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Regulation of Industries


By 1997, when the Conservative government left office, the only remaining industries left in public control within the UK were the Post Office and Air Traffic Control. Privatisation had been pursued with an almost religious fervour. It was seen as a way of revitalising inefficient industries and opening up hitherto closed markets to competition, thereby benefiting the consumer. Privatisation took many forms, it involved selling state-owned industries, such as telecoms, steel, gas and electricity, water and railways. It also included the tendering of services in the public sector and the creation of public/private partnerships.


For the critics, however, privatisation created new problems. In order to ensure a successful flotation, many of the nationalised industries were privatised as virtual monopolies (e.g. gas, electricity supply, water and steel) or, at best, as oligopolies (e.g. electricity generation and telecoms). What happened was that the public monopoly was simply transferred into private hands. For the critics, the potential for lower prices and better services was unlikely to be fully realised, if at all.


Has UK Privatisation Been Successful?

Between 1979 and 1997, the proceeds from privatisation were some £90 billion. Firms which were loss making under public ownership now began turning a profit. A recent study of 33 privatised enterprises found that, prior to privatisation, they absorbed £500 million of public funds annually and £1 billion in loan finance. By 1987, once privatised, the 33 contributed £8 billion per year to the Treasury. As well as greater profitability, bills have also fallen. Telecom bills have fallen by 49 per cent between 1984 and 2000, gas by 31 per cent between 1986 and 2000, and electricity by 20 per cent between 1998 and 2000.


Given these figures, it would seem to be very hard to argue against privatisation. For some of these industries, however, it was not the power of competition that brought such success, but rather the power of regulation and control over business actions. In other words, it was only with continued government intervention that such benefits have been realised. The regulatory framework put in place following privatisation was designed to look after the interests of consumers and to ensure that the privatised utilities did not exploit their dominant market position.


Regulation in the UK

All the major utilities have a regulator, such as OFTEL for telecommunications, and OFGEM for gas and electricity. The system of regulation in the UK has four pillars:

  • Price-cap regulation. Regulators, via a price-setting formula, determine the prices that can be charged by the utility. In its simplest form, the formula is RPI – X. This means that permitted prices increases are determined by the percentage rise in the retail price index (RPI) minus an amount X, where X is the reduction in price required for the industry as a result of expected improvements in efficiency. So for telecoms, between 1997 and 2000 the price formula was RPI – 4.5 per cent. This means that if inflation was 6 per cent, BT would be allowed to raise its prices by only 6% – 4.5% = 1.5%. If inflation was 3 per cent, BT would have to put its price down by 1.5% (i.e. 3% – 4.5%). Further elements might be added to the formula, such that it might take the form RPI – X + Y + Z , where Y is an allowance for unseen business costs, e.g. a rise in fuel costs. Y is not determined in advance but varies as cost changes. Z is an allowance for taking into account the cost of meeting environmental standards. The privatised water companies are allowed a Z factor.
  • Licensing. The regulator, as well as determining a utility’s price, controls other aspects of the company’s service provision. For example, the Strategic Rail Authority (SRA) specifies the number of trains that a train-operating company must run and the percentage that must be on time.
  • Behavioural rules. To ensure flexibility, the regulator can change provisions within the licence in the light of experience. For example, new environmental standards or safety considerations could be incorporated.
  • Attempts to increase competition. Regulators also impose and monitor levels of competition within an industry. They can impose a ceiling on the share of a market that might be controlled by a dominant producer. For example, British Gas is only allowed 40 per cent of the market for industrial gas users. OFTEL has recently extended price controls over BT for holding back competition in the sector. It has threatened to cap BT’s profits if its market share fails to fall further.


Strengths of the UK regulatory system

The price-cap system of regulation used in the UK has a number of strengths. These include the following:

  • The regulators are independent. They do not have to answer to government or the firms involved, and have the discretion to act as they choose. They have specialist knowledge and understanding of the industry they regulate, and, on this basis, it can be argued they are the best people to decide whether the industry is acting in the public interest.
  • It is flexible. The price formula (the value of X) and the licensing provision applied to the industry are not fixed: they can be changed if circumstances change. For example, the impact of fibre optics on the costs of providing telecoms services had been considerably underestimated by OFTEL. As a result, OFTEL raised the X factor from 3 to 4.5 per cent in 1989, from 4.5 to 6.25 per cent in 1991 and from 6.25 to 7.5 per cent in 1993, to ensure that some of the cost savings were passed on to the consumer.
  • It offers an incentive for efficiency. The privatised utilities always have an incentive to be efficient. Any cost savings greater than X means that they make greater profits. Alternatively, if they do not manage to reduce costs as much as X then their profits will be lower and they could even make a loss.


Weaknesses of the UK regulatory system

There are three main weaknesses with the UK regulatory system.

  • In order for businesses to plan long term, they require a degree of stability, especially concerning price. If the regulator gets X wrong and subsequently changes it, this will disrupt any planning the business may have done based on current prices. This may as a consequence breed an element of short-termism into the regulated utility. Equally, if the utility feels that that any profit it makes will result in the regulator setting a higher X next time, it may refrain from cutting costs as far as it might.
  • Regulators make decisions within imperfect markets and with imperfect information. When setting a price cap, the regulator does so based on estimates for potential efficiency gains. There is a real chance that any price determined in this way may be incorrect. Furthermore, the more complex the pricing formula becomes, the greater the chance there is of this occurring.
  • There is also the potential problem of ‘regulatory capture’. As regulators work closely with those they regulate, there is a danger that they may come to see things from the managers’ perspective or have the ‘wool pulled over their eyes’. This might seriously compromise the public-interest requirements that regulators are supposed to uphold.


As a result of these weaknesses, there has been a move, wherever possible, to replace regulation with competition.


How Is Competition To Be Introduced And What Problems Are There With It?

In most cases, when we refer to a public utility as being a ‘natural monopoly’, we are in fact only referring to that part of the business which is based around some kind of grid. In the case of gas and water it is the pipelines. With railways it is the track. With electricity it is the power lines. Other parts of the industry are potentially competitive.


Even when there is a natural monopoly, it can be made more contestable. One way of doing this is by franchising. Here operators are given a license for a specific time period, where they will act as a monopoly supplier. Each of the rail companies has a regional franchise and thus has a monopoly over all or most services within the region. The awarding of such franchises can, however, be highly competitive: rival companies bid against each other in respect to fare prices, the number of trains they will operate and the quality of the service they will provide.


With the grid or natural monopoly element separated from general supply, it is possible to introduce competition. Take electricity, any number of energy generators might supply the market, so long as they have access to the electricity grid. The same case could be made for suppliers of gas, so long as there was access to a supply pipe competition might be vigorous.


So as to prevent market dominance, say through progressive mergers and acquisitions, regulators have set limits to the share of the market that dominant firms are permitted to own. As mentioned, BT and British Gas have been subject to such restrictions.


Is it then possible to dispense with regulation completely and rely upon the market to deliver a fair outcome? The answer to this is that it is probably highly unlikely. Competition has its own problems. One of the problems of franchising became apparent recently when the rail operators came to renew their franchising contracts. The contracts were to be extended from 7 to 15 years, the reasoning being that many rail operators were not prepared to invest long term with a franchise of only 7 years, given that they did not know whether their franchise would be renewed beyond that. The difficulty here is that the more secure the franchise operator is, the less it will be conditioned by the forces of competition.


Other problems with competition are that it might fail to take adequate account of environmental or social objectives. Thus electricity generation can have detrimental effects on the environment and thus a regulator might insist on the use of cleaner technology. A public utility should provide public services, many of which, when supplied, go beyond the mere pursuit of economic profit (e.g. the provision of loss-making public transport to rural areas). Also, the natural monopoly element in grids and the limited number of firms in other parts of the industries concerned, will inevitably demand some regulatory presence to ensure that the public interest is not compromised and that industry behaviour is constantly monitored.


Thus, although the market may replace many aspects of regulation, it is unlikely that regulation will ever be totally abandoned.




E-mail Steve Margetts