What Factors Account For The Pressure To Change Regulation From A “Command And Control” Approach To “Incentive-Based” Regulation?

In the UK the Conservative Government’s large levels of privatisation and its desire to introduce competition to many industries since the 1980s resulted in a wave of regulation in order to ensure competitiveness and welfare. Until recently there has been a slow but steady growth in regulation. However, there was a shift in Government opinion, following Labour’s publication of Modernising Government in 1999. Like many other countries the UK has now accepted that there may have been too much regulation in many areas and that a more relaxed system built upon strong incentives, rather than a more commanding and controlling approach would be optimum. This is because the cost of regulation was spiralling out of control, with very inefficient and uncoordinated policymaking, as a result of old and duplicative regulations. The recent shift has been a relief to many firms who have lobbied heavily to reduce the burdens put upon them in the hope of increased profits. Also, supra-national factors, such as institutions like the European Commission and the European Court of Justice and global competitiveness puts a further impetus for governments to search for alternatives to heavy handed regulation.

Despite the potential benefits of privatisation there has been the spectre of price fixing, lack of investment and the disenfranchising of the poor, as firms may reduce welfare in order to make higher profits. Consequentially the Government created regulators such as OFWAT (water) and OFGAS (gas) to monitor the privatised firms’ industries and place demands on them. Regulators had roles such as enacting price ceilings or investment requirements, encouraging competitiveness and preventing the socially disadvantaged from loosing their services. Regulation also extended to the public sector, with huge guidelines to inspect areas such as education and the NHS and the ability to make changes to correct faults.

However, there are many problems associated with such regulation. An OECD report concluded that “The regulatory task of designing a pro-competitive system of regulation based on the separation of potentially competitive and natural monopoly sections of this type of sector was an unfamiliar one for governments and presented enormous technical and economic difficulties.”[1] Regulation had grown too large, with regulators increasing their organisations excessively as a result of poorly thought out policies which often duplicated costs because of mutual and overlapping interests between regulators. In 1997 there were between 14,000 and 20,000 regulator organisations, with annual costs of between £750m and £1bn.[2] The costs of regulations can be so great that it reaches ten percent or more of GDP in some countries.[3]

An overburdened regulatory network can easily create incoherent and time-wasting policies as a result of complex and uncoordinated procedures. Over time it can get progressively worse. The OECD argued that regulation becomes more complex as “pressures to compete and to coordinate are imposed on regulators at the domestic level” and that it gets worse as governments don’t give enough “attention to reviewing, updating, and eliminating unnecessary or harmful regulation.” [4]

The most striking reform of regulation introduced by Labour was Modernising Government in 1999. In order to address the aforementioned concerns, which even Labour had been previously guilty of, there have been some streamlining of policies and a removal of many burdensome regulations to avoid duplication and enable more effective policy direction. This opinion is backed up by an OECD report in 1997 which found that “reducing red tape and government formalities can produce substantial payoffs in government efficiency and economic cost-savings.”[5] As a result there have been mergers of departments, such as the coordination of electricity and gas regulation and fire safety reforms have been unified so as to create one simple risk-based fire safety regime.

However, the move from the more aggressive style of giving demands to firms and public organisations to the “light touch enforcement of regulation”[6] is likely to be more effective. Described by Hood, James and Scott as an aspiration to combine “the iron fist of Draconian central interventionism with the velvet glove of self-regulation,”[7] it involves transferring the main thrust of legislative effort on areas of higher risk and underperformance and allowing areas of low risk or strong performance to have less stringent reviews. For example, in 1997 OFSTEAD (the regulator for education) allowed plans for less stringent inspection of the best performing schools. Also the savings from risk-based audit and inspection of local government by the Audit Commission was reported to save £24m in government expenditure each year.[8]

There has been stronger pressure from the business community than the Government for a relaxation of its heavy-handed approach to some industries, as they have a strong financial incentive for deregulation. For example, the Government suggested that licensing reforms alone could save businesses £1.9bn in costs in the first ten years and an annual saving of £6.5m in court costs dealing with business tenancy reforms.[9] In other countries it can be even more beneficial, such as Mexico where in the late 1990s it could take up to a year and a half to set up a business.[10] It is also believed that price regulation “can restrict competition, or in the case of a monopoly reduce the quality of service,”[11] which would affect levels of investment in the future. Galli and Pelkmans even went on to suggest that the gap in EU and US productivity was as a result of lack of enough incentives in regulation.[12]

There is a constant concern that some regulators get too heavily influenced by the firms they are in charge of. They fall into the regulatory trap, whereby the regulator ends up setting ineffective rules but protects the interests of some firms in the industry. Gabriel Kolko[13] even went on to suggest that US regulation originated in self interested demands by business groups for government action to stabilise market shares, prices and profits rather than in public spirited campaigns to curb those interests. The development of the capture idea may have helped to catalyse the deregulation movement, with captured regulators being described as weak enforcers, being self defeating bureaucrats failing to balance costs of compliance against regulatory benefits and often offering ineffective programme design.[14] For Hood it was surprising that such ideas had failed to strike a chord with the Government by 1994.

Growing economic and legal integration in markets such as the European Union as a result of the European Commission and the European Court of Justice have increased importance on governmental policy and as a result they have modified “the range of options that governments can realistically pursue.”[15] Recent initiatives to improve the regulatory environment in the European Union and creation of a more unified market include the Commission’s White Paper on European Governance in 2001, which outlined an initiative to establish a new, coherent regulatory impact analysis. The European Court of Justice’s ruling in the Cassis de Dijon case in 1979 meant that one Member State’s goods could not be prevented from entering another in the absence of compelling national policy grounds (such as consumer safety). Consequentially there is less heavy regulation over quality standards in some states compared to others as firms have the financial incentive to comply with European standards in order to avoid the possibility of being refused import of goods.

There is a claim that economic interdependence as a result of globalisation and economic integration in the EU would result in countries having to lower their regulatory standards in order to attract (and maintain) capital and highly skilled labour in what is described as a race to the bottom. Using the prisoners dilemma, whereby two governments would end up with the worst outcomes through attempting to counter each other Radaelli cites how “the jurisdictional competition creates a position where everybody is worse off.”[16]

However, this is only a small factor explaining why there may be a desire to deregulate and create more incentives for firms. Radaelli highlights how welfare does not wither away, nor get distorted (by regulatory competition) to the point of the welfare system collapsing. This is backed up by Garret[17] and Swank[18] who also concluded that regulatory competition does not create such a bidding war. Heriter[19] even claimed that in order to assist their own industries governments would attempt to raise European standards to their own level in order to raise the cost of foreign producers so that domestic firms would be more competitive.

Business has been highly influential and the most eager in pressurising the UK Government to reduce its interventionist regulatory style in favour of a more incentive based system which offers leeway to efficient and competitive firms and public authorities. However, for a long time much of this pressure had fallen on deaf ears and was seen by the Government as a simple desire to extract extra revenue or an attempt to capture its regulator. It was a while before the Government came to realise that although regulation is highly important and is probably its strongest tool it had gone too far and that it was affecting its ability to make coherent and effective policy and at a large cost, as well as creating hugely unnecessary costs on business. Supranational institutions such as the EU are creating a more level playing field and have encouraged the reforms further. However, the effect of the race to the bottom for competitive regulatory standards is quite limited.

This report was written by Jonathan McHugh in March 2005

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[1] OECD Regulatory Policies in OECD Countries: From Interventionism to Regulatory Governance, (Paris) 2002. p100

[2] Quoted from Hood et al. Regulation Inside Government (Oxford University Press) 1999

[3] Quoted from OECD Regulatory Policies in OECD Countries: From Interventionism to Regulatory Governance, (Paris) 2002. p22

[4] Ibid. p109

[5] OECD Report on Regulatory Reform, Vol 2, (Paris) 1997

[6] Regulatory Reform: The Government’s Action Plan Internet (www.cabinetoffice.gov.uk/regulation) 2003.

[7] Hood, James and Scott, Regulation of Government: Has it Increased, is it Increasing, Should It Be Diminished? (Blackwell Publishers Ltd) 2000. p283

[8] Quoted from Regulatory Reform: The Government’s Action Plan Internet (www.cabinetoffice.gov.uk/regulation) 2003.

[9] Ibid

[10] OECD Regulatory Policies in OECD Countries: From Interventionism to Regulatory Governance, (Paris) 2002.

[11] Baldwin and Cave Understanding Regulation: Theory Strategy and Practice (Oxford University Press) 1999. p189

[12] Pelkmans and Galli Regulatory Reform and Competitiveness in Europe, Vol. 1. (Horizontal Issues, Cheltenham) 2000:

[13] Kolko The Triumph of Conservatism (Free Press) 1977

[14] Hood Explaining Policy Reversals (Open University Press) 1994

[15] Radaelli The Puzzle of Regulatory Competition (Journal of Public Policy, Col 23, No 1) 2003. p5

[16] Radaelli The Puzzle of Regulatory Competition (Journal of Public Policy, Col 23, No 1) 2003. p5

[17] Garrett, G Partisan Politics in the Global Economy (Cambridge University Press) 1998

[18] Swank Global Capital, Political Institutions and Policy Change In Developed Welfare States (Cambridge University Press) 2002

[19] Baldwin and Cave Understanding Regulation: Theory Strategy and Practice (Oxford University Press) 1999. p151