This paper discusses the objectives of utility regulation, drawing on the author's experience as a regulator in the United Kingdom. It considers the extent to which the promotion of consumers' interests can be taken to be the prime objective and examines the consequences for the setting of price controls and the encouragement of productive efficiency. In doing so, it bears in mind the practical and political realities of the process.

It is normally assumed that the prime function of a utility regulator is to protect customers from the exercise of the market power enjoyed by a natural monopoly. This is indeed the prime function but regulation has often emerged for other reasons and has sometimes been a means of establishing monopoly in order to protect the returns to investment in industries where there are thought to be significant economies of scale.

At the end of the nineteenth century electric utilities in the United States had to obtain operating licences from local authorities but these were not hard to obtain and there was competition. Professor Vernon Smith argues that it was the industry which lobbied for exclusive rights in return for a "fair profit" and price controls and that the first states to adopt regulation were those where prices were lowest and output highest rather than the reverse. Low profits have occurred in infrastructure investments (canals, railways) and regulation has been undertaken as a response, outside the United States often taking the form of public ownership. A recent example has been the introduction of gas to Northern Ireland. An initial monopoly has been granted, in return for a degree of regulatory control, in order to protect the return on the initial investment in pipelines.

In other cases the motive has involved external benefits. Water and sewerage investment is of benefit to those not directly consuming the services because of the improvement in public health which results. Regulation has therefore introduced an obligation to serve and striven to achieve a level of output greater than that which a free market was expected to produce.

Recent privatisations, on the other hand, have seen the regulator primarily as the customer's protection against monopolists. History does not supply many instances where the lack of this protection has resulted in dramatically high prices over a sustained period, presumably because competition from potential (or actual) entrants and from other products (e.g. other sources of energy, or modes of transport) has sufficed. This sort of argument has lain behind views expressed in New Zealand that regulation was unnecessary and that its threat would suffice. However, customers of an existing utility are in a different position from those of a utility which is seeking to establish a market. The customers will have made substantial investments (in knowledge and habit as well as equipment) and a newly freed monopolist would be able to raise prices and capture the value of that investment.

If the state owns the industry it can act simultaneously as owner, regulator, and customers' representative. This combination of roles gives it almost complete power to act. The result has often been to subordinate considerations particular to the industry to general state goals, such as inflation or public finance, with unfortunate consequences for the efficiency of the operation, the quality of service, and the level and predictability of prices. These have in turn caused inefficiencies in the rest of the economy.

In this paper, however, we mean by "regulator" an independent statutory body set up to discharge various specific functions relating to the industry (often subject to appeal to another body) and to propose any other changes which may be thought necessary. The regulator will be given objectives to achieve and may also operate in the context of other regulation, e.g. of the environment. The objectives are likely to be enshrined in statute and so capable of modification through the legislature but they may contain provision for the executive to modify them through ministerial directive.

The Regulator-General in Victoria operates for electricity under the Office of the Regulator-General Act 1994 and the Electricity Industry Act 1993 with the latter prevailing in the event of conflict. The objectives are:

1. ORGA 1994

• to promote competitive market conduct
• to prevent misuse of market power
• to facilitate entry
• to ensure that users and consumers benefit from competition and efficiency

1. EIA 1993

• to promote competition in generation, supply and sale
• to ensure the maintenance of an efficient and economic system for generation, transmission, distribution, supply, and sale
• to protect the interests of consumers with respect to prices, safety, reliability, and quality of supply
• to facilitate the maintenance of a financially viable electricity supply industry.

These are similar to, but significantly different from, the objectives set in Great Britain and, in particular, those governing the Director General for Electricity Supply under the Electricity Act 1989 and the author, when Director General of Electricity Supply for Northern Ireland, under the Electricity Order 1992. These can be separated into three groups:

1. a set of duties, sometimes referred to as "primary", to which the other duties are said to be "subject". They might almost be seen as being like constraints in a linear programme.

• to secure that all reasonable demands for electricity are met
• to secure that licence holders can finance their licensed activities
• to promote competition

1. in the following paragraph, an aim which looks something like an objective function to be optimised;

• to protect the interests of customers as regards price and other terms, continuity of supply, and quality of service

1. and other aims;

• to promote efficiency and economy in production and use
• to protect the public from dangers
• to promote research
• to promote health and safety in the industry
• to take into account the effect on the physical environment
• to take into account the needs of the elderly, those with disabilities, and those living in rural areas and, in some defined areas (as a primary aim), to prevent different prices being charged as a result of geographical location.

Both ORG and UK sets of duties contain the basic themes of protecting consumers, promoting competition, and encouraging efficiency but casual inspection suggests the former is relatively more prominent in the UK duties. The UK duties also contain references to the environment, public safety, and the relative position of different classes of consumer.

Regulators have to balance the various objectives they are given but it is worth considering the extent to which the whole set can be simplified to the single overarching objective of promoting consumers' interests, including in the long term by ensuring that their reasonable demands continue to be met at the appropriate price and quality (by a competitive industry where that is practical and efficient).

Consumers are not the only group involved. Others whose interests might be candidates for promotion are producers - both shareholders and workers, producers in other industries (e.g. coal), and those affected by externalities. There is also a need to balance the interests of different classes of consumer and present and future generations.

The rhetoric of regulation occasionally speaks of "balancing the interests of consumers and shareholders". However, the interests of shareholders are not obviously the regulator's concern at all, except insofar as the provision of finance at a low cost of capital is in consumers' long-term interests.

The Victorian aim of a "financially viable electricity industry" and the UK requirement that licence holders can finance the activities for which they are licensed are unclear but, taken literally, provide little additional restraint. They do not require that bankruptcy should be avoided, but merely that it should be possible for efficient companies to remain solvent. It is difficult to imagine a situation in which it was impossible for electricity to be produced without bankruptcy (i.e. one in which the duty was not fulfilled, licence holders could not finance their activities and the industry was not financially viable) being in customers' interests or satisfying various of the other duties. Thus, the financing duty appears to add little.

There is an interpretation that "can finance" should be taken to mean "can earn a reasonable rate of return". This would make a significant difference but the interpretation is untested and seems to this non-lawyer to be fanciful.

The promotion of an efficient or economic industry also does not require the promotion of shareholders' interests except as a means to an end. Indeed, customers' interests and economy require that input costs should be minimised and, as part of that process, shareholders' interests be promoted as little as possible by giving them the least generous combination of return, risk etc. necessary to induce them to provide the efficient amount of capital stock.

The arguments about the treatment of workers' interests are similar. There is some argument for protecting workers' interests in the short-term to encourage cheaper supply and prevent disruption in the longer term but this, again, is a by-product of other objectives and the case is not made often.

Similarly, the arguments regulators have considered about the interests of, say, the coal industry have centred on the needs of electricity customers in the longer term. Does the preservation of a large indigenous high-priced coal supply provide protection against possible future shocks in world fuel markets? Would the market not finance this to the extent it was economic?

However, the fact that regulators' duties do not require them to take producers' interests into account independently (if that is, indeed, the case) is not an argument that their duties should not be redrawn to make them do so. After all, if producers could be given a gain which was greater than the cost to consumers, there would be a net gain to citizens' economic welfare. This is only qualified to the extent that producers are foreign or other income distribution concerns come into play. The practicality and merits of such a widening are discussed further in later sections.

Externalities, e.g. on the environment, have presented problems for regulation. Mention is often made of them in duties and this implicitly involves valuing impacts on others (or on consumers and producers acting in other roles). The main problem is normally one of interaction with other agencies and of the industry regulator's limited ability to affect choices with environmental consequences. However, the debate over the separation of industry and environmental regulation or the relative merits of environmental control by quantity or price is not the concern of this paper. Inclusion of some form of environmental duty does at least allow an industry regulator to consider externalities in unusual circumstances.

Future generations' interests are important not only in environmental issues but also in matters relating to the funding of long-life assets. Actions, which may affect the future cost of capital, need to be considered in this light since short-term gains must be weighed against possible long-term losses. In practice, the industry's cost of capital is normally used to compare benefits at different times because DCF calculations in price controls use the cost of capital as a discount factor (see Annex A - A Rough Guide to Price Control). This runs the risk of circularity (if the effect is on the cost of capital) and may, in any case not be appropriate for comparing benefits through time to customers who may have limited access to capital markets and a different time preference. The point may not be of great practical significance but should be borne in mind.

The conflict of interest which can cause the greatest problems is that between different classes of consumer, where monopoly utilities may have established cross-subsidies or still offer the possibility of new cross-subsidy between customers who are:

• industrial, commercial, or domestic;
• high or low voltage;
• high or low volume;
• urban, suburban, or rural;
• direct debit, credit, or prepayment;
• and, by correlation with those categories, rich or poor (or elderly or disabled).

Allocative efficiency requires that each class of customer should be charged the costs they impose (with perhaps some Ramsey pricing if there are economies of scale or scope). However, there is a substantial optimal tax literature which is concerned with obtaining optimal combinations of allocative efficiency, productive efficiency, and income distribution. Cross-subsidy affecting the price of a low-elasticity product such as connection to an electricity system might be part of such an optimum.

In 1997 the incoming government in the United Kingdom set up a review of utility regulation and, in March 1998, published a consultative "Green Paper" entitled A Fair Deal for Consumers: Modernising the Framework for Utility Regulation.

The paper put forward forty two proposals, with varying degrees of endorsement or neutrality, of which the following are particularly relevant here.

The first of these changes was argued in the previous section not to be significantly different from the present situation. The second (and the fourth) address the difficult question of importing other interests into regulators' considerations but run the risk as presently proposed of

• increasing uncertainty and thereby raising costs, and
• reintroducing the danger of interventions in the operation of regulated industries for short-term political ends without adequate consideration of the costs and benefits.

Some argue that UK regulators are already so influenced by ministers that the proposal would make little difference but such a view is difficult to sustain. There are many examples of regulatory independence from ministers and even a cursory examination of how the industries were managed when nationalised and under more direct control by ministers provides a vivid contrast.

The third stems, in part, from a discussion of a hybrid revenue control based on CPI-X with an "error correction mechanism" triggered by achieved profits and is a comment on the proper objectives of price control, which is the subject of the next section of this paper.

The central objective of a price control must be to prevent the use of market power to raise prices and reduce output, while retaining incentives to minimise costs. There is a tension between holding prices down to costs so as to encourage efficiency in consumption and permitting regulated companies to keep prices up after they have made cost savings so as to encourage them to achieve efficiency in production.

A regulator with the sort of duties described above will normally seek to minimise the price paid by customers subject to ensuring that:

1. demand at that price will be met - normally achieved by ensuring that the price control formula permits marginal revenue to exceed marginal cost;
2. the quality of supply for which customers would be prepared to pay is provided - a difficult process (G.Horton Utility Regulation: The Regulation of Quality 1998);
3. any price reduction is not outweighed by a likely increase in future prices as a result;
4. no group of customers is disadvantaged unreasonably (to an extent which is incompatible with statutory duties);
5. other objectives (safety, social, environmental) are met.

Achieving these objectives involves confronting the dilemma of holding prices up so as to encourage efficiency and realise shareholders expectations so as to reduce future costs and prices, but not to the extent where there exists an efficiency gain retained by producers which is larger than the future price reductions which would result from the retention.

These considerations are of importance in determining the length of period over which a price control is set, whether there is any feedback from profits to prices during the control period, and the extent to which profits are returned to "normal", "cost of capital" levels at the time of the review.

There is some confusion in discussion of efficiency and an overly simplistic view that regulators tend to sacrifice efficiency gains by attempting to redistribute any gains that are made to consumers.

Suppose a regulated monopolist achieves a reduction in costs. There is an infinite (before discounting) future stream of savings which can be distributed between monopolist and customer. The obvious null hypothesis is that the monopolist retains savings within the price control period but that they revert to the customer after that point. To the extent that the monopolist does not retain all the savings there is a reduction in incentive to make them and the possibility arises that costs would not be incurred to make the savings even when they were substantially lower than the savings.

But consider the situation in a competitive industry. Such an industry would make savings if these were greater than the costs of doing so. The price would be likely to be that which would cover the total costs of a new entrant. If the nature of the advance was such as to leave some of the existing industry's assets stranded the incumbents may not cover their costs of making the saving.

If a regulated monopoly faces a permanent CPI-X where the price is invariant to costs actually incurred it will have a full incentive to make the saving. If, on the other hand, it faces the prospect of price control revision it will receive the value of the saving for the remainder of the price control period and, depending on the methodology used to revise the control, some recognition in future price controls of the costs incurred to make the saving.

Suppose the form of the revision is a rate of return assessment or a DCF calculation as outlined in Annex A. The precise method of benchmarking costs or of calculating the initial asset base will affect the outcome. If the costs incurred to make the saving are capital costs (or are capable of being capitalised) they will be taken into account in setting future price controls and recovered. If capital costs are benchmarked and set by comparison with other similar utilities costs will still be recovered providing that the area where savings have been made is also benchmarked. Indeed, almost the full value of the savings would still accrue to the utility until others made the same saving.

A problem with incentives occurs when the cost of making the savings is not capitalised and operating costs are not assessed by comparison with other companies (or those companies have made the same savings). In the period after the price control review operating costs may be assessed on a forward-looking estimate which includes the savings but the costs incurred to achieve them (e.g. redundancy payments) may not yet have been recovered but would not be included in the cost base unless the regulator was willing to make a special provision. This puts the company in an uncertain position unless it can obtain a commitment from the regulator. Indeed, there may also be uncertainty about whether costs will be taken into account even when they are capitalised. Thus there may be a tendency for cost-cutting measures to be bunched near the beginning of price control periods, particularly if they are not.capital-intensive and, where marginal, not undertaken at all.

A permanent unrevised CPI-X would create its own problems. Given the difficulties involved in making any forecast, it would be likely that prices would soon diverge from costs and this would create inefficiencies in consumption as too little or too much of the monopoly product was consumed and resources pushed towards or taken from other less or more productive uses. It is debatable whether any production efficiency gained would be as large as the consumption efficiency losses. Indeed, given the possibility of management inertia and the political risks in being seen to make supernormal profits production efficiencies might not even be realised.

In any case, such a situation would not be sustainable. Regulators' duties would not normally permit them to take such a stance because they would have a duty to favour consumers unless, by doing so, they produced an adverse effect on future prices which outweighed the gain. . If the duties were drawn up differently, there would be no confidence that they would remain in that form.

The idea of independent regulation is to remove the activity from the political arena. However, the activity is political in that the regulator is acting on behalf of the state and all acts of the state are political. Since it is sovereign (perhaps within limits set by a constitution or federal association), the state can decide to act differently and change the regulator's objectives. The UK is now proposing a change for regulators which have been in existence for between four and thirteen years.

The pressure to revise a price control for a company which was clearly earning supernormal profits would be immense. If the regulator resisted it, the government would be likely to act. If the government resisted, it might lose the next election to a party which would act. In practice, there can be significant pressure to revise CPI-X price controls even within a 5-year price control period. This was the case in the 1990-5 UK electricity distribution price control, which was not re-opened for fear of creating expectations of asymmetric outcomes in future price controls.

A perpetual CPI-X would not create additional production efficiency incentives because it would not be credible.

This is no great loss. Apart from the trade-off with consumption efficiency mentioned earlier there are two features of the real world which make it unwise to place regulated companies' welfare in regulators' objective functions. The first is information asymmetry and the second, which partly stems from the first, concerns exposure to argument and dialogue.

Information asymmetry is often cited but perhaps not often appreciated fully. Price control and other regulatory decisions are taken on the basis of information about regulated companies. Although the regulator may have the advantage of having slightly better access to information about other regulated companies than does any single regulated company, this is outweighed not only by the massive difference in knowledge about the company itself but also by the difference in resources applied to the review. It would be usual for each one of a number of regulated companies to deploy significantly more resources on the review than the regulator. The information and resources available to consumers and consumer organisations is even smaller. The structure of informational power does not lend itself easily to a position where the regulator furthers the interests of companies and customers equally.

The informational structure is reflected in exposure to debate. In the author's experience there is naturally a slightly confrontational atmosphere between regulators and companies, particularly during price control reviews. Arguments are deployed in many (perhaps hundreds of) papers and meetings. There may also be a confrontational atmosphere between consumer bodies and regulators but the former are not normally in a position to conduct sustained analysis and argument. By default, the regulator has to act on their behalf and any system which pretended that was not the case would either be a sham or a recipe for regulatory capture.

Regulators do not generally have a separate responsibility for the welfare of producers in regulated industries as well as consumers. In theory, this might lead to some loss of productive efficiency. However, if price control review is conducted well the loss is likely to be small and outweighed by allocative efficiency gains. In any case, political and practical considerations make it most unlikely that an alternative system would actually realise greater gains in productive efficiency.