On regulatory capture

Why regulators work for the companies they oversee, and what to do about it.

Why are regulators so spineless?

I ask because Ofcom’s inquiry into X’s publishing child sex abuse material is likely to take some weeks, even after cajoling by the government, and is not expected to take strong action against the company. David Allen Green has written:

Ofcom may take decisive action against X, like requiring it to apologise in eight months on a webpage so buried that nobody will read it.

Such scepticism is based in the evidence that regulators have consistently given companies a free ride. Ofcom has repeatedly allowed GBNews to broadcast biased news. Ofwat allows water companies to jack up prices enormously whilst pouring shit into our rivers and sometimes not even delivering water. And Ofgem allows electricity companies to charge some of the highest domestic and industrial electricity prices in the world.

The reason for all this lies in a simple idea: regulatory capture. As George Stigler wrote (pdf) in 1971:

As a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.

Which is the case with UK regulators.

These aren’t captured because they are small organizations. They’re not. Both Ofcom and Ofgem employ over 1000 people and spend over £200m a year. If they were companies, they’d be among the 0.1% biggest in the country.

Instead, it’s for three other simple and related reasons.

One is that companies can buy regulators by offering them jobs. Most water companies have executives who previously worked at Ofwat, and bosses at Ofgem, CQC and Ofcom have also found work in the companies they oversee. Regulators know that they’ll be well rewarded if they don’t rock the boat.

Moralists might call this corruption, but it’s merely vindication of Adam Smith’s observation that people have a natural “propensity to truck, barter, and exchange one thing for another” - in this case, power for money.

Secondly, there are information asymmetries. Regulated industries know more about themselves than do outsiders and know better how to distort the presentation of this information to their own benefit. This puts them at an advantage over both regulators and the public.

Thirdly, there’s the collective action problem described by Mancur Olson. Small groups of individuals with a lot at stake find it easy to organize and lobby. Larger groups, however, do not, because for any individual the costs of organizing people outweigh the benefits. The result is that even if society as a whole would benefit from tough regulation, lobbying militates against it.

For these reasons, we should regard regulatory capture as the norm.

This is why I’m sceptical of the government’s promise to abolish Ofwat. Of course, Ofwat deserves to be blasted to oblivion, but the same pressures upon its successor to give water companies an easy time will continue.

It’s why I’m also sceptical about calls, such as those from Dieter Helm and Andrew Sissons and John Springford, for better regulation. Their ideas are good. But they are examples of what I’ve called “if I were king” politics. They assume that regulators could, with government encouragement, have the power and will to impose better regulation. But how could they given the forces towards regulatory capture?

We should instead ask: how could we put into place the socio-economic conditions which militate against this capture and so would make good policy possible?

It’s not good enough to call for more competition. True, competition is the best regulator. But well-functioning competition is not possible for many regulated companies. Water and electricity distributors are natural monopolies; it would be senseless to have many different pipes and wires. And media companies are insulated from competition because their rich owners are motivated not by profits but by the desire for political influence which means they tolerate the losses that would ordinarily drive bad companies out of business.

Instead, what we need is countervailing power. The idea here was described by J.K. Galbraith in 1952:

Private economic power is held in check by the countervailing power of those who are subject to it. The first begets the second. The long trend toward concentration of industrial enterprise in the hands of a relatively few firms has brought into existence not only strong sellers, as economists have supposed, but also strong buyers. (American Capitalism: the concept of countervailing power).

For example, he said, US Steel had a dominant position in supplying steel. But this was constained both by strong buyers such as General Motors and by a powerful trades union.

Our problem is that powerful regulated industries have not begotten any countervailing power.

Such power could consist of strong trades unions. These tend to reduce CEO pay, as remuneration committees are loath to pay CEOs a lot if they fear unions will demand comparable pay rises. And so unions might also curb incentives for managerial rent-seeking.

But we also need consumer power. We need organizations that give customers impartial advice on where to get the best deals on, say, electricity, broadband and phones. Such organizations could also become campaigning groups helping both to raise the political salience of the damage done by poorly regulated industries and to lobby regulators directly.

These organizations should be funded by consumers themselves. That’s because if we pay for something we’re more likely to use it and value it. Also, organizations serve their paymasters, so a consumer-funded group is more likely to act in consumers’ interests.

We could go further. In the early 20th century American farmers formed cooperatives to buy farm supplies. These solved two problems which face UK customers for many goods today. One was that of weak bargaining power: there were only a few large companies producing fertilizers and herbicides. In ganging together, buyers formed a countervailing power to these monopolies. The other was than of asymmetric information. Farmers often didn’t know which fertilizers were best for their soil and crops, or even what was in them. Employing specialist buyers renoved suppliers’ information advantage.

This principle extends. Not only does rural America have farm supplies coops but also coops for telephone services and electricity distribution. In the UK we have only one of the latter, Co-op Energy. But the number could in principle be increased, as a means of reducing customers’ informational advantage.

The problem is though that consumer groups - be they advice and advocacy or cooperatives - aren’t going to emerge unaided simply because of the collective action problem. They need government support. One way to achieve this is for the government to give people a small sum per year which they must spend on such organizations. Just £100 per household - £2 a week - would raise £2bn for these groups - more than enough to compete against regulators and industry lobbyists. That’s a small price to pay to get better functioning markets and to cut the cost of living.

But would a government want to do this? Such a plan would of course be resisted by industry lobbyists. And it would require a shift in the ideology of much of the political class, which is loath to grant power to ordinary people. On the other hand, though, it would retain what for governments is an advantage of the present system. “Independent” regulators allow governments to avoid responsibility for polluted rivers, high electricity prices or mendacious broadcasters; governments sometimes want strategic impotence and accountability sinks. Powerful consumer advocacy groups would retain these, with the difference that governments’ claim to impotence is accompanied by more powerful consumers.

It’s an open question whether such a system is politically feasible. But just be clear what pessimism about its prospects would imply - that UK capitalism is incompatible with a well-functioning market economy which gives customers a fair deal and reasonable prices.