The Political Economy of Incentive Regulation: Theory and Evidence from U.S. States

by Carmine Guerriero

The determinants of incentive regulation are a key issue in economics. More powerful rules relax allocative distortions at the cost of lower rent extraction. Thus, they should be found where rent extraction is less salient because the information-gathering process is more efficient, and where the reformer wants to incentivize more investments through higher rents. This prediction is consistent with U.S. electricity market data. During the 1990s, performance based contracts were given to the firms whose generation costs were historically higher and operating in states where the regulators had stronger incentives to exert information-gathering effort because elected instead of being appointed. Considering the endogeneity of regulatory institutions to technological and political forces suggests that OLS overestimate the impact of incentive regulation on costs, which was negative and statistically significant.