5.1 New Regulatory Processes
In section 3.2 I suggested that economic regulation needed to focus on
processes rather than outcomes. This was because old measures of the outcome
of regulation now have little meaning and that what matters is the way that investment requirements are decided and incentivized. A key way to do this is shift responsibility for deciding on network investment requirements on to the buyers and sellers of network services. The central idea is that decisions on investments in capacity and quality should be negotiated between the parties in the industry. The regulator would still be formally responsible for approving any network investment plans within the context of regulatory price control review – assuming that these had not been deemed to be excluded from monopoly regulation. The
regulator would move from being the key decision maker to being the auditor of decisions agreed between the buyers and sellers. The regulator might continue to provide independent assessment of the scope for efficiency improvement or the
social value of particular investments. This is a variant of a ‘negotiated settlements’
approach practiced in North America (Doucet and Littlechild, 2006) or of
the ‘constructive engagement’ approach introduced by the Civil Aviation Authority
for the regulation of airports in the UK (CAA, 2005).
Negotiated settlements have several theoretical (and practical) advantages.
First, they shift much of the risk for getting decisions wrong on to the companies
or consumer representatives involved in the negotiations. This is especially
true when buyers of network services have to say how much quantity and quality
they are prepared to pay for. Clearly getting this wrong may impact negatively or
positively on their profitability of the companies, yet it is also true they should be
in the best position to predict future demand requirements. Second, they will tend
to better allocate risk between the consumers and the regulated companies relative
to a regulator imposed solution. This is because if the regulator has to predict what
the investment requirements are, they will tend to be conservative and be likely to
leave the consumer with costs of overinvestment or underinvestment, socialized
within network tariffs. Third, negotiated settlements will produce innovations in
regulatory processes as the transaction costs of regulation are determined by the
parties to the negotiation. Companies will seek to reduce these costs by suggesting
how negotiated outcomes might be arrived at, at less cost. Fourth, negotiated
settlements will be better at making more informed trade-offs between quality and
cost as these will be jointly negotiated by the companies rather than, as they usually
are, treated separately by the regulator. Finally, negotiated settlements are likely
to produce more innovative regulatory outcomes as private companies are good at
drawing up contracts between them which efficiently allocate risk and reward.
Evidence on the operation of such approaches is growing. Stephen Littlechild
has published a series of papers looking at their operation in North and
South America (much of which he summarizes in his paper in this issue). His examples
are interesting because the arrangements examined have been introduced
in parallel with market liberalization.
It seems clear that for transmission investments (and gas distribution) it
is reasonably easy to envisage ways in which such an approach would work. Ownership
unbundling (in England and Wales at least)24 of electricity and gas networks
ensures that the seller – National Grid – faces an array of significant corporate
buyers – the generators and gas suppliers.
Doucet and Littlechild (2006) show how negotiated settlements were
introduced to determine the price of oil and gas pipeline services in Canada. An
important advance was the setting of a regulatory weighted average cost of capital
(WACC) each year, which could be used in the negotiations, thus eliminating a
potential source of disagreement between the buyers and sellers. Littlechild and
Skerk (2008) detail the important Argentine experience with voting rules for deciding
whether new electricity transmission investments were to be undertaken.
The UK would seem well suited to moving towards a negotiated settlements approach
in electricity and gas transmission given the existing ownership structure.
A key question is the extent to which negotiations could be used to determine
electricity distribution investments. Here integration between the distribu-
tion network owners and generators and suppliers is potentially a problem. There
might also be issues to do with coordination across negotiations as the same parties
negotiate the investment plan for each network area. However the prospects
for progress seem encouraging. Littlechild and Ponzano (2008) discuss the development
of a ‘sub-transmission’ plan (high voltage distribution – mainly 132 KV,
but also some 66 KV)25 in Buenos Aires Province (the area around Buenos Aires)
involving negotiations between 200+ buyers and the local sub-transmission company.
They find that negotiations did result in the agreement of a ten-year plan for
a range of sizes of investment. The process did not involve large transaction costs
(as many of the smaller players let larger parties with aligned interests negotiate
on their behalf).
Negotiated settlements would seem to have good prospects when conducted
between companies. They might however usefully be attempted on behalf
of individual consumers where suitable consumer representatives exist (which is
not the case in most European countries with no tradition of elected consumer
representatives). In North America however experience is somewhat different.
Littlechild (2007) reports on the role of the consumer advocate in Florida who
with a small annual budget successfully negotiated significant packages of price
reductions for utility customers using his public profile and the threat of referral
to the Public Utilities Commission for price review in the absence of agreement.
This consumer advocate could have an important role in European countries, such
as the UK, in the area of proposing social tariffs, offered by energy retailers to
poor consumers.26 A powerful and informed consumer voice is likely to be more
important as electricity and gas prices rise. It might also be the case that Consumer
Protection Authorities could take more of an interest in poor energy customers
especially with respect to potential mis-selling and unfair contract terms.
Closer to home, Ofgem has recently had very positive experience with
setting gas distribution prices (where gas networks are unbundled), with active
contributions from the largest gas supplier who provided constructive input into
the regulation with the aim of keeping the gas distribution charges to its customers
down.
It is worth discussing some of what has happened during the constructive
engagement process used by the regulator, the CAA, at Heathrow and Gatwick
airports (see Bush, 2007 and CAA, 2008a, b). This has recently ended. However
there has been substantial agreement between the airlines and the airport owners.27
In particular there has been agreement about the incentive scheme to be placed
on the airport owner, BAA, for the delivery of new investment and the automatic
traffic growth triggers for new investment. There has also been agreement on levels
of service to be provided by the airports and the penalties and risk sharing for
non-delivery. The CAA reports that the process has been slow to get going and
that airlines have been critical of it – perhaps because it was a new form of regulation.
However it has built substantially on the existing Airport Consultative Committees,
which existed at each airport prior to the current price control review.
This suggests that negotiated settlements can work in the UK and can build on
existing informal processes of consultation between buyers and sellers of network
services. The application of negotiated settlements for UK airports remains controversial
with the CAA the subject of an independent review of airport regulation.
The CAA’s recommendation to deregulate Stansted, following the failure of
constructive engagement there, was rejected by the government.
Indeed one could go further and suggest that the fact that the process
has been useful in an industry with an incumbent monopolist with a very poor
reputation and a group of very diverse (in terms of size and quality preferences)
purchasers in the airlines suggests much more scope for the success of constructive
engagement in electricity and gas.28 This is because relations between the
different companies in electricity and gas are usually much less adversarial than
in the UK airline industry. The evidence, in the papers mentioned above, from Argentina,
Canada and the US in electricity and gas suggests that parties can reach
agreement without acrimony, albeit in the presence of appropriate cost allocation
rules and substantial common interests between the buyers of network services
(something that was not the case in UK airlines).
Looking to the prospects for negotiated settlements in other EU countries,
it is clear that the separation of the ownership and operation of energy networks
greatly facilitates negotiated settlements approaches. This would provide
an even greater imperative for the Third Energy Package in the EU which emphasizes
the ownership unbundling of electricity and gas transmission networks (see
Pollitt, 2008b).
In section 3.2 I suggested that economic regulation needed to focus on
processes rather than outcomes. This was because old measures of the outcome
of regulation now have little meaning and that what matters is the way that investment requirements are decided and incentivized. A key way to do this is shift responsibility for deciding on network investment requirements on to the buyers and sellers of network services. The central idea is that decisions on investments in capacity and quality should be negotiated between the parties in the industry. The regulator would still be formally responsible for approving any network investment plans within the context of regulatory price control review – assuming that these had not been deemed to be excluded from monopoly regulation. Theregulator would move from being the key decision maker to being the auditor of decisions agreed between the buyers and sellers. The regulator might continue to provide independent assessment of the scope for efficiency improvement or the
social value of particular investments. This is a variant of a ‘negotiated settlements’
approach practiced in North America (Doucet and Littlechild, 2006) or of
the ‘constructive engagement’ approach introduced by the Civil Aviation Authority
for the regulation of airports in the UK (CAA, 2005).
Negotiated settlements have several theoretical (and practical) advantages.
First, they shift much of the risk for getting decisions wrong on to the companies
or consumer representatives involved in the negotiations. This is especially
true when buyers of network services have to say how much quantity and quality
they are prepared to pay for. Clearly getting this wrong may impact negatively or
positively on their profitability of the companies, yet it is also true they should be
in the best position to predict future demand requirements. Second, they will tend
to better allocate risk between the consumers and the regulated companies relative
to a regulator imposed solution. This is because if the regulator has to predict what
the investment requirements are, they will tend to be conservative and be likely to
leave the consumer with costs of overinvestment or underinvestment, socialized
within network tariffs. Third, negotiated settlements will produce innovations in
regulatory processes as the transaction costs of regulation are determined by the
parties to the negotiation. Companies will seek to reduce these costs by suggesting
how negotiated outcomes might be arrived at, at less cost. Fourth, negotiated
settlements will be better at making more informed trade-offs between quality and
cost as these will be jointly negotiated by the companies rather than, as they usually
are, treated separately by the regulator. Finally, negotiated settlements are likely
to produce more innovative regulatory outcomes as private companies are good at
drawing up contracts between them which efficiently allocate risk and reward.
Evidence on the operation of such approaches is growing. Stephen Littlechild
has published a series of papers looking at their operation in North and
South America (much of which he summarizes in his paper in this issue). His examples
are interesting because the arrangements examined have been introduced
in parallel with market liberalization.
It seems clear that for transmission investments (and gas distribution) it
is reasonably easy to envisage ways in which such an approach would work. Ownership
unbundling (in England and Wales at least)24 of electricity and gas networks
ensures that the seller – National Grid – faces an array of significant corporate
buyers – the generators and gas suppliers.
Doucet and Littlechild (2006) show how negotiated settlements were
introduced to determine the price of oil and gas pipeline services in Canada. An
important advance was the setting of a regulatory weighted average cost of capital
(WACC) each year, which could be used in the negotiations, thus eliminating a
potential source of disagreement between the buyers and sellers. Littlechild and
Skerk (2008) detail the important Argentine experience with voting rules for deciding
whether new electricity transmission investments were to be undertaken.
The UK would seem well suited to moving towards a negotiated settlements approach
in electricity and gas transmission given the existing ownership structure.
A key question is the extent to which negotiations could be used to determine
electricity distribution investments. Here integration between the distribu-
tion network owners and generators and suppliers is potentially a problem. There
might also be issues to do with coordination across negotiations as the same parties
negotiate the investment plan for each network area. However the prospects
for progress seem encouraging. Littlechild and Ponzano (2008) discuss the development
of a ‘sub-transmission’ plan (high voltage distribution – mainly 132 KV,
but also some 66 KV)25 in Buenos Aires Province (the area around Buenos Aires)
involving negotiations between 200+ buyers and the local sub-transmission company.
They find that negotiations did result in the agreement of a ten-year plan for
a range of sizes of investment. The process did not involve large transaction costs
(as many of the smaller players let larger parties with aligned interests negotiate
on their behalf).
Negotiated settlements would seem to have good prospects when conducted
between companies. They might however usefully be attempted on behalf
of individual consumers where suitable consumer representatives exist (which is
not the case in most European countries with no tradition of elected consumer
representatives). In North America however experience is somewhat different.
Littlechild (2007) reports on the role of the consumer advocate in Florida who
with a small annual budget successfully negotiated significant packages of price
reductions for utility customers using his public profile and the threat of referral
to the Public Utilities Commission for price review in the absence of agreement.
This consumer advocate could have an important role in European countries, such
as the UK, in the area of proposing social tariffs, offered by energy retailers to
poor consumers.26 A powerful and informed consumer voice is likely to be more
important as electricity and gas prices rise. It might also be the case that Consumer
Protection Authorities could take more of an interest in poor energy customers
especially with respect to potential mis-selling and unfair contract terms.
Closer to home, Ofgem has recently had very positive experience with
setting gas distribution prices (where gas networks are unbundled), with active
contributions from the largest gas supplier who provided constructive input into
the regulation with the aim of keeping the gas distribution charges to its customers
down.
It is worth discussing some of what has happened during the constructive
engagement process used by the regulator, the CAA, at Heathrow and Gatwick
airports (see Bush, 2007 and CAA, 2008a, b). This has recently ended. However
there has been substantial agreement between the airlines and the airport owners.27
In particular there has been agreement about the incentive scheme to be placed
on the airport owner, BAA, for the delivery of new investment and the automatic
traffic growth triggers for new investment. There has also been agreement on levels
of service to be provided by the airports and the penalties and risk sharing for
non-delivery. The CAA reports that the process has been slow to get going and
that airlines have been critical of it – perhaps because it was a new form of regulation.
However it has built substantially on the existing Airport Consultative Committees,
which existed at each airport prior to the current price control review.
This suggests that negotiated settlements can work in the UK and can build on
existing informal processes of consultation between buyers and sellers of network
services. The application of negotiated settlements for UK airports remains controversial
with the CAA the subject of an independent review of airport regulation.
The CAA’s recommendation to deregulate Stansted, following the failure of
constructive engagement there, was rejected by the government.
Indeed one could go further and suggest that the fact that the process
has been useful in an industry with an incumbent monopolist with a very poor
reputation and a group of very diverse (in terms of size and quality preferences)
purchasers in the airlines suggests much more scope for the success of constructive
engagement in electricity and gas.28 This is because relations between the
different companies in electricity and gas are usually much less adversarial than
in the UK airline industry. The evidence, in the papers mentioned above, from Argentina,
Canada and the US in electricity and gas suggests that parties can reach
agreement without acrimony, albeit in the presence of appropriate cost allocation
rules and substantial common interests between the buyers of network services
(something that was not the case in UK airlines).
Looking to the prospects for negotiated settlements in other EU countries,
it is clear that the separation of the ownership and operation of energy networks
greatly facilitates negotiated settlements approaches. This would provide
an even greater imperative for the Third Energy Package in the EU which emphasizes
the ownership unbundling of electricity and gas transmission networks (see
Pollitt, 2008b).
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