The Contamination Problem in Utility Regulation
Fernando Camacho () and
Flavio M. Menenzes
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Flavio M. Menenzes: School of Economics, The University of Queensland, https://economics.uq.edu.au/
Authors registered in the RePEc Author Service: Flavio Menezes
No 352, Discussion Papers Series from University of Queensland, School of Economics
Abstract:
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: 2007
New Economics Papers: this item is included in nep-mic and nep-reg
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Persistent link: https://EconPapers.repec.org/RePEc:qld:uq2004:352
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