DEFINITION of Revenue Cap Regulation
Revenue cap regulation seeks to limit the amount of total revenue that can be earned by a firm operating in an industry with no or few other competitors. An industry such as this, where one or few companies control the entire production and sale of a good or service, is known as a monopoly. Revenue cap regulation is a form of incentive regulation, which uses rewards and penalties, and allows producers some discretion, to reach a desired outcome for a society. Revenue cap regulation is common in the utility sector, which includes many industries with monopolies sanctioned by a government, or franchised monopoly industries.
BREAKING DOWN Revenue Cap Regulation
Governmental regulatory authorities impose revenue cap regulations on industries that have regulated monopolies, such as gas, water and electric utility producers. Because these industries supply essential services to the populace, regulators seeking to balance the availability, affordability and quality of the service with the costs incurred by producers to provide the service. Revenue cap regulation is similar to price cap regulation, which seeks to control the prices companies can charge, and rate of return regulation, which seeks to control the rate of return earned by companies.
Determinants of Revenue Cap Regulation Guidelines
Regulators can adjust revenue caps over time, with adjustments typically based on a formula incorporating increases in inflation and a factor that favorably considers gains in efficiency. Inflation refers to the rate at which prices are rising or falling over time for a good or service, and as inflation rises, revenue caps generally rise as well. Gains in efficiency in the usage or production of a utility over time are also encouraged by revenue cap regulation. For example, because revenue cap regulation determines a level of revenue per year that a firm can collect from its customer base, producers have an incentive to encourage minimal demand per customer, through the efficient use of energy, since they will not make any revenue from excess demand beyond the regulated revenue cap. Gains in efficiency generally result in an increase in the revenue cap imposed on a company as well.
Critiques of Revenue Cap Regulation
Revenue cap regulation can encourage improvements in efficiency, both in production by the regulated company and by users of the utility. They can also encourage a company to reduce its costs in order to maximize profit on the maximum revenue it is allowed to earn. On the negative side, revenue caps may encourage firms to set prices above where they would be in an unregulated environment, and may discourage utility companies from adding customers regardless of the benefit to society.