Infrastructure Investment in Network Industries: The Role of Incentive Regulation and Regulatory Independence

CESifo Working Paper No. 2642

Infrastructure Investment in Network Industries:
The Role of Incentive Regulation and Regulatory
Independence

Abstract

This paper finds that coherent regulatory policies can boost investment in network industries
of OECD economies. Rate-of-return regulation is generally thought to result in
overinvestment, while incentive regulation is believed to entail underinvestment. Yet,
previous empirical work has generally found that the introduction of incentive regulation has
not systematically changed investment in network industries. According to the theoretical
literature, regulatory uncertainty exposes both types of regimes to the danger of
underinvestment. However, regulatory uncertainty is arguably higher under rate-of-return
regulation because investment decisions (what can be included in the rate base) are usually
evaluated in a discretionary manner, while firms operating under incentive regulation are less
affected by this behaviour. In addition, incentive regulation encourages investment in cost-
reducing technologies. Using Bayesian model averaging techniques, this paper shows that
incentive regulation implemented jointly with an independent sector regulator (indicating
lower regulatory uncertainty) has a strong positive impact on investment in network
industries. In addition, lower barriers to entry are also found to encourage sectoral investment.
These results support the importance of implementing policies in a coherent framework.

JEL Code: L51, L97, L98.

Keywords: network industries, regulation, incentive regulation, price cap, cost-plus
regulation, rate-of-return regulation, regulatory independence, investment.

Balazs Égert

OECD, Economics Department

[email protected]

The author is indebted to J0rgen Elmeskov, Tomasz Kozluk, Giuseppe Nicoletti, Jean-Luc
Schneider, Fabio Schiantarelli, Douglas Sutherland, and participants of an OECD internal
seminar, as well as Irene Sinha for editorial assistance. The opinions expressed in this paper
are those of the author and are not necessarily shared by the OECD.

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