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What do the British know about regulation that we don’t?



Regulation is back in the spotlight. Moody's, the bond rating agency, just issued a review of  regulation worldwide, that started with these words:  "Prudent regulation key to mitigating risk…"  The bond rating agency put its emphasis on mitigating the risk of carbon mitigation but pretty much opened up the relevance to other risks.  What about   regulation itself as a risk  factor, especially when the regulators decided to change  policies?   American regulators, we know,  have begun to re-examine  their policies in light of experiments elsewhere designed  to encourage  utilities to operate  more efficiently and then pass on  savings to consumers—- most notably the British  effort  that  began in 1990 which failed to radically reduce  prices  but did line the pockets of the utilities.  Whether shifting  American regulation to the British model will reduce risk is a big question.  Evidence indicates that it won't,   but who knows?


What's wrong with American-style regulation?  Critics oppose  it  because it focuses on  rate of return.  The regulator sets prices calculated to cover all operating costs plus a fair return on the investment in assets dedicated to serving the public.    Thus, the American utility has no incentive to reduce costs because it can pass on all costs to customers, and it has every incentive to over- invest  because it can earn a guaranteed return on that investment.   


Way back in 1962, two economists, Harvey Averch and Leland Johnson, published an article making that case, and  policy makers — including the British— have latched onto  the Averch-Johnson Effect ever since. But maybe the policy makers  missed the point,  which economists, incidentally did not.   Namely that  no sensible managers will invest capital unless they expect that investment to produce a return in excess of its cost. 


Financial theory tells us that when a company earns more than its cost of capital, its stock  sells  above  its  book value.  Successful companies generally earn more than cost of capital, so no big deal.    Regulated utilities, though,  have given up their right  to earn a high return profit in exchange  for protection from competition.  Regulators, instead,  set a fair return, generally defined as  cost of capital.  Yet,  the price of utility stocks in the post war period  fell below book value in only 14 of the 71 postwar years.   (Twelve of those fourteen years encompassed the nuclear building disaster and the Energy Crisis.)   Furthermore, the stocks generally sold substantially above book value.  Financial experts  agree that  utilities  should earn more than   cost of capital, as a precautionary matter,   but how much more?


Perhaps, then, the real issue is not  whether rate of return regulation itself encourages expensive over -investment but rather whether regulators set the correct return.  As for whether alternative regulatory formulas encourage greater efficiency in operations,  studies show that they do, but they also increase the cost of capital.. So, for  the alternative system to work for consumers  over the long term,   the additional operating efficiencies must  exceed the increase in  cost of capital. 


We can understand the desire of policy makers to do something different, but perhaps  doing the job they presently have better might be a good start. 


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