A Simple Regulatory Incentive Mechanism Applied to Electricity Transmission Pricing and Investment

Abstract

The informationally simple approach to incentive regulation applies mechanisms that translate the regulator’s objective function into the firm’s profit-maximizing objective. These mechanisms come in two forms, one based on subsidies/taxes, the other based on constraints/price caps. In spite of a number of improvements and a good empirical track record simple approaches so far remain imperfect. The current paper comes up with a new proposal, called H-R-G-V, which blends the two traditions and is shown to apply well to electricity transmission pricing and investment. In particular, it induces immediately optimal pricing/investment but is not based on subsidies. In the transmission application, the H-RG-V approach is based on a bilevel optimization with the transmission company (Transco) at the top and the independent system operator (ISO) at the bottom level. We show that HR-G-V, while not perfect, marks an improvement over the other simple mechanisms and a convergence of the two traditions. We suggest ways to deal with remaining practical issues of demand and cost functions changing over time.

Keywords: Electricity Transmission, Incentive Regulation, Multi-Level Optimization

JEL Classification: D24, L51, L94, Q40