_firms find that the utilities business is just that: a business with limited upside but significant downside, because regulators limit profits and pressures exist to reduce prices further or enhance access and quality without commensurate compensation._ _When the level of prices becomes insufficient to expand systems and to provide quality service calls for reform arise. The value of private firms falls. Eventually governments may decide to buy up private firms at fairly cheap prices and try to solve the problem through nationalization. Yet, because prices are low, state firms cannot perform either without subsidy_<sup>_11_</sup> _. Thus the cycle starts again._ _Some countries, depending on the sector, have seen several cycles of privatization and nationalization, some only one and a few none. The key to end the cycle is the ability to commit to adequate prices that allow infrastructure firms to perform, whether they are privately or state owned._

# **_Establishing regulatory commitment_**

Typically governments announce some form of regulatory regime for infrastructure service providers – be they private or state-owned firms<sup>12</sup> . Firms then invest. Then it becomes clear what actual demand is like and firms operate the system to meet demand. Finally, regulators rule on the actual revenue that firms can make. At this stage regulators may de facto renege on the pre-announced pricing rule if they are under pressure to lower consumer prices or reduce profits deemed too large. Private firms know that agents of the sovereign may do so. This is a form of political risk. Firms underinvest when political risk is of significance. State-owned firms equally shy away from money-losing operations. Even in countries with strong legal systems and long regulatory traditions pressures to renege on ex ante rules can be strong. For example, in the United States in the few cases where utility regulators are actually elected by consumer-citizens pressures to curb prices have tended to undermine service provision.

To render a price regulation regime sustainable one needs to consider various mechanisms to curb ex post opportunism on the part of regulatory authorities. The mechanisms comprise i) the nature of the pricing rules themselves, ii) the legal framework under which rules are made and administered and iii) the organizational arrangements for administering the rules.

# **Pricing rules and commitment**

Consider first the pricing rules. The greatest danger of ex post expropriation exists when some form of UK-style price cap is used. The idea behind price cap or incentive regulation was to provide firms with an incentive to perform efficiently. Thus a price would be set. If firms could provide quality service at lower cost than anticipated they could keep the resulting profit. Ex post profits may seem “too high” when the

> 11 South Africa provides a vivid illustration of the politics of pricing in a state owned water system. Government efforts to raise prices so as to cover more costs were strongly attacked by opponents under an anti-privatization banner, even though no privatization was actually proposed, just price reform. The word “privatization” provided emotional pull.

> 12 For state-owned firms governments may use performance contracts such as the contrat-plans found traditionally in France

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