There is a difference between the regulatory requirements of utilities, such as waste management, electricity, water, and telecommunications, and other forms of public infrastructure, such as roads.
Tariff adjustment mechanisms for utilities are discussed below within two basic categories: cost-plus mechanisms and price-cap mechanisms.
Cost-plus or rate of return mechanisms permit regulated firms to pass all operating expenses and capital costs on to the consumer, including an after-tax return on investment. Under this system, there is no adjustment unless the operator applies to the regulatory authority and requests a review and reset.
The regulator reviews the operator's overall cost base in response to any proposal that higher (or lower) prices are needed to cover their full costs. In theory, this approach provides the best match of prices to incurred costs, but delivers weaker incentives for efficient operation and development since the recovery of a rate of return is assured.
Cost-plus regulation has the potential to encourage firms to inflate operating costs, rather than pursue efficiency. It nevertheless has a strong element of certainty from an investment perspective, which may mitigate risk.
Revenue or price-cap regulation, on the other hand, provides a more direct incentive for efficiency. Revenue or price caps are put in place to control the quantum of revenue over a period or specific prices, but the firms are given leeway to increase earnings through performance improvements. Under this mechanism, a firm can change its price level and its tariff structure according to an index that typically includes an inflation measure and a "productivity offset" (commonly called the X factor). This approach may provide a stronger incentive to improve efficiency and reveals the true costs of providing services.
The choices of regulatory approach is driven by many factors, including the economic expertise available, the accounting and auditing system, investment requirements of a sector, and motivation for efficiency. During the early stages of development when regulatory capacity is being developed, price caps may be a better choice. Prices can be set high enough to attract capital. At a more mature stage of regulation, cost-plus mechanisms might be appropriate to attract large-scale investment.
Many regulatory systems encompass aspects of revenue or price-cap and cost-plus mechanisms in a hybrid, tailored approach, as well as methodological approaches to sector-specific issues.
Nevertheless, the form of regulatory system should be subject to detailed analysis and consideration, which takes account of country, sector, industry, and infrastructure capital investment profiles.
Regulation of nonutility infrastructure PPPs takes a slightly different form and is typically articulated through the PPP contract. Under an infrastructure PPP, the fundamental goal of regulation is to allocate risks rationally and maintain stability between risk and expected return.