The Contamination Problem in Utility Regulation
This paper formally examines the implications of a utility’s diversification into an unregulated industry. In our framework, the utility is the most efficient provider in the unregulated industry (up to a particular capacity) and, as such, there is no question about the desirability of allowing it to operate in that market. Nevertheless, the risk faced by a diversified utility is greater than the risk faced by a utility that operates only in a regulated market. This additional risk can potentially affect the diversified utility’s credit rating and, therefore, increase the cost of capital for the regulated business that will be recovered from ratepayers. We show that by allowing a regulated firm to diversify into an unregulated market, the regulator faces a trade-off: a lower cost in the unregulated market versus a higher cost in the regulated market. If the regulator only cares about welfare in the regulated market, then a ringfencing requirement is optimal subject to implementation costs not being substantial. Of course, the ring-fencing requirement effectively prevents the firm from achieving a lower cost in the unregulated market. Therefore, if the regulator cares about welfare in both regulated and unregulated markets, ring-fencing may no longer be optimal.
|Date of creation:||2007|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: +61 7 3365 6570
Fax: +61 7 3365 7299
Web page: http://www.uq.edu.au/economics/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Sappington, David E. M., 2003. "Regulating horizontal diversification," International Journal of Industrial Organization, Elsevier, vol. 21(3), pages 291-315, March.
- Palmer, Karen, 1991. "Diversification by Regulated Monopolies and Incentives for Cost-Reducing R&D," American Economic Review, American Economic Association, vol. 81(2), pages 266-70, May.
- Brennan, Timothy J, 1990. "Cross-Subsidization and Cost Misallocation by Regulated Monopolists," Journal of Regulatory Economics, Springer, vol. 2(1), pages 37-51, March.
- Brennan, Timothy J & Palmer, Karen, 1994. "Comparing the Costs and Benefits of Diversification by Regulated Firms," Journal of Regulatory Economics, Springer, vol. 6(2), pages 115-36, May.
When requesting a correction, please mention this item's handle: RePEc:qld:uq2004:352. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (SOE IT)
If references are entirely missing, you can add them using this form.