The Questions the Ofgem Review Isn't Asking

The past is important. Who knew?

Ofgem is the independent regulator of the UK’s energy sector. What this means for normal people not immersed in the field is that it’s their job to scrutinise the performance of private companies, prescribing and limiting how they can behave using tools like licences to operate and codes of behaviour. These tools ultimately acquire their force from legislation passed by the Government, and so Ofgem’s independence and freedom of action is ultimately limited by statute.

Ofgem does things like pass consumer protection requirements that oblige public energy suppliers to meet certain standards of consumer service, as well as regulating how much monopoly networks like gas and electricity can charge for the use of their services; so-called ‘economic regulation’. It’s done so - in one form or another - since privatisation. And it’s now under review.

The Government has launched a Call for Evidence as the first part of this review. Rather surprisingly - at least to me, who spends a not inconsiderable amount of my time pondering the intricacies of economic regulation, it hasn’t looked at the big strategic issues that face the very concept of independent regulation itself.

The theory that underlies independent regulation is that it provides assurance to capital that political intervention won’t be quasi-random and interfere with their ability to make returns on investment. This is particularly critical for network infrastructure, which represents investments that can pay back over decades. There are two problems with this theory. The first is that it has never been true.

Almost from the outset of the newly privatised industry, politicians quite happily got on the phone to independent regulators to nudge them when they thought they’d got it wrong. This is rather dramatically - and fascinatingly - recounted in Stephen Littlechild’s account of resetting economic regulation measures (“price controls”) in the 1990s.

Littlechild was leant on by Michael Heseltine, at the time the relevant Minister, when his initial attempt at a price control for the power networks was judged to be too generous to the private sector. Although Littlechild was reluctant to reopen the price control - stability being the cornerstone of the regime he himself had designed - he found it prudent to do so.

Similarly, Jonathan Brearley, Littlechild’s contemporary successor, has seen fit to embrace the Labour Government’s Clean Power 2030 target, even though it goes beyond the advice of the Climate Change Committee. While I am happy to endorse the 2030 target, it is very odd that the regulator has raised no question about the cost of doing so. You may argue that the target was in the manifesto of a democratically elected Government, but again the point of independent regulation is that it is indeed independent of political cycles.

Despite this, investors still seem to like the principle of ‘independent’ regulation, for a reason that illuminates our second problem. To set a price control the regulator needs to have enough knowledge of the sector they’re regulating to ensure that the companies involved can make a reasonable return and not gouge consumers for all they can. The problem is that they will never have more information than the companies they regulate. This is known as the information asymmetry problem of economic regulation. What tends to happen is that:

1. A regulator will levy a price control based on incomplete information.

2. Regulated companies will make an outsize return through greater understanding of the structure of that control as it applies to their sector.

3. At the next price control the regulator makes changes to compensate for the failures of the prior control.

4. Regulated companies again make an outsize return through the new loopholes the new price control offers.

This is a repeat game, and as regulators attempt to tighten and tighten the terms of the control it grows ever more prescriptive to the point that the regulator does things like specify the days when specific pylons need to be built. The endgame is a sector so hyper-regulated that it becomes unable to build at pace because the scrutiny of the regulator is so rigorous that independent thought is quashed. But, somehow, they will still make an outsize return.

This terrifying image is what our AI thinks lower levels of regulation entails. I have no idea what the sentient bowling balls are about.

Incidentally, the biggest challenge in delivering the Government’s Clean Power target, as well as the biggest impediment to growth, is the rate at which we can build pylons to connect new projects.

Despite this criticality, the Review is not asking the following:

• Do capital markets really believe that Ofgem is meaningfully independent of Government?

• Have Ofgem’s attempts to manage the information asymmetry problem been (a) adequate and (b) not been so onerous as to prevent infrastructure build-out?

These problems beset all sectors - arguably, the state of the water sector is largely a consequence of political pressure in the 2010s to reduce investment and thus cost. The temptation officials will face is to assume they’re someone else’s problem as a result. But the Government keeps reviewing independent regulation as a whole and getting nowhere because the sectors it covers and the methodologies of each regulator are so heterogenous as to prevent it coming to a meaningful conclusion. There is a pressing problem facing the energy sector that demands Government at least ponder the above.

Indeed, the Call for Evidence almost seems to take pains to avoid asking the question of whether Ofgem has been any good at discharging its duties. It does so obliquely through questions about scrutiny but avoids asking almost any backward-looking questions. Arguably ignoring the regulator’s history will undermine any attempt to think about its future. Officials may take the view that asking such a question would impact on Ofgem’s independence, but given the document is asking questions about expanding its remit one should probably figure out whether it can discharge its current remit first.

There is, however, a deeper problem that the Call for Evidence skirts around but does not grapple with directly. Regulation has a cost, and its imposition represents a trade-off. Consumer protection measures may benefit a minority of consumers while increasing costs for everyone else. Ofgem is not responsible for the overall consumer bill but can add to it in service of its consumer protection goals. Each incremental addition may be justified in itself, but the total cost stack of regulation may be disproportionate to the consumer risk it reduces in total. Regulation is not like the Power Rangers. It may be less than the sum of its parts.

The person most responsible for the total consumer bill is the Secretary of State for what is currently named the Department of Energy Security and Net Zero. But because the regulator is independent, their officials are reluctant to suggest cost reduction measures that tread on its toes. This means that cost becomes baked into the regime over time without any meaningful route of recourse. This is fundamentally antithetical to democracy.

Another illustration of this trade-off problem comes in innovation in the energy retail market, something very close to my heart. Ofgem can only act within the framework of various Acts that gave rise to the privatised regime, which constrains its thinking to how it can manipulate licences to create freedom to innovate. The Government views Ofgem as being responsible for retail energy and therefore its efforts to think through how to drive innovation are bounded by the existing regime.

This gives us our third missing question:

• Does the boundary between the powers and duties of DESNZ and Ofgem represent the right boundary for managing trade-offs, particularly on costs?

This, again, is nodded to on page 13 but is couched very much in the context of the changes necessary to establish NESO. My view is that there is a very strong case for returning retail policy to DESNZ wholesale; far too much of the thinking we need to unlock a future market is split and fragmented and requires further coherence. Moreover, radically cutting the cost of energy obliges the Government to grapple with the intricacies and layers of regulation that applies to market participants; it cannot do that when much of it is deemed untouchable.

But this points to our fourth and final problem:

• Is independent regulation of energy, and consequently putting it beyond reach of the demos, a risk to democracy? To what extent does it drive the rise of populism?

To be kind, I would not expect officials to answer this problem. But I hope they keep it in mind as they undertake the review. It is an excellent opportunity for Government to rethink the way in which our independent regulator is structured and make it considerably more accountable.

I also suspect it might be one of the few remaining chances for Ofgem to demonstrate the value of independent regulation as a concept; nationalisation - and thus the elimination of independent regulation - grows ever more popular as the challenges of independent regulation become ever more apparent. Eventually, the people will want their utilities back.