Price-cap regulation

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Price-cap regulation is a form of regulation designed in the 1980s by UK Treasury economist Stephen Littlechild, which has been applied to all of the privatized British network utilities. It is contrasted with rate-of-return regulation, in which utilities are permitted a set rate of return on capital, and with revenue-cap regulation where total revenue is the regulated variable.

The system is also known as ""CPI - X", (in the United Kingdom "RPI-X") after the basic formula employed to set price caps. This takes the rate of inflation, measured by the Consumer Price Index (UK Retail Price Index, RPI) and subtracts expected efficiency savings X. In the water industry, the formula is "RPI - X + K", where K is based on capital investment requirements. The system is intended to provide incentives for efficiency savings, as any savings above the predicted rate X can be passed on to shareholders, at least until the price caps are next reviewed (usually every five years). A key part of the system is that the rate X is based not only a firm's past performance, but on the performance of other firms in the industry: X is intended to be a proxy for a competitive market, in industries which are natural monopolies.

In most industries in the UK, estimation of a firm's efficiency is carried out by comparing regional monopolies and using a total factor productivity method. However, for telecommunications, Ofcom instead relies on international comparisons.

In practice, the distinction between price-cap and rate-of-return regulation may be lost, as regulators may end up making implicit decisions on the acceptable real rates of return on capital employed in order to arrive at price limit determinations. This has been the experience in the UK water sector, where the 1999 periodic review led Ofwat to determine a standard (real post-tax) cost of capital of 4.75%, with minor adjustments for smaller companies. This standard rate was then used to help calculate X.

Price-cap regulation is no longer a uniquely British form of regulation. Particularly in the telecommunications industry, many Asian countries are implementing some form of price cap on their newly-privatised operators. In addition, many US Local Exchange Carriers are now regulated by price-cap rather than rate-of-return regulation: in 2003, of the 73 companies reporting to the ARMIS database, 22 were regulated according to an RPI-X price cap (and a further 35 were subject to other retail price controls).