Discussion Paper. Incentive Regulation: Theory and Practice

Transcription

1 Discussion Paper Incentive Regulation: Theory and Practice September 2014

2 We wish to acknowledge the contribution of the following staff to this report: Kian Nam Loke, Richard Creagh, Ralph Donnet, John Fallon, Dan Kelley Queensland Competition Authority 2014 The Queensland Competition Authority supports and encourages the dissemination and exchange of information. However, copyright protects this document. The Queensland Competition Authority has no objection to this material being reproduced, made available online or electronically but only if it is recognised as the owner of the copyright 2 and this material remains unaltered.

3 Queensland Competition Authority Error! No text of specified style in document. SUBMISSIONS Closing date for submissions: 12 December 2014 Public involvement is an important element of the decision-making processes of the Queensland Competition Authority (QCA). Therefore submissions are invited from interested parties concerning its assessment of Incentive Regulation: Theory and Practice. The QCA will take account of all submissions received. Submissions, comments or inquiries regarding this paper should be directed to: Queensland Competition Authority GPO Box 2257 Brisbane Q 4001 Tel (07) Fax (07) research@qca.org.au Confidentiality In the interests of transparency and to promote informed discussion, the QCA would prefer submissions to be made publicly available wherever this is reasonable. However, if a person making a submission does not want that submission to be public, that person should claim confidentiality in respect of the document (or any part of the document). Claims for confidentiality should be clearly noted on the front page of the submission and the relevant sections of the submission should be marked as confidential, so that the remainder of the document can be made publicly available. It would also be appreciated if two copies of each version of these submissions (i.e. the complete version and another excising confidential information) could be provided. Where it is unclear why a submission has been marked 'confidential', the status of the submission will be discussed with the person making the submission. While the QCA will endeavour to identify and protect material claimed as confidential as well as exempt information and information disclosure of which would be contrary to the public interest (within the meaning of the Right to Information Act 2009 (RTI)), it cannot guarantee that submissions will not be made publicly available. Public access to submissions Subject to any confidentiality constraints, submissions will be available for public inspection at the Brisbane office, or on the website at If you experience any difficulty gaining access to documents please contact us on (07) iii

4 Queensland Competition Authority The Role of the QCA Task, Timing and Contacts THE ROLE OF THE QCA TASK, TIMING AND CONTACTS The Queensland Competition Authority (QCA) is an independent statutory authority to promote competition as the basis for enhancing efficiency and growth in the Queensland economy. The QCA s primary role is to ensure that monopoly businesses operating in Queensland, particularly in the provision of key infrastructure, do not abuse their market power through unfair pricing or restrictive access arrangements. In 2012, that role was expanded to allow the QCA to be directed to investigate, and report on, any matter relating to competition, industry, productivity or best practice regulation; and review and report on existing legislation. Task, timing and contacts The QCA Research team supports the QCA's regulatory and public policy work. The team focuses on providing analysis and evidence to support regulatory and public policy decisions which affect both the community and industry. Key dates Release of Discussion Paper 26 September 2014 Submissions Due Date 12 December 2014 Registration of interest Contacts Enquiries regarding this project should be directed to: ATTN: Kian Nam Loke Tel (07) research@qca.org.au ii

5 Queensland Competition Authority Incentive regulation: theory and practice INCENTIVE REGULATION: THEORY AND PRACTICE Background All forms of regulation are likely to impact on incentives but the term incentive regulation has evolved to describe a form of regulation that attempts to address two key problems with economic regulation: (i) the incentive for a regulated firm to hide its true cost profile; and (ii) the lack of incentive for the regulated firm to operate and invest efficiently. The economic literature refers to these two problems as adverse selection or hidden information and moral hazard or hidden action respectively. These problems arise due to the fundamental asymmetry of information between the regulator and the regulated firm. The two basic forms of regulation that operate in practice are rate-of-return regulation (or cost-of-service regulation) and price-cap regulation. In general, rate-of-return regulation (where regulated prices are based on actual realised costs) focuses more on the adverse selection problem while price-cap regulation (where regulated prices are set ex ante and firms have the incentive to cut costs) focuses more on the moral hazard problem. The general approach as has been implemented in Australia is a hybrid method that comprises features associated with both forms of regulation. A form of incentive regulation known as menu regulation has been developed to try to better address both of the information problems in particular, the perverse incentive for regulated firms to submit exaggerated cost proposals to secure higher prices so that over time the regulated prices will converge to the efficient level despite the information disadvantage of the regulator. As part of its continuing effort to keep abreast of developments that might provide ideas for revising and modernising its regulatory tools to improve consumer welfare and improve the efficiency of regulation, the QCA commissioned a research paper by Professor Flavio Menezes of the University of Queensland to investigate the theory and application of incentive regulation. The research paper produced by Professor Menezes is attached. Professor Menezes worked closely with QCA staff in developing the paper. The purpose of this Discussion Paper is to make the research paper available for public comment. The incentive regulation techniques discussed in the research paper are at the cutting edge of economic regulation. While it is too early to make recommendations for change in current practices, the QCA is interested in stakeholder views about the potential applicability of incentive regulation to sectors it regulates. Menu regulation Under the menu-based approach, the regulator offers a range of options including various combinations of a cost allowance, a sharing ratio (the percentage of underspend or overspend against the allowed expenditure levels that the firm is allowed to retain) and an additional income component (an additional amount added to the firm's cost allowance), where the regulated firm is given freedom to commit to one of the options. The menu is designed such that it is incentive compatible the choice that maximises the firm's expected profit coincides with the choice that best reflects its beliefs about its future costs. In other words, the menu incentivises truth-telling from the firm. For example, suppose a regulated firm believes that its efficient costs for the next regulatory period is $X. Under standard price-cap regulation, this firm has the perverse incentive to exaggerate its cost requirement to secure higher prices (hence higher profits). Under menu regulation, however, by asking for a higher cost allowance, this firm will get a lower sharing ratio and a smaller (or even a negative) additional income component. This means that, even if this firm greatly underspends its allowance during 1

6 Queensland Competition Authority Incentive regulation: theory and practice the regulatory period (as it has chosen an inflated cost allowance in the first place), because of the low sharing ratio and additional income component that correspond with its choice, the net return from this underspend will also be small as a result. An incentive-compatible menu ensures that this firm will be better off proposing $X to be its cost allowance in the first place. In addition to truth-telling incentives, as under menu regulation the regulated firm cannot change its decision once the regulated prices are finalised, this provides an incentive for the firm to be cost efficient during the regulatory period in order to earn a higher return. The menu approach has been implemented for some time at Ofgem and Ofwat in the United Kingdom. Some aspects of incentive regulation are also being implemented by the Australian Energy Regulator (AER) in Australia. Ofgem The experience of Ofgem is reviewed in the research paper. The menu approach was implemented with an incentive scheme known as the Information Quality Incentive (IQI) which was a totex (opex and capex) menu. A totex menu has the additional characteristic of ensuring that the regulated firm has no particular incentive to prefer a type of expenditure (e.g. capex) over another. The Ofgem experience provided some evidence on whether the menu approach has been effective in providing truth-telling incentives for regulated firms. On a cumulative basis, in the regulatory period where the IQI was first implemented, there was a total 514m underspend (6.7% of the total allowance) for capex and a 322m underspend (9.1%) for opex. In the first year, firms underspent against the capex allowance by a total of million (27%) and underspent against the opex allowance by 77.6 million (5%). Although this indicates that the menu approach might not have addressed the issue of asymmetric information in determining the baseline, this conclusion would be premature given this was Ofgem's first attempt at implementing menu regulation. Companies might be unfamiliar with how the IQI would operate, thus their decision making was distorted. Similarly, underspend could be a result of the firms s cost-cutting initiatives over the regulatory period rather than the issue of adverse selection. Ofwat The experience of Ofwat with incentive regulation covering the period (PR09) is also reviewed in the research paper. In PR09, a menu-based approach was implemented by Ofwat but for capex only. For opex, Ofwat applied an efficiency carry-over mechanism. One issue with Ofwat's regime is that there appeared to be a stronger incentive to achieve opex efficiency relative to capital efficiency (a capex bias). This might lead to suboptimal allocation of resources, where companies opt for capital-incentive solutions in order to reduce opex. Recognising such an issue, Ofwat has indicated that it will adopt a totex-based approach in the next review. In addition to cost-efficiency incentives, Ofwat also applied a broader incentive mechanism to provide incentives for firms to provide better services to customers. Prior to 2010, this mechanism applied was known as the Overall Performance Assessment (OPA). The OPA entailed the specification and scoring of 15 specific performance measures including measures covering general performance, customer-focused measures and environmental measures. While the OPA was associated with considerable improvements in service quality, there were still a material number of complaints. As the OPA was based on a number of narrowly defined measures, it distracted companies from the need to focus on the overall experience of customers. The OPA has been replaced by the Service Incentive Mechanism (SIM). One important element of the SIM is its reliance on customer surveys in addition to quantitative measures. Customer 2

7 Queensland Competition Authority Incentive regulation: theory and practice surveys could capture the overall satisfaction level of consumers, encouraging innovation from companies to improve customers' experience. AER Australian regulators have made limited use of incentive regulation to address adverse selection. They tend to rely exclusively on ex ante assessments of cost proposals to mitigate the risk of inflated cost proposals. However, there have been some attempts to encourage cost efficiency. The AER's regime has carry-over schemes designed to provide continuous incentives to pursue opex and capex efficiency. This is to mitigate the issue of the periodicity of incentives caused by the introduction of periodic reviews, where the regulated firm's incentive to cut costs falls over time within a regulatory period. The AER's approach is similar to Ofwat's approach to opex. Moreoever, the carry-over schemes (one for opex and one for capex) are set up such that companies have the same level of incentives to underspend both capex and opex at any point in time, which also eliminates or mitigates capex bias. The fact that the AER has designed two incentive schemes to tackle the issues of periodicity of incentives and capex bias shows that the AER acknowledges the significance of these issues in that they may lead to distortions in the decision making of regulated firms. Also, while the AER regime does not directly address the adverse selection problem with a menu-based approach, it has indicated that it will make greater use of benchmarking to address this issue. Consultation Submissions from stakeholders on whether there is potential to improve regulation in Queensland through the adoption of menu regulation or other incentive regulation techniques are welcome. 3

8 Prepared for Queensland Competition Authority Subject Incentive Regulation Author Professor Flavio M Menezes School of Economics, The University of Queensland In collaboration with Kian Nam Loke and John Fallon 4 August 2014 UniQuest Project No: C01400

9 Title Incentive Regulation Disclaimer This report and the data on which it is based are prepared solely for the use of the person or corporation to whom it is addressed. It may not be used or relied upon by any other person or entity. No warranty is given to any other person as to the accuracy of any of the information, data or opinions expressed herein. The author expressly disclaims all liability and responsibility whatsoever to the maximum extent possible by law in relation to any unauthorised use of this report. The work and opinions expressed in this report are those of the Author.

10 TABLE OF CONTENTS EXECUTIVE SUMMARY INTRODUCTION THE CONCEPTUAL FRAMEWORK Rate-of-return versus incentive regulation Rate-of-return regulation Price caps Revenue cap Optimal regulation A simple analytical framework Incentive regulation and service quality Incentive regulation and the optimal tariff structure Incentive regulation and the efficient pricing of capacity Incentive regulation and benchmarking The dynamics of regulation IMPLEMENTATION ISSUES The regulatory process Price-cap regulation Determination of allowed costs Productivity measurement Productivity-based regulation and X-factor Service quality Ex-post treatment Menu regulation Incentive strength Periodicity of incentives Capex bias UniQuest File Reference: C01400 Page 1

11 3.6 Partial versus comprehensive incentive schemes INTERNATIONAL EXPERIENCE WITH INCENTIVE REGULATION Energy sector in the UK General information Ofgem s approach to incentive regulation Determining the cost baseline: cost assessment Incentive mechanisms: an overview Equalising incentives The totex menu: ensuring incentive compatibility and equalising incentives Preliminary assessment of the menu approach The future of electricity distribution regulation in the UK Water sector in the UK Capex incentives Opex incentives Performance incentives Future developments Summary and conclusion THE AER APPROACH TO INCENTIVE REGULATION Background Efficiency benefit sharing scheme (EBSS) Capital expenditure sharing scheme (CESS) Service target performance incentive scheme (STPIS) Summary and conclusion GLOSSARY REFERENCES UniQuest File Reference: C01400 Page 2

12 EXECUTIVE SUMMARY Incentive regulation is a tool to encourage the regulated firm to provide more accurate cost forecasts and to operate more efficiently, so that over time the regulated price will converge to the efficient level despite the information disadvantage of the regulator. This paper investigates the theory of incentive regulation and describes how it has been implemented by regulators in Australia and the United Kingdom. The role of incentives in regulation Two types of incentives are particularly important when assessing a regulatory regime. The first is the incentive for regulated firms to make regulatory submissions that more accurately reflect their actual expectation of cost required for providing the regulated services over the next control period. The economic literature refers to the case where the regulated firm has an incentive to overstate its cost forecasts as adverse selection (or hidden information). The second is the incentive for firms to reduce costs during the regulatory period below those initially approved by the regulator. The economic literature refers to the case where firms have no incentives to reduce costs as moral hazard (or hidden action). Adverse selection and moral hazard are related to a fundamental asymmetry of information between the regulator and the regulated firm. Adverse selection may result as the regulator cannot perfectly determine whether the regulated firm s cost forecasts reflect best practice. For example, some cost drivers may only be observed by the regulated firm, and not by regulators or external experts advising the regulator. In a similar vein, the regulator may not be able to observe the opportunities that the firm has for cost reduction, which can lead to moral hazard. For example, the regulator may not be able to observe managerial effort to reduce costs. This paper explains that rate-of-return or cost-of-service regulation, in its simplest form, addresses the adverse selection problem but creates a moral hazard problem. Faced with the certainty of being reimbursed only for costs actually incurred in providing the services (including the return on capital and economic depreciation), a regulated firm has little incentive to exaggerate cost forecasts. That is, the adverse selection problem does not exist. This assumes that auditing of costs will be effective in addressing the information disadvantage of the regulator (to prevent the firm from overstating what it has spent). However, the same guarantee of reimbursement of costs means that the firm faces no incentive to reduce costs, as any reduction in cost would be fully returned to consumers in terms of lower prices that is, there is a moral hazard problem. UniQuest File Reference: C01400 Page 3

13 In contrast, this paper explains that price cap regulation, also in its simplest form, addresses the moral hazard problem as, faced with a fixed price for the duration of the regulatory period, the regulated firm is fully incentivised to produce at the least cost possible. This is because the regulated firm retains 100 per cent of the amount that it underspends vis-à-vis the costs that it has been allowed to recover (the gap between the cost per unit of production and regulated price), at least until the next regulatory review. However, in a price cap regime where allowed costs are based on forecasts of future costs, the regulated firm will have an incentive to exaggerate such forecasts in its submissions, which is in effect an adverse selection problem. In addition, as it is not feasible to fix prices for the duration of the life of regulated assets, price caps are typically reviewed every three to five years. This review process raises the prospect of the costs incurred in the previous period being used to set future prices; this also introduces adverse selection. Moreover, the incentives to reduce cost under price cap regulation can also lead to underprovision of quality. The nature of the trade-off is that by making the incentives for cost reduction (vis-à-vis a baseline) stronger, price cap regulation may lead to the regulated firm reducing production cost at the expense of service quality. In practice, price cap regulation and rate of return regulation have many elements in common and both are subject to some degree of moral hazard and adverse selection. For example, costs that are reimbursed under rate-of-return regulation are often subject to ex-post, prudency (or efficiency) tests, which can mitigate the moral hazard problem. Similarly, under price cap regulation, cost forecasts from the regulated firm are often subject to a process of extensive review by the regulator, consultants and interested parties, which mitigates adverse selection. The paper also discusses intermediate forms of price regulation, or profit sharing schemes, where incentives for cost reduction are not as strong as under a price cap regime, or nonexistent as under a rate-of-return regime. Under a profit sharing scheme, the regulated firm shares a fraction of any cost savings (against the baseline cost set by the regulator) with consumers. Such a mechanism can be made symmetric, such that cost overruns are also shared with consumers. This type of regulation helps to reduce moral hazard, as the firm is still incentivised to reduce costs, and mitigates potential adverse impacts on quality as incentives for cost reduction are not as strong as under a pure price cap. The profit sharing fraction can be calibrated to determine how powerful the incentives for cost reduction are. Instead of setting a single profit sharing fraction and a single figure for the baseline costs, the regulator may offer a menu consisting of various choices for these parameters. A key insight UniQuest File Reference: C01400 Page 4

14 from the literature on incentive regulation, as highlighted in this paper, is that such a menu can be designed in order to provide incentives for the firm to choose a baseline cost that is closer to its expected cost of delivering the regulated services. While there may still be some incentive for the regulated firm to try to inflate the baseline cost, this incentive is lower than under a pure price cap regime. Moreover, the report covers benchmarking techniques that are useful in determining efficiency costs under both menu and price cap regulation. The discussion of implementation issues associated with various regulatory regimes provides useful insights into how incentive regulation works in practice, as well as its limitations. For instance, one feature is that the different treatment of capital expenditure (capex) and operational expenditure (opex) may lead the regulated firm capitalising operating expenditures (i.e. having an inefficient preference for capital solutions). This is known as a capex bias and it is an important reason for ensuring that incentives for capex and opex are not distorted by the form of regulation. The paper also highlights the distortion that a fixed regulatory period has on incentives and discusses practical approaches, such as setting up an efficiency carryover mechanism. Through this mechanism the firm is allowed to retain savings from underspend for a fixed period of time from when the savings are realised, rather than only until the next regulatory review. The conceptual framework developed in this paper, which includes both theory and general implementation issues, identifies three key potential issues arising from the incentives embedded in existing regulatory frameworks: the extent of asymmetric information, and the imperfect nature of ex-ante efficiency tests (and the limited use of benchmarking), mean that adverse selection is likely to be prevalent. This implies that the costs allowed by regulators are unlikely to reflect the full potential for efficient costs and regulatory outcomes might not be in the best interest of consumers; the different treatment of capex and opex may lead the regulated firm to capitalise operating expenditures (i.e. having an inefficient preference for capital solutions). This capex bias means that regulated firms are not spending customer s money to deliver the best outcomes in the most efficient way; and a fixed regulatory period (typically five years) distorts the regulated firm s decision as the strength of the incentives is reduced as the regulatory review date approaches. UniQuest File Reference: C01400 Page 5

15 The United Kingdom experience with incentive regulation The regulatory experience in the United Kingdom, especially in the water and electricity industries, provides some useful insights on what can be done to address these three issues. The review of the electricity distribution regulatory arrangements in the United Kingdom explored the role of incentive regulation in mitigating adverse selection. Allowing the regulated firm to choose from a menu of various combinations of allowed costs and incentive strengths provides powerful incentives for truthful revelation of expected costs while preserving the incentives for pursuing cost reduction opportunities. The use of a total expenditure (totex) menu, with a fixed split between fast and slow pots, eliminates any capex bias generated by applying different incentive rates to capex and opex. The experience of the water regulator, Ofwat, in addressing two of the three key issues, namely adverse selection and timing distortions, is also relevant. Instead of a totex menu to address adverse selection, Ofwat used a menu approach only for setting capex allowances. While in the latest review most companies proposed capex forecasts that were higher than Ofwat's baselines (in some cases, they were more than 30 per cent larger), it is difficult to evaluate whether this reflects gaming or truth-telling from companies. The companies actual expenditures throughout the regulatory review will provide important information that will inform the development of the menu for the next review period. To address the timing distortion, Ofwat used rolling incentives for opex, which was largely similar to the Australian Energy Regulator's (AER) approach, except that the scheme was asymmetric and one-off savings would be fully retained by companies. Ofwat also allowed more efficient companies to receive additional rewards through opex multipliers. Finally, the incentives for opex efficiency were considerably higher than that of capex, and this might cause a capex bias. This has motivated Ofwat to move to a totex-based approach for the next regulatory review. Clearly, regulators in the UK have paid considerable attention to the incentives that were embedded in previous decisions when designing new approaches to regulation. While incentives to exaggerate forecasts to try to influence the baseline in the menu may still exist, they are lower than under price cap regulation. Moreover, both water and electricity regulators in the UK make extensive use of benchmarking, increasing the effectiveness of the ex-ante assessment of the baseline. Australian experience There has been limited use of incentive regulation to address adverse selection by Australian regulators. They tend to rely exclusively on ex-ante assessments to overcome adverse selection UniQuest File Reference: C01400 Page 6

16 and make considerably less use of benchmarking than their United Kingdom counterparts. Nevertheless, the proposed approach of the AER focuses on incentive mechanisms (carryover schemes) designed to provide continuous incentives to pursue opex and capex efficiency. Under the AER s proposed regime, network services providers have the same level of incentives to underspend both capex and opex at any point in time, which also eliminates or mitigates capex bias. Implications for the QCA The QCA plays an important role in shaping the regulatory frameworks for water, retail electricity, ports and rail access in Queensland. With the exception of electricity retail, the other three sectors have natural monopoly characteristics and require price setting or monitoring. An assessment of the existing regimes would examine: the extent to which ex-ante tests are exclusively used for assessing efficiency and the potential for more extensive use of profit sharing/menu regulation; the extent to which benchmarking is used in ex-ante assessments of efficiency and the extent to which this could be improved; evidence of capex bias and, generally, whether incentives embedded (i.e. not explicit) in the regime favour capex over opex; and the feasibility of introducing efficiency carryover mechanisms to mitigate timing distortions. UniQuest File Reference: C01400 Page 7

17 1. INTRODUCTION This paper investigates the extent to which incentive regulation could be effectively employed in regulating firms subject to the oversight of the QCA. The basic aim of incentive regulation is to provide incentives for the regulated firm to take appropriate actions to deliver outcomes in terms of cost-reducing efforts, innovation, quality and investment that are consistent with those that would emerge in a competitive market. At a high level, incentive mechanisms include price and revenue caps, and profit-sharing mechanisms. However, in practice each of these high-level incentive mechanisms is supported by many other features that constitute the overall regulatory regime. These include the determination of allowed costs that the regulated firm can recover from customers, the duration of the regulatory period, the determination of the price path, and the existence of opportunities for the firm to seek cost pass-throughs. The interaction between various aspects of the regulatory regime determines the overall power of incentives provided to the regulated firm. While this interaction may well lead to incentives for cost reduction, efficient production and investment decisions, it may also create perverse or unintended incentives for the regulatory firm, such as distorting the decision of when to invest or what type of expenditure to undertake. The approach of this paper is to first develop a conceptual framework to assess when incentive regulation can be useful and the format that it should take. In order to achieve desirable outcomes (those consistent with achieving economic efficiency), the regulatory framework and associated tools need to ensure that: (a) (b) the regulated firm has the incentive to outperform the allowed costs; and the gap between the regulated firm's efficient cost and allowed costs is minimised without compromising desired quality. These requirements are related to the fundamental problem of information asymmetry. Information asymmetry exists when the regulated firm has better information about its cost profile and demand attributes than the regulator setting the firm's prices. At the same time, the regulator does not observe the firm's managerial effort directly. Given the circumstances, the best the regulator can do is to ensure that the regulated firm has sufficient incentive to pursue UniQuest File Reference: C01400 Page 8

18 efficiency (if there is scope to do so), and attempt (within the regulator's capabilities) to reflect any efficiency improvements in the regulated prices over time. Clearly, these two requirements are linked. Outperformance can easily occur if the existence of information asymmetry between the regulator and firm leads to setting allowed costs that are greater than the expenditure required to deliver outputs, or to understating the scope for future efficiency improvements. At the same time, regulation needs to ensure that there is no distortion causing the firm to favour one type of expenditure over another (for example, capital expenditure over maintenance). Having defined a conceptual framework, the second step is to examine implementation issues that have the potential to create a wedge between theory and practice. In general, this step entails identifying the issues and considering the implications for designing a regulatory regime. The third and fourth steps involve reviewing relevant international and Australian experiences with a view to exploring how the implementation issues have been resolved in practice to date. The focus is on experiences that are most relevant to the industries regulated in Queensland. UniQuest File Reference: C01400 Page 9

19 2. THE CONCEPTUAL FRAMEWORK Consider the problem facing an economic regulator responsible for setting the price that a regulated firm is allowed to charge customers. In particular, assume that the regulator sets a unit price based on a unitised cost, which includes the return on assets and amortisation (economic depreciation). That is, the firm is subject to a break-even constraint but costs include a return on and of capital. The focus of this preliminary analysis is on setting a price for a single, homogenous service that allows the regulated firm to recover its costs under circumstances where the regulator knows less than the firm about the costs of providing such a service. The optimal tariff structure for efficient allocation of fixed costs to heterogeneous consumers is not considered in this paper. Before exploring the details of different forms of incentive regulation, it is first helpful to explain how incentive regulation is related to optimal natural monopoly pricing. The standard model of natural monopoly regulation is illustrated in Figure 1. The regulated monopolist produces a single product and faces economies of scale and a constant marginal cost. The firm s average cost (denoted by AC), marginal cost (denoted by MC), demand (denoted by D), and marginal revenue (denoted by MR) curves are depicted below. Under standard assumptions, marginal-cost pricing is the first-best option because it leads to maximisation of social surplus (i.e. zero deadweight loss). 1 However, in this example (natural monopoly), marginal-cost pricing does not allow the regulated firm to recover its fixed costs the point where the demand and marginal-cost curves intersect is below the average cost curve (see Figure 1). In this case, first-best pricing would require government transfers (subsidies) to the firm to ensure financial sustainability of the firm. Average-cost pricing is second best in the sense that it is the minimum common price that allows the firm to recover its costs in the absence of government transfers. The basic model typically assumes perfect information the regulator has all the relevant information and will hence set the price at P. In practice, as discussed in more detail below, the regulator faces the problem of information asymmetry. The regulator might not know where the cost and demand curves lie. Often, the price set by the regulator is forward looking and based, 1 Short run marginal cost is the optimal cost concept to the extent that it measures the additional cost to society of the incremental decision. Fixed costs are not included in marginal costs and are costs that are not sensitive to the marginal output decision. They need to be financed if the firm is to stay in operation in the long term but in terms of social welfare they are not relevant in terms of defining the optimal level of output. The optimality of this rule from an economic efficiency perspective requires that all relevant costs (including any external costs) be reflected in marginal costs and that the rule is applied uniformly elsewhere in the economy (the problem of the second best). See Kahn (1995). UniQuest File Reference: C01400 Page 10

20 at least partly, on the information provided by the firm about the expected cost of providing the service. The firm then has an incentive to exaggerate such costs. Even if the firm provides accurate cost forecasts, it might be inefficient and have a higher AC curve than one associated with best practice. Incentive regulation is a tool to encourage the firm to provide more accurate cost forecasts and to operate more efficiently so that in the long run the regulated price will converge to the efficient level despite the information asymmetry. Figure 1 Standard model of natural monopoly regulation. 2.1 Rate-of-return versus incentive regulation Rate-of-return regulation The problem faced by a regulator with limited information about the regulated firm s cost profile can be illustrated by assuming that the regulated firm can either be high cost (c h ) or low cost (c l ). The difficulty arises from the fact that, if the regulator asks the firm what the cost will be of providing the service to consumers, a low-cost firm has an incentive to pretend to be a high-cost firm, as by doing so it secures a higher price and hence higher profits for the firm. This phenomenon is known in economics as an adverse selection (hidden information) problem. Rate-of-return regulation (also known as cost-of-service regulation) represents a solution to this problem. Instead of asking the firm what the cost of providing the service would be, the regulator simply sets the price (or resets it after a year) to allow the regulated firm to recover costs that have actually been incurred. Since the price is based on realised costs, subject to auditing and other requirements (for example, inputs are purchased from third parties through competitive tendering), the issue of hidden information is no longer relevant. This assumes that auditing of costs will be effective in addressing the information advantage of the regulated firm. As prices are based on costs that have already been incurred, it is convenient to think of rate-of-return regulation, at least in this stylised form, as a form of ex-post regulation. UniQuest File Reference: C01400 Page 11

21 The guarantee of cost recovery, however, introduces another problem known as moral hazard. Given that it is not possible for the regulated monopolist to earn additional profits above the rateof-return determined by the regulator, there will no economic incentives to exert any managerial or cost-reducing efforts. There are no "excess profits" left on the table. In addition, as capital attracts a regulatory rate of return, while operating and maintenance expenses do not, and to the extent that the allowed rate of return is greater than the firm s true cost of capital, the firm might have an incentive on the margin to overinvest in capital assets. This is known as the Averch-Johnson effect, which can manifest itself through gold plating or biased technology choices. 2 In practice, however, rate-of-return often includes ex-ante or ex-post prudency reviews of capital investment and operating expenses. While it is unlikely that these reviews can completely overcome the information asymmetry problem, they may mitigate adverse selection and moral hazard. 3 Moreover, as explained further below, the incentive on the margin to overinvest in capital might also emerge even under price-cap regulation. Therefore, in practice the distinction between price cap and rate of return regulation is less stark than what is assumed in the basic stylised examples. Rate-of-return regulation has evolved over many decades (mostly in the US given the prevalence of privately owned utilities) through a combination of judicial and legislative oversight, advocacy by firms, governments and other interest groups, and an increased understanding of the challenges involved in regulating prices. This evolutionary process has incorporated elements of incentive regulation, a theme that is explored in more detail below. Nevertheless, as the focus of this paper is on the fundamental differences between different regimes, it will be useful to refer to the stylised (or abstract) versions of the existing regulatory arrangements Price caps In contrast to rate-of-return regulation, under price-cap regulation the regulator sets a maximum price that the firm is allowed to charge customers. The key idea is that as the price cap is established and fixed ex-ante by the regulator based on cost and demand forecasts, such arrangements will create incentives for the regulated firm to be cost efficient. If the cost allowance indeed reflects the efficient level, the corresponding price cap will impose cost discipline on the regulated firm (to deliver the service at efficient costs) as the firm does not 2 Averch (2008). 3 See, for example, Joskow (1974 and 1989) and Joskow and Schmalensee (1986). UniQuest File Reference: C01400 Page 12

22 recover any spending above the pre-determined cost allowance. 4 If the cost forecast is inflated (i.e. inefficient) or there is an unanticipated scope for productivity improvements, the firm will be incentivised to pursue cost efficiency as it will earn higher profits by delivering the regulated service at cost levels lower than initial forecasts. Therefore, there is no longer a moral hazard problem. 5 The use of price caps, however, reintroduces the issue of adverse selection. The regulated firm has the incentive to exaggerate cost forecasts the regulator uses to determine prices higher cost allowances translate to higher prices, hence higher profits for the firm. Higher approved cost allowances mean there will be more room for outperformance (which increases the firm's profits) during the regulatory period. The regulator does not have perfect information to determine whether the regulated firm s cost proposals reflect best practice. Another key difficulty with a price-cap regime is that regulated assets have very long lives and economic circumstances can change quite drastically over time. Thus it is neither desirable nor feasible to fix the price a regulated firm can charge for the next thirty to forty years. In practice, prices are set for much shorter periods, typically three to five years, creating opportunities for the regulator to take account of information such as actual costs and demand during periodic price reviews. Thus, any economic rents excess returns above normal levels that would exist in competitive markets that may arise when prices are set ex-ante are only earned until the next price review (if the productivity gain is observable to the regulator). A shorter review period can potentially reduce the incentives for the regulated firm to initiate long-term cost reduction for fear that it would not be able to fully benefit from such actions, as the price cap might be adjusted downwards at the next review to reflect the firm's new cost profile. This is one of the distortions introduced by undertaking periodic price reviews. This issue is pervasive in the implementation of any type of incentive regulation and it involves consideration of the optimal period length where prices are fixed. This is discussed further in Chapter 3. Price reviews also rely on a number of auxiliary mechanisms, such as information gathering, auditing, and accounting systems that were traditionally associated with rate-of-return 4 While it is possible to set the cap too tightly, which could result in the regulated firm facing financial distress, in practice there is a range of mechanisms, including automatic pass-through of certain costs and the possibility of reviewing prices prior to the end of the next regulatory period, that minimise such risk. 5 There are additional incentives associated with price-cap regulation. The regulated firm has an incentive to maximise quantity sold as long as the regulated price cap is above its incremental cost of increasing supply. This is why incentivising regulated firms to invest in energy efficiency requires decoupling revenue from quantity. See, for example, Brennan (2010). The interaction between different incentives is discussed further below. UniQuest File Reference: C01400 Page 13

23 regulation. The use of these mechanisms reinforces the view expressed above that, in practice, the distinction between price cap and rate of return regulation is less pronounced than what is widely assumed in the theoretical literature. When price caps were first introduced, mostly following the process of vertical separation and re-regulation of infrastructure businesses that took place around the globe in the 1990s, there was an expectation that competition might replace regulation as the governance mechanism for the determination of prices in sectors such as electricity, telecommunications, and rail. 6 Competition did not materialise in many regulated markets, and, in fact, price cap regulation was extended to other sectors, such as termination charges for mobile telephony (the rate that mobile companies charge other mobile companies to terminate a call in their network). Price-cap regulation, like rate-of-return regulation, has evolved over time a process that is accompanied by a number of implementation challenges. The real-world application of price cap mechanisms is complicated in practice, interacts with a range of other incentive schemes, and deviates considerably from the stylised version described above. Chapter 3 explores many of the implementation issues in more detail, including how to set initial prices and the different approaches for adjusting prices until the next regulatory review under a price cap regime. It also discusses some of the mechanisms that have emerged to address particular shortcomings of price-cap regulation, including cost pass-throughs that allow the regulated firm to shift certain risks to consumers, and efficiency carry-over mechanisms that allow the firm to retain additional profits resulting from a cost reduction initiative beyond the next regulatory review. These mechanisms, along with a legal and administrative framework that allows for effective information gathering, have in practice been crucial for implementing a sound regulatory regime Revenue cap Revenue cap regulation entails the regulator setting the maximum revenue that the firm is allowed to charge its consumers over the regulatory period. A revenue cap is similar to a price cap, in the sense that they both provide incentives for the regulated firm to reduce costs, as long as the firm is allowed to retain some benefits from any cost savings. The key difference between a price cap and a revenue cap is who bears the volume risk: 6 Beesley and Littlechild (1989). UniQuest File Reference: C01400 Page 14

24 (a) (b) Under a price cap, the firm bears the volume risk. A price cap is fixed prior to the start of the regulatory period based on forecast demand. Actual revenue earned will depend on the actual demand. Under a revenue cap, customers bear the volume risk. The firm recovers the revenue cap irrespective of the actual demand. Future revenue allowances are adjusted to ensure that the firm recovers (or returns) any revenue as a result of under- (or over-) performance in demand that has occurred previously. This difference means that there may be a moral hazard problem under a revenue-cap regime. While the regulated firm facing a revenue cap has the incentive to be cost efficient (if there is no clawback of abnormal profit), it has limited incentive to improve total demand (for example, the number of trains running in a rail network) as the firm does not benefit from any increase in demand from its customers the maximum revenue it can earn is capped. 2.2 Optimal regulation As discussed above, while rate-of-return regulation can address the adverse selection problem, it does not address the issue of moral hazard as the regulated firm faces no incentives to contain costs. In contrast, under price-cap regulation the regulated firm is incentivised to reduce costs, but adverse selection is reintroduced, as the firm might have a perverse incentive to exaggerate cost forecasts the regulator uses to determine prices. Perhaps not surprisingly, the optimal (second-best) regulatory mechanism includes both ex-ante and ex-post elements, such that the regulated price is partially determined ex-ante but can be subsequently adjusted to reflect certain types of deviations from predicted costs. 7 This can be implemented through a profit-sharing agreement where the firm and the regulator agree on how to share any excess profits with customers. Laffont and Tirole (1993) have shown that the optimal mechanisms can be implemented by a menu of contracts with different combinations of fixed and variable components. To illustrate the reasoning behind this result, consider a regulator that allows the regulated firm to choose between a fixed price (price cap) and an ex-post price based on realised costs. This menu allows the regulator to offer a lower price cap relative to the case of a pure price-cap regime. If the firm cannot break-even (in terms of cost recovery) at the price cap offered, it will simply choose the 7 This refers to the best outcomes from a societal viewpoint taking into account existing constraints such as asymmetry of information by the regulator who does not know the regulated firm s costs. In the absence of asymmetric information, and considering a single homogenous product, second best refers to average cost pricing. See Lipsey and Lancaster ( ). UniQuest File Reference: C01400 Page 15

25 ex-post arrangement. The break-even constraint still includes a return on capital and depreciation. In contrast, a firm with unitised cost below the specified price cap has an incentive to select the fixed price arrangement. This is because the firm will be able to retain any excess profits from its cost reduction efforts (at least until the next pricing review). Customers will benefit in two ways: (1) the price cap is lower than what it would be if the firm did not have the options; and (2) there would be lower prices in the long run, as periodic price reviews would adjust prices to reflect any improvements in the firm's efficiency. In reality, as there are many possible types of firms (in terms of cost attributes) and the regulator has limited information with regard to the regulated firm s type, it is best to offer a range (menu) of contracts with different combinations of a fixed (ex-ante) price and an ex-post rule. These combinations are chosen to take into account the regulated firm s break-even constraint and to ensure that low-cost firms choose a high-powered scheme (that is, a larger weight on a fixed price) and high cost firms choose a lower powered incentive scheme (that is, a larger weight on the ex-post arrangements for cost recovery). 2.3 A simple analytical framework Following Joskow (2013), a simple analytical formulation of the optimal regulatory contract for the basic case where the regulated firm can be either high or low cost is presented here. Note that the firm is assumed to be operating on its efficiency frontier regardless of its cost-type (i.e. a high-cost firm will have high efficient cost with normal managerial effort), but the frontier can shift over time through productivity gains realised by additional managerial effort. The allowed unit price is denoted by p, the firm s actual realised unitised cost by c, and the regulator s assessment of the efficient costs by c. For ease of explanation, the quantity is normalised to one so that there is no distinction between the unit price and revenue. The allowed unit price can be expressed as: p = α + (1 β)c In this formulation, the allowed unit price (which can also be interpreted as the allowed revenue) is determined based on a fixed component α and a second component that is contingent on the firm s realised costs c and where β is the sharing parameter that defines the responsiveness of the firm s revenues to realised costs. The different regimes can be characterised as follows: UniQuest File Reference: C01400 Page 16