Implicit and explicit incentives within economic regulation

Abstract

In the wake of widespread privatisations of publicly owned utilities such as water, gas, electricity and telecommunications providers, regulatory systems have evolved to protect consumers from the often local monopoly or oligopoly power such organisations enjoy. Economic regulators impose inter alia price or revenue caps for the goods or services provided by the regulated entities. For this, regulators need to assess the scope for efficiency savings at such entities using historical and forecast data. There is, however, a moral hazard in regulated companies revealing the full scope for efficiency savings because the regulator can then incorporate them into ever more demanding efficiency savings in future. Relatedly, unduly demanding short term targets may compromise long term service delivery. It is incumbent upon regulators, therefore, to construct regulatory processes which incentivise entities to reveal progressively more efficient operating practices, which are genuinely achievable. The paper explores both explicit and implicit incentives in the context of economic regulation. Explicit incentives are those regulators have purposely designed to influence the choices regulated entities make. In contrast, implicit incentives are a form of by-product of the scientific models used to assess the scope for efficiency savings. The paper concludes with a summary of a new system put forward in the literature for incentivising firms to reveal efficient operating practices.