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Sawyer: The UK Economy 16e Chapter 9 Privatization and Regulation Privatization • Privatization is the transfer of ownership from the public sector to the private sector. Privatization in practice involves rather more than a change of ownership (though some of the changes are closely related to the change of ownership). • The objectives of privatization have been variously summarised and usually taken to include the reduction of government involvement in industry; improvement of efficiency in both the privatised companies and the remaining public sector; reduction of the governments’ borrowing; weakening the power of trade unions in public sector wage bargaining; widening share ownership; the encouragement of employee share ownership and the gaining of political advantages. Privatization • The privatisation programme shifted all of the major utilities with the exception of the postal service from the public to the private sector, as well as selling a wide range of companies such as Britoil, Jaguar Car, National Freight. • Employment in public corporations fell from 1,867 thousand in 1981 to 599 thousand in 1991 and further to 379 thousand in 2002 (Economic Trends, September 2003). Theory of Regulation • The general analysis of regulation by government (and its agencies) in a market economy arises from the ‘market failure’ approach. • The privatized utilities were, at least initially, in a monopoly position, and hence the perceived need for regulation of their prices and other activities. • The ‘agency capture’ argument is that there will be a degree of capture of the regulatory agency by the regulated utility (its owners and managers), and that the regulatory agency will come to reflect the interests of the producers (public utility) rather than the consumers. Modes of Regulation • The rationale for the regulation of ‘natural monopolies’ arises from their monopoly power, and hence focuses on control of their prices and/or profits. • The ‘direct’ route would be to impose controls on the level or rate of profits, often used in the United States under the heading of rate of return regulation (ROR). In effect, public utilities are there constrained to a maximum rate of return on assets. • This mode of regulation was seen to have some undesirable effects, particularly in terms of effects on costs and efficiency. The basis of the argument was that a constraint on the rate of return provided the managers of public utilities with the wrong incentives. Modes of Regulation • The approach to utility regulation in Britain has been described as drawing on three principles: ‘the rejection of rate-of-return regulation; the rejection of direct government control; and the rejection of the assumption of monopoly as a permanent feature’ (Helm, 1995). • The first principle led to a general mode of regulation (the precise application of which varies between industries as will be seen below) generally described as ‘RPI - x’ where RPI refers to the general rate of inflation and x is a figure fixed by the relevant regulatory authority. Modes of Regulation • The second principle led to the appointment of regulators who, subject to general specified duties, operate independently of government. • The third principle has been reflected in the liberalisation of the gas and electricity markets whereby the previous monopoly positions of British Gas and the regional electricity companies have been replaced by competition in the supply of gas and electricity. Modes of Regulation • There may be a ratchet effect in operation whereby the achieved productivity growth in one period feeds into the target productivity growth for the next period. If the regulator underestimates the productivity growth potential, then there can be a profit bonanza for the public utility concerned. • The regulation of price leaves the issue of the quality of the product to be purchased for the regulated price. • Some incentive for the regulated firm to lower quality to reduce its costs. • The regulatory agency is then drawn into issues of quality. Modes of Regulation • The relationship between the regulator and the regulated has aspects akin to the principal-agent problem, where one person (or group of people) – the principal – contracts another person (or group of people) – the agent – to undertake a range of activities on their behalf. The principal-agent problem arises since the principal lacks complete information on the possibilities facing the agent, and cannot fully monitor the activities of the agent. Regulation of Public Utilities • The major regulatory agencies are Office of Water Services (OFWAT), Office of the Rail Regulator (ORR), and initially the Office of Electricity Regulation (OFFER) and Office of Gas Supply (OFGAS) now placed together as Office of Gas and Electricity Markets (OFGEM), and the Strategic Rail Authority (SRA). Office of Telecommunication (OFTEL) was the first to be established and has been absorbed in late 2003 into Office of Communications (Ofcom). Regulation of Public Utilities • For the water industry (covering England and Wales only) the general formula for the price cap has been described as RPI + K (in contrast with the RPI - x rule elsewhere with prices generally falling in real terms). Regulation of Public Utilities The roles of the Strategic Rail Authority (SRA) include the awarding of franchises to operate particular rail networks, within which the ‘franchise agreements…specify minimum service levels and subsidy (or payments), define performance standards for incentive regime and enforcement purposes, and regulate the price of certain fares’. Regulation of Public Utilities • The formation of OFGEM, combining the regulation of gas and electricity markets under one regulator was in part a response to the mergers between utility companies, and particularly between gas and electricity companies. • The gas industry was privatised in 1986 and electricity in 1989. Following privatisation, gas and electricity prices were subject to regulation of the RPI-X form. • The regulation of the National Grid Company by OFGEM follows the RPI – x formulation with x currently set at 3 per cent though with an initial reduction in price within the control period. But the allowed revenues as calculated by OFGEM are based on average pre-tax cost of capital of between 5.5 per cent and 6.25 per cent. Regulation and Consumer Protection • There are numerous laws governing trading activities, setting product standards and contractual terms on the sale of goods and services. • These laws could be viewed as part of the regulatory framework for the operation of business. There are also other limitations on the activities of firms come from legislation relating to consumer protection, much of which is enforced by the Office of Fair Trading (OFT) and by Trading Standards Officers. Regulation and Consumer Protection • The OFT has a duty to collect and assess information on commercial activities, so that trading practices which may affect consumers’ interests may be discovered. • The OFT has sought to draw up codes of practice in a range of industries (covering, for example, direct selling, double glazing, motor trade and credit) and can set in motion procedures which can lead to the banning of specified trade practices. Under the Fair Trading Act 1973, the DGFT can seek assurances on future good conduct when traders persistently disregard their obligations under the law in a manner detrimental to consumers, and if such assurances are not given or given and then broken the DGFT can bring proceedings to obtain a court order (breach of which may result in action for contempt of court). The DGFT has powers to refuse, grant or suspend licence applications in particular areas of business and trade. Regulation and Consumer Protection • One particular area of regulation and consumer protection which is overseen by the Office of Fair Trading is credit licensing, under which an individual or firm wishing to provide credit requires the necessary licence. Thus, the conditions of entry into the ‘credit industry’ are controlled. Possibilities of confusion of consumers as to the terms on which credit is being supplied, the impacts of excessive debt, and perceptions that there may be an imbalance of information and power between those supplying and those requiring credit are amongst the reasons behind the licensing of credit provision.
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