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



First, theory suggests that none of the existing regulatory regimes is immune to the danger of
over- or under-investment in network infrastructure. Whether a particular regime provides firms
incentives to invest depends to a large extent on the particular set-up of the system. While rate-of-
return regulation is traditionally thought to result in over-investment, the more recent literature
emphasised that under-investment can also occur under certain circumstances. The regulated firm
may choose to under-invest if the timing of the regulatory cycle is too short to recoup investment
costs or, it may also decide not to invest, delay investment or invest sequentially (or to increase its
leverage) in the case of regulatory uncertainty. The regulated firm may also cut back investment
in the face of uncertainty arising from the use of
ex post rather than ex ante information with
regard to the inclusion of investment in the rate base.

Second, while it is widely accepted that incentive price regulation is a powerful tool to eliminate
short-run cost inefficiencies, it is also thought to incite regulated firms to under-invest in network
infrastructure with a view to increase short-term profits. Like rate-of-return regulation, incentive
regulation may depress investment if the regulatory cycle is not long enough to break even, if the
regulator revises efficiency targets before the next review period, if it sets unrealistic efficiency
targets or if the rate base is evaluated with the wisdom of hindsight. The fact that risk is shifted
back from consumers to shareholders implies higher risk and higher cost of capital also
potentially translating into less investment.

Third, regulated firms may nevertheless want to increase investment spending because incentive
price regulation offers more opportunities to increase revenue and profit by investing in cost-
reducing technologies. A regulated firm will engage to upgrade its existing infrastructure if it
decreases operating costs, if it permits the launch of new profitable services or to improve service
quality.

Fourth, the empirical literature suggests that shifting away from traditional rate-of-return
regulation did not generally cause under-investment in network industries. For instance, overall
investment in the UK railway sector did increase in the aftermath of privatisation and the
introduction of incentive regulation. Empirical studies also highlight that incentive regulation was
very helpful in promoting the deployment of new technologies in the US telecommunications
sectors in the late 1980s and early 1990s.

Finally, the empirical results in this paper suggest that the introduction of incentive price
regulation or the establishment of an independent sector regulator do not have a positive influence
on investment by themselves. However, once these policies are implemented jointly, they are



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