RPI X Regulation Nick Crafts University of

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 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, %) 72/3 -78/9 +4. 2 78/9 -86/7 -93/4 -2. 8 +0. 1 +9. 0 78/9 -86/7 -94/5 +8. 2 +2. 0 +1. 5 78/9 -88/9 -97/8 -5. 0 +3. 8 +1. 8 72/3 -78/9 British Steel +3. 3 72/3 -78/9 British Gas +3. 0 72/3 -78/9 British Coal 86/7 -99/00 72/3 -78/9 British Airways 78/9 -86/7 78/9 -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) Total Factor Productivity Source: O'Mahony (1998) Labour Factor Productivity

Regulated Prices in the UK

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 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 (Mc. Guckin 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)

Labour Regulations, 2005 (0 -10) Source: IMD, 2005

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 Correlation coefficient -0. 51 t-statistic -2. 29 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 Product market regulation (inward-oriented), 1998 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 1998 2003 France 6. 50 7. 05 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 USA 0. 30 0. 50 Italy Nickell (2005)

IT Expenditures (% of GDP), 1999 IT Expenditures and Employment Protection Legislation • US • CA • UK • AU • FI • SE • NE • NO • GE • FR Correlation = -0. 72 • JA • SP • IT Employment Protection Legislation, Index, 1998

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) Source: Nicoletti and Scarpetta (2005)

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