Dynamically-Efficient Incentive Regulation: Application of the Bad News Principle

Abstract

Incentive regulation allows decentralised decision-making under regulatory parameters set on the basis of industry characteristics. When there is uncertainty, sunk costs, and flexibility in the timing of investment a monopoly will invest later than is socially desirable because it garners only a fraction of the benefits. This study considers the design of regulatory profit caps based on a measure of cost, either historical or replacement cost, to which a regulatory rate of return is applied. It demonstrates that the sources and extent of supply and demand uncertainties, and thereby characteristics of the industry, determine whether historical or replacement cost regulation is desirable. The welfare optimising level of the regulatory rate of return differs between historical and replacement cost regulation, this return is generally higher than the weighted average cost of capital, and welfare is degraded much more if it is set below, as opposed to above, the optimal regulatory return.

Keywords: Uncertainty, Sunk Costs, Incentive Regulation

JEL Classification: G18, G31, L5