Two issues are common to most forms of incentive regulation. The first issue is how to treat extraordinary events that impact earnings. In rate of return regulation, where high or low earnings relative to the cost of capital trigger price reviews, it is unusual for the regulator to make price adjustments simply because of an extraordinary event. Instead, the regulator normalizes the financial impact of the event, which means that the regulator spreads the effect over time. With price cap regulation, the price cap index captures how the event affects the average firm in the economy, so the regulator considers the impact of the event only if the event affects the operator disproportionately relative to the average firm in the economy. If the effect on the operator is disproportionate, then the regulator considers the extent to which the effect of the event on the operator is within the operator’s control because, for the incentives built into price cap regulation to be effective, the regulator should not intervene in areas where the operator should be taking action. Following this analysis, if the event affects the operator disproportionately and if the effects are beyond the operator’s control, then the regulator may make a price adjustment. The situation for revenue cap regulation is the same as that for price cap regulation. With benchmarking, the regulator first considers whether the event affects this operator disproportionately relative to the other operators included in the benchmarking analysis. If the effect is disproportionate, then the regulator again considers the extent to which the operator can affect the impact of the event.
The second and related issue that is common to all of the forms of regulation, except pure price caps, is the treatment of controllable and non-controllable costs. Controllable costs are those that the operator can influence and, conversely, non-controllable costs are those that the operator cannot influence. In some instances the regulator allows the operator to pass through to customers changes in non-controllable costs. A historical example is the cost of fuel for electricity generation. This price was traditionally considered beyond the control of the electricity generator. For this reason, and because fuel was a significant portion of the cost of generation and fluctuated frequently, regulators frequently allowed changes in fuel prices to be passed through to customers.