this chapter considers the issues faced by regulators in attempting to establish appropriate standards for the quality of service provided by network companies subject to price regulation. It begins by considering why the separate regulation of service quality arises as an important issue in price-cap regulation. It then considers the options available to regulators in attempting to address this prob-lem. In each case practical applications of how regulators have addressed these problems are described, drawing examples from the water, electricity, rail, tel-ecommunications and postal sectors.
The problem of service quality when regulating prices
Stephen littlechild’s original conception of price-cap (rPI – X) regulation for bt was that it provides a simple mechanism that creates incentives for the regu-lated company to become more efficient, because by reducing costs the firm is able to increase its profits and retain this increase, at least until prices are re-set at a subsequent review (littlechild, 1983). this may be adequate in simple textbook examples, but when applied in reality regulators must also take into consideration the potential impact of price regulation on the quality of service provided.
competitive markets create incentives to reduce costs, because firms are price takers and cannot pass on excessive costs to their customers. In addition, com-petition provides incentives for companies to supply the quality of service that customers desire, because customers can choose to switch supplier if they are not satisfied with what they get. different firms may choose different trade-offs between price and quality, and in this way segment the market they are serving.
So provided there is no significant asymmetry of information between buyers and sellers there is every reason to expect competition adequately to address quality issues.
In contrast, while price-cap regulation alone can create strong incentives for companies to reduce costs, it may not send the right signals to the regulated company regarding the quality of service it provides. In general, when unregu-lated firms have market power, they may not have the appropriate incentives to set an efficient level of service quality (a useful review of the literature in this area is provided by Sappington, 2005). depending on the relationship between the marginal customer’s valuation of service quality and that of the infra-marginal customer, it is possible for an unregulated monopoly to choose either
too low or too high a level of service quality. this is because, in the absence of any additional attention to service quality the regulated company can increase its profits not merely by increased efficiency, but also by cutting back on the quality of service it provides.
there are many aspects of service quality which could potentially suffer in a regulated environment. of most common concern is the impact of price regula-tion on the reliability of the service provided. For example, the frequency with which the service is interrupted is a key aspect of the value of the service to end users in all network industries. there is every reason to expect that there is a link between the regulated company’s level of investment in network assets and its long-term ability to maintain a reliable service. Furthermore, reductions in operating costs may also impact on reliability or reduce the regulated company’s ability to react to failures or unforeseen events, thus extending the duration of interruptions even if the initial cause of the interruptions may be outside the company’s control (such as adverse weather bringing down power lines or a freeze–thaw causing pipe bursts and supply interruptions).
In some cases, for instance water supply and airport services, the quality of the product itself may be affected by the company’s efforts to reduce costs. the latter case presents particular difficulties because of the multi-faceted nature of the service being offered and difficulties in creating objective measures of quality.
In addition, the impact of price regulation on the way in which the regulated company deals with its customers is a material concern; in particular how the regulated company interacts with its customers across a wide range issues, in-cluding its handling of queries or complaints.
What are the options for addressing the quality issue?
the issue for regulators in choosing the appropriate instruments for promoting quality standards is to strike the right balance between the costs and benefits of intervention. Furthermore, it is necessary to ensure that any incentives put in place to improve service quality are neither so weak that they are ignored, nor so strong that they encourage the regulated company to ‘gold plate’ its service.
under price-cap regulation there may be some incentive to maintain service quality depending on the way in which investment expenditure is capitalized into the company’s regulatory asset base (rab). rather than cut investment to make higher profits in the short term, a company may choose to maintain (or increase) capital investment with the aim of earning higher profits in the long run.1 How effective this mechanism is will depend on the ability of the regulated company to pass these investment costs into its rab and the trade-off between the profit thus generated and the profits created by cutting costs in the short term.
analysis of the trade-off between the incentive to cut costs and the gain from
‘over capitalizing’ has tended to suggest that the overcapitalization incentive
cannot be relied on by itself to ensure adequate standards of service quality. For instance, laffont and tirole (1993) note that in the uS ‘there has been concern that “incentive regulation” … conflicts with the safe operation of nuclear power plants by forcing management to hurry work, take short-cuts, and delay safety investments’. In the uk an analysis of bt’s performance after privatization suggests that the incentive to reduce costs outweighed the incentive to overcapitalize.2
assuming that the incentive to raise investment in search of higher long-run profits is insufficient to ensure adequate service quality standards, there are a number of ways in which incentives to achieve particular service levels can be added to a price control regime, including:
1. the setting of legally binding targets for specific service levels, with the potential for legal action being taken against company directors in the event that the company fails to comply.
2. the imposition of customer compensation payments for service failure, intended to make the regulated company internalize the impact of service failures on its customers.
3. the inclusion of specific financial incentives in the price-cap formula, to encourage improvement performance by rewarding successful companies with higher profits.
4. the use of ‘peer pressure’ to encourage improvement, by publishing league tables of company performance against particular targets.
In designing the optimum regulatory regime, a regulator needs to take into consideration how effective each of the above options is likely to be in the rele-vant circumstances and the potential cost of falling short of (or exceeding) the desired quality standard (rovizzi and thompson, 1995).
In all cases, there are significant practical problems to be faced regarding the quantification and measurement of service quality and the relationship between the actions of the regulated company and the impact these actions have on service levels. this latter point is particularly important in the context of four- or five-yearly periodic price reviews. the national audit office (2002) noted that pipe and wire networks have an underlying resilience and it could take some time for inadequate or inefficient expenditure on maintaining them to be re-flected in declining performance against output measures. Hence regulators may be justifiably concerned that focusing on current service performance may miss the longer term picture as investment decisions in the present may be needed in order to secure service quality in the future, at a time long after the end of the regulatory price control period in question. How in these circumstances can the regulated company be given the incentive to invest sufficiently for long-term quality issues?
Binding targets
the first category, that of binding legal standards, is more akin to command-and-control rather than economic regulation. It is most an approach often reserved for that category of standards where the cost of failure to meet the necessary quality is unacceptable. obvious examples include drinking water quality and safety standards that apply in transport sectors like aviation and rail.
In most cases these standards will be defined by national (or eu) legislation and enforced by government agencies that are separate from the economic regu-lator.3 However, there is a feedback from this type of quality regulation into the activities of the economic regulator in two ways. First and most simply, these enforceable quality standards provide a framework that the economic regulator has to work towards in determining prices and spending limits. Second, and more contentiously, it falls to the economic regulator to decide what allowance in costs should be made for meeting the standards imposed by government.
taking the england and Wales water industry as an example, drinking water standards are enforced by the drinking Water Inspectorate (dWI), which can prosecute water companies for failing to comply with its instructions on water quality. on the other hand, price limits are set by the office of Water Services (ofwat), but dWI’s rulings are not legally binding on ofwat. ofwat takes the view that it will make allowance in price limits for ‘new Statutory obligations’, but will not fund compliance with existing standards. to do so might encourage water companies to let standards slip in the knowledge that ofwat would allow the funding of additional compliance work in the future.
In practice, however, this division of responsibilities from time to time leads to a conflict in approach between dWI and ofwat. one grey area arises when the dWI changes its view on the steps a water company needs to take to address a particular problem. In these cases, the dWI may order enforcement of quality standards that involves the water company in significant additional expense, but because the problem is a longstanding one, ofwat will not recognize these costs in price limits because it is not a new obligation.
the second conflict of regulatory approach arises when ofwat takes the view that the company’s plan to deal with the enforcement order is not justified on cost–benefit grounds. For instance, the company may be required to solve a water quality problem, but the costs of doing so are uncertain. the regulator may agree to recognize the cost of a pilot study to assess the total cost of com-pliance, but not the costs of actually complying, because those costs are as yet uncertain. this can leave a company in a regulatory no-man’s land as regards how to fund a legally binding obligation.4
Compensation payments
customer compensation payments have been extensively used as a method of inducing regulated companies to meet specific desired levels of service.
exam-ples exist in the uk electricity and water sectors, fixed line telephony (for bt) and postal services. In passenger rail, train operating companies (tocs) are obliged to pay compensation to ticket holders if individual trains are excessively delayed and also compensation to season ticket holders if the average standard of the service, in terms of punctuality and train cancellations, does not meet government set targets.
the underlying logic of compensation payments is that they cause the regu-lated company to internalize the social cost of poor quality service (in particular supply interruptions) into its planning. If the payment levels are set at the correct level then, in theory, the regulated company would have the correct incentives to provide an efficient quality of service.
there are, however, several problems with such an approach. First it may be extremely difficult, if not impossible to identify the ‘efficient’ level of compen-sation. In principle it would be as much a fault to set the compensation level too high and encourage excessive expenditure by the company to avoid the need for compensation as it would be to set it too low. Second, it may be difficult to get customers to be aware of the compensation they are entitled to, or to get them to go to the trouble of claiming, as the amounts involved may be relatively small.
third, compensation payments are only really feasible in the context of clearly identifiable events that can be attributed to particular customers, like supply interruptions. In the context of rail travel, compensation for late arrival is difficult as most rail tickets are sold on a ‘turn up and go’ basis, without seat reservations, which makes it difficult to prove whether a given individual was on a particular train.
In general, the uk experience is that compensation payments tend to be set at low levels and that the uptake of these payments is poor. both of these fac-tors tend to suggest that in practice compensation payments to customers have little impact on making regulated companies improve their quality standards.
For example, in the electricity sector Frontier economics (2003a, p. 31) found that ‘in a typical year the sums involved are not large in comparison to total price control revenue – tens to hundreds of thousands of pounds (price control revenue is typically £100–200 million per year)’. In the water sector markou and Waddams Price (1999) note that, in the early years after privatization, the uptake of payments under the regulator’s guaranteed Standards Schemes was poor. Indeed, the regulator is quoted as believing that those who made claims represented ‘only 1–2% of all the justifiable claims, and attributed the differ-ence to customer ignorance (only 15% know of the scheme) and/or a belief that the compensation involved (£5 for most claims) was not worth it’ (markou and Waddams Price, 1999, p. 387).
one issue that distinguishes compensation schemes is whether they are cali-brated to compensate consumers from the loss of value resulting from a failure
of supply, or merely to refund sums paid by customers for services that were not delivered. there can be a significant gap between these two figures. We would expect the value most customers to place on utility services to be sub-stantially in excess of the price paid. Hence compensation intended to reflect the social cost of a service failure should be significantly greater than the price of the service itself.
If compensation payments are small because they only reflect refunds of the sums paid by customers for short periods then this will exacerbate both the problems identified here: that payments are too small to make the utility change its behaviour and too small for customers to bother with claiming.
Examples of compensation payments
Water In 1989 the statutory guaranteed Standards Scheme (gSS) was intro-duced, offering financial protection to customers suffering from poor service.5 this initially involved fixed payments, which in 1993 was changed into an automatic compensation scheme, together with higher penalties and tighter targets.6
the current penalties under the scheme are summarized as follows:
l failing to keep an appointment: £20;
l failing to make a timely response to an account query: £20;
l failing to respond to a complaint within 10 working days: £20 for domes-tic customers and £50 for businesses;
l insufficient notice of a planned interruption: £20 for domestic customers and £50 for businesses, plus £10 (£25 for businesses) for each 24 hour period the supply remains interrupted;
l failure to restore supply in a timely manner after an unplanned interrup-tion: £20 plus a further £10 for each 24-hour period the supply remains unrestored for domestic customers; £50 plus a further £25 for each 24-hour period the supply remains unrestored for businesses;
l sewer flooding: customers may be entitled to receive a refund of their sewerage charges for the year up to a maximum of £1000 for each flood-ing incident;
l low pressure: if a customer is affected by low pressure on two occasions, with each lasting an hour or more in a period of 28 consecutive days, then the company must pay the customer, or credit their account, to the sum of £25.
Electricity as will be made clear in the discussion below, ofgem has placed more emphasis on incentives in the price-cap formula than on customer com-pensation as a mechanism of incentivizing improved service quality.
However, electricity customers do receive compensation for supply interrup-tions, which amount to £50 for domestic customers for a supply interruption of 18 hours and an additional £25 for each subsequent 12 hour period.
Fixed telephony/BT a formal customer compensation scheme was first intro-duced in 1989 by bt, which offered financial compensation whenever the specified standards of service in terms of line installations and repairs were not met. It has been subsequently extended and now makes up the customer Service guarantee, which specifies target response times for orders and repairs, as well as the speed of connection. In addition, it also guarantees compensation when a financial loss is incurred by a customer due to a failure of service quality. an example of the penalties paid under the customer Service guarantee following a line interruption and failure of repair is given in table 4.1. this quality meas-ure provides an integral part of the annual reports published by ofcom on telephone service.
Table 4.1 Compensation related to delay in repairing a line fault
delay Financial compensation
1–3 days one month line rental 4–6 days two months line rental 7–9 days three months line rental 10 days plus Four months line rental
Source: bt customer Service.
Post under its operating licence outlined in the Postal Services act 2000, in the uk the royal mail is responsible for service quality defined by the geo-graphical density of the postal service provided and by its standard in terms of delivery of post within a specified timeframe. Sixteen such delivery targets have been defined, examples being first class mail of which 93 per cent has to be de-livered on the next working day, and second class mail which has to arrive within three working days. In addition a ‘tail of mail’ target has been set out such that all post has to be delivered within three days of the expiry of the required standard.7
there are mechanisms to provide incentives so that these targets are met:8 these cover both formal adjustments to royal mail’s allowed revenue and a compensation scheme established in 2003 for retail and bulk users relating to delay, but not to loss or damage of items. retail users are entitled to free stamps or monetary payments if post is subjected to serious delay. compensation for bulk users is based on the extent to which royal mail fails to achieve the quality
of service target for each service. customers of any service which has failed its quality target by 1 per cent or more automatically get a refund of 0.1 per cent of their expenditure on that product that year for each 0.1 per cent failure.
compensation is capped at 5 per cent of spend. this cap is justified by the
compensation is capped at 5 per cent of spend. this cap is justified by the