Goals and Techniques of Price Cap Regulation

Underlying Theory of Price Cap Regulation

Price cap regulation is designed to give the operator to use its superior information to lower prices for customers. The operator knows more about its ability to operate efficiently than does the regulator.

If the operator can benefit from operating efficiently, then it may be willing to do so. In effect, the regulator pays the company extra profits (i.e., more than its cost of capital) to show the regulator what the company is really able to do.

This raises issues of opportunism. Once the company reveals its ability to be efficient, what keeps the regulator from simply demanding that the company be that efficient and withhold the reward? If the company believes this is what the regulator will do, the company will not reveal its true abilities.

Basic Restriction

Prices are initially set to allow the company to receive its cost of capital. Thereafter, prices are allowed to rise, on average, at the rate of inflation, less an offset.

is the average percentage change in prices allowed in a year

I is the inflation index

X is the offset

The critical issues for regulators should be: What is the ¢®¡Æoffset¢®¡¾? What is the measure of inflation? And, what does it mean that prices are allowed to rise on average? X is the offset factor. The X factor should represent the difference between the regulated firm and the average firm in the economy. The two key differences are the ability to improve productivity changes in input costs:

X > 0 implied by

The regulated firm can improve its productivity more than the average firm in the economy

The input prices for the regulated firm increase less than for the average firm in the economy

X < 0 implied by

The regulated firm cannot improve its productivity at the same rate (or greater rate) as the average firm in the economy.

The input prices for the regulated firm increase more than for the average firm in the economy

Example

Consider a situation in which the average firm in the economy improves its productivity by 3% per year and its input prices increase 1% per year. Further assume that the regulated firm can improve its productivity by 5% per year and its input prices actually decrease 2% per year.

The appropriate X factor is: X = (5 -3) - (-2-1) = 5

"A policy that links allowed prices to realized inflation, adjusts automatically for economy-wide variations in cost increases and productivity gains. The regulator need not speculate about the absolute levels of likely cost increases and productivity gains. The regulator need only posit likely differences in cost increases and productivity gains between the regulated firm and the rest of the economy." (David Sappington)

Approaches for setting the X factor: Historical changes in productivity: Estimate Total Factor Productivity (TFP) for average firm in economy and for regulated firm. Set X equal to the difference after adjusting for differences in input price inflation.