6.4. Price-cap regulation
After privatization, a form of price control may be required to prevent monopolistic behaviour and to encourage improvement in productivity (Littlechild, 1983). A price-cap regulation would be implemented to encourage the privatized utility to earn reasonable returns on new investment (the K factor) and to reward efficient production (the X factor). The price-cap can contain an automatic adjustment mechanism to allow for cost changes that are beyond the utility’s control, for instance, the price hike imposed by mainland China which supplied 70% of Hong Kong’s water in 1996. The
Hong Kong Government can continue to negotiate the terms of the supply contract with the Chinese authorities.
The annual adjustment in the price of this East River water can be included in the price-cap formula (the Y factor). Hence the price-cap formula can take the following form:
CPI + K - X + Y,
where CPI is the percentage change in consumer price index, K is the factor which reflects the percentage change in price required to finance expansion, X is the productivity factor (as a percentage) and Y is the cost passthrough.
Any change in the purchase price of water from mainland China would be automatically passed through to customers. The Y factor in the above formula is similar to the automatic fuel adjustment clause adopted by electricity companies in Hong Kong; it reflects the effect of any change in the factor price on the overall price level.