The Promotion of Innovation in Regulated Network Industries

Abstract

The capital intensive network industries such as electricity and gas delivery infrastructures exhibit natural monopoly characteristics because of their high economy of scale relative to the size of the market. Due to the absence of direct competition in these regulated industries, infrastructure providers hardly undertake the appropriate level of innovation activities to optimise the operation and continuity of their services; a review is provided to show how different countries support innovation in the network industries. As innovation activities are costly and risky undertakings, a relevant query is how to incentivise innovation through economic regulations. This paper models three generic schemes of innovation promotion: individual incentive contracts, competitive innovation fund and cooperative innovation program. We show how each of these schemes affects the firms' incentives for innovation activities. The results confirm the effectiveness of all three schemes. However, implementing an individual incentive contract is information-intensive, while competitive or cooperative schemes do not require an informed regulator. A comparison is provided between the schemes.