RPI – X Regulation

1. RPI – X Regulation Peter Bedson – Managing Director

2. 20 Years History • British Regulatory Model • Independent Regulatory Agencies • RPI – X Price Cap • Promotion of Competition • Applied to a range of industries • Telecommunications • Electricity • Gas • Water • Transport • Widely used as a model internationally

3. What is RPI-X? • Incentive based regulation – Regulator sets price control for a period but leaves the company to determine how to work within that • Companies incentivised to save money as this is retained – at least until the next review • Incentive for early savings as these are worth most • Reveal efficient costs

4. How did we get here? • Based in a number of policy developments in the 1980s • Thatcher Government • “Rolling Back The Frontiers of The State” • Privatisation • Reducing PSBR – particularly in the areas of Telecoms, Water and Transport • Selling off state monopolies • By 1983 preparation for the first major utility privatisation - telecoms was underway. The Government needed to solve problem of regulating what was in effect a monopoly.

5. An Independent Regulator • Initial government plan was for telecoms to be regulated by the Office of Fair Trading (OFT) • OFT successfully argued against this: • The task was too big for a competition regulator • The ongoing monitoring required of a sector regulator would not fit with OFTs other work • Resulted in establishing the Office of Telecommunications (Oftel) headed – like OFT – by a Director General as the model for the regulation of the utilities • Sector specific regulators

6. Telecoms in 1983 • Telecoms was a very different industry in 1983 from now • Restricted to fixed line telephones • Mobile phones were an expensive and niche product • No internet, cable TV etc. • BT operated an effective monopoly • Only competition was from the much smaller Mercury (mainly long-distance calling) • Mercury-BT duopoly retained until 1991

7. Restrictions on Privatisation • Government decided against breaking up BT as had been done in the USA with Bell/AT&T • The need for several years trading history ahead of privatisation conflicted with desire to get significant investments in digital telephony off the PSBR • Duopoly of BT & Mercury retained for some years at retail level • Mercury was granted a licence in 1982 following a Government call for proposals • Mercury business based on long distance trunk network mainly using BT’s “last mile” • Mercury’s main shareholder Cable & Wireless was also being privatised!

8. Role of Regulation • The basis of RPI-X regulation comes from the 1983 Littlechild Report: • “Competition is indisputably the most effective – perhaps the only effective means – of protecting customers against monopoly power. Regulation is essentially the means of preventing the worst excesses of monopoly; it is not a substitute for competition. It is a means of “holding the fort” until competition arrives.”

9. Alternative models of Regulation • Potential Models: • No specific regulation – rely on general competition regulation and antitrust measures • Rate of return regulation (as common in USA) • Maximum Rate of Return • Output Related Profit Levy

10. Why RPI – X? • Maximum Rate of Return • Profit regulation not price regulation – Input focus • Intensive, high cost system – potentially frequent revisions if costs change • Requires highly detailed analysis/understanding of costs • Incentivises utilities to increase denominator to earn margins above comparable assets • Results in overcapitalisation • Results in distortions between capital expenditure and operational costs • Companies make decisions the regulator will approve, not efficient decisions • As the allowed Rate of Return is approached it is equivalent to 100% marginal tax rate!

11. RPI-X – Output focussed • “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.” Littlechild 1983 • Allows the company to manage within the overall price cap • Less vulnerable to “cost-plus” inefficiency • Allows greater flexibility to adjust prices within the basket (and freedom outside it) • Simpler to operate • But: • Where price controls are repeated and x is regularly reset outcomes are similar to rate of return regulation • Depends on regulator understanding “efficient costs” • However price controls are more forward looking, and more focussed on incentives compared with rate of return regulation • Forecasting is crucial – extra reward for risk in forecasts • Incentives based – will reveal efficient costs over time but risk of public outcry if too generous

12. Permanent Regulation Vs Temporary Price Cap • Original expectation in Telecoms was that direct competition and technological evolution would render the need for RPI-x temporary • In water, gas, electricity etc. networks there is no expectation that this will be the case and the issues are therefore different: • “In deciding how far to revise x …needs to examine the company’s production methods and investment programme. He must ascertain the scope for cost and price reductions…needs to predict the consequences of x on what the company will do, how it will do it…” Littlechild 1986 (On Water regulation) • Hence Rate of Return considerations are implicit in setting X and the incentive benefits can only be maintained if the utility can be confident in how they will be rewarded over the longer term

13. Telecoms RPI-X in Practice • Littlechild’s original price cap proposal for Telecoms was not implemented • This would have resulted in rapid elimination in cross-subsidy between services allowing competition to develop • Instead a single RPI-X tariff basket was introduced which constrained this evolution • Price cap has been gradually withdrawn from most of the retail market but the wholesale market remains regulated with competition mainly developed in the retail market via resale of BT capacity (with limited “facilities based” competition from cable and mobile)

14. Moving Away From Telecoms • RPI-X has been adopted in a number of other industries subsequently: • Electricity • Water • Gas • Airports

15. Moving Away From Telecoms • These have moved away from the simple RPI-X to incorporate increasingly complex efficiency and service level incentives, recognition of special one-off capital programmes (eg in water), and disaggregated price controls in an attempt to deal with issues of applying RPI-X to increasingly complex issues • Revenue sharing clawbacks • Specific quality/service incentives • Capital project allowances • There is however no single methodological basis for price controls between the different regulators and similar costs and trade-offs are treated differently in different industries

16. RPI-X in Water • No possibility of competition replacing regulation • Many regulated companies (>40) with different service areas some providing water only and others providing water and sewerage services • Regulation needs to address differences between companies and be transparent in price setting • Regulator acts as surrogate competitor – using cost benchmarking but this drives requirement for standardised accounting/reporting which in turn may reduce efficiency as companies tend not to innovate as this does not fit the structure • Benchmarking was only possible because of the number of companies

17. Building Blocks Approach • Regulator has developed a “building blocks” approach to regulation • Expenditure is classified as: • Maintaining customer service • Quality enhancements (water and environment) • Maintaining supply-demand balance • Enhancements to customer service • Costs are viewed as: • Operating costs (including maintenance) • Return of capital (i.e. depreciation of the assets) • Return on capital (i.e. payments to shareholders and debt providers) based on assumed “efficient capital structure” • Taxation • Key element is RAB and depreciation • What is included – what investors paid, what they should have paid, or what they would pay now? • Depreciation policy implies inter-generational allocation of costs

18. Building Blocks • Relies heavily on comparative competition to determine allowable costs: • Uses econometric models for Opex and Capex • Standardised unit costs based on inter-company comparisons • Significant penalties for loss of comparators

19. Output measures are not easy to establish for networks especially quality • May require audit/standard reporting which add to costs and can stifle innovation

20. Price control based on: • “catch up” assuming all companies improve their efficiency towards the best performers • “efficiency frontier” assumed to move for all • Individual price controls • Getting it right: • Approach was to determine the “right answer” ahead of time rather than allow RPI-X to reveal the true level of efficient costs • 1994 – “Glide path” for returns over 10 years • 1999 – Shortened price control to 5 years and introduced P0 (one off cut at the start of the 5year control) with rolling incentive to allow companies to keep benefits of savings for at least 5 years • 2004 – Building blocks continue

21. Criticisms • Over reliance on econometric models • Models do not reflect accurately drivers and so differences between “efficient” and “less efficient” may be more to do with the models than the company • Modelling and data have not “moved on” • Increasing reliance on “special factors” specific to each company • Reported cost data is not robust – differences in interpretation may be more significant than real • Over reliance on comparative techniques in cost assessment (looking backwards rather than at the market) • Distorts incentives (Opex vs Capex) and assumptions may become “targets” reducing incentive to seek efficiencies • RPI-X and Rate of Return essentially similar

22. Does It Work? • Sir Ian Byatt (water regulator) identified that: • “Over the 15 years (to 2005) the annual average household (water) bill will have risen by some £38. Quality improvements will have accounted for an increase of £99, while other improvements and growth in supply will have accounted for an increase of £22. Offsetting these, efficiency improvements will have accounted for a decrease of £83.” • In energy the following savings have been achieved: • Electricity distribution –50% since 1990. • Electricity transmission –41% since 1990. • Gas transportation –41% since 1994

23. Annual Opex savings:

24. Quality is up: Source:Ofgem

25. Network investment is up:

26. WACC low as a result of certainty & unbundling

27. RPI-X has squeezed costs • Is this sustainable?: • Other industries have different pictures – for gas distribution expected savings are yet to come • Do we need to move from squeezing costs to spending to save?

28. Issues? • Can RPI-X sustain investment with asset lives significantly beyond the control horizon? • Different treatment of risk between networks with large new investment need and others? • RPI-X is supposed to be forward looking but increased “add-ons” increase the probability that it becomes effectively ex post rate of return regulation • Differences in treatment of similar issues between regulators – surely there must be a “right answer” • Both RPI-X and Rate of Return are regulatory “games” • Information asymmetry – what efficincy savings are possible etc.