| | Rate of return (ROR) | Price cap |
| Prevent exercise of market power | Yes. The regulated firm can only earn a normal rate of return. | Yes. The CPI-X constraint in the price cap formula prevents the firm from exercising market power (if chosen with care). The firm may exercise market power in prices for individual services, provided that the average price of the basket of services is within the cap. Some regulators impose additional caps on individual services to prevent this. |
| Technical efficiency | No. The regulator directly controls profits. If the firm lowers costs by becoming more efficiency, and so increases profits, prices will be lowered in the next rate case. The firm will not reap the benefit from reducing costs and so has no incentive to do so. | Yes. Firms are automatically rewarded with higher earnings when they reduce costs or expanding demand (and penalized when costs increase). This encourages efficient behaviour |
| Allocative efficiency | No. Prices usually based on embedded costs, not forward-looking costs. Prices for individual services need not equal the costs of the service. | Yes. Firms have flexibility to set prices for individual services based on forward-looking costs. It is possible for individual prices to deviate from costs, particularly if the X-factor is set incorrectly. |
| Dynamic efficiency | No. The firm does not retain any increase in profit from introducing new technology or services, and so has no incentive to do so. | Yes. The firm has incentives to invest efficiently, because it must justify its investment on the profits it expects to earn from the investment (like firms in competitive markets). |
| Promote competition | No. Does not generally permit pricing flexibility for the firm to set prices to reflect forward-looking costs in response to competition. Compared to price cap regulation, the firm is better able to misreport costs between competitive and non-competitive services, in order to cross-subsidize competitive services.
| Yes. The firm is less likely to cross-subsidize services. It is common to group regulated services into separate baskets for less competitive and more competitive services, preventing cross-subsidization. The firm has sufficient pricing flexibility to respond to competitive pressures by setting prices that reflect underlying costs and demand conditions |
| Minimize regulatory costs | No. Rate proceedings are often lengthy and resource intensive. | Yes. Price cap proceedings are less costly than rate proceedings, and are infrequent (once every 3 to 5 years). Between reviews, regulatory costs are low. |
| Ensure high service quality | Yes. The higher the net book value of the firm’s assets, the greater the return it is permitted to earn. There is a risk that service quality may be higher than efficient levels. | No. Firms have strong incentives to reduce operating costs, which may lead to reduced service quality
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| Prices competitive with other jurisdictions | No. Prices are generally set with no reference to prices in other jurisdictions. | No. Prices are generally set with no reference to prices in other jurisdictions. |
| Generate compensatory earnings | Yes. Rate of return regulation ensures that the regulated firm generates sufficient compensatory earnings. | No guarantee. If the X-factor is chosen correctly and the firm performs, the firm should generate sufficient compensatory earnings. A sound price cap penalizes the firm for business mistakes or poor performance. |