related
subsidies to the state-owned entities. Consequently, these entities face very

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

soft budget constraints and are unlikely to respond to regulatory incentives in

nearly the same way as private firms might be expected to respond. So,
regulation per se cannot be expected to improve significantly the performance
of state-owned firms in the absence of substantive internal reform of these
firms themselves.

The only way to have good regulatory outcomes when state-owned utilities
are involved is to transform them into “private” firms, either via sale of equity
and loss of direct state control, or by maintaining control but stripping away
their government department character: have similar employment policies,
have similar managerial and labor incentives, credibly deny them open-ended
budgetary hand-outs and empower management to make commercially
sensible decisions. Although the Indian state has failed to credibly implement
the second route time and again, commitment to this route is piously intoned
by elements of the Indian polity every time straightforward privatization is
proposed, the political class is clearly loath to part with the milch cow
fattened over decades. For instance, a red herring regularly tossed into this
debate is that instead of privatizing state-owned utilities, it is sufficient to
“corporatize” them. While the change of legal status from government
department to corporation is a necessary first step for reform, it will not by
itself necessarily subject the organizations to external market discipline or
force them to create internal systems of accountability. The setting-up of good
internal and external incentive structures is of paramount importance for a
well-functioning utility and the Indian state is yet to demonstrate its ability to
set up such institutions. In the absence of credible state initiatives in this
respect, privatization of a number of activities is the only realistic solution of
the problem.

In conclusion, the prescription for successful reform of Indian urban utilities

can be summed up in the following simple mantra: (a) introduction of
competition in the provision of services wherever possible, (b) independent
regulation of providers where competition is infeasible, (c) introduction of
meaningful user charges, (d) subsidies to the poor via direct transfers rather
than via price distortion, (e) either the privatization of utilities, or of various
functions, or at the very least, a substantial overhaul of the internal and
external incentive structures that govern the utilities. The general thrust of
these reforms is a shift from a bureaucratically-managed command-and-
control system that pays scant attention to incentive issues to a system that is

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms
 Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

based as far as feasible on market-determined incentives. Successful transition

is complicated as it requires parallel reforms in many interlinked areas such
as labor and financial markets, organizational forms, corporate governance,
etc. Experts recommend various institutional features that are needed if
markets are to satisfactorily determine prices and patterns of investment in
the area of urban utilities. In our study, we give particular attention to
regulation as one such institutional feature. Yet, and here is the rub, the
creation of these institutions and the implementation of complementary
reforms is in the hands of the very political class that stands to lose the most
from these changes. Slow and hesitant attempts to untangle the mess are
under way in the face of pressure from the stakeholders. However, the
strengthening of these weak institutions requires a statesman to rise above
myopic political interests and cut the Gordian knot. In terms of the contest for
control, the vested interests who stand to lose from reforms are already
organized within the firm and the state, and have direct influence and control
over decision-making. In order to counter and overcome these vested
interests, reformers need to build potent coalitions for reform if the reforms
are to succeed.
This essay is the summary of the findings of a project done by the author for WSP-
SA, World Bank

http://www.indicus.net/media/index.php/2008/1246-lessons-from-power-
sector-reforms