One simple line in the recent Energy Policy Act sets the stage for broader geographical ownership by current utilities and easier ownership from outside industries. Readers know very well that one...
attempt to redress the imbalance. Regulatory decisions were, thus, likely to favor the public, which made the RECs reluctant to address issues involving benefits. For instance, although mergers between certain RECs could improve industry efficiency, the RECs found little incentive to merge since most of the benefit would fall to the public rather than shareholders. At the same time, the public demanded compensation from the RECs for floating their stock in the National Grid Co. and jeopardizing the entire undertaking.
The new price caps also made the RECs attractive takeover targets for predators from outside the industry. With excellent earnings and moderate capital spending requirements, the RECs would have strong free cash flows. Yet their use of these funds would also be limited by public criticism of their wealth, which already constrains dividend increases. On the other hand, a nonutility with large cash needs would be subject only to minimal public scrutiny. The RECs had been set up, and the Trafalgar House bid to buy Northern Electricity drove the point home. For the regulator, a series of takeovers carried the risk of making the industry more difficult to regulate by reducing the already scant available data.
Littlechild thus faced a dilemma. If he allowed the new price caps to remain in effect for the next five years, the credibility of the price-cap regime might suffer, and takeovers might make the industry increasingly difficult to regulate. If he revised the price-cap formula, the RECs incentive to innovate might be undermined.
The ROE Constraint
In the end, Littlechild decided to review the new price-cap formula. The effect of that decision will probably depend more on how it is viewed than on the revision itself. Littlechild can, of course, argue that the revision should be considered part of the recent review process, since the new price caps had not yet taken effect. But ultimately Littlechild must convince the RECs that a revision is in everyone's best interest. To do this he will need to offer a new perspective on the U.K. regulatory process.
The British often point out that they have chosen to cap prices instead of returns. Still, all regulation is partly rate of return regulation, since there are always limits to how much a regulated company can make for itself without becoming counterproductive. A price-cap formula must produce a competitive rate of return on average. If returns are too far above the competitive level, political opposition will emerge. If the returns are too low, quality of service will suffer.
The difference between price-cap and rate-of-return regulation is one of emphasis. Both cap prices and returns, but permit revision as needed to keep the return near a desired level. Price-cap regulation holds prices fixed for extended periods and allows the return to fluctuate, but eventually resets the price cap to produce a desired return.
Price-cap regulation cannot be successful unless it produces returns comparable to those earned elsewhere. The price caps for 1995-2000 will not work without revision. If the RECs come to appreciate this, the coming revisions need not have a lasting adverse