The political economy of incentive regulation: Theory and evidence from US states

The determinants of incentive regulation are an important issue in economics. More powerful rules relax allocative distortions at the cost of lower rent extraction. Hence, they should be found where the reformer is more concerned with stimulating investments by granting higher expected profits, and where rent extraction is less necessary since the extent of information asymmetries is more limited. This prediction is consistent with US power market data. During the 1990s, performance based contracts were signed by firms operating in states where generation costs were historically higher than those characterizing neighboring markets and the regulator had stronger incentives to exert information-gathering effort because elected instead of being appointed.

► More powerful incentive rules produce lower allocative distortions and lower rent extraction. ► More powerful incentive rules produce higher profits and stronger investment inducement. ► The most powerful rules should be observed where the extent of asymmetric information is lowest. ► The most powerful rules should be observed where the reformer's investment concern is strongest. ► The model's predictions are consistent with recent reforms in the US power market.