Regulation

Facts, Analysis and Comment.

Government & Regulation

This note should be read alongside the note on regulatory independence and accountability.

Governments have always wanted to influence the behaviour of state-owned industries (or else why own them?) whilst also wanting them to be well-managed, efficient and customer responsive.  As John Vickers and George Yarrow put it:-

In the post-war period, a principal objective of the legislation that established public corporations was to create an ‘arm’s length’ relationship between government and management. … [However] ... Following the extensive nationalization programme of the 1945-51 Labour Government, it was not long before the breakdown of the arm’s length principle became widely recognized. ...  the objectives of nationalized industries are set out in their Statutes.  As we have already noted, however, statutory duties are frequently couched only in the most general of terms, and the stipulated requirements … offer very little in the way of specific guidance. … … The imprecision here is an open invitation to managers and politicians to pursue their own objectives under the guise of acting in the national interest:  wolfish self-interest is all too easily cloaked in the public interest sheepskin.

Every industry tended to have its own, distinctive approach to issues, including pricing policies, despite a 1967 White Paper that was intended to bring greater coherence across sectors approaches by stipulating (i) a long-run marginal cost approach to price setting and (ii) the avoidance, where possible, of cross-subsidisation.

… ministers could, at any stage, use their considerable formal and informal powers to override managerial decisions … and, in the event, they did just that.  Thus, at different times, there were ministerial decisions to hold down prices … to force prices up … to speed up investment programmes and slow down plant closures … and so on.  … even if managements of the public corporations had seriously wanted to pursue the economic efficiency objectives implicit in the White Paper [of 1967], their efforts would substantively been undermined by politicians’ behavior.”  

Why this volatility?  Well, political priorities are inevitably volatile, not just because ‘a week is a long time in politics’, but also because voters’ priorities change, and government want to win elections every four or five years. But it was clear that political meddling, to use a pejorative term, was having a serious negative effect on the UK’s economic performance.  Trades unions, too, were inevitably more powerful within monopolistic industries funded by customers who could not shop around. 

Privatisation and independent regulation was meant to be a cure for the above problems, amongst others.  Rational economic decision making was to  be detached from political decision making, and regulators were for many years encouraged to be fiercely independent as they pursued their relatively straightforward (though not easy) task of encouraging competition where possible, and encouraging efficiency, controlling prices and performance where not.  But the pendulum, perhaps inevitably, began to swing back, as demonstrated by developments in three areas.

Individuals or Commissions?

The first and perhaps least important development was the gradual replacement of powerful individual regulators with Boards or Commissions.  This inevitable softened any rough edges that might have developed in the relationship between government, regulator and industry.  The Chairs and Chief Executives within these regulators had to spend more time justifying their policies to colleagues, and Ministers could gradually change the regulatory culture, for instance by appointing Commissioners from within (and possible therefore sympathetic too, the regulated industry.

Social and Environmental Guidance &
Strategic Policy Statements

Another interesting development around the year 2000 was the introduction of Social and Environmental Guidance to regulators.  The development of these documents was encouraged by a small minority of socially and environmentally conscious backbench MPs, and it was much easier for Ministers to legislate for their existence than to use up scarce political capital in opposing their creation.  In practice, however, Ministers, senior officials and senior regulators did not expect the documents to make much difference to the way in which the regulators carried out their duties.  A large part of the guidance was pure common sense and/or ‘motherhood and apple pie’ – and regulators would have taken decisions consistent with the guidance without it having been written down.  The rest of the guidance tried to take regulators into areas which were way outside their statutory responsibilities, and was pretty much ignored by both the regulators and their industries.

The guidance issued to the Postal Regulator in 2001 is probably a pretty good example.  It was 13 pages long (excluding title page, index and annexes) and sensibly required the regulator to consult properly, to take account of the needs of vulnerable users, to be concerned about affordability for those on low incomes, to ensure that the postal service could cope with peaks in demand, to mandate free services for the blind, and so on.  (These were, though, things that the regulator would have done without such guidance.)  Less sensibly, it contained environmental objectives – such as fuel economy, and greater use of rail transport and bicycles – which were of a quite different nature to – and inconsistent with - the regulator’s principal statutory duty to safeguard an inexpensive universal postal service and if possible introduce competition into the industry, both of which required costs to be minimised.  They were also inconsistent with the affordability guidance earlier in the same document. 

Thankfully, from its point of view, the regulator was required by law to do no more than ‘have regard to’ the guidance.  The regulator was expected to carry out its functions in a way which was ‘alert to the wider policy picture and, where possible, supportive of it’.  But ‘it [was] not the purpose of this guidance to act as a means of instructing the [regulator]’.  The one-year-old regulator took the hint and in practice paid very little regard to the environmental guidance, believing that it was for others in government, such as those setting fuel duties and rail access charges, to determine the extent to which the Royal Mail used, trains, vans and bicycles.  The regulator was never questioned about, nor criticised for taking, this stance. 

Fast forward twelve years, however, and you come to the publication of the first Strategic Policy Statement – incorporating Social and Environmental Guidance, sent to Ofwat in May 2013.  This 38 page document (excluding title page, index and annexes) is harder edged.  It starts by summarising Ofwat’s four ‘Overarching Statutory Duties’ and its seven other Statutory Duties.  It then draws attention to ‘the challenge of increased water scarcity due to climate change and demographic trends’ and highlights ‘an increased emphasis on resilience, long term planning and customer choice’.  So far, so good, even if no organisation should sensible be asked to balance eleven different duties.

But then we read that the guidance itself which is issued under Ministers’ power ‘to give general directions to Ofwat on issues to which they should give priority’; such directions ‘not [being] intended to affect the position of Ofwat as an independent economic regulator, but [being] designed … to provide a strong steer on the outcomes Government wishes Ofwat’s activity to contribute to delivering’.  Ofwat is also required ‘to report on the steps they have taken in response to this steer’. 

The heart of the document then consists of three separate pieces of text. 

I make that 63 duties, priorities etc. which need to be taken into account by Ofwat, although some of them are overlapping or duplicative.  Further comment is nevertheless unnecessary!

Appeals

There was a growing feeling around 2010, that the ability to appeals regulatory decisions on their merits, as distinct from on procedural grounds, were delaying and/or standing in the way of the ability of regulators to deliver certain outcomes that were desired by Ministers, including faster roll out of broadband communications, and competition in the water industry.  Thought is accordingly being given to reducing the scope for merits reviews.  Click here for a more detailed discussion of this subject.

Demotion and Promotion of Competition

Ofgem, in particular, has long suffered from the trilemma that it is asked to achieve three key outcomes - sustainability, security of supply, and affordability.  As each of these pull in different directions, it has become clear that Ofgem cannot avoid being constantly criticised by one stakeholder group or another.

Ofgem’s policy making is made even more difficult because politicians and other have from time to time whether its principal duty to promote competition might not in fact be the best way of achieving any or all of these objectives.  Faced with rising prices, some commentators thought, for instance, that Ofgem should re-regulate retail gas and electricity prices.  Indeed, the Energy Act 2010 added the new requirement that “Before deciding to carry out functions … with a view to promoting competition ... the Authority shall consider …  whether there is any other manner … in which … the Authority … could carry out those functions which would better protect those interests.” 

Ofgem’s response was to point out that all the evidence showed that competition was better than regulation in reducing prices, and that, in a wide range of countries and circumstances, utility company profits were strongly (and positively) correlated with the amount of regulation.  But critics then criticised Ofgem for not referring the energy market for a full CMA investigation, until it finally did so in 2014.

The Principles for Economic Regulation

During the first decade of the 2000s, some civil servants became concerned that some of their colleagues - and some politicians - had insufficient understanding of the principles which, if followed, would help ensure effective utility and similar regulation. They accordingly drafted, with the help of some external advisers, a set of Principles for Economic Regulation‌ which were then adopted as firm government policy - although it remains to be seen whether the principles are in fact followed when they are found to be politically inconvenient. The headline principles are ...

... But there is a lot of useful detail and advice in the Principles for Economic Regulation‌ document itself.
 
As noted above, the basic rule is that politicians should make social and environmental decisions such as how much to subsidise the phone or energy bill of less affluent consumers, and/or those living in rural areas. Regulators should then implement those decisions when establishing regulatory frameworks and making regulatory decisions. It is in practice difficult to achieve this pure separation as politicians need to understand the detailed impact of their policy choices, and regulators need to be mindful of the unintended consequences of their regulatory decisions, especially for vulnerable customers. There therefore needs to be good communication between regulators and government departments, even if this appears to detract from regulatory independence. But politicians need to remember that - although it is tempting to use regulation as a taxation or redistribution mechanism, as it is easy for subsidies and policy costs to be hidden in regulatory determinations - it is ultimately undemocratic and unreasonable to ask economic regulators to take important social and environmental policy decisions, especially when the regulator's consultation on the choices is less than fully transparent.

By way of background, it is useful to remember that the privatisation of UK utilities has had three somewhat conflicting objectives:

    1.    To raise (sometimes large sums of) cash for the government
    2.    To facilitate increased competition, and hence efficiency, better customer service, innovation and lower prices. (This in turn required the appointment or recruitment of senior management with a different set of skills.)
    3.    To encourage wider share ownership.

The first objective was generally achieved. The second was delayed (so as to maximise the sale proceeds resulting from the sale of a monopoly) but usually achieved later with the help of a regulator charged with (a) ensuring that the privatised utility did not abuse its powerful market position, and (b) encouraging the development of competition. The third was achieved only temporarily. The number of individuals who owned shares rose from 7% to 20% by 1997 but is now back below 7%.