Price Cap Regulation

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21 Aug, 2024

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Price Cap Regulation refers to the imposition of a ceiling or limit by the government on the companies while setting the prices of utilities. The prime objective of this rule is to increase productivity and remove the industry's control over prices for four to six years.

Price cap regulation has a phenomenal role in the utility industry. It helps to maintain the price balance in the market. In addition, it also boosts productivity levels. Also, there is equal distribution of profits among all firms. However, it can be difficult for regulators to adhere to the price cap regulation of utilities.

What Is Price Cap Regulation?

Price cap regulation, in economics, is a government rule restricting utility firms (or operators) from raising prices with a limit for a certain period.
Here, regulators control them and ensure that operators sell within the same price level. However, the latter can either reduce input costs or increase efficiency.
The concept originated in 1982 when the U.K. condom brand London International Group or Durex had price caps.
Price caps apply to utilities like electricity, power, gas, and water services.

Price Cap Regulation Explained

Price Cap Regulation is a regulation proposed by the government where the regulator company gets restricted from rising the prices of utilities. The main theme of this regulation is to protect customers and distribute certain profits to businesses.

In this case, utility refers to electricity, water, power, and gas services. In contrast, an operator or regulated company refers to the firm providing these services. Besides, a regulator is an organization that regulates and controls these operators. For example, the Federal Energy Regulatory Commission (FERC) is the utility regulator in the U.S.

The concept of price cap regulation provides three goals for the firms to select from. Operators can either choose a reward-penalty program, select its goals or a structure for achieving them. So, in the first case, if the firms want to earn rewards (profits), they have to reduce their efficiency and vice versa. Likewise, if operators reduce their costs by a certain percentage, it will give them more profits above their cost of capital.

For example, firms can keep the surplus if costs decrease by 10%. They can negotiate better input prices with suppliers, decrease overheads, and others to achieve this. Thus, if operators reduce costs, they will automatically achieve higher efficiency.

History

The origin of the price cap regulation dates back to the 1980s in the United Kingdom. In 1982, the Monopolies and Mergers Commission noticed an excessive pricing strategy in the country's privatized firms. As a result, they suggested that the annual price rate should stay within the annual cost index growth of 1.5% for five years. The main benefit was that these regulatory firms needed help to control the cost index.

Thus, it provided two different goals for the firms to choose from. Therefore, in 1982, price caps were imposed on the firm London International Group, which owns the Durex brand. However, the base for it was set up by Professor Stephen Littlechild. Later, in 1983, Littlechild presented a report on the development of price cap regulation of utilities to the Department of Industry. Littlechild also argued that it must be applied to firms like British Telecom (BT), where their monopoly existed.

During the 1990s, PCR was more popular in the United States than other regulations. Therefore, by the end of the 20th Century, more than 80% of the states had adopted the price cap regulation.

Factors

Price cap regulation reliability depends on the Inflation index (I) and productivity (X-factor). Here, the X-factor is the difference between an operator's productivity and the other average firm in the economy. So, the prices of the average firm will change as per inflation. Plus, the earnings will be equal to the cost of capital. However, it differs for the operator. They need to have a proper balance between input prices, earnings compared to inflation, and cost of capital. So, if the operator's input costs rise faster than the inflation rate, it will be a competitive phase for them to raise retail prices to cover the cost of capital.

Likewise, productivity will increase if the operator functions like an average firm. However, the retail prices and revenue will decrease. Therefore, the price cap regulation reliability feature allows them to earn profits by reducing costs and increasing efficiency. Regulators have also developed service baskets that prevent operators from changing certain services' prices.

Formula

Although there is no proper price cap regulation formula, a formula exists (for determining the X-factor for the price caps. Let us look at it:

X-factor =

Where:

Change in the operator's productivity refers to the change (%) every year. Likewise, it is the same for an average firm.
Change in Input prices is the change in input costs compared to last year.

Examples

Let us look at the examples of price cap regulation for a better understanding of the concept:

Example #1

Suppose General Electricity Ltd is the largest electricity provider in the United States. It enjoyed a huge monopoly within the eastern region. However, it caused certain exploitation to the customers. Therefore, the government imposed a price cap regulation prohibiting operators like General Electricity from charging high retail prices.

However, the operator saw it as a disadvantage that would reduce profits. As a result, regulators like the FERC provided a solution to either improve efficiency or reduce costs. Thus, the firm could negotiate input prices from suppliers and reduce retail prices. It leads to selling more units at a lower price, covering the capital cost.

Example #2

In February 2023, the European Union (EU) and the United States (US) imposed a price cap regulation on Russian petroleum products. This decision was enforced after the Price Cap Coalition of the Group of seven (G7) nations. The price cap will follow certain petroleum products traded at a discount or at par. Some of them include jet fuel, petroleum, and diesel.

As a result, there was a limit put on petroleum products.
While the E.U. enforced it on February 4th, the latter introduced the same on February 3rd, 2023. However, the U.S. enforced it on February 5th, 2023.

Advantages And Disadvantages

Let us look at the advantages and disadvantages of the price cap:

Advantages	Disadvantages
There are smaller administrative costs.	The operators might reduce their quality to reduce retail prices.
It increases the efficiency and productivity of the operators.	Regulated companies need to get the opportunity to serve different classes of customers.
Protects the customers from hype prices and lets operators still make profits.	If price caps are set high, the consumer surplus for the firms can vanish.
Avoids or minimizes the Averch-Johnson effect by reducing capital accumulation by operators.	Operators with high fixed costs might notice demand fluctuations.
Provides an incentive to acquire inputs at lower prices from suppliers.

Price Cap Regulation vs Cost-Plus Regulation

Although price-cap and cost-plus regulation focus on pricing strategies in the utility industry, they have different features. So, let us look at the major differences between them:

Aspect	Price Cap Regulation	Cost-Plus Regulation
Meaning	It refers to the regulation prohibiting the operators (or regulated companies) from over-charging the customers.	Cost-plus regulation is a rule proposed by the government where the operators can charge prices considering increased accounting and overhead costs.
Objective	Here, regulators have already set a constant price level for four to six years.	Here, regulators have already set a constant price level for five years.
Limitations	The quality of utilities might reduce during the process.	Here, operators receive no incentives for cost control.

Frequently Asked Questions (FAQs)

1. When does electricity price cap regulation become distortionary?

Imposing an artificial price ceiling that discourages investment and competition discourages innovation and energy efficiency. Also, it may ultimately result in shortages or higher costs, and regulation of electricity price caps can become distortionary. Thus, to prevent unforeseen outcomes, the regulation must be properly designed.

2. What is the importance of price cap regulation?

Price cap regulation can be a savior for customers and economies with uneven inflation rates. It helps the regulators set a constant price level for a longer period. Also, customers do not overpay for utility services. In addition, it incentivizes the operators to balance input prices, cost of capital, and retail prices.

3. What is the difference between revenue cap regulation and price cap regulation?

In revenue cap regulation, the regulators restrict the operators from earning a limited revenue. The only intention behind this is to prevent monopoly firms from making huge profits. This regulation prevails more in the United States. In contrast, price cap regulation focuses on limiting the price level utility companies charge.