Where one network is cheaper than two, competition is not the answer and the price has to be set by somebody.
Two families of instrument do it, and each creates a different distortion.
How does rate-of-return regulation work?
Rate-of-return regulation sets the price so the firm recovers its prudently incurred costs plus a fair return on invested capital. The revenue requirement is built line by line: operating expenses, plus depreciation, plus a tax allowance, plus the allowed rate of return multiplied by the rate base, which is the regulator-approved value of the assets used to serve customers. Divide by volume for the tariff.
The distortion has a name and a date. Harvey Averch and Leland Johnson showed in 1962 that a firm allowed a return above its true cost of capital has an incentive to over-invest in capital. Every additional rupee in the rate base earns the allowed spread for as long as the asset lives, while every rupee of operating cost saved is handed to customers at the next tariff review.
The bias is not a moral failure. A manager who chooses the capital-intensive solution is doing exactly what the regulation rewards.
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How does price-cap regulation work?
Price-cap regulation breaks the link between the firm's own costs and its own price. The regulator sets a starting tariff and a formula, usually inflation minus an efficiency factor X, and fixes it for a control period of four or five years. Inside the period the firm keeps every rupee it saves, including savings with no capital component at all.
Price caps create their own two problems, and both are visible in real determinations. The first is quality: with revenue fixed, the cheapest route to a margin is to cut maintenance, so a cap regime that is not paired with enforceable service standards and penalties will degrade the asset. The second is the ratchet. If the regulator resets X at the next review to claw back everything the firm outperformed, the firm learns that outperformance is confiscated and stops trying in the second period.
The length and credibility of the control period is therefore the real policy variable, more than the value of X itself.
Hybrid regimes, and one cost saving under both
Two hybrids sit between them. Sliding-scale or earnings-sharing regimes let the firm keep a stated fraction of outperformance and return the rest, trading incentive strength for consumer protection. Yardstick regulation sets one firm's allowance from the measured costs of comparable firms, so a firm cannot inflate its allowance by inflating its costs, provided the comparators really are comparable.
Worked Example 7 builds a revenue requirement and then runs the identical cost saving through both regimes. Under rate-of-return regulation a saving that requires capital is worth something to the firm and a saving that requires no capital at all is worth exactly zero. Under a five-year cap the same saving is worth over fifty million dollars.