Many approaches have been developed to regulate prices. Price cap is one of the most widely accepted ways of price regulation. It was designed as an answer to weaknesses in the rate of return regulation.
The UK was the first country to introduce price-cap retail price regulation and the first country to remove them. In narrowband (voice telephony), the introduction of suitable wholesale products, such as wholesale line rental (WLR), allowed Ofcom to abolish retail price controls in 2006 and remove ex ante retail price regulation altogether in 2009.
Price cap regulation is sometimes called RPI-x regulation. It allows the operator to change its weighted average price level by the change in the retail price index (RPI) less a productivity factor (x). Sometimes, a price cap regime allows for exogenous price shocks (z) to be passed-on so the formula for the change in the price of the basket (P) is then,
P = RPI – x + z where these are all per cent changes
This is also known as incentive regulation because if the operator achieves greater efficiencies than required by x, it can retain the difference as increased profits. If it makes greater price cuts than are necessary to meet the formula in any year, it may be allowed to credit the surplus against changes required in the next period. This has been the case in Australia where retail price controls were first introduced in 1989.
Box 7.2: RPI-x in Australia
The details of the price cap change have changed between the many price control periods in Australia. But, the basic system with its control over the level of tariffs and the amount of tariff rebalancing is still intact until June 2012.
There is no overall basket but four separate baskets of services. The first basket of services consists of local calls, trunk (national long-distance and fixed-to-mobile) calls, international calls and line rentals. The second basket consists of Telstra’s most basic line rental product offered to residential customers. The third basket consists of Telstra’s most basic line rental product supplied to business customers and charity customers. The fourth basket consists of connection services.
The services in the first basket are subject to competitive pressure and x is set at the change in the RPI (CPI in Australia) so the weighted average of all services in the basket must not increase in nominal terms. In fact, in the year to June 2010 they fell 0.9 per cent overall (and just over 10 per cent for international calls). Tother with an unused credit from the previous year of 2.9 the carry forward credit was 3.7 per cent. Carry-forward credits have been abolished but this has been off-set by reducing x from RP to zero.
The remaining three baskets remain subject to a zero x and all saw actual price changes larger than RPI funded by unused credits brought forward from the previous year. However, the remaining carry-out credits have been abolished.
The current regime will expire in June 2012.
Sources: ACCC Telstra’s compliance with the price control arrangements: 1 July 2009 to 30 June 2010
Price caps can be complicated to administer and simpler variants such as revenue caps are worth considering.