UK: REGULATORS' POWER. - The jobs the utility regulators took up were ill-defined, allowing the raw recruits to carve out far bigger and far more controversial roles than ever expected.

by David Smith.
Last Updated: 31 Aug 2010

The jobs the utility regulators took up were ill-defined, allowing the raw recruits to carve out far bigger and far more controversial roles than ever expected.

Short of dating the Princess of Wales, or streaking at Wimbledon, or both, there is no speedier way of achieving fame and notoriety in Britain these days than to become a utility regulator. Who would have heard of Professor Stephen Littlechild had he remained just an academic, professor of commerce at Birmingham University? Ian Byatt's former role as deputy chief economic adviser at the Treasury did not get him many headlines.

Neither had many people heard of Clare Spottiswoode before she swept to prominence as an aggressive regulator.

Now, as utility regulators, Littlechild, Byatt and Spottiswoode are part of a select but high-profile club. In their respective roles as director-generals of the offices of electricity supply (Offer), water supply (Ofwat) and gas supply (Ofgas), they have become some of the most important decision-makers in the country, their judgments affecting millions of customers and shareholders and tens of thousands of employees. Together with Don Cruickshank, director-general of the telecommunications regulator Oftel, they make up a powerful foursome, whose role has been more prominent, and more controversial, than anyone predicted at the time of privatisation.

Utility regulators, along with Britain's hoards of small shareholders or 'Sids', as they are known, are a direct result of privatisation. For, along with bringing in billions of pounds for the Exchequer, privatisation created a headache. If you set up a series of giant, private sector utilities, all of them providing essential services to both the public and to business, how do you prevent them from abusing their monopoly position?

The question did not arise when gas, electricity, water and telecommunications were state-owned. Or, if it did, it could be dealt with. As owners, governments could and did direct public sector utilities, controlling their prices and interfering in their management decisions. Above all, governments maintained very tight controls on the utilities' finances, controls which became all the more burdensome the greater the pressure on the public sector borrowing requirement (PSBR).

This was precisely the kind of interference which provided a large part of the economic rationale for privatisation, but it also necessitated the development of an efficient and publicly acceptable system of regulation. Thus Britain, which gave the world privatisation, also gave it a peculiarly British form of utility regulation in which the role of each individual industry regulator (in each case supported by a sizeable staff) was paramount.

This was not the only innovation. The most significant development was that of regulation based around a RPI-x formula, or a variant of it. RPI-x was invented by Littlechild, with help from Professor Michael Beesley, emeritus professor of economics at the London Business School, economic adviser to both Offer and Ofgas, and one of the foremost experts on utility regulation. The essence of RPI-x was, of course, to limit utility price rises over a set period to something below the rate of inflation, as measured by the retail prices index (RPI). Thus, if x is three and the rate of inflation averages 5%, the utility in question would be required to limit its annual price rises to 2%. The main exception to this general rule, while remaining true to the overriding principle of a pricing formula, was the water industry which, instead of x factors was governed by k factors, in the form of RPI+k. Such generosity was to allow price rises to be set above the rate of inflation in order to provide for the larger amount of investment believed to be necessary in an industry which had been starved of capital while under state ownership.

The Littlechild-Beesley approach, based around RPI-x, has become known as the Austrian approach, after the Austrian school of free market economists.

This is because, on the face of it, the model provides a guaranteed pricing deal for customers, with the minimum amount of direct regulatory interference in the running of the privatised businesses themselves.

Set out in this way, utility regulation seems like an undemanding occupation.

Once every five years, the white smoke would emerge from the regulators' offices, setting out the x or k factors under which the industries in their charge would operate.

In practice, however, things have not been nearly so straightforward.

Apart from the need for regulators such as Oftel's Cruickshank to get themselves involved in public interest issues such as the quantity of telephone numbers available in the system, the regulators have been obliged to operate in a more hands-on way than the arms-length philosophy of the Austrian approach would suggest.

Littlechild himself, for example, created huge controversy last year when, in the middle of the Government's sell-off of its remaining stakes in the generators National Power and PowerGen, he announced he was reopening the pricing review he had completed eight months earlier. The decision, prompted by a series of takeover bids for regional electricity companies - which appeared to indicate that under his existing regime, operating in the electricity industry was a licence to print money - brought allegations that the Government was selling its stakes in the two companies under a false prospectus. It also called into question the competence of the regulator.

For Littlechild, the decision to reopen the pricing review was part of the complex process of 'regulating in a changing environment'. 'Since the Government removed the golden shares on the distribution companies, there have been many proposals for mergers and takeovers involving electricity companies,' he says. 'The operation of the capital market can bring benefits in terms of pressure for greater efficiency.

'But mergers and takeovers can present potential detriments of one kind or another unless appropriate steps are taken to deal with them. In some cases, as with the proposed mergers involving National Power and PowerGen, the potential detriments have been so great that it has not been possible to find ways of avoiding them. In contrast, other mergers involving acquisition by overseas electricity companies, water companies or non-utility companies, have been dealt with by appropriate modifications to the electricity and water licences.'

When the game changes, in other words, the regulator responds. It is not just a question of setting the rules and retiring a safe distance.

The regulator's role is a continuous one. And if the regulator appears to be going too far, the firms have recourse to the Monopolies and Mergers Commission (MMC), a route increasingly being threatened, and in some cases chosen, by disgruntled utilities.

Most recently Spottiswoode appeared to raise the regulatory stakes to an unprecedented level by proposing cuts of between 20% and 28% in the gas transmission charges levied by TransCo, British Gas's pipeline division, followed by annual price restrictions on a RPI-5 formula. The proposals, described by Philip Rogerson, British Gas deputy chairman, as 'one of the biggest smash-and-grab raids ever', which would threaten the loss of 10,000 jobs, while bringing consumers an average £30 a year reduction in their gas bills, were later revised in the light of new information provided to Ofgas by British Gas. The immediate reduction was set at 20%, and the annual formula, to apply over five years, at RPI-2.5, but this did not prevent British Gas from wanting to take the issue to the MMC.

The episode raised a number of important questions about the future of regulation in Britain. Did the Ofgas proposals, Littlechild's tougher regulatory regime for the electricity industry and BT's war of words with Cruickshank over new Oftel plans to regulate anti-competitive behaviour in the telecommunications industry signal a new and much tougher regulatory approach? Was this a foretaste of what some see as an era of 'regulatory socialism' if Labour is elected, including controls over the salaries of utility directors? Are the regulators in fact competing to prove that they are tough enough to enact the kind of regime Labour might want to impose on the utilities? Is their duty of care to consumers so heavily emphasised that it could be at the expense of the very survival of the firms they are regulating?

The regulators would argue that all that is happening is an evolution of the regulatory process. It is self-evident that the initial pricing regimes faced by all the privatised utilities were relatively generous both to give them a chance to establish themselves in the private sector, and to ensure they were attractive to investors. In all cases, subsequent moves by the regulators have been to toughen up these regimes, and in most this has become an ongoing process. As for warnings from the utilities that the regulators could kill the golden goose, or at least amputate some of its limbs, these are seen by the officials, probably correctly, as the natural tendency of the regulated to cry wolf.

Evolution we may be having, but few would say we yet have a satisfactory system of regulation in Britain. Regulators too often give the impression of swinging suddenly to a new stance, creating stock market turbulence and an atmosphere of mutual hostility between regulator and regulated.

Are these problems, and the tensions between regulators and utilities inevitable? Irwin Stelzer of the American Enterprise Institute, an expert on utility regulation in the US, argues not. During the privatisation process in Britain and the setting up of the regulatory framework, four serious weaknesses, he says, were built in.

These, Stelzer says, are as follows. Unlike the US's open regulatory procedures, the British system is secretive and thus struggles for public credibility. And it emphasises the role of a single regulator for an industry, thus establishing the cult of the personality, in contrast to the more anonymous multi-person regulatory commissions in the States.

Meanwhile, rather than using profit controls to regulate the utilities, the British system was based on 'wild and, in the event, incorrect guesses about attainable productivity improvements'. Thus, the regulatory system has allowed the privatised utilities to earn vast monopoly profits, and their executives to reap fatcat salaries. 'The public sector companies were so bloated, so inefficient, so unconcerned with the customer, that it was what teenagers call a "no brainer" for managers to increase efficiency at a rapid rate,' says Stelzer.

And, perhaps bigger than all these weaknesses, was the fact that, so concerned was the Government to get the nationalised industries into the private sector, that the sell-offs came first, the restructuring later, with consequences that will throw up regulatory difficulties for years to come.

Nobody appears to have envisaged, for example, that the privatised utilities, by their nature local monopoly suppliers (or in some cases near-national monopolies), would seek to take over other utilities, thus creating super-monopolies such as United Utilities, the product of North West Water's acquisition of Norweb. And nobody expected that the separation between the power generators and regional electricity distribution companies would be challenged by a new, and worrying, form of vertical integration.

As Professor John Kay, chairman of London Economics, points out, 'The principal concern in all privatisations was to achieve a successful flotation.

That was largely perceived as an end in itself. To the extent that the architects of the programme thought beyond that, it was simply assumed that the change in ownership would bring about the desired results.'

Kay argues that the RPI-x framework has produced undesirable results.

'Firms submit inflated and pessimistic assumptions,' he says. 'Regulators, knowing this to be the case, impose arbitrary reductions. And when companies do better than regulatory projections, there is no way of knowing whether this is the result of larger improvements in efficiency or the success of the companies playing the regulatory game. The effect on profits is the same.'

The difficulty is in thinking up a replacement for RPI-x which does not destroy incentives, in a way that profit restrictions would. The most likely outcome is to retain RPI-x, but to supplement it in various ways.

Labour, for example, is looking at options which include shortening the period for which a given RPI-x would apply to an industry from the present five years, and giving parliament a greater role in overseeing the regulatory process.

Another modification, which would probably do more to change the image of regulation in Britain than any other, would be to kill off the idea of the single, macho regulator. Shadow energy minister John Battle talks of a depersonalised, multi-person utility regulatory body, which would operate in a similar, anonymous way to ACAS, the Advisory and Conciliation Service.

All those high-profile regulators would be well-advised to make hay while the sun shines. They may be about to replaced by the grey brigade.

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