Choosing the wrong path: regulatory review in energy

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While I was away on holidays, the ‘stage two’ report on regulatory review for electricity and gas was released. See here. Unfortunately, now that I have read the report, I come to an unsatisfactory conclusion:

  • The report correctly identifies some of the problems with the current review system, but
  • the recommended solution will make these problems worse.

The current limited merits review process is a regulatory no-man’s-land. It can only focus on bits of a regulatory decision made by the Australian Energy Regulator (AER) and this has led to claims of ‘cherry picking’ by regulated companies. To avoid this problem the Panel had two alternatives:

  1. Allow review of a regulator’s decisions that opens up the whole decision to ‘re-evaluation’; or
  2. Narrow the focus of the review to only matters of error in law or economics.

The Panel puts forward the key factor for the second alternative  – then chooses the first!

Why does a ‘full review’ make no sense? The Panel outline the idea behind a full review:

The Panel’s interpretation of merits review – that it implies reconsideration of the AER’s overall revenue/price determination to assess whether or not it was the preferable decision – … (p.24)

In other words, regulation of energy utilities is not a precise science. There are a wide range of alternative decisions that a regulator can reach, all of which are reasonable.

[A] primary regulator can, in a particular factual context, usually satisfy a given set of rules and principles in myriad different ways, not all of which lead to closely similar outcomes in terms of the final, aggregate revenue determination (p.28).

Unless it makes an error of law or gets the economics manifestly wrong, the regulator can choose one of a variety of alternatives from this ‘myriad’, which is ‘reasonable’ and ‘justifiable’. But there is no single ‘optimal’ choice. The Panel’s mistake is to believe that there is an objective way to evaluate a ‘preferable’ decision against a benchmark (the Panel’s benchmark is the ‘long term interests of consumers’).

If, therefore, the purpose of merits review is to help find the most preferable of these myriad, possible decisions, … (p.29).

As a matter of economics (and in the absence of perfect foresight) there is no way to objectively choose such a preferable decision. Of the range of regulatory decisions, no one decision may be ‘preferable’ to any other decision except on a subjective basis. Or to put it another way, two regulators may differ in their views of the importance of different incentives in a regulatory regime (e.g. the incentive to invest, the incentive to keep prices down, the importance of stable prices to underpin consumer investments, etc). As such, they can differ in their view as to which regulatory decision is ‘preferable’. Neither regulator is ‘wrong’ or ‘right’. It is a difference in subjective evaluation.

By failing to recognise that a ‘preferable’ decision is subjective,  the Panel concludes that there should be a review if a ‘better decision’ can be reached. But if the determination of a ‘preferable decision’ is subjective and there is a range of reasonable alternatives, then to say to a review body that it should ‘choose a better one’ is simply to replace the subjective evaluation of the regulator with the subjective evaluation of the review body.

Such an approach would only make sense if the review body were somehow ‘better placed’ than the regulator. Indeed, the Panel appear to recognise this. So on p.29 the Panel refers to regulatory capture and the ‘psychological … biases’ that may undermine appropriate regulatory decisions. It states that:

Good regulatory systems, including good review arrangements, are designed to mitigate these unwanted influences.

The implicit conclusion – that a regulator is subject to biases or capture, but a review body is not – appears baseless. Certainly the Panel presents no evidence. But in the absence of this conclusion, a ‘full review’ such as that recommended by the Panel simply replaces one choice of regulatory outcome with another. It does not seek a right answer. It simply reviews on the basis of subjective opinion. And that is just a waste of time and resources. It also allows the regulated firm to continue to have two bites. Don’t like the choice of the regulator? Let’s roll the dice again at the review body!

Given that there is not a single ‘correct’ regulatory decision but there are a range of reasonable decisions, a better solution is to recognise and accept this breadth. So long as the regulator has chosen one of the set of reasonable alternative decisions, then the regulator’s decision should stand. In other words, unless the regulator has made a legal error, or has made a decision which, on any economic basis, is manifestly unreasonable, the regulator’s decision should stand. The review process should be narrowed, not broadened.

So, in summary, the Panel starts at the right point, but they have an (unsubstantiated) belief in the ability of a review body to objectively choose a preferable decision from a set of reasonable decisions. They are mistaken, and this leads them to the wrong conclusion.

Finally, let me highlight my potential conflict of interest. I am a member of the Economic Regulation Authority of WA (ERAWA) – which is also subject to merits review. The views expressed here are mine alone and do not represent the views of the ERAWA. 

 

3 Responses to "Choosing the wrong path: regulatory review in energy"
  1. Stephen

    You make a lot of sense here. One point, though, is how you define a decision that is, on any economic basis, manifestly unreasonable. This seems to be part of the problem – that grounds for a legal review of a decision are very narrow, but a full merits review is far too broad and leads to poor incentives for the regulated firms. How do you bring in an ‘economically unreasonable’ test without turning the appeal into a full merits review?

  2. Hmmm, not so sure.

    The problem here is as old as the hills: who regulates the regulator.

    AER regulatory decisions are very big, complex and important decisions. Seems to me that allowing a second pair of eyes over the regulator’s decision will act as a discipline on the AER, and will allow egregious mistakes to be corrected.

    Of course the aspiration of the reviewer must be that it believes a better decision is possible, it could not accept a decision for review if it did work from this point.

    Seems to me to be no bad thing to work from this point, and I doubt the argument that simply because the review body does not command the resources of the AER, that it will necessarily not deliver a better decision than the AER.

  3. Phht. The review is irrelevant, and addressing a problem that’s been and gone.

    Prices were low. Demand went up. Infrastructure couldn’t cope.

    The rules allowed extra infrastructure to be built and paid for. Prices went up. Demand went down.

    This is pretty much what an Econ 101 class might have been taught 20 or 30 years ago.

    (And thanks to Steven King for disclosing potential conflicts of interest. It is to Bruce Mountain’s shame that he did not do likewise.)

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