The opportunity to keep additional profits is the incentive feature employed in the basic forms of regulation. This raises two challenges. For the regulator of a state-owned operator, the prospects of additional profit may not be an incentive for improved performance. This means that the regulator must identify other rewards that the operator finds attractive and design an incentive scheme around those rewards. Also, whether the regulator uses profit or some other incentive, the regulator must determine how much reward is needed to induce the operator to improve performance and to know whether the additional efficiency gained is worth the additional reward allowed. Smaller incentives are needed for easy efficiency gains than for more difficult efficiency gains.
To simplify the exposition, throughout the remainder of this section, incentive regulation will be described as if the reward were profit. Regulators using other rewards should note that they will need to adjust the incentive mechanisms according to the reward(s) they will use.
Regulators use two approaches to allowing operators additional profits or losses. One approach is simply to commit1 that the operator can keep at least some portion of its earnings that are above the cost of capital. In the case of pure price cap regulation,2 the operator is allowed to keep all of these earnings, but the operator is also required to bear all of the cost of having earnings below the cost of capital. This is called a high-powered incentive scheme. With earnings sharing, the operator keeps or bears something less than 100 percent of the difference between the actual earnings and the cost of capital. Schemes under which the operator keeps only a small percent are called low-powered incentive schemes.
The other approach that regulators use to allow operators to keep additional profits or losses is to allow the operator to keep the difference between its earnings and its cost of capital for some period of time before adjusting overall price levels. This is called regulatory lag. Rate of return regulation typically incorporates regulatory lag by using historical test years, which is a system by which price levels following the price review (or rate case) are based on costs incurred in a previous year. U.K. regulators also use regulatory lag in their RPI-X schemes when they wait until a scheduled price review before establishing glide paths to adjust price levels that align actual earnings with the cost of capital. A glide path is a transition period for such price changes.
A mechanism that regulators may inadvertently use to allow operators to keep additional profits or losses is to misestimate the cost of capital. If the allowed rate of return, which is the regulator’s estimate of the cost of capital, is greater than the actual cost of capital, then the operator has an incentive to increase returns to shareholders by increasing its investments. This is called the Averch-Johnson effect, or gold plating or padding the rate base, and is a common criticism of rate of return regulation. If the regulator errors in the opposite direction, the operator has an incentive to under invest.3
Allowing the operator to keep additional profits or losses has the additional effect of shifting risk from customers to shareholders.4 If the operator’s earnings are constantly kept in line with its cost of capital, then profits are stable, but the prices that customers pay change to match changes in the business. In this scenario, customers are bearing at least some portion of the business risk. In the other extreme, such as pure price cap regulation, shareholders must bear all of the fluctuations in earnings, so they bear most of the risk. In general, it is preferred that shareholders bear risk rather than customers because shareholders are generally in a better position than customers to diversify their risk by creating diversified investment portfolios. Furthermore, regulators sometimes use glide paths, which phase in price changes over time, to soften price impacts on customers or to distribute risk between customers and investors.
If the regulator is using both competition and incentive regulation to overcome information and objective asymmetries,5 and if the incentive regulation includes elements of rate of return regulation, then the operator has a mechanism to shift costs from its non-regulated operations to its regulated operations. This has the effects of increasing total profit and possibly giving the operator a greater market share in the competitive market and decreasing risk. Regulators attempt to control for this by employing sophisticated accounting separation techniques, as described in Ring Fencing and Control of Cross Subsidization in Financial Analysis.
- Foundations of Regulation includes discussion of the difficulty governments have with keeping commitments.
- See Price Regulation.
- See Principles.
- Both NPV Concepts – Project Analysis and Risk Adjustments and Determination of Cost of Capital examine risk.
- See Foundations of Regulation for a discussion of the basic approaches for overcoming information asymmetries.