IDEAS home Printed from
   My bibliography  Save this paper

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.

Suggested Citation

  • Fernando T. Camacho & Flavio M. Menenzes, 2007. "The Contamination Problem in Utility Regulation," Discussion Papers Series 352, School of Economics, University of Queensland, Australia.
  • Handle: RePEc:qld:uq2004:352

    Download full text from publisher

    File URL:
    Download Restriction: no

    References listed on IDEAS

    1. Sappington, David E. M., 2003. "Regulating horizontal diversification," International Journal of Industrial Organization, Elsevier, vol. 21(3), pages 291-315, March.
    2. 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 115-136, May.
    3. Palmer, Karen, 1991. "Diversification by Regulated Monopolies and Incentives for Cost-Reducing R&D," American Economic Review, American Economic Association, vol. 81(2), pages 266-270, May.
    4. Brennan, Timothy J, 1990. "Cross-Subsidization and Cost Misallocation by Regulated Monopolists," Journal of Regulatory Economics, Springer, vol. 2(1), pages 37-51, March.
    Full references (including those not matched with items on IDEAS)

    More about this item

    NEP fields

    This paper has been announced in the following NEP Reports:


    Access and download statistics


    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. 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) or (Rebekah McClure). General contact details of provider: .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.