Have the utility regulators run out of control?

The repercussions in the City of last week's electricity shock has thrown the spotlight on the watchdogs. Paul Rodgers reports

FEW people recognised the power of Britain's four main regulators until one of them flexed his muscles last week. At a stroke, Professor Stephen Littlechild, the mastermind behind utility privatisation:

q embarrassed the Government over its £4bn sale of National Power and PowerGen shares and opened it to potentially expensive litigation;

q smashed the defence of takeover target, Northern Electric, and forced its would-be conqueror, Trafalgar House, to abandon its £1.2bn bid;

q sent share prices in the electricity sector tumbling;

q created renewed uncertainty over the intended £5bn stock market flotation of National Grid Holdings.

Professor Littlechild and his regulatory counterparts were charged yesterday by Sir Iain Vallance, chairman of British Telecommunications, with wielding more power than the Prime Minister.

Between them, Ian Byatt (water), Clare Spottiswoode (gas), Don Cruickshank (telecommunications) and Professor Littlechild (electricity) oversee 20 per cent of Britain's gross domestic product. The levers that the directors- general can pull to control these industries go far beyond setting a simple price cap. Their deliberations and the reasoning behind their decisions do not have to be revealed. Balanced against this is their ability to create a pseudo-market that promises better management, cheaper prices for customers and healthy returns to investors.

Professor Littlechild's decision to reconsider his proposed price caps for the regional electricity monopolies has raised tough questions about the way regulation works. Some people - echoing the Roman poet Juvenal when he said: "Quis custodiet custodes?" ("Who guards the guardians?") - worry that the regulators have almost unbridled power. Others fear that the system is sliding towards the discredited US model by a backdoor route, or that it is not democratically accountable. Still others insist that the system merely needs a bit of tinkering, that the status quo is essentially healthy.

Even the regulators are split on how much change is needed. Mr Cruickshank refuses to address the questions at all, saying they are a subject for Parliament. Ms Spottiswoode has lobbied hard with the Department of Trade and Industry to have controls formally implemented. Mr Byatt and Professor Littlechild argue the system is basically sound and headed in the right direction, although they admit improvements are possible.

Academics are also divided. Geoffrey Whittington, a member of the Monopolies and Mergers Commission and Price Waterhouse Professor of Financial Accounting at Cambridge University, dismisses the turmoil in the electricity market last week as a simple case of the regulator playing hardball. "It's what's known in the housing trade as gazumping," he said. "I'm sure some of the companies would happily do the same to the regulator if they got the chance. Business is a hard game."

Professor Paul Grout, an economist at Bristol University, sees the upheaval as a fundamental threat to confidence in the system. "We are in grave danger of having a totally unsatisfactory halfway house between the US and British regulatory models," he warned. Ironically, Professor Littlechild is both the architect of the UK model and, if Professor Grout is correct, the man behind the wrecking ball.

In a 1981 paper for the Institute of Economic Affairs, Ten Steps to Denationalisation, Professor Littlechild outlined how the Government could sell off its utilities without allowing them to fall into the lethargic stupor common in America. US utilities are regulated by rate of return, a system that guarantees investors a fixed profit no matter how well or poorly the company performs. They are not allowed arbitrarily to boost prices to fatten their earnings, nor are they encouraged to cut costs. On balance, the customers lose.

In contrast, the British model, championed and essentially originated by Professor Littlechild, relies on a fixed price cap, which allows companies to increase their profit margins by being more efficient. After the investors have enjoyed the fruits of their capital for a set period, usually five years, the regulator sets a new benchmark, transferring the future benefits of past efficiency improvements from the shareholders to the customers. The longer the licence period, the greater the incentive to cut costs.

That was essentially the regulatory model for the flotation of British Telecom in 1984, the first privatisation that needed a statutory counterbalance to the virtual absence of market forces to challenge its monopoly power. That set the pattern for the sale of British Gas two years later, although when the electricity and water industries were privatised in 1989 and 1990 the regime was made more complicated by the decision to break each of those industries into several companies. While it was difficult for them to compete with one another, the belief was that comparison of their relative performance would create what was known as "competition by emulation".

The key to the UK model is the principle that shareholders should be allowed to keep any gains they make during their five-year licence period. Yet Professor Littlechild's move appears to endanger that. It is widely accepted that the regional electricity companies (RECs) were privatised at too low a price, so investors have seen a dramatic increase in shareholder value. Professor Littlechild decided not to try to claw any of that increase back - until he saw Northern Electric, under takeover pressure, offering to hand over £5.07 a share to investors, replacing the lost equity with higher borrowing.

In an article the Financial Times last week, Professor Littlechild explained that he was responding to public concern over booming electricity share prices and the Northern Electric defence strategy. His timing, he said, was affected by the fact that the Trafalgar bid was due to close on Friday. At best, this suggests that he erred last summer because he did not have enough information from the RECs. At worst, it implies that far from being independent of politics the regulators are subject to the same public pressure as MPs.

Professor Littlechild insists that he is committed to the principles of regulation he first outlined 14 years ago. Improve- ments will come gradually as more real competition is introduced, not from a dramatic redesign of the system. "It's not clear to me that we need to make radical changes," he said. "I think regulation is evolving." Much of the present short-term uncertainty would disappear in future rounds of price setting as the bugs were shaken out of the system.

Many captains of industry disagree. John Baker, the chief executive of National Power, proposed a six-point reform of the regulators long before his share sale was disrupted. Among other things, he called for regulators to publish strategic plans for their industries to set down their objectives, more transparency in the decision-making process, quick appeals before a panel from the MMC and the replacement of single individuals with tribunals.

Former Ofgas director-general, Sir James McKinnon, now chairman of Calor Group, a gas marketing and distribution company, thinks much of the public abuse aimed at regulators could be deflected by changing the way price caps are set. In addition to the RPI-minus-x formulae, there should be a requirement that companies reduce prices by 20 per cent of any saving due to improvements in efficiency. "As long as the gain to the shareholder is greater than the gain to the customer the incentive to cut costs will be there."

The most scathing attack came from Sir Iain Vallance. Within their fields the regulators act as "legislator, prosecutor, judge, jury and executioner," said the BT chairman. His main complaint is that a regulatory system designed to restrain a monopoly while new competitors got started has outlived its purpose. In telecoms, technology is changing so fast that innovative companies can often outmanoeuvre ex-monopolies. Yet the giants, in this case BT, face limits that the upstarts do not. Cable companies are allowed to offer telephone services, for example, but the phone company can not transmit television signals down its lines. "In its early phases, the British regulatory regime was exemplary," Sir Iain said. "It is now past its sell-by date."

While this may be true for telecoms, other utilities operate in strikingly different environments. Natural gas is a business driven less by technological change than by the operators' luck when drilling offshore. Electricity distribution was divided at privatisation between 12 similarly sized RECs, so there was no single large player. Water companies are burdened with heavy environmental obligations that will keep them cash negative for a decade or more.

Still, common threads run through the suggestions of Sir Iain, Sir James, Mr Baker, Professor Grout, Ms Spottiswoode and even some of the regulatory regime's strongest supporters.

The most common criticism about the regulators is that their power is unchecked. Only two routes of appeal exist, and both are flawed. The first is to go to the MMC, which has the right to look at all aspects of a case, not just the detail in question. The second is to use the courts. However, judicial reviews can only look at whether the regulator acted within the law. An independent panel of adjudicators, possibly an ad hoc committee of the MMC, or greater judicial powers to review regulators' decisions could redress the problem without becoming burdensome.

Another often repeated suggestion would be to give the regulators more supervision, particularly by Parliamentary select committees. Mr Byatt, who has appeared before such a committee only once, is particularly critical of the way politicians have washed their hands of the process. "I have, on the whole, been disappointed by MPs. I would welcome more involvement by them," he said.

Some would also like to see individual regulators replaced by panels. Mr Byatt proposes that the regulators form a college, with each taking the leading role in their field of expertise.

Whether any of these changes are ever implemented will largely depend on the political pressure brought to bear on the Government. Last week's events show that the process is far from perfect. Thousands of small investors in the RECs, National Power and PowerGen will no doubt make that abundantly clear to the Government.