input prices, quality and efficiency targets imposed by the regulator. The possibility that costs and
prices can diverge during the regulatory period provides firms incentives to implement cost-
reducing investment and innovations aimed at improving operating efficiency to outperform the
efficiency target.
Incentive regulation, such as a price cap that does not account for quality changes appropriately,
encourages the regulated firm to increase profit by reducing service quality at unchanged prices.
And typically, there have been complaints that service quality declined shortly after price caps
were introduced.5 In order to prevent the firm from reaping extra profit by reducing quality, the
regulator may wish to adjust the regulated price by some measure of quality.
2.3 Regulatory features affecting investment behaviour
There are a number of additional features of regulation besides the basic pricing regime that can
result in under-investment.6 These include basically, the so-called regulatory asset base, the
timing of regulatory reviews and uncertainty about the regulator’s actions („regulatory
opportunism’).
The regulatory asset base and cost disallowances
The so-called “regulatory asset base” or “rate base” is a critical regulatory parameter, which
constitutes the base for the calculation of the rate of return. If the rate base includes all assets of
the firm, the firm may be tempted to invest imprudently. To avoid this problem, regulators may
select investments that they allow to be included in the rate base.7 Such “cost disallowances” may
lead firms to cut back or reschedule investment plans (Guthrie, 2006). If the regulator assesses a
firm’s investment ex post rather than ex ante, it will use information that was not available at the
time the investment decision was made. Consequently, the regulator may not allow the inclusion
of the whole investment to the rate base.
5. This has been reported in the United Kingdom and the United States' telecommunication sectors,
for example (Laffont and Tirole, 2001)
6. Other factors, not considered here, that can influence investment include difficulties in obtaining
environmental licenses and planning permission or complying with health and safety
requirements.
7. While this is primarily a concern for rate of return regulation, the regulator may take into account
planned investment during regulatory price reviews in incentive price regulation. For example,
Hern (2001) reports that the water regulator in the United Kingdom allowed generous capital
expenditure programmes until 1999, at which point it set more ambitious efficiency targets with
lower implied rate of returns.