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 revenue requirement.

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 unnecessarily.

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 electricity sold.

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.