From RPI to RIP: what I have learned about regulation

In his final Agenda article as a Director of Oxera, Mike Toms looks back on a 35+ year career in economic regulation, highlighting some of the key changes and drawing out lessons learned over that time. Is economic regulation in a better place now than it was when Mike found it?

In 1986 I was appointed to my first job in the infant art of regulation, as economic regulation manager of the soon to be privatised BAA plc. Over the following 36 years I served first as a regulation executive, then as the chair of a regulated utility, and for the last 15 years as a consultant at Oxera, authoring about a dozen Agenda articles on the way.

Over that period, the world has changed almost beyond recognition. In 1986 UK Prime Minister Margaret Thatcher was negotiating the end of the cold war with leader of the Soviet Union Mikhail Gorbachev and US President Ronald Reagan. In the same year the Chernobyl power station exploded, Alex Ferguson became the manager of Manchester United Football Club, and work started on the Channel Tunnel. The iPhone was still 20 years away and the state of the art in spreadsheet programmes was something called Lotus 123.

Likewise, our own small world of regulatory economics has changed dramatically. But just as Argentina won the World Cup in 1986 and again in 2022, some general characteristics have become remarkably deep-rooted. Interactions between regulators and regulated companies can still be explained by attitudes and behaviours that have become entrenched over time. In this, my final contribution to Agenda, I’d like to set out some of the lessons I’ve learned about the way the game is played. The views I express are my own; I expect (and hope) to offend colleagues from across the spectrum, in the sure knowledge that I’ll never have to plead for a position again.

Regulators and the frailty of the flesh

When the first regulators were appointed, there was a general assumption that they would conduct themselves with the discipline and dignity of High Court judges. They would approach each case with an open mind and no preconception of the right outcome; they would consider the evidence presented to them—and only that evidence—and weigh it objectively, culminating in a carefully reasoned conclusion and an appropriate determination. They would also protect their quasi-judicial reputations by avoiding any fraternising with prosecution, defence or ministers of justice during proceedings.

As the song says, I’m much older than that now. I have witnessed regulators shimmying round the Whitehall warm white wine circuit with politicians, senior civil servants, industry executives and other interested parties, soaking up views and reading the runes, even as they are preparing determinations. I have also been surprised and often disappointed by how much baggage regulators have taken out of their briefcases on their first day in office, including, from time to time, some blatant personal prejudice. I don’t recall an airport regulator who didn’t set out believing that a dose of competition between airports would improve the chances of delivering another runway to serve London. That worked out well, didn’t it? Even now, without any evidence, some regulators seem to believe that engagement between today’s wholesale customers and their monopoly suppliers will in some way lead to good outcomes for future retail customers, when basic theory tells us the very opposite.

I also set out with the naïve belief that regulators would be alert to the long-term nature of the businesses they were asked to regulate. They would understand that, where businesses with long histories of underinvestment were being asked to invest in infrastructure with lives of 50 years or more, they would need to set stable regimes which incentivised that investment. Instead, what I have often seen is prices being pushed down over five-year periods in industries where marginal costs are clearly rising. Thus, we have seen water regulators cutting the investment programmes of water companies, and taking the credit for price falls. When the fan has been hit by the resulting effluent, I have not seen them putting their hands up to say that they failed to take account of the inevitable consequences. By that time, they were probably enjoying their retirement among the great and the good.

Regulated businesses: the good, the bad and the ugly

Lest you think that I’m prejudiced, I have also been taken aback by the attitudes of many companies to working in a regulated industry. But before I launch into that, a brief word of credit for the best companies: those which realise that regulation is integral to their business, manage it seriously, treat their regulators with unfailing respect (whether they deserve it or not), and recognise that the best strategy for a regulated business is to understand and love its customers more than the regulator does. I have in mind companies in water and energy which I have been privileged to work with, although I’ve no intention of naming any of them, since my admiration would probably do them no good at all with their regulator. The alpha companies even go one stage further. They divine the regulator’s immutable prejudices, accept them and put their positions in language the regulator wants to hear—whether they agree with it or not.

Unfortunately, I’ve seen more companies with less enlightened approaches to regulation. There are those which see the process as a commercial negotiation, failing to understand that the regulator holds all the cards. These are the companies which make unrealistic bids based on the assumption that the higher the ask, the higher the mid-point at which the regulator will settle. It really doesn’t work that way, guys. If your bid is not credible then neither are you.

Then, there are the companies which forget about regulation until a review is looming, then hope that those economists and lawyers on the fourth floor will look after it with the help of some consultants and without bothering the executive team too much. At a late stage, they realise that they have no narrative with which to engage the regulator beyond some superficial PR statements which bear little scrutiny.

Finally, there are the companies which think that they can pull the wool over the regulator’s eyes, even to the point of fiddling the figures. Of course, they get caught out sooner or later, and the damage takes many years to repair.

Quis custodiet ipsos custodes (aka ‘who guards the guards’)?

Some regulators will justify their decisions on the basis that if the customer doesn’t like it, they can always appeal. And some companies think they can intimidate regulators with the threat of an appeal, either to the UK Competition and Markets Authority or to the courts. Regulators know that it is a threat often made, less often carried out, and even less often carried out successfully. It is also a course of action which will tie up a company’s leadership for many months, cost millions and unsettle investors. And at the end, if the company is successful, there may be enduring relationship damage. As Graham Greene put it in Brighton Rock, it can amount to a ‘victory more damaging than defeat’.

The good news

Having damned most of the participants in regulation with very faint praise, the reader is entitled to ask what should be done instead. For all their frustration, I suspect most businesses would prefer regulation to the force of a fully competitive market. And I suspect that most regulators prefer their own administrative processes to freeing monopolies to exploit their customers. So to paraphrase Winston Churchill on democracy, regulation as practised today is the worst form of oversight, except for all those other forms which have been tried in the past.