Good Regulatory Lags

Abstract

The regulatory lag- the number of years between price reviews - determines the power of a price-cap contract. Around the world, most price-cap contracts have a regulatory lag of four to five years. However, this practice doesn’t seem to be based on any optimality consideration.Schmalensee (1989) used a static model to study the optimal power of regulatory contracts. He found that medium powered contracts are generally superior to the polar cases of high or low powered contracts. In this paper, we extend the Schmalensee model to a dynamic setting to study “good” regulatory lags for price-cap and rolling-cap contracts.Rolling-cap contracts are a variant of price-cap contracts that were recently introduced in the United Kingdom. We study a particular linear quadratic structure using numerical simulation and different combinations of demand and cost parameters.We find that if we ignore the waste of resources in price reviews, a 2 year lag is the median of the optimal distribution. Also, a benevolent regulator will prefer in most of the cases a rolling-cap contract over a price-cap contract. However, with a reasonable level of waste in price review process (1% of sales) a four year lag is the median of the optimal lag distribution. In this case, price-cap contracts become more attractive than rolling-cap ones in more cases. The great dispersion in the distribution of the regulatory lags indicates that a case by case approach based on relevant fundamentals is a better strategy for the regulator.