Regulating innovation | KPMG | GLOBAL

Regulating innovation

Regulating innovation

In today's environment, the innovation lifecycle is counted in months, yet with infrastructure assets, lifecycles can stretch decades.

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In today’s environment, the innovation lifecycle is counted in months — sometimes even days. Yet, when it comes to infrastructure assets, lifecycles often stretch for decades.

The problem is that traditional infrastructure focused on capital expenditure is very expensive and, in many cases, susceptible to market failures. And that means that governments and infrastructure authorities often need to provide strong regulatory oversight to ensure that what customers demand is developed and maintained.

Governments, therefore, have two basic choices. They can build and operate the infrastructure themselves. Or, as has more often been the case in recent years, they can create regimes either through private public partnerships (PPPs) or regulated private companies and concessions to engage  private organizations to fund and operate the infrastructure on their behalf.

Yet, as the pace of innovation picks up, many governments and regulatory authorities are starting to wonder how they might rationalize the need to embed and drive value from new innovation against the equally strong need to provide investors and operators with long-term security and confidence.

The challenge with long term

In a fully competitive market, this isn’t much of a problem. The price and the service level is set by the most competitive provider which, invariably, is the one that uses the most up-to-date technology and processes. Better technology usually means that customers benefit from better service, better solutions and better prices.

However, due to the nature of most infrastructure assets (where the vast majority of the costs are locked up in large upfront capital expenditures) infrastructure tends to be based on fixed contracts, concessions or licenses that do not always offer enough flexibility for continuous improvement, innovation ortechnological disruption.

Consider, for example, the optimal PPP structure for a reservoir or a nuclear power station. In order to incentivize private investment and finance, governments often need to provide very long-term contracts that provide a high level of visibility in terms of revenue and pricing. And that means that the price that ‘customers’ pay is generally also fixed over a longer term. Any benefits of innovation that may be achieved through the life of the contract, therefore, tend to flow back to the investor, not the customer.

Accounting for innovation

In the regulated utility sector, there has always been room for innovation and improvement. And, as a result, regulated utilities generally follow somewhat more dynamic models that do allow for the benefits of innovation to be recognized and captured by customers.

Generally speaking, most regulated utility contracts (those with large, up-front capital expenditures, in particular) tend to follow what is called a financial capital maintenance model, in which the investor is expected to recover all of their invested capital over a set time period. Period reviews can create incentives and shorter term goals but to a limited extent. In contrast, under the operational capital maintenance models, new technologies can be reflected in prices to customers, but this creates risks which are often unacceptable to investors in infrastructure. This allows contracts to be ‘reopen’ to adjust for expected and reasonable improvements and innovations. Calculations are made to assess at what cost a new entrant into the market would be able to provide the same service, and the contract is then adjusted to reflect this new reality.

Even then, the pace of change significantly lags that of modern innovation cycles. Most operational capital maintenance model reopeners are set anywhere from 1 year to 8 years. In an environment in which technology lifecycles can run full circle two to three times in a single year, the ability of traditional regulatory models to respond to actual technological change is still limited. 

New ideas needed

While the operational capital maintenance model provides some leeway for new innovation, it is a rather crude model for capturing the potential innovation within other, non-utility, infrastructure sectors. The pace of the reopeners is one challenge. However, it also offers little comfort for those assets that require large up-front capital costs.

One potential takeaway is that governments and those developing PPP contracts may want to start thinking about how they can include these types of reopeners, at a more frequent pace, into longer-term contracts but within limits to ensure a degree of price and revenue visibility that private investors need, but this is likely to require more active economic regulation.

Another is that infrastructure procurement authorities should start thinking in terms of systems rather than individual assets. One of the reasons that utilities are able to live with reopeners is that as part of a larger system or network, there is significantly more room to apply new innovations. If you simply focus on one single asset, the scope for change is limited. If, however, you are looking to drive improvements across an entire system, the potential to leverage new technologies increases (without putting an undue burden on a single asset or investor).

Finding new models will require significant debate, innovation and partnership between all parties, particularly policy makers, regulatory authorities and private investors. And it will require renewed focus on what is best for the consumer.

We look forward to the debate. It won’t be easy. But it will be incredibly valuable — for governments, infrastructure authorities, private investors and, above all, for consumers.

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