The reform of utility regulation in
The privatization of the British utility
industries by Conservative governments from the early 1980s entailed a new
regulatory system to replace public ownership. That new system has been the
subject of much criticism, and the remodelled Labour party, while in
opposition, committed a new government to its reform. "New Labour,"
however, ruled out a return to the old system of nationalization in favor of a
reformist program [Blair 1995, 2-4]. During summer 1997, the newly elected
Labour government announced the setting up of a wide-ranging review of utility
regulation to be undertaken at an inter-departmental level. The review was to
examine many of the reform proposals advanced by critics of the existing system
and was to lead to the issue of a government Green Paper - a consultative
document - on favored reform measures.
This paper seeks to explore some of the key issues in the modern reform
debate by drawing on the store of regulatory practice accumulated in
In contrast, this paper suggests that insights may be drawn from earlier
British regulatory experience. There are historical and institutional parallels
between utility regulation prior to World War II and in
In the period before World War II, the regulatory system, as today, was the focus of substantial criticism. The eventual outcome in the earlier period was the displacement of existing forms of utility regulation by nationalization although it is debatable as to what extent this marked a radical new departure. Control of utilities through various forms of public ownership, as well as control of private companies, was already characteristic of prewar Britain as noted in the report of the Next Five Years Group [1935, 89-96] and in the account of H. Macmillan [1938, 174]. A mixed system of regulation was a hallmark of the British system, and variety was one of the principal features of British public utility control, as J. M. Keynes pointed out [1927, 644-6]. Public ownership was supported by many non-socialists, so it is important also not to overemphasize the ideological aspects of public ownership before the war. New problems required varying forms of regulation, as the American observer M. E. Dimock noted in the early 1930s [1933, 43]. It was mainly the advent of a Labour government in 1945 that brought about the nationalization form of public ownership, and partly as a result, other prewar forms like municipalization declined in significance.
The first part of the paper examines the particular form of price cap control that has been central to British utility regulation since the early 1980s and investigates the alternative regulatory tools suggested by critics. Recent attention has focused upon "hybrid" forms of regulation with particular interest in the "sliding scale mechanism." This paper makes a comparison with various methods of regulation before 1939 and suggests that some ideas that are now exciting interest were tried then and found wanting. Indeed, the charge that regulatory mechanisms, like the sliding scale, were not working encouraged some prewar critics to advocate deregulation in a manner reminiscent of some market-oriented economists today.
A key issue at the present time in
RPI-X Price Control: The Rough and Ready Short-Term Solution?
Arguably, the most distinctive feature of the new regulatory system
introduced in
The choice of price caps appears to have been a deliberate rejection of traditional U.S.-style rate-of-return regulation,(1) which was believed to provide little incentive to improve efficiency and might give firms an incentive to overinvest [Bishop, Kay, and Mayer 1995, 4; Helm 1995, 31]. The principle behind price cap regulation is that by fixing prices utilities are given the incentive to reduce costs and increase profits; compared with conventional rate-of-return regulation, there is a reward for efficiency. Further suggested advantages of RPI-X regulation, when it was first introduced, was that it allowed "regulation with a light touch" and avoided the complexity and administrative expense involved in establishing appropriate rates of return [Rees and Vickers 1995, 359]. This fitted in well with the notion expressed by the editors of a recent British survey that the most important feature of regulation is that there should be as little of it as possible [Bishop, Kay, and Mayer 1995, 16], and it suited the new regulatory agencies, the nature of which will be examined later in the paper.
Apart from the suggested merits of RPI-X price control already mentioned, free market ideology also had some significance in its choice for the new regulatory system. The then Conservative government minister Nigel Lawson, reflecting on the privatization of British Telecom in 1984, believed that RPI-X provided a stopgap measure until regulation became unnecessary because of the growth of competition. He noted in his autobiography that the RPI-X formula was "originally envisaged as a rough-and-ready short term solution" [Lawson 1992, 223]. This perception of RPI-X regimes, as essentially temporary ones, fitted the market-oriented view that regulation should be about managing the emergence of competition and was one of the original criteria selected by Littlechild for choosing a regulatory mechanism [Burns, Turvey, and Weyman-Jones 1995b, 3]. It is a view principally identified with the Austrian school, as M. E. Beesley [1991, 155] has pointed out.(2)
The British "model" of price cap regulation also exercised an
influence in the
R. R. Braeutigam and J. C. Panzer [1993, 197] believe that limited
The Twin-Track Approach to Regulation and Criticisms of the Current Price-Capping System
The maxim frequently adopted by those concerned with regulatory issues in
The Labour party's A New Industrial Strategy for Britain, published in September 1996, showed commitment to the rule of encouraging competition where practicable and efficient but provided regulation in the core natural monopolies [Dickie 1996, 8]. John Battle, in his first major speech as energy minister in the new Labour government in June 1997, reiterated the principle of the twin-track approach. During the previous month, he had met the gas and electricity regulators to discuss concerns that the pace of energy market liberalization had slackened.(3)
In practice, RPI-X has endured far longer than some imagined, but since it was first introduced, a range of variants has developed that do not all have the same clear properties identified by supporters [Waterson 1994, 116-7]. Price control has tended to become tighter and more involved, according to R. Rees and J. Vickers [1995, 359; also Vickers 1996, 91; Lennard 1995, 41]. The demands of quality regulation, which have become more urgent, have contributed to the complexity of RPI-X regimes. L. Rovizzi and D. Thompson [1995, 345-6] have argued that adjusting the price cap might appear simple, but there are real problems in establishing a quality index and appropriate regulatory mechanisms. The idea that the regulator should construct a formula that can reward the various quality dimensions founders upon the very large number of such characteristics that are relevant in the view of C. Hicks [1993, 91]. Some of these issues are familiar from prewar British regulatory history. P. Chantler regarded problems of service deterioration and limitation as key problems in utility control. " Elaborate, and within limits, effective methods of controlling profits, prices and quality of the product may be employed, but the problems of service specification and control leave a core of weakness in the system" [Chantler 1938, 78; see also Batson 1933, 1-2].
Under the RPI-X system, the firm has a strong incentive to produce at lowest cost and maximize profits subject to the price constraint. But critics argue that in industries where technological progress is occurring and that have economies of scale, "undeserved" or abnormal profits have been made that are not the product of managerial action [Waterson 1994, 117]. Public dissatisfaction with the very high profits made by utilities has increased pressure on regulators to improve the periodic revisions to the price cap formulae. They have used rates of return earned in order to calculate these formulae, and some have suggested that this represents a change from RPI-X to what supporters of RPI-X say is the less efficient but superficially more equitable rate-of-return legislation [Burns, Turvey, and Weyman-Jones 1995, 1]. M. Call [1993, 24] observed that a drift toward rate-of-return regulation has crept into regulatory decision making over the last decade [see also Helm 1995, 1618]. S. Glaister [1996, 36-38] has warned of a possible danger of overinvestment in the British water industry in the future that may come from inflating the capital base and "gold- plating" - problems traditionally associated with rate-of-return regulation. Whether there truly has been a shift toward rate-of-return regulation is a matter of some controversy. M. Waterson [1994, 117-118], for example, has questioned whether rate of return provides a real alternative to RPI-X and is clearly different from it. In setting the price cap, the regulator is concerned that the firm can cover its costs including the cost of capital; this means estimating a fair rate of return on assets. Although it is not the basis for decision or action, in this sense RPI-X and rate-of-return regulation are not entirely mutually exclusive. J. Kay remarked recently that "it was always appreciated by most thoughtful commentators on RPI-X that it would, in reality, have many of the characteristics of rate of return regulation, and that much of the regulatory intrusiveness which had become familiar under that regime would arise here also" [Kay 1996, 156].
Analysis of the recent experience of price cap regulation in
The Rediscovery of Sliding-Scale Regulation in
In the search for alternative regulatory tools to RPI-X, the idea of a sliding scale has been resurrected, a system that existed in Britain up to 1939 [Chatwin 1995, 45; Cunningham 1995, 59]. Basically, a sliding scale involves a regulatory mechanism or formula whereby there is an inverse relationship between profits or some measure of profitability and prices. Increases in profit beyond a standard level are only allowed if prices also fall below a particular level. Conversely, prices may rise if profits fall below the stipulated level.
According to a recent evaluation, sliding-scale regulation was first
introduced as a way of bringing peace to the regulatory chaos of the pre-1875
gas industry [Burns, Turvey, and Weyman-Jones 1995, 2-4]. Subsequently, the
system drew the attention of American observers dissatisfied with rate-of-return
regulation in the United States.(4) Sliding-scale regulation spread to the
United States, being used, for example, in the electricity industry in
Washington, D.C., during the early 1930s [Bussing 1936, 5]. In
C. D. Foster has suggested that the original sliding scale used in
Certainly, there are very mixed views about the efficacy of the sliding-
scale system, which may lead us to question the recent assumption of Burns and
colleagues that it "may once again offer peace" to the regulatory
difficulties that exist today in
However, this rosy picture of the sliding scale perhaps needs to be toned
down. Critics have pointed to institutional defects and have suggested a less
successful history of the sliding scale in
Chantler noted that the sliding-scale system was being superseded by the
"basic" system of price and profit control. Between 1920 and 1937,
the basic system had been adopted by 36 companies together supplying more than
half of all gas sold by companies in
In the late 1930s, the McGowan Report on the reorganization of the British electricity industry also pointed to the defects of the "old sliding-scale" system of regulation; according to an account written at the time, the minimum prices determined under the sliding scale became "farcical" very quickly, since no allowance was made for the effects of improvements in science and technology on costs [Jones 1938, 268].
A report on the gas industry on the eve of World War II argued that the current system of regulatory control with statutory maximum rates, the sliding scale, and the basic system was too complex and obstructive and believed that there was a clear case for simplifying the public regulation of gas prices [PEP 1939, 170-172].
Both the reform group Political and Economic Planning (PEP) and Chantler, writing about the same time, pointed to the growth of competition in the gas industry and argued that the regulatory system needed to be overhauled with a strong case being evident for discontinuing the sliding scale, basic system, and statutory maximum rates [PEP 1939, 176; Chantler 1938, 105].
The electrical industry appears to have moved away from sliding-scale price control to rate-of-return regulation by the late 1930s, with Jones suggesting that "recourse has been had not only to American practice but also to American theory" [Jones 1938, 269].
The overall impression of prewar regulation in
Regulated and Unregulated Sectors
Diversification of utility companies in
One recently suggested remedy to the regulatory problems brought by diversification is to link price in the regulated sector inversely to the total overall profits of the firm in both the regulated and unregulated sectors [Waterson 1994, 103, 120; see also Corry 1995, 4]. Waterson, indeed, has commented that a mechanism designed by Braeutigam in 1993 [Braeutigam 1993] along the lines described is the modern equivalent of the sliding scale.
Hybrid Regulatory Mechanisms
During the last few years, there has been considerable interest in Labour
party circles in the idea of moving away from the present RPI- X regimes. An
assortment of alternative tools and "hybrid" mechanisms has received
attention including "rate-of-return sliding scales" and modified
price cap regulation in which companies have to share profits above a certain
level with customers. To an extent, the debate about sliding-scale regulation
and measures to control utility profits has followed developments already put
into practice in parts of the
T. P. Lyon [1994, 16] has observed that a useful characteristic of hybrid
regulatory mechanisms is that they address problems of implementation not dealt
with by theorists. Furthermore, they are seen as a "flexible
combination" of the alternatives of rate-of-return and price cap
regulation [
The new Labour government in
However, the government has been under strong pressure from vested interests to drop some of the more radical proposals considered in opposition. Michael Hughes, chief executive of the U.S.-owned regional power company Midlands Electricity, warned recently that "profit sharing is bureaucratic and it puts up costs. It damages incentives and it pushes up prices" [Godsmark 1997b]. Ian Byatt, the water regulator, has argued that "sliding scale formulae can never obviate the need for thorough periodic pricing reviews" [Beavis 1995]. It appears that Margaret Beckett, Trade and Industry Secretary, has been persuaded that dropping price caps would reduce incentive toward greater efficiency [Wighton 1997]. Less than two weeks into the government review of utility regulation, a commentator suggested that Trade and Industry department [DTI] civil servants had identified what they considered to be severe barriers to profit sharing schemes. Foremost was the suggested difficulty of designing a complex mechanism to calculate profit ceilings for each of the utility companies [Godsmark 1997c].(7)
Any change in the regulatory tool, for example, toward profit sharing would
have important repercussions for the regulatory authority. Profit sharing
embroils the regulator in additional measurement, asymmetric and other problems
calling into question the appropriateness of the particular institutional form
of regulation. Significantly, in
The Single-Person Regulator
Privatization of utilities from the early 1980s in
The idea of independent, sole regulators with discretion appeared to offer a less expensive, less rule-bound, less cumbersome, and more flexible alternative to U.S.style commission regulation at the time of privatization [Bishop, Kay, and Mayer 1995, 10]. It fitted in well with the prevailing ethos of light-touch regulation, promoting competition, and only substituting regulation where it was essential [Spottiswoode 1995, 60; Whittington 1995, 61]. A key objective of the regulator, as observed already in discussion of RPI-X systems above, was to "incentivize" the monopoly so that in the longer term "there would be the added bonus of the disappearance of the regulator" [McKinnon 1991, 95].
Resource Constraints on British Regulation
Recognition of the need for more or less permanent regulation coupled with a
drift toward more regulatory intrusiveness within RPI-X regimes, noted earlier
in the paper, has led to a questioning of the limited resources put into the
regulatory agencies in
Plans to regulate profits in addition to prices will put additional pressure
on the limited resources available to the regulatory authorities, which may
face a subtle assault by cash-rich firms deploying the cleverest consultants to
argue their case. The urge for the regulator to investigate more widely and
deeply will, according to liberal critics like C. Veljanovski [1991, 25],
eventually lead to a merging of regulator and industry interests. Fear of
regulatory capture was a strong concern of the Conservative government at the
time of privatization, as noted by D. Souter [1994, 74], and is still an issue
[see, for example, worries recently voiced by the Consumers' Association in Dee
and Meek 1997, 118-123]. Anxiety has also been expressed in
The highly personalized approach of the British system in appointing one individual as a kind of lone supremo with wide discretionary powers has raised questions concerning the accountability and control of the regulator as found in recent studies [Veljanovski 1991, x; Odgers 1995, 7; CRPU 1996, 55-56].
Unlike the
The Commission Form of Regulatory Authority
A persistent theme in current reformist literature is a demand for some kind of commission or executive board to replace single-person regulators as found in recent studies [Corry 1995, 11-14; Souter 1994, 84-86; CRPU 1996, 12]. The commission form would be a way of depersonalizing the system and of creating a certain degree of anonymity; it has also been advocated as a means of achieving a broader balance of regulatory objectives. As noted above, RPI-X is mainly identified with efficiency considerations and the promotion of competition. In contrast, critics have insisted that there are multiple and sometimes conflicting objectives [Corry 1995, 10; Ernst 1994, 194-7], and that the aim of regulation should be to balance the interests of the various stakeholders including a public interest [Souter 1994, 35-54]. The commission form, rather than the single regulator, might provide a more suitable framework for monitoring the attainment of these wider objectives, although the British experience before 1939 suggests that other regulatory structures are also appropriate for the pursuit of social ends. H. E. Batson [1933, 4] gave the example of tramways, which were encouraged to discriminate against short-distance passengers in order to help the decentralization of the population in their area. Some of the current reform ideas, particularly ones favored by those associated with the Institute for Public Policy Research (IPPR), are close to the thinking of American institutionalists who support regulation [see, for example, Trebing 1995; Miller 1995, 1996].(10)
One criticism of the commission form is that, in order to achieve balance between the various stakeholders, unsatisfactory compromises may be reached in a process that is less speedy and less decisive than one headed by a single-person regulator [Carsberg 1995, 131-132]. C. D. Foster [1995, 137] has similarly argued that lack of clarity in decision making may also be prevalent where the commission is weakly chaired. Another fear, expressed recently by J. Dickie [1996, 16], is that if non-executive directors are appointed to a panel and called upon simply for their expertise or experience, power would still reside at the center and this would "institutionalise vested interests at the heart of regulation."
Some reformers have toyed with the idea of creating a superregulatory agency covering all the utilities. There is the need, of course, to ensure that regulation is consistent between utilities, especially in the light of cross-sector utility mergers, the first being United Utilities, which started business on January 1, 1966. However, Margaret Beckett, the Trade and Industry Secretary, has agreed that there should not be a super-regulator for all utilities [Beavis and Weston 1997].
Experimentation with different types of regulatory agencies was a feature of the British system before 1939. J. McEldowney [1995, 410, 419] has suggested that the system of inspectors and boards in the nineteenth century bears a strong resemblance to present regulatory structures. In both periods, it is argued, there was a similar combination of the enforcement of statutory powers, ministerial supervision, and independent regulatory agencies. Accusations of bias and favoritism were levelled at individuals involved in those earlier agencies just has they have been toward particular regulators in recent British experience.
During the late nineteenth century, some regulatory agencies in
The traditional argument regarding why the independent commission was not
more favored in Britain focuses on the contrast between the U.S. system of
judicial supremacy and the British tradition of Parliamentary responsibility.
Certainly, these constitutional matters - and a dislike of legalism and
formalism - acted as a deterrent to the commission form and do so today,
although a certain legalism has crept into some recent proposals for reform.
Evidence of the vulnerability of
Moreover, because much British utility regulation before 1939 took the form of price fixing or sliding-scale arrangements implemented by charters or franchises, often in a very local context, arguably the commission form of institutional structure neither fit nor was appropriate.
Now that public ownership has been abandoned in
Conclusions
The broad ranging review of utility regulation by the cross-party Commission
on the Regulation of the Privatised Utilities [1996] demonstrated a widespread
and growing lack of confidence in the existing system of utility regulation in
This paper has focused on key aspects of the reform debate, namely a discussion of pricing policy with a suggested need for alternative regulatory tools and a demand for changes in the nature and character of the regulatory agencies. Attention has also been drawn to likely interactions between the choice of particular regulatory tools and the institutional forms of regulation. Unlike the bulk of recent scholarship, the paper has located the regulatory debate not only in the present, but in a longer-term historical framework, taking into account the period before nationalization. The mixed system of control before World War II included private companies, and it may be, as Foster [1992, 4] has suggested, that there "is much in that experience that is still relevant to the design of a modern regulatory system."
This paper suggests that evidence from earlier British experience points to
inherent difficulties in pricing regulation and does not necessarily lend
support to some suggested reforms such as the adoption of a sliding scale. The
variety of forms of regulatory agency was matched by a complexity of regulatory
instruments, making it difficult to establish appropriate linkages. Commissions
of the U.S.-type never gained a significant foothold in
As more competition is introduced into the utility industries in
The advent of a Labour government has raised some fears of an increase in the regulatory burden. Kay [1996, 156] has warned of an increase in "regulatory intrusiveness" over the last decade in Britain, a problem that he believes is endemic in RPI-X as well as rate-of-return regimes. The Labour politician Herbert Morrison, one of the chief advocates and architects of public ownership of utilities before and after World War II, foresaw a possible danger in tightening the controls on private utilities, which is perhaps worth bearing in mind today. "What becomes of capitalist 'incentive'," he argued, "if dividends are limited? . . . regulation would tend to be meticulous, irritating and severe . . . the very evils of bureaucracy, red tape, interference . . . which the Conservatives advance against socialism as a general doctrine . . . would in fact tend to be greater" [Morrison 1933, 77].
Nearly a quarter of a century ago, Trebing warned that regulation in the