With concerns around company outperformance and information asymmetries playing strongly on the minds of economic regulators, the UK regulatory model has moved on from the ‘fixed price’ paradigm of ‘RPI – X’. Regulators have looked to set more challenging price settlements, while also rebalancing risks within regulatory contracts to protect against windfalls. The model now resembles the rate-of-return approach it was intended to replace. Is this the right way forward? And what alternatives might there be?
Economic regulation in the UK has long drawn on the RPI – X model, in which prices or revenues are fixed in advance for multiple years and a company’s returns depend on how its outturn costs compare to the allowances baked into the settlement.
The potential for outperformance is a critical part of the incentive package under this form of regulation—it is what drives companies to become more efficient over time, and it unlocks benefits to customers as these efficiency savings are passed on at the next price review.
However, regulators face the challenge that companies may outperform a price settlement by:
- taking positive actions that generate efficiencies or enhance performance;
- benefiting from factors outside their control; or
- ‘gaming’ the regulator into setting allowances that are too lenient, and which can be easily outperformed.
This distinction has come under increasing focus in recent years. The latest round of UK price reviews, particularly those in energy (RIIO-T2 and GD2) and water (PR19), took place in the context of concerns that networks were getting too easy a ride from their regulators. According to this view, companies were outperforming not because they were high performers (a), but simply because the regulatory settlements were too lenient and/or things had gone in their favour (b/c). This can be clearly seen in Ofgem’s assessment of energy networks’ financial performance over the course of the RIIO-1 control:1
As a result, it was important to regulators that they be able to demonstrate that strong financial performance was down to companies doing positive things, as opposed to luck, bad regulation or ‘gaming’. This meant striking a new balance between company incentives and consumer protections.
Towards rate-of-return regulation
The regulators responded through a combination of:
- tougher upfront price controls with lower allowed returns, more challenging efficiency assessments and tougher performance targets;
- greater use of within-period adjustment mechanisms to reallocate risk/reward—such as cost-sharing rates, use-it-or-lose-it allowances, indexation of real price effects, indexation of financing costs, return adjustment mechanisms, and volume risk shares.
At RIIO-2 Ofgem took things a step further. It chose to apply an explicit downward adjustment to the price cap for companies’ anticipated outperformance, known as the ‘outperformance wedge’.2 Ofgem deliberately ‘aimed down’, on the basis that it believed history showed that it (and other regulators) had been too generous in the past. The use of such a wedge illustrates the levels of mistrust that the regulator had in the accuracy and truthfulness of companies’ business plan forecasts and, perhaps more notably, in its own ability to forecast efficient costs.
With the UK regulators purposely setting out to impose tougher price controls on companies in the latest round of reviews, the question is whether these price controls struck the right balance.
The backstop for companies that disagree with their regulator is an appeal to the Competition and Markets Authority (CMA). When considered in the context of the number of companies that are subject to regulation, regulatory appeals have been relatively rare over the last 35 years.
This has changed in the last two years, which have seen an unprecedented number of appeals in a short space of time. First, the UK air traffic controller NATS referred its RP3 determination to the CMA.3 Shortly thereafter, four water companies (Anglian, Bristol, Northumbrian and Yorkshire Water) chose to follow the same route on receipt of their PR19 settlements.4 Finally, energy networks made industry-wide appeals on a number of grounds to the CMA in relation to the RIIO-2 decision (including the outperformance wedge discussed above).5
The outcome of the CMA reviews was generally favourable to the companies. NATS received a (small) uplift in its allowances, while the water companies were provided with material increases in allowed costs and the removal of disputed regulatory mechanisms.6 The CMA saw these adjustments as necessary to meet regulatory financing duties and promote investment in these sectors, suggesting that the regulators had ultimately been too tough in their assessments. (There was less movement for the energy companies in the CMA’s RIIO-2 assessment, due partly to the higher legal threshold for changes under the energy appeals mechanism—but the outperformance wedge was successfully appealed.)
Interestingly, the CMA chose to reject regulatory ‘innovations’ by Ofwat and Ofgem that were designed to protect against company outperformance (i.e. the gearing outperformance-sharing mechanism in PR19, and the outperformance wedge in RIIO-2).
Where does this leave regulation?
A notable aspect of the CMA reviews was the criticisms made by early advocates of economic regulation on how the UK regulatory model has evolved. Professor Stephen Littlechild (the pioneer of RPI – X regulation) and Sir Ian Byatt (the first Director General of Ofwat) both made submissions to the CMA raising questions over the effectiveness of the current model.7 Another early proponent of utility regulation, Sir Dieter Helm (Professor of Economic Policy at the University of Oxford) had already pronounced the death of RPI – X in 2018, having seen the publication of Ofwat and Ofgem’s methodologies for PR19 and RIIO-2.8
The main criticisms of where things have landed relate to:
- the continued regulatory focus on efficiency and driving down prices in the short term, even though these are arguably no longer the main challenges for these sectors.
- increasingly complex price settlements, more closely resembling rate-of-return than incentive regulation.
- a highly resource-intensive regulatory process, with price reviews routinely taking more than three years.
- the adversarial and confrontational regulatory landscape, with low levels of trust between the regulators and the companies that they regulate.
Professor Littlechild’s verdict is particularly damning and raises the question of whether there are preferable alternatives:9
What are the potential alternatives?
We consider three potential options below.10
One potential solution is for customer representatives to play a greater role in the determination of regulated companies’ charges and performance specifications.
There is a long history of customer engagement in the aviation sector, with airlines providing a strong counterparty as airports and air traffic controllers develop their plans. This has allowed the CAA to step away from setting price caps for Gatwick, Manchester and Stansted airports. There are also examples of negotiated settlements from US energy regulation and the 2015 Strategic Review of Charges for Scottish Water from the Water Industry Commission for Scotland (WICS).
Over the last decade, Ofcom and Ofgem have tried to introduce similar customer challenge in the form of independent Customer Challenge Groups. Companies have been encouraged to develop plans that reflect local priorities and test them with their company-specific challenge groups. This has been reinforced by incentive mechanisms—for example, bespoke output/outcome delivery incentives.
Ofwat notes that it has seen a cultural change in companies’ approaches to customers over the last two price controls:11
However, while these customer representatives have played a role in the price review process, the regulators have retained their control over all major decisions relating to prices.
Some companies have been left disappointed, as regulators have taken positions that appear to be contrary to the evidence coming out of customer research and the challenge groups.12 Ofwat has also voiced concerns about the research undertaken by companies and the cost of the customer engagement processes followed at PR19.13
As a result, Ofwat has announced that it is seeking to develop a more targeted approach to capturing customers’ views at PR24, focused on areas where they can have a meaningful influence.14 In a step back from the last two reviews, companies will no longer be required to have a local Customer Challenge Group.
Alan Sutherland (CEO of WICS) has recently published an insightful article on WICS’s experiences of direct customer–company negotiation (in the form of the Customer Forum, which was established for SRC15 as a ‘conduit for the views of customers’).15 He highlights the challenges for customer representatives to avoid straying into policymaking, the difficulties posed by information asymmetries between the company and customer body, and (most importantly in his view) the fact that the focus on affordability made it hard for Customer Forum members to agree to the price increases necessary to deliver the required investment. As discussed further below, WICS has chosen to move on from the negotiated settlement approach to a new set of regulatory principles.
Consequently, the direction of travel, in the water sector at least, appears to be a move further away from the negotiated settlement ideology (albeit with Ofwat and WICS moving in different directions).
An alternative route if regulators do not trust themselves to set effective price controls is to put infrastructure investment out to the market—and, indeed, there are a growing number of examples of regulators pursuing competitive tendering for infrastructure assets.
This approach has been supported by both the UK government and the National Infrastructure Commission. In 2019, the Commission recommended that greater competition to build new infrastructure was desirable to facilitate additional investment, innovation and efficiencies in the energy, telecoms and water sectors.16
This was further captured in the UK National Infrastructure Strategy (November 2020); the Energy White Paper (December 2020)—which outlined the government’s intention to legislate to enable competitive tendering for onshore electricity transmission infrastructure; and the Economic Regulation Policy Paper of the Department for Business, Energy & Industrial Strategy (January 2022).17
The rationale for introducing these models is the belief that increasing competition has the potential to create better consumer outcomes (for certain projects) through lower capital and operational costs, lower financing costs, and innovation.18 Where these networks are currently subject to economic regulation, with fixed price controls, this relies on the assumption that the market will reveal a level of cost and financing efficiency for new investments that the regulators could not achieve through their price review processes.
Ofwat and Ofgem have both been pursuing a competitive delivery of network infrastructure for a number of years.
- Energy networks. A competitive tendering approach has been in place for the development of the offshore transmission network since 2009. Ofgem’s Integrated Transmission Planning and Regulation project concluded in 2015 that it would be in the interest of consumers to extend the use of competitive tendering to (new, separable and high-value) onshore transmission assets.19 The Department for Business, Energy & Industrial Strategy and Ofgem have both recently set out consultations on proposals to develop competition in the market for onshore electricity transmission networks.20
- Water networks.Ofwat has also been pursuing competitive delivery models in the England and Wales water sector. This follows the competitive procurement of the Thames Tideway Tunnel project in 2015.21 For PR19, Ofwat introduced its Direct Procurement for Customers initiative,22 which involves companies competitively procuring delivery of infrastructure projects that meet set criteria. Five water companies initially submitted infrastructure projects to be undertaken via Direct Procurement for Customers in their PR19 business plans.
These developments suggest that it is inevitable that more projects will be delivered through competitive processes, rather than under traditional regulatory frameworks. However, the benefits of such a policy are still contested—competitive tendering could create as many pitfalls as it is intended to resolve, and poses a considerable risk given the investment requirements across infrastructure sectors. Indeed, the Direct Procurement for Customers approach has so far led to noticeable project delays.
A quite different approach to regulation is being trialled in Scotland. In the context of the Strategic Review of Charges 2021–27 (SRC21), WICS concluded that, while a cash-based approach with fixed, six-year price settlements has delivered benefits for Scottish customers historically, it is no longer the optimal regulatory approach in light of the long-term challenges facing the sector (in particular, decarbonisation and asset replacement).
Its rationale is that the rigidity and short-term nature of this approach, as well as the strong incentives that it places on regulated companies to minimise cash costs in the current regulatory period, are unlikely to best support the achievement of the sector’s target long-term outcomes.
Consequently, it has made a significant change to its approach, adopting an innovative new model of regulation based on the principles of Ethical Business Practice and Ethical Business Regulation. The intention of Ethical Business Practice is that a company commits to creating an ethical culture and adopting a set of behaviours centred around doing the right thing, and communicating this to stakeholders openly and transparently. Ethical Business Regulation is the regulatory framework and interactions that encourage and support Ethical Business Practice.
Key elements of this approach include:
- the company taking full ownership of developing its strategy, decision-making, meeting its commitments, and the communication of its progress to relevant stakeholders, to gain trust and build consensus;
- rich communication between the regulated business, the regulator, and other stakeholders, with frequent conversations at all levels of the organisations to ensure confidence in the system and the company’s performance. These interactions are continuous in nature (‘little and often’), as opposed to the regulator periodically ‘dipping in and out’ at set touch points;
- openness, transparency and a willingness to engage in candid conversations among all parties;
- ensuring that customers and communities are engaged in how the company makes decisions, including at the planning stage, with a step change in customer and community engagement relative to what has been expected historically;
- keeping traditional tools and powers open to WICS (but with the expectation that these will be used sparingly).
The concepts of Ethical Business Practice and Ethical Business Regulation underpinned the approach that was taken to SRC21.23 There are two points of particular interest in WICS’s SRC21 approach.
First, unlike with previous SRC processes, Scottish Water’s investment programme has not been fixed for six years as part of SRC21, and instead will be continually developed and updated using a new Investment Planning and Prioritisation Framework that will take account of the priorities of all stakeholders. The intention is that this framework will allow for a more agile and dynamic approach to investment decision-making, with greater ability to make trade-offs between the competing priorities of stakeholders. The counter to this is that there is considerably less certainty over what will be delivered, as there will no longer be a technical specification to monitor progress against.
Second, to provide funding for the substantial increase in investment that will be required to decarbonise and replace ageing assets, WICS has indicated that it will allow real bill increases of up to 2% p.a. from now until 2050. This provides an interesting contrast to England and Wales, where Ofwat is requiring companies to make further cuts to real bills. It also highlights WICS’s intention to adopt a long-term perspective on prices and investment, rather than focusing on a single price control period.
The new approach seeks to reduce information asymmetries and regulatory ‘gaming’ by moving away from rules-based regulation, encouraging open dialogue and reporting, and promoting a culture of doing the right thing for customers. It is too early to conclude whether the approach will be successful in achieving these aims, and there is a question about whether such an approach could be applied as readily to privately owned businesses—but this will make for an interesting point of comparison with regulation elsewhere.
Same, same but different
Outperformance by regulated companies has increasingly been seen as a regulatory failure rather than a necessary process of incentive regulation. The most recent round of price controls was generally seen as ‘much tougher’ from the companies’ perspective, and introduced a host of mechanisms that more closely resemble rate-of-return regulation than an incentive-based approach. This led to multiple CMA appeals and raises questions about how regulation should evolve next.
Some commentators have called for a fundamental shake-up of the UK regulatory model. For the time being, based on Ofwat’s initial outlook for PR24 and the CAA’s approach to price reviews for Heathrow and NATS, it appears that changes to the underlying regulatory model will be evolutionary rather than revolutionary.24 The biggest changes for companies could come through the government’s pursuit of competitive delivery models for infrastructure projects.
1 Ofgem (2018), ‘RIIO-2 Framework Consultation’, March, p. 5.
2 Ofgem (2020), ‘RIIO-2 Final Determinations for Transmission and Gas Distribution network companies and the Electricity System Operator’, 8 December.
3 Competition and Markets Authority (2020), ‘NATS (En Route) Plc / CAA Regulatory Appeal’, August.
4 Competition and Markets Authority (2021), ‘Anglian Water Services Limited, Bristol Water plc, Northumbrian Water Limited and Yorkshire Water Services Limited Price Determinations, Summary of Final Determinations’, 17 March.
7 Littlechild, S. (2020), ‘Submission to the CMA on Ofwat price determinations’, 24 May; Byatt, I. (2020), ‘Water Price Appeals 2020; Anglian Water, Bristol Water, Northumbrian Water and Yorkshire Water: Submission to CMA on its Provisional Findings’, 22 October.
9 Littlechild, S. (2020), ‘Submission to the CMA on Ofwat price determinations’, 24 May, p. 3.
10 For a more comprehensive discussion of alternatives, see Sutherland, A. (2021), ‘The good, the bad and the ugly: How we might future proof economic regulation?’, May.
11 Ofwat (2020), ‘PR24 and beyond: Reflecting customer preferences in future price reviews – a discussion paper’, December, p. 19.
12 See, for example, Competition and Markets Authority (2021), ‘Anglian Water Services Limited, Bristol Water plc, Northumbrian Water Limited and Yorkshire Water Services Limited price determinations’, Final Report, p. 80, paras 2.143–4.
13 Ofwat (2020), ‘PR24 and beyond: Reflecting customer preferences in future price reviews – a discussion paper’, December.
15 Sutherland, A. (2022), ‘Solving the customer engagement conundrum’, WICS; Water Industry Commission for Scotland (2017), ‘Innovation and Collaboration: future proofing the water industry for customers. Methodology for the Strategic Review of Charges 2021–2027’, April, p. 10.
16 National Infrastructure Commission (2019), ‘Strategic Investment and Public Confidence’, p. 13.
17 HM Treasury (2020), ‘National Infrastructure Strategy’, CP 329, November, p. 54; Department for Business, Energy & Industrial Strategy (2020), ‘Energy white paper: Powering our net zero future’, December; Department for Business, Energy & Industrial Strategy (2022), ‘Economic Regulation Policy Paper’, January.
18 Ofgem (2016), ‘Extending competition in electricity transmission: impact assessment’, 27 May; Ofgem (2015), ‘Integrated Transmission Planning and Regulation (ITPR) project: final conclusions, Impact Assessment – supporting document’, 17 March, pp. 13–14.
19 Ofgem (2015), ‘Integrated Transmission Planning and Regulation (ITPR) project: final conclusions’, 17 March, p. 13.
20 Department for Business, Energy and Industrial Strategy (2021), ‘Competition in Onshore Electricity Networks’, 3 August; Ofgem (2021), ‘Consultation on our views on Early Competition in onshore electricity transmission networks’, 3 August.
23 Water Industry Commission for Scotland (2017), ‘Innovation and Collaboration: future proofing the water industry for customers—Methodology for the Strategic Review of Charges 2021-2027’, April.
24 Civil Aviation Authority (2021), ‘Economic regulation of NATS (En Route) plc: further update on approach to the next price control review (“NR23”)’, CAP2160, October.