3 Incentive Regulation

Generally all forms of regulation are based on incentive regulation. Incentive regulation can be defined as the practice of using rewards and penalties to “induce the utility to achieve desired goals where the utility is afforded some discretion in achieving goals” (Lewis and Garmon,1997).The goals may be set by both the regulator and the operator, but the operator enjoys the freedom to decide how it will achieve the stipulated goals. Incentive regulation may also arise because of information asymmetry problems which disenable the regulator from taking the correct decisions. The manner in which Oftel has used the price – cap to effect British Telecom behaviour, by rewarding co-operation and punishing non-cooperation, is a useful illustration of the effectiveness of correctly applied incentive regulation. However incentive regulation (using price caps) has been criticised for overlooking the needs of low income customers. It should be noted that effective incentive regulation is premised on the regulator’s capacity to monitor the operator, to fund the related administrative costs and to gain adequate insight into the operations of the service provider.

4 Yardstick Regulation

Compares companies and rewards those with superior performance, penalizes those with inferior performance, or both. The advantages of yardstick regulation, include, providing companies with incentives to improve efficiency and it also dampens the effects of information asymmetries between companies and regulators. However developing appropriate yardsticks is resource intensive and may not be possible in some situations.

5 Performance-Based Regulation (PBR)

Another term applied to situations in which performance measures are used to prompt the utility. Good performance measures should be:

• accurately observed and verifiable
• reflect the utilities’ efforts
• structured to reduce the impact of random variation
• adjusted according to how specific or diverse are the utility’s performance areas

6 Franchise Regulation

The firm bidding the lowest retail price (subject to meeting quality requirements) becomes the supplier. The strengths of incentive regulation, include, it provides incentives for cost containment through competitive bidding for the right to provide service in a geographic area. However, re-contracting issues arise at the end of the period capital maintenance “lock-in”.

Choosing the right combination of tools is critical as there is no single system of regulation that is the best system for all situations. The most common approach requires regulator to use a combination of tools.

David Sappington (1994) identified ten guidelines for designing incentive regulation plans:

• Use incentive regulation to better employ the firm's superior information.
• Prioritize regulatory goals and design incentive regulation to achieve stated goals.
• Link the firm's compensation to sensitive measures of its unobserved activities.
• Avoid basing the firm's compensation on performance measures with excessive variability.
• Limit the firm's financial responsibility for factors beyond its control.
• Adopt broad-based performance measures where possible, unless their variability is excessive.
• Choose exogenous performance benchmarks.
• Allow the firm to choose among regulatory options, while recognizing the interdependencies among the regulatory options that are offered to the firm.
• Promise only what can be delivered, and deliver whatever is promised.
• Plan for the rare, unforeseen event, but minimize after-the-fact adjustments to the announced regulatory policy.
  

Study Activity

1. As a new regulator you are required to implement a regulatory framework which will discipline an incumbent who displays the following characteristsics:

• resistance to sharing information
• reluctance to interconnect
• protests about number portability

 Visit the discussion forum this Friday afternoon at 16h00.  Through team effort decide which style of regulation you will adopt. Explain. Identify at least one example where an incumbent resisted competition and a similar style of regulation was adopted. (Ensure that the response you post as team is comprehensible).

2. As a new regulator you are required to implement a regulatory framework which will encourage competition: there are two incumbent mobile operators who are nervous about investing in the local market.  Visit the discussion forum this Friday afternoon at 16h00.  Through team effort decide which style of regulation you will adopt. Explain. (Ensure that the response you post as a team is comprehensible).