23 April 2018

The burning injustice of our unreformed utilities


Minutes after being appointed Prime Minister, Theresa May was talking of her mission to fight burning injustice. “If you’re one of those families, if you’re just managing, I want to address you directly,” Mrs. May said. “The government I lead will be driven not by the interests of the privileged few, but by yours.” So far, that’s turned out to be an empty promise.

Take utility regulation, which affects how much all of us pay for gas and electricity, water and sewerage, rail travel and flying out of Heathrow. At the moment it systematically over-rewards investors and means consumers pay too much. In a powerful speech last month, environment secretary Michael Gove attacked the abuses the system gives rise to. Owning a water company is a licence to print money that would made even the ITV franchisees of the 1960s and 1970s blush, Mr. Gove suggested.

New Labour recognised the problem, but its answer wasn’t a solution. A windfall tax came about because take-over bids for freshly privatised electricity companies revealed that they were worth much more than they had been privatised for. But the tax did not address the root of the problem and left the existing system untouched. So much for the tough on crime, tough on causes of crime rhetoric.

In part, the utilities take-over frenzy occurred because the scope for efficiency gains assumed in the first price control had been underestimated. Companies were achieving more than three times the efficiency gains that had been assumed. But a bigger reason was that their borrowing capacity had been massively underestimated. Firms could borrow a ton of money against those licences to print money, which would allow bidders to pay multiples of what taxpayers had got at privatisation and enable companies to finance huge cash pay-outs to shareholders in the form of super-dividends and share buybacks.

Britain’s RPI-X form of price regulation has many advantages over American capital-based regulation. For example, it gives companies strong incentives to make efficiency gains. In the first instance these accrue to shareholders, but in the process are revealed to the regulator, who can then hand them to customers after the subsequent price review.

However, RPI-X price caps share a critical weakness of capital-based regulation. Investment is treated as a pure pass-through cost and regulators have to decide an appropriate return on utility companies’ balance sheets. As with capital-based regulation, regulators must determine the allowable profits – in regulator-speak, the firm’s cost of capital. But they always err on the high side. If they didn’t, investment would dry up. From the point of view of economic efficiency and consumer welfare, this has two undesirable consequences.

First, it pays utilities to over-invest. To many politicians, investment is ipso facto a good thing. But capital investment is a cost which has to be paid for and wasteful investment results in higher prices. This problem has been known about since 1962, when economists Harvey Averch and Leland Johnson wrote a paper on what became known as the Averch-Johnson Effect, which predicted that firms subject to rate of return regulation have an incentive to acquire additional capital. This results in a “misallocation of economic resources,” the paper concluded.

The second is that regulated firms can make money by exploiting the gap between their assumed and actual cost of capital. It means they can make more profit from financial than real engineering, giving rise to hugely complex financial structures designed to maximise the amount of debt that can be supported by the gold-plated returns generated from firms’ regulatory asset base and minimise the corporation tax they pay – if they pay any at all.

There were positive signs the government had decided to grasp the issue. The first pledge made in last year’s Conservative manifesto was to deliver a strong economy built on “better regulation.” What this meant was spelt out three pages later, with the promise to “deliver a better deal for customers and sharper incentives for investment efficiency.” The pledge was bang on the money. If the government intended to address the perverse incentives embedded in the existing system of regulation, this was a great start. Since then — other than Michael Gove’s speech — silence.

The manifesto also set the ambition that the UK should have the lowest energy costs in Europe. That too has been dropped, but there was also a pledge to carry out a cost of energy review. Dieter Helm, Britain’s leading energy economist, was asked to carry it out and reported six months ago. The report’s coruscating criticism of utility regulation should have had ministers sitting bolt upright.

Local distribution and transmission costs account for 27 per cent of electricity bills. In eight years, electricity transmission revenues rose by 146.6 per cent. As Helm documents, Ofgem’s most recent price cap review has been a fiasco, with the transmission – principally National Grid – forecast to beat its capex and opex assumption by a staggering £1.94bn over the eight-year price control period. Consumers are being charged for what National Grid promised to spend but isn’t, with, in the case of investment, a cost of capital premium on top. It turns out that National Grid is an even bigger money-printing license than owning a water company.

Helm’s conclusion is unequivocal: “The broad RPI-X regulatory framework has run its course.” There are far better ways of establishing what an electricity distribution company’s costs should be, Helm argues. All its activities could be, in theory, put out to tender, inviting other companies to bid for the operations, maintenance and enhancements. Helm’s suggestion could be applied to water companies – if a new reservoir is needed, open it out to competition – and to expanding Heathrow, where ministers opted for the more expensive proposal because it was frightened the incumbent would sabotage a competitive solution.

Who is blocking reform to end the systematic over-charging of customers and the abusive gaming the existing system gives rise to? The Treasury fears that if investors expect market returns, rather than the above-market returns they’ve become used to, foreign investment will dry up. National Grid CEO John Pettigrew shamelessly plays on these fears, claiming that foreign investors are going to shun the UK because of regulatory risk. You’d never know from Mr. Pettigrew’s protests that thanks to weak regulation, where National Grid earns a whopping 56 per cent higher return in the UK than it does on regulated activities in the US (12.5 per cent vs. 8 per cent).

Re-orienting regulation on the principles of competition and contestability hardly amounts to the expropriation that Railtrack’s shareholders experienced – an act the then Rail Regulator says was unlawful. Neither does the Treasury seem aware that over the last four years, the Big Six energy companies have lost £2.9bn generating the electricity needed to keep the lights on from their coal and gas-fired power stations, thanks to increasingly hostile environmental regulation and massive subsidies to wind and solar.

Underlying this is a crippling mindset. According to the Governor of the Bank of England, Mark Carney, the UK subsists on “the kindness of strangers”. This is as demeaning as it is untrue. It explains why the government is making such a mess of Brexit. Investors put their money in Britain because Britain is a great place to invest. If the government wishes to avoid the impression that its principal characteristic is weakness – political, intellectual and moral – it will act to end the burning injustice of systematically over-rewarding investors at the expense of people whose interests the Prime Minister says are paramount.

Rupert Darwall is the author of Green Tyranny: Exposing the totalitarian roots of the Climate Industrial Complex