I am giving a talk at the ACCC regulatory conference later this week. For those interested, here is a brief summary of what I am going to talk about.
The topic is the future of regulation in Australia. The perspective is the lessons from the last 20 years.
About 14 years ago, I was at a similar ACCC conference talking on a very similar topic. I had one simple point to make: regardless of what it was called, infrastructure regulation in Australia was effectively rate-of-return regulation.
In many ways, that simple point remains valid. Whatever we call it – building block regulation, cost of service regulation, or rate-of-return regulation – infrastructure regulation both in Australia and around the world follows a very similar, simple pattern.
We have had more than 40 years of modern regulatory economics but very little of this research has made a practical impact. Indeed, the take-away from 40 years of research can probably be summarised as “incentives matter”. So why don’t regulators use the mechanisms developed in economics over the last 40 years except in a superficial and peripheral way?
The answer is simple. The regulatory problem is just too hard. Most regulated firms do not provide final goods or services. They provide inputs to further production. For example, gas pipelines, electricity distribution systems, airports and telephone networks. Efficient regulation needs to consider upstream costs and downstream competition. If there is imperfect competition downstream, for example between telephone retailers, then upstream regulation has multiple economic objectives: keeping the regulated firm in business, creating incentives for the regulated firm to make the right capital investments, creating incentives for the regulated firm to minimise costs, establishing an efficient pricing structure so that final consumers receive prices that reflect marginal costs, making sure downstream firms face the correct input prices so that they do not use too little or too much of a regulated input, and establishing an appropriate configuration of downstream market participants. In simple terms, there are a variety of complex objectives and the regulator simply does not have enough tools to achieve all of these economic efficiency objectives. Even if the regulator had perfect information it could not achieve all of these objectives with the small number of instruments that it has at its command. Put simply, when dealing with upstream regulated input providers and a goal of economic efficiency, the regulator’s task is impossible.
As a consequence, regulators both here and around the world implement a third-best solution. Regulators let the imperfectly competitive downstream sector look after itself. They make sure the regulated firm doesn’t go bankrupt. And, to the degree possible, they provide the regulated firm with some modest incentives to be efficient. In Australia we call this building block regulation. And it is about as good as we can get.
So what have we learnt?
First, we have learnt that good regulation is hard and perfect regulation is impossible.
Second, we have learnt that regulators are a poor alternative to markets. This is not a new lesson but it is one that every generation of economists appears to have to relearn. Every generation of economists believes it has the skill and the ability to regulate infrastructure firms in ways that are cleverer and more efficient than our intellectual forefathers. And every generation (so far!) is wrong. We have learnt that economists and regulators need to be humble. We need to recognise that we have insufficient information and insufficient regulatory tools to achieve economic efficiency or to design a market that will be optimal for customers.
So what can a humble regulator actually do? A humble regulator will recognise its own flaws. It will recognise that where ever possible it should step out-of-the-way and let competition work. Even imperfect competition will often be better than the best regulator in terms of maximizing economic efficiency and delivering benefits to customers. So the first objective of the regulator should be to work out how to get out-of-the-way of competition. Only if competition is clearly inappropriate should the regulator intervene in a limited way, for example in electricity transmission networks. And the regulator should always have an objective to make itself redundant. The long-term objective of regulators should be to foster competition where possible so that the regulator is no longer need.
In those situations with the regulator needs to act, how should the regulator implement building block or cost of service regulation?
Noting that the key objective is to maintain the regulated firm and to help it pursue efficient activities, regulation is largely about risk allocation. The regulator needs to consider what risks are borne by which party. These decisions need to be made upfront and built into the regulatory process. There is no point in exposing regulated firms to risks that they cannot manage. There is every reason to expose regulated firms to risks that they are best placed to manage. An implication of this is that in our standard financial models that are used for regulation, regulated firms should face very little systematic risk. This means that the return to the regulated firm’s shareholders as compensation for systematic risk should be very low.
The third and final lesson is what I will call the ‘Australian problem’. In Australia most of our regulated infrastructure firms are government-owned. But we insist on pretending that they are not. This approach, sometimes called ‘competitive neutrality’, makes no sense. Competitive neutrality may be sensible if government businesses are competing with private firms. But in that case we don’t need regulation. If we are regulating an infrastructure provider it is because competition is not feasible. And if it is a government-owned infrastructure provider we should treat it like a government-owned infrastructure provider. We don’t. The area of Australian regulation crying out for more research is the regulation of government business enterprises. Is this regulation really a question of optimal taxation? After all, the profit from the government-owned business is simply government revenue – just like tax revenue. How do we deal with the situation where tax payers are the shareholders? And what are the implications when the same taxpayers are the main consumers of the relevant final goods and services? Surprisingly, after almost 20 years of regulating government-owned enterprises in Australia, these questions are largely unanswered. And that is a significant problem.