Incentive Regulation in Telecommunications: Why States Don’t Choose Price Caps

Abstract

Since 1984, when regulators in the United Kingdom began to apply one to British Telecom, “incentive regulation” schemes have been adopted for the telephone industry by the Federal Communications Commission (FCC) and by over 30 state regulatory commissions. The new regulatory plans are substitutes for the traditional United States vehicle of rate-of-return (RoR) regulation; the name refers to what the plans hope to overcome: the variety of perverse incentives associated with rate of return regulation. These perverse incentives include:

• Regulation can dampen incentives for innovation, if regulators quickly match revenue changes to cost changes. In doing so, regulators remove links between profits and either innovation or managerial efficiency. Without such a link, utility managers have weak incentives for innovation and cost control.

• If the allowed rate of return differs from the cost of capital faced by the firm, utilities will have incentives to use inefficient combinations of inputs (the Averch-Johnson effect), resulting in higher costs.

• Utilities have strong incentives, under RoR regulation, to misrepresent costs in order to obtain higher gross and net revenues.

• Conflicts among utilities, regulators, and other parties, due to unexpected changes in demand and input costs, as well as conflicts arising from recognition of perverse incentives, lead to large and growing costs of administering the regulatory compact.

• When a diversified utility sells service in unregulated, competitive markets as well as in regulated markets, RoR regulation can provide incentives to utilities to cross subsidize competitive markets, to misreport attributable costs, and to choose inefficient output levels (Braeutigam and Panzar 1989).