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'Good chap' regulation is simply not the answer

The regulator is there to make sure the private sector utility monopolies do not abuse their power by over-pricing. In each industry affected there is one regulator, acting alone and directly accountable to no one, who sets a price cap every five years. This limits the price increase allowed, usually to some rate lower than inflation. Yet the most obvious result of this system has been huge profits (and executive remuneration) for the privatised utilities.

The problem is that the system, devised by the electricity regulator Stephen Littlechild, is bound to give that result. To set the price cap, the regulator tries to assess the situation facing the company over the next five years and, in particular, what sort of investments they will have to make. But this information has to come largely from the regulated firm itself, which naturally has an incentive to emphasise the problems and costs it will have to face.

After the price cap has been set, it is almost inevitable that the firm discovers it can do without some of the investment previously thought essential, or finds there is even more room for efficiency savings. The result is the recurring headline of massive profits for the privatised utilities.

Yet, as many firms have recognised, this is not in the long-term interests of the firms and their shareholders. If the system is not seen to be fair, there will be pressure for change. This is exactly what happened in electricity when, only months after making his announcement of price caps, Professor Littlechild decided he had been too weak and announced he would tighten them further. The result is "regulatory uncertainty", with damaging consequences for long-term planning.

There are several reforms which could restore confidence in the system. Since the regulator is always going to lack information, the price cap must be augmented with a "clawback" mechanism. This should say that once firms have earned a reasonable rate of return, anything above that is shared, fifty-fifty, with consumers. This would retain the vital incentive for firms to maximise profits and make efficiency gains, but assures consumers that they will get their fair share of these.

It is high time we deserted the idea of personalised regulation. Professor Littlechild does not have to argue his views with anyone before announcing what is a virtually unchallengeable ruling. Replacing the single regulator with a panel would ensure internal debate and better decision-making, and would avoid the instability inherent in what is termed "good chap" regulation.

Because every decision the regulator makes has enormous implications for the lives of so many people, the regulatory body should contain people with backgrounds in these areas. It also needs to be far more open to public scrutiny.

We must scrap industry-specific regulators and replace them with a single energy regulator. At present, investors' decisions are made as much upon guesses about whether Clare Spottiswoode (the gas regulator) or Stephen Littlechild is the softest touch, as upon the underlying fundamentals. This change is urgent, for combined gas and electricity companies are now emerging.

Dan Corrie

The writer is editor of the report from the Institute for Public Policy Research, 'Profiting from the Utilities - new thinking on regulatory reform', pounds 9.95 plus 50p p&p from IPPR (0171-379 9400).