In the next few days the heads of Britain’s regulators will be sending their replies to a letter from Keir Starmer in which, according to Sky’s Mark Kleinman, the Prime Minister has demanded that they “remove barriers to growth” and “submit a range of pro-growth initiatives.”
Recently I wrote a paper for the Social Market Foundation on the challenges for regulators and ministers in balancing economic growth, consumer protection and other political priorities. In this post I thought I’d set out some of the things they can do differently if they decide that growth is indeed their overriding priority.
I’ll start by assuming we are not talking just about maximising the total output of the economy in the current year, important though that is. (That kind of short-run growth is mainly driven by the business cycle or temporary fiscal or monetary stimulus.) Nor is it simply about the one-off increase to output that can come from getting more people working and for longer hours, either through active and flexible labour market policies or through more immigration. Instead, I assume the goal is to increase the long-run rate of growth of the British economy in line with the government’s mission for the UK to have the highest sustained rate of growth in the G7. As the Nobel prize-winning economist David Romer writes, ‘The welfare consequences of long-run growth swamp any possible effects of short run fluctuations’.
That means focusing on measures that increase not just output but productivity i.e. the output that can be produced per hour worked, which is something where the UK has been lagging in recent years. The best way to raise productivity is by investing in the inputs that can boost economic output. These inputs include physical assets like energy, transport and telecommunications infrastructure; innovation, such as in artificial intelligence (AI); and human skills and capabilities. That is why the Prime Minister and the Chancellor are right to put such an emphasis on the importance of investment.
In some cases, regulators get to influence investment directly e.g. signing off on the plans of companies that run regulated monopoly networks. In other cases they do so indirectly, by impacting the costs facing companies that might choose to invest in the UK, or by changing in other ways their perceptions of the UK as an investment environment. And in other cases, regulators can see what needs to be done but they do not themselves have the relevant statutory powers, so they will have to give advice to ministers on what is needed. When the regulators reply to the Prime Minister’s letter asking for ideas on what can be done to boost growth, they need to think about all three of these categories.
In those cases where a regulator has the job of signing off on investment plans directly, the choice is relatively clear. It can allow more investment and for more of the costs to be passed on to consumers. This is what Ofwat now appears to be doing in its current price review and it represents something of a departure from historic practice. After the utility privatisations of the 1980s and 1990s, economic regulators generally allowed for relatively low levels of capital investment on the basis that the job was to ‘sweat the assets’ and focus on securing operating efficiencies which could be passed on to consumers in the form of lower bills. In recent years there has been a greater acceptance among regulators that more investment is needed, either to renew crumbling infrastructure (e.g. in the case of water) or to meet new challenges (e.g. connecting renewable energy to the electricity grid). Regulators still need to ensure that the proposed investments are in the interests of the consumers and businesses who will ultimately pay for them, as otherwise the misallocated capital will be a drag on growth rather than a contributor to it, but where they are satisfied that the investment is needed they can allow it.
Regulators could also allow higher returns to be made on that investment (by forcing consumers and businesses to pay higher bills) and in some ways this would actually mean returning to a more traditional approach to utility regulation. Traditionally, when a regulator calculated the cost of capital of the regulated companies it would look at the various estimates provided by the companies themselves and also do its own analysis in order to end up with a range of estimates. Rather than choose a cost of capital at the mid-point of the range they would tend to ‘aim up’ because of the asymmetric risks. If the regulator’s designated cost of capital turned out to be too high, investors would earn too much money, but if it turned out to be too low, the companies might be unable to finance their functions and could go bust. That’s why regulators often thought it was safer to aim up, and so the unveiling of a new price control would often by followed by a share price spike at the listed companies, as investors calculated the regulator was allowing them to make more money.
In more recent years there has been political and public pressure to move in the opposite direction, especially in water where there were accusations that companies and their private equity owners had ‘profiteered’, so Ofwat took a tougher approach with the companies and put more of an emphasis on keeping bills down. Regulators could switch tack in order to allow more investment in the utilities but doing so will mean customers’ bills going up. That is unlikely to be popular so the chief executives of the regulators are going to have to make the case publicly for why it is the right thing to do and, even more importantly, ministers will have to back them publicly. If regulators are going to allow higher returns on investment, they will need political cover.
When it comes to the second category – regulation of companies that are operating in a market rather than as a monopoly – the challenge is different. Theoretically, the main protection for consumers in a market should come not from a regulator but from competition i.e. consumers’ ability to switch to a different supplier if they are unhappy with the price or quality of the product or service they are getting. However, regulators have been pressed to intervene more and more in markets over time. For banks, the global financial crisis led policymakers to conclude that they had taken on too much risk and that more stringent capital requirements were needed in order to make the system safer. In response to a range of scandals around mis-selling, the FCA has also imposed a wide-ranging obligation on financial services companies to ensure they are putting their customers’ interests first. For energy suppliers, the important nature of the service means they are required to hold licences which between them impose over 1,000 pages of conditions.
These regulations can help protect consumers – but they also impose costs and create risks. For a start, there are challenges in designing the regulation. On its own, a well-designed and appropriately enforced new regulation might seem sensible and might even have the backing of academic economists to give the proposal credibility. But new regulations tend to be created in the midst of media pressure and political lobbying, so what makes sense in economic theory might not be what ends up in the rule that is finally passed. Second, once a rule has been created companies face the direct administrative costs of complying with it. Third, there are the unintended consequences e.g. the companies might decide to reduce investment in the UK because of the higher costs or even exit the market completely; and the new rules might constitute a barrier to other companies entering the market, meaning competition is reduced. Fourth, the new rules might not eliminate the problem fully, or its knock-on effects might create pressure for the regulation to be tweaked (usually making it more complex), meaning the cycle continues. Fifth, there is the cumulative effect of regulations which individually might be sensible but which collectively undermine economic dynamism. Might there be a straw that breaks the camel’s back?
We have certainly seen that regulation tends to get more complex over time as more problems are identified which require more rules, or unintended consequences are found with existing rules which must then be fine-tuned, all enforced by a regulator which needs more staff to do it. The cumulative effect of this happening across a range of sectors is to increase the cost of doing business in the UK and to divert the attention of talented people from productive economic activity to rent-seeking.
These arguments are being made most strongly at the moment in financial services, with pressure on the FCA to deregulate in order to make the UK’s financial sector more competitive internationally. The FCA and other regulators can heed this pressure but we should not underestimate how tough this will be, both for the regulators and politicians. There is not a huge amount of obvious ‘wasteful bureaucracy’ and ‘red tape’ that can be cut painlessly. For the most part, regulations address identifiable harms and provide identifiable protections for consumers and citizens. I know from experience that it can be hard for regulators to resist the pressure to ‘take action’ in response to a perceived or actual consumer harm. That is why, again, if regulators are to resist pressure to intervene they will need the comfort that ministers will stand behind them when the going gets tough. In her Mansion House speech, Rachel Reeves gave a public indication that she intends to do so in the financial sector. She said, “The UK has been regulating for risk, but not regulating for growth”, that this “has gone too far” and that it “has had unintended consequences which we must now address.”
When regulators still identify harms that they think need to be addressed, they can try to do so where possible through one-off interventions, for example through the enforcement of competition and consumer protection law, rather than by creating new and permanent regulatory regimes. And when regulators intervene, they should remember that the behaviour of businesses and investors will be impacted as much by the process the regulator follows as by the final outcome. For example, in merger control, the number of deals ultimately blocked by the CMA is tiny, but if the initial announcement of an investigation comes as a shock, or if the process of the investigation is more onerous and takes up more management time than in other jurisdictions, it can still negatively affect perceptions of the UK investment environment. The CMA has recently undertaken a set of changes designed to strengthen the predictability, proportionality and pace of its work.
When it comes to ministers, they will likely find it easier to say no to pressure to create new regulations (and new regulators) rather than to try and remove existing regulations which now have vested interests behind their continuation. This is particularly relevant for the current government given the number of areas in which the Labour manifesto suggested it might introduce new or stronger regulation, including in energy, water, the private rental sector, building safety, children’s social care, further and higher education, gambling and football.
That leads us neatly to the final category, where the policy levers affecting investment are not in the hands of the regulators but of elected politicians. Several recent essays on this category of issues have been read by thoughtful policymakers in Westminster. In Foundations: Why Britain has Stagnated, Ben Southwood, Samuel Hughes and Sam Bowman have explained how investment in a whole range of areas, particularly in transport, energy and housing, has been made unaffordable and often entirely illegal and that this must be reversed. Planning reform is a very good place to start but there are more. Research has pointed to number of specific areas where the UK government or devolved administrations could take action in ways that would promote broadly-based economic growth, from transport infrastructure improvements in major non-London conurbations to regional distribution of public support for R&D. John Kingman has explored a number of these in a recent post on Comment is Freed, several of which would have a particularly strong impact on growth outside London, including transport capital projects like the Transpennine upgrade, an expansion of city devolution and a more sustainable university funding model.
What a lot of these proposals have in common is that they are politically difficult to implement, either because their supporters lack political capital or their opponents have a plentiful supply of it, or both. We have already seen that regulators need political cover from ministers in order to take difficult decisions. Well, here is where they can return the favour. When you speak privately to senior regulators, they often have well-informed expert views on how to improve economic performance, but they are wary of commenting publicly on policy issues that are outwith their narrow statutory remit, even insofar as they pertain to their own sector. Regulators could work with ministers to be public advocates of reforms that they believe to be sensible, lending their expertise as ballast in media and political debates. For example, Ofgem should have a strong interest in planning reform and the CMA’s microeconomic unit should be able to help ensure the industrial strategy is pro-competitive across a range of sectors. Engaging in areas of political controversy feels uncomfortable for regulators but it is a lot easier to do it at the current early stage in the lifetime of a parliament than it will be in two or three years’ time when a general election is closer.
Of all the sectors where these debates are playing out, the most important for us to get regulation right is in technology. The venture capitalist Ian Hogarth recently drew attention to the extraordinary contribution that the tech sector has made to economic growth in the United States. The US is home to eight of the nine trillion-dollar tech companies in the world and in the past two decades GDP growth has far outpaced that of the EU or UK. Hogarth writes, “Put simply, the economic benefits, not to mention national security and geopolitical benefits, of these companies are extraordinary – they’re a wealth engine to pay for other things a company might want to do.”
The importance of tech, including the potential of AI, means governments have a strong incentive to compete with each other to attract investment, including through their approach to regulation. Europe’s approach to regulation is often criticised – whether it is the EU’s Digital Markets Act or the CMA’s merger investigations into AI partnerships (and I will try to write a separate post on this soon) – but Hogarth also talks about the broader range of factors that have helped the US become so dominant in tech compared with Europe. For a start, it is simply easier to start a business in the US due to its fewer cumbersome rules. Its network of experienced founders and venture capitalists are willing to fund start-ups with more risk and for longer gestation periods. When companies are spun out of American universities, they tend to demand smaller equity stakes, which improves conditions for commercialising research. And the US approach to corporate governance has also helped, as it is easier for companies to stay independent for longer if their founders have complete control of their boards and can resist short-term investor pressure to sell early e.g. Mark Zuckerberg successfully managed this when Facebook rebuffed Yahoo’s attempt to buy it for $1bn in 2006.
In conclusion, we see that regulation can have a significant impact on growth, both positive and negative. But action cannot be left to the regulators alone. Some of the levers are in the hands of regulators but they involve sensitive trade-offs which will require political cover from ministers. In other cases, the levers are in the hands of ministers but regulators can provide expert advice and public advocacy for reform. These different parts of the British state will have to work together better in order to achieve the objective that they – and we – ought all to support.
