Regulatory credibility and the irresistible urge to meddle

When the great utilities were being privatised, one of the key objectives was to establish a regulatory regime which would be credible to investors and fair to customers. The way it worked was that the companies would be given fixed contracts ex ante, and these would be reset on a periodic basis. Within the period, prices would be fixed by an RPI-X formula.

The logic was very clear: the only way in which the performance of the companies could be improved was to incentivise them to do so. Fixed-price, fixed-period contracts gave them the chance to outperform, and it was this outperformance which managers would chase after in the interests of their shareholders. The regulators would re-base the prices at the end of the period as the companies revealed what they could actually deliver, rather than what they told the regulators ex ante.

It was all very simple, and that was its attraction. But it never worked out as intended, for the very good reason that regulators and politicians could not resist the urge to intervene. Faced with the chance to curry favour with the customers, politicians kept up the pressure and most regulators eventually obliged. Indeed it is hard to think of many periods when there has not been some form of intervention, and the companies quickly learned that there was, in effect, a tolerable band of outperformance, beyond which the risk of intervention would be high.

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