Modified Historical Approach

Set X equal to X0 + S.

S is a “stretch factor” that accounts for the stifling effects of historic regulation and/or anticipated changes in industry conditions.

Examples of Explicit Stretch Factors

FCC for AT&T: 0.5%

FCC for LECs: 0.5%

Maine, Massachusetts,

Illinois: 1.0%

Pennsylvania: 0.2%

Canada (LECs): 1.0%

Choose X-factor similar to similarly situated countries and projected expenses (see outline for rate of return tools above).

Inflation index: is generally based on good approximation of previous year’s inflation. Appropriate inflation index, should reflect general price movements in the economy and must not be focused on a particular segment of the economy. It must be a reliable indicator and be based on reliable data, and must be available in a timely manner and not subject to frequent revision.

Average Price Change: General principle: “Price changes on services that affect many customers should be counted more heavily than identical price changes on services that affect few customers” (David Sappington). Therefore, use weighted average of price changes. Weight percentage change in each service price by the proportion that his service’s revenue is of the company’s total revenue.

Steps

1. Calculate each service’s revenue, total revenue, and the proposed percentage change in each price
2. Divide each service’s revenue by total revenue, multiply the quotient by the service’s proposed percentage change in price, and multiply by 100.
3. Sum the resulting products across all services

Example

Assume a company has two services. Service 1 provides 60 percent of the company’s revenue and Service 2 provides 40 percent. The company proposes to increase the price of Service 1 by 10 percent and the price of Service 2 by 5 percent. The resulting average price change is: (0.6 * 10% + 0.4 * 5%) * 100 = 8%

Adjustments for exogenous factors: Exogenous factors are one-time (or rare) events that are beyond the control of the company and that affect the company differently than the average firm in the economy. For example, a special tax placed on the company

Service baskets: A service basket is a group of services that are placed under a common I – X – Z restriction. The company is allowed to change the relative price levels of the services within a basket, subject to two possible restrictions

Limits on Individual Prices

• Sometimes regulators will place an absolute limit on some prices; for example, local line rental may not be allowed to exceed $20.
• Sometimes regulators will place percentage limits on price increases; for example, no individual price may increase more than 10% in a given year.

Cases of using price cap regulation: UK Regulation of British Telecom (BT)

The UK implemented price regulation for BT in 1984, and were guided by four basic reasons:

1. Price regulation would provide BT with incentives to decrease costs;
   
2. Because BT had been a government-owned service provider, information necessary for rate of return regulation was not available;
   
3. The UK wanted to minimize the amount of adversarial litigation that had characterized US rate of return regulation;
   
4. The UK believed that regulation would serve primarily as a brief transitional mechanism to full competition. Pricing reviews occurred in 1984-1989, 1989-1991, 1991-1993, 1993-1997, and 1997-2001.

Price review procedure follows the sequence set out below:

1. Issuing of Consultation documents;
   
2. Proposal of license changes by Oftel;
   
3. BT either accepts the changes in full or rejects changes and appeals to Ministry. Appeals take up to one year. Oftel controls the agenda by making a take-it-or-leave-it proposal. Oftel has used an RPI-X formula, where RPI is the retail price index. In the process followed the following steps:
   

First step: Oftel identifies areas that require price control.

Second step: Oftel chooses X and other price restrictions so that, given expected demand growth, technical change, competition, and increased efficiency, BT can be expected to earn a rate of return that is just equal to its cost of capital. Actual results are sensitive to assumptions about what RPI will be at the start (called RPIt). Actual earnings are too high if RPIt is lower than expected, or too low if the reverse is true. Oftel thus introduced a K-factor to compensate for this outcome, and the overall price formula became:

Pt = [1 + (RPIt - X) / 100] x Pt-1 + Kt
Kt = [(RPIt-1max - RPIt-1act) / Qt] x (1 + It)

where:

RPI = retail price index

P = price index

Q = quantity

I = interest rate

t = the review period

Oftel could have chosen lagged inflation. This would have removed need the to correct for errors, but may not be an accurate indicator of actual inflation. The chart in Box 1 shows how Oftel has changed the X-factor over time. The general trend has been to increase X over time except for the 1997-2001 decision. This growth in X may have been related to Oftel’s concomitant expansion of services covered under RPI-X (see Box 2 below)

The chart in Box 2 shows changes in services or elements subject to price control. Each price review has resulted in increasing numbers of services being subject to the price cap constraint.

The chart in Box 3 shows the percentage of BT’s turnover that is under price control for each period. This percentage grew from 48% during the first period to 71% during the 1993-1997 period.

Oftel’s Decision for 1997-2001

This price review marked a reversal of the trends established by the earlier reviews. The X factor is lower than previously as are the numbers of services and revenues under RPI-X. The new retail price controls came into force in August 1, 1997.

The retail price control is RPI-4.5% on the bills of 4 out of 5 of BT’s residential customers. The price controls apply only to low to medium spending customers -- the revenues and calling patterns of the first 80% of residential customers by bill size. BT uses packaging to effect targeting of the price control. BT is expected to ensure that no residential bill rise by more than the RPI in any given year. The effective X for the first 80% of residential customers in terms of price cuts derived has over the last six years actually been only 2.7% when the headline X's was 6.25% and 7.5%. BT was required to offer a package for business customers with call charges no higher than those used for the residential market and line rental increases of no more than RPI per year. The 'control' package was made available to any business customer. Only 26% of BT's group revenues were subject to retail price caps as against 64% now. At the network level, only 40% of charges would be capped and a further 20% would be subject only to safeguard controls. BT will have increased freedom to set retail prices and the network charges which other operators pay for use of BT's network.

Elsewhere, Berg and Foreman (1995). assesses the UK’s price cap experience with BT and the FCC’s price cap experience with AT&T and the RBOCs. Assessment is based on traditional rate evaluation criteria of simplicity and public acceptability, freedom from controversy, revenue sufficiency, revenue stability, price stability, fairness in apportionment of total costs, avoidance of undue rate discrimination, and encouragement of efficiency.

Simplicity and public acceptability: It is unlikely that price caps have resulted in simplicity and administrative savings. Design of price caps has required attention to baskets, bands, floors, and ceilings. Increasing public and other stakeholder acceptability has created need for additional control features. Each feature has provided an opportunity for increased debate and litigation.

Freedom from controversy: All the terms of price caps have been controversial, including service quality, how to handle “excessive” returns, and public perceptions of the legitimacy of the regulation. Earnings sharing assessments in the US are sensitive to the same arbitrary cost allocations as rate of return regulation. RBOCs were given optional regulatory contracts. RBOCs generally chose the lower productivity factors even though these included higher earnings sharing requirements.

Revenue sufficiency: Competition has complicated this objective. This is true regardless of the method of regulation. Weisman (1994) concludes that regulators have less interest in revenue sufficiency once the price cap deal is struck

Revenue stability: This objective becomes one of net revenue stability (i.e., net income). Price caps needs an explicit method for universal service subsidies to help achieve this objective

Price stability: The price cap formula explicitly improves price stability by aligning price changes with changes in general inflation indices

Avoidance of undue rate discrimination: Price caps uses ceilings and floors to contain price discrimination. Oftel made three general changes to the price cap regime over time:

• increased the X-factor, perhaps in response to high earnings by BT
• added special constraints to some prices, such as residential exchange line rental
• additional services and baskets (such as the median residential bill) have been added

Encouragement of efficiency: BT has been allowed significant opportunity for rate rebalancing. Attenborough et al (1992) found a total welfare gain of £2 billion per year in 1990/91 prices, 30% of this gain was from moves towards Ramsey pricing. Price regulation allows companies to improve allocative efficiency by aligning prices with marginal costs, but competitive pressure, political constraints, and non-efficiency-related regulatory objectives may prevent this from happening.

Principles of Benchmarking

May include any of the following:

• Comparative competitio
• Yardstick competition (Scheifer) using average industry costs
• Statistical techniques, the are two approaches which one can utilise
  • Regression analysis – gives benchmark for company to comparison. Company may be better or worse than benchmark.
  • Data envelope analysis – gives best practice for company comparison

Choosing items to benchmark: Choose a general measure, not many specific measures. For example cost per line, not employees, trucks, and operating expenses per line. Cost per line focuses on efficiency. Employees per line focuses on labour intensity, which may say or may not say how efficient the company is. Relate to actual goal, not the means to the goal. Use Few benchmarks rather than more. Giving the company numerous benchmarks sends conflicting signals because company probably has to make tradeoffs

Choosing comparable companies: Choose companies in similar situations. For example, if the goal is cost efficiency. Choose companies in similar economic and geographic situations, for example, if goal is line growth, choose companies in similar teledensity and economic situations

Developing rewards and penalties: the general rules are reward superior performance, and penalize inferior performance

Assessing relative efficiency: Find the best cost performers and use them as benchmark for others to work towards. Use good, audited data. Bad data give bad answers. Be open and transparent about analysis. Allow companies to review data and processes. Require poorer performers to justify why their costs are high relative to other firms.

Developing and implementing hybrid systems: Most regulators use combination of rate of return tools, price cap schemes, and benchmarks

Earnings and revenue sharing techniques: Earnings sharing involves establishing a benchmark rate of return, allowing the company to keep all market returns within a specified band around this benchmark rate of return, and having the company share with customers earnings outside of the specified band.

Market return: The rate of return received from the market (Retained return is the rate of return the company is allowed to keep).

Example

Benchmark return is 13%. Company keeps 100% of market return if it is between 10% and 15%. Company shares 50-50 with customer if market return is between 15% and 20%. For market returns above 20%, company returns all returns in excess of 20% to customer. If market earnings fall below 10%, prices allowed to increase to level that would provide 10% market return.

UK approach to conducting a price review (Green, 1997)

The regulatory process needs to begin two years before the new control is due to come into effect.

The review process includes:

• Gathering and analyzing information on costs, investment plans, and demand forecasts;
• Forecasting revenue requirements;
• Choosing whether to use price caps or revenue caps;
• Projecting revenue and cash flows using different price control parameters (such as the service baskets and the anticipated efficiency gains) to find a set of parameters that result in the appropriate cash flows.
• Making the announcement: In making the announcement, the regulator should release information at several stages of the review process so that interested parties are kept informed.

Timing in the price review process is as follows:

(Time “ahead” refers to the amount of time before the new prices are scheduled to go into effect.)

• Request information (2 years ahead);
• Assess and amend information (18 months ahead);
• Determine form of control and rate of return (15 months ahead);
• Calculate revenue needs (1 year ahead);
• Select candidate price control and predict revenues, iterating until match revenue needs (1 year to 9 months ahead);
• Propose price control (9 months ahead);
• Complete appeal process (3-9 months ahead);
• Implement price control (1 month ahead).