Basic Forms of Regulation

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There are four primary approaches to regulating the overall price level1 – rate of return (or cost of service) regulation, price cap regulation, revenue cap regulation, and benchmarking (or yardstick regulation).2 Rate of return regulation adjusts overall price levels according to the operator’s accounting costs and cost of capital. In most cases, the regulator reviews the operator’s overall price level in response to a claim by the operator that the rate of foreturn that it is receiving is less than its cost of capital, or in response to a suspicion of the regulator or claim by a consumer group that the actual rate of return is greater than the cost of capital. However regulators in some countries practice rate of return regulation by scheduling price reviews in advance, such as conducting an annual price review. Determination of Cost of Capital in Financial Analysis describes how rate of return and cost of capital are calculated. Once the regulator, using rate of return regulation, has decided to review the operator’s price level, she estimates the operator’s actual rate of return, applying the prudency, used and useful, and known and measureable standards discussed in the Asset Valuation Techniques section of Financial Analysis. The regulator also identifies what she believes to be the operator’s cost of capital and orders a rate level change that is intended to bring the actual rate of return in line with the cost of capital.

Price cap regulation,3 which is sometimes called RPI-X regulation,4 allows the operator to change its price level according to an index that is typically comprised of an inflation measure, I, and a “productivity offset,” which is more commonly called the X-factor. The precise meaning of the X-factor and principles for choosing I are described in more detail below. Typically with price cap regulation, the regulator groups services into price or service baskets and establishes an I – X index, called a price cap index, for each basket.5 Establishing price baskets allows the operator to change prices within the basket as the operator sees fit as long as the average percentage change in prices for the services in the basket does not exceed the price cap index for the basket.6

Revenue cap regulation7 is similar to price cap regulation in that the regulator establishes an I – X index, which in this case is called a revenue cap index, for service baskets and allows the operator to change prices within the basket so long as the percentage change in revenue does not exceed the revenue cap index. Revenue cap regulation is more appropriate than price cap regulation when costs do not vary appreciably with units of sales. An example might be electricity distribution where distribution lines drive costs, but prices are often based on kilowatt-hours of electricity sold.8 Revenue caps also relieve the regulator from the duty of overseeing price structures, which in some cases can be costly to regulate because they are complex.

Benchmarking is comparative competition in that the operator’s performance is compared to other operators’ performance and penalties or awards are assessed based on the operator’s relative performance.9 For example, the regulator might identify a number of comparable operators and compare their cost efficiency. The most efficient operators would be rewarded with extra profits and the least efficient operators would be penalized. Because the operators are actually in different markets, it is important to make sure that the operators’ situations are similar so that the comparison is valid, and to use statistical techniques to adjust for any quantifiable differences over which the operators have no control. As noted elsewhere, benchmarking is rarely used by itself and is commonly combined with price cap regulation as an input for determining the X-factor.

The two most common forms of statistical analysis used in benchmarking are data envelopment analysis (DEA) and regression analysis. DEA estimates the cost level an efficient firm should be able to achieve in a particular market. Using DEA analysis the regulator would reward operators whose costs are near the efficient frontier with additional profits. Regression analysis estimates what the average firm should be able to achieve. Using regression analysis the regulator would reward firms that performed better than average and penalize firms that performed worse than average.

Recently, regulators have begun using a virtual company approach in which analysts construct a simulation model of the operator and estimate the cost level of an efficient operator. The virtual company approach is subject to strategic behavior by analysts because the model represents what the analyst says the operator should do, which is by design not what the operator really does. With any approach, best practices indicate that the regulator should account for varying operating conditions across firms and that are beyond the operators’ control. Such factors could include macroeconomic conditions, geography, demographics, and history.

Some regulators release benchmarking information to the media. If the media publish the information, this has the advantage of bringing public pressure on poorly performing operators.

Generally regulators use a combination of these basic forms of regulation. Combining forms of regulation is called hybrid regulation. For example, U.K. regulators combine elements of rate of return regulation and price cap regulation to create their form of RPI-X regulation. Some regulators use earnings sharing,10 which is an approach that allows the operator to keep some portion of its earnings above its cost of capital and bear some portion of the difference if earnings are below the cost of capital. Revenue sharing is another option in which the operator keeps only some portion of revenue changes.

Footnotes

  1. See Principles.
  2. 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.
  3. See Price Regulation.
  4. RPI stands for Retail Prices Index and is a measure of inflation used in the United Kingdom.
  5. Because of this feature, some authors refer to price cap regulation as service basket or price basket regulation.
  6. As Tariff Design explains, in many instances the regulator and the operator are in agreement on how prices should be designed. This feature of price cap regulation allows the operator to use his superior information to make decisions that the regulator would also make if she had the same information as the operator.
  7. See Revenue Caps.
  8. In some instances regulators combine price and revenue caps, applying price caps to costs that vary with sales and revenue caps to costs that do not vary with sales.
  9. See Principles of Using Efficiency Measures for Yardstick Regulation. See Market Structure and Competition for information about competition in the market and competition for the market.
  10. See Earnings and Revenue Sharing Techniques. In U.K.-style price cap regulation, financial modeling is used to estimate the X-factor. In these approaches, the cash outflows of the operator are forecasted as is the rate base value that will exist at the end of the price control period. These values are discounted back to the present. Then revenues are forecasted, using an iterative process until the net present value of the enterprise is zero.