The X-factor in the price cap formula is an efficiency target chosen to reflect the productivity growth potential of the regulated firm over the (forward-looking) term of the price cap.
The inclusion of the X-factor ensures that prices change over time to reflect productivity gains. If the regulated firm’s actual cost reductions exceed the X-factor, the firm is rewarded. On the other hand, if the firm’s actual cost reductions are not as great as required by the X-factor, then the firm is penalized.
Care is required in setting the X-factor. The firm’s financial success will depend on its ability to reduce unit costs while there is a price cap. This therefore be taken into account in setting the X-factor.
There are generally two ways to calculate the X-factor:
In addition, some regulators include an additional component in the X-factor, to provide a consumer productivity dividend, or “stretch factor”.
Forward-Looking Financial Model
Under this approach, the regulator develops forecasts of the regulated firm’s costs, revenues and profits over a given period of time. The regulator selects an X-factor that will ensure that (in the absence of better than expected efficiency improvements) the firm’s internal rate of return is no greater than a normal return on profit, usually measured by the weighted average cost of capital.
If the firm’s rate of return is higher than its cost of capital (or significantly below the cost of capital) at the beginning of the price control period, the regulator can:
- Impose a one off price adjustment at the beginning of the period, to bring the rate of return in line with the cost of capital, and set X so that the internal rate of return is no greater than the cost of capital (as above), or
- Set X so as to bring the internal rate of return into line with the cost of capital by the end of the price control period.
The choice between these two options depends on:
- Whether the regulator believes that “excess” profitability at the beginning of the price control period reflects monopoly power, or is due to past innovation and cost reductions, and
- Whether the regulator prefers to avoid large price adjustments at a given point in time.
Total Factor Productivity Differential Approach
Under this approach, the regulator calculates the firm’s total factor productivity (TFP), and compares it to the economy’s TFP. Ideally, the regulator should use the TFP of the telecommunications industry, rather than the individual firm. This will maximize the good incentive properties in the price cap, by encouraging the firm to outperform other firms in the sector.
The regulator must also examine the firm’s (or, ideally, the industry’s) input prices, and compare them to input prices in the general economy.
The general formula for the X-factor under this approach is:
In words, X is calculated as:
- The difference between the rate of economy-wide input price growth, and input price growth in the telephone industry (the input price differential), plus
- The difference between the rate of total factor productivity growth in the telephone industry, and economy-wide total factor productivity growth (the TFP differential).
Consumer Productivity Dividend / Stretch Factor
Some regulators include a consumer productivity dividend or “stretch factor”, in price caps. A stretch factor adds an amount to the productivity target to provide additional benefits to customers.
This additional factor recognizes that in many cases the efficiency gains from a price cap come about because the previous system allowed inefficiencies to accrue. That is, compared to, say, rate of return regulation price caps should generate additional efficiencies.
A stretch factor is, in effect, a type of guarantee. It ensures that ratepayers will in fact be better off under a price cap regime, because it directly passes any efficiency gains from price cap regulation to customers.
In general, a stretch factor is only warranted where the introduction of a price cap regime significantly improves efficiency incentives.
RELATED INFORMATION
Price Cap Baskets
Assessing Price Variations
Service Quality Factors
Exogenous Cost Factors