UK: REGULATING THE REGULATORS.

UK: REGULATING THE REGULATORS. - Regulators are meant to be more mothers-in-law than marital partners to the privatised. Public spats are frequent, may even be part of the game. A debate, often bitter, surrounds this raw relationship.

by Malcolm Brown.
Last Updated: 31 Aug 2010

Regulators are meant to be more mothers-in-law than marital partners to the privatised. Public spats are frequent, may even be part of the game. A debate, often bitter, surrounds this raw relationship.

CEDRIC BROWN

The chief executive of British Gas thinks that the regulatory procedure should be depersonalised:'We have a situation where too much power is invested in one individual regulator'.

SIR CHRISTOPHER FOSTER

This senior partner at Coopers and Lybrand believes that British Gas is wrong in criticising its regulator, James McKinnon. Indeed, he thinks that, in general, the head of Ofgas has 'done a marvellous job'.

SIR JAMES MCKINNON - Ofgas

Trained as an accountant, this controversial figure has worked most of his life in industry. His last post was finance director of the Imperial Group. Aged 63, he became director-general of Ofgas in 1986 and has since taken great pleasure in tweaking the tails of 'the Pooh Bahs of Rivermill House'. The difference between British Gas's outlook and his own, he thinks, is to do with attitude.'I represent a different culture in the sense that everything I have ever done before was designed towards change. I realised that if you did not change continuously you would fall behind. British Gas never had any need to do this because it was actually creating the parameters of the marketplace as a 100% monopolist.' He insists his powers are heavily circumscribed, 'I'm not in a position to tell British Gas to do anything, even to turn out the light. It has the option of accepting my recommendations or not. People may say that it is a very dramatic step to go to the MMC, and too draconian a solution. It may be, but it is the only way available. I didn't set the rules.' He admits to using the media as a weapon. 'We put out press notices to express our view'.

"If we express our point of view forcefully we're regarded as ferocious Rottweilers. If we go out in a namby pamby way it's a toothless watchdog."

IAN BYATT - Ofwat

Educated at Oxford and Harvard, Byatt is an economist and expert on the regulation of public utilities. He lectured in economics at Durham University and the London School of Economics. His last job before being appointed to Ofwat was deputy chief economic adviser to the Treasury.

The 61-year-old Byatt believes in total openness. 'Regulators have to make difficult decisions and decisions which are not popular. People should know why they have made them'.

DON CRUICKSHANK - Oftel

He took up the post on 1 April so he is still an unknown quantity. He was previously commercial director of Times Newspapers (1977-80), director of the information and entertainment division of Pearson (1980-84), managing director of the Virgin group (1984-89) and chief executive of the NHS in Scotland (1989-93). Aged 50, he is well aware of the problems. 'One of the issues I will be looking at is the obligations and the accountability of the regulator'.

STEPHEN LITTLECHILD - Offer

In his previous post as professor of commerce at Birmingham University Littlechild advised on regulatory regimes for British Telecom and the water industry. He was largely responsible for drawing up the RPI minus X formula, now used, with variations, for all the utilities. Aged 49, the professor claims he has a good relationship with the electricity industry. 'All parties accept there is a role for a regulator and the preference is to work with him rather than against him'.

Cedric Brown, the chief executive of British Gas, may not dance a jig on 31 October, but watch him closely and you may see an extra spring in his step. For that is the day when Sir James McKinnon quits the job of director-general of the Office of Gas Supply (Ofgas). It is also the day he stops being the bane of Brown's life. British Gas's boss has never actually referred publicly to Sir James as the devil incarnate but he treats him as if he were.

McKinnon is one of the four regulators appointed during the 1980s and early 1990s to protect consumer interests in the wake of the privatisation of gas, telecommunications, electricity and water. British Gas's story is that McKinnon has gone off the rails. Instead of acting in a quasi-judicial, even-handed manner, curbing British Gas's monopolistic instincts here, protecting customers there, he has, employees say, developed an animus against the company and all its works. The regulator's evidence to the Monopolies and Mergers Commission (MMC) - he wants to break the company into 12 independently-owned and controlled regional gas supply companies - is seen as the most glaring example of this.

Sir Christopher Foster, a senior partner of Coopers and Lybrand and author of the recently published, Privatization, Public Ownership and the Regulation of Natural Monopoly, thinks that the idea of McKinnon as a wrecker is nonsense. He regards Sir James as the nearest thing Britain has ever had to the great American regulator, Charles Francis Adams, who brought the US railroad industry into line by shining the remorseless light of publicity on it. 'I think McKinnon has made one or two mistakes,' says Foster, 'but they are technical ones. The fact is that he has done a marvellous job.'

An intense debate is now going on between those like Foster who think the regulation system we have is broadly right, though it could be improved here and there, and those, like Brown, who believe it is deeply flawed and needs a complete overhaul. Brown and other critics think the regulatory function should be depersonalised and carried out in future, not by an individual, but by some sort of regulatory commission - a kind of mini Monopolies and Mergers Commission. 'We have a situation where too much power is vested in one individual regulator,' says Brown. 'It's not in our interests for regulation to be weakened. We accept the need for regulation, but we're looking for a better understanding. In any future review of regulation the question that needs to be addressed is, "Who regulates the regulator?"'

The question is being asked not just of Sir James McKinnon but his opposite numbers in the other major privatised utilities - Professor Stephen Littlechild of Offer (the Office of Electricity Regulation), Ian Byatt of Ofwat (the Office of Water Services) and the most recent recruit, in place only since April, Don Cruickshank of Oftel (the Office of Telecommunications). These four men between them hold sway over industries with a market capitalisation of more than £60 billion and combined pre-tax profits of over £5 billion. The key concerns are how they exercise that enormous power and whether they ought to be made more accountable. Before these issues can be explored, it is necessary to understand what the regulators are and what it is that they are supposed to do. The regulator is part consumer champion, part surrogate competitor, part facilitator of competition. Privatisation does not, in itself, make industries competitive. It certainly did not with the utilities. Three of the four (telecoms, gas and water) were floated as potentially highly profitable monopolies or near monopolies while the fourth, electricity, though slightly more competitive looking, involved, at its heart, a generating duopoly. So some kind of countervailing regulation was necessary to prevent the privatised monopolies abusing their power.

The regulator's job was to administer economic regulation in the form of price controls, promote competition, and ensure quality and service levels. The exact mix differed in each case. Telecommunications is a market which ought ultimately to be totally competitive, so Oftel has focused on promoting competition and protecting customers. This is seen as necessary until a fully competitive market develops. In water, by contrast, there is almost no prospect of real company-to-company competition (each of the water companies is, in effect, a regional monopoly) but there is a need for massive capital investment because of under-investment in the past. Ofwat's main job therefore has been to encourage efficient capital expenditure while ensuring that the customer is treated fairly in the process.

The regulators have two main regulatory instruments at their disposal. The first is the ability to review the terms of the licence which the Secretary of State issues to the privatised utility (the licence spells out the constraints on the privatised company's freedom). The second is the ability to review the price-capping formulas which set a limit to the rate of increase in prices which regulated companies are allowed to charge. However, the regulator cannot force his recommendations on the industry. If the two sides fail to reach agreement, the matter must be referred to the MMC.

It is how powers, such as the renegotiating of licences, are wielded - and to what end - that has caused disquiet. The critics have focused on three issues in particular: the danger of breaching the so-called 'regulatory bargain' (the implied deal struck between government, industry and shareholders at the time of flotation); the personalisation of the regulatory regimes; and the fundamental question of accountability - who regulates the regulators? The criticism about the regulatory bargain concerns the fact that the privatisation prospectuses involve an un-official bargain between government, industry and shareholders. The prospectuses and draft licences laid down the terms and conditions (including the regulatory conditions) under which the industries were to be run. Changing those conditions, it is argued, is unfair on the companies since they need some stability if they are to plan ahead. It may also be unfair on shareholders. If, for example, shares were bought on the understanding that the organisation would go on being largely monopolistic, shareholders would be right in feeling aggrieved at a change - especially if the regulator started pressing for the industry to be broken up into competing companies.

Another bone of contention is the so-called RPI minus X price-capping formula which might also be part of a regulatory bargain. RPI is the Retail Price Index and X is a factor reflecting expected efficiency gains. RPI minus X limits the increase in charges for a basket of services. The idea was that the formula should not be revised during the first five years but, in practice, regulators have found it almost impossible to keep to that, because of the enormous post-privatisation profits.

Professor Stephen Littlechild, director-general of Offer, who was largely responsible for drawing up the RPI minus X formula while lecturing at Birmingham University, is very conscious of the dangers of this sort of intervention. 'If you keep stepping in and changing the goal posts and changing the timetable that was laid down, investors are going to get worried. They're going to say, "This is a company with regulatory risk. We're going to demand a higher rate of return if we're putting our money in this." If a company has a higher cost of capital in that way it is eventually going to result in higher prices for the customer.' It may also discourage the company from reducing its costs and seeking more efficient ways of doing things - which rather makes a nonsense of the price-capping system. The RPI minus X formula was chosen instead of a cost-plus formula precisely because it would encourage efficiency by rewarding it.

Sir Christopher Foster believes that post-privatisation profits are always going to be higher than anticipated and this means regulators are bound to be tempted to step in prematurely. His solution is a once-and-for-all price review about two years after privatisation to bring prices back to levels consistent with the promises made when the companies were privatised. 'But then the regulator should stand back and, as first intended, there should be a period in which, if they improve their efficiency and all the rest of it, they make more profits - which was the very real intention. It's tragic that we've got into a situation where almost every year or two there is some kind of row and a clawing back of profits.'

Rows, if the press is to be believed, appear to be endemic in the relationship between British Gas and Sir James McKinnon of Ofgas. Dr Cento Veljanovski, director of the economic consultancy, Lexecon, and author of The Future of Industry Regulation in the UK, believes the personalisation of regulation poses the biggest threat to its legitimacy and that McKinnon proves the point. Under privatisation legislation the director-general has a personal duty to enforce the law and regulate the industry. The individual regulators are seen as personifying the regulatory constraints and style. The trouble, according to Veljanovski, is that their personalities can affect the way they are seen by the regulated industry. He believes that there is a debilitating degree of acrimony between British Gas and McKinnon which must make the whole process suspect. 'British Gas believes it now has a regulator who has exceeded his remit and is out of touch. It complains of lack of discussion and take-it-or-leave-it dictates.'

If Veljanovski is right and there is a grudge match going on between McKinnon and British Gas, is there any way of restructuring regulation so that we get the rule of law, not of men? A regulatory commission like that suggested by Cedric Brown is one possibility. Veljanovski's preferred solution is to beef up the role of the MMC itself so that all major decisions are refer-red to it. 'In one sense that's the model now, but I'm suggesting we strengthen that and take out of the regulator's hands the ability to really negotiate terms without going through a formal procedure.'

Littlechild is not sure that such a scheme would be practicable. 'I think it would be a very cumbersome procedure. It would mean that you would have to have a Monopolies Commission reference every time you thought a change was necessary, even if the firm agreed.'

Of course, the other way to read what has been going on between McKinnon and British Gas is as a piece of premeditated theatre - on both sides. How much of the snarling is heartfelt and how much just posturing to try and achieve their respective ends? Perhaps their stance is just a means for British Gas to retain as much of its monopolistic privilege as it can, and for McKinnon to make it more competitive and look after the consumer. Perhaps the heat being generated is not a sign of breakdown, but an indication that the system is working well.

Foster certainly sees it all in a different light to critics like Veljanovski. 'If you're going to make an impression on a big monopoly then you've got to use every device of public relations to make an impact. It's a way of behaving which these large monopolies haven't been used to. They have been used to settling things in corners.'

Accountability is perhaps the thorniest and the most insoluble of the regulation problems. The basic complaint is that four unelected officials now have enormous powers over a big chunk of the UK economy but are virtually unaccountable for their actions. If regulator and industry cannot agree, the legislation encourages them to appeal to the MMC. However, most people in the regulated industries seem reluctant to take this route.

'The trouble is that when you have an MMC reference, you, or the Secretary of State, can bring in everything. It is no longer an appeal. You have got a system which looks like an appeal system. The legislation makes it quite clear that if there is a disagreement between the regulator and the regulated then it can be referred to the MMC, but what is to be referred, is not clear.' He thinks if the reference could somehow be limited to the issue on which agreement has failed people would be happier to use the MMC as an appeal mechanism and that would, of course, improve accountability.

Is there any other way, apart from a reformed MMC procedure, which would make the regulators more accountable? McKinnon thinks there is: an annual grilling by a House of Commons select committee. 'I would welcome it absolutely. I believe the Select Committee for Trade and Industry should have a spotlight on the regulators because when you put telephones, electricity, gas and water together the amount of service that gives the public is enormous. We are not elected and I have got a feeling that this is a serious defect. I believe that the elected body of the country, Parliament, should scrutinise our affairs very closely.'

Find this article useful?

Get more great articles like this in your inbox every lunchtime