Incentive regulation and investment: evidence from European energy utilities

This paper investigates the relationship between investment and regulatory regimes (incentive vs. rate-of-return regulation) for a sample of EU energy utilities from 1997 to 2007. We control for the effect of firm ownership and for cross-country differences in the underlying energy demand and energy supply. To deal with potential endogeneity of the regulatory regime, we apply instrumental variable methods (2SLS and GMM). Our results show that investment rate is higher under incentive regulation than under rate of return regulation. Using original data on the regulatory tools (X factor and WACC), we find that investment of incentive regulated firms appears highly sensitive to the X factor, consistent with efficiency- and profit-seeking motivations. Electric utilities investment is also sensitive to the level and change in the weighted average cost of capital (WACC). Finally, we find that the positive relationship between private control and investment is not robust to IV estimations, suggesting that in Europe regulation may have reduced the differences between private and public firms' incentives to invest.