Monopoly Power (MOP) and Market Power (MAP)

courts define “mop” and “map” in ways vague and inconsistent….WHY?: courts fail to recognize that they are just 2, nearly identical, manifestations of anticompetitive power, that could harm consumer welfare.

map = exercised by restricting one’s own output [= ability (thus, high probability) to raise prices above prices in a competitive market]
mop = exercised by restricting the output of one’s rivals [= ability (thus high probability) to control prices or exclude competition]

-An illegal attempt to mop/map occurs, only when there is a high probability that the defendant will succeed.

-Certain antitrust violations [ “per se” offenses], do not require proof of map/mop.

-antitrust is a “a consumer (<> padi’s wpi EEAC] welfare prescription: a practice restrains trade, monopolizes, is unfair, or tends to lessen competition, if it harms consumers, by reducing the value or welfare they would have obtained, absent the practice

For example, the Sherman Act shows that Congress intended the antitrust laws to protect small business to the extent that this could be accomplished without harming consumers.

Recognizing the distinction between map/mop, clarifies the definition of relevant markets, the measurement of market power, the treatment of unexercised market power, and competitor standing to sue.

A single firm or group of firms may profitably raise price in two ways:

a. it may raise price above the competitive level, directly by restraining its own output (“control price”). This is the classical or “Stiglerian” market power.

b. a firm or group of firms may raise price above the competitive level by raising its rivals’ costs, and thereby causing them to restrain their output (“exclude competition”). This is also called exclusionary or “Bainian” market power.

Either way consumer welfare is reduced, because output below the efficient competitive level denies consumers products that they value in excess of the marginal cost of production, and transfers wealth from consumers to producers.

In addition, for Bainian market power, production efficiency also is reduced.

map/mop can occur either independently or simultaneously.

Bork contends that “the only legitimate goal of antitrust is the maximization of consumer welfare.”

the trends observable in antitrust … are:

(1) a movement away from political processes, toward political choice by courts;

(2) a movement away from free markets, toward regulated markets;

The tension between economic freedom and regulation, mirrors the tension between liberty and equality.

competition and regulation have the same ultimate goals [ to prevent the illegitimate acquisition and exercise of market power, for an efficient allocation of resources]… but competition is the best way…. however, many transition and developing countries continue to be highly regulated, with large state-owned sectors and oligopolies or inefficient firms operating in markets insulated by barriers.

13 May 2021 FACEBOOK, INC and FACEBOOK UK LIMITED v. THE CMA

the Court of Appeal dismissed Facebook’s appeal against the decision of the CMA

. 2. Facebook completed a merger with GIPHY, Inc on 15 May 2020. On 9 June 2020, the CMA made an IEO (Initial Enforcement Order) against Facebook and GIPHY, for preventing “pre-emptive action”. CMA also appointed a Hold Separate Manager to ensure that GIPHY’s business was preserved as a going concern and operated independently from Facebook, pending its review.

3. Facebook paid some US$400 million for GIPHY, less than 0.5% of Facebook’s annual turnover. The Enterprise Act 2002 provides for the CMA to conduct a two-stage review of completed mergers. In Phase 1, it decides whether or not to make a Phase 2. In Phase 2, it decides whether “a relevant merger situation has been created” and, if so, whether that has resulted, or may result, in a substantial lessening of competition within any UK market. If it has, the Competition and Markets Authority can take action to remedy the substantial lessening of competition or to prevent any adverse effects of it.

5. On 26 August 2020, Facebook applied to the CAT for a judicial review of the CMA’s refusal to grant the derogations it had sought from the Initial Enforcement Order (IEO). Facebook said that the CMA’s refusal to grant its CarveOut Requests (COR) was irrational and disproportionate, and the IEO had freezed hundreds of Facebook’s businesses and more than 50,000 employees worldwide. Facebook contended that the restrictions “could not be rationally or proportionately justified because “the CORs would still preserve the CMA’s remedial options”. Facebook also argued that the CMA had wrongly demanded information about direct and indirect links between GIPHY and the Facebook business, before dealing with the CORs.

7. The CAT (Master of the Rolls) decided that Facebook’s case was based on two misapprehensions:

1-the powers of the CMA were not limited to requiring divestiture of GIPHY. The Enterprise Act 2002 allowed the CMA to remedy, mitigate or prevent adverse effects from any substantial lessening of competition. For example, if Facebook decided to abandon completely its own sticker library as a result of its acquisition of GIPHY, the CMA could, in theory, order it to reverse its decision.

2- Facebook had not properly engaged with the CMA. It had made CORs and then refused to answer the CMA’s questions….3- a consequence of the UK merger regime being prospective (forthcoming) is that the CMA is required to act quickly. That is why it has developed IEOs. But Facebook refused to cooperate with the IEOs. .

Accordingly, the Court of Appeal unanimously dismissed Facebook’s appeal.

Why Competition is Superior to Regulation :

Economic regulation (wrt competition) leaves a larger number of people with a reduced real income and a lower standard of living; and imposes costs on society in terms of its establishment and administration, its distorting effect on ee, and the significant time and expense associated with its removal.
there are substantial dynamic costs associated with retaining regulatory regimes that stifle competition and innovation…..regulation won’t be efficient if it costs more than the harm that it seeks to address.
regulation cannot deal with ‘with the unexpected.”: eg. The Internet is based on an open competitive innovation between web sites. This competition is not just between commercial web sites. But, the US was not the first “online society”. Actually it was France, where a decade before the Internet was born, the Minitel system was in wide use. One could bank, book air tickets, find out information and so on over that network. But Minitel floundered. Why? Because it was a a monopoly run by France Telecom using a “locked in” technology. It couldn’t innovate, so it was slow and attempts to innovate got bogged down in committees.
generates better conditions for democratic institutions. This is because the democratisation and the decentralisation are mutually reinforcing.

4 Justifications for Regulation:

- to address market failure: public goods/services
- to advance the “wpi”
- to advance special interests
- to assist in the transition to a competitive market

Regulation to address Market failure : Types of market failure:

1-public goods/services :

Examples include national defence, parks, public schools, flood control protection, lighthouses, and road construction and maintenance (except toll highways).

Public goods are goods for which the marginal cost [the cost of extending the service to an additional person] is virtually zero.

so government must DECIDE [<> padi jr] what public goods/services are to be produced.

2- Natural monopolies: when it is less costly for a single entity to supply the entire market [than to have competition] e entities. Regulation, of prices or conduct, of the natural monopoly, tries to ensure that such monopoly is not abused. An example is electrical transmission.

3- High sunk costs: when prospective entrants into a market must incur high costs that they would not be able to recoup if they were to exit. Putting wires and pipes in the ground are examples of sunk costs, but so are the costs of learning and negotiating the regulatory regime that promotes confidence and predictability.

4- Demand side network externalities: giving rise to new natural monopolies, where there are enormous benefits to being a member of a network or standard. As the network or standard is embraced by more people or organisations, its value to existing members rises.

5-Supply side network externalities: when the cost of providing services to additional consumers reduces the overall cost of the network. As an existing network grows, potential competitiors cannot compete with the “first mover” or the growing network. The dominance of VHS over Beta is the most cited example of this type of externality. In emerging network industries, policy-makers are still unsure whether to allow competition to decide winners and losers, or whether to regulate (cl and policies)

6-information asymmetries. Such asymmetries can lead consumers to under or over consume, or even be victims of fraud. thus, professional standards, product labelling, deceptive marketing practices and securities trading need to be enacted.

7- when government attempts to promote competition between state-owned enterprises (SOEs). This type of a situation is difficult to sustain over the long run because the implicit or explicit guarantee against bankruptcy and mandate to maintain employment create incentives to predate that are much stronger than for profit-seeking privately firms.

Thus, a market supplied by competing SOEs eventually descends into inefficient competition , incurring huge losses for taxpayers. Accordingly, creating competition between SOEs should only be considered as a short term step, in a longer process of privatisation and deregulation.

Regulation to advance the wpi:

Regulations related to health and safety, the environment, labour, food and drugs, transportation (e.g., airline, trucking and rail services), securities, insurance, health care and investment.

can be effected via legislation that establishes a licensing regime, prevents or requires certain types of behaviour, imposes foreign ownership restrictions, or imposes product or technical standards.

Unfortunately, in the pursuit of legitimate wpi goals, this type of regulation often distorts competition.

in the financial sector, regulation is for prudential reasons [=to prevent systemic instability]. Systemic failures in financial systems have proven to be very costly, with official “rescue” packages for failed financial institutions costing upwards of 20 per cent of GDP in some cases.

Thus, systemic stability is a legitimate wpi goal that warrants regulatory intervention. However, often have distorted competition to a greater degree than necessary, for example, by preventing foreign financial institutions from competing in various segments of the financial services industry, or by preventing competition between participants in two or more parts of the the financial services industry, e.g., between banks and insurance companies; or between banks and investment dealers.

Special Interest Regulation:

is to protect the interests of some participants in the economy at the expense of others. Examples of this include supply management schemes (which are common in the agricultural sector – for example, the dairy, poultry, pork, grain and fruit industries), labour codes, licensing regimes which make it difficult for foreign and other firms to enter markets (these types of restrictions are common in the transportation and financial services sectors), product and technical standards (common in the construction sector) and foreign ownership restrictions (can be both wpi and special interest) e.g., the desire to promote a national champion or local employment, can coincide with the special interest in protection from competition.

Unfortunately, special interest regulations cannot simply be eliminated by a government….an alternative would be to amend them to minimise their adverse impact on competition.

the legal instruments establishing the regulatory regime should include, as one of their objectives, the promotion of ee, and, if possible, competition in areas not subject to regulation.

these legal instruments, as well as the regulator’s policies, practices and procedures, should be highly transparent and predictable, giving domestic stakeholders and foreign investors confidence that the rules will not be arbitrarily changed.

competition should be introduced to all activities, except to natural monopolies, to the maximum extent possible. This includes minimising any restriction or distortion of competition to achieve environmental, social or other wpi goals. 2 steps :

1/ identify segments of the industry or market that can support new or more competition, and

2/then, introduce or expand competition within those segments.

The onus (of proof of need for wpi regulation) is on those who wish continued regulation…. The onus should not be the need for competition.

A good example : changes to the manner in which electricity is metered, can affect purchasing behaviour and the overall efficiency of the industry: If electricity use is priced minute-by-minute, as opposed to the month-to-month, the peaks in electricity demand to be blunted and generator firms would have less market power because customers can respond to high prices by reducing their demand, so the overall costs of the electricity system also can be lower.

Even if a segment of an industry or market displays natural monopoly characteristics, competition can increase the efficiency of the regulatory regime. This can be achieved by creating competition for the market, for example, by auctioning off the right to be the monopolist supplier.

Finally, competition and efficiency can be increased by minimising the transition period (from regulation to competition). In some situations, regulation can be removed overnight, whereas in other situations is best to do it slowly

the three pillars of successful regulatory reform:

a. establishing the right market structures,

b. establishing the right rules

c. establishing the right regulatory institutions.

a. establishing the right market structures:

privatising a monopoly is a poor policy because it normally takes a very long time for monopolies to be eroded, and not much time for privatised monopolists to establish private regulations (competition restraints) to replace the former public regulations.

Accordingly, is best to break up a monopoly into a number of competing firms before it is privatised and/or deregulated.

the right structural conditions for competition, particularly in industries where there are significant economies of scale, is to remove regulatory impediments to entry by foreign or other potential competitors.

In addition to creating the right horizontal structure, it is important to make sure firms create separate subsidiaries for regulated and non-regulated activities, and ensure such structural separation is maintained, since is crucial that costs are properly allocated between competitive and regulated activities.

b. Establishing the Right Rules

an effective domestic competition law, minimising the number of exemptions from that law and making a vigorous enforcement.

domestic competition laws should be enacted as early as possible in the market opening process.

Where prices in one part of an industry (for example, long distance telephone services) have artificially subsidised prices in another part of the industry (for example, local telephone services), it also is important to adjust prices in the subsidised part of the industry to reflect their underlying costs. In short, suppliers should recover the costs of each product through the prices charged for that product. This will have the salutary effect of eliminating a strong disincentive to efficient entry by new competitors in the market for the supply of the subsidised product.

set a clear time limit ( a sunset clause) on the transition period as a whole or on certain aspects of it. Where clear time limits are not appropriate, clear milestones should be established

include “carrots and sticks” in the transitory regime, to provide incentives for the incumbent firm(s) to reach the milestones as quickly as possible.

a code of conduct can reduce regulation, such code would be oversight by an independent party.

anti-competitive conduct should be dealt with by the domestic competition law, rather than by the regulator

c. Establishing the Right Institutions

Regulatory institutions should have budgetary independence, and also independence from the enterprises they regulate, and from government….exception: if legislation requires the regulator to make decisions based on a wpi test, then government input might be desirable, to safeguard democratic legitimacy.

regulators must be given sufficient powers to obtain the information they require to make their decisions. This includes not only powers to compel oral testimony or representations, but also written submissions and paper or computer records or other documents.

CAs should be under a duty to protect the public from anti-competitive conduct and mergers while giving the sectoral regulator responsibility to control pricing by natural monopolists of former monopolists that are still dominant.

Competition and Universal Service (US)

A big challenge in designing regulatory reform in developing countries, is how to ensure US (uneconomic for firms)….under competition, firms would supply US only to the rich, and leave the poor out….thus, a well-designed US regulation is needed, to make Universal service and competition fully compatible, and competition can reduce the cost of providing universal service….so, how should US be designed?:

Poorly designed subsidies can have unintended effects. For example, if only a fraction of the population can afford (subsidised) telecom services, then it is really a subsidy from the average taxpayer to the rich. … thus, public subsidies should be granted via auctions, where firms bid for the lowest subsidy, to provide the (uneconomic) US.

Utility regulation

began in the UK in the 1980s when the Thatcher Government started privatising the previously nationalised industries, beginning with telecoms. they were all monopolies.

-utilities crave predictable regulation, and unexpected interventions lead to underinvestment

Ofgem

has long suffered from the trilemma that it is asked to achieve three key outcomes – sustainability, security of supply, and affordability. As each of these pull in different directions, it has become clear that Ofgem cannot avoid being constantly criticised

Faced with rising prices, some commentators thought, for instance, that Ofgem should re-regulate retail gas and electricity prices. Indeed, the Energy Act 2010 added the new requirement that before deciding to promote competition … Ofgem shall consider … to regulate….but Ofgem’s response was to remind them that all the evidence shows that competition is better than regulation at reducing prices, and that utility company profits are positively correlated with the amount of regulation. But critics then criticised Ofgem for not referring the energy market for a full CMA investigation, until it finally did so in 2014.

gov make PI policy decisions, (such as how much to subsidise the phone or energy bill of less affluent consumers, and/or those living in rural areas). Regulators implement those decisions

There therefore needs to be good communication between regulators and government, even if this detracts from regulatory independence. But politicians need to remember that – although it is tempting to use regulation as a taxation or redistribution mechanism, as it is easy for subsidies and policy costs to be hidden in regulatory determinations – it is undemocratic and unreasonable to ask economic regulators to make the PI policy decisions, specially because the regulator’s consultation on the choices is not transparent.

Huge costs associated with tiny improvements in drinking water quality, and in the quality of river and sea water, have led to huge increases in water bills. pushing for tighter environmental regulation, left the resultant costs passed on to consumers, via Ofwat’s price determinations.

the privatisation of UK utilities has had three conflicting objectives:

1.   To raise cash for the government
2.   To facilitate increased competition, and hence efficiency, better customer service, innovation and lower prices.
3.   To encourage wider share ownership.

so…the number of individuals who owned shares rose from 7% to 20% by 1997…. but is now back below 7%.

‘Regulatory asymmetry’ takes three main forms:

The regulated (eg utility) companies deploy huge resources – millions of pounds. In contrast, the two main consumer bodies (Consumer Focus and Which?), and even the specialised consumer bodies such as the Consumer Council for Water, have only a relatively tiny numbers of resources.
The utilities’ monopoly of information (aka information asymmetry*).
Regulatory policy is implemented by the same cos who deliver it. This leads to the larger companies having a big say in how regulatory, environmental and social objectives are delivered – a much bigger say than consumer bodies.

This leads to quite a dilemma for regulators. In practice, therefore, the regulators generally see themselves as representing consumers – or at least the wider public interest – against industry opposition.

*OTHER INFORMATION ASYMMETRY

switching is harder for those with low incomes, poor numeracy, and/or limited access to the internet. eg. very high prices charged to those who pay for their energy via pre-payment meters….Energy suppliers and financial institutions often offer exactly the same product at wildly different prices to different customers. They exploit their customers’ ignorance or frailty in a way which verges on immorality.

PRICE CONTROLS

Unchecked market power (monopoly power) does not necessarily lead to price increases. The relative lack of competitive pressure can also leads to one or more of lower product or service quality, or a reduced product range, or poorer customer service. Price controls therefore need address all of PQRS – price, quality, range and service – for otherwise a tight price control will merely lead to greater problems

uk regulators impose price controls via an ‘Inflation-X’ formula:- prices are allowed to rise in line with an inflation index less an X% reduction each year, to pass on to customers the benefit of improved efficiency. The most common formula has been RPI-X but CPIH is gaining ground in place of RPI.

there are three main players in the regulatory contest: the company, its investors and the regulator.

Regulated companies kick up a fuss in price control discussions (with regulators), claiming that there is no way that they can meet the regulators’ ‘-X’ efficiency target, and trying to browbeat the regulator into making concessions. But when the new price control kicks in, the investors put pressure on the company’s managers to cut costs, so as to beat the price control and make extra profits

There are often then complaints that the companies are making excessive profits (albeit after charging lower prices) and the regulator responds by cutting prices yet further( in the next price control). The company then responds by finding yet more cost savings ….

(The devastating 2018 Paradise/Camp Fire in California was caused by sparks from power lines due to cutting maintenance costs.)

this formula reduces the incentive to innovate and invest in the short term, even though such investment might benefit both consumers and the company in the longer term.

Ofgem faces tricky decisions about whether it should incentivise investment in renewable energy. Why should the regulator ‘tax’ all gas and electricity customers in order to meet ‘green’ targets? Shouldn’t such taxation be imposed transparently by Parliament?

How Are Price Controls Calculated?

The level of permitted prices is generally calculated by adding together:

Operating Expenditure,
Capital consumption (depreciation and the like), and
Financing Costs (dividends, interest etc.) Financing costs are assessed by applying an appropriate rate of return (the Cost of Capital), to the Regulatory Asset Base (the RAB). the RAB can include wasted capital expenditure, such as the large amounts of money that owners of Stansted Airport spent on seeking permission to build a new runway. Even though those plans were abandoned, the costs were still remunerated within the RAB.

The result is a permitted average annual price rise of RPI-X ,which often has to be apportioned amongst various products, so that some prices may rise a little faster than RPI-X as long as others rise less fast than RPI-X.

The NAO criticised Ofgem’s 2013-2021 distribution rail network price control, saying that: targets were set too low, budgets too high, and if the information available had been used on financing costs, for example, could have saved consumers at least £800 million.

Revenue Forecasts

Regulated companies will sometimes forecast reductions in revenue, such as fewer passengers following the Covid pandemic, or fewer letters following the introduction of email etc. They then claim that they need a price rise to compensate. This is wrong because the normal response to losing customers is to cut prices to attract them back. Ever-increasing prices and ever-decreasing customer numbers can rapidly lead to a corporate death spiral.

The Cost of Capital

Price controls in capital intensive industries – and most utilities are highly capital intensive – are greatly influenced by the Cost of capital.

even a 0.1% shift in cost of capital can hugely increase or reduce allowed prices – and hence profits. But… to estimate the cost of capital with of accuracy is nearly impossible….This chart which clearly shows that regulators’ estimates of the cost of capital have always exceeded the cost that they eventually met in the market.

Given that total regulatory capital was c.£200 billion, this (issue of regulators overestimating of cost of capital) translates into a transfer from customers to shareholders which cumulatively reached £s tens of billions.

Regulators, when challenged, point out that the risk could have fallen the other way (they could have underestimated the cost of capital), in which case customers would have benefitted greatly.

But this is incorrect, because regulated companies can apply to re-open price controls should significant unfavourable movements result which increase their costs significantly.

Customers should get refunds if the forecasts were seriously wrong.

interesting paper

Regulatory independence and accountability

gov found that regulation is more effective if de-politicised, so that regulators take decisions free from political interference. This also helps politicians avoid blame for unpopular decisions. And yet many regulatory decisions are essentially political.. as a result, some regulators are much less ‘independent’ than others.

Competition authorities are the obvious example of high independence, together with NICE and the medicines regulator (authorised use of the covid vaccines)…Successive Health Ministers have nevertheless managed to keep a reasonable distance from the decisions of NICE (the National Institute for Health and Clinical Excellence) which decides which treatments and medicines should be made available free of charge on the NHS. nice approves the use of medicines and other treatments on the basis of calculations, not politics or popularity. this helps to avoid “postcode lotteries” and largely keeps politicians out of the process. …Commons debate MPs of all parties lined up to criticise NICE for not providing drugs for a range of rare conditions afflicting their constituents. funding medicines on the basis of what you think “people on the street” want would be a step backwards. Britain may be sick of experts, but getting rid of them is no way to help the sick…..A Home Office white paper on immigration last year said that ministers wanted fewer migrant workers because of “the public’s view” that foreign labour drove down wages — something the government’s own economic evidence does not demonstrate

regulators have to make political decisions, for which they have no democratic mandate, but they need to look to government for guidance and expectations, which reduces their independence.

But it is clearly not possible for politicians to assert that they have washed their hands of responsibility for PI decisons by regulators…..eg sos for Health and his officials should take responsibility for, and do something about, the NHS’s many failings.

The huge expansion in regulation has caused growing concern about

the burden of regulation, and
the accountability of the Regulatory State,
Is the independence of regulators from government quite as strong as it is supposed to be?

this “State within a State” is how gov delegate politically difficult decisions (eg. control of interest rates; choice of medicines available through the National Health Service).

All the utility regulators have wide powers, such as the power to establish price controls etc. for the companies which they regulate. Some, such as the energy regulator Ofgem, can go further and make laws, in the form of Statutory Instruments, albeit subject to the approval of Parliament. The CMA can establish a price control or require businesses to behave in certain ways, and is binding on companies and individuals – and require no parliamentary approval whatsoever.

too much power is in the hands of regulators, without proper political oversight.

To save ministers from blame, regulators became over-accountable – in particular to the courts and via the media. this affects their transparency and causes bureaucracy.

regulators’ ‘sponsoring’ gov department:

promotes the legislation which specifies and constrains the regulator’s duties,
makes the most senior appointments (e.g. to the regulator’s Board) and approving other senior appointments (e.g. of the Chief Executive),
controlls the regulator’s budget, often via approving the corporate plan etc., and
sets the regulator’s senior salaries.

regulators can only, ultimately, be as independent as minister will allow them to be.

Why Independence is Important

regulators should be totally divorced from short term political pressure, ow they cannot be trustworthy….Examples:

the Bank of England – for failing to raise interest rates in 2010 and 2011 for fear of damaging the prospects of economic recovery, despite their main purpose being the control of inflation.
the Financial Reporting Council – for allegedly regulating the big four accountancy firms in a quite gentle way, for fear of damaging their health and maybe causing one of them to fail, so reducing competition even further
Ofgem – for paying too much attention to their subsidiary objectives – such as encouraging low emission generation and protecting vulnerable customers – at the expense of their principal objective of encouraging efficiency and low energy prices.

also, companies prefer the more expert, better decision-making that emerges by keeping politicians well away from setting price controls, merger control etc. politicians bestowing independence on a regulator shows commitment to good decision making. Politicians also welcome being kept well away from the complex investigations

Independence of Financial Services Regulation?

The most serious recent threat to regulatory independence arose before the 2007 Financial Crisis when financial services regulators became under government pressure to apply ‘light touch’ regulation to banks etc.

Ofgem, too, combines a large number of government functions with a more traditional utility regulatory role. It now works very closely with the Energy Department and big energy investment decisions have in effect been nationalised.

Ofsted is now little more than an agency of the Department for Education. It is told what to do by the department, and is severely resource constrained.

Much the same applies to Natural England. the agency’s grant had been cut by 45% over the previous five years and its HR, financial, press and communications functions had been moved into Defra.

Pollution

‘The polluter pays’ sounds like a simple and attractive rule, but it quickly unravels. because the attempt to handle environmental problems through legal processes has not worked well : How long and indirect can the chain of consequences be? Were the emissions caused by the electricity-generating company, or by whoever sold the polluting fuel, or financed the power station, or used the electricity – or by all of these?

An American attempt to pursue the legal route – through the ‘Superfund’ – only achieved that the funds intended to benefit victims of pollution have ended up in the hands of lawyers, and have increased business uncertainty by holding individuals and companies liable for events long in the past.

why regulated firms EXHIBIT WICR ?

a regulator thinks in terms of long-term value whereas lenders and rating agencies care more about short and medium term. When these two worlds collide, a regulator can find it is unable to satisfy rating agencies’ ratios and is forced to assess what steps it should take to discharge its duty to secure that companies are able to get finance…..therefore, regulators should bring forward part of that compensation, to eliminate the [wicr = mismatch [in the timing of compensating lenders for inflation financing]

When a company is not able to accommodate the real/nominal mismatch, the regulator has a legal duty to explain how to finance its activities

shareholders injecting new equity is a viable option, [and attractive because it permits regulators to hold prices low in the short term].

why regulators bother examining short-term financial ratios at all. ?….

regulators could be capturing short- term benefit for customers, at the expense of higher prices in the medium to long term.

– three key questions:

why do regulated companies sometimes fail financial ratio tests?
is it right for regulation [in solving financeability issues] to reach to the choices, actions and identity of shareholders?
why problems caused by a mismatch [in the timing of compensation for inflation] should not be solved by resolving the mismatch?

The real/nominal mismatch:

the origins of financeability problems lay in a mismatch between the real rate of return [that regulators incorporate into price limits] and the nominal interest payments [that companies make to most lenders]. .. the real/nominal mismatch is artificially constraining companies’ ability to borrow…..this puts responsibility on the regulator because companies would not be failing financial ratio tests if it were not for the way in which regulators set returns.

Impact on customers

At a time when there are genuine concerns about the affordability of water and sewerage services, using the capital markets to finance companies through a period of tight cashflow minimises upward pressure on prices. this means that customers barely notice the financeability issues that businesses are encountering.

What is important is whether new equity finance is provided by existing shareholders or new shareholders….

existing shareholders see their property rights eroded if they do not participate in an equity raising exercise initiated by the industry’s economic regulator. These persons are faced with the choice of buying shares that they would otherwise prefer not to buy, or seeing their stake diluted by new shareholders….If the affected individuals are very small shareholders, this is not a major issue. But if the people affected are large shareholders, a regulatory equirement for new equity mY alter a company’s ownership..In making equity injections mandatory, Ofwat is saying that it is okay to force shareholders to choose between further share purchases, and/or dilution of control.

a regulator has no right to force these choices

shareholders will respond to the risk of forced equity issuance, and/or forced dilution, by demanding additional returns from the companies…..but…crucially, this will eventually feed through into the bills that consumers pay

investors can, of course sell shares. But this brings us back full circle to Ofwat interfering in and destabilising ownership

regulators should regard the timing of income streams as crucial to their decisions. …if not, cocoo will foc wpi v tegs, to protect consumers

-are Ofwat’s assumptions about the quantum of index-linked debt issuance reasonable? ( this can be verified empirically.) …No

. If companies are paying the costs of inflation now, then it’s wrong for the regulator to provide for compensation in future , if ever. This is distorting future competition, by giving price limits that include only a real rate of return, when new entrants will be forced to recover their financing costs as they are incurred.

the real/nominal mismatch creates a duty on the regulators to explain why they set price limits in the way that they do….when there are better alternative ways of compensating for inflation, which do not create the weakness in cashflow

REGULATION. Wicrs.