Chile Water Privatization

Justification for intervention for economic regulatory efforts arises out of alleged inability of the marketplace to deal with particular structural problems. Of course, details of any program often reflect political force, not reasoned argument. Yet thoughtful justification is still needed when programs are evaluated.[1]

The case of water reform in Chile is an interesting one. First of all, it allows us to think about a situation where regulatory reforms face political decision-making through the outcome of proposed legislation. Secondly, the case doesn’t deal with lack of political commitment, but rather involves a situation where the government now faces an important question of passing a legislation that directly affects their households – the main question is not whether to privatize, but how to regulate what will be privatized. Finally, it shows us the importance of having a credible and independent regulatory framework in order to have effective reforms.

Despite the successful accomplishment of SENDOS, government had few concerns it was facing with publicly owned companies:

- It had to restructure the public entity that was responsible for regulating quality while providing the service. SENDOS did not have the authority for economic regulation and control of tariffs which was under the Ministry of Economy. Only after the reforms a regulatory agency, SISS was established and given a right, among others, to set tariffs and audit companies. But even then, it was constrained it its ability due to much dependency on the government.

- The regulatory system did not provide the government with credible checks and balances system. Besides defining a geographic area the company was obliged to serve, a lot was unclear including indefinite duration of concessions, giving companies the right to transfer or sub-contract to another provider which could be revoked by the government for non-compliance with procedures for revocation that were not spelled out. This added to the next issue of financing of water utilities.

- The government heavily depended on appropriations from national budget and loans. Because of the existence of insufficient tariffs to cover operating costs, government had to bring changes in management and the structure of regulation separating the quality and tariff regulatory functions from those of service provision. Sewerage treatment needed significant investments in water treatment especially in metropolitan area Santiago. Although three new water treatment plants were planned to be constructed under BOT with EMOS, targets of treating 100 percent of all wastewater by 2005 set by the Chilean administration did not seem realistic given an increase (up to 80 percent) in the amount of funding now needed for annual investment. Although reforms under new democratic government in 90s successfully restructured management of water utilities, under CORFO, public corporations still remained unable to issue debt to finance operations and investment. This was a key difference between public and private corporations after reforming the ownership structure.

Part of the success of improving performance of the CORFO-owned companies was outsourcing elements of their operations to the private sector under service contracts which resulted in very high staff productivity. However, this was the case mainly with EMOS which had most of its activities outsourced.

While analyzing the case, it’s important to keep in mind that, although water service was successful under public ownership, question remains whether the success will be sustained given the constraints mentioned below:

a. Government’s limited national budget
b. Lack of positive incentives, such as profit sharing or bonuses. No incentives were provided to spur management to the levels of efficiency that might be attained by a private profit-maximizing firm.
c. Although political intervention seemed to only be aimed at facilitating reforms for better, the potential risk of political pressure on the boards of the water companies still existed. Political interference becomes especially important in the debate of Congress resolving the issue.
d. Goal 1 of the new legislation: “Separate the quality and tariff regulatory functions from those of service provision” doesn’t seem to serve its purpose due to the fact that the service provision which is under SENDOS and responsible for social regulation remains under the same Ministry as the tariff regulatory agency SISS, both of whom are under the Ministry of Public Works. The rest of the four goals cannot be achieve if a strong independent regulatory framework is not created

The fact the Lo Castillo failed to meet the expectations of the government and population in providing efficient service and coverage, it doesn’t mean that private participation fails for same reasons.

Lo Castillo’s problem may have resulted from its corporate goal of profit-maximization and prioritizing on shareholders’ return on investment rather than ensuring public welfare which in turn resulted in underinvestment in infrastructure to expand its water supply. Assuming that the company had the financial and managerial capacity to invest in expansion of services but failed to deal with the crisis also proved that the family-run business prioritized its profit-maximization in the short-run. One can argue that lack investment of Lo Castillo was due to the pending approval of its development plan by SISS in both years 1991 and 1995. However, SISS, as a regulatory agency was unable to impose substantial fines on the company or have clear procedures in place for revoking company’s concession. This resulted in failure of Lo Castillo to use its water rights to meet the growing demand, thus, proving regulatory contracts very important in state-owned enterprise reform along with performance and management contracts.

To attain desired outcomes – improved enterprise performance, privatization with regulation works well when governments do three things: first, reduce the firm’s information advantage by increasing competition; second, devise rewards and penalties, primarily in the form of pricing regulations, that induce the firm to operate efficiently and pass some of the savings on to consumers; finally, demonstrating commitment to protect producers against opportunistic behavior by future regimes so that owners will make investments necessary to upgrade and extend service.[2] The second measure seems to be the central question for SISS given the fact that the government was unable to compel the company to solve the problem.

In addition, as claimed by the general manager of the Enersis, 75 percent of the problem was simply a managerial issue. If that is the case, this points to the problem of lack of incentives to stimulate the management of the CORFO-owned companies.

Although Enersis was able to solve Lo Castilo’s problem during the crisis and has the management experience, as the first multi-utility company in South America and a privatized monopoly of electricity in Chile, there is no guarantee that it will not face unforeseen obstacles it managing another strategic utility sector of water and sanitation. The obstacles, mentioned above, could only be avoided if an effective regulatory framework is in place through legislation that doesn’t involve political interference and affect fair and equitable price-setting, for both investors and consumers.

In answering the question of divestiture of all or portion of the water companies to private operators, I would suggest careful examination of the proposed regulatory reforms. The question for Chile is whether these reforms were enough and would protect consumers and investors. It is important to note that the ownership share of EMOS and ESVAL is unlimited (up to 100 percent) whereas private ownership of the remaining eleven companies is legally limited to 51 percent, making the legislation reform even more important and take into consideration Enersis’ plan to strategically position itself to own specifically EMOS and ESVAL. Under no condition Chilean government should divest from water utilities until it ensures credible and effective autonomy of SISS accompanied with increased resources and effective regulatory reforms as proposed by the Lower-House of Congress, and not the Senate. The government may create even bigger problems with disastrous outcomes if the Senate approves 100 percent divestiture on top of removing the bill’s main regulatory provisions.

The optimal solution is establishing a regulatory framework that is independent financially and administratively from the central government, and ideally backed with strong judiciary, and rule of law.

The case of Chile shows us that it is crucial for a regulatory agency to establish strong and independent monitoring and auditing arm. Certainly, any reform must first be politically desirable to the leadership for it to be successful and have the support of key actors such as members of the legislature, as well as be credible to investors. It seems important for the Chilean government to make sure politics stays apart from decision-making of the reform, especially in issues of economic regulation that effect the whole country; potential threat is that Congress members might vote for a reform in favor of Santiago’s upper-income area.

In conclusion, successful regulatory regime should provide incentives to invest, expand services, operate efficiently and protect consumers from exploitation.

Tariffs should be calculated in order to make sure they cover the costs (investment, operating, maintenance etc) at the same time are fair to consumers.
[1] Regulation and Its Reform, Chapter 1 – Typical Justifications for Regulation; Stephen Breyer, Harvard University Press, 1982
A World Bank Policy Research Report, New York, Oxford University Press, 1995. Chapter 3, Contracting: What Works, What Doesn’t, And Why

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