Cost Reductions, Cost Padding, and Stock Market Prices: The Chilean Experience with Price-Cap Regulation

Every four years, you feel you are going to war.

Alejandro Jadresic, former Minister of Energy of Chile

The flaws of traditional rate-of-return regulation are well known. They include a lack of incentives to reduce costs, as well as a tendency for firms to choose the wrong mix of inputs and to misreport costs in order to inflate the revenues allowed by the regulator. Political discretion in implementing this regulatory regime may further discourage efficient investments by giving firms reason to fear holdup problems after investments are made, particularly when consumer groups are able to capture the regulator.¹

The introduction of price-cap regulation was expected to correct some of these problems. By guaranteeing prices rather than returns and by using long regulatory lags, a price-cap system gives firms the incentive to cut their costs, since they get to keep the residual between prices and costs. Beesley and Littlechild, for example, argue that price-cap regulation “is less vulnerable to ‘cost-plus’ inefficiency and overcapitalization.”² Moreover, price caps largely limit firms’ incentives to game the system, both because adjustments within review periods are predetermined and because, in practice, review procedures often include an element of yardstick competition.³ Limiting regulatory discretion is expected to be particularly useful in developing countries. Price caps can potentially enhance political commitment, reduce holdup problems and lobbying by regulated firms, and therefore encourage more efficient investment decisions.⁴ Another advertised benefit of price-cap regimes is the reduced burden it places on the regulator. These theoretical advantages have encouraged the adoption of price-cap regimes across the developed and developing world.

Partly because of the system’s relatively recent introduction, little empirical work has been carried out on industry performance under price-cap regulation. Some empirical work focuses on the U.S. telecommunications sector, which has used a price-cap system for several years. Mathios and Rogers provide evidence of significant price reductions (of up to 7 percent) in states that changed rate-of-return for price-cap regulation.⁵ A number of issues naturally arise. Do price reductions measure the extent of efficiency gains? Was this a one-off gain, or will further efficiency gains materialize over time? Moreover, since states adopt regulatory changes voluntarily, one should also wonder if these reductions are simply capturing the fact that these states have very active regulators (that would have achieved similar reductions with rate-of-return systems), rather than reflecting a general property of price caps. Are these gains bound to occur in other countries that adopt price caps, or are they very dependent on having a judiciary system of U.S. levels of independence?

Another important open question is the distribution of efficiency gains between firms and consumers. It is often argued that to make price caps less vulnerable to capture by producers or consumers, the system should remove discretion and contain a high degree of commitment. But this could make the system more vulnerable to strategic behavior by firms. In other words, the cost of credibility is a set of inflexible rules that may not always serve the regulatory needs of the country.

In this paper, we collect data on the performance of firms in the Chilean electricity distribution industry from 1988–99. The sector is characterized by privately owned firms operating in a regulatory system that was designed to operate as a pure price cap based on a significant regulatory lag (four years), with the explicit intent of reducing political discretion. The regime adopted has the properties that characterize price-cap regimes.⁶ The broader institutional setting allows for a meaningful test of the performance of regulatory institutions, since Chile’s judicial system and administrative bureaucracy compare favorably to other countries.⁷ Perhaps the most significant feature of the Chilean price-cap regime is the attempt to explicitly limit the regulator’s discretion at regulatory reviews. This includes a request to construct a model efficient company from which to derive the rates that will apply to all companies of...