metadata: authors: 0: author: Pargal,Sheoli
count: Latin America,Caribbean
docna: 0: docna: Regulation and private sector investment in
            infrastructure - evidence from Latin America
docty: Policy Research Working Paper
subtopic: Telecommunications Infrastructure,State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Railways Transport,Energy Policies & Economics,Hydrology,Privatization,Energy Privatization,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: International Economics and Trade
abstracts: cdata!: The author assesses the importance of
            the regulatory framework as a determinant of private sector
            investment in infrastructure. She uses recently compiled
            data on private and public sector investment in the water,
            power, telecommunications, railroads, and roads sectors
            between 1980 and 1998 in nine countries in Latin America.
            The author finds that the most significant institutional
            determinant of private investment volumes is the passage of
            legislation liberalizing the investment regime. This is
            important because it indicates that the legal basis for
            reform is probably more critical in determining the quality
            of the investment climate than specific aspects of the
            institutional framework governing private sector
            participation. In accordance with intuition, the
            author's results indicate that government action to
            increase regulatory certainty and minimize the perceived
            risk of expropriation through the establishment of
            independent regulatory bodies is a critical determinant of
            the volume of private investment flows. She also finds that
            the general relationship of private to public investment is
            one of substitutability.
repnme: repnme: Regulation and private sector investment in
            infrastructure - evidence from Latin America
display_title: Regulation and private sector
            investment in infrastructure - evidence from Latin America
listing_relative_url: /research/2003/04/2329630/regulation-private-sector-investment-infrastructure-evidence-latin-america
topicv3: Water m1326522 137,Power and Electricity Sector m1327094 515,Privatization m1327236 1283,Telecommunications and Broadband Access
            m1327340 286,Railways m1327400 166
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: Policy Support (SECPS)
no_of_pages: 48
author_keys: 0: author_key: 95761
model_extractions: | POLICY RESEARCH WORKING PAPER 3037

# Abstract

Pargal assesses the importance of the<sup>regulatory</sup> framework as a determinant of<sup>privatesectorinvestment</sup> in infrastructure. She uses recently<sup>compileddata on</sup> private and public sector investment<sup>in the water,power,</sup> telecommunications, railroads, and<sup>roadssectors</sup> between 1980 and 1998 in nine countries<sup>inLatin</sup> America. The author finds that<sup>the most significant</sup> institutional determinant of private<sup>investmentvolumes</sup> is the passage of legislation liberalizing<sup>the investment</sup> regime. This is important because<sup>it indicatesthatthe</sup> legal basis for reform is probably<sup>more critical</sup><sup>**in**</sup> determining the quality of the investment<sup>climatethan</sup> specific aspects of the institutional<sup>frameworkgoverning</sup> private sector participation. In<sup>accordance withintuition,</sup> the author's results indicate that<sup>governmentactionto</sup> increase regulatory certainty and<sup>minimizetheperceived</sup> risk of expropriation through the<sup>establishment of</sup> independent regulatory bodies is<sup>acriticaldeterminantof</sup> the volume of private investment<sup>flows.Shealso finds</sup> that the general relationship of<sup>privateto public</sup> investment is one of substitutability.

This paper-a product of the<sup>PolicySupportDivision,CorporateSecretariat-ispartofalargereffortintheBankto</sup> understand the role of institutions<sup>**in**development. Copies of the paperare available freefrom the World Bank,1818H</sup> Street NW, Washington, DC 20433.<sup>PleasecontactSheoliPargal,room MC11-153,telephone202-458-1951,fax 202-</sup> 522-1630, email address spargal@worldbank.org.<sup>PolicyResearchWorkingPapersarealsopostedontheWebat</sup> http.//econ.worldbank.org. April 2003.<sup>(43pages)</sup> _The Policy Research Working_<sup>_Paper Series disseminates the findings of_</sup><sup>**_ivork_**</sup><sup>_inprogress to encourage the exchangeof ideas about_</sup> _development issues. An_ **_objective_** _of_<sup>_the series is to get the findings out quickly,even_</sup><sup>**_if_**</sup><sup>_the presentations are less than fully polishedThe_</sup> _papers carry the names of the auithors_<sup>_and should be cited accordingly. The findings, interpretatiozs, and conclusions expressed_</sup><sup>**_in this_**</sup> _paper are entirely those of the authors._<sup>_Theydo not necessarily represent theviewof theWorld Bank,_</sup><sup>**_its_**</sup><sup>_ExecutiveDirectors, or the_</sup> _countnes they represent._ Produced by the Research Advisory<sup>Staff</sup>
Regulation and private sector investment in infrastructure: Evidence from Latin America by Sheoli Pargal*

* The World Bank. Funding from the Regional Studies Program of the LAC Region of the World Bank is gratefully acknowledged, as is the invaluable guidance of Luis Serven. Thanks to Cesar Calderon and Luis Serven for disaggregated investment data and Luis Guasch for information on the characteristics of regulatory regimes. Thanks also to Phil Keefer, Michel Kerf, Arijit Sen, and Nils Tcheyan for helpful comments.
# I. **Introduction**

> This paper assesses the importance of the regulatory framework as a determinant of private sector investment in infrastructure, using recently compiled data on private and public sector investment in the water, power, telecommunications, roads and railways sectors in nine large countries in Latin America. Controlling for standard'determinants of investment, we

> analyze the impact of variables that represent different aspects of the prevailing regulatory regime on a country's ability to attract private investment in infrastructure.

During the last decades of the twentieth century many countries in Latin America undertook public sector reform and introduced private participation in formerly state-dominated sections of their economies through management contracts, concessions or outright privatizations. In the infrastructure sectors this was motivated by a desire to improve performance and increase efficiency in service provision, as well as by the fact that govemments were constrained in increasing service coverage or improving public utility performance by limited fiscal resources and a multitude of competing claims on these resources. But investment in infrastructure is characterized by large up-front, usually sunk, costs that lead to a high risk of expropriation, long gestation lags before revenues are generated and revenues that are usually generated in local currency. These aspects lead to a need for both long-term commitment and long-term financing in local currencies. However, the limited depth of nascent capital markets is rarely able to generate funding of the maturity and volume that were necessary to finance private infrastructure investment in Latin America, which resulted in an effort to attract foreign capital. Analysts agree that an environment of macroeconomic and political stability, policy credibility, and the existence of a sound regulatory framework are necessary for lowering the perceived risk of expropriation and thus for attracting private capital. In particular, the character 3
of the entities entrusted with<sup>regulationdeterminesconfidencein the integrity of the systemas a</sup> whole (see, e.g., Kerf et<sup>al1998). In thispaper,we relatethe amount of privateinvestment</sup> attracted in each infrastructure<sup>sector in the countriesstudiedto a set of independentvariables</sup> that includes the characteristics<sup>of regulatoryentities.Thisis a first attempt to test the assertion</sup> that the lack of independent<sup>regulationcan be a major hindranceto attractingprivate sector</sup> investment in infrastructure<sup>in developingcountries.</sup> The study is of particular relevance<sup>for reforming countriessince the LAC regionis,</sup> among the regions in the<sup>world, furthestalong the road to deregulationof basic infrastructure</sup> services. It faces second-generation<sup>issues of appropriateregulationthat othershave yet to</sup> encounter. By characterizing<sup>regimes in termsof their ability to attractprivateinvestment in</sup> infrastructure, the analysis<sup>providesanempiricalfoundationfor policy choicesrelatedto</sup> institutional structure and<sup>regulatoryframeworks.Inaccordancewith intuition,our results</sup> indicate that government<sup>action to increase regulatorycertainty and minimizethe perceived risk</sup> of expropriation through<sup>the establishmentof independent regulatory bodiesis a critical</sup> determinant of the volume<sup>of private investment flows.</sup> This paper is organized<sup>as follows. SectionII providesbackgroundonthe broad</sup> experience of the countries<sup>beingstudied and the approachtaken here towardsassessing the</sup> quality of the regulatory environment.<sup>SectionHIdiscussesthe data.Section IV and V describe</sup> the estimation strategy and<sup>empiricalfindings of theanalysis.</sup>

[l. Private investment in infrastructure<sup>in Latin Ameriaes</sup> Our study covers Argentina,<sup>Brazil, Bolivia,Chile, Colombia,Ecuador,Mexico, Peruand</sup> Venezuela between roughly<sup>1980 and1998.Averageannualpublicand privateinvestment</sup> 4
levels by sector and country<sup>beforeand after the passageof legislationpermitting private entry</sup> are shown in appendix<sup>I (Table 5a).AppendixII displays the evolutionof private and public</sup> investment by sector and<sup>country over theperiodstudied.</sup> Telecommunications,<sup>power, and roadsare the sectors for whichalmostall the countries</sup> in our sample had passed<sup>liberalizinglegislation by themid1990s.Thereiswidevariationinthe</sup> year in which legislation<sup>was passed in thesecountries,with Chile and Argentina being the</sup> earliest movers -- the<sup>first infrastructure regulatoryagency inChile (Subtel)was establishedin</sup> 1977. Liberalization<sup>(through the introduction of competitionand privatesector participation)</sup> has also been deepest<sup>and most wide-rangingin Chileand Argentina.For example,these arethe</sup> only countries to have<sup>enacted legislationopening thewater sector to private investment.</sup> Interestingly, the passage<sup>of legislationpermittingprivate entry wasnot alwaysa pre-condition</sup> for private sector investment<sup>indifferentsectors.In Bolivia,for instance,threerailway</sup> concessions were granted<sup>in1996 while the relevantlegislationwas enacted only in 1998.</sup> However, in general, the<sup>enactmentof legislationformalizesthe liberalizationof the sectorand</sup> provides greater security<sup>about the irreversibilityof the process of openingup.</sup> The striking increase<sup>in averageannualinvestment in telecommunications and electricity,</sup> as well as the large jump<sup>inthe share of privatesectorinvestmentin thesesectorsandin the</sup> roads sector after liberalization<sup>areillustratedin Figures1 through 6.In telecommunicationsand</sup> power the average annual<sup>share of public spending in total investmentspending declined to</sup> significantly less than<sup>50%almostacrossthe boardafter liberalization.Prior to theopeningof</sup> the sector, in fact, private<sup>investment in telecommunications was negligibleor actually zero.</sup> Following liberalization,<sup>private investment increasedand publicinvestment declined,so that by</sup> 1998 private investment<sup>exceeded publicspending in thesector in almostall the countries</sup> _5_
> studied. Most countries in the sample granted initial exclusivity periods to privatized telecommunications firms or set limits on entry into the sector.<sup>1</sup> In general, the liberalization of

> access and tariffs came later. Similarly, between 1980 and 1998, public investment in the power sector generally declined while private investment increased, ultimately exceeding public

> spending. Liberalization in the power sector was usually accompanied by the restructuring of vertically integrated utilities.

> While legislation permitting private entry into the roads sector had been approved in five of the nine countries by 1993, the role of the state continued to be substantial even after that. With the striking exception of Mexico, which launched an ambitious toll-road program in the late 1980s, annual public investment in roads in most Latin American countries remained much

> higher than private investment. Private investment in roads increased slowly - the share of the private sector in total investment after liberalization typically remained below 50%.

> Public investment in the water sector also greatly exceeded private investment in Latin

> America throughout the period, reflecting the limited liberalization of the sector. This was true even in Chile. However, largely driven by the concession contract for Buenos Aires, private investment in water in Argentina grew to exceed public spending during the 1990s. Interestingly, private investment in Bolivia's water sector also rose to substantially exceed public spending, particularly after 1991 - despite in the absence of the passage of enabling legislation.

> A possible explanation for the difference in the average share of private investment in

> roads and water as compared to power and telecommunications may lie in the natural monopoly

> elements of the roads and water sectors. The low traffic density of rural and secondary road networks means that they are less amenable to cost covering tariffs and thus less attractive to

> lColombia and Ecuador did not privatize. However, Colombia allowed "controlled competition" in long distance

> and free entry in fixed line local service.

6
private concessions. So there is likely to always be a need for public spending on roads. A similar argument relating to the cost of provision and scale economies has been applied to rural water systems. In addition it is often politically difficult to "auction off" the responsibility to ensure road access or the responsibility for basic water service to the private sector because of the perception that these are core infrastructure services that it is the state's obligation to provide. Finally, water and power are the sectors in which the need for tariff adjustment is usually most pressing. This makes the political economy of private entry especially relevant in these sectors. Particularly in the case of water, where the general public (and not a small group) is often affected, anecdotal evidence points to the political difficulty of raising tariffs to cover costs. In fact, such tariff increases led to the failure of several concession contracts in the late 1990s.

# **III. Analytical approach**

While there is a large empirical literature on the determinants of investment, including investment in infrastructure, this literature has mainly focused on testing traditional economic theories of investment behavior (see Everhart and Sumlinksi (2001) for a recent overview) rather than on assessing the contribution of the regulatory framework to the environment for investment. Recent empirical work has, however, demonstrated the critical role of the institutional environment in determining the magnitude of investment flows. For instance, the option approach to investment reviewed by Serven (1996b) underlines the deterrent effect of uncertainty on private investment, especially when investment is sunk. Investor perceptions about the probability of reform reversal are often a key determinant of their willingness to invest. The general lesson from this analytical and empirical literature is that, by affecting investor confidence, the stability and predictability of the incentive framework may be even more 7
important than the level of investment incentives<sup>in determiningthe volumeof private</sup> investment.

Recent econometric work by Scott Wallsten<sup>(2001 a, 2002) on telecommunications</sup> reform in developing countries is very relevant<sup>tothe analysisdescribed in thispaper.Wallsten</sup> (2001a) finds that country level telecommunications<sup>performanceis positively relatedto</sup> regulation, as measured by a dummy indicating<sup>whether the countryhad establisheda separate</sup> telecommunications agency not directly under the<sup>controlof a ministry.That study usesa fixed</sup> effects approach to explore the impact of privatization,<sup>competitionand regulationon</sup> telecommunications performance in Africa and<sup>LatinAmericabetween1984and1997.</sup> Wallsten (2002) shows that countries that established<sup>separate regulatoryauthoritiesprior to</sup> privatization saw increased telecommunications<sup>investmentcomparedto countries that did not,</sup> and, also, that investors are willing to pay more<sup>for telecommunicationsfirmsin suchcountries.</sup> These findings are consistent with the hypothesis<sup>that investorsrequirea risk premium to invest</sup> where regulatory rules remain unclear. Our analysis<sup>contributesto thisliteratureon the role of</sup> regulation in private sector development. We<sup>use detaileddata on measuresof regulatory</sup> independence in addition to sectoral data on both<sup>private and publicinvestmentacross the major</sup> economies of Latin America. This allows us<sup>to more thoroughlyinvestigatethe importanceof</sup> independent regulatory institutions for the climate<sup>for private investment.</sup> The effectiveness of regulatory institutions depends<sup>on thestructure andprocessof</sup> regulation, key aspects of which are the independence,<sup>competenceand clarityof mandateof the</sup> regulatory agency, the transparency and openness<sup>of the regulatory processand the existenceof</sup> formal oversight and timely judicial review.<sup>2Smith(1997a,b) discussing the "desirable"</sup> attributes of utility regulators considers independence<sup>fromthe regulatedfirm,customers and</sup> 2 See Noll (2000) for an exposition.

8
political authorities as being<sup>essential.Heunderlines theimportant trade-off betweentheneed to</sup> limit regulatory discretion (as,<sup>for example,throughregulation by contract)in order to reduce the</sup> risk of expropriation and the<sup>needto retainthe flexibility to respondto new environmentaland</sup> market conditions (for example,<sup>in rapidlychangingsectors like telecoms).The opennessand</sup> transparency of the regulatory<sup>process lessen the probability of captureby different interest</sup> groups. An important additional<sup>considerationis the country'sstabilityand reputationfor</sup> respecting private property<sup>rights --whichcan go a fair way inassuaging investor concerns,and</sup> would allow the regulator<sup>to retainsubstantialdiscretionwithout significantly increasingthe cost</sup> of capital. But the ultimate<sup>accountabilityof theregulator is critical.</sup> In this paper we have described<sup>theregulatory environmentin the countriesand periods</sup> under study in terms of<sup>the followingaspects:</sup> o The passage of legislation<sup>that permits privateinvestmentin sectorstraditionallyreserved</sup> for the public sector. The<sup>passageof enabling legislationis particularlyimportant</sup> because Latin American regulatory<sup>frameworksare rooted in civillaw.</sup> o The existence of a regulatory<sup>body.</sup> O Whether the regulator<sup>is autonomousor not.Autonomy or independenceis captured by</sup> the regulator's attributes<sup>-whether the regulatory body is housed outside the government;</sup> whether the regulator has<sup>a separatesourceof funding(i.e., independentof the vagaries</sup> of annual budgetary appropriations);<sup>and,the degreeofpopularsupport for the regulator,</sup> measured by whether both<sup>the legislatureand the executivebranchare involved in</sup> appointing the regulatory<sup>body.Lacking data,we wereunableto assessthe importance</sup> of aspects of independence<sup>such assecurity and natureandlength of tenure of regulators</sup> (e.g., staggered terms that<sup>are not coincident with the electoralcycle), etc.</sup> 9
- The size of the regulatory agency. A larger body would limit the probability of capture by different interest groups (as well as the government). Whether or not the prospect of being able to capture the agency would make a smaller agency more attractive to private investors is an empirical question. A larger size would allow for a range of professional expertise and diversity of opinion (see, e.g., Smith 1997a, b, c), both critical to the competence of the agency. On the other hand, commentators have argued that a smaller agency could be more efficient in decision making and more predictable and that

individual regulators might be more accountable than those in large commissions - which would all make a smaller agency more attractive from the investor point of view. Thus, the direction of the relationship between the size of the regulatory body and private investment would depend on the net effect of these factors.

- The degree of risk borne by the investor as measured by whether the tariff regime is rate of return or price-cap. Rate- of-return tariff regulation limits the risk taken by the investor vis a vis a price-cap regime and might hence be positively related to private investment in infrastructure. Also, Alexander and Irwin (1996) present evidence that price-cap regulation, by subjecting firms to greater risk, increases the cost of capital.

# ffV. Data

Data sources are described in Table 1. Macroeconomic data are taken from the World Bank's World Development Indicators database and the IMF's International Financial Statistics. Investment data by sector were obtained from official publications and directly from the governments of the countries studied. (Further details are provided in Calderon and Easterly (2001)). Data on regulatory variables were obtained from Guasch (2001).

10
As a control variable, we use a physical<sup>measureof the infrastructurecapital stock each</sup> year by sector. This consists of<sup>the following:for roads,total road lengthand paved road length;</sup> for railroads, total length of the<sup>rail network;for telecommunications,the number of telephone</sup> mainlines; for energy, the electric<sup>generatingcapacityin kilowatts,and,for water,the growthin</sup> the percentage of the population<sup>with accesstocleanwater. Pritchett(2000) haspointed out that</sup> standard expenditure-based units<sup>of capital,particularlypublic capital,areofteninaccuratein</sup> what they measure. Especially<sup>whenit comesto the publicsector and incountrieswhere the</sup> government is a large investor,<sup>the divergencebetweeninvestmenteffort and public sector</sup> capital stock is very high.<sup>3</sup> This<sup>renderssuspectanalysesthat equatepublic spendingon</sup> infrastructure to the value of infrastructure<sup>capital.With that caveat in mind,wehave chosento</sup> use physical measures of capital<sup>stock ascontrols, eventhoughthey are not comparableacross</sup> sectors.

The regressions include a dummy<sup>thatis 1 in years followingthepassageof legislation</sup> permitting private investment in utilities<sup>(since thesesectorswereoftenconsidered the</sup> prerogative of the state). Even though<sup>privateentryhadcommenced prior to thepassageof</sup> relevant legislation or the setting-up<sup>of formallegaland judicial frameworksfor private</sup> participation in some countries,<sup>we usethe passageof legislation(ratherthanthe earliest private</sup> entry into the sector in each country)<sup>as our measure of liberalizationsincethereis greater</sup> certainty implied by the existence<sup>of a formal legal basis for private investment.</sup> Summary descriptive statistics for the<sup>entiredataset and for theset of variablesmeasuring</sup> regulatory structure are included<sup>in AppendixI, Tablesla and2a.Since,for the most part,</sup>

> **3** "(T)he potential contribution<sup>to current andfuture productionof a capitalstock isnot thesame aswhat happened</sup> to have been spent on it, especially<sup>when governmentsarethe investors."Pritchett (2000),ppxx.</sup>

11
liberalization and the development of regulatory frameworks started only in the 1990s, there are substantially fewer observations on the regulatory variables.

Table 1. Data sources

|Variable|Datasource|
|---|---|
|RealGDP|WBWorldDevelopmentIndicators|
|Investmentdeflator|WBWorldDevelopmentIndicators|
|GDPdeflator|WBWorld Development Indicators|
|Interestrate|IMFIFS|
|Realpublicinvestment|Calderon and Easterly, 2001|
|Realprivate investment|Calderonand Easterly, 2001|
|Regulatoryvariables|Guasch,2001|
|Physicalcapitalstock|CalderonandEasterly,2001|

Appendix I, Table 3a is the correlation matrix for the complete dataset and indicates how different determinants of private investment flows in infrastructure hang together. Public and private investment are significantly negatively correlated, supporting the idea that they are overall substitutes. Private investment is also significantly positively correlated with the dummy for the passage of reform legislation and with the existence of a regulatory body. The passage of reform legislation and the existence of a regulatory body are highly positively correlated but not perfectly so - reform legislation had been passed in only 40% of sector-country combinations prior to the establishment of a regulatory authority. Appendix I, Table 4a is the correlation matrix for the set of variables measuring aspects of the regulatory regime. The correlation between private investment levels and the passage of legislation opening the sector to private investment is significantly more positive in this subset of the data.

12
# V. **Estimation**

This paper examines two<sup>basicmodelsin whichfixed effects regressionsare used to</sup> explore the relationship between<sup>different groupsof independentvariables and private</sup> infrastructure investment.<sup>Inallmodels thedependentvariableis the logof real privatesector</sup> investment by country, year,<sup>and infrastructuresub-sector.</sup> The first model examines<sup>the determinantsof privateinfrastructure investmentusing (1)a</sup> dummy for whether or not<sup>a regulatorybody existed that year,and (2)a dummyfor whether</sup> had<sup>been passed by that year,as the only indicatorsof theregulatory</sup> enabling legislation environment. This model<sup>is also estimatedfor the four major sectorsseparately-</sup> telecommunications, roads,<sup>electricityand water -in aneffort to capturesector specific</sup> idiosyncrasies. The second<sup>modelis estimated for theyearsduringwhicha regulatory body</sup> exists. This permits the<sup>inclusion of characteristicsof the regulatoryregimeas explanatory</sup> variables in the analysis<sup>and providesan opportunitytoassessthe impactof the typeof</sup> regulatory regime on private<sup>investment flows to infrastructure.</sup> The reduced form equation<sup>being estimated,for eachcountry i,sector j, andyear t is:</sup>

**Ipijt=** f (Ig&jt, GDPit- ,<sup>**r,jt, pijt,**Kijt- l,</sup><sup>**Rij, Djt**)</sup>

where,

**Ipu,t=** Private sector investment

Igijt= Public sector investment GDPit-I = Gross domestic<sup>productlagged</sup>

**r,j=** Real rate of interest

**P,t** = Price of investment<sup>goods</sup>

**K,jt-** = Previous period<sup>physicalcapitalstock inthesector</sup>

**Rj** = Regulatory regime

**D,,t=** Dummy for whether<sup>or not a reformlawhasbeen passed</sup>

13
We are agnostic about whether public sector investment is complementary to or a substitute for private investment in the sector, noting the lack of consensus on this issue in the literature. Lagged capital stock would be expected to be negatively related to investment based on standard accelerator theories as well as marginal productivity and cost of capital arguments. The sign on lagged GDP is expected to be positive since higher income should lead to greater capacity to invest. The real rate of interest is included to capture the impact of the cost of financing on investment decisions, and a measure of overall investment goods prices<sup>4</sup> is included to account for the actual cost of investment. Both these "price" variables reflect the opportunity cost of capital and are expected to have a negative relationship with the amount of private investment attracted to a particular sector.

> The existence of a regulatory body and the passage of reform legislation would both be expected to be positively related to the volume of private investment flows since both represent

> government commitment to constraints on its own power. This results in less scope for discretionary/arbitrary action (e.g., against investor interests) and thus would imply a more

> certain business environment. The notion that investors require a risk premium to invest where regulatory rules remain unclear is supported by Wallsten (2002), who finds higher investor willingness to pay for telecommunications firms in countries that have established regulatory authorities.

In the second set of regressions the dummy for the passage of reform legislation is augmented by the following regulatory indicators: whether regulatory decisions involve ministerial input or the regulatory body is part of a ministry; whether the appointment of regulators involves both the legislature and the executive or only the executive; the size of the regulatory body; whether the- regulatory body is funded solely by the government; and, whether Investment price is calculated as the ratio of the investment deflator to the GDP deflator.

14
the tariff regime is rate of return<sup>or not.Most of these variablescapturethe degreeof autonomy</sup> of the regulator from the executive<sup>branchand the susceptibilityof the regulatoryregime to</sup> government control or subversion<sup>by capture(e.g.,by regulatedentities).</sup> Regulators who are appointed by<sup>the executivebranchof thegovernmentand thosethat</sup> are entirely dependent on the government<sup>for fundingare unlikelyto beindependent.Low</sup> autonomy, as indicated by these<sup>two variables,isexpected to be negatively related to investor</sup> confidence and private investment<sup>flows.</sup> One would expect that the regulatory<sup>body beinghoused in a ministry or ministerial</sup> involvement in decision-making would<sup>be negativelyrelated to privatesector confidencesince</sup> an arms-length relationship between<sup>the regulatorand the governmentis generallydesired.On</sup> the other hand, a ministerial stamp<sup>can be an importantsignalof commitment for private</sup> investors, which would imply a<sup>positiverelationshipwith privateinvestors.</sup> The expected sign on the coefficient<sup>of agency size is ambiguous:To theextent thata</sup> larger agency is likely to be more<sup>balanced and competent--and less likely to becaptured-- a</sup> positive relationship between the<sup>size of the regulatory body and privateinvestment might be</sup> expected. However, ease of capture<sup>might beattractiveinsome governancecontexts.</sup>

# VI. **Empirical** rmdings

This exploration of the determinants<sup>of private infrastructure investmentover time uses</sup> the log of annual private sector<sup>investment(in millions of 1992 US$) ineachsectorand country</sup> (e.g., telecommunications in Argentina<sup>in1995) as the dependentvariable.Economy-wide</sup> control variables are: the log of<sup>publicinvestment in the sector and country eachyear,realGDP</sup> lagged one year, one period lagged<sup>physical capital stock inthe sector in the country,the real</sup> 15
price of investment goods, the real rate of interest, whether or not a law permitting private entry has been passed, and whether or not a regulatory body for the sector exists in the country. We include a time trend and sector dummies (omitted sectors are railways and gas) and pool the data over all years, sectors and countries covered. The estimation accounts for the panel structure of the data by using country fixed effects.

We report results of regressions in which both the investment price and the real rate of interest are included although including the real rate of interest leads to the loss of some 200 observations. This is because comparable real interest rate data was not available for some countries during the earliest years covered in this analysis.<sup>5</sup>

# _Detenninants of private sector investment_

The results of the primary regressions are presented in Models I-I[ in Table 2. Model I is largely consistent with intuition. The overall relationship of private investment and public investment is one of substitutability. As might be expected, private investment is positively related to past period real GDP, indicating that richer economies generate higher private investment flows. A 1% increase in previous period real GDP is associated with an increase of 4.6% in private investment levels. We use lagged real GDP as the explanatory variable to reflect the potential causal relationship between GDP and private investment.<sup>6</sup>

> 5Dropping the real rate of interest from the regressions and using only the investment price led to higher significance of the latter and no changes of note in the signs or significance of the coefficient estimates on the other variables.

> **6** Since the dependent variable is private investment in different infrastructure sub-sectors, and not total investment in the economy, the issue of reverse causality from investment to income or GDP is less likely to be a problem. We expect the effect _on_ GDP of private investment to be very attenuated and, given that infrastructure investment has long gestation lags, to act only over time.

16
Table 2. Country Fixed Effects Estimation

|Dependentvariable:|Logof<sup>realpri</sup><br>|<sup>vateinvestm</sup><br>|<sup>ent</sup><br>||
|---|---|---|---|---|
||**Model **<br> <br>|<br>|Model**II**<br>||
||Coef.<br>**t**<br>|<br>|Coef.<br>|t<br>|
|**Log**ofrealpublicinvestment<br>|-.1201513<br>|-2.033**<br>|-.3324242<br>|-3.109**|
|LogoflaggedrealGDP|4.607274<br>|6.695**<br>|6.830853<br>|2.893**<br>**|
|**Trend**<br>_|.2715046|5.483**<br>|.3513241<br>|2.157<br>|
|**Laggedcapitalstock**|2.94e-07|2.488**<br>|-1.80e-07|-0.482|
|Regulatorybodyinplace<br>|.2573572<br>|0.497<br>|||
|Realrateofinterest|-.0118967<br>|-3.775**<br>|-.0131696<br>|-0.420<br>|
|**Investmentrice**<br>|-.131716<br>|-0.112<br>|.7038148<br>|0.145<br>**|
|Dummy:Passageoflegislation<sup>opening</sup><br>**thesector_**|3.640372<br>|7.026**<br>|6.087679<br>|5.717<br>**|
|Dummy:Telecommunications|.5296759<br>|0.819<br>|6.806443<br>|3.200<br>|
|Dummy:Roads<br>|.6889568<br>|1.258<br>|1.643749<br>|1.179<br>|
|Dummy:Water<br>'|-2.344596<br>|-4.135**<br>|1.604541<br>|0.982<br>|
|Dummy:**Electricity**<br>|.9701421|1.789*|1.725853<br>|1.181<br>**|
|Regulatorybodyinsidetheministry<br>|||4.018742<br>|2.858<br>**|
|Dummy:Appointmentofregulator<br>approvedbylegislature<br>|||-5.512656<br>|-2.370<br>|
|Number of membersofregulatory<br>commission<br>|||.2788061<br>|1.556<br>**|
|Dummy:Regulator'sbudget<sup>solely</sup><br>fromgovernment|||-5.512654<br>|-3.489<br>|
|Dummy:Rateofreturnlegislation|||-.9717241<br>|-0.472<br>|
|Constant|-55.26021|-6.700**|-86.95147<br>|-3.107**|
|NumberofObs.|693||183<br>||
|R-sqwithin<br>|0.5122||0.6469J||
|*Significantat10%level<br>**Significantat5%level|||||

Investment volume is negatively<sup>related to the realrateof interest and to thepriceof investment</sup> goods but significantly positively<sup>related to whetheror not legislationenablingprivate entryhas</sup> been passed - the mere act of<sup>liberalizingprivateentry into a sector increasesprivateinvestment</sup> by 3.6%. Interestingly, the<sup>dummy for passageof suchlegislationabsorbsa fair amount of the</sup> effect of having a regulatory<sup>body in placeand indicatesthat in manycasesthe legal basis for</sup> private entry is probably more<sup>importantthanthe actualinstitutional frameworkgoverning</sup> private sector participation.<sup>7Usinga dummy to capturetheopening of the sector is limitingin</sup> that it does not capture critical<sup>elementsof the competitiveenvironmentpost-</sup>

> 7 When we ran the regressions<sup>without includingthe dummyfor legislationliberalizingprivate entry we obtained</sup> higher significance on the existence<sup>of a regulatorybody.</sup>

17
opening/privatization which would affect incentives to invest. Whether a firm facing competition is likely to invest more or less than a monopoly is an empirical question. In several cases Latin American state-owned infrastructure firms were privatized as monopolies or granted "exclusivity periods" of varying lengths, as in the telecommunications sector. As shown by Wallsten (2001b) in his study of telecommunications privatization in developing countries, granting a monopoly concession seriously reduces investment by the privatized firm relative to firms that face competition. Unfortunately such data were not available for most of the sectors and countries studied.<sup>8</sup> The estimation includes previous period capital stock since the coefficient on it is highly significant, although it is a physical measure that varies by sector and is not easy to interpret. The coefficient on capital stock is positive, which is contrary to what theory would suggest. However, this appears to be an artifact of aggregation since it is uniformly negative in the regressions disaggregated by sector.<sup>9</sup> Finally, the primary regressions show that after controlling for other factors, the water sector received significantly less private investment than the other sectors, while private investment in power was relatively higher than in the other sectors.

# _Characteristics of the regulatory system_

Given that a regulatory body exists, what aspects of the regulatory structure are critical to attracting private investment in infrastructure? Model II in Table 2 presents the results of a fixed effects regression restricted to the years after a regulatory body had been established. The

> 8 In a study of Latin American countnes, Martin et al (2001) show that infrastructure privatization has an impact on GDP per capita, with the effect both, being dependent on whether privatization occurs in the transport or the utilities sectors and _varying by the form of privatization:_ whether **it** is through greenfield investment, divestitures or concessions. Since our investment data are not disaggregated by the form of private participation we have used the date of the passage of legislation opening up the sector in the analysis.

> 9 Dropping this variable made no difference to the sign or significance of other variables.

18
passage of legislation opening the sector is still a significant and positive determinant of the volume of private investment flows, and public investment volumes are clearly being substituted for by private investment. While the sign and significance of the other economy-wide variables are unchanged, the real rate of interest and investment price index are no longer significantly different from zero. Also, after controlling for regulatory factors, the telecommunications sector appears to attract significantly more private investment than the others.

In _terms_ of the regulatory variables, some results warrant deeper analysis. For instance, private investment volumes are significantly positively related to the regulatory body being located inside a ministry or with ministerial involvement in regulatory decision-making.<sup>10</sup> In addition, systems in which regulators are appointed by the executive are associated with greater private investment than those in which the selection of the regulator involves both the legislature and executive. On the face of it, both these aspects of the regulatory structure should militate against private investor interest since they imply lower constraints on the government's power to expropriate the value of an investment. However, on more reflection, these results may underline the critical need of investors for regulatory predictability and credibility. For instance, investors are likely to expect that decisions taken by a regulator housed in a mninistry will not be overturned. In addition, a regulatory body appointed by the executive may be considered stronger by virtue of having the full power of the executive branch behind it, and be perceived to speak with a clearer voice than a regulatory body whose appointees have to go through approVal by the legislature. A natural question is whether these considerations are specific to Latin

> **10** Smith (1997a) notes that a dedicated regulatory unit set up within a ministry is often a first step in the transition from the traditional model of ministerial regulation to a fully autonomous agency. Such a unit coordinates regulatory activity and fosters the development of the necessary technical skills and professional norms, often contracting outside professionals for technical tasks. Alternatively, as in some agencies in Colombia, ministerial participation in the regulatory agency is observed, although the agency has most of the attributes of an independent entity.

19
America. They may result from the historical existence of generally strong executive branches on the continent, which would mean that such arrangements increase investor certainty about government intentions and would, thus, result in higher private investment than otherwise.

Consistent with intuition, , private investment is positively associated with the regulator not being funded _solely_ by the government. This is an important element of regulatory independence. In addition, the number of commnissioners or regulators is positively related to investment volumes (significant at 12%) reflecting the possibly greater independence, broader expertise, and lower likelihood of capture of a larger commission.'" Although not significant, investment volumes are negatively related to rate-of-return tariff regulation which limits both downside and upside risk and also caps possible returns to investment. Alternative tariff regulatory mechanisms such as price caps would provide the opportunity to earn higher than the fixed rate of return, which would compensate for the higher risk of investment in sectors like infrastructure.

_Sector specific results_ Table 3 presents the results of the base regression for the telecommunications, roads, electricity and water sectors separately. Multicollinearity among the indicators of regulatory structure and lack of variation of these variables over time within each country led to the decision not to run sector specific models with regulatory variables included.

Public and private investment in telecommunications and power are strong substitutes. A somewhat weaker but still substitutable relationship is observed in the water sector. In roads the relationship is complementary but not significant. A complementary relationship between public

> 1 As noted earlier, ease of capture could go either way in attracting investor interest. It is likely, however, that the true relationship between the size of the regulatory body and private investment is non-linear - reflecting the tradeoffs in terms of speed of decision-making vs. risk of capture between small and large regulatory bodies.

20
and private investment in the roads sector would indeed be expected because of the difficulty of obtaining private financing for non-primary highways.<sup>12</sup> In all cases higher lagged GDP is associated with higher private investment volumes, and, in contrast to the findings of Models I and II, lagged capital stock is negative and significant in all the sectoral regressions apart from the one for water.

Table 3. Fixed Effects regressions by sector

|In_pvt|Telecoms||Roads||Power||Water||
|---|---|---|---|---|---|---|---|---|
||Coef.|t|Coe£|**t**|Coef.|t|Coef.|t|
|Logof**realpublic**<br>**investment**|-0.2942|-3.189**|0.1825|0.409|-0.7662|-2.500**|-1.0194|-1.55|
|Logoflaggedreal<br>GDP|5.8493|4.356**|5.7597|4.312**|4.0419|3.435**|6.4141|4.003**|
|Trend|0.4144|3.608**|0.3525|3.278**|0.5119|4.703**|0.3059|2.852**|
|**Laggedcapitalstock**|0.0000|-2.168**|0.0000|-4.703**|-0.0004|-4.101**|0.0018|0.000|
|Regulatorybody**in**<br>place|-1.0046|-1.077|-0.6995|-0.692|0.1993|0.202|0.3486|0.292|
|**Investmentprice**|1.3759|0.628|4.2064|1.815*|1.6965|0.783|1.7566|0.798|
|**Realrateofinterest**|-0.0058|-0.967|-0.0059|-1.007|-0.0092|-1.620|-0.0205|-3.493**|
|Dummy: Legislation<br>**opening thesector**|5.2836|5.6**|5.4172|5.148**|1.8347|1.780*|1.8979|1.476|
|**Constant**|-67.5412|-4.189**|-66.2719|-4.447**|-41.5051|-2.912**|-76.1823|-3.974**|
|NumberofObs.|159||142||159||109||
|R-sqwithin|0.7068||0.6322||0.5499||0.5274||
|*Significantat10%le<br>**Significantat5%le|vel<br>vel||||||||

The passage of legislation opening the sector to private entry is significantly positively related to private investment volumes in telecommunications and roads but less significant in the power sector and virtually not at all in the water sector. The result on power is somewhat surprising since liberalization of telecommunications and power has been deeper and wider than of the other sectors, with a decline in the importance of government investment going hand-inhand with the increase in private participation. This may reflect the fundamentally competitive

> 12 Consistent with our findings on roads, Dailami and Leipziger (1998)'s analysis of credit risk premiums in foreign currency private loans to greenfield infrastructure projects in developing countries finds that road projects commanded the highest risk premium in 1994-96.

21
nature of power generation, which may make the formal liberalization of entry less important than in other less contestable sectors. As in the regression on pooled data<sup>(ModelI), the</sup> existence of a regulatory body is not a significant determinant of private<sup>investmentin anysector</sup> after controlling for the passage of enabling legislation.

This leads to the question of whether the water sector perhaps differs in some crucial respect from other infrastructure sectors. As mentioned earlier, the natural<sup>monopolyaspectsof</sup> water distribution and transmission are stronger than in other utilities.<sup>Also,opening up the</sup> water sector to private investment, which may require an increase in tariffs<sup>to cover costs,</sup> generally tends to be politically more difficult than liberalization in "non-essential"<sup>sectors.' 3</sup> Investors may thus expect higher scrutiny for water sector investments. In view of<sup>the risks</sup> deriving from both the political sensitivities of privatizing water service<sup>provisionand the huge</sup> sunk costs of investment in the sector, investors are likely to be less willing<sup>to invest in water</sup> simply because the necessary legislation permitting private entry into<sup>thesector has been passed.</sup> They may look for a better developed regulatory framework and more<sup>detailed investor</sup> protections before committing funds to the sector. Finally, it is worth noting<sup>thatprivate entry</sup> into the water sector has usually taken place through the award of large concession<sup>contracts-</sup> which may not be linked to the passage of legislation. All these factors would<sup>lead to the</sup> observed lack of correlation between private investment and the passage of<sup>legislationpermitting</sup> private entry.

> 13 Perhaps in view of the perceived higher political risk of investments<sup>inwater, the numberof largeprivate</sup> international operators is lower than in the other sectors.

22
# VII. **Conclusions**

This paper has presented<sup>findingson institutionalfactors that affectthe investment</sup> climate for infrastructure<sup>using recent data fromthe nine largestLatinAmericancountries.We</sup> find that the most significant<sup>determinantof privateinvestmentvolumes overall(after lagged</sup> GDP) is the passage of<sup>legislationliberalizingthe investmentregime.This is important because</sup> it indicates that the legal<sup>basis for reformis probablymore criticalin determiningthe qualityof</sup> the investment climate<sup>thanspecific aspectsof the institutionalframeworkgoveming private</sup> sector participation. We<sup>also find that the generalrelationshipof privateto publicinvestment is</sup> one of substitutability.

The results on regulatory<sup>structureunderline investors'need for stability and</sup> predictability and reflect<sup>the historicalexistence of strong executivebranchesin most Latin</sup> American countries. A<sup>particularly intuitive result isthat privateinvestmentis positively</sup> associated with the independence<sup>and credibilityof the regulator,particularlyitsability to</sup> commit.

Over the period analyzed,<sup>controllingfor other factors,the water sector received</sup> significantly less private<sup>investmentthanother sectors whileprivateinvestmentinpower was</sup> relatively higher than<sup>in the other sectors.The sectoralanalysis indicatesthatthe water sector</sup> differs materially from<sup>the other threesectors: private investment in water is not significantly</sup> affected by the passage of<sup>reformlegislationin the sector and publicexpenditure is very</sup> important and only mildly<sup>substitutablefor private spending.Politicaleconomyconsiderations</sup> appear to make private<sup>investors morewary of enteringthewater sectorthan the roads, power</sup> and telecoms sectors.

23