RPI – X Regulation
Nick Crafts
(University of Warwick)
Regulation of Privatized Industries
• Regulate to prevent abuse of market
power in cases of natural monopoly or
high entry barriers
• British approach based on price capping
whereas traditional American version used
rate of return
• RPI – X aims to stimulate cost reduction
as well as preventing high price cost
margins
Productivity and Prices
• In a competitive market p=mc=LAC (including a
normal rate of return on capital)
• In the absence of productivity growth, over time
output prices would rise at the same rate as (the
weighted average) of input prices
• More generally, output prices in a competitive
market rise at the rate of growth of input
prices minus productivity (TFP) growth
Price Capping
• If prices are allowed to rise at RPI-X, the
industry will be able to maintain normal
profits providing it achieves TFP growth
equal to the national average, TFPUK, + X
• If TFP growth is greater than (less than)
TFPUK + X, the formula implies
supernormal (subnormal) profits
RPI-X vs Rate of Return: Key Arguments
RPI-X
RATE OF RETURN
Strong incentives for cost
reduction and innovation
Prices stay in line with costs
BUT
BUT
Quality may suffer
Likelihood of excessive
investment
Prices exceed costs on
average
Quality ‘assured’
Weak incentives for
productivity improvement
The Averch-Johnson Problem
• Rate of return regulation which allows the firm
to earn a rate of return above the cost of capital
encourages the firm to accumulate an excessive
capital stock
• The equity value of the firm will be
proportional to the capital stock and, provided
the allowed rate of return is above the cost of
capital, the share price will be positively related
to the capital stock
• Have to rely on the regulator to identify
unnecessary projects and disallow them from
the cost base
The Water Industry
• Regulation is a hybrid
• It’s the Averch-Johnson problem that we should fear in
the long-run ….. especially given populist pressures
• Excessive capital stock encouraged by
–
de-luxe quality directives
–
ensuring no supply interruptions
–
no peak load pricing
Key question: is marginal benefit (willingness to pay) less
than long-run marginal cost?
RPI-X Regulation: Further Points
• Optimal length of price reviews trades off gains from
cost reduction against losses from excessive prices ….
is shorter the lower is the sensitivity of costs to costreducing effort and the higher is price elasticity of
demand
• Mitigating ‘regulatory risk’ with sunk costs through
credible commitment by regulator is desirable
• Uncertainty lowers advantages of price caps if need
to ensure non-negative profits
• Setting X well requires good way of estimating potential
for productivity improvement
Managerial Effort and Productivity Growth
• Implementing productivity
improvements/cost reductions requires
managerial effort, i.e. has disutility for
managers
• Monitoring managers in context of
asymmetric information encounters free
rider problems in private sector and may
offer no reward in public sector
• Competition is antidote to agency
problem
Privatization and Managerial Effort
• Asymmetric information does not go
away
• Private shareholders may improve
monitoring/incentivizing of managers
• Competition may increase
• Regulator may have to try and
compensate for weaknesses of
shareholders and/or competition
Privatization and Productivity Performance
(Green and Haskel, 2004)
• TFP growth raised by the privatization process
not by private ownership per se
• Productivity growth increased in some cases as
X factor made more demanding (e.g. water)
• Regulation central to quality implications of
RPI-X incentive structure
• Overall picture is dominated by levels effect of
eliminating inefficiency
Total factor productivity in the UK public
sector (annual rate of increase, %)
British Airways
British Coal
British Gas
British Steel
72/3-78/9
78/9-86/7
86/7-99/00
+3.0
+3.3
+4.2
72/3-78/9
78/9-86/7
86/7-93/4
-2.8
+0.1
+9.0
72/3-78/9
78/9-86/7
86/7-94/5
+8.2
+2.0
+1.5
72/3-78/9
78/9-88/9
88/9-97/8
-5.0
+3.8
+1.8
72/3-78/9
78/9-84/5
84/5-94/5
+3.2
+3.0
British Telecom +0.6
Privatised 1987
Privatised 1994
Privatised 1986
Privatised 1988
Privatised 1984
Comparative Productivity: electricity, gas and water
sectors, 1979-95 (UK = 100)
250
500
200
400
150
300
100
200
50
100
0
0
1979
1989
Total Factor Productivity
USA
France
Source: O'Mahony (1998)
Germany
1995
Japan
1979
1989
Labour Factor Productivity
USA
France
Germany
1995
Japan
Regulated Prices in the UK
BT
REC Distribution
Gas Transportation
NGC Transmission
Water
180
160
140
120
100
80
60
40
20
0
20
20
20
19
19
19
19
19
19
19
19
04
02
00
98
96
94
92
90
88
86
84
Conclusions
• Productivity performance in privatized
utilities may be affected by the incentive
structures of the regulatory framework
• In practice, not clear that RPI-X has
generally been a strong driver of TFP
growth
• Introducing competition where possible
delivers stronger incentives to improve
productivity
GROUP WORK
1. When would you expect regulation to
have a powerful impact on the
productivity performance of a privatized
business?
2. How should a regulator decide the
precise value of ‘X’ at a price review?
Regulation and UK
Productivity Performance
Nick Crafts
(University of Warwick)
Costs and Benefits of Regulation
• Regulation that corrects market failures
provides gains from a more efficient
allocation of resources
• Regulation also incurs costs so it is
relevant to ask how benefits compare
with costs
• The costs of regulation may be felt in
terms of lower GDP per person
Questions
• In what ways can regulation affect
productivity outcomes?
• How good are measures of regulation?
• Is the UK lightly regulated?
• Does regulation actually have a big impact
on labour productivity growth?
Regulation and Productivity
• Compliance costs have direct productivity
implication
• Additional adverse impacts if disincentives
to investment and to innovation
• May create barriers to entry that reduce
competition
• Impact has not been well quantified
Compliance Costs
‘Administrative Costs’ = 3 to 4% GDP and
‘Policy Costs’ = 7 to 8% GDP (BRTF, 2005)
• Direct measurement effect will be to
reduce measured TFP by an equivalent
amount of productive resources diverted
away from producing output
• No time series evidence on compliance
costs but difficult to believe these direct
effects have reduced annual TFP growth
much in recent past
Regulation as a ‘Tax’
• Investment and innovation are key
determinants of labour productivity growth
• Appropriable returns underpin incentives
to investment and to innovate
• Regulation may reduce net present value
of projects
• For example, employment protection and
ICT expenditures (Gust and Marquez, 2004)
Regulation as Barrier to Entry
• For example, costs of setting up new business,
licensing rules, planning restrictions
• Empirical evidence of cross-country comparisons
shows tighter regulation reduces entry and
raises price-cost mark-ups (Cincera and Galgan, 2005;
Griffith et al., 2006)
• Retailing productivity growth example of regulatory
barriers having seriously adverse impact in Europe
compared with US (McGuckin et al., 2005) in ICT era
Competition and Productivity Growth
• Absence of competition allows managers to be
sleepy if ineffective control/monitoring by
shareholders
• Competition is strongly positive for productivity
outcomes in UK firms without dominant
shareholder (Nickell et al., 1997)
• Competition promotes better management
practices (Bloom and van Reenen, 2006)
• Patenting performance of UK firms suggests
inverted U-shaped relationship with price-cost
margin which peaks at about 20% (Aghion et al.,
2005)
Policy Impact on Rate of Technology Adoption
Firm Type
Maximizing
Agency Problems
Competition Policy
Negative
Positive
Industrial Policy
Positive
Negative
Maximizing Firms
Competition Policy lowers expected profit from innovation
Industrial Policy raises expected profit from innovation
Agency Problem Firms
Competition Policy cuts rents and raises cost-reducing effort
Industrial Policy pays subsidies and lowers cost-reducing effort
Regulation and the Growth Rate
• If regulation is a disincentive to
investment and innovation, they will be
lower as a result
• Endogenous growth models predict that the
rate of growth will be adversely affected
• This would be the most serious consequence
of excessive regulation rather than the
diversion of resources through conventional
compliance costs
Measuring Regulation
• Evidence on compliance costs quite limited
• Investigators looking at relationship between
regulation and productivity performance have
used indices constructed by OECD, World Bank
and surveys of expert opinion conducted by
IMD, World Economic Forum etc.
• Both product market and labour market indices
available
BUT how good are they?
Measures of Regulation
• ‘Subjective’ vs ‘Objective’
• Comprehensive?
• Take account of enforcement and
litigation?
• Include ‘extraneous’ aspects?
IMD Survey Questions
• Business Regulations:
“Regulation intensity does not restrain
the ability of companies to compete”
• Labour Regulations:
“Labour regulations do not generally
hinder business activities”
OECD Regulation Indices
• Product Market Regulation (Conway et al., 2005):
index designed to reflect the extent to which the
regulatory environment is conducive to
competition including indicators of state control,
barriers to entrepreneurship
• Employment Protection (OECD, 2004): index
designed to reflect legislation as employer-borne
tax on employment adjustment including
difficulty of dismissal and extent of severance
pay
Is the UK Lightly Regulated?
• OECD measures say yes
• Subjective indicators more equivocal,
cf. IMD scores where UK has been
slipping down the league
• Overall, within OECD UK closer to
‘relatively liberal’ group including
Australia, Canada, Denmark, Ireland, USA
than the ‘relatively strict’ group including
France, Germany, Greece, Italy, Portugal
and Spain
Business Regulations, 2005 (0-10) (Source: IMD, 2005)
Belgium
Italy
France
Germany
UK
Greece
Spain
Netherlands
Ireland
New Zealand
USA
Japan
Portugal
Canada
Switzerland
Australia
Sweden
Austria
Norway
Denmark
Finland
0
1
2
3
4
5
6
7
Labour Regulations, 2005 (0-10)
France
Germany
Belgium
Portugal
Spain
Greece
Netherlands
Sweden
Italy
Australia
New Zealand
Norway
Finland
Ireland
UK
Austria
Japan
Canada
USA
Switzerland
Denmark
0
Source: IMD, 2005
2
4
6
8
10
Product Market Regulation (0-10)
1998
2003
France
4.17
2.83
Germany
3.17
2.33
Italy
4.67
3.17
Spain
3.83
2.67
UK
1.83
1.50
USA
2.17
1.67
Source: Conway et al., (2005)
Product Market Regulation and Productivity Growth
• Regulation that creates barriers to entry raises markups and reduces innovation, investment and productivity
growth (Griffith and Harrison, 2004; Griffith et al., 2006)
• At the macro level de-regulation has been associated
with better TFP growth (Nicoletti and Scarpetta, 2003)
• Product market regulation is negatively correlated with
the contribution of ICT-using services to aggregate
productivity growth (Nicoletti & Scarpetta, 2005)
• UK shows up well on OECD measures compared with
other European countries
Multifactor productivity acceleration and product market regulation
Difference in average MFP growth rate between 1990-2000 and 1980-1990
Adjusted for hours worked
2
1.5
Australia
Canada
1
Ireland
0.5
Sweden
US
UK
Denmark
Germany
0
-0.5
0.3
0.8
1.3
1.8
Greece
Finland
2.3
Netherlands
2.8
Belgium
France
3.3
3.8
Italy
-1
Japan
-1.5
-2
Correlation coefficient -0.51
t-statistic -2.29
Spain
Portugal
-2.5
Product market regulation, inward oriented, 1998
Source: Nicoletti & Scarpetta (2005)
Regulation and the contribution of ICT-using services to
aggregate productivity growth
ICT using services, 1996-2001
Correlation coefficient: -0.62
t-statistic: -3.35
MEX
USA
1.3
AUS
GBR
0.8
IRL
SWE
CAN
NLD
0.3
JPN
AUT
NOR
DNK
FIN
CHE
KOR
BEL
DEU
ESP
ITA
FRA
-0.2
0
0.5
1
1.5
2
Product market regulation (inward-oriented), 1998
2.5
3
3.5
Source: Nicoletti & Scarpetta (2005)
Retail Trade: Labour Productivity Growth
(% per year)
1990-5
1995-2001
US
2.0
6.5
EU
1.7
1.3
Germany
2.8
0.7
UK
1.2
3.7
France
2.1
1.9
Italy
1.3
1.1
Source: GGDC, 2004
Implications for Regulatory Impact
Assessments
• The Competition Assessment component
is important
• In practice, “this is often cursory and there
is scope for more timely liaison with OFT”
(National Audit Office, 1006)
• Traffic Light Scores:
1
7
5
• Is the competition filter (5 yes out of 9) in
the RIA too weak?
ICT Expenditure and Employment
Protection Legislation
• Are inversely correlated
• Firing costs delay adoption of ICT … but
do not generally deter investment
• Effective use of ICT often involves
upgrading labour force skills and reorganization, i.e. labour turnover
Employment Protection Index (0-10)
1980
1990
1998
2003
France
6.50
7.05
7.00
7.00
Germany
8.25
7.60
6.50
5.60
10.00
9.45
7.50
4.85
Spain
9.55
8.70
7.00
7.50
UK
1.75
1.75
1.75
1.75
USA
0.30
0.50
0.50
0.50
Italy
Nickell (2005)
IT Expenditures and Employment Protection
Legislation
2.8
2.6
•US
2.4
2.2
2
•CA
•AU
•UK
•FI
•SE
•NE
1.8
•GE
1.6
1.4
•NO
•FR
•JA
Correlation = -0.72
1.2
•SP•IT
1
0.8
0.5
1
1.5
2
2.5
3
Employment Protection Legislation, Index, 1998
3.5
Reduction in PMR and UK Productivity
Performance
• Nicoletti and Scarpetta (2003) results
imply UK has had modest TFP growth
advantage over France and Germany in
the past 20 years
• This is reflected in decline in TFP (but not
other) component of labour productivity
gap.
A Decomposition of UK Labour Productivity Gap
(percentage points)
France/UK
Germany/UK
1979
Labour Productivity Gap
31
30
Labour Quality
6
5
Physical Capital
17
9
TFP
8
16
21
17
Labour Quality
4
4
Physical Capital
17
12
TFP
0
1
2000
Labour Productivity Gap
Note: In 1979 Germany is West Germany only.
Sources: Broadberry & O'Mahony (2006); Crafts & O'Mahony (2001)
Change in TFP Growth over 10 years from
Adopting Best Regulatory Practice (% points)
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
France
Germany
Source: Nicoletti and Scarpetta (2005)
Italy
Spain
UK
Conclusions
• Regulation does have implications for
TFP
• In particular, this is true of regulation
that inhibits competition
• Administrative costs of compliance
are not the key issue