December 1, 2013 10:01 pm

How regulators became part of the problem

Referee. Illustration by Andrew Baker©Andrew Baker

Along with the superior efficiency of the private sector, one of the justifications for the privatisations of the 1980s was the need to take state businesses out of the political arena. Instead, independent regulators would act as referees, ensuring that the ensuing efficiency benefits would be shared with customers too.

It did not work like that. The privatised companies are more contentious than ever. Energy policy and prices are in turmoil, and an official report finds that UK rail costs per passenger km are 40 per cent higher than the rest of Europe. Baffling prices, hidden subsidies and faux competition seem endemic among the utilities.

Meanwhile, regulation is the fastest-growing arm of the state. No one knows the full cost, but a roll call finds 60-plus official regulators, not including local government and professional associations, analysts, inspectors and auditors. With kennelfuls of dogs to bark on citizens’ behalf, you might think politicians would pipe down. Not a bit of it.

Far from the promised world of stable policy and uncontroversial technocratic management, we seem to have the exact opposite. Under the privatisation-and-regulation regime, controversy reigns, while companies are more subject to political micromanagement (GPs’ appointments, train ticketing, comparison prices for petrol, energy prices) than ever before.

How has this come about? In the real world, designing a market turns out to be harder than it appears. The high cost of British rail is partly down to the fragmented structure imposed by privatisation. But a more fundamental problem is that in a system that (mistakenly) privileges shareholder claims over all others, it is consumers who foot the bill for the markets’ dysfunction. Hence sky-high train fares and the furore over soaring energy bills.

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This is the itch that politicians are constantly compelled to scratch, while regulators devise new prophylactics to stop it occurring again. As economics professor John Kay wearily described the process when he launched his financial review: “Dysfunctional structures … give rise to behaviour we don’t want. We respond … by identifying the undesirable behaviour, and telling people to stop. We find the same problem emerges, in a slightly different guise. So we construct new rules. And so on. And on.”

Thus in the US, 2002’s Sarbanes-Oxley Act, designed to prevent future Enrons, did nothing to stop the 2008 crash and was followed in its turn by the even more voluminous Dodd-Frank Act.

The result, Prof Kay noted, was regulation that was extensive and intrusive yet also ineffective and prone to regulatory capture (in which regulators come to view problems through industry eyes).

The problem is compounded by the confusion of regulation with management. Regulation nowadays is not just broad-brush policy stuff. Increasingly, governments and regulators specify not simply what organisations should do but how they should do it. Official procedures are encoded in computer software; departments specify how work should be designed, targets set and providers paid.

But management and regulation are not the same. In a 1995 Harvard Business Review article, strategy guru Michael Porter and Claas van der Linde noted that while “good” regulation could foster innovation and lower total costs, “bad” regulation did the reverse. Their rule No 1: regulate for outcomes, not methods, and rely on managers in competitive markets to find better ways of achieving them. Prescribing methods perversely switches off the market’s most compelling quality. The indirect costs to organisations of complying with regulation rather than finding new ways of doing things dwarf the direct costs.

Regulation is a false god. It cannot substitute for political will where political decisions are necessary, nor can it impose moral purpose on businesses that insist on putting shareholders first. It is the responsibility of boards of directors to ensure energy tariffs that are comparable and comprehensible to users, just as it is to set proportional executive salaries. Perhaps it is time to revisit the recommendations of the Better Regulation Task Force in 2005.

Beware unintended consequences it said, noting that governments should not automatically assume that prescriptive regulation was the answer. “Solutions that give stakeholders the flexibility to solve problems themselves are often preferable to imposing rules on them.” One of the other alternatives it should consider was: do nothing.

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Costly decisions

The Organisation for Economic Co-operation and Development has described regulatory spending as “the least controlled and the least accountable” of all government costs.

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