Price, quality and regulation: An analysis of price-capping and the reliability of electricity supply

This paper examines the relationship between price cap regulation and the reliability of supply of a private monopoly. Two situations are considered: one in which reliability is excluded from the price cap; and one in which it is included. If reliability is excluded, it is shown that there is a tendency for the firm to protect profits by lowering reliability when cost increases must be absorbed, whereas if reliability is included then this tendency is eliminated. However, this inclusion creates an incentive for the firm to exploit the positive relationship between price and reliability when cost increases can be passed on. But this problem can be controlled by reducing the exogenous weight applied to reliability in the price cap formula.