Profit-sharing
47. A common suggestion
for regulatory improvement is that RPI-X should be replaced by
some form of profit-sharing formula. The DGES states that "RPI-X
already does share the benefits of cost reductions": this
is done "by setting price limits based on projected
cost reductions, and by setting subsequent limits reflecting experience
of actual cost reductions".[87]
The prospective benefits of this will therefore be built in to
the prices charged under the control.[88]
However, shareholders get the rewards first, and customers in
the subsequent price review period through lower prices for the
future. Research undertaken by National Economic Research Associates
has shown that "over time, customers get over 70% of any
efficiency improvement, and shareholders under 30%".[89]
Whilst efficiency is an important aspect of the price control
formula, the economic profits that the monopolies make, even though
they derive from out-performance of the regulators' surrogate
competition through price controls, may be perceived as "excess"
profit gained by the abuse of monopoly power. Whatever the reasons,
there have been dramatic profit increases, and it is understandable
that consumers are concerned that they might not be receiving
their fair share of the benefits of efficiency savings; and it
is widely believed that shareholders have benefited far more than
consumers (see paras 182-188).[90]
Such concerns have led to proposals for reforming the RPI-X regulation
formula.
48. Several variants of
profit-sharing, such as "annual formula" profit-sharing
and "sliding scale" schemes, have been referred to by
witnesses. Such schemes would give customers a greater or earlier
share of any unanticipated efficiency gains than the RPI-X formula
does. Annual formula profit-sharing requires fixed rebates based
on the actual profit earned in the year. A profit threshold is
determined for the company and, if actual profit is greater than
the threshold, then a proportion of the excess profit is returned
to customers, usually by way of price reductions or a rebate in
the following year. With sliding scale regulation the company
can choose to set lower prices in return for a lower rate of profit-sharing.
If the profit-sharing scheme is symmetrical as regards risk,
then the company might also be allowed to raise prices if profits
fell below the given threshold level of profit.
49. The main advantages
of a profit-sharing mechanism are that it ensures that prices
do not get significantly out of line with costs, it creates an
automatic correction over any lax price formula and, most importantly,
it results in an earlier, more equitable distribution of efficiency
benefits between shareholders and consumers.[91]
Several disadvantages were also put forward:
-- any
sanctions on profits would have detrimental effects on incentives
to reduce costs compared with the existing RPI-X control;[92]
-- although
customers might receive a larger share of the profits in the short
term, this is likely to be more than offset by the higher cost
base which they would ultimately have to bear;[93]
-- there
is a risk that it would give companies incentives to manipulate
profit levels so as to minimise or eliminate any requirement to
reduce prices to customers;
-- above
all, profit-sharing would make regulation more detailed, complex
and uncertain as it would involve defining `normal' and `excess'
profits, and annual discussions between the regulator and the
company.[94]
50. After consulting on
the issue of profit-sharing, the regulators have, on the whole,
rejected the idea in favour of the existing system chiefly on
the grounds that extensive annual profit-sharing arrangements
are likely to reduce incentives to increase efficiency. For example,
the rail regulator opted to start with the RPI-X form of control.[95]
According to OFGAS, "evidence from the US, where such a
[profit-sharing] form of control has been implemented, does not
indicate compensating advantages".[96]
The DGES's response has been not to reject it completely. He
believes that there is a case for considering alternatives akin
to sliding scale regulation in certain circumstances, and has
proposed a form of a sliding scale control on NGC's revenue from
transmission services.[97]
51. The GCC argues that
sliding scale regulation "should not be lightly discarded
by regulators".[98]
However, the weight of the evidence suggested that profit-sharing
has not yet been sufficiently developed. The MEB believes "that
such an approach requires further careful consideration and investigation,
with possibly a limited trial to assist wider debate, prior to
any serious consideration being given to its introduction in the
future".[99]
52. None of the witnesses
put forward definitions of `normal' or `excess' profits, thus
reinforcing the view that such terms would be difficult to define.
The MEB believes that the regulators "have tended not to
commit themselves other than in broad terms" to addressing
these issues.[100]
With regard to the determination of the proportion of the profits
to be returned to customers, a 50:50 split was suggested, but
reasons to support this ratio, as opposed to any other, were not
given; nor was there any discussion of the implication this would
have for the incentive regulatory framework.
53. The MEB argued that
the nature of profit-sharing within the current RPI-X regulation
is not explicit and is, therefore, not well understood.[101]
The extent to which this contributes to the dissatisfaction with
the current regime, rather than a belief that there are fundamental
flaws with the RPI-X formula, is unclear. A more explicit form
of profit-sharing might be more acceptable politically, but whether
profit-sharing is on balance a desirable alternative to RPI-X
regulation depends on judgements of the extent of the disincentive
to efficiency, the increased regulatory burden and the relative
weights placed on efficiency and equity objectives. We were interested
by the Director General of Water Supply's recent proposals for
a voluntary acceleration scheme for the earlier sharing of profits
with consumers: because it is a voluntary scheme it should not
destroy incentives to efficiency.[102]
By its very nature, such a scheme cannot be imposed by Government
or the regulators; nevertheless, we urge companies to consider
voluntary acceleration.
54. British Gas argued strongly
for a profit-sharing mechanism to be introduced alongside the
current RPI-X control for a different reason. It pointed out
that RPI-X regulation provides strong incentives to achieve efficiency
gains at the beginning of the price control period compared to
the end of the period. British Gas told us that "savings
made earlier in the formula period were worth far more than savings
made toward the end because lower costs, under gas regulation
thus far, are incorporated in the revised and lower cost base
for the next period".[103]
It believes that the formula encourages a short-term focus on
efficiency gains and that a better balance needs to be achieved
between the short-term interests of gas consumers and the need
to finance the business. Essentially British Gas's concern is
that the company's shareholders will not benefit from the lower
cost level created as a result of its restructuring programme;
instead the benefits will be passed to consumers through lower
prices. British Gas considers that a profit-sharing system would
allow the efficiency incentives to be the same throughout the
period, and it would prefer a profit-sharing system which would
allow some element of `roll-over' of cost-savings whereby benefits
accrued to shareholders as well as customers. OFGAS rejected
British Gas's proposal on the basis that it was potentially subjective,
interventionist, and the calculations involved would be complex.
Instead, OFGAS proposed a risk sharing mechanism relating to
the costs associated with the introduction of competition in domestic
gas supply.[104]
We think that British Gas's point about RPI-X regulation providing
stronger incentives to efficiency in the earlier years is an important
one. However, it appears to us that the proposal which British
Gas have put forward would benefit shareholders the most. We
support the DGGS's decision not to introduce British Gas's proposals.
55. None of the options
we have examined is perfect. Although many witnesses criticised
the RPI-X form of incentive regulation by periodic review, the
weight of our evidence did not support a move towards a rate of
return approach.[105]
In fact, witnesses regarded the rate of return method as having
significant and numerous deficiencies compared with the RPI-X
formula.[106]
The arguments for incentive regulation are powerful and the advantages
of the RPI-X incentive regulation outweigh those of rate of return,
and other forms of profit-sharing, such as annual formula profit-sharing
and sliding scale regulation, because they are likely to erode
incentives. Therefore, the RPI-X form of incentive regulation
has much to commend it over other methods, above all, because
it provides powerful incentives to companies to reduce costs through
efficiency improvements, a feature we regard as central in any
formula chosen. The weight of our evidence suggests that there
are strong arguments in favour of the continuity and fine-tuning
of the current formula. Given the complexity of price control
regulation and the clear advances being made by regulators, we
would regard the abandonment of RPI-X as being a reaction to past
deficiencies. We therefore support the continuation of RPI-X
incentive regulation in its broadest sense on the grounds that
it is essential for the maintenance of effective incentives to
efficiency but believe that further work needs to be done to improve
the estimation of X. We recognise that profit-sharing has not
been sufficiently developed or tested and we do not rule it out
as an option for the future. We recommend that the use of
RPI-X incentive regulation be continued.
87 "Utilities Regulation Consultation for Change",
Professor Littlechild, Industry Forum Conference, 1995, p.8. Back
88 Ev.
p.276. Back
89 "Utilities
Regulation Consultation for Change",
Professor Littlechild, Industry Forum Conference, 1995, p.8. Back
90 eg.
Q.428; Mem. p.93. Back
91 eg.
Ev. p.176; Ev. p.96. Back
92 Mem.
p.31. Back
93 Mem.
p.34. Back
94 eg.
Mem. p.85; Ev. p.191. Back
95 Mem.
p.18. Back
96 Ev.
p.248. Back
97 Ev.
p.276. Back
98 Ev.
p.96. Back
99 Mem.
p.31. Back
100 Ibid. Back
101 Ibid. Back
102 Ev.
p.237. Back
103 Ev.
p.313. Back
104 Ev.
p.248. Back
105 eg.
Mem. p.31; Ev. p.114. Back
106 eg
Ev. p.324. Back
