Viewpoint° The World Bank October 1995 Note No.60 Post-Privatization Performance- Regulating Telecommunications in the U.K. Testing for regulatory capture AntonyDnes After privatizing British Telecom (BT) in 1984, to subject newly privatized utilities to a regu- the British government privatized all other ma- latory regime with two main elements. The re- jor utility industries in succession-gas in 1986, gime was designed to substitute for competition water in 1989, and electricity in 1990. Debates by encouraging the regulated firm to operate soon emerged about whether the benefits from efficiently, and to promote competition when- privatization in these industries have been eq- ever possible. The regulatory agencies adopted uitably distributed between shareholders and price capping (rather than rate-of-return regu- consumers. This Note discusses the post-priva- lation) to limit the exercise of monopoly power tization performance of BT, the longest-stand- and simultaneously sought to stimulate entry.2 ing privatized utility in the United Kingdom, to This regime was based in part on the U.K. shed light on some of the problems of regulat- government's view by the 1980s that technical ing privatized utilities. A recent event study of advances (fiber optics, for example) had weak- BT suggests that regulation has checked mo- ened traditional arguments for limiting entry nopoly power and that the impact of the in industries once thought to be natural mo- regulator's decisions has been heterogenous- nopolies. Even in utility industries still thought with some decisions favoring consumers, some to be natural monopolies (for example, gas dis- favoring BT, and some favoring BT's competi- tribution) because of the cost advantages of tors. This event analysis could usefully be ex- having just one firm operate, the government tended to the other utilities, which were came to believe that the cost control discipline privatized on different terms and are subject to exerted by competition would produce net ben- different regulatory packages. efits. Therefore, a key feature of post-privati- zation regulation has been the regulatory The problem of utility privatization agencies' assumption of antitrust responsibili- ties. The Office of Telecommunications Regu- Nationalized utilities invariably operate with little lation (Oftel), the Office of Electricity Regulation or no competition, as many are natural monopo- (Offer), the Office of Gas Regulation (Ofgas), lies or perhaps natural oligopolies. Competition, and the Office of Water Regulation (Ofwat) all where it is possible, cannot emerge until a pri- have responsibility for encouraging competi- vate market has been created. A privatizing gov- tion in their industry.3 ernment therefore is immediately subject to the criticism that it is creating private monopolies- There is at least some evidence that post-priva- especially when newly privatized utilities have tization regulation has checked monopoly to rebalance their charges-raising some and power. A series of decisions to open utility mar- lowering others-to remove the inherited cross- kets to competition gave the regulatory bodies subsidies that are a major financial liability.' a distinctly pro-competitive look. A notable early example of this pro-competitive stance With these hurdles in mind, the U.K. govern- was the October 1985 decision to grant BT's ment decided early in the privatization process only serious competitor, Mercury Communica- kEg fia Private Sector Development Department . Vice Presidency for Finance and Private Sector Development Post-Privatization Performance-Regulating Telecommunications in the U.K. tions (a wholly owned subsidiary of Cable and tial referee working to maximize the value of Wireless), the right to interconnect with BT's total output. This view tends to be regarded as local networks at advantageous access prices. naive by economists working on regulatory top- Comparable rulings from Ofgas have allowed ics, who often expect to find evidence of cap- entrants to compete in the supply of domestic ture or of regulation working as a tax and and industrial gas. The impact of post-privati- subsidy arrangement. zation regulation has not been uniform, how- ever. For example, BT benefited from the Testing for capture duopoly policy that limited its potential com- petitors to Mercury until 1990. And Oftel's plans One way to test whether a regulatory package to open the U.K. telecoms market (in practice, has been captured is to compare the stock mar- to U.S. cable operators) were not as tough as ket returns for a regulated company or group BT had feared. of companies over a long period with the re- turns for a comparable sample of firms not af- A recent detailed study of the post-privatiza- fected by the regulation. Abnormally high returns tion period assessed the overall effect of regu- could indicate capture by the regulated indus- latory events in U.K. telecoms.4 This study is try if they can be associated statistically with outlined below. changes in the regulatory environment (regula- tory events). Lower-level capture would be re- Regulatory capture flected in an association between returns and and the public interest individual regulatory events. A cumulative ef- fect from all the regulatory events is consistent Theories of regulation may be broken down with top-level capture (bear in mind that some into public interest and private interest ap- events will have a positive effect, and some proaches.5 There is also a mixed view,6 which negative). Standard statistical techniques exist argues that regulation should be seen in pub- for testing for association between regulatory lic finance terms as benefiting some groups at events and abnormal returns while controlling the expense of others. Among the private in- for the effect of other possible influences.8 terest approaches is the capture hypothesis, associated with the work of the late George Data Stigler.' This hypothesis is now generally un- derstood as arguing that it is in the private Event data for BT are available from the ar- interest of a vote-maximizing government to chives of the Financial Times or Wall Street allow regulatory programs to reflect the inter- Journal for the period 1984-94. A basic event ests of powerful electoral groups. A particular diary includes both regulatory and non- concern is that firms in a regulated industry regulatory events. An important nonregulatory will influence the regulatory environment in event that affected all quoted companies was their favor-or capture the regulatory process. the perturbation in stock markets in October This capture may occur in the legislature (top- 1987. Data on the daily share prices for a com- level capture), as policy is formulated and leg- pany are most conveniently drawn from a com- islation passed, or in the regulatory agency and mercial service such as Datastream. An event the ministerial decisionmaking (lower-level study also needs an index of normal market capture), as regulatory decisions are made af- returns for comparison, which in the United ter the regulation is in place. Kingdom is usually based on a market index such as the Financial Times Stock Exchange The private interest view is often contrasted Index of 100 leading firms (FTSE-100).9 The with the public interest approach that emerges technique, which may involve measuring thou- from traditional welfare economics. The pub- sands of changes in share prices for each com- lic interest view sees government as an impar- pany, has heavy data requirements. The use of a market index based on the FTSE- charges for Mercury, showed up as a robust 100 (but excluding utility companies) implies negative effect on BT's returns. Another signifi- that BT is in a risk class similar to that of blue- cant result that accords with expectations re- chip companies. That is in fact a reasonable as- lates to the ending of the duopoly policy in 1990. sumption if utilities' lower risk is linked to their Although it was always known that this policy monopoly status and, ultimately, to regulatory would end, press reports that its end was immi- tolerance of their situation. In explaining utili- nent in the period just before publication by ties' low risk, their monopoly status should be the U.K. government of a consultative paper, emphasized rather than the fact that they sup- "Competition and Choice," produced a signifi- ply necessities: after all, food retailers also sup- cant negative effect. The publication of the pa- ply necessities, but their returns in the United per in 1990 produced a robustly significant Kingdom have been anything but stable since positive effect on BT's returns that can be inter- they entered into a competitive price war a few preted as reflecting the removal of uncertainty. years ago. The use of the FTSE-100 allows iso- Similar relief among investors may explain the lation of abnormally high returns (or, indeed, robust positive effects on BT's returns stemming any reduction in the variance of returns) for from Oftel's decision at the end of 1988 to re- utilities attributable to their monopoly status. solve a lingering dispute over the nonprice terms for interconnecting Mercury. Investors also ap- Results pear to have been reassured by the outcome of the August 1992 negotiations between BT and In the event study of BT's post-privatization Oftel, which led to a decision not to refer BT to performance, the company's average daily re- the Monopolies and Mergers Commission turns turned out not to be significantly higher (MMC), the entity responsible for applying many than the market index, ruling out top-level cap- aspects of U.K. antitrust law-even though the ture. The results do not, of course, rule out the decision was also associated with proposals to possibility that BT had attempted such capture, tighten the price cap. wasting resources in the process. The decisions to liberalize private networks and Regulation may go through a life cycle, how- to license new mobile services (including Mer- ever, and can become lower-level captured "in cury) in mid-1989 and the publication of an- action" over time. Individual events or groups other consultative document taking a tough line of events may favor industry interests, creating on price controls in 1992 all appear to have short-term abnormal returns, even if abnormal had a negative impact on BT's returns. These returns do not show up for the full period un- events can all be reasonably regarded as regu- der examination. The event study for BT there- latory moves that oppose BT's commercial in- fore also examined the effects of particular terests. Another event that could be added to regulatory events by isolating the impact of min- this list is the February 1988 decision to relax isterial and Oftel decisions during 1984-94. The the rules on entry into satellite services, which event study showed few statistically significant favored competition from U.S. sources and had regulatory events affecting BT over the post- a negative effect. But it occurred too close to privatization period: of seventy-five identifiable an event that followed to allow reliable infer- regulatory events, only twelve were signifi- ences to be drawn. cant.'0 Furthermore, within this group of sig- nificant regulatory events, some were more At least two pro-competitive decisions appear robustly significant than others (as measured to have had a significant positive effect on BT's by standard statistical tests). returns. These are the decisions to suspend the monopoly on installation approval (January Reassuringly, Oftel's interconnection ruling in 1987) and to open the market to more competi- October 1985, which set low interconnection tion (October 1993). Another potentially posi- Post-Privatization Performance-Regulating Telecommunications in the U.K. tive event is the 1988 decision to open compe- tory function effectively and avoided capture. tition in specific services, although this event Although precise statistical tests need to be car- also is too close to another to allow reliable ried out for gas, water, and electricity,12 press inferences to be drawn. At first sight, these posi- reports suggest that a heterogeneous pattern tive effects are counterintuitive. But investors of regulatory effects also characterizes these may believe that creating a generally competi- utility industries. Thus, the post-privatization tive environment forces BT to become cost-effi- performance of utilities in the United Kingdom cient and ultimately improves its profitability. shows how decentralized regulation, based on price capping and promotion of competition, The event study of BT also revealed some "dogs can prevent privatized utilities from becoming that failed to bark.1' Threats by Oftel to exam- private monopolies. ine BT's prices or to refer BT to the MMC over pricing issues appear to have had no impact Illustration by Ruth Sofair Ketler. on BT's returns. These threats usually resulted C Cross-subsidycannotbe justifiedbysocial-welfareeconomic analy- in negotiated settlements, which sometimes had sis either. See D. Swann, The Retreat of the State (Harvester significant positive effects on BT's returns. This 2 Wheatsleaf, 1989). M.E. Beesley and S.C. Littlechild, 'The Regulation of Privatized outcome is consistent with the view that BT Monopolies in the UK," RAND Journal of Economics 20: 456-72, has earned normal market returns and with fi- 1989. nancial market expectations that BT will face SeejohnMooie, "The Success of Privatization" inJohn Kay, Colin -Mayer, and David Thompson, eds., Privatization and Regulation- such scrutiny. Announced revisions of the price The UK Experience (Oxford: Oxford University Press, 1986. John cap had no significant impact on BT's returns, Moore was financial secretary to the Treasury in the early Thatcher probably because financial markets fully an- government. A.W. Dnes and J.S. Seaton, "The Regulation of British Telecom: ticipate changes that hold BT to a normal mar- An Event Study," Discussion Paper, The Nottingham Trent Univer- ket return. Although not strictly regulatory sity, Department of Economics, Nottingham, March 1995. events, the commencement of share trading fol- See T. Weyman-Jones, "Deregulation," in P.M. Jackson and CM. Price, eds., Privatization and Regulation (New York: Longman, This series is published lowing the BTI, BT2, and BT3 share offers 1994). to share ideas and invite between 1984 and 1993 had no significant im- 6 See R. Posner, "Taxation by Regulation," BellJournal of Econom- discussion. It covers ics 5: 22-51, 1974. financial and private pact on returns. 7 G. Stigler, "The Theory of Economic Regulation," BellJournal of sector development as Economicsandsl anagementScience2: 137-46, 1971. well as industry and Conclusions 8 See Dnes and Seaton, "The Regulation of British Telecom." energy. The views The analyst must exclude the companies in the event sample from expressed are those of the market index. the authors and are not BT seems to have earned normal market re- to Sign/ifcance refers to statistical significance (that is, the associa- intended to represent turns for the most part and thus does not ap- tion could not have been generated by chance). SimilarLy, ro- an official statement of h bustlysignificantmeans thatthesignificance is maintainedthrough- Bank policy or strategy. pear to have captured the regulatory process. out different formulations of the economic model used in the There were no individual events suggesting the event study. Comments are welcome. early capitalization into share prices of antici- " "Is there any other point to which you would wish to draw my Please call the FPD attention.5" Note line to leave a pated future abnormal returns. And a detailed "To the curious incident of the dog in the night-time." message (202-458-1111) review of regulatory events revealed no clear "The dog did nothing in the night-time." or contact Suzanne pattern favoring or opposing BT's commercial "That was the curious incident," remarked Sherlock Holmes. (Sil- Smith, editor, Room ver Blaze, from the Vemoirs of Sherlock Holmes, by Sir Arthur G8105, The World Bank, interests. Moreover, since BT has not been Conan Doyle, 1892) 1818 H Street, NW, pushed below a normal market return, there is Work is being carded out by economists at the University of Ox- Washington, D.C. 20433, no evidence of capture by consumer interests. ford on a recent tightening of the electricity price cap. And econo- osmith7eworldhank.org. Instead, the regulatory pattern of events is het- mists, including the author, based at the Nottingham Trent Uni- ssmith7~~~~~~~~~worldban ~~~~~~~~~versity and Loughborough University of Technology are carrying erogeneous, with some events favoring BT, out studies of the post-privatization performance of all the SPrinted on recycled some favoring its competitor, Mercury, and privatized utilities. paper. some favoring consumers. Antony W Dnes, Professor of Economics, The The event study of British Telecom therefore Nottingham Trent University, Nottingham, suggests that Oftel has carried out its regula- England (email: EPA3Dnesaw@ntu.ac.uk)