Designing Incentive Regulation in the Electricity Sector

David P. Brown and David E. M. Sappington

November 2023

In industries with extensive infrastructure needs and pronounced scale economies, consumers can be better served by well-designed regulation than by competition. Regulation that replicates the discipline of competitive markets can enhance the welfare of electricity consumers. However, replicating competitive discipline is challenging when regulators have limited knowledge of relevant industry conditions and when the regulators’ policy instruments are restricted. Incentive regulation attempts to harness the regulated firm’s superior knowledge of industry conditions to achieve regulatory objectives. This paper reviews key principles of incentive regulation, and examines how incentive regulation can be designed to enhance performance in the electricity sector.

Keywords: Incentive Regulation, Electricity

JEL Codes: L51, L94, Q40, Q48

* The final version of this working paper will appear as a chapter in the forthcoming Handbook on Electricity Regulation, edited by Jean-Michel Glachant (Florence School of Regulation), Paul Joskow (MIT), and Michael Pollitt (University of Cambridge) and published by Edward Elgar. We thank Paul Joskow and Michael Pollitt for very helpful comments and suggestions. We also thank Bonnie Luo and Yuchen Zhu for excellent research assistance.