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New Perspectives on Industrial Policy for a Modern Britain$

David Bailey, Keith Cowling, and Philip Tomlinson

Print publication date: 2015

Print ISBN-13: 9780198706205

Published to Oxford Scholarship Online: August 2015

DOI: 10.1093/acprof:oso/9780198706205.001.0001

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Regulation and Governance of Public Utilities

Regulation and Governance of Public Utilities

(p.310) (p.311) Chapter 16 Regulation and Governance of Public Utilities
New Perspectives on Industrial Policy for a Modern Britain

Michael Waterson

Oxford University Press

Abstract and Keywords

This chapter provides a considered evaluation of the regulatory regimes and ensuing competition within several UK utility industries that have been privatized. One of the salient points emerging from this analysis is for policy-makers to exercise greater care (and attention) in implementing policy which alters industrial structures, since such changes are often very difficult to reverse in the event of policy mistakes. Moreover, policy should also be aware that firms will act strategically in reaction to new regulations and incentives, which in itself can compromise policy objectives. This is a wider lesson for industrial policy per se.

Keywords:   regulation, privatization, industrial policy, public utilities, competition, public interest

16.1 Introduction

One of the underlying political reasons behind the initial drive to privatization in the UK thirty years ago was the attempt to depoliticize such industries. Actually, in examples as diverse as energy and rail transport, this has not happened. If energy prices rise, it is seen by the public to be the government’s role to tackle the issue. The government is also, of course, intimately involved in decisions about HS2, the proposed new high-speed rail link to the West Midlands and North of England. Originally, a mix of competition amongst private firms and regulation was intended to tackle the governance issues of the public utilities. In this context, it is salutary to look back at what was written by one of the principal architects of the structure, Stephen Littlechild, in his analysis of the case. One key theme was ‘Competition where possible, regulation where necessary’, and of regulation being a ‘means of “holding the fort” until competition arrives’ (Littlechild, 1983, para 4.11). Littlechild was right about many things, but the brave warriors in the fort must be getting somewhat weary now.

Actually another main driver, and ultimate source of problems, was the perceived need for private money to fund necessary infrastructure improvements in the various utilities. This inevitably led to conflicts between providing sufficient incentives for firms to take part and tightness of constraints on their operation. There was a third, unspoken, driver: most nationalized industries were heavily unionized and the government of the day wished to reduce union power; it was thought that by privatizing the industries, the role of unions would be reduced.

(p.312) Examining the scoresheet, it is clear that there are examples where no sensible commentator would want to go back to the framework prior to privatization and regulation or anything resembling it. It is now difficult to remember the control exercised by BT over such simple things as the telephone instrument in our home, the long wait for a phone line, and so on. Competition in the mobile phone industry, without the national operator BT as a competitor unlike in many other Western European countries, has given us a modern, well-operated system providing people with considerable utility, at least on a revealed preference basis. It would also be difficult to imagine going to the British Gas showroom as the only place to buy our cooker. These examples exhibit a failing of the public utility, disguising self-interest through safety considerations. But they also reveal a deeper truth, still valid today. Whereas we could not trust our nationalized industries fully to serve the public interest, no more can we now trust our privatized industries with this.

On the other side of the scoresheet, there are real difficulties in financing certain long-term activities through private money without substantial public involvement. There seems no way for one government to bind the next and its successors in such a way that gives sufficient confidence for investors in major capital projects to put their own money at risk for extended periods within the existing system. Britain is moving into a potential real shortage of power plants. Initially, private firms were happy to build gas-fired power stations—a turnkey construction job, plus a long-term contract for gas and a long-term contract for power output, de-risks such a project, and long term in this case might mean only ten years. They are nowhere near as happy to finance a new nuclear power plant, they know they are in a strong position in making an agreement to go ahead, and the government knows they know this. So, the only agreement that de-risks this project sufficiently appears to drive a hole right through the current wholesale power market, with guaranteed prices (massively above current prices) for forty years into the future.

There is a further force of general significance. Over the period since the first privatizations, Britain has experienced substantial increases in inequality across consumers (Cribb, 2013). At the same time, implicit subsidies that were commonly built into many of the operations of public utilities have been stripped away, meaning that the distribution of entitlements to rather basic services by the poor has been severely impacted. As a result, growth in fuel poverty, for example, has been marked.

In this chapter, I will to some extent discuss each of the major industries, pointing out particular features of their development as privatized concerns worthy of note—each has its peculiarities. In doing this, I focus almost exclusively on Great Britain.1 However, since a large proportion of the innovations were first tried in Britain, this focus is not as parochial as it might seem. In this, I shall not cover postal services; in my view it is too early to be reflective on the area. I discuss telecoms under the general context of RPI-X, then develop themes for each of the other cases, concluding with a few brief, more general thoughts.

(p.313) 16.2 RPI-X regulation

It is thirty years since the UK moved into the arena of economic regulation, through the privatization of British Telecom (BT) in 1984. At the time, the idea of privatization was extremely controversial, and the regulatory approach was viewed as very novel, whereas now both are seen as quite routine. But now is a suitable time for an assessment, albeit a personal one. How has it been, for us? Luckily, few mistakes were made in this first foray into privatization. This was a mixture of caution and design. Caution was exercised by engineering an initial partial sell-off of BT, rather than the whole business. In designing the framework for regulation, Littlechild (1983) produced an excellent blueprint.

It is worth dwelling on the nature of the task on which Littlechild was engaged. He was asked, in short order, to write a report on an appropriate form of control over BT. He was given a set of potential objectives and a pair of models to consider. In the event, he changed both the ranking and the scope of the objectives, as well as (at literally the last moment) adopting a basic framework substantially different from either of those he was supposed to compare.2 Despite the assumptions made being demonstrated significantly at error, the underlying model has proven resilient enough to be adopted in some form or another in all subsequent UK privatizations of industries with a natural monopoly character as well as being widely adopted in other jurisdictions.

The mechanism Littlechild proposed, RPI-X, as a formula for regulating a basket of prices of products coming from the regulated firm has been significantly complicated in subsequent cases, yet retains its basic appeal. For him, this was the measure that scored better overall than others, including no explicit controls (the one he initially favoured), on the five criteria: protection against monopoly (which included BT abuse of its dominant position), encouraging efficiency and innovation, minimizing the burden of regulation, the promotion of competition, and (a poor last, in his opinion) maximizing the proceeds to the Treasury.

He proposed this as a short-term solution, regulation ‘holding the fort’ because, in the light of the times, he saw facilities competition in telecoms as an imminent possibility. In practice, this has not materialized, or at least not in the way envisaged. But then, of course, he was writing before the advent of the Internet. The only practical way in which most consumers can get stable and extensive access to the Internet is through a fixed-line telephone connection that otherwise lies for the most part unused. In order to do this, they need to pay a line rental and for all but the small minority of consumers who are supplied by cable, this in turn means using BT’s Openreach division’s services. Without access to the Internet, tablets such as the iPad would, frankly, be boring; TV would be limited for most people to programmes broadcast terrestrially; and nifty new devices such as can control central heating remotely would not function. Absent the Internet, mobile phones plus services such as Skype would provide the functionality of fixed lines in competition with BT. So, Littlechild was overly optimistic about facilities (p.314) competition developing, even in telecoms, let alone in, say, water, where he clearly viewed it as being more problematic (Beesley and Littlechild, 1989).

This question of what would happen at the end of a (five-year) period in a regulatory regime was always going to be a vexed one. It was optimistic to expect facilities competition to develop rapidly, and yet it was clear that an unchanged price cap could not be a long-term solution because of the tendency to lead either to politically unacceptable levels of profit or, at the other extreme, to difficulties in operation and potential need for bailouts. So, in periodic revision of the formula, an obvious approach is to tighten it if earnings appear excessive, to loosen it if earnings are too low to fund necessary investments. But this means in turn that decisions about revision to the formula turn on the rate of return being earned on capital, compared with a benchmark rate calculated for that industry, and on the cost trends in the industry. This is a far cry from the initial anticipation that ‘[The regulator] does not have to make any judgements or calculations with respect to capital, allocation of costs, rates of return, future movements of costs and demand, desirable performance, etc’ (1983, para. 13.20). In fact, at the time of a five-yearly review, regulators do find the need to make judgements about all these issues, in telecoms just as in other industries.

Littlechild also reckoned without the lawyers. The early regulators (including Littlechild himself) had a much-admired independence of spirit, able to take tough decisions that were firmly opposed to their regulated company charges in many cases. They did not feel the need to explain, in detail, every move they made. How different this has become, with the possibility of judicial review of every aspect of a decision seen, for example, in telecoms appeals cases, where vast quantities of materials are provided by the relevant parties to justify a position and explain why the regulator is wrong, in turn leading to considerable volumes of paper from the regulator justifying their decisions. Thus, rather than a five-yearly decision process, there are continual skirmishes between telecoms operators and the regulator, OFCOM, on just such matters for judgement as likely trends, for example, in costs and demand, valuation of existing long-lived assets, and so on. This brings with it the ever-present potential problem of ‘capture’ of the regulator by those it is supposed to be regulating independently. The regulator always needs to take an independent line, despite the difficult life this can create.

Here there is an important but indirect link between the valuation of long-lived assets and the issue of returns to the Treasury. Many privatizations, from the earliest (BT) to the latest (Royal Mail) at time of writing, have generated a substantial furore regarding the price at which the business was sold. This may well be a justifiable concern. The initial governmental aim, of making sure that privatization was a ‘success’ in the narrow terms of being able to place the shares on the market and therefore being extremely conservative about pricing the initial offering, is lamentable (and press comment upon it similarly so). In a capitalist system, if investors with cash see a bargain they will go for it; giving these people a bargain is not a success in any sensible terms.3 But there is, or should be, a clear distinction between selling off a business around which competition (p.315) will develop and selling off monopoly rights, a long and disreputable tradition in British (and other) political systems.4 The sale of a business with long-lived assets for a particular price implies a valuation on the assets of that business, if they can be separately identified. Thus a high initial price carries with it the danger that, when the time comes for a five-yearly review, implications are drawn about the anticipated return to shareholders (or, as it would be put, shareholders’ legitimate expectations) on those long-lived assets. Surprisingly, this can be an issue even thirty years after the event.

One novel feature of the regulatory regime developed has survived and proved its long-term worth, albeit subject to substantial changes. The standard pattern of regulated industries in the US was that the whole business was regulated. Littlechild’s novel approach was that what should be regulated is those parts of the business unlikely to be subject to competition. Thus he proposed a tariff basket approach, where a basket of business and residential rentals of the phone line, plus local call charges, would be regulated, but not other types of call, where he saw competition developing. In practice, the final blueprint included a wider basket of goods, and indeed the basket was changed over time in the light of experience, but the idea has been retained.

A further point is relevant here. If price is regulated, the regulator needs at the same time to ensure that service quality does not slip, because one obvious way for a monopoly provider to reduce costs is by relaxing on service quality. Here, the early decision by the telecoms regulator to collect, publish, and make use of quality information is to be commended.

In many respects, the Littlechild report was a leap into the theoretical darkness. Because rate-of-return regulation had been around for some time, its potential limitations were well known, most famously the Averch-Johnson (1962) effect meaning that there is a tendency for ‘gold-plating’ of capital.5 There was also, of course, the famous Ramsey (1927) result, although it had probably not been thought of in the regulatory context at that stage and, much nearer to time, Baron and Myerson’s (1982) well-known paper on the problem of regulating a firm with unknown cost. But most of the academic literature discussing the positive and negative features of price cap regulation post-dates the Littlechild report, rather than providing useful input into the initial thinking.

As an example, one major issue that arises when part of an industry is subject to regulation and another part is not is that of access. If competition is to develop and, as is very common, in order to compete effectively that competition needs access to monopolized facilities owned by the regulated firm, then competition will not develop if means are found to limit access or make it unprofitable. For example, in telecoms, a competitor to BT needs access to the BT system in order to provide a complete service—if the person (p.316) I want to phone is on BT, my operator needs to make use of the BT network (at least the ‘final mile’ to that customer’s landline phone) in order to terminate my call. But if the access cost is high, my chosen operator may find it very difficult to provide a service that is competitive with BT’s own.6 Thus one common issue facing a regulator is how to price access to the monopoly elements of a service. There is some acknowledgment of this problem in the Littlechild report, in the form of advocacy (para 13.15) of ‘tough non-discrimination clauses in BT’s licence to prevent predatory behaviour against competitors’, plus the requirement to publish its tariffs. Access pricing is a complex issue, more complex than the ‘efficient component pricing rule’ (ECPR) originally set out in Willig (1979) and Baumol (1983), both relatively obscure sources that were available at the time Littlechild wrote. It was not until some years later that Laffont and Tirole (1994) and Armstrong et al. (1994) set out a comprehensive analysis of the main issues. Put loosely, mandated access at the marginal cost of providing access creates incentives on the part of the monopolist to find non-price means of restricting access, whilst providing access on the basis of the opportunity cost (including foregone revenues) of that access (the ECPR) is too unsubtle—the opportunity cost of course contains a monopoly rent. In fact, the access issue is one that relates not only to cases where essential facilities are supplied by a firm that competes in the same final market as the firm seeking access, but also in a different form to situations where there is vertical separation between the essential facility and the competitive sector (as in electricity).

Indeed, the access pricing difficulties are significant as regards BT retail and BT Openreach, despite an accounting separation between the two. This is partly because they share many facilities, for example office premises and ductwork; indeed some facilities such as telephone exchange buildings are shared also with other providers such as TalkTalk and Sky; therefore issues arise regarding services provided to the facility (such as cooling), rather than provided to any party in particular.

One general issue that access pricing raises, but which manifests itself in most sectors, is the need for a great deal more measurement at various stages than was undertaken whilst the industry was in state hands. In a state monolith, there is only limited need for measurement at intermediate stages, and often there was only vague information on where costs were incurred. Once a number of separate players enter the picture, the need to understand costs in some detail becomes much more apparent. In turn this creates a significant need for measurement. Often flow volume, which is commonly assumed in economic models to be the primary driver of costs, plays only a small part in the overall cost structure, yet costs are not truly fixed. For example, many facilities (e.g. trunk networks) where continuous service is required generate costs proportional to maximum throughput, rather than average flows. This requires measurement of at least peak flows, but often also measurement at many points, in order to determine bottlenecks in the paths taken by the service, the impact of exogenous (p.317) factors, and so on, together with efficient means of collecting and interpreting these measurements in real time, so as to take decisions. This becomes most obvious in the energy sector.

16.3 The Network Energy Industries

The next activity to be privatized following BT was the gas industry. Network energy industries (i.e. electricity and gas) exhibit many features in common with each other,7 although the development was initially quite different. A significant compromise was made in the case of gas, so that initially it was privatized as a whole, from well head to appliance supply, on somewhat spurious arguments. It was not until ten years after its privatization that it came to resemble the current vertically separated structure, with supply companies being separate from transmission activity. To a large extent, in terms of their current structure and regulation, both industries can be discussed as one, and indeed many of the participants are active in both markets.

First though, some crucial technical differences. Gas is an industry with one-way flows, from producer to consumer, whereas electricity has the potential for two-way movements, although the network has not normally been set up to facilitate these, so it requires adjustment. Gas also has some leeway on the match between demand and supply, because it can be stored and the transmission network can itself act as storage, through variable line-packing. In electricity it is crucial that supply is equated with demand at all times. In addition, electricity is generated through a variety of technologies, whereas gas comes (in more or less homogenous form) from a small number of locations. Hence electricity requires a greater degree of control, with more sophistication built into the economic regulatory system. The regulator, whilst initially separate, is now the same body. Thus the discussion below focuses on electricity, since it raises the issues of both. This is also one of the most controversial industries.

Initially a very bold move was made in electricity, to separate the industry in England and Wales vertically into four layers: generation, transmission, distribution, and supply.8 Of these, transmission and (local) distribution were seen as naturally monopolistic activities (particularly the former, given the strong need for coordination imposed by the technical need to equate demand and supply at all times). The transmission system operator (TSO) has a quasi-command and control role, buying or selling electricity in near time (less than one hour in advance of delivery) in order to balance the (p.318) system.9 Thus, separating it out avoids one of the potential errors in restructuring an industry on privatization, namely that the separation becomes fixed into the structure even if it outlives its usefulness; it is difficult to see how technological change would render this particular separation subject to change within the medium-term future, at least. Nevertheless, it may be that along with the increased growth of two-way electricity movements at distribution level, together with the growth of storage technologies, there will be some need for replication of this function also at local level. Initially, suppliers were the same companies as distributors, and were regulated as regards both activities. However, since 2002 all supply across both electricity and gas has been deregulated, so in discussing supply we refer only to the structure in place currently.

One of the main functions of a supplier is absorption of pricing risk. The exact technical link between supply and demand, coupled with the substantially inelastic short-run relationship between demand and price, means that very large wholesale pricing movements are experienced over short time intervals in order to equate supply and demand. It is neither technically possible (at present) nor socially feasible to pass these wild fluctuations on to consumers. Therefore, the supplier in effect acts like an insurance company (or, perhaps more exactly, a bookmaker) to tackle the issue. Suppliers purchase a portfolio of contracts for future delivery, in order to balance certainty against price given their expected supply commitments. Only a small amount of electricity (perhaps 3 per cent) is traded directly through the balancing mechanism (Simmonds, 2002). This is in contrast to the situation prior to 2001, which is when the New Electricity Trading Arrangements (NETA) commenced. Previously, in common with the systems operating in most other countries and electricity regimes, most electricity was traded through the Pool, a central market mechanism.

A key feature of the Pool was that generators were paid the system marginal price (SMP) for the relevant time period. Therefore, generators with low marginal cost would bid into the system, knowing that they would be selected and paid significantly above their bid. For example, nuclear plants would be bid in on this basis. Of course, these low marginal cost plants commonly had high fixed costs, so that the gap between SMP and their marginal cost provided a return to past investment and also a signal as to the profitability of new investment in generation. Thus, by comparing the Pool price path with the cost of a fuel to generate electricity (allowing for a given efficiency in generation), together with likely construction costs, a good indication of the potential profitability of a new plant could be developed.

The context of the move to NETA was the concern about market power in generation in England and Wales, stemming from the concentrated nature of the market at privatization (with two strategic players) and the origin of the firms’ key decision-makers in a single firm, the Central Electricity Generating Board (see Green and Newbery, 1992). This implied that collusion, or at least knowledge of likely responses by the other party, was a clear possibility. The regulator was concerned enough about limited competition (p.319) in generation to persuade the two major strategic generators to divest 4GW and 2GW of capacity respectively to a third force by mid-1996. Indeed, these concerns prompted another move by the regulator, namely to allow the limited integration between generators and suppliers in return for further divestment in 1999. This started a rush to integrate between generators and suppliers, so that by around 2002, all six major suppliers had developed or purchased significant generation capacity as well as capturing around 99 per cent of the domestic supply market, leaving only a very small independent supply sector. Independent generators remained important, but suffered from their weakened bargaining power once NETA was implemented and, in the case at least of Nuclear Electric and one of the other merchant generators, led to a ‘re-capitalization’ in order that they continue to operate.10

Arguably, supply is a rather competitive business. Indeed, when supply competition was first mooted, it was envisaged that companies in industries entirely different from energy but with strong reputations for consumer service and significant knowledge of their customers’ requirements (such as supermarkets) would be significant players. This happened only to a limited extent. However, the combination of two separate decisions (NETA and allowing vertical integration), both of which might well have been innocuous in their own right, and carried out for the best of motives, has in practice proven problematic. The problem stems from the opacity of the wholesale market. For example, a House of Commons committee inquiry (2008) received significant evidence from small entrants to the supply business that they were unable to create a sufficiently attractive offer because so much of the wholesale market involved internal transactions between different parts of the same integrated businesses. In the days of the Pool, the evidence of pricing was there for all to see; following NETA (and its extension to Scotland in 2005 under BETTA), prices except for a very small amount of near-to-close pricing became something of a matter of guesswork (or assessments) available from price discovery agents such as Heren and Pratts—at a price, of course.

The problem is that customers and the media express disbelief (and in the case of some customers, face real hardship) when energy suppliers swiftly raise prices by significant double-digit percentages at fairly short intervals. Of course, sometimes they lower them, but the suspicion remains that they are slower to lower prices than to raise them. And the key question—To what extent are these prices reflecting costs?—is almost impossible for an outsider to answer accurately. Remember that suppliers are purchasing a portfolio of futures-dated contracts in often opaque markets at various prices. It is difficult for the regulator to discover, or for the big six to refute, the potential for profit-taking when prices to consumers rise sharply. Because energy prices are such a sensitive consumer issue, politicians on all sides are keen to wade in with their own (in my view) simplistic ‘solutions’ to the problem. Thereby, one of the potential benefits of privatization, the de-politicization of the energy markets, has disappeared.

(p.320) There is another aspect of this issue. The opacity of prices means that independent merchant generators are extremely reluctant to engage in new investment in generation plant. Thus the UK has been walking into a problem of declining margins of safety between likely maximum loads on the system and available generation capacity, a problem that will worsen as old nuclear plants are retired and old and relatively dirty coal plant is forced into retirement. Here we have a classic political problem—lead times for new generation, particularly nuclear generation, are long, longer than the political cycle. Therefore governments have a tendency to shelve problems until they become urgent. The saga over building a new nuclear facility at Hinkley Point is a good example. This has been mooted for some time, but it is an immensely costly investment, and therefore risky in a market where output prices fluctuate significantly. Thus guarantees have been sought, and obtained, from the government for long-term price support for the project, in which EDF, one of the big six suppliers, is the key partner. This is not a desirable basis on which to conduct long-term energy policy, nor a good basis for the regulator to work from. The regulator is in a hard place between being captured by the industry and being captured by the government of the day.

There are additional factors to be brought into the mix, both concerning climate change. One is the policy, driven by the need for greater renewable power, to develop strategies to supply it. The British are not as naturally ‘green’ as many other European countries—the Germans have made huge (and somewhat costly) strides in the direction of both wind and solar power, and the presence in particular of photovoltaics has smoothed out the German midday peak in demand; Italy and Spain also have moved significantly into solar power. France has a very substantial nuclear fleet, which is ‘green’ by some people’s standards, and much of Scandinavia relies heavily on Norwegian hydropower. Everyone in Britain likes to have electricity available, but few people like to be surrounded by wind turbines. A cynic would suggest that people of southeast England were happy when much of our power was generated through giant coal-fired plants situated along the river Trent, because they could use electricity but not see it being produced. They are now happy to have wind farms, so long as they are somewhere else. The upshot of this is that offshore wind, an inherently expensive technology, is politically likely to be most easily developed.

The other aspect of wind and solar power is that it is unbiddable, unlike conventional thermal power. Thus increased renewables of this type require either significant development of storage technology or, more likely in the medium run, increasingly intermittent, and therefore less efficient, use of gas-fired technologies. This is not widely appreciated. But it is a factor in the discussions of developing the capacity market—a market for payments to power stations to be available, rather than paying them only when they produce power.

The overall impact of these policies is that we are moving rapidly away from a model of generation as a competitive market system towards one where, paradoxically, almost all types of power plant are in some sense subsidized—nuclear, wind, photovoltaic, biomass, plus coal and gas via payments for capacity availability. This in an industry where the externalities are generally negative; not a good recipe for efficient regulation!

(p.321) Of course the other alternative, or complementary, aspect of electricity is demand side management. It has always struck me as a somewhat strange idea that the energy supply companies have been pushed into the ‘turkeys voting for Christmas’ role of attempting to promote energy-saving measures. Unfortunately also, the approaches adopted by their agents have been badly managed, so that no records appear to be kept of who has installed significant loft insulation, who has solid walls and is therefore annoyed by constant calls from companies offering to install cavity wall insulation, and so on. In retrospect, it would have been better if parties with a more genuine incentive to reduce and smooth customer consumption could have been put on to this activity.

16.4 Water and Sewage

It was always acknowledged that the scope for competition in the water and, particularly, sewage sector was very limited. The less famous Littlechild report on water (1986) acknowledges that in an industry where regulation is inherently long lived, considerations of rate of return loom much larger, because most of the investments are long term and investors need some assurance that the assets will not be stranded. Initially on privatization in 1989 at least, the industry was also subject to an above-RPI form of price regulation, because purity standards in water and sewage needed to be increased to Continental European levels. In this sense, the industry inherited and needed to remedy a dubious recent past, despite the Victorians’ early advances both in water and sewage services.

Here an interesting new concept was developed, that of ‘yardstick competition’. The industry was reorganized into river basin catchment areas, so far as the ten water and sewage companies were concerned, plus a number of usually much smaller water-only companies that often relied on idiosyncratic local supplies, either from rivers or from boreholes into aquifers. In total, there were approximately thirty water supply businesses, and although there were only ten sewage companies, because economies of scale in sewage are modest, this involved a much larger number of individual sewage works. Thus in both water and sewage, there was (just) enough scope for statistical comparison across companies, in order to identify relatively efficient and relatively inefficient operation, and to penalize the latter. Also, many investment tasks are essentially standard, such as laying a particular length of trench, installing a pump, and so on, so in evaluating investments, these standardized tasks can be (and have been) developed into standardized allowed costs for the task, so enabling cross-company comparison and control.

As far as continuing operations are concerned, water provision is somewhat idiosyncratic. Some sources and treatment requirements are inevitably more costly to work than others. Some involve a rather denser network of pipes than others, some involve substantially more pumping than others. This leads to regression models of output on costs in which control variables such as population density, pipework density, pumping (p.322) heights, and so forth are inserted. The regression residuals then hopefully indicate relatively efficient and inefficient operators. In practice, although these comparisons might be seen as moderately sophisticated, they have not been significantly enhanced to encompass developments in econometrics, since they were instituted in the early years of privatized water companies. Therefore, in my view they do not make the best use of the information in the regulator’s hands, for reasons which are understandable but not convincing. There is also a tendency to make ex post adjustments, rather than building these into the regression framework.

There is also an unfortunate side effect on the industry structure. In any other industry, if two small companies operating in non-contiguous areas of the country were to find good reasons to merge, this would not trouble the competition authorities. However in water, this can mean the loss of a vital datapoint. Hence the case is examined in detail, with costly consequences. Finally, there have been more recent attempts, first in Scotland, to develop competition in water supply (for example different grades of water for industrial use). This is only ever going to be a small element of the overall industry, in my opinion.

16.5 Transport

The final sector I will consider is transport. Here the main aspects I will look at are rail and local bus services. First, however, a few words on airports. Whoever first designed the system of ownership of privatized airport facilities in Britain certainly seems not to have had competition at the back of their mind. It seems odd that the British Airports Authority, when privatized as a whole in 1987, had a monopoly both of the three main London airports and the two main Scottish airports, and one plausible competitor for the London airports in the form of Southampton, together with Aberdeen in Scotland. Since there is no good reason for the London airports or the Scottish lowland airports to be under the same control, it is unsurprising that the Competition Commission, in a trenchant landmark report in 2009 (CC, 2009a), recommended and eventually (after a long and hard-fought battle in respect of Stansted) was able by early 2013 to enforce divestiture of two of the three London airports. It is a little early to see the full fruits of this action, but it is clear that the incentives of the three different parties who now hold the three London airports will be substantially different from the incentives of the set of airports taken together.

Rail privatization was a somewhat untidy affair, developed at speed against a background of significant opposition prior to the 1997 election and in some parts insignificant recognition both of the idiosyncratic nature of the rail network as it exists in Great Britain and of the limited scope for on-rail competition. A complex vertical structure with a web of contractual relationships was developed, including a complex system of regulation, with the best of intentions perhaps, but certainly vulnerable to criticism.

(p.323) In retrospect, one of the main issues turned out to be a significant knowledge deficit so far as the state of the infrastructure was concerned, made worse by the loss of skilled employees to contractors or other sectors. This infrastructure was severely tested and found wanting as a result of the substantial growth in patronage, leading to a series of extremely damaging incidents in the late 1990s to early 2000s. The infrastructure operator (Railtrack, a private company) was seen as incompetent and over-interested in profit at the expense of other things. Key upgrade projects proved difficult and cost overruns were legendary. As a result, Railtrack was put into administration and what is effectively a nationalized company, Network Rail, has assumed the role. However, it is still the case that by far the majority of delays to services are attributable to infrastructure failings.

Most operations so far as passenger services are concerned are carried out by franchised operators. It was seen that the rolling stock to be used by these was both expensive and long lived. Because the franchises could not plausibly cover more than a small part of the likely life of the rolling stock (which might be forty years) three leasing companies were developed, from whom the necessary vehicles could be rented. However, although three suppliers might seem enough to get broadly competitive pricing in many industries, given the idiosyncratic nature of much of the network, for many lines at most two suppliers would have appropriate equipment and for some, only one. Thus the leasing structure, although it allowed investment in new stock and allowed a range of competitors for a franchise, was far from perfect and has been much criticized as well as the subject of a Competition Commission report (2009b).

Rail fares have been raised in real terms for many years, but despite this, there has been a substantial and sustained increase in rail travel from privatization onwards, even through the considerable macroeconomic fluctuations in the late 2000s. To this extent, the experiment should be judged a success. However, there are two connected caveats regarding operators that are significant. Operating franchises are awarded on the basis of competitive tenders, for relatively long periods of time. It is important to note that these do not represent ‘Chadwick auctions’ of the type proposed by Demsetz (1968). Rather, the competition is won by the supplier (subject to quality constraints) which offers the largest payment schedule to the government. Also, because of the growth in expected passenger numbers, franchise proposals commonly consist of a schedule of payments rising over the life of the contract. However, the assumptions underlying these, which may themselves derive from Department for Transport (DfT) forecasts, can be over-optimistic and lead to franchise operators ‘walking away’ from franchises early in the period. This has brought the process, and with it the DfT, into some disrepute. Indeed, it has successfully been legally challenged, by Virgin Trains. What happens when a franchisee walks away? The answer is that Directly Operated Railways, a government body, takes over for a while. Unfortunately, in many eyes, this same body is ruled out of competing directly for the award of franchises, despite its good record in cases such as the East Coast where it has stepped in.

In the main, the operators of services are companies also active in the bus market, although several have significant input from Continental European operators. In this sense, the franchise structure has succeeded in creating a system in which companies (p.324) expert in transport in other contexts play a significant part. There has been significant consolidation amongst the firms, but at least for the present there probably remains sufficient competition between them.

There is quite a marked contrast within local bus transport. One cannot help a suspicion that the contrasts between the system devised for buses in London as opposed to outside London is suggestive that the rest of the country is of little interest to those in government. The well-organized system of five-year (Chadwick auction) franchises within London is well respected outside the country and leads to a system with attractive network properties, significant monitoring of service quality, and a rising patronage. Outside London, apart from the relatively small fraction of those services viewed as socially necessary which are franchise operations,11 the model is completely competitive.

The introduction of competition in buses has some benefits,12 but until the subsidization of fares for those of pensionable age bus patronage had been declining, quality of service remains variable, and network benefits have commonly been lost so far as passengers are concerned. This is not a model that is the envy of Continental European cities. In the case of relatively rural routes and small towns, where network benefits (the ability to complete a journey using more than one bus) are rather unimportant and obviously poor operations can be supplanted by better services (as has happened in some notable instances), the completely free competition on fares and routes works reasonably well. But in the larger urban centres, as a result of various benefits of large-scale operation, even poor-quality operators survive for many years. In certain cases, this is boosted by the important role of operator-only weekly and monthly passes, which commonly have a much stronger role in the market than the all-singing-all-dancing variants rather indifferently marketed at higher prices by local passenger transport authorities. In the case of some large metropolitan areas, there have been sustained attempts to introduce a local franchise framework similar to that which exists in London; so far, however, these have not borne fruit. One significant issue is the possibility of legal challenge to the change to a franchise scheme—it is unclear what exactly the current operators ‘own’ in a particular location. Thus the bus market outside London exhibits the problem of ossification of a structure that may well be sub-optimal, created by the initial design of the privatization.

16.6 Conclusions

The point just made is one of wider importance. In organizing the structure of an industry for privatization, certain decisions are made which then become irreversible in practice. Therefore it is important, in making structural changes, to think them through (p.325) carefully. There have been examples of changed structures ex post, most significantly perhaps in the case of British Gas, but these are undoubtedly difficult to engineer, particularly when the industry has now become fragmented.

A final thought: Devising a market remedy is not like devising a remedy for a crime, such as a prison sentence, because the latter can be enforced. In redesigning a market, the difficult lesson is that given a set of incentives, firms will act in a strategic manner. They will optimize subject to those incentives or remedies. This is a difficult lesson, because it is tempting for a regulatory body to see a problem and devise a remedy for that problem without seeing what the firm(s) might do in relation to the remedy; several examples could be cited. Not only may firms prevaricate, they may also see through to a solution that satisfies the ‘remedy’ but does not have the intended effect on the industry. This suggests that proposed remedies, or changes to a system, should be tested on cynical industry insiders who cannot themselves benefit from the change, but can nevertheless see how others could benefit, and can therefore caution against particular proposals towards others that have a similar effect but without similar problems. Easy to say, but no doubt difficult to put into action!

Note: Michael Waterson has been a Member of the Competition Commission, but he was not involved in any of the Inquiries specifically cited in the text. He would like to acknowledge the opportunity offered to air some of the ideas expressed here in a short lecture series delivered at the University of Verona in April 2014.


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(1) That is, Northern Ireland, which has significantly different regimes in almost all industries considered below, is not discussed.

(2) See the discussion in Bartle, 2003.

(3) Of course, this was probably one of the political aims at the time, to create a society in which a wider range of people felt confident in investing in the stock market.

(4) As a historical note, the taxation of salt as a revenue-raising device has in Britain, France, India, Russia, and China led to substantial health problems and many severe protests. Thus by analogy, it is important to see the difference between selling off a particular salt works and selling off the right to sell salt in a country. The latter would maximize returns to the seller, but ossifies the structure of the industry.

(5) This tendency can persist in an RPI-X-type scheme once the scheme is up for review and the capital base is being considered. A trenchant view on this, with evidence of ‘gold-plating’ at Stansted Airport, was given in Ryanair’s evidence to CC (2009a; see para 7.71) in respect of Stansted.

(6) It is in this sense that what I wrote about earlier in the context of the Internet should be read. If everyone I need to call has a mobile phone, then a competitor to BT need not use BT’s final mile to terminate their call.

(7) There is a clear distinction between electricity and gas, where the network is an integral part of the delivery process, and oil, where the ease of handling, high value, and energy content to weight means that decentralized road transport is an efficient means of delivery. This industry has not been in state hands since the Second World War.

(8) This was probably the first conceptual separation between distribution and supply. It took place in Scotland somewhat later.

(10) Clearly, if you own an asset whose debt is expensive to service, but you can operate at low marginal cost so you have a revenue stream into the indefinite future, then if the capital and hence the debt servicing costs are written down enough, you can continue to operate.

(11) Some authorities appear to be much better at eliciting tenders for these than are others; clearly local practices differ. This can be, and has been, a useful route for smaller operators into larger service provision.

(12) Here it may be useful to note that Oxford is in the almost unique position of having a stable, largely duopolistic structure to its bus services and, given the nature of the city, this structure works well.