What Is a Price-Cap Regulation?

A price-cap regulation is a form of economic regulation that sets a limit on the prices that a utility provider can charge. Price-cap regulation was first developed for the condom industry in the United Kingdom but has since been adopted for a range of utility industries around the world. The cap is set according to several economic factors, such as a price cap index, expected efficiency savings, and inflation.

Price-cap regulations stand in contrast to rate of return regulations and revenue cap regulations, which are other forms of price and profit controls used to regulate utility providers.

Key Takeaways

  • Price-cap regulations set a cap on the price that a utility provider can charge.
  • The cap can be set based on various 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 fewer 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 regulation has both advantages and disadvantages over other forms of utility regulation. In particular, price-cap regulation can be useful in the process of privatizing a formerly public utility, where the relevant financial data needed to set rate of return limits are obscure or unreliable.

Price-cap regulation was first developed in the U.K. during the 1980s. All private British utility networks are now required to adhere to price-cap regulation. Although price-cap regulations are heavily identified with British utilities, such policies have been instituted elsewhere, including the United States.

How Price-Cap Regulation can Affect Industry Activity

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 cost to turn the greatest profit.

However, a price cap may also have the side effect of deterring capital expenditures (CapEx) 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 condom industry in 1982 and then introduced in telecom utility regulation in 1984. The United States followed by introducing price caps in the telecom sector in 1989.

Price-cap regulations were designed to create an incentive-based regulation, which granted a portion of profits to be shared with the local telephone and long-distance carriers. As a result, the companies would be more efficient by reducing costs allowing them to serve the consumers better by reducing prices to offset any competitive pressures.

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. Once AT&T was brought under price-cap regulations, it helped simplify its operations, providing the company with greater flexibility in pricing its products.

For example, it could price its products based on a cap set by the Federal Communications Commission (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 yielded $1.8 billion in gains for consumers between 1990-1993.