A dynamic model for firm-response to non-credible incentive regulation regimes

Economic network regulation increasingly use quantitative performance models (from econometrics and engineering) to set revenues. In theory, high-powered incentive regulation, such as revenue-caps, induces firms to cost-efficient behavior independent of underlying model. However, anecdotal evidence shows regulated firms occasionally maintaining cost-inefficiency under incentive regulation even under slumping profitability. We present a model for firm-level efficiency under a regime with a probability of failure explaining this phenomenon. The model is based on the hypothesis that the regulatory choice of method can be associated with intrinsic flaws leading to judicial repeal and replacement of it by a low powered regime. The results show that the cost efficiency policy is proportional to the type of firm (cost of effort), value of time (discount factor) and the credibility of the method (risk of failure). A panel data set for 2000-2006 for 128 electricity distributors in Sweden is used to validate the model predictions (radical productivity slowdown, failing profitability and efficiency) at the launch and demise of a non credible regulation method. The work highlights the fallacy of viewing incentive regulation as a method independent instrument, a result applicable in any infrastructure regulation. (C) 2015 Elsevier Ltd. All rights reserved.