The CMA on governance Part 2: DECC and Ofgem

Matthew Lockwood, IGov Team, 14 July 2015 

About Matthew: http://geography.exeter.ac.uk/staff/index.php?web_id=Matthew_Lockwood

Twitter: https://twitter.com/climatepolitics

This is the second in a two-part post on governance issues raised in the Competition and Markets Authority energy market investigation provisional findings (full report now out) published last week. The first post focused on codes; this one is about the relationship between the government and the regulator. This is again an issue that is at the heart of the IGov project, and the CMA investigation has done everyone a great service in opening up and giving visibility to a crucial set of issues. The Authority has concerns about ‘lack of robustness and transparency in regulatory decision making’ in energy. It appears to be exercised about three things which are distinct but closely related.

Something better change

The first is the idea that Ofgem has done a number of things over the last few years that have failed to promote effective competition, including not introducing locational transmission losses charging, prohibiting regional price discrimination and imposing limits on tariffs in the retail market review. The CMA makes an association between these actions and changes to the objectives and duties of Ofgem, especially the ‘downrating’ of its ‘competition duty’. This refers to the introduction under the 2010 Energy Act that demoted the pursuit of promoting competition ‘where appropriate’ from Ofgem’s primary objectives in the original legislation at privatisation to general duties, and instead required Ofgem to consider means of promoting consumers interests other than competition before deciding on a competition route. The CMA argues that overall these changes ‘may constrain Ofgem’s ability to promote competition’.

The CMA argument here seems to hinge on changed wording in Ofgem’s objectives and duties. They think that previously Ofgem still had some margin of interpretation about whether promoting competition was the best way to promote the welfare of consumers, but that the 2010 Energy Act changes give an anti-competition direction. On its own this argument is not wholly convincing. It is not unreasonable to require the regulator to demonstrate that competition is always the best way to promote the welfare of consumers. For example, the Authority itself recognises, unbridled competition may not always be appropriate, as shown by its suggestions (albeit as a ‘transitional’ measure), the introduction of regulated ‘safeguard’ tariffs for vulnerable sticky customers.

In addition, it is not clear that the decisions by Ofgem the CMA mentions were made because of the wording changes introduced by the 2010 Energy Act. As Ofgem makes clear in its decision on transmission losses charging, the potential benefits of greater efficiency were highly uncertain, while the distributional consequences were large, and the advent of European legislation would quickly make the whole debate redundant in any event. In the cases of regional price discrimination and retail market reform, the real issue was political pressure on Ofgem via DECC, as discussed below.

Blurred lines

A second concern is about overlaps between Ofgem and DECC. The report notes that while DECC is in principle responsible for setting policy: ‘Ofgem inevitably takes decisions which develop further these policy objectives and go beyond mere implementation.’ The issue is then a lack of coordination between the two bodies leading to ‘suboptimal decision-making’. The report gives several examples, including the electricity balancing Significant Code Review pursued by Ofgem and the introduction of a Capacity Market by DECC which were developed in parallel both aimed at addressing a perceived ‘missing money’ problem. The CMA doesn’t have specific proposals here; it just notes the development of a Strategy and Policy Statement that might provide more clarity about respective roles of DECC and Ofgem.

The blurred lines of policy-making and implementation between government and regulator seem a real issue, but there are really two related but distinct problems here. One is about coordination and clarity about handover between policy-making by DECC and implementation by Ofgem. This could be sorted out by better communication and coordination between the two. But the other is about the degree to which Ofgem is de facto making policy, which is more of a structural problem. Compared with economic regulators in most other European countries, Ofgem has grown into a large body with many functions and duties. It has been allowed to drift into policy making in a way not seen elsewhere. In Denmark, for example, the regulator has a much more focused role assessing market practices against legislation. It sets regulatory parameters, but does not make changes to the regulatory regime.

I fought the law, but the law won

A third concern is that DECC has been leaning on Ofgem to act in particular ways (for example on tariff simplification) by using the threat of legislation if Ofgem did not act, and that this is undermining the perceived independence of the regulator. Here the CMA state that

‘it is neither realistic nor credible for DECC always to refrain from exercising its discretion over elements of policy and we note that it is always possible that DECC and Ofgem will disagree on a particular area of policy’.

They go on to argue for a mechanism whereby such disagreements can be surfaced, such as allowing Ofgem to publish its views on particular government policies. Such a mechanism is probably a good idea, but it does not really address the underlying issues.

As the CMA notes the rationale for an independent regulator is that it takes certain decisions out of the hands of politicians and under a technocratic authority guided by rules, with the aim of reducing political uncertainty and lowering the cost of investment. But there are two obvious limitations of this model.

One is that this does not eliminate politically difficult decisions, but rather moves them to a different location. Given that no government will give up power of intervention completely, when an issue becomes too hot, politicians will always become involved if they think that the regulator is not responding. This is clear in the the case of tariff reform, since it was the Prime Minister, no less, who promised action to protect vulnerable consumers would be taken. DECC was simply the messenger. Ofgem could publish its views on the efficacy or otherwise of such a regulatory intervention, but this would not prevent the intervention itself. Nor would it prevent industry actors from seeing that the regulator is not truly independent in moments of political crisis.

A second problem arises from giving an independent regulator a broad remit with multiple objectives as discussed above. On the one hand, such an arrangement leaves the regulator to interpret how to prioritise different policy objectives (i.e. in the trilemma of cost, security and decarbonisation) in the way it chooses. On the other hand, trade-offs between objectives lie at the heart of politics, and it is therefore inevitable that politicians will want to give a greater steer if they think there is regulatory inertia. Indeed, seen from the point of view of Government’s (as principal) getting Ofgem (as agent) to give a greater priority to sustainability objectives was a long and frustratingly slow process through the 2000s, as described in DECC’s 2011 review. None of this will be changed by the proposed Strategy and Policy Statement framework, which explicitly does not mandate how Ofgem should handle trade-offs. Indeed this approach does not follow the advice from BIS’s 2011 Principles for Economic Regulation (quoted by the CMA), which states that economic regulators should have ‘clearly defined, articulated and prioritised statutory responsibilities focused on outcomes’ (emphasis added).

The CMA has identified a real problem, but framed it in a narrow way. Making the relationship between DECC and Ofgem more transparent would help, but the wider issue is that Ofgem has taken on (or been given) too many roles for what was originally supposed to be a minimalist economic regulator especially in de facto policy making (as suggested by our work on public value energy governance). Seen in this way there is something odd about the CMA statement above. Surely it is actually not only realistic or credible but also undesirable for DECC to delegate policy making to a regulator. This is obviously related to the point above about blurred lines between policy making, policy implementation and regulation. Other institutional set-ups where other actors taken on responsibility for the sustainability of the energy system and where a smaller, leaner regulator focuses exclusively on economic efficiency appear to have done better (see Denmark again).

Get up, stand up

Finally, there is also an interesting institutional politics to the whole CMA review of this area. A general point is how the whole concept of referral by the regulator to a back-up authority has become disjointed from the multiple objectives of the regulator. Thus by statute the only authority that Ofgem can call for back-up from is a competition authority. While its primary objectives now also include promoting sustainable development, it cannot have recourse to, say, the Committee on Climate Change to review the regulatory framework.

Going back to the CMA report, a lot is made of the fact that Ofgem asked the Authority specifically to look at the structure of their objectives and duties, which Ofgem presented in their submission to the investigation as ‘complex’. They also said that if the CMA instructed them to give a greater priority to the promotion of competition this would be difficult to reconcile with that complex structure. Later the report notes says that Ofgem asked the CMA to comment on the independence of the regulator, and that Ofgem had expressed: ‘the hope that the investigation would recognise the importance of independence and reinforce its role in the regulation of the sector’.

It is perhaps not too much of a stretch of the imagination to read this as the appeal to a teacher by a child who feels bullied. This section of the CMA report on governance reads as if there is considerable sympathy for the regulator, which is perhaps not surprising given that it is written by competition economists. It certainly looks like an attempt by Ofgem to reassert its independence, implying that it feels that this has been undermined. However, for all the reasons given above, it is not clear that having a lot of power and a broad mandate is compatible with classic regulatory independence in practice.

Posted by: rhoggett

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