Price cap regulation constrains the price changes a regulated firm is allowed to impose on its customers. In each period, the regulated firm is responsible for calculating:
- The Price Cap Index (PCI). This index is the overall constraint of the firm’s prices in a given period, and is calculated based on the price cap formula,
- The Actual Price Index (API). This index shows the actual level of prices, and should not exceed the PCI, and
- A Service Basket Index (SBI) for each basket, where services are grouped into different baskets.
Regulators need to check the calculation of the API and the PCI to ensure that the company’s actual price changes do not exceed the constraints of the price cap.
Calculating the PCI
The PCI is the overall constraint in a price cap plan. The PCI changes annually according to the price cap formula.
In the base period for the price cap (T-1), the PCI is initially set equal to 100.0. The PCI is allowed to change in each subsequent period according to the values of inflation, X and Z. To illustrate, Table 1 gives an example of PCI calculations for a hypothetical price cap.
Table 1: Hypothetical PCI Calculation, X-factor of 3.5%
Period | Inflation | X-factor | Z | PCI |
T-1 | | | | 100.0 |
T | 4.0% | 3.5% | 0.0% | 100.5 |
T%201 | 3.5% | 3.5% | 2.0% | 102.5 |
T%202 | 3.7% | 3.5% | -2.0% | 100.7 |
T%203 | 4.2% | 3.5% | 3.2% | 104.6 |
T%204 | 3.8% | 3.5% | -0.5% | 104.4 |
Calculating the API
The API tracks the firm’s actual price changes, to ensure actual prices do not exceed the PCI. The API is normally assigned the value of 100.0 at the beginning of the plan, and changes when the regulated firm changes its prices.
Each time the regulated firm files new tariff revisions, it must calculate the API for each basket, and report this to the regulator to show that the price changes do not exceed the PCI.
Most price cap plans use the following formula to calculate the API:
In the above formula:
APIt is the actual price index value following proposed price changes,
APIt-1 is the existing actual price index value without the price changes,
i is the number of rate elements in the price cap,
Pt equals the proposed prices for each of the i rate elements,
Pt-1 equals the existing prices for the i rate elements, and
vi is current estimated revenue weights for the i rate elements. This is calculated as the ratio of base period demand for the i rate element prices at the existing rate, to base period demand for the entire basket of services priced at existing rates.
Table 2 provides a hypothetical example of an API calculation. The example assumes a basket with two services, and calculated the API for two periods. The example demonstrates how the API can change even when one service price increases and the other decreases by the same percentage amount. This occurs because the two services account for different shares of the total basket revenue.
Table 2: Hypothetical API Calculation
RELATED INFORMATION
Price Cap Baskets
Calculating the Productivity Factor
Service Quality Factors
Exogenous Cost Factors