Contractual Design and Renegotiation: Impacts on Yardstick Competition Efficiency

Abstract

Yardstick competition models assume a perfect regulatory commitment that relies on complete and rigid yardstick contracts, which are never renegotiated. Therefore, yardstick competition makes it possible to provide strong incentives to firms, while decreasing the informational asymmetries between the parties. However, in reality, renegotiation may occur with this regulatory mechanism, as noted by Hesseling and Sari [2006] for instance, in the case of the Dutch energy regulator. In this paper, I build a yardstick model that can explain the enforcement difficulties encountered in reality. For that purpose, the regulated firms are assumed to be not totally homogenous, since idiosyncratic exogenous shocks may impact the firms’ costs. This assumption enables to show that, in equilibrium, yardstick competition may lead to negative ex post profits. Moreover, the regulator’s ability to enforce negative profits is assumed to be limited, creating a possibility of firms-led renegotiation (under the assumption that the firms will try to renege on the yardstick contract only in case of negative ex post profits). In this context, the model shows that a limited regulatory commitment doesn’t prevent from the implementation of yardstick competition, but requires an adaptation of the contractual design. The contractual design choice depends on the efficiency of renegotiation, the cost of public funds as well as the regulator’s ability to manage endogenous and exogenous pressures. These points (enforcement problems and contractual design choice) are not taken into account in the literature on yardstick competition. However, as regards concrete implementation made by regulators, it seems that they are key variables in understanding the reality of this regulatory scheme.