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.