[BETA] Fortnightly

Regulation of the United Kingdom's 12 regional electricity distribution companies (RECs) has sought to promote efficiency through the use of price caps that are supposed to remain in place for five years without regulatory intervention. The benefits of cost reductions between reviews accrue to shareholders no matter how much earnings might rise. The idea was to provide more incentive than if earnings were subject to review whenever they exceed some specified level.

Productivity has increased enormously under this system. However, the regulator has decided to revise the price caps that just took effect on April 1. The progress that the United Kingdom has made in insulating electricity prices from unpredictable regulatory intervention will be undermined unless it comes to terms with the subtle link between price-cap and rate-of-return regulation.

The U.K.'s price-cap regime was designed by Stephen Littlechild, director general of the Office of Electricity Regulation, the U.K. electricity regulatory agency. The price caps are reviewed at five-year intervals; each review sets the price for the initial year and provides a formula for price adjustments over the next four years. Basically, the formula allows the RECs to raise their rates for distribution services by the percentage change in the retail price index (RPI) less "X" percentage points. This is referred to as "RPI less X." If the RECs improve their productivity by more than the "X" factor, their profit margins and earnings will improve, and they will keep the benefits until the next price review.

The initial price review, which set prices for the five-year period ending March 31, 1995, was very successful. Productivity gains were extraordinary; earnings excellent. Some RECs have cut their headcount by as much as 25 percent, and rates of return on equity (ROE) have typically been in the area of 20 percent.

The Next Five Years

Given the high rates of return the RECs have been earning, industry observers expected Littlechild to cut prices sharply in setting price caps for the 1995-2000 period. Indeed, his preliminary proposal was tough enough to draw strong protests from some RECs. Unfortunately, Littlechild was at a disadvantage in evaluating whether the RECs' protests were valid, since the U.K. regulator does not have access to as much detailed company data as U.S. regulators. For this reason, or simply out of a disinclination to stand up to the RECs, Littlechild's final proposal was surprisingly lenient. Under the new price caps, the RECs stand to achieve ROEs that approach 20 percent for the next five years. The RECs gleefully embraced the proposal.

Nevertheless, the new price caps failed in two crucial respects. They did not cut the prospective ROE for the RECs to levels comparable to those earned elsewhere in the U.K. economy. Nor did they assign ratepayers as much of the productivity gains of the last five years as the public expected. These shortcomings have undermined public support for the privatization effort, reinforcing a perception that too much benefit accrues to shareholders and not enough to the public.

In addition, since Littlechild had clearly erred in favor of the RECs, he would likely