Regulators should beware when the cap doesn't fit

When the price cap is too severe, sobs of pain will be dismissed as crying wolf

One of the biggest smash and grab raids ever, they called it. When Ofgas chief Claire Spottiswoode pronounced last week on the prices to be set by the British Gas subsidiary TransCo, the company hit the roof.

Sids - the little shareholders - were marshalled to express their distress about their dividends. And British Gas hollered about job cuts in their thousands, and the threat to future investment.

So here we go again, another round in the ongoing controversy about utility regulation. Whatever the regulators do they provoke a fuss. If they go too easy on the companies - as they undoubtedly have done since privatisation - the public and politicians scream about excess profits. If they are too tough, they jeopardise the future safety of critical industries. Either way they and the regulatory system they operate have become the targets of fierce criticism.

It seems strange then that Ms Spottiswoode should decide to reject what promised to be the grand solution to her problems. Lost amid the controversy last week came the news that Ofgas had investigated an alternative regulatory approach for TransCo, based on sharing profits rather than capping prices.

British Gas was keen, the Labour Party was interested, the experts lined up in support - but Claire said no. Could she have made a foolish mistake? Certainly the existing price-capping framework isn't working too well. Under the RPI minus-X system, the regulated companies are allowed to raise their prices by the rate of inflation (RPI), minus some amount (X) determined by the regulator to reflect projected cost savings. Any extra savings the company makes in the meantime, it can keep - or pass on to shareholders. Supposedly this provides management with incentives to look for new improvements, and the consumer then benefits when prices are revised again in the next review.

It all sounds sensible enough. The trouble is it has been a disaster in practice. At the heart of the matter is what economists call the "asymmetric information problem".

Companies know far more than the regulator about the future costs they will face, and the real prospects for savings. But they can cheerfully offer pessimistic forecasts during the review and keep those savings for profits instead of price cuts.

Excess profits - especially on the scale that our recently privatised utilities have reported over the last seven years - will always provoke a political and public outcry and send the regulator scuttling back to review earlier mistakes. But the more frequently the regulator returns, the less the incentives to managers.

Dieter Helm, director of Oxford Economic Research Associates, points out: "The politics of energy are such that the public will never allow abnormal profits to pile up over five years."

The result is that the regulator has to keep returning to the companies, clawing back their profits and incentives. If there are to be any incentives for companies at all, Mr Helm argues, the public need a direct interest in the accumulation of abnormal profits; they need a share.

Of course the regulators can make mistakes in both directions. A suspicious regulator assumes that the companies are always lying, and can always make much tougher cuts than they claim. When the price cap set is, in fact, too severe, the sobs of pain from the companies will be dismissed as crying wolf, but several years down the line we may discover that our utilities are in trouble.

The regulators can only give utilities the space they need to properly invest in the future if they feel they have a way to deal with excess profits, and ensure companies are not pulling a fast one.

Enter profit-sharing. Under this form of regulation, extra profits (or losses) are shared between consumers and shareholders, rather than kept entirely for the management and shareholders to enjoy (or endure). Papers were written, conferences held, research commissioned. The Labour Party flirted with the idea, and Ms Spottiswoode signalled her interest, commissioning detailed work from outside consultancies on the logistics of profit-sharing for TransCo.

One variation - the Helm version - is to set a price cap, then split the unexpected profits 50-50 between customer and shareholder. The version considered by Ofgas, was "sliding scale regulation". Instead of setting just one price cap, the regulator provides the company with several alternatives.

If prices are low, shareholders can keep most of the extra profits (because low prices mean customers have already had their cut). On the other hand, if prices are high, then the customer gets a bigger rebate from profits. Hence the sliding scale.

Either way the regulator has a safety net against unduly gloomy forecasts by the company, whilst unexpected and damaging changes in costs which surprise the regulator can easily be accommodated.

Yet for all these arguments, Ofgas ditched the idea. One concern for it clearly was the fear that profit-sharing, by reducing the cash that firms can keep, would reduce their incentives to make improvements, too. But this is a weak objection. So long as political pressure forces them to push prices down and cut profits back, there will be no incentives under price-capping, anyway. And, as a report that was recently commissioned by Ofgas points out, shareholders will quickly revise the incentive structure for managers if they fear they are not maximising profits under the new arrangements.

Ofgas had other more technical concerns, however. It feels any form of profit-sharing still embroils it in all the same kinds of measurement and asymmetric information problems as before - as a result, the credibility of the regulatory regime is not increased.

Supporting that position in a recent issue of Fiscal Studies, John Vickers and Colin Meyer argue that: "Profit measures of performance are particularly subjective and prone to manipulation in utilities, because of difficulties in determining asset values."

A spokesman for Ofgas said: "There are other ways of tackling the problem that profit-sharing purports to solve, and we believe they will be more appropriate." What Ofgas calls "error correction mechanisms" aim to allow the prices to respond to changes in the utilities' costs that the regulator had not anticipated - either because the company proved to be wrong or because external circumstances changed.

It may be right. And it has probably around two years to prove it, if a Labour government is elected. If on the other hand the regulators cannot devise a framework that provides incentives, protects the industries' future and keeps the customers happy, they should brace themselves for change.

Mr Stakeholding himself, John Kay of London School of Economics, wrote in a recent edition of Prospect magazine: "The attempt to establish a "regulatory contract" under which firms maximise profit subject to an external constraint, is an unavoidable source of dissatisfaction. We must move away from the plc structure, while retaining the advantages of managerial autonomy and commercial discipline in a framework focused on customers, not the capital market."

Profit-sharing is one possibility for the future of the utilities, but the regulators should beware or public dissatisfaction will fuel the case for more radical change.