02 Mar 2010

(by Bruce Lyons) The perennial question in the regulation of monopoly prices is: what cost increases should a typically ill-informed regulator allow to be passed through to customers? BT wants to be able to recover at least part of its £8.8b pensions deficit by getting it can charge downstream rivals for broadband and telephone lines. In practice, this would raise the ‘X’ factor in the standard RPI + X regulatory formula.* BT claims that changes in government pensions policy and increased longevity lie outside its control. It points out that other businesses are also affected. BT’s regulatory contract currently takes no account of either pension deficit payments or previous pension holidays. Ofcom responded by consulting with ‘stakeholders’, thus implying they saw possible merit in BT’s case.

Hardly surprisingly, downstream users and competitors like BSkyB, Cable & Wireless and Carphone Warehouse are crying foul because the bill would land on their cost base. Their argues that much of the pensions deficit has been self-inflicted by: failure to plan for the original £0.6b privatization deficit in 1984 with index-linked gilts that would have generated a £4b surplus by now; a £2b underfunding of an early retirement scheme 1990-2004; and relying on only BT’s in-house investment expertise with the resulting costly mistake of increasing its exposure to riskier assets at the same time as the number of retirees was rising.

It is not the purpose of this note to weigh the details of each side’s claim as to the avoidability of pension cost increases. That would, of course, be central to a ‘cost plus’ approach to price regulation. But we have RPI + X in the UK which explicitly avoids the need to apportion costs. Of course, expected future cost increases are crucial for setting an appropriate X, but that is different. Increasing future X on the basis of past cost increases should only be considered if to do otherwise would significantly raise the cost of capital for BT and so the sustainability of low prices. It is far from obvious that BT’s credit rating and cost of capital depend on this decision.

Meanwhile, consider the following three sets of incentives for:

(i) private pensions management (i.e. BT’s adoption of sound pension contribution and portfolio management policy in the future);

(ii) static and dynamic allocative efficiency in downstream telecom services (i.e. both for BT and other providers); and

(iii) good corporate governance (i.e. for BT shareholders to monitor and incentivise senior management to adopt a long-term view, and not to grab short-term profits through ‘pension holidays’, etc).

In each case, and with an important demonstration effect for other regulated firms, incentives will be most appropriate if current customers are not made to pay for BT’s past mistakes – or even for a bit of past bad luck.

* RPI + X determines the rate at which regulated firms in the UK are allowed to adjust their prices. Price is allowed to increase at the rate of inflation (RPI) plus or minus some ‘X’ factor. Possible plus ‘X’ factors conventionally include investing in the network, in new technology or meeting environmental commitments. Minus factors generally include productivity gains or other cost savings.