ECO N O M I CS & REG U L AT I O N Building Trust in Regulation A global study of operator-regulator relationships A DVI SO RY © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION Contents Forew ord About the research Executive sum m ary Introduction 5 The state of relationships KPM G Com m ent: Working m ore constructively together 11 The consequences of m istrust 13 KPM G Com m ent: Em erging issues in em erging m arkets 20 The m echanics of trust 21 10 KPM G Com m ent: Building fi rm foundations for the regulatory process 25 11 KPM G Com m ent: Tackling uncertainty, safeguarding investm ent 27 12 The people factor 29 13 KPM G Com m ent: Converged data, im proved perform ance 31 14 Conclusion: A positive outlook for trust 33 15 Appendix: Survey dem ographics 35 © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION Foreword Trust is the glue that holds relationships together but also the lubricant that keeps things moving This study, from the Economist Intelligence Unit, commissioned by KPMG International examines the current state of trust between regulators and the industries they regulate around the globe Many of the findings relate to the need for better communication and ensuring that regulators and operators can establish a common understanding between one another: concerns that KPMG firms care deeply about and work with many clients to address While it is encouraging that levels of trust seem to be improving, these relationships can be extremely fragile Moreover, as global economic uncertainty continues, the potential cost of related regulatory uncertainty is an unnecessary burden at a time when investment and revenues are under threat Now, more than ever, trust between parties is critically important This is not to say that we all ‘hug a regulator’, or that we throw away robust regulatory strategies, or that regulators shouldn’t take decisions that might negatively affect certain stakeholders, but it’s the environment in which you communicate those decisions that is important: one characterized by respect We hope that the findings stimulate further thoughts in an area of consistent change and challenge and would be delighted to talk with you about what KPMG firms are doing to help our clients build levels of trust that enable better regulation and benefits to the economy Finally, I would like to thank the survey’s participants and interviewees for their time David Thomas Global Head of Communications Regulation, KPMG © 2009 KPMG International KPMG International is a Swiss cooperative Member firms of the KPMG network of independent firms are affiliated with KPMG International KPMG International provides no client services No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm All rights reserved BUILDING TRUST IN REGULATION About the research KPMG International commissioned the Economist Intelligence Unit to write Building Trust in Regulation The report is based on the following research activities: The Economist Intelligence Unit conducted a survey, completed in 2009, of 213 executives who are closely involved with the regulation of current and former utilities The survey brings together practitioners from both sides of the commercial operator-regulator divide, including 165 respondents from operators and 48 from regulators All are closely familiar with their organization’s key regulatory relationships, and they hail from five heavily regulated industries – telecommunications, power, water, transport and post The survey sample is global, with 36 percent of participants based in Europe, 23 percent in North America and 20 percent in Asia-Pacifi c A total of 77 respondents – 36 percent of the sample – are based in developing countries To supplement the survey, the Economist Intelligence Unit conducted a program of interviews with senior executives of both commercial operators and regulators in the aforementioned industries We are grateful to the survey participants and interviewees for sharing their valuable time and insights The views and opinions expressed herein are those of the Economist Intelligence Unit and not necessarily refl ect the views and opinions of KPMG International or KPMG member fi rms The KPMG comment sections were written by professionals from KPMG member fi rms © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION Executive summary Recent revelations of failures in regulatory oversight have helped to put regulation under the microscope Effective regulation resulting in effi cient markets, however, is the result not only of the regulator’s performance but also of the quality of interaction between the regulator and the market’s commercial players In heavily regulated sectors where existing or former public utilities are dominant – telecommunications, power, water, transport and post – and where policy reforms over the past two decades have created new regulatory bodies and competitors, relationships between regulator and regulated have frequently been troubled Trust is the foundation of any good relationship; it has arguably been in shorter supply among market players in these sectors than others, and the lack of it has stifled aspects of market growth even in fast-growing economies This study of operator-regulator2 interaction in five heavily regulated sectors reveals, perhaps surprisingly, a large percentage of regulatory relationships in which the parties deem the level of trust to be “ high” However, the research – based on a global survey of 213 operator and regulator executives, as well as a series of one-onone interviews with practitioners – also suggests that relationships in some sectors and parts of the world are weaker than others It also makes clear that, even where relationships are good, trust is an extremely fragile commodity which does not take much to undermine Mistrust often breeds uncertainty, which can have tangible negative consequences for market players Following are the main conclusions of the research: • Operator-regulator relationships are evolving for the better This is encouraging in a global context that has seen renewed calls for a more vigorous approach to regulating competitive markets More executives in our survey characterize the level of trust between operators and regulators in their sector as “ high” than those who think the opposite, and more participants believe that operator-regulator relationships are improving than those who see deterioration Operators are less satisfied than regulators with the levels of mutual trust, and operators in developed economies are not as positive in their assessments as their counterparts in the developing world But majorities of both operators and regulators in our survey expect improvement in their mutual relationships in the coming years • Breakdowns in trust often result from regulatory uncertainty, which can negatively impact industry development Uncertainty and a resulting loss of trust carry a variety of This study’s coverage of the power sector includes electricity and gas utilities In the transport sector the research focuses on railways, airports and other ports The term “operator” is used in this report to refer to commercial service providers in the five sectors covered by our research Other terms, such as “ utility” or “ company”, are also commonly used in different parts of the world to describe these entities © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION potential consequences for market players, from direct financial losses to an increase in litigation Operators in the survey cite the most frequent outcomes of regulatory uncertainty to be direct increases in cost, lost revenue, cancelled or postponed investments, business initiatives put on hold or increased litigation Taken at overall market level, the uncertainty can quickly translate into slower market development and service penetration • Achieving genuine trust between operator and regulator hinges on the development of a mutual understanding of each side’s objectives and constraints With each party’s perception of the other shaped by its own experience, culture and market interests, the ability to understand the influences and motives driving the other side is a vital factor in building trust Operators are adamant that regulators must achieve a greater appreciation of business operations and risks Regulators, for their part, insist that operators gain an improved knowledge of regulatory and policy objectives • Transparency of processes and clarity of the regulatory framework increase levels of trust The trust gap widens on issues that are susceptible to political influence and unpredictability, while routine, process-oriented interaction tends to proceed more smoothly for the parties For example, both operators and regulators highlight licensing as a largely problem-free area of interaction, with monitoring and compliance, consumer protection, and data transfer also proceeding relatively smoothly • Industry consultations, a key tool in building trust, will widen the trust gap if they are more form than substance While the survey revealed a consensus on the need for consultations on key issues, several operators voice concern with the consultation process itself, complaining that regulators treat consultations as no more than a formality Generally speaking, operators also tend to value informal consultations over the public variety By contrast, regulators seem more wary of such informal exchanges, which they see as contradicting the need for transparency • Processes and frameworks are important, but people and personal relationships are the critical ingredients in building trust Asked to identify the most important contributors to an effective operator-regulator relationship, both groups of survey respondents point with equal emphasis to good personal rapport between senior executives from both parties Strong personal relationships help to smooth potentially antagonistic relationships by offering each side some visibility into the motives and constraints of the other, and they ultimately help build trust among the parties • Trust suffers without strong mechanisms to share relevant and accurate information The provision of relevant information is another important rung in the trust-building ladder, but information-sharing remains an area of friction between operators and regulators There is a substantial gap between the regulator’s need of information to fulfill its mission, and operator willingness to share information, owing to concerns around confidentiality and relevance of information Ultimately, the parties must work together to make the informationsharing process productive © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION Introduction The role of industry regulation across the world has risen in prominence with an economic crisis brought about – at least in part – by regulation in a number of sectors that appears to have been inadequate to the task “As a consequence of the economic crisis, we are in a fundamentally different place than we were fi ve years ago,” according to Lord Carter, former UK Minister for Communications, Technology and Broadcasting, speaking of the challenges facing regulators and policymakers in today’s environment Rapid response to problems posed by the crisis is imperative, he says, but existing policy frameworks not necessarily allow for this Even prior to the global downturn, however, the fundamental nature of market regulation was already evolving in a number of industries Rapid technological change and increased competition broke the traditional, silo-based structure of the telecommunications market, for example In many countries, increased environmental concerns refocused regulation in the energy and water sectors even as they were being opened to competition Security considerations led to an expansion, in some parts of the world, of the regulatory purview in the transportation sector To societies and governments, the effective regulation of certain industries is a necessity in order to ensure that the latter’s services or products are made available to the population in as affordable, safe and efficient a manner as possible This is particularly the case when it comes to services provided by existing and former “ public utilities”, such as telecoms, water, power, post and transport The suppliers of these services and products also benefi t from good regulation in many ways, but many of the largest suppliers tend to view regulation less as a virtue than as an unavoidable aspect of doing business Over the past two decades, markets for these services have been liberalized to some degree in many parts of the globe, resulting in the emergence of competitors to erstwhile monopoly providers This has not only made the regulatory agencies’ tasks more complex, but has greatly © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION expanded the scope for potential confl ict between regulators and regulated In many heavily regulated industries, the numbers of people employed to deal with these issues – both at regulators and commercial providers (here termed “operators” for convenience of use) – have expanded in a like manner This expansion reflects a recognition on the part of both regulator and operator that smooth and effective interaction usually benefits both the industry as a whole and most of the players that operate in it In turn, effective regulation is now widely acknowledged as a core foundation of a sustainable industry growth framework operator is a crucial requirement of regulatory effectiveness Operators need to trust the regulator’s ability to maintain distance from both policymakers and other operators, to deliver consistent, timely and transparent decisions, and to have the requisite authority to oversee the sector Conversely, regulators need to trust operators to abide by established rules and be co-operative As this study makes plain, the ability to build trust in regulation requires enormous patience and fortitude from regulators and operators alike Even as regulators become more engaged, however, their effectiveness in increasingly competitive environments has become a function of their ability to act as – and be seen to be – independent arbiters In this context, trust between regulator and © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION The state of relationships The level of operatorregulator trust in the fi ve industries researched in this study is surprisingly strong in light of the expanding role of regulation across industries and countries over the past ten years More executives in our survey characterize the level of trust – between operators and regulators – in their sector as “ high” than those who think the opposite Similarly, trust-building seems to be moving in the right direction: more participants believe that operator-regulator relationships are improving than those who see deterioration While by no means glowing assessments of the mutual relationships, these findings are encouraging in a global context that has seen renewed calls for a more vigorous and potentially more intrusive approach to regulating competitive markets Lord Carter, for one, is not surprised by the improvement in relationships and the relatively high levels of trust registered in the survey One reason for this, in his view, is a vast improvement achieved in the quality of regulatory execution in recent decades “ In the UK and elsewhere in Europe, we have seen a ‘professionalization’ of the regulatory discipline in the last 25-30 years.” An increasingly professional and thorough approach on the part of regulators helps also to engender respect – and trust – from operators The assessments of trust are not uniformly positive across all groups of executives Operators, for example, are more guarded than regulators in their appraisal of existing levels of trust Among operators, views also differ between executives based in developing economies – where 42 percent of operators say relationships are improving – and those in developed economies – where only 23 percent say they are © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION 24 When the needs of transparency and confidentiality clash In a west European energy market where retail tariff changes are subject to regulator approval, an energy utility submitted a request for tariff adjustment To review the demand, the regulator noted the need to conduct further economic analysis and requested additional information from the utility, including some details on the utility’s cost structure The company rejected the regulator’s request, on the grounds that the information was of a sensitive nature and considered confi dential The regulator The adequacy of resources The quality of the relationship between regulator and regulated also hinges on the resources available to the parties, and on this score there is cause for some optimism, but also considerable room for improvement, particularly when it comes subsequently rejected the tariff changes, mainly citing the inability to assess the changes objectively based on hard data This set the stage for several rounds of recrimination between both parties Such cases, the regulator says, are “ lose-lose” situations that ultimately hamper trust between the parties and overall market development While the operator has a right to be concerned at the risk of publication of sensitive information, the ability of a regulator to make critical market rulings hinges on its ability to have access to relevant data and assess it as objectively as possible, to regulators The clear majority of operators in the survey deem the volume and quality of financial and human resources assigned to the regulatory function in their companies as adequate to the task It is not as clear, however, that regulators are similarly satisfied with the resources available to them We pointed consistent with its overall mission In the end, to help assuage operator concerns that sensitive commercial information could be divulged, the regulator has developed a stringent set of rules for information collection and circulation This highlights the importance of both sides understanding and buying into each other’s objectives The regulator should create a process that reduces the likelihood of information leakage, and operators must understand that relevant and accurate information is a critical element of operator decision-making out earlier that one-third of regulators in the survey cite insufficient resources available to it as a key factor in instances of regulatory uncertainty This is not merely a concern about financial resources; it is also a concern about the most important factor of all in operator-regulator interaction – the people managing it © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved 25 BUILDING TRUST IN REGULATION KPMG Comment Building firm foundations for the regulatory process It should be of little surprise that information – the gathering, sharing and use of data by regulators and network industries – continues to be an area of debate and concern. For instance, a quarter of business respondents stated that the required information is not relevant to the situation of their business or market. Even some regulators have concerns that the data they are requesting is not entirely relevant with a quarter of North American regulators suggesting this is so. KPMG views relevant and reliable information to be the one of the fundamental cornerstones of effective regulation. Our member irms work closely with regulators to identify what should be requested from business and how they might interpret it, and with businesses to develop effective means of gathering data and providing the right level of assurance over it – both inancial and noninancial data. This can be a costly process for regulated industries that may historically have had little reason or incentive to establish the systems and processes necessary to produce the information that regulators demand – for example activity based costing – thus requiring new systems, skills and often signiicant revisions to underlying databases such as asset registers. In emerging markets, the transformation from a paperbased to a computerbased inancial and operational recordkeeping system presents unique challenges in the face of signiicant resource costs Therefore regulators should seek to make a strong case for how the data requested will beneit competition, and ultimately consumers, if business is to trust that regulators are being fair and proportionate whilst causing network industries to incur signiicant expenditures for new recordkeeping systems. Many regulators may not have suficient capabilities and experience in inancial accounting and operational inance to be able to best interpret the data for regulatory purposes and understand the context in which it was gathered: inancial data can prove dangerous in the wrong hands, particularly in the development of policy based on misunderstandings. In our member irms’ experience, the closer that regulators, businesses and their auditors work together on deining the information requirements, the less likely it is that poor policymaking results. These discussions should also focus on the degree of assurance needed to be proportionate in the circumstances. These can vary from the business self reporting to involving external assurance which covers light touch “agreed upon procedures” all the way through to “fairly presents” opinions. Conidence in a business’ own data can reap signiicant beneits. KPMG irms have helped companies challenge regulatory decisions by making a case based upon robust evidence from the business’ own systems, saving them millions of dollars. KPMG irms have also advised regulators on the imposition of fair and proportionate reporting frameworks that seek the right balance between robustness and relevance. Finally, in small markets and developing countries there is an added risk that resource constraints lead regulators to take a ‘cut and paste’ approach to regulation – requesting the same level of data of a small island operator, for example, as a US multinational. A proportionate approach by a regulator tailored to local markets is likely to build trust with business, taking concerns and resource constraints into account and demonstrating fairness. Widespread trust in the data that forms the basis of regulatory decisions provides the foundation for trust in policy and the broader trust in the process of other stakeholders – without this conidence, other aspects of regulation are likely to suffer. Relevance versus reliability – a financial reporting conundrum Many regulators around the world struggle with setting a balance in regular reporting of inancial performance by regulated entities. At one end of the spectrum is robust inancial reporting that companies already perform for the inancial markets and shareholders, under strong national and international sets of accounting principles and rules, by a large body of professionals who know how to do it. Certainly robust, but how relevant to the answering of specic economic questions? At the other end of the spectrum there are “bottomup” models of speciic products or markets that are forward looking, use engineering and economics and modelling skills and use concepts such as current costs and long run incremental costs. Highly relevant to answering a speciic economic question – but how robust and reliable when models differ country by country, on each iteration and depending on whether the operator, the regulator or a third party builds it. KPMG irms work with both regulators and operators in inding a balance between these polar opposites. © 2009 KPMG International. KPMG International is a Swiss cooperative. Member irms of the KPMG network of independent irms are afiliated with KPMG International. KPMG International provides no client services. No member irm has any authority to obligate or bind KPMG International or any other member irm visàvis third parties, nor does KPMG International have any such authority to obligate or bind any member irm. All rights reserved. BUILDING TRUST IN REGULATION 26 © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved 27 BUILDING TRUST IN REGULATION KPM G Comment Tackling uncertainty, safeguarding investment Debates about strong versus weak regulation are generally less useful than consideration about the levels of certainty whole regulatory environments provide In some emerging markets, certainty has been supplanted by significant levels of uncertainty when economic conditions have triggered changes in regulatory arrangements from those embodied in licenses It is in the interests of both regulators and businesses to reduce uncertainty to levels that give investors sufficient comfort to invest in licenses, infrastructure and skills This also provides management teams with the opportunity to deliver performance under a stable reward system In some sectors the pace of change is being driven by climate change In the energy sector for example, the UK government altered the principal objective of Ofgem in 2008 to ensure it addressed the interests of future customers; a further change is proposed in the 2009 White Paper (the low carbon implementation plan) to make clear that this includes reducing carbon emissions And changes to market design are also heralded, with concerns that the pace of change will test electricity markets during the transition to a low carbon economy But where change is necessary, development of new regulatory paradigms and market designs are likely to be more attractive to investors than a period of prolonged regulatory uncertainty Furthermore, there seems to be an increasing acknowledgment that the focus on protecting consumer interests must be balanced with investor needs in developing regulation In its recent Digital Britain report (2009), the UK government stated that it intends to rebalance the primary objectives of the unified communications regulator to ‘amend the Communications Act 2003 to make the promotion of investment in communications infrastructure one of Ofcom’s principal duties alongside the promotion of competition’ As many governments around the world increasingly look to private regulated industry to meet public objectives such as universal access in communications, improved water quality or lower carbon emissions, it is crucial that investors understand the risks they undertake ahead of acquisitions, mergers, alliances, divestments or major capital expenditure Significant changes in government and regulator policy can result in stranded assets and significant loss of revenue If, for instance, a regulator is not confi dent that a monopolistic operator is simply incapable of acting in a profi t-maximising way, its approach may be to attempt to micro-manage the business through regulatory intervention with severe consequences for the level of trust and investor confi dence Moreover, the tremors that have shaken the world economy continue to challenge prior assumptions about the cost of capital, the availability of debt and the stability of exchange rates Insufficient due diligence on the part of investors or poor preparation and understanding of regulatory impact by regulators raises the prospect of increased likelihood – and costs from – litigation, with an associated reduction in trust between stakeholders Equally, the survey’s corporate participants widely acknowledge that insuffi cient trust and a lack of certainty is a cause of postponed investment (over 30 percent), inability to implement major initiatives (46 percent in developing countries, 23 percent in developed countries), direct loss of operator revenue (45 percent developed, 38 per cent undeveloped) and a direct increase in costs (47 percent developed, 42 percent undeveloped) [See graph on page 18] Global investments and revenues of industries, with economic regulations, amount to hundreds of billions of dollars every year If even a small proportion of that indicated by respondents is put at risk by regulatory uncertainty, the figures lost will still be in billions of dollars In KPMG firms’ experience, being able to combine a global understanding of corporate finance and due diligence, with deep knowledge of the local regulatory environment can offer clients a better picture of the potential impact of the risks they are undertaking © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION 28 Trusting the regulator in times of market uncertainty? Operators and markets should be able to trust regulators to maintain reasonable certainty by acting consistently with broader economic environment and market expectations. For example in December 2008, in the midst of the global credit crisis, the Australian Energy Regulator (AER) published for consultation its irst periodic review of Weighted Average Cost of Capital parameters for future regulatory determinations of electricity network serviced prices. However the AER’s proposals did not appear to relect relevant market realities. It assumed such things as: • investors would continue to contribute capital to Australian regulated energy infrastructure for a signiicantly lower return; • the cost of equity risk had fallen compared to that applied by regulators historically; and • regulated businesses could maintain a higher credit rating with the same level of gearing (and lower revenue) than that applied by regulators historically. Such assumptions could hardly be further removed from prevailing market conditions. The publication of the draft determination provoked signiicant reactions from the inancial sector which immediately and explicitly focussed on consistency of the regulator’s signals to the markets. For example among a wide range of similar commentaries by the inancial media and advisors, Macquarie Equities stated that: While the regulator modiied some of its controversial draft parameter determinations in its inal review, both the process and the substance of the decision making appears to have reduced market trust in the AER’s behavior. It may be reasonably expected that this particular regulatory uncertainty and the risks of future periodic reviews, will be priced by the market into the cost of capital for the long term assets regulated by the AER, for some time to come. “This is a negative surprise to us and the market and in our view runs inconsistent with recent commentary by the AER …There is no doubt the market will be disappointed in this decision. At a time when investors are nervous enough about the levels of debt in these businesses, this is the last thing the market needed The decision to move away from a BBB+ metric in the current debt environment is confusing. We struggle to understand why the AER has chosen to move this parameter in possibly one of the most skittish markets in history.”7 “Regulated Utilities – WACCed”, Macquarie Research Equities, 12 December 2008 © 2009 KPMG International. KPMG International is a Swiss cooperative. Member irms of the KPMG network of independent irms are afiliated with KPMG International. KPMG International provides no client services. No member irm has any authority to obligate or bind KPMG International or any other member irm visàvis third parties, nor does KPMG International have any such authority to obligate or bind any member irm. All rights reserved. 29 BUILDING TRUST IN REGULATION The people factor parties This is true across industries, but applies with particular urgency in highly competitive environments. Strong personal relationships help to smooth potentially antagonistic relationships by offering each side some visibility into the motives and constraints of the other, and they ultimately help build trust among the parties. In at least one area, operators and regulators are unanimous. Asked to identify the most important contributors to an effective operator regulator relationship, both groups of survey respondents point with equal emphasis to good personal rapport between senior executives from both What you view as the most important contributors to an effective operator-regulator relationship? Select up to two 10 20 30 40 50 46% Good personal rapport between senior executives at both organizations 46% 38% Good understanding between junior managers responsible for regular interaction between the organizations 25% 29% High degree of regulator independence from the government 19% The regulator has the capacity and means to drive regulatory strategy forward 26% Simplicity/ease of information-transmission procedures between operator and regulator 26% 31% 31% High business relevance of information required by the regulator 100% or majority commercial (non-state) ownership of the operator(s) 18% 31% 2% 6% Operators Regulators Source: Economist Intelligence Unit 2009 The quality of such personal interactions varies across markets. As already noted, many operators state that they have good relationships at the highest level, with commissioners or very senior staff. By contrast, the rapport with daytoday staff does not earn such high assessments. This creates something of a disconnect, as commissioners – who in many cases have varied backgrounds – largely build their decisions on the ground work carried out by the daytoday research staff. “One of the key challenges for operators is to grapple with the differences between the commissioners and the daytoday staff” says Lew Owens of Australia’s ETSA. Mr Nyoka of Vodacom agrees: “Commissioners (or in the case of South Africa, councillors) make the decisions, but they have a variety of backgrounds © 2009 KPMG International. KPMG International is a Swiss cooperative. Member irms of the KPMG network of independent irms are afiliated with KPMG International. KPMG International provides no client services. No member irm has any authority to obligate or bind KPMG International or any other member irm visàvis third parties, nor does KPMG International have any such authority to obligate or bind any member irm. All rights reserved. BUILDING TRUST IN REGULATION 30 and come at issues from different vantage points,” he says. Daytodaystaff and backroom researchers, by contrast, have considerable inluence – and yet the interaction between operators and these background actors is not as meaningful as it can be. Another challenge may be parties that do not appear to speak the same language, not an uncommon occurrence in light of often antithetical objectives. In turn, operators have to continuously adapt their teams to the nature of the regulation. “When a market moves from ministry based regulation to more independent regulation,” says Michael Pollitt of Cambridge University, “the regulatory teams of the operators have to adapt.” In the view of Lord Carter, the former UK Minister for Communications, Technology and Broadcasting, the regulatory function and relationships work best when the regulator is staffed by technical experts: “Regulators need to be able to attract irst class people with a thorough knowledge of their ield.” In operatorregulator relationships, he says, “mutual respect of each other’s expertise help to build the trust dynamic.” Staff cross-over: help or hindrance? One factor that could help smooth personal relationships – or alternatively, complicate them – is the crossover of staff between regulators and operators. Staff crossovers have the advantage of mixing people with varied experiences and create an environment in which the parties have a keen understanding of the other side’s drivers and constraints. “Having people with diverse backgrounds raises the quality of the debate,” says Dr Pollitt, “and that helps the overall process.” Crossover is not a frequent occurrence; no more than 12 percent of operators in the survey and even fewer regulators say they experience it often. Among those operators where crossover does occur, half see such staff movement as a positive factor, and over threequarters of regulators where it occurs say the same. While there is an unquestionable value to crossovers, frequent switches can also be unhealthy for a sector. First, they can lead to environments that are closed to original thinking, with the same staff simply recycled from one side to the other. Perhaps more importantly, frequent crossovers can impact public perception negatively and erode the public trust. This leads Steve Smith of Ofgem to say that while crossovers can be beneicial, “you should not have too much of it. It is important to avoid the impression in the public’s mind that this is all a cozy club.” The level at which the crossover takes place is also important; as one regulator noted, staff crossover is healthier at a lower, operational level and drives negative public perception if too intense at senior, more exposed levels. Other pitfalls include potential conlicts of interest or worse. Ultimately, there appears to be general agreement that crossovers are only healthy in small doses To manage the practical concerns generated by staff changing sides, a number of governments have adopted a set of stringent crossover rules, notably for moves from the public sector to the private sector. In some markets, for example, no crossover within the same industry is allowed within two years of leaving the public sector. Needed: leadership at the top The underlying question in building trust is whether the emphasis should be put on people or on overall structural frameworks. Human beings are unquestionably at the core of operatorregulator relationships and as such, are foundational factors in building trust in regulation. Personal competence, character and integrity – or the perception thereof – have a direct impact on regulator performance. “You can’t divorce the character of the people from trust issues” says Sean Williams. “Trustworthy people must be involved in the process”. Likewise, the role of the leadership – on both sides – is critical. “Building trust largely depends on leadership commitment to do it right,” assert Mr Williams. “You decide you want to engage and you set about doing it from the start – in the type of people you bring in, the processes you establish and so on”. In many markets, the personality of the chief regulator and the identity of the institution itself are often not separable. It is the commitment of the leadership to building trust and honestly engaging the other side that ultimately deines the depth of the relationship and the trust that is derived from it. Nonetheless, people alone are not enough, warns ICASA’s Mr Motlana. “The smoothness of personal interactions alone doesn’t improve the quality of the argument,” he says. Mr Owens of ETSA agrees, adding that people have to operate within a given structural framework Trust is ultimately a function of both the people and the structure within which they operate. Weakness in one element can undermine the overall foundation. © 2009 KPMG International. KPMG International is a Swiss cooperative. Member irms of the KPMG network of independent irms are afiliated with KPMG International. KPMG International provides no client services. No member irm has any authority to obligate or bind KPMG International or any other member irm visàvis third parties, nor does KPMG International have any such authority to obligate or bind any member irm. All rights reserved. 31 BUILDING TRUST IN REGULATION KPMG Comment Converged data, improved performance In our report Finance of the Future: looking forward to 2020 (KPMG International, 2008) we explored the trends and opportunities in inance functions that might emerge in the next decade Though focused upon the inance function, many had implications across the business, not least regarding regulation. Particularly during an economic downturn, leading businesses are able to deliver added value through identifying what needs to be measured and managed, whether that is inancial or noninancial data, through the CFO, the head of regulation or elsewhere. As Finance of the Future expressed it: …organizations are beginning to seek beneits from a more rigorous risk control regime. Using technology and culture management, they are incorporating it into “business as usual”. The challenge now is to ensure that controls are eficient and to put policies, procedures and processes in place that allow the organization to continue to grow and evolve while still managing its businesswide risks. It also identiied better data management and increased standardization as having an impact: Constantly evolving internal and external reporting needs will require businesses to constantly review and update their underpinning data sets and capture processes. If organizations are to eficiently and effectively meet new reporting requirements, such as carbon reporting, they will have to ind innovative ways of capturing and processing new business metrics. The data sets will support the decade old aspiration to have “management dashboards” that provide a realtime and simpliied matrix of corporate data. By 2020, if management is to have a realtime grip on the business and a rapid understanding of the impact of its decisions, dashboards need to become reality. This will include regulatoryreporting. To take the example of communications, before the 1980s and 1990s, many state owned ixedline operators were run as government departments. Decades on longerliving assets from preprivatization days are not properly accounted for and former state incumbents are inding it necessary to reconcile operational and inancial data to face the challenges from regulators and the more commercial new entrants to the market. As companies become increasingly cost conscious in current market conditions, the beneit of productlevel data becomes increasingly evident. Or take the example of smartmetering in energy where in some markets the mandatory introduction of the technology for public policy objectives bring the potential for a much greater range of products targeting more speciic consumers. Data that might enable regulators to make decisions on behalf consumers or ministers the state, might prove signiicant commercial advantage. The challenge, therefore, is in deining and accepting standardized data sets which can both deliver policy objectives and commercial demands The development of effective ‘management dashboards’ will require regulatory functions that can stand shouldertoshoulder with their inance colleagues, cogent expressions of corporate strategy and a logical and well communicated means of demonstrating which indicators need to be managed and why. In a converged world, it will be the shapers and adaptors who are likely to beneit most from change. © 2009 KPMG International. KPMG International is a Swiss cooperative. Member irms of the KPMG network of independent irms are afiliated with KPMG International. KPMG International provides no client services. No member irm has any authority to obligate or bind KPMG International or any other member irm visàvis third parties, nor does KPMG International have any such authority to obligate or bind any member irm. All rights reserved. BUILDING TRUST IN REGULATION 32 Regulatory information – Absence of trust Over several years the former gas and electricity network regulator in the Australian State of Victoria had expressed mistrust8 of the information submitted to it by utilities in support of their revenue submissions. On the other hand, in some areas at least, the regulator’s capacity to acquire and understand information did not appear to be either well founded9 or trusted by operators. However, the regulator sought to make information requirements increasingly “probative”10, which among other things transferred risk of misunderstanding by the regulator to operators and imposed signiicant compliance risk on operators. This approach led to: • an increased focus on the form of information submission including independent information being prepared in anticipation of possible submission as expert witness reports to a subsequent judicial review of the regulator’s decision; • the admissibility of evidence submitted by operators rather than its substance becoming a matter of focus This included the regulator’s process seeking to discredit independent experts with opinions that supported operators’ submissions11, without necessarily fully considering their reports12; and • appeals becoming common. For example in the 2006 Electricity Price Review 4 out of 5 businesses appealed the regulator’s decisions and in the 2008 Gas Access Arrangement Review, all 3 businesses appealed, on multiple grounds. The consequence was an adversarial and increasingly prescription process of information provision founded on assumptions of absence of trust. It is dificult to see how this could be regarded as a good regulatory outcome for operators, the regulator or energy customers. p17, “Gas Access Arrangement Review 2008-12 Consultation Paper No 1”, Essential Services Commission, May 2006 For example, see “Powercor Australia and CitiPower Response on Guideline No.3 Draft Decision”, Essential Services Commission, November 2006 10 p17-19, “Gas Access Arrangement Review 2008-12 Consultation Paper No 1”, Essential Services Commission, May 2006 11 p86-88, “Gas Access Arrangement Review 2008-12, Final Decision”, Essential Services Commission, March 2008 12 For example, see para 126 at Essential Services Commission Appeal Panel Ref E1/2008, November 2008 © 2009 KPMG International. KPMG International is a Swiss cooperative. Member irms of the KPMG network of independent irms are afiliated with KPMG International. KPMG International provides no client services. No member irm has any authority to obligate or bind KPMG International or any other member irm visàvis third parties, nor does KPMG International have any such authority to obligate or bind any member irm. All rights reserved. 33 BUILDING TRUST IN REGULATION Conclusion A positive outlook for trust For all the challenges outlined in Building Trust in Regulation, operator executives and regulators appear generally optimistic that their relationships w ill continue moving in the right direction How you think the operator-regulator relationship w ill change in the future? 10 20 30 40 50 18% It will improve in the short to medium term 27% 33% It will improve in the long term 44% 12% It will deteriorate in the short to medium term 4% 2% It will deteriorate in the long term 0% 31% It will remain unchanged 23% 4% Don't know 2% Operators Regulators Source: Economist Intelligence Unit 2009 © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION 34 Will this be the case? Strengthening the regulatory body and its staff, for one thing, is critical if relationships are to improve and trust to be expanded “ The keys to building trust ultimately will be to improve the skill set of the regulator and to ensure transparent processes,” believes Mr Motlana, himself a senior regulator At the institutional level, the overall policy framework requires clarity, and regulators need the requisite authority and power of enforcement and sanction Such power should, however, not be unbridled “ There is nothing wrong with power,” says the regulatory manager of an Australian energy provider, “ but you don’t want power without accountability” The aim of better policy frameworks, expanded resources and greater commitment to improving the skills of staff managing operator-regulator relationships must be to improve the understanding of both sides toward each other’s core objectives “ Each party needs to recognize the institutional legitimacy of the other’s activity and goals,” confirms Lord Carter Operator respondents are adamant that regulators must achieve a greater appreciation of business operations and risks Regulator respondents, for their part, insist that operators gain an improved knowledge of regulatory and policy objectives The development of real trust between them hinges on the development of such mutual understanding © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved 35 BUILDING TRUST IN REGULATION Appendix Survey demographics The global survey of 213 senior executives closely involved w ith operator-regulator relationships was conducted by the Economist Intelligence Unit in January-February 2009 The spread of respondents is outlined below © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION 36 Respondents by region Role within industry Asia-Pacific Regulator North America Operator 9% Western Europe 20% Eastern Europe 23% 12% Middle East and Africa Latin America 8% 23% 77% 28% Respondents by region Role within industry Source: Economist Intelligence Unit 2009 Source: Economist Intelligence Unit 2009 Operator sectors Number of sectors regulated by respondents’ regulators13 Post industry Power industries 8% 9% Telecommunications Transport more than industries 10% 16% Water 41% 39% 57% 20% Operator sectors Number of sectors regulated by respondents’ regulators Source: Economist Intelligence Unit 2009 Source: Economist Intelligence Unit 2009 13 Responses were gathered from both operators and regulators © 2009 KPMG International. KPMG International is a Swiss cooperative. Member irms of the KPMG network of independent irms are afiliated with KPMG International. KPMG International provides no client services. No member irm has any authority to obligate or bind KPMG International or any other member irm visàvis third parties, nor does KPMG International have any such authority to obligate or bind any member irm. All rights reserved. 37 BUILDING TRUST IN REGULATION We w ould like to thank the follow ing people w ho graciously gave their tim e to be interview ed for this publication: • Lord Carter of Barnes • Patricia De Suzzoni, Commission de Régulation de l’Énergie (CRE) • Paul Foran, American Water • Karabo Motlana, The Independent Communications Authority of South Africa (ICASA) • Nkateko Nyoka, Vodacom • Lew Owens, ETSA Utilities • Michael Pollitt, University of Cambridge • Steve Smith, Ofgem • Julie Veach, Federal Communications Commission (FCC) • Sean Williams, BT As well as those who declined to go on record We would like to thank contributors this project from the Economist Intelligence Unit, including Denis McCauley, the editor of the report, and Guy Zibi, its author Thanks also go to KPMG firms’ contributors to this publication, including: Tim Aldrich, Pablo Bernad Ramoneda, Jamie Carstairs, Sean Collins, Alan Finder, Mark Hartley, Keith Lockey, Daniel Singer, Lisa Thomas and Ted Tolfree © 2009 KPM G International KPM G International is a Sw iss cooperative M ember fi rms of the KPM G netw ork of independent fi rms are affi liated w ith KPM G International KPM G International provides no client services No member fi rm has any authority to obligate or bind KPM G International or any other member fi rm vis-à-vis third parties, nor does KPM G International have any such authority to obligate or bind any member fi rm All rights reserved kpmg.com David Thomas Global Head of Communications Regulation KPMG in the U.K. +44 7801 310 811 david.thomas@kpmg.co.uk Sean Collins Global Chair, Communications and Media KPMG in Singapore +65 6372 3300 seanacollins@kpmg.com Michiel Soeting Global Chair, Energy and Natural Resources KPMG in the U.K. +44 20 7694 3052 michiel.soeting@kpmg.co.uk Ashley Steel Global Chair, Transport KPMG in the U.K. +44 20 7311 6633 ashley.steel@kpmg.co.uk Or your local KPMG contact The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. © 2009 KPMG International. KPMG International is a Swiss cooperative. Member irms of the KPMG network of independent irms are afiliated with KPMG International. KPMG International provides no client services. No member irm has any authority to obligate or bind KPMG International or any other member irm vis à vis third parties, nor does KPMG International have any such authority to obligate or bind any member irm. All rights reserved. Printed in the United Kingdom. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Designed and produced by KPMG LLP (UK) s Design Services Publication name: Building Trust Publication number: RRD 152640 Publication date: August 2009 [...]... reporting frameworks that seek the right balance between robustness and relevance. Finally, in small markets and developing countries there is an added risk that resource constraints lead regulators to take a ‘cut and paste’ approach to regulation – requesting the same level of data of a small island operator, for example, as a US multinational. A proportionate approach by a regulator tailored to local markets is likely ... [on strategy]”, says a regulatory manager at one west African telecoms operator interviewed for this study. Another frequent outcome of uncertainty is litigation, as market players seek some inality to compensate for the lack of regulatory clarity. Regulators that Percentage of operator respondents stating that regulatory uncertainty has had a “somewhat” or “severely damaging” impact on their investments,... The regulator should create a process that reduces the likelihood of information leakage, and operators must understand that relevant and accurate information is a critical element of operator decision-making out earlier that one-third of regulators in the survey cite insufficient resources available to it as a key factor in instances of regulatory uncertainty This is not merely a concern about financial... a breakdown in trust to the other side Regulator respondents, for example, blame regulatory uncertainty on insufficient resources at their disposal but also point to inaccurate or inadequate information submitted by operators Past operator behavior can play a role in deepening the trust gap Paul Foran, Vice President, Regulatory Programs of American Water, a US water utility, points out that past abuses... financial reporting conundrum Many regulators around the world struggle with setting a balance in regular reporting of inancial performance by regulated entities. At one end of the spectrum is robust inancial reporting that companies already perform for the inancial markets and shareholders, under strong national and international sets of accounting principles and rules, by a large body of professionals who know how to do it. Certainly robust, ... information, the ability of a regulator to make critical market rulings hinges on its ability to have access to relevant data and assess it as objectively as possible, to regulators The clear majority of operators in the survey deem the volume and quality of financial and human resources assigned to the regulatory function in their companies as adequate to the task It is not as clear, however, that regulators... A full 41 percent of the operators polled say they have suffered a direct loss of revenue due to instances of regulatory uncertainty, and 44 percent say uncertainty has led directly to increases in operating costs. Of operators who state that regulatory uncertainty has had an impact on planned investments, nearly onethird claim the impact has been damaging to their business in monetary terms The impact is more frequently damaging for ... International or any other member irm visàvis third parties, nor does KPMG International have any such authority to obligate or bind any member irm. All rights reserved. 19 BUILDING TRUST IN REGULATION acknowledge increased regulatory uncertainty in their markets highlight an increase in litigation as among the leading consequences of such uncertainty Litigation is by no means ideal for operators “As an operator, you only go to court as a last resort – when all else has failed,” says... subjectivity in decision-making, regulators increasingly build on past jurisprudence, international benchmarking and objective economic analysis to develop their opinions In this context, the accuracy, relevance and timeliness of the information become critical Indeed, regulators in our survey highlight inadequate or inaccurate information as one of the primary causes of regulatory uncertainty (along with... KPM G International have any such authority to obligate or bind any member fi rm All rights reserved BUILDING TRUST IN REGULATION 28 Trusting the regulator in times of market uncertainty? Operators and markets should be able to trust regulators to maintain reasonable certainty by acting consistently with broader economic environment and market expectations. For example in December 2008, in the ... reserved BUILDING TRUST IN REGULATION 28 Trusting the regulator in times of market uncertainty? Operators and markets should be able to trust regulators to maintain reasonable certainty by acting consistently with ... is a vital factor in building trust Operators are adamant that regulators must achieve a greater appreciation of business operations and risks Regulators, for their part, insist that operators... countries there is an added risk that resource constraints lead regulators to take a ‘cut and paste’ approach to regulation – requesting the same level of data of a small island operator, for example, as a US