Sustainability of Regulatory Reform in Latin America: Unraveling Commitments Carlos Rufin*Babson College Evanán Romero** Prepared for presentation at the 2004 Annual Research Conference of the Association for Public Policy Analysis and Management Washington, D.C., 6-8 November 2004 Please do not cite or quote without the corresponding author’s permission. 2 November 2003 Abstract: We examine the likelihood of indirect expropriation of private assets—appropriation—or the capture of regulatory agencies by private interests. We first consider different theories that explain time inconsistency in public policy towards infrastructure sectors: ideology, political strategy, political transaction costs, and legitimation. We then compare the post-reform experience with regulatory independence and capture in the electricity industry in three Latin American countries: Brazil, the Dominican Republic, and Guatemala. Our comparison shows that in these countries, domestic resistance to reform packages that originated mainly abroad introduced imbalances into the implementation process that have progressively undermined the reforms. The result may be a vicious cycle in which the imbalances lead to crises that are then used as an excuse to reverse reforms by reasserting political control over the industry. We show that this process is largely consistent with the theoretical perspectives, and conclude with recommendations for reducing time inconsistency in pro-market reforms. * Corresponding author (Babson Park, MA 02457, USA, and [email protected]). We are very grateful for the financial support of the Institute of Latin American Business at Babson College, which generously funded research assistance and field research for this project. We have also benefited from extensive discussions and analytical perspectives of participating researchers in the Inter-American Development Bank’s project on the sustainability of regulatory institutions in Latin America, and from panel participants at the LASA 2001 Conference in Washington, DC. The material presented here, however, represents our individual views alone and all errors are ours. ** Former Visiting Scholar at Harvard University’s Center for Business and Government, John F. Kennedy School of Government and former Visiting Scholar, Institute of Latin American Studies, University of Texas at Austin.Introduction: The Context of Electricity in Latin America The last two decades have witnessed a fundamental shift from state to market throughout the world. Latin America has been no exception. If the 1980s were a decade of macroeconomic reform, involving attempts to rein in inflation and public spending to address unsustainable levels of foreign indebtedness, the 1990s brought “second generation” reforms of a more microeconomic nature, intended to expand the role of market forces in Latin American economies in order to spur economic efficiency, private investment, and economic growth. These reforms included active participation in the “amazing and broadly contemporaneous revolution” that is taking place in the organization of markets for infrastructure services worldwide (Hogan, 2000): the introduction of market systems of resource allocation in activities that until very recently were considered to have natural monopoly characteristics, such as local telephony or electricity generation. Chile, for instance, pioneered electricity market reforms in 1982. The reform of infrastructure sectors throughout Latin America has been largely driven by the lack of domestic capital—including public capital—and up-to-date technology to improve and expand the provision of infrastructure products, as well as ideological considerations regarding the superiority of markets as allocative mechanisms (Rufín, forthcoming 2003). In turn, reform has entailed a redefinition of the boundary between government and business. Specifically, the public sector has retreated from the direct provision of goods and services to focus on policy formulation and regulation—especially the protection of consumers from anti-competitive abuses—as more effective means of attaining goals such as economic competitiveness and growth. Private investment, and especially foreign direct investment (FDI) responded strongly to reform. For example, from 1998 to 1999 FDI jumped 32%, from $73 bn to $97 bn, exceeding Asia in net FDI inflows for the first time since 1986 (UNCTAD, 2000). US and European investors flocked to Latin America and bought into public offerings, involving large commitments in both new and privatized facilities. The private sector became the primary 2investor in, and operator of, infrastructure companies in telecommunications, electricity, and natural gas in many Latin American countries. In electricity and natural gas, of the $187 bn invested by the private sector in energy in 76 developing countries during the 1990s, 42% went to Latin America, with privatizations in electricity generation representing the major investment. Spain and the United States were first and second, respectively, as sources of capital for the energy sector in Latin America. A key part of the redefined role of the state involves economic regulation. Regulation is needed to redress the market imperfections of infrastructure sectors, where natural monopoly arises due to the network externalities involved in infrastructure service delivery, but without unduly discouraging private investment. The “capture” of regulatory entities by the regulated companies can impede the correction of market imperfections and is thus a cause for concern upon the implementation of market-oriented reforms. At the same time, the involvement of the public sector through regulation raises the possibility that, as in the not-so-distant past, the current reforms will end in another cycle of expropriations (Gómez-Ibáñez, 1999), or more likely—given the budget limitations of most governments in the region—in what Wells and Gleason (1995) term1 “appropriation,” defined as a “gradual erosion” of private property rights as private companies are not allowed to charge prices that cover their replacement cost of capital. In this paper, we examine different factors affecting the likelihood of appropriation or capture, as suggested by a variety of theories, and contrast them with the factors suggested by a comparative and inductive analysis of recent post-reform experiences