Energy efficiency and price regulation

Abstract

This paper examines the incentives embedded across different regulatory regimes - price cap, rate of return and mandated target regulation - for investment in energy efficiency programs at the supplier’s end of the network. In our model, a monopolist chooses whether or not to undertake an investment in energy efficiency, which is not observable by the regulator. We explore how the monopolist’s choice of effort changes under different regulatory regimes. We show that, in equilibrium, the monopolist chooses to exert positive effort more often under price cap regulation than under no regulation or mandated target regulation and that she exerts no effort under rate of return regulation. In terms of expected welfare, however, the results are ambiguous and complex. In particular, we provide a full characterisation of the optimal effort, optimal prices (regulated or unregulated) and expected welfare for the different regimes and show the trade-offs between rent extraction and incentives.