Revenue-cap regulation

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Revenue-cap regulation is a system for setting the prices charged by regulated monopolies by limiting the total revenue in a given period. It is contrasted with rate-of-return regulation, in which utilities are permitted a set rate of return on capital, and with price-cap regulation where price is the regulated variable.

As with price-cap regulation, the system uses "CPI - X", or, in the United Kingdom "RPI-X" to set revenue caps. This takes the rate of inflation, measured by the Consumer Price Index (UK Retail Prices Index, RPI) and subtracts expected efficiency savings X. The system is intended to provide incentives for efficiency savings, as any savings above the predicted rate X can be passed on to shareholders, at least until the price caps are next reviewed (usually every five years). A key part of the system is that the rate X is based not only a firm's past performance, but on the performance of other firms in the industry: X is intended to be a proxy for a competitive market, in industries which are natural monopolies.

The choice of a revenue-cap rather than a price cap means that the regulated enterprise does not face any quantity risk. This may be appropriate in cases, such as electricity distribution, where the quantity demanded is largely outside the control of the regulated firm, and where costs may be insensitive to short-term variations in quantity demanded.

In practice, the distinction between revenue-cap and rate-of-return regulation may be lost, as regulators may end up making implicit decisions on the acceptable real rates of return on capital employed in order to arrive at price limit determinations.

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