Regulation
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, and contains the following sections:
Let's begin by looking at the first of the three key truths of utility regulation which is that ...
It is very important to remember that utility regulation is a poor second best to, or substitute for, a properly functioning competitive market. Although regulators are often seen as a useful agent for those who want to change the behaviour of utility industries in various ways, the principal 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 follows that legislators should not impose regulation without first considering (a) whether the market will not provide an optimal outcome and, if not, (b) why not? Only then is it possible to consider the best way to address the market failure through instruments which might include targeted exemptions from taxation, or targeted taxation. In the energy field, for instance, would it not be better to reduce the income taxation of those with low incomes, rather than introduce social energy tariffs, which in effect tax other energy users in a stealthy way? After all, we don't mandate social tariffs for other key products, such as food or clothing.
It also follows that legislators should set tasks and duties for regulators - not outcomes - and should in particular require regulators to encourage competition. (Good legislative formulae include phrases such as "... the Commission shall exercise its functions in the manner which it considers is best calculated to further the interests of users ...", "... wherever appropriate by promoting effective competition ...".) Legislators should thus allow competition (or, in its absence, consultation with customers) to determine outcomes which may vary over time, from place to place, and depending on the nature of the company and customer.
The second key truth about utility regulation is that ...
No-one ever buys a product or service because it is inexpensive. At the very least, we expect that it will be delivered to us within a reasonable time, and will not harm us. In regulators' jargon, we endeavour to maximise PQRS - an appropriate combination of the price that we are charged (P), the quality of the goods etc. being sold (Q), the range of products and services made available (R), and the associated service that is offered to customers (S). In an unregulated market, we choose the combination of P, Q, R and S that best suits us at a particular time. We sometimes choose to shop in a large supermarket, and we sometimes pop into our local store. We sometimes shop in Harrods Food Hall, and sometimes in Lidl. We sometimes have an expensive meal in a posh restaurant, and sometimes we pop into McDonalds.
This fundamental fact poses real problems for those involved in utility reguation. Put positively, if market failure requires the imposition of regulation, then someone has to decide what quality, range and level of services should be provided, and at what cost. Put negatively, it is no use forcing prices down if the regulated company is allowed to provide a poor service to its customers. This is an important issue for e.g. the energy regulator which requires licensees to pay compensation for missed appointments, the postal regulator which requires Royal Mail to meet certain prompt delivery targets, and the airports regulator which does not have effective ways of forcing airport operators to provide a decent and reliable service to passengers - see further below.
More generally, however, many if not most trade-offs (between P and QRS) are better decided by elected politicians than by unelected regulators. It is also much better for politicians to resolve the tensions between the needs of present and future consumers - such as whether current consumers should pay more for their gas and electricity so as to facilitate investment in green/renewable technologies which will benefit future generations. There is in practice an effective division of responsibility in the case of postal regulation, where Parliament has mandated a 100% universal postal service, however remote the customer, and a reasonably effective division in the case of water regulation, where politicians in London and Brussels mandate water quality, and Ofwat then determines the maximum prices that may be charged by water companies in order to provide water of that quality. (Only 'reasonably effective' because I do not believe that politicians are aware of the cost consequences of their determination to mandate ever-increasing water purity.) But energy regulation is currently a complete mess because of politicians' failure to take decisions on a number of social and environmental issues, preferring to leave these to an increasingly overwhelmed regulator.
The third key truth of utility regulation is that ...
The network nature of utility 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.
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.
Turning to consumer representation, 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. There is also a good deal of (what is known in the trade as) 'regulatory asymmetry' which takes three main forms:
This leads to quite a dilemma for the regulators. They would generally prefer to act as even-handed arbitrator between consumer representatives on the one hand and utility companies on the other hand, receiving contrasting submissions and making quasi-judicial determinations based on those submissions. But this would disadvantage consumers as the regulated industries would inevitably have much greater power and influence. In practice, therefore, the regulators generally see themselves as representing consumers - or at least the wider public interest - against industry opposition.
One partial solution is 'constructive engagement', first used by the Civil Aviation Authority in setting landing charges etc. - when they asked the airports and the airlines to agree as much as they could (for instance about the need for new investment) in advance of the regulator finalising the price control. It didn't work brilliantly in practice but it was a brave attempt and at least led to sensible and helpful information exchange. The very complex Gas and Electricity Code Modification processes - in which the industry and consumer representatives take the lead in agreeing changes the the rules regulation of these industries - can perhaps be seen as another form of constructive engagement. But these techniques only work if the customers (such as the airlines) are very powerful or the issues relatively uncontroversial. In most other cases it is inevitably necessary for the regulators' staff to ensure that the customer's voice is properly heard by decision makers.
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. This formula works well in a wide variety of circumstances, mainly because 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' '-X' efficiency target, 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.
Such efficiency targets are often met through capital investment but it is sometimes argues that the formula may reduce the incentive to innovate and invest in the short term, even though such investment might benefit both consumers and the company in the longer term. But the CAA has managed to overcome this problem by incentivising terminal and runway investment vis its price controls. Ofgem, however, faces tricky decisions about whether it should incentivise investment in renewable energy. Why should the regulator in effect tax all gas and electricity customers in order to meet 'green' targets? Shouldn't such taxation be imposed transparently by Parliament?
Click here to read about Energy Regulation
Click here to read about Postal Regulation
The Civil Aviation Authority (CAA) is responsible for controlling the prices charged to airlines for landing and taking off at London's Heathrow, Gatwick and Stansted Airports. Unfortunately the legislation is very old, predating the privatisation of the British Telecom which establishing licensing as a regulatory tool. Regulatory discussions are accordingly held only every five years and focus on price, rather than service quality (i.e 'P' rather than 'PQRS' - see further above). This weakness became all too apparent in the late 2000s when passengers at the main London airports suffered from severe delays following the tightening of check-in security, and again just before Christmas 2010 when a mere 25cm of snow caused 5+ days of chaos at Heathrow. Some relatively small penalties were introduced into the regime in 2008 and then, following the 2010 problems, Ministers vowed to make more substantial improvements via legislation.
Another odd feature of the regime is that the CAA has to consult the Competition Commission before finalising the price controls - the 'quinquennial' reviews - whereas more modern regulatory regimes allow the regulator to set price controls and any associated QRS conditions for any convenient periods, and the CC becomes involved only if the regulator cannot reach agreement with the industry. The 2007 (Heathrow and Gatwick) and 2008 (Stansted) quinquennial reviews led to the following charges being determined for 2008/9:- Heathrow = £11.97 per passenger +RPI+7.5% every year thereafter. Gatwick = £6.07 2008/9 & then +RPI+2%. Stansted £6.53 & then +RPI+1.63% after two years
The regulation of Stansted is particularly complex because the CAA believes that price controls are not necessary as Stansted is competing for traffic from elsewhere, whereas both the CC and the Department for Transport believe that effective competition has not yet been established. In addition, the airlines - and particularly Ryanair - do not want to have to pay for what they regard as over-grand plans to lay down a second runway and build expensive new terminal facilities.
A yet further complication is that the CC have carried out a separate Market Investigation and concluded that BAA - who once owned Heathrow and Gatwick and Stansted - should sell both Gatwick and Stansted so as to encourage competition and so benefit passengers. Gatwick has already been sold.
The CAA was at the forefront of promoting 'constructive engagement' between the airports and their customers in the run up to the 2007 quinquennial reviews - see further above.
Text to be added idc.
The PPP Arbiter had the interesting task of acting as 'piggy in the middle' between two sets of monopolists. On the one side there were Metronet Railways and Tube Lines, the companies that ran London's underground railway lines, and on the other side there was their customer, Transport for London (TfL), who are a monopoly supplier of most of London's railway and other transport services.
The PPP itself was always controversial, having been forced on TfL in 2003 by then Chancellor of the Exchequer Gordon Brown. The Government believed that private sector operators would be more efficient, and more willing to stand up to the equally-monopolistic employees and their unions, than public sector TfL. But TfL and others complained that the PPP was extremely and damagingly complex, and (in their view) likely to cost TfL more than if they had run the underground railway lines themselves. One reason for the likely extra cost was that it would cost the private sector companies more than taxpayer-backed TfL to borrow the money to fund the necessary investment in London's ageing railway system. Partial evidence supporting the critics' point of view was the collapse into administration of Metronet in 2007. TfL then took back the running of Metronet's lines. But the Arbiter subsequently found that much of the cost of running the former Metronet lines was higher than the cost of running the remaining private sector Tube Lines lines.
The (as it turned out final) key regulatory development was the Arbiter's decision, in March 2010, that TfL should pay Tube Lines £4,460m over the 7.5 years from 1 July 2010, to include the cost of upgrading the ageing Piccadilly and Northern Lines as required by TfL. TFl said that this was £460m more than they could afford. They therefore needed either to reduce the scope of the work that they wanted Tube Lines to carry out, or somehow find that money. (TfL had hoped that the Arbiter would require Tube Lines to borrow the missing £460m and be paid at a later date, but the Arbiter did not think that this was sensible, as it would cost Tube Lines more to borrow this money than it would cost TfL to do the same thing.) This was followed in May 2010 by TfL's decision to acquire Tube Lines assets for £310m thus bringing an end to this PPP, as well as the Arbiter, its associated regulator. It seemed likely, however, that TfL would then save money by slowing down its rate of spend on upgrading the underground transport system.