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REVENUE Seminar Leuven June 9th 2004

WP2.3 Management of investment funds

and theory of incentives

Yves Balasko

David Meunier

Emile Quinet

ENPC, CERAS

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Synthesis• 1 Introduction• 2 The principal agent model• 3 The case for an investment agency• 4 Public-Private Partnership • 5 Three polar cases

– motorways, – new rail tracks, – issues about multi-principals

• 6 Elements for case studies

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Principal-agent model

• Principal (P) wants agent (A) to produce according to P’s objectives, but divergence of objectives and asymmetry of information (adverse selection, moral hazard)

• P designs a menu of contracts for A, linking fee paid to A to (imperfect) observations incentive power of contracts : from cost-plus to price-cap

• thus, P selects a better A or obtains more from A, but at the expense of rent plus transaction costs; problem for implementation of control (audits, enforcement,…)

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Incentive regulation

• what is the order of magnitude of present welfare loss due to divergence of objectives ?

• what is the regulatory environment ?• informational ?

• transactional ?

• administrative and political ?

• importance of timing issues

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Investment agency

• Direct regulation of transport, or investment agency ?

• Missions:– implementing infrastructure investment, advising

and information gathering  

– planning / scheduling / organizing / implementing infrastructure operation (includes operating investments)

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Investment agency

• Discussion of advantages:–  independence : credibility of commitments, continuity of

infrastructure development–  outsourcing of debt, and outsourcing of risk ?–  better borrowing conditions (sometimes)–  reduction of costs, but possible transaction costs

and risks of deviation–  skills in contract engineering –  reduction of information asymmetries : may give precious

help whatever the precise definition of the agency

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Public-Private partnership (PPP)

• The choice between public and private management (and the balance between them) depends highly on :– divergence of objectives (externalities, market power)– financial aspects (cost of public funds compared to the

risk premium; leverage, ratings,...)– efficiency of control (depending on information

asymmetry, power of the regulator, commitment, ..)

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Three polar cases: the framework

• a public authority, possibly acting through an investment agency endowed with financial autonomy

• this public authority (or investment agency) can :– either build and run the infrastructure by itself– or franchise it to a private concessionaire under a BOT

contract– these two cases are extreme situations, many

intermediate possibilities are open

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Three polar cases: Motorways• Characteristics:

– uncertainty on traffic forecasts– externalities, for motorway users and outside, congestion and

environment– information asymmetry on real time operation– downstream market is competitive– superposition of demand segments :

• by nature (freight vs passengers; professionnal vs leisure;…)• by network use (long distance vs short, international vs nat ’l)

multiple principals or interest groups vs quasi-unicity of product (per motorway link).

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Three polar cases: Motorways

• Recommendations:– rue defining a bonus on the fee linked to the technical

quality of service provided,

– price-cap on average tariffs, allowing for time modulation, with appropriate principal monitoring § control

– the extra tariff (above the average price-cap) necessary to achieve a predetermined level of service should go to a fund managed by the public authority, not by the concessionaire

– consider endogenous duration of franchises (beware of possible side-effects)

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Three polar cases: Motorways

• Recommendations (continued):– size of the concession – furthermore, size of the

regulatory scope- should be adapted to size of the transport market; area concession ? (to take into account congestion externalities)

– if externalities are too high (case of urban areas) the system of concession is to be questioned compared to direct command and control by the public authority (with outsourcing but fee paid to outsources set independently of revenues from infrastructure charges)

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Three polar cases: New rail tracks• Characteristics:

– distinction infrastructure / operations– externalities lower than for roads– access to infrastructure more difficult to achieve : both pricing and

regulation (path allocation)– demand is segmented but products may be more differentiated– operators have more influence on final demand than for roads– downstream market is monopolistic / oligopolistic, incumbent

operator has higher cost but better information on demand;– very difficult to extract information from incumbent in order to

optimize the downstream market, and to control the proper level of investment and quality of service

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Three polar cases: New rail tracks

• Recommendations: – roughly the same as for motorways, plus (due to potentially

conflicting objectives of a profit-seeking infrastructure manager and of a regulator, e.g. for path allocation) :

– the concession to a private firm could preferably be limited to the cases of small links (tunnels)

– the oligopolistic nature of the market should lead to set infrastructure charges below marginal cost, and information asymmetry could lead to differentiation of charges between incumbent and entrant.

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Three polar cases: issues about multi-principals

• Characteristics :– several adjacent regulators (e.g. country regulators)

– European Commission operates somewhat like a super-regulator above country regulators

– regulators suffer from information asymmetry vis-à-vis the operators

– sub-networks may be in the same time complementary and substitutable, depending on the demand segment considered

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Three polar cases: issues about multi-principals

• Consequences:– for infrastructure funding, multiple regulators are likely to achieve a lower

efficiency level (but may be positive for commitment, protecion from collusion, …)

– adjacent regulators may induce sub-optimal pricing § investment

– each regulator should cover the « most completely possible pertinent transport market » (but pb of interconnected networks)

– on the ground of incentive and commitment, a hierarchy of regulators (decentralization) should be better than a single one (provided that local information on actions is better)

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Framework for case studies

• 1. Main actors and their missions/ strategies :

• 2. Relations between actors (delegation, contracts, co-ordination, collusion,..) :

• 3. General frame of contracts :

• 4. Resources and constraints :

• 5. System used for measuring  : reduction of information asymmetry ?

• 6. Incentive schemes and regulation :

• 7. Global analysis of organizational setting : incentive power of the system ? Efficiency ?

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Rather favourable elements Rather unfavourable elements Difficulties Clear public objectives Changing or vague objectives Conflict between objectives

Multiple authorities or interest groups Well-defined scope Unprecise scope or external dynamic

effects Relevant scope may evolve on the long term

Major information asymmetry

Minor information asymmetry (re)design an information system and impose it in the contracts

Good systemic analysis

Poor systemic analysis Analyse properly the actors and their interactions, the coherence of agency’s missions, and the acuteness of internal constraints

Good notions about demand and production functions

No notion or poor notions

Real will to have an independent entity Will to monitor very closely the agency Estimating the « right level of independence or autonomy »

Good vision of infrastructure needs Bad or biased vision of infrastructure needs

Low transaction costs High transaction costs Estimating transaction costs supposes to have a good analysis of the monitoring system needed to reach efficiency

Clear view of constraints allowed, proper definition and measure

Vague view of constraints allowed, wrong definition or measure

Defining the constraints beforehand, rather than after a major problem has really occurred

Identification and control of possible side effects or of multiple principals

No checking for possible side effects, or ignorance of multiple principals

Side effects may appear during specific phases of a dynamic process and become critical for selecting final equilibrium

Existence of reasonable external regulation Poor external regulation, or too tough external regulation

External regulation changes on the mid and long term

Better borrowing conditions for an agency Equivalent or more constrained borrowing conditions

Exogenous factors