Regulatory Lags Research Articles

Regulatory lag, efficiency, and performance. Lessons from a case study

Our main contribution is to identify the risks implied by the existence of prolonged regulatory lags. We hypothesize that a likely first response is to reduce OPEX, increasing efficiency. If the lag persists for enough time, a vicious circle of inefficiency, disinvestment, and reduced performance can follow. We use a regulatory episode affecting natural gas distributors in Argentina as a natural experiment, controlling with other Latin American countries’ utilities not exposed to the same regulatory stimuli. We evaluate the relative efficiency of fourteen firms for five countries, in seven years, using Stochastic Frontiers Analysis (SFA). Thus, we perform a regulatory impact analysis (RIA) to assess the consequences on the performance of two idiosyncratic regulatory policy instruments applied in the distribution gas industry in Argentina in the 1998–2021 period (the 2002 Public Emergency Law and the 2016 Integral Tariff Review).

Reinforcement Learning for Blast Furnace Ironmaking Operation With Safety and Partial Observation Considerations.

Making proper decision online in complex environment during the blast furnace (BF) operation is a key factor in achieving long-term success and profitability in the steel manufacturing industry. Regulatory lags, ore source uncertainty, and continuous decision requirement make it a challenging task. Recently, reinforcement learning (RL) has demonstrated state-of-the-art performance in various sequential decision-making problems. However, the strict safety requirements make it impossible to explore optimal decisions through online trial and error. Therefore, this article proposes a novel offline RL approach designed to ensure safety, maximize return, and address issues of partially observed states. Specifically, it utilizes an off-policy actor-critic framework to infer the optimal decision from expert operation trajectories. The "actor" in this framework is jointly trained by the supervision and evaluation signals to make decision with low risk and high return. Furthermore, we investigate a recurrent version of the actor and critic networks to better capture the complete observations, which solves the partially observed Markov decision process (POMDP) arising from sensor limitations. Verification within the BF smelting process demonstrates the improvements of the proposed algorithm in performance, i.e., safety and return.

The low cost of quality improvements in the electricity distribution sector of Brazil

We analyze the impact of introducing output-based incentives in the price-cap regulatory regime of the Brazilian electricity distribution sector. We focus on the trade-off between operating costs and quality improvement, hypothesizing a positive relationship. Operating costs include maintenance and repair expenses. The regulator sets limits for service continuity and non-technical energy losses in each regulatory period. Service continuity refers to the average length of interruptions in electricity distribution. Non-technical losses refer to losses due to factors specific to the distribution segment. Quality incentives include peer-pressure and penalties/rewards for compliance with minimum quality standards. We model operating costs using a GMM framework to acknowledge endogeneity of variables. The model is dynamic given the inclusion of regulatory lags to recognize past cost behavior. Findings reveal a small trade-off between costs and quality. We conclude that quality improvements are not costly relative to the potential savings from complying with quality standards. We also find that the impact on operating costs is larger when energy losses increase compared to the cost effect due to increases in duration of outages. These findings suggest areas of attention in managerial decision making, and serve as valuable information to the regulator in tailoring quality incentives for this sector.

The Theory of Optimal Stochastic Control as Applied to Insurance Underwriting Cycles

We use the theories of optimal stochastic control and engineering process control to analyze the well-known phenomenon of insurance underwriting cycles in continuous time. We show in a continuous time framework that underwriting cycles can be explained with a model where premiums are set rationally, but where there are various reporting and regulatory lags. We find that the observed cycle length depends on the length of these underlying lags. Our result can be seen as consistent with previous empirical work showing underwriting cycles varying across countries and lines of insurance. In the event that no lags exist, our result is also consistent with more recent literature suggesting that insurance cycles may not exist.

Regulatory lags, liberalization, and vulnerability to banking crises

AbstractThis article explores the effect of delays in updating prudential regulation on the likelihood of a country experiencing banking crises, and it disentangles the impact of different aspects of regulation on crisis onset. I argue that delays in revision to banks' prudential regulation allow banks to adopt risky behavior, which increases a country's vulnerability to systemic banking crises. This effect, however, is conditional on the level of liberalization of the financial market. At lower levels of liberalization, banks have stronger incentives to escape the constraints of regulation and to take advantage of regulatory lags. At high levels of liberalization, the effect of regulatory lags is curbed, possibly by market discipline. Statistical analyses on a sample of developed and developing countries from 1974–2005 support this argument and help rule out the competing learning hypothesis. These results suggest that the effects of institutions can vary with the passage of time.

Regulatory Lags, Liberalization, and Vulnerability to Systemic Banking Crises

What factors make countries vulnerable to banking crises? Particularly, how do reforms in regulation affect the likelihood of banking crises’ onset? Several recent articles describe the “anatomy” of banking crises. However, the economic indicators that precede these crises do not necessarily imply causality. Furthermore, the broader literature on financial crises finds a set of institutional causal factors to be important for financial crises, but these factors likely do not apply to banking crises. In the last 20 years banking crises have affected countries that should be impervious to them, while countries at risk have been surprisingly resilient. I argue that differences in vulnerability to banking crises are a result of the asymmetry between financial market evolution and regulation update. Although regulation tends to follow the developments in the financial market everywhere, lags in regulation have different effects at different levels of financial market liberalization. This paper analyzes the interactions between financial market liberalization and regulation update on a world-wide sample between 1973 and 2006.

A modified yardstick competition mechanism

This paper expands Shleifer’s (Rand J Econ 16:319–327, 1985) theory of yardstick competition and develops a modified yardstick competition mechanism (MYC), where the yardstick employed consists of a tariff basket and total costs. This mechanism has a significant information advantage: the regulator “only” needs to observe total costs, prices and output of all firms. The MYC mechanism can ensure a socially optimal outcome when allowing for spatial and second degree price discrimination. We also introduce regulatory lags to the model. In addition, we compare the two approaches for the case of unobserved firm heterogeneity, and provide numerical estimations of the effects. The MYC mechanism fares better in the case of unobserved heterogeneity, and may thus be a useful extension of Shleifer’s yardstick mechanism.

Good Regulatory Lags

The regulatory lag- the number of years between price reviews - determines the power of a price-cap contract. Around the world, most price-cap contracts have a regulatory lag of four to five years. However, this practice doesn’t seem to be based on any optimality consideration.Schmalensee (1989) used a static model to study the optimal power of regulatory contracts. He found that medium powered contracts are generally superior to the polar cases of high or low powered contracts. In this paper, we extend the Schmalensee model to a dynamic setting to study “good” regulatory lags for price-cap and rolling-cap contracts.Rolling-cap contracts are a variant of price-cap contracts that were recently introduced in the United Kingdom. We study a particular linear quadratic structure using numerical simulation and different combinations of demand and cost parameters.We find that if we ignore the waste of resources in price reviews, a 2 year lag is the median of the optimal distribution. Also, a benevolent regulator will prefer in most of the cases a rolling-cap contract over a price-cap contract. However, with a reasonable level of waste in price review process (1% of sales) a four year lag is the median of the optimal lag distribution. In this case, price-cap contracts become more attractive than rolling-cap ones in more cases. The great dispersion in the distribution of the regulatory lags indicates that a case by case approach based on relevant fundamentals is a better strategy for the regulator.

The Interest Rate Risk Exposure of Financial Intermediaries: A Review of the Theory and Empirical Evidence

The paper surveys current and previous research on financial institutions’ interest rate risk exposure. The implications of such exposure are discussed and motivating insights are emphasized. Various theoretical frameworks and models are presented. For each one an overview of the studies and any relationship to each other is provided. In a cross‐industry analysis, other idiosyncratic risk factors are considered and their importance is delineated. A number of empirical relations are established. More specifically, there is an inverse relationship between interest rate changes and common stock returns of financial institutions. The intermediaries’ apparent yield sensitivity is mainly attributed to the duration gap inherent in their balance sheet structure. Furthermore, the aforesaid equity sensitivity due to other possible dynamics such as dividend yield, unanticipated inflation and regulatory lags is also considered. Changes in economic regimes have altered volatility in market yields with a subsequent effect, positive or negative, on financial intermediaries’ equity returns. The issue of the risk‐return compensation is further analyzed, and findings suggest that the interest rate risk is priced by capital markets. Finally, a few other issues are identified as avenues for future research.

Towards an efficiency interpretation of regulatory implementation lags

Regulatory agencies are often legally obliged to use a cost-benefit rule in revising environmental standards to reflect improvements in pollution-control techniques, but have considerable discretion over the timing of such revision. How should the agency use this discretion? Longer lags tend to encourage more intense R&D effort by the regulated industry itself whilst discouraging parallel effort by external developers. Optimal implementation lags are characterized. The analysis calls into question the conventional view that “footdragging” by agencies is necessarily evidence of incompetence or regulatory capture. More generally, whether or not subject to conscious manipulation by regulatory agencies, the delays routinely observed in implementation may enhance welfare.

Competition and ‘Local’ Communications: Innovation, Entry and Integration

This paper suggests that the imminent introduction of new local access competition using existing new technologies should end any possibility of a natural monopoly in local exchange. The paper questions whether the fundamental economics of the local exchange really require regulation of local telephone service rather than the narrow regulation of interconnection. It also points out that technological development is sharpening competitive forces in practically all aspects of telecommunications. Moreover, the willingness of some local exchange providers to unbundle has laid the foundation for a further rollback of regulation in areas of the USA. Finally, the paper contends that regulatory lags require that regulation take a forward-looking perspective and attempt to deal with the industry as it will be, not as it was. Copyright 1995 by Oxford University Press.

Interest Rates and Profit Cycles: A Disaggregated Approach

Interest Rates and Profit Cycles: A Disaggregated Approach Abstract Changes in the performance of property-liability insurers have been dramatic, resulting in problems that affect the supply of insurance and the solvency ofinsurers. Numerous researchers have examined the behavior of returns in this industry and have concluded that they may be characterized as cyclical. This paper redefines the nature of returns that are studied and concludes that disaggregated models with interest rate terms perform better than simple autoregressive models in explaining the behavior of profits. Introduction Recent movements in prices and profits in the property-liability insurance industry have led to the assertion that the industry returns are cyclical, and all previous empirical work supports this conclusion. Cycles in the underwriting profits of the property-liability industry have been attributed to a number of causes. Doherty and Kang (1988) attributed cycles to fluctuations in interest rates, Smith (1981) attributed them to regulatory lags, Stewart (1981) attributed them to changes in capital flows into the industry, Jablonski (1985) attributed them to adaptation under imperfect information, and Venezian (1985) and Cummins and Outreville (1987) attributed them to procedural lags in the process of estimating marginal costs. Most prior work has examined the available data in the context of highly restrictive models. This paper seeks to expand on prior work in several ways. One is to introduce financial variables to reflect the effect of investment returns for individual lines of insurance. The second is to improve upon the by-line models of Venezian (1985) by allowing the error terms in various lines of insurance to be contemporaneously correlated. The third is to determine whether an aggregate model for the industry or separate models for individual lines are more consistent with the data. Financial Variables Models of insurance determination [Biger and Kahane (1978), Kahane (1978), Fairley (1979), Hill (1979), Myers and Cohn (1981), Kraus and Ross (1982) and Venezian (1983)] lead to the conclusion that calculation of the required rate of return on equity from entering the insurance business should reflect both underwriting income and income derived from the investment of reserves and net worth. It is assumed that the measures of profit, both Joseph A. Fields is Assistant Professor of Finance at the University of Connecticut. Emilio C. Venezian is Chairman and Associate Professor of Business Administration at Rutgers University and President of Venezian Associates. underwriting and operating, are determined from a portfolio based model, where the level of return is based on the decision concerning the level of risk undertaken and exogenous economic variables. In view of the general agreement that overall operating profits and returns depend on both underwriting and investment income, it is surprising that cycles have usually been analyzed using data on the underwriting rather operating profit.(1) Foster (1977) showed that underwriting ratios do not contain as much information as operating ratios concerning the economic value of the insurance company. The use of operating margins would lead to an analysis of the cyclical nature of the true price of insurance representing both the economic profit to the insurer and the opportunity cost of funds to the insured. Interest Rate Effects Most of the models that address rate of return from insurance essentially focus on the that would occur in long-run equilibrium. Krauss and Ross (1982) argue that, in the context of their model, the risk free interest rate should be considered as a real or inflation adjusted rate if expected claim costs are set at current prices. On the other hand, if costs are based on forecasts that include inflation the appropriate rate of interest should be the nominal rate. …

The Pricing of Interest‐Rate Risk: Evidence from the Stock Market

ABSTRACTThis paper addresses the issue of whether firms are required to pay an ex ante premium to investors for bearing the risk of interest‐rate changes. A two‐factor APT model with the market and changes in the yield on long‐term government bonds as factors is employed. The paper shows that, empirically, most of the interest‐sensitive stocks are in the utility industries, and that there is reasonable evidence that the interest factor is priced in the sense of the APT. Several sources for the interest sensitivity are considered, and regulatory lags are focused on as a likely candidate.

Asymmetry of Information, Regulatory Lags and Optimal Incentive Contracts: Theory and Evidence

Asymmetry of Information, Regulatory Lags and Optimal Incentive Contracts: Theory and Evidence

Asymmetry of Information, Regulatory Lags and Optimal Incentive Contracts: Theory and Evidence

procurements. The procurement process and the equilibrium bidding behavior is modelled in sections II and III and the effect of contract parameters and other structural variables on expected procurement costs are explicitly derived. The existing models are enriched by incorporating a technology for cost reduction where the investment in cost reduction made by the contractor is unobservable to the utility. In the presence of such informational asymmetry, the optimal incentive parameter to be used is derived in terms of information available to the utility. In section IV the effects of changing contractual parameters and other structural variables (number of contractors bidding, the riskiness of the production process, etc.) on equilibrium bidding behavior and ex post cost reduction incentives are derived. In section V we relate some of the implications of our model to a sample

Asymmetry of Information, Regulatory Lags and Optimal Incentive Contracts: Theory and Evidence: Discussion

Asymmetry of Information, Regulatory Lags and Optimal Incentive Contracts: Theory and Evidence: Discussion

The Regulatory Cobweb: Inflation, Deflation, Regulatory Lags and the Effects of Alternative Administrative Rules in Public Utilities

The author argues that regulatory lag or the determination of regulatory prices based on previously recorded accounting costs generates a model of regulation quite similar to the classic cobweb model in agricultural economics. This model is then used to calculate the present value of the costs and benefits to consumers and to the regulated firm of the pattern of prices and outputs generated by regulatory lag as opposed to prices and outputs that might be generated by some regulatory equilibrium or textbook model of regulation in which price is always equated to average cost. The costs and benefits of regulatory lags in regulated electric utilities are calculated under alternative assumptions concerning demand elasticities, cost functions, rates of inflation, and rates of growth of demand. The model indicates the gains and losses due to regulatory lag may be quite large, and that the profitability of electric utilities is extremely sensitive to the rate of inflation under existing regulatory institutions. The model also provides some interesting insights into the currently observed phenomenon of voters simultaneously litigating against public utility rate increases (via various consumer groups) yet at the same time observing some basis of political support for various forms of aid tomore » utilities such as state guarantees of credit, increased investment tax credits, and outright subsidies. 26 reference.« less