accountability and regulation - reporting · pdf fileaccountability and regulation - reporting...

PROCEEDINGS 27

ACCOUNTABILITY AND REGULATION - REPORTING PERFORMANCE

Cemil AltinRob BaldwinStan Chaplin

Mark CourtneyCarl Hetherington

Jim MarshallIan Rowson

Jean Spencer Peter Vass

Phil Wynn Owen

ACCOUNTABILITY AND REGULATION - REPORTING

PERFORMANCE

Proceedings of a CRI Conference

held on 7th March 2001 at

One Great George Street, London

Chaired by Professor Ralph Turvey

Edited by Peter Vass

Desktop published by Jan Marchant

© The University of Bath All Rights Reserved ISBN

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PREFACE The CRI is pleased to publish the papers from its conference on Accountability and Regulation - Reporting Performance, as its 27th set of Proceedings. Regulation benefits from having a coherent and explicit framework of objectives which can be a reference point for judging the performance of the system and holding the regulators, and the regulated, to account. The government has been taking significant steps in recent years to ensure that regulation is cost-effective and meets the principles of ‘better regulation’, set out by bodies such as the Better Regulation Task Force and, internationally, by the OECD. We hope that the CRI conference, and its set of Proceedings, will contribute to the debate. In that respect, we are indebted to the authors and presenters at the conference for their contributions. The CRI would welcome comments on these Proceedings and further analytical work in the area. The CRI publishes work on regulation by a wide variety of authors, and covering a range of regulatory topics and disciplines, in its International, Occasional and Technical Paper series. The purpose is to promote debate and better understanding about the regulatory framework and the processes of decision making and accountability. The views of authors are their own, and do not necessarily represent those of the CRI. Comments, enquiries or manuscripts to be considered for publication should be addressed to: Peter Vass, Director-CRI, School of Management, University of Bath, Bath, BA2 7AY. Peter Vass Director, CRI August 2001

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CONTENTS Preface

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1 The policy framework for ‘better regulation’ Phil Wynn Owen and Mark Courtney

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2 The role of regulatory accounts: the joint regulators’ consultation document Peter Vass

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3 Ofgem’s information and incentives project Cemil Altin

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4 Regulatory accounts in the gas and electricity industries Carl Hetherington

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5 Regulatory accounts: a multi-utility framework Stan Chaplin

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6 Integration of periodic reviews and regulatory accounting: lessons from the transport sector Ian Rowson

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7 Accountability with customer ownership: the Kelda proposals for restructuring Jean Spencer

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8 The accountability of regulators: international aspects Jim Marshall

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9 A risk framework for regulatory accountability Robert Baldwin

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Phil Wynn Owen, Director Mark Courtney, Deputy Director Regulatory Impact Unit, The Cabinet Office

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1 THE POLICY FRAMEWORK FOR ‘BETTER REGULATION’ Phil Wynn Owen and Mark Courtney

Working to change the regulatory approach in Whitehall and Brussels Introduction Phil Wynn Owen set out his view of the importance of better regulation and what its key elements were, and described the UK and European experience of regulatory reform. The coverage of this part of his talk was similar to the recent paper by Mark Courtney of the Regulatory Impact Unit, which is reprinted below from the CRI Regulatory Review 2000/2001, updated for recent developments. Phil Wynn Owen also described the terms of reference of the Better Regulation Task Force’s current review of the economic regulators and its progress to date. The development of this review has been tracked on the Regulatory Impact Unit’s website.∗ The report was published in July 2001, entitled Economic Regulators (BRTF, Cabinet Office, London). The executive summary of the report includes the following five recommendations:

∗ see www.cabinet-office.gov.uk/regulation/taskforce/programme0001.htm

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• Regulators’ objectives - to address the problems which can arise from statutory objectives that “can be contradictory and it is difficult for companies to judge how regulators will prioritise between them”,

Recommendation 1 Regulators’ annual business plans should include a clear explanation of how they will prioritise their different objectives. Regulators should also explain how the decisions they take relate to their objectives. • Costs and benefits - because “the costs of regulation are rising

despite the development of competition, and contrary to the original assumption that this would lead to a reduction in regulation”,

Recommendation 2 Economic regulators should be required to produce assessments of costs and benefits for proposals with a significant impact on business activity. • Individual or board? - “regulatory regimes should be

consistent and predictable” and “to suppport the trend away from individual regulators”,

Recommendation 3 The boards of regulatory bodies should include both executive and non-executive members. They should be appointed for their expertise rather than to represent stakeholder groups. • Consultation - in order that “the experience and expertise of

stakeholders should be used to shape proposals from an early stage”,

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Recommendation 4 Regulators should include in their work plans proposals to encourage an innovative approach to consultation, allow a real dialogue between different stakeholders and demonstrate how proposals have been amended following consultation. • Withdrawal from competitive markets - given “clear exit

strategies should be implemented and regulators should justify the need for any continued regulation where competition has developed”,

Recommendation 5 Regulators should set out a programme in their annual work plans to review market sectors for lifting price controls and the removal of outdated licence conditions. Companies should be able to challenge failure to complete these programmes.

The remainder of this chapter is the paper by Mark Courtney.∗

BETTER REGULATION: PRINCIPLES AND PRACTICE The need for better regulation There are two conflicting pressures which account for the increasing attention which is being paid to the quality of regulation - not only in Britain but in many countries. On the one hand, there is the frequent demand for increased regulation. There are two reasons for this:

∗ First published as Chapter 8 of the Regulatory Review 2000/2001 - Millennium edition, pp 149-162, CRI, University of Bath, 2001, but updated for recent developments.

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• With greater prosperity there is an understandable demand for more regulation to provide greater protection against involuntary risks. For example, levels of death on the roads or industrial injuries that were acceptable a generation ago would not be tolerated now, requiring more stringent regulation of vehicle safety and workplace practices.

• Scientific and technical advances have brought enormous

benefits but have also created new risks, and thus have created the need for new regulations. In addition, we now have increased knowledge about long-standing hazards, such as asbestos and global warming, and increased technical competence to do something about them.

Set against the demand for increased regulation is the growing recognition that, while each individual regulation may be justifiable, there is a danger that their cumulative effect may be to stifle freedom of initiative in both businesses and citizens. A similar effect was recognised earlier in the field of fiscal policy, where it came to be seen that, no matter what the desirability of public expenditure, there is a limit to the proportion of national income that can be taken in taxation or used in public expenditure before the incentives to the private creation of wealth are weakened excessively. Indeed, the tightening of fiscal discipline in recent years in almost all of the industrial countries has been one of the reasons for the increased pressure on regulation. Since governments are unable to increase public expenditure to achieve policy goals, there is greater pressure on them to turn to regulation of private activity to achieve the same effect. While the analogy between fiscal and regulatory burdens is not exact, and the methods that can be used in measuring or controlling them are quite different, there is general agreement that some of the rigour that is customarily applied in the fiscal area needs to be brought to bear on the continued growth in government regulation. The net effect of these two forces - greater demand for regulation and a recognition of the cumulative burden of regulation - has been to put a premium on


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better regulation. There are two aspects to this: first, to make sure that new regulations are cost-effective in the sense that they bring the greatest social benefits for the least costs imposed on business, consumers and the government. Secondly, to have a procedure whereby laws and regulations that have become obsolete, duplicative or unnecessary can be weeded out. Modernising government - the regulatory impact assessment In the United Kingdom, part of the response to the pressure for better regulation has been to set up more or less independent regulators for the public utilities and for financial services. The extremely important role that they play is not the theme of this chapter, but is covered, in large part, elsewhere in this edition of the Regulatory Review. For the main bulk of government regulation not covered by the independent regulators, the process of reform started in the 1980s with the requirement that regulations should be accompanied by an assessment of the compliance cost that they imposed on business, and was continued with the passage of the Deregulation and Contracting Out Act in 1994, which, by introducing a new kind of amendable secondary legislation, made it easier to repeal obsolete regulations, some of which might be contained in Acts of Parliament. The new Labour Government elected in May 1997 broadened this process and made better regulation an integral part of its Modernising Government programme, where it fits naturally into their overall theme of making government policy evidence-based and responsive to people’s needs. As from August 1998, new legislation or regulation which has a significant effect on business, charities or the voluntary sector has had to be accompanied by a regulatory impact assessment which should set out not only the expected costs to business,

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consumers and government but also the expected benefits. These should, as far as possible, be quantified and expressed in monetary terms. This assessment has to be available in the form of a partial (that is, a provisional or preliminary) regulatory impact assessment when collective Ministerial agreement is being sought to the principle of legislation or regulation in a particular area, and when public consultation is being carried out. Special attention should be paid to any burden placed on small businesses. As from October 2000, if the proposals affect small businesses, then the Small Business Service (which was set up in April 2000) must be consulted. It will help in organising consultation with small firms and representative associations and it has the right to have its views recorded in the regulatory impact assessment. Subsequently, a full regulatory impact assessment is developed to include the results of public consultation and is the basis on which Ministers decide on action. As from October 2000, the responsible Minister must sign a declaration that, having read the regulatory impact assessment, he is satisfied that the benefits justify the costs. The final regulatory impact assessment should then be placed in the libraries of the House of Commons and House of Lords when the regulation or legislation is presented to Parliament.1 Modernising regulation - principles and practice The previous section described the mechanics of producing a regulatory impact assessment, a process overseen at the centre by the Regulatory Impact Unit (RIU) within the Cabinet Office,

1 Cabinet Office, Good Policy Making: A Guide to Regulatory Impact Assessment, August 2000. The general principles of cost-benefit analysis to be used in a regulatory impact assessment are those in HM Treasury, Appraisal and Evaluation in Central Government, ‘The Green Book’, 1997, HMSO.


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working with departmental RIUs within each government department. But the process only produces better regulation when it is used at an early stage in the formulation of policy to identify all the options – including non-regulatory options – that might help achieve the policy objective under consideration, and then to choose the most cost-effective form of action. It also needs to work closely with other aspects of good policy-making, including, where appropriate, environmental assessments and the input from scientific advisory committees.2

In the nature of things, the successes in the early stages of this process are not often visible, since they consist of the weeding out of costly or cumbersome proposals that might initially have been a preferred course of action, and their replacement by cheaper, more effective or non-regulatory alternatives. But there are some clear examples of the sort of improvements that have been made later on in the process, when initial proposals that had already been published were subsequently modified: • National minimum wage: reporting requirements were

reduced – eg, there was no longer a requirement to put the national minimum wage on pay slips or to keep detailed records.

• Stakeholder pensions: an exemption was introduced whereby

employers with four or fewer employees would not be required to provide access to stakeholder pensions or deduct pension contributions.

• Working time: revised regulations removed many of the

administrative burdens for businesses, including reduced record keeping in respect of those who opt out of the protection of the regulations and those who essentially determine their own working hours, subject to a minimum.

2 Consultation on a Code of Practice for Scientific Advisory Committees, DTI, July 2000.

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• Food Standards Agency: an initial proposal to fund the Agency by a separate levy on all food shops was replaced by funding through taxation.

Good regulation requires not just effective regulation in particular areas, but an ability to take the overall effect of government regulation into account. One reason the Government is paying particular attention to getting early estimates of the impact of proposed legislative and regulatory measures is to enable a more balanced legislative programme to be constructed, taking forward those measures which contribute most effectively to the Government’s overall aims. In addition, the Panel for Regulatory Accountability was established in November 1999, to allow departmental Ministers to explain to it what initiatives they are taking to modernise regulation.3

Regulatory reform Besides an improvement in formulating new regulation, there needs to be a system for reviewing existing regulations to see whether they are still necessary or if they should be amended. Sometimes such a review can be anticipated at the time a regulation is introduced. For example, the government has given a commitment that the operation of the student loan recovery system will be reviewed after one year to establish whether routing repayments through the payroll system places too heavy a burden on small businesses.

3 Current membership is: Minister for the Cabinet Office (chair), Secretary of State for Trade and Industry, Chief Secretary to the Treasury, Parliamentary Secretary in the Cabinet Office, Chairman of the Better Regulation Task Force, Chief Executive of the Small Business Service. For a general guide to the operation of Cabinet Committees see: cabinet- office.gov.uk/cabsec/2000/guide/index.htm.


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But there is also a need to examine the body of existing regulation. This is one of the principal aims of the Better Regulation Task Force, whose independent, unpaid members come from large and small businesses, citizen and consumer groups, the trade unions and the voluntary sector, and which has been chaired, since it was established in September 1997, by Lord Haskins. This task force can examine any area of legislation and regulation as it affects particular sectors or particular aspects of doing business, publish reports and make recommendations. Recent reports have covered:4

• payroll review; • helping small firms cope with regulation – exemptions and

other approaches; • red tape affecting head teachers; • tackling the impact of increasing regulation – a case study of

hotels and restaurants; • alternatives to state regulation; • protecting vulnerable people. The government has committed itself to responding to the reports of the Better Regulation Task Force within sixty days, and has most often accepted their recommendations. Examples from earlier reports include: • Licensing Hours: The government’s White Paper included

three proposals which had been recommended by the Better Regulation Task Force: more flexible opening hours balanced against the needs of local residents; the development of a personal licence scheme; and the transfer of responsibility of liquor licensing to local authorities.

• Funding for the Voluntary Sector: The Better Regulation

Task Force persuaded the government to simplify the rules in order to avoid discrimination against small voluntary groups.

4 Better Regulation Task Force, Annual Report 1999-2000, Cabinet Office, October 2000.

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• Long Term Care: The Better Regulation Task Force helped to get agreement to a new approach based on national rules, ensuring that council homes are inspected to the same standard as private homes.

A second strand in the government’s programme of regulatory reform is the action taken to improve the order-making power under the Deregulation and Contracting Out Act 1994 to make it easier to remove regulatory burdens from businesses, the voluntary sector, charities, the wider public sector and citizens. The Regulatory Reform Act 2001 provides a much wider reforming power than in the 1994 Act, which has mostly been used for quite small changes.5 In particular, it allows the reform of an entire regulatory regime, involving the repeal and replacement of one or more Acts, together with their subordinate legislation. This will allow Ministers to propose reform, for example, in cases where a burden stems from overlapping, out-dated or over-complex legislation. Regulatory Reform Orders, in the process of re-balancing regulatory regimes, will be able to impose burdens as well as remove them, so as to ensure that regulatory burdens are distributed fairly. These wider powers are balanced by stricter safeguards, such that the desirability of making an order depends on the extent to which it reduces burdens. Any necessary protection must be maintained, and no order should prevent anyone from exercising an existing right or freedom which they might reasonably expect to continue to exercise. And any new burdens imposed must be proportionate and must strike a fair balance between the public interest and the interests of the persons affected. The mandatory requirements for thorough public consultation and rigorous Parliamentary scrutiny remain: draft orders must be considered twice by both the Deregulation Committee in the

5 Publication of the draft Regulatory Reform Bill, Cm 4713, April 2000. Further details on the Bill are at: http://www.cabinet-office.gov.uk/regulation/index/bill.htm.


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House of Commons and the Delegated Powers and Deregulation Committee in the House of Lords before the Committee reports are voted on by the relevant House (this is sometimes called the ‘super-affirmative’ procedure). In addition, Ministers bringing forward regulatory reform orders will be required to present more explanatory information to Parliament than they did with deregulation orders, explaining the burdens that are being removed or reduced; how the tests of the continued exercise of existing rights and the restrictions on any new burdens are being met; and the consultation carried out on the draft order. Examples of the sort of regulatory reform which could be undertaken under the order-making power are: • reform of fire safety legislation (currently enshrined in

approximately 120 Acts of Parliament and a similar number of statutory instruments);

• removal of the duplicative accounting for charitable funds by

NHS bodies, whereby they must currently submit accounts of charitable funds to the Charity Commission under charity law and also to the National Audit Office under health legislation;

• allow school governing bodies to provide after-school

childcare. European regulation By most measures, around half of new regulations taking effect in the UK have their origin in EU initiatives. A better regulatory climate must, therefore, involve improving these measures too. There are two stages to this: improving the transposition and implementation in the UK of European Directives and improving the quality of European Directives themselves.

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In transposing European Directives into UK law, a broadly similar process of impact assessment must be made as for regulations introduced on a domestic UK initiative.6 But there are, of course, additional considerations. In transposing European Directives into domestic legislation, one should neither introduce stricter provisions than necessary (over-implementation) nor leave out essential elements (under-implementation). In contrast to the perception of over-assiduous implementation, the UK is in the middle of the European pack in terms of the overall timeliness and completeness of its transposition of European legislation. But it is always necessary to strive for better quality implementation. Rules should be as clear as possible, even if the original Directive is not, but without introducing prescriptions that do not necessarily follow from the Directive (there can be occasions when there are benefits to exceeding some minimum standard in a European directive but, if so, that should be a conscious and not an inadvertent result). We should avoid simply adding EU-based regulations to existing regulations in a particular area – a process known as double-banking. Within the existing system, obtaining better European legislation in the first place is the outcome of making an early assessment of possible measures, lobbying the Commission, Council, European Parliament and other Member States, and negotiating to try to make sure that any piece of legislation represents a proportionate response to the policy need and that it contains sufficient flexibility to allow its implementation to make a positive contribution to welfare in each member country (especially, from our own point of view, in the UK). The European Commission has its own business impact assessment system, known as the fiche d’impact. This applies, however, only to proposals thought to have a significant effect on business and, it would be fair to say, is usually produced only towards the end of the policy-making process, and therefore has

6 Cabinet Office, The Guide to Better European Regulation, 1999.


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less impact on its formation. There is also a system for review of legislation at EU level known as Simpler Legislation for the Internal Market (SLIM). It has, for example, simplified the rules governing agreement to the Recognition of Diplomas in certain sectors, making it easier for these professional qualifications to be recognised across the EU. The European Council meeting in Lisbon in March 2000, realising the need to improve European competitiveness, gave a very significant push towards better European regulation when it asked:

“…the Commission, the Council and the Member States, each in accordance with their respective powers…to set out by 2001 a strategy for further co-ordinated action to simplify the regulatory environment, including the performance of public administration, at both national and Community level”.7

This aim was reaffirmed at the Stockholm Council in March 2001 where the elements of regulatory reform were further defined. The Commission is now committed to bringing forward a regulatory reform strategy for the Laeken Council in December 2001, which will include consultation on proposed regulation, assessment of the impact of regulations, as well as the introduction of schemes for codification and recasting of European legislation and legislation review systems. The public sector Apart from legislation which affects society at large, there is an enormous body of internal regulation and procedures which affects the ability of the public sector to deliver front line

7 Paragraph 17, Presidency Conclusions, Lisbon European Council, 23 and 24 March 2000, ue.eu.int/newsroom/main.cfm

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services. Originally designed to ensure accountability or specify standards of service to the public, it can, like other regulation, grow unchecked and, cumulatively, have a stifling effect on efficiency. Many departments have, as part of the Modernising Government programme, undertaken reviews to look for more efficient ways of serving the public. One focus of this work was the establishment, in November 1999, of the Public Sector Team within the Regulatory Impact Unit in the Cabinet Office. Its first report, the result of close collaboration with the Home Office and the police forces in England and Wales, resulted in agreed recommendations for the reduction of police paperwork which will result in time savings equivalent to the work of ninety policemen every year.8 The second report, with DfEE, resulted in 4.5 million hours saved across the school system. The third report dealt with paperwork burdens on General Practitioners: the overall estimated annual savings for GPs directly resulting from the outcomes achieved are around 7.2 million appointments plus 750,000 hours. In all its work, the team aims not just to produce reports but to facilitate outcomes and get agreement on action that will make a real difference on the ground. Enforcement Good regulation does not consist only in having well-drafted legislation in place, but also in having it respected and enforced in an effective but sympathetic and flexible way. This Government has adopted an approach based on co-operation between enforcers and those subject to enforcement, by developing an Enforcement Concordat with the close involvement of representatives of business, the voluntary sector,

8 Public Sector Team, Regulatory Impact Unit, Making a Difference, Reducing Police Paperwork, Cabinet Office, April 2000; Reducing School Paperwork, December 2000; and Reducing General Practitioner Paperwork, March 2001.


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the enforcement community and consumer groups.9 The Concordat is a non-statutory code that describes for businesses and others what they can expect from enforcement officers, with the emphasis on helping businesses to comply, on the basis that prevention is better than cure. Central and local government enforcement bodies commit themselves voluntarily to its principles and procedures. By June 2001 the Concordat had been adopted by over 90% of the local authorities in England and Wales (including all County Councils), by all the local authorities in Scotland and by the vast majority of central government agencies. The principles of the Enforcement Concordat can be summarised as follows: • standards: service standards that business can expect from

local authority enforcers will be published annually with performance against them;

• openness: information will be given in plain language and advice will be disseminated widely;

• helpfulness: staff will work on the basis that prevention is better than cure;

• complaints procedures: well publicised and timely; • proportionality: any action required will be proportionate to

the risks; • consistency: arrangements will be in place to ensure that

different enforcers treat businesses in the same way. The Concordat also sets out procedures, including: • a business will be told what is good advice and what is a legal

requirement; • as far as possible in the circumstances, there will be discussion

before formal action is taken;

9 Cabinet Office, Enforcement Concordat, March 1998. Also available at www.cabinet-office.gov.uk/regulation/1998/enforce.htm

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• if action does have to be taken for urgent reasons, this will be followed by a prompt written explanation of the reasons.

Enforcement authorities adopting the Concordat commit themselves to production of an implementation plan setting out any changes that are needed to their procedures or officer training to ensure compliance with the Concordat. Adopting authorities are also required to produce an annual report on their performance against the Concordat. The Regulatory Impact Unit in the Cabinet Office is co-ordinating the adoption of the Concordat, and intends to commission independent research into its effectiveness on the ground. Conclusion Better regulation is a continuing process. Initiatives taken over recent years should ensure that individual regulations and legislation are introduced and enforced with better knowledge of whom they will affect and in what way, and that they will have a better balance between costs and benefits as a result. In a society of increasing technical complexity, where fewer activities are undertaken by the public sector and more by the regulated private sector, it is unlikely that the cumulative volume of regulation will ever actually decrease. But timely reassessment of old regulations and rigorous scrutiny of new ones should minimise the burden of regulation and ensure that it contributes as effectively as possible to the goals that society sets itself.

Peter Vass, Director, CRI and Senior Lecturer, University of Bath School of Management

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2 THE ROLE OF REGULATORY ACCOUNTS: THE JOINT REGULATORS’ CONSULTATION DOCUMENT Peter Vass Introduction Regulation is for a purpose; not for its own sake. To achieve good regulation there must be a framework of objectives to inform regulatory action, and criteria which are demonstrably appropriate to judging the performance of regulation, including both the regulator and the regulated. The list of questions to be asked includes issues such as: • is the focus of regulation on outcomes, rather than just inputs? • are the incentive properties of the regulatory system good, or

mis-aligned, leading to perverse or unintended outcomes? • is the regulatory system consistent, for example, as between

its treatment of competition and public service obligations? • has the cost-benefit test been applied, both to the setting of

quality and service standards, and by the regulator in costing the effect of regulatory action on all parties?

• are the rewards of out-performance equitably divided between

stakeholders and, in particular, do the rewards reflect management effort?

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Harmonisation of regulatory accounts Regulatory accounts are important for the accountability of the regulator and the regulated, and help answer questions such as those listed above. This is because they are prepared regularly; reflect the ambit of regulatory action and, in the series of accounted profits and costs, reflect the outcomes of the incentive based, RPI-X price control system (to be compared with the forecast outcomes made at the time of the regulator’s periodic review of price controls). It was, therefore, a welcome policy development arising from the Labour Government’s ‘review of utility regulation’ which emphasised the fact that harmonisation and consistency of regulatory practice across sectors was to be an important further development in promoting public confidence and understanding of the generic regulatory system that applies to all of our (mostly privatised) utilities and network industries. One practical outcome was the Joint Regulators’ Working Group, set up to address in a more formal way common regulatory issues and procedures. Since 1999 it has reported annually, and therefore has particular potential as a catalyst for change, cross-sectoral harmonisation and debate. The question is whether it will be used positively to find further common ground - or whether it will more often than not be used to approve the perpetuation of different approaches, albeit to like issues. The form of regulatory accounts is an ideal topic to test the new, cross-sectoral approach - in part because the spotlight has often been on the high theory of the economics of regulation, and accounting for regulation has been seen as a detail to be left to the ‘bean-counters’; in part because, in practice, the substantive impact of regulation is to be found and discussed in terms of accounts, but the conventions of accounting and their apparent ‘flexibility’ makes for suspicion and uncertainty as to what is being measured and how it should be interpreted.

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Joint ownership? The regulators and the regulated have a joint interest in regulatory accounts, and this reflects the fact that each periodic review is underpinned (even if the general public is not made aware of it) by forecast regulatory accounts based on the regulator’s calculations and assumptions for setting the price controls. As these reflect the regulator’s decisions, then they are ‘owned’ by the regulator, and could be used to show, for example, that the price controls set are consistent with the company earning a normal rate of return (which will demonstrate the key role of the regulatory asset base in consistently allowing, through the rolling forward method, a return on investment until the return of investment). Other practical aspects of regulation, such as the treatment of any discount on assets purchased at privatisation (and the allocation of that discount between regulated and unregulated assets), clawback of disallowed revenues or carry-over of out-performance into the next period’s allowed revenue in order to enhance incentives, could equally well be reflected in the format and presentation of the forecast regulatory accounts (and different methods of presentation of carry-over could be developed, based either on enhancing asset value (‘goodwill’) or showing a higher than normal allowed rate of return). The regulated companies, however, prepare, and hence ‘own’, the outturn accounts. These outturn accounts will show the companies actual capital (CAPEX) and operational expenditure (OPEX). It is the comparison between the forecast and the outturn accounts which provides the insights into the performance of the regulatory system. Fair comparisons, however, require ‘like for like’ comparisons, and there needs to be flexibility to consider what regulatory adjustments might be necessary to ensure that. Whilst it would be helpful to achieve consensus that both are prepared on a consistent, like-for-like, methodology, there may be legitimate reasons for differences between the approach of the regulator and regulated in reporting


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results. So it is necessary to conclude that the regulator has to be responsible for the ‘integrity’ of a set of published, outturn accounts which can be fairly compared with the regulator’s forecast accounts (which might, for reasons of commercial confidentiality at the time of each periodic review, only be published - in full or in part - at the next periodic review as part of the retrospective comparison with the outturns in order to judge performance). This issue has surfaced quite interestingly with Ofgem’s proposal that each company should publish its own estimate of its regulatory book value.1 Prima facie, it would be expected that the regulator should be the guardian of a properly constructed, rolled forward regulatory asset base which took account of allowed acquisitions in the period and deducted allowed depreciation consistent with the methodology of the periodic review. This is illustrated in a number of responses to Ofgem’s consultation paper:

“we have some reservations about the value of the company’s view of its regulatory asset value (RAV), since in the past there has always been a difference in view between the regulator and regulated about the regulatory asset value”.

British Gas Trading

“Ofgem suggests that regulated businesses should include their own interpretation of their asset value in their regulatory accounts. This implies that Ofgem is unwilling to agree accounting principles for determining regulatory asset values”.

Transco In anticipation of possible similar proposals from the water regulator, a water industry commentator prepared a draft response as follows:

1 Ofgem (August 2000), Regulatory accounts - consultation paper.

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“any published regulatory capital value (RCV) should be one that is recognised and agreed (with Ofwat) - it would be misleading and unhelpful for companies to report their estimate of the RCV, taking account of, for example, discretionary expenditure if Ofwat subsequently take a different view of the allowability of investment, or indeed change the rules retrospectively”.

Timing: sectoral and joint consultations The regulators published their joint consultation paper in October 2000.2 The publication by Ofgem in August 2000 of its own regulatory accounts consultation paper has been noted above, and it might have been expected that Ofgem’s final proposals would await the final conclusions from the inter-regulatory working group, following their consultation, before issuing its own final proposals. However, Ofgem published its own final proposals in November 2000, reaching broadly the same conclusions as their August 2000 document (and the final proposals from the joint regulators had not been published by the time of the CRI conference in March 2001, of which this is the Proceedings - it was published in April 2001 under the same title as its consultation document but with the by-line, final proposals paper). Whilst there were important timing reasons for the development of the Ofgem proposals, including the requirement of the Utilities Act 2000 to separate distribution from supply licences in electricity, and the progress of Ofgem’s Information and Incentives Project [see in particular the chapters by Carl Hetherington and Cemil Altin which follow], it has to be said that the timing has been unfortunate in undermining, to some

2 Ofgem, Oftel, Ofwat, Ofreg, ORR, CAA, Postcomm (October 2000), The role of regulatory accounts in regulated industries, consultation paper, inter-regulatory working group, Ofgem.


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extent, belief in the integrity of the consultation process, for what should be seen as an important ‘top-level’ framework document aimed at harmonising practice. The cynic has been left with the view that the final inter-regulatory proposals, when published, will accommodate whatever sectoral practice is in place. This is regrettable, but was perhaps inevitable because Ofgem’s own consultation document showed clearly the tensions between the aim of reporting to reflect the objectives of regulation and reporting consistently with generally accepted accounting practice (GAAP). This could be termed a ‘developing debate’. Ofgem fully recognised a problem with the existing regulatory accounts, as shown from the following extracts (August 2000 consultation document):

“at present regulatory accounts do not include the information necessary to make proper comparisons between actual performance and the assumptions underlying network price controls”,

and

“these factors suggest that the primary purpose of regulatory accounts should be to support the regulation of monopoly businesses subject to on-going price control”,

but concluded that the regulatory accounts should be:

“prepared on the basis of historical cost accounting principles (HCA) but with disclosure of each company’s estimate of its regulatory asset value”,

even though they were to be:

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“presented in such a way so that they can be reconciled in a reasonably straightforward way with the assumptions underlying the price controls and the statutory accounts”.

One reason for the emphasis on historical cost accounts being comparative practice:

“however, at present it is not clear to what extent companies in general will move toward modified historical cost accounting (MHCA) principles and so the case for HCA principles remains compelling”,

and “the financial modelling, which is used during the price control review to inform judgements about the financial viability of network businesses, uses HCA principles, as this is broadly consistent with the approach adopted by the credit rating agencies”.

But does this miss the point? We should note too that it is generally accepted accounting practice that any form of modified historical cost accounts should include a reconciliation to historical cost profit in accordance with Financial Reporting Standard (FRS) 3, Reporting Financial Performance. An accounting digression The conflict reflected in the above Ofgem statements arises because price controls are not specified in terms of historical acquisition costs. The regulatory system is based on financial capital maintenance, whereby an indexed asset base is used to provide a real rate of return. This conflict over the price base can be summed up as follows:


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A key accounting principle

• Revenues are ‘matched’ with expenses for the year to determine profit or loss

• Properly defined to include the cost of • opex • capital consumption (depreciation) • capital finance (cost of capital)

then we have ‘economic’ profit (or loss) for the year.

• But Revenue = Price x output (P.Q) and Expenses = Cost x output (C.Q)

so not comparing ‘like with like’ if P and C are not on the same price base.

The importance of preparing regulatory accounts which are consistent with regulatory objectives and price control procedures was certainly recognised by respondents to the Ofgem consultation paper, some of which follow:

“we believe that current cost accounting (CCA) concepts are important to an understanding of the performance of the business with long lived assets such as ours, and should therefore be an integral part of the price review process”,

and went on to note comparatively:

“since Ofwat, Oftel and ORR require current cost regulatory accounts, the replacement of CCA by HCA by Ofgem would be a step away from consistency”.

United Utilities

“the primary purpose of the regulatory accounts is to enable stakeholders to compare actual performance to

PETER VASS

25

the assumptions underlying the price control. This requires that the regulatory accounts reflect the basis of price controls”,

so that Transco:

“firmly rejects Ofgem’s proposal that regulatory accounts should be prepared on a historical cost basis on a number of grounds, including that such accounts would not reflect the basis of the price controls and so would not be consistent with the primary purpose”.

Transco

The joint regulators’ proposals The joint regulators’ proposals reflect the same tensions. They state the usefulness of regulatory accounts as follows:

“some of the practical applications of regulatory accounts can include:

• monitoring performance against the assumptions

underlying the current price control; • informing future price control reviews; • assisting in the detection of certain anti-competitive

behaviour, such as unfair cross - subsidisation and undue discrimination;

• assisting comparative competition; • assisting in monitoring financial health;


26

• improving transparency in the regulatory process (regulatory accounts are the main source of regular, published and audited information about regulated companies)”,

but then give precedence to sectoral practice and explicit authority for reporting standards to each regulator. This is well reflected in the following extracts, which represent a pot pourri rather than harmonisation:

“the proposed common regulatory accounting framework will provide a structure for the preparation of regulatory accounts”,

but propose that:

“regulatory accounts will be prepared and audited using either the regulatory accounting guidelines (RAGs) for the industry or, where a RAG does not cover the issue, UK GAAP. Where there is any conflict between RAGs and UK GAAP, then the RAGs will take precedence”,

going on to reinforce the use of sectoral discretion based on existing differences as follows:

“nevertheless, the approach adopted by each regulator reflects the specific circumstances of the industry concerned”,

with the result that:

“given this diversity of valuation methods it is not possible to achieve consistency in the basis of preparation of regulatory accounts”.

PETER VASS

27

Diversity of accounting practice It is true that there is diversity of regulatory practice, which will be reflected in different series of accounting numbers, but each is consistent with the regulatory objectives in the sector for profiling revenue, and reflects an underlying financial capital maintenance system, that is, none of them are historical cost. The three main models are: • acquisition cost accounting, with acquisition costs updated by

the RPI; • replacement cost accounting, with uprating by the RPI: a

regulatory hybrid which allows for current depreciation charges to reflect replacement cost but with an abated regulatory book value to avoid windfall gains to shareholders where there was a substantial discount at privatisation (the Competition Commission, and it predecessor body, the Monopolies and Mergers Commission, dealt with the problem by applying a market to asset ratio (MAR) adjustment which in effect applied the acquisition cost model);

• renewals accounting, with future cash flows met by an annual

repairs and renewals provision, and with acquisition costs (Capex) at privatisation, or for improved levels of service, capitalised as non-depreciable assets on which a rate of return is earned.

The importance of current cost values is reinforced by the approach adopted by the Competition Commission with respect to Mid-Trent Water, which is referred to explicitly by United Utilities in their response because its report shows that, first:


28

“the Competition Commission therefore regards current cost depreciation as more significant than HC depreciation for water companies, and by extension to other network industries with long life assets, such as electricity distribution”,

second,

“the replacement cost of a network in a current cost balance sheet provides valuable information on the annual cost of maintaining that network”,

and, thirdly:

“for a regulator to include less than the forecast maintenance expenditure in price limits would be unfair to future generations since it would mean that today’s customers were paying insufficient to maintain the asset base and future customers would have to make up the deficit in higher bills”.

The audit statement The joint regulators’ proposals include the need for reconciliation to the underlying regulatory objectives:

“The published regulatory accounts should also include a comparison between the actual performance of the company and the assumptions underlying its price control”,

which is very welcome, but is undermined, not only by the sectoral discretion, but by the weakening of the audit opinion, as follows:

PETER VASS

29

“reflecting the fact that RAGs may take precedence over the UK GAAP in the preparation of regulatory accounts, then it may no longer be appropriate to use “true and fair view” in the audit opinion”,

therefore proposing “ presents fairly in accordance with”,

which fails to emphasise that there is a set of objectives for regulation, and fails to put an additional onus on regulators to issue accounting guidelines which properly reflect the underlying objectives, spirit and approach of regulation. Conclusions • disappointment [at this stage] that the opportunity has not

been taken by the joint regulators’ working group to put regulatory accounting and reporting centre stage - and to recognise the direct link between the periodic review methodology and the primary regulatory accounts - something which is essential to providing accountability and public understanding;

• it is not too late for the joint regulators’ final proposals to

reconsider, and to surprise us; • but then, even if it doesn’t, the regulatory accounts will

develop because they are important to the evolution of the RPI-X system. For example, if we are to extend the review period from five to perhaps ten years then that might have to be associated with some form of profit sharing and we would need to account for profit correctly;


30

• the practical reality of financial capital maintenance being the basis of the regulatory system (which takes account of changing prices) will remain the underlying driver for regulatory accountability and, hence, reporting, even if it is partially obscured by historical cost accounting.

Cemil Altin, Project Manager, IIP, Office of Gas and Electricity Markets (Ofgem)

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3 OFGEM’S INFORMATION AND INCENTIVES PROJECT Cemil Altin Introduction I intend to concentrate on the information side of the Information and Incentives Project (IIP), which has been the focus of our work so far. I will also talk a little about the next stage of the project which will be about translating the information that we collect into an incentive scheme to strengthen the incentives on companies to deliver the appropriate quality of supply. 1999 DPCR review The commitment to undertake the IIP was born out of the last distribution price control review (DPCR) of public electricity suppliers (PESs), undertaken in 1999. From that process it was recognised by all sides that there were problems in the way in which price controls were reviewed and implemented - problems that could be avoided. This work has built on the foundations of RPI-X price controls which have demonstrated strong incentives on companies to reduce costs.

Some problems with RPI-X Quality and accuracy of information - it was clear from the last price control review that the quality and accuracy of information that the companies were providing to the regulator was not of a satisfactory level. A significant amount of time during the price review was spent cleaning up cost data to make it more

OFGEM’S IIP

32

consistent - little work was done on the side of quality. It was recognised that this was an untenable position, therefore the current work of regulatory accounts (on costs) and IIP (on quality) has sought to improve the information that we collect from companies. Concerns about company behaviour - There are incentives on companies to game the regulator at the time of the price review, rather than continually focusing on beating objectively set targets. There is also a distortion with respect to the incentives on companies to reduce costs - associated both with the periodicity of the price control process and the way in which operating and capital expenditure are treated. At the last review not enough was known about the relationship between operating and capital expenditure to set a total cost price control…this may change in the future. The search for more competitive solutions - One way of overcoming some of the problems associated with the periodicity of price controls, and for improving incentives on companies, is to introduce an increased element of competitive solutions, or greater use of comparative assessment. What happened in 2000 The focus for the IIP has been on the fourteen electricity distribution businesses of the public electricity suppliers. However, some of the principles identified during the IIP could be applicable to other network regulated businesses. For example, the ongoing review of Transco’s price control has identified the need to have a greater focus on outputs and on improving the quality of information that the company provides to the regulator. Ofgem also intends to introduce stronger incentives on Transco to deliver quality of service to its customers - using guaranteed and overall standards of performance and a new incentive scheme. The incentive scheme

CEMIL ALTIN

33

is analogous to the IIP scheme but in eventuality it may differ in its framework for a variety of reasons, including a different industry structure. The work on the IIP so far has focused on improving the quality and accuracy of information about quality of service provided by companies to the regulator. We found that up to 30 per cent of the differences between companies on quality of supply performance could be due to different degrees of accuracy in the measurement systems used by companies and different definitions. It would not be possible to base the incentive scheme on this information. Therefore steps have been taken to improve the situation. We now require that the companies report to a specified level of accuracy for the number and duration of interruptions to supply (as set out in the licence condition) and using consistent definitions as set out in the Regulatory Instructions and Guidance (RIGs). The new requirement specifies that companies must report to a 95 per cent accuracy level, at high voltage (HV) level and 90 per cent at the low voltage (LV) level for the number and duration of interruptions to supply. We published our initial thoughts on how companies would be assessed against these accuracy requirements in the covering letter to the February version of the RIGs. Taking this forward is an important part of the work this year. The RIGs, which set out consistent definitions and related instructions and guidance for all IIP information, will also improve matters. If companies fail to meet the required levels of accuracy Ofgem will need to consider what action is necessary. This could include the imposition of financial penalties under the Utilities Act 2000. We have also specified the information that companies must report to Ofgem on the medium term performance of their networks - this is covered by IIP. This information will help improve the understanding of the impact of decisions on the medium term performance of the network - both involving

OFGEM’S IIP

34

expenditure by the companies and regulatory decisions. The information that must be provided covers two broad areas - a detailed analysis of fault trends and their causes and an explanation of the asset management strategy that companies are pursuing. Reporting and audit We published a ‘final’ version of the RIGs in February 2001. This was to provide the companies with a degree of comfort that Ofgem would not change the reporting requirements ahead of them accepting the IIP licence condition. Going forward there is an explicit change process for both the RIGs and the licence condition which sets out how, and in what circumstances, there can be changes. We anticipate that there will be a need for changes to the RIGs as our, and the industry’s, understanding of the IIP output measures improves. In this respect the change will not be bad thing, although it will be necessary to consider the timing for making changes so as not to burden overmuch the companies or Ofgem with the associated consultation process. Once the licence condition has been agreed it will be included in Section C of the new standard distribution licence.1

Ofgem intends to appoint an auditor to help develop the audit framework and undertake the audit. We intend to appoint one set of auditors as this will help to ensure consistency of approach and help identify any differences across companies. This will be different to the arrangements in the water industry where there are company appointed reporters who owe a duty of care to the regulator. However, the circumstances are also different. We are concerned about improving consistency as soon as possible and appointing a single auditor will give this process further impetus. There may be changes in the future. For example, the

1 Since the CRI conference in March all the companies have accepted the IIP licence condition and it is now in the standard distribution licence, which must be determined by the Secretary of State.

CEMIL ALTIN

35

water model may become appropriate or companies could have responsibility for auditing each other, given that they will all have an interest in each other’s data! As part of this year’s work we are also looking at how IIP reporting relates to other reporting requirements on the distribution businesses, which includes guaranteed and overall standards of performance; quality of supply reports, condition 6 reports on network performance and new requirements, such as the proposed long term development statement (as required by the Utilities Act 2000). It will be important to remove any unnecessary duplication and ensure consistency in definitions and approach where appropriate. We also need to think about how Ofgem reports on companies’ performance under the IIP and how this relates to other areas, such as reporting on regulatory accounts and guaranteed and overall standards of performance. In particular, we may need to think about whether there are advantages in having a more overall type of report which covers a number of areas, or whether this may actually reduce transparency. The incentive scheme - context One of the main aspects of the IIP this year will be on developing the incentive scheme which will apply to the fourteen distribution businesses from April 2002. We have explicitly stated that the IIP is not meant to re-open the existing price control and this commitment will guide us in how we develop the detail of the framework. It is also important to think about the other incentives applying to distribution businesses in developing the IIP arrangements. These include: the incentives delivered by the main price control; the Utilities Act 2000; environmental and social guidance;

OFGEM’S IIP

36

NETA; and embedded generation. It will be important to ensure that companies are not provided unclear or distorted incentives. IIP in 2001/2 - key principles There are two main principles or objectives for the incentive scheme - reinforcing existing quality of supply targets and injecting more comparative assessment. The IIP January document set out two broad models for the incentive scheme. The first of these is about strengthening the incentives on companies to deliver the price control commitments on quality which they agreed with the regulator (the absolute model). This relates to the relationship between a company and its own customers, and therefore any transactions regarding failure or success against these targets should take place between these two parties. For example, if a company fails to meet its target it could be required to reduce its prices to its customers. The second model was at the other extreme and was based on a company’s performance being assessed relative to that of its peers. This will help in overcoming problems associated with the periodicity of the price control and, more importantly, provide an ongoing incentive on companies to continually focus on the delivery of quality of service to its customers, ie, help to encourage ‘frontier’ behaviour. This relates to the relationship between companies, as it should be expected that those companies that are out-performers should earn a higher rate of return relative to under-performing companies. This suggests that it should be funded by some form of transaction between companies rather than between a company and its customers. However, work has only just begun in this area and the consultation process has just got underway. In any event, the two models outlined in the January document probably reflect the two extremes of possible outcomes.

CEMIL ALTIN

37

IIP in 2002 - application issues The work on IIP has suggested that changes need to be made to targets to make them more robust and to reflect changed circumstances. These changes fall into three main categories: changes for new definitions; changes for improved measurement systems; and changes to take account of inherent (topographic and demographic factors) and inherited factors which are outside the control of companies and impact on network performance. In deciding how much revenue to put at risk to the incentive scheme, and to each output measure, it will be important to consider a number of factors, including: the quality of information that is collected; the views of customers; and the need to avoid creating perverse incentives if companies expect a different amount of revenue to be subsequently put at risk to the IIP. We also need to think about how companies’ performance will be measured. For example, should there be an end target or a normalised starting point, and should performance be assessed on an annual or rolling basis. These are all important issues which will be occupying our minds over the coming months. IIP timetable The timetable in Table 1 is reasonably self-explanatory, and things are still on track to begin the incentive scheme in April 2002.2

2 Since the CRI conference in March 2001, Ofgem has published its update paper (May 2001) which sets out in more detail the work programme on the IIP over the next 18 months.

OFGEM’S IIP

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Table 1: IIP Timetable September 2000 Final information proposals January 2001 Consultation - RIGs,

Incentives, initial thoughts February - March 2001 Information licence modification April 2001 Update, including work programme June 2001 Initial proposals December 2001 Final proposals April 2002 Implementation 2003/2004 Next distribution price control review

(DPCR)

Carl Hetherington, Head of Regulatory Accounts, Ofgem39

4 REGULATORY ACCOUNTS IN THE GAS AND ELECTRICITY INDUSTRIES Carl Hetherington Overview Offer first published a consultation paper on regulatory accounting in the electricity industry in October 1998. Ofgem expanded the review to include the gas industry. A consultation paper was published in August 2000 and a final proposals paper was published in November 2000. It is intended that the changes to regulatory accounting in the gas and electricity industries will be effective from April 2001. The provision of high quality regulatory information is important in ensuring that the regulatory process is as efficient as possible. Regulatory accounts are the primary source of regular, audited financial information about the businesses regulated by Ofgem. Improving the quality and relevance of information that companies provide to Ofgem has been the main focus of this review of regulatory accounts. This is also the focus of other important areas of work, such as the Information and Incentives Project (IIP). An inter-regulatory regulatory accounts working group is also examining regulatory accounting issues for gas, electricity, telecommunications, water and sewerage, rail, airport and air traffic control services and postal services. It published a consultation paper on cross-industry issues in October 2000 and a final proposals paper will be published in April 2001 (now published). Ofgem’s proposals in the gas and electricity industry are consistent with the proposals of the working group.

OFGEM - REGULATORY ACCOUNTS

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The main regulatory accounting issues in the gas and electricity industries that have been identified by Ofgem are that regulatory accounts should be: • prepared only by those separate licensed businesses subject to

price control; • prepared on the basis of historical cost accounting principles

but with disclosure of each company’s estimate of its regulatory asset value and its return on that basis;

• presented in such a way that they can be reconciled in a

reasonably straightforward way with the assumptions underlying price controls and also with the statutory accounts;

• subject to a more rigorous audit process; • published annually on a timely basis and that they will include

more information and narrative. Main issues This section of the paper will provide a summary of the main issues involved in the review of regulatory accounts in the gas and electricity industries. Further information about these issues can be found in the publications identified below. Inter-regulatory working group An inter-regulatory regulatory accounts working group was set up to identify and develop areas of consistency within published regulatory accounts. The group meets on a regular basis to discuss regulatory accounting issues. The working group published a consultation paper in October 2000 and a final proposals paper will be published in April 2001 (now published).

CARL HETHERINGTON

41

Price control For Ofgem, the main purpose of regulatory accounts will be to inform future price control reviews and monitor actual performance against current price controls. As a result of the focus on price controlled businesses, Ofgem is removing the requirement for most of the supply or generation licensees that currently prepare regulatory accounts to prepare them in the future. At the same time, Ofgem is strengthening the requirements on price controlled companies. There will also be more disclosures about the regulatory asset value (RAV). In particular, the notes to the regulatory accounts will set out the regulated company’s estimate of its RAV, how the RAV was determined, the return on the RAV, where appropriate, the return on the price control basis, and other performance indicators. Regulatory accounting guidelines (RAGs) The working group identified a common regulatory framework under which regulatory accounts should be prepared. As part of this framework Ofgem will develop RAGs for the following businesses: • electricity distribution businesses; • NGC and the Scottish transmission businesses; • Transco. In most cases the RAGs will comply with UK GAAP. Where the RAGs do not cover an accounting issue then UK GAAP will be used. If the RAGs do not comply with UK GAAP, then the RAGs will take precedence. It is hoped that a paper on the RAGs for the electricity distribution businesses will be published in April 2001 and that the new arrangements will be effective


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from April 2001. Working papers on the RAGs for NGC and the Scottish transmission businesses and for Transco should be published in September 2001, proposals will be published in December 2001 and it is hoped that the new arrangements will be effective from April 2002. It is hoped that a working paper on the RAGs for Transco will be published in 2001 or 2002. Basis of preparation Ofgem’s November 2000 regulatory accounts proposals paper, and the working group’s April 2001 proposals paper on the role of regulatory accounts in regulated industries, both discuss the issue of the basis of preparation in some detail. The approach adopted by each regulator to the basis of preparation reflects the specific circumstances of the industry concerned. Given the different methods used by the regulators to value regulated assets it is not possible to achieve consistency in the basis of preparation of regulatory accounts. Each regulator will use the basis of preparation that is most appropriate for its industry. Nevertheless it is possible to identify some of the main considerations governing the choice of the basis of preparation by each regulator. These include: • transparency; • the method used to set price controls; • how the RAV is determined; • consistency within the industry concerned; • consistency with the statutory accounts of the companies

concerned; • views of consumers; • nature of the industry concerned; • the extent of competition within that industry. Other important points to consider when discussing the basis of preparation issue are:

CARL HETHERINGTON

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• There is no one correct valuation of a company; whether or not a valuation is appropriate depends on the specific circumstances of the company and the user of the regulatory accounts.

• An important aspect of the discussion on the basis of

preparation is that the transparency of the regulatory accounts should be improved by including in the regulatory accounts a note setting out a detailed disclosure of the basis of preparation of the regulatory accounts, the regulated company’s estimate of its RAV, how the RAV was determined and the return on the RAV. The vast majority of the respondents to Ofgem’s regulatory accounts consultation paper from the gas and electricity industries supported the use of HCA as the basis of preparation of the regulatory accounts, with disclosure of information about the RAV.

• Most companies in the gas and electricity industries that will

prepare regulatory accounts in the future, at present prepare their statutory accounts using HCA as the basis of preparation.

• Companies can always include additional financial

information, based on other bases of preparation, in their regulatory accounts.

Audit The main issues involve: • appointment of auditors: Ofgem has proposed a number of

reserve powers which will allow it to appoint another auditor if the audit of the regulatory accounts is unsatisfactory or there is a requirement for another auditor to be involved;

• duty of care: the auditor should owe Ofgem a duty of care for

the audit of the regulatory accounts;


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• materiality: Ofgem will have a reserve power to set the approach to materiality for the audit of the regulatory accounts if it is unhappy with the current arrangements;

• audit opinion: the audit opinion in the regulatory accounts will

be ‘presents fairly in accordance with’; • engagement letter: an engagement letter for the regulatory

accounts will be agreed between the regulated company, the regulator and the auditor.

Publication The regulatory accounts will either be published as a stand-alone document or in the company’s statutory accounts. The main issue is ensuring that regulatory accounting disclosures are transparent to the users of the regulatory accounts. It is also important to decide how much of the information provided to the regulator should be included in the published regulatory accounts. The main issue concerns what information a monopoly price controlled business should be allowed to regard as being commercially sensitive.

CARL HETHERINGTON

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Useful publications 1. Offer’s October 1998 regulatory accounts consultation paper. 2. Ofgem’s August 2000 regulatory accounts consultation paper. 3. Ofgem’s November 2000 regulatory accounts final proposals paper. 4. Ofgem’s April 2001 working paper on electricity distribution businesses regulatory accounting guidelines. 5. Inter-regulatory regulatory accounts working group’s October 2000 consultation paper on the role of regulatory accounts in regulated industries. 6. Inter-regulatory regulatory accounts working group’s April 2001 final proposals paper on the role of regulatory accounts in regulated industries.


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Stan Chaplin, Finance Director, North West Water

5 REGULATORY ACCOUNTS: A MULTI-UTILITY PERSPECTIVE Stan Chaplin Introduction Before looking at regulatory accounts from a multi-utility perspective, an introduction to the ‘new look’ United Utilities. The main subsidiaries of United Utilities are shown in Figure 1.

Service Delivery Customer Sales Contract Solutions Vertex Norweb Telecom

United Utilities Group PLC

The managementand operation ofWater,Wastewater andElectricityDistribution assetsin the North West

The managementof sales of waterand otherservices tocustomers

The managementand operation ofother people’sassets in the UKand internationally

The provision ofbusiness processoutsourcingservices,specialising incustomerrelationshipmanagement

The provision ofvoice and datatelecommunicationssolutions for smalland medium-sizedenterprises

New businesses

Figure 1: New business structure

• Service Delivery - a new business including the regulated

networks in the North West; a multi-utility operation. • Customer Sales - the equivalent of energy supply for water

and wastewater services. This business uses Vertex as its agent in managing the interface with customers.

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MULTI-UTILITY PERSPECTIVE

48

The restructuring is preparing us for changes in the market place - utility management and competition. All three new businesses identified in Figure 1 can respond to this and are dealt with in more detail below. Vertex is now much less dependent on internal customers, and is winning new external contracts regularly. Table 1 sets out our main purpose behind the restructuring.

Table 1: United Utilities

United Utilities is a multi-utility with a focused strategy to: - improve the efficiency of its regulated

businesses - maximise multi-utility synergies - develop its non-regulated businesses using

its core skills of asset management and customer relationship management

Service delivery Large efficiency savings are required following the regulatory reviews in water and electricity. There is considerable focus on this in the service delivery business, as shown in Table 2. Further multi-utility synergies are being achieved. Note the large investment programme; £3.1 billion of which is on water over the five years to 2004/5. £1 out of every £4 of UK environmental capex is spent in the North West.

STAN CHAPLIN

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Table 2: Service delivery

The service delivery business: - brings together the management and operation

of licensed water and electricity distribution assets to secure more multi-utility synergies

- delivers the programme of £400 million cost reductions required from the regulators’ price reviews of the businesses

- delivers a regulated capital programme of £3.6 billion over the five years

- holds the stewardship of regulated asset bases Customer sales Setting up trading arrangements between service delivery and customer sales (see Table 3) gives us two market leading opportunities: • learning about the complexities of competition; • influencing the regulatory position, and the development of

competition in water. This includes developing pricing arrangements between service delivery and customer sales which reflect the regulators’ aspirations of a low risk networks business.

Table 3: Customer sales The customer sales business: - was created from United Utilities water business - exploits different skills to asset management - actively participates in the emerging and

competitive water market - is a new business, selling water and wastewater

services within and outside the North West and enhancing the value of our relationship with our existing and new customers

- sells new products and services


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Contract solutions Contract solutions as set out in Table 4 will be our vehicle for entering the utility market place, other than on North West regulated assets. The recent acquisition of Hyder industrial is worth noting. Also the contract won to operate assets and facilities for Welsh Water.

Table 4: Contract solutions

The contract solutions business: - builds on our core asset management skills - manages third party assets throughout the UK

and selected areas overseas - responds to increased outsourcing by utilities

and others in the UK - includes renewable generation, metering and

connections businesses Regulatory accounts I start with a reflection from Edmund Burke.

“The objects of a financier are, then, to secure an ample revenue; to impose it with judgement and equality; to employ it economically; and when necessity obliges him to make use of credit, to secure its foundations in that instance, and for ever, by the clearness and candor of his proceedings, the exactness of his calculations, and the solidity of his funds”.

Edmund Burke An apt quotation for the session on accountability and regulation!

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Objectives The objectives (in Table 5) were set out by Keith Mason (Ofwat) in a paper to the Centre for the study Regulated Industries (CRI) two years ago. These are still relevant issues and I will cover each of these in the presentation, and show how well these are covered by the present arrangements.

Table 5: Tests for regulatory accounts

- consistency? - comparability? - monitoring and informing price reviews? - transparency?

Context First of all it is important for us to put the process of regulatory accounts in context, as set out in Table 6.

Table 6: Context of regulatory accounts

- different information for various stakeholders - current cost accounts

• cost of maintaining the asset base • sustainability of dividends • costs faced by new entrants

- historical cost accounts • relevance to debt markets and equity

investors • key indicators such as interest cover and

gearing - what about regulatory asset value? - all the above are relevant and can co-exist


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There are different informational requirements by different groups of stakeholders as referred to below: • CCA - important in setting price limits for long-lived asset

bases and therefore should be retained as the key basis - this is also an indication of the costs faced by new entrants which is important for the competitive market.

• HCA - important for issues relating to access to funding, a

primary check on price setting assumptions and assisting in monitoring financial health.

• RAV - this is important as it represents the value of a

regulated company’s net assets for price control purposes. In the water industry this is more commonly known as regulatory capital value (RCV).

Because of the divergent needs of stakeholder groups it is legitimate for all three bases to be disclosed. Consistency For regulatory consistency Ofgem should be in line with Ofwat, ORR and Oftel, so that pipes, sewers, rails and poles/wires are reported on a current cost basis, representing the value of the consumption of assets on long-lived networks. RAV provided as a supplementary note would improve transparency and awareness. It is not a replacement for MEA/CCD. For those not involved in utility regulation, RAV is another key building block in deriving the amount to be funded by customers. It represents the allowed asset base which earns the regulators’ allowed return; this drives a flow enabling returns to equity and debt holders to be funded. I have summarised these issues in Table 7.

STAN CHAPLIN

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Table 7: Consistency

- with the economic framework • MEA and CCD are fundamental in

assessing true economic cost and consumption of assets

• supplementary note on how RAV would link to price setting

• concern with Ofgem’s proposal to replace CCA with HCA, conflicting with Ofwat, ORR and Oftel

- measuring asset values and trends - accounting standards

• after FRS 12 and 15 now inconsistent with GAAP

- demonstrating no cross-subsidy. • consistency between regulators is required • avoidance of cost exhaustion

- single auditor for efficiency and effectiveness

I believe that having a joint regulatory approach to signing off cost bases and allocation is important for multi-utilities. - audit I don’t agree with Ofgem’s earlier proposal to have different sets of auditors for regulatory and statutory accounts, which would increase costs to customers. Why should the regulator require reserve powers to appoint a separate set of auditors? Ofwat define the coverage expected from auditors and are particularly prescriptive in regulatory accounts guideline (RAG) 5 which defines transfer pricing arrangements and how they should be audited.


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Our regulatory and statutory auditor is clear that on these issues he has a duty of care to the regulator. Having one auditor for regulatory, statutory and transfer pricing purposes ensures there is a joined-up and consistent approach and ensures the lowest cost to customers. Activity based costing Figure 2 is a stylised example of the application of ABC, and is particularly relevant to multi-utility operation where synergies are being achieved. Also the growth of outsourcing in the sector makes this issue more prominent generally. As a generalisation, direct costs should represent at least 80% of the costs being charged to businesses, and preferably up to 90%.

Business A

Joint andCommon Costs

Activity 1 Activity 2 Activity 3

Direct Costs

Business B

Figure 2: Activity Based Costing

In addition to direct costs, multi-utilities have joint and common costs appropriate to regulated businesses and therefore to be funded by customers. It is important to avoid cost exhaustion where legitimate costs fall down between the regulatory cracks. This could arise if regulators are not joined-up in how costs are signed off. It is therefore important for regulators to have a joint

STAN CHAPLIN

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approach to allocation and sign-off, which encourages the sharing of resources and facilities and the delivery of multi-utility synergy benefits. Comparability Water data comparability is relatively good and RAV % returns would be more meaningful than MEA, and would produce a narrower range of outcomes. Ofwat took the lead on regulatory accounting guidelines but there have been few developments over the last few years, apart from RAG5, which deals with transfer pricing. Ofgem seem prepared to let Ofwat take the lead, particularly on transfer pricing; nevertheless this is not an issue if there is a consistent application. Nevertheless, Table 8 sets out my main conclusions on this issue.

Table 8: Comparability

- consistent data for comparative competition particularly on opex and capex

- reporting of returns on RAV more meaningful than on MEA

- greater consistency required in RAGs and UK GAAP standards across utilities

Monitoring and informing price reviews The regulatory contract is less well-defined in electricity compared to water. It needs better definition before monitoring becomes meaningful. It is important to legitimise the existence of a regulatory contract in both electricity and water. Regulatory accounts are not the only part of the monitoring process and there are other submissions, for example, the quality of supply report (distribution) and the June return (water).


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The focus of comparison and monitoring should be on outputs; Ofwat’s desire for detailed financial variances should be reconsidered and Ofgem should be persuaded not to go down the same path. For example, Ofwat’s detailed activity analysis could be simplified and targeted to key decision points, eg, company efficiency targets and overall high level performance. The regulator had his own regulatory accounts at the 1999 price review; this reduces the value of a process set up to achieve transparency. Once again, I have summarised my main conclusions in Table 9.

Table 9: Monitoring and informing price reviews

- comparison with regulatory contract

• supplementary statement possible at high level, eg, returns and performance

• important to have a clear contract in the first place

• regulatory accounts should be part of an overall consistent reporting package

- focus on outputs rather than line-by-line accounting. Ofwat’s proposal is to include detailed variances

- activity analysis helpful at a simplistic level - regulator’s own set of regulatory accounts for

price reviews reduces value of process Transparency Some regulators are now promising to share details of their financial models used in price setting as a response to requests from companies for more transparency. This is important as greater transparency on the different ways in which regulators set the allowed return and how published numbers relate to those used in modelling would be helpful. My key conclusions are in Table 10.

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Table 10: Conclusions

- give more formal and explicit recognition of RAV through annual sign off in supplementary statement • links actual investment to future

remuneration of asset base - streamline June return and regulatory

accounts information to avoid duplication and inconsistency

Conclusions • CCA accounts should be continued in water and extended to

electricity. • Supplementary information on RAV is an important part of

the regulatory price setting building blocks which would benefit from annual disclosure and sign-off by regulators within a short timescale.

• Regulatory consistency is of concern, particularly in multi-

utilities, and is required to avoid the risk of cost-exhaustion. • Focusing ‘contract’ monitoring and reporting on outputs rather

than detailed variance reporting would be beneficial. and I close with a reflection for today.

“It sounds extraordinary but it’s a fact that balance sheets can make fascinating reading”.

Mary Archer No doubt this is a true and fair view!


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Ian Rowson, IMR solutions 59

6 INTEGRATION OF PERIODIC REVIEWS AND REGULATORY ACCOUNTING: LESSONS FROM THE TRANSPORT SECTOR Ian Rowson Introduction This chapter draws from experience in recent periodic reviews in the transport sector to identify more general lessons for the regulation of utility network businesses. It relates to the role of regulatory accounts and the need for reform along the lines recently proposed by the Rail Regulator. Recent transport reviews include the Rail Regulator’s periodic review of Railtrack, concluded in October 2000, which needed to put in place the economic conditions for the company to finance a substantial enhancement programme. A little earlier in the year, the Civil Aviation Authority (CAA) concluded its advice to the Secretary of State on the initial price control for National Air Traffic Services (NATS), the air traffic control service, to follow its partial privatisation as a Public Private Partnership this spring. The background to this review included considerable uncertainty in the scale of the capital programme over the five years of the control period. In both cases, the issues had a material bearing on the profile of revenues over the respective control periods and, thus, on the profile of reported financial performance.

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The CAA is currently carrying out a fundamental review of the regulation of airports. It is too early to comment on the accounting implications of this review, but features of the last reviews of the four regulated airports - Heathrow, Gatwick, Stansted and Manchester - had other issues for regulatory accounts. Objectives of regulatory accounts The joint regulatory consultation paper published by Ofgem in October 2000 stated that the main purpose of regulatory accounts should be to provide financial information about regulated businesses for use by the regulator, industry, investors, consumers and other stakeholders. The paper expanded on this fairly uncontroversial statement by identifying some of the main applications: • monitoring performance (against the assumptions underlying

current price controls); • monitoring financial health; • transparency in the regulatory process; • informing future price control reviews; • detection of anti-competitive behaviour; • comparative competition. The Accounting Standards Board’s (ASB) Statement of Principles for Financial Reporting puts it more succinctly as follows:

“The objective of financial statements is to provide information about the reporting entity’s financial performance and financial position that is useful to a wide range of users for assessing the stewardship of the entity’s management and for making economic decisions”.

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These two objectives, assessing stewardship and making economic decisions, are also highly relevant for regulators. The objective of economic regulation is, broadly, to create the conditions for efficient management of the regulated business. The objective may be expressed in terms of the interests of customers, taxpayers (as the funders of subsidies) or even the economy, but the core of the objective remains the same. Two aspects of management are at issue: operational management (the management of service delivery, including the enhancement, renewal and maintenance of the corresponding assets) and financial management (raising finance and remunerating the providers of finance). The statutory duties of regulators often refer more or less explicitly to these aspects of management, though duties usually refer to the ability to raise finance rather than the wider (but still relevant) issue of financial management. To these ends, the regulator puts incentives in place to help align the interests of the firm with the regulatory objectives. Thus regulators operate variations on the RPI-X regime to ensure that a shareholder value maximising management will work to manage the business efficiently, ultimately for the benefit of customers as well. I deliberately use the phrase ‘shareholder value maximising’ instead of the familiar term ‘profit maximising’. This paper is about accounting, and accounting profits are not the same as shareholder value added. Indeed, for a regulated firm, the relationship between the two is complicated by the periodicity of regulatory decisions and discrepancies between UK GAAP accounting and the economic basis of setting price controls. Such complications, arising from legitimate regulatory decisions that have been made across the sectors in recent years, have had a material effect on the reporting of companies’ financial performance and will continue to affect UK GAAP accounts in the future.


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This means that UK GAAP accounts could (and do) have serious deficiencies in reporting the stewardship of managers or the financial position of the regulated business. This in turn can frustrate the regulatory objective. These issues are not uniquely, but perhaps most starkly, the case in transport. Transport sector experience The most celebrated example of a discrepancy between UK GAAP accounting and regulatory decisions is the remuneration of Railtrack’s capital renewals on a pay-as-you-go basis. This contrasts with the normal UK GAAP depreciation of capital costs over the service life of the relevant assets.1

All three industries (rail, airports and air traffic control) have examples of regulatory profiling of revenues across control periods. In airports, a leading issue of the last London airports review in 1996 was the question of pre-funding for terminal 5. In the event, the building of terminal 5 has been delayed by the public enquiry, but in 1996 the CAA adopted the Monopolies and Mergers Commission (MMC) recommendation that possible price reductions should be significantly moderated to provide some up-front funding for terminal 5. In air traffic control, the CAA consultation on the price control for NATS highlighted a key issue of allowing revenue to help fund an uncertain capital programme. In rail, the Rail Regulator explicitly specified a value of required revenue that would be remunerated after the end of the control period (subject to review later this year).

1 Although FRS 15, the relevant accounting standard, permits a renewals accounting method of estimating depreciation, FRS 15 limits this option to specific circumstances where it is not practicable to calculate depreciation normally. Thus FRS 15 is presumably meant to be a proxy for normal depreciation rather than a fundamentally different accounting basis.

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The rail industry also offers an example of an incentive mechanism resulting in the possible build up of ‘regulatory value’ to be drawn down in the following control period: the volume incentive. This incentive would be objectively determined and would reflect the company’s regulatory performance during the period but the account of regulatory value would not normally meet the asset recognition criteria of UK GAAP. Other more generic examples include: • the profiling of revenue within the control period to meet a

variety of regulatory objectives, notably to facilitate the financing of major capital programmes;

• the assessment of regulatory depreciation on a basis that

differs from the UK GAAP depreciation charge; • the indexation of the capital employed valuation (the

regulatory asset base). Other differences we might anticipate in future arise from new accounting standards, such as the pensions cost standard FRS 17 which provides a basis for pensions cost accounting that does not sit well with the way pensions costs have been remunerated since most regulated industries were privatised. Taken together, it is easy to see that there are not just material differences between UK GAAP and regulatory interpretations of financial performance but that these differences can also be fundamental.


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It means that UK GAAP accounts may present at least an incomplete view of the financial performance and the financial position of a regulated business. Arguably, UK GAAP accounts fail to meet the principal qualitative characteristics of good financial reporting in these special circumstances and fail to meet the needs of their principal audience, investors.

Impact on operational management Does this matter to regulators? Fundamentally it does. The regulator, in maintaining incentives for the ‘firm’, aligns the interest of the firm with the regulatory objectives and then relies on the corporate governance framework to encourage managers to exhibit value maximising behaviour. Importantly, it is managers that need incentivising, and shareholder incentives are simply the means to that end. I have no doubt that the framework of corporate governance is potentially the most powerful means to that end, but its power does critically depend on there being effective accountability of managers. For most companies, an important forum for accountability is the annual accounts prepared under generally accepted principles (UK GAAP). Indeed the first use of accounts referred to in the ASB quote above is for assessing the stewardship of the entity’s management. For regulated companies, however, these material and sometimes fundamental differences between the basis of determining allowed revenues and UK GAAP measures of cost mean that the pattern of reported company profits under UK GAAP only partly reflects the generation of shareholder value. Instead, regulatory decisions about price profiles can significantly tilt the pattern of UK GAAP profits, creating an overwhelming level of noise in the reporting of financial performance.

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From a regulator’s point of view, this situation creates a real risk that carefully crafted incentives will be diluted - managements’ success or otherwise will be obscured by the ‘regulatory noise’ in the profits figures, undermining the effectiveness of the corporate governance framework on which the regulator is depending. It will be difficult or impossible for investors to differentiate good from poor stewardship, a situation which could create the conditions for inefficiency to be tolerated and the efforts of good managers to be sapped. At an organisational level, it could encourage companies to focus less on improving performance and more on the selective use of regulatory explanations to justify reported profits. For these reasons, the joint proposals of the utility and transport regulators (due to be finalised shortly after writing) encourage more transparent comparison of financial performance against the assumptions underlying the price control in regulatory accounts. This is a huge step forward for incentive regulation. But it is only part of the picture.

Impact on financial management The incentive framework for financial management of regulated businesses has not been subject to as much analysis as that for operational management. Yet it is of critical importance for sectors engaged in substantial investment programmes. The regulator has an interest in ensuring that the company manages its financial affairs over the investment cycle so that it is able to raise finance at appropriate stages. The regulator has an important role in creating the right economic environment but, subject only to that, financial management should surely be the responsibility of the company, not the regulator. Across the sectors, I sense that too little thought has been put into this aspect of incentive regulation.


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The accounting difficulties discussed above, of course, do not help. Although analysts now increasingly value price regulated companies by reference to their regulatory asset base valuations, it is argued that the financial position of a company from a credit rating perspective can only be assessed using UK GAAP accounts. Recent periodic review reports have set out the criteria for ‘financeability’ using financial indicators on a UK GAAP basis. It is acknowledged that credit rating agencies increasingly look to cash based indicators and take account of the underlying business risks, but the key accounting measure of EBIT interest cover remains remarkably influential in both regulatory decisions and company analysis. This is not surprising, since no one has offered a compelling alternative view of a company’s financial position. Conventional regulatory accounts have been prepared on a current cost basis, but they are practically meaningless, providing no insights into regulatory valuations or regulatory performance, and have succeeded in discrediting the whole idea of regulatory accounting. A better alternative is only now beginning to emerge. Investors, in particular lenders, do need better measures of a regulated company’s financial position. It is rather worrying that accounts presenting a systematically distorted view of a regulated company’s earnings before interest and tax can be presented as the gold standard for the assessment of credit ratings. Maybe credit rating agencies are not so short sighted, and they take into account the specifics of a regulatory determination before reaching a conclusion, but in practice it has been extremely difficult even for a regulatory expert to disentangle short- and medium-term regulatory influences from a company’s results. There is often insufficient information published about the regulator’s assumptions to make the necessary adjustments - indeed, the Competition Commission noted in its August 2000 reports on Mid Kent Water and Sutton and East Surrey Water that even the companies had not been given key information

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about their allowed depreciation until its inquiry was under way. The joint proposal by the utility and transport regulators to include financial performance comparisons against the assumptions underlying the price control in regulatory accounts should at least provide some necessary data; but, the presentation of information on a regulatory basis in supplementary tables will not have the authority of accounts that present fairly the financial performance and financial position of the company. Ofgem’s proposals for regulatory accounts, for example, requires them to be prepared under UK GAAP with only supplementary information on a regulatory basis. The audit opinion will by implication relate to the view of financial performance and position under UK GAAP. Investors deserve to be given relevant and reliable information, for example, information that gives a meaningful indication of a company’s ability to support interest costs over the term of a bond. There are always questions about the longer term future, but the regulator can hope to address some of these in developing a sustainable framework of regulation. For a company specific view, investors will look to the accounts. The last thing they need is information that is systematically distorted by regulatory decisions, especially when those distortions are technical distortions that can be adjusted for in regulatory accounts. The regulator has a regulatory interest in specifying such a basis of accounting, as the Rail Regulator has now done. The existence of systematic differences between the accounts and the basis of setting a price control distorts the financial management environment. These differences often have a periodicity to them. It creates opportunities for companies to over-borrow when financial indicators are improved by the differences and look to the regulator to fund them when the accounting catches up. Railtrack’s recent calls for the advancement of £1.5 billion have other causes, but financing issues for some companies addressed in the water review might in part have been a function of past


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borrowing on the strength of unsustainable UK GAAP financial indicators. By overlooking the importance of ‘proper’ transparent regulatory accounting, a regulator may be failing to engineer a balanced incentive environment for the companies’ financial management. If the regulator can bring greater transparency to the presentation of a company’s financial position in regulatory terms, investors will be better placed to see early warning signs which will encourage company managers to manage their finances over the investment cycle rather than the periodic review cycle. I have illustrated the problem of how regulatory objectives are undermined as Figure 1.

Figure 1: Undermining the regulatory objectives

finance-ability

finance-ability

finance-ability

finance-ability

economicincentiveseconomicincentiveseconomicincentiveseconomicincentives periodic

review

operationalmanagementoperational

managementoperational

managementoperational

management

management’sresponsibility




financialmanagement

financialmanagement

financialmanagement

financialmanagement

regulatory brinkmanshipregulatory brinkmanship

accountability weakenedaccountability weakened

regulatory ‘noise’regulatory ‘noise’

‘non-economicreality’

accounts

‘non-economicreality’

accounts

objectives underminedobjectives undermined

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The way forward - the ASB and the Rail Regulator The Accounting Standards Board published its Statement of Principles for Financial Reporting in December 1999. The principles form an important foundation for a regulatory accounting framework and, indeed, were referred to in the inter-regulatory consultation paper on regulatory accounts. We are now in an era of greater regulatory transparency. Regulators now disclose rather more information about their regulatory decisions that they did just five years ago. The commitment to require comparisons of outturn against the assumptions underlying the price control implies comprehensive disclosure of those assumptions - already regulatory best practice. The regulators surely should now have the courage to provide a regulatory accounting framework based on this information that presents unambiguously the financial performance and position of their companies in regulatory terms. There is no need to beat around the bush and confuse the issue by presenting competing views in the same set of financial statements. Nothing is lost by specifying a regulatory basis properly - investors will still have statutory accounts on a UK GAAP basis. But much will be gained in terms of regulatory transparency and underpinning of the regulatory objective. The periodic review calculations define measures of regulatory value. The regulatory asset base is the principal one, but there will be other aspects of value implicit in the decisions - accrued timing differences of various sorts. The regulator will also have defined appropriate accounting policies for the presentation of performance against the underlying assumptions, including the (usually) pre-tax, pre-interest return. In other words, the work on accounting definitions will be done anyway.


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As regulators in the UK generally operate a financial capital maintenance framework in present value terms (subject to the important effect of incentives), with a market derived valuation of the regulatory asset, regulatory accounts presented on a regulatory basis would provide a meaningful indication of investor value and how value is being created. It is akin to the ASB’s definition of a value-in-use accounting basis. Because the regulatory measures of value are rooted in market realities, they surely represent at least a legitimate basis for financial reporting and surely a better basis for presenting regulatory accounts, especially as they carry the implied stamp of regulatory authority. Such accounts would improve the ‘qualitative characteristics’ (as defined by the ASB) of financial reporting in a number of important respects that are relevant to the regulator and investors looking to interpret the regulated economic environment. Pointing the way, on 8 March 2001 (unfortunately the day after the CRI conference) the Office of the Rail Regulator published a notice of proposed modifications to Railtrack's network licence covering regulatory accounts. The key phases in the proposed modifications provide for regulatory financial statements which:

• “shall be prepared such that, insofar as reasonably practicable, the definition of items in primary statements; the valuation of assets and liabilities; the treatment of income and expenditure as capital or revenue; adjustments in respect of the provision, utilisation, depreciation and amortisation of assets and liabilities; and any other relevant accounting policies shall be consistent with the Regulator’s valuation of the Regulatory Asset Base for the purpose of determining access charges; and the Determination Assumptions for the corresponding period”;

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• “shall include, as a primary statement, a statement of regulatory financial performance comparing income, expenditure, profits and losses for the period with the Determination Assumptions”;

• shall include “a report by the Auditors addressed to

the Regulator . . . stating whether, in their opinion, the regulatory financial statements present fairly the financial performance and financial position of the licence holder in accordance with this Condition and any Regulatory Accounting Guidelines.”

I couldn’t have put it better myself.


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Jean Spencer, Head of Regulation, Yorkshire Water 73

7 ACCOUNTABILITY WITH CUSTOMER OWNERSHIP: THE KELDA PROPOSALS FOR RESTRUCTURING Jean Spencer Kelda’s proposals for a new ‘mutual’ structure were withdrawn at the end of July 2000 because of Ian Byatt’s response at the time. Since then, there has been much discussion about alternative ownership structures for the water sector and Philip Fletcher, Director General of Water Services, has recently given the go-ahead to the acquisition of Dwr Cymru by a not-for-profit company, Glas Cymru. My chapter focuses on Kelda’s proposals, but in looking at accountability the principles also apply to Glas Cymru’s structure. Before getting into the detail of Kelda’s proposals for restructuring and the implications of a not-for-profit structure on accountability, let us go back to June 2000 when Kelda announced the results of its strategic review. Kelda announced that it was going to: • focus on water and waste business; • sell non- core businesses (now largely complete); • restructure Yorkshire Water and refinance as a mutual, which

is covered in more detail below.

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Why did Kelda see the need to restructure? There was no financial crisis in Kelda or Yorkshire Water. In accepting the final determination of prices - although extremely challenging - we believed that we could finance the investment programme of around £1.5bn over the next five years. Compared to many other companies, Yorkshire Water starts the period with a strong balance sheet. However, at the time there had been a huge decline in the share price - over 50% from the previous year, down to something around £2.20. Kelda was vulnerable to take over and, also, very importantly, the lack of confidence of the equity market was seen to be impacting on the capital market - the uncertainty about underlying value was not good for fund raising. The final determination left the industry with some key issues to be addressed: • the long run challenge of financing large investment

programmes - across the industry capital investment over the next five years is over £15bn. We can expect this level of investment to continue in the future as new quality obligations emerge and there is the continuing need for capital maintenance investment.

• the shareholder is not a practical source of finance (except to

the extent of retained profits) - there is an unwillingness to input additional equity funding;

• financial markets willingness to fund water utilities was not

(and is not) stable - as seen by widening spreads that did not reflect the credit ratings of companies;

• scope for future operating cost reductions is likely to be low -

we need to look for other ways of delivering further efficiencies to customers.

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This led Kelda to develop its mutual proposals. It was believed that the mutual structure presented a way forward which: • better aligned the interests of management with the

community - removing the conflict between customers’ and shareholders’ interests;

• provided the opportunity for obtaining the lowest cost of

borrowing for large investment programmes - and therefore the lowest bills for customers;

• also provided the best scope for future improvement -

maximising the scope for investment and also lower costs through competitive tendering processes;

• and, not to be disingenuous, of course, the proposals also

allowed private shareholders to exit at a fair price for the assets.

So, in summary, there were seen to be benefits for all stakeholders: • Shareholders - they would have received a return of capital

invested in the business. A final price for the acquisition by the Yorkshire Water Mutual was not concluded - but shareholders might have expected to receive of the order of £2.75 per share - compared with a share price that had recovered to around £3.40 at the time. It has to be remembered that the entire premium on the value of the business had been stripped out by the final determination. Shareholders would have had a continued investment in Kelda as an operating business.

• Customers - customers would have seen lower prices over

time as a result of the lowest cost of capital and the benefit of tendering for all operating contracts. Community ownership and involvement in the business was also seen as a benefit -

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reflecting the importance of water to the community. Community ownership is the most common form of structure for 85% of western economies.

• Regulator - it was seen as a significant benefit that the

interests of the mutual owners, customers and the regulator would be aligned - taking out the ‘gaming’ that inevitably exists in the current arrangements.

• Lenders - lenders would also have increased protection

because of the structured nature of the finance and because of the substantial cash reserves which would be put in place to enable the business to withstand shocks. The aim was to put credit ratings on a stable footing - halting the deteriorating trend in ratings that otherwise were the case.

• Employees - employees are often forgotten in debates such as

these. One has to remember the employment climate which has persisted for many years in the water industry. Since before privatisation there have been persistent cuts in employment - in Yorkshire’s case we have reduced from a workforce of around 6,500 just before privatisation down to some 2,300 employees in the regulated business today. Following the determination we went through another round of significant job cuts. The proposals were seen as providing the opportunity for growth within Kelda as it developed as an operating business. This is set out in Figure 1.

So that is why we were proposing a mutual structure. What did the proposed model and relationships look like?

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Figure 1: The Kelda Group structure

StructureStructureCustomers

Yorkshire WaterAssets and Licence Holder

Yorkshire Water Mutual

Membership ServiceRelationship

Ofwat - Economic Regulation

DWI Regulation

EA Regulation

CapitalContracts

Operating services & capital mgtcontracts - water & waste water

Property Development

Existing principal outsourced contracts

Fee Base

Day to DayService

Principal Contract

Customer Mt contractMgt Contract

Debt providers

• Yorkshire Water Mutual would have been established under

the Industrial and Provident Society legislation. It would have owned the Licenced Undertaker (ie, Yorkshire Water) - including all of the assets, key systems and licences and consents - needed to deliver water and waste water services. All customers would be eligible to be members of the mutual. The mutual’s and Yorkshire Water’s activities would have been limited to the provision of water and wastewater activities.

• Yorkshire Water would retain accountability for the service

relationship with customers and, of course, the relationship with the economic regulator - Ofwat - and the quality regulators - the Drinking Water Inspectorate and the Environment Agency. Statutory responsibility remained clear - there was no question of trying to pass on accountability to the operating contractors. And, of course, there was no

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question but that Yorkshire Water would continue to be regulated in exactly the same way as any other water or sewerage undertaking. This has been emphasised recently by the Director General in his response to the Glas proposals. Safety and quality of service would have remained the top priority.

• Yorkshire Water - the regulated business - would then let a

number of outsourced contracts for the delivery of day to day operations and services and delivery of the capital investment programme. It was key that Yorkshire Water would retain sufficient experienced staff to be able to control activities. Also, because of the importance of asset management and the investment programme, Yorkshire Water would have retained the contractual relationship with the capital contractors and would have had a close involvement in delivery of the capital investment programme. It was proposed that in the first instance the operating contracts should be with Kelda but that these would then be competitively tendered over a 3 to 4 year period - we did not wish to put service at risk by tendering all contracts too quickly.

• Debt providers - last but not least - there would of course be

a key relationship with the debt providers who finance the assets of the business and future investment programmes.

In comparing this structure to the proposals made by Glas Cymru - as I understand Glas’ proposals - the structure is very similar, except that Glas Cymru is a company limited by guarantee rather than a mutual In practice, the effect is the same in that Glas will effectively be owned and run for the benefit of the community and customers. So where does accountability sit in a customer ownership structure - whether that customer ownership is achieved through a mutual model or a company limited by guarantee?

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There is accountability to each of the key stakeholders:

• customers • regulators • debt providers and financial agencies I will deal with each of these in turn. First, in establishing any structure such as those proposed by Kelda and Glas Cymru there is the need for the endorsement of customers and the community before it can proceed. Glas has successfully obtained that endorsement - having received clear support from the Welsh Assembly and their Customer Services Committee. Yorkshire Water was in the process of consulting with customers and an extended timetable for consultation had been agreed with Ofwat when the mutual proposals were withdrawn. It could have proceeded without obtaining unequivocal customer support. Second, the corporate governance arrangements are key in achieving accountability to customers: • In our case there would have been oversight by the Registrar

of Friendly Societies, acting in the interest of members. • A strong independent board - with a majority of non-executive

directors acting in the interests of customers. In our case we were proposing a Board comprising 2 executive directors and at least 5 non-executive directors - members (ie, customers) would have directly elected 2 of the non-executive directors through a ballot in addition to approving the appointment of the other non-executives.

• Independent financial and legal advice to the Board (of the

Yorkshire Water mutual in our case and to Glas Cymru more recently) in relation to the acquisition of the licenced

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undertakings is also imperative in protecting the interest of customers.

• Prescriptive rules - either through the memorandum and

articles of association or through licence amendments introduced by Ofwat - are also key in protecting the interest of customers. Examples include limitations on the activities of the company and rules on the use of surpluses.

Accountability is also dealt with directly through regular and transparent reporting to customers and members. Glas Cymru are proposing to issue an annual ‘members report’ and to hold bi-annual members’ conferences. The Yorkshire Water Mutual had made similar proposals. Enhanced disclosure would also improve accountability. For example, much concern has been expressed about management incentives for efficiency in not-for-profit organisations. Not-for-profit organisations are just as focused on delivering efficient services as any other organisation. Nevertheless, the establishment of management incentive schemes which place significant weight on comparative efficiency and service, and which are in the public domain, should help to demonstrate in an open and transparent way the effectiveness of management. Finally, the Customer Service Committees could play an enhanced role in reviewing and challenging the performance of the regulated businesses and holding management to account. Moving on to the accountability of customer owned businesses to the regulators. In the first instance, customer owned structures can only be established after obtaining regulatory approval. Glas Cymru has recently received the go-ahead from the Director General to progress with its proposed ownership structure for Dwr Cymru. Such approval can only be obtained after satisfying the Director that the interests of customers are protected and that real benefits in terms of lower prices and improved services will be delivered.

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On an ongoing basis, the existing accountability to the regulators - the quality regulators as well as Ofwat - remain. There will still be detailed reporting to Ofwat through the June Return. Accountability for the quality of drinking water and environmental quality remain unchanged. The regulators will continue to publish their reports comparing the performance of all companies, irrespective of their ownership structures. It should also be noted that the provisions for the appointment of a special administrator remain. Accountability to the economic regulator, Ofwat, will also be enhanced because of additional licence requirements. For example, Ofwat are seeking changes to Dwr Cymru’s licence requiring them to submit a procurement plan - to ensure that the licenced business is achieving effective and fair competitive tendering of services. Another example, relates to a licence modification requiring an undertaking from Glas Cymru on the provision of information to Ofwat on their activities and the financing of Glas. In terms of the provision of the initial finance to fund the establishment of a new ownership structure - certainly in our case - the board of the mutual were receiving independent financial advice that the proposed acquisition price and financing structure was sustainable. Separately the banks, which were underwriting the finance, were receiving their own advice that the structure would work. On an ongoing basis the rating agencies play a key part in reviewing, in detail, the finances and performance of the business. In the case of Glas Cymru it seems that a monoline insurer, that is a AAA-rated company, will step in to guarantee a large proportion of the debt. Such an insurer would also play a key role in scrutinising, in substantial detail, the financial performance of the company.

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As to reporting of performance, in our case it was envisaged that there would be, at least annual, bondholder meetings to report performance, very much as companies currently report interim and final results to the equity markets. Information would also be published on the company’s financial and trading position and the results of its operations in line with the listing rules for a company listed on the stock exchange - so there is no diminishment of financial reporting. Finally, where ownership structures are 100% debt financed, it is likely that the finance will be obtained through what is known as ‘structured finance’. This could include, for example, clear requirements as to the levels of cash reserves which must be established as a buffer to enable the business to withstand shocks and still be able to make interest payments. Companies would also, for example, be unable to rebate any operating surpluses to customers until the required levels of cash reserves have been established. Loan agreements are also likely to allow bondholders to intervene in the event that credit quality reduces. In conclusion, I hope that I have highlighted the key features of a not-for-profit structure - as proposed by Kelda and subsequently developed by Glas Cymru - and that it is clear that overall accountability to the key stakeholders can be enhanced.

Jim Marshall, Assistant Auditor General National Audit Office

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8 THE ACCOUNTABILITY OF REGULATORS: INTERNATIONAL ASPECTS Jim Marshall One of the players on the accountability stage is the external auditor. And the theme of my chapter is that the auditor has a positive role to play in helping the regulator, and all those with an interest in the regulated industry, focus on the outcomes which regulation is trying to achieve. I shall try to demonstrate this positive role, first, by looking at the UK scene and the work of the National Audit Office (NAO) in helping to secure the accountability of regulators. I shall then broaden that out to look at some key accountability issues world- wide, and how they are being addressed by the national audit agencies of the member states in the United Nations, the International Organisation of Supreme Audit Institutions (INTOSAI). The UK scene The story starts with privatisation, but it does not end there. The challenge for governments when they sell state owned industries into the market place with monopoly powers is consumer protection. Few will disagree that competition offers better protection than regulation. But in the short run, and as a second best, the UK developed the system of industry specific regulation operating at arms length to government. These are public bodies funded by the taxpayer - although recovering their costs through

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licence fees - charged with developing competition, and in the meantime controlling dominant or monopolistic suppliers. The work of the regulators of key utilities, such as water, gas, electricity and telephones, impinges on everybody in the country. So the first point about regulator accountability is the wide range of stakeholders - all those organisations and individuals who have an interest in what they are doing. Often, of course, these are competing interests. There are government departments operating at arms length to the regulators, but with shared responsibilities in a number of key areas. There is Parliament, keenly interested in the effect on all citizens of the regulators’ decisions. There is the Competition Commission and the courts to whom appeals may be made against these decisions. In addition to these bodies, to whom regulators are formally accountable in a variety of ways, there are, of course, the regulated industries themselves, new entrants to the market, the financial markets, the public (as taxpayers and customers) and the media. The role of the National Audit Office How does the National Audit Office fit into this accountability scene? We are Parliament’s watchdog on public expenditure. Each year we audit some 600 accounts of central government and a variety of public bodies, including the regulators. In addition we publish 50 major value for money (VFM) reports for Parliament. We currently cost approaching £50 million a year to run, and we aim to save £8 for every £1 of yours we spend. So we have a target of saving, through our work, nearly £400 million a year. I am glad to say we have so far managed to meet our target, saving over £1.3 billion for the taxpayer and the citizen during the last 3 years. We have about 770 staff. Most of our auditors are qualified accountants and we also have audit staff with specialist skills, including economics, corporate finance, operational research and statistics.

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Our role is to give assurance to Parliament and the public on how public bodies are carrying out their tasks, and in the process to provide a stimulus to them to do things better, and advice on how to do so. Our value for money reports cover three aspects - the economy, efficiency and effectiveness with which public bodies are carrying out their work. Given the enormous influence of regulators, by comparison with the typical size of their budgets, our studies and reports to Parliament on their activities have focused on the third of these aspects - how effectively are they achieving their objectives. Over the last ten years or so we have produced many major reports to Parliament on regulatory effectiveness, addressing issues such as quality of service, consumer protection, price caps and indices, the introduction of competition and anti-competitive behaviour (See Appendix). Our work is not just about prices but also the wider impacts of regulation, so we have examined issues relating to energy efficiency and also health and safety. Savings to consumers from the National Audit Office’s work Let me give three examples from the area of consumer savings where our work has helped improve regulatory effectiveness. In 1998 we reported on the energy efficiency scheme. This is a package of measures, funded by a levy on electricity consumers, aimed at increasing the efficient usage of energy by domestic consumers. Our report contributed to re-focusing these measures on more energy efficient projects, such as the greater use of energy saving light bulbs. This work has so far resulted in savings to domestic consumers totalling £14 million. Second, in carrying out the water price review in 1999, the water regulator took account of recommendations Parliament had made, having regard to our reports, which contributed to the step changes in prices which have saved customers some £340 million in the last 12 months alone. Our reports on the introduction of competition into the domestic gas and electricity supply markets showed that,


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through changing supplier, domestic consumers could save up to 15 per cent on their bills. The international scene Turning now to the international scene, the National Audit Office chairs a working group on the audit of privatisation which comprises over 30 members of the International Organisation of Supreme Audit Institutions. These countries represent economies at all stages of development. Some are advanced, such as Australia, Austria, Germany and New Zealand. Others have been in transition from the former communist system, such as the Czech Republic, Hungry and Poland. Some are developing countries, such as Zambia. Others have features of developing as well as developed economies, such as Argentina, Peru and Turkey. In this way the group is an interesting cross- section of countries, in some of which ten years ago everything was state owned but is now privatised, in others where that process is still continuing, in some where only a proportion was in state ownership but that significant, and others where the privatisation process has yet to start. Privatisation audit guidelines In 1998 the group produced a set of comprehensive guidelines on best practice in the audit of privatisations. The guidelines concentrated on the sale process and set out practical advice for vendors and auditors alike, with examples of what has worked well. So the guidelines are also intended to help those engaged in the privatisation process itself as they strive to get the best value and outcome for the taxpayer. Since these guidelines were adopted, the group has been monitoring their application, and at the same time drafting a further set of guidelines on the audit of economic regulation, informed by a survey of INTOSAI members, reports and case

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papers. You can access all these documents - and more, in particular guidelines on PFI contracts - on the working group’s website.1

Economic regulation world-wide It is useful to consider the development of the economic regulation audit guidelines. The members of INTOSAI were invited to complete a questionnaire on the industries that were the subject of economic regulation in their countries, and their accountability arrangements, including audit. The national audit agencies of 67 countries replied, covering 1,139 industries, 775 of whom were regulated. Telecommunications turned out to be the most regulated industry (in 96% of countries) with railways much less regulated (in 60% of countries). The survey showed that economic regulation takes many forms. It can be part of government or at operate at arms length; it can be provided by a general competition regulator (as in New Zealand) or be industry specific (as in Argentina and the UK); and it can be carried out by a public body, or in some cases there is self-regulation. The survey showed that, in the vast majority of cases covered by the responses, regulators report to the government: in 76 per cent of regulated industries. But some regulators report to more than one body: in 17 per cent of cases, the regulators report to parliament and in 7 per cent of cases to the regulated industries. Also in 7 per cent of cases they report to the public. In 56 per cent of regulated industries, regulators are required to consult government before reaching their decisions; in 33 per cent of cases the regulators consult the companies they regulate, and 9 per cent of cases the public. The survey also showed that governments can give directions to regulators in 45 per cent of the regulated industries covered by the replies and that this right has been exercised at least once in 30 per cent of cases.

1 www.nao.gov.uk/intosai/wgap/home.htm

http://www.nao.gov.uk/intosai/wgap/home.htm


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Issues for economic regulation A number of the issues turn on the competing objectives which have to be addressed by economic regulators. These include the tension between protecting consumers and ensuring that suppliers of vital utilities can finance their business; also the tension between controlling prices and promoting quality of service, and between promoting competition and securing supply. How can the regulator demonstrate fairness in regulatory decisions and monitoring while avoiding the imposition of bureaucratic burdens on the regulated industries? Transparency in decision taking is seen as key, but what of protecting commercially sensitive information? What is the trade-off between health and safety and efficiency? What costs is it reasonable to impose in order to protect vulnerable consumers? And how does the regulator balance the need to have knowledge of the industry against the danger of being captured by the industry? Economic regulation audit guidelines The guidelines developed by the working group address these issues with a number of propositions. These include the importance of deciding on the regulatory structure when privatising: it is very difficult to put matters right afterwards. The regulator needs competent staff with access to expert advice. The regulator also needs sufficient reliable information about suppliers. In order to gain the confidence of suppliers and consumers, there need to be clear rules and procedures about how decisions will be reached. Accountability includes consulting widely, being able to justify decisions and being responsive to consumer complaints. The regulator needs to guard against discrimination among different groups of consumers so as to avoid socially inequitable outcomes. It is important to guard against industries responding to price controls through cutting quality (there is a role for standards and

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benchmarking here). Where the regulator has been successful in developing competition, experience suggests the need for vigilance, to combat anti-competitive practices. Conclusion Promoting regulator accountability in a constantly changing environment is important not least because, even with the growth in competition, economic regulation shows no sign of going away. Rather it is changing its emphasis, increasingly addressing issues such as the maintenance of newly competitive markets, and consumer protection in the face of multiple choices, and sometimes inadequate information. In that sense utility regulation is beginning to display some of the characteristics of regulation in the highly competitive field of financial services. In all of this changing scene the external auditor can play an important role in the accountability process, through helping to illuminate the way in which regulatory objectives are being pursued, assessing the effects of regulation, and examining the alternatives.


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Appendix Reports on economic regulation published by the national audit office and by the committee of public accounts since 1996

NAO REPORTS PAC REPORT OFGAS: The regulation of gas tariffs (the Gas Cost Index) (HC 287) March 96

1st Report 1996-97

The work of the Directors General of Telecommunications, Gas Supply, Water Services and Electricity Regulation (HC 645) July 96

16th Report 1996-97

The water industry in England and Wales: regulating the quality of service to customers (HC 388) December 97

36th Report 1997-98

OFTEL: countering anti-competitive behaviour in the telecommunications industry (HC 667) April 98

64th Report 1997-98

OFFER: improving energy efficiency by a charge on customers (HC 1006) July 98

12th Report 1998-99

OFFER, OFGAS, OFTEL, OFWAT: How the Utility Regulators are addressing the Year 2000 problem in the utilities (HC 222) February 99

30th Report 1998-99

Ofgem: giving customers a choice - the introduction of competition into the domestic gas market (HC 403) May 99 update report (HC 843) November 99

8th Report 1999-00

OFT: protecting the consumer from unfair trading practices (HC 57) December 99

37th Report 1999-00

ORR: ensuring that Railtrack maintain and renew the railway network (HC 397) April 00

35th Report 1999-00

OFWAT: leakage and water efficiency (HC 971) November 00

Ofgem: giving domestic customers a choice of electricity supplier (HC 85) January 01

Professor Robert Baldwin, Centre for Analysis of Risk and Regulation (CARR), The London School of Economics and Political Science

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9 A RISK FRAMEWORK FOR REGULATORY ACCOUNTABILITY Robert Baldwin Much talk of regulatory accountability concerns the procedures by which a policy or decision-maker can be scrutinised or held to account by another institution or individual. We accordingly speak of this, or that, Director General or Commission being accountable to such and such a select committee, minister, consumer organisation and so on.1 Here, however, I want to focus on another aspect of accountability as highlighted in the question: accountable for what? My suggestion is that accountability can be seen in relation to risks that undesirable outcomes may result from policies or decisions. On this view it is appropriate to hold a party to account because there is a risk of errant behaviour or an unwanted outcome. If, after all, there is no risk of an uncontentious or undesirable result, there is arguably little need to account. At this point we may look more closely at the ‘accountable for what?’ issue, consider the nature of the risk involved and unpack its elements.2 To give an example, we might look at

1 On accountability in general see C. Graham ‘Is there a Crisis in Regulatory Accountability?’ CRI Discussion Paper 13, (1995) (reproduced in R. Baldwin, C. Scott, and C. Hood, Reader on Regulation (1998); R. Baldwin and M. Cave, Understanding Regulation (1999, Chapter 21). 2 On ‘Who is Accountable?’, ‘to Whom’ and ‘for what’ see C. Scott, ‘Accountability in the Regulatory State’ (2000), J. of Law & Society, 38, 41.

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accountability for a rail accident similar to the tragedy at Hatfield. At first glance we might seem to be considering the risk ‘that a train will be derailed, causing injury and loss of life’. To think thus is, however, to see the risk as a single, self-contained and discrete event. This is a common approach - seen, for example, in the recent National Audit Office (NAO) report’s reference to the risk that a service will not be delivered on time or will be of poor quality.3 In reality though, such an approach often conceals the truth that reference is being made to an accumulation of risks or to a risk-laden process. We might, for instance, say that there is a risk of personal injury on the railway because there is: • a risk that the system of gaining information on the state of the

track is ill-equipped to pick up faults; • a risk that information on faults that exist will not be acted

upon; • a risk that the track design is inherently hazard-laden; • a risk that the policies and rules governing reactions to track

faults are unacceptable or inappropriate; • a risk that, even if full information on faults is available and

the policies are adequate, the mechanisms for applying those policies on the ground are inadequately resourced or inefficiently applied;

• a risk that strategies on train movements and speeds are not

adequately linked to assessments of track risks; • a risk that the train is insufficiently robust to withstand

derailment without harm to passengers.

3 National Audit Office; Supporting Innovation: Managing Risk in Government Departments HC 864 Session 1999-2000; 17 August 2000.

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The list can be extended but enough has been said to make the point that risks can be seen as clusters of events whose undesirable aspects may be the products of operational, managerial or regulatory failings - or, indeed, some interaction of operational, managerial and regulatory outcomes that, in themselves, are not vulnerable to criticism. Risk avoidance and control If we now proceed to examine how risks of undesirable outcomes can be avoided this will, in due course, offer pointers on who, in a given situation, might properly be held to account for what. To make concrete the issue of risk avoidance or control let us take the topical example of the risk that houses will be flooded following heavy rainfall. My argument is that four issues will routinely be central to questions of control and management. These issues can be outlined as follows: The phase of risk development The issue concerns the point in the development of a risk at which action is taken to manage it.4 At the preventive stage, the key question is whether the risk will be run or allowed to arise. In the case of house flooding, a preventive action might be the local authority’s decision to refuse planning permission for the construction of houses on flood plains. Another preventative step might be the State’s instituting controls on global warming. At the act stage the danger has arisen and the issue is how best to reduce the chances of harms occurring. Steps might be taken to raise the river banks or build flood barriers. At the harm phase the damage has been done and the issue is how best to deal with

4 See S. Shavell, ‘The Optimal Structure of Law Enforcement’ (1993) J. Law & Econ 255.

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the negative consequences of this. In the flooding example, measures such as evacuation schemes and compensation regimes might be resorted to. The stage of risk management and control This second dimension of risk control takes on board the notion that a scheme of management or control needs to progress through three stages if it is to impact on the world.5 First, information needs to be collected about the nature of the risk and how it is perceived. Information on the prevention, act and harm phases of the risk will need to be gathered. At this stage in the flooding scenario, a purchaser, builder or regulator will seek out data on the probability of the river spilling over the banks and the number of houses likely to be at risk. Also in point will be the way that the public views both flooding risks and the need to build homes on flood vulnerable sites. Second, it is necessary to develop policies or rules as a basis for controlling and managing the risks. Again these policies/rules will need to address the prevention, act and harm phases of risk development. In relation to floods, for instance, policies/rules will be devised on such matters as the conditions under which houses may be built on flood plains, whether barriers will be erected, whether the building regulations will demand special flood resilience and whether there is to be a strategy of evacuation or compensation. Thirdly, it is necessary to enforce and implement the above rules and policies by means of appropriate inspection, oversight and sanctioning regimes. The government, for instance, must ensure that the appropriate agencies are equipped with the resources to undertake such tasks as checking the locations of houses, seeing

5 For discussion in the context of different risk regulation regimes see C. Hood, H. Rothstein and R. Baldwin, The Government of Risk (Oxford, 2001 forthcoming).

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that construction methods incorporate flood resilience, and ensuring that evacuation procedures are maintained property. In the management context, the construction company may have to inspect its building work to see that appropriate company rules on flood resilience are being put into effect. The degree of focus The degree of focus involved in risk control relates to the specificity with which a risk is influenced. A specific focus involves a regime of control that is specially dedicated to the particular problem. In relation to house flooding, for example, rules and policies would deal expressly with house flooding risks (eg, a rule might govern construction next to rivers). In contrast, a general regime would be characterised by broader rules so that house flooding, would be dealt with as an aspect of across-the-board building regulations (eg, the rules on flooding would take on board resilience to wetness alongside a host of other factors). Risk controls based on incidental methods would involve control effects that are secondary to other objectives - so laws on economic development might give priority to industrial uses of land and a side effect of this could be a lower incidence of domestic house building on flood plains. The target of control/management The object of control or management may in a risk regime, be an individual, group or organisation (eg, a corporation). To control house flooding dangers by an individual approach, the state might aim promotional material at individuals who are potential house purchasers - for example, by distributing documents warning of flood dangers. Groups might be targeted by directing controls at teams of construction workers and organisations could be spotlighted by, for example, licensing firms to develop high flood-risk sites.

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The four dimensions can be represented as the sides of four triangles thus:

ACTHARM

SPECIFIC

ORGANISATIONINCIDENTAL

GENERAL INDIVIDUAL

GROUP

PREVENTION

ENFORCEMENT

INFORMATION POLICY

The implications of seeing risk control management around the above four issues are significant when the question of accountability arises. This ‘four dimensional’ view makes it clear, first, that accountability for, say, a flooded house, may relate to the actions of an individual, a group, or organisation or some interaction of these. Second, that accountability may look to the actions of managers or to the conduct of regulators. Third, it is clear that in accounting for the house flooding we may have to consider both risks that are imposed (eg, by acts of God such as storms) as well as risks that result from an appetite for risk (eg, a profit-seeking firm’s decision to build houses on a known flood plain). Fourth, the four dimensional view shows that accounting for under performance concerning risks may relate to informational deficiencies or inadequacies of policy/rules or of enforcement. Finally, it can be seen that those held to account for a risk failure may have influenced (or might properly have influenced) the risk specifically, generally or incidentally; they may have responded to the risk (or should have responded) at the prevention, act or harm stage.

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The implication of the above points is that holding to account for risk failures may involve at least 81 combinations of deficiency – since action involves choices on four groups of three issues as follows:6

Information Prevention Specific Individual Policy Act General Group Enforcement Harm Incidental Organisation

To stay with the flood example, if there is an appetite to hold to account after house flooding there is a huge range of possible approaches. To take, say, the top and bottom lines of the above groups of issues, we might look to individuals' house purchasing decisions and their failure to collect sufficient information on specific preventative issues (eg, options for purchasing in non-flood vulnerable areas). Moving to the bottom line, we might look to deficiencies in the actions taken by organisations (eg, local authorities) to enforce the rules on harm-managing operations such as evacuation procedures – for example, because they have cut the budgets of the relevant agencies and lack of enforcement has been a by-product of such cuts. Seventy-nine other combinations of potential accountability calls can be formulated along these lines. This flows from the above analysis once it is accepted that parties can be held to account for their omissions (eg, to prevent risks from arising) as well as their commissions (eg, their use of poor information to formulate policy). The same argument can be made about, say, holding a regulator to account for deficiencies in service quality in the utilities, or holding a service provider to account for the same failing. To hold a party to account for their dealings concerning a risk calls for a series of assumptions to be made about responsibilities for risk control and causes of risk. If, for instance, there is a demand 6 If, moreover, regulatory as well as managerial accountability is considered, the number of scenarios doubles.

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that the builder of a flooded house should be held to account for the flood harm, it might be responded that other parties have played various roles in the flooding. The purchaser might be thought accountable for the risk because he/she chose to buy on the flood plain; the local authority gave planning permission; the building inspector failed to collect information on the flood danger; the Environment Agency may have failed to give prompt flood warnings, and so on. A host of parties may be held to account for a host of roles in risk creation, control and management. Not only that but a series of regulators and managers may have played simultaneous, often overlapping, roles in relation to different aspects of the risk. An approach to accountability that unpacks risks of under performance is especially valuable in the modern ‘regulatory state’.7 In this state we see a movement away from central government delivery of services towards regimes in which key services are increasingly provided by non-state institutions who are acting under schemes of supervision that owe as much to contract law as public law. This brings high degrees of fragmentation in operational, managerial and regulatory functions – carrying out these functions involves ever more shared activities and traditional models of linear accountability strain to gain a purchase on different actors and activities. If this movement is viewed through a ‘four dimensional’ risk lens it becomes clear not merely that various institutions are linked with and accountable to various other bodies by a host of different

7 See Scott, loc cit p.44; G. Majone, ‘The Rise of the Regulatory State in Western Europe’ (1994) 17 West European Politics 77; M. Loughlin and C. Scott, ‘The Regulatory State’ in P. Dunleavy, A. Gamble and I. Holliday and G. Peele (eds.) Developments in British Politics (1997) and F. McGowan and H. Wallace, ‘Towards a European Regulatory State’ (1996) 3 J. of European Public Policy 56. On accountability and the ‘New Public Management’ see C. Harlow, ‘Accountability, New Public Management and the Problems of the Child Support Agency’ (1999) 26 J. Law & Society 150; see also G. Morris, ‘Fragmenting the State: Implications for Accountability for Employment Practices in Public Services’ [1999] Public Law 64.

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processes and methods, but that patterns of responsibility (and in turn accountability) will vary across phases of risk development (prevention, harm, act); stages of management and control (information-gathering, policy-making, enforcement); degrees of focus (specific, general, incidental) and target of control or management (individual, group, organisation). Within a given policy domain a series of networks of responsibility may accordingly be encountered.8 9 Put another way, there may in any policy area be a host of different regulatory regimes each with their appropriate framework of accountability.10 A forlorn exercise? Does this mean that holding to account in regulation is a forlorn exercise - that to concede the complexity of risk causation is to decline to hold to account? This is not the case. The ‘four dimensional’ approach put forward here emphasises, first, that, rather than homing in on one actor, or on a binary relationship between actors, it is necessary to look to the pattern of responsibilities and accountabilities that relates not merely to a policy domain but to a particular risk. The advantage of such an approach is that it avoids scapegoating and looks to the array of actions and omissions that make up the process leading to a risk or harm. Let us consider a further example. One of the accountability issues that has been most debated in recent years has been the death of Diana, Princess of Wales. In the thousands of column

8 And, indeed, values – see Scott, loc. cit p.57 and pp.48-54 (where ‘interdependence’ and ‘redundancy’ models of accountability are distinguished). 9 Contrast Scott loc.cit at p.55. 10 On regulatory regimes and their definition see Hood, Rothstein and Baldwin, op.cit; on different regulatory ‘spaces’ see L. Hancher and M. Moran ‘Organising Regulatory Space’ in L. Hancher and M. Moranles in Capitalism Culture and Regulation (1989).

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inches devoted to this event little attention was paid to the accountability of the road planners who allowed the construction of a road tunnel that offered no crash-barrier protection along the concrete pillars that were sited adjacent to a carriageway. Debate centred largely on a chauffeur’s behaviour and blood content. The lesson is that the public’s appetite for holding specific individuals or institutions to account can be founded on highly simplistic notions of risk causation. A ‘four dimensional’ approach would have suggested that in the Diana tragedy a broader analysis of causal roles and responsibilities might have been used to underpin accountability demands. A second implication of the approach put forward here is that in holding particular parties or institutions to account for particular failings we should be clear about the tradeoffs and overlaps that exist between specific, general and incidental policies and rules; between the actions of individuals, groups and organisations; between information-gathering, policy-making and enforcement activities, and between preventative, act-based and harm-related actions. All of these aspects of risk may be undertaken, managed or regulated by different parties, groups or organisations according to different processes. Once this point is accepted it follows that a number of parties may be held to account in different ways for a failure - it does not mean that no-one is to be held to account since no-one is responsible. The four dimensional approach thus assists in dealing with the familiar accountability - shedding argument that: ‘I was not responsible, other people were involved’. This contention is dealt with by an analysis of accountability that urges: ‘You were responsible for the following aspects of risk control and will be accountable accordingly. Clarity concerning risk creation processes allows us to note that other parties are to be held to account for other aspects of the risk-creation process but that is a separate issue’. A related advantage of the approach put forward here is that modes of accountability can be correlated to the patterns of responsibility associated with different parties. In

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relation to some parties and functions, for example, market, consumer or contract-based modes of accountability may be appropriate whereas other parties engaged in different tasks many more properly (and effectively) be held to account by Parliament, monitoring bodies, judges or review agencies.11

It may be argued that complex webs of accountability and responsibility can be exploited in order to ‘hold regimes in appropriate tension’ - so that different managers, contract holders and regulators, auditors, stakeholders and politicians with their ‘competing agendas and capacities’ will keep each other honest.12 Benign results, however, cannot always be assumed - complexity may lead to the dissipation of responsibility rather than clear lines of account. The challenge is to arrange accountability regimes so that clarity rather than confusion results. Here, again, a four dimensional analysis can assist by unpacking areas of responsibility. Rules on transparency of operations are necessary but not sufficient - open mechanisms of accountability amount to little unless there is clarity on allocations of responsibility - on who might have avoided/controlled which risks at which stages in conjunction with whom. Fragmentations and overlaps of responsibility and accountability are liable to be constant issues in regulation but these should not present insuperable problems. Difficulties only arise if excessively simplistic causal analyses are employed and if roles are not analysed clearly. A third message follows. It is that the law often provides no easy answer to accountability issues. If a statute provides that X is responsible for regulating issues A, B and C, this tells us little about the various other parties whose regulatory or managerial actions may impinge on issues A, B and C. Nor does a typical regulatory law make it clear what other more custom-made

11 See C. Scott, 'Privatisation, Control and Accountability' in S. Picciotto, J. McCahery, and C. Scott, Corporate Control and Accountability (1993); N.Lewis, ‘The Citizens Charter and Next Steps: A New Way of Governing?’ (1993) Pol. Q 316 12 See Scott, loc.cit p.57

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general laws may affect issues A, B and C. Incidental effects on A, B and C may flow from other items of legislation and, again, the law will hardly ever demarcate areas of responsibility, influence or accountability. A typical regulatory law, furthermore will say little about the non-statutory modes of accountability (political, managerial, governance and so on) that maybe relevant. A fourth point is that regulatory and managerial responsibilities and accountabilities are very often meshed together and that, instead of dealing with these in two separate compartments, it is advisable to look at them together and in relation to a selected aspect of the risk. To give an example: if there is a rail crash due to a track failure that should have been noticed, an accountability analysis might investigate such matters as the regulators’ and managers’ interactions relating to information-gathering on track failure (not to mention policy-making and its enforcement or implementation). There, accordingly, is little wrong in stating that managers and regulators can be jointly responsible for a failure and that those holding to account should recognise this. To start such an accountability debate by asking: ‘How do we hold managers to account for the crash?’ tends to lead to buck-passing, a diffusion of responsibility and a dissipation of accountability. It is more productive to start with the risk creation process rather than pick out the usual suspect. Fifth, the possibility should not be ruled out that no individual, group or organisation is directly accountable for a failure. It follows from the above analysis that some risks and harms are the products of genuine accidents of system failure – where, for example, the actions of managers and regulators are undermined by tax incentives or governmental policies so that the overall set of influences on a risk fails to produce acceptable levels of restriction or management. An outcome may thus be the fault of no person, group or institution and it may be proper not to hold anyone to account. That said, where it is possible to locate an overall system designer, that person, group or institution may be held to account for the confusion of responsibility.

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Finally, a point to be drawn from the four dimensional approach is that in the complex processes of managing and controlling risks, there are likely to be frequent changes of inter alia players, roles, policies, rules and strategies. A regulator, for instance, may allow a set of firms or an association to self-regulate in a new manner in the hope of establishing more effective risk control. Those firms or that association will then play a stronger role in the direct control of the risk and it will be appropriate accordingly to hold them accountable in a manner that reflects changes of roles and responsibilities.

Conclusions As initially noted, many discussions of regulatory accountability proceed in an actor- focussed manner and consider the processes by which those actors can be monitored, called on to explain, criticised, disciplined or sanctioned. I have suggested that such treatments of accountability produce a number of dangers, notably: of scapegoating; of building on simplistic causal assumptions concerning failures and risks of failure; of failing to deal with the complexities involved when managers and regulators play concurrent roles and when numerous parties are involved in operational as well as risk control/management processes; of giving insufficient attention to the shifting nature of roles and responsibilities; and, even more seriously, of buck- passing and the diffusion of accountability where there is a lack of clarity on actual and potential roles relating to risks of failure. The four dimensional approach advocated here turns this ‘traditional’ approach to accountability on its head by using an analysis of the risk creation process to construct the appropriate accountability profiles of the various parties involved in the risk creation and control processes. It counters the notions that regimes of accountability apply in a constant fashion right across policy domains and that such regimes do not vary in character over time. The advantages of the approach have been set out and

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discussed above and the most important of these is the imperative to analyse overlaps and concurrencies as well as contradictions of roles and responsibility. Only by coming to grips with these is it possible to deal fairly with those we are holding to account. This is a message relevant risk management and regulation wherever it occurs - be that the utilities or any other sector.

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