Regulating communications for the future: some options for customer engagement within a building block approach. Stephen Littlechild 16 October 2015

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1 Regulating communications for the future: some options for customer engagement within a building block approach Stephen Littlechild 16 October In September 2015 the Ministry of Business, Innovation & Employment (MBIE) published Regulating communications for the future, Review of the Telecommunications Act 2001 (henceforth Regulating communications). Chorus has asked me to explore further the comparison between Total Service Long Run Incremental Cost (TSLRIC) and Building Block Model (BBM) approaches, and to set out some relevant options for customer engagement that could be considered for application in the NZ telecommunications sector from 2020 onwards. 2. Previously, in 2013, Chorus had asked me to comment on the MBIE Discussion Document. 1 My resulting paper focused on the regulatory framework to apply from It argued that the TSLRIC approach was problematic both in theory and in practice. It suggested that it would be better to replace TSLRIC by a BBM approach. It also explained that various methods of better involving users were increasingly being adopted. Such approaches including negotiated settlement, constructive engagement and customer engagement - had merits in terms of discovering and implementing the services and contractual terms most preferred by customers. 3. I greatly welcome Regulating communications. It recognises the significance of the many ongoing changes in the sector, the importance of competition and customer choice, the need for an appropriate regulatory framework, and the contribution that stakeholders, businesses and consumers can make to this discussion. It shows an awareness of the problems associated with some present arrangements and makes some good suggestions for change. 4. In particular, the MBIE proposes to replace the TSLRIC approach by a BBM approach. The opening sections of the present paper support the MBIE s proposal by providing some further discussion of the problems associated with a TSLRIC approach, as illustrated by regulatory thinking in the UK. 5. The following sections discuss some of the issues and challenges facing a BBM approach. The latter include the time and complexity involved, the determination of future investment, costs and product mix, the discovery and incorporation of customer preferences, the encouraging of innovation and change, and so on. These sections illustrate how various different BBM Emeritus Professor, University of Birmingham; Fellow, Judge Business School, University of Cambridge; and former UK Director General of Electricity Supply. 1 MBIE, Review of the Telecommunications Act 2001, Discussion Document, August TSLRIC and the nature of competition: A contribution to the review of New Zealand s telecommunications policy framework, 11 September

2 approaches have been adopted around the world. They have increasingly involved various forms of customer engagement in order to provide greater customer responsiveness and legitimacy, and less regulatory intrusion. There would seem to be useful scope to incorporate greater customer engagement, in an appropriate form, in the future regulatory framework for communications in NZ. 1. Some difficulties of the TSLRIC approach 6. Regulating communications discusses the two most relevant cost-oriented pricing methodologies for UFB services, namely TSLRIC and BBM. It says The Government s preliminary view is that BBM (as described) is the most appropriate pricing methodology for any future economic regulation of UFB services (p 75) and it indicates that BBM is an option for future regulation of copper. (p 82) It also says that "While there are some risks associated with applying BBM to UFB services, these look to be manageable." (p 76) I agree with the descriptions of the two methodologies and with the Government s preliminary view. The following sections seek to substantiate that view, and to suggest that greater involvement of customers in BBM regulation can help to address the "manageable risks" of possible over-investment and greater regulatory intrusion. 7. The MBIE Discussion Document says of the TSLRIC approach that The pricing principles (the use of forward looking costs for network replacement) remain sound, and reflect international best practice. (para 18, p 14) Variants of that approach are certainly used in the US and UK telecoms sectors, but I question whether it is a sound approach that reflects best practice. 8. TSLRIC is based on a static concept of competition, which assumes the appropriate benchmark is an industry in long run competitive equilibrium with price equal to long run incremental cost. It abstracts from changes in technology, products, incomes, customer tastes, and so on. 9. This is not the world that obtains in reality, particularly not in the communications sector. A more realistic concept of competition is a rivalrous discovery process taking place over time. Prices in a competitive market are typically not equal to any long-run cost. For example, they may start out above it and subsequently be competed down to, or below, such a level. The possibility of higher profits provides an incentive to enter the market and to innovate, to the benefit of customers later. Such an incentive would be absent, or at least much reduced, if price were from the start somehow set equal to long run cost. 10. However, I do agree with the MBIE Discussion Document that the implementation processes may not be optimal during the transition period, when replacement of a legacy network by new technology is actually underway. This is because international benchmarking can be difficult, the process of setting prices based on long-run forward-looking costs using costs models can be very time-consuming (usually several years) because complex modelling and extensive consultation are involved, and the costs of 2

3 a replacement fixed line network in New Zealand are already known. (para 18, p 14) 11. My previous paper cited a report by CEG that illustrated these points convincingly and in some detail The UK airport regulator s view of a LRIC approach 12. As it happens, the Civil Aviation Authority (CAA) that regulates UK airports has recently concluded its periodic price control review. Part of that review considered the case for different kinds of price control arrangements at each of the three airports then regulated: Heathrow, Gatwick and Stansted. For Gatwick (and initially also for Stansted), the CAA considered inter alia the possibility of a Long Run Incremental Cost (LRIC) approach. Although telecommunications networks are obviously different from airports in some respects, there are also some important similarities, including the large scale and long-lived investment, government involvement in planning capacity, and the nature and sensitivity of price control calculations. It is therefore worth considering what the CAA had to say about a LRIC approach and how far its views are applicable to the NZ telecommunications sector. Moreover, one of the CAA s adopted forms of regulation could have attractions for the NZ telecommunications sector. 13. On LRIC the CAA says: The main potential benefit of a LRIC approach is that, in principle, it could signal the long-term average price that might emerge from a competitive market, in that it reflects the costs that a new entrant would have to incur to provide equivalent capacity. Price protection for users is assured by setting a price cap based on LRIC and fixing it for a number of years I have suggested above and in the previous paper that a long-term average price is not what would emerge in a real-world competitive market, and hence is not to be taken as a potential benefit. A price cap based on LRIC and fixed for a number of years could indeed provide price protection for users, but a price cap based on other measures of cost and fixed for a number of years could provide equal protection for users. 15. The CAA commissioned consultants Europe Economics (EE) to evaluate LRIC approaches with considerable thoroughness. 5 The CAA examined the EE report, heard views from Gatwick airport (GAL) and other interested parties, and asked EE to reconsider its report in the light of points made by the airport. The CAA then concluded as follows. 3 Review of Existing Telecommunications Regulatory Framework, a Draft Report for Chorus, Competition Economists Group, Sydney, July Economic Regulation at Gatwick from 2014: initial proposals, CAP 1029, CAA, April Europe Economics, December 2012, Advice on the application of long run incremental cost estimates for Gatwick and Stansted, %20of%20long%20run%20incremental%20cost%20estimates%20for%20Gatwick%20and%20St ansted%20-%20nonconfidential%20version.pdf 3

4 12.55 In summary, although the CAA recognises the potential benefits of an LRIC approach, it also acknowledges its drawbacks. The CAA is concerned that a combination of the following will mean that the implementation of a LRIC based control at Gatwick could undermine its primary duty: the practical difficulties in its calculation, the specifics of airport capacity in the south east of the UK that may render it inappropriate, the significant sensitivity of the calculation to regulatory judgement, and the data intensive nature of the calculation. On balance, therefore, the CAA considers that this option is not suitable for regulating GAL s airport charges in Q6 given the risk it could undermine, rather than support, protection for users and the promotion of competition. 16. The CAA s primary duty is to further the interests of users of air transport services that is, passengers rather than airlines and to do so, where appropriate, in a manner which it considers will promote competition. This is not dissimilar from the duty obtaining in the NZ telecommunications sector, to promote competition for the long-term benefit of users. Consider, therefore, the four concerns that the CAA believed could undermine its ability to discharge this duty, and whether they are specific to UK airports or more generic and equally applicable to NZ telecommunications. 17. The CAA s first concern was the practical difficulties in the calculation of an LRIC approach. It is not entirely clear to what the CAA was referring here, but it listed a number of what seem to be practical difficulties (paras ): - As LRIC is a long-term forward-looking measure there is a risk of over and under recovery in a particular period. This means that LRIC may not be wellsuited as a benchmark to indicate whether a particular price is proximate to the competitive price at any given time. Though it may be possible to smooth volatility in cost recovery over time, while ensuring changes are cost neutral, this may be difficult if this approach is used in the short term to facilitate a transition to a more competitive sector. Charging a flat LRIC price over time also raises similar issues as any other 'smoothing' effect, for example is that existing passengers may be asked to pay for future improvements from which they may not benefit. - It has also been argued that LRIC is not an effective proxy for competitive airport prices where investments are very lumpy for example LRIC may not reflect the capacity cycle which, in a competitive market, could produce significant price volatility. When considering prices it is important to take account of the effects of the capital intensive nature of airports and of the lumpiness of capacity increments. - Difficulties in determining the appropriate increment to use. As noted above, EE considered that the most credible increment would be the replacement of an airport (rather than, for example, a small amount of incremental capex or a new runway). - Greater uncertainty (and loss of accuracy) due to the need to make a judgement as to the efficient levels and types of investment required rather than using historical values that were spent. - The potential for greater uncertainty of remuneration of investment. As charges are not related to historical investment costs, then this increases uncertainty to the regulated company over the remuneration of investment, particularly if the current configuration of the airport is not ideal. 4

5 - Greater potential for volatility, for example if input prices or technology changes. 18. Although there are a number of references to airports here, the difficulties do not seem specific to airports. Similar difficulties were instanced by the CEG and by MBIE itself. They are equally applicable in both sectors and countries, they are intrinsic in the heroic notion of trying to guess what a different and hypothetical world would have looked like, and how theoretical calculations are best applied to it. 19. The CAA s second concern was the specifics of airport capacity in the south east of the UK that may render it inappropriate. By this, the CAA meant the significant role of government in determining investment EE s sensitivity analysis indicated that changes to the inputs and assumptions could lead to quite significant changes in a LRIC estimate. More fundamentally, EE questioned the relevance of an estimate of the competitive price obtained through LRIC given the level of government involvement in planning of airport capacity, particularly in the south east of England [In response to the airport s concerns, EE] re-iterated its view that the value of LRIC was reduced if entry and expansion is driven more by government planning and less by price signals. There must surely be a significant level of government involvement in the planning of telecommunications capacity in NZ too. 20. The CAA s third and fourth concerns were the significant sensitivity of the calculation to regulatory judgement, and the data intensive nature of the calculation. As the CAA explained, A LRIC approach is data intensive and requires regulatory judgement to define the increment. This can lead to significant uncertainty over future price profiles and it may be possible to generate large price increases or decreases depending on the assumptions used, limiting the protection to users and introducing variability owing to regulatory judgements. Again, is this different in the NZ telecoms sector than in the UK airports sector? 3. Conclusions on TSLRIC 21. The UK telecom regulator Ofcom has indeed used variants of LRIC pricing for example, in setting maximum charges for wholesale call termination. Whether it will continue to do so in future is unclear: its latest thinking is focused on targeted regulation and opportunities for deregulation. 6 The above excerpts show that another UK regulatory body the CAA - considers that LRIC approaches have serious disadvantages. 22. My own view is that TSLRIC approach introduces an unnecessary risk for the regulated company. There is no assurance of a reasonable return on an efficient investment. Of course, there is no such assurance in a competitive market. However, in making an investment under TSLRIC rules the company not only has to guess what the market will do, it also has to guess what the 6 Ofcom, Strategic Review of Digital Communications, Discussion document, 16 July 2015, section 14. 5

6 regulator thinks the market will do. That could be a much tougher task, particularly in a politically sensitive climate. It does not seem a regulatory regime that is conducive to significant levels of investment. 23. Another major consideration is the relationship to customers, the ability and incentive to meet the needs of customers by investing in the kind of network facilities they want, to provide the services that they want and when they want. In the normal competitive market this is done by negotiation between buyers and sellers leading to the agreeing of contracts between them. As explained shortly, a BBM approach to regulation still enables this kind of process using various forms of customer engagement, so that additional services or investments can be agreed in return for additional prices or revenues. In contrast, the TSLRIC approach is an obstacle to both these approaches. It seeks to determine the equilibrium price and thereby take price out of the hands of the customers, beyond the reach of the parties most involved. This does not seem conducive to the timely provision of the services that customers want. 4. Arguments for a Building Block Model 24. The alternative for consideration here is a Building Block Model (BBM) and possible variants thereof. Wikipedia has a remarkably informed, comprehensive and balanced article about it. The opening paragraph summarises the BBM calculation and indicates its widespread adoption. The building block model is a form of public utility regulation that is common in Australia. Variants of the building block model are currently used in Australia in the regulation of electricity transmission and distribution, gas transmission and distribution, railways, postal services, urban water and sewerage services, irrigation infrastructure, and port access. The Australian Competition and Consumer Commission has stated that it intends to use a version of the building block model to determine indicative access prices for fixed-line telecommunications services. The building block model is socalled because the allowed revenue of the regulated firm is equal to the sum of underlying components or building blocks consisting of the return on capital, the return of capital (also known as depreciation), the operating expenditure, and various other components such as taxes and incentive mechanisms. [references removed] 25. I summarised some of the advantages of a BBM approach for NZ telecommunications in my previous paper. 35. in the context of the New Zealand telecommunications sector, a duty to promote competition for the long-term benefit of users does not restrict the regulator to trying to calculate the equilibrium market price at any time, as expressed in TSLRIC, and repeatedly resetting prices on that basis. Rather, the regulator should aim to put in place the conditions under which market participants can themselves discover the most efficient and mutually convenient prices, products, quality of service, risk-sharing arrangements and other contractual terms. 36. A building block model, as mentioned in the Discussion Document, has a number of attributes that make it more suitable than TSLRIC for promoting this discovery process for the benefit of users. A number of these are described in the CEG report, notably that locking in a regulatory asset base 6

7 substantially reduces risk and therefore the cost of capital, which is greatly to the benefit of users in a capital-intensive network sector. Second, it is possible to provide incentives to efficiency, which over time can be used to reduce prices to users. Third, the whole process is conceptually quite straightforward, so outside observers including users can participate to the extent they are encouraged to do so. 26. I went on to suggest that a BBM approach had a flexibility that would be advantageous in the NZ telecommunications context. 38. It is also possible to build into the building block model provisions to ensure that network prices reflect the broad evolution of prices in a competitive market, to which the Discussion Document attaches importance. For example, once the Regulatory Asset Base has been set, it would be possible to make provision for depreciation and expected obsolescence in the forthcoming period, and to true up these provisions in the next period, while still ensuring that, over time, the network provider recovered the allowed value of the Regulatory Asset Base. 27. Let me now suggest seven other reasons why it would be worth considering a BBM approach to NZ telecommunications in preference to a TSLRIC approach. 28. First, variants of a BBM approach have been adopted almost universally not least in the US, Canada, the UK, elsewhere in Europe and of course in NZ itself. 29. Second, the approach has proved remarkably durable. When it was first enunciated and put into effect is unclear, but an early version was being systematically applied in the US in the nineteenth century, so it has lasted for well over a century, and seems to be still going strong. 30. Third, one of the reasons for the adoption and longevity is its remarkable flexibility and compatibility with other forms of regulatory innovation. Consider some of the options used in the UK, for example. It has proved consistent with RPI-X incentive regulation, with price and revenue caps, with menu regulation, with RIIO (Revenue = Incentives + Innovation + Outputs), with fast-tracking, with totex models (instead of separate opex and capex models), with price commitments in lieu of a price control, and with gainsharing via financial tramlines. 31. Fourth, it has been consistent with various forms and degrees of government policy and public interest considerations, including for environmental and social reasons. 32. Fifth, it has been consistent with a transition to competition, in those sectors where this has been feasible. 33. Sixth, it does not necessarily mean one size fits all: it is consistent with developing contracts and agreements with users, for example. 7

8 34. Seventh, it is consistent with developing various forms of customer engagement. 35. In my previous paper, I acknowledged that 37. The approach is not perfect, not least because it is time-consuming and therefore costly, and I have suggestions for improvement. I concluded Nonetheless, it is an approach that has stood the test of time better than the TSLRIC approach. That still seems a valid conclusion today, and consistent with the preliminary conclusion in Regulating communications. 5. Varieties of a BBM approach in UK airport regulation 36. I now illustrate some of these last points with the CAA s approach to UK airport regulation. There are three regulated airports in the wider London/SouthEast catchment area Heathrow, Gatwick and Stansted - each with very different characteristics from the other two. Nevertheless, until recently they were all regulated by a similar BBM approach involving a Regulatory Asset Base (RAB). However, the process had been an increasingly painful one not because of the BBM/RAB approach per se, but because of the strongly opposed interests of the market participants. 37. In 2005, approaching a new price control review, the CAA was concerned that the previous review had taken place in a very confrontational manner, with airlines and airports seemingly agreed on very little, leaving the regulator to make most of the major decisions about airport investment, service standards, and so on. 38. So the CAA proposed what it called constructive engagement. It invited each airport and its airlines to see if they could agree an important subset of the price control parameters at that airport, primarily future traffic forecasts, quality of performance standards and the future capital investment programme. If they could do so, the CAA would incorporate those agreements into the price control determination, and the CAA itself would decide other parameters such as the cost of capital, financing and the form of the price control. 39. There was considerable scepticism, but in many respects agreement was reached at Heathrow and Gatwick, though not initially at Stansted. The agreed parameters were indeed incorporated in the price control. In particular, the investment programmes were in effect determined by customers rather than by the airports or regulator. The CAA was encouraged to use constructive engagement again in determining the price control for air traffic control (NATS), where it worked well. 40. The CAA proposed the process again for the most recent airport price control review, and invited the parties to engage on a wider range of issues, including operating cost. Circumstances were somewhat problematic because in parallel there was a new process for determining whether an airport should be 8

9 regulated. 7 (There was some fear at Stansted and Gatwick that an agreement between the airport and airline would indicate that there was no need for regulation.) Nevertheless, progress was made on capital expenditure, traffic forecasts and service quality at most airports, although there was no agreement on opex efficiency (nor, not surprisingly, on cost of capital). 41. Now consider how the price control approach developed differently at each of the three airports. 42. Stansted is the smallest of the three airports and the extent of its market power seemed to be decreasing. A few years earlier the CAA in fact proposed deregulation of Stansted but the Government decided against. In the previous price control review the CAA had used a RAB (BBM) approach to set a price cap but stressed that, in view of changing market conditions, it was not committed to using that approach in the next period. In this most recent review, the CAA considered that a form of price monitoring would be the preferred approach, with calculations of RAB, LRIC and comparators as reference points. In the event, the CAA later concluded that Stansted did not have market power and would henceforth not be regulated. 43. Heathrow (HAL) was at the opposite extreme to Stansted: it was the largest airport and its market power was not really in doubt. The question was how to regulate it. Under the sub-heading Stability in the RAB-based methodology for setting price caps, the CAA said: 23. The CAA s calculation of the maximum price caps for Q6 is derived on the basis of a single till Regulatory Asset Base (RAB) [ie BBM] model the same methodology that calculates the present price cap. The CAA considers this form of regulation is appropriate given HAL s degree of market power. The RAB is a well-known model for regulation across different sectors where the regulated company has SMP. For example, it used in regulated sectors such as energy, water, rail, and wholesale telecommunications. 24. The RAB approach is also appropriate where there is a requirement to ensure that there is a well-understood way of balancing the needs of users today and the needs of users in the future. This is because the RAB approach ensures that airport charges should be no more than the minimum needed to remunerate an efficient airport operator, whilst ensuring a fair return on investment. Appropriate investment in facilities for the benefit of future passengers can be remunerated from present revenues. Given the significance of HAL s previous investments and its continuing need for significant investment in Q6, the CAA considers the RAB to be the most appropriate form of regulation There was a high level of consensus between the airport and airlines that a continuation of the RAB-based approach at Heathrow was appropriate. The 7 The Airports Act 2012 provided that the CAA could only regulate an airport if 1) that airport had market power, 2) this could not be adequately addressed by competition regulation and 3) the benefits of CAA regulation outweighed the detriments of such regulation. The CAA eventually agreed that it could not meet these conditions at Stansted. The MBIE might wish to consider such an approach in the NZ communications sector in order to implement its first principle for regulation, that regulation should only be imposed where it is clearly justified. Deregulation should be considered where sufficient competition exists. (Regulating communications p 24) 8 Economic regulation at Heathrow from 2014: initial proposals, CAP 1027, April

10 main challenges for the CAA at Heathrow were to identify the appropriate capital expenditure plan, to decide between the radically different views that the airport and airlines had on the matters of profitability (cost of capital) and operating efficiency, and to specify appropriate passenger quality standards. 45. At Gatwick (GAL) there was a difference of view on the need for regulation: the CAA and airlines considered the airport had market power and should be regulated, the airport did not. However, Gatwick offered to make commitments on price and other matters in lieu of a price control. The CAA was sympathetic to the concept but was not initially satisfied with the level and enforceability of the particular commitments offered by Gatwick. It indicated that its preferred alternative was a continuation of a RAB-based (BBM) price control reflecting what the CAA called a fair price. In the event, Gatwick offered revised commitments that were close to the CAA s fair price, and accepted that these commitments should be made enforceable by including them in the licence. 46. This brief account of UK airport regulation shows that a BBM approach is very flexible: it can be applied in different ways depending on the competitive context; it can supplement, or be supplemented by, other approaches; and it can be withdrawn if the evolution of competition indicates that that would be appropriate. The discussion also explains how airlines came to play a larger role in airport regulation than was traditionally the case with BBM regulation. I return later to the approach used at Gatwick airport, since that may be particularly relevant for some aspects of the NZ communications sector. 6. Negotiated settlements in North America 47. Any form of regulation has certain disadvantages. For example, the process of determining the regulated prices may be time-consuming and costly. The outcome may be uncertain, and may be subject to challenge. Several US jurisdictions using forms of BBM approaches have found a way to reduce these disadvantages by involving users in the process of determining prices to an even greater extent than in the CAA s constructive engagement process. The term negotiated settlements is used to describe this approach. 48. Negotiated settlements seem to have first been promoted on any scale by the US Federal Power Commission (FPC) in the 1960s. Faced with a sudden backlog of cases, the FPC encouraged pipelines and their users to negotiate and agree rates rather than go through a lengthy formal regulatory process. This proved effective, and had an unexpected bonus: the parties typically agreed rates for fixed periods of time, say 2 to 4 years, and agreed not to request rate changes during that period. This gave more certainty to the parties than the standard regulatory process, which allowed requests for changes to be filed at any time. This in turn provided greater incentive to increase efficiency a forerunner of the RPI-X incentive price cap. 49. Many other US jurisdictions (but not all) took a similarly encouraging line. I briefly summarised developments in my previous paper. 10

11 40. At the Federal Energy Regulatory Commission (FERC) a high and increasing proportion (now some 95%) of standard rate cases are settled by negotiation between the participants rather than litigated. 9 FERC staff in fact play an active role in facilitating these settlements. Some state regulatory commissions such as Florida have seen many settlements. 10 In Canada the National Energy Board (NEB) has successfully encouraged settlements by oil and gas pipelines and their customers. 11 Since the mid-1990s such settlements have essentially replaced litigated hearings. In almost all jurisdictions where settlements are common, not only have the parties demonstrated their preference for such an approach, there are also reports of better, and better informed, relationships between the parties. 50. Regulatory stances differed. In some jurisdictions, commissions were sympathetic to negotiated settlements if they occurred, but took little action to encourage them. In other jurisdictions, regulatory staff were very proactive. For example, when a utility brought a base rate case to FERC seeking a rate increase, staff would produce in three months a detailed indication of how they assessed the case. Staff would then gather the interested parties and assist them to negotiate an agreed outcome, typically somewhere between the two proposals presented. To facilitate agreement, staff might indicate outcomes that the commission would be likely to approve or disapprove, so that agreement was not prevented by misunderstandings or unrealistic expectations. Note that, in all cases, the final decision is made by the regulatory commission, which could reject or modify a negotiated settlement if it chose to do so. 51. There was an interesting development by the National Energy Board (NEB) in Canada. To avoid the time and costs of frequent (often biennial) and tedious hearings to determine the cost of capital for oil and gas pipelines, the NEB set out the formula it would use. The parties were then able to fill in the numbers and generally agree settlements based on this. Often these were five year incentive-based agreements, and several pipelines and their users agreed longer-term frameworks within which they would negotiate particular parameters on a more frequent basis. 52. Of course, settlements are used for other kinds of cases in the US as well as simple base rate cases. For example in Texas, the precise routes of nearly 3000 miles of new transmission lines have been decided in the last few years, mostly as a result of negotiated settlements between transmission companies and landowners, with transmission line design as well as routing being factors in the bargaining. 9 S C Littlechild, The process of negotiating settlements at FERC, Energy Policy, 50, November 2012: S C Littlechild, Stipulated settlements, the consumer advocate and utility regulation in Florida, Journal of Regulatory Economics 35(1), February 2009, S C Littlechild, The bird in hand: stipulated settlements in Florida electricity regulation, Utilities Policy,17 (3-4), September December 2009, S C Littlechild and J Doucet, Negotiated settlements and the National Energy Board in Canada, Energy Policy, 37, November 2009,

12 53. Settlements have generally been welcomed in North America because of the time savings they bring, at least in terms of formal hearings before the regulator. They facilitate the tasks of the regulator, provide outcomes closer to customer preferences, reduce risks for companies, and often improve understanding. 54. It is important to bear in mind, however, that a typical US rate case is simpler than a typical UK price control review, and one would need to consider where NZ telecommunications cases fit into this spectrum. In the US, rates will be set to reflect costs in a recent test year: there is no attempt to forecast actual or efficient costs five years ahead. Comparisons with other similar companies are typically not regarded as relevant. Only investment already in place and in the rate base counts: the assessment of actual or prospective new investment may not even be part of the case, and might be assessed during a separate process. Much of the argument might focus on the appropriate rate of return or cost of capital which is an important element of a UK price control review, but only one of several such elements. 55. In addition, North American rate cases have typically been fought out between utilities and major users for a long time, and the users have become expert in all aspects of these negotiations. This has typically not been the case in the UK, where a few large users and some customer representatives have typically put in evidence, but the heavy lifting of the regulatory process has been left to and indeed has been seen as the responsibility of the regulatory body itself. 56. Negotiated settlements as such have not been widely adopted in the UK. With five yearly price control reviews that are complex and encompassing,, and with customer representatives hitherto less geared up to taking a major role, UK regulators have so far seen advantage in a more cautious and limited role for customer involvement, with greater regulatory guidance. 7. Involving users in regulatory decisions 57. The advantage of involving users in regulatory decisions is not just a matter of reducing time, cost and uncertainty, though these are important advantages. In the UK, regulatory price control reviews are not just a matter of determining a price for an existing network or regulated entity. These reviews are also a means of reviewing investment plans, product offerings, quality of service and other parameters for the future, typically for the next five years. 58. This raises important questions, including: How best to discover what sorts of products and quality of service customers want? How to determine the efficient costs of providing these services? 59. I have already mentioned negotiated settlements in North America and constructive engagement invited by the UK airport regulator, both of which approaches have sought to address these questions. I now explain how the UK energy and water regulators Ofgem and Ofwat have addressed these issues. Both started from a basic BBM model but modified it to adapt to a world of 12

13 ever-changing technologies, which is the context emphasised in Regulating communications. 8. Fast-tracking and customer engagement in the E&W energy and water sectors 60. In 2008 Ofgem reviewed its RPI-X form of price cap regulation (a BBM model) after 20 years of use. It noted considerable achievements: greater efficiency, 30% lower network prices, 30% greater reliability, more investment and good returns to shareholders. But it also noted some weaknesses: the price control reviews were time-consuming, costly and complex. Innovation was good but focused on operating cost efficiency and finance. There was little innovation in the design, operation and pricing of networks, which would be increasingly important in the future with the advent of low-carbon technologies. There was no incentive for regulated companies to put forward good business plans because they would be put through the same onerous scrutiny process as other companies. And the companies were increasingly focused on Ofgem instead of their customers. 61. Ofgem decided that a new approach was needed, to create more innovative and flexible networks that would work with suppliers, producers and customers to understand and respond to the needs of customers. It called this RIIO: Revenues = Incentives + Innovation + Outputs. This used a BBM approach as before but built in more incentives to reward the provision of customer value. It focused on outputs rather than inputs: what customers wanted and got (eg capacity and reliability) rather than what companies spent. It focused on Totex rather than opex and capex separately. It set up new funding competitions to encourage and reward innovation. It proposed to put large projects out to competitive tender for potential delivery by third parties. It continued to use the weighted average cost of capital (WACC) but also calibrated all incentives in terms of the Rate of Return on Equity (RORE). 62. All these modifications of the basic BBM model may have potential application in the NZ communications sector. But for present purposes, let us focus on one more modification. Ofgem now offered the possibility of a fast track for those companies with well-prepared business plans that were supported by well-informed customers after a good process of engagement. These companies would have only a light touch applied to their business plans before those plans were used as a basis for setting the price controls. Other companies whose business plans were not well-prepared or not supported by their customers would need to go through the traditional and onerous review process. Ofgem quantified this: 6 months for fast track versus 18 months for the conventional process. 63. In 2010, Ofgem applied some of these ideas in its transmission price control review for the period beginning Subsequently, it applied the same concept to its gas and electricity distribution network price control reviews, the latter just completed. Ofwat too used a similar approach in its recent price control reviews of the England and Wales water sector. What were the outcomes? 13

14 64. The totex approach is said to have enabled a new and clearer evaluation of costs, avoiding a perceived bias towards capital expenditure. But there were some concerns about complexity, comparisons, calibrations and particular calculations. There was active participation in the new funding competitions. An increased proportion of allowed revenues came from incentive schemes, but there were some questions about customer value. It seems to have been an ambitious approach, with a promising beginning but also with scope to improve. 65. What about the fast-tracking approach with its customer engagement? The companies and the customer representatives were enthusiastic about this new approach. They participated wholeheartedly in the customer engagement process. Most companies made numerous significant adjustments to their business plans to meet customer preferences. And in essentially all cases the regulators judged this customer engagement to be very good. 66. The approach also meant less regulatory prescription, so that companies could better discover and respond to the preferences of their customers. 12 The aim was to give companies ownership of their business plans, rather than have the regulator dictate these. 67. In both sectors, it was eventually necessary for the regulator to indicate an appropriate cost of capital as a basis for the returns embodied in the business plans. Ofwat also gave risk and reward guidance. 68. However, it transpired that good customer engagement was only a necessary condition for fast-tracking, not a sufficient condition. Two of the four transmission companies were held to deserve fast-tracking, but only one of the six electricity distribution companies, one of the ten water and sewerage companies and one of the eight water-only companies. 69. The main reason for failing the other companies was their insufficiently challenging assumptions (from the regulator s perspective) about the scope for cost efficiencies. The regulators subsequently indicated what levels of efficiency were required. Once the company business plans had been appropriately revised, the regulators used them as the basis of the price controls, in many cases reflecting the projects and service levels supported by the customer groups. 70. It remains to be seen what impact this has on customer engagement in future energy and water price control reviews. An obvious concern is that parties will have been discouraged from engaging as a result of the high proportion of customer-supported business plans that were rejected by the regulator. 12 Ofwat s Chief Regulatory Officer put it this way: Like with a Lego kit, a prescriptive set of instructions for companies to build their business plans in line with may have been the easier option and would have resulted in a generic set of plans that look the same. We didn t do this and we didn t do this very deliberately because it has meant that companies have the opportunity, for the first time ever, to build a business plan that is right for their customers we think that the benefits are worth it. Sonia Brown, Keynote Opening Address, Water 2013, 13 November

15 71. I am hopeful that it will prove possible to better coordinate (1) the process for discovering and determining possible improvements in cost efficiency, and (2) the process for discovering customer preferences and determining service standards and associated capital expenditure. At least two possible methods seem worth exploring. 72. One method would be by providing regulatory guidance earlier in the price control process rather than at the end. The present process of fast-tracking might still be used to encourage aggressive operating cost reductions, but conducted slightly earlier in the price control review, before submission of the final business plan. Then companies and customers could engage with a better understanding of what levels of operating cost reductions would be involved. 73. The other method would be by the regulator providing more information to customer groups as to what efficiency improvements other companies were offering. Then each customer group could judge for itself whether to accept what its own company was offering or to press for something better. The customer groups might need some kind of support in order to appraise these comparative offers, but that remains to be seen. I have conjectured elsewhere that it might be possible to generate some kind of competitive process in setting price controls What this experience shows is that a BBM model with significant regulatory input can be combined with active customer engagement to yield innovative and customer-sensitive outcomes in a sector characterised by numerous different regulated companies. What would be the situation with a single regulated company, which might be more relevant to the situation of Chorus in the NZ communications sector? There is one more UK example of customer engagement, and a notable one. 9. The Customer Forum in the Scottish water sector 75. The Water Industry Commission for Scotland (WICS) took a more proactive and structured approach to its price control review than did Ofwat, the water regulator in England and Wales. Together with Scottish Water the government-owned water company in Scotland - and Consumer Focus Scotland, WICS created a Customer Forum. The members were primarily persons that had demonstrated an interest in customers. The role of the Customer Forum was explicitly defined: to carry out research with Scottish Water to ascertain the views of customers, and to represent those views to Scottish Water and to WICS during the price control process. 76. Later, the Customer Forum was asked to seek to agree a business plan for Scottish Water, consistent with guidelines that WICS would issue over a period of time. It was implied, though not stated, that an agreed plan would be used as the basis for the price control. 13 S C Littlechild, RPI-X, competition as a rivalrous discovery process, and customer engagement, Utilities Policy, 31, December 2014,

16 77. Throughout the process WICS gave guidelines on what range of assumptions would be likely to be acceptable to the regulator and were consistent with draft ministerial objectives - for example, on operating costs, the size of the capital programme, assumptions on growth, and overall performance assessment. Views of the environmental regulators were to be respected. WICS also indicated some innovative arrangements for dealing with future outcomes insofar as they diverged from what might be expected. These were embodied in financial tramlines that envisaged scope for risk-sharing and gainsharing In the event, all parties approached this process with cautious enthusiasm, as in England and Wales. Increasingly, both Scottish Water and the Customer Forum responded strongly. There was greatly improved understanding on both sides. Many new avenues were explored, and the need or otherwise for particular pieces of capital expenditure was extensively discussed. The Customer Forum thoroughly challenged the company's thinking and proposals. The company s business plan evolved in the course of this process. At the end, Scottish Water and the Customer Forum were indeed able to reach agreement, on a business plan and a price path that they both believed represented a better deal for customers than could otherwise have been achieved. WICS subsequently proposed a price control that reflected this agreed business plan This example indicates that a regulator does not have to specify everything in detail. It can give guidance on key parameters of concern to itself or to the government. This can leave a space within which the company and its customers in this case the Customer Forum - are able to engage and negotiate a mutually acceptable set of inputs and outcomes. 10. More on regulation at Gatwick airport 80. The final example explores in more detail how the latest price control review at Gatwick airport developed. The CAA as regulator started from a BBM-type model, but the eventual process and outcome were perhaps more similar to what might be expected under a Propose-Respond model, which is familiar in NZ but not in the UK. 81. Recall from section 5 above that the CAA started with the expectation that Gatwick (GAL) would continue to be regulated by a RAB-based (BBM-type) price control. The airport argued that it should not be regulated because it did 14 Unlike in England and Wales, WICS does not use a regulated capital value and weighted average cost of capital in setting water charges. Instead, it sets price limits based on overall cash requirements, consistent with maintaining a level of financial strength that allows for the sustainable financing of Scottish Water, as reflected in a suite of financial ratios. 15 For a more detailed account of the process, see The Customer Forum for Water in Scotland, Legacy Report, Lessons learned from customer involvement in the Strategic Review of Charges, February 2015, available together with other related material at See also S C Littlechild, The Customer Forum: Customer engagement in the Scottish water sector, Utilities Policy, 31, December 2014,

17 not have market power. However, Gatwick offered to make commitments on price and other matters in lieu of a price control. The CAA was sympathetic to the concept but was not initially satisfied with the level and enforceability of the particular commitments offered by Gatwick. After a period of discussion, Gatwick offered revised commitments that were sufficiently close to the CAA s fair price. 82. Agreement was thus reached. The approach gave Gatwick airport more flexibility (e.g. as to pricing and ability to offer airline discounts via long-term contracts) while at the same time the CAA satisfied itself, by using a BBMtype calculation, that the commitment would constrain overall airport charges to a reasonable cost-based level. The CAA also specified a monitoring regime that would Require GAL to undertake a shadow regulatory asset base (RAB) calculation in case tighter regulation needs to be reintroduced. 83. The CAA summarised at some length its reasons for thinking that commitments in the licence, informed by a BBM-type calculation, addressed a wide range of issues and offered the most sensible way forward. 8. The CAA considers that its proposed licence, which incorporates GAL's commitments, together with a monitoring regime, is the best way to further its duties, particularly the primary duty to users, for several reasons. - While the price in the commitments is higher than the CAA's view of a fair price, CAA's monitoring and the threat of additional licence conditions create incentives for GAL to moderate price increases and deliver growth at the airport and further the interests of passengers. - Licence-backed commitments will provide a better framework to diversify the service offering and to incentivise volume growth. This is because the commitments encourage bilateral contracts which can allow service quality, capital investments, operational practice, volume commitments and price to be better tailored on an integrated basis to the needs of individual airlines and their passengers. RAB-based regulation allows for bilateral contracts only on a limited basis, and cannot provide the same degree of tailoring. - Licence-backed commitments should promote competition by facilitating innovation and diversity of the services offered. These are important, although not sufficient in themselves, for effective competition between airports. Although existing and future capacity limits reduce competition between London airports, it is nevertheless an expansion of choice for at least some users if airports are enabled to diversify their service offerings. - Embedding the commitments within a licence provides a timely and effective backstop protection for users in the form of a licence enforcement regime, for instance if there are reductions in service quality or price increases that are against users' interests. - Licence-backed commitments will encourage GAL to improve its efficiency as the airport operator can retain savings during the commitment period. The longer time period of the commitments should provide GAL with greater incentives to reduce operating expenditure and outperform commercial revenue assumptions. - Licence-backed commitments will facilitate efficient investment as GAL will have flexibility to tailor its investment to the needs of airlines, while the licence will provide users with timely and effective backstop protection to ensure that investment is undertaken in users' interests. - A specific licence condition has been inserted which requires the licence to be amended before the main costs of a second runway can be passed through 17

18 to users. This will ensure that the development of any second runway was undertaken in a manner that furthers users' interests in the cost and quality of airport operation services (amongst other interests) and promotes competition in airport operation services. - Licence-backed commitments will prospectively ensure that an efficient GAL has adequate financial resources and can finance its provision of airport operation services. The CAA has checked GAL's potential financial ratings and assumed that GAL would not have proposed commitments that it could not finance. - Licence-backed commitments will provide protection on operational resilience, by allowing the CAA to undertake licence enforcement action if there are problems with operational resilience. - Licence-backed commitments will provide protection on financial resilience through commitments and licence obligations As just one illustration of the new contractual and customer-oriented approach, consider Gatwick s approach to performance standards. From April 2014, Gatwick Airport began operating under a system of environment of contracts and commitments with our airlines. In this new way of operating our service standards are agreed with our airline partners and endorsed by the CAA. This is in contrast to the previous regulated system where the CAA set and measured all our standards. As a reflection of our new way of operating, we now publish one key performance report which touches all areas of our business and measures our service standards against what has been agreed with our airlines Here then is another example of a price control approach that does not involve the regulator setting everything in detail. Nor- unlike a TSLRIC approach does it involve the regulator trying to guess what a competitive market would or should look like, if constructed from scratch. Rather, the regulator indicates its high-level general concerns - about excessive profits at the expense of customers, about improving service standards and efficiency, about its ability to enforce any commitments made by the airport and then considers how the regulated company proposes to address these. The company, for its part, is talking to its customers (the airlines). It does not seek a joint agreement with these customers they are, after all, often competing with each other but instead seeks a series of bilateral contractual relationships within the common proposed framework of assurances. This provides so much more flexibility to respond to individual preferences and to adapt to changing market conditions. 11. Concluding remarks 86. The task of this paper has been to compare the merits of TSLRIC and BBM approaches for use in the NZ telecommunications sector, and to consider the possible role of various customer involvement approaches. In the light of the foregoing survey of the field, my thoughts are as follows. 16 Economic regulation at Gatwick from 2014: notice of the proposed licence, CAP 1139, 9 January accessed 13 June

19 87. TSLRIC seems a remarkably arcane and artificial approach, requiring sophisticated modelling by experts but relatively alien to the outside observer. It is therefore suspect and not conducive to affirming the legitimacy of regulation. Nor does it seem conducive to ensuring the significant additional investment that still requires to be made in the telecommunications sector. Its main claim for adoption is based on a concept of setting price equal to the level that would obtain in a competitive market. But this claim is in turn based on a concept of a long run competitive equilibrium that is nowhere to be found in the real world. In reality, prices, costs and products are constantly changing, and the risks of investment are high because no one knows for sure what future consumers will want. 88. Using TSLRIC as a basis of remunerating a telecommunications company seems to increase that risk by adding in uncertainty as to what the regulator will decide would have been built from scratch in a hypothetical world if no one had built what they actually have built. A more uncertain context means a higher cost of capital and hence a higher cost for customers. In addition, the TSLRIC approach does not seem to address the question what should be built in future, and how this can best be tailored to the preferences of final customers and the business plans of the users of the telecommunications network. Decisions about price are divorced from decisions about future investment and desired quality of service. 89. In contrast, a BBM approach is grounded in reality. At each price control review of a telecommunications network it says, in effect: this is what we have asked you to build in the past, this is what you have spent, this is what we have so far paid for, and this is what is left to be paid for. Let us now discuss how to proceed for the next five years (say). We have two basic sets of questions to decide: - First, what proportion of the outstanding amount is to be paid for over this next period, at what rate should we remunerate your outstanding investment given the costs of capital presently obtaining in the financial markets, and how should the required revenue be charged over the various products and services that this investment provides? - Second, what additional replacement investment is required to continue to provide present services, and more interestingly what new services could and should be provided to meet evolving customer preferences, what will this cost and what would be the implications for present and future prices? 90. Some kind of BBM approach has been found appropriate in most countries and in most sectors for over a century. It has been relatively simple to understand and operate. It has facilitated substantial investment at broadly acceptable prices and quality of service. RPI-X and related incentive arrangements including price caps, revenue caps and more recent variants - have considerably increased efficiency, to the benefit of customers. 91. BBM approaches are not without limitations, some of which are shared with TSLRIC and other approaches to regulating prices. The review process can be time-consuming, uncertain, costly and adversarial. And it may not take 19

20 sufficient account of customer preferences. However, recent regulatory developments have sought to improve on previous traditional versions. Thus, negotiated settlements in the US have enabled regulated companies and their customers to agree proposals to put to the regulators, thereby reducing time, costs and uncertainty. These settlements typically relate to the ongoing costs of existing networks, rather than to the more challenging regulatory issues associated with new investment in changing economic conditions. 92. In the UK, the convention has been for regulators to request information from regulated companies, which may include business plans, then to form their own views of efficient costs and investment programmes should be. These views have been challenged by companies, and regulators have felt increasingly uncomfortable taking decisions that second-guess companies and their customers. 93. In consequence, there is now an active search for improved methods of regulation in the UK. The hope is that these will reduce the time, cost and uncertainty of regulatory proceedings, will involve cooperation rather than confrontation, and will involve customers more substantively in the process. Rather than take all the decisions in detail, regulators are looking to provide more clarity on their expectations, and thereby to set a high-level framework within which interested parties can explore, discuss, negotiate and hopefully agree arrangements that meet their own needs while being acceptable to the regulatory body, with all its statutory responsibilities. 94. There are numerous examples of such customer engagement processes in the UK. All seem to have enabled a more fruitful dialogue between companies and customers, moderated by the regulator. They have attuned future investment more closely with customer preferences, and thereby brought more legitimacy to the whole regulatory process. 95. The fast-tracking and customer engagement models adopted by Ofgem and Ofwat have perhaps been the most comprehensive and most explicitly documented by these regulators, explaining their thinking in advance. On the whole results have been encouraging. However, the fast-tracking incentive process, as it played out across the numerous companies in each industry, meant that relatively few companies produced business plans that satisfied the regulator. This caused some tension with the customer engagement process. 96. Of perhaps greater relevance to the NZ communications context, and to the situation of Chorus in particular, are two other approaches, each involving a single company viz Scottish Water and Gatwick airport. In both cases the regulator in effect invited the company to propose a way forward. In both cases the regulator facilitated an active role for customers. And in both cases the process was in the context of clearly stated regulatory concerns and preferences, an indication of what would be acceptable to the regulator. Within that context it was open to the company and its customers to discuss and agree a way forward. 20