Regulating Utilities: Have We Got the Formula Right?

Although much copied, Britain's RPI-X approach may not be the best way to drive better service and efficiency in the long run A formula based on the use of rolling historical benchmarks could provide better incentives Since Margaret Thatcher began selling off state-owned utilities in 1984, the United Kingdom has become something of a role model for privatization. Governments around the world have embraced not only the privatization ideology but also its methods. The RPI-X formula, which is used to set the prices that UK privatized utilities charge their customers, has driven gains in efficiency so successfully that it is becoming the method of choice in countries from Argentina to Australia. But RPI-X is imperfect, and over the past few years flaws have begun to emerge. It is appropriate for driving efficiency improvements in the early years after privatization, but something different will be needed in the longer term. One possible replacement is a system based on rolling historical benchmarks. Why regulate? The productivity of a country's utilities plays a vital part in the productivity of the overall economy for two reasons. First, the price other companies pay for their share of these essential services affects their own performance. Second, utilities in themselves generally make up some 10 percent of a nation's GDP. It is the importance of the utilities to the national well-being that explains why, at least until the 1980s, most governments chose to own them. But state ownership often undermined efficiency and investment - problems that gave rise to the recent trend toward privatization. Private ownership also makes it possible to introduce competition, which should in turn force improvements in performance. In reality, however, a significant proportion of the core activities of a utility consists of natural monopolies; either the market is not large enough to support two players operating at the minimum efficient scale or a single system confers major benefits. (Having one gas pipeline down a street, say, is clearly cheaper than having two.) Competition therefore cannot drive efficiency for these activities, although technological advances may change the minimum efficient scale. In any event, natural monopolies, like monopolies in general, have the power to charge high prices and thus need to be regulated. In the United States, where utilities have always been privately owned to a large extent, independent regulators cap prices so that profits are confined to the cost of capital return on a utility's asset base. Unfortunately, this "rate-of-return" regulation gives utilities no incentive to improve their performance by reducing operating costs or spending capital more efficiently. If anything, it encourages companies to spend as much money as possible gold-plating their assets to create a bigger asset base on which to earn a return. (*) So when the first big UK privatization, that of British Telecom, took place in 1984, a new form of regulation was introduced: RPI-X. (**) The RPI-X formula was specifically designed to give companies an incentive to improve their efficiency and to pass on the resulting gains to customers. The prices a company may charge are set for what is known as a "control period," typically lasting five years. These prices are supposed to let the company earn what is deemed a fair return on its assets if it operates as efficiently as would a benchmark company. An independent regulator first assesses the savings the utility achieved by improving its efficiency during the previous control period and translates them into an initial reduction in its prices. Next, the regulator forecasts what a "reasonably efficient" benchmark company would require during its next control period to cover its operating costs, its renewal capital investment (to replace existing assets), and its enhancement capital investment (to deliver such additional outputs as increased capacity, reduced environmental impact, or improved service). …