Regulation-by-Contract and Municipal Services: The Problem of Contractual Incompleteness

Two approaches to the economic regulation of utilities may be contrasted as ideal types: regulation-by-contract, which focuses on the terms of the agreement reached between the parties and relies on the judicial system to resolve disputes (and is typically used for public-private partnerships – PPPs), and regulation-by-commission, which depends heavily on discretionary authority given to a specialized regulator. Most of the drawbacks of regulation-by-contract stem from the inevitably incomplete nature of the contracts. Given asset specificity and the potential opportunism of the parties, unconstrained renegotiation between the parties in the face of changed conditions is an unreliable way of coping with contractual incompleteness. This study begins by setting out a conceptual framework and assessing different ways of coping with contractual incompleteness. In the tradition of the new institutional (transaction cost) economics, the study uses two present-day case studies, involving municipal services, to explore whether the problems with regulation-by-contract are intrinsic to the approach or whether it failed in the past (e.g. in the U.S. in the late 19th and early 20th centuries) for reasons that can be avoided, at least in certain contexts. Both case studies involve privately constructed and operated municipal solid waste incineration plants: one in Lyon, France, and the other in Saugus, Massachusetts. An examination of the French system and the Lyon case study suggests that, regardless of formal aspects that are conducive to regulation-by-contract (a specialized administrative court system and a body of background rules that serve to fill gaps), the French system has functioned relatively smoothly mainly because of extra-legal (relational) norms and influences: a culture of “délégation” and deference has helped to solve the incomplete contracting problem. In contrast, the Massachusetts case highlights, in a non-relational context, the inadequacy of the ordinary court system and conventional arbitration in the U.S. (which lack appropriate background rules and specialized adjudicators) for tackling even simple regulatory issues. The study also proposes ways to strengthen the regulation-by-contract approach for municipal services, involving a concession referee board that builds on the dispute review boards used with success in the construction industry and a comprehensive effort to develop a corpus of default legal rules.