Working Paper: NBER ID: w13679
Authors: Severin Borenstein; Meghan Busse; Ryan Kellogg
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.
Keywords: Principal-Agent; Utility Regulation; Market Inefficiency
JEL Codes: L51; L95
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regulatory incentives (G18) | excess caution (D81) |
| excess caution (D81) | reduction in efficient market transactions (G14) |
| regulatory penalties (G18) | utility company behavior (L94) |
| utility company behavior (L94) | market inefficiencies (G14) |
| regulatory incentives (G18) | market inefficiencies (G14) |
| tight supply conditions (Q31) | forward price for natural gas exceeds expected spot price (Q47) |