Mastering Strategy: Regulated Industries

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Regulated businesses face almost all of the strategy issues which confront conventional firms, and some additional ones that are specific to their own environment. As deregulation spreads across Europe, the gap between those firms which handle these specific issues effectively and those which respond to regulation and regulatory changes with hostility, complacency or defeatism will widen rapidly.

Strategy in Regulated Industries

Even in market economies, the state is deeply involved in economic activity. Some businesses are mainly undertaken by government – education, defence, policing. Others sell to the government – defence contracting. Still others are undertaken in a framework in which many ordinary commercial decisions, such as those that concern pricing, investment and product design, are wholly or largely fixed by the state. The regulated industries with which this article is concerned are this third group.

The normal rationale for such intervention is the existence of some market failure, which means either that a competitive industry structure is not possible or, if it is possible, is likely to have an outcome which is inefficient or undesirable. The existence of inevitable market power is one such kind of market failure, as with electricity transmission or water distribution, where a proliferation of suppliers is hopelessly uneconomic. Markets fail through externalities, as with environmental or health and safety issues, where actions have consequences that do not immediately fall on those who engage in them. And an increasingly common source of market failure is information asymmetry: the seller knows far more about the product than the buyer.

Typically, the main regulated industries are ones in which several of these market failures arise. These include gas, electricity and water utilities, telecommunications and media industries, transportation, professional and financial services, pharmaceuticals. All of these have been regulated in most countries for a century or more. Yet there have been important recent changes in the style of regulation.

The existence of some market failure was often used in the past as a springboard for wide-ranging supervision of the management and operations of the businesses affected. Airline regulation was clearly needed to secure the safety of passengers and the public at large. Yet around the world such regulation rapidly extended to control of fares, frequencies and the financial stability of carriers. In many industries, including airlines, regulation took the form of nationalisation and there was political accountability for specific management decisions.

Over the last two decades, the focus of regulation has been narrowed. Most regulation is now targeted on specific market failures. Control over air fares, for example, is fast disappearing. Privatisation has limited the involvement of government in utilities to specific issues of the control of pricing and the appraisal of investment programmes. At the same time, however, competition and globalisation have meant that much of what was formerly tacit regulation has become formalised, creating the apparent paradox of simultaneous deregulation and reregulation. Financial services display this tension most clearly.

Many of the strategic issues faced by regulated industries are similar to those faced by ordinary businesses. Those that are not fall into two main groups. First, the management of government and regulatory relations – a significant issue for all companies – takes on an overriding importance for a regulated firm. Second, many of the ordinary rules of competitive interaction and influences on market and industry structure are suppressed in regulated firms. I consider each of these issues in turn.

The management of regulation

Regulation is culturally specific. An increasing number of regulated firms operate across national boundaries, although globalisation is less developed in many regulated industries than in business generally, partly for this reason. Still, there are few internationally transferable skills in regulation management, and considerable sensitivity to the local environment is required. Around the world and across industries, there is a broad spectrum from specific, rule based structures to regulation based largely on individual political negotiation. There is no ideal system, either for the firms affected or for the public interest: these differences are the product of broader differences in the business and political environmental and specific characteristics of the industries concerned.

In the United States, regulation is characteristically formal and rule-based. This frequently leads to litigious and adversarial regulatory processes, and specific forensic and technical skills are required in the management of regulation. British regulation is more discretionary. As a result, technical argument is equally significant but adversarial approaches are usually counter-productive: establishing a relationship of trust with the regulator acquires central importance. France is still further along the spectrum. The concept of independent regulation, mediating between company and state, is barely familiar there and regulation is integrated into conventional political processes.

At both extremes, these forms of regulation collapse. Rule based regulation can become so cumbersome that subverting or by-passing it becomes the main skill of the regulatory manager: discretionary regulation can degenerate into cronyism or corruption. As so often, the extremes of a spectrum differ little from each other.

Whatever the formal process, all mechanisms of regulation are managed in the context of the same underlying regulatory game. The regulated firm is concerned to maximise its own returns. Its managers have superior knowledge of what costs are necessary, of what efficiency gains are available, of what investments are appropriate. The regulator is of necessity less well informed than the firms he regulates. In this environment, he seeks to impose objectives which differ from the firm’s own. In a rule based system, these objectives may simply be to interpret a set of statutory obligations: in a more discretionary system, to pursue broader public interest objects: in a political framework, to balance the concerns of a range of different constituencies.

The regulatory purpose is to find a structure that will make it advantageous – ideally directly profitable – for the firm to pursue the regulatory objective. Considerable ingenuity has been deployed in constructing formulae – incentive based regulation – which are aimed at that result: the objective is to minimise direct control by regulators of individual management decisions. But the formulae themselves, and the information needed to apply them, are inescapably the subject of political negotiation. The regulatee’s purpose is to manage the presentation of information which is used in developing the regulatory structure and to make operational decisions which will maximise profits within it. All this is subject to the constraint – which rises in importance as the degree of regulatory discretion rises – that behaviour which undermines trust in the regulatory relationship will in the long run prove counter-productive.

The most effective strategy of regulatory management is regulatory capture – in which the regulatory agency increasingly adopts the objectives of the regulatory firms as its own. In the airline industry, for example, regulators came to operate a cartel on behalf of established carriers, in the belief that there was an overriding public interest in the financial stability of the industry: the same outcome can often be seen in financial and professional service industries.

More generally, regulation normally operates to the advantage of incumbent firms relative to entrants. The very complexity of regulation acts as an entry barrier: requirements for regulatory approval are routinely obstacles to product innovation and the use of new delivery mechanisms, two of the most common entry strategies. Many regulatory requirements demand a negligible share of the turnover of large firms while identical obligations may be burdensome for small companies.

The profession of regulation, and of the management of regulation, is still in its infancy. There are some textbooks on how to regulate: as yet no serious text on how to be regulated. Yet the returns from skills in regulatory management can be very large. It is common for managers simply to berate regulation, or to seek diversification into unregulated activities, although many of the most persistently profitable firms, from Merck to Microsoft, have achieved this result precisely because of their effective exploitation of the regulatory framework within which they operate. It is not an accident that established firms in many industries resist the introduction of regulation – and also resist its removal.

Regulation and competition

Industrial structures in regulated industries have been established in conditions where competition was restricted, or even eliminated altogether. In most markets, dominant firms are those which have developed and exploited their competitive advantages. In many regulated industries, dominant firms have emerged as a result of national protection or statutory monopoly. Within the last few years, privatisation and deregulation has made many of these market structures contestable. This raises some of the most intriguing issues in strategic management today.

There is one general rule about how these liberalised structures will evolve. It is that in future market shares will reflect, not historic strength, but competitive advantage. The US airline industry illustrates this transition well. At the time of deregulation in the 1970’s, the structure of the industry had been ossified for almost fifty years. A wave of new entry and innovation followed. Most of these entrants failed. So did some older companies with great names and histories. Eventually, the industry reconcentrated around a smaller number of carriers. The survivors included both entrants and members of the former cartel. All these were the firms which had developed real competitive advantages – strong hubs, powerful brands, lightly managed operations – and deployed them effectively.

As competition reaches many more regulated industries, these developments will repeat themselves. Outside regulated industries we rarely encounter firms with large market share and resources but no competitive advantage It is these companies that will go the way of Eastern and Pan American – household names which have disappeared or become a shadow of their former selves. We can expect this to happen to several large banks, telecom, energy and media companies.

In the main, competition in regulated industries requires artificial stimulus. The hopes of early liberalisers were that merely removing statutory restrictions on competition would lead to competitive outcomes, but these hopes were repeatedly frustrated. Only where governments have insisted on access to established networks and other essential facilities, restructured incumbents, or tilted the playing field in favour of entrants, has competition emerged. That raises issues for both incumbents and entrants.

In general, the rational strategy for an incumbent is to resist liberalisation, and this is normally what is done: yet experience suggests the issues are not so clear cut. If competition is inevitable, the early experience of it may be valuable both in a domestic market and internationally. At first sight, it seemed that British Gas – which maintained its effective monopoly – had won a battle which the British electricity industry – which was dismembered – had lost: yet with hindsight the electricity companies won more managerial autonomy and a more competitive market positioning. Incumbents find it difficult, politically and organisationally, to be monopolists at home and competitors abroad.

Entrants may choose organic or inorganic approaches. Purchases of assets in liberalising markets have repeatedly suffered from the “winner’s curse”. Given intense competition, the successful bidder is the one who overpays. Greenfield entry naturally focuses on areas where regulatory distortion is greatest. Almost all competition in telecommunications, for example, has focused on areas – such as long-distance business traffic – where the gap between prices and costs is highest, rather than on those where the incumbent is least efficient. This strategy offers short run benefits, but may not prove sustainable. Mercury Communications’ strategy as a duopolist of sheltering under the BT tariff structure failed when the government instituted full liberalisation.

Conclusions

There is a canard that the management of regulated businesses is easy: this their managers justly resent. It is true that many such companies come to competitive markets with a historic legacy of assets and a scale of resources which others envy. It is also true that it is hard for a regulated firm to go broke – although it is certain that over the next few years some will. But regulated businesses face almost all of the strategy issues which confront conventional firms, and some additional ones that are specific to their own environment. As deregulation spreads across Europe, the gap between those firms which handle these specific issues effectively and those which respond to regulation and regulatory changes with hostility, complacency or defeatism will widen rapidly.

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