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Flashcards in RPI - X vs ROR Deck (16)
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1
Q

What is ROR

A

Used for regulation of investor owned utilities in the US
Allows utilities to pass through costs deemed necessary by regulator to ensure adequate levels of service provided to customers
Allows the Utility to cover its operating and capital costs as well as a return on capital

2
Q

Aim of ROR

A

is it ensure that the industry concerned achieves a ‘normal’ ROR.

ROR involve close involvement of the regulator in the day to day planning and operation of the regulated business

3
Q

Weakness of ROR regulation

A
  1. Lack of incentive to reduce costs and improve efficiency
  2. High levels of information and intervention
  3. When ROR exceeds cost of capital, incentive to spend more capital
  4. Input choices by the firm will not be cost maximising
  5. The UK adopted the RPI-X to avoid the Averch-johnson effect
4
Q

The Averch-Johnson effect

A

If the rate of return is set to high it encourages firms to adopt inefficient high capital-labour ratios. This is known as the Averch-Johnson effect.

5
Q

Price Cap Regulation RPI-X

A

In the UK, price capping has been known as “RPI-X”. This takes the rate of inflation, measured by the Consumer Price Index and subtracts expected efficiency savings X. So for example, if inflation is 5% and X is 3% then an industry can raise their prices on average by only 2% per year

Littlechild’s BT report (1983) designed RPI-X system for the UK.

Price for the remainder of the price control are allowed to rise by the retail price index less X percentage points, where X is chosen by the regulator based on scope for technical progress and efficiency gains in the industry

If the firm is able to beat the cap then it can retain those profits until its next review

Strong incentive to minimise costs and adopt optimal ratios of the factors of production

No scope to pass on cost increases, or to make higher profits by expanding the capital base

6
Q

Advantages of RPI-X

A
  1. It is easy & inexpensive to implement
  2. Information requirement is modest
  3. System is flexible
  4. The system offers incentives
7
Q

Disadvantages of RPI-X

A
  1. Profitability of firm is scrutinised, not prices
  2. Resetting value of P0 and X is not an easy task
  3. Difficulty setting price right
  4. lack of quality incentives
  5. Incentives to ‘cut corners’
8
Q

ROR X formula

A

R= (B-xr) + E + D +T

9
Q

5 Criteria for fair ROR

A

 ROR substantial enough to attract capital > ROR too low > decline investment
 Regulators consider efficient consumer rationing of services
 Regulator must ensure regulated monopoly uses efficient management practices
 Must investigate long term stability > prospects
 Fairness to investors > receives capital it needs to satisfy investors

10
Q

RPI - X and ROR similarities

A

Both accept the need to secure an adequate return for the companys shareholders in order to induce them to continue to finance the business, without conceding unnecessary high prices at the expense of customers.

11
Q

Differences

A
  1. Exogenous risk period
  2. Forward looking approach
  3. Degrees of freedom
  4. less requirement to explain is that there is a greater scope for bargaining in RPI-X than in ROR.
12
Q

Exogenous Risk Period

A

RPI-X embodies an exogenously determined risk period between appraisals of prices, whereas ROR regulation makes the duration of this period exogenous.

In the UK the regulator can propose a modification of X in the risk period, something BT regulator considered

13
Q

RPI-X is more forward looking than ROR

A

The latter tends to be based on historical costs and demands, with adjustments for the future limited to an adjustment for inflation or the extrapolation of historic trends. In contrast RPI-X embodies forecasts of what productivity improvements can be achieved and what future demands will be and is set on the basis of predicted future cash flows

14
Q

More degrees of freedom

A

There are more degrees of freedom in setting X that are involved in ROR regulation. The latters system does allow flexibility but it would seem difficult to change these decisions repeatedly.

15
Q

UK regulator has more discretion

A

in setting X the uk regulator has more discretion and less need to reveal the basis for decisions than does his US counterpart. The US tradition is to place all evidence in the public record. In the UK, there is less pressure for due process. In the UK, neither governments nor regulators have given detailed reasons for their decisions on X. This reduces the basis for challenge.

16
Q

Conclusion

A

Whether the difference between RPI-X and ROR regulation is significant depends on whether or not the regulator is able to use the additional bargaining power affectively. This depends on the underlying scope for efficiency improvements and upon the extent and quality of the information available (Vickers and Yarrow, 1988). These factors will differ from one industry to another.