Incentive Regulation in Theory and Practice: Electricity Distribution and Transmission Networks

Paul L. Joskow

Chapter in NBER book Economic Regulation and Its Reform: What Have We Learned? (2014), Nancy L. Rose, editor (p. 291 - 344)
Conference held September 9-10, 2005
Published in June 2014 by University of Chicago Press
© 2014 by the National Bureau of Economic Research

Public utility network industries--such as telecommunications, natural gas, electric power, and railroads--historically evolved as either state-owned or private regulated vertically integrated monopolies. Over the past thirty years, many countries have privatized and restructured these sectors. The reform program typically involves the vertical separation of potentially competitive segments, which are gradually deregulated, from remaining network segments, which are assumed to have natural monopoly characteristics and continue to be subject to price, network access, service quality and entry regulations. An important part of the reform agenda frequently includes the introduction of "incentive regulation" mechanisms for the remaining regulated segments, as an alternative to traditional "cost of service" or "rate of return" regulation. Although significant research has focused on the performance of potentially competitive segments that have been deregulated (such as the wholesale electric generation markets described in chapter four), the performance of new incentive regulation mechanisms in the segments subject to ongoing regulation is of considerable economic importance. This chapter reviews the theoretical and conceptual foundations of incentive regulation theory, discusses some practical implementation issues, and examines how incentive regulation mechanisms have been structured and applied. Particular attention is paid to its implementation in United Kingdom electric distribution and transmission networks, where the application of these mechanisms is most advanced. The implementation of incentive regulation concepts is more complex and more challenging than may first meet the eye. This has important implications for regulatory resources devoted to information collection, monitoring, and dynamic regulatory adjustments.

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