Takeover frenzy that blew the fuse

The utilities are in a privatised pickle. Jeremy Warner looks at why it all went wrong, and how it might be put right

Privatisation is probably Britain's biggest single intellectual contribution to the evolution of post-war commerce. All over the world, its pioneering path is being followed. Most business people agree that the process has yielded enormous benefits.

But get the regulatory framework wrong, and you throw all those benefits away. And in most people's minds, the privatised utilities have become nothing short of a national scandal: soaring profits, excessive executive salaries, spectacular returns for shareholders and a raw deal for customers.

A frenzy of takeover bids for regional electricity companies (RECs), the latest of which was PowerGen's pounds 1.95bn offer yesterday for Midlands Electricity, has heightened the impression of an industry whose regulatory structure conspires to serve the interests of the City and shareholders before those of the customer and taxpayer. Even the regulated themselves, the privatised utilities, see the system as perverse, arbitrary and unfair.

Against a background of a growing consensus that something must be done, Labour is having a field day. At a conference today of regulators, analysts and industry executives, Jack Cunningham, Shadow Trade and Industry Secretary, is to spell out his own prescription for reform.

The Government seems to have been embarrassed into silence. Ministers mouth an increasingly hollow defence of the regulatory set-up. Privately, they are furious, blaming the individuals who head up thequangos for the shambles. Publicly they are impotent, for the problems go beyond bad decision-making and poor PR.

To be fair on the Government, this is a debate not as cut and dried as it might first appear, not least because utilities regulation is intimately bound up with the politics and philosophy of privatisation.

To understand the present furore, you have to return to the roots of privatisation. With each utility sell-off, the Government's overriding priorities were to sell as quickly as possible for as much as possible.Since there was no precedent, the regulatory system had to be deliberately lax to attract investors. As in all commercial negotiations, there was also an amount of deliberate deception involved. Managements played down the real worth of their businesses and the scope for efficiency gain so as to flatter their own performance in the aftermath of privatisation and help to justify lucrative share option and bonus schemes.

The same was true of the City, which in its own interests bid down the price of sell-offs as much as it could. In this it was assisted by the Labour Party, whose campaigns against each privatisation generally had the effect of making the price much more favourable to investors. By the summer of 1989, for instance, fierce campaigning by a combination of Labour and Friends of the Earth had convinced the City that the water authorities were largely unsellable. The campaigners then publicised a leaked Government document showing the soon-to-be-privatised companies as capable of delivering a rising dividend stream into the indefinite future on the generous regulatory framework proposed. Labour thought it had discovered a scandal; instead, the campaigners ended up shooting themselves in the foot, by convincing the City to buy.

Even so, the water companies had to be primed with massive "green dowries" - a process that the passage of time showed to have been unnecessary.

With all the utilities, tariff controls are set so as to give an "appropriate" rate of return, hedged against inflation, minus an amount as an incentive to encourage efficiency. This is called "price cap" regulation and it was largely invented in Britain. In theory it is a highly effective way of balancing the interests of customers and shareholders. In practice it may leave something to be desired.

Forecasting future cash flows, deciding on "appropriate rates of return", is an inexact science, even in businesses with a stable source of monopoly revenue. The rate of return, in nearly all cases, has turned out higher than assumed. This is supposed to be compensated for through periodic review of charging controls.

The RECs could not believe their luck when they saw the results of Professor Stephen Littlechild's first review of electricity prices. The regulator seemed hopelessly to have underestimated the scope for cost cuts, as well as misunderstanding what an "appropriate rate of return" might be for monopoly suppliers of this type.

Furthermore, the transitory gains shareholders get ahead of periodic review can be substantial. In the case of the RECs they have been vast, with ordinary dividends, special dividends, share buybacks and the like delivering the sort of returns more normally associated with a blockbuster product discovery than a bog standard utility.

Over time, excessive returns associated with the early years of privatisation begin to diminish, as the regulatory screw tightens with each successive review.

Even if the problem is eventually self-correcting, however, the perception remains that the system isn't working. Nor is it only consumers and opposition MPs who see it this way. The City and the utilities have their own concerns. Harry Moulson, managing director of Transco, the British Gas transmission system, likens the regulator's rule to a constant process of chiselling, so that you never know where the parameters lie or what the priorities are meant to be.

Peter Strickland, strategy manager at British Telecom, complains that in BT's case, the terms of the original regulatory contract have been written over with such frequency that it is no longer possible to know what that contract is. The City, too, regards any regulatory change not provided for in the privatisation prospectus as at least a breach of faith, if not of contract. Any form of retrospective action, such as a windfall profits tax, would be seen by the City as a form of theft - like attempting to up the price of a car after it has been sold.

So what is the solution? One of the most obviously appealing options is profit sharing, dividing up excess returns on a predetermined basis between shareholders and customers. Like most good ideas, it is not new. A variation of it - "sliding scale dividend control", which dictates that dividend rises have to be matched by a corresponding reduction in customer tariffs - was widely used by private sector gas utilities in the past century.

Like most suggested remedies, however, it has drawbacks, the most obvious of which is that it can act as a disincentive to efficiency. Dermot Glynn, managing director of National Economic Research Associates, likens profit sharing to the effects of very high taxation.

Ian Byatt, the water industry regulator, goes further. He believes that profit sharing would act as such a powerful disincentive to efficiency that it could result in the customer sharing in losses, not profits, with the utilities failing to meet even the undemanding targets set by regulators.

In any event, it would be a retreat to the discredited "return on capital" type of regulation used in the US, a system widely believed to contribute to overweight organisations and excessively high charges.

Despite these drawbacks,profit-sharing clearly has political appeal. Labour has embraced it wholeheartedly, and some utilities regard its introduction as almost inevitable - to some extent pre-empting it with their own watered-down voluntary profit-sharing schemes.

But if not everyone agrees with reform of price cap regulation, there is a degree of consensus emerging around institutional reform. Few would disagree with the proposition that regulation needs to become more open and publicly accountable. Moreover, personality-driven regulation, with decision-making concentrated in one man or woman, is plainly a bad thing that has led to obvious mistakes. A more collegiate and transparent approach might have mitigated some of the worst abuses. It is hard to see how anything would be gained by merging all the regulators into one monolithic bureaucracy - a possibility being explored by the Labour Party - but the idea of regulatory panels, public consultation and discussion has clear attractions.

The American system of making price review subject to public inquiry also seems to have much to commend it, though many with direct experience of these procedures express horror at the irrelevance of the process. Professor Ralph Turvey, chairman of the Centre for the Study of Regulated Industries, once testified before such an inquiry and found its adversarial nature incapable of producing any illumination. Irrelevance of debate, however, is part of the price you pay for democracy. If greater public accountability makes utility regulation more acceptable, it can only be an advance. (Case study captions omitted)