Regulating Quality in the Water Sector: A Theoretical Perspective

Abstract

Regulating quality is challenging because in public utilities such as water and sanitation, quality is multidimensional, is not always objectively measurable, and can be hard to verify, both ex ante and ex post. It is therefore useful to review the main insights from the New Economics of Regulation theoretical literature on quality provision to guide public policy. Focusing on formal utilities, this normative approach emphasizes the asymmetry of information between a regulator and the regulated companies. The analysis shows that when quality is verifiable, it can be included in a contract exactly like a quantity variable. Its provision, however, will be distorted as a result of regulated quantities also being distorted due to asymmetric information. When quality and quantity are complements, service quality ends up being lower because in the optimal regulatory contract, quantities are distorted downward for rent extraction. If quality is not verifiable but is observable by the users, the operator freely chooses its quality investment. It tends to underprovide quality when an improvement in quality raises the gross consumer surplus more than it increases the gross profit of sales because it does not take into account the nonmonetary benefit generated by its investment. It tends to overprovide quality otherwise. In order to correct these distortions, the regulator has to use a production allocation rule to simultaneously lower the informational rent and boost quality. The regulator has a single instrument to achieve the conflicting goals of rent extraction and quality provision. Quantities can be higher or lower than the first-best optimal levels depending on the correction needed to control quality. Finally, when quality is neither verifiable nor observable by consumers, as is typically the case with credence attributes such as those concerning process of production impacting security or pollution, the optimal level of quality investment from the firm’s perspective is zero. In this case, the easiest solution is often to impose a minimum standard and either rely on certification agencies to ensure that this minimum target is met or directly audit the quality investments made by the regulator. Finally, when improving the quality of water and sanitation services requires the creation of new infrastructure or institution, the high opportunity cost of public funds in developing countries raises the question of whether it is optimal to commit public funds for such investments. The analysis illuminates the trade-off between financing those investments with private funds and protecting consumer surplus.