WTI Crude

Loading...

Brent Crude

Loading...

Natural Gas

Loading...

Gasoline

Loading...

Heating Oil

Loading...

Rotate device for more commodity prices

Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

More Info

How British Energy Regulations Benefit Investors

Electricity

During the glory days of Margaret Thatcher, the British instituted a new kind of utility regulation. It was modeled after a price control scheme designed for a monopolistic condom manufacturer, Durex. Regulating electricity prices, like other "necessities", must've looked simple.

The regulator, Ofgem in this case, would set a price formula for five years. The formula would allow utility prices to rise no higher than the rate of inflation minus a productivity factor. The latter was to encourage utilities to become more efficient. More on this later. The UK then privatized its utilities (electric, gas and water) and placed them under this market tolerant price framework.

One particular aspect of UK utility privatizations attracted attention from investors. In a fairly radical departure, the regulator was not going to limit profitability of these former monopolies. It's not rocket science. In a five year framework, radically cut costs in year one and keep the savings for four more years. No one got that type of deal in the U.S. It was a way to earn far more than investors had come to expect in these type of fairly low risk businesses that sold essential services.

After five years, regulator sets a new price formula and the process begins again. The British sent a message to investors and utility managers: be innovative and efficient. We won’t punish you by taking away operational savings, and force disgorgement of profits at least not until the end of the formula period. This seemed at the time a better way to regulate utilities. The stodgy US method regulated profits. The UK instead would regulate prices. Their goal was for utility managers to manage their costs aggressively without facing regulatory retribution. Which they did. And then they sold out, literally.

But, after a decade, the government changed. Labor was now in. To them, it appeared that electric utilities were over earning. Their solution was a windfall profits tax. But the original owners, at the time of privatization, had already sold their utility interests to European and American companies. The new owners in effect paid the tax on profits legally earned by the previous owners. Not fair, but the government said this was a onetime event.

Now, after years of high profits, the water companies face a similar tax. The water regulator has been accused of making bad estimates of borrowing costs and taxes that were too generous when setting water prices. Politicians now want to impose a windfall profits tax on water companies. The aim is to return excess profit supposedly earned due to the regulatory errors. Related: Why Oil Companies Must Look Beyond Oil To Survive

There is a conceptual problem for us of a windfall utility profits tax in the UK. If your scheme is to regulate prices stick to that. Decrease utility rates. That reduces profitability. Otherwise it makes it seem that government lacks faith in its regulatory bodies and these taxes are effectively admonishment to the regulators.

In a somewhat similar vein unregulated retail electricity sales have drawn the ire of consumer officials. It seems consumers have found it exceedingly difficult to select tariffs that would afford them the lowest rates. This has been an issue for more than a decade.

If the government still sets electricity prices, either by administrative formula or taxation, why pretend the power market is deregulated? The implication is that retailers have not passed on low wholesale prices to consumers, which may be true. But this whole asset sales and deregulatory Thathcherite scheme came about during a period of relatively high underlying inflation and interest rates. The idea of s steady stream of modest electricity rate increases did not seem at all unattractive at the time. What the regulatory scheme has instead confronted has been deflationary: aggressive cost cutting, low natural gas prices and low interest rates. We think it fair to say not one of which was adequately appreciated at the time.

Wholesale electricity prices are both variable and cyclical. Retailers hope for high margins when wholesale prices are low to offset low margins when prices are high. If the government puts a lid on prices are they also willing to put a guaranteed floor under price?

American regulators have been reluctant to approve long term, open ended rate agreements with most utilities. As a result, returns have been more modest but with less business risks. Which has been a big plus in terms of obtaining capital at reasonable rates.

The UK system, despite the appearance of taking its cues from "the market", still retains an aspect of regulatory retroactivity, a looking backward and saying, "Oh, that was way too much to earn". Related: How Peak Oil Was Misunderstood

Note the asymmetrical character of the British situation. If the water regulator (or the electric regulator as in the previous situation) underestimated corporate expenses and had set prices too low, utility profits would have suffered. Would regulators hit consumers with a surcharge to make up for the profit deficiency? Probably not.

British regulators remain locked in a conceptual framework of neo-liberalism and market based structures within an inflationary context. We're not haggling about ownership of the means of production here. Circumstances have been such that UK regulatory schemes have proven generous to both utility management's and the providers of capital. With each new administrative "solution" another problem is born.

The secret behind British utility regulation? The stated intent was to give corporate managers more economic incentive. Mission accomplished. But like most administrative schemes, they work best in periods of modest incremental change. None of the changes in electric utility cost structures since about 1990 can be deemed even remotely incremental. And with that the politicians respond though seldom in aid of poor, deserving bondholders and shareowners.

By Leonard Hyman and Bill Tilles

More Top Reads From Oilprice.com:




Back to homepage


Leave a comment

Leave a comment




Oilprice - The No. 1 Source for Oil & Energy News