In the next three videos, we're going to look at the UK water sectors regulation experience. A novel form of economic regulation of privatized utilities emerged here. It offered the promise of a simpler less intrusive approach than the rate of return regulation approach that Dale just described in the previous video. So we're going to focus on economic regulation here. Leaving aside environmental, social, and customer related regulations. In this first video, we'll describe what was novel and promising about the economic regulation approach suggested for the privatized England and Wales Water industry. In the second video, we'll then describe how the economic regulation approach will be dealt in practice. In the third video, we'll explore how regulation may enable or constrain possibilities for renovation to address future challenges in the water sector. We showed this like, previously in our session on the UK water privatization experience. These are the various stakeholders that make up the privatized water sector in England in Wales. That are separate economic, environmental and social regulators. Here, the economic regulator is Ofwat. As Dale has said, in an industrialized country setting like England and Wales, the economic regulator of a privatized water utility is mainly concerned with preventing abuse of natural monopoly power by controlling what water prices can be charged. To customers who are not free to choose their water company supplier, given that there's no competitive market. Typically here, we are talking about economic regulation to keep prices down. Unless, there are compelling reasons for prices to be allowed to rise within certain limits. For instance, to fund improvements to the water service. Let me discuss the UK's water privatization experience. We saw it was an outlier of sorts. The UK government chose full divestiture privatization of the England and Wales water industry, a rare option. The UK is also an outlier because of its water sector economic regulation approach. Within the UK's broader privatization program, a novel approach of price cap economic regulation was invented. This economic regulation approach was then adopted for setting water prices in England and Wales. It's called RPI -X price cap regulation. RPI stands for the retail prices index and is the measure of inflation. X is an efficiency challenge. We'll give more detail in a worked example about this later in this video. Just as we saw a key individual in Mr. Privatization, in the UK water privatization story, there's also a Mr Regulation and IU cable to regulation account. This is Professor Stephen Littlechild. He's a fellow of the Judge Business School, University of Cambridge and Emeritus Professor at the University of Birmingham, where he trained in the UK as well as the University of East and in the USA at the University of Texas at Austin. Professor Littlechild was a member of the Competition Authority, the Monopolies and Mergers Commission in the UK from 1983 to 1988, and the inaugural regulator or director general of electricity supply from 1989 to 1998. He now consults internationally on matters of privatization, regulation, and competition in various utility sectors. Professor Littlechild was an essential figure in the invention of RPI- X price cap economic regulation. John Stern of the London Business School has described as the 1983 Littlechild Report as one of the most famous but least read economic papers. The 1983 Littlechild Report develops an idea about having a temporary cap on price changes in the UK telecom sector at a fixed rate below the retail prices index, or RPI, measure of inflation. Specifically, the rate of inflation or RPI -2%. This would be until a competitive telecoms market emerged that would incentivize telecom companies to set their prices competitively. Littlechild modified this idea for a temporary, fixed price-cap rate below the rate of inflation. Into a flexible price cap, or RPI -X that could be used for different utility sectors, not just telecoms. And it could be used permanently to provide an efficiency challenge in utility sectors where competition might not emerge. RPI -X is a price adjustment formula. It is applied to the initial price paid by customers for the utility service. The X factor is determined through the process of economic revelation. Having a flexible X factor in the price adjustment formula instead of a fixed percentage meant that a utility company can make a bid to the economic regulator for the X it wishes to charge. By bidding for a particular X factor, the utility company is bidding for a future price rate that will either adjust its initial price upwards or downwards, relative to the initial RPI-based measure of inflation. So utility company might bid to adjust its initial price to customers at a rate below the RPI measured rate of inflation. If it believed, it could still meet its required targets by charging a reduced price in real terms, or a utility company could bid to adjust its initial price to customers above inflation if it knew it had to invest, say, to improve its utility networks so much that it would have to charge its customers an increased price in real terms. So Littlechild took a specific idea for a temporary price adjustment cap on telecom service prices of RPI -2%, and turned it into a new general approach to price cap regulation that could be applied to any privatized utility sector. For land economist John Stern has said of the publication of this intellectual innovation in the 1983 Littlechild report that the world of utility regulation economics and policy making, would never be the same again. There have also been 20th, 25th and 30th anniversary events and academic journal special issues, to celebrate Professor Littlechild's intellectual innervation in the field of economic regulation. RPI -X price cap regulation has since been used in utility sectors in Australia, New Zealand, Latin America, parts of Europe, and in some US telecoms regulation. And in 2005, a portrait of Professor Littlechild was part of an exhibition in the UK's National Portrait Gallery in recognition of his contributions. Before the Littlechild report, the prices that privatized utilities could charge was set by the regulator using the rate of return approach. This is where the economic regulator sets a rate of return on capital investment for the privatized utility that tries to mimic the price that would yield this rate of return. As Dale has mentioned, a drawback is that a privatized water utilities capital investment plan therefore need to be scrutinized in great detail by a regulator. This is to avoid unnecessary capital spending given that rate of return regulation rewards capital spending. So for example, a privatized water utility may build assets jot because they are strictly needed or demanded by customers but rather because doing so increases its rate base upon which it is permitted to earn a return. It may also build assets that far exceed required operating standards to increase its rate base. This is known as gold plating, and over-capitalization in general is called padding a capital program. With price-cap regulation, instead of capping the rate-of-return a water utility can earn, the average price that can be charged is capped for a particular set of services, for a specified period. A regulator receives bids for X from the privatized utility companies to decide how to set limits on prices. So in theory, it does not need to get involved in onerous micromanagement of scrutinizing utility as to whether its specific case by case individual capital investments are warranted or not. And as Professor Littlechild himself has argued, the regulator's mainly concerned with the factor that is of greatest concern of customers, which si the price of the water services for which they're paying. RPI- X price cap regulation accounts for inflation pressures. If inflation was not taken into consideration, a privatized utility subject to price camps would be increasingly penalized by any increase in the nominal prices of its factor inputs, such as labor, electricity, and chemicals. Littlechild's solution to this problem of inflation was to allow the privatized utilities prices to adjust to inflation. That's the RPI element in RPI -X. RPI -X sets a general expectation for efficiency improvements over time. The regulated utility has to out perform the general inflationary trend in the wider economy. And it has to do to a biased certain percentage specified by the X factor. Otherwise, the regulated utility will make a loss as the real prices netted inflation will fall over time as inflation proceeds. It will not be able to cover costs incurred as a consequence of being inefficient because it can not raise its price above the efficiency challenge price level that has been set for the specified period. To account for changing circumstances over time, the X factor rate can be reset periodically. Let's now go through an example of how RPI- X price cap regulation works. Here are our assumptions. Let's assume an initial price of water of three pounds sterling per cubic meter. This is about what I pay for water and waste water services. Then, let's assume a forecast RPI inflation rate of 3%. And let's assume a water company bids for an x efficiency challenge value of 1%. This is the water company revealing to the economic regulator, Ofwat, that based on its own efficiency estimates it believes it can adjust prices next year 1% below the forecast rate of inflation. Let's assume Ofwat accepts this bid. So what does this mean that the water company can charge it's customers next year? Here's how the RPI-X price cap economic regulation would work out. The price cap for the next year would be the initial price plus the price adjustment. And the price adjustment would be the RPI-X multiplied by the initial price. So the price cap would work out as the initial price multiplied by 1 + the RPI- X. You can pause the video here if you want to work this out for yourself. For this example, the price cap or the price that the water company can charge its customers next year is 3 pounds and 6 pence. So this example has looked at a price cap for the next year. But in the the privatized water sector, following some issues that we'll look at in the next video, the price cap cycle was set at five years. A price cap is determined by the economic regulator, then stays in force for five years. And at the end of five years, water companies bid again for their individual X factors. The economic regulator determines the final X values and a new price cap period runs for the next five years. The price cap is understood to be the maximum price that it is acceptable for water customers to have to pay. If there are no new regulatory tasks that the regulator wants the private water companies to undertake like meeting higher drinking water quality or environmental quality standards, then the expectation will be that the price cap should be a below inflation price adjustments. In other words, that water prices should fall in real terms, thus forcing private water companies to become more efficient over time. But if essential investments are needed in the next five year period, the price cap could include an above inflation price adjustment. So water prices charged to customers are the main leader here of control for the economic regulator. And they should be the primary concern of the water utility companies too. And water prices will be of high importance to customers. And in theory, as we've said, the details of capital and operational spending are left for the managers of the privatized utility companies themselves to manage. And do not have to be scrutinized and approved in detail by a regulator. Let's look now at how the X factor bidding process works. Step one, shown here by the dotted red line, is for the economic regulator to forecast the likely RPI inflation for the forthcoming five years. Step two, shown by the solid red line, is for the regulated water companies to make a water prices bid to the regulator. This is their offer of X. That will lead to their price cap based on the price adjustment their X implies to their initial price. So this step two is the water company telling the regulator how efficient it thinks it can be during the five years by revealing the water prices it wants to be able to charge to cover its costs while still making a reasonable profit for its investors. This, of course, is a strategic moment for all the water company. Do you think it would want to reveal its true X to the economic regulator? There are several information and information asymmetry issues to consider here. First, the water utility may not all have the information it needs to know precisely how efficient it can be over the coming years. Second, from outside the company, the economic regulator may have even less of an idea of how efficient the water company could be. The water company may choose to exploit this information asymmetry or may choose to error on the side of caution about it's sufficiency estimates when it makes it X-factor bid. In step three shown by the dotted orange line, the economic regulator then sets the price caps, this is where the regulator decides to accept the X factors bid for by the water company or to challenge it. But how does the regulator know wether to accept or challenge the water company's X bids without scrutinizing the details of the water company's business plans. In the England and Wales case, the economic regulator Ofwat does this through benchmarking which we'll come to later. And the water companies know Ofwat will do this benchmarking so they perhaps have an incentive to make a true X bid. In this illustrative example, the price adjustment set by the regulator is below the forecast rate of inflation. So this example represents a challenge to the water company to be more efficient that it originally bid. In practice, there's also a right of appeal built incurred if the water company believes the final price limit set by the regulator is unachievable. Step four, shown by the solid blue line is for the company to try to add performance RPI-X price adjustment during the five years of this price setting period. The incentive here is that if the water company can become more efficient and reduce its cost below the cost levels assumed by its price adjustment, then it can continue to charge its customers based on the price adjustment associated with its assumed costs rather than what the price adjustment would be if it recalculated with the more efficient actual cost. Until the new price-setting process in five years’ time. So it profits from out-performance for the five years shown by the green arrow here. Conversely, if the water company performs less efficiently than its assumed costs, then it still has to charge prices to customers based on the original price adjustment. And the company shareholders will have to bare the cost of the company's pool performance until the end of the five year price setting period. So the water company may have to release its dividend to shareholders and so forth, making it less desirable to stop stock market investors. Step five is that the price-setting period begins again, and the process repeats. The economic regulator here takes into account the actual performance levels of the water company in the previous five-year period, when it decides whether to accept or challenge the water company's next bid for a new X factor for the next five-year price period. This maintains a challenge to water companies to keep becoming more efficient over time. And it maintains the incentive for water companies to do so because they get to keep any profits due to out performance for five years in the next cycle too. Let's look now at how can the economic regulator know whether to accept or to challenge a water company's bid for an X factor. How can the regulator know a water company's bid is reasonable without getting into the details of the water company's business plans? Because if it had to do that, it would nullify the benefits of simple RPI- X price cap regulation, say, over more intrusive rate of return regulation. Professor Littlechild wanted this information to be revealed by a process he called rivalrous discovery. He wanted rivals. Here, that means multiple water companies to have to compete for water customers, and for water companies to discover how to become more efficient in that process of competition. But how could this work with England and Wales with a set of large regional monopoly privatized water companies? This slide shows the operating boundaries of the 10 main large regional monopoly water and sewage companies created in privatization in England and Wales in 1989. There are also some smaller water only company boundaries shown here. Benchmarking the performance of the ten main water and sewage companies, and also the smaller water only companies Could substitute for little child's rivalist discovery process here. The idea would be that each water company would reveal information about the water prices it thought it had to charge to cover it's costs and make a profit by bidding for a particular x factor for each price setting period. If each water company could have it's own individual x factor than this would reveal relative efficiency information. Individual water companies could then be bench marked against each other. This is also known as yardstick or bench mark competition. The UK government through its golden share arrangement that prevented foreign takeovers until 1994 and Ofwat through its duty to scrutinize the value of any mergers taking place in the sector resulted in no mergers taking place between the large water companies. This preserved a base of 10 large companies for little child's rivalist discovery process to play out. Some water companies did want to merge arguing that they can achieve the economy of scale by doing so. But of what highly value team importance of retaining enough compare to water companies to benchmark against each other. In my research, I've been told the Ofwat director general, Ian Byrd who in statutory terms was the economic regulator at the time with power to make the executive decisions indicated that any merger between the ten large water companies should have to demonstrate around £1 billion net benefit for it to be worth doing. Clearly he felt that all ten of the water companies were vital data points for Ofwat's comparative bench-marking process. There are three important problems with this yardstick competition approach. First, it can be distorted by pack behavior, or even collusion. Imagine, all the water companies could simply set their ambitions very low and say all ask a for price caps that did not challenge them to become much more efficient. Then if all water companies perform inefficiently, how can one benchmark them to incentivize them to improve. Second, if all water companies get more efficient overtime but experience diminishing returns until they eventually reach some efficiency limit, what happens then? Without innovation, no company might ever exceed this efficiency limit. Then all water companies' performance levels would become indistinguishable. And simply benchmarking them would not incentivize them to improve over time. Third, if the benchmark is based on particular key performance indicators, then the water companies could simply choose to become very good just as measured by the indicators and leave other efficiencies improvement aside. In other words the regulator performs as measure could be captured by the water companies. The water companies could all eventually score on all the 100% on this bench mark score measure but then not continue to improve in other aspects over time. In all three instances here, comparing the water companies performances to each other loses it's incentive value. The Ofwat data in this slide arguably shows one, or possibly all, of these three processes at work. The lines plotted here show the overall performance assessment, or OPA, scores achieved by the England and Wales water companies. OPA was a competent indicator of Ofwat's key performance of measures of water supply, sewage service, customer service and environmental performance. It includes things like risk of low water pressure, unplanned interruptions drinking water quality, properties at risk of sewer flooding, response to written customer complaints, and response to telephone based customer contacts. Let's assume here that these performance levels were revealed by the water companies themselves, again not requiring intrusive scrutiny by Ofwat. The OPA scores are shown here for three successive price reviews. In 1999, dark blue, 2004, magenta and 2009 light blue. On the left are the three lines for the scores of the ten large water and sewage companies at these three successive reviews. And on the right are the lines for the smaller water only companies. Each water company is a data point on the line for that particular price review year. Overall in these 10 years across the three price reveals, all water company OPA scores improved. But they also became more similar, this reduces their value for bench marking. For instance in 1999, the worst performing large water companies, shown here with a red circle were clearly distinguishable from the best performing ones, shown here with a green circle. Having about a 30% lower OPA score. In this kind of performance league table, the worst performing companies look back at their shareholders and to their customers, to the media and to politicians. With lower performance levels, these are the water companies where it is likely that the economic regulator Ofwat would challenge their price bids. For instance, how could a poorly performing water company defends its bid for price increases when it may need to increase prices due to being inefficient, rather than due to increased cost requirements say to meet higher levels of service? Conversely, Ofwat may be more inclined to accept the price bids by the water companies it knew were performing well here. It might trust that their price boost were justified given their past good performance. By 2004 and 2009 the magenta and light blue lines here it becomes hard to see this kind of clear performance difference. And perhaps harder for Ofwat to base its decisions to accept or challenge price bids by water companies that are only 10% or so different in performance levels. There is, also, a fourth problem with this bench marking approach as a way for the economic regulator to decide whether to accept or challenge water company price bids under the RPI minus x approach. That's the problem of whether you want to view the water sector in isolation or to benchmark its performance more broadly. Back in 1998 Ofwat commission consultants to consider this kind of problem. Consultants explored whether you can benchmark water company performance against non-water compare it to sectors. This slideshow some of the consultants suggestions. They considered potential benchmark industries that were comparable in terms of processes use, scale of operations or similarity of products and services. For example, perhaps efficiency trends in the softdrinks industry might be a relevant benchmark for water companies, or those for the dairy products industries. These are process industries delivering consumable foods stuff products after all with some similarities to water supply service. To the best of my knowledge, this research has not altered Ofwat's bench marking processes. And whilst separately, Ofwat also keeps breast of developments in water sectors elsewhere in the world, as far as I've seen this is only through qualitative comparisons and does not lead to direct deficiency challenges for the England and Wales privatized water companies. In this video, we've reviewed a novel approach to the economic regulation of privatized water utilities to prevent abuse of monopoly power through excessive water price increases to customers. RPI minus x price cap regulation offered the promise of a less intrusive approach than rate of return regulation. Water companies would bid for their desired adjustments to their initial water prices based on their own management decisions about costs and capital investment levels. And the economic regulator would be able to decide whether to accept challenge water companies' price adjustment bids by bench marking water companies performance against one another. Based on performance levels published by the water companies themselves, rather than economic regulator having to gather this information. And the economic regulator would not have to scrutinize cost or capital investment on case by case basis in detail, say to avoid the risk of padding or gold plating of water company's rate basis. And all of this would be made possible in the England and Wales water privatization case because there were multiple comparable water companies available for bench marking. There are two serious issues though, with a theoretical RPI minus x economic regulation approach we've just described. First remember that RPI minus x is a price adjustment formula. It is critically dependent then on the initial price that one adjusts from. But the RPI minus x formula does not enable you to determine the initial price from which you then adjust. So let's say a privatized water company is permitted to adjust from a high initial price. It may then be less worried about being given a below inflation RPI minus x price adjustment. But a water company starting from a low initial price may later become unable to finance its functions if it's given a below inflation RPI minus x price adjustment. Say at the same time is being required to undertake a program of capital investment to improve its network., to meet higher drinking water, and environmental quality standards. Second, Ofwat's OPA measure did not exist at the time of privatization of the England and Wales water industry in 1989. So privatization, there was no standardized bench marking information that Ofwat could use to accept or challenge water company price bids. Together these two issues meant that the RPI minus x price cap regulation was never used in the England or Wales prototype water sector. Exactly as little child may ever literally envisioned. And the use of RPI minus x economic correlations has not been simple or non intusive in reality. That's what we'll look at in our next video. Thanks for watching.