Regulation of the United Kingdom's 12 regional electricity distribution companies (RECs) has sought to promote efficiency through the use of price caps that are supposed to remain in place for five years without regulatory intervention. The benefits of cost reductions between reviews accrue to shareholders no matter how much earnings might rise. The idea was to provide more incentive than if earnings were subject to review whenever they exceed some specified level.
Productivity has increased enormously under this system. However, the regulator has decided to revise the price caps that just took effect on April 1. The progress that the United Kingdom has made in insulating electricity prices from unpredictable regulatory intervention will be undermined unless it comes to terms with the subtle link between price-cap and rate-of-return regulation.
The U.K.'s price-cap regime was designed by Stephen Littlechild, director general of the Office of Electricity Regulation, the U.K. electricity regulatory agency. The price caps are reviewed at five-year intervals; each review sets the price for the initial year and provides a formula for price adjustments over the next four years. Basically, the formula allows the RECs to raise their rates for distribution services by the percentage change in the retail price index (RPI) less "X" percentage points. This is referred to as "RPI less X." If the RECs improve their productivity by more than the "X" factor, their profit margins and earnings will improve, and they will keep the benefits until the next price review.
The initial price review, which set prices for the five-year period ending March 31, 1995, was very successful. Productivity gains were extraordinary; earnings excellent. Some RECs have cut their headcount by as much as 25 percent, and rates of return on equity (ROE) have typically been in the area of 20 percent.
The Next Five Years
Given the high rates of return the RECs have been earning, industry observers expected Littlechild to cut prices sharply in setting price caps for the 1995-2000 period. Indeed, his preliminary proposal was tough enough to draw strong protests from some RECs. Unfortunately, Littlechild was at a disadvantage in evaluating whether the RECs' protests were valid, since the U.K. regulator does not have access to as much detailed company data as U.S. regulators. For this reason, or simply out of a disinclination to stand up to the RECs, Littlechild's final proposal was surprisingly lenient. Under the new price caps, the RECs stand to achieve ROEs that approach 20 percent for the next five years. The RECs gleefully embraced the proposal.
Nevertheless, the new price caps failed in two crucial respects. They did not cut the prospective ROE for the RECs to levels comparable to those earned elsewhere in the U.K. economy. Nor did they assign ratepayers as much of the productivity gains of the last five years as the public expected. These shortcomings have undermined public support for the privatization effort, reinforcing a perception that too much benefit accrues to shareholders and not enough to the public.
In addition, since Littlechild had clearly erred in favor of the RECs, he would likely 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 effect on the industry. If the RECs also realize that there are limits to the returns they can expect to capture, there may even be some net benefit. t
Charles M. Studness is a contributing editor of PUBLIC UTILITIES FORTNIGHTLY. Dr. Studness has a PhD in economics from Columbia University, and specializes in economics and financial research on electric utilities.
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