Printed in the Business Monday newspaper on April 11th, 2011
The Fair Trading Commission, as a regulator of public utilities, has a mandate to ensure that each utility operates efficiently so that rates are kept as low as possible. At the same time the Commission must offer utility companies an opportunity to make a reasonable return on their investment in order to ensure their long-term sustainability as well as safeguard the reliability of supply to customers.
It is critical that the method of regulation implemented by the
Commission sends the right signals to both the utility and the consumer
so that the overall efficiency of the system is safeguarded. This
article will look specifically at price regulation and the range of
approaches generally relied upon by regulators to generate the most cost
effective utility rates.
There are four primary approaches to regulating the overall price of
utility services - rate of return (cost of service) which the Commission
applies to the Barbados Light & Power Co. Ltd.; price cap
regulation which the Commission uses to regulate Cable & Wireless
(Barbados) Ltd. (trading as LIME); revenue cap regulation, and
benchmarking (or yardstick) regulation. The latter three techniques
separate cost of service from revenue earned for a pre-specified period,
allowing companies to benefit from increased earnings if they can
reduce the cost of providing the regulated service.
Under Rate of Return (ROR) regulation the operator’s revenue requirement
is determined and prices set so that the utility company attains this
In rate of return regulation all costs are passed through therefore the
consumer assumes the risks associated with increased input costs and the
company bears a correspondingly lower risk on its own. Low risk for
utilities is especially important in electricity regulation since fixed
costs are high and the ability of the utility to attract loans and
investment is critical to its ability to provide reliable service. The
main limitation of the ROR system is that it typically does not provide
as many incentives for efficiency and innovation as other regulatory
schemes. The success of any rate of return system depends on the ability
of the regulator to ensure that the utility is prudent in the use of
resources and that it does not engage in behaviour that increases rates
Price Cap Regulation allows an operator to increase its rates annually
by an amount equal to an inflation factor minus the productivity factor.
This system of regulation allows the utility to capture the benefits of
actions it takes to increase efficiency during the term of the plan
before the formula is reset. One disadvantage of this system relates to
the calculation of the productivity factor which may be difficult to
quantify. Price Cap uses a formula to determine the maximum allowable
price increases for a regulated operator’s service for a specified
number of years.
Revenue cap is a variation of the price cap system which is sometimes
used in electricity regulation. The difference between revenue cap and
price cap is that there is a maximum set on the total revenue the
company can gain rather than just on the average price. The utility can
vary prices as long as the maximum allowed revenue is not exceeded.
Revenue cap regulation is more appropriate than price cap regulation
when the cost of operation does not vary very far from what is actually
used. An example might be electricity distribution where distribution
lines drive costs, but prices are often based on kilowatt-hours of
Benchmarking refers to the process of using data from other similar
firms from different locations; or from other types of businesses in a
market with similar risk. This data is used to determine appropriate
targets, indicators or returns for the utility being considered. In
benchmarking the cost level that a utility is expected to achieve may be
compared to another utility that is similar. Alternatively a utility
may be compared to another whose costs are different, in such cases
adjustments are made for differences in input costs. Note however that
benchmarking is not generally used on its own but in conjunction with
cost of service regulation and incentive regulation.
Regulators also use a combination of these basic forms of regulation.
Combining forms of regulation such as adding performance elements to the
standard ROR regime, is called hybrid regulation. One method which
maintains the use of basic rate of return methodology yet provides
incentives for better performance is revenue sharing. In this method the
company is encouraged to increase its rate of return but any additional
earnings must be shared with consumers.
In some cases the regulator may develop efficiency or reliability
indicators which the utility must comply with in order to earn the
returns allowed by the regulator’s decision. Such mechanisms add
performance elements to the standard ROR regime.
The appropriate combination of rate of return, price or revenue caps, or
benchmarking, depends among other things on a country’s goals, the
level of competition in the utility sector, and economic stability. The
Commission continually evaluates the types of price regulation applied
to the regulated sectors and makes changes if and when necessary to
ensure the provision of efficient regulated utility services.