Regulating Vertically Integrated Utilities When Transfers are Costly but Revenues are Beneficial

This paper considers regulating a vertically integrated utility under asymmetric information about efficiency gains due to integration. The benchmark case--benevolent regulation--implies a divestiture of a technically efficient integration, unless the cost savings due to integrating are substantial. This highlights how private information causes a deviation from the standard perfect information framework. This result is at odds with the worldwide experience with public utilities that remained integrated almost throughout the 20th century despite that integration offered meager or no savings as now becomes evident. Of course, this divergence between normative analysis and facts is no surprise for public choice. Indeed, a rather mild kind of a Leviathan motive--regulators dislike transfers to the utility, and by symmetry, like revenues--coupled with the "secrecy" only integration offers due to private information explains why a regulator has an interest to keep even economically inefficiently integrated firms integrated. This is in line with Crew and Rowley (1988) that public regulation serves to "milk" rather than to impose efficiency. Copyright 2003 by Kluwer Academic Publishers