Incentive regulation1 is generally implemented by controlling the overall price level of the operator. There are four basic schemes to regulating overall price levels. The first approach is generally called rate of return regulation or cost of service regulation. This regulatory instrument establishes an overall price level that allows the operator to receive accounting profits that are just equal to the operator’s cost of capital at the time the price level is set. Actual profits may deviate from the cost of capital until the next time the regulator reviews the operator’s profits.
The second approach is called price cap regulation or RPI-X regulation, which is a method that establishes the operator’s overall price level by indexing the price level according to inflation minus an offset, called an X-factor.2 The X-factor should reflect the difference between this operator and the average firm in the economy with respect to their abilities to improve efficiency and to changes in input prices. Directly measuring these efficiency and input price inflation differences to establish an X-factor, while ignoring the operator’s actual profits, is called pure price cap regulation.
The fourth approach is called benchmarking or yardstick regulation. This form of regulation provides competition between markets by comparing operators across markets, in effect forcing the operator to compete against the performance of comparable operators in other markets. In practice benchmarking or yardstick regulation is an input used in price cap or revenue cap regulation, and sometimes in rate of return or cost of service regulation.
Many regulators adopt hybrid incentive schemes, which are approaches that combine features of the three basic methods of incentive regulation described above. For example, the U.S. Federal Communications Commission once combined elements of rate of return regulation and price cap regulation. Under its scheme, operators could choose from a menu of options. Each option included an X-factor and a formula that determined the proportion of accounting profits that the operator would be allowed to keep. Options with more aggressive (larger) X-factors allowed operators to keep larger proportions of their accounting profits. Regulators in the U.K. often use elements of rate of return regulation and benchmarking analysis to establish X-factors in price cap regulation. This is described in the subsection Financial Analysis.
Another approach for combining elements of rate of return regulation and price or revenue cap regulation is to include pass through elements in the scheme. For example a regulator might use revenue caps to regulate the revenue of an electricity distribution operator, but allow the operator to pass through changes in fuel costs to the extent that these cost changes are beyond the operator’s control.
- Alternative Forms of Regulation in Price Level Regulation covers this topic in more depth.
- As explained below, some regulators using price cap regulation incorporate elements of rate of return regulation.