Select Committee on Constitution Sixth Report

CHAPTER 2: Regulatory Roles and Activities: Accountability for what?

Three purposes of regulation

17.  The Committee received evidence about a wide range of regulators and regulatory activities.[2] Regulation can usefully be divided into three broad categories - economic regulation aimed at controlling the abuse of monopoly power; regulation of public goods and external effects, such as environmental pollution; and social regulation.[3]

18.  The role of the regulatory state is therefore about much more than regulating business decisions, important as that is. The state is concerned with promoting public goods in many areas of citizens' lives - for example, promoting charitable works, culture and civil society - whilst at the same time avoiding public bads: for example, prohibiting racial abuse, theft and speeding. Regulating such non-market conduct therefore involves changing both positive and negative types of conduct. In a general sense, both can be grouped under the heading of 'non-market conduct failures', given too little of a good thing is as much a failure as too much of a bad thing. Both command the attention of Governments to consider the right way to deal with each problem, whether by regulation or some other intervention.

19.  In some circumstances, the market does not operate, the most notable example being national defence. What are known as 'missing markets' are a good example of where the Government steps in as the provider of goods and services, rather than as regulator. The Government takes responsibility for providing these types of public good, although it may still contract out to the private sector for the supply of defence goods and services. Technically, these 'pure' public goods may be classified by economists as a form of market failure, but the example illustrates that the public good is the objective of Government provision or regulation, whether caused by market or non-market failures.

20.  The concept of market failure is usually more directly related to negative conducts, such as deliberate anti-competitive behaviour by a company, or external effects on third parties, such as environmental pollution, but it can encompass more positive elements, such as the need to improve consumer information about markets so that the market overall works more effectively. This often involves action to correct information asymmetries between producers and consumers, including requirements for product labelling, or as between investors and company boards, related to obligations to publish financial information.

21.  Income redistribution to ensure that all citizens can afford access to essential services, or the imposition of universal service obligations on the utility and network industries (water, energy, transport and communications), are other examples of state intervention to regulate what would otherwise be unacceptable market outcomes.

A broad definition of regulation

22.  Regulation is achieved by decisions intended to control or influence specific elements of the regulated activity.[4] They are implemented by the setting, monitoring and enforcement of standards designed to achieve chosen objectives. Our concern is with the accountability of regulators for those decisions and for the choice of those objectives.

23.  Inspectors act as agents both of Ministers in their regulatory capacity and of independent regulators. They are accountable to the regulatory authority by which they are employed. The Office for standards in Schools (Ofsted) has the appearance of a regulator but functions as an inspectorate reporting to the Secretary of State for Education.[5] Our focus is not on inspectors but on the accountability of the regulatory authorities themselves. They are also subject to a form of inspection. The National Audit Office (NAO) can audit their accounts and report on their procedures and practices. While this provides them with an incentive to seek efficiency and best practice it does not impact on their policy decisions and is not, therefore, the subject of our enquiry.

24.  The Better Regulation Task Force has provided a broad definition of regulation to accompany its five principles of good regulation. It states that "Regulation may widely be defined as any measure or intervention that seeks to change the behaviour of individuals or groups". The BRTF illustrates this definition by going on to say "it can both give people rights (eg equal opportunities) and restrict their behaviour (e.g. compulsory seat belts),"[6] in effect saying that any action by a Government body or its equivalent in carrying out certain public functions which aim to change behaviour is regulation. Publishing league tables which affect behaviour can then properly be seen as a form of regulation, and the regulators who use them should be accountable for their decision to use them. However, this type of regulatory decision can clearly be distinguished from a formal decision affecting an individual or organisation, and which requires them to take, or stop, a specific action (a binding decision).

25.  A broad definition is helpful because it focuses attention on the key issue for our Inquiry, which is that regulators should be accountable for their decisions and actions, judged against the purpose for those decisions and actions (i.e. the why of regulation), and the appropriateness of those decisions (i.e. the how of regulation). This involves questions of statutory authority and the effectiveness of the particular regulatory instruments chosen. Statutory functions and the powers and duties of regulators must therefore be the starting point for addressing the accountability of regulators. As to the why of regulation, the reason for making regulatory decisions is to achieve better outcomes. The question of 'accountability for what?' can therefore be answered: accountability of regulators for achieving good regulation through effective regulatory performance in practice. How regulation is carried out is therefore a key focus for scrutiny.

26.  Regulators have made it clear in their evidence that their regulatory functions are the responsibility of Parliament, since they are created by statute, and therefore carry out only regulatory functions designed and passed into legislation by Parliament.[7] For example, Philip Fletcher, the water regulator, put it clearly and succinctly: "We are creatures of statute and work within that framework, subject to judicial review of our actions".[8]

27.  The Department for Trade and Industry (DTI), which has general responsibility for co-ordinating economic regulation across Government, confirmed this basic fact, notwithstanding the different histories of the development of regulation in each sector: "Despite establishment at different times and in different ways, the regulators share a basic model: a sector specific regulator charged with a responsibility to operate under a hierarchy of statutory duties to achieve a range of public policy objectives".[9]

28.  The DTI also confirmed that whilst Parliament sets the statutory framework, the statutory duties are framed in such a way as to allow necessary flexibility and discretion to independent regulators in the exercise of their functions: "The statutory objectives of the regulators are expressed as general duties. Some of these duties express matters which are to be achieved through the exercise of the regulators' functions, others identify issues or concerns which the regulator must take into account when exercising its functions. In some cases, though not all, one or more of the duties is identified as having primacy or precedence over other duties".[10]

29.  As regulation starts with Parliament, the ultimate responsibility for regulation rests with Parliament. This sets regulatory accountability in a broader setting, which starts with parliamentary responsibility for establishing the right legislation and ends with effective parliamentary scrutiny of both process and outcomes, whilst at the same time recognising a hierarchy of regulation: regulatory responsibility might in some cases be devolved formally, or informally, to Government appointed regulators for executive implementation of regulation. The question of the independence of regulators, and the impact that has had on their accountability, is therefore important, and one on which the Committee received much evidence.

Accountability for effectiveness (regulatory outcomes)—the why and how of regulation

30.  Accountability for effectiveness has therefore to be considered in two parts. First, what are the purposes, or outcomes, to be achieved by regulation in terms of addressing market or conduct failures (the outputs of regulation)? Secondly, how has regulation been carried out to achieve those outcomes (the inputs of regulation)? Was regulation done well or badly? If done badly, is it the fault of the specific regulator, or a systemic fault in the design of the regulatory system and the statutory powers and duties under which the individual regulator operates, for which Government and Parliament must then take responsibility? In principle, regulation should be proportionate, in that it achieves the desired outcome in the most effective and least burdensome way. In short, effective regulation is cost-effective regulation, where cost is used in a general sense. The why and how of regulation have therefore to be taken together in addressing the question, accountability for what?, so that our focus is on achieving effective regulation and the means by which accountability helps achieve that end.

31.  These questions - and the burden of regulation - were at the heart of much of the evidence we received from the regulated. The UK mobile operators told us that whilst "we are one of the biggest success stories of policy and market liberalisation in this country…we are very highly regulated and therefore regulation is a very significant constraint in what we do in our commercial and competitive activities".[11] The burden of regulation came up repeatedly, including the volume of consultation. The Royal Mail told us "…sometimes there has been almost too much consultation on some issues. For example, Postcomm's powers are such that we cannot alter the terms and conditions of one of our services to even the smallest extent without their agreement unless we can show that it is for the benefit of the customer. This has resulted in delays of six, seven, eight, nine months to try and effect even the smallest change to our terms and conditions. … There has to be proportionality - more consultation for big issues where there is a real political dimension".[12] BAA told us of 'regulatory creep', which has increased the burdens: "However, the light touch approach has suffered progressive deterioration, as five-yearly reviews have expanded from 12 months to 32 month investigations, with significant duplication of effort between the CAA and the Competition Commission.... Regulation has therefore become a significant burden and distraction to all parties, including BAA's airline customers".[13]

32.  The burden of regulation can particularly affect small businesses, as we were repeatedly told by firms of financial advisers: "The FSA Handbook is vast and almost incomprehensible - the only way to look at it is via the search engine on the FSA website as apparently if printed out it would stand 9 feet high!"[14] There was therefore a considerable emphasis in the evidence we received for a greater focus on deregulation. Scottish and Southern Energy plc told us "The fact that Ofgem is such a high-cost organisation, with regulatory activity seeming to increase in inverse proportion to the number of activities actually regulated, implies that it warrants detailed scrutiny and analysis of it effectiveness. This is amplified by the absence of basic standards of performance".[15] The UK mobile operators identified a lack of trust in the market, telling us that "to some extent we have to trust the market. I do not think recently there has been much trust of the market. As soon as a problem pops up someone feels that they have to go and deal with it rather than saying 'that is how competition works, when there is a problem competition deals with it'. If you always regulate all of the problems away you are never going to get rid of regulation".[16] Innogy noted that Ofgem "has made progress towards removing regulation in some areas, but would now like to see a more concerted effort to review detailed sectoral regulation. Non-regulatory options should be examined before further regulation is introduced and, where competition is effective, Ofgem should rely on enforcement by competition law".[17]

The roles of Parliament, Ministers and independent regulators

33.  The third aspect, alongside a broad definition of regulation and consideration of the effectiveness of how regulation has been carried out, is the inter-related responsibility of Parliament, ministers and independent regulators. Each plays different parts at different times - more or less independently, but is orchestrated within an overall framework for an effective regulatory state which achieves cost-effective outcomes for citizens, and operates in the public interest.

34.  Parliament sets the statutory framework embodying the objectives to be achieved by regulation. It legislates, however, for that regulation, in many cases, to be carried out by independent regulators. The reason has been well summed up by the OECD: "The key benefits sought from the independent regulatory model are to shield market interventions from interference from 'captured' politicians and bureaucrats".[18]

35.  Independent regulators must therefore be held accountable for their actions, but independence is not fixed in stone, and Government and Parliament retain responsibility to review regulation and ensure that the legislation remains fit for purpose. It can therefore be expected that Parliament will change the legislation from time to time. The DTI made reference to this in its evidence: "The primary means by which the regulators' role may be changed is through parliamentary amendment of the duties specified in the statutory framework. The role of regulators has been changed in this manner over time".[19]

36.  The water industry regulator has provided us with a clear example, which also illustrates the relationships between various regulators. Standards of drinking water, and for discharges of used water back into the environment, are the responsibility of ministers, supported by the expert advice of the Drinking Water Inspectorate (DWI) and the Environment Agency (EA) respectively (whilst noting that the Minister's decision itself might reflect the incorporation into law of a European Directive on the subject). These two bodies advise Ministers but are not accountable in that role for the Minister's decision, which is incorporated appropriately into law. As regulators, however, they carry out functions of inspection (monitoring) and enforcement where the standards set by Ministers, and approved by Parliament, are not being met. The regulators may have discretion as to when and how they exercise their powers.

37.  Once the Minister has set (or been minded to set) certain standards, the economic regulator in England and Wales (the Office of Water Services, supporting the Director General or, as now, Authority, following the Water Act 2003) is responsible for protecting customers' interests by controlling the abuse of monopoly power which might otherwise be exercised by private sector water service providers. His statutory duties include customer protection, ensuring that all reasonable demands are met, and the duty to ensure that the regulated water service providers carry out their proper functions (for which they have been granted a licence) and can finance themselves. His regulatory role is independent of Ministers and set out in statute. The key regulatory decisions relate to setting maximum price controls for each water service provider for a period of years, typically five years. This decision has, however, to allow the regulated companies the financial wherewithal to maintain the quality standards set down by Ministers. Environmental and quality regulation is therefore incorporated as a constraint into economic regulation.

38.  The balance between standards and affordability is debated as part of the deliberative cycle of the periodic review, involving the Department of the Environment, Food and Rural Affairs (DEFRA), Ofwat, the Electricity Association (EA) and the industry. The cycle has been formulated into an explicit timetable for submission of draft and final business plans by the regulated companies. This integrated and commendable approach developed from a challenging debate on accountability for setting quality standards and the implications for consumer bills, promoted by the original water regulator, Sir Ian Byatt.[20] His concern was whether ministers properly applied the cost-benefit test in making decisions, and took accountability for it. "… I thought it was important to start a proper debate on what I called the cost of quality where I would say 'this is what quality might cost'…Then I said: 'Of course the people who are making the decisions on the quality are the ministers so please will the ministers take notice of this and that I am making the decisions on financing of functions. So whatever the ministers decide then I will finance the functions'. I would sometimes do this in what I regard as a relatively challenging way, 'Are you sure you really want to spend the money in this way?' I would have liked to have been able to challenge the European Union rather more than I was able to do".[21]

39.  The key development, therefore, was to formalise the interrelationships, and hence the accountabilities, within the regulatory framework as a whole. It showed how the regulatory framework can evolve, and particularly where regulators, being independent, thereby have the opportunity to identify and raise a problem and achieve a change in the relationship; a contribution which was noted by Sir Christopher Foster: "What Ian Byatt did in the circumstances was as good as could be expected because, at least to some extent, he institutionalised the conflicting forces".[22]

40.  The consequence of this unbundling of the regulatory state has been to sharpen the accountabilities of specific regulators, Ministers and Parliament in relation to their respective roles and responsibilities, emphasising the interconnectedness of the various parties within the regulatory framework as a whole. If regulators are independent for a particular purpose, they nevertheless still fall within the overall responsibility of Government and Parliament for the regulatory system. It is independence within Government, rather than independence of Government per se. The Minister of State at the DTI, Mr Stephen Timms MP, captured this when he said: "Inevitably there is an impact by regulators on a range of government concerns. I do not think the regulators exist in a vacuum outside government policy. Inevitably the decisions of regulators do impinge on government policy; there is no point trying to pretend that is not the case, it clearly is the case. The best way to handle it is for government to be explicit about what it is looking for from the regulators in those respects and for the regulators to make their decisions in that context".[23]

41.  One consequence of this, as we have seen earlier from Sir Ian Byatt's evidence, is the increasing formalisation of the relationships within the regulatory framework, constraining or empowering the parties, one in relation to the other, as appropriate. The development of ministerial guidance has been referred to as a case in point in written evidence by the DTI: "In addition the Utilities Review 1998 led to the establishment of an additional process through which regulatory objectives may reflect government policy objectives. The review led to subsequent legislation introducing a duty on the energy and postal regulators to have regard to governmental guidance on social and environmental objectives … similarly water in the water bill".[24]

42.  In practice, our Inquiry has concentrated on the independent economic regulators. The scope of activities of these regulators encompasses both regulatory and non-regulatory activities and their independence from Ministers brings with it additional important considerations for accountability. In any event, environmental regulation and advice to Ministers is an important aspect of utilities' economic regulation in practice, and social regulation has also played an important part in the debate on regulatory accountability and the role of ministerial guidance.

43.  Evidence and requirements related to the effective accountability of these independent regulators therefore provides a model for the accountability of regulators generally.

2   See Appendix 8 for a summary of the range of witnesses by type. Back

3   See, for example, standard economic texts such as Richard Lipsey and Alec Chrystal, Economics, 10th edition (Oxford: Oxford University Press, 2004). Back

4   The Oxford English Dictionary defines to regulate as "to control, govern or direct by rule or regulations; to subject to guidance or restrictions…to adjust…with reference to some standard or purpose". Back

5   As we have noted previously, "the Education (Schools) Act 1992 had established a new schools inspection system, and made provision for the publication of school 'league tables'", House of Lords Select Committee on the Constitution, Annual Report 2002-03, 2nd report 2003-04, HL paper 19, p. 19, para 21. Back

6   Better Regulation Task Force, Principles of Good Regulation (2003), p. 1, paragraph 1. Back

7   For the development of regulators and their functions, see Appendix 9. See also the annexes to the written evidence of the DTI (Vol.II pages 378-389). Back

8   Vol. II p197  Back

9   Vol. II p372 Back

10   Vol. II p373. See also annex 1 of DTI submission for summary of duties of economic regulators (Vol.II pp 378-383). Back

11   QQ1165 & 1167, Vol II p436  Back

12   Q643, Vol.II p234  Back

13   Vol.III p14, paras 3 and 4. Back

14   Vol.III p180  Back

15   Vol.III p157 Back

16   Q1168, Vol.II p437 Back

17   Vol.III p105 Back

18   Regulatory Policies in OECD Countries - From Interventionism to Regulatory Governance, p. 97: Reviews of Regulatory Reform (Paris: OECD, 2002). Back

19   Vol.II p373 Back

20   The Cost of Quality: A Strategic Assessment of the Prospects for Future Water Bills (Birmingham: Ofwat, 1992).  Back

21   Q14, Vol.II p6 Back

22   Q209, Vol.II p73 Back

23   Q1097, Vol.II p392 Back

24   Vol.II p373 Back

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