Commitment in utility regulation: A model of reputation and policy applications

This paper builds a dynamic model of utility regulation where a government cannot commit to a time-inconsistent policy of not expropriating investment. By allowing the government’s type to change over time, I explore how reputation concerns may generate partial commitment. Restricting attention to equilibria that are strongly renegotiation proof, I show that there is a unique perfect Bayesian equilibrium. This contains episodes of investment and good behaviour followed by periods of expropriation and non-investment. I then apply the model to consider how the power of the incentive scheme and decentralization may influence the properties of this equilibrium. In the case of the power of incentives, the model suggests that price-caps may worsen commitment in developing countries, but not in developed ones. Similarly, the model suggests that decentralisation is likely to have a significant effect on commitment, but that this effect will depend on the general ability of the government to commit. Overall, we conclude that the effect of such policies on commitment will be different across countries, depending on the institutional environment.

► I model government regulation when optimal policy is time-inconsistent.
► A government’s concern for its reputation may generate partial commitment.
► The model is applied to two policy issues in utility regulation.
► I show how the effect of these policies on commitment depends on the country context.