What Is the Role of the Regulator? How Should Regulators Act in Order to Support Positive Outcomes. Keep Readi

It is all too easy to describe something in terms that make it seem difficult. But in this context, what do we mean by ‘difficult’? Is it something we are unable to do? Or, perhaps, something we don’t want to do? It is such human dilemmas that are at the heart of economic regulation. All of us are, as human beings, very good at procrastinating. We can all find excuses as to why something we do not want to do either cannot be done or should not be done. In a market, a participating firm has no choice, it has to observe, to analyse, to understand. It may have more or less time, but its success, or even its survival, depends on responding to the actions of its competitors, the expectations of its customers or even understanding what some new technology might mean. Think Xerox, Kodak or Polaroid! A natural monopoly business – one whose function cannot easily (or should that be profitably) be replicated – does not experience these same pressures. There is no immediate existential threat. Economic theory suggests that monopolies can be good and bad. They can be good in that they can often access economies of scale and should be able to incur unit costs that are much lower than could be achieved if there were multiple suppliers. They can be bad because they could set prices for services that we all need at levels that would allow them to earn a significant economic rent – some amount higher than a fair return for what they have done and the risks they have managed. Economic theory often concludes by asserting that the pricing power of monopolies needs to be curtailed. But is this right? Do we want to curtail pricing power, or do we want to encourage more responsive, more innovative and more customer-oriented behaviours? I would argue the latter. If the job is simply to curtail pricing power, the challenge that faces the economic regulator is relatively straightforward. It is not too difficult to do the analysis, to diagnose the issues that have to be addressed, and to set charges that should allow the regulated entity to earn a fair return for its efforts. But how does an economic regulator create the conditions that will lead to those better behaviours and, ultimately, outcomes? Observing more closely what actually happens in a competitive market might help – in other words, taking the time to understand the underlying dynamics of markets. In a very competitive market, participants tend to be ‘price takers’. There is a market price that consumers of a particular good or service are prepared to pay. That price is what it is. A decision to participate in the market accepts the prevailing market price. Such acceptance does not, however, say much about how the entity will participate, how it will gain and retain a share of the market, how it will meet the expectations of its customers, or how it will provide a return to its investors that meets their expectations. These are all questions that the market participant’s management will have to address. And those who have invested in this market participant will inevitably hold the management to account for just how well they answer these questions. It is immediately clear that a market participant’s success ultimately depends on just how well it understands what is happening in its marketplace. Are there new technologies available? Are customers’ tastes changing? Can I just keep doing what I am doing – even if a little better each year? So, what do these observations of the dynamics of a market tell us about the appropriate role of an economic regulator? If an economic regulator just focuses on setting a fair price – where the monopoly earns a fair return for its efforts – there is little reason for the regulated monopoly to fear the future, or to ask itself the difficult questions that a participant in a competitive market has to ask itself. From a societal point of view, this has to be a problem! For a market participant the failure to ask these questions can be existential as the Kodak,

Source: Original reporting via Water Industry Commission for Scotland