The term “incentive regulation” refers to types of regulatory mechanism that seek to improve on the weak incentives for efficiency in traditional rate of return regulation.
Incentive regulation includes:
Banded Rate of Return Regulation
With banded rate of return regulation, the regulator specifies a range of authorized earnings for the regulated firm at the beginning of the regulatory period. If actual company earnings fall within the range, the company’s prices are considered to be fair and the regulator does not intervene.
If the firm’s earnings fall outside the permitted band the regulator intervenes:
- If earnings are higher than the permitted ceiling, the firm must share these gains with its customers,
- If earnings are lower than the floor, the company is permitted to increase rates.
Prices are thus initially set so that earnings fall within the permitted band, and price adjustments are required only if earnings fall outside the defined range.
Banded rate of return regulation is not a common form of price regulation. This is because banded rate of return shares most of the weaknesses of traditional rate of return regulation. It does not eliminate the need for frequent rate hearings and does little to provide incentives for the regulated firm to reduce costs, unless the regulator defines a very wide band.
Earnings Sharing
Earnings sharing is very similar to banded rate of return regulation, but uses a more precisely defined mechanism for sharing excess profits with customers. The regulator defines a band (referred to as a “deadband”) within which the firm is free to keep all earnings. Earnings above or below some deadband are shared in various proportions between the company and the customer.
The deadband under earnings sharing tends to be wider than under banded rate of return regulation. As a result, the firm has greater incentives to achieve productivity growth and increase efficiency.
Some regulators have used earnings sharing mechanisms when a price cap plan is first introduced, to reduce the risk to customers and the firm of moving to a new form of regulation.
For example, earnings sharing plans were popular forms of incentive regulation and were a component of some of the initial price cap plans implemented in the United States. However, earnings sharing does dilute the incentive efficiency properties that exist under a pure price cap regime. Over the past decade, companies and regulators have moved away from this form of incentive regulation.
Revenue Sharing
Revenue sharing regulation is not common. Revenue sharing requires the regulated firm to share with customers any revenues over a specified threshold. (This contrasts with earnings sharing regulation in which regulated firms are required to share earnings net of costs.) Typically the regulated firm retains all of its revenue provided that total revenue does not exceed a specified threshold. The firm must share some proportion of any revenue generated above that threshold with its customers.
Price Freezes
A price freeze specifies that a company’s prices cannot change within a defined period of time. At the end of the defined period, the regulator may undertake a rate review. The ability to capture any additional profit during the period if a price freeze give the firm an incentive to reduce its costs.
Regulators tend to use price freezes in conjunction with other forms of regulation, especially price cap regulation. In telecommunications, price freezes in a price cap plan usually apply to basic residential service. These services have historically been set at low levels due to universal service concerns and there is often a desire to maintain that policy under a price cap regime.
Rate Case Moratoriums
A rate case moratorium is an agreement between the regulator and the regulated company to abstain from general rate increases for particular services. A rate case moratorium usually also suspends investigations of the firm’s earnings, guaranteeing the regulated firm that profits made at current prices will not be taken away.
A moratorium imposes a regulatory lag. This is intended encourage the regulated firm to reduce operating costs, because the firm will be able to retain the resulting increase in earnings. The length of a rate case moratorium is typically between two and five years, and is usually specified in advance.
Pure Price Cap Regulation
Under price cap regulation, the regulator controls the prices charged by the firm, rather than the firm’s earnings. This focus on prices (and not profits) is what provides for improved efficiency incentives.
The regulator determines an annual price cap formula. This formula determines whether prices should change in each annual period, and by how much. The regulator usually specifies in advance how long the formula will apply for.
Under a typical price cap, the regulated firm is permitted to alter its average price for a basket of regulated services at the rate of the general level of inflation minus an efficiency factor based on the regulated firm’s expected efficiency (the “X-factor”). Some regulators also allow the firm to adjust for changes in costs beyond its control, by including an exogenous cost component in the price cap formula (the “Z-factor”). A general example of a price cap formula is:
In the above formula, PCIt and PCIt-1 are the price cap index in the current year and the previous year, respectively. CPI is the Consumer Price Index (or an alternative index of inflation). X and Z are adjustments for expected efficiency gains and for exogenous costs, as discussed above.
Price caps have a number of advantages over other forms of regulation that focus on the firm’s realized earnings. The fact that the regulated firm is permitted to retain any realized earnings creates strong incentives to improve efficiency and reduce costs, beyond the level required by the X-factor. The infrequent reviews of the price cap formula reduce regulatory costs (by avoiding frequent rate cases), and encourages the firm to implement strategies to reduce costs in future periods, as well as in the current year. Finally, under price cap regulation, the regulated firm has much more flexibility in the prices that it can charge its customers as long as average prices do not exceed the cap.
Regulators around the world have used price caps extensively in the telecommunications industry. The regulator in the United Kingdom introduced price caps in 1984, and they are now increasingly common in the rest of Europe. In the United States, price cap regulation began replacing traditional rate of return regulation for telecommunications carriers in 1989. By the mid to late 1990s, nearly every state had a price cap regime in place for the telecommunications industry.
Hybrid Price Cap
Under a hybrid price cap scheme the regulator combines a price cap mechanism with a mechanism that uses realized earnings to determine prices.
The most common type of hybrid price cap is one where the regulator sets a price cap formula and an explicit earnings sharing requirement. If the firm’s regulated earnings exceed a certain threshold then it must share part of the gains with customers. Conversely, if earnings fall below the threshold a share of the losses falls on customers. This provides the firm an incentive to improve its efficiency, while also addressing concerns about excessive profits (for example, if the regulator sets an X-factor that subsequently appears to be too generous).
RELATED INFORMATION
Why Regulate Prices?
Rate of Return Regulation
Rate of Return Regulation versus Price Caps
Implementing Price Caps
International Benchmarking of Prices