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A Simple Regulatory Incentive Mechanism Applied to Electricity Transmission Pricing and Investment

Discussion Papers 1696, 32 S.

Mohammad Reza Hesamzadeh, Juan Rosellón, Steven A. Gabriel, Ingo Vogelsang


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The informationally simple approach to incentive regulation applies mechanisms that translate the regulator’s objective function into the firm’s profit-maximizing objective. These mechanisms come in two forms, one based on subsidies/taxes,the other based on constraints/ price caps. In spite of a number of improvements and a good empirical track record simple approaches so far remain imperfect. The current paper comes up with a new proposal, called H-R-G-V, which blends the two traditions and is shown to apply well to electricity transmission pricing and investment. In particular, it induces immediately optimal pricing/investment but is not based on subsidies. In the transmission application, the H-RG- V approach is based on a bilevel optimization with the transmission company (Transco) at the top and the independent system operator (ISO) at the bottom level. We show that HR- G-V, while not perfect, marks an improvement over the other simple mechanisms and a convergence of the two traditions. We suggest ways to deal with remaining practical issues of demand and cost functions changing over time.

JEL-Classification: D24;L51;L94;Q40
Keywords: Electricity transmission, incentive regulation, multi-level optimization
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