Price-cap regulation - Definition and Overview

price-cap regulation is a form of regulation designed in the 1980s by UK Treasury economist Steven 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.

The system is also known as "RPI - X" after the basic formula employed to set price caps. This takes the rate of inflation 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 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 cost of capital of 4.75%, with minor adjustments for smaller companies. This standard rate was then used to help calculate X.

See also

• Ofwat, Ofgem
• market failure

External link

• Ian Alexander and Timothy Irwin (1996), "Price Caps, Rate-of-Return Regulation, and the Cost of Capital" [1] (http://rru.worldbank.org/Documents/PublicPolicyJournal/087irwin.pdf)

Example Usage of regulation