In practice, price adjustment clauses are an important element in the tariff regulation for services where the private partner's revenues result from charging final users. If the price review is frequent and the price adjustment is backward-looking, i.e. the regulatory lag is small and past changes in costs are considered to compute a new tariff level, the private-sector party has little incentive to undertake cost-reducing efforts. This is so because, if the private-sector party anticipates that any cost reduction in the present will lead to a tariff reduction in the future, it may prefer not to exert cost-savings efforts. The literature refers to this incentive distortion phenomenon as the 'ratchet-effect' (Milgrom and Roberts, 1992). The situation is the opposite when the regulatory lag is large and the price adjustment is forward-looking, i.e. expected future changes in costs are considered in tariff determination. In this case, the private-sector party do have incentives to undertake cost-savings efforts because it can reap the benefits from lower than expected costs until the next price review (Laffont and Tirole, 1993; Armstrong et al., 1994).62
In the review, the tariff cap should be adjusted by inflation and efficiency gains in a forward-looking way, i.e. using expected values for inflation and productivity growth, so that ratchet effects are avoided. By introducing a forward-looking price indexation, the regulator attempts to compensate the private-sector party for expected costs overruns outside its control. And by subtracting expected efficiency gains, a transfer is made to consumers through a lower relative price of the service. In addition, excessive profit-making by the private-sector party is deterred; to be precise, the private partner appropriates additional benefits to the extent that cost-savings efforts increase efficiency above the expected level already discounted in the current tariff.63
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62 In practice, however, 'expected' costs tend to be computed using projections based on historical costs, so the line dividing forward- and backward-looking tariff determination blurs.
63 From this observation, an implication is derived for choosing the optimal regulatory lag in a price cap regulation. A trade-off arises when a lengthy lag is considered: on the one hand, the private-sector party has incentives to undertake cost-reducing efforts because it might exceed the expected efficiency gains; on the other hand, there is a higher probability of allocative inefficiency arising from the excessive profits that will be observed if the private-sector party actually exceeds the expected efficiency gains (Armstrong et al., 1994).