Why incentive regulation?
40. Several witnesses contrasted
the RPI-X form of incentive regulation with the `rate of return'
method adopted in the US, which is based on controlling the profits
of regulated companies. A particular advantage of the rate of
return system is that it reduces the possible extremes of profit
or loss. However, a system which permits the firms to earn no
more than the specified rate of return each year does not give
the company strong incentives to reduce costs because the company
will receive no benefits from efficiency improvements.[65]
In fact, as we found when we visited the United States, there
is an incentive to undertake excessive capital expenditure in
order to expand the asset base on which the rate of return is
to be earned (a process known as `gold-plating'). This is regarded
as the major drawback of the rate of return system. The DTI and
the energy regulators argue that this system would also require
more regulatory intervention, for example, the rate of return
would have to be monitored closely.[66]
Mr Eggar described rate of return regulation as "too cumbersome,
costly and legalistic".[67]
He also pointed out that most countries introducing regulatory
systems "are adopting the United Kingdom system of price
control rather than the United States system." [68]
41. Several witnesses, including
the Energy Advisory Panel and Midland Electricity plc, regarded
the RPI-X form of incentive regulation as superior to rate of
return regulation because it gives management a direct financial
incentive to become more efficient, as well as allowing control
over the level of prices charged to consumers.[69]
If the company can increase efficiency by an amount greater than
that allowed for by the regulator it can retain the additional
profits (economic profit), for the period of the price cap.[70]
This provides powerful incentives to reduce costs. Conversely,
if efficiency improvements are less than expected, profits are
reduced. In addition, the price caps are reviewed periodically
in order to achieve an equitable balance between additional returns
to the shareholders from that improved efficiency, which maintains
incentives for the future, and the passing on of the further improvement
to consumers, either by a one-off cut in prices in the year following
the review, or by a tighter annual value for X (i.e. a lower price
to customers from the date of the periodic review).[71]
65 Ev. p.247; Mem. p.29. Back
66 Ev.
pp.248, 277, 324. Back
67 Ev.
p.71. Back
68 Q.311. Back
69 Mem.
p.117; Ev. p.324; Mem. pp.31-2; Ev. pp.276-7; Mem. p.51. Back
70 Mem.
p.116. Back
71 Ev.
pp.276-7. Back
