(Don't Fear) The Reaper......of uncertainty

All our times have come, Here but now they're gone, Seasons don't fear the reaper, Nor do the wind, the sun or the rain, We can be like they are.

Lyrics courtesy of Blue ?yster Cult, (Don’t Fear) The Reaper

A classic tune with a simple reminder.? It is usually better to not fear things that are inevitable. There are some things that just are.

I put the weather – like our own mortality – in this bracket. To be more precise, I put the uncertainty of our weather in this bracket.

It was once my ambition to be a trainee weather forecaster. While still at secondary school I found myself at a desk in Partick Burgh Hall sitting an entrance exam to become a junior trainee at the Met Office. I did quite well but not well enough to make the move down to Bracknell.

So my second best was to try economics and the rest as they say became my history. As it turned out being a weather forecaster and being an economist wasn’t that different. They both tempt us into fearing things that are inevitable.

In this piece I want to suggest that being a bit more like the seasons might help our economic regulators. Just as the seasons don’t fear the reaper, economic regulators don’t need to fear the reaper…. of uncertainty.

On risk vs. uncertainty

My starting point is prompted by yet more insight gleaned from the book Radical Uncertainty by John Kay and Mervyn King.

The insight is that we – here I mean the collective we covering policy-makers, regulators, economists and maybe even weather forecasters - have been entranced by the idea that risk and uncertainty are the same thing. And somehow risk and therefore uncertainty is something we can manage away. Something we can hedge. We can hedge risk, but we can’t hedge uncertainty. Uncertainty just is. And we can handle it well or we can handle it badly.

This conflating of risk and uncertainty is fundamentally wrong and ends up being unhelpful. At least that’s the conclusion I have reached after reading (again) Kay and King.

Frank Knight on risk vs. uncertainty

Through Kay and King I have been re-introduced to the distinction between risk and uncertainty – a distinction that really belongs to the American economist Frank Knight. In his 1921 book Risk, Uncertainty and Profit, Knight lays out the distinction as:

Risk: A situation where the probability of an outcome is known and can be quantified, so steps can be taken to protect against it.

Uncertainty : An event where the probability is unknown and cannot be predicted.

Therefore, according to Knight, risk applies to situations where we do not know the outcome of a given situation, but can accurately measure the odds of each potential outcome. Uncertainty, on the other hand, applies to situations where we cannot know all the information we need in order to set accurate odds in the first place.

It is the latter that characterises the radical uncertainty described by Kay and King.

And bringing this back to our world of economic regulators, regulation is not a game of chance as understood by Knight. It lives in the world of radical uncertainty as described by Kay and King.

My basic thesis is that economic regulators have forgotten these nuances between risk and uncertainty. And as a result our regulatory approaches to the management of uncertainty are too blunt and potentially counter-productive.

A confusion between risk and uncertainty in water?

If you want a good example of the confusion between risk and uncertainty look no further than Ofwat’s recent PR24 final determinations.

We know the headlines are around substantial bill increases as a consequence of record levels of investment in the AMP8 (2025 to 2030) period. The PR24 enhancement programme of ￡44 billion dwarfs anything we have seen before. The previous high was PR19 with ￡11 billion allowed for AMP7.

I have consciously referred to enhancements here because enhancements represent new stuff. This is the new territory in terms of what is required (outcomes, service to customers and the environment etc) and what is expected to be delivered by our water companies. Here we find the seeds of the long-term delivery strategies, water resource plans and of note the newly found enthusiasm for things like smart metering and nature based solutions.

When we can’t predict the weather with 20:20 conviction, perhaps it should be no surprise then that what all of this looks like 5, 10, let alone 25 years from now becomes a source of regulatory fear.

And the response we can see with PR24 is indicative of a kind of regulatory fear. This is the list of "Delivery Incentive and Monitoring Arrangements for AMP8" that Ofwat described to the sector’s investors:

Source: Ofwat, PR24 final determinations, 14 Jan 2025, https://www.ofwat.gov.uk/wp-content/uploads/2025/01/PR24-final-determinations-webinar-slides.pdf

The appendix to the Final Determinations covering Price Control Deliverables (PCD) alone runs to 311 pages of text! All aspects of water company operations have some level of PCD attached to them.

Whether it was intended as a source of comfort or a warning to the sector’s investors this paints a picture of a regulator fearful of the reaper of uncertainty. A regulator seeking to hedge a risk of non-delivery through engineered “no-worse” off guarantees for bill-payers.

My reading of this picture is one of a regulator desiring to de-risk for bill payers the delivery of the largest ever enhancement programme. A laudable desire, but the question in my mind is at what cost? Will we all end up being worse off through this new complexity? Is there a better way of dealing with the inevitable uncertainty? Or perhaps most radically, is the inevitable uncertainty even something to be feared? Shouldn’t we - based on Knight’s insights - embrace the opportunities that arise with uncertainty?

Growing a regulatory tolerance for uncertainty

I have a sense that our regulatory frameworks lack resilience when it comes to uncertainty. That lack of resilience might be rooted in an over-weighting of financial approaches to risk management and an under-weighting of using profit incentives to drive the new entrepreneurial behaviours that have always thrived under conditions of radical uncertainty.

This absence of resilience is akin to what the students of meditation might label dys-regulation when it comes to how we handle long term uncertainty in our water sector

The danger we face in water is that we just end up creating yet more regulatory conditions that give rise to a problem that Arthur Downing so nicely and recently articulates.

The problem is under-investment in our utility infrastructure as just one symptom of poor economic performance in the UK. Arthur’s view is that this is nothing to do with our planning systems and more to do (in the case of utilities) with the liberal privatisation model. I get these arguments, but my point of departure – at least for water – is that any problem of under-investment is rooted in our regulatory frameworks more than any model of privatisation. And those regulatory frameworks as evidenced by PR24 grow ever more complex and it is that complexity which erodes the incentive to invest.

This evidence also reminds us that regulators are habitually risk-averse. This direction of ever-growing regulatory complexity is fuelled by a culture of de-risking that is driven by the laudable attempt to protect customers and bill-payers from the consequences of failure.

And de-risking has become synonymous and conflated with eliminating uncertainty.

De-risking works fine in the right situation. Knight’s distinction applies here. Managing risk belongs to situations where the game of chance is well defined and the probabilities are known. It doesn’t work well when we live under conditions of radical uncertainty. When probabilities are unknown, can’t be known and outcomes cannot be predicted we need to look at how we manage the inevitable uncertainty in different ways. These different ways need to move away from a culture of de-risking and loss aversion towards a regulatory mindset that embraces options. In the words of Kay and King:

“Knight’s insight – that it is radical uncertainty which gives opportunity for entrepreneurship – is fundamental to an understanding of social, technological and economic progress....

Through evolutionary processes – biological, institutional, political, market driven – entrepreneurship drives us forward...Humans thrive in conditions of radical uncertainty when creative individuals can draw on collective intelligence, hone their ideas in communication with others and operate in an environment which permits a stable reference narrative….

Within the context of a secure reference narrative, uncertainty is to be welcomed rather than feared…

In politics and business, uncertainty is a source of opportunity for the enterprising, though also associated with paralysis of decision-making in bureaucracies staffed by risk-averse individuals determined to protect their personal reference narratives.....

Embrace uncertainty; avoid risk.”

Source: John Kay and Mervyn King (2020), Radical Uncertainty: Decision Making for an Unknowable Future, page 431-432.

What we require instead is a Goldilocks approach to uncertainty. Avoiding the approaches that are too hot or too cold, but get things just right. Better to be broadly right than precisely wrong is what I was taught. And getting things broadly right is how I still think about the original and simpler model of price cap regulation.

Price cap regulation by design is forward looking and how it should deal with uncertainty can be rooted in 3 simple ideas:

1. We can't know the future
2. The future is still to be created
3. We want the best possible future

And the regulatory mechanics in my experience were also simple. Regulators should use the price cap to mimic what happens in markets – markets where radical uncertainty is a fact of life.

That uncertainty creates the noise of markets, but the lesson of markets is that someone will always find a direction to the best possible future. The regulatory challenge is to ensure there is always the someone. In markets entrepreneurs and the creatives can always sniff out the opportunity for excess returns.

And that was the simple objective of the regulator. Sow the seeds (options) for excess returns and let the unknown future evolve to reap those returns. Then the regulatory task was to monitor performance and then intervene to share the gains. Periodic price adjustments were always intended to be about the sharing of the rewards. Give back to customers through lower bills and prices their share of the collective gain.

The language here matters. “Rewards”, “gains”, “sharing” are all rooted in a different regulatory mindset. A mindset that will have grown to be tolerant of uncertainty.