Principal-Agent Incentives, Excess Caution, and Market Inefficiency: Evidence from Utility Regulation

63 Pages Posted: 21 Dec 2007 Last revised: 19 May 2021

See all articles by Severin Borenstein

Severin Borenstein

University of California, Berkeley - Economic Analysis & Policy Group; National Bureau of Economic Research (NBER)

Meghan R. Busse

University of California, Berkeley - Haas School of Business

Ryan Kellogg

University of California, Berkeley

Date Written: December 2007

Abstract

Regulators and firms often use incentive schemes to attract skillful agents and to induce them to put forth effort in pursuit of the principals' goals. Incentive schemes that reward skill and effort, however, may also punish agents for adverse outcomes beyond their control. As a result, such schemes may induce inefficient behavior, as agents try to avoid actions that might make it easier to directly associate a bad outcome with their decisions. In this paper, we study how such caution on the part of individual agents may lead to inefficient market outcomes, focusing on the context of natural gas procurement by regulated public utilities. We posit that a regulated natural gas distribution company may, due to regulatory incentives, engage in excessively cautious behavior by foregoing surplus-increasing gas trades that could be seen ex post as having caused supply curtailments to its customers. We derive testable implications of such behavior and show that the theory is supported empirically in ways that cannot be explained by conventional price risk aversion or other explanations. Furthermore, we demonstrate that the reduction in efficient trade caused by the regulatory mechanism is most severe during periods of relatively high demand and low supply, when the benefits of trade would be greatest.

Suggested Citation

Borenstein, Severin and Busse, Meghan R. and Kellogg, Ryan, Principal-Agent Incentives, Excess Caution, and Market Inefficiency: Evidence from Utility Regulation (December 2007). NBER Working Paper No. w13679, Available at SSRN: https://ssrn.com/abstract=1077805

Severin Borenstein (Contact Author)

University of California, Berkeley - Economic Analysis & Policy Group ( email )

Berkeley, CA 94720
United States
510-642-3689 (Phone)
707-885-2508 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Meghan R. Busse

University of California, Berkeley - Haas School of Business ( email )

2220 Piedmont Avenue, #1900
Berkeley, CA 94720-1900
United States
510-642-9489 (Phone)
510-643-5180 (Fax)

HOME PAGE: http://faculty.haas.berkeley.edu/meghan/index.html

Ryan Kellogg

University of California, Berkeley ( email )

310 Barrows Hall
Berkeley, CA 94720
United States

HOME PAGE: http://are.berkeley.edu/~kellogg/index.html

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
29
Abstract Views
756
PlumX Metrics