From Rate-of-Return Regulation to Price-Cap Regulation

Rate-of-Return Regulation and the Review Process

For many years, the dominant method of regulation for private monopolies was so-called rate-of-return regulation. The regulated firm was allowed to charge prices that would cover its operating costs and give it a fair rate of return on the full value of its capital. If costs moved out of line with those prices, the firm would ask for a new set of prices. The main virtue of this "regulatory contract or compact" was to guarantee that the company would recover its costs. This absence of risk could attract capital at a low price. However, this method did not give incentives to the firm to keep its costs down.

To improve efficiency, "prudency reviews" were introduced to assess whether a new investment was necessary. If an investment was not judged "used and useful," then the regulator might not allow it to enter the rate base. Prudency reviews raise the concern of excessive micromanagement by regulators. Furthermore, by allowing regulators to substitute their own business judgement for that of the utilities' managers and boards, they potentially jeopardize the guarantee against expropriation afforded by rate of return regulation. Prudency reviews have therefore remained relatively limited.

The bureaucratic delays of the lengthy process leading to price revisions generated so-called regulatory lags, which had the beneficial side effect of creating some incentives for cost minimization. Indeed, during such lags, the firm was residual claimant of any cost decrease. To mitigate the effects of these delays on profits regulators introduced indexation clauses, for some items outside the control of firm, or pass-through clauses. For example, an electric company might be entitled to a complete pass-through to the consumer of its energy purchase expenditures in the wholesale market. A danger, then, is that the firm has little incentive to bargain for low prices of the corresponding inputs.

Another important feature of rate-of-return regulation is that individual retail prices are determined through accounting procedures and therefore do not obey commercial principles. In particular, they poorly reflect demand considerations. As discussed earlier, the review process determines a revenue requirement meant to cover operating costs plus a fair rate of return on undepreciated capital. Loosely speaking, this revenue requirement sets an average price or price level. It does not yield the price structure. The latter is the outcome of a cost allocation process. Costs that can unambiguously be allocated to a service are included in the price of this service; costs that are common to several services (which is the case for most equipment, be it wires or switches) are allocated according to some accounting rule to the different services. Price-Cap Regulation

Price-cap regulation was introduced in the United Kingdom under the name of "RPI - X". The firm is required to keep the weighted increase in a basket of its prices to less than the increase in a specified price index (for example, the retail price index, RPI), less x percent. The x percent factor induces a decline in real terms to account for anticipated technological progress. The price control remains in place for a fixed period of four to five years during which the firm fully bears its cost.

In practice, price-cap regulation resembles rate-of-return regulation in some respects. On the one hand, the revision of price cap every four or five years uses all the information available about the firm including its present and projected operating costs, its assets, its investment plans, and its demand forecasts. This information enables the regulator to constrain the rate of return of the firm on the upside. (Sometimes rent extraction is performed more explicitly when earning-sharing schemes are appended to the price cap to redistribute excessive profits to consumers. A consequence of such profit sharing, of course, is a weakening of the incentives for cost minimization) On the other hand, the profit downside is also partly insured through a common understanding that the regulator should allow a reasonable rate of return; indeed, regulatory statutes include an appeal mechanism to protect the company against excessively zealous regulators.

Price-cap regulation differs from rate-of-return regulation in other respects. First, the revision of the regulatory constraint is in principle less frequent, thus providing stronger incentives for cost reduction. Second, and conceptually a more drastic departure, the firm has flexibility as to the choice of its price structure. As we have seen, the firm is then able to price-discriminate in a way that minimizes the social distortion associated with cost recovery. In contrast with the regulator, the regulated firm has strong incentives to acquire the information about demand elasticities and to make use of this information; if it misjudges demand elasticities or does not act on knowledge of them, its profit will be substantially smaller.