The regulator’s decision making and uncertainty
The move from rate-of-return to incentive price regulation shifts risk from consumers to
shareholders and consequently raises the cost of capital for the regulated firm. The implications
are that if the regulated firm is not allowed to earn a return on its capital that incorporates the
higher risk (the implicit rate of return determined by the price cap), it will not invest in new assets
(Alexander and Irwin, 1996). This risk would be exacerbated in cases when the regulator is
unduly influenced by politicians or the public and may be tempted to set prices or the rate of
return too low. Obviously, the regulated firm may choose to reduce investment faced with the risk
that its rate of return on investment may be seriously constrained. This may further discourage
high-return and, thus, more risky investments.
Uncertainty about the regulator’s actions poses a non-negligible threat to investment in network
industries. If the regulator is unable to make a credible commitment that it will not change prices
after the firm invests, the firm will tend to under-invest.9 The regulated firm may either delay
investment or invest sequentially to see the outcome at the next regulatory review. Regulatory
uncertainty does not only generate under-investment but will also affect the composition of the
investment, as the regulated firm may choose a technology with lower fixed costs (Spiegel, 1996).
The regulated firm can also react to the lack of commitment by issuing more debt. A rise in the
regulated firm’s leverage (debt-to-equity ratio) increases the probability of future financial
distress which may in turn induce the regulator to allow higher prices. 10 However, higher prices
may not eliminate the under-investment bias because the firm also faces the risk and costs of
bankruptcy stemming from higher leverage (Spiegel and Spulber, 1994).
Under-investment resulting from regulatory uncertainty can be mitigated by establishing
independent regulatory bodies.11 For example, credibility can be achieved through financial,
political and institutional independence from the government while being accountable to a
mandate. This can enhance the time consistency of policy and minimise uncertainty about future
actions. This sort of regulatory uncertainty can also be alleviated by implementing ex ante profit
9. The academic literature often uses the term “regulatory opportunism” to define this kind of
regulatory behaviour.
10. For instance, Bradley, Jarrell and Kim (1984) and Bortolotti et al. (2007) report evidence that
regulated firms have high debt to equity ratios in the United States and in Europe.
11. This is similar to the problem of a central bank that seeks to reduce inflation but that cannot fully
commit itself to its final objective (Kydland and Prescott, 1977; Stern and Trillas, 2003).