Rewards for cost-containment – What incentives should a regulator introduce in order to promote cost-containment?

[Response by Sophie Trémolet and Diane Binder, November 2010]

Cost-containment is an issue that is particularly important in cost-plus regulation[1] in order to avoid gold plating[2], which means that private operators tend to intentionally inflate costs to increase their returns on the asset base. In addition, regulators must ensure that operators do not misuse or over-dimension the infrastructure by engaging in service provision that is not tailored to customers’ needs, e.g. financing in-house connections while users do not require and cannot pay for such service, and do engage in cost reduction strategies (such as reducing technical losses[3]).

In order to build effective incentives for cost-containment, the necessary first step for the regulator is to measure operating and maintenance costs, and capital expenditures and to identify areas for cost-reduction. Costs are usually differentiated between fixed and variable costs, the latter varying with the volume of service provided. Green and Pardina also make a distinction between controllable, non-controllable and one-off costs [4]. Benchmarking or yardstick regulation can help set a target for controllable costs that an efficient firm could meet while non-controllable costs are passed on to customers[5]. Areas for cost reduction can be measured through the assessment of an operator’s performance against pre-set targets[6] or through benchmarking[7].

In traditional rate of return regulation, incentives for cost-containment and efficiency are rather weak. The following incentive tools may complement such a regulatory regime:

• Earnings sharing is a case of hybrid regulation where the regulator allows the operator to keep a portion of the earnings it receives from the market within a “deadband[8]”: this gives the firm an incentive to achieve productivity growth and increase efficiency. This mechanism is usually used as part of a price cap plan, like in the telecommunications sector in the United States (ICT Regulation Toolkit[9]). Price freezes[10] and rate case moratorium[11] are similar mechanisms to incentivize the operators to reduce their costs.
• Price cap regulation[12] focuses on price rather than on earnings. It sets a target productivity change factor and rewards or gives penalties to the operator if it over / undershoots it[13]. This is a powerful incentive for cost-containment, since the operator is allowed to keep efficiency savings stemming from cost-reduction strategies (regulatory lag).
• Benchmarking[14] can be used as a common sense check on the results of cost models. For example in Singapore, the price that the telecommunications operator Singtel can charge is based on the prices of telephone services in neighboring Asian countries, New York and London (ICT Toolkit).
• Franchising can also be used as an incentive for cost containment through competitive bidding for the right to provide service in a geographic area (Berg).

Once incentives for cost-containment have been built into the regulatory scheme, their impact on the level of costs must be monitored. Monitoring can be implemented through periodical assessment of performance indicators to control the firm’s activity and continuously update information.
 

Footnotes

1. See “rate of return regulation” in the glossary.
2. See definition of gold-plating in Incentive Features and Other Properties.
3. See in the same FAQ section the question about non-commercial losses.
4. One-off costs include items that happen once over the life of the project, such as redundancy payments or costs of restructuring (Pardina and Green, 1999).
5. See question on costs pass-through in the Tariff Design section of the FAQ.
6. See previous FAQ question about efficiency targets.
7. See question on efficiency measures in this section of the FAQ.
8. The deadband is the range with endpoints above and below the cost of capital established by the regulator and within which the operator retains all of the earnings it receives (See Earnings Sharing for more details about earning sharing).
9. Chapter 2 Section 5 of the Toolkit:
10. Price freezes specify that a company’s prices cannot change within a defined period of time. At the end of this period, the regulator may undertake a price review aiming at adjusting the retail rate. The ability to capture any additional profit during this period gives the firm an incentive to reduce its costs. In telecommunications, price freezes in price cap plans usually apply to service for the poor due to universal service concerns (ICT Regulation Toolkit).
11. Rate case moratoriums work in a similar way as price freezes. It is an agreement between the regulator and the regulated company to abstain from general rate increases and to suspend investigations of the firm’s earnings, guaranteeing that profits made will not be taken away. A moratorium imposes a regulatory lag and therefore encourages the operator to reduce operating costs, because the firm will be able to retain the resulting increase in earnings (ICT Regulation Toolkit).
12. See Features of Price Cap and Revenue Cap Regulation.
13. See previous FAQ question about: “What are reasonable efficiency targets”?
14. See FAQ question : “How do you measure efficiency in service provision ?” for an explanation about how benchmarking actually works.