The regulation of the telecoms, energy and other network industries has huge economic, social and political importance. This note seeks to summarise the key issues and developments. Comments on particular industry regulation is toward the end of the note.
It is very important to remember that utility regulation is a poor substitute for a properly functioning market. Although regulators are often portrayed as a force for good - and a handy tool for those who want to change the behaviour of industries in various ways - the true purpose of utility regulation is to limit the economic harm that would occur if these naturally monopolistic industries were not regulated. Such harm would likely include inadequate investment and reduced innovation as well as higher prices, poor service and so on. It is of course possible to ask regulators to assume wider responsibilities, such as helping vulnerable groups or improving the environment, but this generally requires regulators to make trade-offs between their economic and societal objectives, and these decisions are in principle better left to politicians.
It is also important to bear in mind that the network nature of these industries means that there are in principle two quite distinct types of utility/network regulation.
In an ideal world, effective rules regulation does away with the need for output regulation as it facilitates effective competition. This was the logic which drove the electricity regulator to abandon retail price controls in 2002.
UK regulators generally impose price controls via an 'RPI-X' formula:- prices are allowed to rise in line with the Retail Prices Index less an X% reduction each year to pass on to customers the benefit of improved efficiency. It is generally believed that this formula works well in a wide variety of circumstances, but - by incentivising regular annual price cuts - does it reduce the incentive to innovate and invest, activities which might increase prices in the short term in order to benefit consumers in the longer term?
It is generally recognised that, although regulators are pretty good at understanding companies' likely responses to regulation, they do not know enough about how consumers respond to information about prices, quality etc., nor how much customers would be willing to pay for improved service quality etc. This makes it difficult for regulators to construct detailed price controls which inevitably have to prescribe what service has to be provided for a particular price.
A closely related problem is the inadequacy of consumer representation on regulatory issues. The regulated firms deploy huge and expensive resources as they tackle regulatory issues which could add or subtract 10s or 100s of millions of pounds from their profits. In contrast, the two main consumer bodies (Consumer Focus and Which?), and even the specialised consumer bodies such as the Consumer Council for Water, have only tiny numbers of staff and are easily outgunned when commenting on lengthy technical consultation documents.
There are three main players in the regulatory contest: the company, its investors and the regulator. Regulated companies, implicitly - and sometimes explicitly - supported by their owners/investors, will often kick up quite a fuss in the final stages of a price control discussion, claiming that there is no way that the company can meet the regulators' efficiency targets, and trying to browbeat or scare the regulator into making further concessions. But the owners/investors change sides when the new price control kicks in, and will generally put a lot of pressure on the company's managers to cut costs to as to beat the price control and make extra profits - and it is amazing how often the supposedly impossible efficiency targets have in practice been exceeded.
The main battleground is the regulation of retail energy:- the gas and electricity that is delivered to voters' doors. The regulator, Ofgem, decided in 2002 that there was sufficient competition to allow it to step back and allow prices etc. to find their own level. This strategy was initially pretty successful as profit margins fell and the suppliers introduced innovative new tariff structures. But then the difficulties which face the regulators of this industry became obvious once again.
However it is regulated, the energy industry has three tricky features:
But the 2002 liberalisation added new problems, in that the retail industry became concentrated in the hands of only 6 suppliers (British Gas, EdF, E.ON, NPower, Scottish & Southern, and Scottish Power). There was little or no new entry and the complex new tariffs - with cheap deals aimed at those willing to switch suppliers - were soon perceived to be confusing and obfuscatory rather than liberalising. Those 'switchers' who shopped around and switched suppliers found that they could generally save 10% of their energy bills, but many consumers - and particularly vulnerable consumers - failed to switch and were thus in effect penalised yet further. The pressure slowly grew to do something to help those vulnerable customers, whose behaviour happened to be indistinguishable from those who couldn't be bothered (or were too well-off to be bothered) to shop around.
Eventually, in 2008, Ofgem decided that they would impose non-discrimination clauses on the energy companies - i.e. force them to offer the same prices to switchers and non-switchers. Unfortunately, however, this decision will have had the perverse effect of reducing the competitive pressure on all 6 companies. This is because the companies will know that there is now very little to be gained by reducing prices in order to attract new customers, as such price reductions now have to be offered to all their existing customers, at great cost to the bottom line. Even worse, such price reductions would probably be copied by competitors (through what economists call 'tacit collusion') and so might not attract any new custom at all. All in all, therefore, it no longer makes much sense for any company to compete by lowering its prices. The regulator has thus chosen to help the vulnerable (as well as those who can't be bothered to shop around) by promoting equal treatment between customers - but at the expense of effective competition and hence lower prices for all. It could even be that the vulnerable will end up paying more for their energy than before - but at least they will have the satisfaction of paying the same as everyone else!