Price Regulation Methods

(prepared for the European Copper Institute)

Dr. Konstantin Petrov

KEMA Consulting GmbH

Kurt-Schumacher-Straße 8 53113, Bonn

Tel: + 49 228 4469000

Mobile: +49 173 515 19 46

Email: konstantin.petrov@kema.com

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1 Rate of Return Regulation

Under rate of return pricing, the regulator sets prices for the utility in such a way that they

cover the utility’s costs of production and include a rate of return on capital that is sufficient

to maintain investors’ willingness to replace or expand the company’s assets. Hence it is

referred to as rate of return regulation. It was widely practiced in US in regulated industries

until the last decade.

An example of a simplified formula for rate or return price control is set out below.

Revenue = costs + return on assets

It shows that the allowed revenue in the year concerned, year t, is set equal to costs (usually

operating and maintenance costs and depreciation), plus, an amount to give a reasonable

return on the assets necessary to provide regulated services.

The formula shows revenue for sake of simplicity. However, under rate of return regulation,

the upper limit is often applied to prices, as opposed to revenue. Where a single product is

produced, the upper limit to the regulated price could be obtained by dividing the allowed

revenue by the projected number of units sold. The allowed revenue or prices are generally

set every one or sometimes two years.

The rate of return regulation has two, well-known and significant disadvantages. It provides

no incentive to control costs, let alone reduce them. The utility knows it will be able to

recover increasing costs with a subsequent increase in price in the following year. Provided

that price reviews take place with sufficient frequency, the firm pays no penalty for

inefficiency. Suppose the regulator tries to reduce costs by setting prices so that costs in

real terms they are a certain percentage lower than last year’s costs. The utility has no

incentive to make these costs savings; if they are made, they are effectively immediately

taken from the utility and given to consumers in the form of lower prices. The utility does not

gain from efforts to reduce costs, as the rate of return earned on capital is still the same.

Hence there is no reward for the effort of holding costs down or reducing them. Moreover,

the rate of return regulation provides an incentive for the utility to over-invest in capital

equipment and plant. Assuming that the rate or return is set at an adequate level, then by

investing more and more in plant and equipment and other assets belonging to the utility,

under rate of return regulation, the company can earn an adequate return on its larger

investment. This incentive is clearly increased if the utility is earning a higher rate of return

than its cost of capital. This feature of rate of return regulation is sometimes known as “gold-

plating”. It can be difficult for the regulator to identify this over-investment by inspecting

investment plans, and hence prevent it from happening.

Other disadvantages include the need for frequent regulatory reviews and hence high

associated costs for both the regulator and the regulated industry.

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2 Cap Regulation

2.1 Nature of Cap Systems

Under cap regulation, prices, or revenues, are set in advance usually for a period of three to

five years, allowing the company to benefit from any cost savings made during that period,

but recalculated at regular intervals in order to bring them back into line with underlying

costs.

The “cap” refers to the upper limit that is placed on prices or revenue, hence the term “price

cap” or “revenue cap”. While a few US precursors can be identified, it was first applied on a

large scale to British Telecoms in the UK in 1984. Cap regulation is designed to give the

utility a strong incentive to reduce costs. This is partly done by setting the prices or

revenues that a firm can earn over a number of years independently of the costs it incurs

over this time. It is also achieved by allowing the company to keep, at least a portion of, the

benefits of any efficiency improvements over an assumed level of improvements.

In order to take account of unpredictable rates of inflation in an economy, a cap-regulation

regime typically allows a firm to vary its prices in any year by an amount linked to the overall

level of inflation, as measured by the percentage change in an appropriate price index, often

on a historical basis. This inflation-adjusted price level is then usually adjusted by a

percentage, the “X”, that reflects, among other things, the real change to costs that the

regulator assumes is reasonable.

The name “RPI-X” is often used, as RPI (or Retail Prices Index) is the name of the general

prices index in the UK. We have used CPI-X here, as CPI (or Consumer Prices Index).

Given that regulation is seen as a set of instruments to mimic market conduct, “cap”

regulation can be used to reproduce “imitation competition”. In competitive industries

intermediate profits can be earned if product or process improvements give an “innovator”

some competitive advantage over his rivals. This advantage can only be sustained as long

as competitors do not imitate the innovation. In competitive, capital-intensive industries, this

intermediate advantage is usually sustainable over several years. In analogy, regulated

utilities are allowed to maintain “intermediate profits” gained through exceeding the

productivity improvement target for periods of between three to five years by instituting a

corresponding period between regulatory reviews.

A simple formula that could apply to either a price or revenue cap (the cap or upper limit can

apply to either prices or revenue) is set out below1:

R t = R t-1 (1 + CPI - X)

1 Sometimes another term, usually denoted as “Y” is added to the right hand side of the equation to represent

costs that the regulated utility is allowed to “pass through” directly to the customer, usually because they are costs that the regulated utility has no control over.

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Where:

Rt is the limit on prices, or, on revenue

CPI is growth rate of the general price index

X is a factor that reflects the assumed productivity growth rate

t is the year index.

This formula shows that the cap or upper limit on either revenue or prices in the current year,

year t is set equal to the upper limit in the previous year and adjusted for general price

inflation (the “CPI” term) and the assumed increase in efficiency net of the effect of other

factors (the “X” term). This is the essence of cap regulation, though in practice other

variables tend to be added to the formula.

The main advantage of a cap system lies within the strong incentives it generates for higher

productive efficiency. Cap systems unlink revenue or prices from actual costs by imposing a

predefined change in revenue or prices over the course of a fixed regulatory period. The

annual change in prices is determined by the X factor. If the utility manages to reduce its

costs in excess of the X factor, it earns additional profits and conversely, if it performs worse

than the X factor, it earns less profit. This is the basic incentive provided by the cap systems

(see Figure 1). Consumers enjoy gains (represented by area A) due to a reduction in the

initial price P0. The utility retains extra profits due to cost savings in excess of the X factor

(area B). For society as a whole, efficiency savings are given by the area A+B.

Economic theory postulates that competitive markets promote efficiency. One of the main

features of a competitive market is that no single company can influence the observable

market price. Each company’s profit is then, amongst others, determined by the extent to

which this company is able to operate more efficiently than its competitors. In the context of

regulated monopolies, similar incentives can be created by setting the allowed price on an

exogenous basis i.e. independently from actually incurred costs. Given that prices are fixed,

ceteris paribus, operating at higher productivity levels i.e. producing the same level of

outputs at lower costs will drive up the company’s profits.

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Time

p0

Prices A+B. Cumulated efficiency gains

Expected Improvements

(X-factor)

Actual

Improvements

A. Benefit to

customers (lower prices)

B. Benefit to firm

(higher profits)

Figure 1 Simplified Representation of the Incentives Provided by a Price Cap System

Source: Ajodhia (2005), Regulating Beyond Price)

2.2 Advantages of Cap Systems

The main difference between cap regulation and traditional rate-of-return regulation is that

under the former system, prices are no longer directly based on the company’s actual costs.

At the one extreme, under a pure rate-of-return scheme, prices would be set on the basis of

the company’s actual costs. This provides no incentives for higher productivity. The other

extreme is to completely unlink prices from actual costs; this provides very strong incentives

for productivity improvement. Cap systems are located somewhere between these two

extremes. That is, prices and costs are detached from each other, but not to a full extent;

there still remains some interdependency.

In practice, the regulator sets prices not on the basis of the company’s actually incurred

costs, but rather on a level of cost that the regulator considers efficient. The difference

between actual costs and the regulatory estimation of efficient costs is reflected in the X

factor. The X factor applies for a given number of years (the regulatory period) and

determines the annual change in prices in such a way that prices move in line with the

anticipated efficiency improvements. Through the X factor, consumers directly participate in

the expected cost reductions in the form of a lower price.2 On the other hand, the company

will also benefit as long as it manages to reduce its costs in excess of the X factor. The

residual cost savings can then be retained in the form of higher profits.

The length of the regulatory period and the level of the X factor are the two milestones in the

cap system. Typically, prices are also adjusted for inflation in recognition of the fact that the

2 In principle, prices are expected to decrease over time i.e. the X factor is positive. However, in some cases the

X factor can be negative i.e. the price-cap results in a price increase. This may be the case if initially, prices were not at cost-reflective levels or there is significant need of new investments during the regulatory period.

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cost of goods and services used in the production process will change over time and that

this change in price levels is generally not controllable by the utility. By limiting the duration

of the regulatory period, the regulator can make sure that differences between actual

productivity improvements and anticipated improvements are retained only for a fixed period.

In practice, a regulatory period of between three and five years is deemed to be a

reasonable compromise. The inflation factor is typically the one published by statistical

institutions and can be the CPI for example as well as the retail price index (RPI), or

producer price index (PPI), or a combination of these with other inflation indices.

If the regulator is able to accurately predict the company’s future productivity improvements,

it could set the X factor on this basis. Then, the company would not earn too high excess

profits while at the same time, financial sustainability of the utility would also be assured. A

better assessment of the company’s true productivity improvement potential can thus lead to

a better balance between the interests of the company and consumers. In summary, the X

factor should be low enough to leave the company with sufficient funds and it should be high

enough so that consumers can also share the ongoing productivity gains. It is, however, the

case that quantifying the productivity potential, and therefore setting the X factor, is seriously

complicated by the regulator’s sometimes poor informational position relative to the

company.

Generally speaking, one may assume the company to have private (albeit incomplete)

information about whether and by how much it could improve on its efficiency. This

information is not available to the regulator and consequently, the regulator is constrained to

compute the most appropriate X factor. Furthermore, the company could strategically exploit

its superior informational position by talking down the X factor – claiming for instance that it

is based on inaccurate estimation and unrealistic or unattainable envisaged targets. Clearly,

the regulator’s ability to assess the company’s true productivity improvement potential can

greatly benefit the effectiveness of the cap system. Benchmarking analysis can play an

important role in this regard.

Compared to rate of return regulation, cap regulation provides stronger incentives to reduce

costs and, through the extension of regulatory lag, ensures the sustainability of these

incentives. Through weakening the relationships between actual costs and regulated prices,

cap regulation minimizes many of the deficiencies of rate of return regulation. It avoids the

need to reset annually the regulated rates and provides greater price stability. However,

cost reductions should not be achieved by prohibitive regulatory arrangements that would

not allow investors to earn an adequate rate of return. In setting the caps, the regulator will

need to ensure that their level is sufficient to cover not only the efficient operation and

maintenance costs, but also to provide an adequate return on the assets necessary to

provide the regulated services.

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2.3 Disadvantages of Cap Systems

Despite the advantages of its strong incentive properties, cap regulation is by no means

perfect. We discuss below some of the disadvantages of the cap systems.

Probably one of the most significant of its unintended consequences is that its strong cost-

cutting incentives tend to result eventually in lower levels of quality of supply. Theory and

practice suggest that cap regulation without additional measures, eventually leads to

degradation of reliability and other aspects of quality of supply. This is because the strong

efficiency incentives (driven by the profit incentive) can have the perverse effect of

encouraging sub-standard reliability levels in the medium to longer term. In simple terms,

under cap regulation a business can increase profits over a regulatory period by decreasing

costs. Hence it will tend to reduce expenditure where possible, even at the expense of

longer-term quality performance. Thus, under cap regulation systems, the inclusion of

elements to regulate the quality of supply is imperative. A system of financial penalties

(quality standards) for not achieving specific targets is often used. In addition, the price

formula may include a parameter which links the revenue/price cap to a specified measure

of the company’s performance, often the company’s performance in relation to a target

quality level.

Sometimes it is argued that because of its strong cost-cutting incentives, the cap mechanism

may not be the best choice for companies needing significant investment. However, this is

not usually sufficient reason for not using cap regulation, as the cap can be set to take the

need for investment into account (e.g. building block-approach as applied in UK, Australia,

Slovenia and Romania). For example, when setting the cap, an allowance could be made to

ensure that the cap will provide sufficient revenue to undertake the necessary efficient

investment (measures may also be needed to ensure that this investment is carried out).

Another disadvantage concerns the difficulties that can be encountered in determining a

reliable estimate of the scope of the regulated firm to make savings over the regulatory

period.3 The success of cap regulation depends on how good an estimate the cap is of the

efficient level of costs4. In order to achieve this, because of the number of years for which

3 The predominant view in the USA on the proper derivation of X in an RPI-X type price cap come from a

particularly important study, Bernstein and Sappington (1999). The regulator’s goal is to keep prices in the industry as low as possible to ensure zero economic profits. Given an RPI-X type price cap, then the X factor that ensures that the industry zero profits conditions holds a function of the difference between the rate by which total factor productivity (TFP) growth in the industry exceeds TFP growth for the economy as a whole, add the rate by which input price growth n the industry exceeds input price growth for the economy as a whole. Thus, according to Bernstein and Sappington, the proper definition of the X factor is a differential of a differential. In Europe the introduction of X was originated by Littlechild at the time of the first UK privatisations in the 1980s. According to Littlechild, the original intentions were simple; X was to reflect how prices (for British Telecom at the time) should fall relative to the economy as a whole, i.e., how real industry output prices should change over time. One of the more fundamental ideas of the price cap was also to avoid lengthy cost of service and rate of return regulation which had proved inefficient. 4

Including an assumption on efficiency gains in the incentive price regulation will enable the efficiency gains made by the firm up to the assumed level to be passed to the consumer over the regulatory period. If no assumption on efficiency gains is used in the cap regulation, then the regulation will still retain its incentive

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the price control will apply, it is generally necessary (to minimise the need to re-open the

regulations at a later stage) to consult reasonably extensively with the industry over the

forecast revenue requirements and, for example, the scope for efficiency gains and sharing

schemes before the price controls are implemented.

properties and encourage the firm to make savings, but these savings cannot be passed to the consumer until at the earliest, the following regulatory period.

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3 Yardstick Competition

Yardstick competition introduces a strong competitive aspect to the process of setting the X

factor. In the original definition of yardstick competition, the price for each company is set

equal to the average cost of all other companies in the regulated industry. There are some

variations on this theme. For example, the price can be set on the basis of the average cost

of all company (including the company under consideration), or one could apply some

quantity weighted average of costs to calculate the yardstick price.

Yardstick Competition was suggested by Shleifer (1985). Each in a group of comparable

regional monopolists has a price cap determined by the average cost of the others in the

group. In this model, operating costs ACi of firm i depend on the amount of effort expended

by the firm. For n ≥ 2 identical firms, the regulator defines for each of them the allowable

cost. An example of a simplified formula for the yardstick regulation of business i is:

)∑

≠= −=

n

ijj

ji

n

ACAC

,1 1(

Where:

ACi are the average costs (per unit sold/transmitted) of business i

n is the number of businesses being regulated.

Irrespective of the specific formulation, the main idea is that the company’s profitability is no

longer determined only by its own cost performance, but is driven by how well it manages to

reduce costs relative to others. This gives a strong incentive to increase performance –

similar to the incentive observed in competitive markets. If a company manages to reduce its

costs by more than the yardstick, it will earn a higher profit and conversely, company that lag

behind average performance will earn lower profits and possibly even incur losses. As all

companies have an incentive to reduce costs, this also brings down the average cost within

the industry. Thus, a continuous downward adjustment of the prices would take place

whereby each company’s effort to reduce costs in excess of the average simultaneously

leads to a decrease in the yardstick itself.

In the price-cap context, the X factor under a yardstick competition scheme would be set on

the basis of actual improvements in productivity. Thus, there is in principle no need for the

regulator to make any predictions about productivity improvement potential as this

information would be automatically revealed through the yardstick scheme. Also, as prices

continuously track realised improvements over time, efficiency gains are quickly transferred

to consumers. In essence, under yardstick competition the regulator would no longer have to

set the X factor but would simply adjust prices each time on the basis of some index of

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average cost.5

In his seminal paper on yardstick competition, Shleifer (1985) noted that an important aspect

of measuring the yardstick is the need to adjust for possible structural differences between

companies. Setting prices on the basis of average costs suggests that companies are

perfectly comparable to one another. This may not necessarily be true as there may be

structural differences in the operating environment across companies. Some companies may

have to deal with specific factors, which lead them to incur relatively higher costs than

others. Furthermore, one also needs to take into account the multi-dimensional nature of the

company’s production process. There may be more than a single input or output factor

involved in providing the regulated service. Neglecting such factors in the determination of

the yardstick would disadvantage some companies and provide others with an unintended

advantage. To deal with this problem, more sophisticated notions of average costs could be

used. The use of benchmarking methods, which incorporate multiple input and output factors

and allow to correct for structural differences, can play an important role in this process.

In addition to the comparability problem, there are two other main problems attached to

yardstick competition, namely commitment and collusion (Weyman-Jones 1995). The

collusion problem is related to the fact that the companies may strategically cooperate to

influence the outcome of the yardstick system. For example, companies may collectively

report higher costs than actually incurred in order to drive up the yardstick. The scope for

collusion increases as the number of companies is smaller. Therefore, in order for yardstick

competition to be effective, a large number of participating utilities is a necessary (but not

sufficient) condition.

Yardstick competition assumes that the regulator is committed to the regulatory contract.

This means that, irrespective of the outcome, the process by which the yardstick is

calculated is not changed afterwards. In principle, this should also hold in the case of

bankruptcy of one or more of the participating utilities. Similarly to a competitive

environment, companies who perform better then the yardstick earn exceptional profits while

others that lag behind will either earn less, or even in the limit will potentially become

unprofitable and eventually go bankrupt. If the yardstick system is to remain credible,

bankruptcy of one or more companies should not be excluded as a potential outcome,

implying that the regulator should not adjust the rules of the system ex post to prevent ill-

performing companies from going bankrupt. However, bankruptcy of an electricity

distribution utility has substantial social and therewith political impact. It therefore remains

questionable what is the meaning of bankruptcy in this case and if such (distribution) utilities

would in practice be allowed to go bankrupt.

5 If the regulator needs to set prices at the start of the regulatory period, initially an estimation of the X factor can

be made. At the end of the regulatory period, the X factor can be adjusted based on realised cost developments. This approach is, for example, followed in the Netherlands

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4 Sliding Scale and Profit Sharing Regulation

Lack of information about the firm’s true productivity improvement potential may, as

discussed earlier, lead to two basic problems. On the one side, the X-factor may be set too

low and the firm will earn excessive profits. On the other side, the X-factor may be set too

high; this can cause financial problems for the firm. Taking this into account, the regulator

could decide to adjust the allowed revenue in such a way that the firm’s profit varies only

within a given range. Under this strategy, which is known as sliding scale, the regulator may

adjust the allowed revenue as a function of the profitability of the firm (e.g. as measured in

terms of its rate-of-return).

Ad jus ted RoR

R ORmax

ROR min ROR max

RO Rmín

RoRAd jus ted RoR

ROR min ROR maxRoR

Sliding Sca le withou t

Sharing

Sliding Sca le with Sharing

Figure 2 Sliding Scale Scheme

If, at the end of the regulatory period, the firm’s profit exceeds some predetermined band,

the revenue is adjusted such that profits are brought back within this band. Conversely, if

actual profits are higher than the allowed maximum, the revenue is adjusted in such a way

that these profits are reduced down to the level of the maximum. A similar procedure would

also apply for the minimum profit level. In between the two extremes, the revenue would not

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be adjusted i.e. the firm would earn the rate-of-return as observed at the end of the

regulatory period.

Optionally, the regulator can apply a sharing mechanism where the revenue is adjusted only

partially in the case that profits exceed the predefined band. In that case, the firm would be

allowed to keep a part of the profits achieved in excess of the maximum level. Conversely, if

the firm earns less than the minimum profit, it would be forced to absorb part of the losses.

The sliding scale strategy assures that profits remain within certain limits but also has the

problem that it does not provide any (strong) incentives for the firm to perform in excess of

these limits. The firm will not pursue any further productivity improvements once the

maximum profit has been attained. In the case that sharing is applied, the firm only has

limited incentives as it keeps only a fraction of the realised improvements. From the firm’s

point of view, additional improvements come at higher efforts but are not necessarily

associated with any rewards. Similarly, the firm may well opt for the guaranteed minimum

profit level (if this level if sufficiently high) rather than investing in productivity improvement.

These problems become particular relevant in the case that the maximum and minimum of

the profit range are set too low and high respectively.

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