Abstract
The liberalization of utilities has generally led to the creation of an economic regulator, nominally independent of government. The United Kingdom, as a pioneer of this process, has more than 30 years of experience with independent regulators. However, by 2019, the three main regulated utilities in the United Kingdom, energy, water and rail, were in disarray with a combination of high prices, poor service and a failure to achieve the goals of competition set at the time of the reforms. Government, the companies and the regulators must all bear the blame for this situation. We focus on the regulator in this article and argue that there a number of factors behind their failings including a concentration on economic issues to the detriment of other issues such as environment and public welfare, a lack of public accountability and a poor culture in the regulators based on a view that regulatory interventions were always counterproductive. Given that regulators are appointed by government and funded by Parliamentary vote, the claim of independence is not credible and there are circumstances when government should be able to overrule regulators in the broader public interest. We suggest that expanding the range of skills among the regulatory decision makers, regular rigorous Parliamentary scrutiny and a much stronger focus on the attributes consumers require – affordability, reliability and sustainability – rather than the current obsession with competition would improve the regulators’ performance.
Introduction
All three main network utilities in the United Kingdom, energy (gas and electricity), water and rail, were in serious disarray in 2019. It seems clear none of the three of the primary actors involved in these industries should escape blame: government, which determined the structure and sets overall policy for the sectors; the companies, which appear to have put profit maximization ahead of customer service; and the regulators, who failed to control prices and ensure the companies meet high standards. In this article, we focus on regulation. We specifically ask how far blame should fall on the model adopted for countries that have liberalized utility industries of creating an independent sector regulator to set prices for monopoly activities, regulate performance and monitor markets. A major element of the UK reforms was privatization. There is an argument whether public or private ownership is more appropriate for vital industries with a significant monopoly element. There is also an issue of whether and how regulation should differ according to ownership. For example, in the United States, publicly owned utilities like the Tennessee Valley Authority are not subject to price regulation. These arguments are important but are not covered in this article.
The industry structure is very different for these three utilities in the United Kingdom. For energy, the networks (transmission and distribution) are fully unbundled, 1 and there are competitive wholesale markets and retail competition for all consumers. Water remains an integrated monopoly business with a large number of regional companies. For rail, the network is unbundled with the routes separated into a number of regional monopolies. The other major network utility, telecoms, has become effectively deregulated with prices set by the market and is not considered further.
In order to address how far the regulatory set-up is to blame, we ask Who should regulators be independent from and why? Are the regulators representative of the consumers they represent? Are their decisions distorted by ideology?
In the second section, we show the industry structure in 2019 in these sectors and we review the regulatory structure pre- and post-reforms. In the third section, we identify the problems attributable to regulation in the period since privatization and we suggest measures that would mitigate these problems.
The network utilities in 2019
Structure
Energy
The gas and electricity industries for Great Britain were privatized and liberalized in 1986 and 1990, respectively. 2 Since 2003, the national gas and electricity transmission networks have been owned by National Grid Company. By 2019, the 14 regional electricity distribution networks were owned by six companies and the eight regional gas distribution networks were owned by four companies. There are a large number of retail companies offering gas and electricity, several electricity generation companies and a number of gas importers.
However, the ideal of a liquid, competitive wholesale market feeding into a competitive retail business with consumers choosing the cheapest supplier has never been achieved. The liquidity and competitiveness of the gas wholesale market is difficult to determine. The electricity wholesale market has been an oligopoly since 1990, from 2002 comprising mainly six (the ‘Big Six’) integrated generator/retailers. Two are UK-based (British Gas and SSE), two German-based (RWE and E.ON), one French-based (EDF) and one Spanish-based (Iberdrola). The Big Six companies account for the vast majority of generation not contracted outside the market and have no incentive to allow the wholesale market to be an efficient market with low entry barriers, cost-reflective prices and investment in new capacity driven by market signals. Wholesale power is predominantly sold via self-dealing within the Big Six or long-term confidential contracts. The perception of oligopoly has led to massive public distrust in the sector, and in 2015, an opinion poll found the companies were less trusted than the UK banks. 3 Since 2008, the sector has been subject to a series of inquiries and reform efforts aimed at remedying the lack of competition. These include those by the regulator, Office of Gas & Electricity Markets (Ofgem) (Ofgem, 2010), the Government (Department of Energy & Climate Change, 2012), the Competition & Markets Authority the UK’s anti-trust authorities (Competition & Markets Authority, 2016) and an independent government appointed analyst (Helm, 2017). Despite these inquiries, there has been little change to the sector in terms of structure or competitiveness. In most years from 2012, British electricity prices (pre-tax prices for residential consumers) were nearly the most expensive in the European Union. 4
By 2018, the sector had become a ‘Frankenstein Monster’ with every prospect that it would deviate further from the ideal of a healthy competitive market. For low carbon sources, which make up the majority of new capacity, generating capacity is only being built with long-term, fixed real price government contracts to buy all their output. A small amount of fossil fuel capacity, primarily peaking plant, is built with 15-year consumer funded ‘capacity payments’. Capacity payments are paid to generators simply for guaranteeing to be available whenever called upon and are to ensure sufficient generating capacity is available at peak demand. These payments should ensure the plant is profitable even if it never generates. Over the 30 years since privatization, negligible amounts of capacity has been built to compete in the market with most built by the Big Six to supply themselves.
Retail competition appears a little healthier than in the past with the market share to the residential sector of suppliers other than the Big Six increasing to about 20% from about 2% in 2013. This may be due in part to growing consumer dislike for the Big Six and also to government-imposed liquidity measures that have forced the Big Six to guarantee to offer some of their output to the market. However, the new entrant retailers buy primarily from the Big Six and it seems likely the Big Six could ensure these new entrant companies were not profitable, forcing them out of the market. In the 12 months to January 2019, 10 small suppliers collapsed requiring the regulator to find companies to take over supply to more than 800,000 consumers. 5 The UK government decided in 2017 to impose a price cap on the most widely used tariffs that would essentially re-regulate residential tariffs. This was to combat the long-established exploitation by the Big Six of consumers that do not switch. 6 While the wisdom of this measure is doubtful, it has squeezed the profits of the Big Six sufficiently for some to consider exiting the United Kingdom.
Water
The water industry for England and Wales was privatized in 1989 when the 11 regional water and sewerage companies were sold. 7 About half of the companies are now UK-owned water companies while the rest are owned by a mixture of foreign utilities (e.g. Cheung Kong Infrastructure Holdings) and investment companies (e.g. MacQuarie and Morgan Stanley). The UK’s National Audit Office (2015) found that between privatization and 2015, real water prices had gone up by 40%. 8 An early concern was the level of leakage through the pipes which in 1995 was estimated to be 5112 million litres per day. By 2017/2018, the leakage rate was 3183 million litres per day, still about 23% of supplies but the leakage reduction took place almost entirely between 1995 and 2000. 9 Eight of the 18 companies failed to meet leakage reduction targets in 2017/2018. 10 As a result of this leakage, and despite a wet winter in 2017/18, a spell of warm weather in summer 2018 led to water restrictions in some areas. The publicly owned water companies in Scotland and Northern Ireland have a much better record of leakage reduction.
Rail
The rail industry was privatized in 1994. 11 The track and stations were placed in a new privately owned company, Railtrack. The routes were separated into a large number of franchises, typically of 10 years, and sold to new train operating companies (TOCs), the rolling stock was placed with three new privately owned rolling stock companies and track maintenance was sold to 13 companies. As a result of a number of serious accidents, Railtrack was essentially bankrupted and taken back into public ownership as Network Rail in 2002, where it remains. A number of the TOCs had their franchises terminated early due to bad performance, for example, South Eastern trains (2006), or abandoned the franchise because it was not profitable, for example, Virgin Trains East Coast (2018). These failed franchises were temporarily taken back into public ownership then re-sold. The government’s role in franchising has been problematic and in 2012, a franchise decision had to be abandoned because of failures by the Department for Transport. 12 By 2019, there were 17 franchises owned by nine companies, with four large companies accounting for nine of these. All four, two UK-based and two German-based, have international businesses and also provide bus services.
Because of the proliferation of fares, some of which are regulated and some not, it is difficult to determine how much fares have increased since privatization but the common perception is that, overall, real fares have increased substantially. Some of the most commonly used fares, for example, season tickets, are regulated and since privatization, the regulatory formula (RPI-X 13 ) has allowed annual real increases in fares. Given that the franchisee has a monopoly for a given route, there is no competition for consumers with the competition between companies only over who should win the franchise. The common perception is that franchises are awarded on the basis of their financial attractiveness to government – the company offering to pay the most money to the Treasury – with the quality of service offered having little weight.
Punctuality has been a major issue culminating in a near collapse of the system in May 2018 when a new timetable was introduced across the system. This resulted in large numbers of delayed services and cancellations 14 and an introduction of a dramatically reduced emergency timetable expected to be in force in some regions for at least the following year. The rail regulator, Office of Rail & Road (ORR) (2018), and the Department for Transport are carrying out investigations into what went wrong. 15 Bizarrely, the ORR report, authored by the Chair of ORR, describes itself as ‘independent’ despite ORR clearly being party to the disruption.
Regulation
The old model of regulation
With the notable exception of the United States, prior to liberalization, regulation in most countries, including the United Kingdom, was carried out within government ministries and its methods appeared to be ad hoc with few details published. The UK utilities were nationally publicly owned and were therefore under the control of the ministry that also regulated it. This was seen as unhealthy in a number of respects. The nationally owned utilities were large companies generally with vastly more resources than the government ministry assigned to review prices. There were strong suspicions of regulatory capture because the ministries simply did not have the resources to properly evaluate the price proposals by the utilities. The nationalized utilities were seen as ‘bloated’ and charging higher prices than the economically efficient level.
At other times, the government manipulated prices in the pursuit of broader policy objectives, for example, limiting price increases as a way to reduce inflation. For some, such interventions are always counterproductive because they distort price signals to consumers.
The implicit new model
The implicit model for the independent regulatory body is analogous to the independent judiciary. The government has the democratic legitimacy to set the law/policy, which the independent judiciary/regulator implements requiring only objective judgments. The independence of the judiciary/regulator ensures that government cannot arbitrarily intervene in day-to-day decisions to further its own short-term political objectives. The primary job of the regulator was to set prices for monopoly services and, where competition existed, oversee that markets were working well. The model can also be seen as analogous to safety authorities such as for civil aviation and nuclear power. Here, it is apparent that the judgments made are not so subjective, although the question of ‘how safe is safe enough’ is generally not addressed by government and there are strong suspicions that there is frequently an element of regulatory capture (see below).
UK regulatory bodies post-privatization
The sector regulators were set up at the time the industries were privatized. Ofgem was set up in 2000 from the merger of the gas (set up in 1986) and electricity (set up in 1989) regulatory bodies. 16 It covers Great Britain. The Office of Water Services (OFWAT) was set up in 1989 and covers England and Wales. 17 The ORR was set up in 2004 adding responsibility for monitoring Highways England to the rail regulatory body set-up in 1994. 18 It regulates the rail industry in England, Wales and Scotland as well as roads in England. In their original form, the decision maker at these bodies was a single person, the Director General, but between 2000 and 2004, the Director Generals were replaced by Boards of up to 11 members.
Evaluation
Independence
There would be common agreement that regulatory bodies should be independent of the companies they regulate, but this is easier to state than achieve. The skills required by analysts at regulatory bodies and also their inside knowledge of regulatory processes are of significant value to the regulated companies. As a result, there is a significant interchange of personnel between regulators and regulated companies, the latter generally able to offer better salaries. This might contribute to the well-known phenomenon of ‘regulatory capture’ under which regulators, through continual exposure to the arguments of regulated companies, become unduly sympathetic to them.
It is also widely held that, under the new regulatory model, regulators should be independent of government. This is a more arguable position from a practical point of view and from the point of view of democratic accountability. For the UK regulatory bodies, independence from government is claimed through the fact that they are ‘non-ministerial government departments’ rather than being part of a government ministry. Nevertheless, the Board members are appointed by the minister at the sponsoring ministry and funding comes from a levy imposed on the regulated companies and approved by government. So, it is implausible that regulators would be appointed that did not reflect the priorities of the government.
At a more theoretical level, the case for independence is based on the belief that governments should set policy while regulators should simply implement that policy. If we take the analogy with legal system and the independent judiciary, a key difference is that laws are changed infrequently while policy is a living thing with a constant need for incremental changes. Regulatory decisions therefore require such incremental changes in policy. This raises the issue of the democratic legitimacy of regulatory bodies.
The European Commission has, since the passing of the Electricity Directive in 1996 that required Member States to liberalize their electricity markets, been clear that it does not want governments to be able to change regulatory decisions. So, they disapprove strongly of the situation in France where regulatory decisions are advisory, final decisions being taken by government. The representative body for energy regulators in the European Union states (CEER, 2017): For example, legal provisions in some Member States allow the government a degree of instructions on regulatory work whereas legally the NRA [National Regulatory Authority] should be fully independent from political interference. CEER’s (2016) survey found that in 5 countries the energy NRA can be given instructions on regulatory decisions by the government, by the parliament or by a particular ministry.
Accountability
The public has no role in the appointment of regulators and if they disapprove of their policies, they have no way to influence them. The regulatory procedures are theoretically open to all, but the documents produced are so specialized that the only bodies that can participate meaningfully are regulated companies and specialist consultants.
In the absence of this direct control, a next best solution for the United Kingdom would be some form of regular and rigorous scrutiny through the Select Committee system and well-resourced consumer bodies. When the utilities were publicly owned, they were subject to a thorough annual evaluation by a Select Committee. The Public Accounts Committee (PAC) would seem ideal using the expertise of the National Audit Office, a well-resourced and experienced body set-up to carry out investigations into public spending.
Prior to privatization, there were statutory sector consumer councils. For electricity, the Electricity Consumer Council argued that the introduction of markets meant there was no further need for consumer representation while the Gas Consumer Council continued in operation until 2000. Then, a new statutory body, EnergyWatch to cover electricity and gas, was set up and continued in operation until 2008 19 when it was replaced by Consumer Focus, covering all regulated markets. 20 It was subsequently renamed Consumer Futures and abolished in 2014 when its functions were transferred to two established independent charities, Citizens Advice England & Wales and Citizens Advice Scotland. 21
For rail, the Central Transport Consultative Committee set-up in 1947 continued after privatization and is known as TransportFocus. 22 For water, there is the Consumer Council for Water (CCW) set-up in 2005 covering the privatized system of England and Wales.
The resources available to these consumer bodies are small compared to the regulator and CCW’s budget in 2017/2018 was £5.2 million compared to OFWAT’s budget of £25 million. Anecdotally, relations between consumer bodies and regulators are poor with the regulators seen as unwilling to engage seriously with consumer bodies.
Representativeness
In the past 5 years, the make-up of the boards of the regulatory bodies has changed (see Table 1). For example, in 2013, the Board of Ofgem was dominated by white male civil servants and management consultants. However, by 2018, the gender balance had been largely addressed but not the ethnic balance. In terms of background, the base had broadened with more people with an industry, regulatory and academic background brought in. However, representation from those with a consumer, environmental or a trade union background was absent. The academics were all from an economics background. This suggests that the belief is regulators make purely economic decisions and any other skills are not needed.
Make-up of the boards of the regulators.
CEO: Chief Executive Officer; Ofgem: Office of Gas & Electricity Markets; OFWAT: Office of Water Services; ORR: Office of Rail & Road.
Ideology
While the rationale for the UK’s privatization was that private ownership was invariably preferable to public ownership, there was growing unpopularity with the public in the years after the initial privatizations. Privatization was seen as simply transferring a publicly owned monopoly to the private sector, which was able to increase the companies’ profits at the expense of consumers. As a result, for electricity and rail, there was a concerted attempt to make the structure of the sector competitive. The same structure was applied retrospectively to the gas industry. For water, OFWAT frequently expresses an objective to introduce consumer competition for small consumers despite its implausibility and the lack of any consumer pressure for competition. For rail, competition at a consumer level with such a constrained network was not feasible but competitive forces were seen to be introduced by the fragmentation of the industry and the relatively short length of the franchises. By comparison, the franchises for the water companies are effectively unlimited.
To reflect this emphasis on competition, one of the primary duties of the electricity regulator was to promote competition. This was changed in 2002, when the gas and electricity regulators merged, to a single duty to protect the interests of consumers. Whether this had any effect on the way Ofgem operated is debateable. Ofgem’s mentality appeared to be that the best way to protect consumers was to make the industry as competitive as possible. One consequence of this was the failure to carry out proper checks on the credentials of new entrant energy retailers. These began to enter the market in large numbers from about 2014 onwards, but there was insufficient checking on their financial strength and their ability to carry out the job resulting in the large numbers of company failures noted previously. 23 The appointment of market economists to the Boards of the regulators may have reinforced this tendency.
It is arguable that this predominance of competition over protecting consumer interests has distorted the work of the regulators. For largely standard products like utility services, the only benefit to consumers of having choice is if competition reduces prices. If a regulated monopoly would produce lower prices and a comparable service quality, the regulator should be advocating this option.
Critique and proposals
The analysis above leads to the following proposition. The UK’s regulated network industries, energy, water and rail, are failing. While the issues came to a head in 2018, the underlying problems have existed since privatization and the implementation of the independent regulatory body model. For all three industries, prices are high compared to the Britain’s European competitors and have risen despite Britain’s advantages of climate, terrain and a mature network, and despite the promise that private ownership would improve efficiency. For rail and water, service quality is poor. For energy, there is a failure to achieve the primary goal of the reforms, implementing effective competition.
The regulator must bear a significant part of the responsibility for these failures. The reasons for the regulators’ failures are a combination of factors including lack of relevant competence, poor corporate culture and a narrow skills base. How far the model of a regulator independent of the government is an underlying factor is an important issue.
The issues
Skills
There are two problems in the regulator’s boards: the narrow skills base with economics dominant and, reflecting the UK civil service ethos, supremacy of management experience over sector skills and knowledge.
Corporate culture and ideology
The corporate culture of an organization is difficult to change, out-living changes of personnel and management and it may be that to significantly change the culture of the regulators will require them to be dismantled and re-assembled rather than incremental changed. Today’s ethos was set at the time of privatization by the claims that competition among privately owned companies was sufficient to solve sector problems. Competition would take over quickly from monopoly, and Littlechild (Beesley & Littlechild, 1983), one of the architects of privatization, claimed that regulation was only to ‘hold the fort’ till competition arrived when the need for a regulator would disappear. This expectation has not been realized and the major element of the energy regulator’s work has been trying to remedy the failings in the competitive markets. Despite these problems with markets, the ethos persists that regulatory actions should be minimized and any regulatory intervention in the market was invariably distorting.
Accountability
The UK government and Parliament have failed to make the regulators accountable. The regulator’s annual report is published but there is no substantive official scrutiny of it.
Representativeness and diversity
The balance has shifted away from boards dominated by career civil servants and management consultants to those with a regulatory background and to academic economists. However, reflecting the model of a board taking objective technical economic decisions, the skills mix remains dominated by economists. While the regulators have gone some way to improve the gender balance, there is still no ethnic diversity in their decision-making boards.
Solutions
For all three sectors, policy must be a balancing act between the three key objectives: reliability, affordability and sustainability.
Independence
Is the model of a regulator taking objective, technical, economic decisions under the umbrella of a policy framework set by government valid? The claim that the regulators are currently independent, whether or not it is desirable, is not sustainable. The regulators are appointed by government and funded by government vote so they are likely to be sympathetic to the government’s position and are open to its influence. However, the model of government setting policy and regulators simply implementing it is not realistic and many of the decisions made by regulators have a significant policy-setting element in them. Thomas (2016) argued that governments allow regulators to make policy decisions while problems in the sectors are not a major political issue but when things are going wrong, the government must step in, with its democratic legitimacy, to deal with the problems. A more representative appointments panel might go some way to getting decision makers not necessarily strongly associated with the government position.
The role of government
Micromanagement of the regulator by a government department is unattractive and with an apparent increase in the number of populist and even extreme governments, there must be apprehension about allowing governments too much short-term influence over industries that need continuity. Government has been happy to pass responsibility for potentially unpopular decisions to the regulator, ducking its responsibility to set the policy framework. However, a return to regulation within government ministries is undesirable. Yet if the regulatory process is to have democratic legitimacy, there must be scope for government to overrule or modify regulatory decisions where the public interest, reflecting wider concerns than the regulated sector, would be in doing so. Realistically, the regulator will have to take policy decisions, albeit not the most fundamental, which strengthens the need for decision makers who are genuinely representative.
Skills
In terms of skills, while the staff of the regulatory bodies would continue to require the skills, primarily economic, needed to carry out the work, the decision-making board should have a much broader range of skills including consumer, environmental and labour expertise. This would help improve the cultural basis for the regulatory bodies and remove the free market ideological bias that the regulators suffer from.
Accountability
This might be done via a Select Committee, the PAC, perhaps based on a National Audit Office review, a body set-up to review value for money for public expenditure.
Radical solutions
The proposals above can be seen as a ‘technical fix’ to the existing system and it may be that to really transform regulation more ambitious proposals that made the regulator much more representative and democratically legitimate are needed. Under this model, the regulatory decision makers would be drawn from mandated organizations that cover the range of interests the sector covers – public welfare, consumers, environment and labour.
Footnotes
Declaration of Conflicting Interests
The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
Funding
The author(s) received no financial support for the research, authorship, and/or publication of this article.
