Tradeoffs in the Power of Regulatory Regimes

Dennis L. Weisman

doi:10.1515/bejeap-2023-0244

Article

Tradeoffs in the Power of Regulatory Regimes

Dennis L. Weisman

Published/Copyright: January 15, 2024

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From the journal The B.E. Journal of Economic Analysis & Policy Volume 24 Issue 2

Abstract

Performance-based regulation (PBR) has recently experienced increased popularity in North America and Europe. The genesis for this renewed interest in PBR is the potential to strengthen the regulated firm’s incentives for efficiency relative to traditional rate-of-return regulation. The strength of these incentives is referred to as the power of the regulatory regime (PRR). The PRR depends on the share of the efficiency gains retained by the regulated firm and the length of time that it retains them before being appropriated by the regulator acting as a surrogate for competition. Nonetheless, there are tradeoffs in the design of PBR plans that can render it inferior to traditional earning-based regulation in terms of incentive power. This may explain why the empirical evidence on the performance of PBR is best characterized as “mixed.”

Keywords: power of regulatory regimes; price caps; ratchet effect; earnings sharing; efficiency

JEL Classification: L51; L96

Corresponding author: Dennis L. Weisman, Department of Economics, Kansas State University, Waters Hall, Manhattan, KS 66506-4001, USA, E-mail: weisman@ksu.edu

Appendix A

A.1 Derivation of the Static Power of Regulatory Regime Metric (ρ)

The change in the regulated firm’s profits associated with a marginal reduction in c is:

(A1) d Π ̂ = − ∂ Π ̂ ∂ c d c = 1 − s 1 − d p d c Q − p − c d Q d p d p d c d c .

(A2) d Π ̂ = − ∂ Π ̂ ∂ c d c = 1 − s 1 − d p d c Q − p − c p p × Q Q d Q d p d p d c d c

Rearranging terms and simplifying yields

(A3) d Π ̂ = 1 − s 1 − d p d c 1 − p − c p × ε × d c × Q = ρ × d c × Q ,

which is the expression in (1).

A.2 Derivation of the Dynamic Adjustment Factor (DAF)

The regulated firm invests in cost-reducing innovation at the beginning of each period of the n-period regulatory regime. Each period’s investment yields current-period cost savings of $1.

NPV of Period 1 Investment Cost Savings:

1 + 1 1 + r + 1 1 + r 2 + 1 1 + r 3 + ⋯ + 1 1 + r n − 1 .

NPV of Period 2 Investment Cost Savings:

0 + 1 + 1 1 + r + 1 1 + r 2 + ⋯ + 1 1 + r n − 2 .

NPV of Period 3 Investment Cost Savings:

(A4) 0 + 0 + 1 + 1 1 + r + 1 1 + r 2 + ⋯ + 1 1 + r n − 3

NPV of Period n − 1 Investment Cost Savings: 0 + 0 + 0 + 0 + 0 + 0 + ⋯ + 1 + 1 1 + r .

NPV of Period n Investment Cost-Savings: 0 + 0 + 0 + 0 + 0 + 0 + ⋯ + 0 + 1.

Summing the expression in (A4) vertically yields the NPV of the cost savings for an n-period regulatory regime:

(A5) C S n , r = n + n − 1 1 1 + r + n − 2 1 1 + r 2 + ⋯ + 2 1 1 + r n − 2 + 1 1 + r n − 1 = ∑ i = 1 n n + 1 − i 1 1 + r i − 1 .

Two refinements are required for (A5). The first refinement is to express CS(n,r) as a proportion of the competitive benchmark for the NPV of a dollar in cost savings, C B l , r = ∑ j = 1 l 1 1 + r j − 1 . The second refinement is to divide CS(n, r) by n to obtain an average over the duration of the regulatory regime. The DAF is therefore given by:

(A6) D A F n , r , l = 1 n × C S n , r C B l , r ,

which is the expression in (2).

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Received: 2023-07-10

Accepted: 2023-12-28

Published Online: 2024-01-15

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Articles in the same Issue

https://doi.org/10.1515/bejeap-2023-0244

Keywords for this article

power of regulatory regimes; price caps; ratchet effect; earnings sharing; efficiency