Regulating in two industries
Speech by Callum McCarthy, Chairman, FSA
Centre for the study of Regulated Industries, London
24 November 2005
This is a very pleasant occasion for me, as it enables me to see so many old friends from the energy world. It is also a pleasure since it has made me think further about what are the similarities, and the differences, between regulation in energy and regulation in financial services. What are the particular problems in each? What – if anything – is not problematic in each?
I want to start by assuring my friends from the energy world that I haven't changed my spots, my beliefs or my prejudices: by way of prejudice, the use of the word "holistic" is as frowned upon at the FSA as it as at Ofgem; as at Ofgem, to claim to approach some analytic task "with passion" is a cause of immediate disapproval – whereas determination, judgement and independence rather than the cliché of passion are pursued; by way of belief, I have maintained the belief, which should be shared by all sensible regulators, that the best means of allocating resources and satisfying consumer demands is through the operation of efficient markets, and that any sensible regulator first attempts to encourage and promote efficient market mechanisms, and resorts to contemplating regulatory intervention only when the prospect of a market solution is unrealistic.
It is a belief which I held during the five years I discharged my Ofgem duties; it is the belief I now hold in discharging my FSA duties. In both contexts, I have attempted to translate these beliefs into practical realities. This means that in both energy and financial services I have been concerned to intervene through regulatory action only when there is both market failure and when regulatory action has the prospects of doing more good than harm (market failure by itself is a necessary, not a sufficient condition: there are market failures whose harm is increased, not reduced, by regulatory initiative). But I am struck by how much easier it was in my energy job to translate these beliefs into practical reduction of regulatory activity than it is in my present responsibilities for financial services.
In gas and electricity, it was possible to withdraw from regulation of some 70 per cent of the activities which had been subject to price regulation at the time of privatisation of these industries. The activities of Ofgem are now concentrated on price control of natural monopolies (if I am allowed to beg several Chicago school arguments by using this phrase) – the transmission and distribution businesses of gas and electricity; the rules for the wholesale trading of gas and electricity; and the rules for the transmission and distribution businesses. But all end prices of gas and electricity, whether for industrial, commercial or retail customer, are uncontrolled and left to competition. I would add that, particularly in the present circumstances of rapidly rising prices for wholesale gas, the result is, in my judgment, lower end prices than would be possible if price controls had remained.
The position in financial services is very different. The FSA, I am relieved to say, is not a price regulator; the industry it regulates did not come within its responsibilities as a series of vertically integrated monopolies, as occurred with gas and electricity, but is characterised by an industrial structure which is emphatically not monopolistic and is not, in many respects, oligopolistic either. But it has proved very difficult to withdraw from regulation, despite an industrial structure which is more competitive. There has been no recent equivalent to the major move away from regulation to competition which was possible in gas and electricity.
The most recent structural change – Big Bang in 1986 – created competition by eliminating separate cartels, as did changes which opened mortgage markets beyond building societies. But, by creating potential conflicts which had previously been ruled out by industrial structure, they created a demand for regulation. Instead, deregulation has been piecemeal – and often opposed by those regulated, as is at present occurring with the FSA's proposals to withdraw from setting certain training standards. And, as an aside, I would add that the FSA's attempts to confine its responsibilities have not been helped by a tendency of government to add to our responsibilities.
The move from regulation to competition has been much easier in one regulatory context than another. Why is this?
I do not think that the explanation is to be found in differences in legal powers and duties between the Utilities Act which empowers Ofgem and the Financial Services and Markets Act which empowers the FSA. There are of course differences: the Utilities Act gives Ofgem a specific competition objective (albeit in a less absolute form than the original competition objective in the predecessor Electricity and Gas Acts) whereas the Financial Services and Markets Act has competition as a secondary factor; conversely, the Financial Services and Markets Act requires the FSA to conduct cost:benefit analyses of proposals in a way which has no corresponding duty in energy regulation. But I do not think that the difference in ease of substituting competition for regulation lies in legislative differences.
Rather I think the difference lies in the difference between the route adopted towards achieving the end of improved consumer benefit – one a structural route, the other a behavioural route. In gas and electricity, the need for regulation derived directly from the structure of the industries, where in gas one firm – British Gas – owned the gas storage facilities and the pipelines and delivered gas to all customers; and where in electricity one company – the CEGB – generated electricity and owned the national distribution grid, and where other companies, each a local monopoly, took electricity from the CEGB and distributed it over local networks which they owned.
New entry was in practice made very difficult because those who wished to compete in providing electrons or molecules to end users had to use the distribution systems of the incumbent suppliers. Success in introducing competition only came about when structural changes were made which eliminated the conflict of interest between supplier of energy and owner of the energy distribution system. This is most easily illustrated by reference to gas, where the vertically integrated monopoly of British Gas was broken into a network and distribution company BG, and a supplier of molecules company Centrica.
Because it no longer supplied gas, BG was indifferent as to whose gas was distributed over its pipes, which were open to all suppliers. Genuine competition was possible – and end price control no longer necessary. The possibility of structural change rendered much behavioural regulation – rules of access, rules governing connexions, rules governing speed of repairs, bundling of services – unnecessary. And, of course, the initial structure once a competitive structure was created could respond to economic changes – so that Centrica now provides both gas and electricity in a market with other multi fuel competitors; and BG has been subject to changes, some which extended its national monopoly to the transmission systems for both gas and electricity, some of which have reduced its scope, as local monopolies have been sold on.
In financial services, the problem is not essentially structural: although the responsibility for assessing competition questions in financial services lies not with the FSA, I would simply say that, for what my view is worth, structural problems are not particularly significant. But behavioural issues are.
In terms of behaviour, any efficient market requires three conditions to be satisfied: first, there must be customers, actual and potential, who are equipped to make the decisions required of them; second, information must be available in comprehensible forms which can be accessed without excessive cost, whether of money or of time; and third, the providers of goods and services must meet standards of responsible behaviour. All three of these conditions pose problems for the retail financial services market – particularly for investment products.
I won't go into the first of these, the need for a marked improvement in financial capability, since it raises issues which are wider than regulation. Let me simply observe that there is a pressing need to improve the position of those who use financial services: it is hard to believe that investment products will be properly assessed by those adults in Britain – one in five – who do not understand percentages. But both the second and third issues – clear information and responsible behaviour – have required, and continue to require, a raft of regulatory interventions: to define what information must be given (eg on risks, which those selling financial products often omit); or what information must not be given (eg projections of returns based on unrealistic assumptions as to growth); the need for those giving advice to understand the circumstances and risk preference of those they are advising; the need for competent complaints handling procedures. There is no magic bullet, nor any structural change, which enables us to pull back from this type of detailed regulation and move emphatically towards use of competition.
Nor on the wholesale side of financial services is there the prospect of large scale structural change to eliminate conflicts of interest of the sort which transformed the regulatory position in gas and electricity. The conflicts in large financial services firms are both inherent and pervasive – arising from the fundamental conflict which arises when one institution acts as both principal and as agent, but manifesting themselves in a multitude of specific circumstances: how is information to be used (eg by banks which have arranged loans, and then trade either the credit or associated credit derivatives); what timing rules govern transactions for clients and own account dealings; what services can properly be offered to managers of investment trusts (the familiar softing argument); what relationship should be permitted between so called "independent" research and corporate finance. Although some, rather specific, progress can be made by restructuring to reduce particular conflicts, as has been proposed by the SEC to reduce the problem of research analysts who were anything but independent, for the most part these conflicts of interest are too pervasive and deep rooted to be capable of resolution by restructuring: they have to be managed and regulated, but cannot be eliminated. And hence the scope for a competitive solution is much more limited – something I say with obvious regret.
Until now, I have explained why regulation in energy was an easier task than has been regulation in financial services. There is, however, one – important – respect in which financial services regulation has an advantage. It is the fact that it does not involve price regulation – more accurately, that it does not involve price regulation in any significant degree (I am ignoring the designation of the FSA under Unfair Contracts legislation). Thus, while there are price controlled financial products, such as the simplified investment products introduced by the Treasury as a result of the Sandler proposals, those price controls are neither advocated by nor implemented by the FSA. Indeed, we have made clear that if there is evidence that the stripped down process of advice works for these simplified products which happen to be subject to price control we will wish to consider extending the advice regime to other comparable simplified products not subject to any price controls. Similarly, our response to the very wide variation in margin on certain financial products – the threefold variation in the cost of personal payment insurance, for example – is not to seek to control the price, but instead to promote a more competitive market for the product and to ensure that it is not mis sold. This is a long way away from the difficult task of setting price controls for the natural monopolies of transmission and distribution businesses.
Why do I regard this as important? It is not simply a matter of avoiding a task which is difficult – although getting price controls right is a difficult task. After all, if avoidance of difficulty were the criterion, no one at all would take on regulatory responsibilities. Rather it is the harmful effects that price regulation has historically had upon both the exchange of information between regulator and regulatee, and on the style of the relationship between regulator and regulatee.
The effect of price controls as the most important component in the discourse between regulator and regulated was manifest and highly damaging in the early experience of both gas and electricity regulation.
The information problem is well known. I do not want to dwell on the past examples of gaming of the regulatory process by regulatees. The most egregious example was undoubtedly the second electricity distribution price control, where companies which had argued long and hard, supported by their phalanx of advisers – usually, but remarkably in all the circumstance, described as "independent advisers" – that they could not survive on less than certain amounts of cash, suddenly discovered when faced with hostile bidders that they could find very substantial amounts of spare cash. There are lots of other examples.
Please note that, even in the world of regulation, there are costs to gaming the system. The costs can be obvious – the second distribution price review was widely and correctly seen as damaging to the regulatory organisation, but it was also deeply damaging to the regulatees in a way which they should have recognised at the time. It led to the reopening of the price control, in a way which can have done nothing to enhance regulatory certainty or to reduce the cost of capital. It is not surprising that organisations which at the very best were considered poor at forecasting their real budgets were not taken seriously when they argued against the impact on them of the windfall tax in 1997. What comes round, comes round, in regulation as in other fields.
The style problem was also clear in the early years of energy regulation. Whereas the relationship between regulator and regulatee in financial services has for the most part been both professional and institutional, the early history of regulation of British utilities has been distressingly different. The relationship between regulator and regulatee in the early days of regulation was obviously adversarial, and highly personalised. The examples are obvious: discussion of serious issues were conducted in terms of the personalities involved: "Rooke versus MacKinnon" or "Vallance versus Cruickshank". The decisions of the regulatory organisation were discussed by commentators as if all were made by the individual who happened to be the regulators of the day – something from which the MMC as was and the Competition Commission as is has escaped. Decisions were also discussed in terms of startling inappropriateness.
When one of my predecessors as gas regulator – I personalise because it was represented as her decision, not that of the organisation – proposed new price controls for Transco they were described by senior British Gas spokesmen as "The biggest smash and grab raid in corporate history", and as "comparable to Herod's slaughter of the innocents". I should add that the price proposals were subsequently endorsed resoundingly by the MMC, and were significantly outperformed in practice by Transco. It is simply not a sustainable position for British Gas, or any other regulated organisation, to make inappropriate remarks, and then to complain about regulatory uncertainty, and the cost of capital. These remarks were not an isolated incidence: there were many comparable comments, all of which represent a trivialising of the issues, and none of which can be regarded as being helpful to a sensible discussion of issues which have real economic importance.
So there is a great benefit in not having direct responsibility for prices, as it enables a more professional, less charged, more honest relationship to be developed between the regulatory organisation and those it regulates – to the advantage of both sides. I should add that I believe one of the significant achievements in energy regulation over the last decade – indeed in most but not all regulated sectors – has been an increased maturity, and hence greater continuity and certainty, in the relationship between regulator and regulatee – much aided by the depersonalisation of regulation which all sensible regulators pursue, and which the move from individual to corporate responsibilities has facilitated. And I am also conscious that, for some of the newer areas of financial regulation, we have further progress to make to spread the good practices and general culture which are helpfully established in those areas where regulation has a longer history. But the general point remains: responsibility for price control makes a regulator's life significantly more difficult.
There are, of course, many features of regulation which are common to both energy and financial services: the constant struggle to demonstrate the legitimacy of an independent organisation – to answer convincingly the justified question of "if independent, then how and to whom accountable?"; the need to remind both politicians and officials of the lines between their responsibilities and those which Parliament has given to the regulatory organisation; the need to demonstrate that the regulatory organisation is in fact efficient, and to manage to make it so; the desirability of advancing public debate on the balance of regulation, so that regulation is properly challenged without on the other hand a blind acceptance of the fallacy that absence of rules is somehow a desirable state – markets to operate require rules, just as states require laws: the question is whether they are good laws or rules. These are all common features – I suspect of all regulation – certainly of energy and financial services.
This evening I have concentrated on two – the largest, in my judgement – differences between regulation in financial services and in energy: first, the differences between what is involved in structural remedies and in behavioural remedies, and the deregulatory opportunities presented by the former; and second, the pervasive and pernicious implications of price control for the regulatory discourse between regulator and regulate. I will be interested in your comments.