Implementing incentive compatible menus of contracts to regulate electricity distribution investments

• Evaluating efficient network investment is a key issue in distribution regulation.
• Menus of profit-sharing contracts encourage efficiency and mitigate uncertainty.
• However, this mechanisms is rarely used mainly because clear guidelines are missing.
• A simple approach to construct incentive compatible menus of contracts is proposed.
• For illustrative purposes, its implementation in the Spanish context is discussed.

Investment regulation constitutes one of the major difficulties in regulating monopolistic activities such as electricity distribution. Information asymmetries and uncertainties over technology and demand especially hamper the evaluation of the efficiency of network investments. In this context, ex-ante regulatory schemes with ex-post corrections such as profit sharing contracts can be particularly useful. Moreover, menu regulation could encourage distribution firms to provide regulators with more accurate information. However, such a mechanism is rarely applied in electricity distribution. In order to facilitate its diffusion, this paper provides clear guidelines to construct incentive compatible menus of profit-sharing contracts and discusses its possible implementation in Spain.