Global Regulation: Exporting 'America' to the World

Deck: 

Why U.S. public utility commission-style ratemaking has becomes a hit overseas.

Fortnightly Magazine - February 2007

It appears that American-style public utility regulation has become a major “intellectual property” export to many of the world regions including most of Europe, Asia, Latin America, the Caribbean, and Far East. As these countries have turned to private investment to fund new infrastructure, or acquire existing electricity and natural-gas utility infrastructure, the need for a mechanism to regulate private investment was paramount. Outside of the European Union (EU), U.S.-style regulation was introduced as an attraction to private investment. Within the EU the establishment of independent regulatory agencies has been, in some cases, solely to meet EU requirements of mandatory liberalization, i.e., introduction of competition in electricity supply.

Where there has been privatization or liberalization, investors have moved to take advantage of these new investment opportunities. The existence of reasonable regulation is a principal pre-condition for this investment. Thus, both domestic and international electric and natural-gas infrastructure companies need to include a “regulatory strategy” as a required component of their corporate strategy.

As in the case of the United States, where regulatory agencies in the individual states similar in structure can produce different outcomes for investors, so it is true for newly created national regulatory agencies based on the U.S. model. What are some approaches to regulation adopted in recent decades by national governments and the implications for management making international investment decisions?

Globally, two related models of regulation most frequently have been adopted: the 100-year-old “commission” system of the United States and the recent “RPI-X” regulatory model adopted in the UK. Admittedly, both systems share much in common and have been referred to as the “Anglo-American Independent Regulatory Model.” While both have their basis in English common law, the practical administration of each differs markedly.

The “Public Service Concession Model”—used in the French water and sanitation industry and by some cities in the United States for water and sewer—also is available. However, the U.S. and UK model still dominate as models for newly established regulatory agencies

The U.S. Model: A Boon for Investment

Most countries have opted for the U.S. model for mostly political reasons. Additionally, the U.S. Agency for International Development and the World Bank engaged consultants and sponsored seminars during the 1990s in Central and Eastern Europe, Latin America, and Asia advocating U.S.-style regulation. The major attractions of the U.S. system have been the establishment of a multi-member decision body (usually called a commission) and a cost-of-service approach with reliance on administrative-law procedures, rather than on a single regulator and a pricing formula.

The U.S. regulatory model presupposes the notion of public utilities, where private companies are provided monopoly rights in return for which the government sets rates and conditions of services. It is envisioned that private corporations will invest in and operate utility infrastructure in a unique legal relationship with that country’s “independent” regulatory agency or agencies. Investment advisory firms long ago established that a key determinant in the success of a public utility company is its regulatory environment. The United States also has divided regulatory responsibility between the Federal Energy Regulatory Commission, for wholesale rates and transmission service tariffs, and state regulators (public service commissions) for retail-rate regulation. A few larger countries have a similar split between federal and local regulators, most notably Germany and Russia.

Thus, U.S. utility investors looking overseas or international investors looking into the United States usually face a “U.S.-style” regulatory environment. This is significant, as most surveys of utility executives, including those performed a few years ago by Deloitte & Touche LLP, indicate that “regulation” is the number one consideration, risk, or variable facing management.

The British: An Eye on Incentive Ratemaking

The UK established an important precedent with the simultaneous privatization and restructuring of its electric utility industry in 1990 under the government led by Prime Minister Margaret Thatcher. The privatization decision required the establishment of a regulatory mechanism and the Thatcher government commissioned a white paper by University of Birmingham Professor Stephen Littlechild. In his landmark document, Littlechild recommends a regulatory scheme based on U.S. experience in regulating investor-owned public utilities with some modifications and streamlining.

The UK model adopted a small regulatory agency that used an “incentive” formula method for adjustments to rates between rate-case periods. The UK industry restructuring also included the provision of access to competition for all classes of customers and ownership separation of generation from transmission and distribution of electricity.

The UK law for England and Wales restructured the electric industry into six regional distribution systems, a single national transmission company, and multiple generation companies. It also established a national power market. All would be under a regulatory scheme supervised by a newly formed Office of Electric Regulation (OFER) under the Mergers and Monopolies Commission (MMC). Littlechild was appointed the first director general of OFER. Later, the OFER would be combined with the gas regulator to form the Offer of Gas and Electricity Markets (OFGEM) and the MMC would become the Office of Fair Trading or Competition Commission. The OFGEM is now envisioned as a multi-member regulatory commission and is now headed by Sir James Mogg, a career civil servant.

Littlechild’s paper called for the establishment of a regulatory mechanism that would adopt the cost-of-service model of the United States with the further refinement that OFER (now OFGEM) set prices of the monopoly service under an explicit “incentive-ratemaking” procedure every five years using the formula of RPI-X based on an annual inflation indicator and a productivity offset.

The wholesale power market has undergone a number of revisions as the first market was replaced in 2000 with the New Electricity Trading Arrangement (NETA) and further refined in 2004 with the passage of the British Electricity Trading and Transmission Arrangements (BETTA) implemented in April 2005. As a member of the EU, the UK’s restructuring and liberalization preceded and fulfilled the EU’s Electricity Directives requirements.

The European Union: Still Struggling

The member states created the EU with the goal of obtaining benefits to their national economies by establishing a single competitive internal market. The electricity and natural-gas sectors have been among the last sectors to which the EU has applied requirements for open-market competition, i.e., liberalization. The EU adopted an “Electricity Directive” 96/92 EC of 19 January 1996 abolishing the monopoly rights of electricity suppliers, whether nationally or privately owned, over electricity and natural-gas supply. In other words, it introduced liberalization. The directive, however, did not require the privatization of state-owned assets.

To ensure that customers had access to competitive markets, the EU Electricity Directive established requirements for open access on all transmission and distribution networks. The EU, in 2003, added the requirement that each state have a designated authority to ensure “regulated” access to the grid and competitive supply, and to establish rates and tariffs for delivery services. This 2003 provision of the EU directive has led to the recent establishment of regulatory agencies in all the 25 EU member states (not including the newly added Romania and Bulgaria). As in the case of the United States, each country’s national regulator, while similar in some aspects to U.S. regulation, has its own unique characteristics reflecting national priorities, legal procedures and preferences.

While there is no EU-wide regulator, the issue of whether the EU needs a single regulatory agency is being debated heatedly. The EU has established a statutory advisory group of regulators from member states—the European Regulators Group for Electricity and Gas (ERGEG)—whose current chairman is UK regulator Mogg.

Absent an EU-wide regulator, the issue of successful implementation of the electricity and gas directives currently is before both the EU’s energy commissioner and competition commissioner. The Financial Times, on Jan. 5, 2007, released advanced notice of a report to be issued by the EU’s Competition Commissioner Neelie Kroes that finds “evidence of collusion and other severe market failures” in the EU’s power markets.

When the report was released Jan. 10, 2007, the BBC reported that “the commissioner said she wanted to ‘unbundle’ large companies such as Germany’s E.On, and Electricite de France, so that the businesses that generated power and supplied gas were not the same ones that controlled the network of pipelines.

France’s Regulator: No Teeth

The EU’s electricity directive opening up electricity supply to competition was implemented in France with the passage of the Electricity Law of Feb. 10, 2000. France has had a single national electricity system of generation, transmission, and distribution (Electricite de France) owned by the government since 1946. The introduction of competition has resulted in more than 50 suppliers becoming active in France and has led to the establishment of a French power exchange, “Powernext,” according to the 2005 report of the regulator.

The Electricity Law of 2000 also established an independent national energy regulation agency, the Commission de Regulation de l’Energie (CRE). The commission has six members appointed to fixed terms of seven years. In this regard, the CRE follows U.S. practice. Unlike U.S. regulators, the CRE has limited supervisory and advisory powers and is principally charged with ensuring access to the grid by independent power producers. It does have authority for the setting of transmission and distribution tariffs. The CRE does not have authority over the approval of mergers in this sector. As in many other countries, the newly formed regulator shares authority, normally found in a U.S. regulator, with pre-existing government ministries. This probably is the single most significant difference to be found among all the newly created regulatory structures.

Spain: A Separation of Powers

The Spanish parliament implemented the EU’s electricity directive with the passage of its Electricity Sector Law 54/1997. An independent regulatory agency, the Comision Nacional de Energia (CNE), was established in 1998 to deal with issues of third-party access to transmission and distribution as required by the EU. Members of the CNE are appointed by the Ministry of Industry after discussion with parliament. The large size of nine members reflects concerns that all major political parties have some say in decisions in this important sector.

As in the case of other countries with recently established “independent” regulatory agencies, the CNE shares authority with the Ministry of Industry, which has primary authority over the electricity sector in Spain. Decisions of the CNE can be challenged at the Ministry of Economy, another governmental ministry, with the ministry’s decisions able to be challenged at a Spanish Tribunal. The CNE has merger authority when mergers affect the “regulated” sectors under CNE control. Thus, in a recent decision, the CNE blocked a proposed takeover by Gas Natural of Ibedrola. The Spanish electricity market has four major historic players and a number of new entrants. In 2006 the Spanish government produced a White Book advocating a higher degree of competition. This report currently is under discussion and debate.

Germany: Regulators and Government Mix

Up until 2005, Germany was alone in the EU in relying on negotiated third-party access and not having a designated regulated third-party access system. On July 13, 2005, Germany’s Energy Industry Act, in German called Energiewirtschaftgesetz (EnWG), came into force. It created an electricity regulatory authority, and placed it within the Federal Network Agency, which previously had regulated telephone and postal services (BNetzA). In this regard, its jurisdiction would be similar to the typical U.S. state public utility commission, which also included telephone regulation.

This federal agency has a president and two vice presidents and has established ruling chambers for its various responsibilities. The ruling chambers are unique to Germany and are responsible for the regulatory decisions of the BNetzA (the regulator) regarding electricity, gas, telecommunications, and postal services. Companies or industries (as in federations of enterprises, etc.) that are affected immediately by the decisions of a regulatory chamber can be involved in the chamber, but have no voting rights. The Ministry of Economics is responsible for setting up the ruling chambers, but has no right to overrule their decisions. Should a company object to a chamber’s decision, it can challenge the decision in front of a civil court.

There also are multiple governmental ministries continuing to have authority over regulatory matters even though an independent regulator has been established. Much policy direction still will need to come from the various Ministries that retained residual authority after passage of the WnWG law. Similar to the United States, the German political structure includes federal states (Lander) that have their own regulatory agencies with authority over retail electricity, while the national government deals with transmission and wholesale market issues. The German Federal Cartel Office retains jurisdiction over competition issues.

In summary, the need for the establishment of new independent regulatory agencies has been created by the decisions of governments either to introduce competition in electricity supply or to privatize electric industry infrastructure. Few regulatory models have existed outside of that of the United States, which has the longest tradition of regulation of private investment in the provision of monopoly electric services. With origins in the late 18th century, the U.S. regulatory model called for regulatory agencies with appointed (or, in a few cases, elected) commissioners who were independent of the legislatures that created them and whose opinions were subject to only to judicial review. While many countries were able to establish such independent agencies, few have been able or willing to strip existing governmental ministries, tied to parliamentary majorities, of all their pre-existing regulatory authority over various aspects of the electricity supply chain. Thus, international investors in these jurisdictions face the same state-by-state (country-by-country) due diligence they should apply when looking at an investment opportunity in the electricity sector in the United States. While regulatory structures and even regulatory schemes can appear similar on the surface, the details do matter, as each specific regulatory agency and scheme follows it own unique regulatory strategy and approach.