Understanding Regulation

Second Edition

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UnderstandingRegulationTheory, Strategy, and Practice

Second Edition

Robert Baldwin, Martin Cave, Martin Lodge

1

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n ACKNOWLEDGEMENTS

We are grateful to a number of individuals for their help with this book. For

research assistance, textual comments, and work on manuscripts, we thank

Vanessa Finch, Amanda Tinnams, and Emma Wilson.

We also express our appreciation to all of those colleagues at LSE who have

assisted in a variety of ways in the production of this textand, not least we

thank colleagues with whom we have taught on the LSEs M.Sc. in Regulation

and on the LSEs Short Course on Regulation. Martin Lodge would like

particularly to acknowledge the support of the ESRC Centre for Analysis of

Risk and Regulation. We are grateful also to the colleagues with whom we

have co-authored or co-edited works on regulation and who have allowed us

to draw on those publications in writing this book. We thank in particular

Tony Ballance, Julia Black, Damian Chalmers, Veerle Heyvaert, Ian Marlee,

Henry Rothstein, and Lindsay Stirton.

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n PREFACE TO THE SECOND EDITION

Since the rst edition of Understanding Regulation was published in 1999, the

practice and study of regulation has changed dramatically. Politically, there

have been shifts from emphases on deregulation to better regulation and

back again. There have been calls for lowerings of regulatory burdens on

businesses and for increasing resort to lighter-touch regulatory systems and

regimes that delegate controls to businesses. These calls fell silent after the

start of the credit crisis of 20079, but they can be expected to re-emerge in

coming years. The legacy of such movements and political fashions has,

however, been a developed interest in non-traditional strategies of regula-

tionin methods of inuence that constitute alternatives to command and

control. Newly popular devicessuch as nudginghave found their way on

to politicians agendas and there have been redoubled concerns to debate such

issues as the legitimacy of different regulatory systems and approaches.

Regulatory studies and theories have also progressed signicantly over the

past dozen years. Regulation has become the subject of discrete courses and

degree programmes around the world and new journals have emerged to deal

with the subject. Most disciplines now provide numbers of scholars who see

regulation as a primary area of research and teaching. As a result, a host of

new theories and perspectives have been brought to bear on regulation and

have enriched understandings.

This edition seeks to come to grips with all of the newer develop-

ments referred to. In doing so, it continues the broad approach of the rst

edition and sees regulation as a subject that is best understood from a multi-

disciplinary perspective. The addition of Martin Lodge, a political scientist, as

co-author is a happy furthering of this position.

Robert Baldwin, Martin Cave,

and Martin Lodge,

March 2011

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n CONTENTS

LIST OF FIGURES xi

LIST OF TABLES xii

ABBREVIATIONS xiii

1 Introduction 1

PART I FUNDAMENTALS

2 Why Regulate? 15

3 What is Good Regulation? 25

4 Explaining Regulation 40

5 Regulatory Failure 68

6 Regulating Risks 83

PART II STRATEGIES

7 Regulatory Strategies 105

8 Self-regulation, Meta-regulation, and Regulatory Networks 137

9 Franchising 165

10 Emissions Trading 195

PART III RULES AND ENFORCEMENT

11 Enforcing Regulation 227

12 Responsive Regulation 259

13 Risk-based Regulation 281

14 Standards and Principles 296

PART IV QUALITY AND EVALUATION

15 Cost-Benet Analysis and Regulatory Impact Assessment 315

16 Accountability, Procedures, and Fairness 338

17 Regulatory Competition and Coordination 356

PART V REGULATION AT DIFFERENT LEVELS OF GOVERNMENT

18 Multi-level Regulation 373

19 Regulation and the European Union 388

20 Regulation and Development 409

21 Global and International Regulation 425

PART VI NETWORK ISSUES

22 Regulating Prices in Natural Monopolies 443

23 Using Competition in Network Industries 452

24 Separation and Contestability in Network Industries 466

25 Implementing Price Controls 476

26 Efciency and Innovation in Network Industries 492

PART VII CONCLUSIONS

27 Conclusions 505

SELECT BIBLIOGRAPHY 509

INDEX 531

x CONTENTS

n LIST OF FIGURES

11.1 Regulatory tasks: the DREAM framework 227

12.1 The enforcement pyramid 260

12.2 The enforcement strategies pyramid 261

12.3 The three aspects of smart regulation 266

18.1 Four views on multi-level regulation 381

22.1 Average and marginal cost in a natural monopoly 445

22.2 Pricing options for a natural monopolist 447

22.3 Efcient pricing for a multi-service utility 449

24.1 Alternative forms of separation 468

25.1 A simplied nancial model of the regulated rm used to

set a price cap 484

26.1 The effect on project choice of truncating high returns 493

26.2 Identifying the efciency frontier 499

n LIST OF TABLES

2.1 Rationales for regulating 24

3.1 Benchmarks for regulation 39

4.1 Variants in interest group politics 48

4.2 Contrasting control styles according to cultural theory 51

4.3 Explaining regulation 67

5.1 Regulatory failure 77

7.1 Regulatory strategies: posited strengths and weaknesses 134

9.1 Allocating franchises 193

9.2 Franchising problems 194

16.1 Regulatory regimes and perspectives on accountability 353

21.1 Variations in global regulation 427

23.1 Competitive potential in electricity, gas, posts, railways,

telecommunications, and water and sewerage 457

25.1 Implementing a price cap regime: an illustration 479

25.2 An illustrative timetable for resetting a price cap 482

25.3 Selected price caps operating in the UK utilities 483

n ABBREVIATIONS

ALARA As Low as Reasonably Achievable

ALARP As Low as Reasonably Practicable

BATNEEC Best Available Technology Not Entailing Excessive Costs

BAU Business as Usual

BCC British Chambers of Commerce

BRE Better Regulation Executive

BRTF Better Regulation Task Force

BT British Telecom

C & C Command and Control

CAA Civil Aviation Authority

CBA Cost-Benet Analysis

CDM Clean Development Mechanism

CRI Centre for the Study of Regulated Industries

DAB Digital Audio Broadcasting

DG Director General

DGES Director General of Electricity Supply

DTI Department of Trade and Industry

ECJ European Court of Justice

EMS Environmental Management System

EPA Environment Protection Agency (US)

ESRC Economic and Social Research Council

ETS Emission Trading Scheme

EU European Union

EUI European University Institute (at Florence)

FCCC Framework Convention on Climate Change

GAAR General Anti-avoidance Rules

HSE Health and Safety Executive

IA Impact Assessment

ILR Independent Local Radio

ITA Independent Television Authority

ITC Independent Television Commission

JBL Journal of Business Law

MLR Modern Law Review

MMC Monopolies and Mergers Commission

NAO National Audit Ofce

NCC National Consumer Council

NRA National Regulatory Agency

OFFER Ofce of Electricity Regulation

OFGAS Ofce of Gas Supply

OFGEM Ofce of the Gas and Electricity Markets

OFT Ofce of Fair Trading

OFTEL Ofce of Telecommunications

OFWAT Ofce of Water Services

OJLS Oxford Journal of Legal Studies

OMB Ofce of Management and Budget

OMC Open Method of Coordination

ONP Open Network Provision

ORR Ofce of the Rail Regulator

PBR Principles-based Regulation

PCC Press Complaints Commission

PIG Public Interest Group

RA Radio Authority

RAB Regulatory Asset Base

RCBA Risk Cost Benet Analysis

REC Regional Electricity Company

RIA Regulatory Impact Analysis

ROSCO Rolling Stock Leasing Company

RPI-X Retail Price Index less efciency factor X price cap

SFAIRP So Far As Is Reasonably Practicable

SME Small and Medium Enterprises

TOR Tolerability of Risks

TUC Trades Union Congress

xiv ABBREVIATIONS

1 Introduction

Our aim in writing this book is to introduce readers to those practical and

theoretical issues that we see as central to the study of regulation. We set out

to describe the nature of those issues, to indicate how regulatory practitioners

and scholars have dealt with them and to offer arguments on potential

responses to regulatory difculties. The focus is not on providing how to

accounts of regulatory experience. Instead, our aim is to highlight the con-

tested areas and issues that are produced by regulation. We hope that this

volume will add to exchanges between different viewpoints. Many of the

examples in this book draw on the British experience, but we aim to make

the text relevant to a wider international audience interested in regulatory

activities broadly dened.

Over the past decades, regulation has been a topic that has stimulated

discussions in a host of disciplinesnotably law, economics, political science

and public policy, sociology, history, psychology, geography, anthropology,

management, and social administration. Given this breadth of interest, regu-

lation is a subject or eld of study that calls for a multi-disciplinary approach.

Economists, for instance, are likely to benet from the insights of political

scientists and sociologists on such matters as the practicalities of implemen-

tation and enforcement. Similarly, lawyers messages concerning the limita-

tions of different kinds of rules and enforcement processes might protably be

taken on board by economists and others. Analogous points could be made

from the perspectives of other disciplines. This edition is written by a lawyer,

an economist, and a political scientist, but will attempt both to draw from a

wider range of disciplinary perspectives and to be accessible across disciplines.

Highly technical approaches and terminology will be avoided where possible.

It is hoped, therefore, that the analysis offered will prove useful to regulatory

studies in a wide variety of areas.

Regulation has become a matter of topical debate in a way that it was not

even a single decade ago. This global phenomenon was partly prompted by

the activities of international organizations. Criticisms and concerns with

regulatory orthodoxies became increasingly prominent during the nancial

crisis of 20079, when calls for deregulation and light-touch regulation

suddenly gave way to daily demands for more rigorous regulation of the

nancial markets. Elsewhere, too, regulation had attracted supporters and

opponents alike. Supporters saw regulation as a technocratic device that had

the potential to exert rational controls over important economic and social

activities. Sceptics regarded regulation as little other than red tape and a

potential burden on economic activity.

It is, therefore, fair to say that by 2011, the claim that we are living in an age

of the regulatory state had become widely accepted as the R-word had

penetrated ever more social domains across countries.1 Over the past decade,

regulation has risen in the academic agenda to become both a eld of study in

its own right and a fertile source of new perspectives on the agendas of longer-

established disciplines. Substantial contributions to regulatory debates have

been made by political scientists, economists, lawyers, sociologists, anthro-

pologists, and others. Writings on regulation have become well-represented

across scholarly publications, and a diversity of university courses and pro-

grammes, as well as research centres, have emerged to deal with various

aspects of the theory and practice of regulation. Some of these have treated

regulation as a generic subject taught in interdisciplinary programmes; others

have specialized in specic areas, such as nancial services, environmental

protection, communications, or utilities.

As a consequence, regulation can be said now to have reached a state of

maturity, both in an intellectual and in a practical sense.2 Intellectually,

theoretical perspectives have developed rapidly into an impressive body of

scholarship and, in the world of practice, there has developed a distinct and

expanding international and national regulatory community that shares

similar languages, concepts, and concerns. The language of regulation has

penetrated diverse policy domains and talk of regulatory strategy has become

part of administrative life. In this process, central regulatory issues such as

those relating to standard-setting and enforcement have become matters of

regular discussion in different policy and academic communities.

What is Regulation?

Regulation is often spoken of as if an identiable and discrete mode of

governmental activity,3 yet the term regulation has been dened in a number

of ways.4 Selznicks notion of regulation as sustained and focused control

1 See M. Moran, The British Regulatory State (Oxford, 2003); Understanding the Regulatory State

(2002) 32 British Journal of Political Science 391413; and contrast this with G. Majone, The Rise of

the Regulatory State in Europe (1994) 17(3) West European Politics 77101.2 For comparison with the position a decade ago see R. Baldwin, C. Scott, and C. Hood,

Introduction in R. Baldwin, C. Scott, and C. Hood (eds), A Reader on Regulation (Oxford, 1998).

See also R. Baldwin, M. Cave, and M. Lodge, Introduction in R. Baldwin, M. Cave, and M. Lodge(eds.), Oxford Handbook of Regulation (Oxford, 2010).

3 See Baldwin, Scott, and Hood, Regulation, ch. 1.4 See B. Mitnick, The Political Economy of Regulation (New York, 1980), ch. 1; A. Ogus, Regulation:

Legal Form and Economic Theory (Oxford, 1994), ch. 1; G. Majone (ed.), De-Regulation or

Re-Regulation? (London, 1989).

2 INTRODUCTION

exercised by a public agency over activities that are valued by a community

has been referred to as expressing a central meaning,5 but it is perhaps useful

to think of the word regulation being used in the following different senses:6

As a specic set of commandswhere regulation involves the promulgation

of a binding set of rules to be applied by a body devoted to this purpose. An

example would be the health and safety at work legislation as applied by the

Health and Safety Executive.

As deliberate state inuencewhere regulation has a more broad sense and

covers all state actions that are designed to inuence business or social

behaviour. Thus, command-based regimes would come within this usage,

but so also would a range of other modes of inuencefor instance, those

based on the use of economic incentives7 (e.g. taxes or subsidies); contractual

powers; deployment of resources; franchises; the supply of information, or

other techniques.

As all forms of social or economic inuencewhere all mechanisms

affecting behaviourwhether these be state-based or from other sources

(e.g. markets)are deemed regulatory. One of the great contributions of

the theory of smart regulation has been to point out that regulation

may be carried out not merely by state institutions but by a host of

other bodies, including corporations, self-regulators, professional or trade

bodies, and voluntary organizations.8 According to this third, broad usage

of the term regulation, there is no requirement that the regulatory effects of

a mechanism are deliberate or designed, rather than merely incidental to

other objectives.

As a nal comment on the concept of regulation, it should be noted

that regulation is often thought of as an activity that restricts behaviour

and prevents the occurrence of certain undesirable activities (a red light

concept9). The broader view is, however, that the inuence of regulation may

also be enabling or facilitative (green light) as, for example, where the

airwaves are regulated so as to allow broadcasting operations to be conducted

in an ordered fashion, rather than left to the potential chaos of an uncon-

trolled market.

5 P. Selznick, Focusing Organisational Research on Regulation, in R. Noll (ed.), Regulatory Policy

and the Social Sciences (Berkeley, CA, 1985), 363, quoted Ogus, Regulation, 1.6 See Baldwin, Scott, and Hood, Regulation, ch. 1; J. Black, Critical Reections on Regulation

(2002) 27 Australian Journal of Legal Philosophy 195.7 On the distinction between command-and incentive-based regimes, see S. Breyer, Regulation and

Its Reform (Cambridge, MA, 1982); Ogus, Regulation, esp. ch. 11; and R. Baldwin, Regulation: After

Command and Control, in K. Hawkins (ed.), The Human Face of Law (Oxford, 1997).8 See N. Gunningham and P. Grabosky, Smart Regulation (Oxford, 1998).9 On red light and green light rules and regulations, see C. Harlow and R. Rawlings, Law and

Administration (3rd edn, Cambridge, 2009); Ogus, Regulation, 2.

INTRODUCTION 3

Issues on the Regulatory Agenda

There is a tendency to associate regulation with the post-privatization control

of the utilities. The language and practice of regulation, however, looks back

on a much longer history. In Britain, regulation has been practised since at

least the Tudor and Stuart periods.10 In the nineteenth century, there was

a burgeoning of regulation, with the emergence of specialist regulatory

institutions11 and a host of measures dealing with public health and employ-

ment conditions.12 Developments in the supply of railway, water, gas, and

electricity services led to the introduction of controls over prices, safety,

and quality of service.13 Elsewhere, too, regulation was practised widely and

transferred from one domain to another. For example, initial railway regula-

tion drew on provisions governing turnpikes.

During the twentieth century, a steady growth in regulation took

place from the 1930s onwards. That decade saw the licensing of goods and

passenger carryings by road as well as the advent, in the shing industry, of

marketing boards that fullled both operational and regulatory functions.

The nationalization of core industries, such as the railways, were even framed

as issues of regulation. For example, the godfather of the UK public corpor-

ation model post-1945, Herbert Morrison, dened the ministerial func-

tion vis-a`-vis public corporations as being regulatory and supervisory in

character.14

In the post-war period, marketing boards followed in the cotton, croft-

ing, sugar, and iron and steel industries, and the rst US-style independent

regulatory agency was established in Britain in 1954 with the Independent

Television Authority.15 The ITA was innovatory in combining a degree of

independence from government with the carrying out of adjudicatory and

regulatory, as well as policy-developing, functions. In the United States,

such independent regulatory bodies had been carrying out key functions of

government since the Inter State Commerce Commission was established

in 1887 to limit discriminatory pricing by railroads. In the ITAs wake

followed a series of regulatory agencies that were created in the 1960s and

10 Ogus, Regulation, 612; Regulatory Law: Some Lessons from the Past (1992) 12 Legal Studies 1.11 O. MacDonagh, The Nineteenth-Century Revolution in Government: A Reappraisal (1958)

1 Historical Journal 52.12 P. Craig, Administrative Law (5th edn, London, 2003), ch. 2.13 See J. Foreman-Peck and R. Millward, Public and Private Ownership of British Industry

18201990 (Oxford, 1994), esp. chs 13; C. Foster, Privatisation, Public Ownership and the Regulationof Natural Monopoly (Oxford, 1992), chs. 1 and 2.

14 H. Morrison, Taking Stock, PRO MT 47/15, S.I. (M) (47) (32), 18 July 1947. See also M. Lodge,

On Different Tracks (Westport, CT, 2002).15 B. Sendall, Independent Television in Britain: Origin and Foundation, vol. 1: 194662 (London,

1982).

4 INTRODUCTION

1970s to deal with issues in such areas as monopolies, gaming, industrial

relations, civil aviation, discrimination, and workplace health and safety.

During the 1980s and 1990s, much stress was placed by governments and

commentators on the problems and costs of regulation and the case for

deregulating the economy.16 The privatization drive of the same period,

however, produced a new burst of regulation, carried out by a host of new

regulatory bodies such as OFTEL (1984), OFGAS (1986), OFFER (1989),

OFWAT (1990), and the Ofce of the Rail Regulator (1993). In addition,

administrative changes produced a new Environment Agency in 1996 and

from the creation of the National Lottery there emerged an Ofce of the

National Lottery to oversee the providing private operator, Camelot.

By the mid-1990s, some 25 million customers were served by the main four

regulated utilities industries alone. Their total annual turnover of 51 billion

represented around 8 per cent of the annual gross domestic product of the

UK, and not only the results of regulation but the processes used to regulate

had prompted unprecedented concern. Regulation and deregulation had

moved to positions high on the political agenda. Conservative administra-

tions had sought, since 1985, to deregulate, cut red tape, and substitute

competitive pressures for regulatory action. The Department of Trade and

Industrys Enterprise and Deregulation Unit had been established in that year

in order to review all new legislative instruments and assess the compliance

costs they would impose on businesses. That body, later called the Deregula-

tion Unit and housed in the Cabinet Ofce, had, by 1996, started to subject

regulations to a newly taxing process of regulatory appraisal,17 but the high

point of deregulatory action had come with the passing of the Deregulation

and Contracting Out Act 1994 which inter alia had given ministers the power

to use secondary legislative to eliminate burdens and controls. No rigorous

16 See J. Kay, C. Mayer, and D. Thompson (eds), Privatisation and Regulation: The UK Experience

(Oxford, 1986); D. Swann, The Retreat of the State: Deregulation and Privatisation in the UK and US

(Brighton, 1988); K. Button and D. Swann (eds), The Age of Regulatory Reform (Oxford, 1989); also see

the White Papers: Building Business, Not Barriers, Cmnd. 9794 (London, 1986); Lifting the Burden,

Cmnd. 9751 (London, 1985); Releasing Enterprise, Cmnd. 512 (London, 1988); Department of Trade

and Industry, Burdens on Business (London, 1985); Cabinet Ofce, Checking the Cost of Regulation

(London, 1996); Regulation in the Balance (London, 1996); M. Derthick and P. Quirk, The Politics of

Deregulation (Washington, 1985); V. Wright, Public Administration, Regulation, Deregulation and

Reregulation, in E. Eliassen and J. Kooiman (eds), Managing Public Organisations: Lessons from

Contemporary European Experience (London, 1993).17 See Regulation in the Balance and Chapter 15 below. Under Labour, the Deregulation Unit was

renamed the Better Regulation Unit in 1997. In 2006, these functions were split into two: the Better

Regulation Executive (supporting government departments) and the Better Regulation Commission(tasked with overseeing the implementation of initiatives). In 2008, the Better Regulation Commission

was replaced by the Risk and Regulation Advisory Council (which in itself ended its activities in 2009).

The core of regulatory reform initiatives moved to the then Department of Business, Enterprise and

Regulatory Reform (BERR). At the time of writing (2011), the Better Regulation Executive remained

located within the (now called) Department of Business, Innovation and Skills.

INTRODUCTION 5

review of the impact of such initiatives was, however, carried out by the Major

government and promises of bonres of red tape were not fullled.

It was in the eld of utilities regulation that the most urgent political

debates took place towards the end of the last millennium.18 Attention

focused on the issues of efciency, accountability, and fairness in the system

of regulating by means of Directors General and their accompanying ofces.

A host of books and reports emerged from all parts of the political spectrum

to put forward a large number of reform proposals.19 These were accompan-

ied by signicant contributions, many of which originated to the practice of

economic regulation of utilities, in industrial economics.20

In parallel to these developments in the regulation of economic and

social activities, there was also the rise of regulation inside government. This

included a growing prominence of formal auditing and nancial controlling

activities, the emergence of oversight mechanisms that sought to check on the

quality or effectiveness of public services, such as prisons, schools, hospitals,

and universities, as well as the growing codication of ethics provisions

supposedly guiding public ofcials. All of these processes had been regulated

in one way or another, but, despite considerable variations across domains,

the regulation industry inside UK government witnessed a considerable

growth at a time of wider reductions in public service staff numbers

elsewhere.21

By the turn of the millennium, the appropriateness of regulatory strategies

and structures had become a signicant public concern, and this led to a set of

responses and debates over the rst decade following 2000.22

18 For a review of this debate see R. Baldwin, Regulation in Question (London, 1995).19 See e.g. C. Veljanovski, The Future of Industry Regulation in the UK (London, 1993); Adam Smith

Institute,Who Will Regulate the Regulators? (London, 1992); P. Hain, Regulating for the Common Good

(London, 1994); Centre for the Study of Regulated Industries, Regulating the Utilities: Accountability

and Processes (London, 1994); National Consumer Council, Paying the Price (London, 1993);

C. Graham, Is There a Crisis in Regulatory Accountability? (London, 1995 and reproduced in Baldwin,

Scott, and Hood, Regulation); D. Helm, British Utilities Regulation (Oxford, 1995); M.E. Beesley (ed.),

Regulatory Utilities: A Time for Change? (London, 1996); Regulating Utilities: Broadening the Debate

(London, 1997); DTI Green Paper, A Fair Deal for Consumers: Modernising the Framework for Utility

Regulation, Cmnd 3898 (March, 1998).20 J. Vickers and G. Yarrow, Privatisation: An Economic Analysis (Cambridge, MA, 1988);

M. Armstrong, S. Cowan, and J. Vickers, Regulatory Reform: Economic Analysis and British Experience

(Cambridge, MA, 1994); D. Newbery, Privatization, Restructuring and Regulation of Network Utilities

(Cambridge, MA, 1999).21 C. Hood, C. Scott, O. James, G. Jones, and T. Travers (eds), Regulation Inside Government

(Oxford, 1999); C. Hood, O. James, G.B. Peters, and C. Scott (eds), Controlling Modern Government

(Cheltenham, 2004); M. Lodge and C. Hood, Regulation Inside Government: Retro-Theory Vindi-cated or Outdated? in R. Baldwin, M. Cave, and M. Lodge (eds), Oxford Handbook of Regulation

(Oxford, 2010).22 M. Lodge, Regulation, the Regulatory State and European Politics (2008) 30 (1/2) West

European Politics 280301; T. Prosser, The Regulatory Enterprise (Oxford, 2010); D. Oliver, T. Prosser,

and R. Rawlings (eds), The Regulatory State: Constitutional Implications (Oxford, 2010).

6 INTRODUCTION

One prominent issue was the governance of regulatory bodies. In the

British context, debates on this matter led not just to a merger of regulatory

bodies in energy and communications, they also produced a change in the

leadership structure, with the original, and initially much-feted Director

General-model being replaced by collective decision-making boards. Indeed,

the widely reported collapse of the privatized railway infrastructure provider,

Railtrack, and its transfer into a non-dividend paying public company, as

well as the associated fall-out between ministers and the then regulator,

conrmed arguements that the regulatory reforms of the 1980s and 1990s

were far from achieving depoliticized stability: instead, the world of regula-

tion continued to be one of high politics.23

A second concern related to the effects and biases of regulatory regimes. In

particular, there was a growing worry about investments in infrastructures

and the environmental effects of regulated industries, especially with regard to

climate change.24

A third debate that grew in the new millennium was one driven by the

emergence of new technologies and products. New products have come to

market with increasing speed in recent times and consumers preferences have

shifted, especially as consumers have become increasingly critical of the food

production chain in the light of a series of food safety scandals, starting with

so-called Mad Cow Disease. The arrival of genetically modied (GM) food

and the new communications technologies, for instance, are two areas that

have produced rafts of new control challenges and in another areagambling

via the internetnew technologies have changed the frontiers of existing

regulatory regimes.25

With respect to regulatory strategy, the past decade has witnessed a growing

appetite to explore the potential of non-traditional methods of regulation.

Commentators have, for instance, devoted new attention to the potential and

limitations of market-based control strategies such as franchising and permit-

trading regimes. There has been greater weight given to arguments for

controlling not by state regulation but by meta-regulation and regimes

that focus on auditing the control regimes being operated within businesses

and corporations themselves.26 A further recent change that has emerged in

23 M. Lodge, The Wrong Type of Regulation? (2002) 22(3) Journal of Public Policy 27197.24 D. Helm, The New Regulatory Agenda (London, 2004). For example, the UK government

published proposals to reform energy regulation in late 2010 that was supposed to incentivize low-

carbon forms of energy generation; see Nuclear option poised to test coalition further, Financial

Times, 17 Dec. 2010.25 For a comparison between high and low tech policy domains and regulatory responses, see

J. Black, M. Lodge, and M. Thatcher (eds), Regulatory Innovation (Cheltenham, 2005).26 J. Braithwaite, Meta Risk Management and Responsive Regulation for Tax System Integrity

(2003) 25 Law and Policy 116; C. Coglianese and D. Lazer, Management Based Regulation: Prescrib-

ing Private Management to Achieve Public Goals (2003) 37 Law and Society Review 691730; P. May,

Performance-Based Regulation and Regulatory Regimes: the Saga of Leaky Buildings (2003) 25 Law

INTRODUCTION 7

parallel with such auditing approaches has been the growth of a tendency to

see regulatory issues in terms of risks and to see control issues as questions of

risk management.27 At the same time, governmental bodies have echoed these

approaches, and bodies such as the UKs (then) Better Regulation Task Force

have commended the use of more imaginative thinking about regulation and

have stressed the need to adopt minimalist or self-regulatory controls in the

rst instance.28 Similar ideas have also come increasingly on to the agenda of

international bodies, such as the OECD with its high-quality regulation

initiative and the European Union with its own extensive programme on

(regulatory) impact assessments. As a result of this international and national

concern, the better regulation agenda diffused internationally, moving these

discourses towards emerging economies such as Brazil.29

Such discussions of meta-regulation and steering raised questions about

the bodies that should be given the task of regulating and the level of

government at which regulation should be positioned. Just as calls for

meta-regulation indicated the interest of some commentators in placing

the control function within the corporation, others grew more concerned

about the degree to which regulation operated inside the government itself

and still others saw the important shift to be towards regulation by supra-

national bodies (state or private) within a framework of globalization.30

Another important focal concern has developed in inuence over the last

decade. A strand of scholarship has emphasized the degree to which regula-

tory regimes are fragmented, multi-sourced, and unfocused.31 On this view,

fragmented regulatory authority is frequently encountered within national

systems, and public, private, and (increasingly) hybrid organizations often

share regulatory authority. This perspective suggests that to study regulation

and Policy 381401; C. Parker, Regulator-Required Corporate Compliance Program Audits (2003) 25

Law and Policy 22144; M. Power, The Audit Society (Oxford, 1997); M. Power,Organized Uncertainty:

Designing a World of Risk Management (Oxford, 2007).27 J. Black, The Emergence of Risk-based Regulation and the New Public Risk Management in the

UK, (2005) Public Law 51248; C. Hood, H. Rothstein, and R. Baldwin, The Government of Risk

(Oxford, 2001). See also H. Rothstein, M. Huber, and G. Gaskell, A Theory of Risk Colonization

(2006) 35 Economy and Society 91112.28 Better Regulation Task Force, More Imaginative Thinking About Regulation (London, 2003).29 K. Wegrich, Das Leitbild Better Regulation: Ziele, Instrumente, Wirkungsweise (Berlin, 2011);

M. Lodge and K. Wegrich, High Quality Regulation: Its Popularity, Its Tools and Its Future (2009) 29

(3) Public Money and Management 14552.30 J. Braithwaite and P. Drahos, Global Business Regulation (Cambridge, 2000); D. Kerwer, Rules

that Many Use: Standards and Global Regulation (2005) 18 Governance 61132; E. Meidinger,

Competitive Supra-Governmental Regulation: How Could it be Democratic? Buffalo Legal StudiesResearch Paper Series 2007-007 available at http://ssrn.com/abstract=1001770; P. Pattberg, The

Institutionalization of Private Governance: How Business and Nonprot Organizations Agree on

Transnational Rules (2005) 18 Governance 589610.31 J. Black, Decentring Regulation: Understanding the Role of Regulation and Self-regulation in a

Post-Regulatory World (2001) 54 Current Legal Problems 10347.

8 INTRODUCTION

by looking at single regulatory agencies is to adopt rather a limited viewpoint.

Such decentred interpretations of regulation have also highighted the need

to take on board the multi-level character of regulation, in which standards

may be set or agreed at supranational or international levels and enforcement

may take place in the locality.

When more specic regulatory questions have been explored, there have

also been dramatic changes of treatment during the new millennium.

A regulatory issue that has been particularly productive of fresh theories

and approaches has been that of enforcement and compliance. Long gone

are the days when one might comfortably profess to be an advocate of either

compliance or deterrence approaches. In the wake of the well-established

theories of responsive regulation32 and smart regulation,33 newer theories of

problem-centred34 regulation have moved compliance theory onwards, and

have then been both exposed to criticism and rened. More attention has

been paid to motivations and behaviours,35 to interactions of control sys-

tems,36 and to risk-based and principles-based approaches to regulatory

enforcement.37

As regulation has come to the forefront of public debates in recent years,

some particular issues have exerted an especially strong grasp on public and

political attentionson either a continuing or an ephemeral basis. There has,

for instance, been a sustained concern about the evils of regulation, such as

red tape, overload, and the excessive bureaucratization of economic and

social life. Critics have suggested that regulation creates major barriers to

competitiveness and economic growth, and such worries have been fuelled by

benchmarking exercises and league tables such as the World Banks Doing

Business reports.

In some cases, particular items have shifted place on the regulation agenda

so that debates about the virtues and vices of deregulation and privatization

have, as noted, given way to post-millennium discussions of regulatory

improvement and better regulation. In these newer conversations about

regulation, it has become accepted, not only that regulation is necessary for

the functioning of a market economy, but that regulatory oversight remains

essential in the running of public services, especially those involving

32 I. Ayres and J. Braithwaite, Responsive Regulation (Oxford, 1992).33 N. Gunningham and P. Grabosky, Smart Regulation (Oxford, 1998).34 M. Sparrow, The Regulatory Craft (Washington DC, 2000).35 C. Sunstein and R.Thaler, Nudge (New Haven, 2008); C. Jolls, C. Sunstein, and R. Thaler,

A Behavioural Approach to Law and Economics in C. Sunstein (ed.), Behavioural Law and Economics(Cambridge, 2008).

36 R. Baldwin and J. Black, Really Responsive Regulation (2008) 71(1)Modern Law Review 5994;

J. Black and R. Baldwin, Really Responsive Risk-Based Regulation (2010) 32(2) Law and Policy

181213.37 See Chapters 13 and 14 below.

INTRODUCTION 9

naturally monopolistic elements, such as networks. An initial emphasis on

economic regulation that was supposed to wither away over time has been

replaced by a realization that there is a continuing need for regulatory

oversight and an imperative to add environmental and sustainability objec-

tives to the earlier, primarily economic and social, objectives.

These freshly developing agendas of regulation have not, however, always

gelled into highly coherent packages of policy or theory. The better regulation

group of initiatives can, for instance, be seen as rich in tensions and contra-

dictions. Thus, calls have been made for more evidence-based regulation (and

data-intensive, risk-based regulation) but, at the same time, governments have

demanded that regulators make fewer informational and data supply demands

on businesses. Similarly, the past decade or so has seen the spread of rational-

istic and formal modes of evaluating regulatory proposals (notably Regulatory

Impact Assessments) and, at the same time, many governments have urged

regulators to move towards the kinds of regulatory styles that are least likely to

score convincingly in RIA appraisalssuch as more user-friendly and less

formal modes of control (see, further, Chapter 15). In itself, the better

regulation agenda could be seen as an uneasy rhetorical package that com-

bines a continuation of the anti-red tape message and the belief in techno-

cratic and rationalizing tools for enhancing regulatory quality.38

By 2010, regulation had come to occupy a place at the forefront of public

debate in more than one domain. The nancial crisis that was initially to have

led to a return of the state pointed to the problems that could be caused by

an over-reliance on the self-regulatory capacities of private organization.39 It

also highlighted a series of issues regarding enforcement styles and overall

regulatory arrangements. By 2011, regulatory debates continued to be domin-

ated by demands and warnings, on the one side, to impose more regulation

(in many variants: more rules, tougher sanctions, growing distinctiveness and

professionalization of regulators) and, on the other, cautioning that more

regulation would have considerable undesirable effects. The nancial crisis

also added to global regulation debates on such matters as how systemic risks

could be coped with across jurisdictions, and how national regulators

(through the Basel III agreement) could coordinate their macroprudential

actions and impose capital requirements to cope with overheated national

economies.40 Environmental disasters, such as the Louisiana oil-spill of 2010,

brought their own regulatory disputes.41

38 T.O. McGarity, Reinventing Rationality: The Role of Regulatory Analysis in the Federal Bureaucracy

(Cambridge, 1991).39 M. Lodge and K. Wegrich, Letter to the Editor, Public Administration Review (2010).40 Bank Regulators Agree on Global Sweep to Tackle Credit Bubbles, Financial Times, 11 Jan. 2011.41 National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling (2011),

Final Report (www.oilspillcommission.gov/nal-report, last accessed 14 January 2011). The National

Commission on the BP spill criticized the lack of resources allocated to the regulator and called for the

10 INTRODUCTION

As a result of such developments and crises, regulation now occupies its

place as a central organizing concern for the worlds of practice and research

alike. At the same time, it has increasingly been asked whether regimes of

regulation or self-regulation can satisfactorily solve complex problemsand

not just in the context of the nancial crisis. Advocacy of different regulatory

strategies has, moreover, tended to proceed on a cautious basis and critiques

of regulation have tended to emerge in a process of interaction between the

study and the practice of regulation.

The Organization of the Book

Part I of the book reviews a series of general issues in regulation, namely:

why regulate at all (Chapter 2); how good regulation can be identied

(Chapter 3); how the origins of regulation and regulatory changes can be

explained (Chapter 4); and how regulatory failures can be understood

(Chapter 5). It also considers, in Chapter 6, the challenges of regulating

risks and the vision of regulation as a risk-centred activity.

Part II of the book then looks at strategic issues and how regulation can be

carried out. Central concerns are: choices of regulatory strategy (Chapter 7);

self-regulatory, meta-regulatory, and complex regimes (Chapter 8); franchis-

ing (Chapter 9); and emissions trading (Chapter 10). Part III examines enforce-

ment and implementation matters. It starts with a general review of these issues

in Chapter 11 before looking at the more particular approaches of responsive

regulation (Chapter 12); and risk-based regulation (Chapter 13). The problems

that are encountered in choosing types of regulatory standards are considered

in Chapter 14, together with the case for principles-based regulation.

Part IV turns attention to questions of evaluation of the quality of regula-

tion. Cost-benet testing and Regulatory Impact Assessment are looked at in

Chapter 15. Accountability and procedural fairness concerns are discussed in

Chapter 16. Finally, the role and incidence of competition and coordination

between regulators is addressed in Chapter 17.

Part V reviews a host of issues that relate to the governmental levels

at which regulatory systems are located. Chapter 18 deals generally with

regulation at different levels before Chapter 19 considers the European

creation of a new safety regulator. The Commission also criticized the prevalence of self-regulation inthe sector, especially the role in which the American Petroleum Institute which produced national

and global technical standards, was predisposed to rely on industry autonomy. It called for the

creation of an industry-based safety standard-setting body and enforcinga demand that was widely

contested, with opponents noting in particular the nancial implications of these proposalssee US

cannot walk away from oil in deep water, Financial Times, 12 Jan. 2011.

INTRODUCTION 11

dimension to regulation. Development and globalization issues are

covered by Chapters 20 and 21, respectively. Part VI then looks at utility or

network industry issues, and focuses on: price setting in natural monopolies

(Chapter 22); using competition in network industries (Chapter 23); separa-

tion and contestability in network industries (Chapter 24); implementing

price controls (Chapter 25); and efciency and innovation in network in-

dustries (Chapter 26). Conclusions are offered in Chapter 27.

12 INTRODUCTION

Part I

Fundamentals

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2 Why Regulate?

Motives for regulating can be distinguished from technical justications for

regulating. Governments may regulate for a number of motivesfor example,

they may be inuenced by the economically powerful and may act in the

interests of the regulated industry or they may see a particular regulatory

stance as a means to re-election. Different commentators may analyse such

motives in different ways, and a variety of approaches to such analysis will be

discussed in Chapter 3. To begin, though, we should consider the technical

justications for regulating that may be given by a government that is assumed

to be acting in pursuit of the public interest.1

Many of the rationales for regulating can be described as instances of market

failure. Regulation in such cases is argued to be justied because the uncon-

trolled marketplace will, for some reason, fail to produce behaviour or results

in accordance with the public interest.2 In some sectors or circumstances, there

may also be market absencethere may be no effective marketbecause, for

example, households cannot buy clean air or peace and quiet in their localities.

In this chapter, we discuss the traditional market failure rationales for regulat-

ing, but we also consider the argument that there may be other reasons to

regulate and that these have a basis in human rights or social solidarity, rather

than market, considerations.

Market Failure Rationales

MONOPOLIES AND NATURAL MONOPOLIES

Monopoly describes the position in which one seller produces for the entire

industry or market. Monopoly pricing and output is likely to occur and be

sustained where three factors obtain:3

1 For detailed reviews of public interest reasons for regulating see S. Breyer, Regulation and ItsReform (Cambridge, MA, 1982), ch. 1; A. Ogus, Regulation: Legal Form and Economic Theory (Oxford,

1994), ch. 3; E. Gellhorn and R.J. Pierce, Regulated Industries (St Paul, MN, 1982), ch. 2; J. Kay and

J. Vickers, Regulatory Reform: An Appraisal, in G. Majone (ed.), De-Regulation or Re-Regulation?

(London, 1989); B. Mitnick, The Political Economy of Regulation (New York, 1980), ch. 5; C. Sunstein,

After the Rights Revolution (Cambridge, MA, 1990), ch. 2; C. Hood, Explaining Economic Policy

Reversals (Buckingham, 1995).2 See also J. Francis, The Politics of Regulation (Oxford, 1993), ch. 1.3 See Gellhorn and Pierce, Regulated Industries, 367 and Chapter 15 below. On regulating

monopolies generally see C. Foster, Privatisation, Public Ownership and the Regulation of Natural

Monopoly (Oxford, 1992), ch. 6; Ogus, Regulation, 303; Breyer, Regulation and Its Reform, 1519;

A single seller occupies the entire market. The product sold is unique in the sense that there is no substitute suf-

ciently close for consumers to turn to.

Substantial barriers restrict entry by other rms into the industry, and exitis difcult.

Where monopoly occurs, the market fails because competition is decient.

From the public interest perspective, the problem with a rm occupying a

monopolistic position is that in maximizing prots it will restrict its output

and set price above marginal cost. It will do this because if it charges a single

price for its product, additional sales will only be achieved by lowering the

price on the entire output. The monopolist will forgo sales to the extent that

lost revenue from fewer sales will be compensated for by higher revenue

derived from increased price on the units still sold. The effects of monopoly,

as compared to perfect competition, are reduced output, higher prices, and

transfer of income from consumers to producers.

One response to potential monopolies is to use competition (or antitrust)

laws so as to create a business environment that is conducive to competition.

Where a natural monopoly exists, however, the use of competition law may

be undesirable.4 A natural monopoly occurs when economies of scale avail-

able in the production process are so large that the relevant market can be

served at the least cost by a single rm. It is accordingly less costly to society

to have production carried out by one rm than by many. Thus, rather than

have three railway or electricity companies laying separate networks of rails

or cables where one would do, it may be more efcient to give one rm a

monopoly subject to regulation of such matters as prices and access to the

network. Determining whether a natural monopoly exists requires a compari-

son of demand for the product with the extent of the economies of scale

available in production. If a rm is in a position of natural monopoly then,

like any monopoly, it will present problems of reduced output, higher prices,

and transfers of wealth from consumers to the rm. Restoration of competi-

tion by use of competition law is not, however, an appropriate response, since

competition may be socially costly and thus regulation of prices, quality, and

output as well as access may be called for. The regulator will try to set price

near incremental cost (the cost of producing an additional unit) in order to

encourage the natural monopolist to expand its output to the level that

competitive conditions would have induced.

Francis, Politics of Regulation, ch. 3; E. Gellhorn andW. Kovacic, Antitrust Law and Economics (St Paul,

Minn., 1994), chs. 3 and 4.4 On natural monopolies see M. Waterson, Regulation of the Firm and Natural Monopoly (Oxford,

1988), ch. 2; Foster, Privatisation, ch. 6.2.

16 FUNDAMENTALS

Not all aspects of a supply process may be naturally monopolistic. As Ogus

points out,5 the economies of scale phenomenon may affect only one part of

a given processfor instance the transmission of, say, electricity, rather than

its generation.6 The task of many governments and regulators (at least those

committed to minimalist regulation) is to identify those parts of a process

that are naturally monopolistic so that these can be regulated while other

aspects are left to the inuence of competitive forces.7

WINDFALL PROFITS

A rm will earn a windfall prot (sometimes called an economic rent

or excess prot) where it nds a source of supply signicantly cheaper

than that available in the marketplace.8 It may do so by, say, locating

a rich seam of an easily extracted mineral; by coming upon a material

efciency in a production process; or by possessing an asset that sud-

denly escalates in valuefor example, a boat in a desert town that has been

ooded. Regulation may be called for when it is desired either to transfer

prots to taxpayers or to allow consumers or the public to benet from the

windfall.

Where the windfall is the result of planned investments of money, effort, or

research, or where society might want to create incentives to search for new

efciencies, products, or areas of demand, there is a case for allowing windfall

prots to be retained. (If excess prots are earned, it may be appropriate to

limit these so that rewards and incentives are proportionate to the effort or

investment that has produced the return.) In the desert town, it may be

desirable to encourage some individuals to store boats in order to cope with

periodic oods. If, however, the windfall is the result of good fortune rather

than effort, exploration, or research, the case for taking the prots for public

benet may be stronger. Even in such cases, however, there will still be

an argument for leaving windfall prots where they lie. If the state deprives

a property owner of the windfalls that ow from such ownership, this may be

seen by market actors as rendering property rights less secure, and this

uncertainty may be bad for business generally. The balance between the

publics gains from intervention and any negative effects on markets will

have to be assessed in specic cases.

5 Ogus, Regulation, 31.6 G. Yarrow, Regulation and Competition in the Electricity Supply Industry, in J. Kay, C. Mayer,

and D. Thompson (eds), Privatisation and Regulation (Oxford, 1986).7 See Chapter 23 below, and the White Paper, Privatising Electricity, Cmnd. 322 (London, 1988).8 See Breyer, Regulation and Its Reform, 21.

WHY REGULATE? 17

EXTERNALITIES

The reason for regulating externalities (or spillovers) is that the price of a

product does not reect the true cost to society of producing that good, and

excessive consumption accordingly results.9 Thus, a manufacturer of car tyres

might keep costs to consumers down by dumping pollutants arising from the

manufacturing process into a river. The price of the tyres will not represent

the true costs that production imposes on society if clean-up costs are left out

of account. The resultant process is wasteful because too many resources are

attracted into polluting activities (too many tyres are made and sold) and too

few resources are devoted by the manufacturer to pollution avoidance or

adopting pollution-free production methods. The rationale for regulation is

to eliminate this wasteand to protect society or third parties suffering

from externalitiesby compelling the internalization of spillover costson

polluter pays principles.

INFORMATION INADEQUACIES

Competitive markets can only function properly if consumers are suf-

ciently well informed to evaluate competing products.10 The market may,

however, fail to produce adequate information and may fail for a number of

reasons: information may cost money to produce (e.g. because researching

the effects of a product, such as a drug, may prove expensive). The producer

of information, however, may not be compensated by others who use that

information (e.g. other manufacturers of the drug). The incentive to pro-

duce information may accordingly be low. There may also be incentives to

falsify informationwhere, for example, consumers of the product are ill-

positioned to challenge the falsication and seek remedies for damages

suffered or where they face high costs in doing so. Areas in which consumers

purchase a type of product very infrequently may give rise to this problem.

The information produced may, in addition, not be of sufcient assistance

to the consumerfor instance, because the consumer lacks the expertise

required to render technical data useful. Finally, collusion in the market-

place, or insufcient competition, may reduce the ow of information below

the levels consumers might want. Producers, as a group, may thus fail to

warn consumers about the general hazards or deciencies associated with a

product. Breyer notes that until the US government required disclosure,

accurate information was unavailable to most buyers in that country

9 See Breyer, Regulation and Its Reform, 236; Ogus, Regulation, 358.10 See F. Hayek, The Use of Knowledge in Society (1945) 35 American Economic Review 519;

Breyer, Regulation and Its Reform, 268; Ogus, Regulation, 3841.

18 FUNDAMENTALS

concerning the durability of light bulbs, nicotine content of cigarettes, fuel

economy for cars, or care requirements for textiles.11

Regulation, by making information more extensively accessible, accurate,

and affordable, may protect consumers against information inadequacies

and the consequences thereof, and may encourage the operation of healthy,

competitive markets.

CONTINUITY AND AVAILABILITY OF SERVICE

In some circumstances, the market may not provide the socially desired levels

of continuity and availability of service. Thus, where demand is cyclical (for

example, as with passenger air transport to a holiday island)wastemayoccur as

rms go through the processes of closing and reopening operations.12 Regula-

tion may be used to sustain services through troughsfor example, by setting

minimum prices at levels allowing the covering of xed costs through lean

periods. Thiswould be justiedwhere the extra costs imposed on consumers by

pricing rules are less than those caused by the processes of closing and opening

services in response to the business cycle. The subsidizing of off-peak by peak

travellers will, however, raise issues of equity to be considered alongside ques-

tions of social policy. In the case of some products or servicesfor example,

water servicesit may be considered, as a matter of social policy, that these

should be generally available at least to a certain minimum standard. In the

unregulated market, however, competition may lead to cream-skimming

the process in which the producer chooses to supply only the most protable

customersand services may be withdrawn from poorer or more geographi-

cally dispersed groupings of customers. Regulationmay be justied in order to

produce socially desirable results, even though the cross-subsidizations ef-

fected may be criticizable as inefcient and unfair.

ANTI-COMPETITIVE BEHAVIOUR AND PREDATORY PRICING

Markets may be decient not merely because competition is lacking: they may

produce undesirable effects because rms behave in a manner not conducive

to healthy competition. A principal manifestation of such behaviour is pred-

atory pricing. This occurs when a rm prices below costs, in the hope of

driving competitors from the market, achieving a degree of domination, and

then using its position to recover the costs of predation and increase prots at

the expense of consumers. Preconditions for a rational rm to engage in

predatory pricing are that: it must be able to outlast its competitors once

prices are cut below variable costs; and it must be able to maintain prices well

11 Breyer, Regulation and Its Reform, 28. 12 Ogus, Regulation, 436.

WHY REGULATE? 19

above costs for long enough to recover its prior losses. The costs of entry to

and exit from the market must, accordingly, allow it this period of comfort

before new competition arises. The aim for regulators is to sustain competi-

tion and protect consumers from the ill-effects of market domination by

outlawing predatory or other forms of anti-competitive behaviour.

PUBLIC GOODS AND MORAL HAZARD

Some commodities, e.g. security and defence services, may bring shared

benets and be generally desired. It may, however, be very costly for those

paying for such services to prevent non-payers (free-riders) from enjoying

the benets of those services. As a result, the market may fail to encourage the

production of such commodities, and regulation may be requiredoften to

overcome the free-rider problem by imposing taxes.

Similarly, where there is an instance of moral hazardwhere someone

other than the consumer pays for a service13there may be excessive con-

sumption without regard to the resource costs being imposed on society.

If, for example, medical costs are not met by the patient, but by the state or

an insurer, regulatory constraints may be required if excessive consumption of

medical services is to be avoided.

UNEQUAL BARGAINING POWER

One precondition for the efcient or fair allocation of resources in a market is

equal bargaining power. If bargaining power is unequal, regulation may be

justied in order to protect certain interests. Thus, if unemployment is

prevalent it cannot be assumed that workers will be able to negotiate effec-

tively to protect their interests, and regulation may be required to safeguard

such matters as the health and safety of those workers. Inequalities of bargain-

ing power may thus be the products of relative positions in the marketplace,

but they may also stem from asymmetries of information. Workers, for

instance, may be poorly placed to secure health protections from their

employers because they lack the information that would put them on an

equal footing in negotiations.

SCARCITY AND RATIONING

Regulatory rather than market mechanisms may be justied in order to

allocate certain commodities when these are in short supply. In a petrol

13 See generally G. Calabresi, The Cost of Accidents: A Legal and Economic Analysis (New

Haven, 1970).

20 FUNDAMENTALS

shortage, for example, public interest objectives may take precedence over

efciency so that, instead of using pricing as an allocative instrument,

the petrol is allocated with reference to democratically generated lists of

priorities.

RATIONALIZATION AND COORDINATION

In many situations, it is extremely expensive for individuals to negotiate

private contracts so as to organize behaviour or industries in an efcient

mannerthe transaction costs would be excessive.14 The rms in an industry

may be too small and geographically dispersed to bring themselves together to

produce efciently. (This might happen when small shing concerns in a

sparsely populated area fail to make collective marketing arrangements.)

Enterprises may, moreover, have developed different and incompatible

modes of production. In these circumstances, regulation may be justied as

a means of rationalizing production processes (perhaps standardizing equip-

ment in order to create effective networks) and in order to coordinate the

market. Centralized regulation holds the advantage over individual private

law arrangements, where information can be more efciently communicated

through public channels and economies of scale can be achieved by having

one public agency responsible for upholding standards.15

It is noteworthy that this rationale for regulation is based more on the

desire to enable effective action to take place than on the need to prohibit

undesirable behaviour.

PLANNING

Markets may ensure reasonably well that individuals consumer preferences

are met, but they are less able to meet the demands of future generations or to

satisfy altruistic concerns (e.g. the quality of an environment not personally

enjoyed).16 There is also, as far as altruism is concerned, a potential free-rider

problem. Many people may be prepared to give up some of their assets for

altruistic purposes only if they can be assured that a large number of others

14 See Ogus, Regulation, 412; S. Breyer and P. MacAvoy, The Federal Power Commission and the

Coordination Problem in the Electrical Power Industry (1973) 46 Southern California Law

Review 661.15 In the transportation sector, coordination and regulation by a central agency may be needed in

order to organize a route networksee S. Glaister, Deregulation and Privatisation: British Experience

(Washington, DC, 1998).16 See Ogus, Regulation, 54; R.B. Stewart, Regulation in a Liberal State: The Role of Non-

Commodity Values (1983) 92 Yale Law Journal 1537; Sunstein, After the Rights Revolution, 5761.

WHY REGULATE? 21

will do the same. The problems and costs of coordination mean that regula-

tion may be required in order to satisfy such desires.17

Rights-based and Social Rationales for Regulating

It has been argued, notably by Tony Prosser,18 that the market failure rationale

does not adequately justify the range of regulatory activities that are com-

monly undertaken. He suggests, moreover, that the market failure analysis

treats regulation as second-best to market allocation and that this does not

properly explain or justify current practice. Prosser, accordingly, points to the

relevance of two further rationales for regulatingto protect human rights19

and to further social solidarity.20 In doing so, he takes issue with the assump-

tions that market solutions are always the best ways to deal with decisions on

the allocation of goods and services, and that non-market failure rationales

for regulating are essentially arbitrary. The idea that market allocations are

technical whereas social justice issues are political is also questioned. What

can be said as a matter of description, says Prosser, is that environmental and

many other regulators can properly be seen as seeking to further social

objectives, rather than as simply acting to correct market failures. Even

where markets are involved, regulatory laws, on such a view, are not limited

to merely correcting the market but often serve to constitute market relations,

to provide the frameworks of rights and processes that allow markets to work,

and to protect markets from fragmentation. In many contexts, accordingly,

regulation can be seen as prior, not secondary, to the market and as a rst-

choice method of organizing social relations.21

17 Ogus, Regulation, 54.18 T. Prosser, Regulation and Social Solidarity (2006) 33 Journal of Law and Society 36487; Public

Service Law (2000) 63 Law and Contemporary Problems 6382. See also C. McCrudden, Social Policy

and Economic Regulators in C. McCrudden, Regulation and Deregulation (Oxford, 1999) and M.

Feintuck, Regulatory Rationales Beyond the Economic in R. Baldwin, M. Cave and M. Lodge (eds),

The Oxford Handbook of Regulation (Oxford, 2010).19 See R. Brownsword, What the World Needs Now: Techno-Regulation, Human Rights and

Human Dignity in R. Brownsword (ed.), Global Governance and the Quest for Justice (Oxford, 2004).20 A developing of the argument is offered in T. Prosser, The Regulatory Enterprise: Government

Regulation and Legitimacy (Oxford, 2010), 1120, where four rationales for regulation are distin-

guished: (1) regulation for economic efciency and consumer choice (market-centred regulation);

(2) regulation to protect rights; (3) regulation for social solidarity; and (4) regulation as deliberation

(the provision of processes to resolve problems). See also H. McVea, Financial Services RegulationUnder the Financial Services Authority: A Reassertion of the Market Failure Thesis? (2005) 64

Cambridge Law Journal 41348; J. Black, Critical Reections on Regulation, LSE Centre for Analysis

of Risk and Regulation (CARR), Discussion Paper 4 (2002).21 See C. Shearing, A Constitutive Conception of Regulation in P. Grabosky and J. Braithwaite

(eds), Business Regulation and Australias Future (Canberra, 1994).

22 FUNDAMENTALS

Consistent with such regulatory rationales are examples of regulating for

reasons of distributional justice, rights protection, and citizenshipas, for

example, where regulated utilities are obliged to apply geographically aver-

aged tariffs or to meet universal service obligations. Governments, indeed,

regulate on a host of matters simply in order to further social policies such as

the prevention of discrimination based on race, sex, or age. Social objectives,

moreover, are sometimes furthered by regulating even where this involves

overruling the preferences of market players and acting paternalistically. Thus,

society may, as a matter of policy, decide to act in the face of drivers desires

and demand that seat belts be worn in motor vehicles. In the strongest form of

such paternalism, the decision is taken to regulate even where it is accepted

that the citizens involved would not support regulation and that they are

possessed of full information on the relevant issue.22

Conclusions: Choosing to Regulate

There are, as seen above (and in Table 2.1) a number of well-recognized

reasons commonly given for regulating. It should be stressed, however, that in

any one sector or industry the case for regulating may well be based not on a

single but on a combination of rationalesbe these market failure-, human

rights-, or social solidarity-based. Health and safety regulation, for example,

can be justied with reference to such matters as externalities, information

defects, unequal bargaining, human rights, and paternalism.23

A second point to be borne in mind in considering whether to regulate,

is that the market and all its failings should be compared with regulation

and all its failings. Any analysis of the need to regulate will be skewed if it is

assumed that regulatory techniques will operate perfectly. We will see during

this book that all regulatory strategies have strengths and weaknesses

in relation to their implementation, as well as their design. Regulatory and

market solutions to problems should be considered in all their varieties

and with all likely deciencies and side-effects if true comparisons are to

be effected.

22 Ibid., 514.23 Breyer, Regulation and Its Reform, 34; Prosser, Regulation and Social Solidarity.

WHY REGULATE? 23

Table 2.1. Rationales for regulating

Rationale Main aims of regulation Example

Monopolies and natural

monpolies

Counter tendency to raise prices and lower output. Utilities.

Harness benets of scale economies.

Identify areas that are genuinely monopolistic.

Windfall prots Transfer benets of windfalls from rms to consumers

or taxpayers.

Firm discovers unusually

cheap source of supply.

Externalities Compel producer or consumer to bear full costs of

production, rather than pass on to third parties or

society.

Pollution of river by

factory.

Information

inadequacies

Inform consumers to allow market to operate. Pharmaceuticals. Food

and drinks labelling.

Continuity and

availability of service

Ensure socially desired (or protect minimal) level of

essential service.

Transport service to

remote region.

Anti-competitive and

predatory pricing

behaviour

Prevent anti-competitive behaviour. Below-cost pricing in

transport.

Public goods and moral

hazard

Share costs where benets of activity are shared but

free-rider problems exist.

Defence and security

services. Health

Services.

Unequal bargaining

power

Protect vulnerable interests where market fails to do

so.

Health and Safety at

Work.

Scarcity and rationing Public interest allocation of scarce commodities. Petrol shortage.

Rationalization and

coordination

Secure efcient production where transaction costs

prevent market from obtaining network gains or

efciencies of scale.

Disparate production in

agriculture and

sheries.

Standardization.

Planning Protect interests of future generations. Environment.

Coordinate altruistic intentions.

Human rights Protection of weaker citizens. Discrimination.

Embryology.

Social protection Social solidarity. Broadcasting.

24 FUNDAMENTALS

3 What is Good Regulation?

To decide whether a system of regulation is good, acceptable, or in need of

reform it is necessary to be clear about the benchmarks that are relevant in

such an evaluation.1

A temptation for some economists may be to assert that regulation is good

if it is efcient in the sense that it maximizes wealth.2 It can be objected,

however, that wealth maximization provides no ethical basis for action, that it

cannot justify any particular distribution of rights within society, and that, as

a result, it cannot be used to measure regulatory decisions affecting rights.3

This is because there is circularity in the assertion that one should distrib-

ute rights (e.g. to pollute or to be free from pollution) in a manner that

maximizes wealth. For every particular, given, distribution of wealth, there is

a specic allocation of further rights that will maximize wealththus, how

best to allocate the new supply of petrol would be governed by who owns

the machinery that burns petrol.4 Deciding distributional issues on the basis

of wealth maximization, accordingly, assumes a given distribution from

the start. Similarly, it is circular to state that rights should be allocated to

those who value them mostvaluation itself depends on assumptions about

1 See generally, R. Baldwin and C. McCrudden, Regulation and Public Law (London, 1987), ch. 3;

R. Baldwin, Rules and Government (Oxford, 1995), ch. 3; J.O. Freedman, Crisis and Legitimacy

(Cambridge, 1978); C. Radaelli and F. De Francesco, Regulatory Quality in Europe (Manchester,

2007); J. Stern, The Evaluation of Regulatory Agencies in R. Baldwin, M. Cave, and M. Lodge

(eds), The Oxford Handbook of Regulation (Oxford, 2010).2 See R.A. Posner, Utilitarianism, Economics and Legal Theory (1979) 8 Journal of. Legal Studies

103; id., Wealth Maximisation Revisited (1985) 2 Notre Dame Journal of Law, Ethics and Public

Policy 85.3 See R. Dworkin, Is Wealth a Value? (1980) 9 Journal of Legal Studies 191; id., Why Efciency

(1980) 8Hofstra Law Review 563; id., AMatter of Principle (Cambridge, MA, 1986), ch. 13; S. Kelman,

Cost-Benet Analysis: An Ethical Critique (1981) 5(1) Regulation 33; A. Kronman, Wealth Max-

imisation as a Normative Principle (1980) 9 Journal of Legal Studies 227; C.G. Veljanovski, Wealth

Maximisation, Law and Ethics: On the Limits of Economic Efciency (1981) 1 International Review of

Law and Economics 5; E.J. Weinrib, Utilitarianism, Economics and Legal Theory (1980) 30 University

of Toronto LJ 307; C. Fried, Difculties in the Economic Analysis of Rights, in G. Dworkin,

G. Bermont, and P. Brown (eds.), Markets and Morals (Washington, 1977). For a review of the

literature see N. Duxbury, Patterns of American Jurisprudence (Oxford, 1995), 4006.4 This statement assumes that there are transaction costs. If there are no transaction costs and

parties can bargain in a friction-free manner then, as the Coase Theorem tells us, any distribution ofrights will maximize wealth and the owners of petrol-burning machines will end up using the petrol

even if it is not allocated to them in the rst instance. This implies, again, that wealth maximization

offers no help at all in deciding how to allocate rights. See R. Coase, The Problem of Social Cost

(1960) 3 Journal of Law and Economics 1; Veljanovski, Wealth Maximisation, 5; and L.A. Bebchuck,

The Pursuit of a Bigger Pie: Can Everyone Expect a Bigger Slice? (1980) 8 Hofstra Law Review 671.

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the allocation of rights (one can only value if one has something to value

with or else the valuation takes place in the realms of fantasy). Questions of

justice, it follows, cannot be answered by economists appeals to efciency

and distributional questions such as whether it is right to allow an extra

unit of pollution (thus shifting the balance of rights from, say, river user A to

polluting factory owner B) have to be made on the basis of grounds other

than efciency.5

This is not to say that efciency may not be a factor to be taken into

account in making regulatory judgements.6 Wemay want to take on board the

wealth implications of particular distributional choices when deciding, say,

how to allocate rights between polluters and potential victims. What we

should be wary of is using efciency as a single measuring rod or justication

for regulatory decisions. This will involve either circularity, as noted, or the

assumption that the present distribution of wealth, together with a bias in

favour of those with wealth, is acceptable.7

A further moral objection to wealth maximization relates to its implication

that it is right to allow B to interfere with As rights (e.g. by polluting their

river or exposing them to a hazardous substance) if B generates enough

wealth to compensate A for the harm done. Human beings, the objection

runs, have certain basic rights that it would be morally objectionable to put up

for sale. Certain risks, it might similarly be said, should not be imposed on

individuals lives no matter what the price, compensation, or wealth gain

on offer.8

Five Criteria for Good Regulation

More plausible than wealth maximization is an approach to regulatory

evaluation that involves looking at those arguments that have general cur-

rency when regulatory arrangements and performance are discussed in the

public domain. Certain arguments have force in debating whether this or that

5 For a statement of non-economic substantive goals that would justify regulation according to a

civic republican viewpoint see C. Sunstein, After the Rights Revolution: Reconceiving the Regulatory

State (Cambridge MA, 1990).6 On economists contributions see R. Cooter and T. Ulen, Law and Economics (Glenview, IL,

1988), ch. 1 and see Chapter 15, below, on the cost-benet testing of regulation.7 Those possessing wealth will gain in efciency-based decisions because they value rights more

highly and are better placed than poorer persons to generate further wealth from the rights at issue: seeC.E. Baker, The Ideology of the Economic Analysis of Law (1975) 5 Philosophy and Public Affairs 3;

G. Minda, Towards a More Just Economics of JusticeA Review Essay (1989) 10 Cardozo Law

Review 1855.8 For governmental acknowledgement of this point see HM Treasury, The Setting of Safety

Standards (London, 1996), 9.

26 FUNDAMENTALS

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regulatory action or regime is worthy of support (is legitimate).9 These

arguments involve reference to one or more of ve key tests:

Is the action or regime supported by legislative authority? Is there an appropriate scheme of accountability? Are procedures fair, accessible, and open? Is the regulator acting with sufcient expertise? Is the action or regime efcient?The ve tests, or criteria, should be explained before their role in assessing

regulation is discussed further.

THE LEGISLATIVE MANDATE

This criterion suggests that regulatory action deserves support when it is

authorized by Parliament, the fountain of democratic authority. If the people,

through Parliament, have instructed certain regulators to achieve result X,

and those regulators can point to their having produced result X, then they

are in a position to claim public support. They have fullled their mandate.10

It might be very proper to judge regulators according to their success

in fullling their mandates. Unfortunately, however, it is seldom easy to

state in precise terms what this should involve. Most regulatory statutes give

regulators broad discretions and implementing the mandate thus involves

interpretation.11 A statute, for example, may order a regulator to protect the

9 For governmental statements on the criteria for good regulation see Better Regulation Task Force

(BRTF), Principles of Good Regulation (London, 2003). The principles are: Proportionality, Account-

ability, Consistency, Transparency, and Targeting; Department of the Taoiseach, Regulating Better

(Dublin, 2004), www.betterregulation.ie (looking to necessity, effectiveness, proportionality, transpar-

ency, accountability, and consistency). See also the Australian government, Department of Industry,

Tourism and Resources: Regulatory Performance Indicators (Canberra, 1999); S. Argy and M. Johnson,

Mechanisms for Improving the Quality of Regulations: Australian Productivity Commission (Staff

Working Paper, July 2003). For Canada, see Treasury Board of Canada Secretariat, Federal Regulatory

Process Management Standards (Ottawa, 1996). The World Bank view is set down in World Bank,

Doing Business in 2004: Understanding Regulation (Washington, DC, and Oxford, 2004). See also

OECD, Guiding Principles for Regulatory Quality and Performance (Paris, 2005). For other denitions

of good or better regulation see Mandelkern Group on Better Regulation, Final Report (Brussels, 13

Nov. 2002) (Mandelkern Report).10 If Parliament is yet to provide amandate because no regulatory statute has been passed in an area

say, when a regulatory Bill is being debatedany discussion of good regulation ismore open-ended than

usual. Reference, in such circumstances, is likely to be made to the four criteria other than the mandate

that are discussed here and also to governmental claims to possess a mandate for a certain regulatory

approach (based, for instance, on manifesto statements) and to more general arguments concerningsocial justice. See, for example, the Better Regulation Task Forces 2003 statement that good regulation

should be: Proportionate, Accountable, Consistent, Transparent, and Targeted (Better Regulation Task

Force, Principles of Good Regulation (London, 2003).11 See K.C. Davis, Discretionary Justice (Chicago, 1969), 39 and on British utilities see T. Prosser,

Law and the Regulators (Oxford, 1997), 1531. Lowi suggested that many US regulatory statutes were

WHAT IS GOOD REGULATION? 27

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interests of consumers, but it may be silent on the balance to be drawn

between industrial and domestic or large and small consumers interests.

Such statutes, moreover, often set out objectives that exist at mutual

tension. Achieving certain objectives may necessarily involve trading off

performance in relation to other stated objectives. Regulatory statutes, in

addition, often give regulators scope for exercising judgement and devising

solutions. (They do this because legislators generally have limited information

and expertise in specialist areas and, though knowing that there is a problem,

tend not to know how to solve it.) It is, in such cases, impossible to point to

clear objectives. Legislators, furthermore, may deliberately avoid setting down

precise objectives because they want regulators to have the freedom to cope

with problems as they arise in the futureto meet the emergent challenges

of new risks, innovative operations, novel technologies and so on. For all of

these reasons, regulators are seldom, if ever, involved in the mechanical

transmission of statutory objectives into results on the ground,12 and the

mandate benchmark, though of relevance, will rarely provide an easy answer

to questions of legitimation.

ACCOUNTABILITY

Regulators with imprecise mandates may, nevertheless, claim that they

deserve the support of the public because they are properly accountable to,

and controlled by, democratic institutions. Thus, a regulatory agency might

claim that it is accountable for its interpretation of its mandate to a represen-

tative body and that this oversight renders its exercise of powers acceptable.13

A difculty with this criterion is that controversy will often attend the

selection of the individuals and bodies that provide accountability. If Parlia-

ment itself or another elected institution is not the body holding the regulator

to account, then the arrangement may be criticized as unrepresentative.

Where control is exercised by certain institutions (e.g. courts), the compe-