UK energy: ‘tough love’ regulation will enrich shareholders

How ‘tough love’ from regulator saved a dominant UK monopoly

by Hugh Small
Former Director, European Telecommunications Consulting Practice, Arthur D. Little Inc.

Summary
The Competition and Market Authority’s Energy Market Investigation aims to increase competition between the UK’s electricity utilities. This paper describes how the newly-competitive UK telecom market of the 1990s showed that increasing competition from non-utilities is more effective than increasing competition between utilities. This needs regulatory ‘tough love’ to open the utility networks to the consumer electronics industry and to allow anyone to buy or sell electricity at any time and at any price. The goal, already being achieved in the USA, is an ‘energy internet’.

Background to telecom re-regulation in 1992
Reviews of the regulation of the UK telecoms industry in the period 1984-2000 tend to focus on the innovative RPI-X% price control formula, i.e. ‘economic regulation’. What is often overlooked is the controversial industry-specific regulation of the mid-1990s which for the first time mandated supervision by the regulator of the dominant operator’s (British Telecom’s) capital investment. This was an important shift in regulatory attention motivated by the government’s dissatisfaction with the extent to which competition had developed. At a time when competition is inadequate and investment is necessary in the energy infrastructure, this successful regulatory intervention should be copied.

In 1983 the government imposed the RPI-X% price control formula on the soon-to-be-privatised British Telecom (BT) in preference to the rate-of-return regimes favoured in the US. Rate-of-return regulation tends to encourage over-investment and RPI-X, if the regulator can find a satisfactory value of X, allows both the company’s shareholders and its customers to benefit from cost savings.

A global event occurred soon after when the US Justice Department forcibly dismantled telecom utility AT&T, the largest company in the world, because of its abuse of monopoly. Like BT and the UK energy utilities today, AT&T was vertically integrated in sales, transmission, and distribution and also had a monopoly of ‘customer premises equipment’ (‘CPE’). The Consent Decree separated AT&T into a transmission entity and seven regional distribution networks, and allowed competing transmission networks and CPE. During the 1980s the question frequently came up whether BT should be broken up along similar lines. Competition had been slow to develop in the UK. After privatisation BT was allowed a seven-year period of ‘duopoly’ with one new telecom network operator, Mercury. It was complicated for small customers to ‘switch’ suppliers or to use equipment not supplied by BT, and after seven years BT had lost only four per cent of market share. No significant new services had materialised despite the growing presence of computers within the network. France Telecom, still a state-owned monopoly, had pioneered the use of digital exchanges and was ahead in market penetration, customer service, and innovation.

In the end, no other telephone company worldwide was forcibly dismantled like AT&T, raising the possibility that if AT&T had been less abusive of its statutory monopoly it could have remained vertically integrated. The disruption of the AT&T ‘divestiture’ was widely believed to have cost the US economy several percentage points of growth. It is arguable that the relatively tough position taken by the UK regulator, and the lesson of AT&T, saved BT from being broken up with the same result.

BT’s response to the threat of competition
In November 1989 the first steps to wider competition occurred; the regulator allowed customers who leased private circuits from BT to share them with others (‘simple resale’). It was believed that the Department of Trade and Industry (DTI) would license full competitors at the end of the seven-year duopoly period the following year. Also in 1989 the regulator announced that new cellular licenses would be issued and new frequencies assigned; at the time less than 1 percent of the population had a mobile phone and potential new entrants were widely seen as competitors to the BT landline business. BT itself was prohibited from controlling a mobile network.

In the same year it was reported that BT had reduced its orders of digital exchanges by 25%. An independent expert told the DTI that BT’s slowing down of its network modernisation programme could impede the entry of new competition. New entrants would prefer to use BT’s transmission network to avoid costly investment in the early stages, and this ‘interconnection’ would be impeded by BT’s continuing use of old-fashioned analogue exchanges and transmission equipment.

BT’s true motives may be unknown, but in 1992 when full competition was introduced the regulator imposed a new condition in the price control regime: that BT should not cut back its network modernisation programme. Oftel now demanded that BT should complete the modernisation of the network by July 1997. Oftel’s Director General phrased this in a way that sounded like an ultimatum, as if negotiations with BT had failed:

“I do not believe that regulations should be settled by negotiation between regulator and regulatee. If BT is unable to agree to my proposals I believe that the issues should be referred to the Monopolies and Mergers Commission.”

BT’s reported response was equally confrontational:

BT has reacted angrily to Oftel’s suggestions that it should meet a number of investment targets by the end of the next price control period in [July] 1997. A senior BT executive argues that it represents Oftel’s latest attempt “to manage BT’s business”.

The company did, however, accept the new conditions (rumour has it that Oftel gave them two weeks to think about it):

BT chairman Iain Vallance indicated at last week’s annual general meeting that it would not be in BT’s interest to have the company investigated by the MMC … However, Vallance took the opportunity presented by the AGM to criticise regulation in general [saying] “it is also unclear how the regulators themselves are to be held accountable”

BT then reportedly mounted a campaign of lobbying against Oftel:

BT is asking senior UK government sources to review the role of the Office of Telecommunications (Oftel), the UK telecommunications regulator. It claims that Oftel is making policy decisions that do not come within its remit and which are restricting the freedom of BT managers to manage.

In its anti-regulator campaign BT enlisted a powerful political ally:

Lord Tebbit, the non-executive director of BT who was UK government Trade Secretary at the time of creation of the Office of Telecommunications (Oftel), the telecommunications regulatory body, has told BT staff that Oftel is over-regulating BT. He accused Sir Bryan Carsberg, the former Oftel director general who is now director general of the Office of Fair Trading (OFT), of having sought popularity by attacking BT.

Clearly, then, the new compulsory modernisation requirement was not regarded as trivial either by regulator or regulatee. This was ‘tough love’, far removed from the gentle regulation of the UK energy utilities in 2015.

BT Share priceThe result of tough love
So what happened? BT’s share price (left) tells the story. As the mobile telephone mass market developed to a penetration of about 15 percent by the end of the period allotted by the regulator for modernisation of BT’s network, it became apparent that mobile was not a ‘wireless’ market but more a ‘wireline’ market with characteristics of ubiquity rather than mobility. The cells became smaller and the base stations more numerous, to deal with the extra traffic, and BT was kept busy supplying wireline connections between the base stations and its own network. The new fibre-optic cables demanded by Oftel in the transmission network had massive extra capacity that could be marginally priced, reducing the cost of mobile calls. The cellular operators were more interested in investing in handset functionality than in building a rival transmission network.

The focus of the telecommunications business had moved away from networks towards consumer electronics, as a result of the more innovative attitude and competitive nature of that industry. The trend was accelerated by the growth of the internet, another prolific user of BT’s new digital interconnect and marginal fibre-optic capacity. The value-added in the industry had shifted away from transmission capacity, which was now virtually free, towards the electronic equipment that manipulated transmission. In the same way, value-added in the energy industry is moving away from the energy, now virtually free in the shape of renewables, towards the equipment that makes that energy usable.

The conclusion that today’s energy regulators must learn from telecommunications is that industry-specific regulation can be a winner for dominant operators despite management misgivings. The ‘net neutrality’ now being imposed by US regulators on Internet Service Providers is another example of industry-specific regulation that applies to both telecoms and energy utilities. US electric utility regulators are now imposing ‘open grid’ modernisation programmes on the incumbents, to allow consumer electronics innovation (e.g. microgeneration and storage) to invigorate the market. It is only by learning from these other countries and from other industries like telecommunications that the UK energy regulators can embrace the future and create the ‘energy internet’.

Sources:
Future Controls on BT’s Prices, Oftel (June 1992)
Financial Times Telecoms Markets vols 201, 205, 207, 208 (1992)

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