Principles of price cap regulaion Sephen P. King, Deparmen of Economics, The Universiy of Melbourne, Ausralia. The background o price cap regulaion Price cap regulaion, as an alernaive o radiional rae -of-reurn regulaion, developed as a pracical regulaory ool in he early 980s in Briain. While boh he undesirable feaures of rae-of-reurn regulaion and he ideas underlying price caps were undersood well before his ime, i was in he UK in he 980s ha price caps were firs widely used as an alernaive regulaory rule for limiing abuse of marke power. Following a Mergers and Monopolies Commission (MMC) repor in 98, price cap regulaion was used in Briain o limi abuse of marke power by a dominan supplier of conracepive sheahs (Armsrong, Cowan and Vickers, 994). The MMC argued agains radiional rae-of-reurn regulaion on he grounds ha () i weakened incenives for cos efficiency, () for a muli-produc firm where only some producs were regulaed, rae -of-reurn regulaion involved arbirary allocaions of cos and asses and (3) i was difficul o se an appropriae rae -of-reurn for he regulaed company. The newly privaised Briish Telecom (BT) was regulaed by price caps afer he recommendaions of a repor by Sephen Lilechild in 983. In his repor, Lilechild argued ha price cap regulaion would give BT desirable incenives o achieve and improve producive efficiency, while reducing he informaion burden of regulaion. Unlike rae -of-reurn regulaion, price caps do no require imprecise and ofen arbirary measures of a rae base or reurn on capial, and eliminae he need o allocae coss when only some pars of a firm are regulaed. He also argued ha he simpliciy of price caps would reduce he likelihood of regulaory capure. Since he early 980s, price cap regulaion has been adoped in a wide range of counries. In Ausralia, price caps have been used in he elecommunicaions, energy and ranspor indusries. For example, he newly privaised airpors in Ausralia are subjec o price cap resricions on some of heir services. Wha is a price cap? In is simples form a price cap simply ses a maximum allowed iner-emporal pah for he price of a specific produc. The rules for he pah are se in advance and only depend on facors ha are beyond he conrol of he regulaed firm. For example, he price of a specific produc in any given year may be capped a a level which alers over ime in response o a price index ha is exogenous o he regulaed firm and a facor se in advance by he relevan regulaor. For example, a sandard price cap in he UK (an RPI-X cap) or Ausralia (a CPI-X cap) involves he regulaor seing an iniial For example, he possibiliy of overcapialisaion under rae-of-reurn regulaion was formalised in he economics lieraure in he early 960s. See Averch and Johnson, 96. 46 Infrasrucure regulaion and marke reform
maximum price. This maximum price hen rises in line wih he main index of reail prices (he reail price index in he UK and consumer price index in Ausralia), bu falls a a rae X se in advance by he regulaor. The value of X is mean o reflec poenial cos savings by he firm due o eiher increased efficiency or echnological progress. The X facor enables hese cos savings o be shared wih consumers wihou adversely effecing he incenives of he firm o minimise and achieve hese savings, beween review periods. The value of X and he absolue level of he price cap index are reviewed a se inervals. For example he review period for BT was originally se a five years. In some cases i may be considered ha he uiliy should be allowed o increase is maximum allowed price a a rae faser han he rae of increase of he relevan price index. For example, privaised UK waer companies are regulaed by an RPI+K sysem ha allows prices o rise a a rae faser han he reail price index. In pracice, price caps end o be more complex han simply a se price pah on a single produc. Many regulaed firms produce muliple producs and hese producs may be bundled ogeher in he price cap. The price cap may auomaically adjus for exogenous changes in specific prices ha have srong implicaions for he profiabiliy of he regulaed firm. For example, a price cap on a gas supplier may allow ha firm o increase is price if here is an increase in he purchase price of he gas ha i buys or in an index of gas prices. Price regulaion may have associaed regulaion covering service qualiy. These addiional feaures need o be designed o reain he basic desirable incenive properies creaed by a price cap. Price cap regulaion and efficiency Why does a price cap promoe efficien producion? Suppose a regulaed firm produces one produc. For example, consider a gas reailer/disribuor ha only sells gas o residenial consumers. We will consider wo poenial regulaory schemes. Firs, he firm may operae under a regulaory regime ha limis profis o a se level, say no greaer han $ million. Alernaively, he firm may operae under price cap regulaion. I can se he price of he gas subjec o a cap of 5 cens per MJ. A his price i can sell 00 million MJ resuling in $5 million. Firm profis are given by revenue less he coss of producion. These coss include billing and servicing cusomers, rouine and emergency mainenance of he disribuion sysem and, mos imporanly, he cos of wholesale gas. If he coss of reailing and disribuing 00 million MJ of gas are (iniially) $4 million hen he firm will make $ million in profi under he price cap. In oher words, he firm iniially makes idenical profis under eiher regulaory regime wih idenical levels of oupu and coss of supply. Suppose he owners and managers of he privae gas firm can underake a variey of aciviies ha effec coss. For example, hey can invesigae and implemen improved Armsrong, Cowan and Vickers, 994, refer o he lengh of ime beween reviews as he period of regulaory lag. Noe also ha he value of X need no be consan beween reviews. Raher a simple price cap requires he ime pah of X o be fixed in advance by he regulaor a each review. Infrasrucure regulaion and marke reform 47
sysems of billing, monior he performance of mainenance eams and seek ou cheaper sources of gas. The incenive for owners and managers o pursue aciviies ha reduce coss will depend on he rewards ha hey receive from any cos reducion. If hey receive he full benefi of any cos reducion, hen hey will have srong (and socially desirable) incenives o pursue aciviies ha reduce coss. In conras, if he y receive lile benefi from aciviies ha reduce coss, hey will have no incenive o engage in hese aciviies. Consider profi regulaion. If he owners and managers reduce coss (and increase profis) under his regulaory regime, hen his will have o be offse by a reducion in profis, for example, by lowering he price of gas. Any benefis of cos reducions are passed immediaely on o gas consumers, bu his will desroy he incenives for owners and managers o seek ou ways o minimise coss. Consequenly, here is lile incenive for he firm o operae efficienly and engage in minimum cos producion under profi regulaion. In conras, under price cap regulaion, any cos reducion achieved by he firm s owners and managers will be reained by he firm. If he managers and owners are able o reduce he coss of supplying 00 MJ of gas from $4 million o $3 million, hen he enire $ million reducion in coss will be ranslaed ino increased profis. Under price cap regulaion, he firm can sill sell gas a 5cens per MJ so he 5 per cen reducion in coss will resul in a 00 per cen rise in profis. Clearly, under price cap regulaion here are srong incenives for he firm o operae efficienly and seek ou cos minimising producion echniques. 3 Because he firm reains he benefis of cos reducions under price cap regulaion, his regulaory regime provides powerful efficiency incenives. In realiy, hese incenives may be reduced by a number of facors. If he wholesale price of gas makes up a subsanial par of he regulaed firm s coss, hen i may be desirable o allow he firm o pass hrough any changes in his wholesale price o cusomers. In he absence of such pass-hrough, he gas disribuor could be driven ino bankrupcy by a sudden rise in he price of gas ha pushes is coss above he price cap. However, if gas coss can simply be passed hrough o he consumer, hen he firm will have reduced incenives o seek ou he cheapes sources of gas. In general, any allowed cos pass hrough under he price cap will reduce incenives o minimise coss. Price caps are never se forever. In some indusries, price caps may be used as a one sho regulaory ool while compeiion emerges. More generally, price caps are reviewed and rese a regular inervals. 4 When caps are rese, aenion is ineviably paid o he profis of he regulaed firm and cos savings gained beween reviews, a leas parially, are passed on o consumers. Any allowed profi aspec o price cap reviews will end o reduce he incenives of a regulaed firm o reduce coss beween review. Furher, o he degree ha he regulaor uses pas performance o se he fuure 3 For a more formal, echnical presenaion of his maerial, see Sappingon, 996. 4 In Briain, where price caps were iniially se for BT as a ransiional procedure, he caps have been boh reviewed and exended over ime as he expeced level of compeiion has no emerged. See Armsrong, Cowan and Vickers, 994. 48 Infrasrucure regulaion and marke reform
price cap, all he adminisraive issues associaed wih radiional rae-of-reurn regulaion, such as cos allocaion rules, re-emerge. Even given he caveas above, price cap regulaion will provide more incenives for efficien producion han radiional profi or cos based regulaion. A he same ime, he design of he price cap regime will effec hese incenives and he regulaory design of price caps mus carefully consider he rade-off beween providing incenives o reduce coss and he desire by regulaors o pass on any cos savings o cusomers. CPI-X The regulaed price cap is designed o adjus auomaically beween regulaory reviews. This occurs in wo ways. Firs, he regulaor ses he X-facor which deermines he rae of decrease of he cap. The X-facor provides a way for he regulaor o allow consumers o benefi from cos reducions and improvemens in producive efficiency under price cap regulaion wihou diminishing he incenives for managers and owners o underake aciviies ha creae hese efficiencies. The regulaor ses he X-facor o reflec (i) expeced firm produciviy improvemens in excess of hose expeced for he general economy and (ii) expeced changes in inpu prices for he regulaed firm ha differ from he general economy-wide rae of price change. When seing he value of X, he regulaor ofen has o rely on hisoric informaion abou performance of he regulaed firm or of oher firms in similar indusries. The regulaor may gain informaion abou produciviy improvemens from profi sudies based on he pas rae -of-reurn achieved by he firm. This raises a number of imporan issues. If he firm has previously been regulaed by profi or cos based regulaion, or has been inefficienly operaed under public ownership, hen fuure produciviy improvemens may significanly exceed hisoric raes. I may be desirable for he regulaor o se a relaively high value of X, paricularly in he firs few years of he price cap regime. If produciviy improvemens achieved by he firm exceed he X facor by a subsanial amoun hen he firm will make significan profis and here may be pressure on he regulaor o adjus eiher he value of X upwards or he base level of he price cap downwards beween review periods. Such regulaory opporunism generally should be avoided. The repuaion of he regulaor in abiding by he regime beween reviews will be an imporan inpu o he success of he regulaions. If he firm believes ha any successful reducion in coss below he amoun allowed for in he X facor will simply lead o a reducion in he price cap, hen he managers and owners will no seek o achieve hese exra cos savings. If rae-of-reurn or oher profi measures are used o rese he base value of he price cap or he fuure pah of X when hese values are reviewed, hen his will feed ino he incenives facing owners and managers in he period leading up o he review. In paricular, he incenives for efficien producion will end o fall as he review approaches if managers and owners know ha hese cos savings will be aken from hem in he review process. The regulaor can use a number of Infrasrucure regulaion and marke reform 49
simple devices o help reduce his problem. For example, he regulaor can base he price cap review on indusry wide performance raher han firm specific performance. This may involve explici benchmarking beween similar regulaed firms. The regulaor may also commi in advance o using a glide pah o adjus he price cap a a review. This means ha raher han using a one-sho revaluaion o se he new price index a he review, he regulaor ses a pah by which he base mus move down o is new level over ime. Thus he price cap will be reduced by he X facor (reflecing fuure expeced produciviy gains) and he glide pah facor (reflecing pas gains above he X facor) beween reviews. 5 The regulaor will also need informaion abou inpu price changes ha are idiosyncraic o he regulaed indusry or firm. Again, his informaion may be gained from hisoric daa, subjec o similar caveas as presened above. The approach o reseing X will depend boh on how he regulaor evaluaes profis compared o consumer benefis, and he relaive imporance placed on allocaive and producive efficiency. The higher he re laive weigh placed on consumer benefis relaive o profis, he more he regulaor will wish o claw back excess profis as hey emerge. A he same ime, if he regulaor seizes profis creaed hrough produciviy gains in an opporunisic way, hen his will simply reduce he incenive for hese gains o be made in he fuure, making boh he firm and he consumers worse off in he longer erm. Even if he regulaor evaluaes profis and consumer benefis equally, i is sill desirable o have a posiive X facor and o adjus he cap a regular reviews so ha excess profis are evenually reurned o he consumer. Pricing above rue marginal cos (or above a minimum susainable price) will lead o a loss of allocaive efficiency by eliminaing poenially muually beneficial rade. When considering how quickly excess profis should be removed by ighening he price cap, he regulaor mus weigh up hese allocaive benefis wih he poenial reducion in producive efficiency due o weakened incenives for firm owners and managers. An alernaive o a fixed X facor beween reviews is a scheme of earnings sharing. This form of price cap, which is more popular in he US han in eiher Briain or Ausralia, requires he regulaed firm o share any excess earnings wih consumers. However, such a sharing scheme reduces efficiency relaive o pure price caps. 6 Furhermore, i may raise he coss of regulaion by requiring coninual monioring of firm reurns. 5 For a summary on he incenive aspecs of differen mehods o claw back excess profis, see Cave, 997. 6 Of course, o he degree ha regulaors implicily use sharing schemes when reviewing price caps, here may be lile pracical difference beween he incenives under a scheme of explici earnings sharing and under an acual price cap regime. In fac, incenives may be improved by making he form of sharing explici raher han implici. I hank Mark Jamison for poining his ou o me. 50 Infrasrucure regulaion and marke reform
The price cap also adjuss for increases in general inpu prices over ime. Boh he adjusmen for general and idiosyncraic increases in inpu prices mus be beyond he conrol of he firm o avoid reducing he incenives o search ou he cheapes inpu prices or creaing incenives for managers o manipulae he inpu price index. I is desirable o use a general inflaion measure o adjus he price cap. In pracice, i is sandard o use a measure of consumer prices o adjus he price cap (he CPI). Such an index is clearly beyond he conrol of almos any regulaed firm. Any differences beween he rae of increase in he consumer price index and he rae of increase in he prices of he inpus for he regulaed firm should be included in seing he value of X. Even if he rae of ge neral inflaion is used o reflec general economy wide effecs on inpu prices, and idiosyncraic increases in inpu prices are buil ino he seing of X, here may sill be deviaions beween he acual change in inpu prices and hose allowed for in he price cap. To preven firm disress caused by increases in specific inpu prices ha are beyond heir conrol, i may also be desirable o adjus he price cap o allow for he pass hrough of specific inpu prices. This is paricularly he case when some inpu prices make up he bulk of he regulaed firms coss. For example, 95 per cen of he coss of elecriciy suppliers in Briain are derived from he coss of generaion, ransmission and disribuion and hese coss are passed on direcly o he consumers hrough he price cap (Armsrong, Cowan and Vickers 994). Where pass hrough is allowed, i is desirable o base i on a price index raher han he price paid by he regulaed firm, o creae appropriae incenives. For example Briish Gas can pass hrough an index of wholesale gas prices raher han is paricular purchase coss. Oher facors may also be used o adjus he price cap beween reviews. For example, where he price cap embodies specific assumpions ha can be confirmed a a laer dae, hen he cap may adjus if he iniial assumpions are proved false (Cave, 997). Muliple producs A variey of forms of price cap are used when a regulaed firm produces muliple producs. Some of hese are presened below. 7 Suppose ha he firm produces wo producs. Say ha he price cap is se a he end of year zero and is o be reviewed a he end of year five. For he presen, we ignore boh he CPI and X-facor adjusmens. The firm ses prices for is producs in each year subjec o he price cap. Le he prices se by he firm in year (where is,, 3, 4 or 5) be denoed by p and p. The firm sells he amoun of each produc demanded a 7 For example, Taylor and Weisman, 996, presen a sligh varian on he curren quaniy average revenue regulaion formula presened below where p refers explicily o average revenue raher han a uniform price and he fixed price enering he righ hand side of he formula is se each year a he previous years average revenue for each produc. Infrasrucure regulaion and marke reform 5
hese prices, p and q?? q?? p (where p represens he wo prices p and p ). The firm's revenue in year will be p q? pq. Fixed weigh price cap. The firm can se prices p and p in year so long as p q? p q? p q? p q. The values of p and p may be se a heir = 0 levels wih q? q 0? p 0? and q q 0? p 0??. Average revenue regulaion (curren quaniies). The firm can se prices so long as p q? p q? p q? p q. Average revenue regulaion (lagged quaniies). The firm can se prices so long as p q? p q? p q? p q.???? Tariff baske regulaion. The firm can se prices so long as p q p q? p q.????? p q??? Under each of hese formulae he firm reains some abiliy o rebalance prices. In oher words, he firm may raise he price of one produc and reduce he price of anoher produc wihou violaing he cap. The fixed weigh price cap is adminisraively simpler han he oher caps and limis any possibiliy for he firm o manipulae he cap by seing he quaniy weighs on he lef hand side of he formula and he allowed revenue on he righ hand side of he formula a a fixed level ha is invarian beween reviews. However, his is also he leas flexible cap and may preven he firm from designing price changes ha are boh profiable and in he consumers ineres. Tariff baske regulaion allows he firm o boh aler prices in response o demand changes and o rebalance prices in a way beneficial o boh he firm and he cusomer. To see his, noe ha under ariff baske regulaion, consumers in any year can always buy he same bundle as hey did in he previous year ( ) for he same oal cos. However, o he degree ha prices have changed beween year and year he consumers may prefer o buy a differen bundle of goods. As hey can sill buy he original bundle a he same cos bu may prefer o buy a differen bundle, consumers canno be made worse off by he rebalancing. 8 If he firm finds i profiable o rebala nce prices hen his reflecs a muual gain boh he firm and consumers are a leas as well off under rebalanced prices as under original prices. 8 Of course, if consumers income alers beween years, consumers may be beer or worse off regardless of any price rebalancing by he firm. 5 Infrasrucure regulaion and marke reform
Tariff baske regulaion has been used for BT and he Briish waer companies. Sappingon (997) presens a varian of ariff baske regulaion designed o avoid penalising a firm for pricing below auhorised levels in any year. Average revenue regulaion wih curren quaniies requires he regulaor o forecas demand in advance and o esablish procedures o compensae eiher he firm or consumers if hese forecass are in error. Using lagged quaniies avoids his problem and lagged quaniy average revenue regulaion was used in he US o regulae AT&T. Sappingon and Sibley (99) show ha if wo-par ariffs are incorporaed ino his scheme (inerpreing one of he producs as access ) hen rebalancing may lead o a reducion in boh consumer surplus and oal welfare over ime. 9 The above formulae ignore he adjusmen facors for inpu prices and produciviy improvemens. These need o be added ino he formulae. For example, ariff baske?? regulaion is???? p q p q? CPI X?? p q p q??????. Care mus be aken under price cap regulaion o avoid rebalancing, for example, o preven or delay enry ino one par of he marke. In par, his issue overlaps wih he quesion of which prices should be included in he price cap. If compeiion is expeced o emerge for one produc bu no for anoher, hen usually only he produc ha is no going o be subjec o compeiion should be included in he price cap. Price caps ofen incorporae addiional resricions on paricular prices. This may be required for equiy reasons, for example, o avoid he rapid dismanling of hisoric cross-subsidies o cerain consumer groups. The individual producs may be consrained by a separae specific price cap or may be allowed o move wihin a cerain price band. The band, involving boh a ceiling and a floor on he relevan price, may be designed o limi he rae of change of a specific produc price. Conclusion Price cap regulaion offers subsanial benefis for regulaors, consumers and regulaed firms if applied wih care. However, if price caps are poorly designed and are subjec o arbirary re-evaluaion based on firm performance, hen hey open he scope for poenial abuse by he regulaed firm and may be worse han radiional profi and cos based regulaion. This paper has presened a brief overview of he heory of price caps and he pracical problems ha need o be addressed when esablishing price cap regulaion. Three poins need o be emphasised. Firs, when designing a price cap, he regulaor mus carefully consider he bundle of goods and services o be covered by he cap. If he bundle is poorly designed, hen he regulaion may be subjec o poenial anicompeiive abuse. However, if he price cap provides oo lile flexibiliy o firms, 9 See also Armsrong, Cowan and Vickers, 994, on he poenial for rebalancing ha harms consumers under average revenue regulaion. Infrasrucure regulaion and marke reform 53
hen opporuniies o rebalance prices for boh consumer and firm gain will be limied. Second, he regulaor needs o carefully design he review process. Where possible, informaion used in a price cap review needs o be beyond he conrol of he regulaed firm. If reviews are based on realised profis, hen he price cap may degenerae o sandard rae -of -reurn regulaion. Thirdly, regulaory credibiliy is crucial o he success of he price cap. If he regulaor ses an X-facor ha is oo low, hen he regulaed firm will make large profis. However, if he regulaor uses curren profi informaion o arbirarily revise up he X-facor beween reviews, he regulaed firm will have lile incenive in he fuure o pursue he cos savings ha lead o hose profis. Bibliography Armsrong, M., Cowan, S. and Vickers, J., 994, Regulaory reform: economic analysis and he Briish experience, MIT Press, Cambridge. Averch, H. and Johnson, L., 96, Behaviour of he firm under a regulaory consrain, American Economic Review, 5, pp 05 69. Cave, M., 997, Aspecs of he revision of price caps in he elecriciy supply indusry, Repor o he Energy Projecs Division, Deparmen of Treasury and Finance, Vicoria. Sappingon, D., 997, Basic elemens of price cap regulaion, mimeo, Deparmen of Economics, The Universiy of Florida, Gainesville. Sappingon, D. and Sibley, D., 99, Sraegic nonlinear pricing under price-cap regulaion RAND Journal of Economics, 3, pp 9. Taylor, L. and Weisman, D., 996, A noe on price cap regulaion and compeiion, Review of Indusrial Organisaion,, pp 459 7. 54 Infrasrucure regulaion and marke reform