Efficiency properties of price cap regulation
Price cap regulation has been used to control the monopoly behaviour of utility firms in the UK since 1984. The RPI-X regime currently in operation is very different to the regulatory mechanism originally proposed, and to the theory of pure price cap regulation. We therefore argue that it is necessary to examine how the mechanism is actually designed and implemented, if we are to determine its impact on economic welfare. A detailed description of RPI-X regulation is presented here. This description is used to examine the impact of the price cap mechanism on allocative efficiency, technical efficiency and the efficient delivery of quality of service. We also examine the impact of regulation on welfare by calculating the rate of growth in productivity in the water and electricity sectors since privatisation. Our analysis of the efficiency properties of RPI-X regulation exposes flaws in the regime. There is, however, scope to change the regulatory contract and potentially increase welfare. First, the way in which the price cap is set can be altered. For example, a revised methodology can be used to share cost savings with consumers. Alternatively, the form of the contract can be changed so that more restriction, than a single cap, is placed on the firm's price choice. We consider how the proposed changes may deliver a higher level of welfare given the constraints of the existing legal and institutional framework. The limited relevance and feasibility of the proposed changes, arising from the characteristics of demand and cost functions in the regulated sectors, are also emphasised.