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Should regulator punish or encourage utilities to drive good behaviour? Regulators have been deploying bigger sticks and smaller carrots to try and influence utility behaviour . Martin Blaxall says it's time for a change. In 2002, when introducing a debate on penalties in the energy sector, the minister for industry and energy said: "We aim to have good standards of compliance, not lots of fines." So, is this what has actually happened? Fines have certainly been coming thick and fast from water regulator Ofwat in recent years. There have also been headline-grabbing fines in energy - most notably Ofgem's £42 million fine (cut on appeal to £30 million) on National Grid for stifling competition in the gas meter market. It is important to distinguish between the two sets of fines, though. The Ofwat fines took place under the framework of utility regulation, while the Ofgem fine was issued under competition law. This article addresses the first type of financial penalty, as well as wider regulatory practice on enforcement and incentives, and asks whether it is time for a rethink. At its most basic, a regulatory framework should identify what outputs are expected, what revenues can be charged and what the incentives are. Incentive arrangements are set through price reviews, and issues of performance or underperformance are addressed through the price-setting process and in licence requirements. Any need to go further - to consider sanctions - means that something has gone wrong. Sanctions are designed to encourage good behaviour and secure compliance, both from the offending company and others, to protect the interests of customers. Before imposing sanctions, regulators should ask themselves whether something is wrong with the framework or with their assumptions, whether circumstances have changed or whether the company is indeed responding sensibly to the framework provided. In March this year, Ofwat published its approach to enforcement. In it, chief executive Regina Finn said: "We expect every company to fulfil its obligations. Where a company fails its customers, we will take proportionate action to deal with those shortcomings. Any sanction we take will reflect the seriousness and impact of a company's failure. We do have the power to fine companies, but reserve this measure for the most serious misdemeanours." *Consult* Ofwat promises to consult specifically on its policy on penalties but has already been making extensive use of the powers it acquired in 2005, imposing penalties totalling £74.3 million. The Office of Rail Regulation recently consulted on its approach on the subject in the light of the penalties it levied on Network Rail over the Portsmouth resignalling programme (£2.4 million) and for overrunning engineering works in New Year 2008 (£14 million). Indepen recently held discussions with a number of directors and senior managers on both sides of the regulatory fence regarding the use of sanctions and whether customers might benefit from improvements in the way carrots and sticks are used to encourage correct behaviours. No easy answers were forthcoming, but a number of themes emerged. Respondents recognised that regulatory regimes are complex, sometimes overly so. Some felt the process of piecemeal addition had damaged the coherency of regimes. One commented: "God only knows how [the regime] influences behaviour." On the balance between incentives and penalties, some felt that penalties had been ratcheted up while incentives had been being eroded, that the stick was getting bigger. One said: "We now have potentially large penalties for [bad] customer service, but how should we strike the balance between punishing wrongdoing and rewarding success? It seems that the incentives aren't big enough." Concern was also expressed by companies about how to encourage innovation and appropriate risk-taking against a background of potential punitive punishment. How can this tension be resolved as companies address the major challenges of security of supply and climate change? *Compliance* The Indepen discussion also mulled over how we had got to the point where compliance had to be secured through enforcement action and penalties. After all, there is a range of reasons why it is reasonable to suppose companies want to comply and respond to incentives. It is also in the long-term interest of customer and regulator. Has trust been destroyed, requiring the regulator to delve deeper and deeper into a company? Or are targets and assumptions out of date? There was not always a meeting of minds among respondents about motives and methods. Among the comments aired were: "Regulators need to be seen to be doing something"; "it is unnerving the degree to which regulators feel the need to punish rather than incentivise"; and "for their part, companies have rarely thought through the issues properly." Yet it is surely to the benefit of customers that such a meeting of minds is achieved and that trust is built. One interviewee commented that to work properly, any penalties process "requires reasonable people acting in reasonable ways", while others questioned the nature of the relationship between regulators and regulated companies. It was suggested that too many regulatory relationships are based on stress. Indeed, while some companies recognised that, on the big issues, regulators generally made the right decisions (although it did not always feel like that on the day of the decision), it was in the handling of day-to-day issues that the relationship was harmed. What might provide the confidence to change things? *Sanctions* Our research found that companies understood the need for sanctions but were seeking a greater degree of proportionality, justification for the timing of action taken and an objective process that both sides see as fair (and with the emotion taken out). Fining practice and the level of fines currently vary between regulators. It is possible to explain a degree of variation - for example, sums can depend on potential or actual gain and detriment, enterprise size, and turnover (for turnover-related penalties). However, some respondents suggested that there was a degree of inconsistency or opaqueness because penalties appear to be "implausibly different". While individual regulators do not need to justify any inconsistency between sectors, some respondents questioned whether there were adequate reasons for the degree of variation we have seen. In 2006, the government-commissioned Macrory Review into regulatory justice and sanctions stressed the need to ensure better regulatory outcomes. The ensuing report recommended a wider (and more effective) range of regulatory sanctions than the purely criminal. But what might the regulatory penalties process learn from the rigour of the criminal process - for example, its separation of roles (as detective, prosecutor, judge and jury) and the crucial importance of evidence? Furthermore, courts seek consistency across the thousands of cases they deal with, while regulators have a relatively small number of precedents available to them. Better regulation principles and a growing body of precedents should prevent penalties from being "random and whimsical". But some respondents noted that the lack of willingness in some sectors to take cases to appeal was restricting the validity of the precedents being set. There was widespread agreement that the use of the Competition Appeals Tribunal (as has been the case in telecoms), rather than the courts, might be a useful way to develop a set of precedents more generally for the utilities sector. Regulators currently have big sticks with which to change utilities' behaviour and penalties have improved their weaponry in ensuring compliance. But better alignment both within and between companies and regulators, as well as better processes, have the potential to reduce the need for sanctions and to increase the scope for incentives to operate. Two key questions remain: does the sector have the confidence to make these changes? And, given that the regime is intended to be for the benefit of customers, what is their role in the process? Martin Blaxall is a director at Indepen. Email: MartinBlaxall@indepen.co.uk> Source: Steve Hobson © Faversham House Group Ltd 2009. News articles may be copied or forwarded
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