Gas: Regulatory Responses to Social Need
23 November 1999
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Energy and Environment
1 December 1999
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4 November 2024
Below is the draft of a lecture given on Tuesday 23rd November 1999 as part of the IEA's Regulation Lecture series organised by the late Michael Beesley of the London Business School. This is reproduced with the kind permission of Catherine Waddams Price.
Regulation Lectures
Gas: Regulatory Response to Social Needs
Tuesday 23rd November 1999
Speaker: Professor Catherine Waddams Price, University of Warwick
Chair: Mr Callum McCarthy, OFFER/OFGAS
The 1999 Regulation Lecture Series has now been published.
See Regulating Utilities: New Issues, New Solutions
Below is the draft of a lecture given on Tuesday 23rd November 1999 as part of the IEA’s Regulation Lecture series organised by the late Michael Beesley of the London Business School. This is reproduced with the kind permission of Catherine Waddams Price.
TABLE OF CONTENTS
PRELIMINARIES
1. INTRODUCTION
2. REGULATING FOR EFFICIENCY
3. CROSS-SUBSIDIES AND RELATIVE PRICES
4. REGULATORY RESPONSE
5. INITIATIVES FROM GOVERNMENT AND INTERPRETATION IN OTHER UTILITIES
6. CURRENT PROPOSALS
ENDNOTES
REFERENCES
Preliminaries
The role of social needs in economic regulation of the utilities has changed significantly over the last decade. The original model of privatisation and regulation focused on efficiency rather than equity or distributional issues, but this model has been challenged by public perceptions of the utilities as services necessary for life, and the interaction has been reinterpreted by the current government. This paper follows the development of regulatory response to social needs with special reference to gas, particularly in the light of developing competition, and focuses on the debates surrounding prepayment consumers. It ends with an assessment of current proposals and the interaction between efficiency and equity.
Please do not quote without the author’s permission.
I am very grateful to Sue Cox of Ofwat for a comparison of the 1999 water and energy regulatory mechanisms and to Diane Sharratt and Alison Young of the Centre for Management under Regulation, and to Patrick Law of Centrica, for helpful comments on an earlier draft of this paper; none is responsible for the content and interpretation of the paper.
1. Introduction
The framework established for regulating privatised industries assumed that they would behave just like any other companies. Monopoly power was constrained by general price caps and regulators were given general responsibilities for some specific groups, but not for low income households. The fundamental model was of a textbook profit maximising company, supplying a commodity just like any other, responding to market forces where these existed and constrained by regulation where they did not. There was little recognition or debate about social needs which the nationalised corporations had implicitly undertaken, for example through their policies on disconnection for bad debt, or cross-subsidies incorporated in their price structure. Many managers within the nationalised industries had felt themselves to be in ‘special’ industries, with different responsibilities from those in the private sector (Mulholland, 1998). The privatisation process did little to acknowledge these differences, and critics often saw them as excuses for slack and inefficient procedures. Flanders and Swan even wrote a song about inefficient working practices, with the Gas Man as the eponymous ‘hero’. Privatisation was to streamline and commercialise the industries.
During the nineties, the policy’s success was reflected in growing public concern about the behaviour of the privatised utilities and their responsibilities for broader social welfare, exacerbated by rising prices and share values in the water industry. In the public perception, at least, these industries were not like any other private company, supplying a commodity which consumers could choose to buy or not as they wished; but as monopolies, supplying services regarded as essential to live in a civilised society, they were expected to take a broader responsibility for social welfare, and particularly for ‘vulnerable’ households. In particular, there was concern over changes which were perceived to simultaneously increase the profits of the companies and disadvantage low income or vulnerable households. In gas, the introduction of competition exposed many of the cross-subsidies which had been operating, and was the catalyst for closer inspection of the relationship between regulation and ‘vulnerable’ households. These developments have confronted the original model, and opened new challenges to the industries and their regulators. The next section elaborates the initial regulatory vision and framework; section 3 identifies the issue of cross-subsidies, and section 4 describes the gas regulator’s response. Section 5 outlines the current government framework and its interpretation in other utilities; and the final section assesses the current proposals in gas and electricity.
2. Regulating for Efficiency
To say that the nationalised industries did not enjoy a good reputation for efficiency when they were privatised would be an understatement, and it was no surprise that the Conservative government placed much of the emphasis of the privatisation and regulatory reform on improving efficiency, with very little attention paid to equity and the distribution of any benefits which the system would generate. Such a model is consistent with traditional economic approaches of separating analysis of efficiency and distribution, i.e. the size of the cake and how it is divided. Indeed in many ways the original UK regulation system could be regarded as an economist’s dream. The statutory duties of regulators were primarily to ensure adequate financing for the industries’ regulated activities, with secondary duties to protect consumers, either through the introduction of competition, or price controls, or both. The original Gas Act (1986) specified that the regulator should have regard to the needs of those of pensionable age and the disabled, and the Gas Act (1995) added the chronically sick to the list. Electricity and water regulators were also to have special regard to the needs of consumers living in rural areas. There was no guidance about the nature of ‘regard’ for such groups, which has not so far included those on low incomes.
All the regulators (or the industries) inherited from their nationalised predecessors a duty not to show undue discrimination or preference between any consumers or groups of consumers. Again there was no guidance, and very little precedent, on interpreting this requirement. The debate centred on how to regulate the companies efficiently, rather than the distributional effects of such regulation. The role of consumer representation itself was somewhat confused. Gas was unique in having a separately established Gas Consumers Council, independent of the regulator, rather than sharing its staff as in other industries. This separation proved to be influential in the development of a broader agenda for the role of social needs in gas regulation.
The regulation model, which was applied to all the utilities (and the British Airports Authority), provided high powered incentives to the companies to increase both productive and allocative efficiency. The price cap system, originally designed by Stephen Littlechild (1983) for British Telecommunications, placed a maximum limit on the average price which could be charged for a basket of services where the company still held monopoly power. Unlike the cost of service regulation based on allowed rate of return which had been applied in the US for many years, this gave the company incentives to produce as efficiently as possible to lower its costs, since it could keep any realised savings, at least in the short-term. In this way the system encouraged productive efficiency. At the same time the regulator could design the basket and set the allowed price cap at a level which would ensure that consumer prices reflected these costs in the best possible way, so ensuring allocative efficiency (Bradley and Price, 1988). Compared with the US system this strong incentive scheme required much less information for the regulator, and was therefore cheaper to operate. The anticipated nature of the regulatory burden is illustrated by the initial appointment of a part-time regulator for gas, with an established staff of less than twenty (which did not include an economist). The mechanism seemed at a stroke to establish incentives for the previously ‘sluggish’ nationalised industries to become more efficient, and to provide clear protection for consumers against monopoly exploitation through direct control of price levels.
Discussion of distributional issues was largely restricted to the level of the cap, which would determine what proportion of any cost savings made by the company would be passed onto consumers as a whole in the form of lower average prices. Initial price caps were set as part of the privatisation deal, and tended (at least with the benefit of hindsight) to be rather lax, unsurprising since the government still owned the companies and had an interest in the flotation proceeds. However the need to reset the limits considerably weakened the incentive properties of the price cap system, since realised cost reductions would be passed onto consumers by tightening the cap at the next review. For the capital intensive operations typical of the network sectors which would need long-term regulation, it was difficult to identify any sensible determinant of revenue other than return on capital, and this raised all the difficulties familiar from the US system. The incentives therefore proved to be effective within the price cap period, but only for a myopic company which did not foresee the roles which lower costs or an inflated capital base might play in determining the next cap. However the incentive is strengthened by the comparatively high discount rate of the private sector compared with the public sector. Companies will be keen to lower costs within the price cap period to secure immediate gains, even though eventually these will be passed onto consumers in the form of tighter price controls when the cap is reviewed; meanwhile regulators and consumers should be relatively patient in waiting for their share of these benefits in the form of lower prices.
Efficiency gains were evident around the time of privatisation in many companies, some undoubtedly motivated by the change in ownership. Managers were liberated both from borrowing restrictions and from government oversight, and found such freedom a heady mixture, anticipating that the newly privatised utilities could behave just like other private companies, so long as they complied with regulatory financial requirements. Changes in labour legislation made it much easier to shed jobs (Foreman-Peck and Millward, 1994), and labour productivity soared through voluntary redundancy and revised working practices. Some of these cost reductions were passed on to consumers, and real prices fell in all the utility industries except water, where demands for higher quality drove prices up (for a review of these changes and their distribution see Markou and Waddams Price, 1999). But in gas the increased disconnections for non-payment of bills immediately after privatisation raised concerns about the distribution of gains from the reform, and highlighted fundamental issues about the nature of the utility industries. After regulatory intervention the gas industry reduced the number of disconnections, but increased installation of prepayment meters as a means of controlling debt and enforcing repayment. These prepayment meters became central to later debates about social concerns in the industry.
The first questions were raised about distribution between two large groups: shareholders and consumers (Young, 1998). The original share sale mechanism had led to large gains for shareholders1 , and the incentives given to senior managers in the form of share options yielded especially dramatic gains for some executives. Some of the increased pay reflected the move of companies from the public to the private sector, where rewards to senior staff have traditionally been greater to reflect higher risks. But how far were these industries high risk in the traditional private sense? They were virtually guaranteed a return on capital employed, and their shares bear similarities to government bonds. British Gas came in for particular public criticism over the rewards to its chief executive, Cedric Brown, in 1994, with the visit of Cedric the pig to the shareholders’ annual general meeting. Trade unions were also concerned about the loss of jobs, particularly at a time of high unemployment. Even though there were few compulsory redundancies, many of those who left the industries took early retirement, and so made little direct contribution to the economy. It seems likely that the financial gains for the companies from their saved salaries overestimated the saved resources to the economy, at least in the short term. Many of the continuing jobs were ‘contracted out’, with previous employees being moved to a more casual arrangement, so the productivity gains were partially at the expense of employee welfare.
The incentives to reduce costs provided by price cap regulation and the new private sector freedom were regarded as “too powerful” in one respect, because they led to degradation in the quality of service provided. This became apparent soon after the flotation of the first utility, British Telecom (BT), in 1984. BT allowed the provision of public call boxes to deteriorate, and the regulator intervened to protect consumer interests, just as the gas regulator later acted against increased disconnection.
3. Cross-subsidies and relative prices
While there was some debate about the division of benefits between large groups of stakeholders, including the consumer population, there was little initial change in relative prices between consumers in markets like domestic gas where monopoly was still established, despite the potentially higher profits which such rebalancing could yield. This opportunity arose from the inherited pattern of prices, which contained considerable cross-subsidy, despite a non discrimination requirement similar to that inherited from their nationalised predecessors. Although rarely challenged, such cross subsidy would probably have been justified on the basis of a ‘universal service ethos’, indicating that these services should be made available to all consumers at a similar price, even if the costs of supply differed. But part of the privatisation process was the freeing of managers from such responsibilities, and disconnection of gas supplies for non payment was one example of more commercial behaviour.
Cross-subsidy in the residential gas market was typical. Apart from a small surcharge for prepayment meters, uniform prices were levied across England, Wales and Scotland, despite considerable variations in the costs of supplying different customers. In particular, the lower costs for the company of payment by direct debit and the higher costs of prepayment meter use were not fully reflected in the tariffs. Prepayment is more expensive for companies to operate for two reasons: the meters themselves are more costly to provide and maintain, especially the ‘quantum’ meters used in gas; and prepayment users typically charge their cards by making frequent small payments, which are more expensive to handle than regular monthly bank debits. Many prepayment meter users have a history of gas debt (indeed at times incurring debt has been the only means of acquiring a prepayment meter), and so most prepayment consumers have incurred debt recovery costs in their previous payment method, although this is not strictly speaking a cost of using the meters themselves. Nevertheless both the capital and recurrent costs associated with prepayment meters have been issues for regulation, although the instruments available to the regulator are rather different in each case.
Transco, the pipeline operator, retains an effective monopoly of the network system, enabling it to continue cross-subsidising. Traditionally, Transco has charged the same price for delivery of gas to rural and urban areas, despite differences in cost, and for the provision of credit and prepayment meters, even though we have seen that the latter are more expensive. Within a monopoly structure such cross-subsidy is sustainable, though it is rarely efficient. However it clearly has distributional effects: urban users subsidise rural consumers, credit consumers subsidise prepayers. Given the pervasiveness of such cross-subsidies in the utilities, the political economy of unwinding them is, in practice, rather different from the deliberate introduction of new redistributive subsidies.
Failure to rebalance prices in other monopoly parts of the utilities may have been because the companies had insufficient information about relative costs to identify appropriate changes; or, more cynically, it may have been a deliberate policy to maintain monopoly status, because that would be the only way to maintain the cross-subsidies inherited from the nationalised industry. Such a political motive is consistent with the behaviour of British Gas when it knew that its residential markets would be opened to competition. Unlike telecoms and electricity, where a competition timetable was planned from the date of privatisation, British Gas was privatised with a statutory monopoly in the residential market, which could only be removed by primary legislation. It was not certain that the necessary legislation would be tabled until the Queen’s speech in November 1994; the next day British Gas announced the introduction of discounts for households settling their bills by direct debit. Since the average of prices charged to the residential sector was subject to a price cap, such discounts would enable higher charges for other consumers, particularly those using prepayment meters. The timing of British Gas’s announcement was clearly political, but the changes were inevitable in a competitive market. If the incumbent company had maintained a uniform price structure with different costs of supply, the (low cost) markets with the highest mark-ups were vulnerable to ‘cherry-picking’ by entrants. Unlike monopoly parts of the industry, British Gas was unable to maintain the cross-subsidies even if it wished to do so, because the profitable consumers who provided the subsidy would be seduced away by other suppliers.
The rebalancing caused concern because of the socio-economic characteristics of those using different payment methods. Direct debit was more commonly used by the better off, and a disproportionate number of low income households used prepayment meters (see table 1), while the cheapest method of payment, direct debit, was unavailable, or too expensive for many who most needed lower price energy2 . The issue was therefore a broad one of social exclusion, of which the utilities were a comparatively small part. However simultaneous changes across the utilities meant that effects were to some extent cumulative (Waddams Price and Hancock, 1998). Moreover potential competition was as powerful as realised entry in unwinding cross-subsidies. From the date of privatisation the telecoms line rental had been raised within the price cap by the maximum amount permitted by its separate constraint, adversely affecting those who used the telephone little, especially pensioner households. Direct debit discounts were introduced gradually into the electricity industry from the time of privatisation until and after competition was introduced in 1998, with similar effects as in gas. While regulators did have some unspecified responsibilities for protecting the interests of those of pensionable age, we have seen that they had no remit to protect the poor, and such concerns were clearly outside the intentions of the original privatisation acts which had established the regulatory offices and defined their duties.
Protection of certain groups posed a direct conflict with one of the regulator’s duties: to encourage competition, and with another of her objectives: to encourage cost reflective pricing, raising questions of how to achieve an appropriate balance. The most obvious route was to provide adequate safeguards directly to target households, but acting through the social security system may distort other markets, and both Conservative and Labour administrations have been loathe to use such tools because of their reluctance to raise direct taxes. Cross-subsidies could be imposed via the monopoly networks as a second best tool. Direct constraints could be placed on operators in competitive markets, but this would distort the development of competition, and might harm in the long-term the very groups for whom short-term protection is sought. A consumer survey undertaken at the end of 1997 showed a clear preference for supporting low income consumers via the tax and benefits system, as well as a marked difference between utilities in the perceived merit of providing subsidies (table 2). It is against this background of consumer opinion in favour of direct methods of support, and government reluctance to implement them, that successive gas regulators have had to exercise judgement on social needs.
4. Regulatory response
The focus on cost reflective pricing and the higher costs of providing and maintaining prepayment meters led the owner of the pipes and meters, Transco, to suggest a higher charge for suppliers using prepayment meters. Transco was concerned at the increase in installation of prepayment meters following privatisation and the reaction against the increasing disconnection rates, and feared that the advent of competition in gas retailing would lead to further increases in demand by entrants who had little experience in utility debt management. Given that the costs of such meters were higher, and Transco was revenue capped, it was in their interests to reflect the higher costs in charges to shippers to discourage use. This is an example of the efficiency effects of the price cap regulation system, in encouraging cost reflective pricing. These higher charges would not necessarily be passed onto prepayment end consumers, but in a competitive market that would be the likely outcome. Moreover there might be some scepticism if the regulator allowed the increases, since raising costs for all the competitors downstream increases industry profitability.
The regulator was faced with a dilemma: the current quantum technology was certainly more expensive for Transco to provide and operate than a regular credit meter, but allowing higher charges would be vociferously challenged by consumer groups who were concerned about its effect on low income households. However the continuation of equal charging for all forms of meters clearly constituted cross-subsidy of prepayment meters by other gas users. Although the regulator steadfastly declined to play an active role in encouraging cross-subsidies to particular social groups, it was quite a different matter to condone the removal of historical cross-subsidies where this was not enforced by the competitive market.
In the event, Transco did not differentiate its charges for prepayment and credit meters until October 1998, when it was allowed to introduce a surcharge of £10 for each prepayment meter. This was less than the £20 it then requested, and a request to raise the charge to £30 in October 1999 was refused. The regulator contested Transco’s cost allocations, maintaining that these meters should be depreciated over twenty years as was standard Transco practice, and that maintenance costs should reflect efficient forward looking costs, which are considerably lower than the quantum technology currently employed. These two arguments seem somewhat inconsistent, since transferring to a new technology would mean retiring the existing meters early.
While Transco’s relative prices are a question of cost reflective pricing, a much more acute issue arose from the presence of cross-subsidy in the residential market as it was to be opened to competition, where the effect on low income households was of particular public concern. It was in this context that the independent Gas Consumers Council (GCC) referred the new structure of residential gas prices to the gas regulator in early 1995, alleging undue discrimination against consumers who did not enjoy the new discounts and undue preference towards those who did. The referrals triggered two reports, and an eventual restructuring both of the regulation price cap and of British Gas tariffs.
The referral was made on the basis of undue discrimination, a requirement common to the privatised industries. One reason why it was tested in gas rather than in other industries was the existence of an independent consumer council; in other industries such issues would more likely be mediated internally within the regulatory office, where consumer representatives and the regulator shared resources. Testing this issue in gas arose from the particular political economy and institutional setting of regulation and consumer representation, suggesting that current proposals for more independent consumer councils throughout the privatised industries will give rise to more such references in the future.
The requirement not to discriminate unduly had not been tested robustly in a court room – the closest legal precedent referred to local government and dated from 1912. The gas regulator therefore had to find her own interpretation, and determined that non discriminatory prices should be related to the costs of supplying different markets. The gas regulator had to determine first, the relation of prices to costs, and then whether the mark-ups were unduly discriminatory. In his excellent review of the issue of undue discrimination in these lectures two years ago, John Vickers pointed out that from an economic perspective basing prices only on costs is not necessarily the most efficient outcome (Vickers, 1998). In particular, where a company has market power and cannot cover its costs by putting all prices equal to marginal costs, economic efficiency may be maximised by charging prices which incur higher mark-ups over marginal costs in markets where demand is less responsive to price. This is clearly discriminatory, since demand conditions as well as cost levels determine the relative prices. However in the case of the GCC referrals there was an implicit issue of the distributive effect of British Gas’s discounts. The potential conflict between non-discrimination and economic efficiency was exacerbated by concerns about social impact. The opening of the market put pressure on the incumbent to reflect the different costs of supply more closely in price structures, but this meant relative increases for consumers who could or would not take advantage of direct debit payment, and particular concern for prepayment consumers. In any event the GCC referral led the gas regulator deep into questions of cost and price structure which were far removed from the original ‘arms length’ regulation vision.
The regulator produced two reports in direct response to the GCC’s referrals (Ofgas 1995, 1996), under the 1986 Gas Act, but the issues were further resolved in a report on the structure of domestic gas tariffs published two years later (Ofgas, 1998). Although the final report followed a change of government and the publication of a green paper on utility regulation (discussed in the next section), the conclusions were broadly consistent with the regulator’s earlier rulings.
The company maintained that direct debit consumers were cheaper and prepayment more expensive to supply, and provided accounting cost data to support their case. The regulator ruled that undue discrimination was not present if all classes of consumers met their attributable costs , and none bore an undue burden of joint costs3. A ‘due’ burden seemed to be interpreted as one proportional to the attributable costs for that group. So prices should, by implication, be proportional to attributable costs. This naturally focused attention on the process and outcome of cost attribution. The regulator consistently argued for lower prepayment and higher direct debit costs than the company in an attempt to reduce the prices charged for prepayment meters. Eventually the regulator argued for a single tariff for prepayment and some (slow) credit payers, while allowing discounts for prompt credit payers. This clearly benefits prepayment meter users in the short-term, by capping their prices at a lower level.
Moreover, as competition developed, the cap on average prices had been replaced in 1997 by individual caps on each element of each tariff, i.e. all standing charges and running rates. This prevented British Gas from responding to competitive pressure in one part of the market by lowering prices to those consumers, and recouping lost revenue by increasing prices to others, who were not so eagerly sought by competitors, within an overall average. These individual caps made any rebalancing between tariffs much less likely, so preserving the inherited price structure.
However new entrants seem to agree with the incumbent that the margins for prepayment meter consumers are much lower, since they are offering very little, if any, discount against the incumbent price compared with other markets (Otero and Waddams Price, 1999a)4. The regulator has provided short term protection, presumably on grounds of social needs, but at the cost of discouraging active market entry for these consumers. The issues addressed by the gas regulator clearly raised a number of problems which were of wider concern, in particular where the responsibility for resolving questions of social need should properly lie. The next section takes a broader view of regulating for social needs, both in the energy and other regulated utilities, and the implications of current proposals in the gas and electricity markets are explored in the final section.
5. Initiatives from government and interpretation in other utilities
The present government launched a major review of Utility Regulation within three months of taking office. The Green Paper (DTI, 1998a) confirmed the incoming Labour government’s general support for the model of regulation which it had inherited, but shifted the emphasis considerably towards distributional issues. The government proposed changing the primary statutory duty of regulators to one of consumer protection5 in recognition of the special nature of these industries. The title itself, ‘A Fair Deal for Consumers’ confirmed this new emphasis, and considerable attention was paid to just those issues which had concerned the gas regulator; in particular, the conflict between increasing competition in energy and the impact on prepayment meter users. The Green Paper declared as the government’s objective that “the economic benefits of liberalisation are spread fairly amongst everyone, including the most vulnerable consumers” (DTI, 1998, p. 35). Where regulatory action with financial effects on companies or consumer groups was required on grounds of social (or environmental) need, the government undertook to provide specific guidance or legislation. In the meantime the annual DTI energy review included a comprehensive annexe on fuel poverty, reviewing and bringing together recent work in the area (Hutton, 1998).
It seems that the current parliamentary session will include a Utilities Bill, required to deal with various technical anomalies which have arisen, and this will provide an opportunity for the government to legislate on more general issues of social need. The DTI has recently published details of its legislative proposal (DTI, 1999a) and draft impact assessments of the conclusions of the Utilities Review (DTI, 1999b). The legislative proposals reiterate the intention to issue statutory guidance to regulators after full consultation and with parliamentary approval, and to “implement social and environmental measuresÂ…with significant financial implicationsÂ… by means of new specific legal provision” (DTI 1999a, p.20). If the Bill extends the regulators’ responsibilities to include the needs of low income households this will shift the regulator’s role decisively towards distributional issues and away from efficiency focused control.
Draft guidance has already been issued in the water industry, where response to social needs has been influenced by the provision in the 1999 Water Act that no domestic consumer may have their supply disconnected for reasons of non-payment. The government provided advice to the companies on more flexible payment options for ‘less well-off households’, and draft guidance to the regulator on approval of tariffs. In October specific regulations were issued to protect low income families with three or more children, and those with certain medical conditions, from high charges if their water is metered. The Department of Environment Transport and the Regions (1999) estimates that these measures may add about £1 to the average domestic water bill. However while the regulator welcomes specific regulations, he is reluctant to allow companies revenue in consideration of social tariffs beyond these requirements (Ofwat, 1999). This highlights the question of how much discretion the regulator should retain in addressing social needs, and how far this should solely be at the direction of government. The water regulator seems to be taking a somewhat narrower view than the current energy regulator, an area of comparison explored further in the next section.
Social needs pose a slightly different issue in telecommunications. The telecoms regulator has recently launched a review of universal service (Oftel, 1999); the consultation paper recognises both the importance of telephony for social inclusion, and that the market may require intervention to ensure that all groups, including those on low incomes, have access to ‘affordable telephony’. The last review imposed some obligations (such as a requirement to supply, geographically averaged prices, maintenance of public call boxes and provision of a low user tariff) on the incumbent, and required that it meet the cost of this package without no additional revenue.
There have been fewer developments on social needs in electricity regulation than in gas, but the merging of the regulatory offices for the two industries had brought convergence of policy across the industries. The next section deals with these more recent developments, and the prospects for future regulation for social needs in energy in the light of current proposals from both the government and the regulator.
6. Current proposals
We have seen that the government has reaffirmed its intention to expand utility regulation to include distributional as well as efficiency concerns, but is not yet very explicit about the mechanism. The water regulator, Ian Byatt, is reluctant to permit social tariffs without clearer guidance from government. The legislative proposals suggest that such explicit directives will be forthcoming, and some have already been proposed by the DETR for water, but the government also appears to expect regulators to exercise some discretion in this area. The original model of economic regulation, reaffirmed by this government, is not particularly well suited to delivering social objectives, and regulators differ in their response to the general exhortation to consider distributional concerns. While the water regulator is reluctant to allow companies additional revenue beyond what the government directs, the telecoms regulator is preparing to reassess the extent and provision of universal service. It is in this context that the two most recent gas regulators have developed a Social Action Plan over the last eighteen months.
The original government call for development of a social action plan by the (then separate) gas and electricity regulators was contained in the 1998 Green Paper; but the regulators were given very little time for its preparation, and the document was inevitably somewhat superficial (Ofgas and Offer, 1998). However Callum McCarthy has developed this policy much more proactively since he took over as Director General for both industries – a fact no doubt reflected in the subject of the lecture here tonight. Three major documents have been published in the last six months. A Social Action Plan Discussion document in May and framework document in October (Offer and Ofgas, 1998 and Ofgem, 1999(a)); and a document on prepayment meters (Ofgem, 1999b) in October; more consultation documents are promised. These reflect considerable development of the regulator’s own policies towards social needs. The consultation paper and framework clearly anticipate more proactive guidance from the government, and accept that there should indeed be a ‘social’ aspect to energy regulation. Potential conflicts between social needs and development of competition, and the undesirability of the plan distorting competition are acknowledged, but not fully resolved.
Perhaps the clearest guidelines are contained in the framework for action and the consultation on prepayment meters, both published in October 1999, where proposals are made to amend supplier obligations, make some structural changes to regulation and initiate a programme of research activity. Some of this framework co-ordinates the work and monitoring of the gas and electricity industries, but some new requirements are introduced. The regulator clearly sees the rising numbers of prepayment customers as problematic, and expresses firm support for transferring prepayment consumers to credit tariffs wherever possible, while stating that he ‘has no wish to prevent customers from using prepayment meters’. However he seems to favour an end to the recent increase in such payment methods, and states that ‘suppliers should not impose a prepayment meter Â… in circumstances where an alternative payment method would be better’ (p. 21). The problem is to identify for whom it would be better, another potential conflict of interest.
Ofgem’s priorities can be classified as falling under a number of headings. The main one is to lower barriers to consumers in choosing between alternative payment methods and suppliers, through improving consumer information, ensuring broader options and reconsidering the current barriers to switching for those in debt6. Suppliers are expected to develop and offer a broader range of payment methods, enter ‘effective’ dialogues with consumers in debt, develop innovative schemes to improve energy efficiency, and undertake a range of research activities. Offering a range of payment methods might facilitate product or consumer differentiation in the market, and it is not clear that this would necessarily be optimal. There are also calls for increased transparency to help consumers in changing suppliers. Here there is some tension between helping consumers to make better informed choices and the danger of encouraging tacit collusion among suppliers. Such a possibility makes even more crucial an impartial monitoring of the competitive process, including the pattern and sequencing of price changes within the industry to detect any collusive activity.
Probably the most significant requirement is the apparently innocuous request for supply companies to report on their social programmes. Even without specifying exactly how it will use the information, collecting such data will affect behaviour. In monitoring the information, the regulator is highlighting its significance, and implying that reward or punishment may follow. These steps are likely to increase the cost of supplying ‘disadvantaged’ customers, and so might prejudice development of competition for this group. However the reporting requirements both ensure that these costs are reasonably evenly spread across suppliers, and offer them the hope of some regulatory reward for serving low income households. The response of the Electricity Association and the gas industry in setting up a fuel poverty task force to address these issues and fund independent research suggests that this is exactly how the messages are being read within the industries themselves. Such co-operation, together with calls for increased transparency, may run a risk of collusion in the longer term, and behaviour in the market will need to be carefully monitored to detect and deter any moves in this direction. Naturally I would not wish to discourage the regulator’s call for industry funding of major impartial academic research into these areas; but further work may be required in monitoring future market behaviour also.
The prepayment document distinguishes the capital and revenue costs of prepayment provision. The cap on surcharges which electricity distribution companies may levy for prepayment meters recalls debates about Transco surcharges. Here in the network companies, at least, cross-subsidies can be maintained without distorting competition, albeit at the expense of some misallocation of resources. This will, ironically, encourage over provision of prepayment meters at a time when the regulator would prefer to see their numbers decline.
The regulator has also signalled concern about the level of standing charges. Because energy use increases with income in absolute terms (but not proportionately), high standing charges may disadvantage low income consumers. This is a similar concern to that for low users of telephony. However, like prepayment meters, low use is an imperfect surrogate for low income, and high use may correlate with some forms of disadvantage, e.g. unemployment, disability and chronic sickness (see for example Sharratt, 1999). A study of earlier standing charge rebate systems, forced on the nationalised gas and electricity industries in the early eighties, concluded that it was ‘both mean and wasteful’ (Gibson and Price, 1986). As table 3 shows, it failed to reach many of those in need, and helped many who were not (e.g. owners of second homes). Future proposals to use tariff structure as a redistributive tool are likely to run into similar difficulties, exacerbated by the pressures of the competitive market.
The energy regulator’s Social Action Plan makes an interesting comparison with codes of practice which have developed in the water industry. Where there are differences these reflect both variations in exposure to competition, and the particular characteristics of and public attitude to the industries. For example, budget payment units, the equivalent of prepayment meters, and all disconnections for non payment have been made illegal in water. Water companies are required to provide frequent payment options free of charge, while in energy discounts are offered for payment methods which are cheaper for companies to operate. Most water companies do not differentiate charges according to payment method, so they are continuing cross-subsidies between consumer groups. Customer service levels, including those for disadvantaged customers, are already part of Ofwat’s comparative statistics. In many ways Ofgem’s Social Action plan is proposing measures already operating applied in water. Some of these are more complex to introduce in markets open to competition, but there is clearly a degree of convergence on practical measures. Perhaps it is the lack of competition in his industry which makes the water regulator reluctant to approve further social tariffs unless he is so directed by the government. The gas regulator is inhibited from such action by the constraints of the market itself.
Such convergence in areas of social concern is perhaps surprising at a time when the regulators have recently identified a number of areas where co-operation would be desirable; these do not include social needs – the very area where cross industry co-operation and consistency might seem most desirable. Perhaps this is to avoid exposing different views on how far such regulatory action should be discretionary, and how far enforced by central government. But it is clearly an area where ‘joined up regulation’ would seem particularly appropriate, and where inconsistencies might have some very perverse implications for disadvantaged households. The whole issue of Fuel Poverty, the inability to afford adequate warmth, is a complex interaction of income, housing conditions and conditions of fuel supply (including price). If the government is serious about its eradication the agencies concerned need to work closely together.
Gas regulation has moved a long way from the original efficiency based model – the economists’ dream. Government policy has reflected public opinion that these are not ordinary private companies supplying commodities just like any other. The current regulator has accepted, indeed embraced, the need to address social needs as part of the regulatory process. This raises issues of how far markets can be used to deliver social objectives; and questions of unintended consequences both for the households concerned, and in encouraging co-operation between supplying companies which may not always be in consumers’ interests. These developments have certainly multiplied the cost of the regulatory office by many times that of a part-time Director General and eighteen staff. Whether the inclusion of social needs has turned regulation from an economist’s dream into a regulator’s nightmare, perhaps the chairman is best placed to say.
Endnotes
1 Shares were sold at what seem, in retrospect, to be rather low prices for two reasons. First, the government was keen to encourage individuals who had not traditionally held shares to purchase utility issues, perhaps in part to create a ‘share-owning democracy’ where large numbers of voters would have an interest in preventing the return of the Labour party which remained committed to renationalisation until the mid nineties. Secondly, the extent of inefficiencies within the nationalised industries was not realised until after they were privatised and improved their productivity – one vindication for their incentive regulation scheme.
2 The problem for low income households may not be lack of access to a current bank account and direct debit payments, but the high costs levied by banks if a direct debit payment results in the account becoming overdrawn (Doble, 1998). Households on very tight budgets are more likely to risk such an event, and to avoid direct debit mandates as a result.
3 Attributable costs are not the same as marginal costs, but may be a reasonable surrogate for ‘incremental’ costs in the sense used by Faulhaber (1975).
4 A similar pattern is evident in electricity (Otero and Waddams Price 1999b).
5 Changing the primary duty to one of consumer protection is unlikely to be very significant in itself, since medium term consumer interests will only be served if the regulator allows adequate financing to the companies to continue supplying the service.
6 At present suppliers of consumers with debt can object to their transfer to another supplier.
References
Armstrong, Mark and John Vickers, 1993, Price discrimination, competition and regulation, Journal of Industrial Economics 41: 335-59
Bradley, Ian and Catherine Price, 1988, The economic regulation of private industries by price constraints, Journal of Industrial Economics 37: 99-106
Department of the Environment, Transport and the Regions, 1999, Water Industry Act, 1999, Consultation on Regulations, October
Department of Trade and Industry, 1998a, A Fair Deal for Consumers, March
Department of Trade and Industry, 1999a, A Fair Deal for Consumers, the Future of
Department of Trade and Industry, 1999b, A Fair Deal for Consumers, Regulatory, Environmental and Equal Treatment Appraisals, October
Department of Trade and Industry, 1999c, Gas and Electricity Regulation, The Government’s proposals for legislation, October
Doble, Michael, Eleni Markou and Catherine Waddams Price, 1998, Utility Regulation: Fairness for All? Responses to the Government’s Green Paper, Centre for Management under Regulation Research paper 98/2, University of Warwick
Doble, Michael, 1998, Low Income Consumers in the Competitive Gas Market: why don’t prepayment users switch to cheaper methods?, Centre for Management under Regulation Research paper 98/4, University of Warwick
Faulhaber, Gerry, 1975, Cross-subsidization: Pricing in public enterprises, American Economic Review, 65: 966-77
Foreman-Peck, James and Robert Millward, 1994, Public and Private Ownership of British Industry, Clarendon Press, Oxford
Gas Act, 1986 Gas Act, 1995
Gibson, Michael and Price, Catherine, 1986, Standing Charge Rebates, (with Michael Gibson) Energy Policy, pp 262-271
Hutton, Sandra, 1998, in Department of Trade and Industry (ed) Energy Trends
Littlechild, Stephen, 1983, Regulation of British Telecommunications profitability, London: HMSO
Markou, Eleni and Catherine Waddams Price, 1999, UK utilities: past reform and current proposals, Annals of Public and Co-operative Economics, 70, 3, pp 371-416
Mulholland, Kate, 1998, ‘Survivors’ vs ‘Movers and Shakers’: The reconstitution of management and careers in the privatised utilities in Paul thompson and Chris Warhurst (eds) Workplaces of the Future, Macmillan
Offer and Ofgas, 1998, The Social Dimension: Action Plan, June
Offer and Ofgas, 1999, Social Action Plan: Discussion document, May
Ofgas, 1995, Referral by the Gas Consumers Council relating to discounts for customers paying by direct debit: The Director General’s Decision, London
Ofgas, 1996, Investigation into discounts for British Gas Supply’s tariff customers paying promptly or by direct debit: The Director General’s Decision, London
Ofgas, 1998, Review of British Gas Trading’s domestic supply tariffs: a decision document, London Ofgem, 1999(a), Social action plan Framework document, October
Ofgem, 1999(b), Prepayment meters: a consultation document, October
Ofwat, 1999, MD152, letter to all managing directors of water and sewerage companies and water only companies, 13th September
Sharratt, Diane, 1999 (forthcoming), Fuel Direct – Help or Hindrance? Users’ experiences, Centre for Management under Regulation Research paper 99/5, University of Warwick
Vickers, John, 1998, When is discrimination undue?, in Beesley (ed): Regulating Utilities: Understanding the Issues, Institute for Economic Affairs
Waddams Price, Catherine and Andreas Biermann, 1998, Fuel Poverty in Britain: Expenditure on Fuels 1993-94 to 1995-96, Gas Consumers Council
Waddams Price, Catherine and Ruth Hancock, 1998, Distributional Effects of Liberalising UK Residential Utility Markets, Fiscal Studies, 1998, 19, 3 pp 295-320
Young, Alison, 1998, Consumer Choice? Social obligations, cross subsidies and competition in the privatised utilities, Centre for Management under Regulation Research paper 98/7, University of Warwick.
Gas: Regulatory Response to Social Needs
Tuesday 23rd November 1999
Speaker: Professor Catherine Waddams Price, University of Warwick
Chair: Mr Callum McCarthy, OFFER/OFGAS
The 1999 Regulation Lecture Series has now been published.
See Regulating Utilities: New Issues, New Solutions
Below is the draft of a lecture given on Tuesday 23rd November 1999 as part of the IEA’s Regulation Lecture series organised by the late Michael Beesley of the London Business School. This is reproduced with the kind permission of Catherine Waddams Price.
TABLE OF CONTENTS
PRELIMINARIES
1. INTRODUCTION
2. REGULATING FOR EFFICIENCY
3. CROSS-SUBSIDIES AND RELATIVE PRICES
4. REGULATORY RESPONSE
5. INITIATIVES FROM GOVERNMENT AND INTERPRETATION IN OTHER UTILITIES
6. CURRENT PROPOSALS
ENDNOTES
REFERENCES
Preliminaries
The role of social needs in economic regulation of the utilities has changed significantly over the last decade. The original model of privatisation and regulation focused on efficiency rather than equity or distributional issues, but this model has been challenged by public perceptions of the utilities as services necessary for life, and the interaction has been reinterpreted by the current government. This paper follows the development of regulatory response to social needs with special reference to gas, particularly in the light of developing competition, and focuses on the debates surrounding prepayment consumers. It ends with an assessment of current proposals and the interaction between efficiency and equity.
Please do not quote without the author’s permission.
I am very grateful to Sue Cox of Ofwat for a comparison of the 1999 water and energy regulatory mechanisms and to Diane Sharratt and Alison Young of the Centre for Management under Regulation, and to Patrick Law of Centrica, for helpful comments on an earlier draft of this paper; none is responsible for the content and interpretation of the paper.
1. Introduction
The framework established for regulating privatised industries assumed that they would behave just like any other companies. Monopoly power was constrained by general price caps and regulators were given general responsibilities for some specific groups, but not for low income households. The fundamental model was of a textbook profit maximising company, supplying a commodity just like any other, responding to market forces where these existed and constrained by regulation where they did not. There was little recognition or debate about social needs which the nationalised corporations had implicitly undertaken, for example through their policies on disconnection for bad debt, or cross-subsidies incorporated in their price structure. Many managers within the nationalised industries had felt themselves to be in ‘special’ industries, with different responsibilities from those in the private sector (Mulholland, 1998). The privatisation process did little to acknowledge these differences, and critics often saw them as excuses for slack and inefficient procedures. Flanders and Swan even wrote a song about inefficient working practices, with the Gas Man as the eponymous ‘hero’. Privatisation was to streamline and commercialise the industries.
During the nineties, the policy’s success was reflected in growing public concern about the behaviour of the privatised utilities and their responsibilities for broader social welfare, exacerbated by rising prices and share values in the water industry. In the public perception, at least, these industries were not like any other private company, supplying a commodity which consumers could choose to buy or not as they wished; but as monopolies, supplying services regarded as essential to live in a civilised society, they were expected to take a broader responsibility for social welfare, and particularly for ‘vulnerable’ households. In particular, there was concern over changes which were perceived to simultaneously increase the profits of the companies and disadvantage low income or vulnerable households. In gas, the introduction of competition exposed many of the cross-subsidies which had been operating, and was the catalyst for closer inspection of the relationship between regulation and ‘vulnerable’ households. These developments have confronted the original model, and opened new challenges to the industries and their regulators. The next section elaborates the initial regulatory vision and framework; section 3 identifies the issue of cross-subsidies, and section 4 describes the gas regulator’s response. Section 5 outlines the current government framework and its interpretation in other utilities; and the final section assesses the current proposals in gas and electricity.
2. Regulating for Efficiency
To say that the nationalised industries did not enjoy a good reputation for efficiency when they were privatised would be an understatement, and it was no surprise that the Conservative government placed much of the emphasis of the privatisation and regulatory reform on improving efficiency, with very little attention paid to equity and the distribution of any benefits which the system would generate. Such a model is consistent with traditional economic approaches of separating analysis of efficiency and distribution, i.e. the size of the cake and how it is divided. Indeed in many ways the original UK regulation system could be regarded as an economist’s dream. The statutory duties of regulators were primarily to ensure adequate financing for the industries’ regulated activities, with secondary duties to protect consumers, either through the introduction of competition, or price controls, or both. The original Gas Act (1986) specified that the regulator should have regard to the needs of those of pensionable age and the disabled, and the Gas Act (1995) added the chronically sick to the list. Electricity and water regulators were also to have special regard to the needs of consumers living in rural areas. There was no guidance about the nature of ‘regard’ for such groups, which has not so far included those on low incomes.
All the regulators (or the industries) inherited from their nationalised predecessors a duty not to show undue discrimination or preference between any consumers or groups of consumers. Again there was no guidance, and very little precedent, on interpreting this requirement. The debate centred on how to regulate the companies efficiently, rather than the distributional effects of such regulation. The role of consumer representation itself was somewhat confused. Gas was unique in having a separately established Gas Consumers Council, independent of the regulator, rather than sharing its staff as in other industries. This separation proved to be influential in the development of a broader agenda for the role of social needs in gas regulation.
The regulation model, which was applied to all the utilities (and the British Airports Authority), provided high powered incentives to the companies to increase both productive and allocative efficiency. The price cap system, originally designed by Stephen Littlechild (1983) for British Telecommunications, placed a maximum limit on the average price which could be charged for a basket of services where the company still held monopoly power. Unlike the cost of service regulation based on allowed rate of return which had been applied in the US for many years, this gave the company incentives to produce as efficiently as possible to lower its costs, since it could keep any realised savings, at least in the short-term. In this way the system encouraged productive efficiency. At the same time the regulator could design the basket and set the allowed price cap at a level which would ensure that consumer prices reflected these costs in the best possible way, so ensuring allocative efficiency (Bradley and Price, 1988). Compared with the US system this strong incentive scheme required much less information for the regulator, and was therefore cheaper to operate. The anticipated nature of the regulatory burden is illustrated by the initial appointment of a part-time regulator for gas, with an established staff of less than twenty (which did not include an economist). The mechanism seemed at a stroke to establish incentives for the previously ‘sluggish’ nationalised industries to become more efficient, and to provide clear protection for consumers against monopoly exploitation through direct control of price levels.
Discussion of distributional issues was largely restricted to the level of the cap, which would determine what proportion of any cost savings made by the company would be passed onto consumers as a whole in the form of lower average prices. Initial price caps were set as part of the privatisation deal, and tended (at least with the benefit of hindsight) to be rather lax, unsurprising since the government still owned the companies and had an interest in the flotation proceeds. However the need to reset the limits considerably weakened the incentive properties of the price cap system, since realised cost reductions would be passed onto consumers by tightening the cap at the next review. For the capital intensive operations typical of the network sectors which would need long-term regulation, it was difficult to identify any sensible determinant of revenue other than return on capital, and this raised all the difficulties familiar from the US system. The incentives therefore proved to be effective within the price cap period, but only for a myopic company which did not foresee the roles which lower costs or an inflated capital base might play in determining the next cap. However the incentive is strengthened by the comparatively high discount rate of the private sector compared with the public sector. Companies will be keen to lower costs within the price cap period to secure immediate gains, even though eventually these will be passed onto consumers in the form of tighter price controls when the cap is reviewed; meanwhile regulators and consumers should be relatively patient in waiting for their share of these benefits in the form of lower prices.
Efficiency gains were evident around the time of privatisation in many companies, some undoubtedly motivated by the change in ownership. Managers were liberated both from borrowing restrictions and from government oversight, and found such freedom a heady mixture, anticipating that the newly privatised utilities could behave just like other private companies, so long as they complied with regulatory financial requirements. Changes in labour legislation made it much easier to shed jobs (Foreman-Peck and Millward, 1994), and labour productivity soared through voluntary redundancy and revised working practices. Some of these cost reductions were passed on to consumers, and real prices fell in all the utility industries except water, where demands for higher quality drove prices up (for a review of these changes and their distribution see Markou and Waddams Price, 1999). But in gas the increased disconnections for non-payment of bills immediately after privatisation raised concerns about the distribution of gains from the reform, and highlighted fundamental issues about the nature of the utility industries. After regulatory intervention the gas industry reduced the number of disconnections, but increased installation of prepayment meters as a means of controlling debt and enforcing repayment. These prepayment meters became central to later debates about social concerns in the industry.
The first questions were raised about distribution between two large groups: shareholders and consumers (Young, 1998). The original share sale mechanism had led to large gains for shareholders1 , and the incentives given to senior managers in the form of share options yielded especially dramatic gains for some executives. Some of the increased pay reflected the move of companies from the public to the private sector, where rewards to senior staff have traditionally been greater to reflect higher risks. But how far were these industries high risk in the traditional private sense? They were virtually guaranteed a return on capital employed, and their shares bear similarities to government bonds. British Gas came in for particular public criticism over the rewards to its chief executive, Cedric Brown, in 1994, with the visit of Cedric the pig to the shareholders’ annual general meeting. Trade unions were also concerned about the loss of jobs, particularly at a time of high unemployment. Even though there were few compulsory redundancies, many of those who left the industries took early retirement, and so made little direct contribution to the economy. It seems likely that the financial gains for the companies from their saved salaries overestimated the saved resources to the economy, at least in the short term. Many of the continuing jobs were ‘contracted out’, with previous employees being moved to a more casual arrangement, so the productivity gains were partially at the expense of employee welfare.
The incentives to reduce costs provided by price cap regulation and the new private sector freedom were regarded as “too powerful” in one respect, because they led to degradation in the quality of service provided. This became apparent soon after the flotation of the first utility, British Telecom (BT), in 1984. BT allowed the provision of public call boxes to deteriorate, and the regulator intervened to protect consumer interests, just as the gas regulator later acted against increased disconnection.
3. Cross-subsidies and relative prices
While there was some debate about the division of benefits between large groups of stakeholders, including the consumer population, there was little initial change in relative prices between consumers in markets like domestic gas where monopoly was still established, despite the potentially higher profits which such rebalancing could yield. This opportunity arose from the inherited pattern of prices, which contained considerable cross-subsidy, despite a non discrimination requirement similar to that inherited from their nationalised predecessors. Although rarely challenged, such cross subsidy would probably have been justified on the basis of a ‘universal service ethos’, indicating that these services should be made available to all consumers at a similar price, even if the costs of supply differed. But part of the privatisation process was the freeing of managers from such responsibilities, and disconnection of gas supplies for non payment was one example of more commercial behaviour.
Cross-subsidy in the residential gas market was typical. Apart from a small surcharge for prepayment meters, uniform prices were levied across England, Wales and Scotland, despite considerable variations in the costs of supplying different customers. In particular, the lower costs for the company of payment by direct debit and the higher costs of prepayment meter use were not fully reflected in the tariffs. Prepayment is more expensive for companies to operate for two reasons: the meters themselves are more costly to provide and maintain, especially the ‘quantum’ meters used in gas; and prepayment users typically charge their cards by making frequent small payments, which are more expensive to handle than regular monthly bank debits. Many prepayment meter users have a history of gas debt (indeed at times incurring debt has been the only means of acquiring a prepayment meter), and so most prepayment consumers have incurred debt recovery costs in their previous payment method, although this is not strictly speaking a cost of using the meters themselves. Nevertheless both the capital and recurrent costs associated with prepayment meters have been issues for regulation, although the instruments available to the regulator are rather different in each case.
Transco, the pipeline operator, retains an effective monopoly of the network system, enabling it to continue cross-subsidising. Traditionally, Transco has charged the same price for delivery of gas to rural and urban areas, despite differences in cost, and for the provision of credit and prepayment meters, even though we have seen that the latter are more expensive. Within a monopoly structure such cross-subsidy is sustainable, though it is rarely efficient. However it clearly has distributional effects: urban users subsidise rural consumers, credit consumers subsidise prepayers. Given the pervasiveness of such cross-subsidies in the utilities, the political economy of unwinding them is, in practice, rather different from the deliberate introduction of new redistributive subsidies.
Failure to rebalance prices in other monopoly parts of the utilities may have been because the companies had insufficient information about relative costs to identify appropriate changes; or, more cynically, it may have been a deliberate policy to maintain monopoly status, because that would be the only way to maintain the cross-subsidies inherited from the nationalised industry. Such a political motive is consistent with the behaviour of British Gas when it knew that its residential markets would be opened to competition. Unlike telecoms and electricity, where a competition timetable was planned from the date of privatisation, British Gas was privatised with a statutory monopoly in the residential market, which could only be removed by primary legislation. It was not certain that the necessary legislation would be tabled until the Queen’s speech in November 1994; the next day British Gas announced the introduction of discounts for households settling their bills by direct debit. Since the average of prices charged to the residential sector was subject to a price cap, such discounts would enable higher charges for other consumers, particularly those using prepayment meters. The timing of British Gas’s announcement was clearly political, but the changes were inevitable in a competitive market. If the incumbent company had maintained a uniform price structure with different costs of supply, the (low cost) markets with the highest mark-ups were vulnerable to ‘cherry-picking’ by entrants. Unlike monopoly parts of the industry, British Gas was unable to maintain the cross-subsidies even if it wished to do so, because the profitable consumers who provided the subsidy would be seduced away by other suppliers.
The rebalancing caused concern because of the socio-economic characteristics of those using different payment methods. Direct debit was more commonly used by the better off, and a disproportionate number of low income households used prepayment meters (see table 1), while the cheapest method of payment, direct debit, was unavailable, or too expensive for many who most needed lower price energy2 . The issue was therefore a broad one of social exclusion, of which the utilities were a comparatively small part. However simultaneous changes across the utilities meant that effects were to some extent cumulative (Waddams Price and Hancock, 1998). Moreover potential competition was as powerful as realised entry in unwinding cross-subsidies. From the date of privatisation the telecoms line rental had been raised within the price cap by the maximum amount permitted by its separate constraint, adversely affecting those who used the telephone little, especially pensioner households. Direct debit discounts were introduced gradually into the electricity industry from the time of privatisation until and after competition was introduced in 1998, with similar effects as in gas. While regulators did have some unspecified responsibilities for protecting the interests of those of pensionable age, we have seen that they had no remit to protect the poor, and such concerns were clearly outside the intentions of the original privatisation acts which had established the regulatory offices and defined their duties.
Protection of certain groups posed a direct conflict with one of the regulator’s duties: to encourage competition, and with another of her objectives: to encourage cost reflective pricing, raising questions of how to achieve an appropriate balance. The most obvious route was to provide adequate safeguards directly to target households, but acting through the social security system may distort other markets, and both Conservative and Labour administrations have been loathe to use such tools because of their reluctance to raise direct taxes. Cross-subsidies could be imposed via the monopoly networks as a second best tool. Direct constraints could be placed on operators in competitive markets, but this would distort the development of competition, and might harm in the long-term the very groups for whom short-term protection is sought. A consumer survey undertaken at the end of 1997 showed a clear preference for supporting low income consumers via the tax and benefits system, as well as a marked difference between utilities in the perceived merit of providing subsidies (table 2). It is against this background of consumer opinion in favour of direct methods of support, and government reluctance to implement them, that successive gas regulators have had to exercise judgement on social needs.
4. Regulatory response
The focus on cost reflective pricing and the higher costs of providing and maintaining prepayment meters led the owner of the pipes and meters, Transco, to suggest a higher charge for suppliers using prepayment meters. Transco was concerned at the increase in installation of prepayment meters following privatisation and the reaction against the increasing disconnection rates, and feared that the advent of competition in gas retailing would lead to further increases in demand by entrants who had little experience in utility debt management. Given that the costs of such meters were higher, and Transco was revenue capped, it was in their interests to reflect the higher costs in charges to shippers to discourage use. This is an example of the efficiency effects of the price cap regulation system, in encouraging cost reflective pricing. These higher charges would not necessarily be passed onto prepayment end consumers, but in a competitive market that would be the likely outcome. Moreover there might be some scepticism if the regulator allowed the increases, since raising costs for all the competitors downstream increases industry profitability.
The regulator was faced with a dilemma: the current quantum technology was certainly more expensive for Transco to provide and operate than a regular credit meter, but allowing higher charges would be vociferously challenged by consumer groups who were concerned about its effect on low income households. However the continuation of equal charging for all forms of meters clearly constituted cross-subsidy of prepayment meters by other gas users. Although the regulator steadfastly declined to play an active role in encouraging cross-subsidies to particular social groups, it was quite a different matter to condone the removal of historical cross-subsidies where this was not enforced by the competitive market.
In the event, Transco did not differentiate its charges for prepayment and credit meters until October 1998, when it was allowed to introduce a surcharge of £10 for each prepayment meter. This was less than the £20 it then requested, and a request to raise the charge to £30 in October 1999 was refused. The regulator contested Transco’s cost allocations, maintaining that these meters should be depreciated over twenty years as was standard Transco practice, and that maintenance costs should reflect efficient forward looking costs, which are considerably lower than the quantum technology currently employed. These two arguments seem somewhat inconsistent, since transferring to a new technology would mean retiring the existing meters early.
While Transco’s relative prices are a question of cost reflective pricing, a much more acute issue arose from the presence of cross-subsidy in the residential market as it was to be opened to competition, where the effect on low income households was of particular public concern. It was in this context that the independent Gas Consumers Council (GCC) referred the new structure of residential gas prices to the gas regulator in early 1995, alleging undue discrimination against consumers who did not enjoy the new discounts and undue preference towards those who did. The referrals triggered two reports, and an eventual restructuring both of the regulation price cap and of British Gas tariffs.
The referral was made on the basis of undue discrimination, a requirement common to the privatised industries. One reason why it was tested in gas rather than in other industries was the existence of an independent consumer council; in other industries such issues would more likely be mediated internally within the regulatory office, where consumer representatives and the regulator shared resources. Testing this issue in gas arose from the particular political economy and institutional setting of regulation and consumer representation, suggesting that current proposals for more independent consumer councils throughout the privatised industries will give rise to more such references in the future.
The requirement not to discriminate unduly had not been tested robustly in a court room – the closest legal precedent referred to local government and dated from 1912. The gas regulator therefore had to find her own interpretation, and determined that non discriminatory prices should be related to the costs of supplying different markets. The gas regulator had to determine first, the relation of prices to costs, and then whether the mark-ups were unduly discriminatory. In his excellent review of the issue of undue discrimination in these lectures two years ago, John Vickers pointed out that from an economic perspective basing prices only on costs is not necessarily the most efficient outcome (Vickers, 1998). In particular, where a company has market power and cannot cover its costs by putting all prices equal to marginal costs, economic efficiency may be maximised by charging prices which incur higher mark-ups over marginal costs in markets where demand is less responsive to price. This is clearly discriminatory, since demand conditions as well as cost levels determine the relative prices. However in the case of the GCC referrals there was an implicit issue of the distributive effect of British Gas’s discounts. The potential conflict between non-discrimination and economic efficiency was exacerbated by concerns about social impact. The opening of the market put pressure on the incumbent to reflect the different costs of supply more closely in price structures, but this meant relative increases for consumers who could or would not take advantage of direct debit payment, and particular concern for prepayment consumers. In any event the GCC referral led the gas regulator deep into questions of cost and price structure which were far removed from the original ‘arms length’ regulation vision.
The regulator produced two reports in direct response to the GCC’s referrals (Ofgas 1995, 1996), under the 1986 Gas Act, but the issues were further resolved in a report on the structure of domestic gas tariffs published two years later (Ofgas, 1998). Although the final report followed a change of government and the publication of a green paper on utility regulation (discussed in the next section), the conclusions were broadly consistent with the regulator’s earlier rulings.
The company maintained that direct debit consumers were cheaper and prepayment more expensive to supply, and provided accounting cost data to support their case. The regulator ruled that undue discrimination was not present if all classes of consumers met their attributable costs , and none bore an undue burden of joint costs3. A ‘due’ burden seemed to be interpreted as one proportional to the attributable costs for that group. So prices should, by implication, be proportional to attributable costs. This naturally focused attention on the process and outcome of cost attribution. The regulator consistently argued for lower prepayment and higher direct debit costs than the company in an attempt to reduce the prices charged for prepayment meters. Eventually the regulator argued for a single tariff for prepayment and some (slow) credit payers, while allowing discounts for prompt credit payers. This clearly benefits prepayment meter users in the short-term, by capping their prices at a lower level.
Moreover, as competition developed, the cap on average prices had been replaced in 1997 by individual caps on each element of each tariff, i.e. all standing charges and running rates. This prevented British Gas from responding to competitive pressure in one part of the market by lowering prices to those consumers, and recouping lost revenue by increasing prices to others, who were not so eagerly sought by competitors, within an overall average. These individual caps made any rebalancing between tariffs much less likely, so preserving the inherited price structure.
However new entrants seem to agree with the incumbent that the margins for prepayment meter consumers are much lower, since they are offering very little, if any, discount against the incumbent price compared with other markets (Otero and Waddams Price, 1999a)4. The regulator has provided short term protection, presumably on grounds of social needs, but at the cost of discouraging active market entry for these consumers. The issues addressed by the gas regulator clearly raised a number of problems which were of wider concern, in particular where the responsibility for resolving questions of social need should properly lie. The next section takes a broader view of regulating for social needs, both in the energy and other regulated utilities, and the implications of current proposals in the gas and electricity markets are explored in the final section.
5. Initiatives from government and interpretation in other utilities
The present government launched a major review of Utility Regulation within three months of taking office. The Green Paper (DTI, 1998a) confirmed the incoming Labour government’s general support for the model of regulation which it had inherited, but shifted the emphasis considerably towards distributional issues. The government proposed changing the primary statutory duty of regulators to one of consumer protection5 in recognition of the special nature of these industries. The title itself, ‘A Fair Deal for Consumers’ confirmed this new emphasis, and considerable attention was paid to just those issues which had concerned the gas regulator; in particular, the conflict between increasing competition in energy and the impact on prepayment meter users. The Green Paper declared as the government’s objective that “the economic benefits of liberalisation are spread fairly amongst everyone, including the most vulnerable consumers” (DTI, 1998, p. 35). Where regulatory action with financial effects on companies or consumer groups was required on grounds of social (or environmental) need, the government undertook to provide specific guidance or legislation. In the meantime the annual DTI energy review included a comprehensive annexe on fuel poverty, reviewing and bringing together recent work in the area (Hutton, 1998).
It seems that the current parliamentary session will include a Utilities Bill, required to deal with various technical anomalies which have arisen, and this will provide an opportunity for the government to legislate on more general issues of social need. The DTI has recently published details of its legislative proposal (DTI, 1999a) and draft impact assessments of the conclusions of the Utilities Review (DTI, 1999b). The legislative proposals reiterate the intention to issue statutory guidance to regulators after full consultation and with parliamentary approval, and to “implement social and environmental measuresÂ…with significant financial implicationsÂ… by means of new specific legal provision” (DTI 1999a, p.20). If the Bill extends the regulators’ responsibilities to include the needs of low income households this will shift the regulator’s role decisively towards distributional issues and away from efficiency focused control.
Draft guidance has already been issued in the water industry, where response to social needs has been influenced by the provision in the 1999 Water Act that no domestic consumer may have their supply disconnected for reasons of non-payment. The government provided advice to the companies on more flexible payment options for ‘less well-off households’, and draft guidance to the regulator on approval of tariffs. In October specific regulations were issued to protect low income families with three or more children, and those with certain medical conditions, from high charges if their water is metered. The Department of Environment Transport and the Regions (1999) estimates that these measures may add about £1 to the average domestic water bill. However while the regulator welcomes specific regulations, he is reluctant to allow companies revenue in consideration of social tariffs beyond these requirements (Ofwat, 1999). This highlights the question of how much discretion the regulator should retain in addressing social needs, and how far this should solely be at the direction of government. The water regulator seems to be taking a somewhat narrower view than the current energy regulator, an area of comparison explored further in the next section.
Social needs pose a slightly different issue in telecommunications. The telecoms regulator has recently launched a review of universal service (Oftel, 1999); the consultation paper recognises both the importance of telephony for social inclusion, and that the market may require intervention to ensure that all groups, including those on low incomes, have access to ‘affordable telephony’. The last review imposed some obligations (such as a requirement to supply, geographically averaged prices, maintenance of public call boxes and provision of a low user tariff) on the incumbent, and required that it meet the cost of this package without no additional revenue.
There have been fewer developments on social needs in electricity regulation than in gas, but the merging of the regulatory offices for the two industries had brought convergence of policy across the industries. The next section deals with these more recent developments, and the prospects for future regulation for social needs in energy in the light of current proposals from both the government and the regulator.
6. Current proposals
We have seen that the government has reaffirmed its intention to expand utility regulation to include distributional as well as efficiency concerns, but is not yet very explicit about the mechanism. The water regulator, Ian Byatt, is reluctant to permit social tariffs without clearer guidance from government. The legislative proposals suggest that such explicit directives will be forthcoming, and some have already been proposed by the DETR for water, but the government also appears to expect regulators to exercise some discretion in this area. The original model of economic regulation, reaffirmed by this government, is not particularly well suited to delivering social objectives, and regulators differ in their response to the general exhortation to consider distributional concerns. While the water regulator is reluctant to allow companies additional revenue beyond what the government directs, the telecoms regulator is preparing to reassess the extent and provision of universal service. It is in this context that the two most recent gas regulators have developed a Social Action Plan over the last eighteen months.
The original government call for development of a social action plan by the (then separate) gas and electricity regulators was contained in the 1998 Green Paper; but the regulators were given very little time for its preparation, and the document was inevitably somewhat superficial (Ofgas and Offer, 1998). However Callum McCarthy has developed this policy much more proactively since he took over as Director General for both industries – a fact no doubt reflected in the subject of the lecture here tonight. Three major documents have been published in the last six months. A Social Action Plan Discussion document in May and framework document in October (Offer and Ofgas, 1998 and Ofgem, 1999(a)); and a document on prepayment meters (Ofgem, 1999b) in October; more consultation documents are promised. These reflect considerable development of the regulator’s own policies towards social needs. The consultation paper and framework clearly anticipate more proactive guidance from the government, and accept that there should indeed be a ‘social’ aspect to energy regulation. Potential conflicts between social needs and development of competition, and the undesirability of the plan distorting competition are acknowledged, but not fully resolved.
Perhaps the clearest guidelines are contained in the framework for action and the consultation on prepayment meters, both published in October 1999, where proposals are made to amend supplier obligations, make some structural changes to regulation and initiate a programme of research activity. Some of this framework co-ordinates the work and monitoring of the gas and electricity industries, but some new requirements are introduced. The regulator clearly sees the rising numbers of prepayment customers as problematic, and expresses firm support for transferring prepayment consumers to credit tariffs wherever possible, while stating that he ‘has no wish to prevent customers from using prepayment meters’. However he seems to favour an end to the recent increase in such payment methods, and states that ‘suppliers should not impose a prepayment meter Â… in circumstances where an alternative payment method would be better’ (p. 21). The problem is to identify for whom it would be better, another potential conflict of interest.
Ofgem’s priorities can be classified as falling under a number of headings. The main one is to lower barriers to consumers in choosing between alternative payment methods and suppliers, through improving consumer information, ensuring broader options and reconsidering the current barriers to switching for those in debt6. Suppliers are expected to develop and offer a broader range of payment methods, enter ‘effective’ dialogues with consumers in debt, develop innovative schemes to improve energy efficiency, and undertake a range of research activities. Offering a range of payment methods might facilitate product or consumer differentiation in the market, and it is not clear that this would necessarily be optimal. There are also calls for increased transparency to help consumers in changing suppliers. Here there is some tension between helping consumers to make better informed choices and the danger of encouraging tacit collusion among suppliers. Such a possibility makes even more crucial an impartial monitoring of the competitive process, including the pattern and sequencing of price changes within the industry to detect any collusive activity.
Probably the most significant requirement is the apparently innocuous request for supply companies to report on their social programmes. Even without specifying exactly how it will use the information, collecting such data will affect behaviour. In monitoring the information, the regulator is highlighting its significance, and implying that reward or punishment may follow. These steps are likely to increase the cost of supplying ‘disadvantaged’ customers, and so might prejudice development of competition for this group. However the reporting requirements both ensure that these costs are reasonably evenly spread across suppliers, and offer them the hope of some regulatory reward for serving low income households. The response of the Electricity Association and the gas industry in setting up a fuel poverty task force to address these issues and fund independent research suggests that this is exactly how the messages are being read within the industries themselves. Such co-operation, together with calls for increased transparency, may run a risk of collusion in the longer term, and behaviour in the market will need to be carefully monitored to detect and deter any moves in this direction. Naturally I would not wish to discourage the regulator’s call for industry funding of major impartial academic research into these areas; but further work may be required in monitoring future market behaviour also.
The prepayment document distinguishes the capital and revenue costs of prepayment provision. The cap on surcharges which electricity distribution companies may levy for prepayment meters recalls debates about Transco surcharges. Here in the network companies, at least, cross-subsidies can be maintained without distorting competition, albeit at the expense of some misallocation of resources. This will, ironically, encourage over provision of prepayment meters at a time when the regulator would prefer to see their numbers decline.
The regulator has also signalled concern about the level of standing charges. Because energy use increases with income in absolute terms (but not proportionately), high standing charges may disadvantage low income consumers. This is a similar concern to that for low users of telephony. However, like prepayment meters, low use is an imperfect surrogate for low income, and high use may correlate with some forms of disadvantage, e.g. unemployment, disability and chronic sickness (see for example Sharratt, 1999). A study of earlier standing charge rebate systems, forced on the nationalised gas and electricity industries in the early eighties, concluded that it was ‘both mean and wasteful’ (Gibson and Price, 1986). As table 3 shows, it failed to reach many of those in need, and helped many who were not (e.g. owners of second homes). Future proposals to use tariff structure as a redistributive tool are likely to run into similar difficulties, exacerbated by the pressures of the competitive market.
The energy regulator’s Social Action Plan makes an interesting comparison with codes of practice which have developed in the water industry. Where there are differences these reflect both variations in exposure to competition, and the particular characteristics of and public attitude to the industries. For example, budget payment units, the equivalent of prepayment meters, and all disconnections for non payment have been made illegal in water. Water companies are required to provide frequent payment options free of charge, while in energy discounts are offered for payment methods which are cheaper for companies to operate. Most water companies do not differentiate charges according to payment method, so they are continuing cross-subsidies between consumer groups. Customer service levels, including those for disadvantaged customers, are already part of Ofwat’s comparative statistics. In many ways Ofgem’s Social Action plan is proposing measures already operating applied in water. Some of these are more complex to introduce in markets open to competition, but there is clearly a degree of convergence on practical measures. Perhaps it is the lack of competition in his industry which makes the water regulator reluctant to approve further social tariffs unless he is so directed by the government. The gas regulator is inhibited from such action by the constraints of the market itself.
Such convergence in areas of social concern is perhaps surprising at a time when the regulators have recently identified a number of areas where co-operation would be desirable; these do not include social needs – the very area where cross industry co-operation and consistency might seem most desirable. Perhaps this is to avoid exposing different views on how far such regulatory action should be discretionary, and how far enforced by central government. But it is clearly an area where ‘joined up regulation’ would seem particularly appropriate, and where inconsistencies might have some very perverse implications for disadvantaged households. The whole issue of Fuel Poverty, the inability to afford adequate warmth, is a complex interaction of income, housing conditions and conditions of fuel supply (including price). If the government is serious about its eradication the agencies concerned need to work closely together.
Gas regulation has moved a long way from the original efficiency based model – the economists’ dream. Government policy has reflected public opinion that these are not ordinary private companies supplying commodities just like any other. The current regulator has accepted, indeed embraced, the need to address social needs as part of the regulatory process. This raises issues of how far markets can be used to deliver social objectives; and questions of unintended consequences both for the households concerned, and in encouraging co-operation between supplying companies which may not always be in consumers’ interests. These developments have certainly multiplied the cost of the regulatory office by many times that of a part-time Director General and eighteen staff. Whether the inclusion of social needs has turned regulation from an economist’s dream into a regulator’s nightmare, perhaps the chairman is best placed to say.
Endnotes
1 Shares were sold at what seem, in retrospect, to be rather low prices for two reasons. First, the government was keen to encourage individuals who had not traditionally held shares to purchase utility issues, perhaps in part to create a ‘share-owning democracy’ where large numbers of voters would have an interest in preventing the return of the Labour party which remained committed to renationalisation until the mid nineties. Secondly, the extent of inefficiencies within the nationalised industries was not realised until after they were privatised and improved their productivity – one vindication for their incentive regulation scheme.
2 The problem for low income households may not be lack of access to a current bank account and direct debit payments, but the high costs levied by banks if a direct debit payment results in the account becoming overdrawn (Doble, 1998). Households on very tight budgets are more likely to risk such an event, and to avoid direct debit mandates as a result.
3 Attributable costs are not the same as marginal costs, but may be a reasonable surrogate for ‘incremental’ costs in the sense used by Faulhaber (1975).
4 A similar pattern is evident in electricity (Otero and Waddams Price 1999b).
5 Changing the primary duty to one of consumer protection is unlikely to be very significant in itself, since medium term consumer interests will only be served if the regulator allows adequate financing to the companies to continue supplying the service.
6 At present suppliers of consumers with debt can object to their transfer to another supplier.
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