Orderly exit
Designing continuity regimes in public markets
December 2012
OFT1468
© Crown copyright 2012
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CONTENTS
Chapter
Page
1 Executive summary
4
2 Introduction: Orderly and disorderly exit
6
3 What role can competition play in preventing disruptive
provider exit?
10
4 When do public markets need continuity regimes?
15
5 What are continuity regimes?
20
6 Designing continuity regimes to support competition
38
7 Conclusion
48
1
EXECUTIVE SUMMARY
1.1
The exit of firms is a vital part of competition. In private markets, we
have grown used to exit as traditional companies have been overtaken
by cheaper, more innovative and efficient rivals and leave the market.
Often there will be virtually no disruption to consumers particularly when
they are able to buy similar products in other stores at similar prices.
This is a key way that competition delivers improvements in efficiency,
productivity and quality of the goods and services.
1.2
Public markets should be no different. As different public services are
opened up to competition, so new players can bring in innovative ways
of providing services, creating pressure to innovate, driving up standards
and increasing productivity. 1 Equally, the risk of losing out to new
competitors, and in turn losing a foothold in the market, can incentivise
providers to relentlessly focus on maintaining high standards. In this
way, choice and competition can drive continuous improvements in the
efficiency, productivity and quality of public service delivery.
1.3
But in recent years there have been a series of high profile service
failures in public service markets that have been ‘opened up’ to choice
and competition. Failures such as the financial failure of Southern Cross
Healthcare in 2011 and the service failure of G4S to deliver on its
security contract for the Olympic Games have brought into focus the
need for government to minimise service disruption when things go
wrong. 2
1.4
There is a risk that government responds to failures in public markets by
preventing provider exit. The Office of Fair Trading (OFT) considers this
to be the wrong response. Effective competition requires a credible
threat that firms which fail to provide high quality services will face the
1
OFT (2010) Choice and competition in public services: a guide for policy makers available here:
http://www.oft.gov.uk/shared_oft/business_leaflets/general/oft1214.pdf
2
House of Commons Home Affairs Committee Olympics Security Seventh Report of Session
2012–13 Volume 1 available here:
http://www.publications.parliament.uk/pa/cm201213/cmselect/cmhaff/531/531.pdf
OFT1468 | 4
consequence of losing market share and ultimately exit the market if
their performance does not improve.
1.5
Nevertheless, as the Open Public Services white paper makes clear, it is
not acceptable to simply allow services to fail in situations where service
users will suffer from disruption caused by exit. 3 The challenge facing
policy makers, regulators and contracting authorities therefore is to
facilitate the ‘orderly exit’ of failing providers in a way which protects
service users, and where appropriate ensuring continuity of service,
whilst preserving the credible threat of exit which is an important driver
of competition.
1.6
This working paper aims to address this challenge by drawing on the
insights from a cross-government roundtable the OFT hosted in August
2012 and a number of case studies of how failure and provider exit
works in private and public markets. There are three key insights:
• A ‘virtuous’ competitive cycle can, in itself, go a long way in reducing
the impact of service disruption, to the extent that it encourages a
diverse range of successful and robust providers to enter, compete
and bear the costs of their own actions in the market.
• However, in some public markets strong competition will not be
enough to prevent provider failure from being disruptive. A continuity
regime will be needed to facilitate orderly provider exit in markets
where the impact of short-term discontinuity of service on users is
likely to be high and provider failure is likely to lead to discontinuity of
service.
• How continuity regimes are designed matters. A well designed
continuity regime can support a ‘virtuous’ competitive cycle if it
mitigates the risk of service disruption rather than the risk of exit and
failure.
3
Cabinet Office (2011) Open Public Services white paper available here:
http://files.openpublicservices.cabinetoffice.gov.uk/HMG_OpenPublicServices_web.pdf
OFT1468 | 5
2
INTRODUCTION: ORDERLY AND DISORDERLY EXIT
2.1
Disorderly exit involves a disruption of supply to consumers, usually as a
result of a firm failure. Different types of failure are possible in a public
service market. A provider fails financially usually when creditors refuse
to roll over the debt and it cannot continue to operate. A provider might
fail operationally, meaning that the efficiency and effectiveness of the
delivery of services to services users is not of good enough quality for
the organisation to continue operating. 4 In these cases, the continuity of
supply may be threatened by the sudden or disorderly exit of the firm
providing it.
2.2
In public service markets there are also a range of different ways in
which such failure is determined. Commissioners of a public service
might judge a provider to have failed against the terms of a contract,
creditors might conclude a provider is no longer financially viable, or the
public might vote with their feet and choose an alternative provider. The
failure of a provider will also cause varying degrees of disruption from
the perspective of service users, depending on how sudden or
unexpected the failure is, how vital the service is, and whether other
service providers are available and the ease with which service users can
switch to them. Clearly for some vital public services that we depend on
day to day, the threat that provision might be disrupted, even for a short
period, is an unacceptable policy risk.
2.3
Policy makers, regulators and contracting authorities therefore face a
difficult challenge. They need mechanisms to protect service users from
the potential disruption caused by provider failure. At the same time, if
competition is to work in markets, these mechanisms need to preserve
the credible threat that providers will exit the market, including through
failure. Moreover, their interventions need to be conducive to long-term
4
PWC (2012) Under pressure: securing success, managing risk in public services p.57 available
here:
http://www.pwc.com/im/en/publications/assets/under_pressure_securing_success_managing_risk
_in_public_services.pdf
OFT1468 | 6
competition by, for example, avoiding actions that lead to market
concentration and organisations becoming too big to fail.
2.4
Government is currently addressing these challenges. The 2011 Open
Public Services (OPS) white paper set out six overarching continuity of
supply principles which the government wants to apply across all public
services. These principles are:
• Struggling organisations should be given support to turn around poor
•
•
•
•
•
2.5
performance, within agreed timescales, before failure occurs.
Accountability for providing quality services and good financial
management should remain firmly with the provider.
Where service failure occurs and is the result of poor management,
there should be severe consequences for management and others
involved in the governance of the provider.
Continuity regimes should therefore articulate a short, carefully
selected list of existing data that will be used to identify failure.
There is a role for external bodies, independent of government (such
as regulators), with powers to ensure proper financial management
(including financial robustness where appropriate) and to intervene to
ensure continuity of service.
Systems should be flexible to accommodate the changes our open
public services reforms will bring, and so government departments
should set out the long-term vision for ensuring continuity of service,
as well as any transitional arrangements.
Departments and regulators are currently working with HM Treasury in
developing continuity regimes which reflect OPS principles in areas they
believe require them. Monitor, for example, is currently consulting on
guidance aimed to help commissioners and providers identify the
essential services which will need to be kept running if a provider fails
financially. This builds on the provision in the Health and Social Care Act
(2012) which conferred on Monitor the power to support commissioners
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to ensure that, in the rare event of the failure of a healthcare provider,
patients could continue to access the care that they need. 5
2.6
This paper takes a closer look at the relationship between competition,
provider exit and service user protection. It asks three questions:
1) What role can competition play in mitigating the disruption caused by
provider exit?
2) When does competition not go far enough and when will regulators
and commissioners need to use continuity regimes to ensure a
continuous supply of services?
3) How can continuity regimes be designed to support competition?
2.7
A key message of this paper is that competition can go a long way to
mitigate the risk of service disruption caused by provider failure. First,
the exit of a provider in a market where alternative providers can step in
and take over supply is less likely to lead to widespread disruption than
in circumstances where no alternative providers exist. Second,
competition backed up by the credible threat of exit and failure is more
likely to ensure that weak firms exit markets in an orderly fashion, and
that robust firms survive. By contrast, if there is a suspicion that
authorities will prop-up weak firms to ensure service continuity, such
firms may be tempted to continue in the market, thereby risking eventual
financial or operational failure and disruptive exit.
2.8
The paper draws on lessons that can be learnt from how failure is dealt
with in other markets including water, air and energy markets are
considered. The paper draws in the insights generated from a crossgovernment roundtable the OFT organised in August 2012. The OFT is
very grateful to all those that attended the roundtable.
5
More details about Monitor’s consultation can be found here: www.monitornhsft.gov.uk/monitors-new-role/supporting-the-continuity-services
OFT1468 | 8
2.9
The paper also draws on lessons the OFT draws from its previous work
on the issue of continuity of supply in public markets. The OFT’s 2011
paper Commissioning and Competition in the Public Sector looked at the
options available to government when there is a potential break in
provision of service through a supplier exiting the market either by
mutual consent, business failure or as a result of being acquired by
another firm. 6 In addition, our 2010 Infrastructure Ownership and
Control Stock-take explored the risks surrounding the commercial failure
of an infrastructure asset operator, finding that where there are specific
concerns about the short-term impacts of commercial failure, special
administration procedures can help to alleviate concerns over security of
supply for consumers. 7
6
OFT (2011) Commissioning and Competition in the Public Sector available here:
http://www.oft.gov.uk/shared_oft/reports/comp_policy/OFT1314.pdf
7
OFT (2010) Infrastructure Ownership and Control Stock-take, Final Report: Main findings
available here: http://www.oft.gov.uk/shared_oft/market-studies/ownership-controlmapping/OFT1290.pdf
OFT1468 | 9
3
WHAT ROLE CAN COMPETITION PLAY IN PREVENTING
DISRUPTIVE PROVIDER EXIT?
3.1
Competition in a public market can go a long way to mitigate the
disruption caused by provider exit. But to do so, certain market
characteristics need to be present. These characteristics, illustrated in
the ‘virtuous’ cycle in Figure 3.1 are:
•
•
•
Low barriers to entry which allow alternative providers to enter the
market to take over supply in cases of provider failure.
A diversified supply side so that the failure of one provider leaves a
sufficiently small ‘hole’ in the market for alternative providers to
easily take on service users from the failed provider.
Providers are incentivised to strongly compete by internalising the
costs of their own actions and being rewarded for success and
punished for poor performance. This, in turn, will allow the best and
most resilient performers to expand their market share.
Figure 3.1: The virtuous competitive cycle which can mitigate the disruption
caused by exit
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Low barriers to entry
3.2
The ability of new providers to enter the market has important intrinsic
benefits. Market entry can act as a spur to innovation, put a downwards
pressure on costs, and allow service users to exercise demand-side
pressure by switching to new providers that better meet their needs.
3.3
Low barriers to entry are also important for minimising service disruption
when a provider fails. The failure of a provider in a market where barriers
to entry are high may mean that alternatives are hard to find. Existing
competitors may be able to absorb the transient group of service users,
but this runs the risk of further market consolidation and some providers
becoming ‘too big to fail’. Further, without the failure of one provider
creating the opportunity for new market entrants to compete then the
competitive dynamic is likely to be undermined.
3.4
The barriers to entry that can exist in public markets are well
documented. In some markets, high barriers to entry result from inherent
features of supply, such as having to pay high fixed costs to enter the
market, and economies to be gained from a single supplier operating a
significant proportion of assets. In other markets, barriers to entry can
be created or exacerbated by the behaviour of incumbent suppliers and
the way procurement policies and processes are implemented. In Choice
and Competition in Public Markets the OFT identified barriers to entry
that can be created or enhanced in public markets through the
procurement process. 8 These included:
•
•
•
•
8
the design and implementation of commissioning and procurement
policies and processes
the way in which contracts are aggregated or bundled together to
provide multiple services
the use of joint procurement projects by commissioners and procurers
in different institutions
the use of framework agreements by the public sector.
OFT (2010) Choice and competition in public services: a guide for policy makers
OFT1468 | 11
3.5
In addition, the threat of exit and disruption might lead procurers to be
cautious and erect barriers to entry to mitigate these risks. Procurers and
commissioners of public services need to minimise these barriers to entry
not only to encourage the inherent competitive benefits of supply-side
diversity, but also to create the conditions where alternative providers
are able to take over provision when a provider fails.
A diversified supply side
3.6
For competition to mitigate the disruption caused by provider exit, a
range of different providers need to be able to compete and take over in
cases of failure. In the social care market, for example, supply is
diversified and exit is common. The National Audit Office (NAO) study of
Oversight of user choice and provider competition in care markets
concluded that exit or take-over of care homes and domiciliary care
providers is a feature of local care markets, and that normally other
providers come in to run services with little or no impact on users. 9 The
Department of Health suggests that this is partly due to low levels of
concentration within the market for residential services, and partly due
to the effective management of closures at the local level. 10 Indeed, local
authorities have statutory duties in providing care, and would normally
step in if a provider exits the local market and is not taken over or
replaced by another provider.
3.7
As discussed above, in some markets natural barriers will prevent a
range of providers from being able to enter and compete in the market.
But where diversity of supply is possible and desirable new providers
need to be able to enter, and expand in, the market. In this context,
commissioners need to consider the consequences of their
9
NAO (2011) Oversight of user choice and provider competition in care markets available here:
http://www.nao.org.uk/publications/1012/oversight_of_care_market.aspx
10
Department of Health (2011) Oversight in the Social Care Market: Discussion Paper available
here:
http://www.dodsmonitoring.com/downloads/2011/Market_Oversight_in_Social_Care_Discussion_
Paper.pdf
OFT1468 | 12
commissioning decisions on the structure and diversity of provision in
the market and take steps to ensure that one provider doesn’t get ‘too
big to fail’.
Providers incentivised to strongly compete
3.8
Effective competition depends on providers having consistent
expectations that they are accountable for the consequences of their
actions. If providers believe they will escape penalties if they don’t
maintain financial viability and effective management then they may not
feel sufficient pressure to do so. Not internalising the costs of actions in
this way is the so-called ‘moral hazard’ problem. Equally, providers need
to expect that if they succeed they will be rewarded with a continued or
expanding market share. To set appropriate incentives, successful
providers should have the opportunity to re-win contracts and expand to
take on new service users.
3.9
Public markets can be designed to mitigate or exacerbate moral hazard
problems. Significant barriers that prevent provider exit, for example,
through regulatory and contractual arrangements which keep incumbent
providers in the market, may create the impression that poor
performance will be tolerated. As a result, providers will not be
incentivised to focus on maintaining high quality services. Minimising
barriers to exit, and creating the credible threat of exit from the public
market, will therefore help address moral hazard issues.
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Figure 3.2: The vicious competitive cycle created by failure regimes which
encourage concentration, limited competition and restricted exit
3.10
As illustrated in Figure 3.2, if there are high barriers to entry, supply is
concentrated, there is limited competition, and weaker firms survive then
there is a heightened risk of a large provider failing with no or limited
options for alternative suppliers to fill the gap. This will lead to
significant disruption for service users. In such markets there may be an
onus on the government to use a continuity regime to facilitate orderly
market exit and ensure users are able to access services.
3.11
However, the first best solution for those seeking to minimise the
disruption caused by exit is to increase ‘virtuous’ competition. Only
when this is not possible, or where competition will not go far enough to
protect service users, should continuity regimes be introduced. These
continuity regimes should be designed to support competition by
capturing residual risk rather than reducing the likelihood of provider
failure. Section 5 further explores the circumstances in which continuity
regimes should be used, and Section 6 explores ways in which regimes
can be designed to capture residual risk.
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4
WHEN DO PUBLIC MARKETS NEED CONTINUITY REGIMES?
4.1
When providers fail for financial or service quality reasons in private and
public service markets there is differing levels of disruption. If consumers
and service users are able buy similar products in other nearby stores at
similar prices then there is likely to be virtually no disruption to
consumers. In contrast, when services are essential and consumers
cannot switch to alternative suppliers then failure can be disruptive. For
example, when certain banks teetered on the brink of collapse in 2008,
there would have been unprecedented disruption to financial consumers,
to the payments system and to the economy more broadly had these
banks been allowed to fail.
4.2
The challenge facing policy makers and regulators is to identify the
circumstances in which failure will lead to significant service disruption
and to find measures which will contain the disruption whilst also
supporting long-term competition in the market. There is no ‘one size fits
all’ continuity regime that applies to all public markets. Rather the need
for a regime, the design of that regime and the scope and timing of the
interventions should largely depend on:
• the likely impact of short-term discontinuity of service
• whether provider failure is likely to lead to discontinuity of service.
4.3
11
The OFT’s 2010 Infrastructure Ownership and Control Stock-take
identified these first two factors as important to consider when
addressing the commercial failure of an infrastructure firm. 11 Similar
criteria can be applied in the design of continuity regimes in public
markets. Ultimately, the way failure is approached in public markets
should be guided by the impact provider failure will have on service
users.
OFT (2010) Infrastructure Ownership and Control Stock-take p.59
OFT1468 | 15
What will be the impact of a short-term discontinuity of service?
4.4
Of course, not all public services are the same. Some public services,
such as accident and emergency and defence services are ‘essential’ or
‘vital’ in the sense that:
•
•
•
•
failure would result in a significant loss of income, health and welfare
for those that use the service
there would be substantial public and political objection if the service
was not continuously supplied
there would be a significant knock on impact on other markets if the
service stopped even temporarily
private markets are unlikely to step in and provide the service in the
absence of government support.
4.5
There is likely to be significant disruption if these essential services are
discontinued even for a short period and therefore cessation of the
service needs to be avoided. Therefore, there is an onus on government
to ensure continuity of supply when providers of essential services fail.
4.6
However, the short-term discontinuity of some public services will not
lead to significant disruption. Whilst the continuous provision of elective
surgery, waste disposal and some types of ‘back office functions’ is
desirable, there will not be the same degree of risk to life, health or
knock on impact in other markets if these services temporarily stop. In
such markets, regulatory intervention to ensure continuity of service
might prove costly and unnecessarily distort the market at the expense
of long-term competitiveness.
4.7
Continuity regimes need to therefore be restricted to essential services
where supply is needed continuously. To do so, designers of continuity
regimes need to ask whether short-term discontinuity will:
•
•
•
result in major public harm? (for example, A&E services)
have a knock on impact on other markets delivering essential
services? (for example, IT services)
significantly affect the political dynamics surrounding the market? (for
example, local hospital closure).
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Will failure lead to significant discontinuity of service?
4.8
In addition to assessing whether services are ‘essential’ and need to be
supplied continuously, designers of continuity regimes need to consider
whether the exit of an individual provider will actually lead to
discontinuity of service. Continuity regimes are needed when failure is
likely to lead to service discontinuity and this discontinuity will have a
significant negative impact on service users.
4.9
There are a number of market and service characteristics which, if
present, may indicate that the failure of a provider will lead to
discontinuity of service. These characteristics include:
•
Difficulties finding alternative providers. The impact of failure will be
greater if there are few alternative providers that can step in and take
over the service. Alternative suppliers may be difficult to find if failure
means contracts are seen as undesirable, the services being supplied
are specialist, or alternative providers cannot expand sufficiently
quickly to absorb transient demand. This is particularly likely in rural
areas where services are geographically dispersed.
•
Confidence and trust is lacking. The impact of failure will be greater if
provider exit leads to a lack of confidence in the market and, in turn,
reluctance amongst potential alternative providers to enter the
market. Confidence may be particularly unstable in new markets
where potential providers are using the experience of early market
entrants to assess whether or not they should compete.
•
Failure will have a systemic impact. Many public markets do not
operate in isolation. Markets may be linked through supply chains or
parent companies which operate in other markets. The failure of a
provider in one market may lead to a ‘contagion effect’ and disruptive
service discontinuity in other markets where essential services are
being provided. In such circumstances interventions may be needed
to prevent provider failure from escalating.
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Figure 4.1: When public markets need to be supported by continuity regimes
Will service
discontinuity lead
to significant
disruption?
High risk public markets where
continuity regimes are needed
Low risk public markets
where continuity regimes
may not be needed
•
• The public will not suffer
if services stop in the
short-term
• Other market delivering
essential services will not
be affected
• Failure will not lead to
public and political
objections
•
•
Will failure lead to
service
discontinuity?
Discontinuity will lead to
significant public harm
Discontinuity will have a
knock on impact on other
markets delivering essential
services
Discontinuity will
significantly affect the
political dynamics
surrounding the market
• Supply is concentrated and
there is competition for the
whole market
• Confidence will be affected
by failure
• Providers are dependent on
other markets
• New providers are hard to
find
• Supply is diversified and
there is competition
within the market
• Confidence is unlikely to
be affected by failure
• The market is isolated
• Alternative providers can
take up supply
The relationship between competition and continuity regimes
4.10
Where a decision has been taken to open up public services to greater
choice and competition policy makers, regulators and contracting
authorities need to carefully scrutinise the impact interventions through a
continuity regime will have on long-term competitiveness in the market.
There are two ways in which continuity regimes can have a particularly
negative impact on competition:
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4.11
•
When interventions create significant barriers to entry and make the
market more concentrated and, in turn, less resilient. At the extreme,
continuity regimes may actually create organisations that are too big
to fail where scale is not necessarily a feature of the market.
•
When interventions overly manage the likelihood of provider failure,
creating barriers to exit and, in turn, allowing poorly performing
organisations to remain providing services.
Where there is a justification for using continuity regimes, policy makers
and regulators need to minimise the extent to which their continuity
regimes create these two effects. The next chapter outlines the different
measures that make up continuity regimes and explores the relationship
between these measures and the impact they might have on
competition.
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5
WHAT ARE CONTINUITY REGIMES?
5.1
Continuity regimes should primarily aim to ensure the continuous supply
of a service and minimal disruption to the wider market when a provider
exits the market. Importantly, continuity regimes should not seek to
prevent providers from exiting the market or reduce that likelihood, but
rather to facilitate orderly exit where necessary.
5.2
This section explores the different measures that might make up a
continuity regime including:
•
•
•
•
•
•
•
•
•
procurement rules
licensing conditions
risk sharing pools
market monitoring tools
pricing regulation
market monitoring tools
financial or administrative support
insolvency arrangements and special administrations regimes
supplier of last resort arrangements.
5.3
These measures aim to achieve a range of different objectives and differ
in terms of when and the extent to which they intervene in the market.
Procurement rules and licensing conditions can be used ex-ante to
reduce the likelihood of provider failure. Market monitoring tools provide
early warning of failure and allow regulators and contracting authorities
to prepare for failure. Lenient price regulation and financial or
administrative support might be used in the build up to failure to
temporarily prevent or smooth exit. Risk sharing pools, insolvency and
special administration regimes and supplier of last resort arrangements
tend to operate in the event of failure and provide for exit whilst
preventing service disruption.
5.4
Policy makers, regulators and contracting authorities need to carefully
scrutinise these measures to ensure that they are applied appropriately
and do not undermine the competitiveness and resilience of the market
over time.
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Measures to reduce ex ante the risk of provider failure
5.5
Certain regulatory measures may be taken before providers enter the
market or before they start providing services to screen out those
providers that carry a higher risk of failure. These ex-ante measures
usually form part of the procurement rules or licensing conditions, and
can be more or less prescriptive.
5.6
Prescriptive licensing conditions can create significant barriers to entry
since many firms will either be unable to fulfil them at all or will not
meet the conditions without significant costs. In addition, licensing
conditions or procurement rules that are based, directly or indirectly, on
firms having previous experience in the market can significantly limit the
number of firms able to compete for contracts, or may create an unlevel
playing field. They can also limit innovation by defining success with
reference to previous or incumbent standards or formats of service
provision.
5.7
If such ex ante measures are necessary, it is therefore important that
they be set out according to FRAND principles: fair, reasonable and nondiscriminatory.
Procurement rules
5.8
The procurement process provides an opportunity to control which
providers win contracts and, in turn, mitigate the possibility of failure
before a provider has even entered the market. To do so, procurers could
write into contracts rigid financial and service quality conditions that a
provider has meet in order to win the contract.
5.9
Procurers can also write into contracts contingency arrangements and
the actions a provider has to take in the event failure does occur. These
conditions can preserve continuity of supply. This option is, however,
not always taken up. The House of Commons Public Accounts
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Committee found that in 2009, 56 per cent of public services contracts
did not have a contingency plan in the event of supplier failure. 12
5.10
How stringent the terms of contracts are will have an impact on the
types of provider that are able to compete in the market. Cautious
procurers could restrict market entry to providers that have a proven
track record of relevant experiences. However, as noted in Section 1,
above, this is likely to lead in the longer term to high risks of service
disruption through higher concentrations and less competition. As a
general rule of thumb procurers should therefore seek to develop a
diverse market where a range of providers can compete for contracts.
Where this is not possible and there is a risk of major service disruption
through higher concentration and less competition, contracting
authorities will need to build into the contract provision for the active
monitoring of the financial health of the provider(s), as a means of
achieving effective early warning of potential provider failure.
Licensing arrangements
5.11
Licensing conditions are used in utility, public and private markets as a
regulatory tool to ensure providers meet certain financial and legal
conditions before they can operate in the market. Licences can also be
used as a mechanism to force poorly performing providers to exit the
market. For example, the OFT issues consumer credit licences and will
revoke a licence when it finds licensees are considered unfit to hold a
license, resulting in that licensee being prevented from offering goods or
services on credit or lend money or are involved in activities relating to
credit or hire. 13 Licensing conditions vary across markets, but are usually
issued by a regulatory body.
12
Quoted in Public sector supply chain: risks, myths and opportunities by Zurich Mutual,
www.zurich.co.uk/NR/rdonlyres/82A58CDF-D38F-414F-AC43CB0C4CBB7CBF/0/thebriefingpaperfullversion.pdf
13
More details can be found here: www.oft.gov.uk/OFTwork/credit/enforcement-action
OFT1468 | 22
5.12
A licence can provide reassurance about the robustness and financial
strength of a provider by stipulating limits on indebtedness, testing
assumptions in an applicant’s business model, and by setting
requirements to have all the necessary resources available to run the
business. In the energy market, for example, Ofgem requires network
operators (NWO), as part of their licence conditions, to have available
the financial and operational resources needed to carry on its network
businesses and also places restrictions on indebtedness and the types of
payments and transfers that can be made to affiliates of the network
company. Company boards are required to submit an annual certificate
confirming that the NWO will have the financial resources it needs for
the following 12 months.
5.13
A licence can also provide reassurance about the legal viability of the
potential provider. In the energy market, for example, licences are
dependent on the legal status of the potential licensee, their directors
and shareholders, including whether or they are not insolvent or subject
to voluntary arrangements and any disqualification and criminal offence
statement. 14
5.14
Regulators can vary the intensity of licence conditions. When energy
suppliers (as opposed to NWO) apply for a licence they do not need to
submit financial information or a detailed business plan. This is because
Ofgem does not consider that any check it could perform on a potential
licensee at the time its application will provide continuing comfort about
its financial viability once the licensee commences operations. This
contrasts with the checks performed by the Civil Aviation Authority
described in Box 5.1 below. The following section explores the principles
which should inform how rigid regulators should make licensing
conditions.
14
Ofgem (2010) Guidance for gas and electricity licence applications available here:
www.ofgem.gov.uk/Licensing/Work/Documents1/SupplementaryAppendix2Guidanceforgasnd0electricityapplications.pdf
OFT1468 | 23
Box 5.1: Provider checks in the travel market
The Civil Aviation Authority protects holiday makers by performing a
‘fitness’ and ‘financial’ check on the organisation, or group of
organisations applying for an Air Travel Organiser’s Licence. The fitness
assessment includes the business history of the persons concerned, and
whether persons have been involved in any failed licence holding. The
financial test includes a basic solvency test, known as the Free Asset
Test, which is applied to Standard Licence holders (organisations that sell
over 500 air travel seats to the public per year). The Test shows the
relationship between the level of (free) assets and the projected turnover
of a Licence holder, which gives an indication of whether the asset base
is adequate to support the business.
Source: Civil Aviation Authority (2010) ATOL Policy and Regulations Fitness and
Financial Criteria for grant of licences 2010/04
Ring-fence
5.15
In the regulated industries ring-fences are used to restrict providers from
disposing of or granting security over their assets. In the energy market,
this condition essentially prevents NWO from disposing of network
assets without consent from Ofgem. Ring-fences can also be use to
prevent licensees from bearing the costs of economic activity in their
wider group. They typically ensure there are no cross-subsidies between
the ring-fenced and non-ring-fenced activities, impose rules to constrain
financial transactions across the ring-fence, and require appropriate
governance arrangements in regard to the ring-fenced subsidiary. Box
5.2 below illustrates how Ofwat used a ring-fence to protect Wessex
Water from the collapse of its parent company Enron.
OFT1468 | 24
Box 5.2: Ring-fencing in the water sector
Ofwat uses ring-fencing as part of its licence conditions to address
concerns about the effect the failure of parent companies might have
on the financial viability of regulated water companies in the water
sector. For example, when Wessex Water was acquired by Azurix in
1998, Ofwat modified its licence to ensure that the water company
was ring-fenced from the other activities of the group, including
Azurix’s parent company the Enron Corporation. When Enron
collapsed in 2001the ring fence ensured that Wessex Water was
able to continue to function and essential services were maintained
and consumers protected.
Source: Ofwat (2002) Consultation paper – The Proposed Acquisition of Wessex
Water Limited by YTL Power International Berhad
Measures to provide early warning of failure
Monitoring the market
5.16
A key theme that emerged from our roundtable was the importance of
monitoring developments in public markets so that regulators,
commissioners and policy makers are prepared for the possibility of
provider failure. Section 6 looks at the importance of a holistic system of
market monitoring. Having a coordinated, holistic understanding of
market trends is particularly important when services are commissioned
locally and this fragmentation may result in market trends that cross
geographic boundaries ‘falling between the cracks’.
5.17
Many public markets are developing systems for keeping track of the
health of providers. In the healthcare market, for example, Monitor will
continuously gather financial information about providers to assess
whether they have adequate resources to provide the quality of care
OFT1468 | 25
required of them. 15 This will provide an ‘early warning’ when providers
start getting into financial difficulty, and will allow a guarantee that
providers which are commissioned to deliver services are of a high
quality and are less likely to fail.
5.18
Measures to monitor the market are unlikely to have a significant impact
on competition, providing they are not so onerous as to prevent entry,
and avoid applying a discriminatory burden on new entrants or nonpublic providers. It is also important that monitoring mechanisms are
able to distinguish between genuine financial and operational risks on the
one hand, and the beneficial consequences of innovation in the business
model, or in the way services are provided on the other.
Measures to temporarily prevent or smooth exit
5.19
Regulators and commissioners can use a range of tools to intervene in a
market to provide temporary financial and administrative support to a
struggling organisation. The objective here is to create the time and
space for the organisation to turn itself around and ultimately to prevent
failure from occurring. The risk of temporarily preventing or smoothing
exit is that the measures delay exit and blunt market discipline. Providers
that offer poor quality services might be unduly protected.
Pricing Regulation
5.20
15
In many public markets, particularly where providers face limited
competitive pressure, there is some form of price regulation where prices
are fixed to create ‘yardstick competition’. 16 Examples include the
maximum price limits each water company may charge its customers
and the price tariff system that has been introduced to pay for health
care services in the UK. As each provider will gain prices that are based
Department of Health (2011) Oversight in the Social Care Market: Discussion Paper p.6
16
Roberta Longo, Marisa Miraldo, Andrew Street (2008) Price Regulation of Pluralistic Markets
Subject to Provider Collusion Centre for Health Economics available here:
http://www.york.ac.uk/media/che/documents/papers/researchpapers/rp45_price_regulation_of_pl
uralistic_markets.pdf
OFT1468 | 26
on the costs of all other providers, there is an incentive to keep costs
below the industry-wide reimbursement rate. This creates strong
incentives for cost control: each provider’s cost reducing effort will not
be detrimental to the price it faces.
5.21
The level at which prices are set and the extent to which they establish
a competitive cost benchmark will be a key determinant of the likelihood
of failure, and the extent to which the pricing mechanism drives
efficiency in the market. Set prices too low and efficient firms will fail.
Set them too high and inefficient firms will survive. To reward efficient
firms, regulators need to find out what the efficient firm’s costs are and
to set prices according to that benchmark. This can be difficult to do
when there are few firms against which costs can be compared, or
where marginal costs are bundled with other costs.
5.22
Regulators can also use price setting mechanisms as an indirect way of
ensuring continuity of service. By being more lenient on price, regulators
can ensure firms stay in the market, even if this means rewarding
inefficient services. However, it should noted that even if there is
leniency on pricing, providers may still fail if they are badly managed or
have an unsustainable business model.
Financial or Administrative Support
5.23
The government can provide financial or administrative support to failing
providers in order to prevent or delay the onset of failure. Distress
mergers between the failing organisation and an alternative provider, and
managerial take-overs are two forms of administrative support which can
steer the provider away from failure. Mergers and takeovers happen
frequently among publicly-funded providers such as hospitals and Further
Education colleges.
5.24
Governments can also offer conditional funding in order to keep services
open, as the Australian government did to prevent approximately 400
ABC children centres from closing in 2008. The conditional funding gave
the receiver, McGrathNicol, time to assess ABC’s operations and kept
the centre doors open. Further details are provided in Box 5.3.
OFT1468 | 27
Box 5.3: Paying for the failure of ABC learning centres
ABC Learning centres rapidly expanded its share of the Australian
childcare market through the early 2000s, and by 2008 it had more than
1,000 centres providing services to 120,000 children, which equated to
25 per cent of the Australian long day care market. ABC’s rapid
expansions had mainly been financed through debt. With the onset of the
2008 financial crisis, share prices fell and ABC’s market value dropped to
significantly lower than was previously thought. The provider struggled
to service its debts and fell into receivership on 6 November 2008 owing
almost A$2billion.
To prevent approximately 400 ABC centres from closing the Australian
government provided A$22million of conditional funding to keep all of
the centres open until 31 December 2008. The conditional funding gave
the receiver, McGrathNicol, time to assess ABC’s operations and kept
the centre doors open.
On 15 March 2009 the government announced that it needed another
A$70 million for the scheme that pays entitlements to employees of
liquidated or bankrupt companies. Of this A$70 million, A$50 million was
earmarked for ABC Learning workers, as the receivers of the child care
company announced it could not cover costs such as unpaid annual
leave. ABC Learning received approximately A$300 million in federal
subsidies in 2008 from the government's fee relief program.
McGrathNicol estimated that 720 ABC centres were profitable and would
continue to operate. It was the responsibility of McGrathNicol to sell the
centres. 55 closed by the end of the year, and further 262 centres were
unviable under the ABC Learning business model. The Australian
government provided an additional $34 million to keep the 262 centres
open until 31 March 2009. This group of centres (known as the ABC2
group) became the subject of an Expression of Interest process run by
the Court of Appointed receiver PPB. Of these centres 236 were
transferred to 78 different operators, bringing greater diversity into the
Australian child care sector. 26 ABC2 centres had to close.
Sources: Deborah Brennan and Mab Oloman (2009) ChildCare in Australia
Amarket failure and spectacular public policy disaster. Joint statement by The Hon Bill
Shorten MP and The Hon Kate Ellis MP Delivering quality and stable employment
services for people with disability, Monday 14th May 2012. Dea Clark 'ABC Learning to
be wound up' available at www.abc.net.au/news/2010-06-02/abc-learning-to-bewound-up/851818
OFT1468 | 28
Measures that provide for exit without disruption
5.25
Certain measures aim at providing a continuity of service once a provider
has failed or gone into administration. These measures commonly
provide alternative finance and necessary management expertise to
ensure a service can continue to be provided in the event of a provider
failure. They include risk pooling levies to finance a degree of service
continuity and special administration or supplier of last resort regimes to
administer the continued service provision. Distress mergers with, or
takeovers by, a rival provider can also be a means of providing service
continuity either prior to or during a firm failure. Often these regimes are
used in conjunction. For example, Monitor envisages a risk pool as well
as a special administration regime for providers of Commissioner
Requested Services that get into financial trouble.
5.26
Such regimes face two key challenges from a competition perspective.
The first is to ensure that failed providers are adequately punished for
their failures. This can mean both the shareholders and creditors of the
failed firm, as well as the management, bearing losses as a result of the
failure. The second is to ensure that any transfer of assets or
responsibilities to an alternative provider, under a special administration
or supplier of last resort arrangement, does not result in a high degree of
concentration in the market.
5.27
These challenges are far easier to meet when there is a diversity of
providers in a market and supply is relatively unconcentrated. For
example, a risk pool is more likely to work where there is a large number
of providers over which to pool the risk, and where no single provider
has been allowed to grow too big to fail. Attempts at risk pooling in the
banking sector have arguably failed for this reason. Equally, a diverse
supplier base will make it easier to appoint a provider of last resort or
interim provider without fear of concentration.
5.28
Where supply is concentrated, continuity of service measures need to
pay special attention to their impact on competition. Where incumbent
providers have established risk pools in concentrated markets, there is a
threat that they may use that system to prevent the entry of alternative
OFT1468 | 29
providers or new business models. Equally, the choice of provider to
purchase a failing firm, or act as a supplier of last resort needs to pay
special attention to the risk of reinforcing concentration in the
marketplace, and creating firms that may eventually be too big to fail.
Planning for this failure, and in particular cultivating alternative suppliers
that may reduce, or at least not increase, concentration is important for
avoiding this risk.
Risk sharing pool
5.29
A fundamental issue when providers exit a public market is who pays for
any actions necessary to prevent the failure leading to service
discontinuity. Costs could include paying for insolvency services,
emergency service provision, and compensating users for any disruption
caused. One option is to make the provider pay as part of the
administration process, but in cases of particularly poor financial
management, the provider may not have the necessary finances.
5.30
Alternatively, as a condition for being able to compete in the market,
providers could be made to pay a levy into a mutual risk- sharing
scheme. Box 5.4 illustrates how the Civil Aviation Authority collects an
Air Travel Organiser’s Licence (ATOL) protection contribution from travel
companies. The money is used to then pay for consequences of the
failure. In the case of air travel this includes transporting stranded
passengers back to the UK. This type of risk-sharing arrangement
depends on there being effective trade association(s) in the sectors, and
on all providers being required to be members.
5.31
A key consideration when designing a risk sharing pool to pay for the
consequences of provider failure is whether to make contributions
proportional to the risk posed by the particular provider, or to charge a
flat rate to all providers (as is the case for ATOL). Proportional
contributions have the advantage of potentially lowering the barriers,
smaller less risky providers face in seeking to compete in the market.
Further, proportional contributions can help to mitigate ‘moral hazard’ by
creating less of an incentive for providers to take on more risk. However,
OFT1468 | 30
a flat rate is more straightforward to administer and if the levy is small
may not prevent some providers from seeking to compete in the market.
Box 5.4: Risk sharing in the air travel market
The Air Travel Organisers’ Licence (ATOL) was introduced in the 1970s
to protect consumers against the financial consequences of companies
involved in providing holidays becoming insolvent. All travel companies
that sell air holiday packages and flights in the UK are required by law to
hold an ATOL licence.
As part of the licensing conditions, ATOL holders are obliged to pay the
Civil Aviation Authority (CAA) an ATOL Protection Contribution (APC)
which is a per-passenger levy that ATOL holders are obliged to pay the
CAA. The APC was introduced in 2008 at £1.00 per passenger, but by
October 2009 the APC was raised to £2.50 as a consequence of the
collapse of XL Leisure. The APC is usually built within the overall cost of
the holidays and flights the vendor sells. APC is not a charge on
individual customers.
In the event of an ATOL holder’s failure, the CAA ensures customers
who paid the holder for an air holiday package or a flight do not lose the
money paid and are not stranded abroad. Between 2007-2010 over
100,000 people have been repatriated following business failures and
over 250,000 have received refunds as a result of the scheme.
Previous to the introduction of the APC, the primary protection device
had been the provision of a bond from either a bank or insurance
company.
Source: House of Commons Transport Committee (2012) 4th Special Report - Air
Travel Organisers' Licensing (ATOL) reform: Government Response to the Committee's
Seventeenth Report of Session 2010–12 p.5
OFT1468 | 31
Mergers and takeovers
5.32
Allowing mergers and takeovers between public sector bodies can be an
important alternative to simple closure of less effective institutions and
can play an important role in increasing flexibility in the market. In
general terms, mergers can be thought of as either ‘rescue’ mergers in
which a struggling provider is ‘rescued’ by – and usually amalgamated in
to – a stronger organisation, or ‘strategic’ in which two organisations
that are already fairly successful merge because they believe they will be
even stronger if combined. 17 Rescue mergers can occur in situations
where the target business is not yet in liquidation or administration.
5.33
In any merger situation it is important to take into account whether the
merger could substantially lessen competition, which in turn could
reduce choice or quality of care for service users or increase the cost of
delivering services. When a rescue merger occurs, the merging parties
may claim a 'failing firm' defence. In essence, this defence is that the
target business will exit the market without the merger, and therefore
any harm to competition should not be attributed to the merger.
5.34
In 2008, the OFT restated its position regarding the acquisition of failing
firms. It stated that it would only clear a transaction based on 'failing
firm' claim where it has sufficient compelling evidence that there would
be the inevitable exit of the target business without the merger, and
there is no realistic and substantially less anti-competitive alternative.
5.35
It is important to emphasise that there are other takeover options
besides mergers. In the further education sector, for example,
federations among colleges or among colleges and private providers,
associations of private and/or college providers that enable one point of
contact for contracting purposes, and the operation of a college via a
17
The approach to mergers in Further Education is discussed here:
http://education.staffordshire.gov.uk/NR/rdonlyres/EDD356BF-E212-4F13-BD566EBC3D33CB0C/103711/understandingFEmergers200905.pdf
OFT1468 | 32
contract with another college or private providers, are all alternative
options to a failing Further Education institution merging to be rescued. 18
Special Administration Regimes
5.36
Another way to minimise the disruption to services once a company
enters financial difficulty is to set up a Special Administration Regime
(SAR). SARs operate in number of sectors including water, energy, and
rail and have the overriding objective to ensure the continuation of the
protected service. Older SARs achieve this objective by providing for a
transfer of services to alternative suppliers. SARs set up after the
Enterprise Act 2002 revamped ‘normal’ administration and set out that
the continuity objective may be achieved by rescuing the company as a
going concern or by transferring services to one or more alternative
suppliers.
5.37
By either allowing the company to be rescued or transferring it as a
going concern to another company or companies, the service remains in
operation. In addition, SARs can provide administrators with clarity and
direction to conduct the administration of a failed company, without the
need to make frequent expensive and possibly disruptive applications to
the court for directions. 19 This clarity in turn gives greater confidence in
the administration process and therefore reduces the impact of company
insolvency on the stability of the wider market. Finally, SARs seeks to
get client assets returned quickly.
5.38
A SAR can be triggered when the Secretary of State makes an
application to the High Court for a special administration order. 20 A
Secretary of State would make such an application on the grounds that
18
Further discussion of the options available can be found here:
http://skillsfundingagency.bis.gov.uk/news/pressreleases/GRspeechfemergercollaboration.htm
19
HM Treasury (2010) Special administration regime for investment firms http://www.hmtreasury.gov.uk/d/consult_sar_160910.pdf
20
OFT (2010) Infrastructure Ownership and Control Stock-take, Final Report: Main findings p.58
OFT1468 | 33
the company was unable to pay its debts, or likely to become so. Sector
regulators can usually apply for an order with the consent of the
Secretary of State. Most SARs have a section referring to public interest
which refers to the general right that the Secretary of State has to wind
up a company if that company is not acting in the public interest. 21 A
special administration order can only be made if the court is satisfied
that the company is unable, or is likely to become unable, to pay its
debts.
5.39
However, SARs can be costly to run if the businesses’ operations are
complex, and given that setting up a SAR represents a significant
intervention in the market, they should be seen as a last resort. A SAR
may also add to the risk (perceived or real) that creditors might be worse
off than in a normal insolvency, for example, if keeping the protected
company open and running is not in the best interest of creditors. The
risks to creditors associated with SARs might increase the cost of capital
which investors require before they will lend to providers in that sector.
5.40
The government has introduced a special administration regime for
investment firms in the wake of the collapse of Lehman Brothers
International (Europe) and the subsequent practical difficulties of selling
the investment firm. 22 A new special administration regime for
companies providing NHS-funded services is also proposed for the health
sector. As with existing SARs, the regime will be based on the process
of administration set out in Schedule B1 of the Insolvency Act 1986,
although further details will be determined through a consultation which
will run from the end of October 2012.
Supplier of Last Resort
5.41
Supplier of Last Resort arrangements allow the government to step in
and appoint a supplier when a provider fails and no alternative
21
s157(2)(c) Energy Act 2004. This provision is allowed for under s124A Insolvency Act 1986.
22
HM Treasury (2010) Special administration regime for investment firms
OFT1468 | 34
competitor wants to take over. The key difference between this and a
SAR is that Supplier of Last Resort arrangements are used when no
alternative suppliers can be identified. Supplier of Last Resort
arrangements tend to operate in regulated markets where providers are
large and there is a significant risk of service disruption if these providers
fail. In the event of a supplier failing, the regulator has legislative powers
to appoint a provider to take over supply until contracts can be
retendered in the market.
5.42
A general rule of thumb, Supplier of Last Resort arrangements should be
used when other market-based solutions have been exhausted. As
described in Box 5.5, in the energy market, Ofgem encourages
businesses to be sold in a trade sale, 23 and only when trade sales are not
possible will Ofgem step in and appoint a Supplier of Last Resort.
Supplier of Last Resort arrangements are also only used as a short term
measure before the contract or franchise is re-tendered.
5.43
Supplier of Last Resort arrangements need to be supported by a robust
and transparent process for deciding whether, and how, to appoint a
Last Resort supplier in order to provide more certainty for all parties
involved and to ensure that a degree of competition or, at least, diversity
is maintained in the market should a provider fail. 24
23
A detailed overview of trade sales can be found here:
www.nao.org.uk/nao/intosai/wgap/guide/methods_of_sale/Trade_sale.htm
24
Ofgem (2003) Supplier of Last Resort: Revised guidance available here:
http://www.ofgem.gov.uk/Licensing/Work/Revoc/Documents1/5174SolR_guidance_doc_24nov03.pdf
OFT1468 | 35
Box 5.5: Supplier of Last Resort arrangements in the energy market
Ofgem uses Supplier of Last Resort arrangements to uphold its
responsibility to ensure continuity of supply for energy networks. If
an energy supplier gets into financial difficulty, Ofgem can revoke its
licence and appoint a Supplier of Last Resort for all customers –
domestic and non-domestic. The power allows Ofgem to ensure that
all of a failed supplier’s customers have continuity of supply by
securing the continued use of the assets of an insolvent licensee.
Any gas or electricity supply licensee can be directed by Ofgem to
take over responsibility for a failed supplier’s customers, however
Ofgem prefer to be able to appoint a Supplier of Last Resort that
had consented to the role.
Source: Ofgem (2008) Supplier of Last Resort: Revised Guidance
OFT1468 | 36
Figure 5.1: Failure regime apparatus and their applicability at different stages of
the competitive cycle
Reduce the risk
of provider
failure (ex-ante)
Measure
•
•
•
Procurement
rules
Licensing
Ring-fencing
Provide early
warning of
failure
•
Market
monitoring
Temporarily
smooth exit
•
•
Provide for exit
without
disruption (expost)
Lenient price
regulation
Administrative
and financial
support
•
•
•
•
Competition
concern
5.44
•
Barriers to
entry
• Will not have
an impact on
competition
provided not
onerous
•
•
Preventing
necessary exit
Blunting
market
concerns
•
•
Special
Administration
Regimes
Distress
takeovers
Supplier of Last
Resort
Risk pooling
levy
Ensure that
failure is
punished
Concentration
As illustrated in Figure 3, continuity regimes consist of a spectrum of
measures which range from aiming to prevent provider failure through to
facilitating exit and minimising service disruption. Policy makers,
regulators and contracting authorities need to carefully scrutinise the
measures they use and consider the impact on competition.
OFT1468 | 37
6
DESIGNING CONTINUITY REGIMES TO SUPPORT
COMPETITION
6.1
The design of continuity regimes matters. Effective continuity regimes
can help to generate the trust and confidence necessary to maintain a
competitive public market. On the other hand, poorly designed failure
regimes run the risk of undermining competition and creating service
disruption. This section explores the way in which continuity regimes
can be designed to support competition. It suggests that to support
competition, continuity regimes should aim to achieve six objectives:
•
•
•
•
•
•
mitigate the risk of service disruption rather than the risk of
exit/failure (as discussed in Section 5)
allow for market entry: new providers can enter the market
holistic market monitoring: market trends can be identified early
mitigate moral hazard: providers are incentivised to internalise the
costs of failure
prepare for failure: there are plans in place which allow providers to
exit the market with minimal disruption
be adaptable to changes in the market: the regime should be able to
respond to long-term changes in market and service characteristics.
Allow for market entry
6.2
As discussion in Section 3, effective competition depends on new
providers being able to enter the market. To successfully support
competition, continuity regimes need to minimise the extent to which
they create barriers to entering the market. The potential barriers to
entry created by continuity regimes include:
•
•
•
•
•
credit rating requirements
limits on indebtedness
procurement rules
information requirements
risk pool contributions.
OFT1468 | 38
6.3
25
Commissioners and regulators need to actively identify barriers to entry
and question their appropriateness. There are a number of ways in which
continuity regimes can be designed to minimise barriers to entry. These
include:
•
Concentrate on ex-post rather than ex-ante regulation. As a general
rule of thumb it is better to have rigorous ex-post continuity of
service regulations than create high barriers to entry through rigid
procurement rules. There is a risk that imposing strict ex-ante
requirements raise the cost of participation for some new and/or
smaller suppliers. This may deter potential suppliers from bidding,
even if the relevant risk of failure and the probability of contingency
plans being enacted are low.
•
Restricting the scope of the regime. All continuity regimes, however
‘light touch’ are likely to place some burden on new and existing
service providers. The most effective way of limiting barriers to entry
therefore is to limit the scope of the continuity regime to those critical
services where impact of failure on service users will be significant.
•
Making restrictions proportional to the risk posed by the provider. A
broad range of providers will be better placed to compete if more
rigorous ex-ante checks are limited to providers whose failure would
have a significant impact on the market. Proportional risk
assessments also create an incentive for providers to become more
sustainable, and thus reduce the level of scrutiny to which they are
exposed. Box 7 illustrates how the financial assessments of providers
as part of the licensing process in the air travel market are
proportional to the size of the provider. 25
•
Maintaining a level playing field. Ex-ante market entry conditions
should be proportional to the risk posed by providers, but in doing so
should not overly penalise certain types of providers.
A similar system has been proposed for Monitor’s risk sharing pool
OFT1468 | 39
Box 6.1: The licensing regime in the travel market
The financial assessment of air travel providers have to pass before
they enter the travel market is proportional to size of the licence
holding organisation. Small businesses that sell 500 or less seats a
year can apply for a small business ATOL. Due to the size of the
Licence and the potential impact on failure a small business holder is
usually subject to a simplified process and is not normally required to
meet a financial test on application.
The CAA can undertake a more in-depth analysis of the resources
and financial arrangement of Licence holders where, in the opinion
of the CAA, the potential impact of failure is high and or there is a
higher likelihood of failure. This includes all Licence holders where
the annual licensable revenue in the Public Sales category is £5
million or more. The in-depth analysis involves an evaluation of the
Licence holder’s past and forecast performance, business and
financial risks, risk management systems, financial stability and
liquidity, ability to generate cash, both historically and in the future
and financial flexibility.
Source: Civil Aviation Authority ATOL Policy and Regulations Fitness and Financial
Criteria for grant of licences 2010/04
Holistic market monitoring
6.4
To be able to respond to failure in a timely and pro-active manner,
regulators, commissioners and policy makers need to be able to identify
concerns about particular providers and wider market trends. Public
markets therefore need to be underpinned by a monitoring system which
provides ‘early warning’ indications that the market is heading towards
dimensions in the vicious competitive cycle. In developing any system of
market monitoring, there are a number of design principles which should
be upheld:
OFT1468 | 40
26
•
Coordinated monitoring. A key theme that emerged from our
roundtable was the importance of having a coordinated and
comprehensive understanding of market developments. In markets
where services are commissioned locally but providers stretch across
different local markets, and where failure in one market might have a
knock-on effect elsewhere, then it may be beyond the ability of local
commissioners to keep track of market trends. In such cases, it might
be appropriate for a national body to coordinate and disseminate
information about market trends.
•
Understandable metrics. Any system of market monitoring needs to
produce metrics that are easy to understand and, as a minimum,
provide an insight into the level of risk facing providers and the
capability of these providers to manage these risks. 26
•
Maintain managerial autonomy. The OFT has previously highlighted
that competition will work most effectively in improving outcomes if
those in charge of provider organisations have the ability to innovate
and change the way services are delivered. 27 Any system of market
monitoring should seek to incentivise sound governance and
management practices but not place undue restrictions on providers.
•
Understand the ‘chain of failure’. Any system of market monitoring
also needs to be based on an understanding of the ‘chain of failure’.
Certain indicators are likely to predict the probability of failure. For
example, poor management decisions are likely to precede poor
service provision which is likely to precede financial difficulty which is
likely to precede financial failure. Regulators and commissioners need
Cabinet Office (2011) Open Public Services white paper
27
Some autonomy in heavily regulated markets can, however, have adverse effects. For
example, it is a well known result that certain types of autonomy over pay in public markets can
drive up overall levels of pay at the expense of other inputs, as providers compete over a largely
fixed pool of labour www.oft.gov.uk/shared_oft/business_leaflets/general/oft1214.pdf.
OFT1468 | 41
to keep an interest in the indicators that are best placed to give an
early warning indication that provider failure is on the horizon.
Mitigate moral hazard
6.5
As the OFT highlighted in its review of barriers to entry, exit and
expansion in retail banking, competition may be weakened if inefficient
incumbents are not allowed to exit the market, reducing the incentives,
or ability, of more efficient firms to engage in intense rivalry. 28
Continuity regimes can help weaken competitive incentives if providers
believe they will receive government support in the build up to, and in
the event of, their failure.
6.6
Nevertheless, there are ways in which continuity regimes can be
designed to mitigate moral hazard:
•
Limit administrative or financial support. As the basic premise of a
continuity regime is to ensure continuity of service rather than
providing direct support to failing firm, any direct government
support to failing firms runs the risk of incentivising ‘moral hazard’.
Ultimately, government support might set a precedent and
incentivise poor management on the part of providers. Any
intervention should be undertaken after a full consideration of the
impact the intervention will have on wider incentives in the public
market.
•
Consistently apply the ‘rules of the game’. Providers need clarity
about the circumstances in which the public purse will step in to
offer them support. These circumstances need to be consistently
applied through the course of any contract. Doing so requires
commissioners and regulators to remain firm in the face of pressure
from providers to gain government-backed assistance.
28
OFT (2010) Review of barriers to entry, exit and expansion in retail banking available here:
http://www.oft.gov.uk/shared_oft/personal-current-accounts/oft1282
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•
Accountability in cases of failure. One of the continuity regime
principles in the Open Public Services White Paper is that
accountability for providing quality services and good financial
management should remain firmly with the provider. Holding
providers duly to account for their performance sends an important
signal to the market and creates incentives to pursue good practise.
Options to hold providers to account as part of the continuity regime
include building fines for failure into contracts and restricting failed
providers from being able to re-bid for contracts until the reasons for
failure have been addressed. It is also important to hold
commissioners to account for the impact their actions have on the
market, particularly if a provider has to exit the market as a result of
unrealistic expectations being written into contracts.
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Box 6.2: Interventions in the UK banking system: creating moral hazard?
In response to the exceptional turbulence in world financial markets, the
UK Government set out a number of measures designed to restore financial
stability and safeguard the UK economy. These measures were aimed at
restoring confidence and encouraging inter-bank lending, through the provision
of liquidity, the recapitalisation of the financial sector and the provision of state
guarantees for new debt issuance. In particular, sector-wide schemes included:
•
•
•
•
•
•
the
the
the
the
the
the
Credit Guarantee Scheme
Special Liquidity Scheme
Recapitalisation Programme
Asset Protection Scheme
Asset Backed Securities Guarantee, and
Asset Purchase Facility.
Through the above schemes and one-off interventions, the UK
Government has taken direct action in respect to certain UK banks. For
example, the Government acquired 84 per cent ownership of RBS Group
through an overall recapitalisation of £45.5 billion. Government interventions
aimed at restoring financial stability have, to a large extent, benefitted large
financial institutions. The Bank of England has described this as 'a major public
policy issue that entails a substantial implicit subsidy to the banking system,
mostly centred on the largest banks'. One consequence of the implicit
guarantee by Government to rescue banks that are 'too big to fail' may be the
creation of a moral hazard in banking.
In 2010 the OFT launched a review into barriers to entry, exit and expansion in
retail banking. As part of the review, respondents commented that perceived
public protection and support may have detrimental effect on competition if
such institutions decide to offer better rates than their rivals (who are not
deemed too big to fail), knowing that they will rescued if they risk defaulting.
Other respondents noted that if customers perceive large banks as 'safe
havens', they will be more inclined to deposit funds in these institutions, even if
they are not safer than other banks. The review also pointed to the high levels
of consumer inertia in the retail banking sector which, in addition, might make it
even more difficult for new entrants to attract new customers.
Source: OFT (2010) Review of barriers to entry, exit and expansion in retail banking
OFT1468 | 44
Prepare for failure
6.6
In order for continuity regimes to ensure service continuity they need to
be prepared for failure. To do so, they need to:
•
Plan for failure. Whatever the mechanisms being used to maintain
service continuity, it is important that these mechanisms are
embedded into an action plan that will be triggered in the run up to a
provider exiting the market. These plans should include roles and
responsibilities including sign-off, who will manage the process, who
will be the senior responsible owner. In addition, having an available
set of ‘panic cards’ and clear advice to follow can help.
•
Test plans. Whilst it is important to have plans agreed on paper, it is
also important to test how well these plans would stand up under
various different scenarios. War games and simulation exercises can
be useful exercises to test and communicate continuity plans to
those who have a role to play.
•
Have financial reserves in place. There may need to be financial
provision in place to ensure that if a provider fails and exits the
market at short notice, there are appropriate financial reserves to
ensure service users are protected until another provider can be
found.
Identify and address barriers to exit
6.7
Leaving a market can be expensive and time consuming particularly
when there are barriers to exit that will need to be addressed in order for
a provider to exit the market. Barriers to exit may keep a provider in a
market even though they are financially unviable or are offering poor
quality services. The economic literature identifies three main barriers to
exit. These are:
OFT1468 | 45
•
•
•
Investments in specialised assets and equipment that cannot readily
be used in other industries and therefore are difficult to sell or
relocate.
Highly specialised skills by industry participants that cannot be
utilized in other industries.
High levels of dedicated fixed costs.
6.8
In addition, the actions that governments take in markets can act as
barriers to exit. Actions that temporarily smooth exit such as lenient
price regulation and administrative and financial support can serve to
prevent provider exit and can increase the costs of exit if financial
support has to be written off.
6.9
Where public services are provided through public markets and have
specialised assets and employee skills, designers of continuity regimes
need to consider what will happen to assets and skills in the event of
failure. In some cases, reallocation to alternative providers will be
relatively straightforward, particularly when whole units can be
transferred to an alternative provider. However, exit may become more
complicated when assets are spread across a failed and a well
performing service. These issues are unresolved and there is further
work to be done to explore and identify barriers to exit in public markets.
Be adaptable to changes in the market
6.10
Markets are inherently dynamic. In private markets over time products
will develop, firms will expand and contract, and consumer demands will
evolve. Public markets are no different. Over time, a service that has
historically been considered critical due to market conditions such as a
lack of alternative providers, or untested dimensions of competition, may
no longer apply.
6.11
It is important therefore that continuity regimes have the capacity to
respond to changes in the market. Feedback from providers, periodic
reviews of the suitability of market conditions, and sunset clauses could
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all help to provide an opportunity to reassess how appropriate the
continuity regime is for current market conditions.
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7
CONCLUSION
7.1
As public services are increasingly opened up to new providers and
alternative delivery models the challenge facing policy makers, regulators
and commissioners is how to support competition without allowing
competitive forces to lead to disruption for service users. This working
paper has looked at the role competition can play in mitigating the
disruption caused by provider failure, when a continuity regime might
need to step in to protect service users, and how continuity regimes can
be designed to support competition.
7.2
The paper has suggested that in many markets competition can go a
long way to mitigate the impact disruption that exit might cause. This
can be achieved by commissioning policies designed to achieve:
•
•
•
7.3
The paper has explored when public markets need continuity regimes
and has suggested that regimes should be targeted to situations where:
•
•
•
7.4
Low barriers to entry which allow alternative providers to enter the
market to take over supply in cases of provider failure.
A diversified supply side so that the failure of one provider leaves a
sufficiently small ‘hole’ in the market for alternative providers to
easily take on service users from the failed provider.
Providers being incentivised to strongly compete by internalising the
costs of their own actions and being rewarded for success and
punished for poor performance. This, in turn, will allow the best
performers to expand their market share.
short-term discontinuity of service will lead to significant disruption
provider failure is likely to lead to discontinuity of service
a provider is likely to fail as a result of extraneous circumstances.
Finally, the paper looked at how continuity regimes be designed to
support competition if they:
•
focus on mitigating the risk of service disruption, not the risk of firm
failure or exit
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•
•
•
•
•
•
allow for market entry
holistically monitor the market
mitigate moral hazard
address barriers to exit
prepare for failure
be adaptable to changes in the market.
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