The Dynamic Efficiency of Regulatory Constitutions

Author(s): Richard J. Gilbert and David M. Newbery

Source: The RAND Journal of Economics , Winter, 1994, Vol. 25, No. 4 (Winter, 1994),
pp. 538-554
Published by: Wiley on behalf of RAND Corporation

Stable URL: https://www.jstor.org/stable/2555974

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 RAND Journal of Economics
Vol. 25, No. 4, Winter 1994

The dynamic efficiency of regulatory

constitutions

Richard J. Gilbert*

and

David M. Newbery**

In this article, we model regulation as a repeated game between a utility facing a random
sequence of demands and a regulator tempted to underreward past investment. Rate-of-
return regulation designed with a constitutional commitment to an adequate rate of return
on capital prudently invested is able to support an efficient investment program as a subgame-
perfect Nash equilibrium for a larger set of parameter values than rate-of-return regulation
without such a commitment. Furthermore, rate-of-return regulation is superior to price
regulation according to the same criterion, assuming that the regulator is unable to make
state-contingent transfer payments.

1. Introduction

* Traditional rate-of-return regulation of investor-owned utilities in the United States

requires determination of the assets that are employed by the firm (the rate base) and the
return to which those assets are entitled (the allowed rate of return). Regulatory commis-
sions rarely have strayed far from the principle that a utility is entitled to a rate of return
approximately equal to its cost of capital.' Instead, the focus of regulatory conflict has
been on the assets that should be included in the rate base. This conflict assumed critical
proportions in the 1980s, following large cost overruns and excess capacity from utility
construction programs, particularly nuclear and supercritical coal plants. Between 1980
and 1988, state commissions disallowed over $10 billion in utility investment in nuclear
projects (Oak Ridge National Laboratory, 1989).
In determining the assets that should be included in a utility's rate base, state regu-
latory commissions considered whether the management of the construction programs fol-
lowed norms of prudent business behavior and whether there was an economic need for
the capacity that was built. Both considerations, and particularly the latter, drew on the

* University of California at Berkeley.

** University of Cambridge.
We acknowledge financial support from the University of California Energy Institute and the British
Economic and Social Research Council. We are indebted to David Canning, Eddie Dekel-Tabak, Joe Farrell,
Drew Fudenberg, Michael Katz, John Panzar, Carl Shapiro, Pablo Spiller, and Menahim Yaari for their helpful
comments.
l The key U.S. Supreme Court decision dealing with the bounds of acceptable rate regulation is Federal
Power Commission v. Hope Natural Gas Co. (1944).

Copyright(C 1994, RAND 538

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 GILBERT AND NEWBERY / 539

standard that customers are obligated to pay only for capital that is "used and useful."2
Our objective in this article is to analyze the consequences of judicial constraints, and
specifically the used and useful requirement, in the context of a repeated regulatory re-
lationship. We view this requirement as a constitutional restriction that allows a regulator
to refuse compensation only for the portion of a plant that is idle. Much debate has oc-
curred regarding the extent to which disallowances under the used and useful doctrine
represent a failure of an implicit regulatory compact (see Howe, 1985). We show that in
a long-term relationship, the used and useful requirement has desirable efficiency prop-
erties compared both to a weaker constitution that allows the regulator to refuse compen-
sation for a plant that is actually used, and to a stronger constitution that requires the
regulator to compensate the firm for all investment.
Whether rate-of-return regulation can sustain an efficient investment path as a subgame-
perfect Nash equilibrium depends on the temptations for departure from the equilibrium
path. The advantage of the used and useful rate-of-return regulation (UUROR) constitution
is that it reduces the temptation for opportunism by the regulator, compared to a consti-
tution in which the regulator is not constrained to pay a normal rate of return on capital
that is used. The main problem in sustaining efficient investment lies in inducing the utility
to adequately punish the regulator for deviations. Even in the absence of optimal punish-
ments, UUROR is likely to be superior to rate-of-return policies that do not constrain the
regulator's ability to act opportunistically.
Rate-of-return regulation is often criticized for compensating a utility for its expen-
ditures, rather than for its performance, and for encouraging inefficient production choices.
Price regulation encourages efficient production in the short run. However, we show that
when a regulator uses state-contingent linear prices, the set of parameters for which the
regulator can sustain an efficient subgame-perfect Nash equilibrium is smaller than the set
sustained when the regulator uses rate-of-return regulation. The reason is that price reg-
ulation requires a high price in a state of high demand to encourage the firm to invest.
The high price gives the regulator a large incentive to deviate from her announced policy.
Despite the importance of continuing strategic relationships in public utility regula-
tion, there has been little effort to advance the state of the theory beyond the qualitative
analysis in Goldberg (1976) and Williamson (1976). Salant and Woroch (1992) use re-
peated games in a deterministic model of regulation, and Benhabib and Radner (1992) use
a similar approach in a bargaining model. Several articles explore the consequences of
regulatory commitment in a two-period model. These include Baron and Besanko (1987),
who examine optimal policies with and without commitment, and Lewis and Sappington
(1988, 1991), who consider the design of a regulatory charter that limits intertemporal
conflicts that arise between successive short-lived regulators with different objectives. Be-
sanko and Spulber (1992) examine incentives for investment in a two-period model of
regulation without commitment. Maskin and Riley (1985) analyze the conditions in a static
principal-agent model under which it is superior for a regulator to condition payments on
the basis of a firm's inputs (as in rate-of-return regulation) instead of its outputs (as in
price regulation).

2. Technology and demand

* In each period t, the utility chooses a nonnegative level of investment to bring total
capital in the next period up to the desired level, K,+,. To simplify the analysis, we assum

2 The used and useful standard has its origins in the concept that the utility is entitled to a fair retu
only on capital that is employed for public convenience (Smyth v. Ames, 1898). The standard appears in a
series of decisions by the Federal Energy Regulatory Commission concerning compensation for plants in prog-
ress but not yet in service (see Bonbright, Danielsen, and Kamerschen, 1988). Howe (1983) provides a survey
of regulatory treatment of cancelled plants.

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540 / THE RAND JOURNAL OF ECONOMICS

that the period is sufficiently long that capital completely depreciates if there is no new
investment.3 At the time of the investment decision, demand in period t + 1, D,+1, is no
known, but may take either of two levels (both independent of price over the relevant
range). In the high-demand state (i = H), demand DH = 1 (by normalization). In the low-
demand state (i = L), DL = 1 - C, 0 < oa < 1. The high- and low-demand states occur
with probabilities 1 - P and P, respectively.4 (The inelasticity of demand simplifies the
analysis, but suppresses questions of short-run allocative efficiency.) Expected demand in
the next period is thus 1 - o-P.
As an additional simplification, we assume a fixed coefficients technology. Each unit
of capacity allows the utility to produce up to one unit of output with a constant marginal
operating cost of b per unit. There is an alternative source of supply available at a constant
total unit cost c, where c > b + r, and r is the gross rate of interest (including deprecia-
tion). As the technology has fixed coefficients, excess capacity is well defined.
The utility must choose investment each period not knowing future demand with cer-
tainty, or the revenues that it will be allowed to earn. The sequence of moves for the
utility and the regulator is shown in Figure 1. The choice of investment in period t - 1
determines the capital stock in period t and occurs before demand is realized in t. The
regulator chooses a transfer of revenues to the utility, Rt, which is determined with full
information about K, and may be conditioned on output, Qt. Figure 1 defines a basic game,
which repeats in every period t = 1, 2, ... , oo. The utility moves first, choosing its cap-
ital stock, K. Nature moves second, determining the level of demand, D. The regulator
moves third, and determines the allowable revenues that the utility may earn. Finally, the
utility produces Qt < min(Kt, D,), and payoffs (utility profit, art, and consumer surpl
U,) are realized.
We assume that the regulator is concerned only with consumer surplus. This as-
sumption emphasizes the opportunity of the regulator to engage in strategic behavior with
respect to sunk investments. There would be no efficiency problem if the regulator were
indifferent as to the distribution of income between consumers and the utility (or its share-
holders), or if the regulator were acting primarily in the interest of the utility. Given this
concern for consumer surplus, the one-shot game conditional on the choice of investment
is zero-sum and has a unique Nash equilibrium in which the regulator sets price equal to
variable cost and the utility does not invest. It is well known that the infinitely repeated

FIGURE 1
BASIC REGULATION GAME

H=1 R(Kt, Qt) {MU}

1- --- ,

/~~~~~~ ~ - = 1- a R(Kt, Qt) {MU}

K, 1-5

Utility chooses Demand, Dt, Regulator chooses Payoffs

capital at t is realized reward R; utility realized
chooses output Q0

3 Extending the model to allow for exponential depreciation as in Salant and Woroch (1992) would not
change the conclusions (see Gilbert and Newbery, 1988).
4 Gilbert and Newbery (1988) examine the more realistic, but less transparent, case in which demand is
serially correlated.

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 GILBERT AND NEWBERY / 541

game can support an infinity of subgame-perfect Nash equilibria that are Pareto-preferred
to the Nash equilibrium of the one-shot game. We are interested in investigating how
different constitutional constraints that limit the strategy choices available to the regulator
affect the ability to support the unique optimal outcome as a subgame-perfect Nash
equilibrium.
Before comparing alternative regulatory regimes, as defined by permissible strategy
sets, consider as a benchmark the investment path that is optimal for the regulator. L
be the regulator's payment to the firm in period t (R, may depend on the state of dem
the firm's output and capacity, or other factors). The firm earns rr, = Rt - bQt - rKt,
where Q, ? min{Kt, DJ}. Consumers benefit by avoiding purchasing Q, from an alternative
source at cost c, less the revenues paid to the utility, U, = cQ, - R. Both the utility and
the regulator are risk neutral. The regulator wants to maximize expected consumer surplus,
subject to the constraint that the expected profit of the firm is nonnegative in each period:
co

max EjE t3'U,

t=O

subject to EBt ? 0.

Assuming the regulator could choose capital directly, the optimal program would
maximize (c - b)[(1 - P)Qt(H) + PQt(L)] - rKt, where Qt(H) ' min{Kt, 1} and
Qt(L) ' min{Kt, 1 - u} are outputs in the high- and low-demand states, respectively. Our
interest is in economic environments in which it is efficient for the utility to invest. Ex-
pected costs are linear in the firm's capacity, so that the efficient level of investment is
either K = 0, 1 - a, or 1. For the optimum choice of K to be 1, the marginal benefit of
additional capacity must be greater than its marginal cost. The marginal benefit is the
expected additional savings in operating costs relative to the alternative source of supply,
which occurs only in the high state of demand, and the marginal cost of capital is the
rental rate, r; therefore, the condition for Kt = 1 is

(1 -P)(c-b)>r. (1)

We assume that (1) holds in what follows.

3. Rate-of-return regulation
* Rate-of-return regulation has been criticized from both a normative and positive per-
spective. This regulation encourages excess capital intensity when the rate-of-return ex-
ceeds the cost of capital (Averch and Johnson, 1962; Baumol and Klevorick, 1970) and
creates obvious allocative distortions that result from setting prices at average and not
marginal costs. Also, the cost-plus characteristic of rate-of-return regulation is generally
inconsistent with efficient behavior under asymmetric information.5 However, its advan-
tage in constraining opportunistic behavior appears to have been overlooked.
Naively interpreted, rate-of-return regulation requires that the regulator transfer suf-
ficient revenues in each state to ensure that the utility earns at least a normal rate of return
on its invested capital. Courts, however, have resisted this interpretation, and the actual
returns earned by utilities have varied widely. In the postwar history of utility regulation
in the United States, utilities frequently earned rates of return that exceeded their capital
costs (Joskow, 1973).6 In recent years, regulators have disallowed compensation for

5 The cost-plus characteristic of rate-of-return regulation emerges only as an extreme case of optimal
contract design (e.g., Laffont and Tirole, 1986). Besanko (1985) identifies aspects of rate-of-return regulation
in an incentive-compatible mechanism with imperfect information about the cost of capital.
6 Greenwald (1984) discusses the view that a fair rate of return equates the market value of the firm's
stock to its book value. In the 1960s, the average ratio of the market to book value of regulated electric power
utilities was greater than two.

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 542 / THE RAND JOURNAL OF ECONOMICS

investments that were considered to be either "not used or useful" or "imprudent". Typically,
the first case has involved expenditures on discontinued or unnecessary plants, and the
second has included expenditures on nuclear and supercritical coal plants that have ex-
perienced large cost overruns. In either case, the net effect has been to reduce actual earned
7
rates of return below a normal return on investment in special circumstances.
We define UUROR (used and useful rate of return) as requiring the regulator to pay
at least a normal return on capital used (equal to realized demand in our model), but
allowing noncompensatory rates when there is excess capacity. Suppose that the regulator
pays a gross return, Sb, on base-load capital up to 1 - oa (i.e., up to that level of capacity
that will always be used) and thereafter pays si in the demand state i = {H, L} on the
additional capital, up to a maximum of 1.8 Legally permissible rates of return under UUROR
are

{Sb - r; SH > r; SL ? O}. (2)

Let so =PSL + (1 - P)sH, the expected rate o

load level of demand, 1 - or. The expected profit to the utility is, for 1 - oa ' K ? 1,

E7= (1 -)sb+ ssK-(1 -o-)]-rK.

The regulator can induce the firm to choose the efficient level of capacity (K = 1)
with a policy that satisfies the constraints of UUROR. For example, the policy

R(-) {Sb = r, SL= r -/, SH= r + p}

with 0 < p' = r and p = Ppu/(l - P) + E for E > 0 satisfies this con
this policy extracts all producer surplus. Because the policy induces efficient investment
and extracts all surplus, it is first best for the regulator. Thus, we have9

Proposition 1. A commitment to the UUROR policy R(-) is a first-best policy for the
regulator.

A difficulty that R(-) might pose for the regulator is that there need not exist v
(sL, SH) that support the efficient investment plan as a subgame-perfect Nash equilib
of the repeated game in the absence of a commitment mechanism. To investigate this
question, we need a more formal specification of the repeated game without commitment.

4. The sustainability of rate-of-return regulation

* Although a UUROR policy can achieve a first-best outcome, it remains to be seen
whether a regulator could credibly commit to an optimal policy. In an environment in
which all actions, costs, and demand realizations are public knowledge, a regulator and
a firm could enter into a contract that would require the firm to invest at the proper level
and the regulator to compensate the firm for its actions. However, regulation is typical of
a relationship in which the parties have private information that is relevant to contractual
performance and not easily verified in a court of law. As Hart and Moore (1988) emphasize,
contracts that depend on such information cannot be enforced. For example, a contract
for electricity supply would require conditions not only on the amount that a utility should

Disallowing capital costs shrinks the utility's rate base and thus reduces the rate of return that the firm
actually earns on its total investments, even if the firm's allowed rate of return is unchanged.
8 This is equivalent to a state-contingent return on total installed capacity.
If the efficient level of investment were K = 1 - a (corresponding to the case in which (1) does not
hold), then the policy {Sb = r + ?, SH = r, SL = r- 8} with ? > 0 and 0 < 8 c r satisfies UUROR and
generates a maximum profit for the firm when K = 1- u. Profit can be held arbitrarily close to zero as ? -

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 GILBERT AND NEWBERY / 543

invest, but also on its timing, its reliability, the mix between peak and base-load capacity,
its impact on the environment, its fuel diversity, and possibly other dimensions.0 These
characteristics are difficult to specify in advance and are frequently difficult to verify. If
a dimension of supply, such as quality, is costly to produce and is unverifiable, in a one-
shot contract the supplier would have an incentive to minimize costs by producing the
lowest level of quality, and typically this would be inefficient. Recent experiences using
competitive bidding to award contracts for the construction of new capacity have dem-
onstrated the problems involved in writing complete, enforceable contracts for electricity
supply (see Kahn, 1990).
Compared to an explicit contract, a repeated regulatory relationship relies on past
performance as the determinant of current actions and, in this manner, limits incentives
for opportunistic behavior.1" However, if the regulator cannot be bound to her announced
policy (of setting an agreed upon rate of return or price), then we need to inquire whether
she will ever have an incentive to deviate from her stated policy and whether she can
credibly commit to not deviating. Formally, the regulation game is an infinite repetition
of a basic game, the moves of which are summarized in Figure 1. The game includes a
legislator, who at t = 0 specifies the set of strategies that are legally permissible for the
regulator. When the utility invests, the information is realized demand in period t - 1 and
the history of actions taken by the regulator. In addition, the utility looks ahead to the
return it can anticipate on its invested capital. After demand D, is realized in period t, the
regulator chooses a revenue transfer R., conditional on the realized demand, and the utility
then chooses output Q. ? min{K,, DJ}. The payoff to the utility at the termination of the
basic game is v, = R. - bQ, - rK, and the payoff to the regulator is U, = cQ, - R..

E Game 1. Used and useful rate-of-return regulation (UUROR). We define UUROR

as the state-contingent rates of return {Sb ? r; SH ? r; SL ? 0}, where the first entry is the
return on base-load capacity, and the second and third are the returns on any additional
capacity in the high- and low-demand states, respectively. The equilibria that can be sus-
tained depend on the punishments for defection from announced strategies. The maximum
punishment that the regulator can legally impose on the utility is to make the latter pay a
return of zero on any excess capacity, or to choose the state-contingent returns (r, r, 0).
Given the regulator's punishment strategy, the utility earns zero expected profits with any
level of capacity up to 1 - a, and negative expected profits with any larger capacity. We
assume that the firm responds to a deviation by the regulator from her announced strategy
by reverting to the strategy of investing K = 1 - k forever for some o- ? k ? 1.
Define the normal revenue function by the vector of returns R' = (r, SH, SL) with
SH ? r, SL ? 0 (where SH, SL are chosen to minimize the incentive to deviate) and the
punishment revenue function by RP = (r, r, 0). 12 The utility chooses a level of investment
from a strategy S,( ). Let r be a hypothetical date at which the regulator deviates from
promised revenue R', and consider the following strategy pairs:"3
_ Rn if K>t1 (3)
-RP otherwise. (3)
-1 if Rt1 I?_ Rn
1t=I- k otherwise, whereua:5k?-- 1. (4)
'1 Demand uncertainty presents another problem for contractual completeness. Regulators wo
write contracts that make investment subject to the expected rate of growth of demand, but deman
are difficult to verify. Gilbert and Newbery (1988) provide an example of a repeated regulatory relationship
with serially correlated demand.
" A long-term contract with a supplier would permit strategies such as compensation based on past per
formance, and thus would have many of the properties that we attribute to a repeated regulatory relationship
12 In the normal revenue function, if the utility invests and there are excess returns on additional capaci
in both the high- and the low-demand states, this is equivalent to an expected return on base-load capacity tha
exceeds the cost of capital, r.
13 Strategies (3) and (4) could be extended to include the effects of unverifiable quality, which would

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544 / THE RAND JOURNAL OF ECONOMICS

The regulator's assumed strategy is to pay the normal return R' whenever the utility
invests at least K, = 1. Otherwise, the regulator pays the punishment return RP. Her pun-
ishment is legal under the used and useful constitution. The utility's strategy is to invest
K, = 1 if the regulator pays a normal return and 1 - k (a ? k ? 1) otherwise. The reg-
ulator knows that any deviation from the normal reward will cause the utility to underinvest
forever. She would not deviate if her total expected costs were lower when the utility
invested K, = 1 in each period than when she deviated by paying a zero return on invested
capital, after which the firm would invest the lower amount forever.
Can the strategies given by (3) and (4) support efficient investment as a subgame-
perfect equilibrium? The utility has nothing to gain by investing less than K, = 1 if the
regulator pays the normal reward.14 The regulator, however, may be tempted to pay no
more than RP, the minimum payment allowed by the used and useful constitution. In a
state of low demand, the regulator could legally pay zero instead of SL on the excess
capacity a. The one-period gain from deviating is SLU. This gain would signal a deviation
from the regulator's announced normal return policy, to which the utility would respond
by underinvesting thereafter. The regulator would have to import power at a cost c
in the amount k - a if demand were low and in the amount k if demand were
high. Let v = (1 - P)SH + PSL - r -O, the excess expected return on investment above
base-load demand. The expected cost per period to the regulator when she reneges,
rather than paying the normal reward and having the utility invest K = 1, is
C(k) = (c - b)(k - uP) - kr - uV.15 The regulator would not want to deviate from her
announced normal reward in a low-demand state if

13 C(k)
SLU < C(k), i.e., SL < C <) 5
1-,8 Or

where ,3 = 1 /(1 + r) is the discount factor.

In the high-demand state, the regulator could renege on her announced normal reward
and legally pay a return of r rather than SH on the utility's installed capacity. The one-
period gain from deviating is (SH - r)u. The expected extra cost in each subsequent period
is C(k), and deviation will be deterred if the gain falls short of the present discounted cost;
that is, if

(SH-r)a < 1h C(k), i.e., SH < r + . (6)

Figure 2 illustrates the nature of these constraints on returns in the high- and low-
demand states. The gain from deviating, divided by a. is equal to SL in the low-demand
state, and this is bounded below by zero. Deviation is deterred in low-demand states if SL
is to the left of C(k)/ur. The normalized gain in the high-demand state is SH - r, which
is bounded below by zero from the UUROR constraint. Deviation is deterred in high-

make a one-shot contract an inefficient alternative to regulation. Let 0 represent unverifiable quality, and sup-
pose the regulator requires 0 2 0. Then (3) would be altered to read R,(-) = R' if K, 2 1 and 0 2 0. Assuming
that the regulator could identify inadequate quality with a short lag, this addition would not affect the results
of the repeated game. In equilibrium, the firm would have to invest K, = 1 with 0 = 0. If the lag were long,
then the regulator would have to increase her normal revenue payment to avoid shirking by the firm in the
provision of quality, as in Klein and Leffler (1981) and Shapiro (1983).
14 We do not consider more complicated bargaining strategies such as threats by the utility not to invest
unless the regulator pays a supranormal return. Our concern is with the minimal conditions under which efficient
investment is sustainable, for which the strategies in (3) and (4) are sufficient.
15 Investing K = 1 - k rather than K = 1 saves kr in capital costs, but incurs additional operating costs
of (c - b)k if demand is high and (c - b)(k - a) if demand is low. The term o-v accounts for any excess
return in the regulator's normal revenue function. Multiplying the incremental costs by the demand probabilities
(1 - P and P) and subtracting the savings in capital costs yields C(k).

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 GILBERT AND NEWBERY / 545

demand states if SH is below r + C(k)/o-r. The zero profit line is the lower
the constraint PSL + (1 - P)SH ? r, which (SH, SL) must satisfy to persuade t
undertake efficient investment. The sustainable set of rates of returns (sH, sL) i
in the region ABCD.

Proposition 2. The efficient investment path is a subgame-perfect Nash equilibrium

game 1 if and only if

C Qk) CQk)
SH <r+ , SL ,V ( P)SH + PSL - r ' O. (7)
o'r 0rr

where C(k) = (c - b)(k - o-P) - kr - uv.

Note from Figure 2 that unless C(k)/lrr is larger than r, corresponding to a very
cost from deviating, a sustainable equilibrium requires an excess return on investm
the high-demand state and a below normal rate of return in the low-demand sta
reason is that rates of return that are close to normal in both demand states would pr
a large incentive to deviate when demand is low, which is legal under the UURO
stitution. Reducing the return in the low-demand state and increasing the return in the
state so that the firm breaks even makes it less likely that the regulator would w
deviate from her announced policy.
Proposition 2 holds for any excess return, P. As v -- 0, C increases and boun
BC and CD in Figure 2 move upward or rightward, enlarging the feasible set of sustai
returns, which leads to the following corollary.

FIGURE 2

RATES OF RETURN IN EACH STATE

Return in
state H, SH

ar

o rP C r
Return in state L, SL ar

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546 / THE RAND JOURNAL OF ECONOMICS

Corollary 1. Given the punishment strategies, if an efficient investment path cannot be

supported as a subgame-perfect Nash equilibrium when the utility earns zero expected
profits, there does not exist a subgame-perfect Nash equilibrium with efficient investment.

This corollary provides a justification for the regulator's strategy to compensate the
utility only for the cost of capital for investment up to the base-load level 1 - o-. Any
additional payment for this investment would increase the expected profit of the utility,
with no benefit for the credibility of the regulator's announced policy.
The most favorable case for a subgame-perfect equilibrium has a zero expected profit
for the utility and equal incentives for deviation in both states (otherwise, the incentive
to deviate in the more vulnerable state could be decreased at no cost). This point corre-
sponds to the intersection at point E of the zero profit line in Figure 2 and the line SH - r = SL.
At this intersection, SH = (1 + P)r and SL = Pr. Hence,

Corollary 2. A subgame-perfect equilibrium of the game of UUROR does not exist unless
it exists when SH = (1 + P)r and SL = Pr.

Corresponding to point E in Figure 2, a necessary and sufficient condition for exis-

tence of an efficient subgame-perfect equilibrium is that

Pr ' . (8)

This condition allows us to calculate the critical values of parameters that will support
a subgame-perfect equilibrium. For example, the benefits to the regulator of inducing
utility investment fall with the cost of an alternative source of power, c. The critical value
of c follows from assuming equality in (8) and from the definition of C(k), recalling that
the largest value of C occurs when v = 0.

Corollary 3. If the utility's minimum investment is 1 - k, (a ' k ' 1), there exists a
subgame-perfect Nash equilibrium with efficient investment if and only if

r(k + roP)
c-b+
k - u-p * (9)
The parameter k is a measure of the intensity of the utility's response if the regulator
deviates from her announced normal reward. A larger k corresponds to a smaller invest-
ment in response to the regulator's deviation. Following Abreu (1986, 1988) and Abreu,
Pearce, and Stacchetti (1986), the efficient path can be sustained for a larger set of pa-
rameter values if the firm does not invest at all (corresponding to k = 1) following a
deviation by the regulator from her announced strategy. This grim response can be sup-
ported using strategies that employ mutual penalties for failure to implement the maximum
threats. We give an example of this in the Appendix. Although such strategies are unusual
as elements of regulatory policy, we include them for completeness and note that they
define the largest set of parameters for which the efficient investment path can be sustained
as a subgame-perfect Nash equilibrium.

Corollary 4. With optimal punishments, there exists a subgame-perfect Nash equilibrium

with efficient investment if and only if

b+ r(1 + raP) (10)

1 - aP

By constraining the regulator to pay at least a normal return on capacity used, the
regulatory constitution of UUROR provides some protection to the utility against expro-
priation of capital and, in this way, discourages underinvestment. At the same time, the

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 GILBERT AND NEWBERY / 547

inability to punish shortfalls in efficient investment might be thought to limit the regula-
tor's ability to sustain an efficient investment program, but with optimal punishments, this
turns out not to be the case. The consequences of a regulatory constitution that permits
the regulator to provide any compensation are described in game 2.

El Game 2. Unconstrained rate-of-return regulation. In several countries, there are

no constitutional restraints that require a regulator (or the governing body of a publicly
owned firm) to compensate a firm for its invested capital. Levy and Spiller (1993) have
argued that the lack of such a constitutional requirement was a contributing factor in the
failure of private enterprise in countries such as Argentina and the Philippines. In this
section, we examine the conditions under which efficient regulation is sustainable in an
environment in which a regulator announces a rate-of-return policy, but in which there
are no restraints on the actual return that the regulator may offer.
Game 2 is the same as game 1 except that the regulator can choose any nonnegative16
rate of return, so the punishment strategy RP is (0, 0, 0). The one-period gain to the
regulator from deviating is greater than that with UUROR, as she could pay a zero return
on all invested capital. The one-period gain from deviating is (1 - o-)r + oSH in high-
demand states (compared to U(SH - r) with UUROR) and (1 - o)r + o-sL in low-demand
states (compared to fSL with UUROR). Assuming SH > SL, the incentive to deviate is
always higher in high-demand states with unconstrained rate-of-return regulation. Devia-
tion is deterred by setting

C(1)
(1l-)r + SH <
r

where k = 1 because the utility would not invest given the regulator's punishment strategy.
As SH--> r, the optimal strategy approaches a normal return in both demand states'7 and
the sustainability condition analogous to (10) becomes

b+ r(l + r)
(1 - uP)
The right-hand side of (11) exceeds that of (10) if either a- or P < 1, which implies

Proposition 3. With optimal punishments, the set of parameter values that allows the ef-
ficient equilibrium to be sustained as a subgame-perfect Nash equilibrium is strictly larger
under used and useful rate-of-return regulation than it is under unconstrained rate-of-return
regulation.

The UUROR constitution facilitates sustaining an efficient equilibrium in which the

utility invests because it limits the regulator's gain from opportunistic behavior and the
utility has no incentive to shirk if the regulator follows her announced strategy. Through
proper choice of incentives (see the Appendix), the regulator can ensure that the utility
will cease to invest following a deviation, so that the long-run costs to the regulator of
deviating are not reduced by the UUROR constraint. If the regulator is not able to induce
the utility to employ optimal punishments, UUROR will be superior to unconstrained rate-
of-return regulation only if (9) is satisfied, but not (11). This will be the case if the discount
factor 83 < ,8* where18
1 P
f* -_ < 1. (12)
1-Pu- 1- P

16 We are assuming that the regulator does not have the power t
17 Hence, the restriction that SH 2 SL is not significant.
18 The critical discount rate /3* corresponds to the utility investi
demand in the punishment phase. This is the worst case for the regulator. More generally, for
o- < k < 1, 8*(k) = 1/(1 -Po-) - P/(k/o- P) > /8*.

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 548 / THE RAND JOURNAL OF ECONOMICS

Figure 3 graphs /3* as a function of P for varying values of a. If one thinks of ,3 as

defined by the median lifetime of capital (perhaps 10-20 years), then with a real rate of
interest of 10%, ,B is less than .4. Thus, even with low values of a, j3 < /3* if the prob-
ability of a low-demand state is less than about 40%. The results are summarized as

Proposition 4. Without optimal punishments, the set of parameter values that allow ef-
ficient investment to be sustained as a subgame-perfect Nash equilibrium is strictly larger
under used and useful rate-of-return regulation than under unconstrained rate-of-return reg-
ulation if [3 < [3*, where /3* is defined by (12).

5. Price regulation

* There has been much discussion about replacing rate-of-return regulation with price
regulation, or price caps. Price regulation has the advantage of encouraging efficient pro-
duction in the short run. But would price regulation improve the ability of regulation to
sustain an efficient investment program?
Price regulation can take different forms. With inelastic demand, there is no loss of
generality in restricting price regulation to state-contingent linear prices with state-contin-
gent fixed fees. Suppose the regulator commits to offer the firm a state-contingent contract
(pi, Fe), where pi is the price paid to the firm per unit of output and Fi is a fixed payment

FIGURE 3

CRITICAL VALUE OF DISCOUNT FACTOR

Discount factor

.8

.6

.4

.2

.0 .1 .2 .3 .4 .5 .6 .7 .8 .9 1
Probability of low dem

Sigma

-0 -.1 ---.25 - -.5 -.75 -.95

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 GILBERT AND NEWBERY / 549

to the firm in demand state i E {H, L}. The revenue function is R(i, Q) = piQ + Fi, and
in each period the utility earns expected profits (assuming K ' (1 - o))

Er = (1 - P)[(PH - b)K + FH] + P[(PL - b) min(1 - a, K) + FL] - rK. (13)

We continue to assume that efficiency requires an investment of K = 1 in each period.

The condition for choosing K = 1 is PH ? b + r/(l - P). As before, the regulator is
concerned solely with consumer surplus, U, = cQ, - Rt, and both the regulat
firm are risk neutral.

EJ Game 3. Regulation with two-part tariffs. As in the repeated game with rate-of-
return regulation, suppose that the regulator announces a normal compensation strategy
(pi Fi), which she would pay in demand state i = H, L if the utility invests at the efficient
level. If the utility fails to invest, or if the regulator deviates in a prior period, she pays
punishment prices (pe F'). If the regulator is not constrained to pay a normal return on
capital, she can impose the maximal penalty (pe = b, Fe = 0). 19 As in UUROR, the regulato
may be constrained to guarantee a normal return on all capital that is used and useful. We
focus here on the unconstrained case.
The cost to the regulator of deviating from her announced price regulation policy
(pi, Fl) is C(k) per period, identical to the cost of deviating from an announced rate-of-
return policy, with or without the used and useful constraint, and depends only on the
firm's investment in the punishment phase and on the firm's expected level of profits when
the regulator follows her announced policy. Thus, the incentive to deviate under price
regulation compared to rate-of-return regulation depends only on the one-period gain from
deviating under the different regulatory regimes.
With the appropriate choice of state-contingent fixed payments or subsidies to the
firm, the regulator can duplicate the state-contingent payments of rate-of-return regulation
using price regulation. For example, consider the contract

pH b + r/(l1 P), FH= -Pr/(1 - P)

PL b, FL= r

along with the punishment payment of pi = b for i = H, L. This contract replicates the
normal and punishment payments corresponding to the unconstrained rate-of-return reg-
ulation strategy that has zero expected profits and is least susceptible to deviation by the
regulator. Thus, regulation with two-part tariffs is as good as unconstrained rate-of-return
regulation, in the sense that it can support an efficient subgame-perfect Nash equilibrium
for the same parameter values. Using the same methodology as that leading to Proposition
2, we can also show that the regulator cannot do better using two-part strategies than she
can with these strategies. No other two-part pricing strategies support an efficient invest-
ment path for a larger set of parameter values.
Two-part pricing and rate-of-return regulation are equivalent with respect to sup-
porting the regulator's optimal investment path.20 Note, however, that the optimal two-
part price requires a fixed payment to the firm in the low-demand state and a tax in the
high-demand state. The tax offsets the rents that the firm would earn from the variable
payment in the high-demand state, which must be set high enough to induce the firm to invest.
Regulatory commissions are typically prevented from making fixed transfers to the
firm or from direct taxation, although fixed transfers may be approximated with the use

19 This presumes that the firm can shut down rather than make negative variable profits.
20 If the regulator is constrained to pay at least a normal rate of return on capital that is used and useful,
the contract PH = b + r/(1 - P), FH = -r[1 - o(1 - P)]P/(1 - P) and PL = b, FL = r[1 - of1 - P)] will
replicate UUROR. But note that the firm would earn a normal rate of return only if it produced to maximize
its profit.

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550 / THE RAND JOURNAL OF ECONOMICS

of access charges and low lifeline rates for inframarginal usage. Given the limitations on
the use of fixed transfers, in what follows we restrict the analysis to price regulation with
state-contingent linear prices. This analysis highlights key distinctions between price reg-
ulation and rate-of-return regulation. Price regulation does not pay any return on unused
capacity and, unlike rate-of-return regulation, requires a high variable payment in the high-
demand state to support efficient investment.

EJ Game 4. Linear price regulation. With linear price regulation, the regulator an-
nounces a normal compensation strategy p7, i = H, L, which she would pay if the utility
invests at the efficient level. If the utility fails to invest or if the regulator deviates in a
prior period, the latter pays punishment prices pe. If the regulator is not required to pay
a normal return on capital that is used and useful, the regulator can impose the maximal
penalty pP = b. Otherwise, the regulator would have to pay a normal return on the base-
load capacity (1 - o), although she would not have to compensate the utility for invest-
ment in excess of the base-load amount in low-demand states.
The lowest prices that lead the utility to invest K = 1 and result in nonnegative ex-
pected profits are PH = b + r/(l - P) and PL = b. With these prices, the regulator would
have no incentive to defect in the low-demand state. In the high-demand state, by deviating
the regulator would save r/(l - P) if she were not constrained to pay a normal return on
capacity. This saving exceeds the incentive to deviate with unconstrained rate-of-return
regulation (which is just r for the strategy that is least susceptible to deviation). If the
regulator had to pay the firm at least a normal return on used and useful capacity, she
could deviate in the high-demand state under price regulation and pay b + r rather than
b + r/(l - P) for one unit of supply. This option would save the regulator rP/(1 - P)
and exceeds her incentive to deviate when she employs the most advantageous used and
useful rate-of-return policy. In that policy, she pays a return of r on base-load capacity
and (SH = (1 + P)r, SL = Pr) on any additional investment. The gain from deviating (in
either demand state) is only arP. The consequences of deviation are the same, whether
the regulator employs rate-of-return or price regulation. Hence, without regard to whether
the regulatory constitution specifies at least a normal rate-of-return on used and useful
capital, we have

Proposition 5. The set of parameter values that allow the efficient equilibrium to be sus-
tained as a subgame-perfect Nash equilibrium is strictly larger under rate-of-return regu-
lation than under state-contingent linear price regulation.

Compared to rate-of-return regulation, price regulation results in greater variability

of profits on an efficient investment path when the regulator employs the strategies that
are least susceptible to deviation in each case. Profits gross of capital costs in high-demand
states are r/(1 - P) with price regulation, compared to r(1 + uP) under used and useful
rate-of-return regulation, and r with unconstrained rate-of-return regulation. In low-de-
mand states, the utility would earn nothing with price regulation, whereas both used and
useful rate-of-return regulation and unconstrained rate-of-return regulation would provide
some return. Note that if the regulator were to choose a single price high enough to induce
the efficient level of investment, then the price would have to be at least b + r/(l -P)
and the utility would now make expected profits in good and bad states. Thus,

Proposition 6. Along an efficient path, the variability of profits is higher with linear price
regulation than with rate-of-return regulation. If the regulator sets a single linear price,
efficient investment requires that the firm earn strictly positive profits in high- and low-
demand states.

6. Conclusions
* Has the implicit regulatory contract failed? It is generally perceived that regulatory
constraint increased in the 1970s and 1980s as measured by earned rates of returns (see

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 GILBERT AND NEWBERY / 551

Joskow, 1974, 1989), but this perception is not inconsistent with the equilibrium outcomes
described in this article. An efficient investment path can be sustained as a rate-of-return
regulation equilibrium, with high returns in good states and low returns in bad states. One
could interpret the early postwar period as a sustained good state, followed by a more
recent prolonged bad state.
A survey of planned U.S. electric power plant investments in the past two decades
suggests, however, that there has been a movement toward underinvestment. Excluding
hydro- and geothermal projects, which are in limited supply, in 1977 electric power util-
ities had more than 650 projects in the planning stage, of which about one-half were more
than 500 MW in size. In 1986, the total number was 64, of which 7 were more than 500
MW. Much of this tenfold reduction is the consequence of excess capacity resulting from
the exuberant construction program of the 1960s and early 1970s. However, the sharp
change in capital intensity suggests that utilities are following a risk-minimizing approach
of building for a low level of demand and relying on smaller plants with shorter lead times
in the event of greater than anticipated demand growth. Smaller plants are typically less
capital intensive, and consequently offer the regulator less incentive to expropriate sunk
costs. This pattern of investment-is consistent with an underinvestment equilibrium.
An important result of this equilibrium analysis is that the apparent flexibility afforded
by both price regulation and unconstrained rate-of-return regulation need not be an im-
provement over the regulatory constitution of used and useful rate-of-return regulation.
The ability of a regulatory strategy to sustain an efficient investment path depends on the
particular legislative framework, with used and useful rate-of-return regulation more likely
to be sustainable than unconstrained rate-of-return regulation under a wide range of pa-
rameter values. Without carefully designed state-contingent transfer payments, price reg-
ulation is less likely than rate-of-return regulation to support an efficient investment path,
because the latter allows the regulator to compensate the firm without regard to the state
of demand. Under price regulation, compensation is limited to high-demand states, in
which investment has a positive marginal value to the firm. This fact increases the reg-
ulator's temptation to cheat on her announced rewards.
Both the utility and the regulator can take actions that make expropriation less likely
and therefore contribute to a sustainable regulatory contract. By choosing a production
technique that is less capital intensive (and has higher operating costs), the utility can
reduce the gain to the regulator from expropriation and mitigate the risk to itself should
expropriation occur. Of course this implies that the regulatory bias will be in the direction
of too little, rather than too much, capital intensity. (But see Besanko and Spulber, 1992,
for an example with overinvestment.) The regulator can make expropriation of the utility's
sunk capital stock less attractive by refusing to protect herself from the adverse conse-
quences of supply shortages, as in Williamson (1983). For example, the regulator can
choose not to enter into purchase-power agreements that would provide backup power at
a reasonable price in the event that the utility fails to invest. Not investing in intercon-
nections with other grids or utilities would be an even stronger commitment to the reg-
ulatory compact, but it is also an unreasonable policy, if only because some interchange
of power is necessary to provide security in the event of forced outages. Careful design
of responses to deviation and of state-contingent transfers can further reduce the incentive
to defect.
Much of the recent literature on regulation has emphasized the role of asymmetric
information in a static context. In contrast, we stress the importance of sunk costs and the
risks of regulatory appropriation in a repeated relationship. Efficient investment can be
sustained through the provisions of a binding contract in situations in which the essential
parameters of a contract can be verified in a court of law. When this is not possible, as
we argue is likely to be the case in a regulatory environment, the parties have to rely on
reputation and credible threats in a continuing relationship. Our model, though simple,

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552 / THE RAND JOURNAL OF ECONOMICS

captures essential features of the regulatory relationship and, in particular, the importance
of the "rules of the game" that constrain a regulator's actions.

Appendix

* In this Appendix, we implement optimal punishments with the used and useful constitutional constraint.
The utility's response to regulatory deviation is to embark on a punishment phase of T repetitions of
investment E, after which it reverts to normal investment. Define XT, as the utility's choice of capital at dat
given that it last embarked on a punishment phase at date r. Thus, if the regulator deviates at r, but does not
deviate thereafter,

E e if t ' r + T, (Al)
X It if t>,r+T.
Allowing the utility to respond with a limited period of underinvestment enables more sophisticated interactions
between the utility and regulator, which allow a larger set of feasible returns to be sustained.
Define R' and RP as before, but augment the strategy set in (3) with the conditional payment
Rd = (r + 8, s, s'), 8 > 0. The regulator promises to pay Rd if she deviates from her announced normal reward
at r, provided that the utility embarked on its punishment phase at r and sets K, = XA,t. The regulator's aug-
mented strategy can be subgame perfect if the utility can punish the regulator for failing to implement Rd. This
can be accomplished by having the utility announce that it will restart its punishment phase if the regulator
fails to pay at least Rd following a deviation from the normal return. The expanded strategies are

R- if K, 1,
R,(-) = Rd if K, X, AR, < Rn A Kr_, 2 1, r < t r r + T, (A2)
RP otherwise,

1 if R- IR> ,
S,( ) = x, if R, < R" AR,_, 2 Rd, r < t r+ T, (A3)
Xtt otherwise,
where A is logical "and." The regulator pays the normal return Rn provided the utility invests K, = 1, and
pays the punishment return RP if the regulator has previously not deviated but the utility has underinvested. If
the regulator has deviated at date r, then the utility responds by implementing the punishment strategy. Provided
the utility is following the punishment strategy, the regulator responds by rewarding the utility with a rate of
return r + 8 on the utility's punishment level of investment, E. If the utility underinvests when the regulator
has not previously deviated, or if the utility fails to punish the regulator for past deviations, then the regulator
pays a zero return on excess capacity. If the regulator fails to pay the premium during the punishment strategy,
then the punishment is restarted, indicated by resetting r to t in the last line of (A3).
The key step is to determine if it is worthwhile for the regulator to offer Rd in the first period of the
punishment phase. The one-period extra cost of doing so is bE, but the alternative of not paying this premium
is to delay the date at which the utility returns to investing at the efficient level by one period. The expected
one-period extra cost to the regulator of having the utility invest K = E rather than K = 1 is
C = (c - b)(1 - E - Pa) - (1 - E)r, and the present discounted cost of this to the regulator is j8
that bE < /3T(C + bE), it will be less costly for the regulator to pay the premium each period. If it is worth
paying Rd in the first period of the punishment, then it certainly will be worth doing so in later periods, as
subsequent deviations would further delay the return to normality. Consequently, Rd is the best response to the
punishment xP if

be < .Tc (A4)

1 - pT

The expected cost to the regulator of deviating is C + bE for T periods. The regulator will not be tempted to
deviate in a state of high demand if

f3(1 _ /T)(C + aE) A5)

1-f3 (S

and in a state of low demand if

f3-t) (1 - /T)(C + 8E) (6

1 _ p ~~~~~~~~(A6)
Combining (A4) and (A5) gives a condition for the regulator not to deviate as

3(1 BT) [8C C

pfr < fiff 8 _ (C +E) < 8

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 GILBERT AND NEWBERY / 553

where the last inequality comes from substituting for bE from (A4). Equating the incentive to deviate in high
and low states using (A5) and (A6) results in Corollary 3.
The use of mutual penalties forces the utility to impose its maximum punishment on the regulator. This
has the effect of increasing the parameter k in (9) to one. In addition, the extra cost to the regulator of rewarding
the utility for its maximal punishment is a further deterrent to deviating from its normal reward. This has the
same effect as would an arbitrarily long punishment phase with no reward.

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