ASi" kUCTURE FlOR DEVELOPMENT

private management can become complacent about tance phone services, price caps on the dominant
making the right investments and keeping costs provider, AT&T, are thought to be the only instrudown.
ment needed because profits are limited by compet-
The response-has been to design new "incentive" ing suppliers. But where local monopolies exist (as
regulations in which the prices a provider is al- in local telephone services), rate-of-return considerlowed
to charge do not hinge on costs incurred. ations can reassert themselves so that, over time,
Thus, if costs increase, profits are lowered; if costs price-cap regimes may converge toward their ratedecline,
the provider and investors enjoy greater of-retum predecessors. Nonetheless, price caps do
profits. Incentive regulation therefore seeks to moti- have the advantage of shifting a greater part of the
vate providers to use their superior knowledge of financial risk onto providers of infrastructure seroperating
conditions to lower costs and introduce vices, who cannot be sure that the regulator will
new services.
allow them to recoup excess costs. This threat en-
Price caps. An example of incentive regulation is courages tighter self-monitoring of performance.
the increasingly popular price-cap, or "RPI-X," Yadstick conmpetition. When direct competition or
method for determining permitted increases in ser- competition from producers of substitute products
vice price. RPI is the percentage increase in the retail will not work, competitive forces can be replicated
price index (other indexes of costs that the provider through comparisons with performance elsewhere.
does not control can also be used), and X is the (pre- A utility in one region can be motivated to perform
determined) expected percentage increase in the better by promises of greater rewards if its perforprovider's
productivity- The infrastructure provider mance exceeds that of a similar utility in another rehas
an incentive to lower costs, since gains in pro- gion. However, only if the utilities' input prices,
ductivity greater than the expected X percent con- market demand, and government regulations
tribute to increased profits. To maintain intcentives equate can better performance be attnbuted to the
for efficient production, the X-factor should remain efforts of the utility.
unchanged for a period of several years.
A number of countries use yardstick competi-
Price caps are diffusing widely to different tion, fornally or infonrnally. In France the contracts
countries and, gradually, to sectors other than of the local water company often depend on the
telecommunications, where they originated. The quality of services and their production costs rela-
United Kingdom has led the way, using pnce caps tive to those of other French water companies. The
in airports, telecommumications, electricity distri- water sector regulator in the United Kingdom relies
bution, gas, and water supplv. Elsewhere, how- explicitly on cost comparisons. The Chilean teleever,
their main application has been in telecom- communications industry uses an important vanant
munications, with electricity distribution a distant of yardstick competition. A hypothetical "efficient"
second. In Mexico, for example, the government firn, rather than other Chilean finns, is used in setintroduced
price-cap regulation for Telmex in Jan- ting the prices that telecommunications suppliers
uary 1992 which applies a price cap to the overall can charge. International cost and price trends are
weighted average priee of Telmex's services, rather used to estimate the performance an efficient firm
than a specific pnce cap for each service. In the should achieve, and prices are established based on
United States many state regulatory commissions this estimate. Within this framework, the more effihave
shifted from rate-of-return to price-ap regu- cient the Chilean firm, the larger its financial relation.
Where comparison is possible, as between wards. In electric power, reasonable distribution
different states in the United States, the evidence is costs are estimated for three "reference systems,"
that price caps lead to lower prices than does rate- which vary according to such key determinants as
of-return regulation.
distribution costs, population density, and peak de-
There are also some enirly indications that the dif-- mand. Individual electricity distributors are placed
ference between price-cap and rate-of-return regula- in one of these three systems, and delivery prices
tion may not be as great as originally tlhought Price are regulated accordingly. A distributor benefits if it
caps are rardy observed in their pure form. Most delivers electricity more cheaply than the average
rgulators see a continued need to assess the rate of provider in its reference system. However, manipureturn
and so set the caps on estimaftcs of profitabil- lation of "reference system' costs by the few suppliity,
once again increasing the information require- ers in the market has driven the government to exmeits
for effective regulation. An exception arises plore improvements in its use of benchmarks.
when profits are under the control of competitive Although yardstick competition is limited by the
forces. For example, in the U.S. market for long dis- need for sufficiently refined and comparable infor-
50: