NATURAL MONOPOLY PRIVATIZATION: MINIMIZING REGULATORY TRADE-OFFS BETWEEN RENT EXTRACTION AND INNOVATION

Privatizations of state-owned enterprises are associated with significant gains in efficiency postprivatization, born from both exposure to product market competition and improved managerial incentives resulting from ownership structure changes. However, for some important industries-such as utilities-that are natural monopolies, privatization alone will not engender product market competition. We argue that regulation which induces firms to innovate new products, services, and processes that reduce costs are crucial for privatized natural monopolies. We compare the innovation-incentivizing effects of the two major regulatory regimes, the rate of return (RoR) regulatory model and the price-capping (PC) model. We argue that RoR regulation inhibits innovation in privatized natural monopolies by discouraging managers from minimizing costs and making long-term positive net present value investments. In contrast, PC regulation can induce innovation, but may not prevent utilities from extracting rents from consumers. We discuss trade-offs between discouraging both innovation and rent extraction by adopting RoR regulation, or facilitating innovation but allowing rent-extraction by adopting PC regulation. We present a normative solution, "induced-lag rate of return" regulation, which offers a middle-ground solution to this trade-off problem. This novel regulatory structure allows firms and managers to benefit from long-term innovative investments while maintaining competitive pressure on prices.