1. BSc Economics and related programmes
Economics of Competition and Regulation EC 3015
Week 8: Price Cap Regulation

2. Market Investigations
Aim
To explain different approaches to setting regulated prices for natural monopoly
Market Investigations

3. Market Investigations
Natural monopoly Approaches Rate of return Price cap Political economy
Overview
Some economics of natural monopoly
Different approaches to regulation
Rate of return regulation 
Price cap (RPI – X): the building blocks
Political economy consideration
Market Investigations

4. Market Investigations
Natural monopoly Approaches Rate of return Price cap Political economy
Natural monopoly
One network is cheaper than two...
Price, cost
demand
potential cost penalty from duplication
average cost
Output
Market Investigations

5. Market Investigations
Natural monopoly Approaches Rate of return Price cap Political economy
Natural monopoly
...but much of the advantaqe may be lost if the firm is unregulated
Price, cost
demand
Unregulated price
potential cost penalty from duplication
average cost MC
Output
Market Investigations

6. Examples of natural monopoly?
Natural monopoly Approaches Rate of return Price cap Political economy
Examples of natural monopoly?
Postal services
Telephones
Electricity
Gas
Market Investigations

7. Network cost function characteristics
Natural monopoly Approaches Rate of return Price cap Political economy
Network cost function characteristics
Cost per unit of output
= f(density, scope, sometimes scale)
Density: fixed investment (e.g. pipe laying) spread across larger throughput
Scope: types of output
Scale: Geographic extent
Market Investigations

8. Network externalities
Natural monopoly Approaches Rate of return Price cap Political economy
Network externalities
...are about the benefit to existing users to adding another user.
Clearest example:
telephony – how many people can you call
Less clear but related:
how many places can you get to and from by e.g. rail
Electricity network (e.g. grids)
more extensive =>more efficient generation
Market Investigations

9. Alternative approaches
Natural monopoly Approaches Rate of return Price cap Political economy
Alternative approaches
Market Investigations

10. Alternative approaches
In summary, these are:
public ownership
use of competition policy
rate of return regulation
price caps
concession/ management contracts
Market Investigations

11. Approach 1: public ownership
Natural monopoly Approaches Rate of return Price cap Political economy
Approach 1: public ownership
Developed for posts, then telephones
CEB 1920s (also BBC, as public corporation)
Nationalisation
Worldwide e.g.1930s-70s national flag airlines
Different versions:
direct ministerial control (govt dept.)
via public corporation (Morrison), ministry regulator
with independent regulator
Market Investigations

12. Approach 2: use competition policy
Natural monopoly Approaches Rate of return Price cap Political economy
Approach 2: use competition policy
i.e. ex post regulation
problem: competition policy is not very good at tackling high price abuse
New Zealand tried this but have moved to having regulators
Market Investigations

13. Rate of return regulation
Approach 3
Rate of return regulation
Market Investigations

14. Approach 3: “cost-of-service” regulation
Natural monopoly Approaches Rate of return Price cap Political economy
Approach 3: “cost-of-service” regulation
Was standard in USA and US “empire”/sphere of influence.
Reconciles private property with controlling abuse
Also known as “rate of return” regulation:
key point is assuring “just and reasonable” return on investment
Effective in generating investment, but incentive properties a problem (see below)
Legalistic and cumbersome?
Market Investigations

15. Approach 3: Key elements
Natural monopoly Approaches Rate of return Price cap Political economy
Approach 3: Key elements
Required revenue = operating expenditure plus capital depreciation (= return of the money invested) plus allowed rate of return times net regulatory asset base.
Essentially an accounting approach:
Net regulatory asset base this year = net regulatory asset base last year less depreciation plus new investment.
Market Investigations

16. Market Investigations
Natural monopoly Approaches Rate of return Price cap Political economy
Approach 3: incentives
Investment: Since there is a guaranteed rate of return, all agreed investment tends to get done in time. US electricity system, for example was successful in largely avoiding black- and brown-outs for many decades. Operating cost: Regulatory commission (and consumer advocate groups) keep a watchful eye on costs, but limited by asymmetric information
Market Investigations

17. Rate of return: efficiency
Averch-Johnson effect:
excessive capital intensity
arises from guaranteed return = true cost of capital + “delta”
delta = safety margin to ensure that return is earned
Seen in form of “gold plating”, preference for capital not opex solutions
A form of allocative inefficiency
True extent of A-J effect is contested
Market Investigations

18. Rate of return: process
Companies apply for rate increases when they think justified (or can make a case)
Contested by consumer groups
Adjudicated by Regulatory commissions
heavily legalistic
rewarding to law firms
process looks cumbersome to public
Market Investigations

19. Market Investigations
Approach 4:
price cap: RPI-X
Market Investigations

20. Approach 4: The price cap
Natural monopoly Approaches Rate of return Price cap Political economy
Approach 4: The price cap
Introduced in Britain (1984) for BT as “local tariff reduction scheme”
cost-of-service appeared cumbersome, poor incentive properties, not necessary for “temporary” monopoly
“Prices” are set for a 4-5 year period, usually with price reduction in real terms (see below)
Better incentive properties than cost-of service, at least in short run
Market Investigations

21. Market Investigations
Natural monopoly Approaches Rate of return Price cap Political economy
The price cap: RPI-X
RPI =retail price index
X = relative efficiency improvement assumption, adjusted for
quality/environmental improvements
ensuring need for capital investment
Market Investigations

22. Approach 4: revenue requirements
Natural monopoly Approaches Rate of return Price cap Political economy
Approach 4: revenue requirements
Central equation
NPV(revenues) =NPV( “Cash flow out”)
Cash flows out:
initial regulatory value (year 0)
expected operating costs (each year)
approved capital expenditure (each year)
less final regulatory value
All discounted using “cost of capital”
Market Investigations

23. Market Investigations
Natural monopoly Approaches Rate of return Price cap Political economy
Approach 4
Comments on financial methodology:
would be equivalent to cost-of service if accounting rate of return is economic rate fo profit
Both systems require some assumptions about depreciation, but price cap only requires multi-year aggregates
Market Investigations

24. Approach 4: key differences
Natural monopoly Approaches Rate of return Price cap Political economy
Approach 4: key differences
Price cap is explicitly forward looking –requires cost modelling (next week) to drive real prices down
automatic adjustment for inflation
4-5 year price control period gives incentive for firms to cut costs – benefit up to 5 years might be longer in some methods
--but over time my have A-J effects
Market Investigations

25. Market Investigations
Natural monopoly Approaches Rate of returnPrice capContractsPolitical economy
Approach 5: contracts
Sometimes used especially in water, transport
Management –only contracts:
gov’t owns assets, operated by competitively tendered firms
build, own, operate transfer
e.g. bridges, toll roads
where investment is key requirement
Market Investigations

26. Political economy questions
Natural monopoly Approaches Rate of return Price cap Political economy
Political economy questions
Why are some activities regulated, others not? When the industry seeks (tougher) regulation, why? Can the regulator be captured by the industry? Is the regulatory independent of government? =>issues of accountability, transparency, control, regulatory governance, legal appeals, etc.
Market Investigations