Investment and quality incentives under price cap regimes

Price caps (also known as RPI-X or incentive regulation) encourage regulated companies to cut costs through the profit incentive, by fixing revenues irrespective of the company's own costs for a certain period. However, eventually, cutting costs become less important than incurring costs to expand the level of supply or to maintain and improve its quality. This paper describes two different methods of encouraging expenditure within a price cap regime. In the Netherlands, the regulator intends (from 2007) to use quality indices to adjust price caps for variations in service quality, to encourage expenditure on network reliability. In Britain, the regulator has adapted price caps so that allowed revenues are linked more closely to each company's own costs (while retaining incentives for cost cutting). This paper contrasts each model and discusses what motivates regulators to strengthen the link between price caps and a company's own costs.