Why fairness is the new watchword
There was a time when fairness was a forbidden word in regulatory circles. “It was considered an abstract term, not something that regulators should be concerning themselves with or engaging with,” recalls one observer.
Instead the market, through competition, was going to drive down prices while the regulator was charged with pure economic regulation, leaving the government with limited involvement.
Over the past five years the mood has changed, and not only within utilities. Thinking has shifted within economics itself. Ten years of austerity has also sharpened concerns about those who have problems paying for essential services like energy and water.
As Catherine Waddams, professor of regulation at the University of East Anglia, told Utility Week Congress in October, 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.”
The outlines of the new era of regulation were 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 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 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.”
Regulators must display an increased sensitivity to the broader public mood, Nolan told Congress. “The regulator needs to be able to explain their decisions.”
The minefield of ‘value judgment’
To enter the fairness arena is to enter a slippery world of value judgements, in which regulators’ decisions will have a significant impact on companies’ entire business models.
Ofgem’s concerns over what it perceived as a grey area surrounding its remit with respect to fairness were on display during its tussle last year with government over whether it had powers to introduce the now launched market-wide cap on standard variable tariffs (SVTs).
Energy UK flagged up the risk of equipping regulators with tough powers without a mechanism for appeals against their decisions on the level of the cap. And one industry regulator pointed out: “If you are given that kind of power, there needs to be some correlating protection.”
Would innovation be at risk?
There are widespread concerns about the risks thrown up by a focus on fairness, and whether an overly prescriptive regime on returns will give utilities less scope to innovate and invest.
Economic Insight’s Thompson identified two main models regulators could adopt, one based on giving companies incentives and the other specifying the rate of return they can achieve.
Regulatory models based on incentives pose drawbacks, he said: “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. The “slightly lower” returns can be politically appealing to politicians and organisations that want to avoid headlines about high profits. However, the drawback is that firms don’t have incentive to minimise costs and innovate.”
Control vs freedom
Many fear that easing competitive pressures could lead to worse customer outcomes overall if companies are no longer under pressure to beat one another on price.
One industry regulator said: “While it may look tough, there is a question over whether such moves could undermine customers’ confidence in the market.”
And policymakers must recognise there could be a trade-off between the desire to protect consumers, through mechanisms like the price cap, and delivering the best innovation, Waddams told Congress. “Customers will end up paying more if we rely on regulators rather than the market.”
The system will only work as long as due processes are in place, added 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 Nolan acknowledged that this is one of the big challenges the regulator faces. But a balance can be struck between the interests of investors and consumers, said Ofwat’s Fletcher. Indeed, the public legitimacy of regulation underpins investment certainty, she said: “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.”
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