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



1. Introduction

Liberalisation, privatisation and the introduction of incentive regulation has often been viewed as
a way to promote infrastructure investment in network industries. For example, the separation of
electricity generation and transmission in the United States was intended to boost investment by
encouraging more entry into the market (Ishii and Yan, 2006). Yet, problems arising after the
opening-up of network industries have often been attributed to falling investment in network
infrastructure. For example, a series of fatal train accidents in the United Kingdom (Southall in
1997, Paddington in 1999 and Hatfield in 2000) was widely blamed on under-investment, while
the blackouts in California in 2001 and in New York, London, Italy, Denmark and Sweden in
2003 were largely blamed on under-investment in electricity generation or transmission grids
(Bialek, 2004; Pollitt, 2007; Hirschhauser
et al. 2004; Joskow, 2006).).

Part of the divergence between ex ante expectations and ex post outcomes can be explained by
incoherencies in the overall framework of the reforms. For example in the electricity sector,
Jamasb and Pollitt (2005) argue that introducing sustainable competition in electricity generation
and distribution requires action with respect to liberalisation, privatisation and regulation. First,
vertical unbundling of generation, transmission and distribution (and horizontal splitting in
generation) is necessary to ensure competition by preventing a vertically-integrated company
acting strategically to curb competition and to prevent new entry. Second, privatisation of public
incumbents in generation and distribution is desirable to ensure a level playing field which may
otherwise be prevented by their easier access to capital than for new entrants. Finally, setting up
an independent regulator is needed to supervise the transmission network operator and regulate
prices were needed. It is also claimed that the choice of the regulatory regime may also have a
bearing on the outcome. For instance, traditional forms of regulation such as rate-of-return
regulation that caps the return on the capital and more recent forms of regulation comprising price
cap regulation that incentivises the regulated firms to become more efficient may influence the
investment decisions of the firms.

Against this backdrop, this paper reviews theory and empirical evidence on the effect of
regulation on investment in network industries and on the relevance of consistency of the
regulatory framework for sectoral investment behaviour. The paper then assesses empirically the
impact of the overall regulatory framework on sectoral investment in network industries in a
sample of OECD countries. The main findings of the literature review and the empirical analysis
are the following:



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