Incentives Matter

Tom Adams and Elizabeth Brubaker
July 12, 2001

Energy Probe Research Foundation’s Presentation to the Walkerton Inquiry
Public Hearing Number One: Guiding Principles

Elizabeth Brubaker:

Mr. Commissioner, you have a lot of recommendations in front of you – recommendations regarding specific legislation, policies, plans, and investments. We’d like to focus on something different in this first hearing. Not so much on the what as the why. Not so much on the recommendations themselves as the principles behind them. We want to share with you a few concepts that we find especially useful, both in understanding problems in the existing system and in developing solutions to these problems. Hopefully, these concepts or principles will give you some criteria to evaluate the recommendations that you hear throughout the course of these hearings.

Let me first say a few words about the state of our water systems. This morning, we heard Anne Mulvale, of the Association of Municipalities of Ontario, say that municipalities have done an admirable job of delivering water. Then Judy MacDonald, of the Ontario Municipal Water Association and Ontario Water Works Association, told us that water has essentially been well treated in Ontario. I’m afraid that I strongly disagree. Our systems are in very bad shape. In Part One of the Inquiry, we heard that 367 plants didn’t comply with provincial standards last year. We heard about the 246 boil water advisories. And the reporting problems. And the inadequate training. And the enormous capital investment needs.

It’s very important to understand that these problems are nothing new. They were as serious 10 or 15 years ago as they are today. A study spanning 1987 to 1993 found that at least half of the plants it looked at had problems with operations and monitoring. It noted that many operators did “not understand the fundamentals of water treatment.” Inspections between 1990 and 1992 found that fewer than half of the plants complied with provincial guidelines or objectives. Then again, between 1992 and 1994, inspectors found inadequate sampling at more than half of the plants they looked at.

So the problems that we’re experiencing now didn’t develop under the lax watch of the Harris government. They weren’t created by recent cuts. We can’t lull ourselves into thinking that more staff and bigger budgets will solve our problems. Nor will a change in government. The problems were severe under the Liberals and the NDP, and they continue to be severe under the Conservatives. The problems are built into the very nature of the systems and the institutions that govern them. Unless we make fundamental changes to those institutions, we’re not going to solve the problems.

We believe that there is one overarching problem inherent in the existing system – that is the lack of appropriate incentives. Under the existing system, regulators, operators, polluters, and consumers often have perverse incentives – incentives to do the wrong thing rather than the right thing.

Our challenge is to develop institutions and rules that create positive incentives. Institutions where the pressure to perform well comes from within instead of from without. Rules that work with human nature instead of against it. That’s no small challenge. How can we encourage regulators to enforce the laws protecting public health and the environment? How can we encourage farmers, sewage facilities, and industry to prevent their wastes from entering the environment? How can we encourage the owners of water systems to invest? How can we encourage operators to operate effectively and efficiently? How can we encourage consumers to use water responsibly? How, in other words, can we get the incentives right?

We think the answers are fairly straight-forward: For regulators, we have to eliminate the conflicts of interest that prevent them from enforcing tough laws. For polluters, operators, and consumers, we have to internalize the costs and benefits of their actions.

We’ll be going into detail on how to accomplish these things in the coming weeks. For now, let me focus on the principles involved. Let me start with the principle that conflicts of interest should be eliminated. Our concern is that the provincial government now plays too many roles. Through the environment ministry, Superbuild, OCWA, and its “children” (the municipalities), the government owns, operates, finances, and regulates our water systems. These roles often conflict with one another.

For example, the government understands that if it enforces the law, and requires expensive improvements to water systems, it may have to foot the bill. The environment ministry likewise understands that if it enforces the law, it may well be acting against its own OCWA – an agency that is closely overseen by the ministry, that is financially tied to it, and that is staffed by former ministry colleagues. Who would prosecute himself, or his old friends? Even when the violator is a municipality, it’s still just another level of government. Municipalities aren’t independent of the province. Their relationship is very close. They’re thought of as “creatures of the province” or “children of the province.” Who would prosecute his own children? We believe that these conflicts create a built-in bias against law enforcement.

This concern about bias is nothing new or radical. Indeed, the rule against bias is a fundamental rule of natural justice. The Oxford Dictionary of Law explains that “no man may be a judge in his own cause.” It goes on to say that in any exercise of administrative authority, any decision “is invalid if made by a person with any financial or other interest in the outcome or any known bias that might have affected his impartiality.” We don’t think that there’s any question that you can’t expect impartiality from a regulator that is also an owner, an operator, and a funder.

The economist Friedrich Hayek has written wisely on this subject. He explained that the government will always protect its agencies against criticism: “A state monopoly is always a state-protected monopoly … Where the power which ought to check and control monopoly becomes interested in sheltering and defending its appointees, where for the government to remedy an abuse is to admit responsibility for it, and where criticism of the actions of monopoly mean criticism of the government, there is little hope of monopoly becoming the servant of the community.”

This inquiry commissioned a paper on organizational behaviour that came to a similar conclusion. The question was: Why do well-intentioned organizations make bad decisions? How can the people in them see that a catastrophe is likely to happen, and do nothing to stop it? The answer was: People and organizations act defensively. They want to avoid embarrassment. They want to cover up mistakes – not expose them.

Our current system creates a lot of incentives for defensive behaviour. Those incentives are inherent in the operational, financial, and regulatory conflicts. We believe that the only way to remove these perverse incentives and to eliminate the conflicts of interest is to get all levels of government out of the business of operating and financing water systems. In short, privatize. Privatization would enable the government to focus on its core responsibility: regulating our systems.

I’m going to turn the floor over to Tom Adams for a few minutes. He’ll tell you a bit about Energy Probe’s experiences at the Ontario Energy Board. The OEB has handled the regulation of private gas companies very differently from the regulation of public electricity companies. Our experience at the board has taught us a lot about conflicts of interest, and how to avoid them.

Then, after Tom has finished, I’ll come back to our other guiding principle – that of internalizing costs and benefits.

Thomas Adams:

Ontario’s contrasting experience with regulation of the natural gas distribution sector in the period from the late 1960s until 1998 relative to our experience with electricity sector regulation illustrates the public interest benefits of eliminating conflicts of interest and the public interest consequences of ignoring this principle.

In the natural gas distribution sector, the role of government was clearly conceived and implemented: The government focussed on achieving public interest benefits through a regulatory system that operated at arm’s length from government and was wholly removed from the private industrial sector it oversaw. Due process protected the rights of applicants and intervenors. A very high standard of transparency prevailed.

What were the results of this arrangement? Investor confidence was established and billions of dollars were sunk into pipe-based assets without a penny of taxpayer exposure. The gas distribution network has now been extended to virtually every consumer for whom gas is cost-effective. Distribution rates have been extremely stable and low. An outstanding safety and environmental record has been achieved. Natural gas distribution has realized what might be considered the highest objective of an infrastructure service – anonymity through competence.

By contrast, in electricity the role of government has been mired in conflict. In electricity, taxpayers were de facto involuntary investors in assets of Ontario Hydro and municipal distribution utilities. The ownership of these assets was legally moot. Government regulated through appointment to boards of directors, ad hoc parliamentary and bureaucratic reviews, and starting in the mid-1970s, non-binding, narrowly scoped annual rate reviews by the Ontario Energy Board. Investment decisions were taken either by utility managers without public oversight or through some process of political oversight and intervention. This system achieved some good. The electricity grid grew to be more extensive than the gas grid. A reasonable standard of power system reliability has been established. However, taxpayers became highly exposed. Financial reporting was characterized by significant accounting deficiencies. Rates have been politically determined. Revenues fell well short of costs. Significant environmental concerns prevailed. Controversy has dogged the industry.

Conflicts of interest in the public oversight of energy utilities has attracted scholarly attention. One of Energy Probe’s submissions to the Inquiry discusses the findings of one such review, authored about ten years ago by Queen’s business professor and former member of the Ontario Energy Board Mervin Daub.

Elizabeth Brubaker:

I’ll be brief, in order to allow plenty of time for questions. I just want to spend a few minutes talking about accountability – accountability for polluters, owners, operators, and consumers.

In order to encourage individuals, organizations, and firms to do the right thing, we recommend holding them accountable for their actions. In some cases, this can be achieved through legal liability. In other cases, it can be achieved through market mechanisms. Or through changes to pricing regimes. Whatever the mechanism, the principle behind it is the internalization of costs. Internalizing costs creates incentives to avoid those costs. It creates incentives to reduce risks. To act efficiently. To eliminate waste. Internalizing costs makes the world safer and more sustainable.

Under the existing system, costs and risks are often externalized: They aren’t born by the parties that create them. Instead they’re borne by outsiders – people who often have no control over them. This is both unjust and ineffective.

Take, for example, the pollution of drinking water sources. Farmers, sewage facilities, and industry are best placed to prevent their wastes from entering the environment. But they often have insufficient incentives to do so. They’re rarely held fully accountable for the costs and the risks of their pollution. In a number of cases they’re explicitly exempted from legal liability.

The same is true for the owners and operators of public water systems. They enjoy a number of liability limitations that dull their incentives to act responsibly. They’re also free from the accountability that inheres in the market. Operators who perform poorly aren’t likely to lose their jobs. PUCs don’t have contracts with stiff financial penalties for poor performance. Municipalities won’t be put out of business if they’re negligent. Claims won’t bankrupt them. If Walkerton is any indication, the province will pick up the tab.

Those who have the potential to do harm – in this case, polluters, water utilities, and their employees – should be held responsible for the consequences of their actions. They should be subject to criminal liability, tort liability, and contractual liability. They should be subject to the accountability of the market. Accountability will create powerful incentives to perform well. It will ensure that parties have a financial interest in a safe water supply. It will ensure that their interests are congruent with the public interest.

A few final comments on the accountability of consumers. Under the current system, they aren’t paying the full costs of their water. In some cases, they aren’t even metered. So they don’t have incentives to use water responsibly. Of course, the government can impose water conservation rules. But doing so doesn’t internalize costs. So it doesn’t internalize incentives to conserve. Down in the US, the government’s decision to set low-flow standards for toilets simply created a market for used toilets … and for high-flow toilets snuck across the Canadian border. Far better is a system where the incentives come from within – where it’s in the consumer’s own financial interest to conserve. Universal metering and full cost pricing create such incentives.

Those are our prepared comments. They can be distilled into just two words – two words that we hope will guide your thinking on any number of issues: Incentives matter.

Now we’d be delighted to answer your questions.

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