What is a Price-Cap Regulation?

A price-cap regulation is a form of economic regulation generally specific to the utility industry in the United Kingdom. Price-cap regulations set a cap on the price that the utility provider can charge. The cap is set according to several economic factors, such as the price cap index, expected efficiency savings and inflation.

Key Takeaways

  • Price cap regulations set a cap on the price that a utility provider can charge.
  • The cap is set based on a slew of factors, from production inputs to efficiency savings and inflation.
  • Price cap regulations force utilities to become more efficient in their operations but they can also result in less expenditures to maintain or upgrade their levels of service.

Understanding Price-Cap Regulation

After the rising costs of inputs (inflation) and the prices charged by competitors are considered, the price-cap regulation is introduced to protect the consumers, while ensuring that the business can remain profitable.

Price-cap regulations stand in contrast to rate-of-return regulations and revenue-cap regulations, other forms of price and profit controls used in the United Kingdom. All private British utility networks are now required to adhere to price cap regulation.

How Price Cap Regulation can Affect Industry Activity

Although price cap regulations are heavily identified with British utilities, such policies have been instituted elsewhere, including the United States. For instance, telephone service providers in the U.S. were put under price-cap regulation for a time, though this was largely replaced by rate of return regulation.

The presence of a price-cap regulation can compel utility companies to find ways to reduce their costs in order to improve their profit margins. A favorable case might be made for the efficiencies that are encouraged by the regulations. The upper limits on pricing for the industry mean that companies have to focus on running their operations with the least amount of disruption at the lowest possible price to turn the greatest profit.

A price cap may have the side effect of deterring capital expenditures among utility companies, such as investing in infrastructure. Companies under price-cap regulations might also reduce services as they strive to control costs. This creates a risk of erosion of quality and service from utility companies.

A deterrent to reducing service too much for the sake of cutting costs is that such action can create incentives for new entrants to appear in the market. There may also be minimum requirements enforced by regulators to prevent companies from eliminating essential services. For example, a price floor might be established as a way to discourage companies from lowering their rates to anti-competitive levels that severely undercut rivals.

There can be additional costs for companies as they aim to maintain compliance with price-cap regulation policies. This can include putting time and management resources toward ensuring that the rates and prices applied by the company fall within the designated range.

Examples of Price Cap Regulation

Price cap regulation was first implemented in the U.K.'s telecom sector in 1984. The United States followed five years later, adopting price caps in the telecom sector in 1989. Price cap regulations were intended to replace Rate of Return (RoR) schemes, which limited the amount of "reasonable profits" that a firm could derive from its business.

The breakup of AT&T into regional operating companies in 1984 meant that competitors gained market share at AT&T's expense because it was subject to greater regulation. Beginning in the early 1990s, AT&T was brought under price cap regulations, helping simplify its operations and providing the company with greater flexibility in pricing its products. For example, it could price its products based on a cap set by the FCC without worrying about whether the profits it generated from those prices were compliant (or non-compliant, in states that chose not to regulate it) with regulation. The FCC estimated that the introduction of price cap regulation in the telecom sector had yielded $1.8 billion in gains for consumers between 1990-1993.