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UTILITY REFORM 12: Competition by proxy The regulation of privatized utilities The problem: privatizing monopolies It may prove difficult politically to split up large state-owned utilities and other monopolies prior to privatization. Incumbent telecommunications, gas, water and electricity suppliers may have a dominant position, and in some cases a series of natural monopolies that are hard to untangle. So how to privatize them, and get the benefits of private management into the system, without handing customers over to a rapacious private monopoly? The idea: the regulator as competition While encouraging new entrants to come into the market to compete against privatized utilities, a system of regulatory supervision can be established which acts as a proxy for competition. The aim is to set demanding targets, but ones which a good management team can beat, pushing down prices and pushing up service quality - just what would happen if the service faced real competition. Example: arms-length regulation The United Kingdom was the first country to launch a major privatization programme. Where possible, it introduced competition at the point of privatization. In the case of the telephone company British Telecom, for example, it created a new company, Mercury, to compete for some services, while other companies emerged to compete in other parts of the market, such as mobile telephones, switchboards, and value-added services. But this still left British Telecom, as the owner of virtually all the country's telephone wires, in a highly dominant position. The legislation attempted to extend competition by obliging British Telecom to allow other operators to connect into its network, and a regulatory office was set up in order to make sure this happened. But the regulator - the Office of Telecommunications (Oftel) - was also given a much wider remit in the attempt to bring quasi-market pressures to the dominant player, principally through the regulation of prices to business and domestic telephone users. The price regulation worked through a simple formula - RPI-X - linking prices to the inflation rate (the retail price index or RPI) minus an X factor, which was designed to spur efficiency and downward pressure on costs. Initially the X factor was set at just over 3% - meaning that British Telecom's prices would have to fall by 3% in real terms each year. But the regulator, sensing that there was much more inefficiency to be squeezed out (and that technological change should be reducing the cost of providing telecommunications), soon raised the target to a more than 6% annual real fall in prices. In later privatizations such as gas and water, the RPI-X formula was modified to RPI-X+Y, or RPI+K, allowing unavoidable service-improvement costs (such as infrastructure upgrades) to be passed through to customers. These unavoidable costs included new investment demanded by the government to upgrade the gas network and improve the quality of drinking water and wastewater treatment. Utility prices in the United States have not traditionally used the RPI-X approach, but have been set to allow shareholders a specified rate of return on their investments. This 'rate of return' or 'cost plus' regulation has been criticized for providing an incentive for utilities to over-invest in new capital equipment (on which much of the calculation is based). The UK legislators wanted to avoid this unnecessary investment - 'gold plating' as it is often termed - and focus instead on spurring operational efficiency and service. The 'rate of return' model is also criticized for becoming highly politicized and legalistic. In natural monopolies, where there is no real market, many costs are hard to attribute, so their allocation to different parts of the service is highly arbitrary and complex. Since the incumbent operator is the main source of accounting information, regulators can be misled. This can happen in the UK model too, though the theory is that with price-cap 'macro-regulation' there is less need for intrusive micro-level scrutiny. In constitutional terms, the UK's regulatory agencies are non-ministerial departments headed by a Director General. The legal authority to regulate is contained in the original legislation privatizing the utility. The regulator's powers are spelt out in the licence given to utilities. Originally a single regulator was preferred, in the belief that committees would become politicized and would be slower in making decisions. But after some very personal disagreements between utilities and regulators, current thinking is that a small board is the better structure. In telecommunications, UK price regulation has gradually been scaled back as the market has become more competitive. In international telephony, for example, over fifty new operators were granted licences at the end of 1996. Price regulation is no longer needed because there is now a fully competitive market. In gas and electricity supply, the need for stringent price regulation has also been recently relaxed as more new players enter the household as well as business markets. Even in water, the regulatory body Ofwat has made a point of trying to extend choice for business users, though with mixed results. Gas and electricity customers too now have a choice of which supplier from which to buy their services; and complicated trading arrangements match generators with distributors and customers (see the chapter Pooling Power). This has led to the emergence of 'multi-utility' companies competitively supplying gas, water, electricity and telephones to households in one multi-service package and with just one quarterly or monthly bill. The RPI -X system has been widely copied throughout the world by countries such as diverse as Australia and Argentina adopting the UK as their model. Assessment: formula for success The system of applying quasi-competitive pressure using a single RPI-X price cap appears to have worked reasonably well in the UK. Since the formula applies to the overall pricing structure, regulation can be confined to the macro level and there is less need for micro-regulation delving into the specifics of cost allocations as there is in the US. If subsequent profitability suggests that the X factor has been set too high or too low in one regulatory period, it can easily be eased or tightened in the next. However, the question of whether the X factor has been set too high or too low remains a matter of judgement. If, at the end of a regulatory period, a utility has made a handsome profit, should that be attributed to the X factor being set too low, or the company having innovated and exerted itself to outperform all expectations? And at the same time, the formula has to leave at least some profit in the sector, or else no new entrants will be attracted into the market and regulation will never be supplanted by genuine choice and competition. Clearly, companies need to be reassured that they can retain any profit generated by improved efficiency, but the public need to be reassured that high profits are not the result of targets being set too low and that the 'fat' is being squeezed out. Ideally, the X factor should be set to last for some years: frequent changes would add to regulatory risk and create an unattractive environment for investment. But at the point of privatization, there is an unknown (and often surprising) amount of 'fat' in a state-owned utility, which makes it hard to set the price cap for a long term without the threat of huge 'windfall' profits being made by shareholders as the industry slims down. One way out might be to have some initial 'clawback' arrangement, so that profits above the early expectations are shared between the company and the taxpayer. But such a system should be phased out as confidence grows and profit levels become more predictable. Whilst regulators in the UK have retained their independence, they are appointed and fired by ministers. Consequently, they are not entirely politically independent. In the UK, the absence of a structured pattern of accountability has led to a lively debate over regulators' accountability to Parliament. Committees of the House of Commons regularly ask regulators to appear before them to be questioned on their policies. Some argue that regulators have been given too much discretionary power. This is an exaggeration: regulators can only impose what is in the licence. Regulators' actions are also subject to judicial review. Regulatory offices should not be seen as part of the permanent infrastructure. They can grow all too easily - arguing that they need more staff to collect more information or to enforce the complicated rules that they have themselves created. Occasionally they come to share the values and opinions of those they regulate and become 'captured' and ineffective. Sound legislation will therefore make a regulator's prime task that of promoting competition; and where that succeeds, regulation must be scaled back. One option here is to place a time limit on the regulatory body (see the chapter Into the Sunset), combined with clear targets for the introduction of competition within the regulated sector. Something like this happened in the United States in the 1970s. Where competition was sufficiently effective to allocate resources efficiently, regulation was eliminated. Accordingly, airlines, trucking, stockbroking, buses and natural gas production were deregulated. This resulted in entry by new players, widespread innovation, greater consumer choice and lower prices. For further information:
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Copyright 2002: Adam Smith Institute
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