Corbo-V Lüders, R.; Spiller P. The institutional foundations of economic reforms...

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS

THE INSTITUTIONAL FOUNDATIONS

OF ECONOMIC REFORMS:

THE CASE OF CHILE

by

Vittorio Corbo, Rolf Lüders and Pablo T. Spiller?

April 1, 1995

? Corbo and Lüders are Professors of Economics, Universidad Católica de Chile, Spiller is Visiting Professor of Business and Public Policy, University of California, Berkeley. Spiller acknowledges support from the Global

Operations Program at the University of California. David Decker provided able research assistance.

April 1, 1995CORBO, LUDERS AND SPILLER

I. Introduction

Looking at Chile's aggregate economic and social statistics since the 1970s (see Table I:1), one

cannot but wonder what has made Chile different from the rest of Latin America. Indeed, if we look at

Chile's statistics from the post war till the Allende period (see Table I:2), Chile does not look that different

from its neighbors, like, Argentina, Colombia and Uruguay.? It is tempting to say that the dismantling of the

protectionist state and the creation of a market economy during the regime of General Augusto Pinochet is at

the source of this transformation. We believe that the answer is deeper and more complex. Although the

reforms that were undertaken during the Pinochet regime are behind the transformation of Chile from a sleepy

South American country into the only, so far, Latin American tiger,? the main thrust of this paper is that just

the opening of markets would not have been enough.? What took place in Chile was a drastic institutional

transformation that provided the reforms with a lasting power and thus the required credibility to promote

private investment. This transformation has three basic features: first, the Chilean reformers systematically

(and we are tempted to say purposely) diminished the discretion of the government in the administration and

implementation of stated policy objectives; second, the Chilean reformers complemented the economic

reforms with social and political reforms that systematically diminished the ability of the government to

undertake unilateral changes in governmental policies; and finally, the Chilean reforms were undertaken in

the shadow of an institutional setting which provided for direct enforcement of the above constraints on

governmental decision making.

Indeed, these three conditions satisfy what Levy and Spiller (1994) call the three complementary

mechanisms to provide credibility and effectiveness to a generic regulatory framework --and hence to

facilitate private investment. The main purpose of these three complementary mechanisms is to restrain

arbitrary administrative action. As discussed in Levy and Spiller (1994), the Chilean reformers chose policy

credibility over policy flexibility. Indeed, as we will see, in several instances credibility had its costs as

? If at all, one wonders why Chile was performing worse than its neighbors.? See, Green, D., "Chile: The First Latin American Tiger?", NACLA Report on the Americas, v28, n1 (July-August, 1994), p.12-17.? This is what Douglass North would call, “setting the prices right.” See North (19xx).


reversing some of the chosen policies that turned out to be impractical or inappropriate was very hard to

achieve.

In this paper we focus only on a selected set of reforms, and we analyze how these reforms seem to

have been undertaken so as to limit the potential for governmental administrative discretion, as well as for

reversals by future governments. Thus, we will find that Chile's regulation of public utilities is based on very

specific legislation so that utility regulators have very little discretion on pricing and on which areas to be

regulated; that the appointment process to the antitrust commission is such as to limit potential influence by

either the government or the legislature; that the central bank is similarly organized so as to limit the influence

of politics on monetary policy; that the pension schemes links the interests of the working men and women to

that of Chile's companies; and that the welfare system was designed so as to limit its manipulation for political

reasons.

Overall the reforms seem to have had the intended effects. Although on some dimensions the Asian

tigers still outperform Chile (e.g., Chile's savings are a few points below that of the Asian tigers), its

institutional framework seems to place it on a different and higher level. Chile's reformed institutions limit

government discretion, make difficult any drastic shifts in policies, providing, then, commitment to a market

economy and encouraging private investment. What makes Chile different is that the commitment to the

economic reforms is based on the subtle interplay of economic and political institutions rather than on the

particular personalities of the party leader or president of the day, thus providing a more stable and credible

investment environment.

The purpose of this survey is to provide an in-depth analysis of its policies since the 1970s with

emphasis on the nature of its institutional design. We start with a brief historical background, followed by a

short analysis of Chile's institutions and its implications for policy determination and by an in-depth analysis

of some of the more interesting, and less analyzed, of the reforms.

II. Economic Background


The Chilean Economy at the end of the sixties.?

By the end of the sixties the Chilean economy was dominated by a very large and intrusive public

sector, and experienced almost twenty years of what today may be called moderate inflation: annual inflation

in the range of 30 to 40 percent. Relative prices of tradable goods differed much from foreign prices through

the widespread use of tariff and non-tariff trade barriers. Price controls were widespread, and the financial

sector was repressed through the use of controls on nominal interest rates with real deposit rates at times

becoming negative.

This state of affairs was the result of the implementation of an aggresive import substitution

industrialization strategy (ISIS) that started in the late 1930s as an answer to the world depression, and that

was later pursued as a development model under the influence of Raul Prebisch and the ECLA. To pursue the

ISIS, a battery of instruments were used, including trade incentives, the creation of large public enterprises in

the steel, oil, petrochemical, power, and other sectors. The government also intervened trough the allocation

of credit and the granting of subsidies. In the early "easy stage" of import substitution growth picked up, but

then faltered in the second half of the fifties. By this time Keynesian ideas were making their way in the

region, and aggregate demand policy was used to restore growth only to encounter chronic balance of

payments and inflation problems.

Some attempts at stabilization and liberalization of the trade regime were made during the Alessandri

(1958-1964) and Frei (1964-1970) administrations. The initial attempts failed as the fixed exchange rate that

was used to anchor the stabilization effort had to be abandoned as it was incompatible with the government’s

macroeconomic policy and, as a consequence, a large real appreciation developed. The Frei administration

introduced indexation mechanisms as ways of reducing the relative price distortions associated with moderate

but variable inflation, but the trade liberalization effort of the second half of the period was also abandoned

because of strong political opposition.?

? This section is based on Universidad de Chile (1963), Corbo (1974), and Ffrench Davis (1973). ? See XXXX (19xx).


The Chilean Economy During The Allende Years.?

The Allende administration (November 1970-September 1973) tried to apply a fairly radical

transformation of the economy, expanding drastically the role of the state in the control of production and

distribution of goods and inputs. In pursuing this objective the banking system and a large part of

international trade activities were nationalized. Furthermore, as the government lost control of aggregate

expanditures through a series of populist policies, price controls were established to avoid the emergence of

open inflation.

The isolation from the world economy reached its peak during this period. The average nominal

import tariff was 105%, with tariffs ranging from nil for some inputs and "essential" consumer goods to 750%

for goods considered as luxuries. There were also many non-tariff barriers, including the requirement for a

90-day non-interest bearing deposit amounting to 10 times the import value, import and export quotas, prior

approval for all types of imports, and multiple exchange rates. By 1973, there were six widely different

exchange rates, with the ratio between the highest and the lowest being 52 to 1. As a direct result of the

system of protection, export activities were heavily taxed. Not surprisingly, imports were concentrated on

intermediate goods, followed by capital goods, and a few "essential" consumer goods. Export earnings

became almost entirely dependent on copper exports and prices. Private capital inflows almost totally

vanished.

The government, directly or indirectly, took control of a large part of productive activities. The

agrarian reform, initiated in the Alessandri administration (1958-1964) and intensified during the Frei

administration (1964-1970), was drastically accelerated during the period, and all large states were practically

dismembered. The banking system was nationalized.?

In other sectors of the economy private businesses were taken over by workers' councils, or

alternatively company shares were bought by the government to extend what was then called the area of

? This section is based, in part, on Cauas and Corbo (1972), Bitar (1986) and Larraín and Meller (1991).? As the government could not pass the required expropriation law to take over the property of the banks from the previous shareholders, it offered attractive prices to buy the shares in the open market. This process took place mostly in 1971. By 1972 almost all the banking system was in public hands. CITE


social property. Multinationals were expropriated, in some cases, as with copper enterprises, without

compensation. This brought the government into conflict with various foreign governments, especially with

the US.

On the macroeconomic front, the Allende government pursued populist policies. In 1971, current

government spending grew by 12.4 per cent in real terms, and the fiscal deficit reached 10.7 per cent of GDP.

Fueled by this aggressive demand expansion, GDP grew 9 per cent in real terms in 1971 (Table 1). In the

same year, the money supply grew by 66 per cent in real terms -- a result of the large growth in high powered

money to finance the rising public sector deficit, and the inertia of prices.

Measured inflation in 1971 was relatively low, but price controls and commodity and factor market

rationing became widespread. During the following two years, the government continued its expansionary

policies. The fiscal deficit rose from 2.7 per cent of GDP in 1970 to almost 25 per cent of GDP in 1973. The

monetization of the deficit and import controls put pressure on domestic prices rose. Tighter price controls

were introduced, resulting in the development of active black markets for both final and intermediate goods.

There was a progressive deterioration of the current account deficit, which reached 3.9 percent of

GDP in 1972 (see Table 1). The large foreign reserves inherited from the Frei administration financed the

current account deficits of 1971 and 1972, but by August 1973 the reserves were exhausted, and the stage was

set for a major balance of payments crisis.

Economic Policies During the Military Government?

The government that took power in September 1973 inherited an economy closed to international

trade, dominated by the public sector, with accelerating inflation and a massive current account deficit.

Relative prices were severely distorted and the production and distribution of goods were determined mainly

by bureaucratic rules. The labor market was dominated by a few organizations which were fighting for

political rather than workers' objectives. The country had practically no foreign exchange reserves and the

nonfinancial public sector had a deficit of close to 25% of GDP (Table 1)

? On the reforms of the Pinochet regime see Corbo(1985), Edwards and Edwards(1987), Harberger(1985) Meller(1990), and Wisecarver (1992).


One of the main objectives of the military government that took power in September 1973, was to

eliminate the severe macroeconomic disequilibria that it inherited and to reestablish a market economy. The

reduction of inflation required a deep structural reform of the public sector to reduce the size of the public

sector deficit. To restore the role of the market as the main agent of economic development the Military

government undertook a major revision of public sector responsibilities, involving a drastic reduction in the

size of this sector and in its participation in economic activities, and a deregulation of commodity, financial,

and labor markets.

The initial 18 months of the new administration were spent in liberalizing prices and in initiating a

deep fiscal reform. By 1975, there emerged within the government, a team of economists with very strong

liberal ideas, which was dedicated to transforming Chile into a competitive, market oriented, open economy.

Towards this end, reforms were initiated in eighth main areas: (1) a stabilization program to reduce an

increasing inflation that was reaching a rate of 1000% per year; (2) public sector reforms with the purpose of

achieving macroeconomic stability and improving the efficiency of the public sector and its implications to

the economy as a whole; (3) trade reforms to reverse the existing level of protection and to open the

economy; (4) a social security reform to change from a pay-as-you go pension system into one based on

individual capitalization; (5) financial sector reform; (6) labor market reform to facilitate the drastic

reallocation of labor that had to take place from the highly protected import competing sectors towards the

export oriented activities; (7) a comprehensive privatization program; (8) regulatory reform is the basic utility

sectors; and (8) social sectors reforms to improve the incentive system in the production and provision of

social services and to target the provision of social programs to the poorest groups in the population.

To these major economic reforms, the military government, through a series of popular votes,

introduced major constitutional reforms that changed the way members of parliament were elected, modified

the balance of powers among the different branches of government and, in general, introduced substantial

checks and balances in the work of the government.?

The economic and social implications of the policies pursued by the Military regime have been

? See next section.


discussed at large elsewhere and we will not repeat them here.? Table 1 shows, however, that by the second

half of the 1980s Chile’s economy was growing at an annual average rate of more than 6%, a very rapid pace

for the region. Furthermore, its exports were diversified, its rate of investment and savings were high for the

region, and unemployment levels fell from the high level that characterized the early part of the Military

regime. It is in this macroeconomic environment that a democratic government was reinstituted.

Economic Policies in the 1990s.

The democratic government that came to power in March 1990 inherited an accelerating rate of

inflation (Figure 1), which had reached 27.3% in 1989, the highest level since 1980. The new government,

which was expected to increase attention to social issues, was faced with the immediate task of slowing down

inflation and conveying the message that maintenance of macroeconomic balance would be one of its main

objectives. Furthermore, it had to announce its views on the economic model introduced by the Pinochet

administration.

The newly independent board of the Central Bank implemented from the beginning an aggressive

stabilization program based on a sharp increase in real -- CPI indexed --interest rates on Central Bank paper.

Real interest rates on 10 year Central Bank paper were raised 230 basis points, from 6.9 to 9.2 percent per

year.

The resultant slowdown in real expenditures contributed to a reduction of GDP growth, to an increase

in the trade balance surplus, and to lower inflation. However, in a world of increasingly integrated capital

markets, a high real interest rate policy pulls in foreign capital that tends to offset the desired contractionary

effects of the interest rate increase. Not surprisingly, in 1990 the Central Bank ended up accumulating 2.4

billion dollars in reserves. The issuing of Central Bank debt to finance the reserve accumulation increased

Central Bank losses, as the Central Bank in effect borrowed at high domestic interest rates to invest abroad at

lower rates adjusted for exchange rate changes.

On the structural reform side, the Alwayn (1990-1994) and Frei (1994-) administrations embraced a

? See CITE


substantial part of the model developed during the Pinochet regime, and by now the model of an open

economy pulled by private initiative has achieved a large support across the different sectors of the chilean

society.? A major thrust of this paper is that the institutionalization of the reforms implemented during the

Pinochet years played a central role in the building of the new economic model.

To these major economic reforms, the military government, through a series of popular votes,

introduced major constitutional reforms that changed the way members of parliament were elected, that

shifted the balance of powers among the different branches of government introducing substantial checks and

balances in the work of the government. In this paper we do not intend to provide a comprehensive

discussion of the different reforms. Instead we will focus in detail on a few to highlight how they seem to

have been designed so as to provide commitment to a market based economy through limits on the

discretionary powers of the government. Before discussing the institutional nature of the economic reforms,

it is important to discuss the institutinal environment in which they took place.

III. Chile’s Institutional Background and Its Implications for Economic Reforms

Following Levy and Spiller (1994)? and North (1990), we define the institutional endowment of a

nation as comprising five elements: First, a country's legislative and executive institutions. These are the

formal mechanisms a) for appointment of legislators and decision makers, for making laws and regulations,

apart from judicial decision making; b) for implementing these laws, and c) that determine the relations

between the legislature and the executive. Second, the country's judicial institutions. These comprise its

formal mechanisms a) for appointing judges and determining the internal structure of the judiciary; and b) for

impartially resolving disputes among private parties, or between private parties and the state. Third, custom

and other informal but broadly accepted norms that are generally understood to constrain the action of

individuals or institutions. Fourth, the character of the contending social interests within a society, and the

balance between them, including the role of ideology. Finally, the administrative capabilities of the nation.

? Citation to survey studies.? This section is partially based on Levy and Spiller (1994).


Each of these elements is subject to change, and indeed, as we will see, some of these institutions were

changed by the nature of the economic and political reforms of the 1970s.

The form of a country's legislative and executive institutions influences the credibility of its policies.

The crucial issue is to what extent the structure and organization of these institutions impose constraints upon

governmental action. The range of formal institutional mechanisms for restraining governmental authority

includes: the explicit separation of powers between legislative, executive and judicial organs of government;?

a written constitution limiting the legislative power of the executive, and enforced by the courts; two

legislative houses elected under different voting rules;? an electoral system calibrated to produce either a

proliferation of minority parties or a set of parties whose ability to impose discipline on their legislators is

weak;? and a federal structure of power, with strong decentralization even to the local level.? Governmental

policy is likely to be far more credible in political systems that constrain executive and legislative discretion.

Note, however, that credibility is often achieved at the expense of flexibility. The same mechanisms that

make it difficult to impose arbitrary changes in the rules may also make it difficult to enact sensible rules in

the first place, or to efficiently adapt the rules in the face of changing circumstances.

For almost all its modern history, Chile has been a representative democracy. The period between

1973 and 1989, when Chile went through a period of military rule under General Augusto Pinochet stands out

as a 16-year exception to over 100 years of rule by civilian government.? For the rest of this 100- plus year

period, the country has been governed by a constitution that embodied the principles of separation of powers,

? For analysis of the role of separation of powers in diminishing the discretion of the executive, see Gely and Spiller (1990) and McCubbins, Noll and Weingast (1987, 1989), and references therein.? Non-simultaneous elections for the different branches of government tend to create natural political divisions and thus electoral checks and balances. See Jacobson (1990). For an in-depth analysis of the determinants of the relative powers of the executive, see Shugart and Carey (1992).? Electoral rules have also important effects on the "effective number of parties" that will tend to result from elections, and thus, the extent of governmental control over the legislative process. For example, it is widely perceived that proportional representation tends to generate a large number of parties, while first-past-the-post with relatively small district elections tends to create bipolar party configurations. This result has been coined Duverger's Law in political science. See Duverger (1954). More generally, see Taagepera and Shugart (1993). For analyses of how the structure of political parties depends on the nature of electoral rules (with applications to the UK) see Cain, Fiorina and Ferejohn (1987) and Cox (1987).? On the role of Federalism in reducing the potential for administrative discretion see Weingast (1993) and references therein.? Although there were other brief periods of democratic breakdowns, the Pinochet regime was the longest.


orderly transfer of authority, and regular elections between competing parties. For an extended period,

electoral rules were such that voters were, and still are, divided among multiple parties, with none strong

enough to govern or legislate, except by coalition. As a consequence, legislators' independence from central

party apparatus developed a legislature with a strong sense of local representation.? A series of constitutional

reforms between 1958 and 1973 shifted the balance of authority in favor of the presidency and elevated

national (rather than regional) politics and parties to center stage. These reforms granted more executive

powers at the same time that they developed stronger checks and balances.? The reforms increased the

potential for conflict between the legislative and the executive branches, which became evident during the

regime of President Salvador Allende. Thus, while not completely resistant to extreme pressure, we see

Chile's longstanding set of legislative and executive institutions and the nature of its checks and balances as

potentially providing some credible safeguards against arbitrary changes in government policies. This period

of extended stability, broken only by the military takeover in 1973, developed in Chile a strong respect for

institutions.?

To understand the subtle nature of Chile's checks and balances, it is useful to discuss in some detail

the nature of its formal political institutions, namely, the legislature, the executive, and the judiciary. Chile is

governed by a President who is elected by a ballotage process for a six year mandate.? Chile's legislature is

composed of two chambers. Senators are appointed for 8 years, while members of the Chamber of Deputies

are appointed for 4 years. Fifty percent of the elected Senators stand for reelection every four years, while all

Deputies must stand for reelection every four years. Elections are non-concurrent, so that, as in the United

? At the same time, concurrent elections provided for the development of bipolar coalitions that offered voters choices over national policies without the need to develop strong central parties (Shugart and Carey 1992, p. 174).? Shugart and Carey (1992, p. 183) call the system before the constitutional changes of 1958 and 1970 the "inefficient secret," as the regionalization of politics, and the relatively weak powers of the president, provided for a very dynamic legislature. Concerning the post-1970 Chilean system Shugart and Carey (1992, p. 200) describe it as the strongest among presidential systems. We discuss this issue further below.? One may ask whether this respect for institutions persisted even during the military regime of General Pinochet. Even then signs of respect for longstanding institutions are evident. For example, during the military regime the constitution was amended by a popular referendum. Similarly, the military regime's decision to return the country to a democratic system followed an electoral loss.? In February 1994 the Congress approved a reduction in the Presidential mandate from eight to six years. The President cannot be reelected for a consecutive period.


States, there are mid-term elections.? The Senate is composed of 38 elected and several non-elected

members.?

The electoral rules introduced prior to the 1989 referendum provide an advantage to the minority

parties and a strong advantage to less populated regions.? There are 60 districts for the Chamber of Deputies

and 19 for the Senate. Each district sends to the legislature two deputies and two senators. Each district's

seats are allocated based on number of votes for each party list. Unless the most voted list has more than

double that of the second ranked list, the district will send a representative from the two most highly voted

lists in the district. Thus, electoral rules provide strong incentives for the creation of alliances at the district

level.? On the other hand, presidential election rules (the ballotage) provide incentives for cross-party

alliances at the national level. Electoral districts are of unequal size. For example, for the 1989 elections,

District # 59 had 18,254 registered voters while district #18 had 102,540 registered voters. Even more

extreme differences appear in Senatorial districts. For example, in the 1993 elections, 38,000 voters voted in

Senatorial Region XI while in Region V-Coast, there were 380,000 voters. Thus, the most highly voted

? Because presidential elections are every six years while parliamentary elections are every four years, mid-term elections may occur two or four years prior to the next Presidential election. ? The non-elected members are: all living former presidents that served for six continuous years; two former Supreme Court Justices, to be appointed by the Supreme Court; a former Comptroller General, also appointed by the Supreme Court; four former Commanders in Chief, one respectively from the Army, the Navy, the Air Force and the National Police, to be elected by the National Security Council; a former University President, to be elected by the President of the Republic; and a former Minister of Economics, also appointed by the President. Currently there is no living former President in the Senate as Pinochet is still the Commander in Chief of the Army and Aylwin was President only for four years. The National Security Council is composed of the President, the Chief of the four branches of the military and the Comptroller General. ? The referendum was voted on July 30, 1989 and the Constitutional Reform Law #18,825 was passed by the legislature in August 1989, prior to the first democratic elections of December 1989. The electoral rules of the 1925 constitution, however, provided a slight advantage to the majority party. Although the proportional representation system provided for one deputy for each 30,000 inhabitants, the electoral rule allocated remaining votes to the largest parties (rule of cifra repartidora or división común), providing then a slight advantage. Thus, the Christian Democrats obtain in the 1965 election 55% of the seats in the Chamber of Deputies, with only 42% of the popular votes.? Consider a situation where ther are five independent candidates with the following percentage of popular support: 30, 25, 20, 15 and 10%. If each runs under a separate list, the two with the highest percentage will win. The third candidate, however, could win a seat if it would enter into a single two member list with the first candidate. In that case, the list consisting of candidates 1 and 3 would gather 50% of the vote, doubling the second most voted list. The second most voted candidate, however, could block such outcome by entering into a joint list with the fourth or fifth candidate. Such action, however, would not provide the latter two candidates with a seat but will block the third candidate from winning its seat. Thus, unless the second candidate promises something else in return for their support, the smaller candidates will have no incentive in joining in. Thus, the electoral system provides strong incentives for the creation of regional coalitions at the district level.


senator from Region V-Coast got 115,000 votes, while the most highly voted senator from Region XI got only

11,287 (both with 30% of the popular vote in the region). The upshot of the electoral rules is that regional

representation is important for congressional elections, thus creating a natural fragmentation of parties.

Indeed, in the current parliament, there are eight independent parties in the Chambers of Deputies (there are

also four independent deputies), while six parties are represented in the Senate. The Senate also has three

independent and eight appointed senators. The composition of the current congress shows the bias towards

the minority parties inherent in the electoral rules. In the last elections the second largest party, Renovación

Nacional (RN), obtained 16% of the votes for the Chamber of Deputies, against 27% for the governing

Partido Demócrata Cristiano (PDC). Nevertheless the RN holds 29 seats (or 24% of all seats) against 37 seats

(or 30%) for the PDC.?

The executive has important but not extreme legislative powers. Indeed, the constitutional reforms of

1989 diminished the legislative powers of the president, by limiting the power of its partial veto (from no

override to one with a 2/3 supermajority override), eliminated its decree powers, and eliminated the

president's ability to dissolve the Chamber of Deputies.? The President's main powers are in the realm of

budgetary policy. Only the President may introduce legislation concerning taxes, expenditures, public debt,

social security schemes (including private schemes), creating new public services and collective bargaining.

Also, in budgetary, expenditure or employment legislation, the legislature may not increase any proposed

appropriation. The legislature may, however, delete or reduce any item in the proposed legislation.? There is

also a strong germaneness constitutional limitation on amendments as the legislature may not attach to a bill

an item whose nature is unrelated to the bill in question.? As mentioned, the President has a partial, or line

? In the last presidential elections, which were concurrent with congressional elections, there were two main coalitions, a center-left and a center-right. The PDC was the leading party in the center-left coalition, while the RN was the leading party in the center-right coalition. There have not yet been mid-term elections since the end of the Pinochet regime as the constitution specified a transitory four year term for the first elected president.? See Shugart and Carey (1992).? Chile's constitution also requires a partial balanced budget, as it prohibits the legislature from approving an expenditure increase without identifying the sources of funds needed for such additional expenditures. Also, the President is the only party that can provide an estimate of revenues.? The constitution even requires that if such amendment were to be voted upon, the proponents of the amendment and the President of the Chamber should lose their seats.


item veto, which can be overruled only by a two-third majority in each chamber.

The Supreme Court and the Appeals Court are strongly independent. Their members are appointed

by the President from a slate proposed by the Courts themselves.? Judges of the Supreme and Appeal Courts

are appointed for an indefinite term, but must resign upon reaching 75 years of age. Thus, the Supreme Court,

as in the United States, constitutes a strong source of stability, and to some extent, of "unpredictability," as it

may side on important issues against the government.? There is also a Constitutional Court which is in charge

of determining the constitutionality of the actions of the executive and of the legislature. The Constitutional

Court is composed of seven members who serve for eight years and who cannot be removed. The

Constitutional Court is partially replaced every four years. The Supreme Court elects, in secret and successive

ballots, three of the members of the Constitutional Court. The President of the Republic appoints a lawyer, as

does the Senate. The National Security Council appoints two lawyers. Because of its composition, the

Constitutional Court is another source of policy stability.

Finally, Chile's checks and balances are further developed with the institution of the Comptroller

General. Among other functions, the Comptroller General must approve on the legality of the

administration's actions, including whether its decrees and resolutions (including budgetary resolutions) are in

conformity with the constitution and the law. The Comptroller General is appointed for an indefinite term by

the incumbent President with a positive vote from the Senate and cannot be removed. The Comptroller

General must resign upon reaching 75 years of age. Conflicts of a constitutional nature between the President

and the Comptroller General are resolved through the Constitutional Court.?

Thus, the Chilean system has a strong set of checks and balances based on diffusion of power. While

the executive holds the reign on key budgetary legislation, it will seldom control the legislature. Party and

? In the case of the Supreme Court, that slate must include the Senior Justice from the Courts of Appeal.? This, however, does not mean that the Court will behave in a random fashion. Rather its ability to impose its will is constrained by the composition of the Chilean's legislature. But given the potential for legislative fragmentation discussed above, it is quite reasonably to expect that the Chilean Supreme Court has as much discretion as its counterpart in the United States. For a discussion of the determinants of judicial discretion see Gely and Spiller (1990).? On non-budgetary non-constitutional issues, the President may insist on the legality through a formal decree signed by all its Ministers, in which case the Comptroller General must process the decree or resolution. On budgetary issues, however, the President cannot insist, and a determination of illegality by the Comptroller General is enough to kill the specific decree or resolution. (Constitution, Arts. 87-88).


regional fragmentation implies that the legislature will not respond to a single party, and that parties

themselves will not be that homogenous. Instead, the electoral system provides for electoral coalitions that,

for congressional elections, will have a regional bias, while for presidential elections will have a “national

agenda” flavor. Thus, as emphasized by Shugart and Carey (1992), the Chilean system may provide for

gridlock, as legislation may not pass easily. Given that the initial conditions prior to the resumption of

constitutional rule in 1989 were pro-market, the potential gridlock may translate into a strong signal of

stability. Indeed, as we will see below, the reforms enacted during the Pinochet period were all introduced

through extremely precise legislation, limiting the ability of future administrations to modify policies by

decree, again providing credibility to the initial policy choice. Furthermore, the strong independence of the

judiciary implies that attempts to amend policies through Presidential decrees will be checked by the courts.?

Indeed, over the years the Court has had a stand quite independent of the Government. For example,

Salvador Allende's 1970-73 government repeatedly clashed with the courts over issues of expropriation and

compensation, with the courts refusing to back down. By late 1972, however, the relation between the

administration and the Supreme Court was severely strained, with the administration insisting on the validity

of its actions, and the court just as firmly insisting otherwise. (Galal, 1994). Also, as we will see in the

section on utility regulation, the Courts and the Antitrust Commission, another semi-judiciary entity, were the

main force behind the almost total deregulation of the long distance market by siding against an initial

government determination.

? In this respect it is interesting to mention that the constitution requires that all presidential decrees be signed by the relevant Minister, who is individually responsible for all the acts under its signature and jointly and severally responsible for acts subscribed by other Minister. Furthermore, Ministers who authorize the expenditure of funds contravening the provisions in the Law or the Constitution may be held liable for the reimbursement of those funds and guilty of embezzlement.


IV. Utility Regulation and Antitrust Reforms

The reforms of the utility sector started early in the Pinochet period. They were undertaken in the

shadow of the antimonopolies statutes that were passed as one of the first acts of the Pinochet regime in

December 1973 (Decree Law 211, hereafter DL 211). The Chilean antimonopolies statute has three

components that became a crucial determinant of the evolution of the utility sector: first, it prohibits the

granting of any exclusive monopoly right; second, it limits anticompetitive behavior; and third, it creates a

complex institutional framework and procedure to resolve antitrust complaints raised by both the government

and the private sector. Its prohibition of exclusive monopoly rights implies that unless expressly stated by

sectorial laws, there are no exclusive service territories nor exclusive areas of operation. Thus, from 1973 on,

there was free entry into all areas of economic activity, including the utility sector. Furthermore, private

investors were able to use the mechanisms stipulated in the Decree Law 211 to force themselves in, and to

trigger regulatory changes that limited the power of the incumbent firms.

In the utility sector properly, the reforms started with the creation in 1977 and 1978 of specialized

regulatory agencies for the electricity and telecommunications sectors (the CNE and SUBTEL respectively).

Table B:1 provides the milestones in the utility reform process. As the Table describes, the reforms involve

both a change in the regulatory frameworks, as well as the restructure and eventual privatization of public

companies. Because the antitrust reforms are so important to understand the evolution of the utility sector, we

detail their nature first. Also, because the reforms of the electricity sector were the first and to some extent,

the most radical ones, we will analyze them in more detail than the reforms in the other sectors.


Reforming Antitrust

Although prior to the passage of DL 211 there were antitrust statutes in Chile’s books, they were, as in most of Latin America,

inoperative and ineffective.? As mentioned DL 211 made three important changes: first, it deemed criminal all anticompetitive actions (Arts 1

and 2); second, it prohibited the granting of a monopoly license to a non-governmental entity in any area of the economy (Art 4);? and third, it

created a complex institutional framework to resolve antimonopoly claims by both the private sector and the government. The latter was a

crucial feature to implement the first two. Indeed, in the utility sector, companies, both new and old, utilized DL 211 to attempt to enter into de-

facto closed markets. As the telecommunications case will show, the DL 211 also provided a measure of regulatory flexibility that would not

have existed otherwise.

? For a discussion of Chile’s antitrust statutes in a comparative perspective see Lopez Echeverria (1986). See also Guerrero (1979).? In its Art 4 it specifies that only through specific legislation can a particular activity be reserved for governmental entities.

MILESTONES IN CHILE'S UTILITY SECTOR REFORM1973: DECREE LAW No. 211: Antimonopolies statute, creates Antitrust Authorities1977: LAW No. 1.762: Creation of SubSecretary of Telecommunications (SUBTEL)1978: LAW No. 2.224: Creation of the National Energy Commission (CNE)1979: ANTITRUST COMMISSION opens telecommunications equipment market to competition1981: Beginning of PRIVATIZATION of electricity distribution assets1982: DFL No.1: Regulatory Framework for the Electricity Sector 1982: LAW No. 18.168: General Telecommunications Law1985: MINISTERIAL DECREE: Organization of Central Dispatch Center1985: Beginning of PRIVATIZATION of electricity generation plants

1987: DFL No.1: Reform of Telecommunications Law, introducing price setting framework 1987: PRIVATIZATION of CHILMETRO (largest distribution company)1987: PRIVATIZATION of CHILQUINTA 1987: PRIVATIZATION of CHILGENER (2nd largest electricity generator) 1988: DFL No. 70: Price setting Framework for water companies1988: PRIVATIZATION of CTC (the main local telephone company)1989: PRIVATIZATION of ENTEL (the main long distance company)1989: PRIVATIZATION of ENDESA (main generator) 1989: CTC and other local exchange companies request long distance licenses1989: ANTITRUST COMMISSION allows the participation of telecommunications companies in both

local and long distance services, requiring the introduction of a multicarrier system1990: SUPREME COURT requires from the Antitrust Commission a reconsideration of its 1989 decision

on local and long distance service1991: MINISTERIAL DECREE: Regulatory framework for granting water

company licenses 1992: ANTITRUST COMMISSION prohibits partial joint ownership of CTC and ENTEL.1993: ANTITRUST COMMISSION upholds prior decision to allow telecommunications companies to

provide both local exchange and long distance services based on a multi-carrier system1993: SUPREME COURT upholds Antitrust Commission 1992 blocking of partial joint ownership of CTC

and ENTEL1994: LAW 3A: Introduction of the multi-carrier system for long distance telecommunicationsTable B:1


DL 211 created four entities: The Office of the National Economic Attorney General,? the Regional Preventive Commissions, the

Central Preventive Commission and the Resolutive Commission. These institutions, however, seem to have been designed so as to limit the

ability of the government and legislators to influence the outcome of antitrust cases. Three features are important here: first, a decentralized

appointment process (including random appointees), second, the rotation of membership in the commissions so that no easy quid-pro-quo could

develop between politicians and commissioners, and third, the design of a complex decision making process.

Let us first focus on the appointment procedures. The National Economic Attorney General (NEAG) is appointed, as the Comptroller

General, for an indefinite temr by the President and cannot be removed.? Each Regional Preventive Commissions is chaired by the Regional

Economic Secretary, and it is composed of three other members, one appointed by the Governor of the Region, one appointed by the Regional

Development Council, and one appointed by the Presidents of the Neighborhood Committees. The Central Preventive Commission is composed

of five members. The chair is a representative of the Ministry of Economics, and the other members are: a representative of the Finance Minister,

two university professors (a lawyer and an economist) appointed by the Council of University Rectors, and a representative of the Neighborhood

Committees of the metropolitan area. The Resolutive Commission is composed of five members. It is chaired by a Supreme Court Justice

(appointed by the Court itself), and the other members are appointed in the following manner: the Ministers of Economics and Finance each

appoints one, a Law School Dean and an Economics Department Chair. The latter two are randomly selected from the list of law schools and

economics departments. Membership in all antitrust commissions is for two years.

The appointment process, then, limits the ability of the government to dictate antitrust policy. In particular, although the government

has two representatives in the Resolutive Commission, the other three are appointed in essentially a random fashion. Similarly, the Preventive

Commissions have a heavy regional flavor, with the government always controlling less than half the appointments. Thus, the appointment

process to the antitrust commissions is consistent with the intent of creating indepedent entities.

Another important feature of the antitrust authorities that strengthens their independence from the central government is their formal

interaction and the potential for subsequent appeals. First, the NEAG is in charge of investigating violations of the antitrust statutes. It can

investigate on its own, or at the request of a Preventive Commission. It can request that the Preventive and Resolutive Commissions take actions

under their responsibilities. It can participate in front of the Resolutive Commission in support or against a decision by the Regional Preventive

Commissions, and similarly can participate in front of the Supreme Court in favor or against a resolution by the Resolutive Commission. The

? The exact term is “Fiscalía Nacional Económica”.? The NEAG can only be removed by a process instituted by the Comptroller General.


Regional Preventive Commissions are in charge of resolving antitrust issues in their regions, while the Central Preventive Commission deals with

issues that arise in the metropolitan area or that involve more than a region.

Any person, including the government or the NEAG, may file a complaint in front of a Preventive Commission, who then will

undertake an investigation and will issue an order. A type of order that is of particular interest in the utility sector is that, following a

determination that there is no free competition, the Commission may require from the Ministry of Economics the imposition of regulations on the

supply of particular good or service. All decisions of the Preventive Commissions can be appealed to the Resolutive Commission. The latter’s

decisions are not appealable, except when such decisions impose monetary penalties, require the modification of the statute of a corporation, or

blocks a person from belonging to a particular association. In these cases, the decision of the Resolutive Commission can be appealed to the

Supreme Court.

If DL 211 would have stopped in Art. 4,? then it would not be that different from the previous antitrust statutes, although Art. 4 would

have raised substantial problems to the utility operators as their licenses would have lost the exclusivity. What made Arts 1 through 4 so

important was the creation of a complex system of checks and balances concerning competition issues. As we will see, this process was used

several times by both the government and the private sector, and had a drastic influence in the opening of the telecommunications sector to

competition.

? Articles 1-4 determine what is anticompetitive and that there can be exclusive monopolies or licenses.


Reforming the Electricity Sector?

In 1980 the chilean reformers set up the basis for the first competitive market in wholesale and retail electricity in the world.

Following a blackout-ridden winter in 1979, the National Energy Commission (NEC) initiated studies to reform the electricity sector.? In 1980

?

the NEC developed a novel regulatory regime whose main purpose was to let market forces determine prices, quality and investment levels,

while restricting the government to regulate those parts of the sector in which competition may not fully develop, namely, transmission and

distribution.? In September 1982 the regulatory framework was passed as law through DFL No. 1.

? DFL No.1, with small variants still sets the

framework for competition and regulation in the electricity sector.?

The reforms of the electricity sector were drastic: ENDESA, the main generating company was broken in several smaller generating

companies, while CHILECTRA, the main distribution company, was broken in 19 distribution companies. A pool company (Center of Economic

Dispatch -CED hereafter) was created as a large generators' club.? A wholesale market was created whereby generators could sell under long

? This section is partially based in Spiller and Viana (1994).? The blackouts were partially triggered by CHILECTRA’s introduction of a preferential winter residential electricity tariff (winter is the period of peak consumption). That special tariff drastically increased the use of electric heating devices in the Santiago-Valparaíso region. One of the first steps in the regulatory reform was the elimination of the preferential winter tariff and its replacement, in 1980, by a residential winter tariff with a 100% surcharge over 1979 rates. Eventually, because of negative public response, this tariff was applied only to those consuming more than 250kWh per month during the winter period. See Bernstein (1986) and Philippi (1991). ? The NEC was created in 1978, but only in late 1979, following the disastrous winter and the resolution of pricing conflicts between ENDESA and CHILECTRA, did the agency undertake its first studies that led to the introduction between January and October 1980 of the new pricing schemes. See Bernstein (1986).? Prior to 1980, electricity prices were based on the electricity law of 1931, with the amendments of 1959. The 1959 amendments provided for a maximum rate of return on fixed assets of 10%, and introduced the automatic revaluation of fixed assets. From 1959 on, electricity prices were determined by a Tariff Commission, composed of representatives of the President, the enterprises, consumers and headed by the Director of the Office of Electric Services. During the 1960s, though, the companies seldom reached the maximum allowed rate of return. The sector's financial situation deteriorated substantially during the period 1970-1973, as no price adjustments were allowed even in the face of hyperinflation. In the period 1974-1979, attempts were made to improve the financial situation of the companies. This process culminated with the creation of the CNE and the development in 1980 of the current regulatory regime. ? DFL stands for Decree with Power of Law. This instrument is used when a law specifically delegates to the executive to issue a decree legislating on a particular topic. This decree, then, can only be amended by the legislature, except when the DFL itself stipulates that parts are to be regulated by further decrees.? It is interesting to mention that none of those that develop the reforms were economists. Indeed, the three individuals most connected with the creation of the competitive wholesale market and the regulatory framework which will be described in some detail below were engineers. At the time, energy economists at the World Bank and other lending institutions were not particularly supportive of such drastic reforms. ? The CED was created by a 1985 decree that regulated DFL No.1. The Decree required from large generators (with at least 2% of the system's installed capacity) that are interconnected to a grid to belong to the system’s CED. Small generators that were also intereconnected would then enter into contracts with the large generators, whereby the latter would operate the formers' plants and settle their transactions at the nodal spot price. Thus the large generators may operate their own mini-pools. Large generators that do not want to belong to the CED can also opt to enter into similar contracts with other large generating companies. The Decree also determined in excrutiating detail the way the CEDs are to operate and how they must be organized. For example, Art. 23, ¶2 reads: "By the instantaneous marginal cost of


term contracts to large buyers,? with quantity differences being settled at the relevant hourly nodal price. Sales to the distributing companies were

to be regulated based on a very specific model that was used to forecast short term marginal cost of generation.? This price was to be recomputed

every six months based on a very specific formula. The law also stipulates that if the regulated price differs by more than 10% from the

competitive price, then the regulated price has to be adjusted up or down towards the competitive price. As a consequence, regulated prices have

an anchor in the competitive market place, a main tenant of the "yardstick competition" concept.? Transmission and distribution charges are also

regulated. Because competition in those two sectors was not expected to develop, the DFL No.1 regulates in a very specific way the maximum

prices for distribution. Investments in generation became free from regulation, with investors being able to undertake any type of project without

requesting permission from the NEC.? The DFL No.1, then, grants the NEC a very small planning role.

? Transmission and distribution projects

require of a license and the DFL No. 1 specifies the specific process required to granting such licenses. These licenses have no term and are not

exclusive.

From a policy, and even academic, perspective, the DFL No. 1 1982 was innovative and path breaking in many respects. a) It set up

the basis for the first competitive market in electricity. b) It specified in a precise fashion the parts of the sector that were to be subject to

regulation and those that were not, thus limiting the potential for opportunistic reregulation by the NEC.? c) It implemented for the first time the

concept of "yardstick" regulation in the regulation of power sales to distribution companies.? d) It implemented, also for the first time, a form of

price cap regulation for the distribution companies.? It stipulated that the maximum distribution prices (caps) were to be determined every four

energy it is meant the cost, including the rationing component, that the whole electric system has on average during an hour to provide an additional unit of energy at the respective bus, considering the optimal operation determined by the CED." This, in electrical engineering jargon, represents the shadow value of energy at each node. There currently are two CEDs, one for the CIS and another for the northern system.? Initially, large buyers were those with more than 4MW of demand. The DFL No.1, however, reduced that threshold to 2MW.? This model takes into account the dependency of Chile's electricity system on the current, and forecasted hydrological conditions. Although the model looks complex to a lay person, the computer program that runs it is quite simple, as one year of data required half a minute of CPU time in a Digital Deck 10 computer. The model is a variant of a model previously developed and used by ENDESA. See Bernstein (1986). ? See Shleifer (1985).? The law stipulates a specific, and complex, decision making process for hydro-based generating plants and for the laying of transmission and distribution lines, as long as these facilities require the taking of public or private property.? Initially, though, as all the generating park was in the hands of the public sector, the NEC took a more active role in reviewing those companies’ expansion plans.? Recall that contracts with users with more than 2MW demand were deregulated.? Recall that the regulated price was to be confined within a narrow band set by the competitive price. Inside that band, prices were to be set based on a very precise list of instructions attempting to compute the future average short run marginal cost. The setting of these regulated prices could be appealed to the courts.? Price cap regulation became popular with the privatization of British Telecom in 1984. The price cap scheme was proposed by Professor Stephen Littlechild in 1983. See Littlechild, S. Regulation of British Telecommunications


years by a method based on the "benchmark" competition concept. Individual firm maximum prices were to be based not on the company's costs

but rather on those of an hypothetical efficient firm, computed at replacement level.? Within the four year periods, prices were to be indexed. e)

Finally, it set up "nodal" prices that vary by location taking into account system losses and expected constraints.?

These were all institutional innovations that although at the time were not widely appreciated by the academic community or by

practitioners, their popularity has increased across the region. Indeed, the privatization and regulatory reforms of the electricity systems that are

taking place in Argentina, Peru, and Bolivia closely follow what by now is the Chilean model.

The comprehensiveness of the regulatory structure drastically limits the power of the regulator to deviate from what is specified in the

law, granting the regulator very little discretion. Attempts to modify the regulations also face serious difficulties. Not only modifying the DFL

No.1 requires a legislative act, but the multiplicity of companies participating in the sector makes legislative action difficult in the absence of

consensus.? Furthermore, attempts by the regulator to set prices not in accordance to the explicit regulations can be challenged in courts, and the

DFL No.1 explicitly states that the affected companies can demand compensation from the government.

Consider, for example, the process by which distributing companies’ prices are set every four years. First, the law specifies that such

computation will be done only every four years. It further stipulates the need for the NEC to contract out the computation of a putatively efficient

firm’s costs, and to take into account the estimates provided by the companies’ own consultants. Discrepancies are settled either through the

application of a particular formula or through arbitration. Compare this process to that in the UK whereby the Director General has the power to

unilaterally set the new price cap level at any time and at any level. Objection by the companies may imply a reference by the regulator to the

Monopolies and Merger Commission, without appeal.?

The reforms, then, built in commitment to the initial regulatory system, providing the basis for major private investments in the sector.

Profitability, 1983, London: H.M.S.O. For a general discussion of price cap regulation, see the Autum 1989 issue of the Rand Journal of Economics.? The NEC was instructed to contract out the computation of the replacement costs of the hypothetically efficient firm. The distribution companies could also contract out such studies. The NEC was further instructed to build a small set of hypothetical firm categories, so that distribution companies could be aggregated by type. There are three types, small, medium and large density, with two firms currently being in the "large" category.? Nodal pricing as the basis for the operation of competitive markets is a concept that became popularized with the work of Professor Fred C. Schweppe. See, for example, Schweppe, Caramanis , Tabors and Bohn (1988). For an assessment of the use of nodal prices for pricing transmission see Oren et al (1995).? In a sense, the experience in the United States with stalemate in telecommunications legislation is not that altogether different, except that the FCC and the state PUCs have more power to undertake unilateral action, subject, though to judicial review. Thus, in the United States, the telecommunications sector has evolved into a more competitive environment without a single legislative act. In Chile's electricity and as we will see in telecommunications and water as well, regulatory changes require costly actions by the legislature.? For a discussion of the UK regulatory system, see Spiller and Vogelsang (1994a).


Such institutional commitment, however, may not be feasible if the electoral rules and the organization of the legislature were such that they

provide, as in UK-type systems, for single party control of both the legislature and the executive. In those cases, specific legislation à-la Chile

will provide very little commitment, as the party in government can almost unilaterally change the regulations.? Thus, alternative ways have to be

developed to provide regulatory credibility. The UK and other countries have found credibility in the use of very specific licenses.?

Not only the regulatory system was innovative and provided stability to the regulatory framework, but the restructuring of the sector

was also a contributing factor. While in 1978 the electric system was based on two publicly owned integrated companies, ENDESA and

CHILECTRA, today there are eleven power generating companies, 32 electricity distribution companies and two integrated companies, many of

those being traded in the Chilean stock exchange.? The average daily trading of eleven electricity companies in 1991 amounted to 45% of the

value of all stock transactions in the Chilean stock exchange, with ENDESA accounting for 18.5% of that value and CHILGENER to 13.2%.

(Philippi, 1991). See Table B:2. Table B:3 presents the distribution of ownership across the population for the largest companies. The Table

shows that pension funds are the most important shareholders of the electricity companies. Employees have an important participation in

Chilectra Metro, which has become a holding company of electricity companies both in Chile and in the surrounding countries.

? Indeed, In the UK, regulatory frameworks have traditionally evolved through a series of acts of Parliament. For example, major gas regulation legislation was passed in 1847, 1859, 1870, 1871, 1873 and 1875. Similarly, water regulation legislation was passed in 1847, 1863, 1870, 1873, 1875, and 1887. Systematic regulation of electricity companies started in 1882, only four years after the inauguration of the first public demonstration of lighting by a public authority. The 1882 Act was followed by major legislation in 1888, 1899, 1919, and 1922, and culminating with the Electricity (Supply) Act of 1926 creating the Central Electricity Board. Spiller and Vogelsang (1993), and references therein for discussions of the evolution of utility regulation in the UK.? See Spiller and Vogelsang (1994).? Since 1991 the number of distribution companies recently increased from 21 to 32 through the corporatization of several cooperatives.


This

drastic restructuring of the sector was achieved by separating generation and transmission from local electricity distribution. For example, the

distribution side of ENDESA was broken into several distribution companies each with coherent geographic and economic units, and they were

subsequently privatized. Similarly, CHILECTRA was broken into three units, a generation and two distribution companies. See Tables B:4 and

B:5 showing the main generating and distributing companies, and whether they used to be part of ENDESA or CHILECTRA. Table B:4 shows

that in the Central Interconnected System (CIS), ENDESA still controls more than 50% of total capacity. Nevertheless the extent of divestment

of ENDESA's generating capacity has been quite large, and since there are no legal entry barriers nor big economies of scale, there is no evidence

that ENDESA has been able to exercise any significant market power in the wholesale market.? Tables B:4 and B:5 also show the extent of

concentration in both generation and distribution that characterized the pre-1980s regime. The divestment of the larger companies was done

through sales to the public at large, while the smaller units (less than 50 MW) were sold directly through public auctions (Philippi, 1988).

The restructuring was innovative in several respects. First, although today’s common wisdom is that there are no

? On the other hand, since ENDESA also is the main transmission company, substantial complaints have been raised about its manipulation of the the price setting process for transmission. This has triggered several proposals for

divestiture of ENDESA’s transmission facilities and for changing the way transmission is priced. ENDESA has already divested parts of its transmission network and has also transfered its transmission assets to a fully owned transmission

subsidiary.

ELECTRIC UTILITIES' STOCK TRANSACTIONS(FIRST SEMESTER 1991)

UTILITY US$ Millions Share of Total In %

CHILECTRA 15.3 2.3CHILGENER 89.1 13.2CHILQUINTA 2.0 0.3COLBUN 5.6 0.8EDELMAG 0.3 0.0EDELNOR 2.4 0.4ELECDA 0.9 0.1ELECTRICID 4.6 0.7ELIQSA 0.7 0.1EMELAT 1.2 0.2EMELSA 2.8 0.4ENDESA 125.0 18.5ENERSIS 49.8 7.3PILMAIQUEN 9.2 1.4

SOURCE: Philippi (1991).Table B:2OWNERSHIP OF MAIN ELECTRICITY COMPANIES

(In %; December 1990)

<2><1> CHILECTRA CHILECTRA

OWNERSHIP ENDESA CHILGENER COLBUN METROPOL. V REGION

GENERAL PUBLIC 38.8 8.2 1.3 - -PENSION FUNDS 26.3 31.1 0.0 29.0 17.0EMPLOYEES 3.3 1.5 0.0 28.3 -FOREIGN FUNDS 7.3 9.4 0.0 - 0.0STATE 0.0 0.0 97.4 0.0 0.0OTHERS <3> 24.3 49.7 1.3 42.7 83.0TOTAL 100 100 100 100 100

TOTAL SHAREHOLDERS 51833 1403 864 4751 1738

NOTES:

<1> Pehuenche, SA is owned by ENDESA (95.4%).<2> CHILECTRA METROPOLITANA is owned by Enersis.

<3> Includes other legally stablished companies.Table B:3


economies of scale in generation, that was not the case in the late 1970s. Second, the reformers also challenged the presumption that there were

gains from consolidating distribution companies. Indeed, since the reform the number of distribution companies increased by 50%. Third, the

emphasis in employee ownership and in diffuse ownership provided further safeguards to the political viability of the regulatory framework.


Chile's electricity sector has had a continuous expansion during the last 50 years. But as Table B:6 shows, since privatization the sector has had a rapid growth in generation capacity. Table B:6 shows the slower rate of growth in capacity during the 1970s and 1980s. The 1990s see, however, the highest growth rate since the expansion of the 1960s.

POWER SUPPLY COMPANIESINSTALLED CAPACITY (In MW)

1991 1995SYSTEM OWNER THERMAL HYDRO TOTAL

TOTAL

NORTE GRANDE INTERCONNECTED SYSTEMEDELNER S<1> 86.0 10.2 96.2 250CODELCO S<3> 471.0 0.0 471.0 550ENDESA P 00 0 95NORGENER P 0 00 140Self-generators 132.2 0.3 132.5 naSUB-TOTAL 689.2 10.5 699.7 1035*

CENTRAL INTERCONNECTED SYSTEMENDESA P 349.4 1602.7 1952.1

1855CHILGENER P<2> 511.5 245.1 756.6 757PEHUENCHE P<4> 0.0 500.0 500.0 585COLBUN S<1> 0.0 490.0 490.0 539PULLINQUE P<1> 0.0 48.6 48.6 49PILMAIQUEN P<1> 0.0 35.0 35.0 35OTHERS <5> 0.0 66.3 66.3 167Self-generators 226.6 84.6 311.2 naSUB-TOTAL 1087.5 3072.3 4159.8 4137*

AYSEN ISOLATED SYSTEMEDELAYSEN S<1> 0.0 10.4 10.4 naSelf-generators 2.0 3.7 5.7 naSUB-TOTAL 2.0 14.1 16.1 na

PUNTA ARENAS ISOLATED SYSTEMEDELMAG P<1> 45.6 0.0 45.6 naSelf-generators 47.4 0.6 48.0 naSUB-TOTAL 93.0 0.6 93.6 na

TOTAL 1871.7 3097.5 4969.25172*

NOTES:<1> Previously owned by ENDESA<2> Previously owned by CHILECTRA<3> Self-generator<4> Previously owned by CORFO, now owned by ENDESA<5> Include 3 small companies.S: CORFO (state) controlled companyP: Private company.*: Does not take into account self-generators. Assuming 1991 values for self generators

and isolated systems, total 1995 capacity would be 5725.4MW.Source: CNE, Philippi (1991), and SYNEX.Table B:4

ELECTRICITY DISTRIBUTION COMPANIES (1991)CUSTOMERS CAPACITY

ENERGYSYSTEM OWNERSHIP (In 1,000) (MW) (GWh)

NORTE GRANDE INTERCONNECTED SYSTEMEDELNOR S<1> 140 96 139

CENTRAL INTERCONNECTED SYSTEMCHILECTRA METRO P<2> 1106 902 4741CGEI P 365 217 1138CHILECTRA REGION V P<2> 285 213 1119SAESA P<1> 114 62 328EMEC P<1> 110 55 289FRONTEL P<1> 107 35 184CONAFE P 94 52 271EMEL P<1> 91 37 195ELECDA P<1> 84 36 187EMELAT P<1> 46 36 187EMELARI P<1> 39 17 90ELIQSA P 35 17 90EE DEL SUR P 16 6 29EE PTE ALTO P 14 5 26CE LITORAL P 13 3 14OTHERS 12 4 22TOTAL 2531 1699 8932

AYSEN ISOLATED SYSTEM

EDELAYSEN S<1> 14 8 148

PUNTA ARENAS ISOLATED SYSTEM

EDELMAG P<1> 36 46 72

NOTES:

<1> Previously owned by ENDESA

<2> Previously owned by CHILECTRA

P Private company

S State owned company (CORFO)

SOURCE: CNE, and Philippi (1991), installed MW has been estimated with a .6 load factor, 1988 energy values.Table

B:5


The regulatory system that was implemented in the early 1980s has produced an electricity

system that brings prices close to long run marginal costs, that do not vary by end use, and that depend on the

nature of the location. Since the introduction of the reforms, electricity prices, in US$, have remained

relatively stable, falling during the early part of the 1980s and increasing at the end. See Table B:7. The off-

winter average retail tariff in 1988 was approximately 0.08 US$/kWh (see Table B:8), while the average node

energy price in Santiago at the 220V level was 0.032 US$/kWh, and the peak power node charge was 3.6

US$/kWh (Philippi, 1991).


POWER GENERATION CAPACITY

(MW)

POWER

PUBLIC SELF- GENERATION

YEAR SERVICE GENERATION CAPACITY

1940 179 308 487

1945 202 355 557

1950 390 385 775

1955 541 451 992

1960 600 543 1143

1965 887 566 1453

1970 1457 686 2143

1975 1879 741 2620

1980 2212 728 2940

1985 3094 873 3967

1990 3341 968 4309

1995 5172 na na

Source: Philippi (1991), Synex. Table B:6


As Table B:8 suggests, though, customers have substantial choices among different types of tariffs, some

including interruptable supply, off-peak usage, as well as maximum monthly readings. That prices are close

to marginal costs can furthermore be seen from the high voltage tariff AT2 (which will be used by industrial

and commercial users). The energy charge is 0.0396 US$/kWh while the peak demand charge with partly

peak hour use is 3.93 US$/kw. The energy charge is almost identical to the energy node charge, as is the

CHILE: AVERAGE ELECTRICAL ENERGY PRICES*

CENTRAL INTERCONNECTED SYSTEM

(US$ cent/KWh)

NODE RESIDENTIAL PUBLIC SMALL LARGEPRICE TARIFF LIGHTING INDUSTRY INDUSTRY AGRIC

YEAR <1> (100KWh)<6> <2> <3> <4><6> <5>

1972 1.93 0.721973 1.52 0.651974 1.53 0.611975 2.54 1.211976 3.04 1.701977 4.61 2.911978 4.53 3.051979 6.28 4.261980 8.96 5.11APR 81 4.41 11.70 9.35 10.12 6.31 5.00OCT 81 4.74 12.24 9.85 10.67 6.68 5.15APR 82 4.74 12.25 9.87 10.69 6.68 5.16OCT 82 3.59 8.80 7.55 7.55 5.52 4.02APR 83 3.60 7.59 6.55 6.55 4.87 3.41OCT 83 3.52 7.45 6.45 6.45 1.78 3.37APR 84 3.41 7.37 6.32 6.32 4.67 3.18OCT 84 3.20 6.18 5.28 5.31 3.84 2.65APR 85 2.90 6.70 5.61 5.79 3.97 2.82OCT 85 2.76 6.40 5.37 5.56 3.78 2.74APR 86 2.86 6.53 5.52 5.70 3.91 2.90OCT 86 2.75 6.48 5.44 5.62 3.81 2.83APR 87 2.85 6.58 5.55 5.73 3.93 2.95OCT 87 3.14 7.06 6.01 6.19 4.29 3.29APR 88 3.35 7.34 6.28 6.45 4.53 3.59OCT 88 3.62 8.23 7.28 7.60 4.78 3.97APR 89 3.92 8.78 7.84 8.19 5.18 4.33OCT 89 4.13 9.24 8.25 8.62 5.45 4.56APR 90 4.39 9.84 8.79 9.18 5.80 4.85OCT 90 3.92 8.77 7.83 8.18 5.17 4.32

NOTES:*Since prices do not discriminate by user, this table reflects the most advantageous tariff choice per time of customer.<1> Load factor (LF)=0.6; Voltage level 220KV<2> LF = 0.457, low voltage<3> LF = 0.274, low voltage<4> LF = 0.548, high voltage<5> Hourly tariff, high voltage<6> Series until 1980 may not be comparable with post 1980.

Source: Prices until 1980 from OLADE, various issues, from 1981 on, Philippi (1991).Table B:7


peak power charge. See Table B:9.

That prices also vary substantially across locations can be seen in Tables B:9 and B:10. Table B:9

presents the average prices that ENDESA charged to public service distribution companies and to large

private customers in 1986. First, we observe that large users get either the node peak power price or slightly

above that, while the energy charges for large users is one or two percent higher than that charged to the

distribution companies. Thus, large users' prices are indeed close to marginal costs. Second, there is

substantial variation across regions. Geographical price distributions can further be seen by comparing

TYPICAL ELECTRICITY TARIFFS CHARGED BY

DISTRIBUTION COMPANIES

(1986-1988, in US$)

ELDENOR (Regions I & II) CHILECTRA METROPOLITANA (Santiago)(12/86) (6/88)

Fixed Demand Energy FixedDemandEnergy Winter

Tariff Charge Charge Charge ChargeChargeCharge Surchage

month max kW kWh monthmax kWkWh kWh

month month

BT1 Meteredup to 90 kWh/month .73 - .088 .87 - .08 .16over 90 kWh/month 1.08 - .102 .87 - .08 .16

BT2 Monthly Contractedwithout peak limits 1.08 10.51 .058 .87 10.0 .046 -partly peak usage 1.08 7.00 .058 .87 6.43 .046 -

BT3 Monthly Maximumwithout peak limits 1.72 10.51 .058 1.61 10.0 .046 -partly peak usage 1.72 7.00 0.58 1.61 6.43 .046 -

AT2 High Voltage withMonthly Contractedwithout peak limits 1.08 6.74 .051 .87 6.08 .0396 -partly peak usage 1.08 4.34 .051 .87 3.93 .0396 -

AT3 Monthly Maximumwithout peak limits 1.72 6.74 .051 1.61 6.08 .0396 -partly peak usage 1.72 4.34 .051 1.61 3.93 .0396 -

AT4 Off-Peak Tariff 2.52 - .051 2.41 - .0396 -Plus off-peak demand - .95 - - .76 - -Plus peak demand - 5.79 - - 5.31 - -

SOURCE: World Bank (1988).Table B:8


different locations and type of tariffs to the levels in Valparaíso, which is the load center of Chile. As can be

seen in Table B:10, even in the CIS there are substantial differences across locations. These differences arise

from the workings of marginal transmission prices.

Even though prices seem to be close to marginal costs, that has not stopped the private electricity firms from

making reasonable profits. ENDESA, for example, has had positive profits, except for 1985, with the average

yearly profit level since 1983 amounting to US$ 71 on less than 1,700 MW of installed capacity (in 1989).

See Table B:11.

TYPICAL TARIFFS CHARGED BY ENDESA FOR HIGH VOLTAGE CUSTOMERS

(December 1986)

LOCATION VOLTAGE DEMAND ENERGY CHARGECHARGEUS$/kW US$/kWhmax/month

Public Distribution Companies Taltal 110 4.95 0.034 Diego de Almagro 220 3.94 0.027 San Isidro, Alto Jahuel 220 3.18 0.020 Rancagua 154 2.92 0.020 Temuco 154 2.92 0.020 Valdivia 66 2.85 0.016 Osorno 66 3.03 0.016 Puerto Elviar 23 7.88 0.035

Large Users

Diego de Almagro 220 4.18 0.028 San Isidro, Alto Jahuel 220 3.18 0.020 Rancagua 154 2.92 0.020 Valdivia 66 2.85 0.016 Osorno 66 3.03 0.016

Note: Delivery points are ENDESA's substations. Additional charges may apply for other delivery points. Tariffs do not include value added of 20%.

Source: World Bank (1988), Annex 15.Table B:9


The

regulatory system has also promoted large investments by private electricity companies. In 1991 ENDESA,

PEHUENCHE and CHILGENER had six investment projects (five of those involving hydroelectric plants)

for a total of US$ 1,830 million. These projects were to add 1,429 MW of istalled capacity by the end of

ELECTRICITY PRICES

GEOGRAPHICAL PRICE DISPERSION

NODE RESIDENTIAL PUBLIC SMALL LARGEPRICE TARIFF LIGHTING INDUSTRY INDUSTRY AGRIC

SYSTEM <1> (100KWH) <2> <3> <4> <5>

NORTE GRANDE INTERCONNECTED SYSTEM

Antofagasta 176 122 128 134 139 136

CENTRAL INTERCONNECTED SYSTEM

La Serena 122 110 111 111 115 114Valparaíso 100 100 100 100 100 100Santiago 100 95 102 104 96 92Concepción 91 92 85 86 87 89Puerto Montt 79 86 86 88 83 79

AYSEN ISOLATED SYSTEM

Aysen 175 145 134 136 148 142

PUNTA ARENAS ISOLATED SYSTEM

Punta Arenas 77 79 77 80 72 56

NOTES:

* Since prices do not discriminate by user, this table reflects the most advantageous tariff choice per time of customer.<1> Load factor (LF)=0.6; Voltage level 220KV<2> LF = 0.457, low voltage<3> LF = 0.274, low voltage<4> LF = 0.548, high voltage<5> Hourly tariff, high voltage

Source: Philippi (1991). Table B:10PROFITABILITY OF ENDESA

(In US$ Millions)

1983 1984 1985 1986 1987 19881989 1990

PROFITS 101 33 -65 50 62 179 106104

Source: Philippi (1991).Table B:11


1996. This additional capacity represents an increase of a third of the industry's 1989 installed capacity.? See,

Table B:12. Since 1991, two coal and one hydro projects for a total of 448MW were initiated to be completed by the end of 1997.

The

restructuring process, then, has been quite successful. Electricity prices are closely related to long run marginal costs, private investment is

taking place in all areas of activity (including hydroelectric plants), electricity companies are widely held and are daily traded in the local stock

exchange. The market is very dynamic, with contracts among generating, transmission and distribution companies and their consumers taking

new and varied forms.? The regulatory system has sustained without much problems the financial crisis of the early 1980s, and has shown to be

? In 1989 the installed capacity of private firms was 2,902 MW, while that of public generatingcompanies was only 586 MW. See Philippi (1991).

? For example, recently, generation and distribution companies have started to invest in transmission lines.

ENERGY PROJECTS UNDER CONSTRUCTION

(1991)

COMPANY/PROJECT CAPACITY (US$MILLIONS) PROYECTED DATE

CHILGENER

HYDRO: ALFALFAL 160 Mw US$300 1991 (I SEM)

THERMAL 150 Mw US$200 1996 (II SEM)

ENDESA

HYDRO: CANUTILLAR 144 Mw US$280 1991 (I SEM)

HYDRO: PANGUE 400 Mw US$400 1996 (I SEM)

PEHUENCHE

HYDRO: PEHUENCHE 500 Mw US$500 1991 (I SEM)

HYDRO: CURILLINQUE 75 Mw US$150 1994 (II SEM)

SOURCE: Philippi (1991).Table B:12


resilient to government and interest groups pressures.?

Although the overall picture of the reforms is quite positive, there are some important problems with the regulatory

framework, particularly as it relates to the pricing of transmission for competitive transactions and to the pricing of distribution. The former

problem arises because customers located away from the center of consumption have to pay variable transmission charges in excess of marginal

losses and constraints. As a consequence, local generators have very little competition for those customers, increasing their contract prices.? This

concern has triggered interest by the regulators in alternative pricing schemes for transmission. The latter problem is related to the fixed formula

to arbitrate differences between the prices reached by the NEC’s and the companies’ consultants. The law specifies that for new firms such

differences are solved through binding arbitration. For existing firms, though, such differences are settled based on a fix formula giving 2/3

weight to the values given by the NEC’s consultants and 1/3 to those given by the companies’ consultants. As a consequence, the prices given

by the NEC’s and the companies’ consultants have diverged over time, with NEC’s consultant values going slowly down, while those for the

companies going slowly up. The average distribution price, however, has remained relatively constant.? Thus, there appears to be a gaming of

the price setting system by both the NEC and the companies, which has triggered proposals for reform. The fact that the regulations concerning

transmission pricing schemes are enshrined in legislation, implies that such modification will require substantial consensus among the electricity

companies, limiting the potential for regulatory reform.? This, then, is an example of the unavoidable tradeoff between flexibility and

commitment. The Chilean reformers seem to have sided with commitment over flexibility.

To summarize, Chilean regulatory and institutional changes of the early 1980s has dramatically changed the nature of

the sector. It has brought prices closer to marginal costs, while at the same time has provided incentives for firms to invest in the three basic

segments of the sector. The success of the reforms in motivating private sector investment and in aligning prices with costs is consistent with the

nature of the reforms. First, the regulatory regime substantially limits regulatory discretion; second, the regulatory instrument chosen (very

precise legislation) is compatible with the institutional environment that limits the ability of the government to change legislation, and finally,

? The fact that the major electricity companies are widely held among small investors and pension plans may have also contributed to the stability of the regulatory system. For example, in 1989 two thirds of ENDESA's stocks were held by

small investors (Philippi, 1991). See Table B:3.? For an discussion of this point, see Spiller (1995).? There have been three settings of distribution values since the 1982 law. The first in 1984 and the other two four years apart. In the 1984 setting the average values differed by 5%. In the 1988 setting the values differed by more than 20% and in the 1988 revision they differed by more than 40%. See Agurto and Bernstein (1994).? On the other hand, the reform of the arbitration process for distribution companies may not be that difficult to undertake as it would simply imply eliminating the fixed arbitration formula and instead moving towards a binding arbitration as in the new firms cases. Given that no firm would naturally be hurt from such reform, it could take place following, or even, prior to the next round of price setting in 1996.


those restrains are backed up by both diffused ownership of the electricity companies, and by an independent and strong judiciary that can limit

regulatory and governmental deviations.

Reforming the Telecommunications Sector.

As Table B:1 shows, the reform of the telecommunications sector was undertaken at the same time as that of the

electricity sector. Indeed, the philosophical foundations of the regulation of both sectors is the same: freedom of entry into all areas of the sector,

licenses required only for the taking of public or private property (and in the case of telecommunications, for the use of the spectrum), very

minimal obligation to serve, and minimal government intervention in the sector. There were, however, two main differences in the

implementation. First, the belief that telecommunications was an inherently competitive sector led the writers of the 1982 legislation not to

introduce any stipulation concerning the regulation of prices. Although interconnection was required, the legislation left the terms of

interconnection to be decided by the parties. Second, differing from the electricity sector, the government did not attempt to change the initial

market structure, and hence did not restructure the two main telephone companies. Thus, competition started with two monopoly companies, one

a local service (CTC), and another a domestic and international long distance provider (ENTEL).?

By 1982, then, Chile was the first country to introduce open competition in all sectors of telecommunications with

minimal governmental regulation and with no restructuring of the sector.? Such path- breaking status, however, did not last long, as in 1987 a

major revision of the telecommunications law introduced a tariff setting process.? Following a determination by the Antitrust Commission that

neither local service nor long distance services were competitive,? SUBTEL started the price setting process which culminated a year later, in

September 1989, with the first regulated telecommunications tariffs. Thus, purely from a “free-market perspective” the 1987 reforms seem to be

a backward movement towards price regulation.

A closer examination, however, suggests otherwise. Although since 1982 CTC and ENTEL, the main

? CTC stands for Compñía de Telefonos de Chile, and ENTEL stands for Empresa Nacional de Telecomunicaciones. A third government company was TELEX CHILE that was formed in 1982 taking over the telex activities of the post office. Several other private companies were formed during the late 1970s and early 1980s, but they held less than 5% of the overal revenue. DESCRIBE CITE? This is, indeed, the same policy recently taken by New Zealand.? Cellular and other services were specifically exempted from the possibility of price regulation.? The Telecommunications Law specified that if a sector is determined by the Resolutive Commission to be non-competitive, then SUBTEL can regulate its prices according to a particular process determined in the law.


telecommunications operators,? were allowed to set prices freely, in fact they set their prices following informal consultations with SUBTEL and

the Economics Ministry (Galal 1994). Furthermore, the extent of competition in both local and long distance services did not develop rapidly.

Although since the opening of the telecommunications markets five local companies were created, they tended to locate in areas where CTC did

not have a license,? or where it provided relatively bad service.

? The latter companies, however, faced growing difficulties, and by 1994 they

achieved only 2% of the market (Corbo and Díaz, 1994). Some of these growing difficulties could be related to normal market conditions, but

others were related to the fact that interconnection agreements were not easy to develop.? Indeed, all three companies obtained their

interconnection agreements only following orders by the Antitrust Commissions.?

Thus, by 1987 it was clear that competition did not come to the telecommunications company. Furthermore, from the

passage of the 1982 Act till 1987 the network was growing only slightly faster (at a 6.5% in terms of numbers of lines) than prior to the passage

of the 1982 Act (a 3% rate). From 1987 on, though, the sector has been growing very fast (at more than 20% per annum). Indeed, by 1991, only

three years after its privatization, CTC doubled its number of lines. See Table B:13.

? Until their privatization, the two companies’ shares were held by CORFO, the government’s development corporation. CORFO implemented a policy of segmentation of the two companies’ activities, moving CTC mostly to local service and ENTEL to long distance services. ? Compañía de Teléfonos de Coyhaique (TELCOY) and Telefónica del Sur S.A (CNT) operate in areas where CTC has no operating license.? These companies are Complejo Manufacturero de Equipos Telefónicos (CMET) which operates in parts of the metropolitan region and in other regions, Compañía Teléfonica Manquehe (CTM) which operates only in parts of the metropolitan region, and SERTEL which operates in LOCATE. CTM, CMET, CTC, TELEDUCTOS and others also provide fiber optic services around the metropolitan region. ? The law provided for interconnection agreements to be negotiated by the parties.? Each time, though, the Antitrust Commission castigated CTC with undertaking “activities that have tended to limit free competition in the telecommunications market and tended to limit entry...” See, Resolution 151 of July 18, 1983.


EVOLUTION OF THE LOCAL NETWORK

LINES LINES IN PENDING TELEPHONES TELEPHONE

INSTALLEDSERVICE REQUESTS IN

SERVICE DENSITYYEAR (1,000)(1,000)(1,000)(1,000)(PER 100 PERSONS)

1960 122.5 116.9 63.1

184.6 2.71965 170.1 163.2 63.6

250.9 3.251970 257.8240.9 60.5

352.8 4.141975 340.4 304.7143.1434.2 4.671980 406.9360.3 149.9550.1 5.361981 426.3386.5140.2574.7 5.51982 429.3397.5110.8577.2 5.431983 464.8415.1114.0601.3 5.561984 537.4456.4 176.7651.0 5.921985 549.9505.3151.2718.6 6.431986 584.8527.8219.3749.1 6.591987 614.9548.4230.5770.1 6.671988 634.3591.5 236.4820.2 6.991989 799.9645.9283.9894.8 7.411990 1018.6811.8307.81096.0 8.91991 1164.4 996.7240.61345.1 10.8

SOURCE: Galal (1994).Table B:13


The free-market approach to telecommunicatoins regulation, then, did not help develop the sector prior to 1987,

although it seems to have worked just fine in electricity. The difference could not be explained by the different spead of privatization, as a look

to Table B:1 shows that the main generating companies (CHILGENER and ENDESA) where privatized at roughly the same time as CTC and

ENTEL. Nevertheless, competition and network growth arrived to wholesale electricity from the beginning (see Table B:6). Macroeconomic

circumstances also do not seem to be behind the differential performance, as electricity generation capacity grew rapidly even during the early

1980s,? a period characterized by slow economic growth.? Although other explanations could also

be raised to understand the lack of dynamism of the telecommunications sector, one feature

seems important: the regulatory framework based on pricing freedom was not credible,

particularly when the government also owned the two main telecommunications entities. The

1987 reforms, by formalizing the price setting process, reduced the government discretion in the

determination of telecommunications prices, providing a more credible framework in which to

invest.? See Table B:14 for a description of the 1987 price setting process. As Table B:13

shows, CTC aggresively responded to those incentives.

? We are aware, though, that electricity projects are lumpy and have a relatively long. On the other hand, the deregulation of electricity generation has drastically reduced the gestation life of new projects. See Augurto and Bernstein (1994).? Chile suffered one of the worst recessions in 1982/1983. See Table A:1. ? A particularly compelling alternative explanation is that, at the time, the government required a 100% dividend payout from all public companies, including CTC. This, however, cannot be a full explanation for the slow performance of the sector. First, by 1987 CTC’s debt equity ratio was a mere 65%. It could have, even under public ownership, double its debt by increasing its debt equity ratio to 125% a ratio that it had in the past without too much of a problem. Such increase in debt would have allowed it a rapid increase in assets. Galal et al (1994, at 269). Second, even if CTC could not invest, if the pre-1987 regulatory framework provided was so credible, then such investment could have been undertaken by the private sector. The fact that the sector private sector did not invest much prior to 1987 suggests that the pre-1987 regulatory framework did not provided it with enough invesment incentives. Our reasoning is as follows: CTC doubled its size from 1988 to 1991. Essentially it created another CTC. Assume now that the 100% dividend payout was the main limit to CTC’s investments and that the free pricing regime provided strong ex-ante investment incentives, then why is it that the private sector did not create a separate CTC prior to 1987. Instead the private sector built just 5% of the total number of lines. If the free pricing regime gave strong incentives, and macro-economic conditions were not blocking development, then it has to be that CTC’s presence preempted the competing companies from investing. In other words, was it the fear of predatory investment by CTC that preempted the privately owned companies from expanding prior to 1987? But since CTC could not expand rapidly because of the 100% dividend payout policy, how could CTC predate? Indeed, the 100% dividend payout should have facilitated private sector entry by limiting CTC’s response. Thus, the private sector had to face other constraints to its expansion. As we discuss in the text, the vagueness of the regulatory framework as it relates to interconnection was one important factor, but also the uncertainty about the future evolution of prices may have provided a strong disincentive for private sector development.


Table B:14 shows that the price setting process designed for the

telecommunications sector is almost identical to that in the electricity sector. Prices are based on

long run marginal costs of putatively efficient firms. Are recomputed every five years with

indexation in the interim periods. There are, though, two important exceptions: the use of the

capital asset pricing model to compute the cost of capital of the efficient telecommunication

firm, and that disputes among the companies and the regulator are settled via a binding

arbitration rather than through a fixed formula as in the electricity sector. Thus, again in 1987,

the reformers chose to limit regulatory at the expense of regulatory flexibility.

Although Table B:13 seem to show that the 1987 reforms had an important

impact on the incentives to invest by both CTC and ENTEL, the 1987 reforms do not seem to

have drastically affected their ex-post performance. Table B:15 shows that both companies’

PRICE SETTING PROCEDURES STIPULATED BY THE 1987 AMENDMENTS TO THE GENERAL TELECOMMUNICATIONS ACT OF 1982

1. Demand is first estimated for each service/zone/firm bundle.2. For each service, the incremental cost of development (LRMC adjusted for investment) is then calculated based on the concept of the “efficient firm.” The efficient firm is one that starts from scratch and uses assets only to provide that service.

3. Revenue is then estimated for each service such that the net present value of providing the service is equal to zero.

This revenue is the incremental cost of development.

4. If the incremental cost of development differs from the LRAC, efficient tariffs are increased in a least distortive way so

that firms make a fair rate of return.

5. The fair ROR is defined based on the capital asset pricing model. Thus, the law requires the computation of “betas”

for each firm type.

6. Tariffs are calculated every five years. In the interim, prices are adjusted every two months using a Divisia index for

each service.

7. Disputes among the companies and regulatros are settled by a committee of three experts, one appointed by each party

and a third by agreement.

Source: Galal (1994) and General Telecommunications Law of 1982, as amended.Table B:14


profitability improved following the passage of the 1982 Law, although it seems that the main

beneficiary was ENTEL, as its return on net worth reached almost 40% by 1986. The 1987

reforms also benefited ENTEL, as its profitability exceeded 40% in 1988 and 1989. CTC’s

profitability also increased a bit, but remained below 20%. But as Table B:15 shows, the

companies ex-post performance started to improve not in 1987 but in 1982.


Here is where Chile’s

institutional framework starts to have an impact

on the sector’s development in an unexpected

way. Opposing the entry of the local exchange

companies into the long distance market,

SUBTEL requested in 1989 from the Central

Preemptive Commission to consider whether

entry of local exchange companies into long

distance is in the public interest.? Although the

Central Preemptive Commission sided with the

government, it was rapidly reversed on appeal

by the Resolutive Commission, which ordered

that there should be no segmentation of the

local and long distance services, and requested

the introduction of a multi-carrier system

whereby customers can choose their long

distance provider. Thus, by 1989 Chile could

have moved directly to long distance

competition.

? SUBTEL’s opposition to the local exchange companies’ integration into long distance was based on the potential anticompetitive impact that CTC could have on the long distance market. See Resolutive Commission’s Resolution No.

389 of April 16, 1993. See Gaymer, et al (1993).

The reforms of 1987 and the

subsequent privatization had all the predicted

effects. The network expanded, prices for long

distance services fell more rapidly, while those

for local service increased more rapidly, thus

tending to eliminate the extent of cross-

subsidization from long distance to local

service. See Table B:16. Furthermore, the

profitability of the long distance market

provided a strong signal for potential

competitors, and in 1989 CTC and other local

exchange operators attempted to enter the long

distance market by requesting from SUBTEL

licenses to build and operate long distance

facilities.

RETURN ON NET WORTH

(In Percentages)

CTC ENTEL

1960 7.9 na

1965 14.1 na

1970 10.7 na

1975 -8.6 na

1979 1.68 12.31

1980 4.45 12.14

1981 2.61 11.23

1982 -15.14 11.53

1983 11.89 13.05


EVOLUTION OF DOMESTIC LOCAL AND LONG DISTANCE TARIFFS

LOCAL SERVICEDOMESTIC LONG DISTANCE

FLAT RATEWithout taxes, in June 88 Ch$

1985 Ch$ per lineKM

400KM3250KM

OPERATOR DDD OPERATOR DDD OPERATOR DDD

RESID COMM 3 MIN 1

MIN 1 MIN 3 MIN 1 MIN 1 MIN 3 MIN 1 MIN 1 MIN

1970 1243.93342.2 175.03

557.041799.711971 971.72610.8 175.03

557.041799.711972 778.72092.5 175.03

557.041799.711973 360.91575.6 174.41

555.25971.771974 906.43063.3 191.32

620.89984.201975 842.62848.0 163.37

530.82841.671976 576.01942.7 131.76

429.43679.141977 694.12346.1 144.94

445.79691.351978 848.62868.080.15246.44382.201979 785.02653.286.21265.09411.231980 830.32806.380.11180.90243.661981 788.02663.383.14177.32209.001982 870.92945.183.14177.32209.001983 1034.52413.983.14184.03216.891984 983.11994.756.60125.29147.681985 1390.72387.149.65


ENTEL, however, appealed to the Supreme Court which, in 1990, requested from

the Resolutive Commission a more in-depth study of the technical conditions that would allow for

fair playing conditions, including the supervision of interconection quality (Gaymer, et al, 1993, at

13). The Resolutive Commission took three years to study this issue anew, and, in 1993 it upheld

its prior decision, and requested from the government the implementation in less than eighteen

months of the multicarrier system. The system was introduced in late August 1994 outside

Santiago and a month later in Santiago. Prior to its introduction, and to some extent reflecting the

strong pressure exercised by ENTEL, Congress amended the General Telecommunications Act

limiting for the next five years each operator’s market share in the domestic and international long

distance market. Those carriers affiliated to local exchange companies (mostly CTC) were subject

to stringer restrictions. See Table B:17. The Table shows the nature of the bargain: CTC is

initially limited to a 35% of the long distance market, while ENTEL is required to initially

relinquish at least 30% of the market. But the market share restrictions also provides CTC with

some protection from competition from ENTEL. If ENTEL decides to enter into local service

during 1995 it has to relinquish 80% of its current long distance market share, or 50% more than if

it stays out of the local service market. Thus, Law 3-A reflects a particular bargain struck among

the companies that allowed the implementation of the Resolutive Commission. Although ENTEL

lost at the Resolutive Commission, litigation provided it with 5 years of delay.

MARKET SHARE RESTRICTIONS IN THE LONG DISTANCE MARKETS

DOMESTIC LONG DISTANCE INTERNATIONAL LONG DISTANCE

YEAR AFFILLIATED NON AFFILIATED AFFILIATED

NON AFFILIATED

1995 35% 80% 20%70%

1996 45% 70% 30%65%

1997 55% 60% 40%60%

1998 60% 60% na na

Source: Law 3-ATable B:17


Competition for long distance has had, so far, the expected results. First, twelve

firms requested long distance licenses, and six firms entered the market by late September.?

Following a hectic advertising campaign by all the long distance operators, prices of long distance services fell to a third or half of ENTEL’s

prices prior to September 1994. See Table B:18. Also, as Table B:19 shows, ENTEL’s market share more than halved overnight. Even without

including public telephones, its market share did not to reach 50% by December 1994.? Also, at least so far, the fear that CTC will capture a

large percentage of the market did not materialize, as CTC is still the third largest long distance carrier with less than 30% of the market. The

introduction of the multi-carrier system, then, completed the first round of reforms that started in 1987 with the Resolutive Commission

determination that both local and long distance services were not competitive. While the multi-carrier system improves upon the extent of

competition in the long distance market, it does not affect the extent of competition in local services. This is the next battlefront in the Chilean

telecommunications wars. As with the introduction of long distance competition, competition at the local exchange will require further

refinements in the regulatory framework, which, given the constraints involved in the regulatory scheme, will have to wait the results of litigation

in front of the antitrust authorities and the courts.

? Apart from CTC and ENTEL, Chilesat (the owner of CHILE Telex) and VTR (the owner of CNT and of TELCOY) were already providing long distance telecommunications services. New entrants include Bell South and Iusatel. CNT

also started providing long distance services.? El Mercurio, 1/13/95, B20, estimates that without counting public phones (where CTC has the majority of the outgoing calls) and private lines, ENTEL has 46.2% of the market, CHILESAT 30.6%, CTC-Mundo 11%, VTR 7.4%, Bell South

2.4% and CNT-Carrier 2.4%.


The introduction of the multi-carrier is an excellent example of how the original design of a system of checks and

balances in utility regulation limits the ability of the government to tightly control the evolution of the industry. Indeed, the participation of the

antitrust authorities reversed an original position of the regulator against vertical integration. The participation of the Supreme Court,? another

part of Chile’s complex system of checks and balances, delayed the de-facto deregulation of long distance by four years.? This seems to be

? Recall that the law explicitly granted the right to appeal to the Supreme Court decisions of the Resolutive Commission Anti to few specific cases, involving, among other issues, changes in the statutes of companies, as seems to have been

the case here.? Indeed, CTC complained bitterly about what seemed to have been the manipulation of the system by ENTEL. See, the

presentation by Mr. Germán Ramajo, the Executive President of CTC to a conference on “Telecomunication in Chile: Vertical Integration, Free Competition, June 1992, entitled “Telecomunications in Chile: The True and False Dillemas.”

ADVERTISED TARIFF RATES IN EL MERCURIO

PER MINUTE, US$

(Average per month)

9/94* 10/94 11/94 12/94 1/95

LDN/D 0.047 0.028 0.040 0.083

LDN/N 0.017 0.026 0.016 0.059

LDI/USA 1.602 0.407 0.390 0.328 0.428

LDI/OTHER 2.676 0.497 0.607 0.461 1.285

Notes:

* ENTEL tariffs, prior to the introduction of the multi-carrier system.

LDN/D: national long distance, day time

LDN/N: national long distance, night time

LDI/USA: international long distance, USA

LDI/OTHER: international long distance, other countries.

Source: own survey of El Mercurio.Table B:18


another example of the reformers choice of credibility over flexibility. This time, as may often be the case, credibility came at a cost.

PARTICIPATION OF CARRIERS IN THE LONG DISTANCE MARKET

(In percentage points)

SEPTEMBER/NOVEMBER 1994

DECEMBER 1994

CARRIER DOMESTIC INTERN’L DOMESTIC

INTERN’L

ENTEL 40.2 47.3 36.67

CHILESAT 22.10 24.60 25.44 24.30

CTC-M 28.10 13.70 27.05

VTR 6.00 11.30 7.55

CNT-C 1.90 0.60 0.33

BELL SOUTH 1.70 2.50 1.96 1.42

IUSATEL 0.00 0.10 0.00

Source: El Mercurio, various issues.Table B:19

Corbo-V Lüders, R.; Spiller P. The institutional foundations of economic reforms...

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