Basic Pricing Approaches

1 Cost-of-Service Regulation (Including Return on Rate Base Regulation)

A system of regulation where the regulator observes the operator’s profits (i.e. its accounting records) and lowers or raises the operator’s prices to keep the company’s profits near its cost of capital.

Advantages of Using ROR Tools

Regulation is sustainable over long periods of time if there is no competition because prices can be adjusted to the company’s changing conditions. Inefficiency and cost-shifting incentives of ROR make using ROR tools difficult to sustain when there is competition. Can provide a high degree of comfort to investors, thus lowering the cost of capital. This form of regulation generally results in a lower cost of capital than does price cap regulation (Alexander and Irwin). Company profits can be kept within acceptable levels. Regulators have little discretion because the methods, formulas, and data sources are well known. Computations and analyses can be turned over to consultants. Revenues cover costs and assures adequate supply of services

Disadvantages of ROR Tools

ROR tools provide only weak incentives for companies to operate efficiently. The Averch-Johnson Effect says that companies have an incentive to over invest in facilities when the estimated cost of capital is greater than the company’s actual cost of capital at the margin, and that companies have an incentive to under invest in facilities when the cost of capital calculated is less than the company’s actual cost of capital at the margin.

Companies have reduced incentive to control costs because shareholder interests in profits are at least somewhat protected by the regulator, not by management. Regulators must find, quantify, and charge to shareholders any excess costs. If this is hard, management may spend money on things it wants because there is little or no harm to shareholders. If regulators are overly zealous in finding costs that look inefficient, companies may be too timid to do things that would benefit customers, but that may be difficult to explain to regulators.

In addition, periods of high inflation may cause frequent earnings reviews and provides a mechanism for companies to shift costs from competitive markets to non-competitive markets.

Remedies for problems

Regulators generally try to remedy these perverse incentives through regulatory lag, sliding scales, and efficiency audits/reviews.

• Regulatory lag is the time lag between when a company incurs a cost or receives a revenue and when the regulator responds to this by raising or lowering the company’s prices
• Sliding scales are earnings sharing mechanisms. For example, a regulator may allow the company to earn profits above its cost of capital, but require the company to share some percent of these extra profits with customers through refunds or lower prices.
• Efficiency audits/reviews are audits by regulators that try to assess the operational efficiency of the company by looking for places where the company has been imprudent or has costs that are unnecessary to provide the utility service.

Price Cap Regulation

A system of regulation where the regulator sets prices without reference to the costs the company incurs during the period the prices are in effect.

With pure price caps, the regulator never directly observes the operator’s profits. This form of price caps is rare and indeed may never be practiced except in instances where the regulator is prohibited by law from observing costs and adjusting prices.

Most price cap regimes base prices on past costs or expected costs and prohibit the regulator from adjusting prices according to new information for a set period of time, typically 4-6 years.

These regimes resemble rate of return regulation. The critical differences are that these price cap regimes have fixed time periods between price reviews, while under rate of return regulation price reviews are triggered by high or low earnings (relative to the cost of capital). (Green, 1997)

Benefits

Price cap regulation provides companies with incentives to improve efficiency. It also dampens the effects of cost information asymmetries between companies and regulators. However, incentives to over-invest in capital and to cross-subsidize are less than those prevalent in cost-of-service regulation.

Problems

Service quality and infrastructure development may suffer if meeting appropriate standards is unprofitable for the operator. Difficult to keep regulatory commitments to not observe profits.