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Principal-agent Incentives, Excess Caution, and Market Inefficiency: Evidence From Utility Regulation

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  • Severin Borenstein
  • Meghan Busse
  • Ryan Kellogg

Abstract

Regulators and firms often use incentive schemes to attract skillful agents and to induce them to put forth effort in pursuit of the principals' goals. Incentive schemes that reward skill and effort, however, may also punish agents for adverse outcomes beyond their control. As a result, such schemes may induce inefficient behavior, as agents try to avoid actions that might make it easier to directly associate a bad outcome with their decisions. In this paper, we study how such caution on the part of individual agents may lead to inefficient market outcomes, focusing on the context of natural gas procurement by regulated public utilities. We posit that a regulated natural gas distribution company may, due to regulatory incentives, engage in excessively cautious behavior by foregoing surplus-increasing gas trades that could be seen ex post as having caused supply curtailments to its customers. We derive testable implications of such behavior and show that the theory is supported empirically in ways that cannot be explained by conventional price risk aversion or other explanations. Furthermore, we demonstrate that the reduction in efficient trade caused by the regulatory mechanism is most severe during periods of relatively high demand and low supply, when the benefits of trade would be greatest.

Suggested Citation

  • Severin Borenstein & Meghan Busse & Ryan Kellogg, 2007. "Principal-agent Incentives, Excess Caution, and Market Inefficiency: Evidence From Utility Regulation," NBER Working Papers 13679, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:13679 Note: EEE IO
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    Cited by:

    1. Severin Borenstein & Lucas W. Davis, 2012. "The Equity and Efficiency of Two-Part Tariffs in U.S. Natural Gas Markets," Journal of Law and Economics, University of Chicago Press, vol. 55(1), pages 75-128.
    2. Lucas W. Davis & Erich Muehlegger, 2010. "Do Americans consume too little natural gas? An empirical test of marginal cost pricing," RAND Journal of Economics, RAND Corporation, vol. 41(4), pages 791-810.

    More about this item

    JEL classification:

    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
    • L95 - Industrial Organization - - Industry Studies: Transportation and Utilities - - - Gas Utilities; Pipelines; Water Utilities

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