I joined the distinguished line-up at the Regulatory Policy Institute’s summer conference on Diagnosing Regulatory Pathologies. Other speakers discussed problems with monopoly infrastructure regulation. I focussed on what goes wrong in regulation of competitive markets…

Competitive markets are great at discovering what customers want and getting it to them. Market forces discover not only the ‘stuff’ people want, but also when and where they want it, in how many colours, flavours and sizes, and what price they are willing to pay.

But competitive markets don’t get everything right all of the time. Regulators step in where markets have been shown not to work well (‘market failures’) and substitute regulatory judgement in place of market discovery. The challenge is to substitute for the right things, and judge well.

Can regulators out-judge the market?

Parliament decides which jobs to give to regulators, and which to leave to the market. Although this is typically done sector by sector, there are common themes around when regulators are asked to step in:

• Caveat emptor (or ‘consumers doing all the work’). This theme dates back to medieval regulation of weights and measures. Markets thrive if consumers aren’t constantly on guard against being ripped off, if they can trust that a kilo is a kilo, or a burger is made of beef. This motivates general consumer protection law, such as trading standards. It also motivates a much regulation in financial services – instead of leaving it up to consumers to work out who they can trust with their savings, the regulator steps in. But there is room for debate about where regulators should step in, versus where caveat emptor is the right approach – a debate playing out in relation to cryptoassets right now.
• Financial stability (or ‘letting companies go bust’). This can be motivated by concerns about fragility of the system (as with banking), financial costs of exit (as with retail energy), or social costs of exit (as with football clubs or children’s services). Instead of leaving it to the market to determine levels of capital, leverage, or risk – the authority steps in. There is of course a trade-off with competition: the stricter the financial requirements for running a bank, the harder it is to launch a new one. And public policy can swing between prioritising stability and openness, as we have seen in both banking and energy.
• Choice (or ‘choice overload’). As a rule, markets are great at delivering choice – which is why the convenience store on the corner carries six flavours of hummus. Yet in essential services sectors, such as utilities and insurance, policy-makers worry about ‘confusopoly’ and the ‘loyalty penalty’ – that too much choice is bad for those least able to navigate complexity, who get left with poor deals because they roll-over old contracts rather than shop around. There are market responses to complexity (for example comparison tools, best price guarantees) and a debate as to whether such features operate in or against consumers’ interest. There are also regulatory responses. In retail energy Ofgem limited the number of tariffs suppliers could offer, the CMA concluded this softened competition and reversed the move. In the end the Government imposed a backstop price cap to protect those on default deals. There is, it seems, no stable consensus about the competition-fairness trade-off.
• Market structure (or ‘bigness’). When the market yields a big 4 in audit or banking, a big 6 in energy, or gives Google and Facebook the lion’s share of online advertising – policy-makers can conclude that such concentration is neither desirable nor inevitable. The regulator steps in to make it easier for new firms to enter and for customers to switch, or very occasionally to break a big firm into smaller pieces. It is difficult to shift dynamics in markets such as audit and banking. And when the dynamics do shift – as they did eventually in retail energy – the results can be unpredictable. Competition did drive lower bills, but the savvy minority benefitted more than the inert majority. And spiking wholesale prices revealed the fragility of new entrants, reigniting the debate about stability vs competition.

Markets fail; so do regulators

Regulation is often seen as a response to market failure. The RPI conference explored how regulators fail too. And not just idiosyncratically but in characteristic ways – ‘regulatory pathologies’. Here are three that I would call out in regulation of competitive markets:

• The ratchet effect: The main problem is that it is easier to add interventions than to take them away, and sometimes the unintended consequence of the first intervention requires a second, and so on (for example, the market stabilisation charge in retail energy). Regulation accrues but does not dissipate naturally. This gives rise to periodic efforts to slash ‘red tape’ but these can be shallow and tactical – deep, strategic reduction or streamlining of regulation requires sustained and expert effort, and the experts in question are usually too busy regulating.
• The yo-yo effect: There is no stable consensus about what competitive markets do well, versus where and how regulators should step in. This is not surprising – it is a difficult question that cannot be safely explored in a lab setting, so it is inevitable that there are strong public and political reactions to both market and regulatory failures. But instability in policy settings is damaging to business and consumer confidence, both of which are vital for markets to work well. This is especially true for markets where decisions, assets and planning horizons are measured in decades rather than months or years – as in infrastructure and financial services.
• The Goldilocks illusion: Advocates for intervention can underestimate how hard it is to fine-tune competition, to find the Goldilocks point between stifling innovation and productivity on the one hand, and letting all hell break loose – hurting both consumers and businesses – on the other. ‘Sustainable competition’ is an appealing idea but an elusive target: competition is a powerful driver of change, but you won’t necessarily like everything you get. The development of the tech sector, largely unregulated, over the last 20 years is the ultimate case in point.

As policy-makers design frameworks for regulation in new areas (tech, digital assets, sustainability…) it is important to recognise and design for regulatory failure as well as market failure, and for recurring regulatory pathologies in particular. The RPI conference gave us important food for thought.

The RPI summer conference invited us to explore regulatory pathologies, but postponed the challenge of treating them till the next conference in September. I’ve done the easy bit…

Author

Mary Starks is a Partner at Flint. Mary helps clients anticipate and respond to regulatory developments and navigate complex regulatory challenges, engaging strategically and constructively to secure good outcomes. Mary was previously Executive Director for Consumers and Markets at the energy regulator Ofgem, leading Ofgem’s work on retail markets, innovation, vulnerable consumers and enforcement. Before that, she was the Director of Competition and Chief Economist at the Financial Conduct Authority where she led work on meeting the FCA’s statutory objective to promote competition in the interest of consumers.

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