UK regulators generally impose price controls via an 'RPI-X' formula:- prices are allowed to rise in line with the Retail Prices Index less an X% reduction each year to pass on to customers the benefit of improved efficiency.
This formula works well in a wide variety of circumstances, mainly because there are three main players in the regulatory contest: the company, its investors and the regulator. Regulated companies, implicitly - and sometimes explicitly - supported by their owners/investors, will often kick up quite a fuss in the final stages of a price control discussion, claiming that there is no way that the company can meet the regulators' '-X' efficiency target, and trying to browbeat or scare the regulator into making further concessions. But the owners/investors change sides when the new price control kicks in, and will generally put a lot of pressure on the company's managers to cut costs to as to beat the price control and make extra profits - and it is amazing how often the supposedly impossible efficiency targets have in practice been exceeded.
There are often then complaints that the companies are making excessive profits (albeit after charging lower prices) and the regulator responds by cutting prices yet further in the next price control period. This is sometimes done by imposing an initial P0 price cut, followed by the usual cuts of RPI-X % pa.
Price control efficiency targets are often met through capital investment but it is sometimes argued that the formula may reduce the incentive to innovate and invest in the short term, even though such investment might benefit both consumers and the company in the longer term. But the CAA has managed to overcome this problem by incentivising terminal and runway investment via its price controls. Ofgem, however, faces tricky decisions about whether it should incentivise investment in renewable energy. Why should the regulator in effect tax all gas and electricity customers in order to meet 'green' targets? Shouldn't such taxation be imposed transparently by Parliament?
The level of permitted prices is generally calculated by adding together:
- Operating Expenditure,
- Capital consumption (depreciation and the like), and
- Financing Costs (dividends, interest etc.)
Financing costs are assessed by applying an appropriate rate of return (The Cost of Capital) to The Regulatory Asset Base (the RAB). There is often much nerdy argument about what assets should and should not be in the RAB, and the appropriate cost of capital. Interestingly, though, the RAB can include wasted capital expenditure, such as the large amounts of money that owners of Stansted Airport spent on seeking permission to build a new runway. Even though those plans were abandoned, the costs were still remunerated within the RAB.
The result is an permitted average annual price rise of RPI-X which often has to be apportioned amongst various products, so that some prices may rise a little faster than RPI-X as long as others rise less fast than RPI-X.
The January 2014 rail price control was interesting in that the government had announced that the average price rise would be 4.1%, and the maximum would be 9.1%, Facing voter concern about the cost of living, the government subsequently revised the second figure to 6.1%, without reducing the average increase, thus helping those passengers who would have faced steep increases, but disadvantaging those who would have benefitted from the fare reductions that would have been needed to balance the increases above 6.1%.
Important Note:- Unchecked market power (monopoly power) does not necessarily lead to price increases. The relative lack of competitive pressure can also leads to one or more of lower product or service quality, or a reduced product range, or poorer customer service. Price controls therefore need address all of PQRS - price, quality, range and service - for otherwise a tight price control will merely lead to greater problems in non price outcomes including Q, R and/or S. A further discussion of this subject is here.