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Consumers of basic services delivered by pipes and wires have benefited from lower prices and more reliable services as a result of the way these networks have been regulated, according to a report published today by Sir John Bourn, head of the National Audit Office. The approach to regulation does, however, have some inherent limitations which the regulators are seeking to address.

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The report shows how the Office of Gas and Electricity Markets (OFGEM), the Office of Telecommunications (OFTEL) and the Office of Water Supplies (OFWAT) are regulating the companies owning the pipe and wire networks which deliver water, electricity and telecommunications services to businesses and homes. This involves each of the regulators setting price or revenue limits every four or five years which enable the companies to deliver the services expected of them. The approach adopted, known as RPI-X, is common to all the regulators.

The report concludes that the way the regulators have applied the RPI – X approach has brought considerable benefits to both consumers and companies, in each of the industries examined in detail (water, electricity distribution, electricity transmission and telecommunications). Companies have become more efficient, and these efficiencies have not come at the expense of any reduction in quality of service. The reliability of the networks has increased in recent years and there is no evidence that investment has been inadequate or that the networks have deteriorated. The benefits include:

  • Telecommunications: Following OFTEL’s 2001 price review, charges for some of BT’s network services will fall by up to 13% a year in real terms until 2005.
  • Water and sewerage: In its 1999 review, OFWAT reduced average prices by 12.3 per cent in 2000-01. Since 1990 companies in the water industry have invested some £50 billion in improving drinking water and environmental standards, while the number of unplanned supply interruptions has fallen from 0.4 to 0.2 per cent of properties since 1990.
  • Electricity: The most recent price reviews cut charges by the distribution companies on average by 24 per cent in 2000-01, and caps on the National Grid Company’s revenue that represent the equivalent of falls in charges of 1.5 per cent a year. The number of interruptions to customers’ electricity supply has fallen over the years.

In the absence of effective competition, where regulation may be needed, the main challenge facing regulators, is to maintain incentives for monopoly companies to deliver effective and efficient networks, but without creating distorted or unintended incentives, or imposing excessive burdens on regulated companies. The report highlights a number of risks arising from the limitations inherent in the RPI-X approach that regulators will need to consider in the next round of price reviews, starting later this year, as well as indicating how the regulators are seeking to address them. In particular:

  • The regulators should build on the work they have already undertaken to remove features in their price reviews that give companies an incentive to bias their decision making or accounting to obtain more favourable treatment. In particular, the National Audit Office noted that incentives to find efficiency savings may be weaker towards the end of the 4 or 5 year price control periods. And biased incentives may arise from the differing treatment of operating and capital expenditure.
  • The regulators should continue their drive to identify publicly improvements in outputs and outcomes that they are willing to allow companies to invest in. This would address the risk that companies may defer planning or initiating investment until the next price review because of uncertainty as to whether the regulators will accept that additional investment is necessary.
  • The regulators should encourage network companies to develop risk management models to assess the potential impact of deterioration in asset performance on future levels of service. This would address the risk that regulators may make decisions in their price reviews on the appropriate level of expenditure on assets on the basis of inadequate information because clear links between expenditure and quality of network performance are hard to identify.
  • The regulators should present clearly the assumptions and financial models underlying their price review decisions and the extent to which these will apply at the next review, in line with action which they are already considering or have undertaken to implement. This should help reduce the perception of uncertainty in the minds of investors that may increase the cost of financing new investment.
  • The regulators should continue to address the risk that the process of price regulation may impose excessive demands on companies. Although regulators have sought to set out the information they require from companies clearly, there is a strong perception that they ask for unnecessary information, and they could specify more clearly what they want in future reviews and why. They should also evaluate the different types of analysis they have undertaken in reviews with a view to simplifying the process to reduce costs and concentrate on what really matters.

"The way that the regulators have used their price reviews to drive down the costs of the major utility networks while the quality of the service delivered has improved, represents a great success story. But regulation inevitably has its drawbacks and I am glad that the regulators are considering how to head off the risks we have identified to incentives and future investment."

Sir John Bourn


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