Features of Price Cap and Revenue Cap Regulation

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Price cap regulation1 adjusts the operator’s prices according to the price cap index that reflects the overall rate of inflation in the economy, the ability of the operator to gain efficiencies relative to the average firm in the economy, and the inflation in the operator’s input prices relative to the average firm in the economy.2 Revenue cap regulation attempts to do the same thing, but for revenue rather than prices. The underlying theory is as follows.

Consider how the price (or revenue, in the case of revenue caps) level for the average firm in a competitive market changes relative to inflation. Inflation reflects two things, namely, the change in the value of the country’s money and the change in the productivity of the firms in the economy. By definition, the input prices for the average firm in the economy change at the rate of inflation and its productivity changes at the average rate for the economy. As a result, the average firm’s retail prices change at the rate of inflation and the firm continues to receive earnings that are equal to its cost of capital.

Now consider how a utility operator might be different from the average firm in the economy. First, assume that the operator is just like the average firm, except that the operator’s input prices change at a rate that is different from the rate of change for the average firm. If the operator’s input prices increase faster than (conversely, slower than) the rate of inflation, then the operator’s retail prices (revenue) will need to increase faster than (conversely, slower than) the rate of inflation for the operator to be able to have earnings that are at least as great as the operator’s cost of capital.

Now assume that the operator is just like the average firm, except with respect to the operator’s ability to improve efficiency. If the operator increases its productivity faster than (conversely, slower than) the average firm, then the operator’s retail prices (revenue) will need to decrease (conversely, increase) relative to the rate of inflation.

Combining these two possible differences between the operator and the average firm in the economy, the operator’s retail prices (revenue) should change at the rate of inflation, minus (conversely, plus) the extent to which its input prices inflate less than (conversely, greater than) the rate of inflation, and minus (conversely, plus) the extent to which the operator’s productivity is expected to improve at a rate that is greater than (conversely, less than) the average firm in the economy.

The above analysis identifies two things. First, the inflation rate I used in the price cap index represents the general rate of inflation for the economy. Second, the X-factor is intended to capture the difference between the operator and the average firm in the economy with respect to inflation in input prices and changes in productivity. That is to say, the choice of inflation index and of the X-factor go hand in hand. Some regulators choose a general measure of inflation, such as a gross national product price index. In this case, the X-factor reflects the difference between the operator and the average firm in the economy with respect to the operator’s ability to improve its productivity and the effect of inflation on the operator’s input costs. Other regulators choose a retail (or producer) price index. In these cases, the X-factor represents the difference between the operator and the average retail (or wholesale) firm. Lastly, some regulators construct price indices of operator inputs. In these cases, the X-factor reflects productivity changes of the operator.

The regulator typically constructs service baskets with an eye towards 1) allowing the operator to realign prices within the basket, and 2) restricting the operator’s ability to realign prices between baskets.3 When the operator is allowed to realign prices, the operator will generally change prices in accordance with their price elasticities of demand.4 That is to say that prices for products whose price elasticity of demand is more inelastic will rise relative to the prices for products whose price elasticity of demand is more elastic. This improves economic efficiency, but may be contrary to certain regulatory goals, such as protecting poor customers or customers in the least competitive markets. Sometimes the regulator limit’s the operator’s ability to realign prices within a basket by placing restrictions on individual price changes, such as a maximum percentage by which a price may increase in a given year.

Footnotes

  1. See Price Regulation and Revenue Caps.
  2. Only in pure price cap regulation do regulators explicitly compare the operator to the average firm in the economy. However, all price cap schemes effectively follow this logic by adopting a price cap index based on inflation and a productivity offset.
  3. Rate design is discussed in Tariff Design.
  4. Elasticity of demand refers to the extent to which customers change the quantities they purchase in response to a change in price. If demand is inelastic, then customers’ percentage change in the quantities they purchase is smaller in absolute terms than the percentage change in price. If the opposite is true, then demand is said to be elastic.