Price-cap regulation
Encyclopedia
Price-cap regulation is a form of regulation
designed in the 1980s by UK
Treasury
economist
Stephen Littlechild, which has been applied to all of the privatized British network utilities. It is contrasted with rate-of-return regulation
, in which utilities are permitted a set rate of return
on capital, and with revenue-cap regulation
where total revenue is the regulated variable.
Price cap regulation adjusts the operator’s prices according to the price cap index that reflects the overall rate of inflation in the economy, the ability of the operator to gain efficiencies relative to the average firm in the economy, and the inflation in the operator’s input prices relative to the average firm in the economy. Revenue cap regulation attempts to do the same thing, but for revenue rather than prices.
Price cap regulation is sometimes called ""CPI - X", (in the United Kingdom "RPI-X") after the basic formula employed to set price caps. This takes the rate of inflation
, measured by the Consumer Price Index
(UK Retail Prices Index
, RPI) and subtracts expected efficiency savings X. In the water industry
, the formula is "RPI - X + K", where K is based on capital investment requirements. The system is intended to provide incentives for efficiency savings, as any savings above the predicted rate X can be passed on to shareholders, at least until the price caps are next reviewed (usually every five years). A key part of the system is that the rate X is based not only a firm's past performance, but on the performance of other firms in the industry: X is intended to be a proxy for a competitive market, in industries which are natural monopolies
.
Now consider how a utility operator might be different from the average firm in the economy. First, assume that the operator is just like the average firm, except that the operator’s input prices change at a rate that is different from the rate of change for the average firm. If the operator’s input prices increase faster than (conversely, slower than) the rate of inflation, then the operator’s retail prices (revenue) will need to increase faster than (conversely, slower than) the rate of inflation for the operator to be able to have earnings that are at least as great as the operator’s cost of capital.
Now assume that the operator is just like the average firm, except with respect to the operator’s ability to improve efficiency. If the operator increases its productivity faster than (conversely, slower than) the average firm, then the operator’s retail prices (revenue) will need to decrease (conversely, increase) relative to the rate of inflation.
Combining these two possible differences between the operator and the average firm in the economy, the operator’s retail prices (revenue) should change at the rate of inflation, minus (conversely, plus) the extent to which its input prices inflate less than (conversely, greater than) the rate of inflation, and minus (conversely, plus) the extent to which the operator’s productivity is expected to improve at a rate that is greater than (conversely, less than) the average firm in the economy.
The above analysis identifies two things. First, the inflation rate, I, used in the price cap index represents the general rate of inflation for the economy. Second, the X-factor is intended to capture the difference between the operator and the average firm in the economy with respect to inflation in input prices and changes in productivity. That is to say, the choice of inflation index and of the X-factor go hand in hand. Some regulators choose a general measure of inflation, such as a gross national product price index. In this case, the X-factor reflects the difference between the operator and the average firm in the economy with respect to the operator’s ability to improve its productivity and the effect of inflation on the operator’s input costs. Other regulators choose a retail (or producer) price index. In these cases, the X-factor represents the difference between the operator and the average retail (or wholesale) firm. Lastly, some regulators construct price indices of operator inputs. In these cases, the X-factor reflects productivity changes of the operator.
In most industries in the UK, estimation of a firm's efficiency is carried out by comparing regional monopolies and using a total factor productivity
method. However, for telecommunications, Ofcom
instead relies on international comparisons.
In practice, the distinction between price-cap and rate-of-return regulation may be lost, as regulators may end up making implicit decisions on the acceptable real rates of return on capital employed in order to arrive at price limit determinations. This has been the experience in the UK water sector, where the 1999 periodic review led Ofwat to determine a standard (real post-tax) cost of capital of 4.75%, with minor adjustments for smaller companies. This standard rate was then used to help calculate X. In addition, detailed aspects of the price elements incorporated into the price index may be more important to the actual operation of a price cap regulatory regime than either the X-factor or the inflation adjustment. How rate elements are incorporated and removed from price caps is particularly important in industries with rapidly changing service offerings.
Price-cap regulation is no longer a uniquely British form of regulation. Particularly in the telecommunications industry, many Asian countries are implementing some form of price cap on their newly-privatised operators. In addition, many US Local Exchange Carrier
s are now regulated by price-cap rather than rate-of-return regulation: in 2003, of the 73 companies reporting to the ARMIS database, 22 were regulated according to an RPI-X price cap (and a further 35 were subject to other retail price controls).
Regulation
Regulation is administrative legislation that constitutes or constrains rights and allocates responsibilities. It can be distinguished from primary legislation on the one hand and judge-made law on the other...
designed in the 1980s by UK
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
Treasury
HM Treasury
HM Treasury, in full Her Majesty's Treasury, informally The Treasury, is the United Kingdom government department responsible for developing and executing the British government's public finance policy and economic policy...
economist
Economist
An economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy...
Stephen Littlechild, which has been applied to all of the privatized British network utilities. It is contrasted with rate-of-return regulation
Rate-of-return regulation
Rate-of-return regulation is a system for setting the prices charged by regulated monopolies. The central idea is that monopoly firms should be required to charge the price that would prevail in a competitive market, which is equal to efficient costs of production plus a market-determined rate of...
, in which utilities are permitted a set rate of return
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
on capital, and with revenue-cap regulation
Revenue-cap regulation
Revenue-cap regulation is a system for setting the prices charged by regulated monopolies by limiting the total revenue in a given period. It is contrasted with rate-of-return regulation, in which utilities are permitted a set rate of return on capital, and with price-cap regulation where price is...
where total revenue is the regulated variable.
Price cap regulation adjusts the operator’s prices according to the price cap index that reflects the overall rate of inflation in the economy, the ability of the operator to gain efficiencies relative to the average firm in the economy, and the inflation in the operator’s input prices relative to the average firm in the economy. Revenue cap regulation attempts to do the same thing, but for revenue rather than prices.
Price cap regulation is sometimes called ""CPI - X", (in the United Kingdom "RPI-X") after the basic formula employed to set price caps. This takes the rate of inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
, measured by the Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
(UK Retail Prices Index
Retail Prices Index (United Kingdom)
In the United Kingdom, the Retail Prices Index or Retail Price Index is a measure of inflation published monthly by the Office for National Statistics. It measures the change in the cost of a basket of retail goods and services.-History:...
, RPI) and subtracts expected efficiency savings X. In the water industry
Water industry
The water industry provides drinking water and wastewater services to residential, commercial, and industrial sectors of the economy. The water industry includes manufacturers and suppliers of bottled water...
, the formula is "RPI - X + K", where K is based on capital investment requirements. The system is intended to provide incentives for efficiency savings, as any savings above the predicted rate X can be passed on to shareholders, at least until the price caps are next reviewed (usually every five years). A key part of the system is that the rate X is based not only a firm's past performance, but on the performance of other firms in the industry: X is intended to be a proxy for a competitive market, in industries which are natural monopolies
Natural monopoly
A monopoly describes a situation where all sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient for production to be concentrated in a single form...
.
Now consider how a utility operator might be different from the average firm in the economy. First, assume that the operator is just like the average firm, except that the operator’s input prices change at a rate that is different from the rate of change for the average firm. If the operator’s input prices increase faster than (conversely, slower than) the rate of inflation, then the operator’s retail prices (revenue) will need to increase faster than (conversely, slower than) the rate of inflation for the operator to be able to have earnings that are at least as great as the operator’s cost of capital.
Now assume that the operator is just like the average firm, except with respect to the operator’s ability to improve efficiency. If the operator increases its productivity faster than (conversely, slower than) the average firm, then the operator’s retail prices (revenue) will need to decrease (conversely, increase) relative to the rate of inflation.
Combining these two possible differences between the operator and the average firm in the economy, the operator’s retail prices (revenue) should change at the rate of inflation, minus (conversely, plus) the extent to which its input prices inflate less than (conversely, greater than) the rate of inflation, and minus (conversely, plus) the extent to which the operator’s productivity is expected to improve at a rate that is greater than (conversely, less than) the average firm in the economy.
The above analysis identifies two things. First, the inflation rate, I, used in the price cap index represents the general rate of inflation for the economy. Second, the X-factor is intended to capture the difference between the operator and the average firm in the economy with respect to inflation in input prices and changes in productivity. That is to say, the choice of inflation index and of the X-factor go hand in hand. Some regulators choose a general measure of inflation, such as a gross national product price index. In this case, the X-factor reflects the difference between the operator and the average firm in the economy with respect to the operator’s ability to improve its productivity and the effect of inflation on the operator’s input costs. Other regulators choose a retail (or producer) price index. In these cases, the X-factor represents the difference between the operator and the average retail (or wholesale) firm. Lastly, some regulators construct price indices of operator inputs. In these cases, the X-factor reflects productivity changes of the operator.
In most industries in the UK, estimation of a firm's efficiency is carried out by comparing regional monopolies and using a total factor productivity
Total factor productivity
In economics, total-factor productivity is a variable which accounts for effects in total output not caused by inputs. If all inputs are accounted for, then total factor productivity can be taken as a measure of an economy’s long-term technological change or technological dynamism.If all inputs...
method. However, for telecommunications, Ofcom
Ofcom
Ofcom is the government-approved regulatory authority for the broadcasting and telecommunications industries in the United Kingdom. Ofcom was initially established by the Office of Communications Act 2002. It received its full authority from the Communications Act 2003...
instead relies on international comparisons.
In practice, the distinction between price-cap and rate-of-return regulation may be lost, as regulators may end up making implicit decisions on the acceptable real rates of return on capital employed in order to arrive at price limit determinations. This has been the experience in the UK water sector, where the 1999 periodic review led Ofwat to determine a standard (real post-tax) cost of capital of 4.75%, with minor adjustments for smaller companies. This standard rate was then used to help calculate X. In addition, detailed aspects of the price elements incorporated into the price index may be more important to the actual operation of a price cap regulatory regime than either the X-factor or the inflation adjustment. How rate elements are incorporated and removed from price caps is particularly important in industries with rapidly changing service offerings.
Price-cap regulation is no longer a uniquely British form of regulation. Particularly in the telecommunications industry, many Asian countries are implementing some form of price cap on their newly-privatised operators. In addition, many US Local Exchange Carrier
Local exchange carrier
Local Exchange Carrier is a regulatory term in telecommunications for the local telephone company.In the United States, wireline telephone companies are divided into two large categories: long distance and local...
s are now regulated by price-cap rather than rate-of-return regulation: in 2003, of the 73 companies reporting to the ARMIS database, 22 were regulated according to an RPI-X price cap (and a further 35 were subject to other retail price controls).
External links
- Features of Price Cap and Revenue Cap Regulation from the Body of Knowledge on Infrastructure Regulation
- Data concerning U.S. interstate telephone service price caps
- Ian Alexander and Timothy Irwin (1996), "Price Caps, Rate-of-Return Regulation, and the Cost of Capital" http://rru.worldbank.org/Documents/PublicPolicyJournal/087irwin.pdf