Innovation incentive for regulated network industries

Dr Rahmat  Poudineh, Oxford Institute for Energy Studies, United Kingdom

Mr Seyed Reza Mirnezami, Oxford Institute for Energy Studies, United Kingdom

1.         Background

The capital intensive network industries such as electricity and gas delivery infrastructures exhibit natural monopoly characteristics because of their high economy of scale relative to the size of market. Due to absence of direct competition in these regulated industries, the infrastructure providers hardly undertake the appropriate level of innovation activities to optimise their operation and improve continuity and quality of their services.  The importance of this problem becomes more pronounced when considering that electricity networks around the world are expected to undertake significant investment and innovation over the coming decades in order to address the challenges of decarbonisation. As innovation activities are costly and risky undertakings, a relevant query is how to incentivise innovation through economic regulation. This paper models three generic schemes of innovation incentive: individual incentive contracts, competitive innovation fund and cooperative innovation program. We show how each of these schemes affects the incentive of firms for innovation activities.

2.         Methodology

The model developed in this paper is based on the standard contract theory and game theory. It is inspired by similar problems which have been investigated in the literature. For example, the moral hazard in individual contracts  (Bolton and Dewatripont, 2005), the cooperation models through side contracts between agents in a principal-agent setting (Holmström and Milgrom, 1990; Itoh, 1993; Tirole, 1986) and finally inducing competition in a monopoly environment (Bresnahan, 1997). In the individual incentive contract regulator incentivises regulated network utilities to undertake risky and costly innovation activity in return for a payoff. The contract is designed in a way to address the problem of moral hazard in this situation. In cooperation model we assume regulator encourages collaboration among the firms. We model two network firms which exert joint effort into a project of common interest. The model investigates the incentive for innovation coalition and highlights the challenges of moral hazard in team.  Finally, the competitive model is a rent seeking contest game in which companies compete for innovation fund by submitting proposal for innovation projects to the regulator.

3.         Results and conclusion

The individual incentive contract scheme (between firm and regulator) results in a second-best scheme for innovation activities in which firms are incentivised to exert optimal effort when regulator is not able to observe the firm’s effort but only the performance. The implementation of individual incentive contracts is informational intensive in the sense that regulator needs to have the knowledge of innovation opportunities of the firms, likelihood of success and the marginal probability of success with respect to effort. In cooperation scheme, coalition is formed to create synergy and also to share the risk of innovation activities. The results show that free riding exists in cooperation even if innovation outcome is certain. Additionally, cooperation programmes require an active role of regulator to address the free riding issue. Competitive innovation schemes in which firms put forward innovative proposal can lead to an optimal effort among the competing firms, however, contest among the firms can also dissipate parts of resources. The competitive schemes are more likely to be effective when firms are not very heterogeneous.