sharing schemes that stipulate that the regulated firm must pay back part or the totality of the
excess profit to consumers.12
Regulatory uncertainty may not be fully eliminated, however. For example, under incentive price
regulation the potential efficiency gains may not be fully exploited if the regulated firm faces the
risk that the regulator would impose price caps at the next regulatory review which are partly
based on its past performance.13 Under rate-of-return regulation, what is included in the
regulatory asset base is likely to be a persistent area of uncertainty for the regulated firm.
Implications for the different pricing regimes
In sum, the differences in investment behaviour between rate-of-return and incentive price based
regulation can rest on features of the regulatory regime. As firms under rate-of-return regulation
are comparatively unresponsive to changes in demand, the regulator needs to play an important
role in determining what investment is needed. Furthermore, due to the inherent tendency of
investment being allocatively inefficient there will always be a conflict between the firm and the
regulator over what is included in the regulatory asset base. To some extent, this conflict will be
ex post and regulatory decisions may not adequately reflect ex ante risks. In this light, the
regulator needs to be well informed to minimise allocative inefficiency and ensure that
investment is sufficiently reactive to changes in demand and technology. By contrast, firms
operating under incentive price regulation regimes will have higher levels of allocative efficiency
and will have incentives to invest in cost-saving technology. Such firms, however, face higher ex
ante market-driven risk, which -- other things being equal -- requires a higher rate of return. To
the extent that regulatory risk and uncertainty are present (driven by the timing of the reviews and
changes to the implicit rate of return during pricing reviews, for example), investment will also be
affected. Regulatory uncertainty and risk can be potentially mitigated by granting the regulator
independence and a suitable mandate.
12. Profit sharing was introduced in 1987 in the US telecommunication sector and by 1993 almost
half of US states adopted this regime (just to switch to price cap from the mid-1990s). Under
profit sharing, several rates of return may be specified. Below a given rate of return (for instance
10%), the regulated firm can keep all profits, for a range of rates of return (for instance between
10% and 15%), it can retain part (for instance 50%) of the profits, whereas above a specific level
(for instance 15%), excess profit has to be disbursed to consumers. Threshold rates of return, the
shares to be paid above the threshold and the regularity with which profit rates are monitored
have implications on the extent to which profit sharing reduces or increases incentives for cost
efficiency and investments (Greenstein, McMaster and Spiller, 1995).
13. This is known as the „ratchet effect’ which creates an upper bound on the regulated firm’s
efficiency gains (Freixas, Guesnerie and Tirole, 1985) and lowers the firm’s cost-reducing
investment.