WHAT’S IN THIS REPORT?

 

• Overview: How policy is shaping new priorities
• Why fairness is the new watchword
• The minefield of value judgement – can ‘fairness’ be regulated
• Is innovation at risk: why regulators need to be braver
• Balancing control with freedom and the need to incentivise suppliers
• Is there scope for a single regulator?
• Concluding remarks

Overview: How policy is shaping new priorities

Sorry can never been an easy word for a regulator to say. It was a significant moment therefore earlier this year when Dermot Nolan apologised to consumers for not acting more swiftly to deal with rising prices of energy retailers’ standard variable tariffs. The Ofgem chief executive’s mea culpa in front of the BEIS (business, energy and industrial strategy) committee marked a change from the days when utility regulators liked to cultivate an air of Olympian detachment from the industries that they presided over. “That was clearly a very symbolic moment,” said Dr David Reader, one of the authors of a wide-ranging study of retail energy regulation recently published by the University of East Anglia. The context for this apology is a rapidly changing political backdrop. Utility companies have seen an intense backlash in recent years. The water sector has received intense criticism over excess executive renumeration and corporate profits. Meanwhile, energy utilities have been the butt of criticism over the level of prices that they charge, particularly for those on rolling SVTs. The most graphic manifestation of the hardening public mood towards utilities is that nationalisation of utilities is back on the agenda. The Labour opposition has won widespread public backing for its commitment to bring large chunks of the water and energy industries back into public ownership. The conservative government’s response has been to tighten up on utilities’ returns. A cap on energy retailers’ SVTs is due to be come into effect early next year. And Ofwat’s proposals for the upcoming PR19 price control framework period will place regulatory limits in areas like executive reward and renumeration.  Meanwhile the National Infrastructure Commission has been tasked by the Treasury with conducting a wide-ranging review of utility regulation. The wind of change is even penetrating the corridors of the regulators themselves. Professor Martin Cave, widely seen as the godfather of the price cap, has recently taken over as chair of Ofgem. He recommended curbing SVT prices in what proved to be a highly influential minority report, which was tacked onto the end of the 2016 CMA study of the energy industry. This special report by Utility Week examines this new era of regulation. In particular it explores how the old and relatively narrow concept of economic regulation is crumbling in the face of growing pressure to deliver fair outcomes.

Why fairness is the new watch word

We were given a fairly straightforward task and did it without any political interference The regulatory architecture surrounding the retail energy market in the early days of privatisation and liberalisation was ‘relatively simple’, according to David Reader’s UEA study. Certainly, there was a time when fairness was a forbidden word in regulatory circles and was even banned in discussions at Ofgem board meetings. “It was considered an abstract term, not something that regulators should be concerning themselves with or engage with,” recalls one observer. Instead, “The market through competition was going to drive down prices and the regulator was charged with pure economic regulation and the government had limited involvement,” explains Martin Stanley, who became the first chief executive of Ofcom in 2000 before going on to head the subsequently disbanded Competition Commission. “We were given a fairly straightforward task and did it without any political interference,” Stanley recalls. The regulator would carry out their research, consult on proposals, analyse the feedback and then take their decisions. “It’s a much more complex task being a regulator than it was in my day. It was not easy, but the issues were well circumscribed. This approach was underpinned by a philosophy of economic regulation, which was premised on the idea that greater competition is the best way of improving customer outcomes and incentivising investment that can deliver greater efficiency and better service delivery. Stanley says: “A regulator of my generation would look at what is happening to price and quality. If they were moving in the right direction you are happy to leave everything else.” If bonuses and profits were deemed too high, the regulator would use the next price round to ‘clobber’ the sector, he adds. That picture essentially held true as late as 2011 when the then Department for Business, Innovation and Skills published a paper on ‘Principles for Economic Regulation;’ this stated that “The fundamentals of the UK’s system for economic regulation are sound and are not in need of major reform.” And it’s been a strongly held view that this post-privatisation regulatory regime has presided over unquestionable benefits. Colin Nichol, managing director of SSE, also speaking at Utility Week Congress said that this early phase of regulation had succeeded in creating one of the most reliable energy networks into in the world. He pointed to how the average customer is now 50 per cent less likely to suffer a power cut than in 2002. And when supplies are cut off, they are likely to restored much more quickly with overall reliability having increased from 95 per cent in 1990 to 99.99 per cent today. However, over the last five years the mood has changed. Reader, who is also a lecturer at Newcastle University, is clear about why the pressure to intervene in energy has increased. “The energy market is one of high political salience,” he said. Ian Thompson of consultancy Economic Insight told Congress that a focus on fairness is a theme across all the regulated sectors, from the energy price cap to the Ofwat crackdown on executive returns and rewards. “Support for renationalisation is being driven by the impression that outcomes are not fair.” It’s not just in utilities that this greater sensitivity about fairness can be seen.  A ‘super complaint’ by Citizens Advice, alleging that long-standing customers are getting worse deals their more recently acquired counterparts, has triggered investigations by the Competition and Markets Authority across a range of markets including insurance. Meanwhile shifting thinking within economics itself, inspired by the ‘nudge’ theories of the American Nobel-prize winning economist, Richard Thaler, means a growing body of opinion within the discipline believes that individuals’ behaviour is not purely influenced by the simple price signals that underpin classical economic thinking. “The purely economic viewpoint was never going to be right because people don’t always act in economically rational ways,” says one regulator. Ten years of economic austerity has also sharpened concerns about those who have problems paying bills for essential services like energy and water. An increased awareness on the problems faced by vulnerable customers has been a key driver for a wider-angled approach to regulation, Professor Catherine Waddams, professor of regulation at The University of East Anglia, also told Congress, where the changing priorities of regulation was very much a key theme. “Regulators are expected to have an understanding of what customers’ needs are in a way that would have been unthinkable in the engineering driven industry 50 years ago.” The remit of regulation has widened, agreed Ian Thompson of consultancy Economic Insight: “Economics can’t tell you what fair outcomes are, but economic regulators are now being called upon to ensure that outcomes are fair.” This focus on fairness poses challenges to the traditional framework of ‘pure’ economic regulation, concluded the UEA study, authored by Dr David Reader. “Concern about companies in a market profiting at the expense of consumers, and some consumers achieving better deals than others, has replaced the original emphasis at privatisation,” he says. Reader pointed to two key documents that had marked a shift in thinking at Ofgem towards a greater sensitivity to fairness issues. The first of these was Ofgem’s strategy document in 2014, published in the wake of Ed Miliband landmark party conference speech, in which the former Labour leader had called for a freeze on energy bills. This highlighted how “variations in outcomes lead many to view the energy market as unfair.” The second was published in December 2016, which stated that customers should be confident that they’re getting a ‘fair deal’ from their energy company. The outlines of the new era of regulation was in also in evidence from the regulators themselves at the Utility Week event. During her keynote presentation, Ofwat chief executive Rachel Fletcher said “We need to move away from relying on the very comfortable mantra that we are only focused on narrow issues of service and price. This means stepping beyond the narrow remit originally prescribed for economic regulation.” “I don’t think that the model of providing public services through privately regulated companies will be successful if regulators wash their hands of these broader concerns.” “We have decades of experience as regulators but still have much to learn about how to influence corporate culture particularly where we can’t rely on competition to align companies’ interest with customers interest.” This new approach chimes with public perceptions, added Fletcher. “What people care about transcends the transactional, they care about price and delivering services at efficient prices. “But particularly when it comes to provision of essential services like water they care about corporate behaviour, dividends, executive pay and whether a company is providing a social and environmental benefit.” Also speaking at Congress, Ofgem’s chief executive Dermot Nolan agreed, arguing that there had been a ‘fundamental shift’ in the way regulation is talked about.“The whole idea of regulation being a narrow activity no longer holds true in the public eye. “The narrative has changed – different outcomes are not perceived as acceptable now in a way they were ten years ago.” This means regulators must display an increased sensitivity to the broader public mood, Nolan told Congress. “A regulator that is not aware enough of the public mood and the current in which it swims will ultimately not have confidence. “The regulator needs to be able to explain their decisions,”

The minefield of ‘value judgment’

We should also recognise that we provide essential services … We must earn the right to make a profit SSE’s Nichol told the UW Congress that the peculiar nature of the essential services delivered by utilities make the regulation of utilities a ‘legitimate topic for debate’. “It’s entirely legitimate to hold the view that reform is required: the argument for the status quo is not an option, we need to be open to change as our industries change around us. “We should also recognise that we provide essential services and therefore are to be held to a high standard of transparency, accountability and confidence. We must earn the right to make a profit.” However, entering the fairness arena involves entering a more slippery world of value judgements in which regulators’ decisions will have a significant impact on companies’ entire business models. Former regulator Martin Stanley says: “In the early days, the analysis was essentially economic, and it was about how businesses work. Now you need that and what the civil service would call administrative and policymaking skills.” Ofgem’s concerns over what it perceived to be the grey area surrounding its remit with respect to fairness were on display during its tussle last year with the government over whether the regulator had the powers to introduce a market-wide cap on SVTs. Reader said: “The redistributive effect of introducing price caps went beyond their statutory remit in terms of meeting certain vulnerable customers although Greg Clark was insistent that they had the powers to do this. “Ofgem was of the mind that it went beyond its powers and issues of significant redistribution are a matter for parliament.” Stanley said: “It is regrettable that regulators are being asked to take the decisions about where the benefits should be.” The result was initially a stand-off between the government and the regulator, which was only resolved when the former committed to legislation on the matter. Energy UK flagged up the risk of equipping regulators with tough powers but without a mechanism for appeals against their decisions on the level of the cap. “If you are given that kind of power, there needs to be some correlating protection,” said an industry regulator.

Is innovation at risk?

If you incentivise the wrong outputs, we will end up paying for services we don’t want. And what are the risks thrown up by this focus on fairness? There are widespread concerns that an overly prescriptive regime on returns will give utilities less scope to innovate and invest. The extent to which this happens depends partly on the mechanism that regulators use to achieve the fair outcomes which are increasingly desired, said Economic Insight’s Thompson. He identified the two main models regulators can adopt, one based on giving companies incentives and the other specifying the rate of return they can achieve. Regulatory models based around incentives pose drawbacks, he said: “If the model isn’t calibrated correctly companies may earn high returns not because of good practice but because of poor framework design. “If you incentivise the wrong outputs, we will end up paying for services we don’t want.” But there are pitfalls surrounding the rate of return model too he said. “Companies deliver certain outputs and can only ever earn a certain return. The benefit of this approach is that level of return is certain and is set by a regulator. The ‘slightly lower’ returns that will be available under this model can be politically appealing, he said: “The certainty offered by rate of return models can be particularly attractive to politicians and organisations that want to avoid headlines about high profits.” But there are downsides, Thompson warned. “There is no risk in this approach however the drawback is that firms don’t have incentive to minimise costs and innovate.” Ofgem’s push to reduce the networks’ price control period from eight to five years will give a shorter period for companies to reap the benefits of cutting costs, he pointed out. How regulation can help to foster innovation is the subject of a recently launched Treasury consultation. Fletcher, chief executive of Ofwat, cautioned delegates that it is not the regulator’s job to directly meet customers’ needs. “Companies and not regulators are best placed to understand what customers need and adapt to new challenges and opportunities as they arise.” Jenny Pyper, chief executive of Northern Ireland’s utility regulator, told Congress that there is an increasing realisation that ‘braver choices’ must be made with regards to how regulators deal with innovation. “With the scale of technological change, we need to get a better balance of risk and reward rather than just juggling trade-offs in the trilemma.”

Balancing control with freedom

What might be expedient and make a good news story isn’t necessarily in customers’ long-term interest. Many fear that easing of competitive pressures could lead to worse customer outcomes overall if companies are no longer under pressure to beat one another on price. Martin Stanley, the former Ofcom regulator, says: “The original idea of buying energy from different distributors was that distributors would compete to buy the cheapest energy. The danger is that companies will relax and won’t try as hard to cut costs.” An industry regulator agrees: “What might be expedient and make a good news story isn’t necessarily in customers’ long-term interest. While it may look tough, there is a question over whether such moves could undermine customers’ confidence in the market.” And policy makers must recognise that there could be a trade-off between the desire to protect consumers through mechanisms like the price cap and delivering the best innovation, UEA’s Waddams told Congress. “Customers will end up paying more if we rely on regulators rather than the market. If you want to protect vulnerable consumers, you have to recognise that there is a trade-off.” “Regulators shouldn’t be doing innovation, companies need to do that, but they need to get out of the way,” she told the audience. Michael Lewis, chief executive of Eon, also argued at Utility Week Congress that the energy SVT cap would ultimately be counterproductive in terms of engaging customers. Lewis urged Ofgem to take another look at the amount of headroom the regulator is offering within the price cap to companies. “If the headroom is not sufficient it will have a negative impact on competition and reduce customer engagement with the energy market.” “The worry is if you cut corners it won’t be good for consumers in the long-term because it’s going to impact on investor confidence.” Economic Insight’s Thompson agreed. “The key challenge is how to maintain incentives for companies to invest in assets and services we want to be delivering. Ensuring the right incentives are in place for investment is essential. “The direction of travel is towards greater retail regulation and could come at the expense of incentivising investment in assets that future and current customers need.” The system will only work as long as due processes are in place, says Stuart Cook, managing director of consultancy Complete Strategy and a former senior partner at Ofgem. “When you start messing about with that you start scaring the horses.” Ofgem’s chief executive, Nolan acknowledged that it is one of the most difficult challenges that the regulator faces. But a balance can be struck between the interests of investors and consumers, Ofwat’s Fletcher said: “Keeping a fair balance between investors and customers is in the long-term interest of investors.” Indeed, the public legitimacy of regulation underpins investment certainty, she added. “Expectations are shifting and if we don’t respond and show consumers that we are taking them seriously we will be probably have an unstable framework for investors.”

Concluding remarks

Utilities face growing political and societal pressure, which reflects the essential nature of the services that they provide. And regulators themselves are finding that the extent of their duties is expanding beyond the relatively limited mandate that they were set in the early days of privatisation. In particular, regulators face ever growing pressure to ensure that customers receive fair outcomes from the companies that they police. Regulators themselves recognise that the classical model of economic regulation, which set the tone for this early period of the privatised utility markets, is no longer enough. They also accept they can no longer remain in the ivory tower and must engage with the society that they serve. Extending the regulators’ reach into areas inevitably as value laden as fairness exposes these organisations to the risk of much more intense public scrutiny though. More significantly in terms of customer outcomes, capping prices and tightening up on returns risks stifling competition and potentially inhibiting the flow of investment that could ultimately lead to better quality and more cost-effective services.