INSTITUTIONAL REFORM AND REGULATION IN TURKEY

The main reasons for delegation of the regulatory discretion to IRAsfrom the institutional perspective are to reduce political transaction costs and to ensure a credibleregulatory commit

INSTITUTIONAL REFORM AND REGULATION IN TURKEY

Tamer Çetin Department of Economics Zonguldak Karaelmas University

Turkey

Fuat Oğuz Department of Economics Baskent University Turkey

ABSTRACT

The paper analyzes the transition process to IRAs in Turkey and lessons form the Turkish energyindustry in this process The main reasons for delegation of the regulatory discretion to IRAsfrom the institutional perspective are to reduce political transaction costs and to ensure a credibleregulatory commitment In this context, the first section of the paper examines what politicaltransaction costs and regulatory commitment in terms of delegation of the regulatory power toIRAs mean Later, the paper scrutinizes the political and legal issues occurring during thetransition to IRAs in Turkey Finally, the paper reveals the institutional conflicts in the industry byconsidering cases between the independent regulatory and the government in the Turkish energyindustry

Key words: independent regulatory agencies, transaction costs, independence, Energy, Turkey.

INTRODUCTION

Independent regulators have become part of the institutional structure of the regulatory process inrecent times The institutional structure of the regulatory process in a country determines thecompetence of public utilities, investment decisions and economic performance A well designedregulatory governance mechanism reduces governmental opportunism supports a successfulsector performance (Spiller and Tommasi, 2005)

Regulatory commitment and political transaction costs are the basic tools to evaluate theefficiency of a regulatory process Political and institutional structure of regulation shapes thenature and scope of commitment and interaction among players (mainly the Legislature, theExecutive-IRAs, and the Judiciary) The supply process of regulation determines the magnitude

of political transaction costs (Levy and Spiller, 1996) Arbitrary interventions to the regulatoryprocess increase transaction costs and reduce regulatory commitment

The institutional structure of regulation in a country determines its economic and politicalenvironment Each country has a distinctive regulatory-institutional endowment which affects itsregulatory-institutional structure (Laffont, 2005) As conflicts of interest between institutionsincrease political transaction costs, belief in regulatory commitment diminishes If commitment

is not credible, the choice of optimal policy or equilibrium becomes difficult However, crediblecommitment limits the extent to which a party can engage in opportunistic behavior and henceprovides reliance to the system When commitment is not fully credible, firms have difficulty inmaking long-term plans They will also have weaker incentives to make long-term andirreversible investments, and focus on short-term goals instead (Baron, 1995: 16)

Delegation of power to IRAs reduces political transaction costs and increase commitment(McCubbins, 1985; Majone, 2001) In countries which have little experience in delegatingfunctions to ‘arm’s length’ institutions, independent regulation is controversial Turkey is notexception to this trend The polity in such environments cannot develop regulatory institutions(Spiller and Tommasi, 2003)

Turkey has reshaped its own regulatory institutional structure recently by establishing IRAs.The transition from the state-ownership to the regulatory model created high political transactioncosts (TUSIAD, 2002) The lack of constitutional protection and legal ambiguity surroundingIRAs create a question of legitimacy The inconsistency of policies between the government andIRAs feeds rent-seeking activities, which contributes to the failure of regulatory reforms (Demir,2005)

This paper discusses these issues in depth with a political economy perspective To beginwith, the paper observes the main rationales for delegation of regulatory discretion to IRAs Next,

we analyze the political economy of the institutional change in Turkey with a focus on recentgovernments In the end, we discuss the place of IRAs in the regulatory institutional structure byemphasizing on the issues in transition and lessons from government’s energy policies The paperdraws attention to potential dangers of politically ‘consistent’ but economically ‘inconsistent’attitude toward economic institutions

2 RATIONALE FOR DELEGATION OF DISCRETION TO IRAS: POLITICAL TRANSACTION COSTS AND CREDIBLE COMMITMENT

IRAs represent the best examples of delegation of the regulatory policy-making discretion to majoritarian institutions (Majone, 2001b) Most scholars have focused on how and why electedpoliticians delegated their competencies to IRAs, formal institutional design of IRAs andconsequences of creating IRAs (Thatcher, 2002; Majone, 2001a, 2001b; Epstein and O’Halloran,1999) The main aim of such agencies is to reduce the influence of politicians and private actors

non-in non-industries such as energy, telecommunications and transport IRAs, are seen as the guaranteefor objective and unbiased administration

There are a number of theoretical rationales for delegation of discretion to IRAs, rangingfrom expertise, flexibility, stability to public participation, transparency, and public interest(Thatcher, 2002; Majone, 2001b; Epstein and O’Halloran, 1999) For example, IRAs are closer tothe regulated sector than ordinary bureaucracy and can more easily gather relevant information

They can easily adapt to technology or technical knowledge and build expertise related to regulatory issues IRAs’ autonomy makes them more able to flexibly adjust regulations to

changing conditions IRAs provide a stable and predictable regulatory environment The decision

making process of IRAs is more open and transparent than that of ministerial departments and is

more sensitive to diffused interests such as those of consumers

However, functional advantages are not sufficient to explain delegation of power to IRAs Bypursuing Majone (2001a, 2001b) and Levy and Spiller (1996), we directly focus on two muchmore important rationales; political transaction costs and regulatory commitment Both politicaltransaction costs and regulatory commitment influence each other, and both of them determineefficiency of the regulatory process together Accordingly, the most important function of IRAs is

to reduce political transaction costs and to ensure credible commitment in the regulatory process(Thatcher, 2002)

2.1 Political Transaction Costs

In real world, transaction costs are always positive The concept can be easily related toregulatory decision making processes The regulatory process means interaction within theinstitutional endowment or the governmental-politics structure that plays a prominent roleparticularly in public utility regulation The regulatory institutional endowment consists ofpolitical processes that define property rights, redistribute wealth and determine the direction ofthe economy Transaction costs are usually higher in politics than in the economic sphere.Political processes thus create more inefficiencies (North, 1990) Politicians can manipulate

regulatory processes for political ends and create governance problems (Williamson, 1999).Establishing credible institutions plays a crucial role in reducing transaction costs (North, 1991)

In that case, political transaction costs -the cost of operating the political process and, inparticular, the cost of reaching and enforcing political agreements- may be the reason whypolitical principals choose to delegate policy making powers to IRAs rather than makingthemselves it (Majone, 2001a) The relationship between politicians and regulators are modeledusually a principal-agent problem (Moe, 2006) Thus, the relationship between regulatoryinstitutions playing a role in the regulation game reveals political transaction costs in theregulatory process

Economic, political and social institutions exist to reduce transaction costs According to thisapproach presented by Coase (1937) and developed by Williamson (1975), the reason for theorganization of the economic and the political hierarchies like firms, governments and regulatoryagencies is the minimization of transaction costs

As a result, the level of political transaction costs is one of the foremost factors that shape thedesign of the regulatory framework (Menard and Shirley, 2005) Interactions among relatedgroups affect the magnitude of political transactions costs (Levy and Spiller, 1996) In thisconnection, the attitude of the judiciary, the executive and the legislators determine the structure

of regulatory institutions A strong government does not tolerate regulators to intervene itspolicies In such cases, independence of IRAs can be injured and thus, transaction costs of theregulatory process can increase

2.2 A Credible Regulatory Commitment

Politicians have to signal the credibility of their proposed reforms, if it is to be successful Theabsence of credibility weakens any political reform Regulatory reform proposals around theworld offer many examples, particularly in utilities Utility investments are long-lived, and therole of credibility becomes more important In this environment, if the commitment for reform isnot credible, private investors will stay out of the industry Existing firms will focus on short termprofits instead This process creates disappointments in politicians and gives way to resistanceagainst regulatory reform (Spiller, 1996: 477)

Credibility in public utility regulation is particularly crucial in developing economies wheninstitutional rules are not well established (Laffont, 2005) Efficiency of regulation depends onregulatory governance and commitment Governments can politicize the pricing and expropriatethe firm’s sunk assets by altering rules or regulations (Levy and Spiller, 1996; McChesney, 1987).This possibility discourages firms from making long-term investment commitments

Governments tend to use their discretionary power where institutional costs are low and theexpected utility of the use of such arbitrary discretion is large Thus, the problem of regulatorycommitment in public utility regulation is a consequence of the very nature of the regulatorypolicy-making processes (Majone, 2001a: 61)

Governments send a strong signal to the private sector that it will not interfere in operationalaffairs related to the market processes for political ends by establishing IRAs In this sense,delegation of the regulatory discretion to IRAs is a feasible and popular method for a credibleregulatory commitment However, there are some necessary conditions in order to ensureregulatory commitment in a system with IRAs One of them is the independence of regulatoryagencies With this system, the government binds itself and it is in its interest not to bend rulesthat defines its commitment

Procedural and substantial legitimacy of an IRA provide the background for a goodinstitutional design Ill-defined political property rights in the regulatory policy-making processcan also impede regulatory commitment Delegation to IRAs changes political property rights andguarantees the independence of the agent The guarantee is particularly strong when the legal

basis of the transfer is not a statute but a constitutional provision (Majone, 2001a) The strength

of constitutional rules that protect private or political property and contract rights against agovernmental intervention does not only ensure the independence of the agent, but can alsoestablish a credible commitment or prevent the political attraction of rent-extraction strategies onreturns to private capital (McChesney, 1987)

Another argument for credible commitment is the time-inconsistency or the politicaluncertainty problem in the policy making process (Majone, 2001a; Moe, 1990) In moderndemocracies, principals are elected for a particular time period at regular intervals While today’spoliticians can exercise the political property rights at present, other ones with different andperhaps opposing interests can acquire the right in the next elections Then today’s politicalpreferences are most probably subverted legally by tomorrow’s political authority (Moe, 1990) Insuch cases, elected politicians cannot ensure a credible commitment in long-run policies and thepolitical property rights amounts to the discretionary powers IRAs can solve such a time-inconsistency problem (Majone, 2001a)

2.3 The Dilemma of Independence and Accountability

While there is a consensus over the benefits of delegation, it has also its own problems The majorone is known as the ‘delegation problem,’ which refers to the tension between elected politiciansand tenured bureaucrats Much of that attention has focused on the ways politicians try to

influence agencies indirectly by designing the agency’s environment so as to steer the agencypolicy into a particular policy direction This creates a trade-off between the independence of anIRA and its accountability over its decisions

Independent regulators can pursuit their self-interests rather than public interest (Sigman,2001; Figueiredo et al., 1999; Niskanen, 1975) They can try to maximize their own budget, getmore autonomy, positive recognition and publicity In order to reach these goals, IRAs may usetheir informational advantages to benefit, including higher transfers and rewards In such cases,private interest groups easily become part of the regulatory agenda (Fiorina, 1986; Stigler, 1971)

Or, IRAs can be subject to pressures from politicians (Sigman, 2001) All these considerationssupport the view that there has to be a balance between independence and accountability.Politicians use some tools to establish the balance

The best-known version of these tools is the so-called structure and process hypothesis Byusing structure and process mechanisms, the legislature can control the activities of IRAs But,this method generally injures independence of IRAs, limits accountability and does not solve the

deviation problem of IRAs from public interest According to the hypothesis, legislatures exert ex ante influence over decisions of IRAs by imposing on the agency a particular organizational

structure and decision-making process (Spence, 1999: 413-14) For instance, politicians canstructure IRAs so as to define their regulatory discretions By determining the agency’s mission,establishing its internal organizational structure, and choosing its location within the largerexecutive branch via the structural arrangements, politicians can control discretionary power ofthe agency through structural choices and force the agency in favor of a specific policy outcome IRAs cannot be independent when they are subject to continuous political oversight.1 Foraccountability, instead of direct control or congressional dominance, transparency of an IRA’sactivities can be chosen

The transparency in the regulatory process means the mandatory disclosure of necessaryinformation by the related regulatory institutions to attain a clear regulatory aim (Weil et al.,2006) If IRAs disclose necessary information concerning their regulatory activities, thedemocratic process may improve the accountability without political control For that reason, therelevant laws must specify delegated authorities, roles, duties, responsibilities, and decision-making processes of IRAs In this sense the Turkish experience provides a good case study on theinterrelationships between executive, judiciary and regulatory institutions in a newly established

1 However, active congressional reversal is not necessary; all that is needed is the threat oflegislative action (Carrol et al., 1999) Legislative action on the regulatory discretions of theindependent agencies is sufficient to injure the independence of IRAs

regulatory environment The rest of the paper will take a closer look at the recent Turkishexperience

3 THE POLITICAL ECONOMY OF CHANGE IN TURKEY: FROM COALITIONS TO THE CURRENT GOVERNMENT

Since the 1980s Turkey followed the path to a more liberal economy, with some success.2 Thetransition also gave way to a rent-seeking society (Demir, 2005; Heper, 2000), which emboldenedthe trend to solve economic issues in political markets In the end, political reforms haveproduced unexpected negative results and remained mostly ineffective

The dominance of rent-seeking diverted entrepreneurial incentives unproductive, andsometimes destructive, rents in government rather than productive profits in competitive markets(Akyüz and Boratav, 2003: 1560; Özcan and Çokgezen, 2003: 2064) The institutional structure

of the regulatory process evolved within this structure (Onis, 1998) The privatization experience

of Turkey provides important lesson in this connection Privatizations turned into a policy gameand became part of rent-seeking of political interest groups (Ercan and Onis, 2001)

3.1 The Lost Decade: 1990s

Throughout the 1990s, privatization and regulation became part of Turkish development plans.The seventh plan, introduced in 1996, recommended the privatization of state monopolies andintroduction of competition in network industries It also recommended the establishment of IRAs

in those industries The eighth development plan also gave some room to regulatory institutions.Similarly, international institutions (IMF, EU, OECD, and World Bank) also encouragedregulatory reform

In the political sphere, Turkey lived with coalition governments throughout the 1990s until

2002 The last coalition government took the first crucial steps with its structural reforms in

2001 The transition program prioritized competition and efficiency in the economy andintroduced the institutions of market economy However, the same government faced manycorruption issues The close ties between the political elites and leading holding companiesopened doors to widespread rent seeking and corruption In the absence of a regulatory institution

in the banking industry, excessively politicized public banks have emerged as major instruments

of rent distribution in the political process Both borrowing and leading operations of these institutions have heavily been politicized in the political processes Public banks helped

2 Turkey’s transition to a more liberal market system has been widely discussed in the literature See, for example, Bugra (1995), Onis (1998), Heper (2000), OECD (2002), and TUSIAD, (2002)

governments to transfer public funds to their own constituents including agricultural producers and small and medium sized businesses The duty losses of these banks for

2000 and 2001 are shown in the Table 1 (Alper and Onis, 2002) In the end, Turkey had tocounter financial crises, large costs to the economy and a necessity for fundamental change in thebanking and other industries (TUSIAD, 2003).3

(Table 1 Here)Not only the banking industry, but also other tightly regulated industries and state monopolieswere main targets of rent-extracting and rent-seeking activities As in other developing countries,the state-owned monopolies in Turkey have been inefficient Politicians have manipulated thisinefficiency for their own political ends For example, the electricity industry has long been anarena for wealth transfers to the state and an important variable in political games

Turkey’s political environment has long been defined by coalition governments Theinstability of coalitions made bargaining and strategic behavior an important component of thepolitical life The 1990s was particularly unsteady There were eleven short-lived governments

As seen on Table 2, seven of them were coalitions Turkey faced three biggest economic crises(1994, 2000, and 2001) during this period There is a positive correlation between economiccrises and political instability (Kibritcioglu, 2001) In most cases, coalitions included parties withopposite world views For example, the last coalition government included a leftist (DSP), anationalist (MHP) and a liberal-conservative party (ANAP) This government, as easily predicted,could not implement any significant policy proposal because of conflicting opinions and beliefs.One of the harmful results of the incoherence was the unrelenting budget deficits, which wenthand in hand with inflationary pressures

(Table 2 Here)

Governance by coalitions harms the stability of any regulatory policy No government cantake bold steps in this environment and political bargaining dominates the political market Thecosts of decision-making are relatively higher in coalition governments because of widespreadprincipal-agent problems (Martin and Vanberg, 2004) Interest groups use this systemcompetently to extract rents, as the cost of rent-seeking decreases There are two dominant

3 4 For example, the banking crisis is estimated to cost around $40 billion to the economy(Pazarbasioglu, 2005; 163) This sum is quite large in comparison to the Turkish GDP

channels for the capture On the one hand, campaign financing and other ways of pecuniary gainsinfluence political decision making On the other hand, these groups may provide only beneficialinformation to politicians to persuade politicians (Figueiredo ve Figueiredo, 2002; 161-162).4Coalition governments also increase transaction costs of regulatory procedures Coalitions areusually short-lived So, interest groups spend more resources to get and protect their interests(Olson, 1999) Coalition parties may have conflicting policies toward some industries Thedivergence among parties weakens the power of the government

Allocating regulated industries among coalition parties harms the regulatory process too Forexample, the last coalition government distributed regulation authorities across parties ANAPcontrolled the energy industry, MHP dominated telecommunications and the banking sector wasmainly controlled by DSP These parties had conflicting views about the role of state in theeconomy Policy-making costs surged in this environment

To give an example, two prominent regulatory institutions, the Banking Regulatory andSupervisory Authority (BRSA) and the Competition Authority (CA), were established under thebargaining of coalition parties The government could not appoint their board members for a longtime after their law passed in the parliament because of political haggling Conflicting views ofcoalition parties delayed the institutionalization of regulation and contributed to the economiccrisis in 2001 (TUSIAD, 2001)

The economic crisis of 2001 is an important example of conflicting views on the economyamong the coalition parties The governing parties had separate control areas and tried tomaximize their benefits The regulatory capture was widespread and bureaucrats found ways toseek their own gains within the system This created a fragmented economic system On the onehand, they tried to implement market-based institutions; on the other hand, they had no intention

to let go their rent resources The banking industry, because of rent seeking of political elites, wasnot adequately regulated An ineffective regulatory framework was one of the reasons forproblems in the banking sector that helped to trigger the 2001 crisis, causing vast welfare losses(OECD, 2002; 9)

3.2 The Government and IRAs

The elections in 2002 were held under these conditions The elections brought the AKP a majority in the parliament, which took a liberal position on the economy It sought votes from

4 The structure of the effect of interest groups on politicians is controversial Some downplay thepower of private lobbies See, for example, (Besley and Coate, 2001) In the context of tradepolicy, Hoffman (2005) argues that lobbying is not so strong because of inherent commitmentproblems

both conservative and liberal minded citizens, with its expressed priority of the membership tothe European Union (EU) (Bacik, 2004; 823-824) In terms of regulatory issues, this meant thecontinuity of the reform Expectations for a more stable economy replaced the pessimistic picture.Economic activity boosted and inflationary pressures lost their strength with the newgovernment.5

One of the key characteristics that distinguish emerging market economies like Turkey fromestablished market economies is not the absence of rules and regulations but weakimplementation of such rules and regulations in practice (Alper and Öniş, 2003) For that reason,IRAs are particularly important in Turkey’s regulatory structure, to ensure impartial and effectiveregulation isolated from political influence (OECD, 2002; 37) As shown in Table 3, IRAs haveflourished in the last decade BRSA, Telecommunication Authority, Energy Market RegulatoryAuthority (EMRA) and Capital Markets Board are the major regulatory authorities in Turkey.6 Inparticular, the external pressures of international organizations accelerated the regulatory reform

in Turkey and the establishment of IRAs (Alper and Onis, 2002; 15) The World Bank and theIMF pushed for reforms following the crises of 2000 and 2001 Another crucial factor was theadaptation to the European Union economic structure Almost all regulations follow the EUguidelines On the other hand, the widespread privatization efforts and the increasing role ofregulatory institutions in market economies forced Turkey to implement reforms

(Table 3 Here)

The government, having a majority in the parliament, preferred to control IRAs for politicalends In this sense some of the recent conflicts between the government and EMRA areparticularly exemplary For instance, energy policies of the government increased and go on toincrease transaction costs of the transition to an IRA tradition specifically in energy markets byinjuring independence of IRAs This situation has also impeded realization of the private-sectorinvestments in the electricity distribution and generation markets so far by bruising ensuring acredible regulatory commitment during the reform process of the electricity industry (Cetin andOguz, 2007a) The lack of a constitutional definition and protection of IRAs gave thegovernment the room to impose its preferences to regulatory agencies

5 The abundance of liquidity and low inflation in the world also helped the government inimplementing its economic policies

6 However, in this paper we heavily focus on the energy markets to show public policy toward theregulatory reform more specifically

3.3 The Constitutional Legitimacy of IRAs in Turkey

The legal structure of independent regulators has been widely debated in recent years in Turkey Although IRAs have been given political, organizational and financial autonomy byrelated laws, since Turkey does not have long tradition of IRAs like other continental countriessuch as France and Italy do, the place of these agencies in the Turkish regulatory structure iscontroversial In Turkey, there are different opinions among law and economics scholars about theplace of IRAs in the regulatory structure While some scholars find talking about IRAs in Turkey

as unfeasible considering the tradition of the state and bureaucracy, ,others see it as the leverage of economic growth and some others try to place these agencies somewhere incurrent structure (Cetin, et al., 2008; Cetin and Oguz, 2007a, 2007b; Sosay and Zenginobuz,2006; Karacan, 2002)

IRAs were introduced to Turkey’s economy as ad hoc remedies after economic crises,

without much discussion of their constitutional place7 The Constitution does not mention thoseinstitutions Governments have preferred not to back these institutions with the constitutionalprotection so far The vagueness of the legal structure creates many issues around legitimacy andplace of IRAs in the bureaucratic structure The current government has also chosen not to dealwith constitutional issues

IRAs thus are left without any constitutional description The lacunae create room forpolitical maneuvering Rules governing decisions of IRAs are not clearly defined in anylegislation Even though, the Constitution (articles 123 and 127) requires central government’scontrol over all public services and public enterprises (Ulusoy, 2001), the uncertainty over theindependence and accountability of IRAs continues

Most regulatory institutions are audited by Sayistay, the Supreme Court of Accounts (SCA).However, not all IRAs are audited by Sayistay A second group of IRAs, including EMRA, areaudited by the Supreme Supervision Board (SSB) of the Prime Ministry, which was originallycreated to oversee the activities as well as the financial accounts of the state-owned enterprises inTurkey Neither the founding laws of these three agencies, nor that of the TA specify that their

“financial accounts” are overseen by the SSB or SCA, However, based on the fact that thedecisions of IRAs are subject to adjudication by administrative courts, review by the SSB and the

7 TA, EMRA, SA, TTPABMRA, and PPA were established after the 2001/2002 crises Radio andTelevision Supreme Council was established after the 1994 crisis See for detailed informationTable 3 As mentioned before, the appointment of the board members of the CompetitionAuthority (established in 1994) and the Turkish Banking Regulatory and Supervision Authority(established in 1998) was delayed until 1997 and 2000, respectively

TCA is interpreted as being limited to their budgets and financial issues (Sosay and Zenginobuz,2006).

Another ambiguity is about the appellation procedure for IRAs decisions and regulations Thefirst level appellate court is Danistay, the Council of State, for EMRA, BRSA and CA However,local administrative courts are assigned as the first level of appellation for some IRAs

IRAs are not under the authority of any ministry They are related to relevant ministries.However, this relation is not like a bureaucratic order They are within the structure of thebureaucratic body and, at the same time, outside the direct control of the political authority Thisconstitutional ambiguity restrains their ability to stay at the arm’s length from the government The uncertainty creates a resistance from the judiciary toward IRAs on many issues Courtscannot find any legal basis for their decisions on cases related to regulatory authorities Forexample, in a recent and important decision the Constitutional Court has chosen a middle road.8 Itrecognized their independency, yet confirmed that they are within the public administrationstructure Naturally, the constitutional vagueness increases the costs of transactions for IRAs anddeepens the commitment problems

Turkish Constitution gives right and responsibility to fight monopolies and cartels togovernment (article 167) Judiciary tends to interpret the constitution as a defense of publicprovision of public services As in the case of electricity, this creates distrust on the side ofjudiciary to the governments

4 LESSONS FROM THE ENERGY INDUSTRY

The previous coalition government had initiated the privatization of many state owned enterprises(SOE) The AKP government took over this framework and promised to improve the previousgovernment’s performance over selling many SOEs in 2002 While the government hassucceeded in some privatizations such as TurkTelekom (the State TelecommunicationsMonopoly) and Tupras (Turkish Petroleum Refineries Company), electricity has been a failure.The lack of a consistent regulatory policy in the energy industry between the government andregulator also aggravated the disappointment

In this section we will look at four cases where AKP had conflicting attitude in terms ofeconomic policies Moreover, all these examples show the preference for political expediency Energy policy is one of the major areas where AKP’s expressed aims before elections andbehavior after election deviate Following the World Bank and IMF guidance, the regulatory

8 O.G 4 August 2006