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«Stephen Littlechild The UK utility regulation framework developed in the 1980s was Abstract intended to improve on the restrictive, inefficient and ...»

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Regulation, customer protection and customer

engagement

EPRG Working Paper 1119

Cambridge Working Paper in Economics 1142

Stephen Littlechild

The UK utility regulation framework developed in the 1980s was

Abstract

intended to improve on the restrictive, inefficient and burdensome

regulatory approach in the US. But the UK regulatory process has itself

now become increasingly burdensome. Meanwhile, utilities and

customer groups in the US and Canada have developed methods of negotiating and settling regulatory issues that more directly reflect the

EPRG WORKING PAPER

interests of customers, often embody incentive price caps as in the UK, and avoid unduly burdensome regulatory processes. There is now scope for UK regulators to learn from overseas. This paper summarises these developments. It then examines how three UK utility regulators – the CAA, Ofgem and Ofwat - are responding to them. Briefly, the CAA has moved firmly in this direction, but Ofgem and Ofwat have nominally rejected it while seeking to secure many of the benefits of the approach via a less committed process. There is scope for governments to encourage a regulatory approach that offers the prospect of better outcomes for customers and a less onerous process for all concerned.

Keywords Negotiated settlements, constructive engagement, regulation JEL Classification L51, L9 Contact sclittlechild@tanworth.mercianet.co.uk.

Publication June 2011 Financial Support ESRC Follow-on Fund www.eprg.group.cam.ac.uk EPRG No 1119 Regulation, customer protection and customer engagement Stephen Littlechild1 23 June 2011

1. Ownership, competition and regulation The UK regulatory framework developed in the 1980s was intended to improve on the restrictive, inefficient and burdensome US regulatory approach. Over subsequent years, UK utility regulation has a number of achievements to its credit. Privatisation, the promotion of competition and the imaginative use of incentive price caps have generally led to greater efficiency, price reductions and improved quality of service. However, the regulatory process has become increasingly burdensome and there are growing doubts as to how well it protects customers.

Meanwhile, utilities and customer groups in the US and Canada, encouraged by some regulators, have developed methods of negotiating and settling regulatory issues that more directly reflect the interests of customers, often embody incentive price caps as in the UK, and avoid unduly burdensome regulatory processes. There is now scope for UK regulators to learn from overseas. This paper summarises these developments. It then examines how three UK utility regulators – the CAA, Ofgem and Ofwat - are responding to them.

2. The US regulatory framework

Emeritus Professor, University of Birmingham, and Fellow, Judge Business School, University of Cambridge, Trumpington Street, Cambridge CB2 1AG. sclittlechild@tanworth.mercianet.co.uk.

Tel. 01564 74 2502. Formerly Director General of Electricity Supply 1989-98.

Acknowledgments: An earlier version of this paper appeared in Eamonn Butler (ed.), Reflections on Regulation: Experience and the future, Adam Smith Institute, London, 2011. I am grateful to a referee for helpful comments and suggestions.

EPRG No 1119 When the UK began to privatise its utilities, it looked at how the US regulated its privately owned utilities. The regulator approved price increases only if they provided a “just and reasonable return” on investment that was “used and useful”. The regulator could step in at any time to seek price reductions whenever a company seemed to be making excessive profits.

All this might seem reasonable. However, closer examination by economists suggested at several reservations.

First, this was too much like a ‘cost-plus’ arrangement. There was little incentive for utilities to reduce costs if the savings had to be immediately passed on to customers. There was in fact an incentive to ‘gold-plate’ or ‘pad the rate base’. Also, in setting prices the US framework was backward-looking rather than forward-looking. It looked only at ‘facts’ about actual expenses in a ‘test year’. The regulator could not make judgements about the scope for future efficiency improvements or the need for future capital expenditure. This seemed a serious limitation at a time when increasing the efficiency of the hitherto nationalised industries was a key aim of policy in the UK.

Second, in many industries like airlines, telecoms and energy, US regulators enforced barriers to entry that maintained a monopoly and prevented competition. Customers were denied the protection that competition could provide against inefficient production techniques and misinvestment, against excessive prices and lack of innovation, and against regulators that might be unable or unwilling to act in the interests of customers.

Third, the US legal framework and litigation process seemed unduly bureaucratic and legalistic. Rate cases could take years to resolve, in some cases many years. This was timeconsuming, expensive, inflexible and not conducive to the rapid modernisation that was needed in the UK.

3. The UK regulatory framework

In 1982, the Secretary of State for Industry, Patrick Jenkin, had the task to privatise British Telecom. He needed to reassure investors and customers so as to attract very considerable new investment into this rapidly changing sector. He was also conscious of the limitations of US regulation. He wanted something more flexible and evolutionary. He specified that British EPRG No 1119 Telecom should be regulated ‘with a light rein’. For present purposes, the UK regulatory framework that was designed to meet this aim had three main elements.





First, the regulator was to allow and indeed promote competition wherever possible. This would give customers a choice and stimulate companies to greater efficiency and innovation.

Second, where competition was not possible or not economic, an RPI-X incentive price cap was a simpler and more effective form of regulation than US rate of return control. Set for a fixed-term, it offered a greater incentive for the company to become more efficient and reduce its costs. Requiring prices not to exceed the rate of inflation less an ‘X factor’ provided assurance to customers and company alike. As efficiency improved, customers would benefit from further price reductions over successive price control periods. The price cap was simple to explain, and hopefully would be simple to set. The third element was the ability of the regulator and utility simply to agree a modification to the licence conditions (e.g a new price control) without the need for formal and adversarial legal proceedings. The regulator had the ability to refer the issue to the Monopolies and Mergers Commission (later the Competition Commission) if the utility declined to accept a modification proposed by the regulator.

4. UK regulation in practice

In the event, with a few exceptions, the novel UK policy turned out remarkably well throughout the privatised and regulated sector. The regulators have generally promoted competition both actively and effectively. This is less so in the water sector, but there is some scepticism about the scope for competition there, and Ofwat has been faced with an unenthusiastic series of ministers.

The record on removing price controls as competition develops has been mixed. Offer, Ofgas and Ofgem removed the controls on domestic gas and electricity prices within at most four years of opening those markets. In contrast, Oftel (later Ofcom) took some 22 years to remove the initial RPI-X price control on BT’s retail prices. International comparisons (at least in electricity) suggest that those countries that have maintained price controls have thereby discouraged competition. The low point in the record must be the Government’s overruling of the recommendation of the Civil Aviation Authority (CAA) to remove Stansted Airport’s price control on the grounds that the Airport might have market power in future.

RPI-X price controls have generally provided very effective incentives. Operating costs have significantly reduced, and efficiency has improved. There has been very substantial capital EPRG No 1119 expenditure. Prices are generally lower, or at least lower than they would have been in the absence of these changes. Quality of service is higher. There has been innovation in techniques and in products.

Yet the UK approach, for all its advantages and potential flexibility, seems to have limitations in terms of process. The price control review process is especially and increasingly burdensome. Initially it took about a year, now it takes about three years - to set a five year control. The total length of regulatory documents issued during the price control review of the electricity distribution companies increased from about 250 pages when I did the first review in 1995, to about 500 pages in 2000, to about 2000 pages in 2005. A colleague has estimated that the length may have been about 3-4000 pages in 2010 – at least a twelve-fold increase. It has been said that the volume of annual information required by Ofwat increased tenfold between 2000 and 2010.2 The regulatory process is also intrusive and often a cause of conflict between companies, customers and regulators within each industry. There is minimal role for users and customers.

Regulators are increasingly required to specify or approve quality of service standards and investment programmes on the basis of limited knowledge about customer preferences. The pressure for regulatory uniformity limits the ability to tailor regulation to particular circumstances. There is less innovation, less learning from experience, than one would expect in a competitive market.

Indeed, the burden of the typical UK approach is now so great that it rivals the burden of the US approach in the 1970s that we sought to avoid. If we had seen present UK regulation in action then, I suspect we should have been equally keen to avoid it.

5. Alternative approaches Why has UK regulation run into such problems? The initial RPI-X regimes put a cap on the prices that the companies could charge, but left efficiency improvements and investment and innovation to the companies themselves. Increasingly, however, regulators have sought to specify in advance what levels and kinds of efficiency improvements, investment programmes and innovation could or should take place. Partly this is in response to tougher arguments from the companies, partly to avoid setting targets that seem to be too easily met.

David Gray giving evidence to the All Party Parliamentary Water Group, Utility Week, 9 February 2011.

EPRG No 1119 But how can regulators know what companies can achieve, and what customers want? In order to specify the desired outcomes, regulators have gradually taken upon themselves the discovery process traditionally undertaken by the competitive market. This is proving to be an increasingly challenging task.

Are there different and better ways of regulating? Since stepping down as electricity regulator, I have been exploring how regulation actually works in other jurisdictions, not least in the US and Canada. As in the UK, there has been greater focus on competition than in the past. Where there is no competition, the formal regulatory framework there has not changed much. However, in many jurisdictions the parties have nonetheless found ways to reduce or avoid the previous regulatory burden. Moreover, utilities and customers have secured outcomes that they themselves perceive as better than what the formal regulatory process would have delivered.

The key to this development has been the active involvement of the users and customers themselves, and/or their representatives, in negotiations with the regulated utility. The regulatory body no longer sees its role as taking all the decisions itself. Rather, its role is to facilitate discussion, negotiation and if possible agreement among the interested parties. The price control decision reverts to the regulator in the event that the parties fail to agree.



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