The political economy of incentive regulation: Theory and evidence from U.S. states

The determinants of incentive regulation are a key issue in economics. More powerful rules relax allocative distortions at the cost of lower rent extraction. Thus, they should be found where the reformer is more concerned about incentivizing investments through higher expected profits, and where rent extraction is less salient because the extent of asymmetric information is more limited. This prediction is consistent with U.S. electricity market data. During the 1990s, performance based contracts were given to the firms whose generation costs were historically higher than those in neighboring markets and operating in states where the regulator had stronger incentives to exert information-gathering effort because elected instead of being appointed. Considering the endogeneity of regulatory reforms suggests that OLS overestimate the impact of incentive rules on costs, which was negative and statistically significant.