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

1 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. 

2.3.1.2 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.

Corporate rate plans

Corporate rate plans
Most accounts only have one cell phone listed on the account. Customers typically activate only one phone at a time, and the phone is handled individually. Because of this, wireless carriers are not exactly sure what percentage of their customer base is commercial and what percentage is consumer. If, however, a business has multiple phones with the same carrier, it may qualify to be treated as a corporate account. Each carrier has a minimum number of phones to qualify for a corporate account. It may be as few as 5 or as many as 50.

If a business does not meet the minimum number of required phones, the carrier may make an exception and allow it to start a corporate account anyway. If a business is only one or two phones short of the minimum, it might cut its overall expenses by adding extra phones to qualify for the corporate account.

What is the advantage of a corporate account?
The main advantage of corporate accounts is that the monthly access charge is significantly reduced. Instead of paying hundreds of dollars a month in access charges, corporate accounts typically only charge $15 per phone. The corporate account for AT&T employees has a phenomenally low $10 monthly access fee and airtime only costs $0.10 per minute.

With individual rate plans, it is a gamble each month whether or not the user will use too many, or too few, minutes. In either case, money is wasted. Corporate accounts do not experience this waste. With a corporate account, high users pay a low rate for each minute, and low users only pay the minimal access fee. There are no surprises.

Pooled or not pooled?
Like small group accounts, some corporate accounts use a pool system for the airtime. A typical pooled corporate account may charge $100 for the first phone and $15 for each additional phone. A pool of 1,000 airtime minutes for all the phones to share is included in the plan. The customer must pay for any additional minutes above the first 1,000.

Nonpooled corporate accounts charge the customer a low access fee per phone and bill the customer for each minute of airtime. You probably will not be given a choice between pooled or not pooled, as most carriers only offer one or the other.

Using someone else’s corporate account
Some carriers allow two businesses to combine their mobile phones to qualify for a corporate account. As long as the carrier separately bills the two companies, this is a great situation. I have seen large companies combine with their subsidiaries, customers, suppliers, and even employees to qualify for a larger corporate account. A large business can use its leverage to help a smaller sister company qualify for corporate pricing.

Avoid fraud and waste on corporate accounts
Some businesses allow their employees to put their personal phones on the corporate pricing. As long as the company does not pay for personal phones or a sister company’s phones, this system works great. Larger businesses that do not routinely track their cellular phones and regularly audit their bills may end up paying for an employee’s personal phone. It is not uncommon for an ex-employee to continue using the company-issued cell phone for months after employment has been terminated.

If you are auditing your bills for the first time, find out the name of the user for each cell phone listed on the bill. Some carriers print the user’s name right on the bill. After reviewing your list of phone numbers and employee names, company department managers should be able to tell you which employees should be using company wireless phones. If you still cannot determine who the user is, call the number and see who answers. If all else fails, temporarily disconnecting the service should flush out the user. Be careful, because you may be surprised to learn whose phone you have canceled. I have canceled the phones of ex-employees, ghost employees, high-level executives, the college-aged children of executives, and even a high-level executive’s mistress.

Before disconnecting anyone’s phone, be sure your company’s executive staff are well aware of the pending cancellation. On an account with 25 or more phones, this type of common-sense audit typically turns up one or two illegitimate cell phones.

Remove high-end users from the corporate account
Customers that use corporate accounts will have one or more phones that stand out because they use more airtime than the other phones. A typical corporate account has 20 phones that each use about 100 minutes of airtime each month and one or two phones that use more than 500 minutes of airtime. In this scenario, the larger users could be pulled out of the corporate account and handled as individual accounts.